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Import substitution industrialization (also called ISI) is a trade and economic policy based on the premise that a developing country should attempt to substitute products which it imports, mostly finished goods, with locally produced substitutes. Even though ISI is a development theory, and not naturally a trade theory, its political implementation and theoretical rationale are rooted in trade theory.

As a set of development policies, ISI policies are theoretically grounded on the Singer-Prebisch thesis and practically on the infant industry argument. From these postulates it derives a body of practices, which are commonly: an active industrial policy to subsidize and orchestrate production of strategic substitutes, protective barriers to trade (namely, tariffs), and a monetary policy that keeps the domestic currency undervalued.

Conceptually, ISI could be outward-looking in that it promotes exports (like in Asia, especially South Korea) or inward-looking without significant links to world markets (like in Latin America). In both cases, however, external competition by imports in the markets of the targeted industries are discouraged by tariffs. Hence, policies to pursue ISI have a strong protectionist component and are not favored by advocates of absolute free trade.

A major (theoretical) advantage touted by proponents, which grew out of the Great Depression was this. If most of an ISI-practicing country's industries were native - food, consumer goods like clothing, automobiles, electronics, and even industrial goods - that nation would only be affected slightly, if at all, in the case of another massive worldwide economic shock like that of 1929, being insulated by its self-contained ISI policies.

Contents 1 Latin America 2 East Asia 3 Evaluation and Critique 4 Sources 5 See also

Inward-looking import substitution policies were adopted by most nations in Latin America in the 1930s and 1940s because of the Great Depression of the 1930s. In the 1950s the Argentine economist and UNECLAC head Raúl Prebisch was a visible proponent of the idea. Prebisch believed that developing countries needed to create forward linkages domestically, and could only succeed by creating the industries that used the primary products already being produced by these countries. The tariffs were designed to allow domestic infant industries to prosper.

In reality, inward looking ISI policies did not succeed in significantly expanding and deepening industrialization in the countries applying them. Often they resulted in inferior and costlier substitutes for products that were readily available on world markets. For example, Brazilian small arms production is a result of ISI. Nowadays, Brasil has a native weapons industry, even exporting to countries such as Venezuela, yet these weapons are of inferior quality to, for example, German manufactured small arms.^{[citation needed]} ISI was most successful in countries with large populations or high living standards, having already a more solid economic basis upon which to function. Latin American countries such as Argentina, Brazil, Mexico, and, to a lesser extent, Chile and Uruguay had the most success with ISI (Blouet and Blouet, 2002). Smaller and poorer countries such as Ecuador, Honduras, and Dominican Republic were not very successful in implementing ISI policies.

In Latin American countries where ISI was most successful, it was accompanied by structural changes to the government. Old neocolonial governments came crashing down to be replaced by more or less democratic governments. Banks and utilities and certain foreign-owned companies were nationalized.

Many economists contend that ISI failed in Latin America, being one of many factors leading to the so-called Lost Decade of Latin American economics. Other economists contend that ISI led to the "Mexican Miracle," the period that lasted from 1940 to 1970 in which economic growth of 6 percent or more.

Inward-looking ISI was rejected by most nations in East Asia in the 1960s, and many economists attribute the superior performance of East Asia in the 1970s and 1980s to this difference in policies. Indeed, Asian policies are most commonly not referred to as ISI, even though the rationale and execution of policy design largely followed those recipes. Most East Asian countries while rejecting the inward-looking component of classical import substitution policies also maintained high tariff barriers. The strategy followed by those countries was to focus subsidies and investment on industries which would make goods for export. In pursuing this and to boost its competitiveness in the 1970s , South Korea made large investments into heavy and chemical industries, such as shipbuilding, steel and petrochemicals. The focus on export markets allowed them to create competitive industries. Although these policies later created inefficiencies and other problems, as seen during the Asian financial crisis, it remains a hypotheses that this kind of policies laid the basis for their success.

From: http://hdr.undp.org/docs/publications/ocational_papers/oc24aa.htm

Critics maintain that, in particular in Latin America, the focus of import substitution in promoting industrialization typically resulted in policies which benefited industrial workers at the expense of farmers which made up most of the population of the nations involved. For example to reduce the cost of industrialization, the cost of food was often fixed at an artificially low level. In addition the licensing schemes required for an import substitution strategy led also to rent seeking behaviors which decreased economic efficiency. A lack of comparative advantage and economies of scale in small domestic markets in many of the targeted industries exacerbated that problem inefficiencies and increased the economic costs of the policies.

In order to build up their manufacturing bases, many countries imposed high tariffs on manufactured goods, so that multinational companies would instead produce or assemble them locally. One example of this was in the motor industry, in which manufacturers exported vehicles in complete knock down (CKD) kit form, for local assembly. This often resulted in products that were of poorer quality and more expensive than those imported 'completely built up'. It also became increasingly inefficient for manufacturers to have identical products assembled locally in several countries in the same region, which only served to duplicate resources and reduce economies of scale.

Government subsidies to support domestic production led to a lack of incentive for innovation and improving efficiency and to widening budget deficits.^{[citation needed]} This policy began to fail in the early 1980s, as a result of overspending by the governments involved, mostly from spending foreign exchange reserves trying to keep the currency stable. As the Latin American governments failed, they began to default on their debts and were forced to turn to the International Monetary Fund for help. The failure of ISI led to the rise of the Washington Consensus.

Still, the Asian case shows that a lot of these problems can be related to the inward-looking component of one set of ISI policies, as implemented in Latin America, rather than to the strategy itself. Through export orientation, problems of inefficiency and lack of economies of scale can be tackled by larger (potential) markets and international competition outside of the home country. Besides, modern economic theory that incorporates economies of scale in trade theory, such as New Trade Theory, delivers new arguments in favour of the infant industry argument and hence of ISI policies.

Chasteen, John Charles. 2001. Born in Blood and Fire. pages 226-228.

Reyna, José Luis & Weinert, Richard S. 1977. Authoritarianism in Mexico. Philadelphia, Pennsylvania: Institute for the Study of Human Issues, Inc. pages 067-107.

• International trade
• Commanding Heights for an exposition of the effects of ISI on Latin American economies
• Singer-Prebisch thesis
• Export-oriented industrialization

view	Topics in Trade
Definitions	Balance of payments · Current account (Balance of trade) · Capital account · Foreign exchange reserves · Comparative advantage · Absolute advantage · Import substitution · International trade
Organizations & Policies	World Trade Organization · International Monetary Fund · World Bank · International Trade Centre · Trade bloc · Free trade zone · Trade barrier · Import quota · Tariff
Schools of Thought	Free trade · Balanced trade · Mercantilism · Protectionism
Related Issues	Globalization · Outsourcing · Trade justice and fair trade