Session 7 Import Substitution-Industrialization (ISI)

1. What is ISI

Industrial development program based on the protection of local infant industries through protective tariffs, import quotas, exchange rate controls, special preferential licensing for capital goods imports, subsidized loans to local infant industries, etc.

“A deliberate effort to replace major consumer imports by promoting the emergence and expansion of domestic industries such as textiles, shoes, household appliances,” usually requiring the imposition of protective tariffs and quotas to protect new or infant industries. From Michael Todaro 1994, Economic Development, p. 681.

2. Rationale for ISI

In the “old economic order”, the “international division of labor” was such that industrialized , higher income countries specialized in the production of manufactured goods, while the low income non-industrialized countries specialized in the production of “primary” (agricultural, mineral, forests) products. In this way, it was reasoned, different countries specialize in the production of those commodities with which each enjoys a “comparative advantage” i.e. an abundant resource or factor endowment (e.g. labor, land, technology,). Countries then trade those commodities they produce for those they consume but do not produce. This meant that the low income countries would have to trade their own relatively low value-added primary sector products for the more expensive, higher-value added products in which the industrialized higher income countries specialized.

Two developments beginning around World War II made this international division of labor untenable for the low-income developing countries. First, the War itself forced the industrialized countries to shift production from a civilian consumer market to a wartime military market. Tanks and guns were produced in place of automobiles and bread toasters. This left many developing countries which had come to depend upon foreign manufactured consumer goods imports vulnerable to shortages of those goods. Second, a long-term trend of declining “real prices” (prices adjusted for inflation) for primary commodities began after World War II. This development meant that low income countries specializing in primary commodity production received less and less “foreign exchange” (US$) through trade, and therefore had to pay relatively more for the manufactured goods from trade with the industrialized countries. These “deteriorating terms of trade” meant developing countries dependent upon the manufactured imports from the industrialized countries had to spend more and more money to purchase those imports. Both of these developments made many Third World leaders, especially in Latin America, to decide to promote domestic industrialization to reduce their country’s economic dependence and vulnerability to the First World economies. ISI became the policy strategy they pursued to gain this economic independence.

3. Logic Behind ISI.

(a)   Forward and Backward Linkages in Industrialization Processes. The goal of ISI was to promote native/local industries to replace the foreign produced manufactured products that were consumed as imports. A few principles of manufacturing need to be understood: First, every industrial or manufacturing process involves several stages of production. The number of stages in the production process is a reflection and function of the complexity of the final product. For example, the manufacturing process that transforms alumina into soft-drink containers entails about 5 stages. The manufacturing process that transforms about 17 primary metals into the structure that ultimately becomes an automobile requires over 120 stages. Note also that the “density” (number of stages) of the manufacturing process also influences the “value added” of the final product, and hence the final price that industrialized countries can secure for complex manufactured products.

Generally, we classify these stages of production into 4 inter-related industrial goods sectors:

(1)  Consumer non-durable goods sector (foods, beverages, clothes, pharmaceuticals);

(2)  Consumer durable goods sector (appliances, autos,etc.)

(3)  Intermediate goods sector (pressed steel, sawnwood, prefabricated plastic structures with versatile end uses)

(4)  Capital goods sector  (e.g. blast furnaces, pressure molds, robotic assembly devices).

For any truly autonomous manufacturing process to be free of foreign dependency it would need to develop industries in all 4 sectors to some degree. ISI envisaged that the “backward linkages” from the consumer goods sectors would generate demand for the products that intermediate and capital goods sectors would produce. Ultimately, the goal was to develop a vertically integrated industrial economy in which a few (high capital/output) capital goods manufacturers supplied the entire economy with the basic components for producing intermediate goods. Then, a broader range of intermediate goods manufacturers produced an even broader range of intermediate goods that consumer (durable and non-durable) sectors could shape into final consumer products.

(b)  “Economies of Scale”

The key to success in industrialization requires that individual factories  achieve  “economies of scale” of production.

In most manufacturing processes a point of output is reached after which the cost of producing every additional unit of output diminishes. Different types of industries, given their different production functions (combinations of capital and labor, etc.) obtain different scale thresholds or minimum levels of output necessarily to begin accruing cost savings from large-scale output.  For example, a

mechanical pencil factory may need to sell 5 million units of output (pencils) each year before it can achieve economies of scale of production – efficient level of production. An automobile industry may need to sell 100,000 units of output (cars) to achieve the same level of efficiency.

Clearly, the more units of anything manufactured you can sell the better the chances that your factories (consumer goods and intermediate, and ultimately capital goods) will achieve economies of scale, efficient production.

In a free market global economy, industries that produce inefficiently (without obtaining economies of scale of production) under the protections of ISI have been subject to criticism from more efficient foreign industries – a force driving the neo-liberal  campaign for open markets.

What determines whether a country obtains efficiency – economies of scale in production?  Market size (number of consumers, population) and purchasing power (usually but unreliably indicated by GNP/capita). Hence, larger, richer  economies were more likely to make ISI succeed efficiently, whereas smaller countries with lower per capita incomes were less likely to succeed with ISI.

(c)   3 ISI Strategies

Countries pursuing industrial independence all wanted complete manufacturing autonomy. In reality, hard choices forced development planners toward one of three ISI strategies:

(1)  Complete vertical integration – All stages, all sectors (virtually impossible in most countries over a reasonably 20-year industrialization time-line);

(2)  Selected vertical integration- All stages, but selected sectors.

(3)  Selected horizontal integration – multiple consumer durable/non-durable sectors serving different markets support a single intermediate goods sector.

(d) ISI Policy Instruments.

1.     Tariffs: Ad valorem  taxes imposed on imported products to make them relatively more expensive than comparable domestically produced goods. Such taxes serve to protect local companies from foreign competition in the domestic consumer market.

Two concepts of protection: nominal and effective rates of tariff

(a)   Nominal tariff rate: Percentage difference between the price of a good with and without protection. We can calculated the nominal tariff rate as follows:

t = p1 – p    Where t = nominal tariff rate,

        p                 p = market price of an imported good

                         p1 = price of imported good with tariff

e.g. p = 10, p1 = 12

12-10/10 = .2 or 20% tariff rate.

(b)  Effective tariff rate:  When the nominal rates of tariff for a final product and its component parts or inputs are different can effectively increase the protection of the domestic product beyond the nominal tariff rate.  We calculate the effective tariff rate as follows:

ERP = (Pw)(t) – (Cw)(t1)

                 Pw-Cw

Where, ERP = Effective Rate of Protection

             Pw = Price without the tariff

             t    = Nominal tariff on imported final product

            Cw = Cost of the final product inputs without the tariff

             t1 = Nominal tariff on imported inputs.

For example, Consider a pair of imported Nike shoes with market price of $ 100 (Pw). There are two different nominal tariff rates, one for the pair of shoes itself (t,) say taxed at 50% and another for the shoe laces, one of the shoes component parts (t1), say taxed at 10%. Assume that the cost of producing the shoes without the tariff (Cw) is $50. Plug in the numbers as follows:

ERP = 100(.5) – 50(.1)  = 50-5/50 = .9 or 90%

                100-50

Effective tariff rates vary widely between countries and between products. For example Mexico used to have a 25% nominal rate of

tariff on many manufactured goods, while India imposed a 200% nominal rate. The consequence of tariff protection is that the higher the effective tariff rate the greater the difficulty for foreign manufactures to compete with protected domestic manufactures in the final consumer goods market. Protected industrialization between trading partners generally reduces opportunities for export.

2. Quotas. Limits on the number of units of a foreign product that may be imported into a country. Sometimes quotas are auctioned to the highest foreign bidder.

3. Foreign Currency Exchange Rate Adjustments. In an unregulated currency market the domestic price of a foreign currency is determined by the rate at which the demand for that currency would just equal supply (“equilibrium price”).  When we speak of exchange rate adjustments we are usually referring to the domestic currency value of the US dollar (US$), the principal currency of foreign trade (e.g. how many Mexican pesos exchange for US$ 1.00?). The higher the exchange rate for the US$ the more expensive it will be to purchase foreign product imports. The lower the exchange rate, the cheaper those imports become.  To adjust exchange rates governments must first accumulate enough foreign exchange to affect the domestic supply. Governments do this by regulating foreign trade. For example, the government of Brazil requires that all letters of credit (i.e. purchase orders) for Brazilian exports be payable in US$. The government deposits these US$ in the Central Bank and pays local exporters in the Brazilian currency (Reais). The government can then use these accumulated foreign exchange earnings to pay down the external debt or adjust the dollar exchange rate to make imported goods more expensive. If the government wishes to “overvalue” the Dollar relative to the Real, and thereby make foreign imports more expensive in domestic market, it withholds US$ from domestic circulation. For example, suppose the domestic market demands US$ 1 billion in foreign exchange but the government releases only US$ 500 million into the economy. Obviously the price of Dollars would increase since supply exceeds demand. This situation would make the U.S. Dollar overvalued relative to the Brazilian Real. Conversely, if the government sells more dollars in the local currency market than are demanded, this undervaluing of the Dollar and overvaluing of the Real would make foreign goods more inexpensive.

(d)  Effects of ISI.

While several of the large developing countries (e.g. Brazil, Mexico, India) were reasonably successful in fomenting industrialization through ISI strategies, this approach did have several negative impacts as well.

1.     Sectoral Disparities. Not all sectors of industry benefited equally. By protecting infant industries from competition, many sectors could produce inefficiently and survive, charging customers higher prices than foreign counterpart suppliers. Many times those industries already established founded domestically production intermediate production inputs more  expensive than the foreign inputs that they were buying before ISI. Either

such customers successfully pressured governments for exemptions to the import restrictions or absorbed higher costs of their own production. Thus one sector in a final manufacturing process sometimes benefited by discouraging the development of a domestic intermediate input sector.

2.     Disappointing Industrial Employment Results. In Latin America anyway ISI failed to generate the high levels of employment that government policy-makers had hoped for (Table):

Average Percent Increase per Year

Decade Urban Industrial Jobs Urban Labor Force1950-60                2.6%             3.5%1960-70                3.2%             3.5%1970-80                3.0%             4.3%

In all 3 decades when ISI was the prevailing national development strategy in Latin America, the urban labor force increased at higher rates than urban industrial employment (new job creation), due to combined effects of internal migration and use of modern capital-intensive (and labor-saving) production technology .

3.     Balance of Payments. Instead of improving the situation of the old economic order based on the trade of cheap raw materials (e.g. iron ore) for expensive finished products (e.g. automobiles), ISI, in some cases, aggravated the balance of payments dilemma. Why? New infant industries specializing in final consumer durable and non-durable goods created a demand for intermediate and capital goods which could only be purchased from abroad. As long as final goods themselves were imported the demand for these expensive industrial suppliers did not exist. So, while the structure of imports shifted, from consumer goods to intermediate and capital goods, the total import bill often stayed about the same or even worsened.

Moreover, new heavy industries created new demand for industrial fuels, especially petroleum, which for many countries had to be imported from OPEC. Indeed, oil as a percent of total imports increased from 8.7% in 1960 to 27.4% in 1983 in Latin America. The oil shock in 1973 set in motion the debt crisis of the 1980s. (see Sessions 18 and 19).

Additionally, the ISI process became highly dependent on foreign capital and expensive production technologies. Foreign direct investment in Latin America as a percent of total gross investment increased from –1.1% in 1950 to 18.1% in 1982 before the global recession (Table)

              Foreign Direct Investment in Latin America

(% of total gross investment)

1950 -1.1% Early ISI

1960 6.0% ISI

1970 7.2% ISI

1980 10.3% ISI

1982 18.1% Early post-ISI

1984 -0.3% Post ISI decapitalization

4.     Dependent Industrialization. Although intended to promote economic autonomy and independence, many of the successful industries that were created under ISI were subsequently acquired by foreign investors remitting corporate profits abroad rather than investing them in new domestic industries. Moreover, imported technologies were patented. Their use in newly formed industries required royalty payments. In consequence, a large proportion of the profits from industrialization were paid-out to foreign income remittances (Table):

Foreign Income Remittances from Latin America 

(Percent of FOB Latin American Exports.)

1960 13.2%

1970 18.1%

1980 26.6%

1982 48.2%

5.     Urbanization. Industries tend to locate in urban centers where they can achieve both “urbanization” and “agglomeration” savings. Concentrating in existing cities, ISI promoted an urban population explosion, drawing workers from other locations in search of jobs in the newly expanding industrial sector (see Session 10).

6. Inefficient Industrialization. Many (especially smaller) countries embarked on ISI strategies without having sufficient domestic market to efficiently support the production of many manufactured products. For example, every country wanted an auto industry and all of the dense backward linkages such an industry generates. However, few countries could produce

and sell enough automobiles to make such production profitable. This limited market size problem constrained the effectiveness of ISI. 

Growth of Urban Industrial Employment and Labor Force in Latin

America during ISI Period Percent Growth in

Urban Industrial Employment

Percent Growth in Urban Labor Force

1950-60                2.6%               3.5%1960-70                3.2%               3.5%1970-80                3.0%               4.3%

Foreign Investment as Percent of Total Gross Domestic Investment in Latin America During ISI Years

YearForeign Investment

as % of Total Investment

Prevailing Industrial Policy

1950         -1.1% Pre-ISI decapitalization1960           6.0% ISI1970           7.2% ISI1980          10.3%

ISI1982          18.1% Global recession/early post-

ISI1984           -0.3% Post-ISI decapitalization

Foreign Corporate Profit Repatriation as Percentage of Export Earnings in Latin America During ISI

1960     13.2%

1970     18.1%

1980     26.6%

1982     48.2%