A case for import substitution policies

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.