Import Substitution Industrialization in Latin America: Experience and Lessons for the Future Carlos A. Primo Braga1 I.

Introduction Werner Baers contributions to the analysis of Latin American economic development occupy a well deserved place in the economic literature dedicated to the region. But Werner is an unusual scholar. He has been not only an influential thinker and researcher, but also he has engineered one of the largest informal networks of scholars interested in Latin American economics -- encompassing generations of his students (including myself) and collaborators at Vanderbilt University, the University of Illinois at Urbana-Champaign, the University of So Paulo, the Catholic Universities in Rio and Lima, etc. Accordingly, his impact on the debate of Latin Americas economic experience goes well beyond his writings. In this paper, I discuss his analyses of the pros and cons of import substitution industrialization (ISI) in Latin America, focusing mainly on the case of Brazil. I review a selected number of his many contributions to this literature and, in particular, I ask to what extent some of the questions posed by his earlier papers on ISI remain relevant to the contemporary debate on trade and development. Section II reviews the main insights and questions that can be extracted from some of his contributions to the literature. Section III revisits some of these questions from the perspective of the ongoing debate on trade and development. Section IV concludes.

Carlos A. Primo Braga, Senior Adviser, International Trade Division, The World Bank. Paper prepared for a seminar in honor of Professor Werner Baer, held at the University of Illinois at Urbana-Champaign, December 1-2, 2006. The views expressed here are personal and should not be attributed to the World Bank Group, its Executive Directors, or the countries they represent.

II. ISI: Experiences and Interpretations

This section borrows its name from one of Werners seminal papers (Baer 1972) which analyzed the process of Latin American industrialization in the 1950s and 1960s. In that paper, the nature of ISI, the results of the industrialization process and the prospects for future development policies in the region were reviewed. Stiglitz (1987, p. 141) points out that there are two conflicting paradigms for development strategies. One emphasizes the importance of the principle of comparative advantage, preaching free market and export oriented policies. The other highlights that there is a natural path of development and that path, for most part, involved heavy industrialization. This development strategy has been typically associated with interventionist trade policies and focus on fostering a domestic market via ISI. In his evaluation of the ISI experience in Latin America, Werner Baer adopts an analytical approach that borrows from both paradigms. He presents ISI as destiny while criticizing the excessive attention to efficient allocation of resources that could perpetuate a focus on myopic comparative advantage (i.e., a static rather than a dynamic perspective). At the same time, he recognizes that one-size does not fit all in evaluating ISI experiences in Latin America. Accordingly, he underscores the relevance of some of the criticism coming from adepts of the market-oriented paradigm, while pointing out that some of this criticism applies much better to small economies (e.g., Chile) than to the larger Latin American economies (e.g., Brazil). The point of departure of his evaluation is the proposition that all countries which industrialized after Great Britain, went through a stage of ISI; that is, all passed through a

stage where the larger part of investment in industries was undertaken to replace imports and that in this early ISI process [in Europe and the United States in the XIX century] governments played an active role in encouraging and protecting the development of infant industries (Baer, 1972, pp.95-96). He goes on to attribute the delay with which Latin American countries embarked in this process to socio-economic considerations: an elite focused on the high profitability of primary exports, supply-side bottlenecks (weak entrepreneurial classes, poor endowment of skilled labor, and inadequate infrastructure), as well as limited market size and pressures from external powers interested in the maintenance of liberal trade policies. His analysis of the historical path towards ISI in Latin America differentiates between ISI spurts induced from abroad (associated with external shocks such as the two world wars and the Great Depression) and ISI as a deliberate policy tool for economic development in the 1950s and 1960s. He points out that after World War II, most of the larger countries of Latin America implicitly or explicitly accepted the ECLA analysis of the hopelessness of gearing their economies towards the traditional world division of labor (Baer, 1972, p. 97). In most countries, the mix of trade and macroeconomic policies adopted in this phase typically involved trade barriers and exchange rate controls, taxing export activities and fostering import substitution. In many countries this was complemented by a complex mechanism of preferences for strategic imports (e.g., capital goods and industrial raw materials), the direct participation of the state in the economy (via state-owned enterprises) and cheap credit for strategic sectors. It is worth noting, however, that foreign capital was often an important partner in this process by transferring know-how and

organizational capabilities while benefiting from the rents associated with protected markets. ISI led to significant structural changes in the Latin American economies in the postWorld War II era, with the manufacturing sector expanding its share in GDP between 1950 (19.6 percent) and 1967 (24.1 percent). Structural change was particularly significant in the case of Brazil were industry increased its share in the economy from 19.8 percent in 1947 to 28 percent by 1968. Industrial growth became the main driver of Latin American economies over these two decades. By the 1970s, however, the ISI model was already reaching its limits. Not only the size of Latin American domestic markets constrained the opportunities for further industrialization, but also the accumulation of distortions associated with the panoply of government interventions imposed a growing drag on the growth prospects of these economies. Moreover, monetary and fiscal profligacy often became the macroeconomic companions of ISI, as governments tried to stimulate economies amid growing signs that the growth dividend of the easy ISI phase was gone. These actions paved the way to the growing external debt and balance-of-payment crises experienced by Latin American countries in the 1980s. In a paper co-authored with Don Coes (Baer and Coes, 2002, p. 862), which focuses on Brazil, Werner points out that macroeconomic pressures, especially external ones, were the major forces in bringing this phase [ISI] of Brazilian economic history to an end. Over the last two decades, especially in the 1990s, the pendulum began to swing back to a much more open economic model, in which barriers to foreign trade and capital flows were substantially eased. This characterization can be extended to other Latin American

economies. At the same time, the inevitable question is to what extent can the pendulum once again swing back towards a more interventionist and closed model of development? After all, as pointed out in Zagha, Nankani and Gill (2006, p.9), although nearly every country in Latin America and the Caribbean has pursued economic reform, growth over the last two decades has remained elusive. Against this background, the fact that reform fatigue has become a common-denominator in the region is not surprising. An answer to the chances of recidivism (particularly with respect to protectionist trade policies) has to address not only economic considerations, but also the evolving political environment in Latin American countries. In this paper, I will limit myself to the economic aspects that Baer identified as major challenges for policy-makers dealing with the implications of ISI in the 1970s. It can be argued that these issues (Baer, 1972; 1984) provide a useful reference to judge the extent to which policy options adopted in the 1980s and 1990s have paved the way for a sustainable model of economic integration for Latin American economies.

III. Revisiting the Trade and Development Nexus

One possible characterization of Baers extensive review of the key challenges faced by Latin American policy makers in the aftermath of the ISI phase can be summarized by the following three questions: (1) can trade policy be an effective instrument for a pro-active industrial policy?; (2) could Latin American countries adopt the Asian model (of manufactured-based outward orientation)?; and (3) can the trade regime be reformed in a

way that helps poverty alleviation and fosters a more equitable distribution of income? The answers to these questions are explored below.

The revival of interest in industrial policy By the late 1990s, some analysts felt confident enough to argue that It is generally believed that import substitution at a minimum outlived its usefulness and liberalization of trade is crucial both for industrialization and economic development. (Krueger, 1997, p.1). But the eternal debate about the pros and cons of industrial policy (and trade protectionism) has taken a new format in the last few years, reflecting the contributions of authors such as Rodrik and Hausmann and reviews of the lessons from the 1990s.2 At the core of this debate is the proposition see Baer (1972, p.110) -- that there is no easy economic method to evaluate if the costs of ISI-related inefficiencies dominated the modernization or development brought by ISI. In other words, to what extent the costs of resource misallocation and rent-seeking behavior surpassed the benefits of diffuse externalities associated with technological progress and learning-by-doing. The answer to this question remains controversial. Some (e.g., Rodrik 2006) argue that the focus on static efficiency gains does not amount to a growth strategy. From this perspective, the dismantling of trade interventions will not necessarily pave the way to a new model of export-driven development. According to this perspective, the reduction of the anti-export bias brought by comprehensive trade liberalization in Latin America did not generate enough incentives for steering these countries into an export-driven growth path. These critics emphasize, for example, the importance of self discovery i.e., the knowledge generated by firms that invest in experiments to identify what they are good
2

See Rodrik (2004); Hausmann and Rodrik, (2006), and World Bank (2005).

at producing and exporting arguing that unless there is a pro-active governmental policy to stimulate these experiments this type of entrepreneurship tends to be undersupplied, inhibiting the process of economic diversification and growth. In sum, although the debate on the Latin American experience with respect to ISI has converged to the recognition that wholesale trade protection is not conducive to sustained economic growth, many of the questions posed by Werner Baer in the 1970s remain relevant to the debate about how best to implement trade policy as a lever to a growth-oriented strategy. The revival of interest in policy activism illustrates the currency of many of the points raised in his earlier contributions.

Export Pessimism? Baer (1984, p. 133) poses the question [could] the world have accommodated a situation where many Latin American countries would have emulated the East Asian superexporters? He goes on to quote Cline (1982) suggesting that if most developing countries were to follow this model this would have resulted in untenable market penetration into industrial countries. Export pessimism in its different formats (secular decline of terms of trade for commodity exporters, the political economy of market access in industrialized countries, etc.) has often been at the very core of inward-oriented strategies of development. The Cline experiment focus on the implications of generalizing the manufactured-exports intensity achieved (1976) by the Gang of Four (Hong Kong, China; South Korea; Singapore; and Taiwan, China) to all developing countries and argues that the fallacy of

composition holds i.e., if all developing countries were to adopt an export-oriented strategy the results would be quite different from the experience of the super-exporters. The reality of the expansion of Chinas exports in the last two decades, however, underscores that the scope for expansion of manufactured exports from developing countries was much bigger than export pessimists believed. The absorptive capacity of import markets is often underestimated, in particular, with respect to opportunities for intra-industry trade. Moreover, the main implication of implementing trade reforms that eliminate the anti-export bias of ISI practices is to allow private actors to explore unforeseen export opportunities, contesting new markets that are impossible to predict ex ante. Mexico and Chile, for example, have significantly expanded their export volumes (and value-added) in the last decade, illustrating that an outward-oriented strategy can be successfully pursued by Latin American countries. It remains true, however, that Latin American and Caribbean (LAC) countries have lagged behind East Asia & Pacific (EAP) countries in terms of their integration into the world economy. In the mid 1980s, both regions had similar trade to GDP ratios. By 2004, LACs trade to GDP ratio was 40 percent below that of EAP. In short, the region as whole has remained an underperformer in terms of trade expansion in spite of significant trade reforms in the last two decades. But as EAP countries performance illustrates, the reason for this has less to do with the absorptive capacity of industrialized countries than with macroeconomic variables (e.g., frequent reliance on overvalued exchange rates as monetary anchors) and institutional factors (e.g., government effectiveness, control of corruption), not to mention a distorted structure of production inherited from reliance on extreme ISI.

Trade and Poverty Another theme often addressed in Werner Baers work is the interaction between trade regimes, poverty and income distribution. He highlights (Baer 1972, p. 178), for example, the difficulties in pursuing redistributive efforts in the post-ISI era to the extent that the profile of the productive structure which resulted from the ISI process reflects the demand profile [often based on quite unequal income distribution] which existed at the time when the process was started. Baer (2002) contrasts neo-liberal policies followed by most Latin American countries in the 1990s with the ISI era. He points out that although ISI helped diversify the economies of the region and neo-liberalism increased efficiency by opening the economies to more trade and foreign investments none of the regimes effectively solved the regions distributional problems (Baer, 2002, p. 309). Werner Baers skepticism about the impact of trade liberalization a usual backbone of neo-liberal reforms on poverty and inequality is warranted. After all, it is important to recognize that trade liberalization can be a force for poverty reduction, but the ultimate outcome will depend on many other factors, including initial conditions of the country undergoing reform, the nature of the reform, who the poor are, and how they sustain themselves.3 Analyses of the linkages between trade and growth, both cross-country analyses and country-specific studies, tend to confirm a positive association, even though the magnitude of such a relationship is controversial. After all, there are no examples of countries sustaining long-term growth without being open to trade. Sustained economic

For a detailed analysis of the evidence on the links between trade liberalization and poverty see Winters, McCulloch and McKay (2004).

growth, in turn, is typically associated with improvements in the minimum standard of living and poverty reduction over time. Trade liberalization can contribute to this process not only by promoting growth, but also by changing the relative prices of the products that are relevant to the poor. In developing countries, protection is often higher on relatively skill-intensive goods.4 Thus trade liberalization can benefit the poor over those better-off via its impact on prices. It is well known, however, that trade liberalization generates both winners and losers. Households with little access to credit or that are located in remote areas where subsistence farming is prevalent may not benefit from the process. Moreover, imperfections in the price transmission mechanism are often present in developing countries where markets are characterized by high transaction costs and are poorly integrated into the international economy. In Mexico, for example, world prices have been differentially transmitted on a regional basis, depending on distance from the border and nature of the traded good (Nicita 2005). As a consequence, Northern states can expect more reduction of poverty associated with trade liberalization than Southern ones. In other words, trade liberalization can increase income inequality and this underscores the importance of complementary governmental policies to deal with its side effects. It is also important to recognize that income effects of trade reforms are relatively more important for the poor than consumption effects. If the price of one commodity increases significantly, it is often possible to consume less of it. But it is much more difficult to shift from being an unskilled worker, to being a skilled worker or to become an entrepreneur. The wage rate of unskilled labor remains the key variable in determining if the poor gain more or less than the average in the process of trade reform. In modeling
4

Note that this is not necessarily the case in LAC as pointed out by Perry and Olarreaga (2006).

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trade liberalization in the case of Brazil, for example, Ferreira Filho and Horridge (2005) show that multilateral trade liberalization could improve income distribution in Brazil, reflecting its potential impact on agriculture and related industries in the poorest parts of the country. As pointed out in World Bank (2005, p. 151), however, the evidence on trade liberalization and wage inequality remains inconclusive. In Argentina, Brazil, Costa Rica, the Dominican Republic, and Mexico, the industries that are most exposed to international competition pay the highest wages. To the extent that adoption of new technologies could be fostered by trade openness, this can lead to a relative increase in the demand for skilled labor, leading to more inequality. Actually, Perry and Olarreaga (2006) argue that in the case of Latin America relative factor endowments (relative richness in natural resources), dynamic effects of trade (leading to skill-biased technical change), and a prereform structure of protection biased towards unskilled labor intensive sectors explain increases in the overall income inequality in LAC in contrast with the experience of other developing regions. Summing up, it is clear that trade liberalization is not a silver bullet to deal with poverty and income distribution problems. In this context, Werner Baers concerns remain valid and underscore the complexity of addressing these issues in the post_ISI era. Measures to facilitate trade and market integration, as well as labor market reforms, education policies and social safety nets are important complements to trade reform as far as the final distributive impacts of trade liberalization are concerned. IV. Concluding Remarks

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As illustrated by this brief review of some of Werner Baers contributions to the literature on economic development in LAC, many of the questions raised in his seminal work remain relevant to the modern debate on trade liberalization and models of development. For those like me, who have benefited from Werners intellectual leadership and friendship, this is both a reminder of the relevance of his contributions to the economic literature and a reassurance that North-South academic collaboration can make a difference.

References Baer, Werner (1972), Import Substitution and Industrialization in Latin America: Experiences and Interpretations, Latin American Research Review vol. 7 (Spring): 95122. Baer, Werner (1984), Industrialization in Latin America: Successes and Failures, Journal of Economic Education (Spring): 124-35. Baer, Werner (2002), Neo-Liberalism in Latin America a Return to the Past? Financial Markets and Portfolio Management 16 (3): 309-15. Baer, Werner and Donald V. Coes (2002), National sovereignty and consumer sovereignty: Some consequences of Brazils economic opening, The Quarterly Review of Economics and Finance (42): 853-63. Berg, Andrew and Anne Krueger (2002), Trade, Growth and Poverty, paper presented at the 2002 Annual Bank Conference on Development Economics, mimeo. Cline, William R. (1982), Can the East Asian Model of Development Be Generalized? World Development 10 (2): 81-90.

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Ferreira Filho, Joaquim Bento de Souza and Mark Horridge (2005), The Doha Round, Poverty, and Regional Inequality in Brazil, in Thomas W. Hertel and L. Alan Winters, eds., Poverty & the WTO: Impacts of the Doha Development Agenda (Washington, D.C.: World Bank and Palgrave McMillan). Hausmann, Ricardo and Dani Rodrik (2003), Economic Development as SelfDiscovery, Journal of Development Economics (December). Krueger, Anne (1997), Trade Policy and Economic Development: How We Learn, American Economic Review 87(1): 1-22. Nicita, Alessandro (2005) Mexican Households: The Effect of the Doha Development Agenda, in Thomas W. Hertel and L. Alan Winters, eds., Poverty & the WTO: Impacts of the Doha Development Agenda (Washington, D.C.: World Bank and Palgrave McMillan). Perry, Guillermo and Marcelo Olarreaga (2006), Trade Liberalization, Inequality and Poverty Reduction in Latin America, Paper presented at ABCDE Conference, San Petersburg, mimeo. Primo Braga, Carlos A. (2005), The Policy Coherence Agenda: Connecting Debt and Trade, in Debt and Trade: Time to Make the Connections (Dublin: Veritas Publications). Rodrik, Dani (2006) Goodbye Washington Consensus, Hello Washington Confusion? Journal of Economic Literature, forthcoming. Srinivasan, T.N. and Jagdish Bhagwati (1999), Outward-Orientation and Development: Are Revisionists Right? mimeo Stiglitz, Joseph (1987), Learning to learn, localized learning and technological progress, in P. Dasgupta and P. Stoneman, eds., Economic Policy and Technological Performance (Cambridge: Cambridge University Press).

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Winters, L. Alan, Neil McCulloch, and Andrew McKay (2004), Trade liberalization and Poverty: The Evidence So Far, Journal of Economic Literature XLII (March): 72-115. World Bank (2005), Economic Growth in the 1990s: Learning from a Decade of Reform (Washington, D.C.: The World Bank). Zagha, Roberto, Gobind Nankani, and Indermit Gill (2006), Rethinking Growth, Finance and Development 43 (March): 7-11.

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