Rise and fall of import substitution in an international context | Print edition


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Tea tasting. Tea exports are a good example of how Sri Lanka has benefited.

During a recent webinar, I was listening to an argument between an economist and a businessman. The economist said: “Export expansion will be discouraged by import protection.” Obviously, that was a confusing statement for many and that was exactly the point made by the businessman: “We are talking about import protection, not export expansion; import protection is necessary to protect our domestic industries ”.

I must say at the outset that both statements are correct, but only in their own premises! If they try to enter each other’s domain by justifying these statements, no matter how deep the arguments, they are both wrong! I know, it’s even more confusing now, so I thought I would raise this question to clear up any doubts.

Terrible misconceptions

There is a terrible misconception that “when someone knows the economy, they can do better business”. I haven’t met a lot of economists who have become businessmen either. Even the great English economist who wrote the first macroeconomic book “The General Theory of Employment, Interest and Money” (1936) and who gave birth to the so-called Keynesian economic tradition, would have lost his investment in the stock market! However, this also does not lead to a conclusion. There are those economists and businessmen who could avoid the losses of the American financial crisis in 2008 by following the economic booms.
and busts.

In his above-mentioned statement, the economist was referring to the “economy-wide” outcome of import protection based on established economic principles, which have been studied and tested for hundreds of years now. .

The businessman, on the other hand, was referring to a business activity – perhaps, his own business. There are businessmen all over the world who have made their fortunes with their businesses when competition is blocked by import controls. Needless to say, these companies are plentiful these days. Because of the import controls in place, they could sell at a high price by exploiting customers who had no choice in the open market; of course, this is a welcome initiative from a business point of view for some companies.

It is a terrible mistake, however, as the businessman argued above, if he believes his individual fortune can be multiplied and extended nationally. This error is called in economics, “a composition error” – what is right for a part is right for the whole! The problem can translate into a “crisis” when businessmen with their “composition fallacy” in mind get together and think about formulating development policies for a country!

Why does such a business strategy not work for a country? This is exactly what the economist’s statement meant: “Export expansion will be discouraged by import protection.” There are a few questions that would flow from this statement: The first is the nexus between the two – import protection and export expansion, which appear to be mutually exclusive. The second is that even though the two are connected, then what’s the problem?

Passion and fashion

At the end of World War II, it was in the 1940s that “import substitution” policies became the passion and fashion in “underdeveloped” countries. Intellectual support has been provided by several political economic ideologies such as structuralists, dependency theorists, and neo-Marxists. They pleaded for underdeveloped countries to sever their trade links with western industrialized countries and become “import substitution” economies. This meant that underdeveloped countries had to reduce their “imports” from western industrialized countries – the United States and Europe – and start producing “import substitutes” by themselves and for themselves!

According to all these economic ideologies, the existing trade patterns between western industrialized countries and poor underdeveloped countries were the “mechanism” put in place by the former to exploit the latter – just as the “bourgeoisie” exploits the “proletariat” in Marxist terminology; the first is the capitalist class, while the second is the working class. This means that the Western countries have played the role of “bourgeoisie” exploiting the latter which has played the role of “proletariat”.

We must not forget that this was also the time when the world was caught up in the Cold War – the competition between the capitalist bloc led by the United States and the socialist bloc led by the USSR in order to dominate the world. It was also the time when the colonized underdeveloped countries began to gain their political independence from the Western colonizers. And they were the battleground of the Cold War.

All the “anti-Western” and “pro-nationalist” sentiments prevalent in the newly independent states were in favor of the new development strategy – the import substitution policy, which aimed to dissociate itself from the West. Here is also a new “angel” to support them – the USSR, which was seen at the time as a successful case of “import substitution”. Much more than that, he could stand shoulder to shoulder with the United States and fight the global capitalist enemy.

Disastrous end

Import substitution by import controls, started in Latin American countries with the full support of the Economic Commission for Latin America (CEPA); then it spread to Africa and Asia – almost throughout the underdeveloped world. Import controls were enacted with high tariffs, non-tariff barriers and currency restrictions. From the 1950s to the 1980s, they attempted to replicate the prosperity of the industrialized Western world through an import substitution route based on a different set of economic principles.

Towards the end of the road it was a dead end; they saw that their economies were slowing and unemployment was getting worse; they failed to reduce their import bill but instead found that their foreign exchange shortage had worsened. By taking this route, in fact, they all seemed to have lost about a quarter of a century.

At the same time, four East Asian countries had not subscribed to the import substitution policy: South Korea, Singapore, Taiwan and Hong Kong. Instead of replacing imports, these countries continued to promote exports. They managed to achieve faster growth, higher per capita income and job creation, while overcoming the problem of a currency shortage. Of course, on learning from them, almost all developing countries then embarked on policy reforms in favor of export promotion.

Why have the few export-oriented countries succeeded when all the import substitution countries all over Latin America, Africa and Asia have failed? The question has been well documented, leaving no room for doubt, both theoretically and empirically. These economic studies are immense; some of them analyzed the question of “why did import-substitution countries fail”, while others focused on the question “why did export-oriented countries prosper” . This is where you find the answer to resolve the confusion I raised at the beginning.

Anti-export bias

If a country adopts a set of import controls and offers protection to selected companies, it will have monopoly power in the protected local market to exploit its customers and prosper. Some would justify it by saying that “one day in the future” they will become business tycoons!

But if you adopt it as a “national policy” to protect domestic industries with import controls, this is exactly what underdeveloped countries have done under import substitution policy and have failed miserably. . The main reason is that the domestic market is “too small” for any country. Whether it is Singapore with 5 million inhabitants or China with more than 1 billion inhabitants and, Sri Lanka with 20 million inhabitants or India with more than 1 billion inhabitants, they are all too small for each of them!

By definition, import substitution means adopting policies aimed at artificially making domestic markets more profitable than export markets. Indeed, this results in a reallocation of resources towards production for the domestic market, creating what is called the political bias against exports. While the domestic market is too small to grow, export growth will slow down. This means that countries that adopt import controls are doomed to become more entangled in a currency crisis. Theoretically, import controls are no different from export taxes!

(The author is Professor of Economics at the University of Colombo and can be reached at [email protected] and follow on Twitter @SirimalAshoka).


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