A case for import substitution policies

By Rajiv Sondhi

JAKARTA (JP): The emergence of a trade deficit in June, the first monthly deficit in five years, has sharply focused the recent performance of exports and the supporting policy framework. The policy support extended by the government to promote non-oil or gas exports has brought rich dividends to the country in the last five years.

Non-oil gas exports, in particular manufactured exports, have recorded double digit growth rates. They have very effectively cushioned the economy from the effects of declining exports of oil and gas, and the demands of a growing economy. The sharp reduction in the country's reliance on oil and gas export revenues has been justifiably called a success.

Faced with a declining trade balance, or even a deficit, questions arise about the inadequacies of the existing policy framework. What kinds of policy responses need to be formulated to deal with this situation?

Before dwelling on the future, let us briefly look at recent performance.

The following trends emerge:

1. Exports of non-oil and gas products increased sharply. Supportive government policies helped increase growth rates to a peak of 28 percent in 1992, as comparative economic advantages encouraged a wave of industrial relocation from elsewhere in the region to Indonesia. These growth rates have however been declining since 1992, leading to alarm bells ringing.

2. Imports have also grown. In the non-oil and gas group, imports exceeded exports right up to 1992-1993. Only in 1994 did this trend reverse. The non-oil and gas sector in fact recorded a negative balance of trade up to 1992, and finally began to pay for itself in forex terms in 1994, after breaking even in 1993.

3. The growth rates of imports, on the other hand, have been higher than those of exports in three of the last five years. With a steep increase in project imports expected in the coming years, the aggregate import growth threatens to overtake export growth rates.

4. The aggregate increase in value of total exports in the last five years, at US$ 17 billion, has only marginally exceeded the aggregate increase in imports over the same period ($ 16 billion). The gross value addition in forex terms has thus been a paltry $ 1 billion. After taking into account the related forex flows normally categorized under "service", even this value may disappear.

The bottom line is that while the policy of promoting exports in the non-oil and gas sector have been demonstrably successful, growing imports have substantially eaten away the additional foreign exchange brought in. To be sure, over 85 percent of the country's imports comprise raw materials, intermediate goods and capital goods, all of which no doubt have supported the impressive growth in exports.

Future trends may be influenced by the following developments, which national policy planners may need to bear in mind.

First, foreign investment approvals are soaring. The year 1994, saw a record approval of $ 24 billion. And this year, approvals of $30 billion have already been announced. If aggregated with domestic investment approvals, the increase in total approved investments is similarly large. Such investments would be gradually realized over the next few years. Inevitably, there would be a spurt in imports of project items to support such investment.

This is what seems to explain the trend of trade balance in the first six months of 1995. Upon implementation of the projects, the increase in imports could continue unabated, with additional demand for raw materials or intermediate goods coming in. Unless exports grow spectacularly, the country may need to become used to a trade deficit for the next few years.

Secondly, with the imminent move towards free trade within the ASEAN region, and later within the APEC framework, international competition may intensify. As a result growth in exports could become moderated.

Thirdly, if the growth in exports is inadequate to finance steeply growing imports, large capital inflows will be required to pay the bill. This would require a conducive monetary policy environment, for instance the continuation of attractive interest rate differentials and a regime of relative monetary stability, so that the required amounts of capital can be attracted to the right price.

Fourth, this option of capital inflows will naturally tend to be limited. The inflows can be as debt or equity. The country's offshore debt is already at a high level. From the viewpoint of prudence, any further increases in the absolute amount of national debt should be such that the debt levels bear some correlation to a combination of macroeconomic factors, like the growth in the size of the national economy, exports and the debt service capacity.

The name of the game, then, is not merely export growth, but generation of forex surpluses from the current account. Without diluting the policy support to promote growth in non-oil exports, attention may now be required towards the other component of trade, namely, imports.

In the context of fast disappearing tariff barriers, a policy framework necessary to deal with burgeoning imports must focus on import substitution as a policy objective. The development of local manufacturing capabilities for goods hitherto imported could be supported or actively encouraged by appropriate policies on several fronts. Some of these are:

a. Providing concessional financing for investment proposals where the output's provide opportunities for import substitution, particularly those projects that involve large capital outlays.

b. Development of an ancillary program for certain large scale industries. The ancillary industry, very often medium scale, could be developed as a network for the supply of components or intermediate raw materials at economical prices. Such an ancillary program may need to be supported with appropriate incentives, for instance for the development or transfer of technology. Fiscal reliefs to encourage this would be very effective.

c. With a country as resource rich as Indonesia, it would make perfect sense to target manufacturing industries for products that are closest to the natural raw material resource in the development chain. This does seem to turn conventional wisdom on its head, inasmuch as it provides encouragement for the domestic manufacture of lower value added items.

But the availability of viable locally manufactured raw or intermediate goods can start a chain reaction of forex savings, starting from the lower end of the value added chain. Incentives for such industries could be in the form of easier or concessional allocation of industrial land, power or supply commitments for natural raw materials.

In the past, strong export growth and a manageable import growth has helped to contain Indonesia's current account deficit. However, the time may have come to shift the policies to a higher gear, and to focus on value addition in forex terms as the driving force behind industrial licensing and growth. Let us take a long hard look at why we import what we do and what can be done to reduce it.

The writer is director of Lippo Pacific, Jakarta.