Import Substitution Industrialisation (also called ISI) is a trade and economic policy based on the premise that a country should attempt to reduce its foreign dependency through the local production of industrialised products.
The term primarily refers to 20th century development economics policies, though it was advocated since the 18th century United States.
Adopted in many Latin American countries from the 1930s until the late 1980s, and in some Asian and African countries from the 1950s on, ISI was theoretically organised in the works of Raul Prebisch, Hans Singer, Celso Furtado and other structural economic thinkers, and gained prominence with the creation of the United Nations Economic Commission for Latin America and the Caribbean (UNECLAC or CEPAL).
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Insofar as its suggestion of state-induced industrialisation through governmental spending, it is largely influenced by Keynesian thinking, as well as the infant industry arguments adopted by some highly industrialised countries, such as the United States, until the 1940s.
ISI is often associated with dependency theory, though the latter adopts a much broader sociological outlook which also addresses cultural elements sought to be linked with underdevelopment. A second way to look at import substitution is in terms of its stages. Briefly, it is a two-stage phenomenon. The first stage is the takeover of an existing market for consumption goods from the foreign supplier.
The second and much more difficult stage, consists of extending production backward to intermediate goods, capital goods, raw materials and finally, breaking into the world market.
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This stage includes too many variables and does not reflect the real aim of import substitution. A third way to analyse import substitution is to refer to all arguments to the effect that developing countries cannot rely on exports as an engine of growth.
In a narrow sense, it refers simply to the takeover of an existing domestic market from the foreign producer by prohibiting his imports in one way or the other. Whatever interpretation may be given to the term import substitution it means generally the satisfaction of a greater proportion of a country’s total demand for goods through its own domestic production.
Domestic production, which relates to the replacements of imports, is quite obviously based upon easily identifiable investment opportunities. Thus, the domestic market is assured to the domestic producers either by way of curbing imports altogether or reducing them to a considerable extent.
In a period of balance of payments crisis, import substitution is introduced accompanied by import controls or high tariffs. During its first stage, domestic production of consumer goods grows very rapidly.
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This is made possible by relatively simple technology, less capital requirements and fairly existing demand. This results into rapid growth in industrial output and employment accompanied by a significant decline in the share of imports in total demand for manufactures.
But it is often pointed out that the goods are of doubtful quality, produced in factories of uneconomic size and sold at high prices in the protected domestic market. As an illustrative measure, Johnson finds that the cost of import substitution may greatly exceed that implied by the difference between protective tariff rates and the foreign price of the goods produced.
Self-sufficiency in consumer goods should not be the ultimate goal. As Hirschman stressed: “Thus, the sequential or staged character of the process is responsible not only for the ease with which it can be brought under way, but also for the lack of training in technological innovation and for the resistance to-both backward linkage investments to exporting that are being encountered”.
The next stage in the import substitution process relates to the domestic production of consumer durables followed by intermediate and capital goods. A highly unequal distribution of income due to the initial pattern of capital ownership, a series of controls over the distribution of scarce inputs such as capital and foreign exchange because of government policies and a sheltered profitable market, combine to facilitate this process.
Often this stage is characterised by slow industrial growth, a sharp decline in employment opportunities and little further reduction or even an increase in the import component of total demand for manufactures. The last aspect of the effect is due to strong resistance against backward linkage investment on the part of private industrialists and public authorities.
Further, as the countries move on the higher stages of manufacturing the governments retain the old economic policies that are no longer applicable to the new phase of import substitution.
Moreover, a strong push across-the-board, import substitution in all the sectors indiscriminately leads to the wastage of resources.
Thus, the factors, which tend to initiate import substitution in consumer goods industries, are likely to perpetuate that trend. In the experience of many countries, import substitution has led to more import substitution and bigger controls.
The first stage of import substitution goes easily, but industrial growth slows thereafter because the limit of the existing market has been reached.
Analysts have pointed out that one or more of three other forms of demand should replace the already established consumption demand if growth is to continue.
That is, (i) domestic market for new consumer goods must be found, (ii) manufactured goods must penetrate the export market or (iii) investments must move from finished consumer goods industries to capital goods production, intermediate goods or raw materials. More consumer goods output will inevitably be- constrained unless supported by either (ii) or (iii).
Performance Indicators during ISI Phase:
First World War interrupted the industrial growth since it became difficult to import the much-needed capital goods and no capital goods industry existed in Latin America. In case of Brazil, there was the increased utilisation of the capacity in food and textiles industries.
By 1919, production of textiles, clothing and shoes accounted for 50 per cent of the total value added. Further during 1920-29, the average rate of industrial growth was around 3 per cent as compared to 4.6 per cent in 1911-20. The decline was primarily due to heavy demand for capital goods and pent up demand in the internal market.
In the Great Depression (1929-34) period, increase in the industrial production was based on increased utilisation of existing capacity in the presence of foreign exchange constraint. Thus, by 1939, the share of industrial production was 43 per cent as compared to 21 per cent in 1907 or 1919.
Textiles, metal and paper products were the fast growing industrial products. Brazil attained self-sufficiency in consumer goods and met 80 per cent of its own intermediate goods and 50 per cent of its investment goods through its domestic production.
Similarly in Argentina, during 1930s and the war years (1939-45), growth industries were those using local agricultural and primary inputs foodstuffs, tobacco, textiles, and leather goods.
By 1944, the value of manufactured products exceeded that of agricultural production. In Greater Buenos Aires, import-based industries such as rayon, synthetic rubber and pharmaceuticals showed tremendous growth during this period.
Unemployment level in Argentina hardly reached 5 per cent during Depression period. Also in Brazil, the Second World War provided an opportunity for industrialisation based on import substitution and this process found a large market and natural advantage in the production of ferrous metals, metal products and chemicals. By 1945, manufacturing accounted for 20 per cent of gross domestic product (GDP).
In the postwar years, faced with the balance of payments difficulties, both Argentina and Brazil accelerated the process of import substitution industrialisation under protectionist policy. In Argentina, the government sought to increase the production of consumer durables with imported parts as the demand of which got stimulated by low food prices and high wage rate (under Peron’s regime).
In Brazil, the average annual growth rate of GDP stayed around 6 per cent during 1947-62. Taking however a shorter period of 1956-62, GDP grew by 7.8 per cent per annum, industry leading with 10.3 per Cent and agriculture 5 per cent.
Subsidised credit, low or negative real interest rates, tariff exemptions and lower exchange rate for imported capital goods and liberal profit remittances for foreign investors facilitated the attainment of two digit industrial growth rate in particular and high GDP growth in general.
In Argentina too, capital goods, fuels and intermediate products were imported at a lower exchange rate. Much of the export earnings were used to subsidise the growing imports of fuel and raw materials required by industry.
In general, while major Latin American countries such as Brazil and Argentina weathered the storm of wars and Great Depression relatively well, the post war policy frame turned the terms of trade against their primary sector.
It has been argued that industrial sector was unduly favoured with protectionist measures such as overvalued currency, high tariffs, import licensing, exchange control restrictions and subsidised credit. Rural sector was deprived of modern imported inputs and consequently their share of primary exports declined in the post war years.