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Import substitution industrialization or "Import-substituting Industrialization" (called ISI) is a trade and economic policy that advocates replacing imports with domestic production.[1] It is based on the premise that a country should attempt to reduce its foreign dependency through the local production of industrialized products. The term primarily refers to 20th century development economics policies, though it was advocated since the 18th century.
It has been applied to many countries in Latin America, where it was implemented with the intention of helping countries to become more self-sufficient and less vulnerable by creating jobs and relying less on other nations. The ISI is based primarily on the internal market. The ISI works by having the state lead economic development through nationalization, subsidization of vital industries (including agriculture, power generation, etc.), increased taxation to fund the above, and highly protectionist trade policy. Import substitution industrialization was gradually abandoned by developing countries in the 1980s and 1990s due to disappointment with the results.
Adopted in many Latin American countries from the 1930s until around the 1980s, and in some Asian and African countries from the 1950s on, ISI was theoretically organized in the works of Raúl Prebisch, Hans Singer, Celso Furtado and other structural economic thinkers, and gained prominence with the creation of the United Nations Economic Commission for Latin America and the Caribbean (UNECLAC or CEPAL). Insofar as its suggestion of state-induced industrialization through governmental spending, it is largely influenced by Keynesian thinking, as well as the infant industry arguments adopted by some highly industrialized countries, such as the United States, until the 1940s. ISI is often associated with dependency theory, though the latter adopts a much broader sociological outlook which also addresses cultural elements thought to be linked with underdevelopment.
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Even though ISI is a development theory, its political implementation and theoretical rationale are rooted in trade theory – it has been argued that all or virtually all nations that have industrialized have followed ISI.
Mercantilist economic theory and practices of the 16th, 17th, and 18th century frequently advocated building up domestic manufacturing and import substitution. In the early United States, the Hamiltonian economic program, specifically the third report and magnum opus of Alexander Hamilton, the Report on Manufactures, advocated that the US become self-sufficient in manufactured goods. This formed the basis of the American School, which was an influential force during the United States's 19th century industrialization.
Indeed, Baer contends that all countries which have industrialized after the United Kingdom went through a stage of ISI in which the large part of investment in industry was directed to replace imports (Baer, pp. 95–96).[2] Going further, in his book Kicking away the ladder, Korean economist Ha-Joon Chang also argues, based on economic history, that all major developed countries – including the United Kingdom – used interventionist economic policies to promote industrialization and protected national companies until they had reached a level of development in which they were able to compete in the global market, after which those countries adopted free market discourses directed at other countries in order to obtain two objectives: to open their markets to local products and to prevent them from adopting the same development strategies which led to the developed nations' industrialization.
As a set of development policies, ISI policies are theoretically grounded on the Singer-Prebisch thesis, on the infant industry argument, and on Keynesian economics. From these postulates it derives a body of practices, which are commonly: an active industrial policy to subsidize and orchestrate production of strategic substitutes, protective barriers to trade (e.g. tariffs), an overvalued currency to help manufacturers import capital goods (heavy machinery), and discouragement of foreign direct investment.
In many cases, however, these postulates did not apply: on several occasions, the Brazilian ISI process, which occurred from 1930 until the end of the 1980s, involved currency devaluation as a means of boosting exports and discouraging imports (thus promoting the consumption of locally manufactured products), as well as the adoption of different exchange rates for importing capital goods and for importing consumer goods. Moreover, governmental policies toward investment were not always opposed to foreign capital: the Brazilian industrialization process was based on a tripod which involved governmental, private, and foreign capital – the first being directed to infrastructure and heavy industry, the second to manufacturing consumer goods, and the third, to the production of durable goods (such as automobiles). Volkswagen, Ford, GM and Mercedes all established in Brazil in the 1950s and 1960s.
The major and unifying postulate of ISI can thus be described as an attempt to reduce foreign dependency of a country's economy through local production of industrialized products, whether through national or foreign investment, for domestic or foreign consumption. It should be noted, as well, that import substitution does not mean import elimination: as a country industrializes, it begins to import other kinds of goods which become necessary for its industry, such as petroleum, chemicals, and the raw materials it may lack. The real objective of import substitution is therefore not to eliminate trade, but to lift it to higher stage – that of exporting value-added products, which are not as susceptible to economic fluctuations as raw materials, according to the Singer-Prebisch thesis.
Import substitution policies were adopted by most nations in Latin America from the 1930s until the late 1980s. The initial date is largely attributed to the impact of the Great Depression of the 1930s, when Latin American countries, which exported primary products and imported almost all of the industrialized goods they consumed, were prevented from importing due to a sharp decline in their foreign sales. This served as an incentive for the domestic production of the goods they needed.
The first steps in import substitution were largely untheoretical and based on pragmatic choices of how to face the limitations imposed by recession, even though Populist governments in Argentina (Perón) and Brazil (Vargas) had the precedent of Fascist Italy (and, to some extent, of the Soviet Union) as inspirations of state-induced industrialization. Positivist thinking – which sought a "strong government" to "modernize" society – played a major influence on Latin American military thinking in the 20th century. Among the officials – many of whom rose to power, like Perón and Vargas – industrialization (especially steel production) was synonymous of "progress" and was naturally placed as a priority.
ISI only gained a theoretical foundation in the 1950s, when Argentine economist and UNECLAC head Raúl Prebisch was a visible proponent of the idea, as well as Brazilian economist Celso Furtado. Prebisch believed that developing countries needed to create local vertical linkages, and they could only succeed by creating industries that used the primary products already being produced domestically. The tariffs were designed to allow domestic infant industries to prosper.
ISI was most successful in countries with large populations and income levels which allowed for the consumption of locally produced products. Latin American countries such as Brazil, Mexico, and, to a lesser extent, Chile, Uruguay and Venezuela, had the most success with ISI.[3] This is so because while the investment to produce cheap consumer products may pay off in a small consumer market, the same can not be said for capital-intensive industries – such as automobiles and heavy machinery –, which depend on larger consumer markets to survive. Thus, smaller and poorer countries, such as Ecuador, Honduras, and the Dominican Republic, could only implement ISI to a limited extent. Peru implemented ISI in 1961, and the policy lasted through to the end of the decade in some form.[4]
To overcome the difficulties of implementing ISI in small-scale economies, proponents of this economic policy – some within UNECLAC – suggested two alternatives to enlarge consumer markets: income distribution within each country, through agrarian reform and other initiatives aimed at bringing Latin America's enormous marginalized population into the consumer market, and regional integration through initiatives such as the Latin American Free Trade Association (ALALC), which would allow for the products of one country to be sold in another.
In Latin American countries where ISI was most successful, it was accompanied by structural changes to the government. Old neocolonial governments were replaced by more or less democratic governments. Banks and utilities and certain foreign-owned companies were nationalized or transferred ownership to local businesspeople.
Many economists contend that ISI failed in Latin America, being one of many factors leading to the so-called lost decade of Latin American economics. Other economists contend that ISI led to the "Mexican Miracle," the period that lasted from 1940 to 1975 in which economic growth stood at 6 percent or higher.
ISI was rejected by most nations in East Asia in the 1960s, and some economists attribute the superior performance of East Asia in the 1970s and 1980s to this difference in policies. Indeed, East Asian policies are most commonly not referred to as ISI.
Most "East Asian Tigers" rejected import substitution policies, though they maintained high tariff barriers. The strategy followed by those countries was to focus subsidies and investment on industries which would make goods for export, and not to attempt to undervalue the local currency. This export promotion approach to industrialization in the East asian countries contrasts with the strategy of ISI.[1] In pursuing this and to boost its competitiveness in the 1970s, South Korea made large investments into heavy and chemical industries, such as shipbuilding, steel and petrochemicals. This focus on export markets allowed them to create competitive industries.
The major advantages claimed for ISI include: increases in domestic employment (reducing dependence on labour non-intensive industries such as raw resource extraction and export); resilience in the face of a global economic shocks (such as recessions and depressions); less long-distance transportation of goods (and concomitant fuel consumption and greenhouse gas and other emissions).
A disadvantage claimed for ISI is that the industries that it creates are inefficient and obsolete as they aren't exposed to internationally competitive industries which constitute their rivals and that the focus on industrial development impoverishes local commodity producers who are primarily rural.
ISI also had a number of undesirable effects :
1.Chronic problems with the balance of trade and payments: Import substitution was supposed to reduce reliance on world trade, but every nation needs to import something not available locally like raw materials, machinery, spare parts. The more a country industrialized the more it needed these imports and ISI was strongly biased against exports. Trade protection and overvalued exchange rates raised domestic prices and made export less competitive, and export taxes furthermore discouraged foreign sales. So the industrializing countries were unable to export enough to buy the imports they needed.
2.Deep recessions:
The faster the economy grew, the more it needed imports; but exports could not keep up with the pace of imports and so the country ran out of foreign currency. So what the governments did was to restrict import to essentials and raised interest rate to bring money into the country and keep it at home. It devalued the currency to raise the price of imports and make exports more attractive also reducing the countries purchasing power, which resulted in usually deep recessions.
3.ISI countries tended to run substantial budget deficits and inflation:
Government subsidized industrial investments gave tax breaks to industrial investors and targeted spending at politically important groups but such spending chronically outpaced government revenue , and these budget deficits were usually covered by printing more money. The result was inflation which made domestic goods more expensive which in turn reduced exports even further.
4.Negative impact on income distribution;
Masses of farmers migrated to the cities in search for jobs in the new industries. But import-substitution growth was very capital intensive. Most of the farmers who flooded into the cities found that they could not get jobs that industrialization had promised. ISI countries ended up with dual economies; • On the one hand; modern capital-intensive industries with skilled, well-organized workers earning relatively high wages • On the other hand: a mass of struggling farmers and urban poor frozen out of the modern economy given very low wages and excluded from the social protections which modern sector workers received [5]
5.Incentive for capitalists to resist state planning;
In order to carry out industrial planning, states needed to build the necessary state institutions, such as a Planning Commission, to formulate production targets and later enforce them. But since ISI industries were protected from international competition, capitalists were not compelled by the market to meet international standards of efficiency. This meant that capitalists often resisted state efforts to enforce industrial plans and force investments in improving productivity. In India, for example, Vivek Chibber has shown that efforts by the state to put in place the proper institutional framework for state planning were strongly resisted by Indian capitalists. This resulted in an ineffective state apparatus that was incapable of carrying out coherent industrial planning. Under export-oriented industrialization in South Korea, on the other hand, there was a positive incentive for capitalists to comply with state planning because international competition on world markets would compel capitalists to upgrade production to international standards. This allowed for a different relationship between the state and private sector, and more successful state planning.[6]
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