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The effects of trade strategies on growth: Export promotion achieves more than import substitution

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1983
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Anne 0. Krueger

The determinants of a country’s rate of economic growth are numerous, and there is no universally accepted method of quantifying the contribution of any particular factor to the growth rate. One of the problems of attempting to associate alternative trade strategies with growth rates is that the trade strategy itself is but one influence on the effectiveness with which other factors of production are employed.

Nonetheless, past research suggests a strong association between trade strategies and growth rates. Although countries could be expected to exhibit a varying mix of import substitution and export promotion, a number of factors tend to reinforce initial biases in trade regimes. Thus, each policy, over time, tends to be selfreinforcing.

This article is based on a chapter in the author’s volume, Trade and Employment in Developing Countries, Volume 3: Synthesis and Conclusions (University of Chicago Press for the National Bureau of Economic Research, Chicago, 1983). Much of the analysis in the article is based on earlier research by Krueger published under the title Foreign Trade Regimes and Economic Development: Liberalization Attempts and Consequences (Ballinger for the National Bureau of Economic Research, Cambridge, MA, USA, 1978) and by Jagdish N. Bhagwati, Foreign Trade Regimes and Economic Development: Anatomy and Consequences of Exchange Control Regimes, (Bollinger for the National Bureau of Economic Research, Cambridge, MA, USA 1978).

Alternative trade strategies

Consider first the salient characteristics of import substitution. In principle one could encourage domestic production of an import-competing good with subsidies; however, in practice, encouragement to domestic production is usually given by imposing either tariffs or quantitative restrictions (in the extreme case, import prohibitions) on imports of the commodity. The very act of protecting the domestic industry tends to discourage exports in several ways. First, exporters using the often more expensive protected commodity in their production process are placed at a disadvantage. Second, because the resources employed in the protected industry would otherwise have been employed elsewhere, protection of import-competing sectors automatically discriminates against all other sectors, including potential exporting ones. Third, establishment of a new domestic industry usually requires imported capital goods, and in early stages of the industry’s development the value of these imports is likely to exceed the international value added of import-substituting production. This tends to put pressure on the foreign exchange markets and while this could be offset by currency realignment, under import substitution regimes, there is resistance to doing so (partly in order to facilitate the import of needed capital goods). Usually additional quantitive restrictions are employed to reduce the size of the balance of payments deficit, further increasing the bias toward import substitution.

None of these tendencies constitutes an inexorable and inevitable outcome of import substitution regimes. In principle, a country could decide to protect, say, the metal products sector while simultaneously encouraging the export of petrochemicals. However, in practice such an outcome is seldom observed.

For a variety of reasons (including the important fact that the authorities necessarily have greater ability to affect decisions by domestic producers when the economy is relatively less open), measures to promote import substitution tend to consist of a mixture of pricing measures and of direct quantitative controls over various aspects of economic activity. Thus the hallmarks of an import substitution regime generally include: high levels of protection to a number of industries, with a very wide range of rates of effective protection (that is, protection against the value-added components of imports—see box); fairly detailed and complex quantitative controls and bureaucratic regulations, both over imports directly and often over a number of areas of domestic economic activity (sometimes through the import regime); and an overvalued exchange rate with associated disincentives for exporting.

In contrast, under an export promotion strategy, since tariffs cannot induce production for the international market, a production (or an export) subsidy or a realistic exchange rate is required. Subsidies are costly to government budgets, and since they are clearly visible, excessively high subsidies tend to be politically unpalatable. Therefore, there is a tendency to maintain a realistic exchange rate as an alternative. That in itself encourages exports (and reduces the balance of payments motive for tariff protection), but simultaneously, exporting industries must be permitted to purchase their needed intermediate goods and raw materials at world prices if they are to be competitive. This puts pressure on the authorities to reduce barriers to imports, which in turn may encourage other producers to enter the export market. Thus a genuine export promotion policy must be accompanied by a fairly open and liberalized trade regime.

Effective rate of protection

The effective rate of protection measures the increase in value added made possible by a tariff as compared to the situation under free trade. For example, let us take a table that, in the absence of tariffs, sells for $100 (whether imported or domestically made) and that in its domestic manufacture utilizes imported wood worth $60. The domestic value added is therefore $40. If a tariff of 10 per cent is levied on tables, raising their imported price to $110 (but wood imports remain duty free), then although the nominal tariff on tables will be 10 per cent, the effective rate will be 25 per cent—that is, $10 as a proportion of the $40 worth of domestic value added.

Export promotion has to rely upon pricing incentives rather than quantitative controls. But there are constraints on the degree to which incentives can be differentiated among exporting activities, as a substitute for a realistic exchange rate. The major incentives for export promotion other than a realistic exchange rate are export subsidies (usually expressed as a rate of local currency paid beyond the official exchange rate per unit of foreign currency sales); favorable treatment for exporters on their tax liabilities; and availability of credit at below-market rates of interest. The important point is that these incentives are provided to anyone who exports. They can provide a uniform degree of bias among exporting activities.

Findings

The following analysis of the effects of alternative trade strategies on growth rates is based in part on the results of earlier research (Krueger, 1978). The relationship between the growth of exports and the growth of gross domestic product (GDP) was examined for a group of ten developing countries. An increase in the rate of growth of export earnings of one percentage point annually was associated with an increase in the rate of growth of GDP of about 0.1 percentage point. Even if this does not imply causation, the results indicate a strong relationship between export growth and the overall growth rate.

Trade strategy, export growth, and GDP growth in ten countries
Average annual rate of growth
CountryPeriodTrade strategyExport earningsReal GDP
Brazil1955-60IS2.36.9
1960-65IS4.64.2
1965-70EP28.27.6
1970-76EP24.310.6
Chile1960-70IS9.74.2
Colombia1955-60IS0.84.6
1960-65IS1.91.9
1970-76EP16.96.5
Indonesia1965-73MIS18.96.8
Ivory Coast1960-72EP11.27.8
Korea1953-60IS6.15.2
1960-70EP40.28.5
1970-76EP43.910.3
Pakistan1953-60IS1.53.51
1960-70IS6.26.8
Thailand1960-70MIS5.58.2
1970-76MIS26.66.5
Tunisia1960-70IS6.84.6
1970-76MIS23.49.4
Uruguay1955-70IS1.60.7
Sources: Trade strategy: based upon evidence in country studies (Krueger et al, Trade and Employment in Developing Countries, Volume 1: Individual Studies. University of Chicago Press for the National Bureau of Economic Research. Chicago, 1981). Export growth rates: computed from data in May 1977, IMF, International Financial Statistics. GDP growth rates: World Bank, World Development Report 1978 and World Tables 1976. United Nations, Yearbook of National Accounts Statistics, vol 2, for 1971 and 1969Note: EP = export promotion, IS-import substitution: MIS moderate import substitution.

Although there appears to be a significant positive relationship between rates of growth of GDP and of exports, it is by no means a perfect one. Brazil’s export earnings actually declined between 1955 and 1960, while real GDP grew at an average annual rate of almost 7 per cent. A similar situation occurred in the Republic of Korea during 1953-60. On the other hand, Chile’s relatively high rate of growth of export earnings in the 1960s was accompanied by a positive, though not equally rapid, growth of real GDP. In the case of Colombia the rate of growth of exports reversed from a negative 0.8 per cent to a positive 17 per cent annually, while real GDP increased by about two percentage points annually. To be sure, that represented a doubling in the rate of growth of per capita income, but it was far less striking than the change in the Brazilian or Korean growth rates following their reversals of trade policy and of trends in export growth.

The degree of bias of the trade regime toward import substitution changed for some of the countries studied during the period covered (see table). Shifting to an export promotion policy generally resulted in much-improved performance in the country’s export earnings. The switch from import substitution to export promotion strategies in Brazil, Colombia, and Korea led to significant increases in export growth rates. Pakistan’s improved growth of export earnings represented a move toward a less unbalanced incentive structure in the 1960s, even though the bias toward import substitution was still substantial. The large positive rate of growth of export earnings for Indonesia also followed an abrupt departure from the extreme restrictiveness of trade policy in the period before 1965 toward a more “moderate” import substitution bias.

The important question is why the choice of a trade regime—import substitution or export promotion—contributed to differences in growth performance.

Import substitution

In most countries, after an import substitution strategy was adopted, the growth rate of export earnings (and earnings of foreign exchange from other sources) diminished. In part this was the conscious out come of an import substitution plan, which aimed to diminish dependence on trade. However, while the growth of foreign exchange declined, the growth in demand for imports of goods and services frequently accelerated instead of decelerating. The resuiting foreign exchange shortage caused severe difficulties in many countries and became a binding constraint upon the growth rate.

Virtually every import substitution industry required imports of raw materials, intermediate goods, and machinery and equipment. Policymakers were especially reluctant to deny permission for imports of these goods, since a reduction in capital goods imports would reduce the GDP growth rate and a reduction of intermediate goods and raw material imports would adversely affect output and employment. “Dependence” upon imports for final consumption goods was replaced by “dependence” upon imports for growth not only via the availability of capital goods but also for employment and output, because the newly established factories could not produce without imported intermediate goods and raw materials. Ironically, the import substitution strategy has frequently resulted in an economy even more dependent upon trade than had been the case under the earlier pattern of primary commodity specialization, while simultaneously discouraging the growth of foreign exchange earnings.

In many import substitution countries, increased dependence upon imports and laggard foreign exchange earnings were reflected in periodic balance of payments crises. Brazil, Chile, Colombia (before 1968), Tunisia, and Uruguay all had such episodes in the period studied. These crises, in turn, were associated with intervals during which import licensing was particularly stringent, if not prohibitive, generally resulting in slow growth, if not an outright reduction in output. Very often these periods of severe import restrictions ended with a devaluation and a stabilization program designed to make exporting more attractive, at least temporarily.

The exhaustion of the “easy” import substitution opportunities, even in large countries with sizable domestic markets, such as Brazil, also helped slow down growth. The domestic market was not large enough to support the development of other industries at economic scales of production after import substitution had taken place in industries such as textiles and shoes, where imports have been sizable and outputs fairly standard. Once easy import substitution was over, the incremental capital/ output ratio in the industrial sector rose sharply, and the “leading growth sector” experienced a decline in its growth rate.

The tendency for import substitution strategies to be administered by a detailed and complex mix of policy instruments also contributed to the tapering off of growth rates. Imports were allocated by category of commodity, by type of domestic user, by source of foreign exchange, and by type of use—capital good, intermediate good, or raw material. The proliferation of the control network and its complexity has been a common feature of import substitution regimes and is certainly a characteristic that has had harmful consequences.

Conclusions

Perhaps the most important lesson that has been learned from the experience of the successful countries is that the approach to industrialization and the development of new industries under an import substitution policy tends to be less and less successful the longer it continues. Export-oriented strategies have generally generated higher growth rates than have import substitution. Export promotion, by its nature, avoids some of the costs of the import substitution strategy.

One factor contributing to the high cost of import substitution activities is the very small size of domestic plants. To the extent that there are significant indivisibilities or scale economies in industrial operation, the economic costs of failing to expand plants and industries to sizes adequate to serve more than the domestic market are significantly greater than the gains from trade implied by the static comparative advantage model. The lower the transport costs between a country and its major trading partners, the greater will be the advantages of building optimal-sized plants rather than introduce more, smaller new industries catering to the domestic market. The larger the minimum efficient size of plant, the greater are the economic costs of catering only to the home market.

Korea’s experience provides quantitative evidence on this point. It was estimated that about 18 per cent or one sixth of the growth in industrial output between 1966 and 1968 was the result of manufacturing industries achieving economies of scale or overcoming problems associated with small size.

There have also been occasional suggestions that capital-intensive industries tend to have larger minimum efficient sizes and higher costs of operating below those sizes than do labor-intensive industries. If that is the case, and if an import substitution strategy also tends to encourage the development of more capital-intensive industries than does an export promotion strategy, the gains achieved under an export promotion strategy are further enhanced.

Domestic markets of most developing countries are generally too small to support efficient-sized plants. This makes the traditional criticism that protecting infant industries imposes costs on consumers even more forceful. The development of new industries in most cases probably entails an expansion beyond the boundaries of domestic markets.

For all the countries studied that shifted toward export promotion, a striking feature of their success was the very rapid growth of manufactured exports, often of new products. A firm starting to manufacture a new product is very likely to sell to the domestic market first simply because of transport cost differences; experience demonstrates, however, that this is not always the case. In fact, one major way of starting new industries and new product lines in the exporting countries is for firms in developed countries to subcontract with foreign suppliers to fabricate particular parts and components. The foreign buyer may provide technical specifications, technical assistance, or even capital, and may enter into a joint management or ownership arrangement to produce the subcontracted product. In some cases the entire output may be sold abroad initially, with foreign orders filled first and the domestic market satisfied later. Such instances, though uncommon, nevertheless point to the important fact that new industries are developed and expand under an export promotion strategy, and industrialization is by no means synonymous with import substitution.

An efficient industrialization strategy is thus one in which incentives, when granted, induce activity at minimum efficient size. Incentives should therefore be based upon production, not the destination of output. The evidence is strong that growth performance is better under export promotion than under import substitution. The reasons are readily apparent. What is not known is the relative importance of each contributing factor and the interaction among them. It is probable that each of the phenomena discussed above has contributed to growth, perhaps in different degrees in different countries depending upon such factors as size of domestic market, per capita income level, and proximity to major industrial countries.

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