Many countries have risen out of poverty and underdevelopment through industrialization. Lessons from successful countries in the Asia-Pacific revealed that development through strategic integration into the external economy can be achieved. It has also been observed that the State plays an important role in undertaking strategic integration because it is responsible for enforcing industrial policy – the application of selective government interventions to favour certain sectors so that their expansion benefits the productivity of the whole economy.
Due to globalization, productivity upgrading ceases to be an automatic result of market forces. It is also unlikely to be automatic in the future. Therefore, an industrial policy that suits the conditions of the country is critical. State intervention is necessary for countries seeking development by international integration to support new production activities and to build domestic capabilities.
Industrialization
Industrial policy is a development-oriented intervention that must be aligned to national interest. It must be selective and it must be targeted to important, immature[1] industries. It does not only apply to the manufacturing sector but also to diverse industries, especially the three major classic economic sectors: agriculture, industry, and services.
The effectiveness of industrial policy depends on the context within it was implemented. But, the intention of every industrial policy must:
· Consider the possibility that the State’s perception regarding industrial policy may be erroneous
· Recognize that the objective of the policy is efficiency, not equity
· Seek to benefit the economy as a whole, not just a specific sector
Examples of selective policies include differential tariffs, financial support to specific industries, and tax and import privileges for specific sectors. Many developing countries have utilized and targeted tariff and tax incentives toward foreign investments (since the 1980s).
The dominant development strategy in the 1980’s was the Washington Consensus. It was based on the idea that the State is weak and subject to the politically-motivated decision making. It suggests that since the State has limited capacity, the private sector must be the one responsible for identifying and developing the promising sectors of the economy. This view completely rejects industrial policy.
The slow growth of Latin America revived the interest to industrial policy. Mainstream economic policy now points out three reasons why the Washington Consensus is inaccurate:
· Dynamic scale economies and knowledge spillovers exist.
· The State might be needed to address coordination failures of private investment activities.
· There are important externalities in industrial investment.
Unlike the Washington Consensus, the Schumpterian approach focuses on the role of competition among nations and production agents. It highlights how differences in technology and organizational capacity determine the competitiveness of countries, sectors, and firms. It also introduces creative destruction, a phenomenon which happens when an existing production facility is replaced by newer, larger and more technologically advanced facility. Development is seen as a cumulative process, where active State policy is very important. This framework introduces three innovation theories: firm-based theories, industry life cycle theories, and new evolutionary theories.
· Firm-based theories state that firms play a major role in the process of innovation and technological propagation.
· Industry life cycle theories emphasize that an industry must undergo important stages for it to be fully developed.
· New evolutionary theories state that innovation and industry development patterns must be product specific.
The mainstream view suggests that the private sector searches out the best investments as a result of having the right prices. The Schumpterian approach, on the other hand, focuses on how the struggles of public and private firms represent capabilities that reveal economic and political opportunities for survival and growth. Hence, the State has a role on promoting production capability and the management of private rents, while the private sector supports most of the research and development initiatives.
Governments have no choice but to undertake industrial policy. Countries that are more dependent on exports and the international economy are more likely to undertake industrial policy due to specific features in technology. With strong linkages in the economy, industrial policy could be very vital in attracting foreign investment. The design of the industrial policy is also important in the net cost and benefits assessment. Social capability stemming from project implementation experience is critical, as well as domestic capabilities and technological externalities.
It has been long debated whether the State must be involved in the design and scale of economic investment. It was observed that a State’s insufficient role in investment undermined prospects for growth in many low and middle income developing countries. Investment determines growth and is needed for new activities and capabilities to develop. Although savings cannot be detached from the decision to invest, it has been observed that low-growth economies do not experience much progress not because they do not have sufficient savings, but because investment opportunities are very limited. Hence, the public sector must motivate the private sector by providing them a climate conducive to a high rate investment.
Investment must be directed towards sectors that have the potential for long-term growth and transformation; higher technology production must be pursued. For this cause, proactive domestic policies must lean toward exploring technological opportunities. Technology is not transferred automatically; hence, time, investment, and effort are required.
Trade Investment and Growth
Opening to external markets and capital is not sufficient for greater investment and technological upgrading. The technology must be near the best practice. To do this, economies must deal with increasing returns to scale, strong agglomeration economies, and market and coordination failures.
In East Asia, to compensate for the absence of developed financial markets, the State monitored profits and ensured reinvestment in expanded output and technology. This strategy also allowed enterprises to take advantage of scale economies, achieve higher labor productivity and greater competitiveness; but it prevented the development of financial markets in the long run. This process is called management of economic rents and it stressed the importance of State leadership to act as a mediator and prevent industrial policy from weakening entrepreneurship and hampering growth.
Research studies reveal that employment elasticity of the growth in trade has declined significantly. Thus, developing governments must be proactive in moderating the impact of globalization to labor employment since industrial policy must also ensure that the income of the local population is sustained. Sharp changes in the structure and production methods must be avoided. The State must be committed in employing in industrial policies that increase jobs and reduce poverty in the long run.
International Competitiveness
Firms are responsible for ensuring competitiveness through good technological choices, profit deployment, and policies. They cannot blame uncompetitiveness to the State. At the industry level, competitiveness depends on the effectiveness of networks among domestic firms and State industrial policy. National competitiveness, on the other hand, is not just measured by export growth or balance of trade, but by rising productivity and higher domestic living standards. Rising wage rates also indicate the positive performance of industrial policy. Constantly rising wage rates would be consistent with increasingly rising rents of the industry.
An increase in the wage share could increase domestic consumption, overall economic growth and investment. An increase in capital share could also increase investment, investment, and long-term growth. In the Philippines, capital share has been increasing faster than labour share. This shows that on top of price and exchange rate effects, the country is also losing in competitiveness due to increased profit margins, instead of increased labor costs.
Political Economy of Industrial Policy
Industrial policies must be supported by the government. Some States have unconsciously undertaken industrial policy, like tax and tariff incentives to foreign investment, which benefits specific investors and improves the efficiency of the whole economy. It involves bureaucratic meddling into economic processes.
By standard view, this is considered harmful. Some argue that government intervention might stifle technological progress and inhibit firm natural selection. The dominant and convenient view is for governments to avoid proactive industrial policy. However, in real life, private actors coordinate among themselves to overcome business vulnerabilities. Government intervention to restrain or augment this behaviour results to unconscious industrial policy.
Active industrial policies are composed of:
· Planning, identification, and strategy formation
· Implementation (trade regime, subsidies, regulation of entry and exit)
· Evaluation and strategy adaptation
Powerless State: Myth or Fact
Pack and Saggi (2006) suggest that governments are not competent enough to help domestic firms foresee and deal with unknown changes in their respective industries. On the other hand, some analysts take the opposite view that selective government intervention must be utilized to assist firms. As recent development strategy has shifted its focus to interventions required to meet the Millennium Development Goals (MDGs), it has been observed that the same capabilities that seek to meet the seven MDGs are the same kind of capabilities required for industrial policy.
The policy space for industrial policy is being constrained by domestic reforms and international trade agreements. On the other hand, since the international community is committed in achieving the MDGs, States became more empowered to enact policies aligned with the MDGs. Since economic growth is necessary to alleviate poverty, developing countries have focused on reforming the legal system to approximate the structure of Western countries. However, they missed the fact that complementary institutions and norms are needed to make reform effective. Western States and the private markets have established relationships that might be absent to developing countries. Hence, industrial policies must be backed not only by technological capabilities, but also improvements in State policy institutions and norms of behaviour in the private sector.
The standard analytical framework of economics overlooks innovation and learning when analysing economic growth and development. For developing countries, system construction and promotion must be highlighted. Universities and research institutions must be cultivated especially for the least developed economies.
The policy space of developing countries has been restricted throughout history. During times of high tariffs and industrial protection in the 1960s and 1970s, developing countries experienced rapid growth. Today, international economic relations are shaped by a system of bilateral, regional, and multilateral trade treaties. Analysts have discussed how developing countries can undertake industrial policy under the current system. However, less restriction must be accompanied by transparency and accountability to retain good governance and avoid expropriation and depletion of resources.
Multilateral trade rules from the Uruguay Round, the WTO Agreement on Subsidies and Countervailing Measures, the Agreement on Trade-Related Investment Measures, and the Agreement on Trade-Related Aspect of Intellectual Property Rights have all limited investment and policy space by restricting policy tools, prohibiting subsidies, barring the use of performance requirements on foreign investors, and restricting the use of foreign technology without compensation[2].
The rush toward external markets has increased the completion of developing countries among each other. However, this phenomenon has sometimes resulted to an even constrained policy space. Latin American countries, for example, hasted towards free trade negotiations and agreements with the US. Such arrangements restricted their policy space due to stringent intellectual property protection, access to key service sector, and abdication of policy instruments.
The Potential for State Intervention
The State has no choice but to undertake industrial policy if it wants to address sectoral development and overcome coordination failures in private markets. Even if it avoids it, they still often find themselves taking selective intervention to maintain supply outcomes and respond to political pressure.
The State is responsible for providing protection against financial instability and establishing capability to overcome deficits during contractions and store surpluses during expansion. An active fiscal policy would require recovering fiscal autonomy and eliminating structural deficits.
States must also identify the priority sectors and the type of interventions that are specific with regard to products. Hausmann and Klinger (2006) suggested that countries must identify: products that poor countries should aspire to produce; and the closeness between products so that planning can proceed on where countries might start their industrial policy. At levels above the sectoral level, the role of governments in public investment and FDIs that are consistent with the country’s development strategy is important.
Governments must assist in developing capabilities, coordinating investments in vertically linked activities, and undertaking collective learning. The State must assist small and medium scale enterprises and upgrade domestic capabilities. Large companies can assist the government in these undertakings, but the primary actor is still the government.
Developing countries that want to develop service exports must undertake investment in specific skills, take into account the size of the population, and take advantage of scale economies. Historically, the strongest services exports have involved construction services and specialized services like oil drilling; recently, medical tourism has also been growing. As a significant part of export earnings come from remittance of overseas workers, developing countries must seek to effectively manage and safeguard remittances. In addition, the State could encourage returning overseas workers to impart their skills to indirectly increase domestic capability.
Role of International Institutions in Widening the Policy Space
The State must consider the trade-off between following international rules and commitments and the policy space restriction. The international community currently manages international trade through tariffs, subsidies, and product standards. They must recognize that countries need to be responsible for their own development and their policy space should not be too restricted. Countries must be proactive in framing their development strategy. When the country is still developing its resource-using industries, tariffs could be low or zero for labour-intensive and advance technology products and reverse it later. Without industrial policy, the State will be restricted in protecting existing competitive industries, instead of supporting new industrial sectors.
Source:
Who’s Afraid of Industrial Policy? Asia Pacific Trade and Investment Initiative, UNDP Regional Centre (Colombo, 2008).
[1] State intervention in mature industries will amount to pure subsidy on costs in favour of global consumers.
[2] The WTO Agreement on Subsidies and Countervailing Measures somehow creates additional market correcting policy space for poverty reduction and technological development, and environmental improvement.
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