Import Substitution Industrialization

Import Substitution Industrialization

Import substitution industrialization (ISI) is a trade and economic policy that advocates replacing foreign imports with domestic production. It 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, but it has been advocated since the 18th century by economists such as Friedrich List and Alexander Hamilton.

ISI policies have been enacted by developing countries with the intention of producing development and self-sufficiency by the creation of an internal market. The state leads economic development by nationalization, subsidization of manufacturing, increased taxation, and highly-protectionist trade policies. In the context of Latin American development, the term "Latin American structuralism" refers to the era of import substitution industrialization in many Latin American countries from the 1950s to the 1980s. The theories behind Latin American structuralism and ISI were organized in the works of economists such as Raúl Prebisch, Hans Singer, and Celso Furtado, and gained prominence with the creation of the United Nations Economic Commission for Latin America and the Caribbean (UNECLAC or CEPAL). They were influenced by a wide range of Keynesian, communitarian, and socialist economic thought as well as dependency theory.

By the mid-1960s, many of the economists who had previously advocated for ISI in developing countries grew disenchanted with the policy and its outcomes. Many of the countries that adopted ISI policies in the post-WWII years had abandoned ISI by the late 1980s, reducing government intervention in the economy and becoming active participants in the World Trade Organization. The Four Asian Tigers (Hong Kong, Singapore, South Korea and Taiwan) have been characterized as rare successful examples of ISI policies, although scholars have characterized the approach of these countries as government intervention to facilitate "export-oriented industrialization".

ISI policies generally had distributional consequences, as the incomes of export-oriented sectors (such as agriculture) declined while the incomes of import-competing sectors (such as manufacturing) increased. Governments that adopted ISI policies ran persistent budget deficits as state-owned enterprises never become profitable. They also ran current accounts deficits, as the manufactured goods produced by ISI countries were not competitive in international markets, and as the agricultural sector (the sector which was competitive in international markets) was weakened; as a result, ISI countries ended up importing more. ISI policies were also plagued by rent-seeking.

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History

Average tariff rates for selected countries (1913-2007)

 

Tariff rates in Japan (1870–1960)

 

Average tariff rates in Spain and Italy (1860-1910)

 

Average tariff rates (France, UK, US)

 

Average tariff rates in United States (1821–2016)

 

U.S. trade balance and trade policies (1895–2015)

a After 9 October 1913, 25 per cent.
b After 9 October 1913, 16 per cent.

ISI is a development theory, but 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-20th century as a form of developmental theory that advocated increased productivity and economic gains within a country. It was an inward-looking economic theory practiced by developing nations after World War II. Many economists then considered the ISI approach as a remedy to mass poverty by bringing a developing country to a developed status through national industrialization. Mass poverty is defined as "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".

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 U.S. to become self-sufficient in manufactured goods. That formed the basis of the American School in economics, which was an influential force in the country during its 19th-century industrialization.

Werner Baer contends that all countries that have industrialized after the United Kingdom have gone through a stage of ISI in which much investment in industry was directed to replace imports. Going further, in his book Kicking Away the Ladder, the South 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. Those countries adopted free market discourses directed at other countries to obtain two objectives: to open their markets to local products and to prevent them from adopting the same development strategies that had led to the industrialization of the developed countries.

Theoretical Basis

As a set of development policies, ISI policies are theoretically grounded on the Prebisch–Singer thesis, on the infant industry argument, and on Keynesian economics. The associated practices 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)
• discouragement of foreign direct investment

By placing high tariffs on imports and other protectionist, inward-looking trade policies, the citizens of any given country by using a simple supply-and-demand rationale substitute the less expensive good for a more expensive one. The primary industry of importance would gather its resources, such as labor from other industries in this situation. The industrial sector would use resources, capital, and labor from the agricultural sector. In time, a developing country would look and behave similar to a developed country, and with a new accumulation of capital and an increase of total factor productivity, the nation's industry would in principle be capable of trading internationally and of competing in the world market. Bishwanath Goldar, in his paper Import Substitution, Industrial Concentration and Productivity Growth in Indian Manufacturing, wrote: "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". He continued 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 that.

In many cases, however, the assertions did not apply. On several occasions, the Brazilian ISI process, which occurred from 1930 to the late 1980s, involved currency devaluations to boost 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, government policies toward investment were not always opposed to foreign capital: the Brazilian industrialization process was based on a tripod that 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 production facilities in Brazil in the 1950s and the 1960s.

The principal concept underlying ISI can thus be described as an attempt to reduce foreign dependency of a country's economy by the local production of industrialized products by national or foreign investment for domestic or foreign consumption. Import substitution does not mean eliminating imports. Indeed, as a country industrializes, it naturally imports new materials that its industries need, often including petroleum, chemicals, and raw materials.