Question

Explain the traditional trade strategies for development (export promotion and import substitution policies). What are the main arguments of these strategies? How realistic, do you think, are these strategies in today's world of globalized economy?

Answer 1

Traditional trade strategies for development can be classified into following types :-

1) Outward oriented development Startegy is one that encourages free-trade, multinational companies, open system of communications, and free movement of capital, labour, enterprises, manpower and students.
Outward oriented development Startegy became more popular from the late 1970s. By following this strategy Japan soon became the second largest economy in the world. It was followed by South Korea, Taiwan, Hong Kong and Singapore. Thailand, Indonesia, Malaysia and China also adopted similar strategy and enjoyed sustained growth rates. A country that pursues export-led growth strategy adopt trade liberalization, free capital movement, a floating exchange rate, investment in the provision of infrastructure and minimized government intervention in the market. These are basically market led policies that maximizes the working of the free market forces.

2) Inward Oriented development strategy is one that encourages indigenous manufacturing and the development of indigenous technologies. This strategy also usually involves trade restrictions, labor movement restrictions, communication restrictions and keeping multinational companies away. Basically inward-oriented development strategy is an interventionist strategy where government actively intervenes in the market to achieve a set of desired economic objectives. These are policies and measures in which government plays an active role in manipulating domestic markets and allocating resources.
Inward-oriented development strategy was adopted by many developing countries in the 1950s and 1960s. Developing countries that were newly independent did not want to rely on the European countries and substituting imports from developed nations for locally produced goods became attractive for them.

3) Infant Industry Protection is an economy policy that provides temporary protection of a newly established domestic industry until it is sufficiently competitive in the world market. It is also part of inward-oriented development strategy.

4) Market led strategies are policies that maximize the operation of market forces and at the same time minimizes the role of government in the economy. Korea and Japan supports large domestic corporate conglomerates like Samsung, Daewo, Sony and Mitsubishi and restricted the flow of FDI which was less than 5% of GDP in the period 1987-1992 while Singapore and Malaysia actively attracts large foreign MNCs and FDI that reached more than 30% of GDP in 1992.  Although Korea, Japan and Singapore have floating exchange rates, China and Malaysia had their currencies pegged to the USD until recently.

Countries, according to the structure of their international trade, mainly apply two different industrialization strategies: import substitution (IS) and export promotion (EP). The emphasis that countries have placed in their development strategies in favor of either export led growth strategy or import substitution has in turn influenced the development of their current account balances and growth of output.

Import Substitution strategy is part of inward-oriented development strategy. It is a strategy for economic growth and development which believes in protecting domestic producers from foreign competition by substituting the imported goods with the locally produced goods to meet the internal demand.

This strategy usually involves (a) government selecting certain industries to be promoted, (b) providing subsidies to support these industries, and (c) imposing high tariff barriers to protect domestic producers. Advocates of Import Substitution believe that developing countries should initially substitute imported simple consumer goods (like shoes and clothing) with domestically produced goods. This is the first stage of import substitution. In the second stage, the country should substitute a wide range of more sophisticated manufactured items with local products. Local products from both stages should be protected from competition abroad by high tariffs and low quotas on imports. The government can pursue this strategy not only via tariffs, quotas but also via exchange rate, prices of the factors of production and interest rate.

The main Arguments of Import Substitution strategy

The idea behind this strategy is to raise the price for domestic substitutes for the imported goods. The increased price provides greater incentives for production for the home market by domestic firms relative to production for foreign markets (exports). From a development perspective, the goal of such a strategy has been to promote the growth of the manufacturing sector and therefore transform the economy from an agricultural one to an industrial base.

The objective of import substitution strategies would be to protect infant industries in developing nations. The protection would allow these industries to expand operations so as to achieve economies of scale, as well as to give them time to learn. Once this process was complete, these industries would be able to compete internationally without protection.

In practice IS strategy is applied to consumption good because there is an interval demand for these goods. Furthermore, the firms that will produce such consumption goods are the ones that do not need a advanced technology. The most attractive part of the IS strategy is the decrease in the foreign currency expenditures and hence the decrease in the trade deficit.

Pros of IS strategy

1. Unless the country take the initiative to establish new industries and learn by doing these industries may not developed locally. For instance, if a government does not provide support to a steel industry then it is unlikely there will be a car industry that needs fabricated metals as its inputs. Japanese government initially cultivated heavy industries such as steel, aluminum, car and shipbuilding in the post-war period and then expanded credits to support more advanced industries including electronics and semi-conductors.
2. Newly established industries need to go through a period of learning before they can compete in the global market. Thus, protection is essential to help these industries to learn and acquire new know-how.
3. Import reduction saves much needed foreign exchanges.
4. Reduces economic dependency on multinational corporations.
5. Could protect local culture and social habits by keeping out foreign influence.

Cons of IS strategy

1. Encouraging import substitution usually involves price-distortion practices like generous subsidies and artificially low pricing for resources. This market distortion leads to economic inefficiency.
2. Encourage local monopoly.
3. Local monopoly due to lack of competition has no incentive to produce efficiently and conduct research and development.
4. Lead to high urban wages.
5. May lead to more unequal distribution of income.
6. Government may resort to overvalued exchange rate to keep imports low.
7. The process of import substitution may not move beyond the first stage and cannot successfully develop the economy leading to lower growth and lack of job creation as experienced by Latin American countries in the 1980s.
8. Firms that were protected in the second stage are likely to object to open competition from abroad.
9. Trade protection can lead to retaliatory protectionist measures from other countries.
10. IS strategy has a negative effect on exporters. Since the exchange rate appreciates to protect the internal industries locally produced goods become relatively expensive for foreign countries. This in turn damages the exports and worsens the trade balance.

The economies that abandoned import substitution earliest, such as Korea, and Taiwan, became the most rapidly growing, and now nearly developed, economies. Those that held on to import-substitution policies the longest, such as economies in Africa and South Asia, have been the slowest growing economies of the world.

Export Promotion Strategies refers to Government efforts to increase exports on the assumption that they can improve not only foreign exchange earnings but also increase productivity and growth. In the post war period, export promotion in Europe and Japan sought to overcome the severe foreign exchange constraints associated with reconstruction. Japan started a new model of trade policy that combined relatively restrictive policies towards imports and inward foreign investment with aggressive promotion of export industries.
The main goal of the EP strategy is to prepare the “potential” industries for competition with the foreign rivals. Exporters, facing the increasing competition, must improve their technologies, their quality continuously to compete with their rivals.
Export promotion efforts also included the formation of export- processing zones (EPZs), provided foreign investors with infrastructure and logistical support for export oriented manufacturing and the encouragement of export oriented FDI. The EPZ model was pioneered in Korea, Taiwan and along the Mexican border with the United States, but rapidly spread elsewhere from Ireland to Bangladesh.

Export led growth strategies encourage efficiency and growth through free trade and competition. It exploits a bigger world markets to achieve economies of scale. Economic growth is achieved by focusing on increasing exports and thus export revenue. Export revenue increases national income. A country should produce and export goods that it has comparative advantage. Export-led growth is part of outward-oriented development strategy.

Pros of Export Promotion

1. Many developing countries have comparative advantage in producing and exporting primary goods.
2. Could generate a lot of employment for relatively low skilled laborers.
3. Many developing nations may have comparative advantages in manufacturing simple consumer goods. Japan, South Korea and Hong Kong utilized their cheap labour to produce low skilled and labour-intensive goods like textile.
4. Even simple manufacturing processes increase value-added especially on agricultural goods. Bottling, canning, preserving, packaging are some common methods to add values to agricultural goods.
5. Removes economic inefficiency from import substitution strategies.
6. Access to global markets allows local firms to exploit economies of scale.
7. Increase local competition.
8. Encourage investments and may attract FDI.

Cons of Export Promotion

1. Industrialization often leads to environmental degradation: air water pollution, deforestation, and loss of bio-diversity.
2. Integration into the world economy also means more exposure to the up and down of the world economy.
3. The success of East and South East Asian countries in applying the export-led growth has led to more protectionism from developed nations. Not only average tariff rates for manufactured goods into developed nations is higher at 3.4% compared to 0.8% for manufactured goods from other developed nations, they face tariff peaks, tariff escalation, and non-tariff barriers.
4. Multinational corporations can become too powerful within a country, i.e. dictating trade and economic policy in small economies, exploiting its monopoly power, finding ways to pay less tax, and paying little concern to local environment All these can reduce government tax revenues and social well beings.

Effect of Inport Substitution & Export promotion strategies in today's world of globalized economy

Free Trade policy plays an important role in achieving the objectives of rapid economic growth and self-reliance. When a country specialises on the basis of its comparative cost or production efficiency and export and import accordingly, it enables it to make optimum use and allocation of its resources. As a result, output, income and welfare of its people increase. Through promotion of exports, a developing country can earn valuable foreign exchange which it can use for imports of capital equipment and raw materials which are essential for economic growth.

The higher the level of output the easier it is for the country to escape poverty and to get a self-sustained growth. Hence, if trade raises the level of income, it also, promotes economic development.

Although initial costs of production may be higher than former import prices the economic rationale put forward for the establishment of import substituting manufacturing operations is either that the industry will eventually be able to reap the benefits of large-scale production and lower costs or that the balance of payments will improve due to imports of fewer consumer goods.IS strategy is essential because it helps the infant industry to grow up and be able to compete in world markets. It will then be able to generate net foreign exchange earnings once it has lowered its average cost of production.

Most of the less-developed countries have begun developing by an IS strategy and then they have followed an outward oriented strategy EP. In IS strategy the government determines those sectors best suited for local industrialisation, erects barriers to trade on the products produced in these sectors in order to encourage local investment and then lowers the barriers over time as the industrialisation process gains momentum.  The industries will continue to thrive even as protection comes down. In the export-led growth the competitive pressure generated by the export market is an important stimulus to efficiency and modernisation.

Large developing countries (India and China); small countries like Sri Lanka, Nepal and Zambia etc. pursued IS strategy since the beginning of their political independence to develop domestic industries under a protective wall of tariff and non-tariff barriers. However later on most of these economies have faced severe BoP (balance of payments) crisis at one point of time or the other.

These countries attempted gradual and moderate trade liberalisation towards the beginning of the 1980s and 1990s. As a consequence, there was a significant reduction in both tariff and non-tariff barriers, which opened up, trade. Such trade openness has led to mixed experiences: some of these countries have sustained high economic growth (like China, India, Cambodia), some other countries have shown remarkable export growth (like Vietnam and Cambodia) in contrast to some that have recorded dismal performance (e.g. Nepal and Zambia).

Thus no one strategy can prove to be effective. the two strategies are intrinsically linked. Countries develop their productive capacities and food security thorugh tariffs. As their competitiveness increases and they meet their objectives of food security they begin to liberalise their economies. This trend can be observed in newly industrialised countries and Asian economies in their industrialisation process.