INTERNATIONAL TRADE AND ITS IMPACT ON LOCAL INDUSTRIES

Rangesh Fernando

2 August 2011

Table of Contents

1. Introduction.............................................................................................................3

1.1. Objectives........................................................................................................3

1.2. Methodology....................................................................................................3

1.3. Regulating Trade.............................................................................................3

2. 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

Table of Figures

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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 country’s 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 government‘s 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 government’s recent

reduction of taxes on imported vehicles and the subsequent increase of taxes again.

1.1. Objectives

Objectives of the assignment are as follows;

To understand how international trade functions and MNC’s 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.

Physcal policy adaptations

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Embargos

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 Ricardo’s 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)

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Figure 1: Economics of Free Trade

2.2. Mercantilism

This is where the government’s 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. The theory of

comparative advantage is now used by economies.

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

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benefit from trade by focusing on producing items which has the lowest opportunity

cost.

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 it’s 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).

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Source; (LMD, 2011)

Figure 2: The impact of import duty reduction

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 Diesel

Engine

Capacity

Old Tariff (%) New Tariff (%) Old Tariff (%) New Tariff

(%)

Below 1000cc 187 90 412 179

1000cc – 1600cc 217 115 510 185

1600cc – 2000cc 299 150 524 271

2000cc – 3000cc 299 150 524 271

Over 3000cc 299 190 524 290

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 Tax reduction

Three wheelers Excise duty was completely removed.

68% tax was reduced to 40%.

Tax charged on conversion unit was reduced from

40% to 8.5%.

Motor cycles 15% surcharge was completely removed.

Custom duty was reduced from 15% to 5%.

Lorries and trucks Excise duty was reduced by 15%.

Vans Tax was reduced from 180% to 121%.

Diesel Vans Tax was reduced from 281% to 152%.

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Source; (Media Center for National Development of Sri Lanka, 2010)

Figure 4: The tax reduction on motor vehicles

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 Micro’s 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.

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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.

The vehicles importer’s 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

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Sri Lankan rupees. This inevitable increases the balance of payments gap despite it

being negative already.

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.

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This contributes to the economy in the form of development in infrastructure,

transportation and mobility. It makes the operational activities in a country efficient.

5.0 Conclusion & Recommendations

International trade is one of the key deciding factors for the growth of an economy.

In today’s 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 country’s 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 government’s decision of reducing taxation on imported vehicles;

it’s 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.

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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

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.

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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.

6.0. References

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ArticlesBase SC #4825575, 2011. Hybrid cars demand on a rise in Sri Lanka.

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on-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:

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Fernando, P., 2011. Sri Lanka’s economic gains lead to reduction in poverty levels.

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AND 3 WHEELERS. [Online] Available at: http://www.development.lk/news.php?

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