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The false promise of import substitution industrialisation in India

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Indian Prime Minister Narendra Modi awaits his guests at the G20 Summit in New Delhi, India, on 9 September 2023 (Photo: Kay Nietfeld/Reuters).


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Expectations that import substitution in India might succeed this time around are premised on the twin assumptions that the policy is being implemented in a very different environment from the past and that the instruments being deployed are also different. But the country’s previous import substitution episodes also differed from one another along these dimensions and every one of them failed.

If proponents for import substitution industrialisation judge its success purely on its ability to establish and sustain the targeted industry, one could concede to their argument. With merchandise imports at 21 per cent of GDP in 2022 as opposed to less than 5 per cent in 1970, the economy offers considerable scope for import substitution. The large volumes of imports of many products testify to the existence of a domestic demand for them. Denying entry to their imports will create space for the emergence of domestic suppliers of those same products or close substitutes.

But such success would be no different from the previous rounds of import substitution, which India pursued for several decades after independence. During that era, India successfully established numerous industries — including steel, aluminium, fertiliser, chemicals and automobiles — behind a protective wall.

This time — with no investment licensing, less rigid labour and capital markets, no restrictions placed on large-scale production, freer entry of foreign investors and the absence of restrictions on technology imports — the domestic supply response is likely to be quicker. The difference between import prices and domestic production costs is also smaller, limiting the welfare loss due to distortion caused by the import tariffs.

The true success of import substitution must be judged not by its ability to create and sustain protected industries, but by its capacity to accelerate the entire economy’s growth, however. The case for import substitution crumbles along this metric. Products that receive protection often cost more to produce at home than abroad, while the opposite is true of unprotected products. Protection supports the higher-cost products by incentivising resources to move into them and out of the lower-cost products.

A common fallacy among policymakers is that import substitution can be pursued successfully alongside export promotion to boost GDP. That fails to appreciate that with a fixed volume of resources available at a point in time, supporting a subset of industries means discouraging others.

An examination of the total import and export series for any country over a 10-year period or longer demonstrates that when import substitution successfully cuts the total imports, it also cuts total exports.

Import duties on inputs are one channel through which import duties undermine exports and the final import substitute products. Such duties reduce the profitability of final goods using the inputs, whether they are exported or sold domestically. A more general channel through which tariffs undermine exports is real exchange rate appreciation. Currency appreciation results in the exporter earning fewer Indian rupees for every US dollar’s worth of exports.

Two mutually reinforcing recent developments have further undermined the success of an activist import substitution industrialisation policy. First, as a result of advances in transportation and communication technologies, the cost of moving goods and information over long distances has decreased significantly. Second, modern technology has given rise to complex products of mass consumption, such as smartphones and tablets, with substantial design and information-related content. It has also made it possible to break up the production processes of old and new products more efficiently.

These developments have meant that efficiency is achieved by locating product innovation, product design, production of components and assembly across many nations, depending on their cost advantages. The iPhone is a good example — its innovation, design, manufacture of numerous components and assembly are spread over two dozen countries. Import substitution industrialisation discourages industrialisation by placing obstacles in the way of this international specialisation.

Scepticism towards import substitution industrialisation should not be mistaken for pessimism about India’s economic prospects. Despite returning to a mild form of ISI, India has been taking the right steps in nearly all other dimensions. In addition to removing rigidities in the product and factor markets through liberalising economic reforms, it has been building its infrastructure at breakneck speed, focusing on roads, railways, waterways, bridges, airports, ports and digital platforms.

The central government and some state governments have also been courting multinational corporations to become the ‘Plus One’ in their ‘China Plus One’ strategy. Pursuit of import substitution industrialisation notwithstanding, these administrations are cognisant of the importance of engaging with world markets. In this context, India can enhance its appeal to multinational corporations as the ‘Plus One’ destination by engaging like-minded countries in free trade agreements (FTAs).

To its west, India has launched the India–Middle East–Europe Economic Corridor. Its impact can be greatly amplified by the conclusion of FTAs with the EU and the United Kingdom. India’s engagement with its partners to the east is even more important. Ideally, this would have been best accomplished by joining the Regional Comprehensive Economic Partnership (RCEP). But this has lost political salience in the wake of the recent eruption of the border dispute with China. The next best option is to strengthen the FTA with ASEAN and seek entry into the other large FTA of the region, The Comprehensive and Progressive Agreement for Trans-Pacific Partnership. Without these moves, India risks giving China a free hand in the region.

The effect of the Indian policy regime, which includes import substitution, has been to cut the imports of certain products, but not imports and exports taken as a whole. Total merchandise imports have continued to flourish, rising from a pre-COVID-19 peak of US$518 billion in 2018 to US$721 billion in 2022. Merchandise exports have risen from US$337 billion in 2018 to US$456 billion in 2022. Services exports have performed even better.

If history is any guide, ten years from now import substitution devotees will claim that India’s success was due to its pursuit of import substitution, despite contrary advice from free trade ideologues. After all, the myth of industrial policy’s contribution to the success of South Korea, Taiwan, China and Singapore continues to endure. But this claim is incorrect. India will succeed not because of import substitution, but in spite of it.

Arvind Panagariya is Professor of Economics and the Jagdish Bhagwati Professor of Indian Political Economy at Columbia University.

This article appears in the most recent edition of East Asia Forum Quarterly, ‘Industrial policy 2.0’, Vol 15, No 4.

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