Trade Policy: Import Substitution

India's industrial policy was closely tied to its trade policy. Across the first seven plans, trade followed what is commonly called an inward-looking trade strategy, technically known as import substitution.

What import substitution meant

Import substitution aims to replace imports with domestic production — for example, instead of importing foreign-made vehicles, encouraging industries to make them in India. Under this policy the government protected domestic industries from foreign competition using two instruments:

• Tariffs — taxes on imported goods, which make them more expensive and discourage their use.
• Quotas — limits on the quantity of a good that may be imported.

Both restrict imports and so shield domestic firms from foreign rivals.

The policy rested on the belief that industries in developing countries could not yet compete with those of more advanced economies, but that if protected they would learn to compete over time. Planners also feared that, without restrictions, scarce foreign exchange would be spent importing luxury goods. Little serious attention was given to promoting exports until the mid-1980s.

Effect of the policies on industrial development

Achievements

The record of the first seven plans in industry was impressive:

• Industry's share of GDP rose from 13 per cent in 1950-51 to 24.6 per cent in 1990-91 — an important indicator of development.
• The sector grew at about 6 per cent a year, a commendable rate.
• Industry became far more diversified by 1990, no longer confined to cotton textiles and jute — largely thanks to the public sector.
• Promoting small-scale industries gave opportunities to people without the capital for large firms.
• Protection from foreign competition allowed home-grown industries, such as electronics and automobiles, to develop where they otherwise could not have.

Criticisms

Despite these gains, economists have criticised much of the record:

• Overreach of the public sector. Although the public sector was genuinely needed at the start, state enterprises went on producing goods and services — often as monopolies — long after this was necessary. Telecommunications, for instance, stayed reserved for the public sector even after private firms could have provided it, so that until the late 1990s one had to wait a long time for a telephone connection. The state even ran a bread-making firm, Modern Bread (sold to the private sector in 2001), as though private firms could not bake bread. After four decades no clear distinction was drawn between what only the public sector can do (like national defence) and what the private sector can do equally well (like running hotels). Many scholars argue the state should exit areas the private sector can manage and concentrate on services the private sector cannot provide.
• Loss-making enterprises that could not be closed. Many public-sector firms ran huge losses yet kept operating, because it is hard to shut a government undertaking even when it drains the nation's limited resources. This does not mean private firms are always profitable — indeed several public-sector firms were originally loss-making private firms nationalised to save jobs — but a loss-making private firm will not go on wasting resources indefinitely.
• Misuse of licensing (the permit-license raj). Big industrialists obtained licenses not to start new firms but to block competitors from starting theirs. Excessive regulation prevented firms from becoming efficient, and industrialists spent more time chasing licenses and lobbying ministries than improving their products. …