When we hear the word “trade”, most of us think of traditional things – the exporting and importing of goods. That is natural since, historically, trade has consisted largely of the sale and shipment of goods among countries. Business leaders and policy analysts have been educated on trade theories and case studies that use the physical exchange of goods to demonstrate what economists call “comparative advantage” and the social welfare gains from international trade.

Yet, trade now includes other significant facets – such as services and investment – that are growing in importance with each passing year and have added another dimension to our understanding of what trade is. With these changes in mind, how has trade evolved?

Traditional trade

The economic theory behind traditional international trade describes it in terms of “absolute” and “comparative” advantage. Under conditions of absolute advantage, trade occurs because a certain product is only available in certain places (like bananas), or because a product can always be produced more cheaply in one country than another (like wood exports from Sweden to Germany).

But traditional trade is also driven by a more sophisticated concept – comparative advantage – which is about countries specialising in what they do best. Even if one country can produce anything more cheaply than any other, greater overall wealth will be created if that country specialises in what it does the very best and then trades to obtain the rest.

Consider a simple example of comparative advantage at work. Using the same inputs, Chile can produce more of both red wine and shoes compared to Italy – it has an absolute advantage in both products. If, however, Chile specialises in red wine, thus achieving greater efficiencies in production; Italy specialises in shoes and also achieves greater efficiencies; and they then trade with one another to obtain the other’s product, both countries will be wealthier. By specialising, more wine and shoes will have been produced with the same available inputs.

In practice, traditional trade has been viewed as the sale and shipment of goods between buyers and sellers in different countries. Goods trade is easy to see, easy to measure and therefore easy to understand. Trade in services has existed since the earliest days of goods trading – such as revenues earned from transporting foreign goods – but was often not recognised or measured.

Even today, services trade is under-appreciated, and services trade statistics lag significantly the availability of data on goods trade. While exports and imports of goods are physical and can be counted as they cross borders, services trade is essentially based on the cross-border buying and selling of human behaviour and ideas and is measured via surveys and data collection that often takes place well after-the-fact.

End of the line?

The traditional trade paradigm views foreign markets principally as end-users. Some goods that are sold abroad under traditional trade become an input in a production process and are subsequently re-exported. For the most part, however, traditional trade sees goods being sold internationally to be consumed, or invested to produce things for subsequent domestic consumption. The foreign content of traditional exports is not very high (often 10%-20%), and usually consists of key foreign capital goods or raw material inputs used in production.

One key reason why traditional trade has been predominantly in goods for end-use is the existence of tariff and non-tariff barriers. Trade barriers raise the cost of imports, discourage the general expansion of trade and result in lower trade/GDP ratios.

FDI alternative

If exporting to a particular market is not profitable due to tariff barriers, another option under traditional trade has been to use FDI in order to jump over the trade barriers and build the productive capacity necessary to sell in that domestic market. Such was the historical experience for Canada throughout much of the 20th century. FDI in Canada, usually by American companies, was a substitute for exporting of manufactured goods from the US into Canada. FDI is also used to secure access to natural resources, either as a core business for resource companies or as a key industrial input for more vertically integrated sectors such as aluminum.

Since the traditional view of trade focuses heavily on exports of goods to foreign end-users, limited attention is paid in public policy formation or public discussion to the role of imports in production and consumption. For the public, trade issues largely consist of exports that are being threatened by the protectionist behaviour of another nation, or dumping of imports into the country that hurt a domestic industry. The public seldom takes an interest in a business or consumer being hurt by import controls that make imports more expensive.

Export-oriented

As another example of the pro-export bias, most industrial countries established an export credit agency in the first half of the 20th century, but only a few gave that agency the power to facilitate imports – and then only under very narrow and rare conditions.

Due to this pro-export bias, traditional trade risks being manipulated into a belief that exports are good for the economy but imports are not so good because they compete with domestic suppliers and jobs. Economists call this idea “mercantilism”. This idea is fundamentally flawed since it is impossible for every country to have a trade surplus – every export constitutes an import for someone else. A mercantilist mindset opens countries to protectionist tendencies, particularly when economic growth slows or when underlying economic structures change and specific industries begin to see their market contract. And as history has taught us, protectionism is a recipe for economic under-achievement and conflict between nations.

Balancing act

Traditional trade – the buying and selling of goods to end-users – has generally expected a close relationship between changes in a country’s trade balance and balance of payments current account position and the country’s exchange rate. It should be acknowledged that the past century has seen the international financial system shift from periods of fixed exchange rates (such as the Bretton Woods period from 1945 to 1971) to other periods when exchange rates for most countries have been flexible – like the period between WWI and WWII, or since 1971.

Under traditional trade, if exchange rates are flexible or allowed to float, a country with a trade and/or current account surplus would normally expect to face upward pressure on its currency. Conversely, a country in trade and/or current account deficit would generally expect downward pressure on its currency.

Integrative trade

A new generation of international trade has emerged on the scene – what we will call integrative trade. Integrative trade captures all the elements of international business today – exporting and importing, foreign investment, and the international sale of services. The emergence of integrative trade does not mean that traditional trade is being replaced; on the contrary, it is being enhanced. Traditional trade, as already described, remains important in many sectors and for many countries, and it creates a strong foundation upon which the next generation of new and more dynamic trade opportunities is being built, through enhanced economic integration.

Driving integration

The dramatic reduction in communications and transportation costs, combined with successive rounds of trade and investment liberalisation in the latter part of the 20th century, has encouraged greater international competition for capital, technology and markets. As a consequence of lower international trade and investment barriers, products are increasingly being broken down into components – services as well as goods – and each component is then being produced or delivered in the most advantageous locations. The result is a global product, made in many countries, with production distributed along a global supply chain.

In order to build global supply chains and get closer to foreign customers in order to provide better service, companies are increasingly relying on FDI. The growth in international flows of FDI has significantly outpaced the growth of trade and GDP over the past two decades (see graph). The accumulated global stock of FDI nearly tripled during the 1980s. It more than tripled again during the 1990s, reaching $7,120bn by 2002. Since FDI builds global supply chains, helps to serve foreign customers and thus makes businesses more competitive, FDI in both directions is critical to growing export capacity – which in turn creates the potential for even more trade.

Trade and investment therefore should be seen increasingly as parts of an integrated whole. Businesses are generating revenues and profits not only by exporting and importing goods and services, but also by investing abroad and/or attracting inward FDI to make their business model more competitive. Profits and dividends from foreign investment are transferred between countries and then are reinvested in even more trade and stronger economic growth.

Inseparability

One consequence of this new integrative approach to trade is that the foreign or import content of production, and exports, is steadily rising. Put another way, the domestic content of exports is falling as companies seek the best quality and price for all parts of their supply chain, regardless of the source. Therefore, increased importance should be attached to the efficient flow of imports under integrative trade. It is no longer sufficient or appropriate to treat exports and imports as separate items, since in manufacturing, in particular, exporting and importing are part of the same global supply chain process.

This trend is most obvious in advanced manufactured goods like autos, aircraft or telecom technology, where raw materials, machine tools, capital goods and production technology, parts, partly-finished goods and final products are traded back and forth across borders multiple times before the final output is delivered to a buyer. In these sectors, the domestic content of a finished product is seldom above 40% and may be well below 25% as businesses optimise their global supply chain to improve productivity and stay internationally competitive.

Sale of services

A third element of integrative trade is a much more prominent role for the international sale of services. The Economist defines services by saying, “If you can drop it on your toe, you know it’s not a service”.

Trade in services is most easily understood by thinking about businesses earning revenue from foreign sources that then flows into a company’s income statement. Services exports and imports of all types have been part of traditional trade. Sectors as varied as transport, tourism and management consulting earn revenue from foreigners (ie, export a service) and thus contribute to the generation of national wealth and jobs. Services have grown to 75% of GDP or more in advanced industrial countries and constitute up to 30% of total exports for many mature economies.

Moreover, under integrative trade, the international sale of services is increasingly being driven by FDI. Services now represent 60% of total global FDI flows, up from less than 50% a decade ago. Businesses have determined that delivery of services from foreign affiliates, created via FDI, is often the most effective way to get closer to foreign customers and meet their needs and expectations.

Financial services have traditionally been the largest sector in terms of services-related FDI and sales from foreign affiliates, but the financial services share is slipping as many other forms of services – from technology installation to management advice to entertainment – are being delivered internationally via investment in foreign affiliates.

The evolution to integrative trade means that countries and businesses will earn foreign income and generate foreign exchange in different and expanding ways. Many companies’ income statements will rely increasingly on the reflow of profits and dividends from their foreign affiliates. Remittances from individuals working abroad for their company’s foreign affiliates should grow and become more visible as workers send home a portion of their earnings and savings.

Thus, the so-called invisibles portion of a country’s balance of payments will take on greater importance; and as a quid pro quo, we will have to learn not to be quite so obsessed with monthly or quarterly trade data for goods.

Fair exchange

Finally, the evolution to integrative trade requires us to have a more complex view of the factors driving a country’s exchange rate and balance of payments. In a world of integrative trade, exchange rate movements are guided by different forces in the short term and over the longer term.

In the short term, a country’s exchange rate is heavily influenced by portfolio capital movements. Daily capital movements via currency markets, or what has been called “hot money”, can be many times the amount of underlying trade in goods and services. Developing countries with more narrow economic bases and thin local capital markets are particularly susceptible to fluctuations in the short-term exchange rate due to changes in capital market sentiment, but greater currency market variability is not limited to developing markets.

But over the longer term, a country’s exchange rate and balance of payments trends will still be guided by fundamentals – its changing trade balance and international investment position.

The bottom line?

Trade has evolved beyond the traditional exporting and importing of goods, and has entered the next generation – integrative trade. This is driven by foreign investment and places greater weight on elements such as the integration of imports into exports, trade in services and sales from foreign affiliates established though foreign investment. Like most subtle changes in paradigm, the public has been slow to perceive and grasp the emergence of the integrative trade concept. But rest assured, integrative trade is already here; and we are only beginning to appreciate the implications for how the global economy will operate in a different way.

Glen Hodgson, vice president and deputy chief economist, Export Development Canada. E-mail: ghodgson@edc.ca

The views expressed here are those of the author, and not necessarily of Export Development Canada.