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Industrial Policy

 
For an overview of the Industrial Policy approach and current debates in pdf format, click here - PSD Synthesis Note: Industrial Policy

Laos weaving

It is generally recognised that “[d]evelopment is fundamentally about structural change: it involves producing new goods with new technologies and transferring resources from traditional activities to these new ones” (Dani Rodrik 2007). Further resources on current thinking and experiences in structural transformation can be found below.

Industrial policies are increasingly considered as a central tool in promoting such economic transformation: It is argued that developing countries can never emerge from aid dependency, "if they are unable to use the industrial policies (which) they will need to transform their domestic industries, diversify their economies and build up their own tax bases over time" (Rick Rowden, 2011). Against this background, the synthesis below offers an overview of industrial policy for PSD practitioners. Six current debates are then explored, while Weiss (2013), in a paper published by the DCED, addresses the compatibility between industrial policy and business environment reform.

UNCTAD defines industrial policy as a “concerted, focused, conscious effort on the part of government to encourage and promote a specific industry or sector with an array of policy tools”. The World Bank[1] considers industrial policy as “government efforts to alter industrial structure to promote productivity-based growth”. Pack and Saggi provide a more detailed definition: “any type of selective intervention or government policy that attempts to alter the structure of production toward sectors that are expected to offer better prospects for economic growth than would occur in the absence of such intervention, i.e., in the market equilibrium.”

Industrial policies can apply to manufacturing as well as agricultural or service sectors. For example, Dani Rodrik states that industrial policy “is not about industry per se”, but that “policies targeted at non-traditional agriculture or services qualify as much as incentives on manufactures”.

Suggestions for additions to this page are welcome at any time. Click here to contact the DCED Secretariat.

Background documents: structural transformation

'Big picture' documents on development pathways

Research on growth and structural transformation in Asia

Research on growth and structural transformation in Africa

Six Debates on Industrial Policy

1. Is Industrial Policy Good? If So, When Is It Practical?

The growing interest in industrial policy among development practitioners partly relates to Western governments’ interventionist responses to the Financial Crisis. Meanwhile, the success of many East Asian economies, most recently China, is often associated with industrial policy. Some advocates of industrial policy such as Ha-Joon Chang also argue that despite their promotion of free markets abroad, rich countries have often used industrial policy as part of their own development strategies (e.g. Chang,2009).

On the other hand, critics stress that poorly-designed industrial policies risk having worse outcomes than the market failures they seek to address. Some argue frequent shortages of transparency and technical capacity among policymakers in low-income countries make poorly-designed industrial policies likely. A separate concern relates to the practicality of industrial policy; international trade agreements outlaw many active industrial policy tools, although Least-Developed Countries are sometimes allowed greater flexibility.

While debates continue to rage over the merits of industrial policy, more and more attention is focused on how to design and implement it. Four “how to” issues currently debated among experts and practitioners are outlined below.

2. What kinds of industrial policies are effective?

One aspect of this debate is whether governments should use industrial policies to make the most of their country’s current comparative advantage, or instead invest in higher-productivity industries that are not competitive in the short-term. According to Justin Yifu Lin, former World Bank Chief Economist, where industrial policies fail this is “due mostly to governments’ inability to align their efforts with their country’s resource base and level of development” (Lin, 2010). For Lin, developing countries should first seek to profit from the (mostly labour- and resource-intensive) products and services that they are currently most competitive in. They will accumulate human and physical capital in the process. This capital, Lin argues, can be reinvested over time in more productive industries. An article in the The Economist draws similar conclusions.

Ha-Joon Chang, in contrast, argues that developing countries should defy their comparative advantage. For Chang, the cost of moving capital between industries (e.g. from sewing machines to car plants) means that countries should actively promote high-productivity industries at an early stage in their development. A debate between Justin Yifu Lin and Ha-Joon Chang provides more information on this topic.

Based on empirical analysis of 20 developed countries, a report by the McKinsey Global Institute supports Lin’s view that industrial policymakers should care more if an industry is competitive ,than if it is high-tech. The McKinsey report also finds that the growth and job creation potential of non-tradable sectors such as retail and telecoms is often underestimated.

Some argue that while manufacturing should be given special policy treatment, governments should not favour particular manufacturing industries (cf. UNIDO, 2011). One way to do this is by improving the infrastructure that manufacturers require, e.g. by promoting industrial clusters (UNIDO 2009). The creation of export-oriented Special Economic Zones is a well-known example of this. Critics argue that such an approach may only attract short-term investment, achieving little if any positive spillover into the wider economy (Good and Hughes, 2002).

3. How does Political Economy affect industrial policy?

One dilemma for policymakers in developing countries is that while the “the need to correct market failure is much greater than it is in rich and institutionally advanced societies, the ability of the public sector to tackle such failure is also much more limited ” (Altenburg 2011). Governance systems in developing countries are often structured in clientelistic and patrimonial ways. This increases the risk of policies being captured by special interest groups. Furthermore, the skills and resources needed to design, implement and monitor industrial policies are often lacking.

Some therefore argue that the lower the government’s capabilities, accountability and commitment, the lower the sophistication of industrial policies that the government can be trusted with (e.g. Sanjaya Lall). Where certain pre-conditions are not present, and the risk of political capture is too high, it may be necessary to focus on accountability-enhancing measures and the promotion of a business-enabling environment. On a similar but more optimistic note, Altenburg observes that some governments have succeeded in promoting industrialisation and developed more efficient and transparent bureaucracies, despite their poor performance in other aspects of governance.

In East Asia, where many judge industrial policies to have succeeded, governments had good relations and continuous dialogue with the private sector. In some developing countries the reverse is true: the majority of business owners are allied to the political opposition. As well as dialogue, fairness was important in East Asia’s industrial policies; the granting of privilege was made conditional on export performance (Sanjaya Lall). Dani Rodrik points to another success factor: governments’ ability to recognise mistakes and withdraw their support before it becomes too costly.

4. Is industrial policy compatible with business environment reform?

The donor community for many years has been supporting reforms in developing countries that improve the business environment by reducing legal, institutional and regulatory constraints for doing business and promoting a better investment climate (DCED, 2008). Though this also aims to contribute to the development of the private sector, it is often seen as very different to industrial policy as the latter involves direct interventions to overcome market failures and change the structure of the economy.

Weiss assesses how compatible these two approaches are. Business environment reform is more reconcilable with strategic industrial policy, a more recent approach that focuses on horizontal (non-selective) and market-supporting interventions, and encourages government and private sector dialogue. The potential for contradiction is greatest where industrial policy uses vertical measures, focused on specific sectors or firms. Weiss suggests that differences can be reduced by industrial policy focusing on limited priority areas where an economy has a latent comparative advantage that can be turned into actual competiveness with relatively modest and short-lived support.

5. Does industrial policy serve the poor?

Industrial policy is often guided by multiple objectives. These may include stimulating innovation, productivity and growth, reducing regional and income inequalities, food and energy security, job creation and poverty reduction (Lütkenhorst 2010, in Issue 3 of Making it). Of major interest to the development community is the question whether or not industrial policy is pro-poor.

Assuming that poverty reduction is a major priority, and accepting that there is often a short-term trade-off between equity and growth, disagreements over the main aim of industrial policy reflect the range of views on how likely the poor are to benefit from economic growth in general. Altenburg (2011), citing evidence that growth is not inevitably good for the poor, argues for ‘inclusive industrial policies’. He defines these as policies that aim to promote “structural change in a way as to enhance competitiveness and productivity growth while increasing the incomes of the poor more than proportionally”. Such policies may involve safeguards for vulnerable groups, a focus on labour-intensive industries, or the strengthening of linkages between SMEs and larger firms.

6. What Can Donors Do?

Donors can pay experts to build partner governments’ capacity to design, implement and monitor their industrial policies. For example, experts can advise partner governments on how to update the regulations governing their target industries. Donor-funded technical experts can also help to design and implement reforms that improve the performance of public agencies which support the overall functioning of the target industry. GIZ and UNIDO, for example, have provided technical assistance to investment promotion agencies.

Donor-funded experts can also help to improve the policy formation process, both from a technical point of view, and by using their influence to push for transparency in public-private dialogue. The latter helps to reduce the risk that industrial policy is unduly biased towards special interest groups.

As a complement to industrial policy, donors can support partner governments’ efforts to grow priority industries by ensuring that the service markets which support these industries function well. Strengthening markets for business development services, for example, can assist firms to upgrade their management practices, make well-informed decisions about which new technologies to adopt, and lower their costs through greater resource and energy efficiency. The Ethiopian-German Engineering Capacity Building Program and UNIDO’s Resource Efficient and Cleaner Production Programme are two examples of programmes in this area. Donors can also assist technology transfer by helping firms in target industries to partner with technologically-advanced firms in their home countries, through their network of contacts or through trade fairs. Similarly, donors can promote investment in the physical infrastructure that target industrial clusters depend on. Better railways, roads and ports in the areas where governments’ priority industries are concentrated help these industries to grow.

Resources

For and Against Industrial Policy in Developing Countries

"How to" of Industrial Policy

Experience from Various Countries

Photographs courtesy of Kate Lee, Charles Bodwell, Denny Herlambang Slamet, Russell Brott and MorgueFile.com.

Videos on industrial policy

Ha-Joon Chang, economics professor at Cambridge University, argues that the development agenda has been dominated by free-market thinking, and has not looked enough at economic transformation, industrialisation and how to get developing countries out of dependence on primary commodity exports.

[1] The World Bank (1993). The East Asian Miracle. Washington, DC: The World Bank.