International Trade and International Finance Malabika Roy • Saikat Sinha Roy Editors

International Trade and International Finance Explorations of Contemporary Issues

123 Editors Malabika Roy Saikat Sinha Roy Department of Economics Department of Economics Jadavpur University Jadavpur University Jadavpur, Kolkata, West Bengal Jadavpur, Kolkata, West Bengal India India

ISBN 978-81-322-2795-3 ISBN 978-81-322-2797-7 (eBook) DOI 10.1007/978-81-322-2797-7

Library of Congress Control Number: 2016937967

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This Springer imprint is published by Springer Nature The registered company is Springer (India) Pvt. Ltd. Foreword

The present volume is a collection of articles on various aspects of international trade and international finance, written by a selected group of researchers who have specialized in the respective fields. The planning of this volume was mooted at the meeting of advisory committee of the Centre for Advanced Studies (CAS) of the Department of Economics, Jadavpur University. Since CAS has sponsored a variety of workshops and seminars and hosted visiting fellows, the external experts of the CAS, Profs. Dilip Nachane (former Director, Indira Gandhi Institute of Development Research, Mumbai) and Ramprasad Sengupta (formerly of Jawaharlal Nehru University, New Delhi) suggested that we collate important papers in two volumes to be contributed by the visitors as well as Jadavpur’s own faculty. The reason for planning two volumes is to accommodate the five thrust areas we have in the CAS, namely International Trade, Finance, Resource and Environment, West Bengal Economy and Public Policy related to social sector. The idea is to produce a monograph which will help the readers with some survey papers along with some state-of-the-art research in relevant fields. The present volume International Trade and International Finance: Explorations of Contemporary Issues edited by my two junior colleagues, Malabika Roy and Saikat Sinha Roy, who are themselves spe- cialists in the subject matters included in the book, has a very well-thought col- lection of topics covered under the purview of the book. The papers selected will be of great help for the teachers and researchers in the subject on the one hand and on the other, it would certainly be a handy reference for policy planners and practi- tioners. I must thank the efforts of the editors who spared their valuable time to make the volume useful and interesting. I have faith that the purpose of publishing this volume will be totally fulfilled and we will be having increasing returns to knowledge after reading the volume.

Ajitava Raychaudhuri Professor and Coordinator, Centre for Advanced Studies Department of Economics, Jadavpur University, Kolkata, India

v Contents

Part I Recent Developments in Trade Theory and Empirics The “New-New” Trade Theory: A Review of the Literature ...... 3 Priya Ranjan and Jibonayan Raychaudhuri Time Zones and FDI with Heterogeneous Firms...... 23 Toru Kikuchi, Sugata Marjit and Biswajit Mandal MNEs and Export Spillovers: A Firm-Level Analysis of Indian Manufacturing Industries ...... 33 Maitri Ghosh IPR Regulatory Policy, Commercial Piracy, and Entry Modes of MNC: A Theoretical Analysis ...... 49 Nilanjana Biswas Mitra and Tanmoyee Banerjee Chatterjee

Part II International Trade and Institutions International Trade and the Size of the Government ...... 77 Rajat Acharyya The Effects of Corruption on Trade Flows: A Disaggregated Analysis ...... 97 Subhayu Bandyopadhyay and Suryadipta Roy Enlargement Decisions of Regional Trading Blocs ...... 117 Sunandan Ghosh Deal Breaker or the Protector of Interests of Developing Countries? India’s Negotiating Stance in WTO ...... 159 Parthapratim Pal Is WTO Governed Trade Regime Sufficient for Export Growth? ..... 179 Saikat Sinha Roy and Pradyut Kumar Pyne

vii viii Contents

Part III Issues in Trade, Trade Policy and Development Export Performance in Textile and Garments with China as a Competitor: An Analysis of India’s Situation from the Perspective of Structure-Conduct-Performance Paradigm...... 201 Sarmila Banerjee, Sudeshna Chattopadhyay and Kausik Lahiri Impact of Trade Liberalization on Indian Textile Firms: A Panel Analysis...... 229 Subhadip Mukherjee and Rupa Chanda Trade, Infrastructure and Income Inequality in Selected Asian Countries: An Empirical Analysis ...... 257 Ajitava Raychaudhuri and Prabir De A Theoretical Model of Trade, Quality of Health Services and Signalling...... 279 Kausik Gupta and Tonmoy Chatterjee Smuggling and Trafficking of Workers: A Brief Review and Analysis of the Economics of Illegal Migration ...... 295 Saibal Kar Impact of Trade Restriction on Child Labour Supply and the Role of Parents’ Utility Function: A Two Sector General Equilibrium Analysis ...... 315 Biswajit Chatterjee and Runa Ray

Part IV Issues Related to Foreign Investment Flows The Determinants of Foreign Direct Investment: An Analytical Survey ...... 333 Chaitali Sinha and Kunal Sen Foreign Direct Investment, Capital Formation, and Growth ...... 363 Prabirjit Sarkar Foreign Direct Investment and Macroeconomic Indicators in India: A Causality Analysis...... 373 Basabi Bhattacharya and Jaydeep Mukherjee

Part V Issues Relating to Globalization, Financial Markets and Financial Instruments Exploratory Study of Select Commodity and Equity Indices Around the Meltdown of 2008...... 387 Diganta Mukherjee and Arnab Mallick Contents ix

An Empirical Investigation of Volatility Clustering, Volatility Spillover and Persistence from USA to Two Emerging Economies India and China ...... 405 Ayanangshu Sarkar and Malabika Roy Imbalances, Local and Global, and Policy Challenges in the Post-Crisis World ...... 429 Soumyen Sikdar Testing Non-linearity in Emerging and Developed Markets...... 437 Kousik Guhathakurta, Basabi Bhattacharya and A. Roy Chowdhury

Part VI Issues Related to Foreign Exchange Market Foreign Exchange Markets, Intervention, and Exchange Rate Regimes ...... 469 Ashima Goyal Global Foreign Exchange Market: A Crisis Analysis ...... 493 Gagari Chakrabarti The Impossible Trinity: Where Does India Stand? ...... 511 Rajeswari Sengupta

Part VII Issues Related to Financial Institutions Guaranty Funds and Moral Hazard in the Insurance Industry: A Theoretical Perspective ...... 527 C. William Sealey, John M. Gandar and Sumon C. Mazumdar Performance of Aggregate Portfolios of Equity Mutual Funds: Skill or Luck? ...... 547 Rama Seth and Kamran Quddus Foreign Bank Presence and Financial Development in Emerging Market and Developing Economies: An Empirical Investigation ...... 565 Sasidaran Gopalan Banks, Financial Derivatives, and Crises: A Fourth-Generation Model ...... 585 Romar Correa Introduction

International trade and international finance have always been important areas of research in economics. With globalization, the nature, importance, and scope of the subjects have changed and the horizon has expanded manifold. Instead of treating international trade and international finance as two disjoint areas of study, the present volume brings together a collection of essays from both the fields, some- times overlapping across the two areas. The volume, while focusing on the recent developments and frontiers of research in international trade and international finance, also emphasizes the inherent integrated nature of the two subjects. Theory and empirics in international trade is founded on microeconomic prin- ciples highlighting the gains from trade through specialization and exchange as a country moves from autarky to free trade. The traditional theoretical notion of comparative advantage evolved to include nuances of imperfect competition and product differentiation. This has again recently given way to “New-New Trade Theory”, which centres on the concept of heterogeneity of firms. This latest development in trade theory is an important direction of trade research especially during globalization. With globalization, new sectors have emerged important and the modes of trade considerably vary from that in the past. Further, new institutions, both global and domestic, have emerged and have significant implications for trade. In this volume, the theoretical and empirical papers included deal with recent advances in the subject, emergence of new sectors and institutions in shaping up trade during globalization. International finance primarily developed from macroeconomics to address the same issues about equilibrium level of income, growth of output and employment and effects of monetary and fiscal policies—but in an international context, when more than one economy are interacting with each other in the sphere of trade and finance involving more than one currencies. It is not surprising that traditionally, the issues addressed in international finance were balance of payments and related policies, foreign exchange market and foreign exchange management, global capital markets and cross-border flow of funds, international financial systems and their management. However, globalization brought about not only an integration of financial markets but also an integration of financial institutions. So in the present

xi xii Introduction volume we have included essays that address issues related to international financial institutions along with essays dealing with traditional issues on foreign exchange markets and international financial markets. The present volume contains 28 essays divided into seven thematic parts. Rather than dividing the parts in line of international trade and international finance, we have divided the parts according to thematic uniformity thus establishing a close link between international trade and international finance. However, the chapters included in Parts I–V focus more on issues related to international trade, whereas chapters included in Parts V–VII lean more towards issues related to international finance. Part I covers works on recent developments in international trade theory and empirics. Chapter “The “New-New” Trade Theory: A Review of the Literature” by Priya Ranjan and Jibonayan Raychaudhuri is an account of the developments and progress in “New-new” trade theory models and empirical research centred on the seminal work of Melitz (2003). This chapter also discusses the policy implications and welfare implications of trade liberalization in this context. In Chapter “Time Zones and FDI with Heterogeneous Firms”, Toru Kikuchi, Sugata Marjit and Biswajit Mandal develop a model on the role of FDI in the context of heteroge- neous firms situated in different time zones. It is shown that firms undertaking FDI have higher productivity than non-FDI firms, and the foreign subsidiaries of high-productivity firms serve the home market. In Chapter “MNEs and Export Spillovers: A Firm-Level Analysis of Indian Manufacturing Industries”,inan empirical analysis, Maitri Ghosh looks into the role of firm heterogeneity in export spillovers in the presence of FDI. It is found that firm heterogeneity, measured in terms of productivity and sunk cost, is critical to explaining export spillovers in the presence of multinationals. In contrast to the other chapters in this part, Chapter “IPR Regulatory Policy, Commercial Piracy and Entry Modes of MNC: A Theoretical Analysis” by Nilanjana Biswas (Mitra) and Tanmoyee Banerjee (Chatterjee), relates IPR regulation regime chosen by LDC government to the mode of entry of the MNC: fragmentation or full technology transfer, in the presence of commercial piracy. It is found that entry in this case depends on the transport cost and monitoring. The second part on international trade and institutions covers issues like trade openness and the size of government, issues related to bilateral, regional and multilateral trade. In Chapter “International Trade and the Size of the Government”, using a theoretical framework Rajat Acharyya shows that under certain conditions pertaining to the non-traded public good, trade liberalization in terms of tariff reduction necessarily increases absolute size of the government. The relative size of the government expands when the value of the price elasticity of the public good is small though not less than unity. Corruption in trading countries at the importer level as well as exporter level plays an important role in bilateral trade. In Chapter “The Effects of Corruption on Trade Flows: A Disaggregated Analysis”, Subhayu Bandopadhyay and Suryadipta Roy investigate the impact of importer level and exporter level corruption on bilateral exports for 27 sectors of 100 countries during 1984–2004. The other chapters in this part deal with regional trading blocs or issues Introduction xiii related to WTO. Using an oligopolistic framework in Chapter “Enlargement Decisions of Regional Trading Blocs”, Sunandan Ghosh shows the possibilities of and nature of equilibrium in the expansion or consolidation of regional trading blocs in the presence of technology and market asymmetries between countries. The conclusions are of importance for emerging market economies, which are a part of an existing regional trading arrangement seeking expansion or consolidation. In Chapter “Deal Breaker or the Protector of Interests of Developing Countries? India’s Negotiating Stance in WTO”, Parthapratim Pal, delineates India’s engage- ments in Doha Round of trade talks in the light of the experience with the WTO regime and changes in global trade including proliferation of RTAs along with rising global commodity prices. The last chapter in this part, an empirical paper by Saikat Sinha Roy and Pradyut Kumar Pyne on “Is WTO Governed Trade Regime Sufficient for Export Growth?”, highlights that a WTO-governed trade regime is not sufficient for export growth across countries. In the third part, which focuses on trade and development, there are theoretical as well as empirical papers. Chapters “Export Performance in Textile and Garments with China as a Competitor: An Analysis of India’s Situation from the Perspective of Structure-Conduct-Performance Paradigm” and “Impact of Trade Liberalization on Indian Textile Firms: A Panel Analysis” both deal with different aspects of trade in India’s textiles sector, a very important sector in terms of output, wide range of technology used, foreign exchange earnings and employment. In Chapter “Export Performance in Textile and Garments with China as a Competitor: An Analysis of India’s Situation from the Perspective of Structure-Conduct-Performance Paradigm”, Sarmila Banerjee, Sudeshna Chattopadhyay and Kausik Lahiri analyse textiles exports from India as compared to that from China, which followed a more aggressive approach in terms product and market diversification. The chapter relates such international price and non-price competitiveness to policies adopted in these countries. On the other hand, in Chapter “Impact of Trade Liberalization on Indian Textile Firms: A Panel Analysis” Subhadip Mukherjee and Rupa Chanda show the impact of trade liberalization on improvements in profitability, sales and import of raw materials. In this chapter, the effect of trade liberalization is found to be stronger through the import sourcing channel. The impact of merchandise trade on income inequality has been significant. In Chapter “Trade, Infrastructure and Income Inequality in Selected Asian Countries: An Empirical Analysis”, Ajitava Raychaudhuri and Prabir De show that trade openness and infrastructure have sig- nificant impact on income inequality across countries in the Asia-Pacific region, and country-specific factors turn out to be important determinants of trade openness and income inequality. The chapter also establishes persistence in trade openness and income inequality across these countries. The other chapters in this part deal with issues related to services trade, labour movements and development. Chapter “A Theoretical Model of Trade, Quality of Health Services and Signalling” by Kausik Gupta and Tonmoy Chatterjee build a theoretical model of services trade, health services in particular, and the role of quality signalling therein with respect to southern countries. The chapter arrives at optimum values of health quality and prices of health quality through a two-stage xiv Introduction dynamic game. In Chapter “Smuggling and Trafficking of Workers: A Brief Review and Analysis of the Economics of Illegal Migration” Saibal Kar surveys the issue of economics of illegal international migration in general and smuggling or trafficking of workers. The chapter discusses a policy to lower exploitation from illegal labour migration. The last two chapters in this part deal with the incidence of child labour in the context of an open developing economy. Chapter “Impact of Trade Restriction on Child Labour Supply and The Role of Parents’ Utility Function: A Two Sector General Equilibrium Analysis” by Biswajit Chatterjee and Runa Ray shows that non-trade policies are effective to deal with the incidence of child labour and trade policies remain ineffective. In Part IV the main focus is on flow of foreign investment, i.e. FDI and FII and the role of multinationals. Chapter “The Determinants of Foreign Direct Investment: An Analytical Survey” by Kunal Sen and Chaitali Sinha surveys the literature on the factors determining the location decision of FDI. It is found that economies of scale, management skill and innovative product technologies are the major determinants of location decision of MNCs along with regulatory policies of the government. The chapter analyses the locational decisions of the southern MNCs as against those in the advanced market economies in the context of changing FDI flows in recent years. Both Chapters “Foreign Direct Investment, Capital Formation and Growth” and “Foreign Direct Investment and Macroeconomic Indicators in India: A Causality Analysis” concentrate on foreign direct investment. In Chapter “Foreign Direct Investment, Capital Formation, and Growth” Prabirjit Sarkar examines the relationship between growth of fixed capital formation and direct foreign investment (as % of GDP) in a panel of 61 countries covering a time period of 1980–2006 using alternative methodologies. In Chapter “Foreign Direct Investment and Macroeconomic Indicators in India: A Causality Analysis”, Jaydip Mukherjee and Basabi Bhattacharya analyse the pattern of movement of external capital flows to Indian economy in terms of foreign direct investment (FDI) and the probable impact of macroeconomic indicators, viz. real GDP growth, call money rate, US dollar exchange rate, inflation, T-bill rate, trade openness and Dow Jones Index value on the financial and overall performance of the economy from the period 1997–1998 to 2013–2014. Part V contains four papers each focusing on different aspects of globalization and functioning of financial markets. In Chapter “Exploratory Study of Select Commodity and Equity Indices Around the Meltdown of 2008” Diganta Mukherjee and Arnab Mallik conduct an exploratory study of commodity market performance in and around 2007–2008, when the world was hit by the meltdown resulting from subprime crisis. Their primary focus is to look into the nature of price movement and volatility some of the key base metals have been showing, mainly on the London Metal Exchange and MCX. They also attempt to establish patterns of movement in some of the popular equity indices and establish which one between the equity commodities fared well during the period of negative market sentiment in the years of subprime crisis. In Chapter “An Empirical Investigation of Volatility Clustering, Volatility Spillover and Persistence From USA to Two Emerging Economies India and China”, Ayanangshu Sarkar and Malabika Roy examine the Introduction xv pattern of volatility in the Indian and Chinese stock market during 2006–2011 in terms of its time-varying nature, presence of certain characteristics such as volatility clustering and whether there exists any ‘spillover effect’ between the domestic and the US stock markets. They also estimate the persistence of shock in terms of half-life in each subperiod of study. In Chapter “Imbalances, Local and Global, and Policy Challenges in the Post Crisis World”, Soumyen Sikdar addresses some interesting questions on correct policy choices in the face of the economic slow- down that India and China have experienced as a result of subprime crisis. Some very pertinent questions are: What are the major policy failures that allowed the catastrophe to happen? What type of reforms will prevent a recurrence? Should China, India and other developing economies of Asia and Africa make systematic efforts to ‘decouple’ from the developed countries and work towards greater inte- gration among them? If yes, then how? The chapter attempts to suggest answers to these questions, after examining the impact on the Indian economy and the role of the Indian policymakers during the time of trouble. Future prospects of India and China, the two Asian giants, receive particular attention. In Chapter “Testing Non- linearity in Emerging and Developed Markets” Basabi Bhattacharya and Koushik Guhathakurata explore the possibility of non-linearity in selected stock markets of the world. In Part VI we have included three papers all dealing with foreign exchange market, which is a major area of study in international finance. Chapter “Foreign Exchange Markets, Intervention and Exchange Rate Regimes” is a survey of structure of foreign exchange market. In this chapter Ashima Goyal describes the institutional features of FX markets, with special emphasis on the process of lib- eralization and deepening in Indian FX markets, in the context of integration of currency markets with financial markets and of large international capital flows. Chapter “Global Foreign Exchange Market: A Crisis Analysis” is an exploration of the global foreign exchange market dynamics around the significant financial meltdowns in the past. In this chapter Gagari Chakraborty studies the factors influencing the forex market movements over the last 20 years. She further enquires whether and how the sensitivity of forex market changes, following the changes in the chosen real and financial variables in times of such crises. Finally, in Chapter “The Impossible Trinity: Where Does India stand?”, Rajeswari Sengupta addresses the dilemma of “impossible trinity”. This chapter again is basically a survey chapter. In this chapter, she presents a comprehensive overview of a few empirical studies that have explored the issue of trilemma in the Indian context. Based on these studies she analyses how Indian policymakers have dealt with the various trade-offs while managing the trilemma over the last two decades and also draw relevant policy conclusions. Part VII brings together four studies on financial institutions. In Chapter “Guaranty Funds and Moral Hazard in The Insurance Industry: A Theoretical Perspective”, J.M. Gandar, Sumon Mazumdar and C.W. Sealey develop a model of the guaranty fund insurance company relationship under moral hazard, and examine the nature of adverse incentives in this setting. They also devise workable mechanisms that alleviate the moral hazard problem. Rama Seth and Kamran xvi Introduction

Quddus, in Chapter “Performance of Aggregate Portfolios of Equity Mutual Funds: Skill or Luck?” present some descriptive statistics on mutual funds contrasting the two countries: USA and India. Then they evaluate the performance of mutual funds in an emerging market such as India, borrowing a methodology extensively used in asset pricing literature. Next using bootstrap simulations, they analyse the persis- tence of fund returns, distinguishing skill from luck. The next two chapters both deal with different aspects of international banking. Chapter “Foreign Bank Presence and Financial Development in Emerging Market and Developing Economies: An Empirical Investigation” by Sasidaran G. sets out to explore the empirical determinants of foreign bank entry in emerging and developing econo- mies (EMDEs). Using panel data for over 100 EMDEs, this chapter contributes to the literature by throwing light on understanding the motives of foreign bank entry to EMDEs which remains a relatively under-researched topic in the literature. In Chapter “Banks, Financial Derivatives, and Crises: A Fourth-Generation Model”, taking off from the third generation open economy model of financial crisis, Romar Correa examines the investment plans of domestic entrepreneurs supported by banks. He models outcomes consequent on changes in capital movements and the possibility of multiple equilibria. A unique feature of the proposed volume is that it unravels some new issues in addition to re-examining certain old issues in a new perspective and it covers wide ranging issues with an emphasis on policy. The book covers issues mostly related to emerging market economies, which has increasingly assumed importance in the context of globalization. The book contains some survey papers covering the frontiers of current knowledge on important themes like recent developments in trade theory and empirics, foreign exchange market, interrelation and interaction between international trade and international finance. The book, thus, will be of immense use for advanced undergraduate and graduate teaching as well as for research. We expect the book to substantially contribute to the growing literature on issues related to trade and international finance in emerging market economies and extend the frontiers of knowledge. The editors are grateful to the Centre for Advanced Studies, Department of Economics, Jadavpur University, Kolkata, and in particular to Ajitava Raychaudhuri and Basabi Bhattacharyy for entrusting them with the job. The editors are extremely grateful to the authors as well as the reviewers of the papers for their carrying out their respective duty with responsi- bility. The volume would not have seen the light of the day without the extreme cooperation of the editorial team of Sringer India.