Developmental studies

At the beginning of the twentieth century underdeveloped countries began to look for the ways to diminish their dependency on agricultural exports and to bring on an industrial revolution. The situation which evoked this need was critical. The problem was that the underdeveloped countries developed mainly the policies of supporting primary commodity exports. Transportation policy was used in the infrastructure for delivering the export crop to the harbour.

The research institutions specialized in agriculture worked only on improving crops for export, for example, sugar cane, coffee, cotton, etc. while crops for domestic consumption, for instance, beans or manioc corn, potatoes, left with little or even without expenditure. As a result some of the underdeveloped countries had to follow the policy of import substitution to induce industrialization. Import substitution industrialization will be the goal of study of this paper. This economic policy will be investigated in the frames of an economic term with the necessary characteristics and also in a wider meaning as the experience of the countries of East Asia and Latin America.

In the process of research different points of view, both pro and contra, will be cited in order to shed the light on positive and negative aspects and cover the field broadly. In the conclusion of the paper the main findings will be summed up. The term of import substitution can be defined as an economic process and as a policy strategy. As a process import substitution relates to the situation “where regions (more precisely, existing or new economic activities within regions) take up the production of goods or services which formerly were imported, but, for whatever reasons, now can be viably produced within the region (e.g. as a result of population increases leading to increases in demand or as a result of productivity increases resulting in greater competitiveness. ”(Economic Geography Glossary, 1999)

Import substitution industrialization (ISI) as the economic strategy means encouraging the development of domestic industry by limiting manufactured goods import. The need of ISI implementation arouses from the belief that there is a potential comparative advantage in some of the industries of developing countries, but these industries are too weak yet to compete with foreign well-established ones.

Thus, in order to allow infant industries to establish themselves and to realize their potential, and consequently to be able to compete internationally, governments should support the initial period of their development. The protection of government implies temporary measures such as using tariffs or import quotas to start industrialization in the country. As a policy strategy import substitution can be used to achieve the following goals: 1) to utilize the capacities which are underused; 2) to fight unemployment in the regions;

3) to protect infant industries. The policy of import substitution industrialization, according to the definition provided by the encyclopaedia, is “a trade and economic policy based on the premise that a developing country should attempt to substitute products which it imports, mostly finished goods, with locally produced substitutes. ”(Wikipedia, 2005) The theory of import substitution has much common with the theory of mercantilism. Both the theories promote minimal imports and high exports as the means of inducing the growth of national wealth.

In order to implement the policy of import substitution industrialization, the following three main tenets must be pursued: 1) protective barriers to trade, which can be set up in the form of tariffs. Tariffs or custom duties are applied to the goods which are imported and in this way they artificially protect domestic industries from competition with foreign companies; 2) a particular industrial policy, which orchestrates and subsidizes production of the substitutes; 3) a monetary policy, which will keep the domestic currency overvalued.

Monetary policy is implemented by setting reserve requirements and changing some interest rates directly or indirectly. The chief tools of monetary policy are operations in open market. In open market money circulates through the selling and buying of deferent foreign currencies credit instruments, or commodities. Such sales or purchases create a certain base currency which leaves or enters market circulation. Usually open market operations are aimed at achieving a specific short term interest rate target.

However, monetary policy may also target a certain “exchange rate relative to some foreign currency or else relative to gold. ” (Wikipedia, 2005) Equally important is to note that import substitution as economic protectionalizm can have negative outcomes. Stutz pointed out that “This form of economic protectionism helped some countries industrialize in the past but involves economic risks. ” (Stutz and Souza, 1998) The risks of import substitution meant by Stutz are potential inefficiencies and higher prices.

Successful implementation of this policy as a rule needs massive expenditure on infrastructure. Additionally, import substitution is accompanied by the establishment of state firms in the areas of industry which are thought to be too risky or too large for the private sector (or example, steel, aircraft) or estimated to be too important to be owned by foreign firms (or instance, oil). The policy of import substitution industrialization was argued by the advocates of absolute free trade theory.

Generally, free trade becomes possible when the flow of services and goods between countries is not taxed. In particular, the economists who supported free trade policy stated that economic strategy would become successful only under the following conditions: 1) international trade in services must be without trade barriers, or tariffs; 2) international trade of goods must not be free from any possible tariffs (namely taxes on imports) or trade barriers (for example, quotas on import); 3) the free movement of international labor; 4) the free movement of international capital;

5) the absence of any economic protectionalizm, implemented by trade-distorting policies (for instance, subsidies, regulations taxes, or laws), which gives an advantage to domestic firms, factors of production, and households over foreign ones. Thus, it becomes obvious that free trade proponents advocated the policy which totally contradicted the fundamental tenets of import substitution industrialization. On the other hand, free trade proponents suggested that a foreign subsidy should be considered as another of comparative advantage and consequently domestic barriers should not be imposed on the purchase of goods produced overseas.

Free trade economists pointed out that unlimited imports will be beneficial for domestic consumers which overweighs the loss of domestic producers. Thus, the lower prices of foreign subsidies can be considered as net positive. Therefore, the domestic society where any import restriction is applied becomes “a whole worse off than it would be with unlimited imports. ” (Wikipedia, 2005) Anyway, the viewpoints of the both theories – import substitution industrialization and absolute free trade – were checked in the process of their implementation and in real life experience.

In the period from 1930 to 1940 the policy of import substitution industrialization was adopted in many underdeveloped countries of Latin America. The driving force which precipitated the acceptance of import substitution idea was the Great Depression which took place in 1930s. According to article Concern with Policy-relevance in the Latin American School of Economics authored by Bianchi, “Import substitution was a necessary condition for peripheral growth, in association with structural reforms in the economy.

The focus should be placed on the strenghtening of the domestic market, which was seen as the crucial element of an inward-looking model of development. ” (Bianchi A. M. , 2003) Later on, in the 1950s Raul Prebisch, the prominent Argentine economist, expressed his belief that the only way to succeed for developing countries was to build forward linkages domestically and to create industries which would work on primary products already produced by the countries themselves. The policy of tariffs would help the domestic industry to prosper.

By implementing the policy of import substitution industrialization in the period from 1950 to 1970 a number of Latin America countries, in particular Mexico, Brazil, Argentina, Chile, Uruguay, attempted to reach positive results and to increase their national wealth. The success of the policy in these countries was based on either high living standards or large populations. However, poorer and smaller countries, for example, Dominican Republic, Ecuador, Honduras, were not successful in adopting import substitution policy.

Also it is notable that the countries which succeeded in import substitution industrialization managed to change the structure of their governments. Thus neo-colonialism collapsed and was replaced by democratic way of governing. Nationalization turned banks and utilities into public property and returned to nation some of the companies previously owned by foreigners. A case of implementation of import substitution industrialization can be examined with the help of the example of Brazil.

Brazil was the country which carried the policy of import substitution industrialization later than other underdeveloped countries. The economists in Brazil carefully analyzed its effects and were planning the industrial development of the country while the other countries started import substitution mainly by accident. It is important to note that Brazil initially had all the chances for success in the policy of import substitution, since its population goes up to 170 million, which makes Brazil the fifth largest country in the world.

Also Brazil is the fifth largest country by its land area. And finally, Brazil is rich in forest reserves, minerals, navigable rivers agricultural land, and hydroelectric capability. The development of Brazilian economy in the period from 1950 to the 1970s confirmed the most optimistic views. Brazil with its rich resources and reserves was called “the land of the future”. In 1950 Brazil attempted to establish the largest industry of motor vehicle having practically no sufficient basis. Thirty years later aircraft of Brazil were working on commuter airlines on the United States.

Brazilian shoes spread everywhere. Moreover, Brazil opened up the richest iron mine in the world and Brazilians found out the capital city on the place where previously had been a roadless jungle and built the network of roads going deep into Amazon. When the oil prices rose and began threatening the development of Brazil economy, Brazilians launched huge hydroelectric projects to operate the growing industries of the “Golden Triangle”, which included Sao Paulo Rio de Janeiro, and Belo Horizonte and required the new automobiles to run on rum instead of gasoline.

At the beginning of the 1980s even pessimists agreed that Brazil was “the country of future”, however added “and always will be”. The growth of Brazil stopped, when it was almost close to ripening. The modern cities in Brazil coexist together with miserable shanty-towns surrounded with open sewers. The roads are shared by modern vehicles and hand carts. The wages of Brazilian executives are the highest in the world, but at the same time average workers hardly reach subsistence level. Some economists call Brazil “a Switzerland within an India.

” Other economists consider that the case of Brazil brightly illustrates economic growth without economic development. Economist Celso Furtado characterized the state of Brazilian economy in the following way: “The Brazilian economy constitutes a very interesting example of how far a country can go in the process of industrialization without abandoning its main features of underdevelopment: great disparity in productivity between urban and rural areas, a large majority of the population living at a physiological subsistence level, increasing masses of unemployed people in the urban zones, etc.

” (Development policies, Catching Up, Sec 2, Chap 14) By the 1950s the industrial development by means of import substitution had been already a planned process in Brazil. New industries were protected from the foreign competition with the help of a number of methods. Basic industries (for example, steel, electrical power, petroleum reining) became either fully owned by state or received direct subsidies. Law of Similars aimed at putting high tariffs (sometimes tariffs went up to 300%) on imported goods as soon as any domestic firm somewhere in Brazil started manufacturing something ‘similar’.

The industries considered high priority always could be credited under favorable terms by a national development bank. For some period of time, the government even set multiple exchange rates in order to lower the cost of imported capital equipment while the price of imported finished goods was kept expensive. One of the growing Brazilian industries in the mid of twentieth century was motor vehicles. The government hoped that foreign financing would help to expand Brazilian firms which were already producing motor parts, bus bodies, truck and so on and soon would turn them into real vehicle manufacturers.

But this approach had to be changed for the government of Brazil faced the reluctance of American government to extend loans and the disapproval of the firms from Europe and the USA who owned a critical technology. The world famous giants – Fiat General Motors, Mercedes Volkswagen, and Ford – were threatened to lose their markets in Brazil if they did not manufacture vehicles within the country. It is important to note that modern manufacturing, in particular the production of appliances, motor vehicles, TVs and so on is a complex process that requires substantial knowledge and skill.

Final assembly became possible in Brazil since it was the last stage of production and required the least skill. So, launching modern industries Brazil could start with final assembly and gradually came to more complicated “backwards”, which included more difficult procedures. For example, Volkswagen could start importing complete parts, such as engines, wheels etc. and assemble them in Sao Paulo plant. The tariffs allowed Volkswagen to sell 1960 30% Brazilian Beetle for twice what Europeans would pay even if the quality was not that high. Eventually, most of the parts became produced in Brazil and the quality of assembly improved.

Gradually, the competition from Brazilian Fiats, Fords, and Chevrolets pushed the price down. In this way, Brazilian motor vehicle industry became more and more efficient and even in the 1970s Brazil exported subassemblies and parts to America and to the European countries. By 1980 Brazil started exporting entire vehicles. When import substitution industrialization was implemented in Latin America, the drawbacks of the policy soon revealed themselves. In Brazil as well as in other Latin America countries import substitution model led to foreign ownership in all the sectors in industry except those occupied by state enterprise.

When the interests of foreign firms were threatened by Brazilian taxes, environmental or labor legislation, American, German, Italian, British Japanese or French owners were quick to call on their state departments. In particular, the Department of the United States defined one of its key objects as establishing favorable “business climate”. This meant undermining Brazilian government. Thus, in 1964 some Brazilian generals, being encouraged by American officials, made an attempt to overthrow constitutional government of their country.

Another drawback of import substitution industrialization revealed in the fact that this policy led to huge foreign debts. It was not accidental, that Brazil and Mexico ran into debts in order to cover the expenses of their infrastructure development. The development of infrastructure needs a large number of hard currency imports. If infrastructure grows and increases exports together with hard currency earnings, a country can borrow in dollars. Then, under such condition, the country has to earn dollars in order to make the interest payments.

But import substitution requires borrowing in dollars for the purpose of economic development of the domestic production that will not necessarily expand exports. By the end of the seventies the countries of Latin America faced the problem: Where to go next? And the next logical step was to export the goods which had been already produced efficiently. By the middle of the eighties Brazil became the largest exporter of shoes and coffee, among ten major exports to America, six were manufactured projects. Nevertheless, the expansion of manufactured goods made Brazilian economy vulnerable to retaliatory tariffs.

Moreover, in the 1980s Brazil as well as other underdeveloped countries of Latin America did not manage to pursue the next layer of import substitution ( in particular, microchips, computers, capital equipment), although they attempted to create open markets for their manufactured consumer goods. Unlike the nations of Latin America, the majority of East Asian nations rejected the policy of import substitution industrialization. Due to this, as many economists think, East Asia had its superior performance in the seventies and the eighties of the twentieth century.

Generally speaking, the Asian growth had started before World War II in Japan. The process of Asian growth included three groups of countries whose economic “miracle” began at different times: 1) Japan (after the Second World War); 2) The “four tigers”: Taiwan, South Korea, Hong Kong, Singapore (the sixties of the twentieth century); 3) Indonesia, Malaysia, Thailand, China (from the 1970s to the 1980s) In fact, by rejecting import substitution industrialization Asian nations managed to avoid some negative results of this policy. First, their economies were not dragged by inefficient industries.

Second, East Asia did not have to implement policies benefiting industrial workers at the expense of those working on the farms. This was crucial for Asian countries because farmers made up the majority of their population. In addition, in order to diminish the cost of industrialization, the cost of food needed to be kept artificially low. And also, East Asia attempted to prevent the appearance of rent seeking behaviours, which resulted from the usage of the licensing schemes for import substitution strategy and which usually increased inefficiency of economics.

High tariffs on manufactured goods, which were imposed by many countries in order to create their manufacturing bases, forced multinational companies to assemble or produce them locally. For example, manufacturers of motor industry exported vehicles for local assembly. Their vehicles were delivered ‘completely knocked down’ and the local assembly resulted in poorer quality and higher expenditures in comparison with those imported already built up. Moreover, the local assembly of identical products only duplicated resources and reduced economies of scale, which became increasingly inefficient for manufacturers.

On the whole, at the beginning of 1980s the policy of import substitution industrialization began to fail both in Latin America and in those Asian countries where the policy was adopted. Generally, it happened because the governments involved in the policy started to overspend reserves in order to keep the stability of currency. The governments in Latin America defaulted on their debts and had to turn to the help of the International Monetary Fund. Another process which contributed to the failure of import substitution was globalization.

However, some economists think that the collapse of the policy of import substitution industrialization “should not necessarily be taken as an endorsement of globalization. ” (Wikipedia, 2005) Such point of view was supported by the fact that some countries of East Asia also used high tariff barriers while rejecting the rest of the strategy of import substitution. This mixed policy was focused on investment and subsidies on the industries which would produce goods for export. As a result, these Asian countries managed to create competitive industries.

However, irrespective of all their achievements, the policies described above also proved to be inefficient and later led to many problems during Asian financial crisis. The closing period of import substitution industrialization was in 1989 when the Washington Consensus as a set of policies designed to promote economic growth in the countries of Latin America was presented by John Williamson. The Washington Consensus included reforms which continued the policy of import substitution industrialization offering a modernized version of its tenets.

In particular, the Washington Consensus proposed the following: 1) the discipline of fiscal policy; 2) tax reform. It flattened tax curve: the tax rates on high tax brackets were lowered and the tax rates on the low tax brackets were raised. Also it suggested lowering the marginal tax rate; 3) Competitive exchange rates; 4) Trade liberalization by means of low and uniform tariffs which would replace quantitative restrictions; 5) Reduced limitation for foreign direct investment; 6) Privatization of state enterprises;

7) Deregulation, which implies “abolition of regulations that impede entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudential oversight of financial institutions” (Wikipedia, 2005) 8) Property rights must be legally secured; 9) Public spending should be redirected toward the investment of health, education, and infrastructure; 10) “Interest rates that are market determined and positive (but moderate) in real terms. ” (Wikipedia, 2005) In the nineties the Washington consensus was being disputed.

The critics of the reforms argued that they would lead vulnerable countries to crisis instead of helping to overcome it. Naomi Klein and Noam Chomsky claimed that the neoliberal policies of the Washington consensus would lead to the exploitation of labor market of an underdeveloped economy by a more developed one. (Wikipedia, 2005) Privatization of state industries, deregulation, and tax reform were seen by the opponents as the reforms which would ensure the development of the layer of local monied elite who would pursue local interests and try to maintain local status quo.

Jorge Taiana, the Deputy Foreign Minister of Argentina, also disapproved the Washington consensus saying that such policies never had a real consensus and nowadays “a good number of governments of the hemisphere are reviewing the assumptions with which they applied those policies in the 1990s,” adding that governments are working on a development model which would ensure productive employment and guarantee the generation of real wealth. (Wikipedia, 2005)

Another economist Duncan Kennedy in the article for The Boston Review stated that the Washington Consensus completely opposed the initial tenets of import substitution industrialization and more favoured American political interests: “In the form promoted by the United States, ISI was as hostile to free-market economics as to Communism. The overarching idea of the Washington Consensus was to wipe out every aspect of ISI: the Washington Consensus is both that free markets are good and that ISI [Import substitution industrialization] was bad.

Developing countries were to develop through integration into the world commodity and capital markets, with policies of deregulated private enterprise, foreign investment, and open economic borders. ” (Kennedy D. 2003) All in all, taking into consideration the mistakes of the previous experience and the criticism of the economists, the developmental policy of import substitution industrialization has never been returned since the time of the Washington Consensus. Thus, in the paper import substitution industrialization as a process and as a policy was investigated.

It was found out that import substitution pursues three main goals: utilization of underused capacities, reducing unemployment and infant industries protection. The implementation of the policy of import substitution industrialization is based on three tenets: particular monetary and industrial policies, and protective trade barriers. However, it turned out that success and efficiency of import substitution industrialization was doubted by the proponents of absolute free market.

Potential risks of import substitution were also visible while careful theoretical analysis and pointed out by economists. The underdeveloped countries of Latin America and East Asia implemented the policy of import substitution industrialization. It occurred that the potential risks and the negative aspects found out by the proponents of absolute free market constituted the drawbacks of the policy and finally became the chief factors of its failure.

However, the major part of East Asian countries rejected the policy and experienced economic growth. The example of Brazil demonstrated that the policy of import substitution industrialization can stimulate economic growth for some period of time, but its drawbacks (first of all high expenditures and inefficiencies) pose real obstacles for continuous and strong economic development.

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