Import substitution industrialization

Import substitution industrialization or "Import-substituting Industrialization" (often called ISI) is a trade and economic policy that advocates replacing foreign imports with domestic production. ISI is based on the premise that a country should attempt to reduce its foreign dependency through the local production of industrialized products. The term primarily refers to 20th century development economics policies, although it has been advocated since the 18th century by classical economists such as David Ricardo, John Stuart Mill and Friedrich List.

ISI policies were enacted by countries within the Global South with the intention of producing development and self-sufficiency through the creation of an internal market. ISI works by having the state lead economic development through nationalization, subsidization of vital industries (including agriculture, power generation, etc.), increased taxation, and highly protectionist trade policies. Import substitution industrialization was gradually abandoned by developing countries in the 1980s and 1990s due to structural indebtedness from ISI related policies on the insistence of the IMF and World Bank through their structural adjustment programs of market-driven liberalization aimed at the Global South.

In the context of Latin America development, the term Latin American structuralism refers to the era of import substitution industrialization in many Latin American countries from the 1950s until the 1980s. The theories behind Latin American structuralism and ISI were organized in the works of Raúl Prebisch, Hans Singer, Celso Furtado and other structural economic thinkers, and gained prominence with the creation of the United Nations Economic Commission for Latin America and the Caribbean (UNECLAC or CEPAL). While the theorists behind ISI or Latin American structuralism were not homogeneous and did not belong to one particular school of economic thought, ISI and Latin American structuralism and the theorists who developed its economic frame work shared a basic common belief in a state-directed, centrally planned form of economic development. In promoting state-induced industrialization through governmental spending through the infant industry argument, ISI and Latin American structuralist approaches to development are largely influenced through a wide-range of Keynesian, communitarian and socialist economic thought. ISI is often associated and linked with dependency theory, although the latter has traditionally adopted a much broader sociological framework in addressing the cultural origins of underdevelopment through the historical effects of colonialism, Eurocentrism, and neoliberalism.

History

Even though ISI is a development theory, its political implementation and theoretical rationale are rooted in trade theory: it has been argued that all or virtually all nations that have industrialized have followed ISI. Import Substitution was heavily practiced during the mid-1900’s as a form of developmental theory which believed to increase productivity and economic gains within a country. This was an inward- looking economic theory practiced by developed nations post WW2. Many economists at the time considered the ISI approach as a remedy to mass poverty; to bring a third world country to first world standing through national industrialization. Mass poverty is defined as the: “the dominance of agricultural and mineral activities-in the low-income countries, and in their inability, because of their structure, to profit from international trade,” (Bruton 905).

Mercantilist economic theory and practices of the 16th, 17th, and 18th centuries frequently advocated building up domestic manufacturing and import substitution. In the early United States, the Hamiltonian economic program, specifically the third report and the magnum opus of Alexander Hamilton, the Report on Manufactures, advocated for the US to become self-sufficient in manufactured goods. This formed the basis of the American School, which was an influential force during the United States in the 19th century industrialization.

Werner Baer contends that all countries that have industrialized after the United Kingdom went through a stage of ISI in which the large part of investment in industry was directed to replace imports (Baer, pp. 95–96). Going farther, in his book Kicking Away the Ladder, Korean economist Ha-Joon Chang also argues, based on economic history, that all major developed countries, including the United Kingdom, used interventionist economic policies to promote industrialization and protected national companies until they had reached a level of development in which they were able to compete in the global market, after which those countries adopted free market discourses directed at other countries to obtain two objectives: open their markets to local products and prevent them from adopting the same development strategies that led to the developed nations' industrialization.

Theoretical basis

As a set of development policies, ISI policies are theoretically grounded on the Singer-Prebisch thesis, on the infant industry argument, and on Keynesian economics. From these postulates, it derives a body of practices, which are commonly: an active industrial policy to subsidize and orchestrate production of strategic substitutes, protective barriers to trade (such as tariffs), an overvalued currency to help manufacturers import capital goods (heavy machinery), and discouragement of foreign direct investment.

Due to the exploitation the laissez-faire market indirectly performs third world countries began to self-rely on themselves. To fight mass poverty of the respected country, ISI was an implement for the infant-industry argument. To compete in the world market with first world countries, third world and/or developing countries would protect their “infant” new industries until a sufficient amount of knowledge, capital and comparative advantage is accumulated. Harold J. Burton in his paper ‘A Reconsideration of Import Substitution’ states: “The very idea of import substitution implied this: keep out that which is now imported from the North and produce it at home,” (Bruton 910). That is the North developed and industrialized markets will not be a factor or a source for resources for the undeveloped and developing south.

By placing high tariffs on imports and other protectionist, inward-looking trade policies the citizens of the respected country by simple supply and demand rationale will substitute the lesser expensive good for the more expensive. The primary industry of importance would gather its resources such as labour from other industries in this situation; the industrial industry would use resources, capital and labour from the agricultural. In time a third world country would look and behave similar to a first world and with the new accumulation of capital and comparative advantage, and the increase of TFP (total factor productivity) the nation’s industry will be capable to trade internationally and compete in the world market. Bishwanath Goldar in his paper ‘Import Substitution, Industrial Concentration and Productivity Growth in Indian Manufacturing’ writes: “Earlier studies on productivity for the industrial sector of developing countries have indicated that increases in total factor productivity, (TFP) are an important source of industrial growth,” (Goldar 143). He continues that “a higher growth rate in output, other things remaining the same, would enable the industry to attain a higher rate of technological progress (since more investment would be made) and create a situation in which the constituent firms could take greater advantage of scale economies;” it is believed that ISI will allow this (Goldar 148).

In many cases, however, these postulates did not apply: on several occasions, the Brazilian ISI process, which occurred from 1930 until the end of the 1980s, involved currency devaluation as a means of boosting exports and discouraging imports (thus promoting the consumption of locally manufactured products), as well as the adoption of different exchange rates for importing capital goods and for importing consumer goods. Moreover, governmental policies toward investment were not always opposed to foreign capital: the Brazilian industrialization process was based on a tripod which involved governmental, private, and foreign capital, the first being directed to infrastructure and heavy industry, the second to manufacturing consumer goods, and the third, to the production of durable goods (such as automobiles). Volkswagen, Ford, GM and Mercedes all established in Brazil in the 1950s and 1960s.

The major and unifying postulate of ISI can thus be described as an attempt to reduce foreign dependency of a country's economy through local production of industrialized products, whether through national or foreign investment, for domestic or foreign consumption. It should be noted, as well, that import substitution does not mean import elimination: as a country industrializes, it begins to import other kinds of goods which become necessary for its industry, such as petroleum, chemicals, and the raw materials it may lack. The real objective of import substitution is therefore not to eliminate trade but to lift it to higher stage, that of exporting value-added products, not as susceptible to economic fluctuations as raw materials, according to the Singer-Prebisch thesis.

Latin America

Import substitution policies were adopted by most nations in Latin America from the 1930s until the late 1980s. The initial date is largely attributed to the impact of the Great Depression of the 1930s, when Latin American countries, which exported primary products and imported almost all of the industrialized goods they consumed, were prevented from importing due to a sharp decline in their foreign sales. This served as an incentive for the domestic production of the goods they needed.

The first steps in import substitution were less theoretical and more pragmatic choices on how to face the limitations imposed by recession, even though populist governments in Argentina (Juan Domingo Perón) and Brazil (Getulio Vargas) had the precedent of Fascist Italy (and, to some extent, the Soviet Union) as inspirations of state-induced industrialization. Positivist thinking, which sought a "strong government" to "modernize" society, played a major influence on Latin American military thinking in the 20th century. Among the officials, many of whom rose to power, like Perón and Vargas, industrialization (especially steel production) was synonymous of "progress" and was naturally placed as a priority.

ISI gained a theoretical foundation only in the 1950s, when Argentine economist and UNECLAC head Raúl Prebisch was a visible proponent of the idea, as well as Brazilian economist Celso Furtado. Prebisch believed that developing countries needed to create local vertical linkages, and they could only succeed by creating industries that used the primary products already being produced domestically. The tariffs were designed to allow domestic infant industries to prosper.

ISI was most successful in countries with large populations and income levels which allowed for the consumption of locally produced products. Latin American countries such as Brazil, Mexico, and (to a lesser extent) Chile, Uruguay and Venezuela, had the most success with ISI. This is so because while the investment to produce cheap consumer products may pay off in a small consumer market, the same can not be said for capital-intensive industries, such as automobiles and heavy machinery, which depend on larger consumer markets to survive. Thus, smaller and poorer countries, such as Ecuador, Honduras, and the Dominican Republic, could implement ISI only to a limited extent. Peru implemented ISI in 1961, and the policy lasted through to the end of the decade in some form.

To overcome the difficulties of implementing ISI in small-scale economies, proponents of this economic policy, some within UNECLAC, suggested two alternatives to enlarge consumer markets: income distribution within each country, through agrarian reform and other initiatives aimed at bringing Latin America's enormous marginalized population into the consumer market, and regional integration through initiatives such as the Latin American Free Trade Association (ALALC), which would allow for the products of one country to be sold in another.

In Latin American countries in which ISI was most successful, it was accompanied by structural changes to the government. Old neocolonial governments were replaced by more or less democratic governments. Banks and utilities and certain foreign-owned companies were nationalized or transferred ownership to local businesspeople.

Many economists contend that ISI failed in Latin America and was one of many factors leading to the so-called lost decade of Latin American economics. Other economists contend that ISI led to the "Mexican Miracle," the period that lasted from 1940 to 1975 in which economic growth stood at 6% or higher.

East Asia

ISI was rejected by most nations in East Asia in the 1960s, and some economists attribute the superior performance of East Asia in the 1970s and 1980s to this difference in policies. Indeed, East Asian policies are most commonly not referred to as ISI.

Most "East Asian Tigers" rejected import substitution policies, though they maintained high tariff barriers. The strategy followed by those countries was to focus subsidies and investment on industries which would make goods for export, and not to attempt to undervalue the local currency. This export promotion approach to industrialization in the East Asian countries contrasts with the strategy of ISI. In pursuing this and to boost its competitiveness in the 1970s, South Korea made large investments into heavy and chemical industries, such as shipbuilding, steel and petrochemicals. This focus on export markets allowed them to create competitive industries. Export-oriented policies stem competition. Through competition lies innovation and invention in the technological realm of economic behaviour. With innovation costs are cheaper and total factor productivity increases, growth attains and a greater presence in the world market will be present. Goldar summarizes his paper “A significant positive relationship was found between TFP growth and output growth, and a significant negative relationship between TFP growth and import substitution. It seems from the regression results that a 1 per cent higher growth rate in output was associated with about 0.5 per cent higher growth rate in TFP. Further, a 10 per cent higher contribution of import substitution to change in output was associated with about 0.6 per cent lower annual growth rate in TFP,” (Goldar 160). An additional reason to the success of East Asia was the change in government practices. They changed their autocratic government to that of a democratic fashion.

Advantages and disadvantages

The major advantages claimed for ISI include increases in domestic employment (reducing dependence on labour non-intensive industries such as raw resource extraction and export); resilience in the face of a global economic shocks (such as recessions and depressions); less long-distance transportation of goods (and concomitant fuel consumption and greenhouse gas and other emissions).

A disadvantage claimed for ISI is that the industries that it creates are inefficient and obsolete as they are not exposed to internationally competitive industries, which constitute their rivals, and that the focus on industrial development impoverishes local commodity producers, who are primarily rural.

Rather than maintain an ‘inward-looking’ economy, the idea of catching up can be much faster with strong competition rather than the domestic competition of people with similar levels of human capital. In continuation, with small external scale economies, the country’s costs maintain high and knowledge accumulation will not steadily or slowly increase. Goldar takes note that in India “that policies of import substitution and domestic industrial licensing have led to considerable inefficiency in the industrial sector, and that policies for checking concentration (restrictions against large industrial houses, discrimination in favour of small scale units, etc.) have resulted insignificant loss of scale economies,” (Goldar 144). Additionally, import substitution was in place as a remedy for mass poverty, unemployment and economic growth however,

“The collections of Balassa and Little et al. made abundantly clear that import substitution policies had created major distortions and had thereby resulted in a misuse of resources. 33 So it was increasingly evident that something needed fixing. Two other sources of concern appeared in the early 1970s and suggested that there were other things that needed fixing as well. The first, already referred to, was that the demand for labor in the new activities was growing more slowly than the rates of growth of output and investment had led most observers to expect. As a consequence of the slow growth of employment (and other things), poverty was alleviated only modestly,” (Bruton 917).

Crises

ISI can cause crises by several ways:

Chronic problems with the balance of trade and payments

Import substitution was supposed to reduce reliance on world trade, but every nation needs to import something not available locally like raw materials, machinery, spare parts. The more a country industrialized, the more it needs these imports, and ISI is strongly biased against exports. Trade protection and overvalued exchange rates raised domestic prices and made export less competitive and export taxes furthermore discourage foreign sales. So the industrializing countries are unable to export enough to buy the imports they needed.

Nations which practiced ISI had rates of protection so high that they allowed many inefficient firms to run. They’re costs were larger than their profit and the economy was losing money rather than gaining.

Deep recessions

The faster the economy grows, the more it needs imports, but exports cannot keep up with the pace of imports and so the country runs out of foreign currency. The governments try to restrict import to essentials and raise interest rate to bring money to the country and keep it at home. They devalue the currency to raise the price of imports and make exports more attractive, also reducing the countries' purchasing power, which resulted in usually deep recessions.

ISI countries tended to run substantial budget deficits and inflation

Government subsidized industrial investments give tax breaks to industrial investors and targeted spending at politically important groups but such spending chronically outpaces government revenue, and these budget deficits atr usually covered by printing more money. The result was inflation, which makes domestic goods more expensive, which in turn reduces exports even further.

Negative impact on income distribution

Many farmers migrated to the cities in search for jobs in the new industries. Since import-substitution growth was very capital intensive. Few of the farmers who flooded into the cities find the jobs that industrialization had promised. ISI countries end up with dual economies;

On one hand, modern capital-intensive industries with skilled, well-organized workers earning relatively high wages

On the other hand, a mass of struggling farmers and urban poor frozen out of the modern economy, given very low wages and excluded from the social protections which modern sector workers received

Incentive for capitalists to resist state planning

To carry out industrial planning, states need to build the necessary state institutions, such as a Planning Commission, to formulate production targets and later enforce them. But since ISI industries were protected from international competition, capitalists are not compelled by the market to meet international standards of efficiency. Thus, capitalists often resist state efforts to enforce industrial plans and force investments in improving productivity.

In India, for example, Vivek Chibber has shown that efforts by the state to put in place the proper institutional framework for state planning are strongly resisted by Indian capitalists. This resulted in an ineffective state apparatus that was incapable of carrying out coherent industrial planning. Under export-oriented industrialization in South Korea, on the other hand, there was a positive incentive for capitalists to comply with state planning because international competition on world markets would compel capitalists to upgrade production to international standards.

This allowed for a different relationship between the state and private sector, and more successful state planning.

Causes for Failure and the Solution to ISI

The major cause for the failure of ISI was the high rates of protection which allows inefficient firms to remain in the industry causing a country to actually lose money than gain profits. Additionally, are the misuse of these protectionist policies and the instability of the institutions and government policies which are detrimental barriers to economic growth and TFP. Many nations practice protectionist policies to trade but those with free trade and governments which do not allow the total division of state and market but remaining democratic can be seemed economically successful and first world such as Canada. Human capital was lacking in these nations post WW2. They did not have the physical means, the well -educated mind nor the monetary resources to succeed. Harold J. Bruton says the success to South Korea and Taiwan after implementing an export-orientated trade policy was well developed human capital to learn from the North and “create, borrow and adapt from the North increasingly productive technologies,” (Bruton 922).

ISI is an inward looking approach to trade, so theoretically, it may be fair that export-oriented trade policies will be the solution. This is correct. However, export-oriented growth is not alone necessary for an increase in TFP. Research have summarised that an increase in human capital is necessary. The implementation and practice of efficient institutions should also be a great concern; if necessary structural change should be of importance.

Opening up to trade “ [provides] significant productivity gains resulting from advances in technology, improvement in labour quality, and learning by doing, it would follow that these favourable influences were cancelled by the adverse effects of certain other factors,” (Goldar 147). The other factors are start-up costs, cultural loss and etc. With a larger market a country will specialize in a certain industry thusly, competing with nations. Competition promotes innovation which constitute to cheaper costs and specialization allows the exploitation of external scale economies. Large scale economies have a larger output which again has cheaper costs. Basic benefit-cost analysis of economic development proves with cheaper costs are larger profits. These larger profits will be invested for further capital accumulation through investment in the respected economy. Goldar states in the aforementioned paper, “... to attain a high rate of TFP growth, the development strategy should be such that domestic producers face strong competition and are allowed and induced to set up plants big enough to exploit scale economies,” (Goldar 160). Then the developing nation will (for example) import agricultural goods at a cheaper cost and focus more on the industrialization of the nation. South Korea and Taiwan are great examples of such practices after dismissing ISI. Bruton in the aforementioned essay concludes:

“The exceptional performance of the Republic of Korea and Taiwan in the 1960s had, by 1970 or so, attracted the attention of the development community. Their growth rates of GDP in-creased markedly in the 1960s relative to the 1950s: from about 6.5 percent to over 10 percent in Taiwan, and from 4.4 to 9.1 in Korea. These increases were much larger than those for any other country. Employment growth and poverty alleviation were also proceeding much better than in most other countries. Taiwan and Korea had made marked policy changes in the late 1950s and early 1960s that reduced distortions and encouraged firms to export. Exports had responded remarkably well. In both countries the rate of growth of exports exceeded that of GDP during the 1960s, and this strong growth was largely among non-traditional products and services. By the early 1970s or so, Taiwan and Korea were widely thought to be market-driven economies…,” (Bruton 921).

With reference to efficient institutions, specialization in a respected industry- agriculture for South Korea and Taiwan- Bruton continues, “knowledge and the fundamental role of searching and learning by firms and governments, of a necessary role for agriculture, of the role of initial conditions and hence of history and institutions, and of the fact that effective implementation of policies is as important as the choice of policies…,” (Bruton 926).

See also

• International trade
• Singer–Prebisch thesis
• Export-oriented industrialization
• Commanding Heights for an exposition of the effects of ISI on Latin American economies

Sources

• Chasteen, John Charles. 2001. Born in Blood and Fire. pages 226-228.
• Reyna, José Luis & Weinert, Richard S. 1977. Authoritarianism in Mexico. Philadelphia, Pennsylvania: Institute for the Study of Human Issues, Inc. pages 067-107.
• UNDP Paper
• Bruton, Harold J. "A Reconsideration of Import Substitution." Journal of Economic Literature. 36.2 (1998): 903-936. Print.
• Bishwanath, Goldar. "IMPORT SUBSTITUTION, INDUSTRIAL CONCENTRATION AND PRODUCTIVITY GROWTH IN INDIAN MANUFACTURING* PRODUCTIVITY GROWTH IN INDIAN MANUFACTURING." Oxford bulletin of Economics and Statistics. 48.2 (1986): 143-164. Print.