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A policy mix may be the best fix

A policy mix may be the best fix

By Prashansa Srivastava

NITI Aayog, in its Three Year Action Agenda, has advised the government against following an import substitution strategy. The Aayog maintains that this would not allow domestic companies to scale and compete globally. The recommendation comes two days after the Prime Minister asked companies to identify and develop five items whose imports could be stopped by 2022.

The think tank warned that focus on the domestic market through an import-substitution strategy may be attractive but would give rise to a group of relatively small firms behind a high wall of protection. An inward looking strategy leads to failure to exploit scale economies as import substitution policies narrow the size of the market only to the home country. The country misses out on productivity gains that come from competing against the best in the world.

Import substitution: At best a temporary measure

Import substitution policies advocate replacing imports with domestic production. It is based on the premise that a country should attempt to reduce its foreign dependency through local production of goods, mainly industrial products. India has for long tended towards import substitution due to benefits such as increased domestic employment and resilience in the face of global economic shocks such as recessions and depressions. The strategy uses tariffs, import-quotas and subsidies to promote and protect import-substitute industries. The idea behind it is to enable industries to grow freely without facing competition from international industries and thereby, improving domestic growth and productivity. An import substitution policy can also stimulate the domestic growth of industries that have lagged behind due to threats of competition and high levels of risk.

However, this withdrawal from full participation in the world economy can have dire consequences in the long run. Industries under import substitution policies end up producing inefficient and obsolete products in the absence of exposure to international competition. Domestic industries grow unaccustomed to foreign competition and lose the incentive to become more efficient. This eventually slows down technological innovation and economic growth.

Though import substitution policies claim to reduce reliance on world trade, a need to import raw materials, machinery and spare parts persists. The faster an economy grows, the more frequent is its requirement for imports. Due to import substitution policies imports are slow and exports are unable to keep up, becoming globally uncompetitive. Government spending outweighs revenue, leading to a budget deficit. This deficit is usually covered by printing more money. This results in inflation, which makes domestic goods even more expensive which in turn reduces exports even further.

In this light, import substitution is at best a temporary measure for accelerating economic growth. However, if there are only short-run gains in growth and those gains come at the cost of a long run economic downturn, the attractiveness of import substitution is greatly diminished. Pre-1991 India had imposed a series of import restriction and import substitution measures to conserve the scarce foreign exchange while simultaneously developing domestic industries. However, this led to plunging foreign exchange reserves, a balance of payments deficit and a large fiscal deficit, following which the economy was opened through policies of liberalisation, globalisation and privatisation.

Export promotion: Leading to specialisation and diversification

Export promotion policy encourages the allocation of resources in export-oriented industries without price distortions. Citing the example of the electronics industry, NITI Aayog said that the domestic market in electronics as of 2015 was only $65 billion as compared to the global market of $2 trillion. It further added that “In contrast, a focus on the global market can potentially result in output worth hundreds of billions of dollars and hence a large number of well-paid jobs”.

The export promotion makes use of comparative advantage, an economic law which refers to the production of those goods and services by an economic actor which hold lower opportunity cost relative to those for other economic actors. Countries benefit from specialisation in international trade and can harness the gains of the diversity of skills.

Hurdles to export promotion

The endorsement of export promotion by NITI Aayog is a step in the right direction. However, appropriate measures must be taken to ease exports and to ensure domestic exporters are not at a disadvantage vis-à-vis their foreign counterparts. The competitiveness of domestic firms in the global market is reduced due to onerous regulations, poor connectivity of production locations to ports and delays at ports. These impede the movement of goods in and out of the country. The export promotion will be slow till these issues are resolved completely.

A policy mix to harness potential

A pragmatic approach to a favourable policy mix can enable India to gain from the benefits of both the policies. It could use import substitution to boost exports, leading to economic gains from a more independent export oriented economy. The two fundamental trade strategies should not be mutually exclusive. When formulated with a clear understanding of comparative advantage and the importance of fostering the presence of domestic industries, the country can harness the potential role of international trade in promoting development.

Featured Image Source: Flickr


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