Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Going down the protectionist rabbit hole

Import substitution made sense in the pre-1990 era, before information and communication technology ushered in global value chains

A week after Prime Minister Narendra Modi boldly proclaimed protectionism to be a global threat, as big as terrorism, at the World Economic Forum, the Union finance minister presented a budget which significantly increased customs duty in more than 10 sectors to discourage imports. The Prime Minister’s word turned out to be pandering to the Davos crowd, but, more importantly, the government’s U-turn reflects its outdated understanding of globalization.

The government hopes that import substitution, which helped industrialize countries like Korea and Japan, will work for India too. When Korea and Japan were industrializing, it meant building entire supply chains domestically. The production process was clustered because economies of scale were needed to achieve the necessary cost competitiveness, and a concentration of know-how helped with innovation and coordination. Securing a market for domestic output was one of the key goals of trade policy and tariffs protected the domestic market for national goods.

Economist Richard Balwin has argued that since the mid-1980s, a number of developments have changed the economics of globalization, making a different set of arrangements more suitable to achieve cost competitiveness, easy knowledge flows and secure a market.

First, improvements in information and communication technology (ICT) have facilitated constant knowledge flows across national borders. If a company wanted to coordinate the supply of components from across the globe, it was difficult to achieve with telephones and fax. The rise in computing power and adoption of internet made it possible. Second, containerization improved the quality and cost of shipping, and air cargo made transport of intermediate goods as reliable as moving them within the company. These two changes are the reason why companies today are able to employ just-in-time manufacturing practices while keeping very little inventories and relying on global freight. Third, as a result of improvements in ICT and freight, it became viable to exploit international wage differences by outsourcing tasks, thereby improving the cost competitiveness of industry.

The ICT revolution, if we may call it that, reduced the share of the G7 economies in manufacturing from two-thirds in the 1970s to less than half today, with an accelerated decline since the 1990s. Most of this decline can be accounted for by the rise of manufacturing in six countries—India, China, Indonesia, Korea, Thailand and Poland. This is matched by their commensurate rise in the share of global GDP.

That developing countries need protectionism to develop local industry continues to have plenty of currency—even the General Agreement on Tariffs and Trade (Gatt), and later World Trade Organisation (WTO), protected them from reciprocity rules that would require reducing tariffs to match those of other countries. But the developing nations’ policies changed from 1990 to reflect the new reality. They unilaterally reduced tariffs in a bid to attract the offshored factories and join the global value chains (GVCs)—tariffs have gone from around 45% and 20% in South and East Asia, respectively, during 1990 to around 15% to and 10% today.

These developments changed globalization, from primarily an exchange in finished goods between countries with inherent comparative advantage in certain goods, to primarily an exchange in know-how that allowed them to combine their comparative advantages—high skills, low wages—and create international supply chains. Thus, the competition between German and Japanese cars was no longer about their respective economies but between German- and Japanese-led GVCs, which included several countries that provided intermediate goods. Instead of engineering a multi-stage sector, developing nations could become competitive in specific components or stages of the process, while being part of a GVC.

In this global division of labour, tariffs are a regressive policy that undermine a country’s attractiveness. Since GVCs already have a global market, securing the domestic market is less important. Second, since GVCs involve countries importing components and re-exporting them after value addition, tariffs increase the cost structure for the entire economy, making it uncompetitive.

The government must give up the obsolete idea that all components of a product should be manufactured domestically. The newly industrializing economies have progressed because they have allowed their industry to participate in the back-and-forth of intermediate goods in the global value chain.

A number of recent policy decisions, like the Bharatmala and Sagarmala plan to improve roads and connectivity to ports, the introduction of the goods and services tax (GST) to create a unified market, and reform in customs processes, are steps in the right direction that will improve the quality of freight and, thus, our manufacturers’ reliability. The government must continue to improve the infrastructure, the dispute resolution process, land acquisition and import-export norms. The old-fashioned fascination with indigenous industries needs to go.

Is increasing customs duty on imports a good strategy to increase domestic value addition? Tell us at views@livemint.com

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