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What’s it: The external sector refers to economic actors located outside the country. They include foreign households, foreign businesses, and foreign governments. They interact with the domestic economy through international trade. They buy domestically produced goods and services and also sell goods and services to the domestic economy. In addition, interactions with them also involve the flow of capital through direct and portfolio investments. Also known as the foreign sector.
When a country interacts with foreign countries, we call it adopting an open economy (as opposed to a closed economy). Trade and capital flows have a major impact on the country’s economy and affect economic indicators such as economic growth, exchange rates, and interest rates.
External sector’s impact on domestic economies
The world’s economies are no longer isolated entities. A crucial factor shaping a nation’s economic well-being is its external sector – the interaction with foreign businesses, households, and governments. This interaction takes place primarily through international trade in goods and services, and the flow of capital for investment purposes. Let’s explore how these external forces influence domestic economies.
Trade in goods and services
Not all goods and services we need are available and produced by domestic companies. Thus, buying from abroad is an alternative to meet our needs.
In addition, some foreign goods may also be cheaper and of higher quality. Interacting with the external sector through trade allows us to satisfy our needs and promote well-being. We get what we need, and we also get cheaper and better quality.
Likewise, domestic companies can also increase their profits by selling their products abroad. Due to their large size, overseas markets offer high growth opportunities. Companies can do this by exporting their products or investing directly, for example, by acquiring companies overseas.
Capital Access
The external sector also plays a role in capital access. Domestic companies or governments can access capital abroad, for example, by issuing global bonds. Many companies in developing countries do so. They issue debt securities abroad with denominations outside their currency, such as dollars. This is cheaper than issuing bonds domestically because of the ample demand, allowing them to obtain a lower cost of funds.
On the other hand, foreign companies may invest directly in a country by building factories or acquiring existing businesses. For example, many multinational companies invest in developing countries to take advantage of close access to raw materials and cheap labor. This foreign direct investment brings capital, technology, and expertise, creating jobs and boosting domestic production.
International investors seeking higher returns can invest in a country’s stocks and bonds. Financial markets also play a part. Capital flows can also involve portfolio investment. Investors seek higher returns by buying financial instruments such as stocks or bonds. For the destination country, the investment increases demand, pushing the price up.
Trade balance
Foreign trade involves exports and imports. Both affect economic growth because they are gross domestic product (GDP) components. Exports contribute positively to GDP. Meanwhile, imports contribute the opposite (a negative sign when calculating GDP). Meanwhile, we call the balance of trade or net exports the difference between the two.
Foreign trade involves the exchange of goods and currencies. For example, when we import goods abroad, we must exchange the domestic currency for dollars to buy them. But, on the other hand, we get dollars as payment when we export. For this reason, trade also affects the exchange rate of the domestic currency.
Factor affecting the trade balance
Several factors affect foreign trade, including:
- Product competitiveness
- Exchange rate
- Economic growth
Product competitiveness is related to product quality and price. When foreign products are of better or cheaper quality than domestic products, it increases the demand for imports.
Product prices are not only affected by production costs but also artificially influenced by exchange rates. For example, domestic currency depreciation makes domestic products cheaper for foreigners. On the other hand, foreign goods become more expensive. As a result, exports will increase, and imports decrease, ceteris paribus.
Economic growth also affects exports and imports. For example, strong global economic growth boosted demand for domestic goods and services, boosting exports. Meanwhile, suppose the domestic economy grows strongly. Then, it may increase imports because domestic households have more money to spend on foreign products.
When imports exceed exports, the domestic economy runs a trade deficit. Assume your currency is non-dollar. In the foreign exchange market, deficits lead to depreciation. This is because the domestic economy needs more dollars than it generates from exports. The depreciation will continue until domestic goods and services are cheap enough for foreigners to buy more.
Meanwhile, the domestic economy experiences a trade surplus when exports are higher than imports. The trade surplus reflects that the domestic economy earns more dollars than it needs to pay for imports. As a result, the domestic currency appreciates.
Appreciation increases the price of domestic goods. This will continue until domestic goods are expensive enough for foreigners to make them reluctant to buy.
Foreign investment
Foreign investment can be direct or portfolio. Direct investment involves control over asset management. It usually involves building a productive asset, such as a manufacturing facility. Investors can also take an inorganic strategy by acquiring foreign companies in the destination country.
Meanwhile, investors buy financial instruments such as stocks and debt securities in the destination country under portfolio investment, usually for short-term purposes, to make an immediate profit.
Unlike acquisitions, buying shares under a portfolio investment does not make the investor a controlling shareholder. They usually hold less than 10% of the common stock with voting rights in the target company. On the other hand, if they acquire controlling shares, it is categorized as direct investment.
Like foreign trade, foreign investment also affects the exchange rate. An increase in foreign investment inflows into the domestic economy will increase the demand for the domestic currency, causing an appreciation. On the other hand, the outflow of foreign investment will result in depreciation.
The Balance of payments
Every country tracks its economic interactions with the rest of the world. This record, known as the balance of payments, tracks all financial transactions between residents of a country and foreign entities. The balance of payments is divided into two main accounts: the current account and the capital account.
The current account: a snapshot of trade and income
The current account reflects a country’s net flow of goods, services, and income. The most significant component is the trade balance, which is the difference between the value of a country’s exports and imports. In addition to trade, the current account also includes net investment income, which refers to a country’s earnings from foreign investments minus payments made to foreign investors. Another component is net unilateral transfers, which encompass one-way transfers of money without expecting anything in return, such as foreign aid or remittances sent home by migrant workers.
The capital account: tracking capital flows
The capital account focuses on how capital moves between a country and the external sector. This includes foreign direct investment, where foreign companies invest directly in a country’s businesses. Portfolio investment, where foreign investors buy a country’s stocks and bonds, is also recorded here. The capital account encompasses other financial instruments and even transactions involving non-produced, non-financial assets such as intellectual property licenses.
Foreign exchange rates
International trade and investment wouldn’t be possible without foreign exchange rates. These rates act as a translator, determining how much of one currency you need to exchange for another.
Imagine a US company wanting to buy machinery from a German manufacturer. The US company pays in dollars, but the German manufacturer needs euros. The foreign exchange rate dictates how many dollars the US company needs to exchange to get the equivalent amount in euros to pay for the machinery. These exchange rates constantly fluctuate based on supply and demand for each currency.
Factors like a country’s economic performance, interest rates, and political stability all influence its exchange rate. A strong economy with high interest rates typically leads to a stronger currency, meaning it takes more of another currency to buy it.
Conversely, a weaker economy might see its currency depreciate, requiring less of another currency to acquire it. These fluctuations in exchange rates can impact both international trade and investment. A weaker domestic currency can make a country’s exports cheaper and more attractive to foreign buyers, boosting exports. On the other hand, a stronger currency can make imports more expensive, potentially discouraging them.
Risks and benefits of external integration
A deeper integration with the external sector, fueled by globalization, presents a double-edged sword for domestic economies. Increased trade and capital flows offer significant benefits, but they also expose a country to external vulnerabilities, such as the contagion effect.
The domestic economy is increasingly connected to the external sector through trade and capital flows, intensified with globalization. As a result, it affects several variables, such as trade balance, exchange rates, interest rates, and asset prices.
Capitalizing on a globalized world
While there are risks, a strong global economy can bring substantial advantages. Increased global demand creates a larger marketplace for domestic companies. This allows them to export more goods and services, leading to higher profits and economic growth.
Imagine a company in a small country that produces high-quality bicycles. Without globalization, their customer base would be limited to their domestic market. However, in a globalized world, they can now export their bicycles to a wider audience, potentially reaching new markets and achieving significant growth.
Furthermore, a strong global economy can attract foreign investment. This foreign capital can come in various forms, such as direct investment, where foreign companies build factories in a country, or portfolio investment, where foreign investors buy a country’s stocks and bonds. This influx of foreign capital offers several benefits.
First, it provides a crucial source of funding for domestic companies and governments, allowing them to invest in infrastructure, research, and development. Second, foreign companies often bring with them advanced technology and expertise, which can boost domestic productivity and innovation. Finally, foreign investment can create new jobs in the domestic economy, further contributing to growth.
The contagion effect
Increasing interdependence with the external sector also increases the contagion effect. External economic shocks can quickly spread to other countries through interconnected trade and financial markets. For example, an economic recession in a country, such as the recession in the United States in 2008-2009, can quickly spill over to the domestic economy. Eventually, it could weaken the domestic economy and, worse, could lead to a recession.
Another example was the Asian financial crisis in 1997. The crisis began in Thailand with the collapse of the baht exchange rate and spread to other countries such as Indonesia, Malaysia, and Singapore. While Malaysia and Singapore are relatively resistant to these shocks, Indonesia is not. As a result, not only was the rupiah exchange rate affected, but the crisis also dragged Indonesia into an economic crisis.
Policy considerations
While the benefits of external integration are undeniable, governments also face challenges in managing their potential risks. To navigate this complex landscape, policymakers have a range of tools at their disposal:
- Trade policy: Governments can use trade policies like tariffs and quotas to regulate international trade. Tariffs are taxes imposed on imported goods, making them more expensive for domestic consumers and potentially encouraging them to buy domestically produced goods. Quotas limit the quantity of specific goods that can be imported, protecting domestic industries from foreign competition. However, these policies can also raise consumer prices and potentially ignite trade wars with other countries.
- Foreign investment policies: Governments can establish regulations to attract or restrict foreign investment. Offering tax breaks or streamlined approval processes can incentivize foreign companies to invest in a country. Conversely, restrictions might be placed on certain sectors deemed strategically important or to protect infant industries.
- Monetary policy: Central banks can utilize monetary policy tools like interest rates to influence the exchange rate. Higher interest rates tend to strengthen a country’s currency, making exports more expensive and imports cheaper. This can discourage exports but make imports more attractive for domestic consumers. Conversely, lower interest rates can weaken the currency, making exports cheaper and imports more expensive, potentially boosting exports but increasing import costs.
