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Industrial policy in small developing countries: Determining an appropriate strategy

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1984
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Issues in determining an appropriate strategy

Barend A. de Vries

In shaping industrial strategy, small countries often face problems different from those of larger economies. Yet much of the literature deals primarily with aspects of industrial policy in the larger countries. Questions of domestic market size, scale of industry and trade policy, availability of savings and investment finance, and the extent and variety of available labor skills are all influenced by the economic size of the country. These factors are often felt most keenly by the smallest of the small economies and by landlocked or island economies.

There are no hard and fast rules for defining a small economy. Most of the development literature stresses two key characteristics: the importance of population size—small populations, of, say, less than seven or eight million, which reduce the size and variety of the skilled labor force; and relative poverty—defined by, for instance, incomes of less than $750 per capita. Combined, these produce GNP of $5–6 billion—indicating a relatively small domestic market that cannot serve as a base for large-scale capital-intensive industries such as steel or fertilizer. In such small home markets many industries cannot take advantage of increasing returns to scale or even reach technically or economically optimum size, unless they can export a large portion of their output. Some typical examples (based on 1981 data) are given in the table; for comparison, the table also shows the proposed Fund quotas which are based on a variety of economic factors, including the level of output and trade. Countries like Kenya and Cameroon clearly are no longer small, but their relatively small markets are a crucial factor in the design of industrial strategy.

Besides domestic market size, several other considerations enter into the design of an industrial strategy. Among these are the nature of national resources and location. Rich agricultural or mineral resources will, of course, help in building up a strong export sector. A strong agricultural sector may release surplus resources to provide the management skills, and financial and material resources to be a nucleus for industrialization. Mineral resources can provide a steady supply of foreign exchange, but many mineral-processing industries risk becoming capital-intensive enclaves that confer few benefits on their host economy. Special attention is called for to ensure that their activities give rise to demand for domestic inputs and help train workers whose skills can be used in other sectors.

Location, especially access to large and dynamic markets, is another major factor. One of the most difficult issues concerns the plight of small landlocked countries. These are often “mono-economies” in that their factors of production are less varied and they rely on fewer export products than their nonlandlocked counterparts. They suffer special difficulties in diversifying their exports—which renders them more vulnerable to fluctuations—and in gaining access to markets. In trade with more diversified neighbors, their exports are less diversified than their imports. Trade between Upper Volta and the Ivory Coast illustrates this point: Upper Volta exports a few agricultural products to the Ivory Coast, but imports a broad range of consumer products from its neighbor. Further, the work force of the landlocked country has fewer skills, and it supplies its neighbors with nonskilled workers. Island economies share many of the characteristics of the landlocked countries, although they have access to sea transport. But many are economically isolated and resource-poor.

Selected indicators for some small economies
Population

(In millions,

mid-1981)
GNP per capita

(In dollars,

1981)
GNP

(In billions

of dollars)
Proposed Fund quotas1

(In millions of

SDRs)
Bhutan1.3800.12.5
Bolivia5.76003.490.7
Botswana0.91,0101.022.1
Cameroon8.78807.692.7
Costa Rica2.31,4303.384.1
Kenya17.44207.3142.0
Liberia1.95201.071.3
Malta0.43,6001.345.1
Mauritius1.01,2701.253.6
Nepal15.01502.337.3
Senegal5.94302.585.1
Togo2.73801.038.4
Sources: World Bank, 1983 World Bank Atlas; and IMF, Annual Report 1983.

Under the Eighth General Review of Quotas.

Sources: World Bank, 1983 World Bank Atlas; and IMF, Annual Report 1983.

Under the Eighth General Review of Quotas.

Thus, manufacturing development in small and poor countries is often restricted by low savings, inadequate labor skills, and relatively scarce natural resources. Rather than relying on manufacturing development, some of them may be able to benefit from development of service industries (as many Caribbean and Pacific islands may rely on tourism, or the Cayman Islands may depend on financial services).

Trade orientation

What are the economic or policy advantages of being small? Leaving aside such crucial sociopolitical aspects as cohesiveness and concentration, three economic factors may be singled out.

First, small size may induce a country toward stronger export orientation and hence greater openness, with all the benefits associated with these. A country’s basic economic position in the broadest sense, including size, location, and resource endowment, often dictates the orientation of its policy, and small countries are more often than not inclined toward outward orientation, while large countries with more diverse potential tend to stress import substitution. Among the smaller economies in the world, those with export-oriented policies have achieved the highest rates of growth, such as, for example, Malta, Botswana, and Mauritius. Robust empirical evidence suggests that open trade policies are associated with higher growth rates, more efficient adjustment, and more rational resource allocation.

A second advantage inherent in small size is that many small countries are in a stronger position than larger ones to expand their exports. Small economic size is often correlated with small shares in commodity markets. Countries with small market positions in standardized primary products can often expand exports without encountering the adverse (economic, social, or political) reactions associated with large market shares. With a smaller market share, countries run less danger of depressing market prices when they expand their exports of standard products.

Small economies are also less inclined (or able) to build up a heavy industrial structure. While larger economies reap benefits in doing so, as their more extensive domestic markets allow economies of scale, the potential benefits for small countries are not so great, while the cost is high. If the effort is too extensive and too fast, as it has often been, the cost may be excessive in terms of inflation—caused in many situations by high investments as well as excessive current expenditures—or a build-up of external debt. Small countries making more cautious decisions on major industrial investments may reap high rewards, particularly in weathering the difficulties of the present external environment.

Aspects of industrial policy

Policymakers in small countries often feel their economies are dependent on one or a few export products and hence sensitive to the fluctuations in their markets in one dominant customer market or neighbor. These aspects reduce countries’ freedom of action and their ability to adhere to targets for development.

Many of the arguments about economic dependence are concerned with the adverse effects of trade fluctuations, which have been especially marked in the 1980–82 recession. Export orientation tends to make a country more vulnerable to these. To cushion adverse impacts, countries have access to arrangements such as the compensatory financing facility of the International Monetary Fund or the STABEX scheme of the European Community. But in the longer term, fundamental diversification is required in both the domestic and the export sectors, and small countries often face special handicaps in achieving this.

However, several small countries have been able to diversify their export industries through importing inputs and using foreign firms to assist in product design, processing techniques, and marketing. These arrangements, often using export-processing zones, can create substantial employment opportunities and increase foreign exchange earnings. They deserve encouragement as well as special attention to enhance their potential benefits. For example, when export growth is based on processing imported components, the benefits to the domestic economy may be increased through improving the skills of domestic labor and management, and contracting the supply of inputs from home industries. In the absence of measures to ensure these effects, the export-processing industries may become an enclave in the economy.

Industrialization in small countries can also be facilitated by regional collaboration. It is true that the coordination of manufacturing investment under regional arrangements (as, for example, under the Andean Pact or among the member countries of the Association of South East Asian Nations) has often been frustrated by national interests. Yet there is considerable scope for collaboration on specific aspects. The success of the CFA franc arrangements in Western and Central Africa points to the important role of monetary coordination—especially the maintenance of stable exchange rate arrangements and convertible currencies among several small countries, and the freedom of capital movements. These arrangements, entailing a de facto guarantee of the repatriation of capital and the remittance of earnings, have been accompanied by substantial capital inflows. More capital and higher investment in manufacturing have resulted from these arrangements.

Regional arrangements may also be instrumental in providing essential technical and legal advice and assistance to member countries in starting up new industries or in attracting and regulating foreign investment that individually they may be unable to achieve. Similarly, help in starting up training programs may also be most effectively provided through regional arrangements. It is essential, however, that regional arrangements not lead to increased protection, which would be an obstacle to export performance.

Regional institutions are also needed to provide financial and technical assistance to the many small industries and firms that play a key role in the industrialization of small economies. Perhaps the most practical are the development banks such as the Caribbean Development Bank and the West African Development Bank, which operate in a small number of neighboring countries and which can play the same role intermediary institutions perform in larger countries. Such subregional banks deserve special assistance to overcome difficulties in the mobilization of domestic finance, the promotion of projects, and the provision of technical and technological know-how.

For many years, development economists have made a case for special financial assistance to small economies. These may be even more valid for those small economies that encounter special obstacles in overcoming the effects of the 1980–82 recession. The special case for aid to small economies is perhaps now more widely recognized than it was some years ago (see box).

In September 1982, the Development Committee and the Group of 24 commented on the plight of small countries in the communiques issued at the end of their Annual Meetings.

“The Committee noted the problems of small island and landlocked states, and recognized the urgent need to review mechanisms and adjustment prescriptions appropriate to the particular circumstances of such states.” (Development Committee)

“Ministers urged that the international financial community pay particular attention to small island and landlocked developing states, having regard to their limited size, their openness, and their vulnerability to the vagaries of the international economic environment. They agree that there is an urgent need for immediate action to review the mechanisms and format of conditionality and the nature and content of adjustment prescriptions requested by multilateral financing institutions in small island and landlocked economies. Ministers recommended that a study on this topic be undertaken.” (Group of 24)

Toward a strategy

No single strategy can be recommended for a diverse group of countries ranging from Chad to Barbados, from Bolivia to the Solomon Islands. However, the previous discussion suggests that several elements may enter into a suitable strategy in many small countries:

• Small countries may derive special advantages from outward orientation, realistic exchange rates, and relatively low and even protection with minimal distortion among individual industrial branches.

• Industrial policymaking and planning in small economies must necessarily concern itself with assistance to a multiplicity of small-scale industries and with the preparation of projects.

• Development of indigenous industries and skills deserves top priority because any strategy must be anchored in what a country has in hand or can develop as its own. Many of the firms in these industries are very small. To obtain adequate assistance, appropriate intermediaries at home and/or in the subregion must be built up.

• Countries should actively seek technological assistance from trading partners, private investors, or regional and international institutions. New technologies often make possible efficient but smaller-scale production and hence their application may be of special importance to small-scale industries and small economies.

• Export programs should be adopted for various industries at an early stage. When a country starts with export-processing activities, it should also ensure that economical backward linkages, skill development, and technical assistance are in place. It should encourage domestic industries to produce inputs for export activities and confine these to low-cost and high-quality production. Small-scale mechanical industries are often prime candidates.

• Food processing industries deserve a special place in countries with agricultural potential. They provide a natural link between manufacturing and agriculture, often operate on a small scale, and are suitable for both domestic consumption and export. They are prime candidates for external technical assistance as well as private foreign investment.

• A broad range of home industries (import substitution) may be economic, and hence deserve a place in industrial strategy in landlocked countries, which, because of high transport cost, enjoy natural protection.

• Countries with mineral resources should start an export industry, often with special enclave arrangements. Private investors and external assistance can play useful roles in providing project design and feasibility studies, and in advising on suitable legal arrangements.

• Given the paucity of private investment resources for small economies, financial and technical intermediaries operating at a regional level can play a key role in furthering countries’ industrial development.

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