The Political Economy of International Trade

LEARNING OBJECTIVES

1 Identify the policy instruments used by governments to influence international trade flows.

2 Understand why governments sometimes intervene in international trade.

3 Summarize and explain the arguments against strategic trade policy.

4 Describe the development of the world trading system and the current trade issue.

5 Explain the implications for managers of developments in the world trading system.

opening case China Limits Exports of Rare Earth Metals

Rare earth metals are a set of 17 chemical elements in the periodic table and include scandium, yttrium, cerium, and lanthanum. Small concentrations of these metals are a crucial ingredient in the manufacture of a wide range of high-technology products, including wind turbines, iPhones, industrial magnets, and the batteries used in hybrid cars. Extracting rare earth metals can be a dirty process due to the toxic acids that are used during the refining process. As a consequence, strict environmental regulations have made it extremely expensive to extract and refine rare earth metals in many countries.

Environmental restrictions in countries such as Australia, Canada, and the United States have opened the way for China to become the world’s leading producer and exporter of rare earth metals. In 1990, China accounted for 27 percent of global rare earth production. By 2010, this figure had surged to 97 percent. In 2010, China sent shock waves through the high-tech manufacturing community when it imposed tight quotas on the exports of rare earths. In 2009, it exported around 50,000 tons of rare earths. The 2010 quota limited exports to 30,000 tons. The quota remained in effect for 2011 and 2012.

The reason offered by China for imposing the export quota is that several of its own mining companies didn’t meet environmental standards and had to be shut down. The effect, however, was to dramatically increase prices for rare earth metals outside of China, putting foreign manufacturers at a cost disadvantage. Many observers quickly concluded that the imposition of export quotas was an attempt by China to give its domestic manufacturers a cost advantage and to encourage foreign manufacturers to move more production to China so that they could get access to lower cost supplies of rare earths. As news magazine The Economist concluded, “Slashing their exports of rare earth metals has little to do with dwindling supplies or environmental concerns. It’s all about moving Chinese manufacturers up the supply chain, so they can sell valuable finished goods to the world rather than lowly raw materials.” In other words, China may have been using trade policy to support its industrial policy.

Developed countries cried foul, claiming that the export quotas violate China’s obligations under World Trade Organization rules, and they have threatened to file a complaint with the World Trade Organization. In January 2012, their position was strengthened when the WTO issued a ruling against China in a related case. This case concerned restriction on exports of bauxite and magnesium from China to Japan that were imposed in 2009. The Japanese filed a case with the WTO, which declared that such export quotas were illegal (China is currently appealing the ruling). Developed states, led by the United States and the European Union, are now arguing that export quotas on rare earth metals must now also be dropped. So far, however, China has shown no signs of doing this.

In the meantime, the world is not sitting still. In response to the high prices for rare earth metals, many companies have been redesigning their products to use substitute materials. Toyota, Renault, and Tesla, for example—all major automotive consumers of rare earth products—have stated that they plan to stop using parts that have rare earth elements in their cars. Governments have also tried to encourage private mining companies to expand their production of rare earth metals. By 2012, there were some 350 rare earth mine projects under development outside of China and India. Bringing new production on stream, however, is not easy, and it maybe 10 years before there is an appreciable increased in supply outside of China.•

Sources: Chuin-Wei Yap, “China Revamps Rare-Earth Exports”, The Wall Street Journal, December 28, 2011, p. C3; “The Difference Engine: More Precious than Gold,” The Economist, September 17, 2010; “Of Metals and Market Forces,” The Economist, February 4, 2012.

Introduction

The review of the classical trade theories of Smith, Ricardo, and Heckscher-Ohlin in Chapter 6 showed that in a world without trade barriers, trade patterns are determined by the relative productivity of different factors of production in different countries. Countries will specialize in products that they can make most efficiently, while importing products that they can produce less efficiently. Chapter 6 also laid out the intellectual case for free trade. Remember, free trade refers to a situation in which a government does not attempt to restrict what its citizens can buy from or sell to another country. As we saw in Chapter 6, the theories of Smith, Ricardo, and Heckscher-Ohlin predict that the consequences of free trade include both static economic gains (because free trade supports a higher level of domestic consumption and more efficient utilization of resources) and dynamic economic gains (because free trade stimulates economic growth and the creation of wealth).

Free Trade

The absence of barriers to the free flow of goods and services between countries.

This chapter looks at the political reality of international trade. Although many nations are nominally committed to free trade, they tend to intervene in international trade to protect the interests of politically important groups or promote the interests of key domestic producers. The opening case illustrates one such situation. In 2010, China imposed a quota on exports of rare earth metals, reducing export supply by 40 percent. Because China at the time accounted for 95 percent of global production of rare earth metals, which are a crucial ingredient in many high-tech products, the immediate effect was to drive up the price of rare earths outside of China and, hence, the production costs of foreign manufacturers. In other words, the policy created an environment that gave Chinese manufacturers a competitive advantage over their foreign rivals. Several developed nations have protested this decision and have threatened to file a case with the World Trade Organization (WTO). Their argument is that the Chinese action is a violation of their obligations under WTO rules (China is a member of the WTO). How this dispute plays out remains to be seen, but it presents us with a clear example of government intervention in international trade that is designed to protect the interests of domestic producers.

This chapter explores the political and economic reasons that governments have for intervening in international trade. When governments intervene, they often do so by restricting imports of goods and services into their nation, while adopting policies that promote domestic production and exports. Normally, their motives are to protect domestic producers. In recent years, social issues have intruded into the decision-making calculus. In the United States, for example, a movement is growing to ban imports of goods from countries that do not abide by the same labor, health, and environmental regulations as the United States.

This chapter starts by describing the range of policy instruments that governments use to intervene in international trade. A detailed review of governments’ various political and economic motives for intervention follows. In the third section of this chapter, we consider how the case for free trade stands up in view of the various justifications given for government intervention in international trade. Then we look at the emergence of the modern international trading system, which is based on the General Agreement on Tariffs and Trade and its successor, the WTO. The GATT and WTO are the creations of a series of multinational treaties. The most recent was completed in 1995, involved more than 120 countries, and resulted in the creation of the WTO. The purpose of these treaties has been to lower barriers to the free flow of goods and services between nations. Like the GATT before it, the WTO promotes free trade by limiting the ability of national governments to adopt policies that restrict imports into their nations. The final section of this chapter discusses the implications of this material for management practice.