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Anuar Buranbayev. The review of approaches to industrial policy: international experience

The change of the direction of the economic policy to a search of solutions for achieving sustainable growth had a significant impact on the understanding of the importance of the role of a country’s industrial development level. Despite the difference of opinions on the necessity of formalization of industrial policy, lately all countries implement it one way or another.

The crisis of 2007-2009 and its consequences have changed the dominant paradigm of building a “post-industrial” society, and so society returned to an understanding that developed manufacturing sector is necessary for sustainable development. Programs of re-industrialization of the United States, the dominant position of Germany and the Benelux countries in the EU, each with their own developed industrial complexes, the rapid growth of the newly industrialized countries, the successes of South Korea, Taiwan and Finland in the transition into the category of developed countries – all these examples demonstrate the importance of manufacturing industry as the main component that adds sustainability to the development.

The known history of industrialization and reindustrialization allows us to highlight its main elements.

The main tool of industrialization is the industrial policy of a country. It can be identified as national government’s course of action for creating, sustaining, and developing industrial activity [1]. Government in this case acts as a subject that acts through certain mechanisms and instruments. Possible industrial policy instruments are defined by the roles that state may take in a relationship with a specific manufacturer:

  • owner (or co-owner);
  • supplier (seller) of the factors of manufacturing;
  • consumer of manufactured goods;
  • tax payments recipient;
  • regulator of manufacturing market factors and final products;
  • regulator of manufacturer’s activity;
  • arbitrator in economic disputes;
  • political entity within the framework of international relations that affect manufacturer’s activity or markets in which manufacturer participates.

Industrialization is necessary for the transition of the economy from a stage driven by personal factors through an investment-driven stage to an innovation-driven stage, and then to the subsequent prosperity of the country. At the same time the nature of the factors that act as drivers for growth highly depends on the pace of industrialization, the need for state’s efforts, and objective obstacles that arise on the path of industrialization.

There are two types of factors: general and specialized. If industrialization in Japan and Korea was mainly driven by cheap labor, then industrialization in Canada, Malaysia and Saudi Arabia was driven by raw materials and natural resources. Accordingly, the implementation and achievements of these countries were different.

The observations lead to the empirical conclusion that developing countries and countries with transitional economies and with plenty of raw materials tend to experience severe difficulties in implementing industrialization and changing raw materials development model. It is mainly explained by a much higher profitability from extraction and primary processing of raw materials and non-tradable service sectors that serve raw material economy, compared to the manufacturing industry.

The main problem is to find the right measures and tools to overcome the “Dutch disease” and to cope with the “resource curse” syndrome. For raw material economies main objective of industrial policy is the alignment of profitability of manufacturing sectors compared to the raw material sectors and non-tradable service sectors. This may make manufacturing industry attractive for private investment. Thus, industrial policy must consider the stage on which a country’s economy and main driving factors currently are.

Industrial policy is implemented in two directions: vertical (strategic) and horizontal (corrective).

Vertical or strategic policy is aimed at the selective development of specific industries and sectors of the industry. Usually it involves direct government intervention in the development of a sector through a variety of mechanisms and instruments. The main mechanism is the planning of the development of an industry at a state level and implementation of the plan through government funding, access to soft loans, provision of tax breaks, subsidy of the factors of production, protectionism, etc. History of industrialization of the countries surveyed show that such a policy is effective in two cases: if there are positive externalities or, where appropriate, changes in monopoly rents.

First, as in the case of Japan and Korea, external opportunities allowed the use of marshallian externalities for achieving required economies of scale at the national level through geographical concentration without the deformation of economy. Most often this approach is used for the creation and development of new sectors of the country with their support until they reach the level of regional and international competitiveness. This approach is based on the belief that economy’s structure is not strictly defined by country’s natural data (benefits) and can be changed through policy and government interventions. Most often this approach is used in the export-oriented model of industry and economy.

Second, vertical policy can be justified in the case of competition of local companies with an oligopoly of global players. Protectionism through protecting its own market, subsidies and support for local companies allow to switch rent from global players to local companies. On that principle the import-substitution-industrialization policy is built. In this case it is necessary to have internal market which allows to achieve returns to scale.

However, active implementation of the vertical policy involves many risks. History knows more failed cases than successful ones. The example of Malaysia: by spending over 30 years implementing strict vertical policy, but often changing development priorities, the country had not achieved significant structural change or any improvements, and only after 1986, when Malaysia determined the model of development and the criteria for selection of industries, the country has managed to make a major breakthrough. At the same time Japan and South Korea were able to take full advantage of the vertical approach even at the cost of subsequent problems and imbalances, but the benefits gained outweighed problems and helped to stabilize the imbalances.

As a rule, the vertical approach is dominant at the initial stage of industrialization or when it is needed to quickly and radically change the structure of an industry. At an objective comparison Kazakhstan, despite its high overall performance, is currently on a factor-driven stage. Its main factors are mineral raw materials and their products of primary processing, including oil. The main risk of this stage of development is dependence on global commodity cycle and currency exchange rates. At this stage vertical policy can play a key role in the creation of new sectors and the development of existing tradable non-resource sectors. Implementation of the vertical approach requires significant state involvement in the creation and development of selected priority sectors. Given the limited resources of the state, the number of priorities should not be large. For example in Japan and South Korea the number of sectors is limited to 8-10, in Saudi Arabia to 5-6 sectors.

Lately, the possibility of using vertical approach has significantly lowered. Most of the international trade agreements, the WTO rules and, in the case of Kazakhstan, EurAsEC dramatically reduced the set of measures and complicated the mechanisms of protectionism and direct support for economy subjects.

Horizontal or corrective policy is aimed at improving economic efficiency through influencing market deformations. Typically, correction is carried out in two directions: investment in the advancement of research and development and help in the adjustment of industrial structure.

Capabilities of local companies at the initial stage of development do not always enable them to invest sufficient funds in research and development. State support for research in private and public sectors can fix these deformations. Examples of Japan, Korea, Poland, Canada and Saudi Arabia show that such an instrument becomes critical in the transition to a global competition. The benefits of a state investment in research and development are received by all market participants.

Another direction of the correction is usually associated with the leveling of negative external influences such as the instability of commodity cycles, currency and trade wars and the creation of positive incentives for the migration of resources from declining industries to new growing ones. An example of such corrections can be changes in the currency exchange rate and interest rates, labor and migration policies, trade policies, market liberalization, increased competition, cluster policy, etc. Such corrective actions are carried out constantly, but they are especially important in the crucial points when market deformations become critical, as it was in Japan in 1970-1980 and 1990-2010, as it was in South Korea in 1980-1990, and as it is currently in Saudi Arabia due to a decline of the commodity cycle. Developed countries such as Canada, the US, and Germany use these measures on an ongoing basis.

Thus, if the use of the vertical policy allows for a dramatic change in the structure of industry and economy in the short- to medium-term, the horizontal policy mainly works in the medium- to long-term.

Another important observation: industrialization and industrial policy cannot be considered in isolation and out of the context of general economic and social policies. With blurred economic policy, conflicts between industrial policy and other parts of economic and social policies are possible.

As a rule, conflicts arise due to a non-compliance of goals and objectives, on the achievement of which industrial policy and its financial support, the allocation of scarce resources of the state between labor productivity, number of employees and the size of wages, measures of protectionism required by a manufacturing industry, and a request for openness from developed primary sectors, the attitude for attracting foreign labor force and population requirements for employment, etc. are directed.

As noted above, the choice of the industry development model determines the policy that will be conducted. Two main approaches depend on the answer to the question “what markets are primary for the industrial development?”

For large countries such as Japan or the United States a local market is dominant for companies, and a subsequent export is an organic solution for the implementation of the growth strategy. Should a problem on global markets arise, a company can always retreat to its mother market in order to regroup and adjust its strategies.

For smaller countries the export-oriented model is the only way to achieve economies of scale required to maintain competitiveness. In this case companies are subject to a much higher risk, and so governments should conduct more delicate policies related to the promotion and development of key industries.

Various geopolitical events and political decisions, the state of global and regional economies, the decisions taken in the key market countries, being in trade unions or exiting them, participation in international trade organizations, etc. – all of these have a major impact on the formation of government’ strategies in relation to selected industries.

In general, it can be noted that if population of a country is less than 100 million people, then import substitution industrialization policies usually do not lead to success, while export-oriented model involves high external risks and can lead to the creation of sectoral enclave economies that are weakly connected to a local economy. Usually small countries in terms of population are successful in choosing the export-oriented model and in the beginning of industrialization target specific regional markets with similar consumption structure and socio-cultural type, subsequently accessing global markets. It worked in South Korea, it is now working in Malaysia and Saudi Arabia. Moreover, being in regional trade unions, with all the risks, provides small countries with an opportunity to achieve returns to scale in the organization of production targeted on export.

To bring the necessary policies into action, programs with estimated budgets and identified sources of funding are necessary.  Setbacks in the implementation of industrial policies are usually related to the problems of their implementation. The inconsistency in the implementation of policies, violation of procedures and lack of funding are the most common causes of failure. The above examples of industrialization of various countries allow to summarize the sequence of steps needed for industrialization: the selection of industries and the creation of common infrastructure and the availability of production factors, the development of industrial and specialized infrastructure for selected industries and sectors, the establishment of production facilities and acquisition of technology, training and development of human resources, the creation of technologies, research and development.

Sources of funding of industrialization vary from country to country. Japan, having a large population, a high rate of savings among the population and a relatively well-developed banking system, could mainly rely only on domestic sources at the beginning of re-industrialization. It has created a developed system of development institutions aimed at the financing of priority industries. With the development of economy and the manufacturing sector, Japan was becoming more and more attractive for foreign investors and foreign creditors, and therefore after 1970 it began to attract foreign investments through the liberalization of capital and trade policy.

Korea, having a small and poor population with low domestic savings, mainly relied on foreign aid (US, UK, etc.) and external loans. The government kept the banking system under strict control and used foreign loans to fund selected sectors and companies. FDI growth began only after the liberalization of policy in relation to foreign investment and trade policies in 1980.

In the cases of Japan and Korea foreign investors mainly acted as donors of technologies, business models and sales channels. Malaysia, Thailand, Indonesia, the Philippines originally bet on FDI as the main source of financing industrialization. This allowed to make a dramatic breakthrough in the beginning of industrialization, but has led to serious problems as the turbulence in the global economy grew. Crises of 1970s, 1997-1998, 2007-2009 showed poor resistance of the model that relies solely on FDI.

Interesting example is the experience of Saudi Arabia, which from the beginning was building an open market economy, offering significant subsidies and preferences for investors. It received the core funding from the budget in sufficient volumes through the created development institutions and shared risks with investors through the creation of joint ventures.

Access to technology and technological development is a crucial element of successful industrialization. The above country cases show different solutions for technology acquisition. Japan and Korea made a long-term bet on the creation of their own technologies through development and investment in their own systems of research and development. Malaysia mainly depends on foreign technologies that come from foreign investors. Poland and Canada are deeply involved in international systems and have access to technology mainly due to their cooperation in their regional unions: Poland as part of the EU’s innovation and technology policy, and Canada – at the expense of deep integration and cooperation with the United States.

People – is the most important condition for industrialization’s success. International experience shows that without significant investment in the development of human capital the transition from the factor-driven stage to the investment-driven stage and especially to the innovation-driven is impossible. Labor policies implemented by countries differ greatly in their success. If Japan and Korea were able to pass the development path of their population from illiterate workers able to perform simple operations to the creation of their own technologies and innovations, Saudi Arabia has faced major issues in the development of its citizens. To the present day more than half of workers in the industry of Saudi Arabia are foreign workers. Malaysia also attracts talents from around the region, while Singapore is doing it on a global level. Canada has special immigration policies for attracting labor force.

Successful industrialization stories demonstrate the importance of properly chosen and timely implemented industrial policy. In general, a successful industrial policy is a balanced combination of vertical and horizontal policies. Depending on the stage of industrialization one can prevail over the other. Another important condition for the transition to the investment- driven stage is the level of investments in the economy. According to the examples of East Asian countries, investments become a driver for the development of an industry after their level reaches 30% of a country’s GDP.

[1] http://www.eionet.europa.eu/gemet/alphabetic?langcode=en