Import Substitution Problem

KOMPAS/LASTI KURNIA

Container loading and unloading activity at Operation Terminal 3, Tanjung Priok Port, Jakarta, on Thursday (20/2/2020). The Central Statistics Agency noted that the value of non-oil and gas exports and imports to and from China had decreased in January 2020.

As reported in the media, the Industry Ministry is drafting an import substitution policy and road map.

In a press release dated 29 July 2020, the ministry announced a plan to reduce imports and replace up to 35 percent with domestic products in a number of industrial sectors by 2022. It planned to do this in part by increasing import tariffs and non-tariff barriers for a number of strategic commodities. According to the findings of some economic studies, the import substitution plan is not the right concept or policy to strengthen Indonesian industry and the economy.

The import substitution strategy in itself is not new to us. From historical economic records (for example, Patunru, Pangestu and Basri, 2018), Indonesia already tried this strategy at the beginning of the 1970s to the mid-1980s, amidst abundant oil export revenues. The 1980s crisis due to the drop in world oil prices, while industrial competitiveness remained inadequate, forced the government to reverse direction towards deregulation and policies that promoted exports.

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In the mid-1990s, as the economy improved, import substitution mixed with corruption, collusion and nepotism (KKN) that again spread under the guise of economic nationalism. This inefficient practice played a major role in the 1997-1998 political and financial crisis, which forced the government to deregulate again towards more open trade and industry policies. However, after the economy recovered in the 2000s, protectionism again returned to the policy arena, the latest being the Industry Ministry’s recent import substitution plan.

What exactly is this import substitution policy? The concept of import substitution first emerged in the 1950s as part of a set of industrialization strategy proposals in newly independent, developing countries. In short, this policy was a departure from the assumption that specialization and free trade hindered the development of the processing industries in developing countries.

The government must therefore build a domestic industry to replace these imported industrial goods, typically by increasing import tariffs and/or limiting the import volume (quotas), until the domestic industry was able to compete in the world market.

The rationale behind this approach was that specialization based on comparative advantage would only “trap” developing countries to produce and export only agricultural products, which continued to decline in exchange value, for them to import industrial products from developed countries. The government must therefore build a domestic industry to replace these imported industrial goods, typically by increasing import tariffs and/or limiting the import volume (quotas), until the domestic industry was able to compete in the world market.

Outdated strategy

So, what is the real problem with the concept of import substitution? Why do economists consider this concept to be obsolete, although it remains popular among both laymen and politicians? To answer these questions, let us discuss some of the fundamental issues of this policy choice.

KOMPAS/P RADITYA MAHENDRA YASA

Workers unload cargo inside containers at Tanjung Emas Port, Semarang City, Central Java, on Wednesday (5/8/2020). The Covid-19 pandemic has had an impact on export-import activities in recent months.

First, import substitution is difficult to implement in practice, even at the design stage. According to Aswicahyono and Rafitrandi (2018), it is almost impossible to determine the optimal increase that must be applied to import tariffs to protect domestic industries so they are able to compete in the world market. This is because it is impossible to predict the long-term, future trend in the price of goods in an increasingly competitive world market, amidst the technological advancements that are rapidly reducing production costs and are often disruptive.

As a result, the amount of increase in import tariffs that have been designed against today’s benchmark of world price forecasts would never be effective in achieving the competitiveness target for the future. Domestic industries would continue to remain an infant industry, its life dependent on government protection.

Second, the import substitution policy is based on a view to minimize the role of imports in industrialization. In fact, Albert O. Hirschman, one of the leading economists and intellectuals advocating the active role of the government in development, observed in his seminal book, The Strategy of Economic Development (1958), that those who supported import restrictions were reluctant to acknowledge the important role imports filled in stimulating industrialization (Irwin, 2020).

I believe Hirschman is right. Empirically, strong evidence points to imports having a positive impact on corporate and industry performance. In Indonesia, data from BPS (Statistics Indonesia) and Rahardja and Varela (2015) show that a 10 percent increase in the import volume of raw materials in the components industry in 2005-2009 correlated with positive value-added growth of 2.3 percent in the industry. Even more, the additional 10 percent in imported raw materials at a particular company corresponded with a 3.7 percent increase in their workers\' wages.

Earlier, Amiti and Konings (2007) used data from the 1990-2001 Indonesian Manufacturing Industry Survey to estimate that a reduction of 10 percent in import tariffs on raw materials would result in a 12 percent increase in the productivity of the importing company. According to the theoretical projections of Grossman and Helpman (1991), imports affect productivity positively by increasing corporate access to various types of input goods, better-quality input goods, and a learning process.

Narjoko, Anas and Herdiyanto (2018) also made a similar projection. Using five-digit aggregate data from 1991 to 2013 in the manufacturing industry, their study also showed that the higher the nominal tariff rate on imported input, the lower the growth in value-added, labor and productivity at raw materials producers.

According to the definition of import substitution and protection, consumers and businesses that use imported raw materials pay more than they should; namely the international market price.

Third, import substitution is detrimental to consumers and businesses that use imported raw materials. Advocates of the import substitution policy, while playing up nationalism and anti-foreign sentiment, often forget or fail to refer to the impacts on distribution. According to the definition of import substitution and protection, consumers and businesses that use imported raw materials pay more than they should; namely the international market price.

The clearest illustration is the case of the rice import ban. Patunru (2019) reveals that more than 80 percent of the Indonesian population, including the poor, are net consumers of rice. As a result of the 2004 import ban on rice, the Indonesian people have been paying far above international prices to buy rice. To illustrate, the domestic price of rice in early 2017 was almost three times the international price. The official price ceiling for rice is still around twice the international price. The same logic applies to every protected product. This is because if domestic goods are cheaper, of course there would be no need for an import ban.

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Fourth, import substitution is prone to corruption and resembles rent-seeking practices. Determining which industries and, accordingly, which domestic companies are to be protected and the amount of protection to be provided is a political process. As is the case in the complex process of politics, lobbying and close political ties with the government are more important than corporate competitiveness or economic efficiency.

KOMPAS/TOTOK WIJAYANTO

Researchers looked at the results of extracts from natural raw materials in the laboratory of the Indonesian Modern Medicine Research Center (OMAI) at Dexa Laboratories of Biomolecular Sciences, Cikarang industrial area, Bekasi, West Java, Wednesday (11/3/2020). Currently imports of pharmaceutical raw materials have reached 95 percent, and about 60 percent of them come from China.

The results of the econometric study by Basri (2001) show that during the New Order, especially in the 1980s and 1990s, the level of protection an industry was accorded was directly influenced by the interests of Soeharto’s cronies. Using 1997 data, Purbasari and Mobarak (2006) support these findings and show that import licenses were typically granted to companies belonging to Soeharto\'s cronies. After Reformasi, the 2013 bribery case of the beef import quota is the most recent example of how import restrictions are linked to corruption.

Fifth, the experience of other countries show that import substitution is not the path to industrialization and long-term, high economic growth. The Indian economy finally emerged from stagnation in 1990 after abandoning this strategy and has been speeding forward since then. Goldberg, Khandelwal and Pavcnik (2008) estimate that a quarter of India’s rapid manufacturing development in the 1990s derived from the production of new goods as a result of greater access to imported raw materials. Although they may not be completely free of government involvement, the Four Asian Tigers are also advancing towards becoming developed countries on an export-oriented industrial strategy, not import substitution.

Strengthening industry

So, what can be done to strengthen domestic industries? First, reduce high and disruptive costs that prevent resources from reaching the most efficient and productive industries and companies. We need to reduce corruption, legal uncertainty, and all other forms of barriers to business. A healthy climate for business competition must be nurtured. Import substitution will occur naturally on changes in comparative advantage stemming from the growth of productive industries and the economy.

It may sound boring and nothing new is presented here, but this fundamental policy cannot be realized without the strong political commitment of government, especially in punishing offenders who usually have close ties to power.Second, if we want to implement sectoral industrial policies, the government needs to direct them as an effort to increase competition in that sector; for example, policies designed to encourage new productive companies (Aghion et al, 2015) or in industry sectors that use a lot of skilled labor (skill-intensive industries), as in the findings of an international study by Nunn and Trefler (2010). In other words, these sectors are those that produce a large spillover effect on productivity through increased competition and skills.

ARSIP UNIVERSITAS LEIDEN

Akhmad Rizal Shidiq

These policy choices, of course, are no popular, nor will they show results by 2022. However, we certainly hope that the government and the bureaucracy will be a little more technocratic and think in the long term.

Akhmad Rizal Shidiq, Economics Lecturer, Leiden University Institute for Area Studies (LIAS)