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The Recipe for Success—or Failure
There are two main reasons for the controversies and confusion about industrial policy in developing countries. First, economists who have studied the matter have tended to focus their attention on the failed policies implemented by developing countries, not on the objectives and the broader strategic choices made in the successful cases. Second, too often, very different types of government interventions are lumped together in regression analyses, with little consideration given specifically to which ones may have attempted to facilitate the emergence of industries that are consistent with latent comparative advantage.
Summing up the research findings on how to achieve sustained growth through structural transformation and the diffusion of ideas and accumulation of knowledge, Romer notes that “the challenge is to find better forms of government intervention, ones that have better economic effects and pose fewer political and institutional risks” (1992: 66). He also points out that “the temptation for economists, however, has always been to duck the complicated political and institutional issues that this kind of analysis raises and instead to work backward from a desired policy conclusion to a simple economic model that supports it.” In fact, the real challenge for economists and policymakers in any country may be instead to identify the new industries that are consistent with the economy’s comparative advantage, which evolves as the endowment structure changes.
A common feature of the industrial upgrading and diversification strategies adopted by successful countries (the most advanced ones and the East Asian NIEs in the postwar period) was the fact that they targeted mature industries in countries not too far advanced compared to their own levels of per capita income. That may have been the single most important cause for their success. Throughout human history, it appears that pioneer countries always played (and often unwillingly) the role of an “economic compass” for latecomers. Going back to the 16th century, the Netherlands played that role for Britain, which in turn served as a model and target to the U.S., Germany, and France in the late 19th and early 20th centuries and to Japan in the mid 20th century. Likewise, Japan was imitated by Korea, Taiwan-China, Hong Kong-China, and Singapore in the 1960s and 1970s. Mauritius picked Hong Kong-China as its “compass” in its catch-up strategy in the 1970s. China chose Korea, Taiwan-China, and Hong Kong-China in the 1980s.
development of new industries in a way that was consistent with the country’s latent comparative advantage as determined by endowment structure. Therefore, their firms, once established with government support in information, coordination, and sometimes limited subsidies, have turned out to be competitive.22 Second and even more important, to ensure that they would tap into their latent and evolving comparative advantage, the governments targeted mature industries in countries that were, on average, about 100 percent higher than their own level of per capita income, measured in purchasing power parity.23 When Britain applied industrial policies to catch up to the Netherland in the 16th and 17th centuries, its per capita income was about 70 percent of that of the Netherlands. When Germany, France, and the U.S. used industrial policy to catch up with Britain in the 19th century, their per capita incomes were about 60 to 75 percent of that of Britain. Similarly, when Japan’s industrial policy targeted the U.S.’s automobile industry in the 1960s, its per capita income was about 40 percent of that of the U.S. When Korea and TaiwanChina adopted industrial policies to facilitate their industrial upgrading in the 1960s and 1970s, they targeted the industries in Japan instead of the U.S., and for a good reason: their per capita incomes were about 35 percent of Japan’s and only about 10 percent of that of the U.S. at that time.24 Looking closely at the elements of successful catch-up strategies, it appears that the specifics of policy interventions depended on the specific binding constraints for these new industries and on country circumstances. But while the interventions were often different, the patterns of industrial development were similar across countries. They all started from labor-intensive industries, such as garments, textiles, toys, and electronics, in the early stage of development and proceeded to move up the industrial ladder step by step to more capital-intensive industries.25 The East Asian NIEs, for instance, exploited the fact that their endowment structures were similar to Japan’s to follow its development in a flying-geese pattern (Akamatsu 1962; Kim 1988). This was possible because the per capita income gaps with their target-country were not large (Ito 1980).26
The idea of a dynamic comparative advantage is often used to justify industrial policy and government support to firms (Redding 1999). In our analysis, however, the argument is valid only if the government’s support is limited to overcoming information and coordination costs and the externalities associated with the pioneer status of firstmovers. The targeted industry should be consistent with the comparative advantage of the economy and the firms in the new industry should be viable, otherwise they will collapse once the government’s support is removed. If the targeted industry is outside the country’s comparative advantage, the required open-ended support to the subsidized firms will crowd out the resources available to other firms that operate in industries consistent with the comparative advantage. This will obviously slow down economic growth and capital accumulation and it will take more time for the economy to reach the stage targeted by the dynamic-advantage policy later than an economy that follows a CAF strategy (Lin and Zhang, 2007).
For the purposes of this paper, the use of per capita income measured in purchasing power parity is better than that of the market exchange rate because in cross-country comparisons, the former reflects the level of development and the cost of production better than the latter.
For a discussion of industrial policies in these countries, see Chang (2003); and for the estimations of per capita income for the above countries, see Maddison (2006).
Countries in similar stages of development may specialize in different industries. However, the level of capital intensity in their industries will be similar. For example, in recent years, China achieves dynamic growth by specializing in the labor-intensive manufacturing industries, such as electronics, toys, and textiles, whereas India’s growth relied on specializing in call centers, programming, and business process services, which are labor-intensive activities within the information industry.
In a similar spirit, Hausmann and Klinger (2006) recently investigated the evolution of a country’s level of sophistication in exports and found that this process was easier when the move was to “nearby” products in the product space. This is because every industry requires highly specific inputs such as knowledge, physical assets, 14 The story of Korea is a particularly good illustration of that strategy. The government there took a pro-active approach to industrial upgrading. It adjusted its strategy to enter industries that were consistent with the country’s latent (and evolving) comparative advantage. In the automotive sector, for example, early in Korea’s growth period, domestic manufacturers concentrated mostly on assembly of imported parts–which was labor-intensive and in line with their comparative advantage at the time. Similarly, in electronics, the focus was initially on household appliances, such as TVs, washing machines, and refrigerators, and then moved to memory chips, the least technologically complex segment of the information industry. Korea’s technological ascent has been rapid, as has been its accumulation of physical and human capital due to the conformity of Korea’s main industrial sectors to the existing comparative advantage and, hence, its changes in underlying comparative advantage.27 As a result, Korea has achieved remarkable GDP growth rates in the past forty years and has performed impressively on industrial upgrading into such industries as automobiles and semiconductors.
Developing countries in other regions of the world pursued the same path with excellent results.
Chile, one of the Pacific Rim countries, successfully targeted industries that were consistent with its comparative advantage determined by its natural endowment, as well as industries that were already mature in more advanced countries. While free-market reforms introduced in the early 1970s brought many benefits to the country, they were slowly accompanied by market failures (Diaz-Alejandro 1985). In recognition of these problems, the government has supported private sector growth through a number of policy instruments, including the provision of agricultural public goods by a state institution (Servicio Agricola Granadero); guarantees for loans to small enterprises; a semi-public entrepreneurial institution (Fundacion Chile) responsible for the development of the salmon industry; the “simplify drawback” mechanism, which provided subsidies to new exports; the various programs of the national development agency (Corporacion de Fomento de la Produccion, CORFO); and the National Council on Innovation for Competitiveness.
In recent years, the country has experienced “a burst of export discoveries of new comparative advantages” (Agosin et al. 2008) and dynamic growth. Key to this success has been the diversification of Chile's traditional resource-based industries of mining, forestry, fishing, and agriculture, coupled with a strong drive to increase exports. The initial dependence on copper has been gradually reduced in favor of aluminum smelting. Forestry products have been expanded into salmon aquaculture and agriculture into wine production, as well as freezing and canning fruits and vegetables. Manufacturing has been less successful but many foreign firms have chosen to locate in Chile as it offers a secure platform from which to supply other markets across South America.
Mauritius, one of the most successful African economies, took off in the 1970s by targeting labor-intensive industries such as textiles and garments. These industries were mature in Hong Kong, its “compass-economy.” Both economies share the same endowment structure and the per capita income in Mauritius was about half of that in Hong Kong-China in the 1970s.28 The Mauritius Industrial Development Authority (MIDA) and Export Processing Zones Development Authority were created by the government to attract Hong Kong-China’s investment in its export processing zone. The vision was to position Mauritius as a world class export hub on the Hong Kong-China model. Together, they have contributed to the country’s emergence as an economic powerhouse.
By contrast, many countries designed and implemented catch-up strategies that were too ambitious for establishing the “commanding height” given their level of development. Historical examples of such mistakes go back to countries such as Hungary or Russia, which tried to replicate industries in place in Britain in the late 19th century (Gerschenkron 1962). While GDP statistics are scarce for individual countries, purchasing power parity estimates by Maddison (2006) indicate that their per capita GDP represented 25 and 30 percent of that of Britain in
1900. Such a large gap made any attempt by the former to develop British industries unrealistic.29 Most developing countries fell in the same trap after World War II. They often targeted advanced industries in advanced economies when their per capita incomes represented only a very small fraction of that of high-income countries. After gaining their independence from colonial powers, many countries considered the development of advanced heavy industries as a key symbol of their freedom, a sign of strength, and a political statement of their reputation on the international scene. Across Latin America, Africa and South Asia, some of these newly independent countries were run by political leaders with leftist inclinations and chose to follow the prevailing Stalinist model of state-led industrialization through the development of advanced heavy industries regardless of their political denominations. State resources were used in the industrialization push, with resources directly allocated to various investments, and large public enterprises set up in almost every sector of the economy—all deemed strategic for the survival and modernization of the nation. Under the “macroeconomics of nationalism” (Monga 2006), the criteria for designing industrial policies and selecting specific sectors for government intervention were mostly political.
In parallel to political aspirations for heavy-industry development, there was an obsession with “market failure” in academic circles—especially in Latin American countries. Many influential economists and policymakers there (Albert Hirschman, Raul Prebisch, Roberto Campos, and Celso Furtado among others) argued that industrialization and growth could not take place spontaneously in developing countries because of structural rigidities and coordination problems.30 They recommended that government support be provided to the manufacturing
According to Maddison (2006), Hong Kong’s per capita income in 1970 measured in 1990 international dollars was 5,695, whereas that of Mauritius was 2,945.
As discussed earlier, a similar policy was pursued successfully in Germany, France, and the USA at the same time. Their per capita incomes ranged from 60 percent to 75 percent that of Britain.
The new field of development economics was regarded as covering underdevelopment because “conventional economics” did not apply (Hirschman 1982). Early trade and development theories and policy prescriptions were based on some widely accepted stylized facts and premises about developing countries (Krueger 1997); these 16 industry for these countries to catch up with developed countries, regardless of the large income gap with the advanced economies.