Columns - The Sunday Times Economic Analysis

Import substitution: Is it a pragmatic economic policy?

By Nimal Sanderatne

Pragmatism, the President told an Australian business audience, was a fundamental approach of the government's economic policies. This is indeed how it should be in a world that is constantly changing and a country that has to face fresh global challenges continuously.

The Sri Lankan economy must always be one that responds to global challenges and continuously adopts countervailing policies to cope with emerging global situations. Countries that have eschewed political ideology and adopted pragmatic policies have prospered in the latter part of the 20th century and in the first decade of the 21st century. Chinese have articulated it well: 'It does not matter whether the cat is black or white as long as it catches mice'. One may parody Alexander Pope's well known couplet on forms of government and say: For economic policies let fools contest, whatever is best for the economy is best.

The best economic policies for Sri Lanka are those that increase exports, enhance investment, increases employment, reduce poverty and promote economic development. Pragmatism requires a proper assessment of resources and possibilities to achieve these objectives. The smallness of the country, limited resource base, small domestic market and international dependence are features that must be recognised in the formulation of the country's economic policies. The current tendency to revert to import substitution economic policies must be analysed dispassionately to see whether it is a pragmatic policy.

Import substitution policies

What are import substitution policies? They are policies that attempt to reduce foreign dependency of a country's economy through local production of food and industrial products. Import substitution policies advocate replacing imports with domestic production. It is based on the premise that a country should attempt to reduce its foreign dependency through local production of goods, mainly industrial products. Many Latin American countries implemented import substitution policies with the intention of becoming more self-sufficient and less vulnerable to adverse terms of trade.

The import substitution strategy is often complemented with state-led economic development through nationalization, subsidization of vital industries and agriculture. Such regimes are characterised by highly protectionist trade policy. Many Latin American countries adopted import substitution policies from the 1930s until around the 1980s. Some Asian countries, especially India and Sri Lanka, pursued such policies from the 1950s.

One of the arguments for import substitution is that all countries which have industrialized went through a stage of import substitution in which investment in industry was directed to replace imports. All major developed countries used interventionist economic policies to promote industrialization and protected industries until they had reached a level of development when they were able to compete in the global market. This policy is also termed the infant industry argument: that industries in their infancy should be protected till they grow up and are strong to withstand competition.

Advantages and disadvantages

The major advantages claimed for import substitution are increases in domestic employment and resilience in the face of global economic shocks such as recessions and depressions. The disadvantages are that import substitution industries create inefficient and obsolete products as they are not exposed to international competition. Other disadvantages include unemployment increasing internationally as World GDP decreases through the promotion of inefficiency. Countries that adopted import substitution policies faced many undesirable effects such as chronic problems with the balance of trade and payments. Although import substitution was supposed to reduce reliance on world trade, there was a need to import raw materials, machinery and spare parts. The more a country industrialized the more it needed these imports and import substitution industrialisation (ISI) was strongly biased against exports.

Trade protection and overvalued exchange rates raised domestic prices and made exports less competitive. Consequently, import substitution industrialising countries were unable to export enough to buy the imports they needed. The faster the economy grew, the more it needed imports; but exports could not keep up with the pace of imports and so countries ran out of foreign currency. In response, governments restricted imports to essentials. The currency was devalued to raise the price of imports and make exports more attractive. Government subsidized industrial investments. Such spending chronically outpaced government revenue and these budget deficits were usually covered by printing more money. The result was inflation which made domestic goods more expensive which in turn reduced exports even further. Sri Lana experienced much of this during its import substitution industrialising period in the 1960s and 1970s.

Past policies

Ideology has played an important role in the formulation of economic policies in the past. The inward looking economic policies that the country adopted for several decades till liberalisation of the economy in November 1977 put the country back and also heaped many burdens on people, especially the poor. Ideological reasons still continue and inward looking economic policies are advocated as better than the liberal export-led economic policies, for nationalistic reasons. These inward policies are often couched in nationalistic terminology that makes them more acceptable irrespective of their economic consequences. Labels in particular are a disservice to pragmatism.

In retrospect, it is recognised that the inward economic policies pursued from the 'sixties till liberalisation was one of the important reasons that put the country's economy on a slow mode of growth. The impracticability and ill advisability of these possibilities were not clear at the time. Many an economist of the time viewed inward looking economic policies to be the means of coping with the serious balance of payments problem and inadequacy of foreign exchange. It was only later that everyone realised that a small trade-dependent economy had to adopt an export-led economic strategy.

International experience:

East Asia

Countries of East Asia and South East Asia were more pragmatic and adopted export-led economic policies with the minimum of import and exchange control policies. This was one of the important reasons for the wide differences in economic performance between East and South Asian countries. The outward economic orientation was one of the important reasons for the rapid economic development of countries like South Korea, Malaysia and Singapore. ISI was rejected by most nations in East Asia in the 1960s. Some economists attribute the superior performance of East Asia in the 1970s and 1980s to this difference in policies. East Asian policies 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 East Asian countries contrasts with the strategy of ISI pursued by Sri Lanka.

Success and failure in import substitution

While import substitution industrialisation was not successful, it must also be recognised that some import substitution policies were a success and contributed to increasing the country's production and economic development. These were in agriculture, where protection afforded to agriculture contributed to increased production of rice and other food crops. It was, however, not only protective import control policies that resulted in food production increasing. The import restrictions were complemented by guaranteed prices for farm produce, research, extension services, marketing arrangements and subsidies in inputs.

This range of policies enabled the country to achieve impressive gains in food production. At the time of independence when the country had a population of only 7 million, the country imported nearly half of her food needs. This includes rice, many subsidiary food crops like chillies, onions, potatoes and poultry. There were also high imports of sugar, wheat flour, milk and lentils (dhal). The latter category remains one where domestic production is inadequate. Rice is perhaps the most spectacular success as the country is able to feed its near 21 million population with domestic rice and there has also been decreased consumption of imported wheat flour that is being substituted by local rice. Per capita rice consumption has increased from less than 100 kilograms per capita to about 115 kilograms per capita, while per capita wheat consumption has reduced. In several other commodities too there has been significant substitution of local produce for imported ones. These include maize, potato, poultry products.

The important lesson to be drawn from this experience is that the price support given by import substitution policies contributed much to the increase in production. However while such price support was important and necessary, it was not sufficient. There were also several other support measures that make the import substitution strategy work. Conversely there were crops where the lack of adequate resources, incentives and other capacities where the import substitution strategy has not succeeded. Sugar production is a good example of this. Although the country still imports about 80 percent of its milk requirements, there is evidence that the improved prices and other incentives and institutional support is contributing to increased milk production.

The experience with respect to industrial import substitution was very different. The reasons for failure were Sri Lanka's limited resource base, small domestic market and investment capacity. Most industries must industrialise on an export-led strategy. There is a need to attract foreign investors who would not only bring in capital but also modern technology, management skills, technical expertise and assured markets. The value addition in Sri Lanka, employment opportunities and technology transfer would add much to the country's economic development. Industrialisation based on import substitution of imported goods will fail as in the past. The country has made important strides in industrial production for export in such as areas as textiles and garments, ceramics, rubber manufactures, electrical goods, solid tyres and boats. These are not import substitution industries but export led industry.

This does not mean that there are no possibilities for import substitution industry. Good examples of possibilities are in the food processing field, where with adequate production of fruit and vegetables, there are possibilities of expanding food processing industries to both substitute for imports as well as export to especially Middle Eastern markets.

Pragmatism, as President Mahinda Rajapaksa rightly said, should be the guiding principle of economic policies.

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