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The Resurrection Of Import Substitution

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The Former Life Of Import Substitution

‘Import substitution’. For free-trading nations, the term conjures up a failed, Marxist-slanted experiment of the mid-20th century. Yet, the pattern of protective measures and counter-measures they have taken since January is unmistakable: import substitution is back.

Amidst post-Second World War decolonisation, many developing countries opted to apply high tariffs, and impose non-tariff barriers, against foreign imports. Behind those walls, domestic businesses could emerge to provide raw materials and intermediate goods to domestic manufacturers of finished merchandise. Countries dubbed ‘Third World’ would not be dependent on foreign ‘First World’ feedstock for final goods – thanks to the ‘substitution’ away from ‘imported’ inputs in favor of domestic ‘substitutes’ for those ‘imports’. And, the Third World would develop home-sourced, vertically integrated supply chains cranking out high-value-added exportable surpluses. No longer would poor countries be peripheral, forever dependent on supplying cheap commodities to the core, their erstwhile colonial rulers.

Powerful intellects, most notably the Argentine scholar Raúl Prebisch (1901-1986) and the German-British scholar Sir Hans Singer (1910-2006), advocated import substitution. Neither of these development economists was a Marxist, but theirs was an era in which Marxist ideas were in vogue. They saw international economic relations in terms of the Dependency Theory of German-American sociologist Andre Gunder Frank (1929-2005) and World Systems Theory of American sociologist Immanuel Wallerstein (1930-).

The Prebisch-Singer Thesis held that the terms of trade of poor countries in a capitalist trading system tend to deteriorate.

With free trade, the price of primary products exported by poor countries falls, whereas prices of manufactured goods, the main exports from rich to poor countries, are stable or rise over time, because they embody higher productivity than primary products. Faced with lower export earnings and higher import costs, poor countries cannot generate savings necessary for capital investment, and thus cannot industrialise. Participation in trade reinforces the international division of labor in which they are trapped in producing and exporting primary commodities and natural resources, and thus stuck at the bottom end of global supply chains.

"This diagnosis was radical, and so was the prescription: if the problem is that the least developed countries in the world system, those most at the periphery, were those with the closest ties to the core, in Europe and America, then the solution is to seek increased autonomy.  "

The means to do so was import substitution.

So, import substitution was all the rage in Brazil from 1939-58, in Korea in the 1950s and 1960s, and for decades in the post-War era in Ghana, Mexico, Pakistan, Tanzania, and Uruguay. In India, import substitution captured the fancy of Nehruvian socialists. The License Raj system was its most memorable tool.

Prime Minister Jawaharlal Nehru and Vice President S. Radhakrishnan with Kwame Nkrume, Prime Minister of Ghana and his wife, in December 1958. (Photograph: Nehru Memorial Museum and Library)

Did import substitution help developing countries build backward and forward linkages in their economies, diversify their production and export base, and industrialise, and if so, at what cost? The empirical evidence is mixed and debatable (and explored by this columnist in the new edition of his textbook).

For now, suffice to say the 1991 reforms in India—sputtering as they were—symbolised the end to the rage, the final death of import substitution not only on the subcontinent, but also across Asia, Africa, and Latin America.

"The adopters of import substitution had learned the lesson that the policy had lost the competition to export orientation, thanks to the far better performances of the East Asian economies that opened their markets by slashing duties and non-tariff barriers."

The New Life Of Import Substitution

Or, maybe that was not the lesson.

Following the 1997-99 Asian economic crisis, the lesson was revised: the Far East miracle was not built squarely on free trade. East Asian governments pursued strategic trade policies, championing certain sectors, through at-the-border and behind-the-border protections, and subsidies.

And, some of their success was attributable not to enhanced total factor productivity, but simply to increased factor endowments. That is, not to greater efficiency in the use of land, labour, human and physical capital, and technology, but to increased supplies of these factors. Succinctly put, the correct lesson about post-1945 Indo-Pacific economic growth taught there is no such thing as free trade, except on the whiteboards of unreconstructed neoclassical economists.

"" - That all cross-border trade in goods—and even more so, services—is managed to one degree or another.

Mindful of this lesson, not blinded by free trade rhetoric, it’s possible to bear witness to today’s resurrection of import substitution. Thanks to American trade actions, the common denominator of which is ‘offensive’ import substitution, China and India have turned to ‘defensive’ import substitution policies.

Offensive Import Substitution

America’s January 2018 Section 201, March 2018 Section 232, and March 2018 Section 301 cases led to it imposing higher tariffs and/or quotas on washing machines and solar panels, steel, aluminum, and anything made in China, respectively. Why?

The technically correct legal formalisms are, respectively, to:

  1. Safeguard against import surges,
  2. Address impairment to national security, and
  3. Combat unfair Chinese acts, policies, and practices

But, the underlying economic ramification is unmistakable: to reconfigure supply chains in which raw materials and intermediate goods are sourced overseas to ones in which they are sourced in America. Import substitution is not the policy purpose of the Trade Expansion Act of 1962 (which houses Section 232), nor of the Trade Act of 1974 (home to Sections 201 and 301).

Nevertheless, used in the way they have been, contemporaneously and in combination, it is reasonable to infer their intended consequence is to incentivise import substitution.

Lest there be doubt, consider the American-led changes to the rules of origin in NAFTA.

Since Jan. 1, 1994, when NAFTA 1.0 entered into force, at least 62.5 percent of the value of a car or truck needed to originate from within Canada, Mexico, or the U.S. to qualify as ‘originating with NAFTA’, and thereby receive duty-free treatment when traded within the region. With NAFTA 2.0, finalised on Sept. 30, the ‘regional value content’ must be 75 percent. Further, at least 40-45 percent of the overall value of a car or truck must be made with labour paid at least $16 per hour. And further still, 70 percent of the steel in the vehicle must come from Canada, Mexico, or the U.S.

This new three-pronged test is not just a rule of origin to keep auto parts suppliers that exploit cheap labor in China or India from entering NAFTA through the back door, supplying 37.5 percent (the difference between 100 and 62.5 percent) of the value of a vehicle. This test is designed to shift an additional 12.5 percent (the difference between 75 and 62.5 percent) of auto parts sourcing away from them, under the noble guise of elevating wage levels, and to America, or at least North America.

Also Read: Trump's Tariffs Spark Surge in Lobbying by Companies on Trade

The great Canadian economist, Jacob Viner (1892-1970), wrote in his 1950 classic The Customs Union Issue that free trade agreements create trade among the parties and divert trade away from non-parties. Those are predictable effects of NAFTA 2.0, and rules of origin are the legal devices to bring about those effects. But, the stringency of the NAFTA 2.0 automobile rules of origin intimates that import substitution, not merely familiar trade creation-trade diversion, is the real aim and/or effect of an FTA.

Simply put, the resurrection of import substitution heralds an expansion in import substitution tools.

In addition to traditional tariffs and non-tariff barriers, there are trade remedies of all sorts, and FTA rules of origin to boot.

Luis Videgaray, Mexico’s foreign minister, from left, Chrystia Freeland, Canada’s minister of foreign affairs, and Ildefonso Guajardo Villarreal, Mexico’s secretary of economy, during a news conference in Mexico City, on July 25, 2018. (Photographer: Alejandro Cegarra/Bloomberg)

Also Read: Nafta Is Dead. Long Live Nafta.

Defensive Import Substitution

China and India have responded to America’s ‘offensive’ import substitution with their own ‘defensive’ analog.

  • Following America’s Section 232, tariffs of 25 percent on steel and 10 percent on aluminum, China imposed two tiers of tariffs, 25 percent, and 15 percent, on 128 different American products.
  • India put up safeguards covering 30 product categories, including almonds, apples, chemicals, diagnostic reagents, hot-rolled coiled products, metals, motorcycles, and walnuts, worth $241 million in trade.

That figure matched the value of America’s Section 232 tariffs on Indian steel and aluminum shipments. India also hiked to 70 percent its tariff on Bengal gram, i.e., chana or chickpeas, and warned of more to come. 

Pulses (lentils and beans) are displayed for sale at a market in Mumbai. (Photographer: Adeel Halim/Bloomberg). 

Also Read: Customs Duty Hiked On Mobile Phone Parts And Other Communication Items

In response to each of the first three of four anticipated onslaughts of America’s Section 301 tariffs, China responded tit-for-tat to the first two, and in a similar manner to the third. Amidst the China-American Trade War, aware of the possibility China and America might dump merchandise, anxious about a plummeting rupee, and a trade deficit that has jumped from 1.9 percent to 2.4 percent in a few months, India is set to boost tariffs on an array of imports, including furniture, mobile phone components, and plastics.

"To be sure, as is true with respect to each of America’s offensive measures, if each one of China’s and India’s defensive actions is viewed in isolation, each one can be rationalised with a concept, a technically correct legal formalism. The label ‘import substitution’ can be avoided.  But the reality of the world trading system is that no event should be examined in isolation.  "

The challenge is to recognise systemic patterns, and correctly apply a systemic label. Prebisch, Singer, Frank, and Wallerstein: they gave us the label – import substitution.

Covering The Tabernacle

The U.S. is not in the position of a least developed country in the latter half of the 20th century, nor are China or India in the position of a developed one in that era. But, is the U.S. worried about dependence on China, and ultimately India, for raw materials and inputs, and even finished goods? Is the U.S. nervous about a map of world trade flows showing American manufacturing off to the periphery and Chindia sitting squarely at the core? Conversely, is it China and India, acting in concert or not, that want to be needed worldwide, and seeking the center stage?

If the answer to these questions is yes, then manifestly the U.S., China, and India have put the free trade model, to which they all profess devotion, back inside its gilded tabernacle and covered that sacredly efficient box-like container with a black cloth.

They still stare at that tabernacle, but they pray for relief from surges and unfairness, and for balance and security. So, pierce through to their hearts. Inquire whether those hearts have been turned to worship import substitution.

And if they have, then ask whether this resurrection will save world trade.

Raj Bhala is the inaugural Brenneisen Distinguished Professor, The University of Kansas, School of Law, and Senior Advisor to Dentons U.S. LLP. The views expressed here are his and do not necessarily represent the views of the State of Kansas or University, or Dentons or any of its clients, and do not constitute legal advice.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its Editorial team.

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