Transfer Problem and Terms of Trade | International Economics

In this article we will discuss about transfer problem and terms of trade in capital movement.

The Transfer Problem in Capital Movements:

The long term capital movement, to be successful, must involve a transfer of real resources (goods etc.) from the investing or lending country to the host or borrowing country. If country A is to invest $ 100 million in country B, it must release domestic real resources or goods worth $ 100 million and export them to the host country B. It enables the transfer of capital in the actual sense. The essence of transfer problem is that the international transfer of financial resources from the investing country must be accompanied by the transfer of real resources of an equivalent value.

The transfer problem arose after the First World War, when Germany was to pay war reparations to France. Another instance of this problem became available in the wake of steep rise in petroleum prices in 1970’s. The petroleum exporting countries such as Saudi Arabia, Libya and Kuwait failed to spend their increased earnings on larger imports from the oil-importing countries. As they tried to reduce their import surplus, that set in deflationary tendencies. So at the heart of 1970 oil crisis was the problem of transfer.

Similarly, the huge foreign investments in the United States resulted in that country joining the ranks of debtor country in 1985. At the .same time, there were record trade deficits of the United States by which the transfer of real resources had been affected.

To examine the transfer problem, it is assumed that the investing and host countries operate under a fixed exchange system and there is a state of full employment in both the countries. It is further supposed that the investing country makes the financial transfer out of idle balances and this amount makes addition to idle balances in the host country. Since expenditure in neither of the countries is affected, there is no transfer of real resources.

In order to enable the transfer of resources to take place, there should be an increase in taxes in the investing country. In this way, its spending can be reduced. Alternatively, there should be tax reduction in the host country with the object of raising expenditure. As the expenditure is reduced in the investing country, it will induce a decline in imports.

On the contrary, a rise in expenditure in the host country can cause an increase in imports. If the balance of trade equilibrium is assumed in the beginning, the changes in expenditure and resultant changes in imports can cause a trade surplus in the investing country and trade deficit in the host country. The existence of trade imbalance in the two countries signifies the transfer of real resources.

Whether the transfer of financial resources is adjusted completely or incompletely with the transfer of real resources is conditioned by the magnitudes of marginal propensities to import (m) in the two countries.

(i) If the sum of marginal propensities to import in the two countries A and B is equal to unity [(m_A + m_B) = 1], there is a complete adjustment and the financial transfer is fully matched with the real transfer.

(ii) If the sum of marginal propensities to import in the two countries is less than unity [(m_A + m_B) < 1], there is incomplete adjustment and transfer of real resources falls short of the transfer of financial resources.

(iii) If the sum of marginal propensities to import in the two countries is more than unity [(m_A + m_B) > 1], there is over-complete adjustment and transfer of real resources exceeds the transfer of financial resources.

If the trade balance in the investing country deteriorates instead of improving, the adjustment between financial and real transfer can be said to be perverse. Such a situation signifies that the transfer of real resources takes place from the host country to the investing country instead of the opposite.

Adjustment between Real and Financial Transfer and Terms of Trade:

If the complete adjustment between the financial and real transfer takes place via income changes, the TOT between the two countries may remain unaffected. In case the adjustment between financial and real transfers via income changes alone is incomplete, the TOT of investing country has to deteriorate to complete the adjustment. On the other hand, if adjustment via income changes is over-complete, the TOT of investing country must improve to facilitate complete adjustment.

The above situation can be illustrated through the following hypothetical numerical examples:

First, suppose country A has to transfer $ 100 million to country B, income in country A falls by $ 100 million and that of B rises by an equivalent amount. If m_A = 0.4 and m_B = 0.6, the imports of A fall by $ 40 million and those of B rise by $ 60 million. The trade balance of country A, therefore, improves by $ 100 million. In this case, there will be complete adjustment between financial and real transfer without any need for TOT to change.

Second, if m_A = 0.3 and m_B = 0.5, the imports of country A will fall by $30 million and those of country B will rise by $ 50 million (or exports of A will rise by $ 50 million). It shows an improvement in trade balance of country A by $ 80 million.

However, a deficit in BOP of investing country A to the extent of $ 20 million continues to exist because a trade surplus of $ 80 million corresponds with capital outflow of $ 100 million. As the transfer of real resources falls short of transfer of financial resources, the adjustment is incomplete. TOT of country A must deteriorate in this situation to make the adjustment complete.

Third, if m_A =0.6 and m_B = 0.8, then the imports of A will fall by $ 60 million and those of B will rise by $ 80 million (or exports of A will rise by $ 80 million. The trade balance of investing country A will improve by $ 140 million. Its balance of payments is in surplus to the tune of $ 40 million as the capital outflow of $ 100 million corresponds with trade surplus of $ 140 million. The adjustment in this situation is over-completed and the transfer of real resources exceeds the transfer of financial resources.

The adjustment process in this case will become complete through an improvement in the TOT for the investing country A.