There is mounting evidence that import substitution curtails economic growth in the long term and holds back progress. Import substitution is an economic policy that advocates replacing imports with local products.
A near perfect example was seen in India, where the Licence Raj kept economic growth in India low until the economy was opened up gradually from 1991 by then Finance Minister Manmohan Singh. Today, India is the fastest-growing large economy in the world with growth expected to be over 6% in 2023.
Short-term effects of import substitution
Import substitution is typically done using quotas, restrictions and tariffs. But in a globalised world where trade is integrated, using import restriction even as a short-term means to help with a foreign exchange crisis can have a snowball effect for the worst.
Import restrictions give government officials the power to decide what products can be imported and by whom. This can lead to corruption, as witnessed in India during the time of the Licence Raj. But even if there was no corruption, it would still lead to economic damage.
Restrictions hit the export chain of a country. Many imports are for local and export industries and the inability to import raw materials and intermediate goods will slow down the export industry. This has multiplier effects throughout the economy, including reduced economic output and larger fiscal deficits. Also, a slowdown in the export industries results in an even larger trade deficit, leading to greater loss of foreign reserves.
The slowdown in economic growth due to the initial import restrictions means tax revenues, which are elastic subject to economic growth, will begin to go down while fiscal expenditure will stay the same due to recurrent expenditure. This results in wider fiscal deficits. As economic output decreases, supply decreases and higher fiscal deficits lead to higher inflation. Inflation results in foreign debt becoming more expensive and the cost of living rising. With higher prices, salaries of state sector employees may need to be increased, resulting in large fiscal expenditure.
If the government does not devalue the currency – as seen in Sri Lanka in early 2022 – this will lead to a large black market exchange rate and remittances coming in through other informal channels, resulting in the government losing even more foreign reserves.
This usually leads to a vicious cycle that cannot be sustained and the exchange rate eventually falling rapidly. While all this is happening, foreign and domestic investments will dry up and there will be a capital flight. This once again results in larger fiscal and current account deficits. But the long-term effects of curbs on imports are even greater.
Long-term effects on economic growth
Many developing countries implemented import substitution in the 20th century, especially in Latin America. The rationale was that, if developing countries kept importing manufactured goods from the developed countries, the developing countries would forever be at a disadvantage and unable to grow their own industries. But import substitution policies can hurt an economy in the long term in many ways.
First, import substitution can lead to higher prices and lesser quality of goods. In the 1970s, import restrictions were made on Japanese cars entering the US market, which led to higher car prices in the US and a decline in the American auto industry. Higher prices can also be due to local companies having a greater say in deciding prices with foreign competition removed. In smaller countries, it is not economically viable to manufacture many products internally as industries serving only the domestic market will not have the economies of scale to produce at a lower price with good quality. This results in inefficiencies and reduced economic output. Industries lacking economies of scale that are protected to serve a smaller domestic market will find it difficult to export. Lack of exports results in slower economic growth.
Second, import substitution results in domestic industries being protected from foreign competition. This discourages companies from innovating as they are comfortable serving the local market. This lack of incentive to invest in new technologies and try different business models has long-term negative effects on economic growth.
Third, import substitution can lead to trade wars. When one country restricts imports to help its domestic industry, the other country may retaliate by importing less, which could lead to a trade war. After the first world war, the US precipitated a trade war when it imposed high tariffs on imports, which also resulted in a sharp decline in economic growth for the US.
Import substitution can have devastating effects in the short, medium and long term for fiscal policies and economic growth. An open economy benefits the consumer with products that are of better quality and price. It also results in local companies becoming more competitive and innovative, resulting in a thriving export industry. This can lead to larger fiscal revenues for governments and greater economic growth.
Talal Rafi is an Economist at the Deloitte Economics Institute and an Expert Member of the World Economic Forum. He is a regular columnist for the International Monetary Fund and a Visiting Lecturer at the Centre for Banking Studies, Central Bank of Sri Lanka.