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Import substitution & Bangladesh

Nazifa Raidah | November 23, 2022 00:00:00

The busy Chittagong Port, the prime seaport of the country

Whenever one hears of import substitution, one thinks of splitting the words according to their meaning, i.e, that it's a policy through which countries get alternatives for imports. But they would be wrong in assuming so. In reality, 'import substitution' is a development policy that encourages developing countries to substitute imports of manufactured goods with domestic production to reduce their dependence on foreign trade.

Import substitution industrialization (ISI) was introduced in two phases to the developing world: ISI1 (the period between 1950 and 1960) and ISI2 (the period after the 1960s to the late 1980s). Why import substitution came in two phases is a question for a later discussion. What's more important to ask is how it emerged and what results may be relevant for Bangladesh as the country tries to join the 'developed country' (DC) club?

Government-imposed ISI had emerged from critiques of the international division of labor in which less developed countries (LDCs) mainly exported raw materials and imported finished manufactured goods from Europe and the United States. The five original ISI musketeers (Raúl Prebisch, Gunnar Myrdal, W. Arthur Lewis, Alfred Hirschman, and Ragnar Nurkse) agreed that any policy emerging from standard economic theory (which doesn't take the economic circumstances of developing countries into consideration), would be inappropriate for LDC application. They criticized the assumption behind the neoclassical model of free-trade that perfect competition would exist between industries: without keeping LDC demographic and financial constraints in mind, their inability to create competition in the first place would not be possible. Developing countries would get stuck in 'comparative advantage', implying that they would get stuck in a monotonous and disadvantageous pattern of industrialization. The musketeers didn't disagree that industrialization was key to development, but they rather said that when developing countries try to 'specialize' products for trade, that is what keeps them from establishing a base for manufacturing.

Prebisch and Hans Singer identified three LDC trade features. First, when countries export only primary products, i.e, goods available from cultivating raw materials without a manufacturing process, declining terms of trade forces them to export more in exchange of fewer imports until eventually the resources of these countries get exhausted, to the point they can no longer capitalize on using those resources to manufacture their own products. Second, since higher wages need to be paid in manufacturing industries compared to other types of industries, the market price would not produce the right allocation of resources, eventually resulting in small-sized industries. Finally, extensive government intervention is required to mobilize capital for economic growth and allocate resources in the right direction.

ISI emergence was both 'descriptive' and 'prescriptive': both described what would happen to countries as they gradually developed the capacity to make goods at home; and also painted the pictures as to what 'should' happen with appropriate government policies.

Prebisch's model: Raul Prebisch, the first Executive Secretary of United Nations Economic Commission for Latin America (ECLA, created in 1948) and first Secretary General of United Nations Conference on Trade and Development (UNCTAD, created in 1964), was also one of the first experts to articulate LDC deprivation in the realm of international division of labor.

Originally his ISI push was not to completely stop imports but rather to regulate it. He recommended that developing countries needed to shift from importing consumer goods ( food, clothing, vehicles, electronics, and appliances) to importing capital goods needed for establishing industries (tools, machinery, buildings, vehicles, computers, and construction equipment). This meant under Prebisch's model, developing countries would now have to reduce foreign exchange spending on non-essential consumer goods and focus investment on goods needed for development. Domestic production would replace the local need for consumer goods. He thought that under the existing international economic model, no win-win outcomes were possible situation in trade between developed and developing countries: the capacity to manufacture goods was far higher than that of capital goods, eventually pushing prices of capital goods down. Even if developing countries could expand their exports, their trade would eventually decline.

Prebisch was skeptical whether the export earnings of developing countries would be enough to finance all the required imports of consumer and capital goods. He also warned that if this protectionist policy is carried too far, it may reduce both imports and exports.

ISI 'Failure': Even as an ISI advocate, Prebisch found fundamental shortcomings in the model. The first issue he cited was that import controls didn't necessarily conserve foreign exchange as he had expected. Through his own ECLA and UNCTAD handling of ISI practices, he noted tariff protection rates were high and the rates varied across industries. Economic logic could not explain that. Only by looking into each individual country's governance could one derive an explanation. Small firms with marginal economic impact could only operate within domestic markets. All these taken together meant that the policies in place that were meant to promote exports were eventually becoming the very obstacle for it.

Prebisch also recognized that one of the major ISI problems could be one industry being broken down into several other industries, thereby reducing capital for the country as an aggregate. The other issue he pointed out that could potentially point towards an ISI failure is that economic efficiency could be compromised if each country rushed to produce capital-intensive goods, then competition would diminish and prevent countries from building economies of scale. Prebisch eventually proposed the ISI model be pursued in a larger common market, i.e., a common Latin American market.

The other reason for ISI failure is that it failed to consider how those countries eventually shifting from consumer-goods-based imports to capital-goods-based imports may not have the necessary technology to produce consumer goods. ISI advocates never discussed in detail what specific policies could best accommodate countries with such contexts.

Ragnar Nurkse identified that for developing countries, the focus always goes towards increasing their foreign reserves as opposed to the existent shortage of investment opportunities in those countries, for which he was skeptical of import substitution.

ISI Alternatives: Other thinkers scratched the ISI surface and proposed variations of the model. In 1957 Gunnar Myrdal completely rejected the idea that market prices be used to judge how resources should be allocated by developing countries. He suggested that developing countries should adopt 'export promotion' through policies that would help diversify exports. Recognizing import substitution as an eventual LDC consequence in the absence of a healthy foreign reserve, Myrdal proposed a different model than Prebisch, suggesting that countries should use import tariffs (tax-based) over quotas (quantity based). This was to minimize corruption, so administration would not take advantage of import quotas by conferring special advantages to those holding import or foreign exchange permits.

On the other hand, Nurkse advocated for the increase of capital investment across a range of industries to diversify growth and create a balance. Restrictions on luxury products, he proposed, would lead to some capital formation in developing nations. By the late 1950s, he questioned if import substitution actually drew resources away from the export sector, thus reducing income and domestic savings.

W. Arthur Lewis in 1953, had recommended a policy entirely different from the ones mentioned. He pushed a 'dual economy system', pertinent for overpopulated countries with plenty of human capital. He stressed for developing countries to focus on agriculture, as he believed it would generate higher income, even trigger industrialization. For countries with low productivity in agriculture, he prescribed shifting labor pools from agriculture to manufacturing. However, he didn't elaborate on a proper trade strategy in this regard. Hirschman, a harsh ISI critic, pushed for export promotion in its opposition.

Bangladesh's Lessons: Since birth, Bangladesh has safeguarded a number of businesses that compete with imports, notably those that produce consumer products like biscuits, footwear, and so forth, to increase the economy's shock absorption and resilience.

Moderate liberalization from the mid-1980s expanded in the early 1990s, successive governments have reaffirmed their commitment to the development of a more liberal trade regime. The country's trading policy evolved on the premise of trade liberalization, implemented as part of the structural adjustment program (SAP) which was initiated back in 1987 and later transitioned to 'enhanced structural adjustment facility' (ESAF) of the International Monetary Fund and the World Bank. However, in the early 1990s, large-scale liberalization of trade was implemented. Since then, successive governments have reaffirmed their commitment to the development of a more liberal trade regime.

Presently, in order to cut costs on product and raw material imports, the government plans to offer subsidies on capital investments for industries that replace imports. A draft of the National Industrial Policy 2022, which is awaiting feedback from the parties concerned, also proposes tax holidays and VAT (value-added tax) exemptions, alongside a subsidy on the interest of running capital. But this proposal might run the risk of repeating the same mistakes of Latin American countries in the 1980s unless certain modifications are applied. For example, the entire purpose of giving these infant industries tariff protection, was to ensure that they might endure and possibly even thrive in the face of foreign competition if and when trade were to be liberalized and tariffs eliminated. However, for Bangladesh, once tariff protection is imposed it is hardly lifted. As a result, most companies in Bangladesh end up asking for more subsidies instead of focusing on self-reliance, the very reason for which the subsidy was provided.

Secondly, even though RMG stands as an example of export orientation, the issue is still the fact that this power only exists as Bangladesh can provide cheap labor, free of external monitoring and compliance maintenance. However, what we have with RMG is a monopoly. In any case, remittance flow goes in a downward direction when there's a monopoly in an export generation. Thus dependence on RMG is not only an issue in terms of diversifying trade, but also bringing in more export earnings. Thus just like Nurkse had suggested, Bangladesh needs to look at its next personal industrial revolution by looking at other sectors, like leather or agriculture, for its actual economic emancipation.

Yet there are lessons to be learned from the discussions, five of them. The first is simply shifting Prebisch's distaste for spending foreign exchange on non-essential consumer imports to luxury goods. Bangladesh's National Revenue Board did so this year, but only because of the Ukrainian-driven war-based inflation, from May. It raised the 0-3% regulatory tax to 20% on 135 products, hoping domestic production would be boosted, a classic case of adopting import substitution. These products included fruits (with a tariff of 58-85 tariff and 3% regulatory), flowers (58% tariffs), furniture and cosmetics (tariffs of 104-127%); wood, iron furniture, and furniture raw materials (20% regulatory tariffs), cars (30%), pick-up vans (20%), and car engines (15%), tires (3-10%), perfumes (20%). In other words, just as the 1930s Depression and World War II drove Latin countries to shift to an ISI strategy, Bangladesh might think about it should the persisting inflationary spiral climb. As Nurkse proposed, such restrictions on luxury products could boost capital formation in addition to production.

Second, the greatest contribution of Prebisch was to push Latin America towards regional trading. In 1960, when he was still at ECLA, the Latin American Free Trade Agreement (LAFTA) did not work out during his time, but the Washington Consensus would produce many still vibrant today, such as MERCOSUR, and from which Bangladesh might find more impetus to create its own. Ongoing negotiations with various countries in Southeast Asia could become a lifesaver if global trading relations deteriorate and should be prioritized further.

Third, pushing that point takes us to another Prebisch proposal: to plan policies ahead of time, rather than jump to them ad hoc under adversity. For example, we should have a Plan B for events like the present inflation far ahead of time, if only to minimize costs and inconveniences.

Fourth, from Mrydal we learn the virtues of diversifying the economy as part of any export-led growth. Our RMG exports have taken us far, but that seems to be the problem: they have done so well that we do not think of a Plan B or other sources of exports. Our DC delivery in the 1940s depends on us having plenty of export commodities or industries. We have a lot of work to do.

Finally, Lewis's 'dual economy' appeals to Bangladesh. We have made huge strides in agricultural production since 75 million of our people faced famine in 1974-75. Today 170 million have achieved self-sufficiency. We need to expand this. Not many countries have the fertile soil as we do, and this huge accomplishment over 50 years suggests that in the next 50 years we could go far beyond. Keeping and encouraging agriculture alongside our RMG and other manufactured exports would show the five original musketeers still have followers in places they never conceived of before, indicating the magic of theoretical arguments when empirical developments go astray.

Nazifa Raidah is Student, Department of Global Studies & Governance (GSG), Department of Media & Communications, Independent University, Bangladesh (IUB)

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