A case for import substitution?

Arvind Panagariya

Taking issue with my conclusion in the May 22 column that the Indian industry needs further trade liberalisation, labour-market reforms, an end to the small-scale industries reservation, effective bankruptcy laws and privatisation to catch up with China, my friend Professor Dani Rodrik of Harvard University writes in a personal note:

“Most of the countries of Latin America did all of that, and the result was a rate of industrial growth (and TFP expansion) that is way below the levels experienced under ISI [import-substitution industrialisation]. The least that India can do is to learn from this experience and not assume that all the good things will follow as soon as trade liberalisation, deregulation and privatisation takes place.”

Rodrik is among a handful of thoughtful critics of trade liberalisation and deregulation who ground their views in serious scholarly research. Therefore, one cannot summarily dismiss his advice.

So how does one respond to Rodrik? To begin with, there are serious limits to applying the Latin American experience to India. Since early 1970s, Latin America has been repeatedly subject to devastating macroeconomic crises. The worst India has seen is the balance-of-payments crisis of 1991.

To place this contrast in perspective, while a 20% inflation rate is synonymous with the absence of inflation in Latin America, it defines the absolute upper limit of tolerance in India.  Four years ago, insufficient appreciation of this difference landed the then chief economist of the World Bank, Joseph Stiglitz, into hot water at a conference in Colombo. 

Drawing on research based principally on Latin American data, Stiglitz argued forcefully that the additional benefit from fighting inflation was zero once it had been brought down to 20%.  That sent the South Asian policy makers present at the conference into fury: how could Stiglitz not know that in South Asia 20% inflation was equivalent to death for the poor!

But leave this qualification aside and examine the case for ISI made out by Rodrik in his recent book, Making Openness Work.  He presents evidence showing that the years 1960-73 define the golden period of growth for developing countries with 30 countries growing at 3% or more in per-capita terms. In contrast, growth rates plummeted during 1973-84 and 1984-94. The decline was especially pronounced in Latin America (columns 2 and 3 of the accompanying table) and Africa.

Growth Rates in the Latin American Countries that Grew 3% or More During 1963-73*

* Barbados and Panama also grew at rates exceeding 3% in per-capita terms during 1963-73 but had to be omitted from the table due to unavailability of export data.

Rodrik argues that ISI policies during 1960-73 “spurred growth and created protected and therefore profitable home markets for domestic entrepreneurs to invest in. Contrary to received wisdom, ISI-driven growth did not produce tremendous inefficiencies on an economy-wide scale.”

For the debacle that followed 1973, including the failure of ISI during the rest of 1970s, Rodrik points to macroeconomic instability as the villain. For the instability itself, he blames external shocks including “the abandonment of the Bretton Woods system of fixed exchange rates, two major oil shocks, various other commodity boom-and-bust cycles, plus the Volcker interest-rate shock of the early 1980s.”

What is wrong with this story? For starters, during 1960-73, industrial countries grew far more rapidly than during 1973-94 and they progressively opened their markets. Both factors helped spur growth in developing countries. While the more open economies of East Asia benefited more, the less open economies of Latin America also benefited from the open and growing markets in industrial countries (column 4 of the table). But this is not all.

If ISI is to be credited with stimulating growth in Latin America, at the minimum, we must be able to establish this persuasively for Brazil, by far the largest economy of the continent. To be sure, Brazil did register the second highest growth of the continent during 1960-73. But evidence hardly credits ISI for it. Thus, during 1960-73, Brazil’s exports and imports grew at the impressive annual rates of 7.8 and 8.9%, respectively, in real terms. More importantly, trade policy specialists on Brazil describe the period 1965-73 as one of “cautious outward-looking trade policy liberalisation” and 1974-80 as one of “renewed inward-looking policies.” During the former period, Brazil corrected the real-exchange-rate overvaluation, introduced several export incentives to reduce the anti-export bias, and lowered average legal tariff for manufacturing (including surcharges) from 99 to 57% and for agriculture from 53 to 34%.

The case for ISI as the key to growth in Latin America during 1960-73 is, thus, seriously undermined. But we are still left with Rodrik’s criticism that trade liberalisation and privatisation during 1980s did not produce significant growth response there. To address this concern, we must once again begin by recognising the role of the slow growth in industrial economies and its impact on Latin American exports (column 5 of the table).

But beyond that, Rodrik’s own explanation for why ISI failed to deliver during 1970s — macroeconomic instability — must be invoked. If ISI is to be rescued from culpability during 1970s by appeal to macroeconomic instability, symmetry demands that trade liberalisation and privatisation be acquitted of the charge of ineffectiveness during 1980s as well since the same macroeconomic instability prevailed then.

The critical question one must still answer from the policy perspective, however, is why the East and South Asian economies escaped macroeconomic instability during 1980s while Latin American economies fell prey to it. Here the principal villain would seem to be short-term capital mobility, which the latter had largely embraced by early 1980s while the former had not. The collapse of the fixed exchange rates and oil crises affected all oil-importing economies symmetrically but the Volcker interest-rate shocks impacted Latin America asymmetrically.

Given that India enjoys the necessary macroeconomic stability and is some distance from embracing short-term capital mobility, the prediction that good things will follow trade liberalisation and privatisation is a safer bet than the alternative.

Economic Times, September 25, 2002