Econ-ity » July 20, 2017

Daily Archives: July 20, 2017

Import Substitution: A Hindrance To Economic Development

As Nepal’s imports vis-à-vis exports continue to surge, more and more voices in favour of import substitution through import substitution industrialization (ISI) have been gaining ground. The fundamental logic is, instead of depending on imports, these (imported) goods should be produced domestically. While it may be tempting to defend this policy on the grounds of reduced reliance on imports and promotion of domestic market, there are quite a few explicit and implicit costs such policy entails.

Developing countries generally adopt ISI with the objective of stimulating economic growth, ironically by setting up trade barriers – imposition of tariffs and/or import restriction through quotas. Protectionist mechanism as such inflates the price of otherwise cheap imports, which in turn induces people to consume domestic alternatives they otherwise would not have in the absence of import tariffs or quotas. Consumers are compelled to bear substantial welfare loss for the sake of protecting few domestic jobs. New jobs replace old ones as a result of technological advancement under what we call the process of creative destruction. Hence, domestic jobs being lost due to foreign competition is a normal phenomenon of “economic evolution”. One way to look at it is as a release of human capital to take on something else where this capital can be employed. The question then would be are the economic policies of a country conducive enough to facilitate that transition?

ISI has proved to be counterproductive time and again. Latin American countries suffered severe ramifications – ranging from overvalued exchange rates to high level of foreign debt – upon adopting this policy. Furthermore, dependence on imported capital goods intensified as a result of attempting to substitute imported consumer goods with domestic goods. There was no improvement on trade deficits whatsoever and in some cases worsened as high exchange rates discouraged exports. And finally, ISI failed to alleviate unemployment in all respects.

Nepal has witnessed soaring trade deficits over the years. A recent finding has shown that Nepal’s imports amounted to Rs.893.09 billion while exports lagged behind at Rs.67.35 billion. Experts have pointed out the need to focus on promoting import substitution industrialization. However, is enforcing import restriction really going to help domestic markets to grow? Gorakhkali Rubber Industry, a domestic tire manufacturing company, was established in 1992 with the goal of reducing dependence on imported tires from India. The price of tires manufactured by this company was more expensive than the ones offered by Indian brands, which are of course levied custom duties. Evidently, Indian brands had comparative advantage over the production of tires as they were able to manufacture them at a lower opportunity cost. Gorakhkali Rubber Industry had to eventually halt production as it faced a supply glut since no one was willing to purchase overpriced tires. The basic principle of trade – countries engage in production of goods that they have comparative advantage over – is entirely disregarded under ISI as it was the case with Gorakhkali Rubber Industry.

Export oriented industrialization (EOI) approach could be more economically viable in generating sustainable growth. Rather than imposing import restriction to retain inefficient domestic industries, Nepal should divert its attention towards industries that actually have comparative advantage in the world market and incentivize these industries to export their products. On the other hand, Nepal is still not at par with foreign producers when it comes to manufacturing capital intensive commodities, say cars. Instead of attempting to manufacture cars on its own to bring down trade deficits, the government should formulate policies that would attract foreign direct investments to establish a plant for manufacturing foreign cars in the country. This significantly shrinks the import-export gap but more importantly, technology transfer that follows foreign direct investment contributes to the extensive development of domestic industries.

Nepal needs to analyze the trade-offs involved in each case and construct policies accordingly – ISI could save a few jobs in the short run at the expense of consumer welfare, and EOI might fail to save those jobs in the short run but enhances productivity and fosters growth eventually. All policies are carved with good intentions; however, good intentions of a policy do not necessarily yield good consequences in the long run. We therefore need to get our priorities right in the first place.

About Sambriddhi Acharya

Sambriddhi is a researcher at Samriddhi Foundation.

Published by: