Import Substitution Industrialization (ISI)

A concept of economic theory that discourages dependence on foreign industries and seeks to replace imports with domestically produced goods

Import substitution industrialization (ISI)  is a concept of economic theory that discourages dependence on foreign industries and seeks to replace imports with domestically produced goods. It is most commonly seen in developing or emerging countries that aim to reduce reliance on developed countries.

It was a common practice among developing countries in the 20th century to protect their infant industries in the early stages of development. They would be protected until they achieve economies of scale and can withstand foreign competition.

The import substitution concept aims to make local economies and nations self-sufficient. 

Some industries in some countries are relatively new and upcoming domestically, whereas similar sectors in other countries may have existed for a long time and are much more developed.

This gives the developed industry a comparative advantage over the domestic industry in terms of lower opportunity costs, economies of scale, or stability regarding cash reserves and market changes.

A well-known theory among development economists is that a nation cannot develop without the manufacturing sector. It is the primary step in the shift from an agrarian economy to a finished goods economy. 

Different currencies

Developing countries show a more significant dependence on manufactured imports of intermediate goods and technology from developed countries due to the inefficiency or inadequacy of domestic industries.

This hinders the long-term development of the domestic economy.

The benefits of industrialization at the expense of imports include the following:

  • By reducing dependence on foreign industries, the domestic economy can be self-reliant in sensitive sectors that involve national security and backbone industries like defense equipment and capital goods industries.
  • By fostering domestic industries, governments can create more job opportunities in the domestic economy. This increases income level, the standard of living, and the quality of life for citizens.
  • Domestic industries contribute to the nation's economic growth, whereas imports are a reduction in a nation's Gross Domestic Product (GDP).

ISI involves the protection of domestic industries along with measures to foster growth in the industry. This enables the domestic industry to become viable in the long run when such actions can be removed. 

The theory of import substitution gained popularity in the 20th century. However, the concept was advocated by Alexander Hamilton as early as the 18th century to justify trade protectionism in the United States. This was to decrease the U.S.' dependence on British imports.

Adopted measures

The ISI concept mainly comprises the following three stages:

  • The domestic production of simple nondurable goods that were previously imported
  • The eventual extension of the domestic output to consumer durable goods and more complex manufactured goods.
  • The continuous development of industries and export of manufactured goods.

To achieve these stages, governments usually follow an integrated policy of 5 main factors mentioned below.

1. Government subsidies 

A common practice among governments is the granting of subsidies. These subsidies directly reduce the input costs of domestic producers and help them compete with foreign industries in terms of price. 

It also promotes an increased production level for domestic industries to help them achieve economies of scale.

By managing subsidies, governments can also organize the growth of strategic industries. That is, giving higher contributions to essential sectors.

2. Protectionism

This refers to protecting domestic producers from foreign competition by enforcing trade barriers. These barriers reduce the number of imports and make them less attractive to consumers.

The most common trade barrier is a tariff or a tax imposed on imports paid by the domestic consumers, not the exporting country. These taxes increase the price of imports closer to their domestic substitutes and reduce their price advantage.

These restrictions are also usually difficult to remove and create short-term costs for the domestic economy. Thus, they are generally discouraged by economists. However, unlike subsidies, they act as a source of revenue and are often preferred by governments.

Another common trade barrier is the import quota, which specifies the number of imports bought in a specific period and of a particular good. Again, governments use this to limit competition, if not eliminate it. 

Government

3. Nationalization

This refers to converting privately-owned companies and assets into public or government-controlled assets. It is the opposite of privatization and expresses a government's desire to control the factors of production. 

4. Increased taxation

Governments tend to increase taxes to provide for the subsidization of industries. 

5. Overvaluation of currency 

Governments' overvaluation of domestic currency discourages foreign direct investment in industries while also helping manufacturers import capital goods or heavy machinery to aid the production process.

Criticism

Countries have discontinued the practice of import substitution since the 1990s with the rise of international trade and globalization. 

Common arguments against the protection of domestic industries are as follows-

  • Public Debt- Due to increased government expenditure, several countries adopting ISI faced a high public debt.
  • Inefficiency- When protected from foreign competition, domestic producers may not be incentivized to improve the quality of goods. This leads to inefficient production of inferior goods as subsidies protect producers.
  • Consumer inconvenience- By limiting imports, governments reduce the choice of goods available to consumers, who are now forced to buy inferior domestic goods.

Furthermore, by restricting lower-priced imports, consumers are compelled to buy high-priced domestic goods, often with inferior quality, reducing their purchasing power. 

Additionally, removing tariffs in some cases may prove costly, complex, or contradictory to some political interests. Finally, such taxes' long-term costs continue to prove detrimental to consumers. 

  • Retaliation- The imposition of taxes and tariffs by a country often leads to the further imposition of restrictions by foreign countries on the exports of the initial country. This can result in a trade war among nations.

Many development economists state that the ability of the government to learn and adapt the production strategies of developed economies to local economies depends highly on the local and social institutions. 

ISI in Latin America 

The most prominent real-world example of import substitution industrialization can be seen in Latin America from the 1950s to the 1980s.

After the Great Depression, several Latin American exports were adversely affected. In addition, leaders realized their dependence on developed economies makes them vulnerable to changes in the international market.

The domestic economies suffer from stagnation in manufacturing industries and high levels of unemployment. As a result, all their revenue from exports, and more, was spent on imports. 

The adoption of ISI became the obvious solution as governments took measures to increase investment in key manufacturing industries. Several industries were nationalized to promote growth and employment opportunities. 

Tariffs, quotas, and licenses were imposed to discourage imports into the economy. Simultaneously, taxes were increased to provide for subsidies. 
The results of the policies were double-edged.

Several countries like Argentina, Brazil, Uruguay, Chile, and Mexico were prosperous in reducing imports and improving employment rates due to proper planning and implementation of policies.

Pile of coins

On the other hand, countries like Peru, Bolivia, and Ecuador were unsuccessful, mainly due to the reluctance of the elite to invest in capital goods and technology.

They reverted to exporting natural resources.

Even countries where the adoption of ISI was previously successful began to default on their sovereign debt, leading to the Latin American debt crisis. 

Eventually, countries had to abandon ISI measures for more neoliberal policies of free trade. This ultimately led to ISI losing its influence in the modern economy.

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Researched and authored by Manya Bhardwaj | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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