Is Import Substitution Still Possible?

Matías Vernengo

For a very long time Import Substitution Industrialization (ISI) was seen as a four-letter word. The notion was that ISI had led to extensive inefficiencies and that the debt crisis of the 1980s was its last breath. The old ideas about comparative advantage were back with a vengeance, and the prescription was for trade liberalization, encapsulated in the Washington Consensus. Export orientation was promoted, since it was widely believed that an emphasis on exports would force integration into world markets, more efficient allocation of resources, and that external markets would impose discipline by eliminating uncompetitive firms.

The problem with the conventional wisdom is that the ISI period corresponds to a high growth phase for most developing countries, one in which they caught up with the developed world despite the fast growth in the latter, which would not have been possible if ISI-driven growth did produce tremendous inefficiencies on an economy wide scale.

Further, the ISI period, which basically corresponds to the 1950s and 1960s, led to only moderate accumulation of foreign debt, and in many cases to falling debt-to-GDP or debt-to-exports ratios, which denotes sustainable debt dynamics.

It was the collapse of Bretton Woods that ushered an era of more deregulated and volatile financial markets. And it was the increase in foreign indebtedness associated with the oil shocks that led, after the hike in interest rates by Paul Volcker, to the Mexican default, the unraveling of the process of development in the periphery and the debt crisis.

To make matters worse the hike in interest rates was associated with a negative terms-of-trade shock that reduced the export revenues in developing countries. As a result debt-servicing requirements went up at the very moment that revenues dwindled. Debt-to-export and debt-to-GDP ratios went up, making financial markets less willing and able to foot the bill. ISI per se was not the problem, even if in some specific cases it did not produce rapid catch-up with the center, financial liberalization was.

The failure of the Washington Consensus during the 1990s, with the sequence of financial crises in Mexico, Russia, Brazil, Turkey and Argentina, showed that there was a serious need for rethinking development. Joseph Stiglitz’s resignation from the World Bank, which ended a very contentious relation, was a symbol of that need to rethink development theories and practices.

The economic boom after 2002, in particular in the periphery, in part pushed by the extraordinary growth in China and by higher commodity prices, allowed for a somewhat complacent attitude, with minimal changes in development strategies, just as the housing market boom and the introduction of the euro had allowed for the continuation of private debt-driven booms in the center. The 2008-9 crisis and its long and persistent aftershocks suggest that this time around developing countries will have to rethink their development strategies.

The question of whether developing countries can simply integrate on the basis of commodity exports, or manufacturing exports on the basis of cheap labor, in a relatively liberalized trade environment with deregulated financial markets, or a more serious push towards the development of domestic markets must be pursued is increasingly moot. China is already moving towards larger reliance on domestic markets. And other developing countries that can rely less and less on demand growth from developed countries will probably do the same.

In the center there is an analogous conundrum about the possibility of social democratic policies, that is, whether higher wages and a robust welfare state are even possible. Both policies were anathema after the fall of communism, and now, with the failure of the free market neoliberal experiment, seem more reasonable. Higher wages and more fiscal expansion to support the crumbling welfare system, in developed countries, are comparable to the need to revive ISI under new and changed circumstances in the developing world.

The new ISI strategies will take place in a new environment, where World Trade Organization rules have narrowed the policy space and where the rapid growth in Chinese manufacturing exports is changing the landscape. For example, several countries in Latin America have increasing access to credit from China, but as noted by Kevin Gallagher, Chinese loans tend to require “that borrowers purchase Chinese equipment, employ Chinese workers and suppliers, and sometimes sign oil sale agreements.” This could be an important limitation for countries that already have significant trade deficits with China. However, the question now is not whether ISI is possible in the periphery, but how it should be implemented.

The Triple Crisis blog invites your comments. Please share your thoughts below.