INTERNATIONAL TRADE AND ITS IMPACT ON LOCAL INDUSTRIES

Rangesh Fernando 2 August 2011

Table of Contents 1. Introduction................................ ................................ ................................ ........ 3 1.1. 1.2. 1.3. 2. Objectives ................................ ................................ ................................ ... 3 Methodology ................................ ................................ ............................... 3 Regulating Trade ................................ ................................ ......................... 3

Trade related theories ................................ ................................ ......................... 4 2.1. Free Trade Theory................................ ................................ ........................... 4 2.2. Mercantilism ................................ ................................ ................................ ... 5 2.3. Zero-Sum Game................................ ................................ .............................. 5 2.4. Absolute advantage ................................ ................................ ......................... 5 2.5. Comparative Advantage ................................ ................................ .................. 5 2.6. Heckscher Ohlin Theorem................................ ................................ ............... 6 2.7. Product Life Cycle Theory by Raymond Vernon ................................ ............. 6

3.

Impact due to governments physical policy changes ................................ ........... 7 4.1. Impact on local automobile manufacturer (Micro Cars Limited)...................... 9 4.2. Impact on car importers and traders................................ ................................ . 9 4.3. Impact on the consumer ................................ ................................ .................10 4.4. Impact on the Economy ................................ ................................ ..................10

5.0 Conclusion & Recommendations ................................ ................................ ........12 6.0. References ................................ ................................ ................................ .........14

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Table of Figures Figure 1: Economics of Free Trade ................................ ................................ ........... 4 Figure 2: The impact of import duty reduction ................................ .......................... 7 Figure 3: The tax system introduced on June 1, 2010 ................................ ................ 8 Figure 4: The tax reduction on motor vehicles ................................ ........................... 8 Figure 5: The impact on economy ................................ ................................ ............11

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1. Introduction
Imports and Exports in a country make a significant impact on a countrys economy. The main areas of concern include; balance of payments, exchange rate, impact on local industries, comparative advantages for efficient management of resources, etc. This short report is a brief analysis on the governments recent physical policy changes in its taxation for motor vehicles. The report is an analysis of the impact

towards the local vehicle manufacturer (Micro Cars), vehicle importers/ traders, consumers and the economy at macro level as a result of the governments recent reduction of taxes on imported vehicles and the subsequent increase of taxes again.

1.1.

Objectives

Objectives of the assignment are as follows;

y

To understand how international trade functions and MNCs operate around the world.

To evaluate how certain protectionism policies are made by the government effectively.

To make recommendations to the Sri Lankan government on how to improve and protect the local industries without jeopardizing the imports and foreign exchange.

1.2.

Methodology

The information was collected from websites, published journals, corporate sites, news paper articles, government approved publications and other types of documents available on the internet. Also several customers and vehicle importers in Sri Lanka were contacted personally to gather data. Gathered data was analyzed using both quantitative and qualitative methods.

1.3.

Regulating Trade

The following are some of the mechanisms used by governments throughout the world to regulate international trade.
y y

Physcal policy adaptations Embargos

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y y y y y y

Quantity restrictions Request for margins Exchange control regulations Sanctions Aid & Loans Protectionism policies

2. Trade related theories

2.1. Free Trade Theory
Free trade is the ability for countries to carry goods and services across without the involvement of the government. As per David Ricardos theory of comparative advantage, both countries will be able to mutually benefit. As the government is not getting involved in the form of taxes, tariff barriers, non-tariff barriers, protectionism policies, etc., the pricing in a free trade environment will reflect a true picture of the demand and supply situation for a product or service.

Source; (James, 2011) Figure 1: Economics of Free Trade

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2.2. Mercantilism
This is where the governments involvement is considered as of paramount importance where international trade is concerned. Here, the government will

regulate the trade by imposing various policies such as monopolization, forbidding trade of certain goods, export subsidies, promoting research and development or infant industries of a country, restricting wages, maximizing the use of domestic resources, limiting domestic consumption, etc.

2.3. Zero-Sum Game

In simple terms this is where the sum of imports and exports amount to Zero. This happens when all economies try to produce, sell and try to compete with other countries in all possible ways. This will automatically cut off gains against gives. In a case where a country increases its exports of a product line, it will increase its production costs due to rising inflation. Another country will then compete in the same production line for a better price. The Zero-Sum Game theory was argued by David Ricardo. comparative advantage is now used by economies. The theory of

2.4. Absolute advantage

This is where an economy produces more from the same quantum of input. Adam Smith explained this by using the input of Labour. As labour in different nations can have different levels of output due to their differing levels of skills, knowledge and attitude.

2.5. Comparative Advantage

This theory of David Ricardo goes on to say that countries need to focus on production of items which they are able to produce at a better price than any of the other and export the surplus. The other products can be imported from countries in which they are produced most efficiently. This is in order for both countries to benefit from trade by focusing on producing items which has the lowest opportunity cost.

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For example, if, using machinery, a worker in one country can produce both shoes and shirts at 6 per hour, and a worker in a country with less machinery can produce either 2 shoes or 4 shirts in an hour, each country can gain from trade because their internal trade-offs between shoes and shirts are different. The less-efficient country has a comparative advantage in shirts, so it finds it more efficient to produce shirts and trade them to the more-efficient country for shoes. Without trade, its cost per shoe was 2 shirts; by trading, its cost per shoe can reduce to as low as 1 shirt depending on how much trade occurs (since the more-efficient country has a 1:1 trade-off). The more-efficient country has a comparative advantage in shoes, so it can gain in efficiency by moving some workers from shirt-production to shoe-production and trading some shoes for shirts. Without trade, its cost to make a shirt was 1 shoe; by trading, its cost per shirt can go as low as 1/2 shoe depending on how much trade occurs.

2.6. Heckscher Ohlin Theorem

Heckscher Ohlin states that a country will export resources which they have in abundance and will import those which are scarce. This is more accurate when the resources are broken down to specifics. For example, a skilled labour intensive country can export its skill and encourage growth of skill in the country. It can import capital and unskilled labour which is scarce.

2.7. Product Life Cycle Theory by Raymond Vernon

After the failure of Heckscher Ohlin Theory, Raymond Vernon states that during the initial stages of innovation of a product, all the required resources for the product will be sourced from the country of origin. Once its developed the sales will also be carried out first in the country of origin before exporting. However, over time even the production will be carried out in a developing country in which the resources for production is cheaper and not the one in the country in which the product originated. For example, personal computers originated from USA. But today it is produced in China in order to exploit efficient and economical resource utilization.

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3. Impact due to governments physical policy changes

The automobile industry and the taxation regulating it is one of the key income generators for the government of Sri Lanka. The taxation on motor vehicles is over 300% for top end luxury vehicles. Whilst a tax rate of approx. 200% was imposed on the medium range and economical range vehicles. The reduction of taxation on the medium and economy vehicles instantly shot up the demand for such substantially due to the price elastic nature of demand. This helped the government to increase their revenues. According to a senior finance ministry official, Sri Lanka imported over 10,000 vehicles within a period of four months after duty reduction. During first nine months of the year 2010, the government was able to earn 15 billion rupees on taxes on vehicle imports. As per in excise duty terms the government earned 9,920 million rupees compared to 1,995 million rupees in the previous year (Lankanewspapers.com, 2010). According to statistics of the Motor Traffic Department a total of 359,243 vehicles were registered in year 2010 which was a 76 percent increase when compared with the year 2009 (The Democratic Socialist Republic of Sri Lanka, 2011).

Source; (LMD, 2011) Figure 2: The impact of import duty reduction

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On the social aspect, it enabled the Sri Lankan middle class to obtain their first brand new vehicle. Especially the Suzuki Marti as this was now at an affordable Rs 800,000 as opposed to Rs 1.3mn prior to the tax reduction. However, the negative side of this is the large cash out flows towards the global automobile manufacturers. The tax system for motor vehicles was as follows. Petrol Engine Capacity Below 1000cc 1000cc 1600cc 1600cc 2000cc 2000cc 3000cc Over 3000cc 187 217 299 299 299 90 115 150 150 190 412 510 524 524 524 Diesel Tariff

Old Tariff (%) New Tariff (%) Old Tariff (%) New (%) 179 185 271 271 290

Source; (Adaderana.lk, 2010) Figure 3: The tax system introduced on June 1, 2010

The tax reduction was applicable to all kinds of motor vehicles. Category Three wheelers Tax reduction    Motor cycles Excise duty was completely removed. 68% tax was reduced to 40%. Tax charged on conversion unit was reduced from 40% to 8.5%.   Lorries and trucks Vans Diesel Vans    15% surcharge was completely removed. Custom duty was reduced from 15% to 5%. Excise duty was reduced by 15%. Tax was reduced from 180% to 121%. Tax was reduced from 281% to 152%.

Source; (Media Center for National Development of Sri Lanka, 2010) Figure 4: The tax reduction on motor vehicles
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4.1. Impact on local automobile manufacturer (Micro Cars Limited)

Micro Cars Limited is the first local automobile manufacturer that is fully established in Sri Lanka. The organization was formed recently and hence is still in the latter part of the introduction stage in its life cycle. Since this is an industry which is new to Sri Lanka, the government needs to take measures to protect these infant industries. The government backing is required for a new company to dilute the entry barriers and to reduce the heat from global automobile manufacturers. The high tax rate imposed on imported vehicles enabled Micro to compete in the market and cater to the lower socio-economic clusters of the society with their fleet of vehicles starting sales price of Rs 350,000/-. The key advantage of the Unique Selling Proposition for Micro was its ability to compete on price. However, with the reduction of taxes on imported vehicles, the prices of small vehicles such as the Suzuki Maruti made a direct impact on Micros range of vehicles. As the buyers opted for the Maruti over Micro due to better brand recognition and brand credibility carried by Maruti. It became difficult for Micro to compete on price and was directly in the playing field with global competition. Hence Micro now lacked its once unique proposition of being able to compete on price. When the government again increased the tax levels however, Micro was again put at ease. However, it had by then already made strategic moves towards producing value added vehicles such as the Micro Panda to compete with global players in addition to targeting the lower end of the market.

4.2. Impact on car importers and traders

At first, when taxes were increase, the importers were unable to reduce their prices of vehicles as the existing stocks were already taxed paid at, at a higher tax percentage.

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The vehicles importers association then put pressure on the government and also agreed to maintain the price until they recovered the tax paid on existing stocks. The traders on the other hand had to face a consumer demand shift from second hand and older models to newer models. Thus, the prices of second hand vehicles had to be reduced due to the inflow of newer vehicles. However, at an overall level the importers and traders were benefited and their revenue increased. The increased demand for vehicles resulted in better revenue generation. The sudden rise of taxes again however requires the trading activity to provision for the tax component.

4.3. Impact on the consumer

There was an increase of sales observed in the Hybrid vehicles such as; the Toyota Prius and the Honda Hybrid range of vehicles as Hybrids were now affordable and cost effective in its usage. The middle class citizens were now able to purchase their first new vehicle; as a Maruti now would only cost Rs 800,000/-. The consumer that was into second hand vehicles now had the opportunity of considering a brand new or a reconditioned vehicle. However, the sellers of used vehicles were faced with the trauma of not being able to recover their money and obtain the expected sales price as prices are usually on the rise for second hand vehicles.

4.4. Impact on the Economy

The reduction of taxes pushed the demand up for vehicles; thus, resulting in a higher number of vehicles being imported to Sri Lanka. This resulted in large outflows of Sri Lankan rupees. This inevitable increases the balance of payments gap despite it being negative already.

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With the simplification of the tax system the government was able to expand its revenue base in order to tighten the budget deficit to 8.8 percent in 2010. But, the rapid increase in imports with high global prices pushed the trade deficit to 10.5 percent of GDP in 2010 from 7.5 percent in 2009. The total expenditure of the country was 23 percent of GDP in 2010 (Wickremasinghe & Jayakody, 2011).

Source; Cited in (Wickremasinghe & Jayakody, 2011) Figure 5: The impact on economy

It also depreciates the value of the rupee. This would then create an impact on the trading of other industries; especially those that are export/ import oriented. However on a more societal and well being element and when considering the long term impact; the penetration of vehicles to the middle class cluster will improve their lives, their mobility and infrastructure. Thus, the efficiency of this segment will increase. This will eventually contribute to the overall development of the economy in the form of development in infrastructure. Thus, the efficiency of this segment will increase. This contributes to the economy in the form of development in infrastructure, transportation and mobility. It makes the operational activities in a country efficient.

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5.0 Conclusion & Recommendations

International trade is one of the key deciding factors for the growth of an economy. In todays economic context and in an environment in which world trade is an inevitable requirement; governments today need to manage an economy in such a way to maintain a balance of payments surplus. A countrys resources and factors that are able to deliver a comparative advantage must be utilized effectively in order to have an advantage over other producing nations. When looking into governments decision of reducing taxation on imported vehicles; its a sole quantitative gain is increase of revenue to the government. But the large outflow of cash is much more harmful and is damaging to the economy in the long run as cash outflow increases the trade deficit. Instead it would be a wise move and beneficial for the economy if the government increases the duty on imported vehicles in an attempt to support the growth and establishment of Micro Cars. Micro is the first and the only Sri Lankan car manufacturer. Automobile production is a new or an infant industry to Sri Lanka. Hence, government needs to support Micro and adopt protectionism policies for Micro to stand against global competition. As in the long run growth of Micro Cars can enhance the technical and managerial skills with regard to automobile industry in Sri Lanka. It will also give the ability to tie up with global players to assemble their vehicles and even export high quality Micro vehicles in order to generate foreign exchange. Thus it will reduce the cash outflow and in fact, it can result in cash inflows. For example, when Kia and Hyundai companies first started their production in Korea, the government of Korea supported them by imposing duties on imported vehicles. This way the Koreans had to purchase Kia & Hyundai vehicles for their requirements. In the short term this would upset the Korean citizen. But today due to

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the government backing, Hyundai and Kia is a global automobile giant and is one of the much sort after brands and renowned for its technical evolvement and quality. In another instance, government allowed an entrepreneur to start a cab service by bringing down Tata Nano vehicles from India. The cab service was able to operate well by giving a comfortable ride to its consumers for an economical price. This was a short sighted decision. The three wheeler hires were getting hit and thus, was affecting the livelihoods of many three wheel drivers. At a broader level, instead of the Tata Nano, the government could have encouraged the cab service to use the Micro fuel efficient range. This way the community will get to experience the ride in a micro vehicle and will help promotion of the brand. Imports and Exports are very sensitive elements of an economy. Especially as it directly impacts balance of payments, inflation and all the internal trade related industries. Hence the government should be very analytical and long-term thinking when making decisions with regard to international trade. With regard to the automobile import duty, the government should encourage consumers to purchase economical range of hybrid vehicles and once produced in the home country, such as the Micro. Other vehicle purchases should be discouraged except for motor cycles. The government further should grow those industries in which Sri Lanka has a comparative advantage over others. For example, industries such as tea and spices from Sri Lanka are re-known for its best quality. The Sri Lankan soil has a

comparative advantage to produce better quality over any other country. The imports should only be carried out for those items which are most essential and are too costly to produce in Sri Lanka. This way it will help Sri Lanka to reduce the trade deficit and eventually a surplus.

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6.0. References
Adaderana.lk, 2010. Tax reduction implies to all engine capacities. [Online] Available at: http://www.adaderana.lk/news.php?nid=8374 [Accessed 8 June 2011]. ArticlesBase SC #4825575, 2011. Hybrid cars demand on a rise in Sri Lanka. [Online] Available at: http://www.articlesbase.com/cars-articles/hybrid-cars-demandon-a-rise-in-sri-lanka-4825575.html [Accessed 9 June 2011]. Cader, S., n.d. Micro Cars builds first luxury double-decker bus. [Online] Available at: http://www.nation.lk/2008/08/17/busi7.htm [Accessed 9 June 2011]. Daily News, 2010. Vehicle import duty reduction hailed. [Online] Available at: http://www.dailynews.lk/2010/06/03/bus01.asp [Accessed 8 June 2011]. Fernando, P., 2011. Sri Lankas economic gains lead to reduction in poverty levels. [Online] Available at: http://www.lankaweb.com/news/items/2011/04/20/sri-lankaseconomic-gains-lead-to-reduction-in-poverty-levels/ [Accessed 9 June 2011]. Fernandopulle, L., 2011. Vehicle sales to reach 100% growth this year. [Online] Available at: http://www.sundayobserver.lk/2011/01/16/fin02.asp [Accessed 8 June 2011]. Fuard, A., 2010. Vehicle sales moving into top gear. [Online] Available at: http://sundaytimes.lk/100620/News/nws_14.html [Accessed 8 June 2011]. Gamage, M., 2008. More on the import tax on vehicles. [Online] Available at: http://www.lankanewspapers.com/news/2008/5/27591_space.html [Accessed 6 June 2011]. Hill, C.W. & Jain, A.K., 2009. International Business: Competing in the Global Market Space. 6th ed. New Delhi: Tata McGraw-Hill Publishing Company Limited. Jayasuriya, S., 2010. WTL launches locally assembled van. [Online] Available at: http://www.dailynews.lk/2010/02/17/bus03.asp [Accessed 9 June 2011].

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Kovilagodage,

J.,

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http://www.lankabusinessonline.com/fullstory.php?nid=349762860 [Accessed 9 June

http://www.lankabusinessonline.com/fullstory.php?nid=1605760899 June 2011].

Lanka Business Online, 2011. Sri Lanka starts taxi service with Tata Nano. [Online] Available at: http://www.lankabusinessonline.com/fullstory.php?nid=112903174

[Accessed 12 June 2011]. Lankanewspapers.com, 2010. Sri Lanka imports 10,000 cars after tax cut. [Online] Available at: http://www.lankanewspapers.com/news/2010/11/61686.html [Accessed 8 June 2011]. Lankanewspapers.com, 2011. Sri Lanka raises taxes on imported vehicles. [Online] Available at: http://www.lankanewspapers.com/news/2011/4/66461.html [Accessed 8 June 2011]. LMD, 2010. Sri Lanka revenue soars after vehicle import tax cut: official. [Online] Available at: http://www.lankabusinessonline.com/fullstory.php?nid=1470785646

[Accessed 8 June 2011]. LMD, 2011. MOTORING IN THE FAST LANE. [Online] Available at:

http://lmd.lk/2011/06/01/leading-edge-5/ [Accessed 8 June 2011]. Media Center for National Development of Sri Lanka, 2010. NEW TAX REDUCTIONS APPLICABLE TO ALL VEHICLES INCLUDING MOTOR CYCLES

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AND

WHEELERS.

[Online]

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http://www.development.lk/news.php?news=583 [Accessed 9 June 2011]. Najmuddin, J., 2004. Micro Cars face crisis situation. [Online] Available at: http://www.thesundayleader.lk/archive/20041226/business.htm [Accessed 12 June 2011]. Perera, Q., 2007. Micro Car manufacturer recognized by the international automobile trade. [Online] Available at: http://www.asiantribune.com/node/6970 [Accessed 9 June 2011]. Perera, K., 2011. Sri Lankan economy bounces back strongly ADB. [Online] Available at: http://srilog.com/sri-lankan-economy-bounces-back-

strongly%E2%80%93-adb_209.html [Accessed 9 June 2011]. Sunday Observer, 2010. Reduction in vehicle import duties, a boost to industry. [Online] Available at: http://www.tops.lk/article19852-reduction-in-vehicle-importduties-a-boost-to-industry.html [Accessed 8 June 2011]. The Democratic Socialist Republic of Sri Lanka, 2011. News Line. [Online] Available at: http://www.priu.gov.lk/news_update/Current_Affairs/ca201102/20110215vehicles_i mports_up.htm [Accessed 8 jUne 2011]. The Economist, 2010. Costs and benefits of the import liberalization. [Online] Available at: http://sundaytimes.lk/100613/Columns/eco.html [Accessed 9 June 2011]. The Island, 2010. Role of Imports in the Sri Lankan Economy. [Online] Available at: http://www.island.lk/index.php?page_cat=article-details&page=articledetails&code_title=5486 [Accessed 9 June 2011]. Wickremasinghe, H.N. & Jayakody, S., 2011. Asian Development Outlook 2011: Sri Lanka. [Online] Available at:

http://www.adb.org/documents/books/ado/2011/ado2011-sri.pdf [Accessed 9 June 2011].

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