View: Why import substitution industrialisation is doomed to flounder, again

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In the wake of Galwan events, a consensus has emerged that India needs to distance itself from China in its international trade. There are three possible policy driven avenues to this goal: tariffs that apply to imports from China alone; tariffs on all imports of products of which China is the principal current supplier; and more favourable treatment of imports from non-China sources through free trade agreements.

The first of these options will require invoking the national security clause of WTO rules, which India can justifiably do given the hostilities on the border. But it will most surely invite retaliation by China, which may include restrictions on its exports to India of products that only it can supply or supplies at costs far below those of the next best alternative. Given the fragility of our own economy today, this is not a desirable route.

The third alternative is non-disruptive and supportive of India’s growth and jobs imperative. It will take time, patience and some hard negotiation but it is the option that India must exercise. If the agreements are forged and strengthened with entities such as the EU, UK, Japan, Australia, Canada and eventually the US, they will complement our strategic relationships.

But it is the second option that seems to find the greatest favour in India at present. For it nicely fits into the broader import substitution instincts of many in India, both in the government and outside. But hard-nosed economic analysis and critical assessment of available evidence reveals it to be the most treacherous route.

For starters, import substitution industrialisation (ISI), which entails progressive replacement of imports by domestic production, is precisely the strategy we had pursued until 1991. That year, we finally recognised its total failure and switched to outward orientation. Those seeking its revival argue, however, that it will be different this time. Rather than take them for their word, let us examine whatever evidence exists.

We embraced ISI in the electronics industry nearly six years ago. Where do we stand today? Imports of electronic goods shot up from $32.4 billion to $55.6 billion between 2013-14 and 2018-19, while exports have inched up from $7.6 billion to $8.9 billion over the same period. Predictably, protected and subsidised, several mobile phone assembly firms have come up but they have not added up to a vibrant electronics industry. Nearly all locally owned firms are small by global standards, with not one that is about to turn into a powerhouse of exports.

Undeterred, we are proceeding with Phased Manufacturing Programme (PMP), under which the production of some of the components used in mobile phones will be encouraged. In public policy, memories are so short that past mistakes get repeated. Accordingly, it is appropriate to remind that the PMP road is also one on which we have travelled before, during the licence permit raj era.

Then, we used to make indigenisation of the product a condition of the licence. For instance, licence for assembling tube lights was given on the condition that imports of specified components would be permitted for a specified period after which they will have to be sourced domestically. The programme failed and we abandoned it alongside licensing in 1991.

A return to PMP in mobile in today’s context will entail raising tariffs and giving subsidy on the components that less efficient domestic producers will replace. That will, of course, raise the cost for mobile assembly firms that have sprung up in the last six years. So we will have to either provide them yet higher protection or let them go out of business.

Instinctively, governments want to pursue ISI in products in which imports account for the largest proportion of domestic consumption because that is where domestic suppliers have the greatest scope for substituting imports. But one must ask why imports have the largest share in domestic consumption of those products? The most likely answer is that those are the products in which domestic producers have the greatest cost disadvantage. So ISI ends up concentrating in precisely those products in which the country is least efficient, a surefire recipe for failure.

ISI has a further problem that predisposes it to failure. It encourages domestic production through tariffs and output subsidies. Both factors attract small-scale firms focussed on making quick risk-free profits with no plans to become exporters. On top of this, the policy itself has a tendency to build a bias in favour of entry of small firms when it comes to domestically owned firms, as is the case with the recent production linked incentives scheme.

If a country feels compelled to pursue industrial policy, it has far better chances of success if it targets products that are already exported or on the verge of becoming exports. Such a strategy benchmarks domestic firms against the best in the world.

Since the luxury of sustained large export subsidies (as opposed to high tariffs under ISI) is not there due to possible retaliation or countervailing duties by importing countries, making a success of such a policy automatically forces the government to address reform of domestic policies. It feels greater compulsion to remove bottlenecks such as high land and electricity prices, labour market inflexibilities and infrastructure bottlenecks.

DISCLAIMER : Views expressed above are the author’s own.





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