From 2009 to 2019 the value of Cambodia`s currency significantly increased. Over the same period its balance of trade deficit increased from 1.6% of GDP to 8% of GDP.
Evaluate whether the exchange rate of a country`s currency is the main factor influencing the country`s balance of trade. (Source: Edexcel AS 2021)
Possible answer –
Before I get into the evaluation let me first present my basic understanding on the Balance of trade and Exchange rate.
Balance of trade is an account that is part of the current account balance and involves in recording the trades (imports and exports) in goods and services with other countries.
Whereas the exchange rate denotes the rate at which the value of a currency is measured in terms of the other country's currency. For example 4000 Riels/$.
Exchange rate and the balance of trade are interlinked with each other. Which means any change in exchange rate will affect the balance of trade or any change in balance of trade in terms of increase or decrease in demand for imports and exports will affect the exchange rate.
The example from the case directs to the earlier condition expressed in the paragraph above. For example, from 2009 to 2019, the value of Cambodia`s currency significantly increased. Over the same period, balance of trade deficit increased from 1.6% to 8% of GDP.
This means the deficit in the balance of trade is likely to have occurred due to the change in the value of Cambodia`s currency, particularly, increase in the value of the currency.
Possibly, as the currency value of the Cambodian currency increased the domestic buyers might have started feeling richer than before as their currency could buy more of goods or services from other countries than before. As a result of that domestic buyers might have ended up buying more foreign goods or services leading to imports being greater than the exports resulting balance of trade deficit for Cambodia.
Exports might have gone down compared to imports because, if the value of Cambodia`s currency got increased then the domestic goods were surely costlier to foreign buyers as they had to pay more for the same amount of goods or services that they used to buy from Cambodia earlier. This had probably incentivize them to buy less if there was no change in their income, leading to lower exports demand for Cambodian goods and services among partner countries. Ultimately, it might have led to a fall in exports quantity for Cambodia. As a result of this two factors Cambodia might have experienced higher imports and lower exports leading to balance of trade deficit.
Though exchange rate could be one factor that had affected the balance of trade, but it might not be the only factor as there were could have other factors too that might have affected Cambodia`s balance of trade.
Those probable factors are as follows, inflation level in the country, inflation level in the partner countries, relative quality of the goods and services produced in the country, availability of resources in the country, elasticity of the imports and exports, relative real income, degree at which protectionism is practiced among the trading countries and the state of the global economy etc.
Let me explain some of the points mentioned above.
Inflation level in the country – the inflation level might have been higher in Cambodia compared to the partner country. This could have resulted the domestic goods to be costly to domestic and foreign buyers leading to domestic buyers buying cheaper imports and foreign buyers demanding less for exports. In such case imports of foreign goods or services must have increased and at the same time exports of domestic goods or services were definitely decreased leading to balance of trade deficit for Cambodia.
Inflation level in the partner country –it is possible that the inflation level could have been lower in the partner country compared to Cambodia`s inflation. This must have resulted the buyers from Cambodia to find it cheaper to buy from the partner country leading to higher imports for Cambodia. On the other hand, buyers from partner country must have found it costly to buy goods and services from Cambodia as they had to pay more leading to exports demand for Cambodia`s goods and services to go down. As result of that Cambodia must have experienced balance of trade deficit.
Relative quality of the goods and services produced in Cambodia – if the goods and services produced in the partner country were better in terms of quality than the Cambodia then it was likely that the goods and services from partner country would have demanded more in Cambodia leading to higher demand for imports. It is also possible that the demand for exports were contemporarily lower due to the production of inferior quality goods and service in the country compared to the partner country. As a result, foreign buyers might have not demanded goods and services from Cambodia. This higher imports and lower exports would have led to balance of trade deficit in Cambodia.
Availability of resources in Cambodia – in order to produce goods and services, a country might need a huge amount of resources. As there is no country in the world that is self-sufficient currently, so countries are dependent on each other to import the required amount of resources to satisfy the needs and wants of the people in their countries. Some countries are dependent too much whereas other are less. It is possible Cambodia needed to import a huge amount of resources to produce goods and services to satisfy the needs and wants of the people in the country rather than exporting them to other countries. It is also possible that Cambodia might have exported some of their output to other countries but that had probably not been greater than the amount they had consumed within the country. If this was the case then it is likely that Cambodia would have experienced higher imports cost compared to lower exports earning. This would again be a reason why Cambodia might have experienced a balance of trade deficit.
Elasticity of the imports and exports - the impact of the exchange rate on the balance of trade could have been greater leading to balance of trade deficit for Cambodia. This might have happened due to the demand for imports and exports to be elastic. Considering the import demand was elastic, domestic buyers might have responded to the increase in the value of the currency in huge manner by buying more imported goods, whereas, foreign buyers might have responded the higher value in the Cambodia`s currency by buying significantly lesser amount of goods and services from Cambodia. As a result of that the balance of trade of Cambodia might have experienced deficit.
Relative real income - Relative real income refers to the comparative income among countries after adjustment of the inflation. it is possible that the relative income among the citizens in Cambodia was higher than the partner country. This could have triggered the demand for imported goods from partner country leading to a deficit in Cambpdia`s balance of trade.
However, there may have many factors including the exchange rate that could have affected the balance of trade of Cambodia, but none of the factors can be guaranteed as there is not enough data available to support the factors. As a result, supporting the effects of exchange rate on balance of trade of Cambodia may remain an effort that can`t be proved.
Further, to put an argument against the effect of the exchange rate, I must say that, though the exchange rate of Cambodian currency has increased in 10 years, but the true effect lies on the size of the change in value of the currency and how long the high value of the currency was maintained. In reality currencies do not stay stable for a long period of time. If the high value of the currency could have caused the deficit then the low value currency could have caused the balance of trade surplus. Unfortunately, the case study did not include any such circumstances during the 10 years period making it harder to analyze the case deeper. To repeat, as we don`t have enough data, so it is hard to tell whether the increase in the value of the currency has truly led the increase in imports leading to balance of trade deficit.
One more reason that debunks the significance of the exchange rate affecting the balance of trade is that the pre-signed long-term contracts for imports and exports. If traders from Cambodia and other partners had already signed the long-term contracts, then, change in currency value in the short run might have not affected the balance of trade. For example customers from Cambodia might have gone for signing long term contracts (10 years) at a forward but fixed rate to import. Such contracts would not be affected by the change in the currency value in the short run as the buyers would pay the pre-decided price only. As a result, changes in the currency value in the short run can’t be used as a guaranteed factor that might have caused the change in balance of trade.
In addition to that, it is also possible that firms would respond to the higher exchange rate by lowering their prices once they feel to have a higher competition from imported goods. This might not allow the exchange rate to have a significant impact on the balance of trade.
One more point to be noted here that the impact of the exchange rate would only be effective if the buyers from domestic market and foreign market are responsive to it. This means that the impact of higher exchange rate depends on the elasticity of the imports and exports. Though the analysis above considered that the demand for imports and exports are elastic, but there is no guarantee for such assumption. It is possible that the demand for imports and exports were both inelastic. If the elasticity of imports was inelastic during that period of time then the value of the currency going higher would let the quantity demanded for imports to rise but not that much. On the other hand, if the elasticity of the exports was inelastic during that period of time then the higher exchange rate would not cause the exports to go down that much. As a result of this, the balance of trade might have not been affected that much as the imports could not increase much whereas the exports would have not dropped that much leading to having a less impact on balance of trade at that time.
To mention about the effect of relative income, though it is assumed that the higher relative income would cause the imports to increase but in reality, it may not be the case as the demand imported goods could be inferior goods, this means, if the relative income were higher then people indeed could have imported less quantities than before. Here to note one point that, though the import of inferior goods would have dropped but that would not make sure that the imports were actually less. This is because, the demand for the luxury goods. Generally, with higher relative income demand for luxury goods are likely to increase. In case of luxury goods were not available in the country at that time means domestic buyers might have chosen to import the luxury goods from other countries leading to have an impact on the balance of trade.
It is also worth to note that, though there are many non-price factors were discussed above but there is no guarantee that Cambodia has really gone through those factors. Changes are likely to occur and impact the balance of trade of Cambodia, if some of those factors affected the partner country during that period of time. This will make it harder to evaluate the real impact of exchange rate on the balance of trade of Cambodia.
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