Import Substitution vs. Export Promotion

How do the strategies of international trade affect growth? Why at times countries adopted different strategies of international trade? How does Import Substitution Industrialization weigh against Export Promotion as a trade strategy?

How does the empirical evidence help us understand this? Trade strategies are classified into two broad strategies, outward-looking development policies and inward-looking development policies. Outward-looking development policies encourage free trade and free movement of the factors of production. While inward-oriented development policies encourage greater self-reliance and restricted trade. Within these two broad approaches lies the debate between Import Substitution (protectionism) and Export Promotion (free trade).

Import substitution (IS) is a well tested way to industrialization which has been followed by most of the currently developed and industrialized countries. Alexander Hamilton’s “Report on Manufactures” (1791) argued in favor of tariffs to protect American manufacturers from inexpensive imports from Britain. In the mid 19th century, Germany, Russia and Japan also practiced protectionism to develop their domestic industries. After the great depression of 1930’s, LDCs particularly Latin American and some Asian economies started practicing ISI and in 1960’s IS became a dominant strategy for development.

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However in the next decade, when industries protected through import substitution failed to achieve targeted productive and allocative efficiencies, countries switched to export promotion strategies. Hong Kong, South Korea, Taiwan and Singapore were among the first to adopt the export promotion strategy. Later, Chile, Thailand and Turkey also joined in. Over the years, the stance of countries has shifted from protectionism to free trade and globalization. So we will begin our paper by analyzing the arguments in favor and against ISI policies.

Then we will discuss the benefits and drawbacks faced by the countries that switched to the export promotion strategy. The paper also explains the reasons for this transition. Finally, it concludes by giving empirical evidence of the real world regarding the effects of these strategies. It has always been in the vested interest of the economies to protect country’s large and strategic markets from foreign competition so that the local industry not only becomes self sufficient but also is in a position to induce industrialization led economic growth.

In order to accomplish such goals, trends have shown (as mentioned above) countries’ increased dependence on substitution policies. Government plays a vital role in the implementation of these policies by imposing tariffs and quotas or altering the exchange rate and interest rate, using macroeconomic policies, to shield its local industries from the competitive foreign producers. Simultaneously, the foreign direct investments (FDIs) are expected to fill the gaps in technology and technical skills between the domestic and foreign industry.

The introduction of IS policy can be attributed to the Infant Industry Argument (Import Substitution In General Equilibrium can be used to demonstrate that how the IS works in infant industry) 1, which favors the protection of domestic industry from international competition. The aim is to remove distortions between the out-dated locally produced goods and the industrialized high quality imports of similar products. Policies which governments adopt includes introduction of tariffs 2; discouraging cheaper import and at the same time encouraging production of the same goods domestically.

Mostly consumer goods are produced under this strategy which ensures that the country is capable of meeting its basic necessities. Moreover, these types of goods require considerably less advanced technology, making the policy easier to adopt. Aristotle has said “What we have to learn to do, we learn by doing”; import protection is the best way to initiate this learning process because the economy is now producing goods that it previously imported - a process of development and learning by doing sets up. The economy can then move towards higher efficiency.

This eventually improves the balance of payments as fewer consumer goods are now imported. It is essential that the learning process is followed by accumulation of capital. This requires the manipulation in Interest rates so as to encourage savings, and these savings can then be invested back in the protected industry. There are some macroeconomic gains associated with this policy, including reduced unemployment and increased tax revenue for the government; increased local production is expected to generate job opportunities and at the same time, tariff on imports become a source of income for the government.  However, the IS policies have been criticized by economists for various reasons. According to them, the protection provided to the industries makes the industries inefficient because the firms start to rely on the provision of subsidies. They have no incentive to cut down costs to achieve minimum efficient scale of production and to increase productivity. Bhagwati in “Import substitution - a survey of policy issues” said that, “…such sheltered monopoly positions in import substituting industries are the prime cause of low productivity”.

Also, the government protection to infant industries is for a limited time period, in which most industries that lurk behind the wall of tariffs never grow up. In import substitution, main focus is on the consumer goods, and therefore the prospects of economic growth are relatively short-lived. For countries to achieve long term economic growth, structural shifts are required towards the production of capital-intensive goods.

However according to Jaleel Ahmad, the protection requires normally zero or low tariff on import of capital goods, hence discouraging development of forward linkages - manufacturing of the capital goods by local industries. Also for Import Substitution to be successful, according to Hirschman, forward and backward linkages need to be well-developed for the industries. This shows that for a country to have a manufacturing sector free from international dependence, it will need to develop other industries in consumer durables, non-durables, intermediate and capital goods.

Another argument against ISI strategies is that it leads to the worsening of Balance Of Payments (BOP) due to the overvaluation of exchange rate, causing the prices of exports to rise but at the same time lowering the prices of imports. As a consequence, producers of exportable goods become less competitive in world market, causing a negative impact on the BOP. Keeping in mind the undesirable impacts of IS policies, economists felt the need to revise the trade strategies.

Trade theorists therefore attempted to elucidate as to why nations engage in international trade, what combination of goods and services they trade, and how firms and consumers gain or lose from trade. It was observed that numerous international trade models rely primarily on the theory of Comparative Advantage (Appendix 1. 1), which describes trade patterns under assumptions of static conditions that hold the factors of production in fixed supply (Perkins). Theory of comparative advantage principally asserts that every country irrespective of its size can benefit from trade.

Trade driven through exports of goods in which the country has acomparative advantage, benefits the country the most. Therefore an export promotion trade strategy involving goods that require raw material, that are abundant in supply, will allow a country to grow more rapidly as stated by the Hecksher-Ohlin model. Proponents of EP mainly argue that free trade utilizes previously unused resources such as land and labor, creates a vent for surplus of unused resources and allows a country to operate on its Production Possibility Frontier (PPF). In contrast, before the opening up of the economy, the market is constrained to the domestic consumers only.

Once a country engages in free trade it acquires the opportunity to earn a global market share, thus earning higher revenues. As the market of local industries expands, demand for labor increases which raises the employment level in the country. This increase in exports stimulates domestic investment (an injection in the circular flow of the income of the country) which gives a multiplied effect on the Gross Domestic Product (GDP) of the economy. Furthermore, the enhanced exports will lead to a greater demand of domestic currency in the exchange market leading to currency’s appreciation (given the floating exchange rate mechanism).

According to the Marshall Lerner condition, which states that the sum of price elasticity of demand of exports and imports is lesser than 1 in short run, a currency appreciation will lead to an increase in the Balance Of Trade (BOT). 3 This relationship of BOT and time is shown through J-curve. An additional argument presented by the trade optimists states that the foreign exchange earned by selling different goods and services will relax the constraints of availability of financial capital or in other words, will fill the foreign exchange gap.

This also helps in relieving the pressure on foreign exchange reserves built by the import of heavy machinery and capital goods. A further extension of export promotion policy is the process of export development. It involves innovation (of new export products) and penetration into new markets. Learning process is instituted and hence increased productivity is observed. This initiates a process of transfer of technology and foreign investment from developed countries, helping the industry to become efficient and gain the economies of scale through mass production - lowering costs and increasing profits.

The increased profits of the industry promote higher savings and as the Harrod-Domar Model suggests, an increase in savings will lead to an increase in the growth rate of the economy. The Export promotion strategy is not free of criticisms as one might expect. The leading criticism of opponents of export promotion strategy is the sluggish growth in the demand of the primary goods. As developing country relies mainly on the export of primary goods, the sluggish growth enhances the volatility in the earnings of the economy. The Prebisch Singer Hypothesis explains this phenomenon in terms of income elasticity and price elasticity of demand.

The thesis postulates that the price elasticity and income elasticity of primary goods are both inelastic i. e. less than 1. As the national income of the developed countries increases, the demand for the primary goods does not increase proportionately. This is also stated by Engel’s Law. A decrease in the prices of the exports will not lead the quantity traded to increase by the same percentage, thus resulting in fall of the exports revenue. This fall in exports revenue leads to a deterioration of Terms of Trade (TOT) of the country.

Other factors that explain the slow growth in primary goods exports include the development of synthetic substitutes and protectionist measures taken 3  by the developed countries. The population growth of developed countries being at replacement level translates into a stagnant demand for primary exports. Empirical evidence shows that heavy reliance on the export of the primary product may actually result in a phenomenon known as the Dutch disease; a country rich in natural resources actually suffers from slower growth as a result of that rich endowment.

This is one of the often repeated facts of history when criticizing the strategy of export promotion. It was mentioned earlier that an appreciation in a country’s currency will lead to an increase in BOT, but this will only remain true for the short run. In long-run the sum of elasticity of demands of exports and imports becomes greater than 1 which consequently causes a fall in the net exports. Therefore the aforementioned argument is valid in the short-run only as in long-run it balances out its own effect on BOT 4 as shown below with the aid of diagram.

In addition to the criticism mentioned earlier, Export Promotion strategy may lead to higher budget deficit. It is a usual practice of the governments to subsidize the exporting industries. These subsidies will be financed either by an increase in taxes or by reducing the expenditure on public and merit goods such as health, education, infrastructure, national defense and other social services. Due to this practice, the development side of the country is often sidelined or overlooked.

Example of China can be the best evidence for our claims about Export Promotion here. China was a closed economy until the 1970s. Nicholas R. Lardy in his article, Trade liberalization and  its role in Chinese economic growth, states that around 1970s, China’s export goods had no comparative advantage and at the same time, high level of control on imports was also imposed. Hence quoting from the article, “China’s share of world trade dropped markedly, from 1. 5 percent in 1953 to only 0. 6 percent in 1977”.

However, during the 1980s the process of trade liberalization began and by the time china entered WTO in 2001, her structure of trade policy was completely changed. China fully realized the significance of the comparative advantage principle and concentrated on export of goods that were labor intensive in production, as the article states that “China’s fastest growing exports have been labor-intensive manufacturers— textiles, apparel, footwear, and toys. Between 1980 and 1998, export of these items rose more than ten-folds, from $4. 3 billion to $53. 5 billion”.

Due to the trade liberalization, China experienced high rates of economic growth. Empirical evidence strongly suggests that pragmatism and eclecticism rules over any other single purpose approaches to trade. Thinking just in terms of an all out import substitution or an export promotion strategy can pose as an impediment to one’s clear understanding of the relationship between these strategies and growth. In future it would be better to avoid labels and to construct strategies from the components of either of these trade policies that seemed to have worked.

Import substitution with its divorce of production decisions from market conditions seems to have lost its modern day relevance. In contrast, export promotion with its orientation towards world markets appears to be in line with the new phenomenon that is globalization. No single optimal prescription in terms of trade policy can be devised for the countries at large due to the dynamism of international trade. No strategy can be concluded as the best strategy for a country but what can be said is its relevance to a country at a point in time.

Although empirical evidence shows that export promotion has helped countries like China to grow rapidly and improve its trade positions but we can also find other countries which developed after adopting import substitution policies like Latin American countries. This suggests that country have to adopt a trade strategy which is most compatible for their country at that time so that they can achieve maximum gains from trade.  Comparative Advantage Theory: The concept of comparative advantage, attributed to David Ricardo, refers to the ability of a country to produce at a lower opportunity cost.

It is the ability to produce the most efficient product as compared to other countries. It is best explained by a two-good, two country framework where countries differ in particular factor productivity or factor endowments. This theory explains that it is welfare enhancing for both countries to specialize in one good and import the other. The conclusion drawn from this theory is that each country gain by specializing in the good where it has comparative advantage and trading that good for other. 1. 2 Trade protectionism and Tariffs:

Government impose trade restrictions in form of tariff in which it collects tax on goods imported by the people, thus discouraging the people to import goods and encouraging the local industries to produce good quality substitute goods. Introduction of tariff increases the world price, which reduces the amount of imports and increases the amount of locally consumed products.  vs. EP 10 1. 3 Inverted J-curve for revaluation of currency: The inverted J-curve refers to the trend of a country’s trade balance following a revaluation or appreciation of the currency.

A revalued currency means that exports are more expensive for the foreign countries, but as in the short run demand for the more expensive exports remain price inelastic so the quantity demanded for exports remains same although foreigners are paying higher prices. This leads to the improvement of balance of trade. Over the long term, as the foreign consumers are able to switch to the other goods, the quantity demanded for exports becomes price elastic so reduction in the export volume and hence export revenues.

This leads to the deterioration of balance of trade and the gains in the short run are off-set by the losses in the long run. In case of devaluation of currency, there are opposite affects.

Infant IndustryArgument(ISI in general equilibrium) :  From diagram 1. 4. 1 it can be seen that before the imposition of tariff the country was producing at point A while consuming C amount of goods under world terms of trade (favorable to its export).

But after the imposition of tariff, production moves towards point B where more of the importable and less of exportable goods are being produced. Assuming that this does not affect the world prices, trade will take place at same TOT. So the new consumption is indicated by point E along the line BD (parallel to line representing world TOT). Initially, by practicing ISI polices, both consumers and trade welfare has fallen due to lower consumption and fewer imports and exports (BE

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