Should Ethiopia Integrate Import Substitution in its Industrialisation Policy?

Local manufacturers face a cavalcade of challenges – foreign currency shortages, import logistics, and frequent power outages, among other things. However, a number of benefits are afforded to those who focus on exporting their goods. The underlying logic is to promote manufacturing and increase export earnings. But is this the best way forward? Some economists and local manufacturers say that a policy that focuses on the local market would benefit Ethiopia’s economy in the long run. EBR’s Ashenafi Endale spoke with industry insiders to learn more about the details of this debate and offers this report.

It has been 22 years since the government introduced the Agricultural Development Led Industrialisation (ADLI) strategy as a policy response to Ethiopia’s food security and agricultural productivity challenges. The policy aims to achieve industrialisation through robust agricultural growth by linking the agriculture and the industrial sectors as well as shifting to profitable crops and the promotion of high-value exports.
As a result, foreign and local investors that are engaged in the manufacturing sector by utilising raw materials provided by the agricultural sector as well as those who export their products have been given attractive incentives, ranging from tax breaks to import duty privileges and access to credit.
More than two decades later, however, the plan hasn’t done a lot to change each sector’s performance vis-à-vis gross domestic product (GDP). Agriculture’s contribution to GDP decreased from 49.1Pct in 2000/01 to only 38.5Pct last fiscal year, while the industrial sector’s contribution to the national economy only grew from 12.9Pct in 2000/01 to 15.5Pct in 2014/15. Rather, the service sector has contributed greatly to the economy, accounting for 46Pct of GDP. What’s dismaying for policy makers is the poor performance of the export sector and skyrocketing import demand, with scarce foreign currency to balance the deficit.
In fact, the export earning capacity of the country has stagnated in recent years. Ethiopia managed to earn roughly USD3 billion in each of the past three consecutive fiscal years, while the import bill reached USD16 billion last fiscal year. As a result, the trade deficit expanded due to growth in total import bills coupled with relatively low export performance.
To be sure, incentives provided by the government have helped the country to attract investors, especially those who are export-oriented. For instance, a report released by the United Nations Conference on Trade and Development states that the foreign direct investment (FDI) inflow to the country reached USD7.2 billion in 2015. Ernst and Young’s attractiveness survey on Africa reveals that Ethiopia accounted for 18.5Pct of FDI in Africa that year.
However, the direct and opportunity cost of these incentives is becoming unbearable for the country. Over the last five years alone, the country has forgone over ETB191 billion in the form of duty-free import by manufacturing companies, according to a report released by the Ethiopian Revenues and Customs Authority.
Furthermore, those manufacturing establishments that produce for the local market are deprived of these incentives, making them vulnerable in the face of those who import finished products using the scarce foreign currency available in the country.
For these reasons, many economists and private sector insiders argue that the government should follow a policy of import substitution by providing incentives to manufacturers that sell products to the local market. Different development literatures define import substitution industrialisation as a trade and economic policy that advocates replacing foreign imports with domestic production. It is based on the premise that a country should attempt to reduce its foreign dependency through the local production of industrialised products. The term primarily refers to 20th century economic development policies, although economists such as Friedrich List and Alexander Hamilton have touted its benefits since the 18th century.
Import substitution policies and strategies were enacted by developing countries with the intention of producing development and self-sufficiency through the creation of an internal market. This growth model works by having state-led economic development through subsidisation of vital industries and by employing protectionist trade policies. Globally, import substitution industrialisation was gradually abandoned by developing countries in the 1980s and 1990s due to the insistence of the International Monetary Fund and World Bank on their quest to develop a liberalisation-driven global market.
However, private sector insiders say this is a far cry from the current state of affairs in Ethiopia, where export-oriented industries reap the benefits of government support, often to the exclusion of those focused on the local market. One company that is operating in such a tough environment without incentives is J&S Steel Structure, a Chinese company involved in designing, producing, supplying and installing steel structures for warehouse and workshop construction in Ethiopia. John Snow, General Manager of J&S Metals, says his company is the only producer of roof steel nails in the country and it had been exporting steel nails to Ethiopia from China for ten years before it established a factory on the outskirts of Addis Ababa two years ago.
The company produces up to four tonnes of roof nails per year and imports raw materials from China. Of the 13 countries J&S Metals’ mother company, which is located in China, exports steel nails to, it is only in Ethiopia that the company established a factory, according to Snow. “We were given a lot of promises by the Ethiopian Investment Commission when we came but none of them materialised,” says Snow. “We have already started expansion but under the current circumstance, it is tough to proceed. Investing in raw materials is especially challenging without duty-free import privileges.”
Stirred by the booming construction sector, the high demand for basic metal products has resulted in boosting local products rather than relying on imports. It was only two years ago that the country managed to rely on local manufactures to fully substitute the import of steel nails. Before that, most other metal product producing companies like J&S Metals had been importing raw materials with tax exemption.
However, after Steely RMI started producing wire rods locally, which is the major raw material for the production of steel nails, the government revoked the duty-free incentives that were given for the import of raw materials. Steely RMI, a private company engaged in steel manufacturing industry in Ethiopia, has the capacity to produce 120 tonnes of raw materials per year, almost double the country’s demand, and produces steel nails through Asmen, its sister company.
However, for the remaining 28 companies that manufacture steel nails, access to the raw material is possible only through importing by paying taxes. A total of 20 tonnes of raw materials were imported for steel nail production over the last nine months of the current fiscal year, while 24 tonnes were produced locally, according to a report released by the Metals Industry Development Institute (MIDI).
The Institution works closely with only seven of the steel nail manufacturers, according to Tilahun Abay, Director of the Planning and Information Directorate at MIDI. “Currently, two major steel nail manufacturers, namely J&S Metals and Asmen, can fulfil the nail demand of the nation,” he added.
Of course, Steely RMI, which has huge factories inside and outside of the capital, enjoys not only large coverage, but also receives a direct supply of power from Koka dam’s full power harvest, according to an official at Ethiopian Power Corporation, who spoke to EBR on the condition of anonymity.
Snow claims that he submitted a letter to different government offices in order to get duty-free import incentives or any other privilege but he says he didn’t receive any response. Snow says his company managed to save close to USD12 million each year that was spent towards the importation of steel nail before J&S Metals came to Ethiopia.
For manufacturers like Snow, who serve the local market, it is unbearable that the government gives more incentives to exporters, but not for those producers that strive to fulfil what the local market’s needs.
However, officials say the government has its own reasons for doing this. “We assume companies that produce for the local market are almost equal to exporting ones,” argues Fite Bekele, Director of the Corporate Communications Directorate at MIDI. “However, companies that produce the raw materials locally also must be protected.”
Fite said that Steely RMI asked for the protection because it can’t compete with raw material exporters in Ukraine. “It had to get protection in the market for its technology transfer, producing the raw materials locally and for creating job opportunities,” he says. “This means others have to pay the tax and import the raw materials.”
Birhanu Assefa (PhD), an industrial engineer at the Addis Ababa Institute of Technology, stresses that it will be wrong to rely on the few companies outperforming those that are growing. “Unless the country starts exploiting its own mining sector and substitutes the raw material that it is importing entirely, the scrap metals some companies use to produce the raw materials for nail production cannot last long and cover the demand,” he argues. “Incentivising companies by providing duty-free privileges is a must.”
Certainly, in the face of the strategic challenges that prevail in the country, the government has attempted to curb development constraints. As a step forward to attract potential investors and pave the way for private investors, the government issued a liberalised investment code in 1996, and later included a series of amendments to make the environment more conducive for both foreign and domestic investors.
The investment incentive packages as described in the Council of Ministers regulation approved in 2014 includes an exemption from the payment of import customs duties and other taxes levied on imports to all investment capital goods, such as plant and machinery, equipment. Also exempted are spare parts worth up to 15Pct of the value of the imported investment capital goods, provided that the goods are not produced and not available locally in comparable quantity, quality and price.
Ethiopian products and services destined for export are also exempted from paying certain taxes, while any income derived from an approved new manufacturing and agro-industry investment or investment made in agriculture shall be exempted from the payment of income tax for a specified period. The income tax exemptions may last up to nine years, depending on the specific activity and the location of the investor.
Despite these incentives, however, some argue Ethiopia’s journey towards industrialisation is sluggish as a result of not handling the export promotion and import substitution strategy equally.
The conclusions drawn from a study entitled ‘Import Substitution in the Construction Sector’, which was submitted as a master’s thesis at Addis Ababa University, support this understanding. It states that since almost all the demand for cement and steel are satisfied using domestic production, an import substitution strategy will be advantageous for the country to shift, with a little more extended effort, in exporting these materials. Based on other countries’ experiences, import substitution with export promotion will result in successful development policy, according to the study.
However, government officials also say in today’s globalised market, an inward-looking growth model is not reliable. “The manufacturing and export sector are the heart of ADLI, which has been in place for a long time now,” explains Ahmed Nuru, Director of the Policy and Program Studies Directorate at the Ministry of Industry (MoI). “Exporting is critical and eligible for incentives because it brings foreign currency. Ethiopia has to push for developing the economy through competition, not protection, before joining the World Trade Organisation.”
Melaku Taye, Director of the Communications Directorate at the MoI echoes Ahmed’s sentiments. “Our domestic market now is very artificial, rounded with government’s protections,” he says. “The economy will vanish at the very introduction of international standards that only work with fair competition.”
In addition to government officials, the mainstream of academic researchers seem to favour export-promoting strategies by arguing that although import substitution policies might create jobs in the short run, as domestic producers replace foreign producers, economics theory shows that in the long run output and growth will be lower than it would otherwise have been. This is because import substitution denies the country the benefits to be gained from specialisation and foreign imports. The law of comparative advantage demonstrate how countries will benefit from trade.
Moreover, advocates of the export-led growth model stress protectionism leads to dynamic inefficiency since domestic producers have no incentive from foreign competitors to reduce costs or improve products. In this way, import substitution can impede growth through poor allocation of resources and its effect on exchange rates harms exports.
Although it is difficult to measure their direct impact on the country’s economic performance, according to a study entitled ‘Narrowing Trade Deficit through Increased Import Substitution’ published by the Addis Ababa Chamber of Commerce and Sectoral Associations in 2011, there is evidence that shows the economic benefits that the country generated from those incentive schemes.
For instance, the incentive schemes on exports have played an important role in the performance of the country’s exports by attracting new exporters and encourage existing ones. The recent expansion of floriculture development in the country could be cited as one example in this respect, though the contribution of other incentive packages could be equally cited.
For these reasons, Ahmed says that the government is working on amending the export strategy, which will be effective next fiscal year. “Exporters will get more incentives based on their export performance and amount, linkage in the value chains and outsourcing,” he explains. “If they don’t export on time or sell the product for domestic market, after importing inputs duty free, they will pay the tax with additional 50Pct penalty.”
Other experts, especially those in developing countries, believe that import substitution is the best policy available for the developing countries and emphasise industrialisation as a major path towards development.
This policy stresses the need for developing countries to implement their own strategies that give room for indigenous technologies appropriate to their respective resources. According to Dominick Salvatore (PhD), Distinguished Professor of Economics at Fordham University, an import substitution strategy is advantageous for developing countries like Ethiopia because it is easier for developing nations to protect their domestic market against foreign competition than to force the developed nations to lower trade barriers against their manufactured exports.
Those experts who hold the middle ground, however, argue that developing countries should be able to adjust to the changing global dynamics, such as decreased global demand for commodities and declining international price, especially for agricultural products. In a global economy where demand of imported goods is declining in developed countries, they argue, it is better for developing countries to look inward. EBR