UCP600 and Documentary Credit

Topic: What is Monetary policy and its impact on International

Trade?

Submitted To:

Prof. Syed Ali Raza

Submitted By:

Halima Hassan

Registration ID:

M15MBA030

Date of Submission:

April 18, 2018

Monetary Policy
Monetary policy consists of the actions of a central bank, currency
board or other regulatory committee that determine the size and rate
of growth of the money supply, which in turn affects interest rates. Monetary policy is
maintained through actions such as modifying the interest rate, buying or selling government
bonds, and changing the amount of money banks are required to keep in the vault (bank
reserves).
Monetary policy involves central banks’ use of instruments to influence interest rates and/or
money supply in the economy with the objective to keep overall prices and financial markets
stable. Monetary policy is essentially a stabilization or demand management policy that
cannot impact long-term growth potential of an economy. Preamble to SBP Act, 1956
envisages monetary policy to secure monetary stability and attain fuller utilization of
economy’s productive resources. In SBP’s view, the best way to achieve these objectives on a
sustainable basis is to keep inflation low and stable.

Low and stable inflation provides favourable conditions for sustainable growth and
employment generation over time. It reduces uncertainties about future prices of goods and
services and helps households and businesses to make economically important decisions such
as consumption, savings and investments with more confidence. This, in turn, facilitates
higher growth and creates employment opportunities over the medium term leading to overall
economic well-being in the country.

In practice, SBP’s monetary policy strives to strike a balance among multiple and often
competing considerations. These include: controlling inflation, ensuring payment system and
financial stability, preserving foreign exchange reserves, and supporting private investment.

Types of Monetary Policy

There are two types of monetary policies.

1. Expansionary Monetary Policy 2. Contractionary Monetary Policy.

Expansionary monetary is when a monetary authority uses its tools to stimulate the
economy. An expansionary policy maintains short-term interest rates at a lower than usual
rate or increases the total supply of money in the economy more rapidly than usual. It is
traditionally used to try to combat unemployment in a recession by lowering interest rates in
the hope that less expensive credit will entice businesses into expanding. This
increases aggregate demand (the overall demand for all goods and services in an economy),
which boosts short-term growth as measured by gross domestic product (GDP) growth.
Expansionary monetary policy usually diminishes the value of the currency relative to other
currencies (the exchange rate). Expansionary monetary policy increases the money supply in
order to lower unemployment, boost private-sector borrowing and consumer spending,
and stimulate economic growth.

Contractionary monetary policy slows the rate of growth in the money supply or outright
decreases the money supply in order to control inflation; while sometimes necessary,
contractionary monetary policy can slow economic growth, increase unemployment and
depress borrowing and spending by consumers and businesses. An example would be the
Federal Reserve's intervention in the early 1980s: in order to curb inflation of nearly 15%, the
Fed raised its benchmark interest rate to 20%. This hike resulted in a recession, but did keep
spiralling inflation in check.

Monetary Policy Objectives

The following are the principal objectives of monetary policy:

1. Full Employment: Full employment has been ranked among the foremost objectives of
monetary policy. It is an important goal not only because unemployment leads to wastage of
potential output, but also because of the loss of social standing and self-respect.

2. Price Stability: One of the policy objectives of monetary policy is to stabilise the price
level. Both economists and laymen favour this policy because fluctuations in prices bring
uncertainty and instability to the economy.

3. Economic Growth: One of the most important objectives of monetary policy in recent
years has been the rapid economic growth of an economy. Economic growth is defined as
“the process whereby the real per capita income of a country increases over a long period of
time.”
4. Balance of Payments: Another objective of monetary policy since the 1950s has been to
maintain equilibrium in the balance of payments.

SBP focuses on achieving monetary stability by controlling inflation close to its annual and
medium-term targets set by the government. At the same time, SBP also aims to ensure
financial stability, particularly the smooth functioning of the financial market and the
payments system. Consensus in literature as well as country experiences suggests that price
and financial stability facilitate the achievement of sustained economic growth in the long-
run.

Instruments of Monetary Policy:

The instruments of monetary policy are of two types: first, quantitative, general or indirect;
and second, qualitative, selective or direct. They affect the level of aggregate demand through
the supply of money, cost of money and availability of credit. Of the two types of
instruments, the first category includes bank rate variations, open market operations and
changing reserve requirements. They are meant to regulate the overall level of credit in the
economy through commercial banks. The selective credit controls aim at controlling specific
types of credit. They include changing margin requirements and regulation of consumer
credit.

SBP is mainly using indirect instruments to implement its monetary policy. Changes in the
policy stance are generally signalled through the SBP Policy (target) Rate. To ensure that the
policy signals are transmitted to other key interest rates in the economy, such as banks’
lending and deposit rates, and financial markets continue to function smoothly, SBP is using
several instruments.

SBP Policy Rate: Through this policy rate SBP targets the overnight money market repo
rate that signals the monetary policy stance. The ‘Policy Rate’ is set within the Interest Rate
Corridor (IRC) bounded by SBP’s Standing facilities that is ‘Reverse Repo (Ceiling) and
Repo (Floor) facility.

Standing Facilities: In order to reduce the volatility in short term interest rates and to
bring more transparency in the implementation of monetary policy, State Bank of Pakistan
introduced an interest rate corridor for the money market overnight repo rates. The corridor
operates through standing overnight repo / reverse-repo facilities (i.e. floor & ceiling), setting
a formal corridor for the money market overnight repo rates consistent with the monetary
policy of State Bank of Pakistan. The interest rate corridor consists of two end-of-day
Standing facilities offered by State Bank of Pakistan:

a) SBP Reverse Repo Facility: The eligible financial institutions can use SBP
reverse repo facility, to obtain rupee funds for one day against approved securities. The
financial institution sells the approved security to the SBP with the agreement to repurchase
the same the day after. The interest rate charged against such lending, the SBP reverse repo
rate, serves as ceiling for the money market overnight repo rate.

b) SBP Repo Facility: This facility allows the eligible financial institutions to place their
excess funds with SBP for overnight and receive Treasury Bills in return. The interest rate
paid to the banks under this facility is termed as SBP repo rate. It serves as a floor to the
downward movement of money market overnight repo rate.

Open Market Operations: Open Market Operations (OMOs) are the most frequently
used instruments for implementing monetary policy in Pakistan. OMOs are conducted to
manage liquidity in the interbank money market; mainly with the objectives to ensure
availability of sufficient funds for smooth settlement of interbank transactions and keeping
the overnight interbank repo rate near the Policy (target) Rate.

OMOs are usually conducted as repo transactions to address banks’ temporary liquidity
needs. These transactions involve central bank purchase (sale) of government securities to
inject (absorb) liquidity in (from) the interbank market with an agreement to sale (purchase)
the underlying security at a specified price at a designated future date. SBP conducts OMOs
through ‘variable rate tenders’ whereby banks disclose both the amount of money they want
to transact and the rate at which they want to enter into the transaction. The tenor of OMOs,
set and announced by SBP each time OMO is conducted, ranges between overnight to two
weeks, but are mostly of one week.

SBP also uses outright OMOs when market liquidity is anticipated to remain short or in
surplus over a longer period of time. The outright OMOs involve purchase or sale of
government securities on permanent basis, i.e. until the maturity of the underlying security.
Unlike the repo based OMOs, in outright OMOs ownership of underlying security changes
between the financial institution and the SBP. Traditionally, SBP has been using outright
OMOs to shift the government debt from its balance sheet to scheduled banks’ balance
sheets.

Reserve Requirements: Reserve requirement of banks is to hold liquid assets in the

form of cash and, approved securities. SBP requires scheduled banks in Pakistan to maintain
two types of reserve requirements, i.e. cash reserve requirement and statutory liquidity
requirement.

Monetary Policy Implementation in Pakistan

Implementation of the monetary policy stance, signalled through announcement of the Policy
(target) Rate, entails managing the day-to-day liquidity in the money market with the
objective to keep the short-term interest rates stable and aligned with the Policy (target) Rate.
Specifically, as an operational target SBP aims at maintaining the weekly weighted average
overnight repo rate close to the Policy (target) Rate. To achieve this operational target, SBP
primarily uses OMOs to manage liquidity in the money market in a manner that there are no
unwarranted pressures that diverges the weighted average overnight repo rate from the Policy
(target)Rate.
In case there is an upward pressure on the repo rate, due to shortage of liquidity in the system,
SBP injects rupee liquidity in the system by purchasing government securities from banks
with the agreement of selling the same on a transaction maturity date – the transaction
generally termed as OMO injection by SBP. On the contrary, if there is excess liquidity
available with the banks, putting downward pressure on the overnight repo rate, SBP mops up
this surplus liquidity by selling government securities to banks usually with the agreement to
purchase the same on the transaction maturity date. This transaction is generally named as
OMO mop-up by SBP. If required, SBP also conducts foreign exchange swaps in the
interbank to impact the market liquidity. Infrequently, SBP also changes the reserve
requirements in case the liquidity shortfall or excess is expected to stay for a longer period of
time.
At the time of introducing the explicit interest rate corridor in August, 2009, the width of the
corridor was set at 300 bps. It remained unchanged at this level until February, 2013 when it
was narrowed to 250 bps. The width has been further narrowed to 200 bps in May 2015.
The lower reliance of banks on SBP and limited volatility in the overnight rate is desirable to
ensure smooth transmission of monetary policy signals to other market interest rates.
Excessive volatility in the overnight rate may distort the term structure of interest rates by
creating disconnect between short and long term rates. Moreover, it can also discourage the
development of financial market instruments (as most of them rely on well-developed yield
curve).
International Trade
International trade is the exchange of capital, goods,
and services across international borders or territories. In
most countries, such trade represents a significant share
of gross domestic product (GDP). While international
trade has existed throughout history (for
example Uttarapatha, Silk Road, Amber Road, scramble for Africa, Atlantic slave trade, salt
roads), its economic, social, and political importance has been on the rise in recent centuries.

Trading globally gives consumers and countries the opportunity to be exposed to new
markets and products. Almost every kind of product can be found in the international market:
food, clothes, spare parts, oil, jewellery, wine, stocks, currencies, and water. Services are also
traded: tourism, banking, consulting, and transportation. A product that is sold to the global
market is an export, and a product that is bought from the global market is an import. Imports
and exports are accounted for in a country's current account in the balance of payments.

Industrialization, advanced technology, including transportation, globalization, multinational

corporations, and outsourcing are all having a major impact on the international trade system.
Increasing international trade is crucial to the continuance of globalization. Nations would be
limited to the goods and services produced within their own borders without international
trade. International trade is, in principle, not different from domestic trade as the motivation
and the behaviour of parties involved in a trade do not change fundamentally regardless of
whether trade is across a border or not. The main difference is that international trade is
typically more costly than domestic trade. This is due to the fact that a border typically
imposes additional costs such as tariffs, time costs due to border delays, and costs associated
with country differences such as language, the legal system, or culture.

Another difference between domestic and international trade is that factors of

production such as capital and labour are typically more mobile within a country than across
countries. Thus, international trade is mostly restricted to trade in goods and services, and
only to a lesser extent to trade in capital, labour, or other factors of production. Trade in
goods and services can serve as a substitute for trade in factors of production. Instead of
importing a factor of production, a country can import goods that make intensive use of that
factor of production and thus embody it. An example of this is the import of labour-intensive
goods by the United States from China. Instead of importing Chinese labour, the United
States imports goods that were produced with Chinese labour. One report in 2010 suggested
that international trade was increased when a country hosted a network of immigrants, but the
trade effect was weakened when the immigrants became assimilated into their new country.

Increased Efficiency of Trading Globally

Global trade allows wealthy countries to use their resources—whether labour, technology
or capital— more efficiently. Because countries are endowed with different assets and natural
resources (land, labour, capital and technology), some countries may produce the same good
more efficiently and therefore sell it more cheaply than other countries. If a country cannot
efficiently produce an item, it can obtain the item by trading with another country that can.
This is known as specialization in international trade.

Let's take a simple example. Country A and Country B both produce cotton sweaters and
wine. Country A produces ten sweaters and six bottles of wine a year while Country B
produces six sweaters and ten bottles of wine a year. Both can produce a total of 16 units.
Country A, however, takes three hours to produce the ten sweaters and two hours to produce
the six bottles of wine (total of five hours). Country B, on the other hand, takes one hour to
produce ten sweaters and three hours to produce six bottles of wine (total of four hours).

But these two countries realize that they could produce more by focusing on those products
with which they have a comparative advantage. Country A then begins to produce only wine,
and Country B produces only cotton sweaters. Each country can now create a specialized
output of 20 units per year and trade equal proportions of both products. As such, each
country now has access to 20 units of both products.

We can see then that for both countries, the opportunity cost of producing both products is
greater than the cost of specializing. More specifically, for each country, the opportunity cost
of producing 16 units of both sweaters and wine is 20 units of both products (after trading).
Specialization reduces their opportunity cost and therefore maximizes their efficiency in
acquiring the goods they need. With the greater supply, the price of each product would
decrease, thus giving an advantage to the end consumer as well.
Advantages of International Trade:

(i) Optimal use of natural resources:

International trade helps each country to make optimum use of its natural resources. Each
country can concentrate on production of those goods for which its resources are best suited.
Wastage of resources is avoided.

(ii) Availability of all types of goods:

It enables a country to obtain goods which it cannot produce or which it is not producing due
to higher costs, by importing from other countries at lower costs.

(iii) Specialisation:

Foreign trade leads to specialisation and encourages production of different goods in different
countries. Goods can be produced at a comparatively low cost due to advantages of division
of labour.

(iv) Advantages of large-scale production:

Due to international trade, goods are produced not only for home consumption but for export
to other countries also. Nations of the world can dispose of goods which they have in surplus
in the international markets. This leads to production at large scale and the advantages of
large scale production can be obtained by all the countries of the world.

(v) Stability in prices:

International trade irons out wild fluctuations in prices. It equalizes the prices of goods
throughout the world (ignoring cost of transportation, etc.)

(vi) Exchange of technical know-how and establishment of new industries:

Underdeveloped countries can establish and develop new industries with the machinery,
equipment and technical know-how imported from developed countries. This helps in the
development of these countries and the economy of the world at large.
(vii) Increase in efficiency:

Due to international competition, the producers in a country attempt to produce better quality
goods and at the minimum possible cost. This increases the efficiency and benefits to the
consumers all over the world.

(viii) Development of the means of transport and communication:

International trade requires the best means of transport and communication. For the
advantages of international trade, development in the means of transport and communication
is also made possible.)

(ix) International co-operation and understanding:

The people of different countries come in contact with each other. Commercial intercourse
amongst nations of the world encourages exchange of ideas and culture. It creates co-
operation, understanding, and cordial relations amongst various nations.

(x) Ability to face natural calamities:

Natural calamities such as drought, floods, famine, earthquake etc., affect the production of a
country adversely. Deficiency in the supply of goods at the time of such natural calamities
can be met by imports from other countries.

(xi) Other advantages:

International trade helps in many other ways such as benefits to consumers, international
peace and better standard of living.

Disadvantages of International Trade:

Though foreign trade has many advantages, its dangers or disadvantages should not be
ignored.
(i) Impediment in the Development of Home Industries:

International trade has an adverse effect on the development of home industries. It poses a
threat to the survival of infant industries at home. Due to foreign competition and unrestricted
imports, the upcoming industries in the country may collapse.

(ii) Economic Dependence:

The underdeveloped countries have to depend upon the developed ones for their economic
development. Such reliance often leads to economic exploitation. For instance, most of the
underdeveloped countries in Africa and Asia have been exploited by European countries.

(iii) Political Dependence:

International trade often encourages subjugation and slavery. It impairs economic

independence which endangers political dependence. For example, the Britishers came to
India as traders and ultimately ruled over India for a very long time.

(iv) Mis-utilisation of Natural Resources:

Excessive exports may exhaust the natural resources of a country in a shorter span of time
than it would have been otherwise. This will cause economic downfall of the country in the
long run.

(v) Import of Harmful Goods:

Import of spurious drugs, luxury articles, etc. adversely affects the economy and well-being
of the people.

(vi) Storage of Goods:

Sometimes the essential commodities required in a country and in short supply are also
exported to earn foreign exchange. This results in shortage of these goods at home and causes
inflation. For example, India has been exporting sugar to earn foreign trade exchange; hence
the exalting prices of sugar in the country.
(vii) Danger to International Peace:

International trade gives an opportunity to foreign agents to settle down in the country which
ultimately endangers its internal peace.

(viii) World Wars:

International trade breeds rivalries amongst nations due to competition in the foreign markets.
This may eventually lead to wars and disturb world peace.

(ix) Hardships in times of War:

International trade promotes lopsided development of a country as only those goods which
have comparative cost advantage are produced in a country. During wars or when good
relations do not prevail between nations, many hardships may follow.

Reasons for International Trade

Because of the limitations, wise business owners are looking to go global and exploit the
many international trade opportunities – after all, in the global economy; practically every
country is a potential customer. Here are seven reasons for international trade;

1- Reduced dependence on your local market

Your home market may be struggling due to economic pressures, but if you go global, you
will have immediate access to a practically unlimited range of customers in areas where there
is more money available to spend, and because different cultures have different wants and
needs, you can diversify your product range to take advantage of these differences.

2- Increased chances of success

Unless you’ve got your pricing wrong, the higher the volume of products you sell, the more
profit you make, and overseas trade is an obvious way to increase sales. In support of this,
UK Trade and Investment (UKTI) claim that companies who go global are 12% more likely
to survive and excel than those who choose not to export.
3- Increased efficiency

Benefit from the economies of scale that the export of your goods can bring – go global and
profitably use up any excess capacity in your business, smoothing the load and avoiding the
seasonal peaks and troughs that are the bane of the production manager’s life.

4- Increased productivity

Statistics from UK Trade and Investment (UKTI) state that companies involved in overseas
trade can improve their productivity by 34% – imagine that, over a third more with no
increase in plant.

5- Economic advantage

Take advantage of currency fluctuations – export when the value of the pound sterling is low
against other currencies, and reap the very real benefits. Words of warning though; watch out
for import tariffs in the country you are exporting to, and keep an eye on the value of
sterling. You don’t want to be caught out by any sudden upsurge in the value of the pound,
or you could lose all the profit you have worked so hard to gain.

6- Innovation

Because you are exporting to a wider range of customers, you will also gain a wider range of
feedback about your products, and this can lead to real benefits. In fact, UKTI statistics show
that businesses believe that exporting leads to innovation – increases in break-through
product development to solve problems and meet the needs of the wider customer base. 53%
of businesses they spoke to said that a new product or service has evolved because of their
overseas trade.

7- Growth

The holy grail for any business, and something that has been lacking for a long time in our
manufacturing industries – more overseas trade = increased growth opportunities, to benefit
both your business and our economy as a whole.
International trade law

International trade law includes the appropriate rules and customs for handling trade between
countries. However, it is also used in legal writings as trade between private sectors, which is
not right. This branch of law is now an independent field of study as most governments have
become part of the world trade, as members of the World Trade Organization (WTO). Since
the transaction between private sectors of different countries is an important part of the WTO
activities, this latter branch of law is now a very important part of the academic works and is
under study in many universities across the world.

World Trade Organization

In 1995, the World Trade Organization, a formal international organization to regulate trade,
was established. It is the most important development in the history of international trade law.

The purposes and structure of the organization is governed by the Agreement Establishing
The World Trade Organization, also known as the "Marrakesh Agreement". It does not
specify the actual rules that govern international trade in specific areas. These are found in
separate treaties, annexed to the Marrakesh Agreement.

Scope of WTO:

(a) provide framework for administration and implementation of agreements; (b) forum for
further negotiations; (c) trade policy review mechanism; and (d) promote greater coherence
among members economics policies

Principles of the WTO:

(a) principle of non-discrimination (most-favoured-nation treatment obligation and the

national treatment obligation) (b) market access (reduction of tariff and non-tariff barriers to
trade) (c) balancing trade liberalisation and other societal interests (d) harmonisation of
national regulation (TRIPS agreement, TBT agreement, SPS agreement)

Trade in goods

The General Agreement on Tariffs and Trade (GATT) has been the backbone of international
trade law since 1948 after the charter for international trade had been agreed upon in Havana.
It contains rules relating to "unfair" trading practices — dumping and subsidies. Many things
impacted GATT like the Uruguay Round and the North American Free Trade Agreement.
In 1994 the World Trade Organization (WTO) was established to take the place of the GATT.
This is because the GATT was meant to be a temporary fix to trade issues, and the founders
hoped for something more concrete. It took many years for this to come about however,
because of the lack of money. The British Economy was in crisis and there was not much
backing from congress to pass the new agreement.

The idea of these agreements WTO and GATT was to create an equal field for all countries in
trade. This way all countries got something of equal value out of the trade. This was a
difficult thing to do since every country has a different economy size.