Deglobalisation — Trade Openness, Exchange Rates and Small versus Large Economies

Case

Table 3: Trade Openness Index for selected countries (2018–2020)

The Trade Openness Index is the sum of a country’s exports and imports as a percentage of its GDP.

Country	2018	2019	2020
China	37.57	35.89	34.51
Singapore	325.34	323.52	320.30
Sri Lanka	53.51	52.38	39.52
USA	27.48	26.29	23.38

Source: The Global Economy, accessed July 2022.

Figure 1: Sri Lanka standing deposit rate and exchange rate (per USD), 2018–2020

	2018	2019	2020
Standing deposit rate	8%	7%	4.5%
Exchange rate (LKR per USD)	160.00	176.00	187.00

Source: Central Bank of Sri Lanka and XE Currency. The standing deposit rate is the benchmark interest rate set by the Central Bank of Sri Lanka.

Extract 10: A world less connected

The COVID-19 pandemic is driving the world economy to retreat from global economic integration. Policymakers and business leaders are now questioning whether global supply chains have been stretched too far. National security and public-health concerns are providing new rationales for protectionism, especially for medical gear and food, and an emphasis on domestic sourcing.

This retreat will not mark the end of globalisation, a process that has reached a historically high level. But globalisation can be reversed, at least partially. The Great Recession of 2008 marked a historic turning point in the degree of global economic integration. Now, in response to the current crisis, policymakers appear poised to take deliberate steps to reinforce the movement toward deglobalisation.

While trade has tended in past decades to grow more rapidly than world output, that is no longer the case. Under President Xi Jinping, China began to turn inward with policies to promote the indigenous development of leading industries, while under President Donald Trump the United States embraced an “America First” policy, shifting away from trade liberalisation toward protectionism. The US also initiated a trade war with China, significantly reducing bilateral trade.

Source: VoxEU, Centre for Economic Policy Research, May 2020

Extract 11: Impact of a disconnected world

It is folly to think that a chaotic, crisis-driven retreat from globalisation will not introduce more — and vastly more serious — problems. Even the US, with its highly diversified economy, world-leading technology and strong natural-resource base, could suffer a significant decline in economic growth because of deglobalisation. For smaller economies and developing countries that are unable to reach critical mass in many sectors and often lack natural resources, a breakdown in trade would reverse many decades of growth.

In 2020, over 26 per cent of the global FDI stock was invested in the United States. By comparison, the second most popular destination, China (including Hong Kong), accounted for only 9.2 per cent, with Singapore taking up 7.5 per cent. Few countries will be spared by the looming spectre of deglobalisation, which threatens cross-border trade and investment.

Source: Channel News Asia, June 2020, and Forbes, January 2021

Questions

(a)(i) Using Figure 1, state and explain the relationship between Sri Lanka’s exchange rate and standing deposit rate. [3] (command: explain)

(a)(ii) Explain how the change in Sri Lanka’s exchange rate will affect its economic performance. [4] (command: explain)

(b)(i) With reference to Table 3, describe the change in the countries’ Trade Openness Index over the period 2018–2020. [1] (command: describe)

(b)(ii) With reference to Extract 11, explain how this change will affect producers and consumers of a national economy. [4] (command: explain)

(c) Using the case material and your own knowledge, discuss the extent to which deglobalisation will adversely affect small economies more than larger economies. [10] (command: discuss)

Answers

(a)(i) Relationship between exchange rate and standing deposit rate [3] — explain

There is a positive (direct) relationship: as the standing deposit rate falls (8% → 4.5%), the exchange rate rises to 187 LKR per USD — the rupee depreciates. As the central-bank interest rate falls, the return on Sri Lankan assets falls, causing an outflow of hot money. The supply of rupees on the foreign-exchange market rises, depreciating the currency.

(a)(ii) Effect of the exchange-rate change on economic performance [4] — explain

This part is open: any two macroeconomic goals may be developed. Taking the balance of trade and growth — a depreciation makes Sri Lankan exports cheaper in foreign currency, raising export revenue (X), and makes imports dearer in domestic currency, reducing import expenditure (M) where demand is price-elastic. Provided the Marshall–Lerner condition holds, net exports (X − M) rise and the balance of trade improves; the rise in net exports lifts aggregate demand, delivering positive actual economic growth. (Conversely, if export and import demand are price-inelastic, the balance of trade could worsen and growth weaken.)

(b)(i) Describe the change in the Trade Openness Index [1] — describe

The Trade Openness Index generally fell for all four countries over 2018–2020.

(b)(ii) Effect on producers and consumers of a national economy [4] — explain

A falling Trade Openness Index reflects retreating trade, which Extract 11 says can “reverse decades of growth”. This may be analysed through the costs of reduced trade:

• Consumers. With less trade, the cost savings from comparative advantage are forgone, so input and output prices rise. Producers raise prices to protect margins, which reduces consumer surplus / utility, ceteris paribus.

• Producers. As trade openness falls, fewer foreign buyers purchase domestic output, so export revenue falls and, ceteris paribus, producer surplus / profits fall for domestic producers.

(c) Extent to which deglobalisation hurts small economies more than large ones [10] — discuss

Introduction. Deglobalisation is a reduction in the cross-border flow of goods and services, capital and labour. A holistic answer weighs at least two of these flows. Stand: deglobalisation will, on balance, affect small economies more adversely than large ones.

Body 1 — reduced trade flow raises inflation. As trade falls, imported inputs decline and the cost savings from comparative advantage are lost, raising input costs and generating imported cost-push inflation. On the AD/AS diagram, aggregate supply shifts left, raising the general price level and reducing price stability.

Evaluation: small economies are generally hit harder, since they “lack natural resources” (Extract 11) and have fewer domestic industries, so the rise in input prices is more pronounced.

Body 2 — reduced capital flow lowers growth. Falling cross-border capital flow reduces FDI and so investment expenditure (I), shifting AD left; national income falls by a multiple through the reverse multiplier. Lower FDI also slows capital formation, reducing productive capacity, so both actual and potential growth fall.

Evaluation: this channel can bite larger economies harder, since they are the main FDI destinations — the US holds “over 26% of global FDI stock” (Extract 11) — so a withdrawal of capital flows reduces their AD and capacity by more in absolute terms.

Body 3 — reduced labour flow raises inflation. Falling international labour mobility lowers the quantity and quality of labour, raising wages and shifting AS left, again reducing price stability. Small economies, with a thinner domestic labour pool to begin with, feel a proportionally larger effect.

Conclusion. All economies are harmed by deglobalisation, but small economies are more adversely affected on balance. They depend disproportionately on trade and capital inflows for growth — Singapore’s Trade Openness Index above 320 makes the point — whereas large economies can lean on sizeable domestic sectors (C, G and domestic I) to cushion the shock. The capital-flow channel is the partial exception, falling more heavily on the large FDI hubs, but it does not overturn the overall judgement.