Going for a “half-and-half”
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File picture of a garments factory which uses a lot of imported raw material.
As we have been stuck at home for weeks under the lockdown set up, sometimes we had to look for different meals from outside for various reasons. One evening, we also placed an order for a meal from a pizza restaurant. Here comes pizza, and they were “half-and-half” pizza.
Usually the customers visiting a pizza restaurant – physically or virtually, have to make up their mind for a difficult choice among varieties of pizza: Tandoori chicken, chicken Hawaiian, BBQ chicken, hot butter cuttlefish, spicy seafood, devilled beef and many other. If your group is large and if there are many youth and children, it is going to be very difficult to accommodate everyone’s specific preferences. You cannot choose so many pizzas for each one, because no one is going to eat that much.
Restaurant managers know the different tastes among their different customers so that they also innovate new ways to accommodate differences in customer preferences, while expanding the range of choices. One way of accommodating two preferences in one pizza – two-in-one – is to offer “half-and-half” pizza. For a full “half-and-half” pizza, you can combine your most preferred two varieties in half and half, but I believe no more than two halves.
Half and half in one
That evening I had to engage in an online communication in which someone has started admiring the beauty of the “import substitution policy” and praising the emerging opportunities to revive that policy again under the COVID pandemic issue. Import substitution swept across the developing countries as the main development policy thrust until the 1970s. It was referred to as a set of policies that were used by the governments to push “production for the home market”. The products for the “home market” were, in other words, the “substitutes for imports” so that the policy was called import substitution policy.
I responded: “For the past two and half centuries since the time of Adam Smith, the economists know that economic progress is limited by the size of the market. The size of the home market is too small to generate incomes and create jobs! If it is too small even for China with 1.4 billion people and for India with 1.3 billion people, how can it be big enough for a country like Sri Lanka with just 21 million people?”
I received a counter argument: “We need both; we need to balance our development strategy with both ‘import substitution’ and ‘export promotion’ policies. We don’t need export promotion by destroying our import substitution activities, just as the way that we shouldn’t forget exports when we promote import substitution.”
“That’s a half-and-half strategy. It has worked well with pizza, but not with an economy. Import substitution requires ‘protection’ and export promotion requires ‘liberalisation’. When we have to design the overall policy environment, we cannot have half-and-half in one economy.”
One stone, two birds!
It is not necessary to look around the world for evidence to prove the point, as Sri Lanka’s own experience is full of case studies. Before, we turn to the question why the two-in-one strategy doesn’t work for a country, let’s bring some evidence from Sri Lanka itself.
Sri Lanka’s import substitution policy commenced after 1956. At the beginning the import controls were brought into effect not necessarily for import substitution, but for the emerging foreign exchange shortages. Thus, import controls were identified as one stone for knocking down two birds – saving foreign exchange and protecting import substitution production. At the initial stages there were import substitution opportunities which started to dry up quickly. In spite of that, the overall import substitution policy environment got strengthened since the early 1960s. And the worsening foreign exchange problem forced the country to move further into import a substitution drive under tightening import controls.
Since the mid-1960s, here comes the two-in-one policy! While import substitution policy continued to remain on the one hand, export promotion was introduced on the other hand – the so-called non-traditional export drive. A duty rebate scheme was designed in 1964 to refund the duties paid on imported inputs into exports. A Bonus Voucher Scheme (BVS) was introduced in 1966 allowing exporters of non-traditional exports to use 20 per cent of their export earnings to finance restricted imports. In the same year, an incentive package was presented to attract foreign direct investment (FDI), though investors never responded to it.
The introduction of a “dual exchange rate system” in 1968 was a remarkable policy measure to accommodate both import controls and export incentives side by side. Under the dual exchange rate system, known as the Foreign Exchange Entitlement Certificate (FEEC), the special exchange rate applied to both non-essential imports and non-traditional exports was 45 per cent above the official exchange rate. The special rate was increased further to 65 per cent above the official exchange rate in 1972. A Convertible Rupee Account (CRA) was introduced in 1973 in order to allow exporters to use 25 per cent of their export earnings to finance restricted imports. In addition to all these specific measures, there were government incentives and institutional arrangements to support exports of minor export crops, light engineering goods, spices, handicrafts, gems and other.
The irony was that the net economic outcome of the dual policies was dismal in either direction. The export structure that was dominated by traditional exports of tea, rubber and coconut appeared to have hardly changed even by the end of the 1970s. The country was subjected to all the economic and social evils of primary exporting countries. Neither the implementation of import substitution policy over 20 years had improved the capacity of the country to generate incomes and jobs.
Incentive structure
What matters is the overall policy environment. In any economy which has recorded higher export growth, the overall policy environment has been export-oriented and not import-substituting. We all may find sporadic cases of import substituting activities in many of the countries for various reasons. But sporadic cases, even if they are successful, do not provide a justification for an overall import-substitution policy environment. They are just the individual cases out of which we never derive any policy.
Why can’t the import substitution policy and export promotion policy co-exist in a country as a “two-in-one” policy? It is because we cannot move in two different directions at the same time! The more powerful policy dominates the other. Import substitution policy environment means creating an incentive structure that favours the production for the home market. Then such a policy environment pulled the resources and capabilities to produce for the home market. The producers too wish to enjoy the “competition-free” home market that guarantees the profit margin. But progress is constrained by the size of the market they cater to.
The export-oriented policy environment means creating an incentive structure which does not discriminate between the home market and the global market, because both markets are different. The global market is unlimited and, there are other suppliers so that it is competitive. The progress is not constrained by the market size.
Why exports?
Export promotion is important not merely because it brings about foreign exchange flows, but it is the progressive path to become a rich country. As the market limitation does not constrain the progress, income growth and job creation depends on production activities which go beyond the boundaries of the home market. In fact, import substitution is a massive implicit tax on export promotion so that the half-and-half policy does not work for an economy.
By looking at the malfunctioning international trade in the context of the COVID-19 lockdown and escalating economic recessions, we cannot find good arguments to justify import substitution. Almost all developing countries were there, but abandoned it due to its miserable outcome which has convinced them more than enough. .
(The writer is a Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk).