Public finance
11.0 Introduction
Governments play significant roles in the economy. As outlined in Chapter 2 the government allocate some of the society’s resources towards the production of public and merit goods, regulates the economy and make it conducive for business, formulate economic policies that are meant to improve the welfare of the society, levy a tax on incomes of the rich and distribute income to the poor through social services to ensure an equitable distribution of income in the economy among other functions. This chapter discuss how the government can raise revenue much needed to finance its activities as well as the formulation and implementation of fiscal policy. By government, we refer to the central government (ministries and government departments), local government (municipalities and town councils) and government corporations (parastatals).
11.1 National budgets
The Ministry of Finance is in charge of the Treasury. The minister announces how much the government is going to spend over the next twelve months, sometime in November through the presentation of the national budget. A national budget is an outline of government expenditure and how it is going to raise the money to pay for its expenditure. It is used to influence economic activity. The level of economic activity depends on the level of aggregate demand. The government can hence influence the level of economic activity by varying its expenditure. There are three types of national budgets
11.1.1 Reflationary or deficit budget
A reflationary or deficit budget refers to a situation where government expenditure is greater than revenue before borrowing. The government will be planning to spend more than what it intends to collect in the form of revenue. This is very normal for all governments including the governments of United States, United Kingdom and other rich nations. The reason to plan for a deficit budget is because a deficit budget increases total demand within the economy, that is, it is expansionary or it boosts the level of economic activity in the economy. In addition, the government can over spend while investing in capital e.g. the construction of schools or universities. The idea is that the government will benefit from a future stream of tax revenue paid by those students who would have benefited from the school or university. Thus these students will help the government to repay the amount borrowed to finance the capital expenditure.
On the other hand, a deficit budget leads to crowding out of private investment which is interest sensitive when compared to government borrowing. That is by borrowing on the market, the government increases demand for funds thereby pushing the level of interest rates up. The cost of borrowing or interest rate will end up being pushed to levels that are uneconomic to the private borrower especially when it becomes impossible to increase the mark up on prices. The private will withdraw from the market leaving the government as the sole borrower because the government can repay the loan by printing of new notes.
11.1.2 Deflationary or surplus budget
A deflationary or surplus budget refers to a situation where government expenditure is less than revenue. A surplus budget reduces total demand within the economy and hence reducing economic activity (deflates economic activity). It is very rare for a government to achieve a deficit budget with the exception of Botswana, United States and United Kingdom all of whom experienced a surplus budget only but once.
11.1.3 Neutral budget
A neutral budget refers to a situation where government expenditure and revenue are the same and total demand in the economy remains constant.
11.2 National debt
An accumulation of budget deficits over the years is called a national debt or public debt. The national debt is the total amount owed by the government to the Zimbabwean citizens and foreigners at a particular moment in time (domestic and foreign debt, respectively). Interest has to be paid on the debt.
11.2.1 Problems of national debts
A large national debt is a problem if: -
a. Interest has to be paid to overseas citizens, so that the balance of payments suffers.
b. Taxes have to be increased to meet interest payments.
c. The concern is that with budget deficit, we will be consuming now while passing the responsibility to pay to future generations.
11.2.2 Composition of the national debt
The national debt can be classified into domestic debt (internal) and foreign debt (external). a.Domestic debt
The domestic debt is the amount of money the government owes the local citizens of that country. It is expressed and repaid in the local currency. The advantages of the government borrowing from local sources include:
i. Domestic debt is relatively easier to source.
ii. The terms of repayment are relatively easier since repayment doesn’t necessarily have to be made in foreign currency.
On the other hand borrowing from local sources is discouraged because:
i. It could be inflationary especially if the government borrows from the banking sector. Borrowing from the banking sector fuels money or credit creation by the financial institutions and hence increasing the level of money supply in the economy.
ii. It can push out private sector borrowing by increasing interest rates in the market to beyond sustainable levels (crowding out effect). Government borrowing is interest insensitive while private sector borrowing is interest sensitive.
iii. The availability of local funds makes local borrowing a big source of blowing government budget deficit. The government will continue to borrow without restrain basing on the misconception that the government can not be broke and that it can always repay.
b. External debt
The total amount of money the government owes to foreigners is the external or foreign debt. External debt is expressed in foreign currency especially the United States dollar which is the most convertible currency. Borrowing from foreign individuals, governments and financial institutions has the following benefits:
i. It’s a source of funds to correct balance of payment deficit. That is, if the country is importing more than its export it can repay for the extra imports using funds borrowed externally.
ii. Foreign debt is a source of finance to buy items that require use of foreign currency e.g. Zimbabwe is known to borrow from countries such as Libya in order for the country to use the foreign currency to import fuel.
On the other hand an external debt has the following disadvantages:
i. A huge external debt could seriously strain the government in repayment because repayment has to be made in foreign currency. This may drive the country into a debt trap, that is, a situation where the government has to borrow money to service interest on debt.
ii. State sovereignty could be mortgaged where the indebtedness is too heavy for the country to meet the repayment commitment.
11.3 Government borrowing
There are various sources of government revenue. Among them is taxation, national insurance contributions, borrowing, charging for services, selling-off state owned assets (privatisation), profits from public corporations, donations and grants.
11.3.1 The public sector borrowing requirement
If the government spends more than its collected revenue, it will have to borrow the difference. The amount the government needs to borrow in a given time period is called the Public Sector Borrowing Requirement (PSBR). Since government consists of three sections, the PSBR consists of: -
a. The Central Government Borrowing Requirement which is the amount of money to be borrowed by the central government (ministries and government departments).
b. Local Authorities Borrowing Requirement which is the amount of money to be borrowed by local authorities (city councils, rural districts and town councils).
c. The Public Corporation Borrowing Requirement which is the amount of money government companies or parastatals requires borrowing.
11.3.2 How the government can borrow
The government can borrow through: -
a. Selling National Savings Certificates.
b. Selling Treasury Bills, which usually mature in 90 days.
c. Selling Securities which earn interest and will be bought back sometime in the future. Securities are sometimes called gilts, stocks or bonds. Government securities are risk free, that is, there is no chance that the government will fail to repay. As a result government securities are referred to as gilt-edged.
11.4 Taxation
A tax is a compulsory contribution to government and this contribution is made without any reference to potential benefits received by the taxpayer.
11.4.1 Reasons for paying taxes
Taxpayers view taxes as bad, in the sense that they do not enjoy paying them. Surely no one enjoys paying taxes especially income tax (pay as you earn). The government still has to collect taxes in order:
a. To raise money to pay for government spending (taxes are a major source of government revenue especially in developing countries like Zimbabwe where taxes contribute more than 80% of the revenue..
b. To discourage people from buying harmful goods like cigarettes that is, it tries to change consumption patterns by making the harmful commodity or demerit good expensive.
c. To influence the level of total demand in the economy e.g. to reduce the level of total demand in the economy the government can increase the level of income tax. This will in turn reduce disposable income where disposable income (Yd) is obtained by deducting taxes (T) from the gross income (Y). Yd=Y-T. Taxation is one of the fiscal policy tools.
d. To redistribute income from the rich to the poor especially progressive taxation that taxes heavily the high income earner and lightly the low income earner. This way the gap between the rich and the poor is reduced.
e. To modify the price mechanism e.g. correcting market failures such as externalities that can be reduced by levying a pigovian tax paid on the polluter of the environment.
11.4.2 Principles of taxation
Taxpayers view taxes as bad, in the sense that they do not enjoy paying them. However, the government can make tax payment tolerable to the tax payer by ensuring that the tax system conforms to the following principles or canons.
a. A tax should be certainso that everyone knows the amount, method and when to make the tax payment
b. A tax should beconvenient so that tax collection is at a time and in a form suitable to the taxpayer. Income tax (PAYE) which is deducted before salaries are paid score highest.
c. A tax should beeconomical with the cost of collection being less than revenue and something being left out to offset the vexation caused. That is, it should be easy to administer and cheap to collect.
d. A tax should be equitable(fair) that is it must be based on the ability to pay so that wealthy people pay more than poor people (vertical equality) and people under the same circumstances pay equally (horizontal equality).
e. A tax should be efficientby achieving its intended objective without acting as a disincentive and stop people from working.
f. A tax should be flexibleso that it is capable of variation and must complement other government policies.
11.4.3 Methods of collection
Tax collection can either be direct or indirect. Direct taxes are paid straight to the Zimbabwe Revenue Authority. They are therefore taxes on income or wealth and the transfer of capital. For example, income tax (P.A.Y.E), capital gains tax, company tax etc. Each individual’s tax liability is assessed separately. Conversely indirect taxes are first collected by the seller and then passed on to the revenue authority. For example VAT which is paid to the seller such as the retail shop before the retail shop submits the revenue to ZIMRA. Direct taxes are therefore taxes on expenditure.
11.4.4 The burden of taxation
Some taxes are fairer than others. However, taxpayers view taxes as bad, in the sense that they do not enjoy paying them. A tax can be described as a: -
a. Progressive tax where the percentage of income taken in tax rises as income rises. The rich pay more than the poor. It is based on the ability to pay principle. Income tax (PAYE) is an example of progressive taxation.
b. Regressive tax where the percentage of income taken in tax falls as income rises. It results in the richer people paying a smaller proportion of their income in tax. Rates are an example of regressive taxation.
c. Proportional tax where the percentage of income taken in tax is constant as income rises. Sales tax is an example of proportional taxation. It takes the same proportion of income at all levels of income.
Fig 11.1 The classification of taxes according to the burden of the tax
O Income
11.4.5 Tax incidence and tax shifting
Tax incidence refers to the final resting place of the tax. It can be divided into statutory incidence which refers to the individual who is legally liable to paying the tax and economic incidence which is the final resting place of the tax. When there is a difference between economic and statutory incidence, it implies that the tax burden has been shifted. Tax shifting occurs through a change in prices of economic goods. There are two types of tax shifting:
a. Forward shifting which refers to the passing of the tax burden to consumers from the producers in the form of higher prices and,
b. Backward shifting which refers to when consumers pass the tax burden back to the supplier. This leads to a fall in the price of a factor of production e.g. P.A.Y.E where the supplier of labour eventually receives less from the consumer of labour (employer).
The ability to shift the burden of tax forward or backwards depends on three factors, namely;
a. The price elasticities of demand and supply.
b. Market structure e.g. it is difficult in perfect competition than in monopoly.
c. Nature of the tax for example direct taxes are difficult to shift as compared to indirect taxes.
11.4.6 Structure of taxation
Taxes are structured along the method of payment into direct and indirect taxes. a.Direct taxes
Direct taxes are paid straight to ZIMRA and therefore are taxes on income, wealth and transfer of capital. Examples include income tax (PAYE), capital gains tax, corporation tax and inheritance tax. Direct taxes have the following advantages:
i. They are progressive in nature and hence there is equality of sacrifice.
ii. Direct taxes collect more revenue especially income tax which raise more than half of the Zimbabwean government’s revenue.
iii. Direct taxes are convenient, that is, tax collection is at the time and in a form suitable to the tax payer.
iv. They act as built in stabilisers, that is, during an inflationary period the higher income group automatically move into the highest tax bracket and pay a higher rate of tax which reduces their disposable income. As a result of a fall in the disposable income the level of aggregate demand in the economy decreases leading to a reduction in the inflationary pressure in the economy. Thus the inflationary period will automatically be curbed.
Conversely, direct taxes have their own disadvantages which can be outlined as follows;
i. Direct taxes are a disincentive to work, saving and investment especially where the tax rate is very high..
ii. They are very unpopular as their impact on income is direct.
iii. Direct taxes are deflationary that is they reduce the level of aggregate demand in the economy. b. Indirect taxes
Indirect taxes are first collected by the seller and then passed on to the revenue authority. They are taxes on expenditure.
Examples include sales tax, VAT, excise duty and customs duty. The advantages of direct taxes include;
i. Indirect taxes are easy to administer and to collect because they are collected by the seller from numerous consumers and the seller will make one bulk remittance to ZIMRA. Thus the seller will collect at their expense and capital outlay hence direct taxes are economical to the tax authority.
ii. They are based on the benefit principal, that is, one who consumes more pays more. As a result they can be avoided by not consuming the product.
On the other hand, indirect taxes have disadvantages in that;
i. They raise the final price of the product and hence they are inflationary.
ii. They discourage the consumption of certain goods such as demerit goods, thus affecting consumption patterns.
11.4.7 Effects of taxation
Taxes have various economic and welfare effects: -
a. Taxes especially indirect taxes raise the final price of products and hence they are inflationary.
b. Indirect taxes on demerit goods affect consumption patterns.
c. High rates on direct taxes such as income tax are a disincentive to work, effort, saving and investment.
d. Taxation reduces aggregate demand in the economy.
e. Taxation may fall heavily on some households than others thus altering the distribution of income.
f. Some households may be pushed into a poverty trap, that is, with higher income a family faces both a rising tax bill and the withdrawal of its social security benefits.
g. Since taxation may be a disincentive to investment it may contribute to a reduced output and level of employment.
11.5 Privatisation
Privatisation involves an attempt to increase reliance on the market forces and on private sector initiative. It encompasses three processes;
a. The selling of some state owned assets such as the disposal of government shareholding in COTTCO and DZL.
b. All the different means by which the disciplines of the free market in the provision of goods and services can be applied to the public sector e.g. commercialisation which happens when a government corporation is structured to operate just like any private corporation. The former PTC was disbundled into three business units namely; Net-One, Tel-One and ZIMPOST).
c. Subcontracting of government services e.g. catering and security at government institutions.
There are various reasons why the government may want to privatise some of its enterprises. Among them are the following benefits:
i. The government revenue much needed to finance its activities such as capital expenditure when constructing schools and hospitals..
ii. Privatisation of loss making parastatals reduces the burden on the public purse since loss-making public corporations are financed from public funds.
iii. If a public corporation is privatised its given freedom from detailed political interference. For once the corporation will be expected to operate on a commercial basis without politicians interfering in its operations e.g. no political appointments to office will be made.
iv. Commercialisation improves the efficiency of the corporation through competition in the market.
v. The privatised corporation stands a high chance of making a profit and hence the tax base is widened in addition to that as a public corporation the company was previously exempted from taxes.
vi. Operating for profit motive will urge innovation inn the privatised corporation.
vii. Privatisation policy can be used to empower the indigenous people e.g. through the ‘employee share ownership scheme’ where priority will be given to the employees to buy shares in the new privatised corporation.
On the other hand the privatisation may be considered as an unnecessary evil. For example the process which was being carried out by the Privatisation Agency of Zimbabwe (PAZ) was halted in 2002 for the following reasons;
i. Once the corporation is privatised it will charge economic or market prices for its products a situation which is likely to see the poor not being able to buy the product. This is a major draw back especially where the product is essential e.g. ZESA Holdings will end up charging electricity tariffs that are beyond the rich of most rural consumers and small scale farmers.
ii. Privatisation has been likened to a farmer selling a heifer which is about deliver. Through privatisation, potential blue chips are sold off to individuals for example COTTCO which emerged as blue chip companies soon after privatisation.
11.6 Fiscal policy
Fiscal policy refers to attempts to influence aggregate demand by altering government expenditure and/or revenue in order to bring about desired changes in the economy. This is deliberate manipulation and hence it is discretionary. Discretionary fiscal policy can be expansionary if it aims to raise aggregate demand in the economy and contractionary if it aims to reduce the level aggregate demand. Fiscal policy is outlined through the presentation of the national budget by the Ministry of Finance.
11.6.1 Tools of fiscal policy
There are three tools of fiscal policy
i. Taxation
The government can manipulate the level of taxation in order to change the level of aggregate demand in the economy. An increase in taxation will reduce aggregate demand while a reduction in taxation will increase aggregate demand. This is because people consume from disposable income (Yd) where Yd = Gross Income (Y) – Taxes (T).
(Yd = Y – T).
ii. Government expenditure
Government spending is a direct component of aggregate demand (AD). Ad is given by the equation AD = C + I + G + X – M. An increase in government spending directly increases the level of aggregate demand while a reduction in government expenditure reduces demand.
iii. Borrowing
If the government budgets for a deficit (budget deficit) it will have to borrow the extra expenditure over and above its revenue. The government can borrow from the non-bank sector which is not inflationary. Alternatively it can borrow from the banking sector which is inflationary and is equivalent to printing new notes and coins.
11.6.2 Problems of discretionary fiscal policy
Compared to monetary policy, fiscal policy is less flexible and requires the approval of parliament before it becomes effective.
In addition the effectiveness of fiscal policy in addressing macroeconomic problems is affected by the following problems. i. Timing
Fiscal policy can only become operational when approved by the parliament. As a result it is not flexible and is affected by time lags. There can be considerable time delays between the beginning of an economic disturbance and the impact of the change in fiscal policy. Economists distinguish between several kinds of delays.
Recognition lags occur when there are delays between changes in economic disturbances and the actual recognition of these changes, especially due to delays in reporting procedures.
Administration lags refer to the time delay that can occur between an economic problem being recognised and administrative actions taken to correct the problem. Correcting the problem is usually through the national budget that is an annual event.
Implementation lags refer to the delay between action taken to correct some economic disturbance (e.g. an economic downturn) and the impact of the action on the economy.
ii. Business uncertainty
Sudden and unexpected changes of fiscal policy either on expenditure or revenue side may create uncertainty among businesspersons causing them to revise their plans.
iii. Expenditure inflexibility
Government expenditure is sticky downwards. That is government expenditure can easily be increased but can be reduced with great difficulty.
International trade
12.0 Introduction
No country is an island. The world is more and more becoming one global village. The actions of one nation affect others, not just near neighbours but countries across the globe. International trade refers to a situation when two or more countries trade with each other. The term ‘international trade’ can loosely be translated to ‘trade between nations’. In this chapter we are going to discuss the reasons why countries engage in international trade, trade protectionism, the balance of payments accounts and the various exchange rate regimes.
12.1 Reasons for international trade
Countries trade with each other for the following reasons: -
a. To gain access to those products which are not found naturally within their geographical boundaries e.g. Zimbabwe need to import fuel from countries that are richly endowed in petroleum deposits.
b. To share cultural heritage and historical experiences e.g. tourists will love to visit the Great Zimbabwe ruins in Masvingo for them to appreciate the life of the great Rozvi Empire.
c. To foster political relations, that is, countries trading with each other consider themselves to be partners and hence will be less likely to engage each other in a war situation. This explains why upon signing political agreements countries proceed to sign trade agreements.
d. To introduce new technology and ideas, for example, developing countries have to import modern technology from the developed countries.
e. Trade stimulates competition that may lead to reduction in prices and improvement in the quality of goods produced.
f. The volume of goods consumed in a country will increase hence the standard of living of the people will improve.
12.2 Gains from trade theories
International trade makes the problem of scarcity less acute or less severe. The following theories illustrate how countries may gain from specialisation and international trade. They are also used to illustrate situations when countries should trade with each other. In other words, countries should trade with each other if there is an absolute advantage or a comparative advantage.
12.2.1 Simplifying assumptions
For the purpose of our discussion, we assume that:
a. There are only two countries in the world, Country A and Country B.
b. Each of these two countries produces two goods, Good X and Good Y.
c. In each of the two countries, there are only two factors of production available, Labour and Capital.
d. There are no barriers to trade and no transport cost that is goods are free to move from one country into another country without for example being charged customs duty or transport cost.
e. Factors of production within each country are perfectly occupationally mobile but can not move from one country to another.
Basing upon these simplifying assumptions we can illustrate absolute and comparative advantages analysis.
12.2.2 The absolute advantage theory
An absolute advantage exists when a country is more efficient than the other in the production of one of the commodities. For example, if with two units of resources , country A produces 20 units of good X and 100 units of good Y, while country B produces 10 units of good X and 150 units of good Y as summarised by the following production possibilities table and frontier.
Table 12.1 Production possibilities before specialisation
Output per unit resources
Country
|
Unit of Good X
|
Units of Good Y
|
A
|
20
|
100
|
B
|
10
|
150
|
Total World Output
|
30
|
250
|
Fig 12.1 The production possibilities frontiers before specialisation
O 10 20 Good X
The diagram shows that with one unit of resources, country A is more efficient in the production of good X, while with the same quantity of resources, country B is more efficient in the production of good Y. Thus country A has an absolute advantage in good X production while country B has absolute advantage in good Y production. Country A must specialise in good X production while country B specialises in good Y production. Each country will move its two units into the production of the good it has absolute advantage in producing. The changes in total world production would be represented by the following production possibilities table.
Table 12.2The production possibilities table after specialisationOutput per unit resources
Country
|
Unit of Good X
|
Units of Good Y
|
A
|
40
|
0
|
B
|
0
|
300
|
Total World Output
|
40
|
300
|
Net Gain
|
+10
|
+50
|
By allowing for specialisation the world total output of both goods has increased. The two countries can trade with each other with each county exporting its surplus in exchange for that commodity it does not produce. For example country a will export surplus units of good X in exchange for units of good Y from country B.
12.2.3 The comparative advantage theory
Comparative advantage analysis arises from a situation when one country has absolute advantage in the production of both commodities. A comparative advantage exists when a country can produce a certain good at a lower opportunity cost than the other country. For example if with its units of resources country A produces 10 units of good X and 8 units of good Y while with the same amount of resources country b produces 2 units of good X and 4 units of good Y as represented by the following production possibilities table and frontier.
Table 12.2 The production possibilities table before specialisation
Output per unit resources
Country
|
Unit of Good X
|
Units of Good Y
|
A
|
10
|
8
|
B
|
2
|
4
|
Fig 12.2 The production possibilities frontier before specialisation
O 2 10 Good Y
The diagram shows that country A has an absolute advantage in the production of both goods. To determine the basis for trade we look at the opportunity cost of one good in terms of units of the other in each country. The opportunity cost of one unit of good X in terms of good Y and that of one unit of good Y in terms of good X, in each country is as follows: -
Opportunity cost table
In country A:
|
1X
|
=
|
0.8Y
|
and
|
1Y
|
=
|
1.3X
|
In country B:
|
1X
|
=
|
2.0Y
|
and
|
1Y
|
=
|
0.5X
|
Country A has a comparative advantage in the production of good X while country B has comparative advantage in the production of good Y. Therefore country A specialises in good X and country B in good Y production.
12.2.4 Causes of cost differences
There are mainly two reasons why the cost of producing one commodity differs from one country to another.
a. Some countries are endowed in certain natural resources or climate conducive to the production of certain commodities than the others. For example Zimbabwean climate is favourable to the production of tobacco than Botswana’s climate.
b. Some people have innate qualities of manual dexterity, scientific ability, and enterprise and which give them advantages over other countries e.g. the Japanese.
12.2.5 Limitations of the gains from trade theories
a. The theories are simplistic. They assume the existence of two countries producing two goods using two factors of productions. In practice there are more than two goods, two factors and trade is multilateral rather than bilateral.
b. Goods are assumed to be of the same quality, that is, they are homogenous. This is unrealistic because the quality of goods differs from one country to another.
c. The theories assume that there are no transport costs and there is free trade. In reality, the advantages of specialisation can be cancelled by trade restrictions and transport costs.
12.3 Terms of Trade (TOT)
Terms of trade refers to the quantity of exports that must be exchanged for a unit of imports. It is the rate at which a country exchanges its exports for imports and it can be expressed as an index as follows:
Terms of trade = Index of export prices x 100
Index of import prices
If the index is less than 100 it is unfavourable terms of trade while if the index is greater than 100 it is favourable terms of trade. Terms of trade reflect the opportunity cost of one good measured in terms of the other. From the previous opportunity cost table, good X and Y can be exchanged for:
0.8Y < 1X < 2.0Y
0.5X < 1Y < 1.3X
12.4 Trade protectionism
Trade protectionism is where a country erect trade barriers with the purpose of hampering the free movement of goods into an economy from the rest of the world. These barriers interfere with the gains from free trade. In other words the gains from trade theories illustrated how countries stand to benefit if they allow for specialisation and trade. In practice, these benefits are eroded by the various tariffs, embargos, etc that are imposed on goods from other countries.
12.4.1 Methods of trade protectionism
The methods that could be used reduce or prevent entry of goods from other countries into a country include: a.Tariffs
A tariff is a tax or customs duties levied on imported or exported goods. The tariff can either be expressed as percentage of value (ad valorem) or per unit of the imported or exported commodity. The effect of a tariff is that it increases the final price of the imported or exported commodity. For example a vehicle imported for US$5 000 may end up costing US$10 000 to a local importer if an 80% customs duty and 20% surtax is added to the import price. Thus tariffs make imports more expensive.
b. Quota
A quota is a quantitative restriction on imports or exports. Once the quota is satisfied or met no additional quantity will be imported or exported.
c. Embargo
An embargo is a complete ban prohibition on trade for example trade in hard drugs such as cocaine.
d. Import controls
Import controls refer to a situation where the government puts in place legislation or measures that regulates the importation of certain products. For example agricultural products such as maize and live animals can only be imported upon receiving the authority in the form of import licenses from the Ministry of Agriculture and Ministry of Health and the Department of Veterinary Services.
e. Exchange controls - Exchange controls refer to when the availability of foreign currency is restricted in order to control the volume of imports. If people do not have the foreign currency they can not import.
f. Subsidies
A subsidy is the opposite of a tax. A subsidy refers to a situation where the government pays a part of the production costs for a domestic commodity. If domestic goods are subsidised, they become cheaper as compared to imports.
12.4.2 Reasons for trade protectionism
Various arguments have been forwarded in favour of the imposition of barriers to trade. Among them are: a. Infant industry argument
The argument is that infant industries need to be protected from foreign competition until growth is attained. An infant industry is a new or emerging industry that usually face high average costs of production because it will not be enjoying economies of scale. Because of its high average costs, the firm will be charging high and uncompetitive prices and can not compete with long established international firms that will be enjoying economies of scale. Infant firms need to be protected from such foreign competition until they are able to compete. However the argument against such protection is that from experience, firms that enjoy such protection prefer to remain small and continue to enjoy the protection than to grow and face the competition.
b. Strategic industry argument
Industries which are vital or strategic for the integrity of the country such as the Zimbabwe Defence Industries or the agricultural industry requires protection from foreign competition. The idea is to reduce dependence on foreign supplies which tends to compromise a country’s sovereignty.
c. Revenue argument
Most governments in developing countries raise revenue needed to finance their expenditure from tariffs such as customs duty. In addition these tariffs earn the government foreign currency.
d. Anti-dumping argument
Dumping refers to the sale of goods in a foreign country at prices lower than that in the home country. Rich countries may dump goods which may be harmful such genetically modified food or untested medical drugs. By imposing trade barriers such goods may not find their way into the country.
e. Balance of payment argument
A country faced with a BOP deficit can either correct the situation by reducing the volume of imports through the imposition of tariffs or increase the volume of exports through export promotions. Thus trade protectionism may be a way to discourage expenditure on imports and thus correcting a BOP deficit.
f. Employment argument
Trade barriers may seek to switch expenditure from imports to domestically produced goods. This will increase demand for domestic goods and domestic production will increase. Thus the level of employment in the country will increase.
12.5 Economic integration
Economic integration refers to a situation when different countries in different parts of the world are organising themselves into economic and political blocs. It can be described as “encompassing measures which are designed to abolish discrimination between economic units belonging to different national states.” Economic integration aims at liberalising trade between countries – either generally or with specific countries.
12.5.1 Criteria for successful integration
A number of common factors stand out as necessary for successful economic integration. Among them is that,
a. Member countries should be at roughly similar levels of economic development.
b. Each member country must be satisfied that it is benefiting from the arrangements.
c. Governments must be prepared to cede some sovereignty to a supranational institution.
d. Political conflict between members must be containable.
12.5.2 Advantages of economic integration
a. Increased specialisation.
b. Promotes peace, security and political stability.
c. Expanded markets both to sellers and buyers.
d. Improved welfare to the members of the region.
e. Ensures uplifting of tariffs between member countries, thus enhancing trade links.
f. A stronger bargaining position with the rest of the world.
g. Accelerated rates of investments in the region.
12.5.3 Disadvantages of economic integration
a. There will be increased competition that may injure domestic industries.
b. Loss of state revenue if tariffs are uplifted.
c. Countries that are better than others may dump goods in poor member countries.
d. Economic domination by those countries which are better than the others e.g. South Africa in the SADC region.
e. Member countries may follow economic policies that can threat co-operational e.g. the land redistribution in Zimbabwe in the SADC region.
12.6 Exchange rates systems
An exchange rate indicates the value of one currency relative to some other currency. It is the amount of Zimbabwean dollars that will be required to buy a unit of foreign currency. It is the price at which purchases and sales of foreign currency or claims of it take place and thus exchange rates act as signal and rationing devices. There are three traditional exchange rate regimes namely flexible, fixed and managed float exchange rate systems
12.6.1 Flexible exchange rates
This is a system in which the market forces of demand and supply determine the rates without any government intervention. No reserves are theoretically required as there is self-adjustment of relative prices of exports and imports through the free fluctuating rates. Demand for foreign currency arises out of a desire to buy imports or to invest abroad or to repay our foreign debt. On the other hand the supply for foreign currency arises from earnings from exports or inflow of capital from foreign investors. The market exchange rate (e1) will be established at the point where the demand for foreign currency equals the supply of foreign currency on the following diagram.
Fig 12.3 Market exchange rates
O Qty of foreign currency
The equilibrium exchange rate is determined by the intersection of demand and supply for foreign currency. The equilibrium exchange rate equals e1 where ZW$600 = US$1. If the exchange rate is above e1, the supply of US dollars will exceed the demand forcing down the value of the US$ relative to the ZW$ (the ZW$ appreciates relative to the US$). The opposite will happen in the case of an excess demand for US$ (the ZW$ will depreciate relative to the US$).
a. Factors affecting demand for and supply of foreign currency
i. Seasonal fluctuations e.g. in Zimbabwe, the supply of foreign currency increases during the tobacco selling season.
ii. Changes in consumer preferences e.g. if Zimbabweans start to prefer American goods demand fro the US$ will increase.
iii. Differentials in interest rates that is if Zimbabwe start to offer high real rates of interest on short term investment foreigners may increase their deposits of foreign currency in the country to benefit from the high real returns (‘hot money’).
iv. Relative price changes (inflation).
v. Granting of foreign loans and developmental aid which directly contribute to foreign currency supply.
vi. Changes in capital flows (foreign direct investment) - where an increase in foreign direct investment results in an increased flow of foreign currency into the country.
b. Advantages of flexible exchange rates
i. There is an automatic correction of BOP disequilibrium through the automatic appreciation and depreciation of the exchange rate to adjust imports and exports. ii. Monetary authorities may devote their effort and resources to other domestic objectives.
iii. There is no need for foreign currency reserves.
iv. There is little risk of controlling the exchange rate for political or selfish reasons.
v. The equilibrium exchange rate is the market rate hence there would be no parallel or black markets.
vi. This market-based rate is a true reflection of economic performance and thus allows rational decisions.
c. Disadvantages of flexible exchange rates
i. Flexible exchange rates are open to speculation and hence fluctuate daily, thus are unstable.
ii. Fluctuations in exchange rates tend to add to the uncertainties of foreign trade.
iii. Fluctuations increase the possibility of domestic inflation, for example, currency depreciation will raise import prices and hence raise costs of imported inputs. This will be passed on in the form of imported cost-push inflation.
iv. Fluctuations may tend to lessen the flow of foreign lending. A small exchange rate change may wipe out several years’ interest from foreign lending.
12.6.2 Fixed exchange rates
Fixed exchange rate refers to a situation where the exchange rates are fixed at pre-announced par values that are only changed when they can no longer be defended. The exchange rate is therefore determined by the authorities and not by market forces. An essential precondition of fixed exchange rates is that the Reserve Bank must be able to buy and sell any quantities of foreign currency necessary to eliminate excess supply and demand of foreign currency at the controlled rate.
Thus the Reserve Bank should set up a reserve fund of convertible currencies in order to carry out this intervention policy.
a. Advantages of fixed exchange rates
i. Fixed exchange rates are very stable because they are not open to speculation and hence they create a certain environment
ii. Stability makes business planning and forecasting a lot easier.
iii. The local currency can be overvalued making foreign currency artificially cheaper and hence capital intensive investment is promoted.
iv. Because of their fixed exchange rate stability there is limited chances of importing inflation therefore fixed exchange rates are anti-inflationary.
b. Disadvantages of fixed exchange rates
i. A currency may remain overvalued or undervalued.
ii. Resources that could be used more productively are tied up in foreign currency reserves needed for the central bank’s intervention policy.
iii. There will be foreign currency shortages causing black and parallel markets to emerge.
iv. Credibility problems, that is, there may be doubts about the government’s ability to maintain the exchange rate at its level that leads to speculative crises.
12.7 Balance of Payments (BOP) Accounts
BOP is an account showing a country’s financial transactions with the outside world over a given period of time, usually a year. The BOP accounts are made up of three separate accounts namely, current account, capital account and official reserves and liabilities account.
12.7.1 Current account
The current account records a country’s commercial transactions, that is, the import and export of goods and services. It is subdivided into two sections: -
a. Trading account which record transactions in merchandised goods that is export and import of goods which are tangible or visible. The balance on the trading account is called the Balance of Trade (BOT). It is obtained by exports less imports of goods. BOT is favourable if it is positive and unfavourable if imports exceed exports.
b. Services account which record trade in services which are invisible or intangible. The balance on the services account is called the Invisible Balance
NB* The sum of the BOT and the Invisible Balance is the Balance on Current Account
12.7.2 Capital account
The capital account records the movement of money for non-trade reasons. That is the inflow and outflow of money for non commercial transactions. The bulk of these flows are for investment purposes. The capital account is subdivided into: -
a. Short-term capital flowwhich measures capital flows arising from investments in assets with contractual maturity of less than one year. These funds are held in bank accounts or treasury bills and move around the world in search of relatively high rates of interest and are referred to as ‘hot money’.
b. Long-term capital flowthat record capital movements that arise from investments in assets whose contracts are for more than one year e.g. bonds and the establishment of industries or construction of factories in foreign countries (foreign direct investment).
12.7.3 Official reserves and liabilities account
The official reserves and liabilities account serves two purposes in the BOP accounts:
a. It records a country’s holding of foreign reserves and gold.
b. It serves as the means of correcting imbalances between inflows and outflows of foreign currency, that is, it is a balancing item. For example, if there were no capital flows and a country incurs a BOP deficit in one year, the difference will be made up by a decline in the official reserves. This section provides a link between the current and capital accounts and hence can be viewed as a balancing item.
12.7.4 The importance of BOP accounts
A country’s BOP accounts are very important because,
a. They show how a country is performing externally.
b. They reveal the trend of trade and the major trading partners of a country.
c. BOP accounts are a barometer of economic performance e.g. persistent BOP deficits implies that the economy is not performing well.
d. Government can see where to intervene with trade regulations.
12.8 The IMF and the World Bank
The two Breton Woods sister institutions were incepted at a conference held in 1944 in Breton Woods. However, they started their operations in 1947. The IMF was created primarily to promote a freer trade and payments mechanism. On the other hand, the World Bank was created to finance developmental projects and the eradication of poverty.
12.8.1 Principles of the IMF
a. All members were to contribute to a large pool of foreign currencies and gold. Each country’s quota was determined by the size of its national income and its share of the world’s trade. This explains why countries like the USA dominate the operations of the IMF.
b. All member countries were encouraged to refrain from using any trade restriction measures that are harmful to trade.
c. Member countries were to adopt an adjustable peg system of exchange rates were devaluation or revaluation were allowed in order to correct BOP serious problems.
12.8.2 The role of the IMF
a. The IMF provides short-term assistance to countries facing BOP deficit problems to enable them to correct the deficit without resorting to harmful trade restrictions.
b. It gives expert advice to member countries on Economic Reform Programs such as ESAP.
a. The fund plays a banking role by allowing member countries to withdraw funds through the Special Drawing Rights (SDR).
It encourages that currency of member countries should easily be exchanged for other currencies (international convertibility of member currencies).
No comments:
Post a Comment