Discuss the relative merits of import substitution versus export promotion free essay sample

Many countries have adopted different development strategies in order to promote growth. One of these, used by the now developed economies following the Industrial Revolution, is import substitution industrialisation (ISI). This is the notion of reducing foreign dependency of a country’s economy through focusing on domestic production of goods and services. An opposing strategy is export promotion. This includes measures taken by the government to increase the quantity and variety of goods and services that are exported. There is often debate among policy-makers about the effectiveness of each as a growth and development strategy with interesting statistical evidence supporting each side. In order to achieve a conclusion, the relative merits and weaknesses of each will be discussed albeit an informed decision depends on a number of explanatory variables. First of all, the import substitution strategy often coincides with state-led economic development through nationalisation and subsidisation of key domestic industries. Adopting such a regime usually means having a protectionist trade policy. Many Latin American countries implemented an ISI policy after WWII until around the 1980s, partly as a response to decades of disappointing growth in the early 20th century. Some Asian countries, especially India and Sri Lanka, also pursued such policies from the 1950s onwards. The rationale for doing so is extensive. One reason is known as the infant industry argument. This is where domestic industries are protected through government backing, help, and intervention. This mainly applies to liquidity-constrained companies that are unable to incur short-term losses. The main benefit is to create a level playing field between a backdated industry and a highly advanced industry producing similar goods and services. Without this protection, it would be difficult to compete with foreign firms on the efficiency and quality of goods and services. Eventually, these infant firms will grow to compete in global markets through developing economies of scale gaining a comparative advantage. In terms of import substitution, referring to an infant economy that needs protection may be more appropriate. Another reason in support of import substitution industrialisation is given by the Singer-Prebisch thesis. This is the observation that the terms of trade between primary export products and manufactured goods tend to deteriorate over time. This is because the income elasticity of demand for manufactured goods is greater than that for primary products – especially food. Therefore, as incomes rise, the demand for manufactured goods increases more rapidly than demand for primary products. This creates a ‘trap’ for many developing countries due to resource dependence. As a result, the current account of the balance of payments of the developing country worsens accelerating the deterioration. Therefore, import substitution provides an escape from the ‘trap’ by allowing for diversification of the economy’s goods and services without trade. However, a critical evaluation point may be that using the Singer-Prebisch thesis to justify import substitution has lost some of its relevance in the last 30 years. This is because exports of simple manufactures have overtaken exports of primary commodities in most developing countries outside of Africa for example. The problems associated with import substitution may also be considered, thus suggesting that a more outward-looking strategy would be more effective. Firstly, the primary effect of imposing import tariffs is a fall in the quantity of imports (Q2 to Q3) and a rise in the price level. This is shown in figure 1. 1 below. The shaded areas in the diagram represent the ‘welfare loss’ to society, whereby marginal social benefit is not equal to marginal social cost. Hence a negative effect of import substitution is an inefficient allocation of resources leading to society not achieving maximum utility. This may carry the added effect of increasing international unemployment as World gross domestic product (GDP) decreases through the promotion of inefficiency. An example emphasising the problems of import substitution is evident through the wide differences in economic performance between East and South Asian countries. Countries such as: South Korea, Malaysia and Singapore rejected import substitution policies resulting in superior performance in the 1970s and 1980s. In contrast, South Asian countries like India and Sri Lanka adopted more a more inward-looking strategy causing significantly lower growth rates than many East Asian countries. An alternative development strategy for policy-makers is export promotion. This entails greater openness to trade through a number of measures e. g. liberalisation of global markets, de-regulation and privatisation. An immediate comparison to import substitution is that there is an absence of retaliation from other trading nations. This yields greater economic benefits. One point providing strong merit for export promotion is backward and forward production linkages. The former is when growth of one industry stimulates domestic production of an upstream input, leading to higher productivity and demand. Forward linkages reduce unit costs allowing for the expansion of downstream industries. This is mainly achieved through foreign direct investment, which import substitution does not allow. Evidence for this is shown in Malaysia’s economy. Primary exports of processed rubber and palm oil is stimulated from the country’s plantation agriculture. Therefore, export promotion can benefit other domestic industries through stimulating production. A major drawback however of export promotion is â€Å"Dutch disease† theory. This is the apparent relationship between the increase in exploitation of natural resources and a decline in the manufacturing sector. The direct impact of influx of foreign exchange or inflows of foreign aid causes a real appreciation of the currency. This results in the nation’s other exports becoming more expensive for other countries to buy, making the manufacturing sector less competitive. A notable example is Nigeria and other post-colonial African states in the 1990s. Considering this, strong empirical evidence exists in support of adopting an export-orientated strategy. Data from the World Bank (1993) showed that the real GDP of export promoted countries (7. 6%) grew at a faster rate than ISI countries (3%) during 1965-1990. It is clear therefore from the arguments listed above that export promotion is the more effective policy, however a hybrid of strategies may be required depending on the country in question.