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 favor of a growing modern
industrial sector.
Less developed countries (LDCs) have adopted two alternative
strategies for achieving industrialization— 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
emphasizes import substitution, i.e., the production of goods at home
that would otherwise be imported.

This can economize 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 emphasizes 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 labor force and the use of more advanced
technology, and tax concessions generate more exports, particularly
labor 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 favor of import substitution (IS) development
strategies. These policies seek to promote rapid industrialization 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 industrialization, 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 industrialization 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 characterized 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 industrialize, the developing nations had to choose

between industrialization through import substitution and export-
oriented industrialization. Both policies have advantages and
disadvantages.

An import substitution industrialization (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 labor costs) domestic firms
utilize relatively capital-intensive production techniques. This means
that employment in a newly industrializing 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 labor-intensive commodities in
which LDCs already have or can soon acquire 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 industrialized 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 favors 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 favors 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 labor-intensive

exports generates employment opportunities, while import-
substitution policies often result in capital-intensive production
processes that displace labor.

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 industrialized 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 globalization.

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, organizational 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 industrialized
countries. Since the labor-intensive manufactured exports pose a
threat to well-established industries in industrialized 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 labor, 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 Industrialization:

In addition, some empirical studies fail to find any positive
relationship between exports and industrialization. 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 favorably to
economic incentives.

The East Asian countries have demonstrated clearly the viability of

trade policies in promoting industrialization 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
specialization.

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 industrializing countries.