External Sector: Its Effect on the Economy

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.

How does the domestic economy relate to the external sector?

The external sector is vital because they affect the domestic economy in several ways. Let’s take an example.

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. As a result, 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. Overseas markets offer high growth opportunities due to their large size. They can do this by exporting their products or investing directly, for example, by acquiring companies overseas.

Capital access. Domestic companies or governments can access capital abroad, for example, by issuing global bonds. For example, many companies in developing countries do so. They issue debt securities abroad with denominations outside their currency, for example, dollars. And it’s cheaper than issuing bonds domestically because of the ample demand, allowing them to get a lower cost of funds.

Alternatively, many multinational companies invest in developing countries to take advantage of close access to raw materials and cheap labor. And, for the destination country, the investment creates more output and jobs.

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.

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.

Increasing interdependence with the external sector also increases the contagion effect. It can be risky, but it can also be profitable. For example, when the global economy grows, it increases the demand for domestic products, boosting exports and domestic economic growth.

The opposite condition also applies. 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 it 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 the rupiah exchange rate was affected, but the crisis also dragged Indonesia into an economic crisis.

Balance of trade

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 not only the exchange of goods but also of currencies. For example, when we import goods abroad, we must exchange the domestic currency for dollars to buy. 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.

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.

In the case of product prices, it is not only affected by production costs but also artificially influenced by exchange rates. For example, the domestic currency depreciation makes domestic products cheaper for foreigners. On the other hand, foreign goods become more expensive. As a result, it will increase exports and decrease imports, 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 makes the price of domestic goods more expensive. And it will continue until domestic goods are expensive enough for foreigners to make them reluctant to buy.

Foreign investment

Foreign investment can be a direct investment or portfolio investment. Direct investment involves control over asset management. That usually involves building a productive asset such as a manufacturing facility. Or investors 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. They are trying 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.

How are transactions with the external sector recorded?

The balance of payments summarizes the transactions of the domestic economy with the external sector. The two components are the current account and the capital account. Sometimes, the capital account is split into capital and financial accounts.

The trade balance usually covers the majority of current accounts. The other components are net investment income and net unilateral transfers.

Meanwhile, capital accounts include direct investments, portfolio investments, financial derivatives, and other investments. In addition, it also records net transactions of non-produced non-financial assets such as contracts and licenses.

External Sector: Its Effect on the Economy