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Import substitution and export promotion: a continuing dilemma for developing countries?
Abstract:
A belief in the inevitability and benefits of globalization has led to the argument that countries should open their economies. Conversely, there is also a belief that the negative effects of globalization outweigh any potential benefits and therefore countries should become more protectionist. These viewpoints reflect an old debate over the pros and cons of import substitution and export promotion. This paper examines the old arguments and suggests that a forced choice between the two may not necessarily be the best approach and that countries should consider ways of adopting both methods.

Keywords: Import Substitution; Export Promotion; Economic Development; Developing Countries.

Subject:
Developing countries (International economic relations)
Economic development (Planning)
Globalization (Analysis)
Gross domestic product (Forecasts and trends)
Import substitution (Analysis)
Author:
Manu, Franklyn A.
Pub Date:
01/01/2009
Publication:
Name: Journal of International Business and Economics Publisher: International Academy of Business and Economics Audience: Academic Format: Magazine/Journal Subject: Business, international; Computers Copyright: COPYRIGHT 2009 International Academy of Business and Economics ISSN: 1544-8037
Issue:
Date: Jan, 2009 Source Volume: 9 Source Issue: 1
Topic:
Event Code: 010 Forecasts, trends, outlooks; 220 Strategy & planning; 950 International economic relations Computer Subject: Company business planning; Market trend/market analysis
Product:
Product Code: 9008000 Economic Programs-Total Govt; 8515300 Development NAICS Code: 926 Administration of Economic Programs; 5417 Scientific Research and Development Services
Geographic:
Geographic Code: 0DEVE Developing Countries
Accession Number:
208535025
Full Text:
1. INTRODUCTION

Developing countries (LDCs) have adopted a number of approaches in their attempts to move their economies and societies from a so-called "backward" orientation towards a more "modern" one. Crucial to this process was a desire to change from a rural-traditional dominance to a more modern-industrial mode for the simple reason that development was equated with industrialization. As a result, LDCs pursued a policy of rapid industrialization primarily through a process of import substitution. Some of the negative consequences of this process led to what is considered to be an opposite approach to economic development, the policy of export promotion. The literature, however, still continues to offer a lot of debate (Razzaque and Raihan, 2008; Shafaeddin, 2005).

2. IMPORT SUBSTITUTION STRATEGY

In talking of import substitution, it is important to distinguish between that which occurs "naturally" in the course of economic growth and development, and that which forms the object of governmental policy. "Natural" import substitution takes place as domestic incomes rise and the range of products that can be produced competitively for the domestic market increases. Goods that were previously imported because domestic demand was too small to support competitive local production are gradually replaced or supplemented by locally produced goods. Import substitution in this paper refers, not to this "natural" process, but rather to that which takes place as a result of a deliberate governmental policy.

The primary incentive for initiating import substitution is the prospect of industrialization and the economic gains associated with it. Behind this incentive lies the desire to be rid of the chronic long-run structural disequilibria in patterns of production and trade. Specifically, import substitution has been based on the following arguments: infant industry protection; instability of foreign market earnings and the need-for self-sufficiency (Prebisch, 1962); savings for investment, since industries are assumed to save more; a need to conserve foreign exchange and improve balance of payments; additional exports of primary products would turn the terms of trade against the exporting country (Cypher and Dietz, 1997).

The policy instruments supporting import substitution regimes are an assorted mix of tariffs, quotas, exchange controls and overvalued currencies. Restrictions on imports protect domestic firms from competition with producers from other countries and are measured using the effective rate of protection (ERP). Empirical estimates by Balassa (1971) and Lewis and Guisinger (1968) indicated an excessively high rate of effective protection, and by implication, a heavy movement of resources into manufacturing sectors. Another concept that provides a measure of the "real" economic costs of production activities that result from protective measures is that of Domestic Resource Costs (DRCs). It gives an empirical estimate of the domestic marginal rate of transformation by adjusting domestic prices for monopolistic rents and factor market distortions, in order to reflect the opportunity cost of producing various commodities. Krueger (1974, p. 218) interprets the DRC as follows: "Thus if an activity has a DRC twice as high as another the implication is that had the first activity not been undertaken and had resources been employed in the second activity, these resources would have produced twice as much foreign exchange earning or saving as under the existing allocation."

There is a very large body of research on the effects of import substitution regimes in developing countries. A major effect cited is the discrimination against agriculture. This happens because protection raises the prices paid for manufactures while depressing those for farm produce. A difference is created in the domestic terms of trade between industry and agriculture, and the external terms of trade, which show the same price relations but at world prices. The net result is a redistribution of income from agriculture to industry. Pakistan's import substitution policy in the 1960s which caused the ratio of manufacturing to farm prices to be twice as high as it was in world markets, amounted to an 11-13% tax on farmers' incomes (Lewis and Guisinger, 1968). Similar estimates by Diaz-Alejandro (1970) for Argentina between 1947 and 1955 gave a tax on farmers of between 30 and 40%. A related effect has been the favoring of profits over wages within the manufacturing sector with a resulting increase in inequity of income distribution. Since import substitution initially focused on the production of final consumer goods it created a demand for a variety of new imports to be used in production processes. This led to an increase in dependence on imports with even more serious consequences in the event of foreign exchange shortages (Athukorala and Rajapatirana, 2000). Now there would be effects on employment and capacity utilization instead of there being only shortages of the formerly imported final product. This kind of situation resulted in the difficulty of further import substitution (Bruton, 1998). The net result was that import substitution did not lead to economic self-sufficiency. As Sunkel (1973, p. 15) indicated, "the transit from the primary export model to the import substitution industrialization model does not mean that they have become less dependent on the international economy, but that the nature of dependence has changed."

Import substitution is also considered in general to have been unable to save foreign exchange. This was partly due to imports for production processes discussed above. In addition, the growth of income resulting from the policy had the effect of increasing leakages into other imports; it was mostly urban dwellers with a high import component of demand that benefited most from this "modernization." Furthermore, it was unable to create enough jobs for the masses in the urban areas nor was it able to change the emphasis on exports of primary goods (Sunkel, 1990).

The major defect of import substitution policies, according to Bhagwati and Krueger (1973), has been their inevitably indiscriminate nature in influencing the behavior of individual firms. The inability to distinguish between low cost and high cost activities led to a roughly proportionate expansion of all firms in a given industry, with little competition among them, ensuring the growth of efficient and inefficient ones alike. This difference in efficiencies can be attributed in large part to the haphazard building of manufacturing capacity, a proliferation that made more difficult the exploitation of whatever economies of scale were potentially available. Still another criticism of import substitution is that it eliminates the gains from trade by favoring production for domestic use over exports. This happens because of over-valued exchange rates that mean a producer will earn a lower amount of domestic currency equivalent by exporting than by selling in the home market. Thus there is a bias against exports. In addition the protective-regimes further penalize exports by tariffs on their inputs and thereby raising the costs of production as well as prices, leading to international non-competitiveness. These effects have been well-documented by Little, Scitovsky and Scott (1970), Balassa (1971) and Anderson et al. (2002) among others.

A final (within the scope of this paper) set of effects has to deal with the lack of linkages between import substitution and other sectors of the economy. This effect cannot be blamed on the policy for it depends on the degree of articulation within an economy.

3. EXPORT PROMOTION STRATEGY

As a result of these criticisms of the policy of import substitution a number of economists e.g. have proposed export-led models of development (Caves, 1970). Export expansion is important for it is almost nearly a necessary condition for sustained growth and development over any lengthy period. Exports are viewed as an "engine of growth", and increases in exports stimulate domestic investment through an accelerator effect. The increase in investment has the consequence of increasing the internal demand while at the same time expanding productive capacity and productivity. If money wages are assumed to increase at the same rate in other trading countries, then the rise in productivity will result in relative price stability and an improvement in international competitiveness. So long as exports keep increasing there will be a self-reinforcing tendency for a country to maintain its competitive position and to continue its economic growth. Exports then make possible the benefits from trade, pay for the imports required in development both directly and indirectly (by adding to borrowing and debtservicing capacity).

Policies to promote export expansion have included the following: subsidies, realistic exchange rates, and trade agreements. Export expansion may generally take two forms: primary commodity export expansion; and manufactured goods export expansion. Export expansion is however not necessarily easier. Todaro (1977) identified factors militating against rapid expansion in exports of primary products, especially agricultural, to the developed countries. On the demand side he cites the following: low per capita income elasticity of demand for agricultural foodstuffs and raw materials; developed country population growth rates at or near replacement levels; low price elasticity of demand for most non-fuel primary commodities; development of synthetic substitutes; growth of

In addition to these factors, there are also supply side considerations in the form of structural rigidities that work against rapid expansion of primary product earnings. Examples of such rigidities are limited resources, antiquated rural institutional, social and economic structures and non-productive patterns of land tenure.

The goal of expanding manufactured exports was given impetus by the "success" stories of such LDCs as Taiwan, South Korea and Brazil during the 1960s and 1970s. In recent times, however, growing protection in developed countries has again dampened the viability of this kind of expansion. This outward-looking strategy of development based on export promotion is generally considered to be a better one than that of import-substitution in the literature (Weiss, 1999; Krueger, 1998). The leading examples of the success of this approach, subsequently dubbed the "Gang of Four" are Hong Kong, South Korea, Singapore, and Taiwan. Taiwan's export expansion was based to a great extent on exports of processed imported materials. Exports of industrial products rose from $12 million in 1957 to $280 million in 1966 (50% of total exports). These exports accounted for about 66% of the total increase in exports from Taiwan over the period. Exports of certain processed foods based on domestic produce such as pineapple, asparagus and mushrooms also increased substantially. This growth in industrial products did not come at the expense of exports of primary products. Taiwan's exports of bananas, for example, rose from 3.2% of total exports in 1962 to 9% in 1966. While Taiwan's success was in part due to external factors such as external aid and the Vietnam war which increased the demand for some of her exports, i.e. metals and building materials, credit must also go to the economic policies followed. These policies included the removal of import restrictions, the maintenance of "realistic" exchange rates, and the provision of export finance and insurance.

Similar economic policies are believed to have contributed in no small measure to the rapid expansion of fish meal exports from Peru and raw cotton from Central America. South Korea embarked upon an export-promotion strategy in the early 1960s after several years of very slow growth. The growth rate rose by over 40% per annum as a result of bias towards exports provided by the economic system. The rate of growth of GNP that was 6.1% in 1965 averaged 10.3% from 1966 to 1972. Brazil also experienced similar success after shifting to an outward-looking strategy in late 1967. Export earnings, which showed virtually zero growth from 1954 to 1967, showed an average annual increase in excess of 25% from 1967 to 1973. The average annual rate of growth of real GDP from 1962 to 1967 was 3.7% but averaged 10.2% from 1968 to 1973.

4. DISCUSSION

Much of the literature deals with these two strategies as either/or propositions but it is doubtful whether this should be the case. While traditional approaches to import-substitution create a bias against exports it is believed this bias can be removed by other policies, as has been the case in Taiwan and Pakistan. Included in these policies are export subsidization and the case of multiple exchange rates. Such an approach would decrease some of the distortions arising from import-substitution to change the structure of the economy. The strategy to discourage primary commodity exports is fully consistent with efforts to reduce traditional patterns of dependence. However, a country cannot export manufactures without building the capacity to produce them and capacity cannot be built without import substituting. This is because the ratio of imports to domestic production of manufacturers in many LDCs is so high that attempts to create domestic capacity is bound to take the form of import substitution. There is thus an implication of a sequence from primary specialization, to import substitution, to exports of manufactures. Findlay (1973) showed that this sequence is attained either by sufficiently large increases in productivity in manufacturing sectors, or through an increase in the propensity to save out of profits. Ahmad (1978) also indicated that the growth of import substitution in manufacturing is positively correlated with the growth of exports. Thus, sectors that showed a high growth of import substitution were also the ones that had a relatively high rate of export growth. The Brazilian experience indicates that significant exports of manufacturers arise only in industries where large scale import substitution has been successfully accomplished. As Chenery (1975, p.505) pointed out "Although Brazil is on its way to becoming an efficient exporter of automobiles and machinery, a period of apparently inefficient import substitution may well have been necessary to structural change in both production and exports". Green (1995) documented how the strategy advanced Latin America's economic development. In the 1960s domestic production provided 95% of Mexico's and 98% of Brazil's consumer goods and from 1950 to 1980, Latin America's industrial output rose six times.

Although countries that have built their development efforts around import substitution have experienced grave problems it is still possible to pursue the policy in a more satisfactory manner. The problems arose as a consequence of the kinds of activities selected and the methods adopted to bring about their development. As Bruton (1970, p. 124) put it, "to implement their import substitution policy, countries have chosen instruments and techniques that seem, in effect, to prevent that very policy from being successful."

What is necessary then is a different approach to implementing the policy of import substitution. At the same time there is the need for export promotion. In effect there is a need for a twopronged approach for the two policies need not be mutually exclusive (Jha, 2008). As Masina (2006) indicated, the East Asian countries that became economically successful used a combination of selective import substitution and export promotion policies tailored to their national industrial strategies. In particular, protection against imports in the form of tariffs and quotas was constrained by limited duration or export obligations for the specific industry. It is therefore clear that the debate continues and will provide challenges for policy-makers and researchers.

BIBLIOGRAPHY:

Ahmad, J. Import Substitution, Trade And Development, JAI Press, Connecticut, 1978.

Athukorala, P. and Rajapatirana, S. "Liberalization and industrial transformation: Lessons from the Sri Lankan experience", Economic Development and Cultural Change, (April), 2000, 543-572.

Anderson, K., Dimaranan, B., Francois, J., Hertel,T., Hoekman, B. and Martin, W., "The Cost of Rich (and Poor) Country Protection to Developing Countries", Journal of African Economies, 10, 3, 2002.

Balassa and Associates, The Structure of Protection in Developing Countries, Johns Hopkins Press, Baltimore, MD, 1971.

Bhagwati, J. and Krueger, A., "Exchange Control, Liberalization And Economic Development," American Economic Review, Papers and Proceedings, Vol. 63, 2 (May), 419-427.

Bruton, H. J., "A Reconsideration of Import Substitution", Journal of Economic Literature, 36, 1998, 903-936.

Bruton, H. J., "The Import Substitution Strategy of Economic Development: A Survey", Pakistan Development Review, Vol. 1O, #2 (Summer), 1970. 123-146.

Caves, R., "Export-Led Growth", in W.A. Eltis et al. (eds.) Induction, Growth and Trade: Essays in Honour of Roy Harrod , Clarendon Press, Oxford, 1970.

Chenery, H., "What We Need to Know: Panel Discussion," in P. Kenen (ed.) International Trade and Finance: Frontiers for Research, Columbia University Press, NY, 1975.

Cypher, J. M. and Dietz, J. L., The Process of Economic Development, Routledge, New York, 1997.

Diaz-Alejandro, Carlos, Essays on the Economic History of the Argentine Republic, Yale University, New Haven, 1970.

Findlay, R., International Trade and Development Theory, Columbia University Press, NY, 1973.

Green, D., Silent Revolution: The Rise of Market Economies in Latin America , Cassell, London, 1995.

Jha, Veena, Import Substitution versus Export Promotion in the DTIS for LDCs, CUTS International, 2008.

Krueger, A. 0., "Why trade liberalization is good for growth", The Economic Journal, (September), 1998, 1513-1522.

Krueger, A. 0., Foreign Trade Regimes and Economic Development: Turkey, Columbia University Press, NY, 1974.

Lewis, and Guisinger, S., "Measuring Protection in a Developing Economy: The Case of Pakistan, "Journal of Political Economy, Vol. 76 (December), 1968, 110-1981.

Little, I.M.D., Scitovsky, T. and Scott, M., Industry and Trade in Some Developing Countries, Oxford University Press, London, 1970.

Masino, Pietro, Vietnam's Development Strategies, Routledge, 2006.

Prebisch, R., "The Economic Development of Latin America and its Principal Problems", Economic Bulletin for Latin America, 7, 1962, 122.

Razzaque, Mohammad and Raihan, Selim, "Trade-Development-Poverty Linkages: Reflections from Selected Asian and SubSaharan African Countries" Volume 1: Country Case Studies, CUTS International, 2008.

Shafaeddin, M., Trade Policy at the Crossroads, the Recent Experience of Developing Countries, Palgrave Macmillan, 2005.

Sunkel, 0. "Reflections on Latin American Development", in Progress Toward Development in Latin America, Dietz, J. J. and James, D. D. (eds.), Lynne Rienner Publishers, Boulder, CO, 1990.

Sunkel, 0., "Past, Present and Future of the Process of Latin American Underdevelopment," Studies on Developing Countries, No. 57 (Budapest), 1973.

Todaro, M., Economic Development in The Third World, Longman, London), 1977.

Weiss, J., "Trade reform and manufacturing performance in Mexico: From import substitution to dramatic export growth", Journal of Latin American Studies, (February), 31, 1, 1999, 151-166.

Franklyn A. Manu, Morgan State University, Baltimore, MD, USA

Dr. Franklyn A. Manu earned his Ph. D. from the Stern School, New York University. Currently he is a professor in the School of Business and Management, Morgan State University, Baltimore, MD, USA and recently completed a sabbatical at the GIMPA Business School in Ghana where this paper was written.
agricultural protection in developed
   countries in the form of tariffs quotas, and
   non-tariff barriers such as sanitary laws.
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