Risk tradeoffs in industrial policy strategies

The main considerations for the development of a new industry are the local production’s distance to the technological frontier, the level of domestic ownership, and the macroeconomic costs in terms of the current account deficit and possible fiscal deficits. Each strategy in developing a new industry – import substitution industrialization, export orientation, or a mix of the two – entails risks. (p. 18, Figure 6)
Risks for import substitution industrialization: this strategy relies on the belief that by closing a domestic market to competition, a sector can become self-sufficient. (pp. 18-19)
There are three categories of ISI, and each has its risks:
1. quasi autarky, where local producers dominate the market and fully own firms protected by trade restrictions; also characterized by minimal imports and no exports, with a minor trade deficit and large rents to producers (India). Minimizing links with MNCs hinders technology transfer, resulting in outdated, low-quality products with little innovation – the industry stays below the technological frontier, eventually risking loss of the entire industry when exposed to competition. (pp. 19-20)
2. a strategy of retaining full ownership domestically while relying more on foreign partnerships allowing for an automotive trade deficit and creating a sizable consumer cost (Malaysia’s automotive industry). (p. 19)
3. economies that negotiate access to their protected local market in exchange for FDI to produce locally, can involve forced technology transfer in exchange for access to a captive market resulting in lower quality/higher cost offerings for the domestic consumer (Brazil’s automotive industry). (p. 19)
4. For both b) and c) there is an increased risk of the appearance of a more technologically advanced industry that is but nevertheless still relatively far from the frontier, and with an internationally uncompetitive cost structure. (pp. 19-21)
Though there is evidence that the use of ISI may have helped jumpstart industries, especially in the “easy stages,” the strategy is not sustainable in the long run; learning, innovation, and competition are lacking, jeopardizing long-term stability of the industry (pp. 19-20)
ISI is often unsustainable, sacrificing welfare of consumers by restricting their choice and making them pay higher prices without developing an internationally competitive (p. 21)
Risks for an export-oriented (EO) approach: Asian miracle economies combined elements of protectionism and export orientation, succeeding at developing competitive firms in sophisticated industries while managing macroeconomic and political economy risks and using support measures and incentives beyond trade protectionism to make them competitive and innovative globally, allowing learning and firm growth; the focus on export orientation dwarfed protectionist policies that entailed risks; providing incentives for domestic firms to compete at the outset without a domestic captive market to fall back on makes firms take state support seriously to do their best, putting them on the path to the technological frontier. (pp. 21-22)
An EO approach requires a much stronger coordination of policy tools and availability of long-term financing in order to support newly created firms until they can become competitive in the absence of protectionism; Asian miracle economies pursued an optimal combination of EO and ISI policies but the strategy required sizable support, entailing the risk of sliding into a traditional ISI strategy; in a globalized world dominated by GVCs, a combination of ISI and EO may not be feasible or desirable requiring strong incentives and incurring high monitoring costs; given the level of trade liberalization and rise of GVCs, an ISI/EO strategy is harder to implement and less desirable. (p. 22)
Industrial policies should aim to create sustainable, innovative, and efficient industries in sophisticated products, the development of which is riddled with market failures; state intervention in these industries without rigid pre-requirements could bring success, but raises the question of what kind of intervention is the most effective; tariffs and local content requirements might not be sufficient and could be counterproductive. (pp. 22-23)
An EO industrial policy, or “true” industrial policy, is flexible enough to mitigate the risks in the 21^st century; this policy should provide different types of support and incentives to firms producing locally while encouraging them to export, without imposing local content requirements or a specific production structure or technology; adoption of tariffs or trade restrictions could provoke retaliation and be fatal in small economies lacking scale. (p. 23)
Several factors require focus as part of an EO strategy: 1) complexity of production is far greater than in the 1960s-70s, requiring firms to build partnerships with the most advanced firms; tariffs and trade restrictions will make establishing partnerships and participating in GVCs more difficult and costly; 2) the EO policy’s key advantage of reliable market signals from export markets mitigates risks of capture and avoids the illusion of self-sufficiency be helping different stakeholders and investors to realize when the need to restructure arises; 3) the incentive to export combined with adequate support and appropriate institutions provides flexibility and incentives to achieve a competitive cost structure while encouraging innovation. (p. 23)
An EO industrial policy can achieve better results at increasing local content and domestic value-added content without imposing such requirements before the local industry is ready with cost-competitive and comparable quality substitutes. (pp. 23-24)