Import Substitution Vs Export Orientation; Case Study of Korean Economy

Why export-oriented countries successful

1. It is widely accepted that countries with an outward-oriented outlook have grown faster
than those with an import substituting orientation. Why? To give light on this matter, let us
first provide a brief historical background of the shift, then after present the outcomes of import
substituting orientation that would make it inferior compared to an outward-oriented approach in
growing the economies, followed by the presentation of findings of why an outward-oriented
approach have gone farther than of an inward-orientation. Lastly, as a conclusion we will discuss
a case study on the success of South Korea.
Historical Context. For several decades after the World War II, numerous countries such as in
Latin America, Africa and Asia actively interfered with trading internationally. Their trade policies
at that time were in the context of Import Substitution, that is, they implement trade prohibitions,
strict quotas and very high tariffs on imports. These measures were intended to “protect” the local
industries so that they could defy comparative advantage and substitute domestic goods for
formerly imported goods. Import Substitution policies were largely based on the notion that
economic growth could be accelerated by actively directing economic activity away from the
traditional agricultural and resource sectors of the economy and towards manufacturing. The
broad range of protectionist tariffs, quotas, and other prohibitions on import that were part of this
policy were not a form of strategic protection. The sectoral model of the economy shows that
strategically chosen protection can be beneficial if the right industries are promoted. But the broad
protection under IS policies usually protected all industries indiscriminately, whether they
generated technology externalities or had the chance of achieving competitive cost (H. Van Den
Berg, 2001).
Consequences of an Inward-Looking. Todaro and Smith (2008) cited five negative outcomes
(making IS strategy of industrialization largely unsuccessful). First, secure behind protected tariffs
walls and immune from competitive pressures, many IS industries remains inefficient and costly
to operate. Second, the main beneficiaries of the import substitution process have been the
foreign firms that were able to locate behind the tariffs walls and take advantage of liberal tax and
investment incentives. After deducting interest, profits, and royalty and management fees, most
of which are remitted abroad, the little that may be left over usually amasses to the wealthy local
industrialists with whom foreign manufacturers cooperate and who provide their political and
economic cover. Third, most import substitution has been made possible by the heavy and often
government-subsidized importation of capital good s and intermediate products by foreign and
domestic companies from which results to worsening of the situation in the balance of payments.
Fourth, many import substitution strategies exhibited detrimental effects on traditional primary-
product exports. Exchanged rates have been artificially overvalued. This has had the effect of
raising the price of exports and lowering the price of imports in terms of the local economy. Later
on it would encourage capital-intensive production methods still further (because the price of
imported capital goods is artificially lowered) and to penalize the traditional primary-product
exports by artificially raising the price of exports in terms of foreign currencies. This effect would
have another effect such as making the local agriculture less competitive in the world markets.
Lastly, import substitution, which may have been conceived with the idea of stimulating the infant
industry growth and self-sustained industrialization by creating forward and backward linkages
with the rest of the economy, has often inhibited industrialization. Many infant industries never
grow up, content to hide behind protective barriers and governments reluctant to force them to be
more competitive by lowering the tariffs. Governments of developing countries themselves often
operate the protected industries as a state-owned enterprises. Moreover, by increasing the costs
of inputs to potentially forward-linked industries and by purchasing their own inputs from overseas
sources of supply rather than through backward linkages to domestic suppliers, inefficient import
substituting firms may in fact block the hope for the process of independent integrated
industrialization.

2. Van Den Berg (2001) also suggest that industries of import substituting economies often failed in
adopting new and cheaper technology (when they were available). In effect, technological
progress slows down. The likely cause of the slowing down can be explained by Schumpeterian
model of endogenous technological progress. He added that for the process of creative
destruction to work, there must be destruction as well as creation, if an initial creation it not
followed by a second creation, which implies the destruction of first creation’s advantage, then
economic growth stops.
Impetus of an Outward-Looking. Export promotion strategies have been preferred than import
substitution approach because it has been observed internationally (particularly the World Bank)
as effective in growth and development (compared to the other approach) in the evidence of the
success of some Asian countries like South Korea and Taiwan. In the words of Paul Streeten,
“outward-looking development policies encourages not only free trade but also free movement of
capitals, workers, enterprises and students,…the multinational enterprises, and an open system
of communications”.
As cited by Manu (2009) on the Journal of International Business and Economics, the goal of
expanding manufactured exports was given impetus by the "success" stories of such LDCs as
Taiwan, South Korea and Brazil during the 1960s and 1970s.
In recent times, however, growing protection in developed countries has again dampened the
viability of this kind of expansion. This outward-looking strategy of development based on export
promotion is generally considered to be a better one than that of import-substitution thing
(Krueger, 1998).
Case Study: The Economy of South Korea
If one were asked to identify the most successful example
of how international trade and trade policy can transform
an underdeveloped country from a condition of
widespread poverty to one of the high-income status in a
single generation, the answer would undoubtedly be
South Korea. Lacking natural resources, Korea’s greatest
wealth are its hardworking people; its drive to succeed; its
strategic alliances between the government and private
industry in selecting and promoting carefully chosen
exports while judiciously protecting them from competing
imports on a temporary basis. South Korea occupies in
the southern portion of the mountainous peninsula
projecting southeast from China and separating the Sea
of Japan from Yellow Sea. South Korea’s only land border
is with North Korea, formed by the military demarcation
line marking the line of separation between the belligerent
sides at the close of Korean War. With over 47 million
people, South Korea has one of the world’s highest
population density. Over the past 40 years, South Korea’s
economic growth has been spectacular. The nation has advanced from being one of the world’s
poorest in the 1950’s to one of the richest today. In fact, in 1996 it was designated a high income
country by the World Bank and joined the Organization Economic Cooperation and Development
in Paris as an industrialized, aid-giving country. But that was before it became principal victim of
the 1998 Asian Crisis.

3. According to Forbes (2013), the 1998 Asian financial crisis exposed longstanding weaknesses in
South Korea's development model including high debt/equity ratios and massive short-term
foreign borrowing. GDP plunged by 6.9 percent in 1998, and then recovered by 9 percent in 1999-
2000. Korea adopted numerous economic reforms following the crisis, including greater openness
to foreign investment and imports. Growth moderated to about 4 percent annually between 2003
and 2007. Korea's export focused economy was hit hard by the 2008 global economic downturn,
but quickly rebounded in subsequent years, reaching 6.3 percent growth in 2010. The US-South
Korea Free Trade Agreement was ratified by both governments in 2011 and went into effect in
March 2012. Throughout 2012 the economy experienced sluggish growth because of market
slowdowns in the United States, China, and the Eurozone.
The nation’s successful industrial growth began in the early 1960s, when the government
instituted sweeping economic reforms emphasizing exports and labour-intensive light industries.
The government also carried out currency reform, strengthen financial institutions, and introduced
flexible economic planning. South Korea’s rapid and sustained development can be ascribed to
a combination of social and economic factors: the high level of industriousness and literacy among
the people, the introduction in the early 1960s of economic reforms aimed at expending exports
and labour-intensive industries, the gradual removal of import barriers, the extreme flexibility of
economic management, the close cooperation between government and private industry, and
the autonomy of the banking system and the development of an efficient financial market. But the
close cooperation between government and export industries during the period of rapid catch-up
with the West is perhaps the most important key to understanding success of its outward-looking
industrialization strategy.
According to Smith (2003), the case of South Korea suggests that it is a combination of industrial
policies addressed to specific market failures, and consistent with underlying market forces (as
well as the local political economy) that promotes industrial development. Without proper attention
to incentives (for both market and rent-seeking activities), these same industrial policies can prove
counterproductive. Countries that cannot find the political will to use protection as a highly
selective and strictly temporary instrument of industrial policy in cases where large, identified
market failures can be shown to exist, are probably better off abandoning this instrument
altogether; the case of Bolivia is probably a good example of this. Even prior to the financial crisis,
Korea's now democratic government is making a series of adjustments designed to make its
market economy function in a more mature way. In the past, the government encouraged giant
conglomerates, or Chaebol, to expand and enter new markets as a way of achieving economies
of scale and scope, to facilitate exporting, and to facilitate its control over the economy by keeping
the number of companies it had to stay in close contact with small. Now that the Korean economy
is established, the Chaebol are seen as liabilities to further growth. They are also seen as political
liabilities, or as companies that unfairly received government advantages in the past from which
other companies did not benefit. Antitrust regulations are now being enacted and enforced; this
will probably make the Korean economy much more competitive in the future. As the Korean
economy approaches maturity, government's role in the productive sector continues to recede.
But the lesson for developing countries that would like to emulate South Korea's success is that
until the world technology frontier is approached, government does have an important role, even
in the productive sector, until domestically-based private industry can establish itself.

By: Justine C. Banta
Course: Econ 312 Development Economics
Topics: Industrialization & Trade

4. References

(2013). Retrieved from Forbes: http://www.forbes.com/places/south-korea/
Krueger. (1974). Foreign Trade Regimes and Economic Development. Turkey: Columbia
University Press New York.
Manu, F. A. (2009, January 1). FPO IP Research & Communities. Retrieved from Journal of
International Business Economics: http://www.freepatentsonline.com/article/Journal-
International-Business-Economics/208535025.html
Smith, S. C. (2003). Case Studies in Economic Development. Retrieved from
http://wps.aw.com/wps/media/objects/277/284582/todarocasestudies.pdf
Todaro, M. P., & Smith , S. C. (2008). Economic Development 10th Edition. Boston, United States
of America: Pearson Education Incorporated.
Todaro, M. P., & Smith, S. C. (2004). Economic Development 8th Edition. Singapore: Pearson
Education South Asia Pte. Ltd.
Todaro, M. P., & Smith, S. C. (2012). Economic Development 11th Edition. Boston, United States
of America: Pearson Education Incorporated.
Van Den Berg, H. (2001). Economic Growth and Development. New York, United States of
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