A child’s guide to Prema-chandra Athukorala chinthana on import substitution

Import substitution which has been a very popular economic strategy in most of the developing countries in the 1960s and 1970s has had a political economy side in addition to the pure economic side as well – Pic by Shehan Gunasekara 

Athukorala says that it is through experience that some countries got themselves freed from this ideology and got their salvation through the opposite policy strategy, namely, producing for the rest of the world rather than for the domestic economy. That strategy was called the export oriented economic strategy which produces for a market bigger than the domestic market. What this meant was that even developing countries can become winners if they produce the right type of goods in the right way to the world market. For them, the conspiracy theory that rich countries are bent on exploiting poor countries did not apply

The Sri Lanka-born world-renowned economist, formerly a Don at the Australian National University, in a webinar hosted by Advocata Institute has outlined his wisdom or ‘chinthana’ on import substitution (available at: https://youtu.be/hHV5UdKxpEw). Aseni, the whiz kid on economics had watched it but could not understand many of the high-flown economic stuff presented there. She sought the assistance of her grandpa, Sarath Mahatthaya, a former employee of the Ministry of Finance, to help her understand it. This is the conversation between the two on the subject.

Aseni: Grandpa, Professor Prema-chandra Athukorala had addressed the Sri Lankan audience through Zoom platform under Advocata’s myth-buster series on import substitution, a hot topic in Sri Lanka today. What is this import substitution?

Sarath: Import substitution which has been a very popular economic strategy in most of the developing countries in the 1960s and 1970s has had a political economy side in addition to the pure economic side as well. The political side goes as follows. These developing countries which had gained independence from their respective colonial masters had called themselves the third world countries to distinguish them from the first world ruled by USA and its military alliance North Atlantic Treaty Organization or NATO and the second world ruled by the USSR and its military treaty called Warsaw Pact. Hence, the division was not economic but political or military.  

The third world countries thought they did not belong to either pact and, hence, non-aligned, which was also an illusive thought since no country could exist without being aligned to these world powers. It was natural that these third world countries had the aspiration to become a developed country within the shortest time possible. However, they had been exporting primary products like tea, rubber, and coconut as in the case of Sri Lanka and minerals and raw materials as in the case of many African and Latin American countries, while importing finished industrial products largely from the first world and to a lesser extent from the second world. 

But they could not realise their dreams because they were faced with adverse market conditions. The prices of the primary products were mostly stagnant, while those of industrial products were rising in the global markets. As a result, these third world countries had to sell more units of primary products to buy a unit of an industrial product. For instance, Sri Lanka had to sell more kilos of tea to buy a motor car. In economics, this is called adverse terms of trade that measures the units of exports which a country must make to buy one unit of imports. Since this was a recurrent feature, the third world countries began to believe that there is a conspiracy on the part of the Western world to exploit their resources. 

This belief which became an ideology was known as ‘Third-worldism’, a term coined by the Venezuelan writer Carlos Rangel in a book published in Spanish in 1982 under the title ‘El tercermundismo’. The title literally meant Third-worldism. This book was published in English in 1985 as Third World Ideology and Western Reality with the subtitle ‘Manufacturing Political Myth’. In this ideology, Rangel said that the third world countries believed that the rich countries have become richer by stealing from poor countries not only during the colonial times but also after independence by offering an adverse terms of trade to them through trade. The third world leaders like Kwame Nkrumah of Ghana and Julius Nyerere of Tanzania firmly believed in this ideology. Sri Lanka’s Bandaranaikes simply followed it. One of the solutions suggested by the third-worldists to address the issue was import substitution. 

Under this, it was suggested that the third world countries should reduce import dependence on the Western world by producing the same in their own countries. This had the support of a very strong political ideology which was appealing to the masses. Hence, when the economists suggested the opposite, there were no takers. This was relevant even to rich countries. Those leaders too advocated that they should produce everything on their lands cutting down imports. If you examine Canada’s motor car industry, you will realise that it is simply an import substitution industry in 1960s and 1970s. A more recent example is the economic ideology of US President Donald Trump. He was and is even now very popular among American voters because of this appealing ideology. 

Aseni: Has Athukorala talked about this aspect of political economy, which is being shared by almost all, including leading economists, in Sri Lanka?

Sarath: No. But he has talked about a different type of political economy later in his presentation. That is, once import substitution is offered by a government as a solution, those who benefit from it – we call them rent seekers because they get an income which they do not earn through sacrifice of resources or hard work – protest its withdrawal even after it has been found that they have produced sub-standard products. If the government is weak and cannot resist their bullying, they yield to their wishes. So, economy continues to suffer as a result of this type of political economy. But Athukorala has said that if the government is strong like the one under President Park Chung-hee in South Korea and Chiang Kai Shek in Taiwan, it can punish those errant rent seekers. Without that, import substitution can build an empire of rent seekers who cannot be defeated easily. 

Aseni: Thanks, Grandpa. But Athukorala has suggested two types of import substitutions, one voluntary and the other forced. What are they?

Sarath: There is nothing wrong in a business firm to take advantage of technology and other resources available within the country, produce a good or a service that is being imported to that country from abroad, and compete with those imports. That company does not seek government’s support for carrying out its business. That is voluntary import substitution which is beneficial and sustainable. As against this, there is the more popular type and the one being promoted by third-worldists in which the government increases tariff or restricts importation of the product so that the local company can produce the same commodity for the local market. That is forced import substitution. What was practiced in Sri Lanka was this second category. 

Aseni: Is there any example of Sri Lanka practicing voluntary import substitution?

Sarath: Very rare. But one example I can quote is the Centric Water Pump manufactured by Jinasena Ltd. At first, it was forced import substitution because the company was able to manufacture and supply this water pump to the local market benefitting from the government’s banning of the importation of water pumps to the country. But this was changed after Sri Lanka went for an open economy system in 1977 when the local market was flooded by cheap water pumps from Taiwan, Hong Kong, and Singapore. 

I recall the MD of Jinasena Ltd., the late Dr. Nihal Jinasena, narrating his story at a public lecture held in the Central Bank in 1989. He said that when these cheap water pumps were introduced to the market, he lost the market to them because his costs were higher. Jinasena Ltd. had therefore decided to hire a British engineer to find out why their costs were high. That engineer had found that about 65% of the parts that had been used in the Centric Water Pump had not served the main purpose of a water pump, namely, lifting water from a lower place to a higher place. 

They therefore reengineered the water pump, cut its costs, and not only successfully competed with the imported water pumps, but also managed to export them to some neighbouring countries. Even today, there is no competitor, price or quality-wise, to Jinasena Water Pump. This is a good example of how a forced import substitution was converted to a voluntary import substitution. 

Aseni: This political economy apart, Athukorala has referred to Prebisch-Singer Hypothesis as economic rationale for import substitution. Who are these Prebisch and Singer?

Sarath: Raul Prebisch and Hans Singer are two leading development economists in the 1950s and 60s. Prebisch was an Argentinian economist and became the founding Secretary-General of the United Nations Conference on Trade and Development, known as UNCTAD, which later became an advocate for the case of the developing world. Hans Singer was a British economist who had got his doctorate from Cambridge University under the supervision of John Maynard Keynes in 1936. Later he joined United Nations Industrial Development Organization or UNIDO. Though Prebisch and Singer had collaborated with each other, the famous Prebisch-Singer Hypothesis was developed by them working separately. This hypothesis is same as what the third-worldists had preached. 

It simply said that world trade is such that developing countries specialise in producing primary products and export them to industrial countries as raw materials. The latter use them for producing industrial goods and send back to developing countries. Since the prices of primary products rise slower than those of industrial products, the developing countries are eternally faced with the problem of adverse terms of trade hitting them. Hence, they remain poor and industrial countries rich. This was in fact sweet music to political leaders in developing countries who are bent on introducing import substitution strategies. 

Aseni: How did that sweet music become coarse music later?

Sarath: Athukorala says that it is through experience that some countries got themselves freed from this ideology and got their salvation through the opposite policy strategy, namely, producing for the rest of the world rather than for the domestic economy. That strategy was called the export oriented economic strategy which produces for a market bigger than the domestic market. What this meant was that even developing countries can become winners if they produce the right type of goods in the right way to the world market. For them, the conspiracy theory that rich countries are bent on exploiting poor countries did not apply. 

Aseni: How does this happen, Grandpa? We were also taught at school that developing countries cannot seek salvation through rich countries which are their enemies. For instance, we were taught that, say for example, USA wants to help Sri Lanka because they have a hidden agenda to exploit our natural resources. Aren’t our teachers correct? 

Sarath: Not only your teachers. Even the educated people share this view. You may recall that at the previous Presidential election in Sri Lanka, Gotabaya Rajapaksa’s election campaign was conducted against the proposed Millennium Challenge Corporation or MCC Grant offered by US Government. His thinktank called Viyathmaga went to the extreme extent. Its leaders who even hold doctorates in medicine and philosophy told people that US Government was planning to create a separate country here and as a result, the Sinhala Buddhists will have to take Visa from that country to visit ancient Buddhist religious places located there. Therefore, this fear of foreigners is imbedded in the psyche of Sri Lankans. 

But Athukorala says that this was not the case with Singapore, South Korea, Taiwan, and Hong Kong. Those countries got themselves freed from the third-world ideology and promoted an export-oriented industrialisation policy. That was a success and they managed to break away from the rest of the herd. By embracing new technology and relying on what is known as total factor productivity, they were able to compete successfully with industrialised countries. 

Aseni: Wow! Total factor productivity? I have heard of the term, but I do not know much about it. What is this, Grandpa, and how does it affect a country’s development strategy?

Sarath: When we produce something, we must use inputs which we call factors of production. There are four, but for simplicity we reduce them to two, labour and capital. Both have some technical output levels, labour contributing to say 70% and capital 30%. Suppose that a man uses his hands to clear a garden of weeds. If he can clear a garden of one acre in eight hours manually, the entire output is his own contribution. Now we will give him a mamoty and he will be able to clear that area within half a day. Therefore, his daily output now is two acres. How does this happen? Because the mamoty makes him more efficient. 

Economists will disaggregate this two-acre clearing into how much by labour alone and how much by capital alone. If that extent is less than two acres, the increase of the extent is due to the combined effect of both labour and capital together. That residual part is called the total factor productivity. Higher the total factor productivity, higher the total output which that country can get. If it is high enough, they can easily compete with any industrial country. This was how these new entrant developing countries could penetrate global markets and have a share in it. Those countries which had gone for import substitution could not get that advantage. 

This fear of foreigners is imbedded in the psyche of Sri Lankans. But Athukorala says that this was not the case with Singapore, South Korea, Taiwan, and Hong Kong. Those countries got themselves freed from the third-world ideology and promoted an export-oriented industrialisation policy. That was a success and they managed to break away from the rest of the herd. By embracing new technology and relying on what is known as total factor productivity, they were able to compete successfully with industrialised countries

Aseni: Then it is a question of failing to follow correct policy strategies rather than being subject to a Western conspiracy. But people still love to hold those conspiracy theories as explanation to their failures, don’t they, Grandpa?

Sarath: Yes, those conspiracy stories give us temporary solace. Therefore, we love to believe in them, talk about them, and share them with others. Also, many in Sri Lanka promote such conspiracy stories to gather personal benefits for them. The current protest wave against many foreign direct investments has its origin in the fear of foreigners. But they are all staged by people with personal agendas. 

Athukorala has referred to some episodes relating to shoe manufacturing in which a single manufacturer had held monopoly power over it under import substitution schemes. When a foreign investor with a plan to manufacture shoes in Sri Lanka eyeing for the export market submitted his proposal to the Board of Investment, the government due to the pressure coming from this manufacturer had killed the project. But Athukorala says that the latecomers to the export-oriented shoe industry like Cambodia have prospered in it creating both employment and export revenue. These are missing of opportunities by Sri Lanka voluntarily due to ignorance of how the world trade takes place. 

Aseni: What this means is that the Government and its leaders should have a wide world outlook and foresight to steer Sri Lanka’s future growth policy. Athukorala has referred to the need for joining the global production sharing networks and be winners in the globe. I hope that this message is positively received by the present policy leaders in the Government. 

Sarath: Yes, indeed. Athukorala has written extensively on production sharing networks, and you can access them by making an internet search. We should exert pressure on Sri Lanka’s economic policy leaders to read them before they seek to design suitable policies for overcoming the present acute economic crisis which will bring the entire country to a standstill soon.

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)