Import Substitution and Export Promotion | Economics

In this article we will discuss about import substitution and export promotion.

Most economists and policymakers view LDCs as consisting of large “traditional” and “modern” sectors. Hence development has come to be seen as a process of contracting the traditional sector and its growth-retarding institutions in favour of a growing modern industrial sector.

Less developed countries (LDCs) have adopted two alternative strategies for achieving industrialisation— viz., inward-looking strategy and outward-looking strategy.

An inward-looking strategy is an attempt to withdraw, at least in the short run, from full participation in the world economy. This strategy emphasises import substitution, i.e., the production of goods at home that would otherwise be imported.

This can economise on scarce foreign exchange and ultimately generate new manufactured exports without difficulties associated with the exports of primary products if economies of scale are important in import substituting industries and if the infant industry argument applies. The strategy uses tariffs, import-quotas and subsidies to promote and protect import-substitute industries.

In contrast, an outward-looking strategy emphasises participation in international trade by encouraging the allocation of resources in export-oriented industries without price distortions. It does not use policy measures to shift production arbitrarily between serving the home market and foreign markets.

In other words, it is an application of production according to comparative advantage; the current expression is that, the LDCs should ‘get prices right’. This strategy focuses on export-promotion, whereby policy measure such as export subsidies, encouragement of skill formation in the labour force and the use of more advanced technology, and tax concessions generate more exports, particularly labour intensive manufactured exports in accordance with the principle of comparative advantage.

Now these two strategies may be compared and evaluated:

Import Substitution Strategy:

For various reasons, many LDCs have ignored primary-exports-led growth strategies in favour of import substitution (IS) development strategies. These policies seek to promote rapid industrialisation and, therefore, development by erecting high barriers to foreign goods in order to encourage domestic production. A package of policies, called import substitution (IS), consists of a broad range of control, restriction and prohibitions such as import quotas and high tariffs on imports.

The trade restrictions are intended to “protect” domestic industries so that they can gain comparative advantage and substitute domestic goods for formerly imported goods. IS policies are largely based on the belief that economic growth can be accelerated by actively directing economic activity away from traditional agriculture and resource-based sectors of the economy towards manufacturing.

The broad range of tariffs, quotas and outright prohibitions on imports that are part of IS policies are clearly not a form of infant industry protection. The infant-industry argument states that sectors and industries that can reasonably be expected to gain comparative advantage, after some learning period, should be protected.

But the broad protection under IS policies usually protect all industries indiscriminately, whether they generate technological externalities or have any chance of achieving competitive efficiency.

IS policies were advocated due to a very sharp decline in the prices of commodities and raw materials exported by many LDCs. Prebisch and Singer convincingly argued that low-income elasticity of demand for primary products implied that, in the long run, the terms of trade of primary product exporters would deteriorate.

In short, the IS approach to development applies the strategic argument for protection to one or more targeted industries in the LDCs. That is, the government determines those sectors best suited for local industrialisation, erects barriers to trade on the products produced in these sectors in order to encourage local investment and then lowers the barriers over time as the industrialisation process gains momentum.

If the government has targeted the correct sectors, the industries will continue to thrive even as protection comes down. In practice, however, the trade barriers are rarely removed. In the end, countries that follow IS strategies tend to be characterised by high barriers to trade that grow over time.

Development through Import Substitution Versus Exports:

During the 1950s, 1960s and 1970s, most developing nations made a deliberate attempt to industrialise rather than continuing to specialise in the production of primary commodities (food, raw materials, and minerals) for export as prescribed by the traditional trade theory.

Having decided to industrialise, the developing nations had to choose between industrialisation through import substitution and export-oriented industrialisation. Both policies have advantages and disadvantages.

An import substitution industrialisation (ISI) strategy has three main advantages:

1 The market for industrial product already exists, as evidenced by imports of the commodity. So risks are reduced in setting up an industry to replace imports.

2. It is easier for LDCs to protect their domestic market against foreign competition than to force developed nations to lower trade barriers against their manufactured exports.

3. Foreign firms are induced to establish so-called tariff factories to overcome the tariff walls of LDCs.

Against these advantages are the following disadvantages:

1. Domestic industries can grow by being accustomed to protection from foreign competition and have no incentive to become more efficient.

2. Import substitution can lead to inefficient industries because the narrow size of the domestic market in many LDCs does not allow them to take advantage of economies of scale.

3. After the simpler manufactured imports are replaced by domestic production, IS becomes more and more difficult and costly (in terms of higher protection and inefficiency) as more capital-intensive and technologically advanced imports have to .be replaced by domestic production.

4. IS policies tend to limit the development of industries that supply inputs to protected industries, which produce consumer goods. The concept of the effective rate of protection suggests that tariffs tend to escalate by stages of processing.

5. The countries that pursue IS strategies tend not to apply high tariffs to capital goods. As such, imported capital goods are used extensively in domestic production. Supported by other domestic policies (e.g., minimum wage laws that tend to raise labour costs) domestic firms utilise relatively capital-intensive production techniques. This means that employment in a newly industrialising sector does not grow at the desired rate.

6. Finally, because the whole development strategy depends upon the choices made by government officials, considerable resources are devoted to rent-seeking activities. In any event, the resources used in these activities could have been devoted to productive enterprises and hence represent additional economic waste over and above the usual deadweight loss of protection.

Evidence:

In the post-Second World War (1939-45) period, many LDCs, after achieving independence, tried to reduce their reliance on imports, focused on IS policies, and a few, like Brazil, had a short period of success following that strategy. But, by and large, the countries following these strategies stagnated or grew very slowly.

Protectionist barriers were erected mainly to help support domestic industries but also to help some firms which enjoy high profits by being insulated from outside competition. In some cases, the inefficiencies were so great that the value of the imported inputs was higher than the volume of output at international prices.

Protection had been granted at times by using the infant-industry argument — the argument that new industries had to be protected until they could establish themselves properly to meet the competition. But in many of the developing countries, the infants never seemed to grow up—protection became permanent.

The idea behind IS policies was that, developing economies would grow faster if they forced their economies to expand their industrial sectors and that faster growth was well worth the short- run cost of lost international trade. But import substitution policies are now seen as having failed to bring rapid economic growth to developing countries.

The economies that abandoned import substitution earliest—such as Korea, and Taiwan—became the most rapidly growing, and now nearly developed, economies. Those that held on to import-substitution policies the longest, such as economies in Africa and South Asia, have been the slowest growing economies of the world.

A common characteristic of industries in IS economies was that, they often failed to adopt new technologies even when they were available. This was due to an inherent contradiction in IS policies. Import-substitution policies are intended to promote the establishment of industries with higher rates of technology growth by offering protection as an incentive, but that very same protection reduces the competition which serves as an incentive for firms to innovate, invest and apply new technologies. Under protection, there is an incentive for an initial innovation, but once a new industry is established in the protected environment, there is little need to engage in creative destruction.

Slow Technological Progress under IS Policies:

The proximate reason for the failure of import-substitution policies is the gradual slowdown of technological progress. The likely cause of this slowdown can be found in the Schumpeterian model of endogenous technological progress.

For the process of creative destruction to work, there must be destruction as well as creation. If an initial creation is not followed by a second creation, which implies the destruction of the first creation’s advantage, then economic growth stops.

In India, Pakistan and many African countries, government planners and anti-market bureaucrats encouraged or even mandated collusion among protected industries. Thus, the initial closing of the market to foreign imports provided a onetime spurt of innovation as new firms were established to take advantage of the profit offered by the protected market.

But then the lack of foreign competition made further innovation less interesting and obstruction of others more lucrative. Hence, eventually, the rate of technological innovation slowed, and so did economic growth.

Seen in this light, import substitution is at best a temporary measure for increasing economic growth. But if there are only short-run gains in growth and those gains come at the cost of short-run static losses from protection, the attractiveness of import substitution is greatly diminished. Recall that import substitution proponents claimed that IS policies would lead to higher long-run growth. The widespread abandonment of import-substitution policies in recent decades should, therefore, not be surprising.

Outward-Looking Development Policies:

As opposed to import substitution (IS) policies, some LDCs have adopted outward-looking development strategies. These policies involve government targeting of sectors in which the country has potential comparative advantage. Thus, if a country is well endowed with low- skilled labour, the government would encourage the development of labour-intensive industries in the hope of promoting exports of these products.

This type of strategy includes government policies such as keeping relatively open markets so that, internal prices reflect world prices maintaining an undervalued exchange rate so that export prices remain competitive in world markets, and imposing only minimum government interference on factor markets so that wages and rent reflect true scarcity. In addition, successful exporters often enjoy external benefits in the form of special preference for the use of port facilities, communication networks, and lower loan and tax rates.

A trade-cum-growth strategy focusing on exports is called export-led growth. Under this strategy, firms get the encouragement to export in a variety of ways, such as being given increased access to credit often at a subsidized rate.

Favourable Arguments:

1. With export-led growth, firms produce according to their long-term comparative advantage. This is not current (static) comparative advantage, based on existing resources and knowledge. It is dynamic comparative advantage, based on acquired skills and technology, and recognition of the importance of learning-by-doing of the improvement in skills and productivity that comes from repetitive performance and production experience. With exports, the demand for the goods produced by an LDC is not limited by the narrow size of the domestic market. The market is the entire world.

2. The advocates of export-led growth also believe that the competitive pressure generated by the export market is an important stimulus to efficiency and modernisation. The only way a firm can succeed in the face of intense international competition is to produce what consumers want, at the quality they want, and at the lowest possible costs.

The growing intensity of competition from the rest of the world (ROW) forces specialisation in areas where low-wage LDCs have a comparative advantage, such as in the production of labour-intensive commodities. It also forces the firms to explore the best ways of producing. International firms often play a positive role in helping enhance efficiency. This also encourages multinational corporations (MNCs) to take advantage of low wages of LDCs, keep costs low and export huge quantities of standardised products like textiles and shoes.

3. Export-oriented industrialisation overcomes the smallness of the domestic market and allows an LDC to take advantage of economies of scale. The expansion of manufactured exports is not limited (as in the case of IS) by the growth of domestic market. This is particularly important for many developing countries that are both very poor and small.

4. Production of manufactured goods for export requires and stimulates efficiency throughout the economy. This is especially important when the output of an industry is used as an input of another domestic industry.

5. Finally, export-led growth strategy facilitates the transfer of advanced technology. Producers exporting to developed countries not only come into contact with the efficient producers within these countries but also learn to adopt their standards and production techniques. They come to realise quickly why timeliness and quantity in production are of strategic importance for achieving success in a global market.

Disadvantages:

On the other hand, there are two serious disadvantages of export-led growth strategy:

1. It may be very difficult for LDCs to set up export industries because of the competition from the more established and efficient industries in developed nations.

2. Developed nations often provide a high level of effective protection for their industries producing simple labour-intensive commodities in which LDCs already have or can soon acquired a comparative advantage.

Evidence:

Only a few countries have followed outward-oriented development strategies for extensive period of time, but those that have done so have been very successful. They include Japan in its post-World War II reconstruction and the newly industrialised countries (NICs) of Asia— Hong Kong, South Korea, Singapore, and Taiwan. In part, because of their success and because of high economic cost of import-substitution policies, many other countries have recently begun to adopt more outward-oriented policies.

An Overall Assessment:

Does the choice of which trade strategy to employ make a difference in the performance of the developing country economy? The World Bank’s World Development Report (1987) examined the experience for 41 LDCs in an attempt to answer this question. It classified countries according to four categories of trade strategy.

A country was classified as a strongly outward oriented economy (SO) if it had few trade controls and if its currency was neither overvalued nor undervalued relative to other currencies and thus did not discriminate between exports and production for the home market in incentives provided.

A country was classified as a moderately outward oriented economy (MO) if the incentives biased production slightly towards serving the home market rather than exports, effective rates of protection were relatively low, and the exchange rate was only slightly biased against exports (i.e., home currency slightly overvalued).

A moderately inward oriented economy (MI) clearly favours production for the home market rather than for export through relatively high protection because of import controls and exports are definitely discouraged by the exchange rate.

Finally, a strong-inward-oriented economy ( MO ) if the incentives biased production slightly toward serving the home market rather than exports, effective rates of protection were relatively low, and the exchange rate was only slightly biased against exports (i.e., home currency slightly overvalued).

A moderately inward oriented economy (MI) clearly favours production for the home market rather than for export through relatively high protection because of import controls and exports and definitely discouraged by the exchange rate. Finally, a strong-inward-oriented economy (SI) exhibits comprehensive incentives towards import substitution and away from exports through more severe measures than in MI.

Comparison of the Two Strategies:

1. Employment Generation and Income Distribution:

In general, countries adopting outward-looking strategy have done better than those which adopted inward-looking strategy. Moreover, empirical evidence suggests that outward orientation rather than inward orientation may lead to more equal income distribution.

The main reason for this is that, the expansion of labour-intensive exports generates employment opportunities, while import-substitution policies often result in capital-intensive production processes that displace labour.

2. Foreign Exchange Reserve:

Another benefit of outward-looking strategy is that foreign exchange reserve is earned permanently. On the other hand, under inward-looking strategy foreign exchange is lost temporarily because the replacement of imports of final goods by domestic production requires imports of raw materials, capital equipment, and components. The end result may be increased rather than decreased dependence on imports.

Theory and Evidence:

The World Bank’s finding and advocates of the doctrine of comparative advantage led to the recommendation of the LDCs which adopt more outward-looking policies. Indeed, the world economy in the late 1980s and the 1990s saw a strong emergence of support for the market.

During the 1980s and the 1990s emphasis focused on the importance of outward-looking economic policies to foster growth and development in the developing countries. Formal statistical analysis has consistently shown that there is a close link between sustained economic growth and development and the ability to export successfully in the world economy.

For example, it has been found that, in the 1970s and 1980s, developing countries’ with open economies grew at 4.5% per year in contrast with an annual growth rate of 0.7% in closed economies. The growth rates of open industrialised economies were also found to be larger than those of their closed counterparts.

In recent years, no country with an inward-focused policy has proved successful in attaining or sustaining a high internal growth rate of GDP. As an example, during the past two decades (1990-2008) Sub-Saharan Africa has lagged behind other developing countries in growth in both exports and income.

By relying on traditional exports with low income elasticities instead of moving into exports with greater growth potential, African countries have sacrificed many of the potential gains that could have been had from fast proliferating globalisation.

In contrast, GDP grew by 7.6% in six of the major East Asian countries and 3.0% in Latin America as exports expanded at 15.7% and 9.6%, respectively, in the two areas. Consequently, Africa’s share of world trade has fallen from 4% in 1980 to less than 2% today.

The critical factor here is that, successful outward-looking policies have generally proved ineffective in attracting investment necessary to stimulate growth and development in developing countries as a group. It is more than pure investment, however, as the foreign component of this investment traditionally brings with it not only scarce capital but also a transfer of technology, management skills, organisational skills, and entry into highly competitive international markets.

In sum, the evidence is convincing that freer trade does impact positively on growth.

Flaws of Outward-Looking Policies:

Despite the seeming advantage of outward-looking policies, some economists and policymakers are reluctant to support the policy fully because of:

1. Protectionist Barriers:

The expansion of manufactured exports, such as that attained by Hong Kong, South Korea, Singapore and Taiwan (the “four Asian Tigers”) can run into protectionist barriers in the industrialised countries. Since the labour-intensive manufactured exports pose a threat to well-established industries in industrialised countries (e.g., textiles-and shoes), restrictions such as the Multi-Fiber Arrangement ( MFA ) in textiles and apparel may stifle this route to development for many LDCs.

2. Shortage of Skilled Manpower:

In addition, the export path may require skilled labour, which is in short supply in LDCs. A huge amount of resources has to be devoted for necessary skill formation and knowledge acquisition. (No doubt import substitution also runs into the same problem).

3. Fallacy of Composition:

There is a ‘fallacy of composition’ in the outward-looking strategy. It is because while any one country may face high price elasticities of demand in exports of manufactured goods, the demand facing all LDCs is less elastic than that facing any one country. Sharp fall in prices may occur if all LDCs follow the same pattern.

4. Lack of Association between Export Growth and Industrialisation:

In addition, some empirical studies fail to find any positive relationship between exports and industrialisation. Some studies suggest that the positive link occurs only above some threshold income level.

Wanted: A Combination Strategy:

In the ultimate analysis, it seems that the two trade strategies—import substitution and export promotion—are not mutually exclusive. They may go hand in hand and may reinforce each other. So, what is called for is a strategy which seeks to combine the virtues of the two strategies.

In fact, some mix or sequence of the two strategies may be appropriate in some cases. For example, South Korea engaged in IS before embarking on its export-led growth path. In cases of infant industries this may be a good strategy.

Economic Integration:

In addition, M. P. Todaro has suggested that economic integration among LDCs may offer benefits because it is a combination of an outward-looking strategy (through freer trade with other LDC partners) and an inward-looking strategy in which the customs union as a whole is turning away from the rest of the world economy.

In any event, the precise extent to which a country should turn outward or inward depends on its own external and internal characteristics. The policies to be recommended can be decided on a case-by-case basis.

Conclusion:

There is clear evidence that those LDCs which have increased exports of manufacturers have succeeded in increasing export earnings. There is also ample evidence that producers in these respond favourably to economic incentives.

The East Asian countries have demonstrated clearly the viability of trade policies in promoting industrialisation through reliance on foreign markets (as opposed to domestic markets) and were based on dynamic comparative advantage that went beyond reliance on primary commodities.

The East Asian experience clearly demonstrated that the earlier export pessimism that underlay the ideas of IS was perhaps more an indicator of inward-oriented trade and payment regimes than an outward focus based on a dynamic comparative advantage. The East Asian experience suggests that LDCs with an outward focus would not lock themselves permanently into a pattern of primary product specialisation.

So the conclusion is that a clear understanding of comparative advantage and the importance of fostering the presence of correct relative prices of products and factors is central to harnessing the potential role of international trade in promoting the development of newly industrialising countries.