Import Substitution of Intermediate Inputs and Local Content Policy

Import Substitution of Intermediate Inputs and Local Content Policy
Chong-Sup Kim Seoul National University

Arguments in favor of Import Substitution Policy
Volatility of primary commodities prices Declining terms of trade Infant industry Linkages: spillover effects

Consequences of ISI Decline of agriculture
Fiscal deficit and inflation Dependency on imports of essential inputs Trade deficit

Effective Rate of Protection
If tj=ti, then ERPj=tj If tj>ti (tariff escalation), then ERPj>tj High ERP reduces the incentives to produce intermediate inputs.

The Case of Mexico: Trade Balance of intermediate inputs
Large trade deficits in intermediate inputs source: INEGI

Large increase in exports vs. Small increase in GDP
parts production GDP Exports parts import GDP -10 -5 5 10 15 20 25 30 35 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 exports GDP

Small increase in employment compared to the increase in GDP
parts import Exports (production of final goods) parts production small increase in employment -10 -5 5 10 15 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 manuf. prod. manuf. empl.

Small increase in investment and large participation of FDI
parts import Exports (production of final goods) parts production FDI Domestic Investment 0% 5% 10% 15% 20% 25% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Inv/GDP FDI/Inv

Export Shares of Transportation equipment and Electric & Electronic Products
source: UN COMTRADE

Share of Transportation equipment and Electronic Products in Manufacturing Production
source: INEGI

Mexico’s trade of Electronics & Electro-domestics products
source: INEGI

Mexico’s trade in Automobile industry
source: INEGI

Causes Situation before NAFTA
Auto: Auto-parts industry was already developed before NAFTA. NAFTA led enabled the industry to reach economies of scale. Electronics: As parts industry was underdeveloped, Mexican government had to implement programs like PROSEC to host investment in assembly industry. However, this policy led still weak parts industry to a collapse. Mexican auto industry was integrated to North American production network, whereas the electronic industry remained as an assembly center.

The Case of El Salvador Mainly exports clothing products, and imports textile products. $million

Global Value Chain (or Global Production Network)
The organization, across national borders, of the relationships (intra and increasingly inter-firm) through which firms conduct research, development, product definition and design, procurement, manufacturing, distribution and support services. Global? or Regional?

GVC and Value Chain After Sales Support Sales and Marketing Production
Procurement Product Development Time-to- market reduction Product quality improvement Material cost reduction Cycle / turnaround time reduction Expense reduction Operating cost savings Time-to-market reduction Inventory reduction Quality improvement Cost-to-serve reduction Revenue enhancement Customer satisfaction improvement Cost-to-serve reduction Customer satisfaction/ loyalty improvement

GPN and Value Chain Production of Parts Sales and Marketing
Procurement Production Product Development After Sales Support Assembly

GVC in East Asia: Flying Geese Model?
The development of production networks has contributed to the rise of successive waves of “new industrialized economies” in East Asia and especially the emergence of the latest wave of new industrialized economies (Thailand, Malaysia, Philippines, then China and Vietnam).

Firms in Japan, South Korea, Taiwan, Singapore, Hong-Kong have gradually moved their production capacity in low-tech, labor intensive sectors to overseas export platforms located in low-wage countries, through foreign direct investment and out-processing operations. These relocations have helped South-East Asian countries and then China, to develop their comparative advantages in manufacturing industries and to progressively upgrade their industrial capacities and exports.

Old New Japan Capital intensive Machinery High-Tech R&D, Equipment NICS Capital intensive Heavy Medium Tech Intermediate Inp China ASEAN Labor intensive Textile Low-Tech Parts South Asia Labor intensive Apparel Labor-intensive Assembly

Inter-sectoral Division of Labor
Indust A capital-int 1 Indust B capital-int 2 Develop A labor-int 1 Develop B labor-int 2 Horizontal Division of Labor Vertical Division of Labor

Intra-sectoral Division of Labor
Indust A H-intermediate 1 Indust B H-intermediate 2 Develop A L-intermediate 1 Assembly Develop B L-intermediate 2 Assembly Horizontal Division of Labor Vertical Division of Labor

Life cycle of parts-final product
trade balance of parts stage 4 stage 3 trade balance of final product stage 5 stage 2 stage 1

Flying Geese and Shortened Cycle
Share of selected developing countries and regions in world clothing exports, 10 20 30 40 50 60 70 Developing countries NICS ASEAN South Asia China Mexico Turkey Others % Share of selected developing countries and regions in exports of electronic products, 5 10 15 20 25 30 35 40 Developing Countries NICS ASEAN China Mexico others % 1980 1985 1990 1995 1998

GPN, Trade, and VA The benefits that low-wage countries derive from their participation in GPN may be smaller than suggested by trade figures. The gains may be unequally spread between the firms involved in the value-added chain. Taking part in the labor-intensive stages of production does not automatically lead to the technological spillovers needed to move up the production chain and to ensure a sustainable economic growth.

Trade and VA in Manufactures

Korean Experience $billion Korea had trade deficit in intermediate inputs until mid 1990s, but trade surplus thereafter. $billion However, Korea still has large trade deficit in intermediate inputs with respect to Japan.

Korean Experience Import Substitution Policy for Machinery Parts and Materials Implemented to increase the local content of the machinery industry According to this plan, hundreds of items with large imports but with strong impacts on the industry if produced domestically were selected and given financial and technical support every year. Special mechanisms were introduced to guarantee some market for the domestically produced material and components. Most of the companies participating in this program were SMEs. So, technology transfer from large companies to SMEs was encouraged. In each of the 1st and 2nd plan( , ), about 4,000 items were produced domestically and contributed to the increase of the local content.

Korean Experience Number of Items developed under Import Substitution Policy for Machinery Parts and Materials (as of 1991) Notified items Completed items Success rate General machinery Auto parts Ship-building Electric/electronic Materials 1,677 857 233 1,278 497 677 528 142 598 267 40.4 61.6 60.9 46.8 53.7 total 4,542 2,212 48.7

Korean Experience Trade Improvement Effect of Promotion of Import Substitution by Sector from 1986 to 1991 (Unit: US $ million, %) Import Substitution Expansion of export Total Rate General Machinery and Copper Parts 1,527 1,034 2,561 36.7 Automotive Parts 782 208 990 14.2 Shipbuilding Equipment 162 58 200 3.2 Electronic Parts 962 879 1,841 26.4 Material 960 401 1,361 19.5 4,389 2,580 6,969 100.0

Korean Experience Operation Structure of Import Substitution Policy for Machinery Parts and Materials

Korean Experience Instruments of Import Substitution Policy for Machinery Parts and Materials 1 category sub-category policy instrument year of introduction related entities support stage Amount in 1989 (billion won) Financial Supports Supply Side Manufacture Industry Development Fund 1980 Korea Association of Machinery Industry, Electronics Industries Association of Korea S1, S2 77 Industrial Technology Improvement Fund 1986 Industrial Bank of Korea, Korea Development Bank S1 36 Fund for Supporting Establishment of New Business 1984 Small and Medium Business Corporation S2, S3 5 Technological Development Fund (National Investment Fund, KDB and SMEs) 1976 Korea Development Bank, All Financial Institutions 192 Special Fund for SMEs, 1987 Industrial Bank of Korea 880 Venture Capital Fund 1970 Korea Technology Finance Corporation, Korea Industrial Technology Association S1, S2, S3 125 Facility Fund of Export Industry and Import Substitution of Material, Parts and Components Industry All Financial Institutions 1000 Lease Fund Lease Companies 850 Demand Side Domestic Machinery Purchase Fund (National Investment Fund, KDB) Korea Development Bank 540 Finance for Consumer of SMEs Products note: S1=R&D stage, S2=commercialization stage, S3=market expansion stage 1989 exchange rate: 1 dollar = 680 won

Korean Experience Instruments of Import Substitution Policy for Machinery Parts and Materials 2 category sub-category policy instrument year of introduction support stage Tax Incentives Tax Exemption Income Tax Exemption for Foreign Engineers 1981 S1, S2, S3 Local Tax Exemption on Real Estate for R&D of Enterprises S1 Tax Exemption for Income from Technology 1979 S2, S3 Special Consumption Tax Exemption on Specimen for Trial Research 1982 Income Tax Exemption for Technology-Intensive Business Founders 1986 S2 Income Tax Deduction and Special Depreciation for New Technology Enterprise Project 1974 Income Tax Exemption and Special Depreciation for Research and Training Facilities 1976 Deduction of R&D Reserve Fund 1973 Tax Credit for R&D and Training Cost Deduction of Technological Service 1977 Tariff Reduction 65-70% of Reduction in R&D goods 30-55% of Reduction in Materials for High-Tech Industrial Facilities 1987 note: S1=R&D stage, S2=commercialization stage, S3=market expansion stage

Korean Experience Instruments of Import Substitution Policy for Machinery Parts and Materials 3 category sub-category policy instrument year of introduction related entities Technical Supports Technical Development Support Specific R&D Project 1982 Government Research Institutes Industrial Technology Based Development Project 1986 Technical Guidance Technical Guidance for Long-Termed Dispatched Researcher Training for Field Technical Personnel 1979 Small and Medium Business Corporation Simple Automation Project 1985 Korea Institute of Industrial Technology, Korea Productivity Center Invitation of Domestic and International Experts for Technical Guidance 1983 Providing Information Technical Information Support 1973 Korea Institute for Industrial Economics and Trade, Government Research Institutes Support for Evaluation Test and Quality Certification Open Utilization of High-Priced Test Analysis Equipment 1984 Inspection and Repair of Precision Machinery 1975 Korea Research Institute of Standards and Science Quality Certification System of Domestic Machinery, Parts and Materials Korea Institute of Industrial Technology Support for Acquisition of Foreign Quality Certification

Korean Experience Instruments of Import Substitution Policy for Machinery Parts and Materials 4 category sub-category policy instrument year of introduction related entities Other Support Comprehensive Support Search and Support for Prospective SMEs: Promoting Prospective SMEs 1983 Ministry of Commerce and Industry, Financial Institutes, Research Institutes Notification System of Import Substitution Items 1985 Ministry of Commerce and Industry Support for Market Expansion Domestic Machinery Exhibition 1974 Korea Association of Machinery Industry Optional Contract and Prior Purchase System for Domestically Developed Products Government Appointment System of Notified Items 1975 Market Protection Support Anti-Dumping Duties System Ministry of Finance Protection System of Manufacturers of Domestic New Technology Products 1977 Ministry of Science and Technology Assessment System of Industrial Impacts 1987 Fair Trade Support Establishment of Fair Trade 1980 Economy Planning Board Arrangement of Council Meetings of Supply and Demand Companies by Parent Company Arrangement of Subcontracts 1986 Korea Federation of SMEs Others Exemption of Military Service for Researchers 1982 Ministry of National Defense Exemption on Import Source Diversification System Korea Industrial Techonology Association Consulting Office for Import Substitution 1984 Korea International Trade Association

Korean Experience Notification System of Import Substitution Items
This system was introduced in 1985. Items with large amount of imports, especially from Japan, and with strong technological spill-over effects are selected every year, and are provided with concentrated support. Selection criteria: 1) large import substitution effect (over $100,000 for parts, over $1 million for finished products and materials), 2) import share of Japan over 40%, 3) strong technological spill-over effects if developed domestically, 4) potential export item, 5) possible to start development in the same year. These items receive technical information and guidance from government research institutes, Korea Institute of Industrial Technology, etc., and loans from Korea Association of Machinery Industry, Industrial Bank of Korea, etc., at a preferential rate.

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