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Hilal English

Bridging the Dichotomy between Import-Substituting and Export-Promoting Strategies

October 2023

The complementary IS-EP policy is expected to create import-competing rather than import-substituting intermediate inputs for their end use in producing exportable final goods. Industrial development herein requires sensible and pragmatic policies where import substitution and export promotion are critical. This article makes compelling arguments for creating complementarity between IS and EP industries for remarkable outcomes.



Development strategies are implemented to build a robust industrial production structure and base. Most developing countries started with an import-substituting (IS) industrialization strategy in this context. It was followed by an export-promoting (EP) strategy, which motivated some other countries to make a strategic shift towards export promotion, creating impressive growth and sharp poverty reduction outcomes.
It is worth noting that the IS and EP dichotomy was originally derived from the static trade models. However, a successful IS strategy was complementary to the EP strategy in more dynamic models where the static parameters are allowed to change. Developing countries are now gradually adopting the recommendations of dynamic models. The complementary IS-EP policy is expected to create import-competing rather than import-substituting intermediate inputs for their end use in producing exportable final goods. Industrial development herein requires sensible and pragmatic policies where import substitution and export promotion are critical. This article makes compelling arguments for creating complementarity between IS and EP industries for remarkable outcomes.
Import-substituting Epoch
The concept of import-substituting industrialization emerged shortly after World War II when many economists argued that, owing to a sequential fall in ‘terms of trade’ and insensitivity of foreign consumers’ demand relative to incomes for their exportable goods, the prospects of developing countries achieving economic growth through trade were thin. They promoted the idea that developing countries should restrict imports of manufactured goods to promote import-substitute industries serving their domestic markets and reduce their dependence on trade. The ‘infant industry argument’ was invoked to provide intellectual legitimacy to protect domestic industries.


The concept of import-substituting industrialization emerged shortly after World War II when many economists argued that, owing to a sequential fall in ‘terms of trade’ and insensitivity of foreign consumers’ demand relative to incomes for their exportable goods, the prospects of developing countries achieving economic growth through trade were thin. 


According to the ‘infant industry argument’, developing countries have a potential comparative advantage in manufacturing some products, but their industries cannot initially withstand competition from well-established foreign competitors. To allow manufacturing to get a strong foothold, developing countries should temporarily support new industries until they are able to face international competition. Thus, protecting new industries by restricting imports to industrialize the country is important.
Many developing countries, including Pakistan, perceived this argument as a compelling reason to provide exceptional support for the development of manufacturing industries. Such support could be provided in a variety of ways, including tariffs and import quotas, subsidies for production, or subsidies for the export of some manufactured goods in which they believe they can develop a comparative advantage or by devaluing the local currency, which would raise import prices in the domestic market. In most developing countries, however, the basic strategy for industrialization has been to develop industries oriented toward their domestic market by using trade restrictions to encourage the replacement of imported manufactures by domestic products.
The idea behind import substitution is simple: Why does a country import goods if it can produce them locally by employing local workers? The proponents of the IS strategy argued that it provides a shield to the vulnerability of a country from trade shocks. Moreover, it enables a country to reduce its import bill. The saved foreign currency can be used for development projects. 


To allow manufacturing to get a strong foothold, developing countries should temporarily support new industries until they are able to face international competition. Thus, protecting new industries by restricting imports to industrialize the country is important.


Despite its superfluous benefits, the IS strategy gradually began to lose favor among economists and policymakers due to the rising cost of protection and weak economic outcomes realized by implementing countries. On top of this, it became clear that countries pursuing IS strategy were not catching up with advanced countries. Some developing countries lagged further behind advanced countries even as they developed a manufacturing base.
Why didn’t the import substitutions strategy work as intended? International experience shows developing countries lacked skilled labor, entrepreneurs, managerial competence, and social organization, making it difficult for them to maintain reliable input supplies for domestic industries and consequently failed to develop at the desired levels.
Another problem was that many countries used complex methods to promote their infant industries. For instance, they used elaborate and often overlapping import quotas, exchange controls, and domestic content rules instead of simple tariffs. In this context, studies show that the extent of effective protection is often both higher and more variable across industries than the government intended. Of course, border smuggling and import under-invoicing erode the protection to a certain degree. These problems were not beyond the reach of economic policy to find a solution, but trade policy was unable to solve them: import restrictions can allow an inefficient firm to survive, but they cannot make it efficient. 
Another cost element is the tendency of import restrictions to promote production fragmentation on an inefficiently small scale. The domestic market is often not large enough to benefit from scale economies. Yet, when a small market is protected, if only a single firm were to enter the market, it could earn monopoly profits. The contest for these profits typically leads many firms to enter the market that does not have enough room, even for a single firm. Thus, production is carried out at a highly inefficient scale. Pakistan’s automobile sector typically represents this situation. The solution for small markets is to specialize in producing and exporting a limited range of products and importing other goods. Ironically, the IS strategy eliminates this option by focusing industrial production on the domestic market and producing virtually everything domestically.


Given the higher trade costs to import inputs, the inputs must be produced and supplied by IS firms, domestic and foreign, at internationally competitive rates to final goods-producing domestic EP firms.


The import-substitution experience of Pakistan is not very encouraging. IS policies created economic inefficiencies via production fragmentation. In short, Pakistan established many small and inefficient enterprises protected from foreign competition. In my study with others, we found that many Pakistani industries had a negative value added at world prices, implying extreme inefficiency. How did they survive? Their survival was obligated to extreme protection.
Export-promoting Epoch
IS remained a preferred policy until the 1980s, when the debt crisis began to surface, forcing developing countries to introduce major corrections in their industrial and trade policies and paving the way for an EP strategy focused on expanding exports and promoting more rapid technological change. It incentivized industries to participate in export-related activities.
Developing countries that followed relatively freer trade policies had, on average, grown more rapidly than those that followed protectionist policies. This change led to a considerable policy shift, as many countries removed import quotas, lowered tariffs, and opened their economies to import competition. 
Trade liberalization introduced at least four effects:
▪ A remarkable increase in the volume of trade.
▪ A change in trade pattern from semi-manufactured to manufactured products.
▪ Realization of the gains from scale economies in terms of lower average cost and bigger product varieties.
▪ A rise in innovative products.
Consequently, academicians and policymakers no longer supported the IS strategy as it became exceedingly clear that it was not delivering on its promise of rapid economic growth and social development.
The EP strategy provided domestic competitive industries—generally labor-intensive and natural resource-based—with exposure to trade on a competitive basis, rather than through protectionist policies. Of course, Pakistan's EP industries are a particular case that draw heavy subsidies from the government. Internationally, EP industries substitute capital with labor, resulting in a lower cost of production and thus enhancing their competitive strength in the export markets. 
Export-promoting industries by earning foreign exchange have enabled countries to sharply build foreign exchange reserves compared to foreign exchange savings made by import restrictions—a lesson to learn by Pakistan. Moreover, a successful EP strategy creates much more productive employment than import substitution. 


The SIFC is assigned a clear mandate to facilitate and promote investment to play a significant role in aligning investment and trade policies to support a more balanced and sustainable economic development approach. It is serving as a ‘One-Window’ platform to fast-track decision-making for the promotion of FDI.


Nevertheless, over-dependence on exports may damage export-oriented industries during global recessions, whereas import substitution industries survive. Therefore, there is a need to adopt a balanced approach to sustain growth. In one of my recent studies with another researcher, it was found that firms that cooperate in outsourcing activities in both domestic and foreign markets are more successful in every respect than firms that exclusively focus on export markets for outsourcing cooperation. Interestingly, this desirable industrial pattern emerged without any state planning or appreciation in Pakistan's textiles and apparel industries.
In some developing countries, the EP strategy was unsuccessful because they could not alleviate constraints faced by EP industries. For example, lack of efficient port infrastructures and logistic facilities, financial risk in the exchange rate, and inexperience with border controls, etc.
Much like IS industries, EP industries also became rent-seekers, revenue-seekers, and tariff-seekers for their domestic sales. EP industries followed this path to hide their inefficiencies and inability to compete globally effectively.
Time for a Shift from Traditional Strategies
Traditionally, IS or EP strategies were considered competitive approaches. The concept of export promotion has become more controversial than it initially appeared. For some experts, export promotion requires a neutral strategy with no policy bias against exports. While to others, export promotion refers to policies that promote exports and do not suggest neutrality between IS and EP policies.
Both traditional interpretations have some well-known flaws. Therefore, a growing realization is emerging that import substitution could be valuable if appropriately implemented and complementarity between IS and EP activities is skillfully created.
Complementarity between IS and EP activities can be explained subtly: EP firms use imported intermediate inputs. Given the higher trade costs to import inputs, the inputs must be produced and supplied by IS firms, domestic and foreign, at internationally competitive rates to final goods-producing domestic EP firms. It may be noted that intermediate input-producing firms are generally large-scale, ensuring various scale economies' benefits are passed on to ultimate user EP firms. Typically, these firms not only satisfy the demand of EP firms but also can export their excess supplies. 
In the long run, such IS firms can become import-competing firms by maintaining high competitiveness and innovativeness. In contrast, pure IS firms working in isolation from EP firms do not work at the frontiers of production and hardly care about improvement in their productivity, efficiency, and innovativeness; they survive due to high protection. As such, they work in their fragmented silos. They do not know much about teaming up with EP firms to expand their businesses to reap higher profits. Without creating the much-needed complementarity between IS and EP firms, achieving the goals of high sustained growth, job creation, and social well-being is impossible. Of course, a shift towards this strategy would need a mindset change at all levels of the economy.
Special Investment Facilitation Council
Realizing the dichotomy between import substitution and export promotion, the government of Pakistan has taken a remarkable initiative, i.e., the Special Facilitation Council (SIFC), to bridge the dichotomy highlighted earlier. The SIFC is a direct response to the perpetual structural problems faced by the economy and pressing requirements for economic revitalization.
It specifically addresses the obstacles posed by bureaucratic red tape and intricate regulations that act as deterrents to foreign direct investment (FDI). With the objective of facilitating smoother collaboration, especially with the Gulf Cooperation (GCC) countries, the SIFC endeavors to open investment prospects spanning pivotal sectors: information technology, agriculture, energy, mineral resources, and defense production. The SIFC is assigned a clear mandate to facilitate and promote investment to play a significant role in aligning investment and trade policies to support a more balanced and sustainable economic development approach. It is serving as a ‘one-window’ platform to fast-track decision-making for the promotion of FDI.
Future Policy Directions
The conventional view that import-substitution is the sole path to development has proved wrong. Several developing countries have achieved remarkable growth while becoming more open to trade. Nevertheless, EP industrialization has limitations, especially when EP firms face problems such as access to foreign markets, especially under global recessionary shocks and pandemic situations. An amicable solution is to promote (not protect) IS industries’ intermediate inputs production for their ultimate use in producing EP industries’ final goods. In conjunction with the SIFC, the creation of complementarity between IS and EP industries, the following policy directions would be useful: 
▪ Promote the production of internationally competitive intermediate inputs produced by IS industries for final goods-producing EP industries.
▪ Make trade diplomacy a top priority for Pakistani missions abroad and embassies. Trade diplomats should actively seek opportunities to join trade agreements regionally or bilaterally.
▪ Being a small domestic market, Pakistan needs to specialize in a limited range of products where it has accomplished a competitive advantage.
▪ Introduce import restrictions that are justified on economic grounds. Import licenses should be auctioned through transparent and competitive bidding processes.
▪ Develop an open foreign investment regime, where foreign firms produce intermediate inputs required by domestic export-oriented industries, and their excess supplies should be exported.


The author is the Principal and Dean of the School of Social Sciences and Humanities at National University of Sciences and Technology, Islamabad.
Email: [email protected].
 

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