Karim Qasim African Trade Organisation ( June 20, 2015)

IMPORT SUBSTITUTION AND EXPORT PROMOTION:

A CONTINUING DILEMMA FOR PAKISTAN

Relevance of Paper to Africa: How do you reconcile anticolonial sentiments and obediently

following recommendations of Bretton woods institutions such as the World Bank? Africans

today want to be independent not only in the political realm but also in economic spheres. This is

a feeling that often clouds our judgment when drafting trade and other economic strategies.

(African Trade Organization)

1

Introduction:

In the ever globalizing world of today, there is a dominating tendency of economic

experts to adopt a sharply marked and bounded understanding of trade-related economic growth

and development due to export promotion in opposition to import substitution. More often than

not this kind of stereotyping has put developing countries (LDCs) in a position of having to make

a choice between the two developmental strategies in their attempts to move their economies and

societies from a so-called "backward" orientation towards a more "modern" one.

For international agencies such as World Trade Organization, World Bank and IMF trade

liberalization has become the linchpin of policy reforms in many developing countries.

Economists in these organizations generally advocate outward-looking export promotion

strategies of growth and cite phenomenal success of adherents of this policy, the Asian Tigers,

China, Brazil and Malaysia. By contrast, the advocates of inward-looking growth policies

believe that the negative effects of trade liberalization outweigh the potential benefits and

therefore espouse more protectionist approach.1

This paper reviews the economic underpinnings of pursuing import substitution or export

promotion as desirable growth strategy. After delineating the exact contours of these apparently

antithetical policies, this paper aims to provide empirical analysis of both the policies in the

context of Pakistan’s economy. It makes no pretense to offer any policy guidelines but merely

tries to examine the issue connected with the formation of a suitable policy for Pakistan. Why,

after pursuing the policy of export-led growth for over two decades, there is a return to

1 Manu, Franklyn A. "Import Substitution and Export Promotion: a continuing dilemma for developing countries." Journal of International Business and Economics (2009).

2

protectionist import substitution in Pakistan? This article will also try to shed some light on the

general trend in export performance in various regimes.

Comparing Import Substitution and Export Promotion for trade based growth:

During the first four decades of the post-World War II period, there was a strong sense of

proclivity in the developing countries towards inward-looking ‘import substitution’ (IS) – the

promotion of industries oriented towards the domestic market by using import restrictions,

through high tariffs, quantitative restrictions and overvalued exchange rates, to encourage the

replacement of imported consumer and manufactured goods by domestic products. This policy

choice was much in line with the ideological consensus in the economists of the day which

supplemented the strong nationalistic and anti-colonial sentiments of developing countries. The

developing countries’ production structure was the corollary of the colonial rule that was heavily

oriented towards production and exports of primary commodities.2 Because of the unstable

markets and low income and price elasticities of demand there was a formidable risk of export

earnings instability with primary-product export dependence. With this view, the advocates of IS

strategy emphasized the need for LDCs to evolve their own style of development through

“learning by doing” using technologies appropriate to the country’s own resource endowments.

They argued that primary-commodity products tend to suffer a secular (long-term) decline in the

terms of trade against imported manufactured goods and therefore, espoused planned

intervention by the governments to support infant industries to replace imports from abroad and

in this way save foreign exchange in order to improve trade balance and achieve greater self-

2 Prema-chandra Athukorala, Jayatilleke S. S. Bandara, Saman Kelegama (Eds). (2011). Trade Liberalisation and Poverty in South Asia, New York, NY: Routledge Studies in the Growth Economies of Asia

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reliance.3 Domestic industries, under government protection, were believed to harness economies

of scale and the external economies of learning by doing and eventually grow up to be

competitive in the international market. Thus IS became the hallmark of development strategy in

many developing countries.

In the late 1960’s there came an intellectual counter-current supporting the outward-

looking “export promotion”. It was observed that domestic industries growing behind protective

tariff walls had no incentive to become efficient in production. Infant industries also never grew

up. In addition, IS policies accompanied by exchange controls promoted the use of more capital-

intensive techniques of production. The exchange controls themselves resulted in a vast increase

in the rent-seeking activities, dramatically increasing the costs of protection.4

The infirmities of IS strategy and the success of Asian tigers that used export promotion

(EP) policy offered enough inducement for the developing countries to slash the distortionary IS

policy in favor of trade liberalization. This called for putting in place an economic system with

improved resource allocation on the basis of prices determined by free market forces; access to

better technologies, inputs and intermediate goods; an economy better able to take advantage of

economies of scale and scope; greater domestic competition; availability of favorable growth

externalities, like the transfer of know-how and promote entrepreneurial class which is more

conducive to generating sustained high economic growth in the long-run.5 Policies to expand

export included lowering of import tariffs and export taxes, removing quantitative restrictions on

3 Prebisch, R. (1950), The Economic Development of Latin America and its Principal Problems (New York, United Nations). 4 Grabowski, R. (1994). Import substitution, export promotion, and the state in economic development. The Journal of Developing Areas, 28(4),

535-554. 5 Dornbusch, R. (1992). The case for trade liberalization in developing countries. The Journal of Economic Perspectives, 6(1), 69-85.

4

trade and reducing barriers to international flows of capital. Governments also tried to get

exporters access to inputs at world price and followed prudent exchange rate policies.

The pattern of redirection for developing countries to EP varied amongst different

countries. This was mainly because of the different factor endowments of different countries and

correspondingly different comparative advantage in either labor-intensive primary products or

capital-intensive manufactured goods. Countries that were heavily dependent on primary-product

exports generally fared badly because of the demand and supply side impediments of primary-

product exports. The demand for primary products was constrained by the income and price

elasticity factors (discussed above), development of synthetic substitutes and distortionary

interventionist policies of developed countries. The supply side was marred by structural

rigidities of developing countries. Conversely, the LDCs that capitalized on their surplus labor to

expand export of manufactured goods ostensibly fared much better.5 Therefore, despite the

widespread support of EP in the economic circles as the ecumenical development strategy, the

varied experience of LDCs hindered its unanimous implementation. The choice of the IS or EP

for a developing country, therefore, was based on the economic and political reality of that

country and more often than not were adopted in tandem. We now turn our attention to the

experience of Pakistan with each of the two mentioned trade strategies.

Trade Regime: The Pakistani Experience

Pakistan has never had a consistent, coherent and well-articulated trade policy. Trading

patterns have closely followed a cycle defined by a major departure from and return to

protectionist import substitution policies.

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The Idea of a single trade-based growth strategy:

At the time of independence in 1947 Pakistan’s industrial base was confined to a few

textile mills, some sugar mills and some cement factories, all totaling 34 units.6 The commodity

composition of Pakistan’s exports was dominated by low-value primary products that

precipitated severe balance of payment crisis and rapidly declining terms of trade. Pakistan

therefore, pursued a policy of import-substitution to protect its infant local industry against

imports and to expand its domestic industrial base. Thereafter, the government began to promote

export growth by taking a number of measures to reduce the anti-export bias of the trade regime

during the 1960s in order to promote industrialization. Firstly, the government introduced the

export bonus scheme in the late 1959, which were in effect a multiple exchange rate system

favoring manufactured exports.

Secondly, industries with export potential were singled out for special treatment such as

preferential access to foreign exchange. Thirdly, import liberalization was undertaken.6 Despite

this marginal liberalization, IS continued to be the seminal strategy whereby tariffs and non-tariff

barriers were used to regulate imports and fiscal incentives were used to expand low cost labor-

intensive manufacturing sector. During this time, the large-scale manufacturing grew at an

average rate of 13.4 percent per annum. The export bonus scheme which was tailored to provide

greater incentives to exporters of manufactured goods was instrumental in increasing the

manufactured exports by 11.4 percent per annum in current rupee term during the 1960s as

against 1.8 percent growth of primary exports and 7.0 percent growth of total exports.

6 Khan, A. H., & Ali, S. (1998). The Experience of Trade Liberalisation in Pakistan [with Comments]. The Pakistan development review, 661-685.

6

Consequently, the share of manufactured exports in total exports increased from 43 percent in

1960 to 67 percent in 1970. 6 However, multiplicity of exchange rates and trade and fiscal

incentives for industrialization led to distortions in resource allocations and encouraged rent-

seeking activities and an industrial structure that was heavily dependent on the protection

provided by the government. As a result, the industrial base remained weak, inefficient and

concentrated which also affected the competitiveness of exports.7

On the Path to being “Open” to the world:

After the separation of East Pakistan in 1971, the government tried to launch more

reforms to further liberalize trade and divert the exports from the protected markets of former

East Pakistan to other countries. The Export Bonus Scheme was abolished, restrictive licensing

system was removed and devaluation measures were undertaken. These measures proved

successful as manufactured exports increased at a compound growth rate of 26 percent per

annum in current rupee term in early 1970s. 6

Pakistan’s terms of trade reached its all-time high

of 257.99 index points in 1973 (Fig. 1). Nationalization of economy, however, did not help the

cause. The net impact of the mentioned reforms was inadequate as disparaging anti-export bias

in the face of export taxes persisted (Fig 2) and the terms of trade eventually declined in the later

part of the decade (Fig. 1).

In 1980s, the process of denationalization was started. The government sought to reverse

the protectionist IS policies of earlier decades to reduce burden on government and encourage

private sector. Under this regime, the country moved to a floating exchange rate system, a

7 Lewis, S. (1971). Pakistan: Industrialization and Trade Policies, OECD: Paris

7

number of non-tariff barriers such as import quotas on non-capital imports were removed and

negative import system was adopted. In addition, a number of tariff reforms were undertaken.

Maximum tariff rate was reduced from 225 percent in 1986/87 to 125 percent in 1988/98 though

the dispersion of tariffs remained the same.6 Export policy was launched that emphasized the

need to generate exportable surplus by increasing domestic production in the agriculture and

industrial sector, with focus on export-oriented industries. Despite these policy reforms, the anti-

export bias persisted because of high tariff rates (Fig. 2 and Table 2) and terms of trade

incessantly declined (Fig. 1).

Pakistan finally announced a shift away from the IS development strategy in the late

1980s towards more outward-oriented EP. It embarked on programs of stabilization and

structural reforms to reduce market intervention in order to improve efficiency of resource use

and the competitiveness of the economy. The tariff structure was simplified: maximum tariffs

were lowered from 80 percent in 1993 to 45 in 1997 and to 25 percent in recent years and the un-

weighted i.e simple average statutory tariff fell from 45.61 in 1998 to 14.78 percent in 2009

(Table 2).8 Simplification and rationalization of tariff rates, the elimination of controls and other

quantitative restrictions and abolishing the negative list have been the important policy reforms

undertaken in the last two decades. At the same time, Pakistan also undertook some export

promotion measures such as export finance scheme, export credit guaranteed scheme etc. 6

These measures evidently brought tremendous export growth. Export earnings showed

substantial growth, increasing from $ 6.7 billion in 1990 to $ 24.7 billion in 2010 (Table 1).

8 Mahmud, M. (2010). A Strategy for Reversing Pakistan's Dismal Export Performance.

8

However, we will see later that this figure is not as impressive as it may seem. The liberalization

reforms also provided strong base for private sector development and foreign direct investment

which is complementary to export promotion.9 As a result, resource allocation improved and

Pakistan experienced an increase in annual average growth of 6 percent (Fig 3).

Despite these achievements, economic growth and export expansion in Pakistan have

lagged far behind East and Southeast Asian countries and even its South Asian neighbors.

Pakistan’s share of world exports has actually declined 17 percent since the early 1990s while

that of Malaysia, Thailand and India increased on average by 185 percent (Table 3). Even

Bangladesh has showed significant improvement since its separation from Pakistan.8

The gains in

terms of exports to GDP remains at a modest 13 percent, very much below the range of 30-50

percent of GDP in successful East Asian countries.

It is generally believed that lower competitiveness and lack of access to the other

countries are the major reasons for the slow progress in export expansion. Despite significant

chance in composition of exports with share of manufactured goods in total exports increased to

77 percent in 2007 from 56 percent in 1990, there is still a high concentration around a few

products like rice and textile. As a corollary of this the terms of trade have continued to be

dismal (Fig. 1).2 It is also important to note here that while there was substantial trade

liberalization during last two decades, there has been an increase in tariff dispersion.8 As a result

trade regime continues to have anti-export bias which is holding Pakistan back from developing

its full trade potential. Further reductions in tariffs have been hampered due to its significant

9 Hasan, P. (2007). Role of the State in Pakistan's Economy: Assessing the Past and Exploring Future Challenges. Economic and Political Weekly, 1623-1630.

9

contribution to the country’s revenue and because of rent-seeking behavior of special interest

groups that benefit from this protection.10

While Pakistan pursued significant liberalization policies, the recent success in export

performance can hardly be accredited to that. Exports only picked up because of accompanying

depreciation of the real exchange rate and due to high international commodity prices as

observed by the Planning Commission of Pakistan.11

This did not happen because of quality

improvement, value-addition and globally competitive prices or efficiencies in the export-

oriented industries. Furthermore, free trade spurred vicious pre-capitalist mercantilism that had

set a process of deindustrialization, kept agriculture stagnant and led to a growth bubble.

Finding the “right mix”:

Global financial Crisis threw a spanner in the process of liberalization complemented

with high current and fiscal account deficits. Pakistan once again introduced heavy protectionism

in the late 2000s, although the regulations were compatible with WTO’s guidelines.11

While IS

served to correct imbalances, it re-introduced major distortions in the trade system. There are

now at least nine standard normal statutory tariffs compared with just four in 2003-04. From the

list of 906 manufactured items that enjoy tariff exemptions, 91 per cent of the listed products

benefit only a single local monopoly producer and five per cent benefit only two producers,

while other producers of the same good, especially the small and medium producers, do not

receive the same treatment. The extremely high protection slows down the development of

efficient and competitive industries and promotes rent-seeking behavior. While this is true,

10 Bashir, Z., & Din, M. U. (2003). The Impacts of Economic Reforms and Trade Liberalisation on Agricultural Export Performance in Pakistan [with Comments]. The Pakistan Development Review, 941-960. 11 Planning Commission`s strategy paper, “Pakistan: Framework for Economic Growth May 2011.”

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selective curbs on imports are inevitable to correct widening trade imbalances in the present

stage of country`s industrialization. A judicious blend of import substitution and export growth,

therefore, can help reduce heavy foreign dependence more rapidly. 12

Conclusion:

The suitability of trade policy – IS or EP- for growth and development still remains a

moot question for Pakistan. After pursuing import substitution in the late 1950s and in 60s,

Pakistan switched to export promotion policies in 1970s and 1980s. IS was considered sine qua

non for industrialization. While it created bias against exports, Pakistan was able to develop a

sound industrial infrastructure particularly in power generation and specialized textile sectors

because of IS.13

Disappointingly, however, it accentuated several economic vices, viz.,

inefficiency in resource allocation, pervasive corruption and growth of inefficient monopoly

houses. Trade liberalization started with partial dismantling of trade barriers in 1980s but it was

only in 1990s when Pakistan initiated a decisive break away from IS and towards outward-

oriented EP, following a massive balance of payment crisis (Fig. 4), which severely constrained

its ability to continue with past policies. While limited protectionism persisted, improvement in

balance of payments following foreign capital and financial inflows between 1995 and 2002, and

a steady growth in exports proved EP as a better choice for growth. A thorough examination of

economic variables, however, proved otherwise. As mentioned earlier, marginal increase in

exports was not due to quality improvement, globally competitive products or efficiencies in the

12 Protectionism and the lure of mercantilism (2011, June 19). Dawn. retrieved from http://beta.dawn.com/news/637874/ 13

Reza, S., Thuraisingam, G. (Eds). (1998). Export-led Growth Strategy for South Asia, Kuala Lumpur, Malaysia: Asian and Pacific Devevlopment

Centre

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export-oriented industries but only because of depreciation of the real exchange rate and high

international commodity prices.

There is a widespread belief that Pakistan has not been able to reap much benefit from

export-led growth strategy due to both product and market concentration. Given the inelasticity

of import basket, only viable option available for the government is to diversify exports.

Manufacturing sector, which is regarded as the engine of growth of economy, has historically

been neglected except for the ones owned by the country’s powerful rentier class. It must be

noted here that significant exports of manufactured goods in past two decades happened in textile

industry where the large-scale IS has been successfully accomplished. It would be wrong,

however, to blame trade liberalization policies for the poor performance of industries. The

unstable political environment, poor infrastructural facilities, lack of discipline of the labor force,

its skill and quality, and lack of backward-linkages have all contributed in the poor export

performance of a country. It is in this context that the policymakers in Pakistan have been

ambivalent about pursuing more liberalization.

The global financial crisis in 2008-09 complemented with high current and fiscal account

deficits, changed the entire economic scenario of Pakistan and brought import substitution back

on the policy map. Much emphasis was given for IS in agriculture industry in which Pakistan has

historically enjoyed comparative advantage. Although the recent trade policy package released

by the Planning commission 2012/13 pays lip-service to the need for continuing liberalization,

the fact remains that the policy-making in Pakistan has reeked of myopic vision, lack of

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governance structure and patronization of the powerful business class by the government. As a

result, Pakistan still faces intractable problems in finding the right trade-based growth strategy.

Bibliography:

1 Manu, Franklyn A. "Import Substitution and Export Promotion: a continuing dilemma for developing countries."

Journal of International Business and Economics (2009).

2 Prema-chandra Athukorala, Jayatilleke S. S. Bandara, Saman Kelegama (Eds). (2011). Trade Liberalisation and

Poverty in South Asia, New York, NY: Routledge Studies in the Growth Economies of Asia

3 Prebisch, R. (1950), The Economic Development of Latin America and its Principal Problems (New York, UN).

4 Grabowski, R. (1994). Import substitution, export promotion, and the state in economic development. The

Journal of Developing Areas, 28(4), 535-554.

5 Dornbusch, R. (1992). The case for trade liberalization in developing countries. The Journal of Economic

Perspectives, 6(1), 69-85.

6 Khan, A. H., & Ali, S. (1998). The Experience of Trade Liberalisation in Pakistan [with Comments]. The Pakistan

development review, 661-685.

7 Lewis, S. (1971). Pakistan: Industrialization and Trade Policies, OECD: Paris

8 Mahmud, M. (2010). A Strategy for Reversing Pakistan's Dismal Export Performance.

9 Hasan, P. (2007). Role of the State in Pakistan's Economy: Assessing the Past and Exploring Future Challenges.

Economic and Political Weekly, 1623-1630.

10 Bashir, Z., & Din, M. U. (2003). The Impacts of Economic Reforms and Trade Liberalisation on Agricultural Export

Performance in Pakistan [with Comments]. The Pakistan Development Review, 941-960.

11 Planning Commission`s strategy paper, “Pakistan: Framework for Economic Growth May 2011.”

12 Protectionism and the lure of mercantilism (2011, June 19). Dawn. ( http://beta.dawn.com/news/637874/)

13

13 Reza, S., Thuraisingam, G. (Eds). (1998). Export-led Growth Strategy for South Asia, Kuala Lumpur, Malaysia:

Asian and Pacific Devevlopment Centre

Appendix A: Tables

Table 1. Exports Receipts & Imports Payments and Balance of Trade. (In Millions U.S. $)

Period Exports (BOP) Imports (BOP) Balance of

Value Growth Rate Value Growth Rate Trade

a c a-c

1970-71 683 -- 1,187 -- -504

1971-72 625 -8.6 954 -19.6 -329

1972-73 766 22.6 889 -6.8 -123

1973-74 1,020 33.1 1,493 67.9 -473

1974-75 978 -4.1 2,114 41.6 -1,137

1975-76 1,162 18.9 2,139 1.2 -977

1976-77 1,132 -2.6 2,418 13 -1,286

1977-78 1,497 32.3 3,174 31.3 -1,677

1978-79 1,644 9.8 3,816 20.2 -2,172

1979-80 2,341 42.4 4,857 27.3 -2,516

1980-81 2,799 19.6 5,563 14.6 -2,765

1981-82 2,316 -17.2 5,771 3.7 -3,455

1982-83 2,627 13.4 5,618 -2.7 -2,991

1983-84 2,665 1.5 5,990 6.6 -3,325

1984-85 2,458 -7.8 6,017 0.4 -3,559

1985-86 2,943 19.7 6,000 -0.3 -3,057

1986-87 3,488 18.5 5,793 -3.5 -2,305

1987-88 4,361 25 6,917 19.4 -2,556

1988-89 4,628 6.1 7,201 4.1 -2,573

1989-90 4,924 6.4 7,414 3 -2,490

1990-91 5,894 19.7 8,387 13.1 -2,493

1991-92 6,761 14.7 9,000 7.3 -2,238

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1992-93 6,782 0.3 10,049 11.7 -3,267

1993-94 6,684 -1.4 8,691 -13.5 -2,007

1994-95 7,776 16.3 10,298 18.5 -2,522

1995-96 8,311 6.9 12,015 16.7 -3,704

1996-97 8,096 -2.6 11,236 -6.5 -3,140

1997-98 8,434 4.2 10,301 -8.3 -1,867

1998-99 7,528 -10.7 9,613 -6.7 -2,085

1999-00 8,191 8.8 9,602 -0.1 -1,411

2000-01 8,934 9.1 10,202 6.2 -1,268

2001-02 9,140 2.3 9,434 -7.5 -294

2002-03 10,889 19.1 11,333 20.1 -444

2003-04 12,396 13.8 13,604 20 -1,208

2004-05 14,482 16.8 18,996 39.64 -4,514

2005-06 16,553 14.3 24,994 31.6 -8,441

2006-07 17,278 4.4 26,989 8 -9,711

2007-08 20,427 18.2 35,397 31.2 -14,970

2008-09 19,121 -6.4 31,747 -10.3 -12,627

2009-10 19,673 2.9 31,209 -1.7 -11,536

2010-11 25,355 28.9 35,872 14.9 -10,517

2011-12 24,696 -2.6 40,461 12.8 -15,765

2012-13 24,744 0.2 39,801 -1.6 -15,056

Source: State Bank of Pakistan (http://www.sbp.org.pk/ecodata/index2.asp#external)

Table 2. Tariff rate, applied, simple mean, all products (%) Year 1995 1998 2001 2002 2003 2004 2005 2006 2007 2008 2009

Value 50.09 45.61 20.16 17.17 16.81 16.17 14.61 14.79 14.9 14.08 14.78

Source:World Bank (http://data.worldbank.org/indicator/)

Table 3. Exports as a Percentage Share of World Exports

Year Pakistan India Bangladesh Malaysia Thailand

1974 0.14 0.56 0.04a 0.55 0.32

1980 0.15 0.43 0.04 0.74 0.37

1990 0.18 0.57 0.05 0.94 0.74

2000 0.15 0.7 0.09 1.61 1.13

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2008 0.15 1.32 0.10b 1.43 1.25 a-1977, b-2007

Source: Mahmud, M. (2010). A Strategy for Reversing Pakistan's Dismal Export Performance. (http://www.creb.org.pk/)

Appendix B: Figures

Fig 1. Pakistan’s Terms of Trade (index points with base of 100) Source: World Bank Data. (http://www.tradingeconomics.com/pakistan/gdp-growth)

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Fig 2. Anti-Export Bias in Pakistan from 1969/70 to 1996/97) Source: Khan, A. H., & Ali, S. (1998). The Experience of Trade Liberalisation in Pakistan [with Comments]. The Pakistan development review, 661-685.

Fig 3. Pakistan’s GDP growth Rate (annual %). Source: World Bank Data (http://www.tradingeconomics.com/pakistan/gdp-growth)

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Fig. 4. Pakistan’s Current account balance (BoP; US dollar) Source: World Bank Data (http://www.tradingeconomics.com/pakistan/gdp-growth)