UNITED NAT IONS
AFRICAN INSTITUTE FOR ECONOMIC DEVELOPMENT AND PLANNING
DAKAR
IDEP, 2nd Semester, 1964-65
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FOREIGN TRADE Import Substitution I. Foreign Trade and the Process of Development·
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IDEP/ET/VII/342 D. Carney
2nd Lecture
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Economie growth and development is generally recognized as consisting of two distinct but relatèd ~rocessesg
a) an increase in total and pe~ capita income and
b) a reallocation of resources among new and existing uses, involving technological change in the production and distribution of goods and services.
National income analysis teaches that in order to increase the level of incarne it is necessary to operate simult3neously on the two major
componente of the income~uation, Y= C + I; but that the more important of the two determinants of incarne is I, if Y is to increase rapidly, since fluctuations in Y are primarily determined by fluctuations in I.
The role of foreign trade in economie development may therefore be conceived as being to supply the two categories of goods comprising the Y-equation:
(i) investment goods and the associatéd technology and services (ii) consumption goods and the associated services
Rapid growth of incarne requirea that, since a developing country's exports are limited at any one time and within a short period of time, the composition of its total volume of imports (which is similarly
limited by its total volume of exports in the abseace of foreign loans ,.~.
and :investment) should be adJusted in favour of inv:lstment goods. In o ·.her l- words, the tendency to a rise in the consumption goods component of
imports under the stimuli of the "demonstration effect" and a rising standard of living should be controlled or held down in favour of an increase in the proportion of investment goods. Furthermore, a policy of diversification of import sources with a view to taking advantage of
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IDJ!;P/ET/VII/342 Lecture 2
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least ëO~t· sources of -supply of capital should re sul t --~:!l·:·n(3gqtiation of bilateral long-term trade agreements 1.-ith selec.ted capi tal-supply countries. Additionally, exporta could be advantageously increased to
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various capital-s".J.pply count::'ie8 with a viewto increasing·forei'gn- eY-olw.nge vri th which t-J incroase the volume of capital imports. For the pu:rpose of this analysis? ra7 mEtte:cial imports wvuld count as investment goods.
-I T,_.. R 1 -f T + "' ' . -~-·· .L · . · ·
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~~-2.:.:._-nn~.~~--;;:u.o_.a-.::_..-~~Y..?..-.:?11 ~-• Wi thin th:-.s ge:1e:c-al tb.eoretical frameworl:? the ro],~ _()f .import
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substituti9n at an early stage of development is directly· linked to theprocess of holding dm-m importe of consum-ption goods. This is achieved in two iVIlys:
(a) by restriction or alimination of luxury consumption ~'71ports (b) by substituting domestio production of consumer goods
previouoly ~mpo:rtod.
Both methods boil down to the se.me tb.ing -- the elimination of inessential consumption imports. Only· at a later .:;to.ge in thG procesn of à.eveJopment does i t become .:worthwhile to substitute domestic production of capital goods for similar imports.
III. Factors to be taken into acco1...:nt i~_0o~_icL_pf !mpor.t-Substi tutiol:!_
(~) Raw material import~ - For sorne commodities substitution of domestic production for imports may mean the substitution of one kind of import (raw materia~s) for another (final cohsumer goods).
Thus in sorne Africa:-1 countries, the domestic production of beer and cigarettes l'fas originally based on imported hops and tobaccoo To the extent that the raw material imports have a value less than
~he previously im~orted final product a b~~oflt is deri~eà. in terms of foreign exchange.saved for more essential imports that cannot be p:r.:oduoed at home. If ho~'rever9 the ra-vr materiti1·s or
in<.~:::-::.~no'-'.:i.~;,·.'::o products are valued more than the final consume:!:' goods originally imported then there is no advantage in pursuing the policy of impor-t; substitut ion for .such commodi ties.
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IDEP/ET/VII/342 Lecture 2
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(b) Knowledge of the import requirements and technical conditions of production of displaced imports --I t. is therefore necessary to know in advance the import requirements and technical conditions of production (including import ()f highly-priced foreign skills) of a particular project before an attempt is made to displace importa by domestic production.
(c) Protection for domestic :product - In arder to get a foothold in the domestic market, it is often necessary t6 impose a tariff barrier to cheaper and more effici~utly produced substitutes from abroad.
This limits the consumer's choice with no guarantee that the domestic product will become popular. Hence it is also necessary to unde~t.~ke a marketing campaign.
(d) Advertising and marketing - A sales ca~raign ta make the domestic product popular is often necesqary, other\ÜOO consumers may scale the tariff barrier to get the foreign substitute. This has been the experience of many African countries - e.g. matches in Ghana, cigarettes in several African countries. One way to set a good example is for the Government to patronize the home product in requisitioning for stores and supplies.
(e) Loss of Import Revenue .. - Import substitution frequently results in a significant sacrifice of revenue especially since the commodities - like soap, salt, matches, beer, textiles - are
commodities of wide and relatively inelastic consumption. Consequent- ly ways must be found to make up this loss of important revenue
sources.
(f) Sales and Excise Taxes on the Domestic Product - One way of making up the loss of revenue on the domestic production of a formerly imported item is to impose an equivalent sales tax on the domestic item. This is easily done with items like locally refined gasoline where foreign enterprise is. often responsible for the operation.
But for other items sales taxation has yet to be widely adopted, and tbis depends on ensuring a system of proper accounting
procedures and the use of accounting machines and cash registers. The adoption of this innovation is a part of the general problem of fiscal reform facing many African countries today.
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.. Excise taxes on production may also be lsvted, ___ and. more easily than sales taJ~;es.
(g) Incentives to foreign and domestic enterprise (ether than tariff protection)to ensure. the suco~ss of a policy of import substitution.
The incentives freq_uently used include tax holidaysfor
5
to 10 years (another revenue loss but only potential as it did not accrue before on this :t:orm of . act·ivi ty) industrial si tes and low-re_nt . factories, concession rates for water and electricity, profit transfera etc.Three important considerations must be kept in mind in the adminis- tration of this policy.
(i) these advantages must be offset by stipulating the reinvestment of a proportion of earnings in expansion of the enterprisa or in diversificatio~;
(ii) adjacent countries should guard against excessive competition against o~e ano~her in the granting of such incentives; otherwise there might result undue duplication of production withou.t regard to ability of the domestic market to absorb the output at non-competitive priees with world substitutes, or a distribution of investment that is non-optimal. A country better suited to the production of a given item may be unable to
attract the foreign investors through inability to engage in urmecessary competition wi th more weal thy neighbours.
African countries have not ~sdaped these difficulties with regard to oil refinery, textile, and other commodities, investment in which could be more rationally and economically distributed.
(iii) Offsetting these advantages under (i) for the foreign
· investor, especially in regard to tax holidays, is the fact that under agreements for avoidance of double taxation the investor may still be liable for taxes in his home country even if not in the country of investment.
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(h) Ad.ditional Employrnent to be c:reated - Theo:re-tically and practically9 more capital-intensive projects >-Till in the long run promo-te mo:::-e output and employment. In the short run 9 however, the need to create more employment may be pressing. Thus countries that seek to aid domestic employment through import-substitution projects should carefully study the employm0nt implications of such projects as are encouraged.
(i) Need for expert aclvice and evaluation in the sektion of 12rojec!_~
for import-substitution - This cannot be too much emphasized as many African governments fail to adopt proper evaluation techniques or to take advantage of available expert advice. Consequently, projects are often encourageù ~>rhich9 on balance 9 are a net loss to the country and increase expenditure rather than saving of scarce foreign exchange. This danger is particularly present where
unsuspecting governments are baited by their mm policy of participa- tion in foreign enterprise. This policy9 pursued without discre- mination9 may land a government in the clutches of shady foreign businessmen who transfer all the losses to the government in an enterprise from Hhich, for reasons of prestige, it cannot back out, while the private partner talees all ...,he profits. There aretoo many
"sucker" governments in Africa today, and politicians often allow personal gain to o~~ide the national interest.
(j) Wisdom and unwisdom of state participation in private foreig~
enterprise under a policy of i~ort substitution
In vie1.-l of the limi ted resources of African gover:ornents at the present stage of their development, state-foreign participation in the production of import substitutes ought to be rather selective in order to avoid unnecessarily tying up government financial résources in fixed form. This counsel holds for industrial participation
generally, the exceptions being basic raw materials of industrial or strategi.n importance. In most cases provision for a reservation of a given percentage of equity for indlligenous investors (or for the state a-t its option on behalf of such indigenous investors to
IDEP/ET/VII/342 Lecture 2
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whom i t will be handed over at an appropriate time) will usually be found adequa.te to prote ct the national economie interest . When to this ic addeél.
a provision for reinvestment of a certa.in pe::rcentage of profits li tt le more could bè deeired. However~ in order to minimize involvement with shady overseas busi~ess e1:.terprises the rlecision to participate or not
should derive from the government's ow~ initiative and not at the invitation of the foreign investor concerneé'._, ~e.riff protection should not be
automatic but depen~ent on such oonsidera~ions as the contribution of the enter :çriee to
(i) net national product (ii) emplo;ywent
( :i.i:i.) saving in foreign exché,:::tge
( j_v) revem.,_e in form of sales and excise taxes c:;.nd1
eventually9 profits ta:::, as against the revenue lost by prccection
( 7) the est:Lmated priee of the final product vis-à--viE~
that of the competine import
(vi) contribution to the use of local materials
(vi~) transfer of skills to the local population in managerial and technical jobs
(v~ii) foreign exchange requirements for salaries of importad personnel and capital and dividend transfers 1 as
against saving in foreign exchange9 etc.
(j) Import-substitution on the basis of domestic materials - This is in gene:::-:::1 the best procedure as it not only may put into use previously unused
re sources but may also significantly re <luce foreign exchange requi:ceme~1tc 1
especially where domGstic lallour and materials consti·Gum t::1e g.1.·ea. ce:c pr.:·T of production costs.
III. Case Studies
(a) Project for the establishment of an oil refinery i:h country A 1v-:·üch
does not produce crude oil out is sorne î 1200 miles from country E ·v:hlch does produce crude oil and has a refinery9 the products of which are more accessible in terms of dista:J.ce to co"Lcntry A than Nere the products
formerly importeàg
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IDEP/ET/VII/342 Lecture 2
Page 7 Import of Petroleum Products
. j.nt9_ coun~ry A (tons}
Year For
1961 1962
(increase) ( decrease) 1967 ( pro,iected at
1 1. 4%)
Consumption 69.9912
77,886
7,974 ( 11. 4%) 133,810(41.5 million gallons approx, )
For Bunker
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Total 375,028 331,473-51,529 (-16.9%) -43,555(-11.6%) 364, 190 (residual on projectecl total refinery output of
498,000 tons or 133 million gallons appro;x:. )
Benefits accruing to Government Revenue and from local Expenditures (i) Local cost of oporating refinery
§Excise tax of
î/ -
(minirrn . .un) per gallon of output for à.omestic useSales tax of a minimum of 1d par gallon of output for domesti8 use
Total
172,916
f_ 2,437,916
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§ Wil~ accrue from imports of petroleum in absence. of refinery project. (ii) Other Benefits : Tax on profits at 9/- per f-1 of revenue will accrue
after 5-year tax-holiday and yield 45% of pre-tax revenue of f- 177,000 i.e. f- 79,650.
(iii) Contingent foreign exchange saving: fè 250,000 (i.e. net of repayment of loans, interest, remittance of dividends, profits, etc.)
Other D3.ta
~iv) Construction cost of refinery f:1,150,000 spent over 2 years, o-f': whicil f- 400,000 would be spent in local currency on materials, sorvice.:::, wages, salaries. Furthermore, the balance of f-750,000 could be available for government expenditure on development proJects on acoount of equipment imported under a foreign Credit Agreer!lent e;~
about 3-1/4%·
\(v) If construction of refinery began in 1963 it would be oompleted in 1965, so that 1966 anà. 1967 would be first and second years of full operation. (this has implications for the output and revenue for 1966).
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(vi) Tariff protection unnecessary sinoe the oil importing principals are the proposers of the project
(vii) Priee of domestic cil would not be higher than that of imported oil
(viii)Government participation sought
Reguired~ A decision on
(1) Whether or not the projec~ should be approved by the Government on the terms stated
•(2) Whether the Government should participate in the equity of the pro jed
(3) Whether additional conditions should be imposed by the Government and if so what conditions could reasone.bly be imposed.
(b) Projoct for establishment of a Plastic Sandal Factory in 1963 based on imported materials, in a country short of skilled men
Estimated output of factory: 300,000 pairs (20% of 1961 imports) Imports of Plastic foctwear: 1957
1959 1961
526,000
Î ,551
,ooo
Il
Principal suppliers: Hongkong
&
France supplying 90% of total imports. Current sale priee of sandalsg 8/6 da pair (1963)Conditionsg Duty-free importation of raw materials and 5-year tax holiday Specifie protective duty of 1/6 d per pair + existing ad valorem duty of 25%. Average ex-factory priceg 4/6 d a pair
( 12 d= 1/- , and 20/- == ~:-1 ) Arrangements :
(i) Financial Arrangements:
Fixed Capital
Plant and machinery (including freight and installation)
Furniture9 fittings, etc.
5:., 20,000
2,500
- - -
5:., 22,500
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Brought forvre.rd , ... .... , . ... 5:. 22 9 500 Vlorking Capital
Raw Materials Stocks and stores Debtors
Contingencies
6,000 1,
so o
5,000
49800 i7 ,300
Total. . .
39, 7 300
(li) Ce.pitalization
Sponsors' Equity
Government Participation (at 8-1/2% interest)
(ij ·~.)Operati~1g Result~
~oo ooO
Sales~ ~ pairs at 4/6 a pair
~xpen~g Materials (plastic, buckles, packing
materials 29~000
Salaries
&
Allowances (6 skilled men)Uages ( 30 eeP:~.-Bkilled and unskilled men)
Accountancy and clerical fee Water and electricity
Maintenance In surance Dep:reciation
Distribution, publicity and discounts (at 7- î/2% of sales) Levy to Government at 11~ of saleE", Contj_ngencies
Gross Profit Loan Interest
7,000
s, o oo
2,000 5,500 1
, o o o
400 39500
( Net profit .18.2% on capital) Reguiredg A decision on~
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25~000
15,000 40,000
61,67.5
5.8 25
1,275
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( 1) "Whether the Government should approve the pro je ct ancl o:J.
what terms
(2) Whether the Governrnent shoulcl participate financially in the project.
