Wrong way to Make In India: Why we must resist the temptation to return to import substitution mirage

by Arvind Panagariya

December 13, 2017

The Times of India

In the immediate post-Second World War era, following the then consensus view, nearly all emerging independent countries chose the path of import substitution to achieve industrialisation. But by early to mid-1960s Singapore, Taiwan and South Korea had broken away from this consensus and switched to export-oriented strategies.

They soon achieved growth rates of 8-10% for the following two to three decades. India chose to stay course, deepening import substitution yet further. Our imports as a proportion of the gross domestic product (GDP) dropped to just 4% in 1969-70 from the peak of 10% in 1957-58.

By mid-1960s we had banned consumer goods imports, which took away the pressure on domestic producers to supply high quality products. The “domestic availability” condition additionally denied our producers access to world class raw materials and machinery whenever equivalent domestic products, no matter how poor in quality, were available.

Quality of our products plummeted and they failed to compete in the global marketplace. Poor performance of exports in turn created foreign exchange shortages, which led to yet greater tightening of import controls. This vicious cycle took its toll on growth, with per capita income rising at the paltry annual rate of 1.5% during 1951-81.

The only way to break this cycle of import controls leading to poor export performance and poor export performance forcing yet tighter import controls was to do away with import controls and let the rupee depreciate sufficiently to incentivise exporters and producers of import-competing products. That is exactly what we did beginning in 1991.

The process was gradual but steady and credible. With top quality products beginning to flow into the country, consumers became more and more discriminating and producers could access world class raw materials, machinery and technology.

This change eventually brought vast improvement in the quality of our products allowing exports to grow alongside imports. Most dramatically, our expanding exports could readily finance the imports of millions of mobile phones that were critical to the success of the New Telecom Policy that the Vajpayee government implemented during 1999-2003.

Our exports of goods and services multiplied six-fold from just $75 billion in 2002-03 to $450 billion in 2011-12. Many today argue that our commitment to the WTO Information Technology Agreement, which bound us to zero custom duty on information technology products, denied us the opportunity to manufacture millions of mobile phones that our citizens bought. I would argue that a protected mobile market would have killed the mobile revolution instead.

While adding at most a small quantity to domestic production, it would have denied access to inexpensive but decent-quality mobile phones to millions of our consumers. We were much wiser to export what we were good at to pay for the mobile phones we imported.

Today, we are in danger of forgetting the lesson we have learnt the hard way. Thanks to the reforms under Prime Ministers Rao, Vajpayee and Modi, we are now a $2.3 trillion dollar economy and our imports stand at $450 billion. Unfortunately, however, the latter fact has created renewed temptation for a return to import substitution to make a success of Make in India.

What better way to get there than to replace this large volume of imports by domestic production, goes the argument. Is this market not ours for taking? Sadly, this line of reasoning can take us back to ruin yet again. Let me explain why.

When we think of replacing imports by domestic production, we are invariably thinking this would be a net addition to Make in India. This is a false premise. Equivalent reduction in exports is almost sure to accompany the reduction in imports. This is because macroeconomic stability requires Reserve Bank of India (RBI) to maintain the exchange rate at a level that keeps the current account deficit (total imports minus total exports) to around 1-2% of GDP. With rare exceptions, RBI has adhered to this policy since we adopted flexible exchange rates.

Put another way, if foreigners cannot sell their goods to us, they will not have the revenues to pay for the goods they buy from us. If we cut back on their goods, they will have to cut back on ours. Even the large decline in our oil import bill during 2015-16 was accompanied by a near equivalent decline in our exports. What is added to Make in India through import substitution will get subtracted by losses in exports.

The key to the gains from international trade is that we export products that we produce at the lowest cost and import those that our trading partners produce at the lowest cost. In this way, we maximise the gains from trade. Import substitution, which relies on raising barriers against imports or subsidising our products, undermines these gains.

Only if import substitution is the result of increased efficiency of our producers does it add to the gains from trade. If politics compels us to intervene to help producers, the least damaging course is to do so on behalf of those able to export to world markets.

In doing so, we are likely to assist producers on the verge of becoming competitive against the best in the world. In contrast, the risk in import substitution is that we may end up propelling sectors in which we are among the costliest producers.