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Truth about industrial policy

By Justin Yifu Lin (China Daily)
Updated: 2010-12-29 08:00

One of the best-kept economic secrets was reconfirmed in 2010: most countries, intentionally or otherwise, pursue an industrial policy in one form or the other. This is true not only of China, Singapore, France, and Brazil - countries usually associated with such policies - but also for the United Kingdom, Germany, Chile and the United States whose industrial policies are often less explicit.

Given that an industrial policy broadly refers to any government decision, regulation or law that encourages ongoing activity or investment in an industry, this should come as no surprise. After all, economic development and sustained growth are the result of continual industrial and technological change, a process that requires collaboration between the public and private sectors.

Historical evidence shows that in countries that successfully transformed from an agrarian to a modern economy - including those in Western Europe, North America and, more recently, in East Asia - governments coordinated key investments by private companies that helped launch new industries, and often provided incentives to pioneering companies.

Even before the global financial crisis and subsequent recession, governments around the world provided support to the private sector through direct subsidies, tax credits or loans from development banks to bolster growth and support job creation. Policy discussions at many high-level meetings sought to strengthen other features of industrial policy, including public financing of airports, highways, ports, electricity grids, telecommunications and other infrastructure, improvements in institutional effectiveness, an emphasis on education and skills and a clearer legal framework.

The global crisis has led to a rethinking of governments' economic role. The challenge for industrial policy is greater, because it should assist the design of efficient, government-sponsored programs in which the public and private sectors coordinate their efforts to develop new technologies and industries.

But history also tells us that while governments in almost all developing countries have attempted to play that facilitating role at some point, most have failed. The economic history of the erstwhile Soviet Union, and Latin America, Africa and Asia has been marked by inefficient public investment and misguided government interventions that have resulted in many "white elephants".

These pervasive failures appear to be due mostly to a government's inability to align its efforts with its country's resource base and level of development. Indeed, governments' propensity to target overly ambitious industries that were misaligned with available resources and skills helps to explain why their attempts to "pick winners" often resulted in "picking losers". In contrast, governments in many successful developing countries have focused on strengthening industries that have done well with comparable factor endowments.

Thus, the lesson from economic history and development is straightforward: government support aimed at upgrading and diversifying industry must be anchored in the requisite endowments. That way, once constraints on new industries are removed, private firms in those industries quickly become competitive domestically and internationally. The question then becomes how to identify competitive industries and how to formulate and implement policies to facilitate their development.

In developed countries, most industries are advanced, which suggests that upgrading requires innovation. Support for basic research, and patents to protect successful innovation, may help. For developing countries, Cameroonian economist and adviser to the World Bank's senior vice-president Clestin Monga and I have recently developed an approach - called the growth identification and facilitation framework - that can help governments in developing countries increase the probability of success in supporting new industries.

This framework suggests that policymakers identify tradable industries that have performed well in growing countries with similar resources and skills, and with a per capita income about double their own. If domestic private companies in these sectors are already present, policymakers should identify and remove constraints on those companies' technological upgrading or on entry by other enterprises. In industries where no domestic companies are present, policymakers should aim to attract foreign direct investment from the countries being emulated or organize programs for incubating new enterprises.

The government should also pay attention to the development by private enterprises of new and competitive products, and support the scaling up of successful private-sector innovations in new industries. In countries with a poor business environment, special economic zones or industrial parks can facilitate the entry of such companies, foreign direct investment and the formation of industrial clusters. Finally, the government may help pioneering companies in the new industries by offering tax incentives for a limited period, co-financing investments or providing access to land or foreign exchange.

Our approach provides policymakers in developing countries with a framework to tackle the daunting coordination challenges inherent in the creation of new, competitive industries. It also has the potential to nurture a business environment conducive to private-sector growth, job creation and poverty alleviation.

As economies around the world struggle to maintain or restore growth in 2011, industrial policy is likely to be under a brighter spotlight than ever before. Given the right framework, there is no reason for it to remain in the shadows.

The author is chief economist and senior vice-president for development economics at the World Bank.

Project Syndicate