UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT

POLICY ISSUES IN INTERNATIONAL TRADE AND COMMODITIES

STUDY SERIES No. 6

INDUSTRIAL POLICY AND THE WTO

by

Bijit BoraUNCTAD and Flinders University of South Australia

Peter J. LloydUniversity of Melbourne

Mari PangestuCentre for Strategic and International Studies, Jakarta

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UNITED NATIONSNew York and Geneva, 2000

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NOTE

The views expressed in this study are those of the authors and do not necessarilyreflect the views of the UNCTAD secretariat.

The designations employed and the presentation of the material do not imply theexpression of any opinion whatsoever on the part of the Secretariat of the United Nationsconcerning the legal status of any country, territory, city or area, or of its authorities, orconcerning the delimitation of its frontiers or boundaries.

Material in this publication may be freely quoted or reprinted, but acknowledgementis requested, together with a reference to the document number. A copy of the publicationcontaining the quotation or reprint should be sent to the UNCTAD secretariat:

ChiefTrade Analysis Branch

Division on International Trade in Goods and Services, and CommoditiesUnited Nations Conference on Trade and Development

Palais des NationsCH – 1211 Geneva

UNCTAD/ITCD/TAB/7

UNITED NATIONS PUBLICATION

Sales No. E.00.II.D.26

ISBN 92-1-112497-2

ISSN 1607-8291

Copyright 8 United Nations 2000All rights reserved

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ACKNOWLEDGEMENTS

The authors would like to thank Bernard Hoekman, Will Martin, Joerg Weber andSusan Teltscher for helpful comments on an earlier draft. Helpful comments were alsoreceived from Rajesh Chand and Miguel Rodriguez-Mendoza, our discussants, when thepaper was presented at the World Bank Global Conference on the Millennium Round, heldat the World Trade Organization in Geneva on 20 and 21 September 1999. Manuela Tortora,the internal referee, greatly improved the paper with her incisive and helpful comments.

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CONTENTS

I. THE ISSUE.................................................................................................................1

II. THEORY OF INDUSTRIAL POLICY..................................................................4

A. Second-best arguments for industry protection................................................................ 5B. Technology development................................................................................................ 7C. Strategic trade policy .................................................................................................... 11

III. EXPERIENCE WITH INDUSTRIAL POLICY IN EAST ASIA....................13

A. General trends .............................................................................................................. 13B. Industrial policy and implementation of Uruguay Round commitments......................... 14C. Changes since the Uruguay Round................................................................................ 15D. Policies towards foreign investors................................................................................. 17

IV. WTO RULES AND INDUSTRIAL POLICY .....................................................19

A. Import protection.......................................................................................................... 19B. Subsidies and export promotion.................................................................................... 20C. Agreement on Trade-related Investment Measures........................................................ 21D. Agreement on Trade-related Aspects of Intellectual Property Rights ............................. 22E. General Agreement on Trade in Services ...................................................................... 23F. Special and differential treatment.................................................................................. 23G. Implications of WTO rules for industrial policy ............................................................ 24

V. IMPLICATIONS FOR DEVELOPING COUNTRIES.....................................26

A. Import protection.......................................................................................................... 26B. Export promotion ......................................................................................................... 27C. Competition policy ....................................................................................................... 27D. Market access for foreign investors............................................................................... 28E. Performance requirements for foreign investors ............................................................ 29F. Special and differential treatment.................................................................................. 31

VI. CONCLUSIONS ......................................................................................................33

REFERENCES.....................................................................................................................35

ANNEX ..................................................................................................................................41

WTO Dispute Panel case on Indonesia: certain measures affecting the automobile industry ............................................................................................................................ 41Indonesia’s automobile policy............................................................................................... 41Objectives of the national automobile programme................................................................. 41Policies................................................................................................................................. 42WTO rules affected by the national automobile programme .................................................. 42Ruling................................................................................................................................... 43State of play.......................................................................................................................... 43Lessons................................................................................................................................. 44

Box 1. Instruments of industrial and export promotion policies:Republic of Korea and Japan ....................................................................... 15

Table 1. Policies and measures to promote exports in Asia ........................................ 39Table 2. Evolution of industrial policies in East Asia................................................. 40Annex table 1. Alleged breaches of multilateral trade agreements

by Indonesia’s national automobile programme ........................................... 45

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I. THE ISSUE

The general objective of promotingexports and achieving rapid structuralchange and economic growth has been anintegral part of development economicsand policy-making for many decades.There has been a succession of differentapproaches and thinking with regard tohow this objective can best be met, rangingfrom inward-looking or import substitutionindustrialization behind high protection, tooutward-oriented or export orientation andpromotion strategies considered to be partof the success story of East Asia. The rangeof instruments used for conductingindustrial policy has also changed with theevolution of multilateral trading rules, aswell as unilateral liberalization, the latteroccurring within a framework of structuraladjustment that is required in order to staycompetitive and in some cases to accessinternational finance. The combination ofstrategy and instruments used has been thesubject of numerous studies, with mixedresults on the value of interventions andtheir outcomes. There has also been aplethora of studies which show thatindustrialization behind protective wallshas often extended beyond reasonableperiods of “infancy” and has led toinefficiency and welfare losses, andentrenched vested interests.

Despite the strong theoretical caseagainst activist industrial policy, it is stillwidely pursued in a number of countries.1

1 A number of countries have pursuedinterventionist industrial policies with some degreeof success. In East Asia, the Republic of Korea,Taiwan Province of China and Japan are threeexamples of where government intervention in theform of activist policies was important for the paceand direction of development (Lall, 1994; Singh,1996; Asian Development Bank, 1999: 208-210).This intervention, however, was broad-based andnot confined to protection. It included aspects of

In the 1990s, however, the context inwhich it is pursued is different. Rapidtechnological change, shorter productcycles and developments in informationtechnology have combined withprivatization, and trade and foreigninvestment liberalization to produce aglobal economy that is distinctly different.In this context, developing countries arestriving to ensure that their industries arecompetitive by using industrial policy topromote particular sectors.

It should be pointed out at theoutset that the term “industrial policy” isnot a well-defined one. It is ill-defined inrelation to the objectives, the industries thatare covered and the instruments that areused. The World Bank (1992) hasprovided a working definition of industrialpolicy as “government efforts to alterindustrial structure to promote productivitybased growth”.2 This definition is usefulsince it focuses on the objective ofeconomy-wide factor productivity growthrather than on merely changing thestructure of industrial outputs.

With regard to objectives, manydeveloping countries have in mind thepotential for long-run productivityimprovements. However, in most casesindustrial policy is pursued with multipleobjectives, including short-termemployment, increased output, better

targeted technological promotion, financing andskill development. In an effort to replicate thissuccess many developing countries have taken theposition that they too should be allowed to pursuesuch policies and not be restricted by multilateralrules.2 A recent paper by Martin and Mitra (forthcoming)shows that the productivity growth rate inagriculture is higher both on average and for groupsof countries at different stages of development.

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income distribution and enhancingtechnological capacity. There are oftenalso, rightly or wrongly, non-economicobjectives of national pride and prestige, aswell as the perceived need to promote“strategic” domestic industries.

These objectives are furtherconfused to the extent that manydeveloping countries have taken the viewthat ownership of assets matters. There is aconcern that foreign ownership may notalways fit in well with broaderdevelopment objectives, includingenhancing domestic capabilities.3 In somecases, foreign ownership could crowd outdomestic firms. Thus, even if the WorldBank definition is adopted andproductivity-based growth materializes, thefact remains that developing countries haveraised concerns about the source of growth.Growth in per capita GDP based ondomestic assets seems to be preferred togrowth based on foreign assets. The latterwould not constitute “development” per se.Some countries may be prepared to tradeoff a lower rate of growth in per capitaGDP combined with lower foreignownership against a higher rate of growthwith more foreign ownership.4

The focus of “industries” almostinvariably seems to be on themanufacturing sector. This leaves outagriculture, services and mining, althoughthese sectors raise much the same issues.Processing of agricultural and miningproducts occurs in the manufacturingsector, and the line between unprocessedand semi-processed products on the onehand and processed products on the other isarbitrary. Similarly, many services sector 3 For a discussion of how foreign ownership mattersin the context of development see UNCTAD(1999a).4 One possible reason for this could be theperception that openness would increase thevulnerability of the country to external shocks.

industries add value to manufactures, andthey raise issues that parallel those ofindustrial development in manufacturingindustries. Restriction of the discussion tomanufacturing industries alonediscriminates against non-manufacturingindustries and leads to inefficiencies in theproduction allocation of the economy.Although the growth of industry output andexports in some developing countries inAsia and elsewhere is concentrated inmanufactures, in others primary andservices sector development is animportant part of growth. In this paper,industrial policy is not restricted by sector.

With regard to instruments, thetraditional focus has been on tariffs oroutput-based subsidies or export subsidiesto industries as a way of rectifying allegedmarket failures due to externalities,missing markets or other failures (Lall,1994). These have also been used to directresources into certain sectors that may beconsidered more conducive to developmentsuch as those with high growth potential.Recently, however, more attention hasbeen devoted to factor markets, especiallyforeign direct investment (FDI). Here thebelief is that FDI is a bundle of assets thatcan contribute to economic development.At the same time, however, the use of theseassets by affiliates of transnationalcorporations (TNCs) can also hinder acountry’s development efforts.Government intervention is then requiredin order to alter the operations of foreignaffiliates so as to minimize their negativeeffects (UNCTAD, 1999b).

In reality, developing countrieshave used a mix of import protection,export promotion, foreign investmentrestrictions and performance requirements,tax incentives and other measures topromote industrialization. The types ofinstruments used by developing economieshave changed, especially since the 1980s,

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owing to increased restrictions on their usethrough multilateral and regionalagreements, as well as domestic regulatoryreforms initiated through structuraladjustment loans or domestic efforts torestructure their economies. The majorchanges faced by countries resulting frommultilateral rules are the various GATTCodes that emerged prior to the UruguayRound, particularly the GATT Code onSubsidies and Countervailing Duties of1979, which restricted signatories’ use ofexport subsidies. The multilateral tradeagreements, agreed upon by WTOmembers as part of the Uruguay Roundnegotiations, have created new disciplineson the use of such policies. Meanwhilecommitments under the Uruguay Roundand regional agreements, and unilateralefforts to liberalize, have led to a decline inthe use of tariff and non-tariff measures.

The aim of this paper is to reviewthe objectives and instruments of industrialpolicy in a changing global context andmultilateral rules and discipline. Theremainder of this paper is divided into foursections. In the next section an analyticalreview is undertaken of the objective of,

and justification for, industrial policypursued by countries. The importance ofhaving an analytical framework is that itbecomes the benchmark against whichobjectives, instruments and outcomes canbe measured. In the third section the useof different instruments for industrialpolicy is reviewed. An attempt is made toassess whether changes have been due tocompliance with multilateral and/orregional commitments, or due to unilateralreform efforts. This section also discusseswhether new non-traditional instruments topursue protection were needed once the useof traditional instruments becamerestricted. The fourth section focuses onthe role of industrial policy in the post-Uruguay Round era with a view to the nextround of WTO negotiations. It examinesboth the theoretical and the applied aspectsof industrial policy before surveying theextent to which existing WTO rules affecta member’s ability to pursue industrialpolicy objectives. The possibilities andimplications of revising rules that affect theuse of industrial policy instruments arediscussed in the fifth section. The lastsection sets out a number of conclusions.

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II. THEORY OF INDUSTRIAL POLICY

This section begins with a briefreview of the traditional argument againstinfant industry protection. This argumentstill lurks behind most advocacy ofgovernment assistance for industrialdevelopment in developing (anddeveloped) countries. Moreover, anexamination of it highlights pitfalls inpolicy development which apply equallyto other modern arguments since they areessentially variants of the old infantindustry argument.

The traditional infant industryargument justified a tariff, or a subsidybased on the output of firms which havean equivalent effect on output, on the basisof some dynamic externality. Kemp(1964) provides probably the first carefulstatement of the argument. He identifiedlearning processes such as worker learningby doing or on-the-job training as thesource of cost saving and distinguishedbetween learning processes which areinternal to the firm and those that areexternal. The former are appropriable bythe firm. Only those that are external tothe firm warrant assistance, and then onlyif the reductions in cost over timecompensate for the higher costs during theperiod of assistance,5 with all flowsappropriately discounted. The tax subsidyis temporary.

This argument immediately raisesa number of policy difficulties. It neverprovides a justification for blanketassistance to all firms in an industry oreven a sub-industry since the existence ofan externality and the required cost savinghave to be demonstrated in every case.

5 If the instrument of assistance is a subsidy ratherthan a tariff, one should add the costs imposed bythe tax that funds the subsidy costs.

Baldwin (1969) raised a seconddifficulty. He pointed out that a tariff (orsubsidy) provides no incentive per se for afirm to acquire more knowledge, becauseit is an output-based intervention. A firmwill increase output by the least costlymethod, not necessarily by acquiring moretechnology. The correct policy implied bythe argument, supposing that it isdemonstrated, calls for a subsidy related toknowledge creation, for example a subsidyon the particular workers who learn bydoing. Most knowledge or skillacquisition is process-, job- or product-specific. In these cases the correctivesubsidy will be confined to the process,job or product, or whatever, and based onthe variable with which the externality isassociated. Thus, there are substantialqualifications to the infant industryargument.

This line of argument is in fact anexample of a much more general theme inthe literature of government intervention.Each externality or market failure calls fora tax subsidy whose base is the variablewhich generates the externality or failure,and the tax-subsidy rate will be the ratethat has the optimal effect. Bhagwati(1971) gives an early statement of the rule.Any tax subsidy other than the optimal taxsubsidy causes what Corden (1974) calledby-product effects that impose costs on theeconomy. Moreover, the tax-subsidy ratevaries across firms in an industry if thestrength of the effect justifyingintervention varies across firms. Evenwhen an intervention is called for, thechoice of a suboptimal instrument withby-product effects reduces the net benefitsobtainable from the optimal instrumentand may in fact be welfare-reducing.

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A. Second-best arguments for industryprotection

There are a number of variants ofthe infant industry argument based on thepresence of other tax subsidies orconstraints that produce an argument forprotection of importable goods. Instead ofderiving from the presence of someexternality that operates over time, thesearguments derive from the presence ofother distortions in the economy, such astariffs or commodity taxes, which areconsidered unremovable and thereforepermanent. These are applications of thetheory of the second-best. In their famousarticle, Lipsey and Lancaster (1956)showed that if an optimization problem ismodified by the addition of newconstraints, the first-order conditions thatcharacterized the first-best optimizationare in general violated.

In the context of internationaltrade, this means that the standard findingthat free trade is the best policy for a smallcompetitive economy may not beapplicable. In the 1970s, a number ofeconomists produced examples of thistheory. For instance, if a subset ofimportable goods is subject tounremovable distortions in the form oftariffs, the second-best optimum calls fortariffs or trade subsidies for some or all ofthe remaining goods whose prices are notfixed. The nature of the second-best set oftax subsidies can be characterized in termsof the relationships of substitutability andcomplementarity between the two sets ofgoods (see Lloyd, 1974; Hatta, 1977).Again, as with the infant industryargument, the optimal governmentintervention and the associated rates of taxsubsidy depend on the exact nature of theconstraints. These arguments usually findthat a tariff is called for on the outputs ofsome industries, but this applies becausein the models that were used each industry

produces only one good. If there aremany-good industries, the second-best taxsubsidies will vary across the goods in anindustry.

These models also pose majordifficulties for policy makers. In the firstplace, it is not clear why we shouldconsider that some tariff rates or othergovernment tax subsidy rates arepermanently totally unchangeable whileothers are freely changeable. Secondly, asthe second-best is the solution to acomplex constrained general equilibriumof an economy, the determination of thesecond-best requires perfect knowledge ofall aspects of the economy. This includesall supply and demand parameters, in factthe determinants of the behaviour of allagents in the economy. This is grosslyunrealistic. Third-best interventions madein ignorance of the true values of somebehavioural parameters may be welfare-reducing.

Specific examples of this type oftheory are to be found in the recentliterature on protection in developingcountries. Some of the authors havechosen a trade-related investment measureas the form of government intervention.6

One example is the use of localcontent programmes. Many developingcountries have introduced suchprogrammes in the automobile industry inparticular – for example, India, Malaysiaand the Philippines in Asia and Mexico,Brazil and Argentina in Latin America(Moran, 1998). This has been donechiefly in the belief that any policy thatincreases the local content of a unit of

6 There is an older literature which makes a similarcase for export subsidies on the ground that tariffsand other policies which promote importsubstitution have discriminated against exports; seeHarris and Schmitt (1999) for a review of thisliterature.

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output, i.e. the proportion of domesticvalue added in the production of thegoods, must be beneficial. This naivebelief ignores the effects whichencouraging the production of oneindustry has on other industries; the greatstrength of general equilibrium theory isthat it brings out the economy-wide effectsof intervention in one industry. Thisbelief also ignores the volume effectswithin the industry. Dixit and Grossman(1982) made an elegant analysis of contentplans in a general equilibrium model witha continuum of stages. Although there isno FDI in their model, the main effects ofa content plan are highlighted. They showthat a content plan will raise the cost ofintermediates to downstream and finalproducers and thereby lower theireffective protection. It will also increasethe range of goods produced but may beanti-protective in terms of the aggregatelabour employed and value added in theprotected industry. Moreover, it iswelfare-reducing.

There are second-best theorymodels that purport to show that contentplans are welfare-improving fordeveloping countries. These modelsintroduce additional constraints due to thepresence of unemployed factors generatedby a fixed minimum wage or a tariff onthe final good.

Chao and Yu (1993) put forwardan argument in favour of protection bymeans of content plans. They constructeda model of a dual economy with urbanunemployment. The urban sectorproduces a processed good and the ruralsector produces an agriculturalcommodity. The production of theprocessed good requires intermediateinputs that can be imported or sourcedlocally. In the tradition of the Harris-Todaro model, a fixed minimum wage isset institutionally in the urban sector

giving rise to urban unemployment, whilethere is a flexible wage in the agriculturalsector. It is easily shown that urbanunemployment makes the marginal ratesof transformation of the manufacture forthe agricultural good exceed the relativeprice ratio. This gap implies an allocativeinefficiency in the economy. Essentially,the agricultural output is under-producedbecause at the margin the social value ofthis good relative to that of themanufacturing good is greater than therate of transformation.

This is a variant of the standardmodel of international trade with a factormarket distortion which has been studiedextensively as an argument for protection.The twist in favour of content protectioncomes from adding structure to theproduction sector of the model. Theassumption made is that the domesticmaterials are produced by the agriculturalsector and used in the manufacture of theurban product, and that the materialssector is an infant industry whosedomestic price is higher than the worldprice. As in the Dixit–Grossman model,the content protection increases thecontent per unit but reduces the aggregateoutput of the protected industry. Thisleads to a decrease in demand for theoutput of the urban sector, which causes areversal of migration to the urban sectorand reduces the gap between the rate oftransformation and the relative price.Chao and Yu (1993) claim that the effectis welfare-enhancing, although in theirearlier paper they found that it waswelfare-reducing.

Richardson (1993) examines theeffects of a content plan in a second-bestsituation due to the existence of a tariff ona final manufacturing good. He adds FDIin both the final manufacture and itscomponent suppliers. The content planapplies only to the foreign investor and is

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therefore a trade-related investmentmeasure (TRIM). A content plan hasoffsetting negative allocation effectsbecause it increases output and reducesimports in the components sector, andpositive revenue effects because itincrease imports of the final manufactureand reduces payments to foreign capitalwhich is specific to final manufactures. Adomestic content policy set at lowpercentages is welfare-increasing in thiscontext.

Rodrik (1987) and Greenaway(1992) have made a similar second-bestcase for TRIMs in the form of exportshare requirements. Rodrik considers aneconomy which is host to FDI by amultinational corporation. The priordistortions are tariffs, which inducedforeign investment or oligopolisticbehaviour in the industry. As is wellknown, foreign investment isimmiserizing if the import industry iscapital-intensive; it exacerbates the loss oftariff revenue. In this situation, an exportrequirement may partially offset thenegative effect of foreign investment bylowering the profitability of the latter,reducing output and increasing imports orlowering the rate of return on foreigninvestment. In the case of oligopolisticinteraction between the multinationalcorporation and the local firms, an exportrequirement reduces the output of themultinational and shifts profits to the localsuppliers. Greenaway (1992) extends thisline of argument to a range of TRIMs.

Morrissey and Rai (1995) alsomake a case for TRIMs based on the priorexistence of a range of restrictive businesspractices by multinational corporations.These practices include some whichrestrict exports from the host country,such as international market allocation andintra-company restrictions on exports byaffiliates.

All these second-best argumentsare subject to the same objections as theinfant industry argument. If, as in themodel of Chao and Yu, the cause of thedistortion is a policy-induced minimumwage, this should be abolished and nofurther action is required. If, as in themodels of Richardson and Rodrik, theprior distortion is a tariff on the finalmanufacture, the first-best plan is toreduce the tariff. If, as in the models ofRodrik and Morrissey and Rai, it is ananti-competitive form of business conduct,the appropriate instrument is acompetition law remedy. First-bestreform avoids the by-product loss ofwelfare due to the increase in the price toconsumers of the output of the protectedsector and the distortions of the productionstructure of the industry. This isrecognized by some of the authors, butthey accept that a tariff on the final goodis unchangeable while an implicit tariff onits components is feasible. Again, theperformance requirements have negativeeffects if they are pushed too far. Acontent plan provides no incentive forupstream firms to acquire moreknowledge. The incentive is merely toincrease their outputs.

These arguments have an old-fashioned ring. They ignored the benefitsof technology and management fromforeign investments, and they belong to anera when there was no pressure ondeveloping countries to lower theirexisting tariffs and not to introduce newtrade-restricting measures.

B. Technology development

Some writers have advocatedborder assistance on the grounds oftechnology development. For example,Balasubramanyam (1991) bases his

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argument for content plans on theincentives provided to multinationalcompanies to develop technology in thematerials sector of the host economy.However, the previous section makes itclear that government interventions todevelop technology should be technology-based, not output-based.

With few exceptions, thetechnologies used by producers indeveloping countries are not the latest ormost advanced in the world. Generallyspeaking, these countries can be classifiedas low- or middle-technology countries.7

When new industries or products areestablished they will, in most cases, use atechnology already developed in someother more advanced or industrializedcountry.

In this context, FDI will beimportant as a vehicle for the transfer oftechnology. The literature has recognizedthat technology may be transferred in twoways:

• Foreign technology has a highertotal factor productivity, which istransferred initially to theenterprise with foreign investmentin the host economy.

• The knowledge of the enterpriseswith foreign investment spills overto other firms in the sameindustries.

Each of these effects occurs withinindustries (appropriately defined); that is,they are intra-industry effects. The firstwill be called the direct technologytransfer effect and the second the spillovereffect.

7 See section 4.4 on the role of the Agreement onTrade-related Aspects of Intellectual PropertyRights (TRIPS) in enhancing technology transferto developing countries.

The direct technology transfereffect derives from an old argument thatforeign investors have a superiortechnology of production, which istransferable to foreign affiliates anddomestic firms. In recent years this effecthas been incorporated into a number ofmodels of technology catch-up ortechnology ladders. They view thetechnology differences across nations asgiven. They are the result of past researchand development (R&D) or otherprocesses of technology acquisition andno attempt is usually made to explainthese differences.

Another model has been developedsince 1990 by a number of authors toendogenize technology transfer by linkingFDI to technological improvement in theform of new varieties of capital input (fora textbook treatment, see Barro and Sala-i-Martin (1995, chapter 6)). In this model,an economy produces a single good, y,using a Cobb–Douglas value addedtechnology:

y = AHαK1-α (1)

where A is an efficiency parameter, Hdenotes the human capital input and K thephysical capital input. The functionexhibits constant returns to scale withrespect to the two inputs. Physical capitalis a composite of different varieties of thecapital good, Kj:

K = j = i

N

∑ [(K j

1− α )]1/1-α (2)

The total number of varieties ofcapital good, N, is produced either bydomestic firms, n, or by foreign firms, n*.Thus, N = n + n*. K may be regarded asunits of effective capital. With thistechnology, the total effective capital

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stock increases as the number of varietiesincreases, for a given number of units ofcapital, e.g. machines. This is a specialform of capital-augmenting technologicalchange.

Expansion in the number ofvarieties occurs as a result of R&D. Thecost of production of a new variety,therefore, has fixed set-up costs, F, andconstant marginal costs. It is assumed thatthese fixed costs are a decreasing functionof n* and of n/n*, that is F = F(n*, n/n*)where the partial derivatives with respectto both arguments are negative. The firstof these variables captures the idea thatforeign firms have an advantage inproducing new capital goods because oftheir accumulated knowledge. The secondcaptures the idea that countries that aremore backward technologically, asrepresented by the number of capitalgoods produced domestically, have anadvantage in catching up. Moreover, theproduction function in equation (1)ensures that the marginal product of anincrease in the stock of capital is anincreasing function of the stock of humancapital in the economy. This model yieldsa regression equation for the economygrowth rate which contains the level ofFDI and an interaction variable, FDIxH,with a positive coefficient. In anempirical study of cross-country rates ofgrowth, Borensztein, de Gregorio and Lee(1998) found that FDI itself has aninsignificant effect on growth rates, butthe interaction terms are significant andpositive.

An alternative model introducestechnological change through the capitalinput again but in a different way. Thismodel assumes that there are a fixednumber of capital input varieties, but eachvariety lies on a quality continuum and issubject to quality improvement over time(see Barro and Sala-i-Martin (1995,

chapter 7)). This yields a positiverelationship between FDI and growth,again with a positive interaction withhuman capital.

These models are simplistic withno international trade in goods and onlyone sector, but they are suggestive. Theyintroduce two key ideas. The first is arelationship between the variety of thecapital inputs and output, and the secondis a complementarity effect between FDIand human capital accumulation in thehost economy. With international trade,the composite capital input adds newvarieties through the importation of newcapital goods since the foreign varietiescan be supplied only by foreign producers.This is one vehicle of technologyimprovement.

The notion that knowledge spillsover from one firm to others has becomepopular in recent years. Blomstrom(1989) provides an early and influentialstatement, although the idea was putforward much earlier by Findlay (1978),who called it “contagion”. This notion hasan intuitive appeal, but it has beenmodelled in different ways.

One strand of the literature makesthe total factor productivity of a firm afunction of cumulative industry outputbecause of learning-by-doing. Grossmanand Helpman (1995, section 2) surveythese models. Suppose that there are onlytwo countries, the home (= host) countryand the foreign (= source) country. Thenthe output of a good (= industry), industryi, in some country is given by theproduction function

Yi = Ai (⋅)φI(vi) (3)

Vi is a vector of primary andintermediate inputs, and Ai (⋅) is the indexof technical knowledge or know-how in

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the country. The subscript for the firm isomitted on the assumption that the samevalue of the coefficients Ai and ai apply toall producers of the good in one country.8

Knowledge is transmitted amongproducers by making Ai some function ofcumulative outputs. The index Ai can be afunction of the cumulative national outputof the good or of the cumulative worldoutput, or sometimes of the output of agroup of related outputs in an industry atthe national or international level; that is,Ai = αiYi + βiYi* where Y denotes thecumulative output in the country, *denotes the foreign country and δi is aconstant. This generates a family oflearning-by-doing spillover models.

In these models, spillovers occur asa function of cumulative aggregateindustry output at some level. It does notmatter whether the output in a country isproduced by home or foreign firms.Alternatively, one could make the shiftfactor Ai (⋅) some function of FDI or of theactivities of the source enterprises.

Thus, there is some factor-disembodied kind of transfer among firmsbut the actual mode of transfer is notspecified. Van and Wan (1999) introducethe idea that much technology transfertakes place through the establishment ofnew domestic firms staffed by workerswho were previously employed by foreignfirms and acquired work and productionskills and knowledge of the technology ofproduction from this employment. Thenew firms may be subcontractors for theforeign firm or competitors, or evenproduce other goods that use a similartechnology. New domestic firms have atechnology that is superior to old domestic

8 In these models it has usually been assumed thatlabour is the only factor of production but thespecification is easily generalized.

firms. This might be called the new firmseffect.

These models do not provide muchsupport for government subsidies or otherinterventions to promote industrialdevelopment. In the direct technologytransfer models, where the technology isassumed to be in the form of some firm-specific blueprint or asset and istransferred costlessly, the firmspurchasing the new capital inputsappropriate the benefits of increasedproductivity. The same applies where thetechnology transfer occurs through theintroduction of new varieties or newqualities of investment goods. The policyimplication of this model is thatGovernments should not impose tariffs orother restrictions on imports of thesecapital goods.

In the spillover models, where theimprovements in total factor productivityare associated with learning-by-doing,there is a kind of externality. However,the host country Government has littlepossibility of capturing the benefits if theyare associated with the aggregate industryoutput in the rest of the world or of thewhole world. If there are spilloversassociated instead with FDI in someindustries, this is an added benefit of FDI,but such benefits will be industry-specificand the Government would have to knowthe mechanism by which the technology istransferred in order to capture them. Forexample, if they are due to the new firmseffect, they will happen in the markets,provided that there are no obstacles to theformation of new firms. FDI incentiveswill be a crude and generally ineffectiveway of capturing the benefits of FDI asthese benefits will be firm- or process-specific, where they exist. R&D subsidiesare not warranted unless there is somegeneral uniform externality associatedwith R&D. The best way to maximize thebenefits of technology transfers associated

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with FDI is through the adoption ofgeneric measures aimed at improving theoverall regulatory and economicenvironment by enhancing competitionand improving human capital skills andtechnological capacity.

The critical question in this debateis the nature of the technology transfer.Grossman and Helpman (1995: 1334)concluded their survey of technology andtrade as follows: “…what can the Southdo to encourage technology transfer toindigenous agents without causing theNorthern innovators to take their businesselsewhere? To answer these questions wewill need models that pay closer attentionto how knowledge is transmitted withinand between firms.”

C. Strategic trade policy

Strategic trade policy is a set ofcases developed in the 1980s thatsupposedly justify governmentinterventions. The distinguishing featureof this body of theory is that thearguments hinge on the existence ofstrategic interdependence among a smallnumber of firms. Brander (1995) surveysthe theory.

The standard example is a modelof two duopolists, each from a differentcountry, competing in a third-countrymarket. If there are no home marketeffects, an export subsidy granted by theGovernment of one of them may improvenational welfare by allowing the domesticproducer to earn additional profits in theexport market that exceed the amount ofthe subsidy payment. Note that in thisthird-country market model an outputsubsidy is equivalent to an export subsidy.The model can be extended to a fixednumber of competitors greater than two.It can also be extended to markets in

which the firms make domestic sales,although in this case the gain is less sincethe increase in profits is offset by the lossof consumer surplus and the optimalintervention by one country is now a tariff.

However, the outcome isextraordinarily fragile as it is subject to anumber of conditions. It requires thatfirms’ decision variables be strategicsubstitutes, in that greater output by thesubsidized firm reduces the profits of itscompetitor. It is not robust with respect tothe assumptions of the model; if theconditions of entry, the choice of decisionvariable (Cournot or Bertrandcompetition, or whatever) or the presenceof economies of scale or other features ofthe model change, the nature of theoptimal intervention changes. Theselection of the optimal level of the(optimal) instrument imposes substantialinformation requirements on theintervening Government. This kind ofintervention also lends itself to politicalmanipulation, with the possibility that thesubsidies will go to producers that seek toprotect themselves from foreigncompetitive pressures rather than to theproducers who can shift profits. Finally,such strategic policy interventions may bein the interests of one country interveningalone but if the second country retaliates,there is a prisoners’ dilemma – both lose.This is because the result stems fromprofit shifting between markets. It is notefficient from the point of view of theworld economy to have any intervention.

Other strategic policy cases withdifferent assumptions about the nature ofcompetition are subject to the sameobjections. Brander (1995: 1446), himselfone of the architects of strategic tradepolicy theory, concluded his survey withthe remark that “It seems natural to expectthat strategic trade policy can only expandthe scope for socially wasteful transfer-

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seeking…Even if free trade does notemerge as an optimal policy in normativestrategic trade policy models, oncepolitical economy considerations are takeninto account, perhaps it is the best we cando.”

There is, therefore, nothing instrategic trade theory to recommend it todeveloping countries. In most markets,these countries are price takers. If themarket conditions should conform to somemodel of strategic trade policyintervention, developing countries do notsatisfy the informational and politicaleconomy requirements for successfulintervention. They would do better to takeaction to increase competition.

There is another even morepowerful objection to the theory. Itignores completely the rules of the WTO.These exclude export subsidies for

manufactures and severely constrain thelevels of tariff rates as most industrialtariffs are now bound. These rules haveevolved over 50 years precisely in order toconstrain national beggar-thy-neighbourpolicies. Moreover, as with the second-best argument for tariffs, one should nottake the conditions of imperfectcompetition as given. The WTO hasbecome more concerned with competitionin world markets in recent years. Mostsmall-number competition markets are theresult of government-sanctioned restraintson entry (such as the tolerance of exportcartels) rather than natural monopoly.Action in the WTO and otherintergovernmental forums such as theOrganisation for Economic Co-operationand Development (OECD) should be toremove barriers to entry and cross-bordercompetition and thereby make marketscompetitive.

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III. EXPERIENCE WITH INDUSTRIAL POLICY IN EAST ASIA

The purpose of this section is toprovide an insight into the practical use ofindustrial policies. The focus is on EastAsia, but this does not mean that LatinAmerica or industrial country experienceis not relevant. In the Latin Americancase, import-substitution policies were thehallmark of development strategy. But, asis widely recognized, the region’seconomic performance did not match thatof East Asia. This may reflect a lateadoption of liberalization policies, orpossibly even difficulties in implementingthe appropriate policies. Similarly, muchof the development of Western Europeand other industrial countries can beattributed to interventionist policies. Thissection points out, through the example ofEast Asia, that active industrial policieswere relevant. The same conclusionapplies to Latin America and theindustrialized countries.

A. General trends

It has always been an issue towhether government interventions usingvarious instruments ranging from creditand export subsidies, protection andexport promotion measures were effectivein the spectacular growth experienced byEast Asia. Some interventions weresuccessful, and part of the success wasbecause interventions, especially exportpromotion measures, were performance-based or contest-based (World Bank1992), unlike government interventionswithout any performance requirements.

Table 1 summarizes the types ofindustrial policy pursued by countries inEast Asia. These policies have evolvedover the past three decades starting withimport substitution, which depending on

the size of the country has evolved intoexport orientation.9 Export orientationnormally begins with assembly or originalequipment manufacturing (OEM) typemanufacturing as well as light industries,and over time the value added of exportsincreases. Often, export-oriented policieswill run parallel to import substitutionpolicies as protection is only removedgradually. However, beginning in themid-1980s, the increased need to attractFDI for technology and market access,pressures from major markets such as theUnited States and Europe for marketopening, reducing trade surpluses,becoming signatories to codes andimplementation of the Uruguay Round,and unilateral moves to reform domesticeconomies as the need to adjust wasrecognized – all these led to greaterderegulation and liberalization in all theEast Asian economies. The economicliberalization and deregulation trends inChina and Viet Nam also provided agreater push to liberalize. Furthermore,the Republic of Korea and TaiwanProvince of China have both been subjectto a great deal of United States pressure toliberalize. Countries wanting to join theWTO have faced the same set ofpressures.

In general, the South-East Asiancountries have adopted a more liberal andmarket-oriented policy regime(Masuyama, Vanderbrink and Chia, 1997)compared with the North-East Asiancountries at the same level of 9 If countries have large internal markets, forexample Brazil, China and India, the importsubstitution programmes allow for economies ofscale for the protected firms. Country size,however, does not mean that the sectors will beefficient. See Bruton (1998) for a discussion of theevolution of import-substitution policies.

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development. This is evidently becausethe South-East Asian economies followedlater in the export-orientedindustrialization strategy in the late 1970sand early 1980s. For instance, Indonesiahad to abandon its export-subsidy schemein the mid-1980s. It consisted of a dutydrawback provision which, because of theway it was calculated, provided both asubsidy and an export credit to exporters,the latter at interest rates below marketrates. To the extent that developingcountries still pursue industrial policy, thetypes of instruments will have to vary.

B. Industrial policy andimplementation of Uruguay Roundcommitments

Singh (1996) provides a usefulsummary of the types of export promotionand import restrictions used by theRepublic of Korea and Japan, which areoften identified as industrial policyinstruments (box 1), and analyses whichones would no longer be valid under theimplementation of the Uruguay Roundcommitments. Table 1 provides a similarcategorization for a number of Asiancountries.

Many of those falling under theexport promotion and import restrictionswould not now be allowed undermultilateral rules, and some of the otherpolicies would violate the newAgreements, especially under TRIMs,subsidies and TRIPS. Only instrumentssuch as government provision ofinformation to exporters and changes inthe exchange rate would still be allowedunder the present rule structure. Exportpromotion agencies such as the JapanExternal Trade Organization (JETRO) arestill allowed, as long as their task is onlyto provide information and not to provideexport guarantees or insurance elements.

Indeed, all the Asian countries in table 1have an export promotion agency, but ofcourse its quality and effectiveness varyacross countries.

Another major instrument forsubsidizing interest rates and preferentialcredit allocation used by the Republic ofKorea was ruled out when linked toexports under the GATT Code onSubsidies and Countervailing Duties, andmore generally by the Uruguay RoundAgreement. Foreign investmentconditional on domestic content or tradebalancing would be in violation of TRIMs.

A number of instruments such asgeneral fiscal concessions, provision ofsubsidized R&D up to a certain level, andmeasures to promote corporate investmentand discourage payment of dividends arestill acceptable.

Since the mid-1980s most South-East Asian countries have adopted export-oriented policies maintaining competitivereal exchange rates (after 1995, with sharpmovements of the yen, this changedsomewhat) and promoting inward FDI.Most of the countries deregulatedrestrictions on FDI, Indonesia being oneof the boldest ones with a dramatic FDIliberalization being introduced in 1994,the year Indonesia was host to APEC.Apart from FDI, South-East Asiancountries have also been more flexible andopen about other factors of productionsuch as labour. Singapore has an openpolicy towards employing skilled andsemi-skilled labour from outsideSingapore, and Malaysia has had todepend on foreign workers (many ofwhom are Indonesians) to meet theshortage of labour domestically(Masuyama, Vanderbrink and Chia,1997).

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Box 1Instruments of industrial and export promotion policies:

Republic of Korea and Japan

Export promotion and import restrictions• Import restrictions, both general and specific;• Favouring particular sectors for export promotion, in some cases particular firms for that

purpose;• Seeking compliance for subsidies given to exporters by means of export targets for

specific firms (Republic of Korea);• Interest rate subsidies and the availability of credit and foreign exchange to favoured

firms that meet export targets;• General export promotion through JETRO (Japan) and KOTRA (Republic of Korea);• Provision of infrastructure, including human capital, in support of exports;• Taxation relief on imported inputs and on R&D expenditures;• Allowing favoured conglomerates to import capital goods and foreign technology and to

raise cheaper finance on international markets.

Industrial policy measures• Lax enforcement of competition policy, including the extensive use of cartels;• Government creation and promotion of conglomerates (Republic of Korea);• Tax concessions to corporations to increase investment;• Promotion of a close, long-term relationship between finance and industry which was

critical to the implementation of the industrial policy;• Labour repression to ensure labour peace in a period of structural change (Republic of

Korea)• Establishment of State industries to enhance industrial development (Republic of Korea)• Extensive administrative guidance

Source: Singh (1996: 163).

Table 2 and other informationindicate first that prior to the crisis therewas a strong trend towards economicliberalization, and second that there hasbeen a greater emphasis oncomplementary policies, which will pushindustrial restructuring. Trade andinvestment liberalization alone are notsufficient. A variety of policies haveemerged to upgrade industrial structure.The types of policies that fall into thiscategory include R&D, infrastructure,development of strategic industries, andpolicies aimed at forming industrialclusters. The Republic of Korea andTaiwan Province of China, for instance,

have emphasized government subsidiesfor R&D. Singapore has attempted todevelop services, and then knowledgeindustries, by providing fiscal incentives.

C. Changes since the Uruguay Round

There has been a general decline inthe use of tariffs for import protection. Inthe Uruguay Round, trade weighted-boundmost-favoured-nation (MFN) tariffaverages declined substantially for Japan(from 3.9 to 1.7 per cent), the Republic ofKorea (from 18 to 8.3 per cent) andThailand (from 37.3 to 28.0 per cent), but

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only slightly for the Philippines (from23.9 to 22.2 per cent) and Malaysia (from10.2 to 9.1 per cent). On the other hand,they increased for Indonesia (from 20.4 to36.9 per cent) because of binding at amuch higher level than applied rates.Even though the percentage boundincreased substantially, the rate at which itwas bound remained high for somecountries. As expected, tarrification ofagriculture led to a jump in the averagetariffs of the East Asian countries after theUruguay Round.

More recent data on applied tariffsfor countries of the Asia-PacificCooperation Forum (APEC), based onUNCTAD Trade Analysis andInformation System (TRAINS) data for 13APEC economies, show that averagetariffs for APEC have come down overtime apart from those in agriculture as awhole, which rose in 1995 and then fell in1998. Average tariffs in agriculture arenow higher than those in manufacturing.At the two-digit level, the agriculture-related sectors of food, beverages andtobacco, agriculture and hunting, textilesand fisheries have above average tariffs.

The incidence of core non-tariffmeasures (NTMs) for the APECeconomies halved over the 1995-1998period. However, the NTMs in agricultureand hunting, and in chemicals went upslightly over the full period, those sectorsand are among the sectors with a highincidence of NTMs, together with themanufacture of food, and forestry andlogging.

Thus, while the average use oftariffs and NTMs has decreased, everycountry has a sensitive sector or a sector itwishes to promote for various reasonswhich retains peak tariffs or core NTMs.Not all NTMs are captured; for instance,tariff quotas are not included. This sector

typically not only has high tariffs but alsois subjected to other types of policyintervention. The automotive sector is agood example where tariffs are still highand there are often content requirementsstill in place.

Tariffs are the most transparentmeans of protection and, as is well known,as tariffs come down, non-tariff barriers orother measures emerge to the extent thatcountries wish to prolong the protection.Examples abound. The MalaysianGovernment has recently announced awide range of financial incentives topromote its domestic automobile industry,justifying it on the grounds of stronglinkage effects (Mody, 1999).

Typically, there has also been acorresponding increase in anti-dumpingduties. Although, as is well recognized,the amount of trade subject to anti-dumping duties is not large, the simplethreat of duties being imposed on aproduct is sufficient for there to be asubstantial impact on exports. There hasbeen an increase in the number of anti-dumping actions by both developed anddeveloping economies since 1995, and in1998 an estimated 300 cases weresubmitted compared with 225 in 1997.

The evidence on the effectivenessof export subsidies and promotion is notconclusive; East Asia is often being citedas an example of their effectiveness.Export promotion that uses incentives toencourage exports works in the same wayas import protection and can be subject tothe same abuses. Export subsidies can beabused through over-invoicing, falseshipments, and ad hoc subsidies that donot necessarily go to the most competitiveexporters. In the World Bank East AsianMiracle study (World Bank, 1992), therelative success of export promotioninterventions in East Asia is because with

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exports, the criteria for performance wasmuch easier to measure. In studies thatlook at what determines exports, exportsubsidies showed little change in the yearsprior to the boom of East Asian exports(Rodrik (1993), as quoted in Mody(1999)). Furthermore, some of the EastAsian economies, such as Indonesia, hadin fact moved away from using exportsubsidies since the mid-1980s.

Obviously, there are other factorsthat influence exports. Supportingmeasures that complement exportsubsidies could be important. In theRepublic of Korea, for instance, detailedsectoral and firm-specific export targetswere identified and given access to exportcredits. There were also benefitsassociated with agencies that developednew markets and testing and standardsorganization.

With regard to TRIMs, fourmembers of the Association of South-EastAsian Nations (ASEAN) notified localcontent policies in their automotivesectors to the WTO.10 In addition,Indonesia submitted local contentrequirements for fresh milk and soybeancake production, and Thailand submittedlocal content requirements formanufactured goods. Notification meansthat they will phase out the measures infive years. However, there have beendivergences in application, as is evidentfrom the national automobile policy ofIndonesia described in the Annex.

Examination of rules under theWTO and the East Asian experience so farindicate that there are many instrumentsthat are no longer valid. However, thereare still instruments that could be used,

10 See the annex for a description of Indonesia’sWTO experience regarding its local contentpolicies in the automotive sector.

and the usual caveats about specificity ofpolicy in relation to the objective or targetapply. Furthermore, the instrument mustbe implemented in a transparent way, havebuilt-in performance requirements andhave a clear exit point. Before the crisisthere were many derogations from suchbasic concepts. These were compoundedby a close relationship between businessand government in channelling capital andcredit to specific sectors.11

D. Policies towards foreign investors

World FDI flows have grown atvery impressive rates. Between 1986 and1991 the annual average was US$ 159.3billion. In 1999 the estimated total is US$800 billion, which is an increase of 25 percent over the previous year.12 While asignificant proportion of the increase isdue to the developed countries, amongstdeveloping countries East Asia’sperformance has been particularlynoteworthy. Between 1986 and 1997 ninedeveloping countries13 in the region haveaccounted for more than 50 per cent oftotal flows to developing countries. Theincrease in the importance of China as ahost country is particularly noteworthy.

The contribution of FDI flows todevelopment continues to be debated;however, the focus seems to be more ondegree. Without a doubt the access toexternal capital and the performance offoreign affiliates in East Asian host

11 In the post-crisis era a number of issuesregarding corporate governance and restructuringare emerging as critical for a sustainable recovery.12 Revised figures and more detail can be found inUNCTAD (1999a) and at www.unctad.org.13 These are the four newly industrializingeconomies – Hong Kong (China), the Republic ofKorea, Singapore and Taiwan Province of China –and China, Indonesia, Malaysia, the Philippinesand Thailand.

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economies have had an impact on theregion’s economic growth. But thesuccess was achieved through a range ofpolicies aimed at attracting andchannelling FDI into specific sectors.14

Consider first the attraction of FDI.The approach adopted by some economies–Hong Kong (China) and Singapore – wasone of liberalization. By selectivelyreducing equity restrictions andperformance requirements they were ableto attract significant quantities of FDI.These policies were complemented by anextensive array of incentives, whichincluded duty-drawback provisions, taxholidays and subsidies. They wereimplemented in an aggressive and targetedmanner, so much so that their goal ofindustrial restructuring using FDI has byand large been successful. Even thesecond-tier Asian countries such asMalaysia and Indonesia have been able toincrease their manufacturing capacity,relative to primary industries, with someassistance from FDI. China in particular,with its State-owned enterprise system, iswell aware of the role that foreignaffiliates can play in helping some of itsprivatized industries to be competitive.

Each of the East Asian countries atone time or another made extensive use ofperformance requirements. These includedlocal content, export performance targets,foreign exchange restrictions, licensingrestrictions, mandatory local participation

14 See Hill and Arthukorala (1998) for a recentsurvey of the contribution of FDI to developmentin the region.

and trade balancing. In the past decade,some countries have removed theserestrictions unilaterally, but others havechosen to retain certain policies. Theresult is a policy landscape for FDI in EastAsia that is rather mixed.

While all countries welcome FDI,there are still a range of impediments toflows and policies designed to alterbehaviour (PECC, forthcoming). Theseimpediments are distortionary and, asshown in section 3, can lead to welfarelosses even if certain non-economicobjectives are achieved. All the EastAsian countries are members of the APECprocess and have committed themselves to“free and open trade and investment” by2010 for developed members and 2020 fordeveloping countries. Furthermore, themembers of ASEAN have signed aFramework Agreement for an ASEANInvestment Area, which includes anegative list liberalization of equityrestrictions by 2010 for members and2020 for non-members. Thesearrangements would seem to indicate thatthere is much support for investmentliberalization, but some caution aboutincluding it in the WTO. The issue, then,is not liberalization, but to what extentperceived gains can be achieved throughhaving binding rules on market access forforeign investors, including licensing,joint ventures and performancerequirements. This is an issue taken up insection 5.

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IV. WTO RULES AND INDUSTRIAL POLICY

A number of provisions in theWTO rules deal with various measuresthat member States can use to protectdomestic suppliers and promote exportsand technology transfer. Articles I and IIIof GATT 1994 lay down MFN andnational treatment for imported goods.However, up to the bound rate (if a tariffitem has been bound), tariffs can still beused to protect infant industries anddevelop domestic capacity. Tariffs areoften complemented by other tools ofindustrial policy such as subsidies, whichare used to both promote particular firmsand industries and to penetrate foreignmarkets. In this section we examine howthe WTO rules have constrained theflexibility of member States in the choiceof instruments that may be used to pursueindustrial policy objectives.

A. Import protection

Tariffs, non-tariff measures andsubsidies protect domestic firms fromimport competition. Although tariffprotection has declined, there continue tobe peak tariffs in some industries in bothdeveloped and developing countries.Also, the dispersion of protection remainshigh in many countries.15

One particular policy, which usedto be quite common, is local contentprotection. This policy was the hallmarkof a number of countries as they tried todevelop large-scale industries withexternalities. In particular, automotive

15 It is useful to distinguish between sunset andinfant industries. The former are industries that aredeclining. The latter are industries that areexpanding and, owing to market failures, requireprotection from competition.

industries around the world have beenheavily dependent on local contentprotection.16 There was much discussionduring the Uruguay Round as to whetherlocal content protection had an impact ontrade. Local content policies wereformally included in the MultilateralTrade Agreement (MTA) through theAgreement on Trade-related InvestmentMeasures (TRIMs). The effect of this isthat such policies have to be phased out byWTO members at the latest by 1 January2002, unless an extension can begranted.17

Import protection can also beachieved by challenging the fairness of thecompetition by using anti-dumping orsafeguard measures. In the context ofindustry policy both measures have oftenbeen used in declining industries. TheFinal Agreement on Implementation ofArticle VI had a few additional provisionsin favour of developing countries as theytry to develop their exports. Moreimportant, there are still systemic issues inthe implementation of Article VI that canfrustrate legitimate attempts by developingcountries to exploit export markets.18

16 Australia, for example, had a national carprogramme in place immediately after the end ofthe Second World War. The first “Australian car”rolled off the production line in 1948. However,protection in the industry only started to declinesubstantially in the early 1990s (Bora and Pomfret,1995).17 A WTO Dispute Panel decision on Indonesia’slocal content protection policies clearly stated thatlocal content policies disadvantage imports. Seethe Annex for more details.18 See Laird (1997) for a discussion of anti-dumping.

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B. Subsidies and export promotion

The Agreement on Subsidies andCountervailing Measures (SCM) increasesdisciplines on the use of subsidies andcountervailing measures to offset anyinjury caused by subsidized imports. Itapplies to non-agricultural products; thereare separate (and more comprehensive)disciplines on agricultural products in theAgreement on Agriculture.

The SCM covers financialcontributions19 made by or at the directionof a Government20 that provides abenefit.21 It defines three areas ofspecificity which would bring a subsidyunder its rules. These are:

• Enterprise specificity – a particularcompany or companies is targeted;

• Industry specificity – a particularsector is targeted;

• Regional specificity – a particularregion is targeted.

If a subsidy fits the specificitydefinition, it is placed in one of threecategories: prohibited, actionable or non-actionable. The prohibited categorycomprises subsidies for exports andsubsidies for the use of domestic inpreference to imported inputs. In additionto non-specific subsidies, the category ofnon-actionable subsidies includes thefollowing exemptions:

19 The Agreement contains a list of types ofmeasures that would be considered to be financialcontributions: grants, loans, equity infusions, loanguarantees, fiscal incentives and the provision ofgoods and services.20 Since this is defined to include any public bodywithin the territory of a member, sub-nationalGovernments, public bodies and State-ownedcompanies are covered by the Agreement.21 The definition of a benefit has not been fullyresolved in cases where indirect financialcontributions are involved.

• Disadvantaged region initiatives;

• Research and development;

• Environment.

The bulk of the subsidies fit intothe categories of actionable and non-actionable rather than prohibitedsubsidies. Action under the SCM relies onproviding proof that subsidies are having anegative effect on the trade of anothermember. This is done by showing thatthere is harm to another member in theform of injury,22 serious prejudice23 orimpairment24 and nullification of benefits.Once this has been proved, the subsidymust be removed or changed to conformto WTO regulations.

The implications of the SCM forindustrial policy are considerable.25 In thefirst instance, developing countries whichdid not sign the Subsidies Code during theTokyo Round are now bound by theAgreement. Second, the SCM nowextends to sub-national Governments.

However, the discipline onsubsidies based on production is weak. Itdoes not apply to agricultural and servicestrade. The main message of the SCM isthat subsidies that have a direct effect ontrade are explicitly prohibited. This rulesout the possibility of developing a sector

22 Injury to a domestic industry caused bysubsidized imports into the territory of thecomplaining member.23 Adverse effects in the market of the subsidizingmember or in a third market.24 This can arise when improved market access dueto a bound tariff reduction is undercut by thesubsidy.25 Take, for example, the case of the Republic ofKorea, which has been notorious for its use oftargeted subsidies. Prior to 1995 it had offered 26different types of subsidies with an annual total of2.5 trillion won. In 1995 it reduced this to onesubsidy to small and medium-sized enterprises ofonly 15.2 billion won (WTO, 1996b).

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by unfairly taking advantage of access in atrading partner’s market.

For developing countries the SCMis a two-edged sword. In the firstinstance, there are a number of loopholeswhich allow them to continue to usesubsidies to promote industrial policyobjectives. However, these loopholes alsoapply to developed countries. Thus,developing countries have no prospect ofusing subsidies to gain a competitiveadvantage vis-à-vis the developedcountries.

There is a grey area with respect tothe use of incentives to attract foreigninvestment. The competition for FDI isintense, and incentives are used widely bynational and sub-national Governments ofdeveloped and developing countries.Most direct and indirect FDI incentivescome within the definition of subsidies inthe SCM. However, the concepts of theAgreement were developed for subsidiesaffecting the trade in goods and may notbe easily applied to FDI incentives.Again, developing countries do not havethe resources to compete with developedcountries, but are in need of the assets thatforeign firms have to offer. Multilateraldiscipline on the use of FDI incentiveswould be in the interests of developingcountries since their own incentives distortthe allocation of capital formation, and itwould level the international FDI playingfield. However, it would still be difficultfor developing countries to developcompetitiveness in a targeted industry.

C. Agreement on Trade-relatedInvestment Measures

Although regarded as a majorinitiative of the Uruguay Round, the finaltext of the Agreement on Trade-relatedInvestment Measures (TRIMs) did not do

much more than clarify some policiesagainst the GATT 1947 text. In particular,the Agreement used an illustrative list toidentify policies that contravened GATTArticles III:4 and XI:1. Nevertheless, thefive pages of text that constitute theAgreement may very well be the lightningrod for developing country objectives inthe next round. Some developingcountries have firmly taken the view thatthe list of illustrative TRIMs should not beextended. Furthermore, the length of thetransition period for developing countrymembers should be extended. There are anumber of reasons for this:

• Only developing countries haveyet to phase out notified TRIMs.26

• There is a perception bydeveloping countries that theAgreement is against theirdevelopment interests, since thepolicies included in the illustrativelist have been consideredimportant for meeting theirdevelopment objectives.

• The five-year transition period(seven years for least developingcountries) was not enough time forthe countries to benefit from thosepolicies.

• The 90-day notification period wasnot long enough for WTOmembers to examine their regimesfor compatibility.

These difficulties arose during arecent dispute settlement case involvingIndonesia (see Annex). In that case thefundamental tension between Indonesia’sindustrial policy objective of “self-reliance” and trade discrimination wasquite clear. Policies that favour domesticgoods in preference to imported goods as

26 Developed countries had two years to phase outnotified TRIMs.

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a mechanism for promotingindustrialization were held to beincompatible with the rules of themultilateral trading system. This couldlimit attempts to build up domesticcapacity and increase the transmission anddiffusion of technology.27

Another concern about restrictingTRIMs is the second-best argument thatpolicies such as export restrictions andlocal content are needed to defend againstanti-competitive practices (UNCTAD,1999b). This argument has somesupporters, but it raises a number ofconcerns, not the least of which isimplementation. The fundamentalproblem is, as stated in section 2, that if itis anti-competitive practices that are theissue, effort needs to be directed towardsdeveloping national and multilateralcompetition rules.

D. Agreement on Trade-relatedAspects of Intellectual PropertyRights

The value of the Agreement onTrade-related Aspects of IntellectualProperty Rights (TRIPS) for developingcountries continues to be hotly debated.The Agreement consists of three parts:standards, enforcement and disputesettlement. It involved, perhaps more thanany of the other Agreements, substantialchanges in national legislation. Thesechanges are designed to strengthen theprotection of intellectual property rights(IPR) and to have a positive impact onlocal innovation, FDI and technologytransfer. However, at the same time anumber of negative impacts, at least as far

27 Moran (1998) cites evidence of the policyhaving a positive impact on the development oflocal capacity. In doing so, however, he does notmention the costs of the policies.

as developing countries are concerned,were predicted (UNCTAD, 1996). Theseincluded higher prices for protectedtechnologies and products, and restrictedpossibilities for diffusion through reverseengineering. Also, new legislation indeveloping countries required furtherexamination of the balance between thedegree of protection required forinnovation and the restricted diffusion oftechnologies.

The strengthened protection hasimplications for industrial policyobjectives. In the case of domestic firmsit means that there is an incentive toinnovate and compete dynamically. TheSCM allows R&D subsidies, and theoutput of this process can then beprotected through the TRIPS Agreement.For foreign firms it means that, wherepermitted, market access through acommercial presence may now be viablesince they have better IPR protection.Developing countries do not in generalhave a comparative advantage ininnovation. Therefore, attempts todevelop certain sectors within the contextof the WTO mean that that they will haveto rely heavily on the transfer anddiffusion of technology from foreigncountries instead of on domesticinnovation.

An important provision fordeveloping countries is Article 66.2,which requires developed countries toprovide incentives to promote technologytransfer to least developed countries. Sofar, little is known about the extent towhich this provision has beenimplemented (UNCTAD, 1999b). It isaccompanied by a transition periodallowance for developing countries.

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E. General Agreement on Trade inServices

The legally enforceable rulescovering the international trade in servicescontained in the General Agreement onTrade in Services (GATS) can also affectindustrial policy initiatives. Relative todisciplines on goods trade, the Agreementas a whole is much less effective in termsof liberalization. It contains a positivelisting of sectoral commitments on marketaccess and national treatment. It allowssectoral bindings on four modes of supply:cross-border supply, consumption abroad,commercial presence and presence ofnatural persons.

Through the inclusion ofcommercial presence as a mode of supply,rules on foreign investment in services arenow part of the multilateral tradingsystem. Members, therefore, can useforeign investment liberalization as tool ofindustrial policy. This has happened tosome extent with bindings in tourism, butnot in other sectors.

As with other forms ofliberalization, the effect of the GATS istwofold. First, market access makes itpossible to develop export sectors.Second, bindings have the effect ofinducing competition in home markets.Developing countries have an exportinterest in a limited range of sectors suchas tourism and professional services. Inthese and other cases a key issue is themovement of natural persons (or mode 4).Horizontal barriers in this area make itdifficult for developing countries to buildexport competitiveness in theircomparative advantage areas.

The competition effects ofliberalization in the area of infrastructureare extremely important for developing

countries. As discussed above, disciplinesin the area of subsidies and performancerequirements are forcing developingcountries to think of more neutral ways todevelop export capacity (Laird, 1997).One of these is infrastructure and, inparticular, telecommunication, financialand transport services.

In addition to market accesscommitments, the GATS has a provisionrelated to performance requirements.However, the prohibition of thesemeasures relates only to a sector that hasbeen inscribed. This means thatdeveloping countries that have taken theview that performance requirements needto be maintained in service industries, as aquid pro quo for liberalization, cannotmaintain them. It is important to note theconsistency of this provision with theSCM, where the quid pro quo argumenthas also been ignored.

F. Special and differential treatment

In GATT 1947 Article XVIII madespecific mention of contracting parties intheir “early stages of development” andallowed them to “maintain sufficientflexibility in their tariff structure”.Section B of that Article provideddeveloping countries with flexibility toimpose trade measures to protect theirbalance of payments, and Section Cenabled them to take such measures forthe protection of an infant industry. In1966, Part IV was added to the GATT,and the Tokyo Round adopted an enablingclause which gave “special anddifferential” (S&D) treatment todeveloping countries. The concept ofS&D allowed non-reciprocal tariffpreferences as implemented throughschemes, under the Generalized System ofPreferences (GSP).

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Prior to the Uruguay Round, littleuse had been made of Article XVIII,section C (infant industry), because theuse of this provision requires the paymentof compensation. As a result, since 1967no country has specifically invoked it.Instead, numerous countries have madeuse of section B (protection for balance-of-payments reasons), which does notrequire compensation.

Infant industry protection, byinvoking Article XVIII for infant industryor balance-of-payments protection, is stillpossible under the WTO, but the newprocedures for balance-of-paymentsconsultation are likely to constrain thescope and duration of such exceptions(Singh, 1996: 166). Furthermore, duringthe Uruguay Round a new approach toS&D developed, which essentiallyamounts to allowing for flexibility innominating sectors for liberalization andin most cases an extended transitionperiod for meeting obligations under theAgreements (Youssef, 1999).

The scope for S&D treatment inthe application of industrial policy existsin each of the Agreements referred toabove, for example:

• Delays in implementation (TRIMs,SCM, Safeguards Agreement,TRIPS);

• Preferential disciplines (SCM,Safeguards Agreement);

• Flexibility to increase protection(temporarily) (Article XVIII);

• Flexibility in approachingliberalization (GATS).

There is mounting concern on thepart of developing countries that theseprovisions do not promote their interests(UNCTAD, 1999b). Two issues need tobe distinguished. The first is the existence

of S&D provisions and second is theirrelevance. Take, for example, localcontent protection. The difficulties facedby developing countries in making thetransition from this instrument arerecognized by allowing them a longerperiod. However, some countries arguethat this allowance is not significant.

G. Implications of WTO rules forindustrial policy

The above review has identified anumber of WTO rules that discipline theuse of government intervention to promoteparticular industries. Different countrieshave different objectives, and wouldtherefore require different sets of policytools. As a result, the impact of the WTOrules on countries would differaccordingly. There are, however, somecommon features of the Agreements,which deserve to be highlighted.

First, each of the Agreements takesa trade, not a balance-of-payments,financing approach to discipliningpolicies. Since Articles I and III are thecornerstones of the rules-based system,any non-border policy that has an effecton the trade in goods and services is underdiscipline or has had an exemptionnegotiated.

Second, the rules are ownership-neutral. Apart from the GATS and TRIPS,where a national treatment standard isapplied, policies such as subsidies andlocal content protection do not distinguishbetween foreign affiliates and domesticenterprises. What is important is the“trade effect” of the instrument. Thismeans that countries seeking to apply aparticular policy to foreign-owned firmsmust first find a provision in theAgreement that allows the use of the

25

policy. Then they can apply it to a foreignfirm as long as there is no “trade effect”.

Third, the promotion of industriesfor investment and export growth is beingnarrowed to generic instead of specificpolicy instruments. This has the effect oflevelling the playing field for internationaltrade. It does little to allow countries todevelop specific industries throughspecific policy instruments.

Fourth, the approach to S&Dtreatment in the Agreements has typicallybeen in the form of transitionarrangements. This means that membershave a certain length of time in which tobring their policies into conformity withWTO rules. In some cases, members areexempt from these responsibilities.

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V. IMPLICATIONS FOR DEVELOPING COUNTRIES

The present WTO rules haverestricted the industrial policy instrumentsavailable to WTO members, as discussedabove. The use of border measures hasdeclined, and the disciplines on the use ofsubsidies together with contingentprotection and intellectual property ruleshave been strengthened. The direction ofany revision of WTO rules depends on thenet assessment of these changes. On theone hand, there is evidence to show that anumber of policies that distort trade arestill allowed under existing rules. On theother hand, the added discipline imposedby the WTO rules has reduced theflexibility of national Governments topursue development objectives. In thissection we examine some of the issuesarising from the possible revision of WTOrules as they relate to the pursuit ofindustrial policy objectives by developingcountries.

A. Import protection

The scope for import protectioncontinues to diminish. Tariffs aredeclining, local content protection is onthe verge of being prohibited andcontingent protection is now somewhatmore disciplined. What scope is there forcontinued import protection? The answeris that it depends on the ability ofdeveloping countries to negotiate aprovision that will allow for greaterdiscretion for protection.

It is important to distinguishbetween import protection for thepurposes of protecting a “sunset” ordeclining industry, and protection topromote an infant industry or newlyexpanding industry, which is beingprotected because of some perceived

externality. Efforts to develop transparentand objective rules for both types ofprotection are needed.

However, the issue related toindustrial policy that we wish to addresshere concerns local content protection andrules of origin in preferential tradingagreements. These are prevalent only inlarge-scale industries where there is scopefor significant linkages with domesticindustries.28 There is evidence that thispolicy has been proved to be successful inestablishing some industries in somecountries. Australia, for example, usedlocal content policies in the establishmentof some manufacturing industries.However, it was an inefficient industry.The policy has recently been abandonedand tariff rates have been reduced (Boraand Pomfret, 1995). The result is anindustry that is more competitive, albeitafter some structural adjustment. Thisabandonment vindicates those who arguethat the policies are not required forefficient competitive industries (Pursell,1999).

However, it is arguable that acontent-protected industry would not existat all if local content policies had not beenused in the first place. This appears to bethe position of the developing countries inthis regard – that as newly industrializingeconomies they have not had the 40-yeargrace period that, say, the Australianautomotive industry had, nor have theyhad the degree of protection and market

28 However, Barbados, Colombia, Cyprus, India,Indonesia, Pakistan, Peru, Romania, South Africa,Thailand and Uganda notified local content in theagriculture industries (Ministry for Trade andIndustry, 1999).

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access afforded to Canada through theCanada–United States Autopact.

Given these considerations, what isthe best way to proceed? If developingcountries have as their objective efficientnational production, content plans distortthe production within an industry andthereby lead to inefficiencies, as noted insection 2. If there is a dynamic learning orcost reduction process, a tariff or subsidytemporarily assisting the processes inwhich the cost reduction occurs is muchpreferable to a continuation of contentplans for the whole industry.

If developing countries have astheir development objective somethingother than efficiency, as in the case of theIndonesian automobile industry (seeAnnex), or as argued by Venezuela,29

there will be an inconsistency with thefundamental rules of the trading system.For example, in the automobile case, whena completely built-up unit is imported forassembly it will usually be feasible tosource at least 20 per cent of the productslocally.30 This means that in order toincrease local content further imports willhave to be displaced. Here, one mustquestion whether the developmentobjective is compatible with efficientlong-run allocation of resources, or

29 Venezuela argues that there are policies which“not only induce growth of their traditional flows,but also promote the structural transformation oftheir economies and the possibility to add morevalue to their exports”. It argues that they are“development policy issues” and that it may bepossible to identify instruments, which could beused to promote development but which areconsistent with the principles of non-discrimination (WT/GC/W/279, 29 July, 1999).30 These would be generic components for whichtransport costs would be high, such as tyres andoil. See the references in the Annex for details ofthe cost structure in the Indonesian automobilescase.

whether it favours some group at theexpense of national development.

B. Export promotion

As has been seen, directintervention by Governments to boostexports is being increasingly restricted bythe WTO rules. This leaves developingcountries little room for manoeuvre in thearea of export subsidies for industrialproducts. Nevertheless, there is a widerange of alternatives that are still pursuedby Governments. These include exportcredit and insurance schemes belowmarket rates, concessional tax and dutyprovisions and export processing zones.While some of these remain WTO-consistent, developing countries need toreassess the extent to which other policieswhich discriminate in favour of particularproducers are in their national interest.This will determine the extent to whichthey should negotiate further restrictionson export subsidies in the next round.Their focus, encouraged by the existingset of rules, should be on reducing fiscaland procedural constraints on exports(Laird, 1997), trade facilitation, andgeneric policies to make the country morecompetitive such as infrastructuredevelopment and an appropriate exchangerate policy. These are still allowed.Furthermore, they are supply-side-based.Human capital formation, innovationpolicies, joint venture agreements andinfrastructure are all important fordetermining export competitiveness.These too are still allowed within theframework of the WTO.

C. Competition policy

One area of generic producer-neutral policies that promote efficientproduction is that of competition policy.

28

Competition policy is the set of policieswhich promote competition amongproducers in markets. Increasingly, asmarkets become globalized, competition isinternational. The aim is to make marketsinternationally contestable.

It has been suggested that theWTO could be the location forinternationally enforceable multilateralcompetition law that could address anti-competitive behaviour affecting persons inother countries. At the First MinisterialMeeting of the WTO in December 1996,the members agreed to establish aWorking Group to study issues relating tothe interaction between trade andcompetition policy. In this WorkingGroup, the major WTO members – theEuropean Union, the United States andJapan – have exhibited fundamentallydifferent views on the scope and approachof competition law. These views largelyreflect differences in national and regionalapproaches to competition law. Thedifferences cover the objectives of the law,methods of analysis and remedies, as wellas the substantive provisions of the law.Given the diversity of views, it is unlikelythat binding multilateral competition lawswill develop in the foreseeable future.

However, the WTO still plays animportant role in promoting competition.One of the most important determinants ofcompetition in markets is the freedom ofmovement of goods across borders and,especially in the service industries, thefreedom of movement of FDI. These aresubject to WTO rules and discipline. Onemerit of the WTO rules in this context isthat they are neutral between foreign anddomestic producers (except to the extentthat exceptions to national treatment areinscribed by members in their GATSschedules). This helps to ensure thatdomestic and foreign producers are able tocompete on equal terms.

Developing countries aresometimes concerned about the restrictivebusiness practices of multinationalcorporations which establish affiliates intheir economies – for example, pricefixing and market allocation. This has ledsome to introduce requirements relating todomestic and export performance in anattempt to counter these practices.However, performance requirements arean inappropriate response as they apply toforeign investors irrespective of theirmarket power and practices; in addition,the Government of the host country has toestimate the second-best level of therequirements. Foreign investors aresubject to the laws of the host economy.When, therefore, the anti-competitivepractices occur in the host economy, theappropriate response is the application,and if necessary the development, ofnational competition laws. This addressesthe source of the problem directly andwithout by-product effects.

D. Market access for foreign investors

Despite the progress made inextending multilateral disciplines into newareas, policies relating to FDI were notincluded in the Uruguay RoundAgreements.31 The substantial growth inFDI during the past 15 years makes it animportant component of the globaleconomy. In the context of industrialpolicy the inclusion of FDI rules, or aGeneral Agreement on Investment (GAI),would have major implications fordeveloping countries.

The precise impact would, ofcourse, depend on the nature of the 31 Apart from those in the GATS dealing with FDIin services and some aspects of other Agreementsthat impact on FDI. WTO (1996a, chapter 4)surveys WTO investment-related rules anddisciplines.

29

agreement – its architecture, scope andprovisions. Currently, there is no broadpolitical support for a full andcomprehensive multilateral agreement.However, in the context of restrictionsplaced on industrial policy that werereviewed in the previous section, it may bein developing countries’ interests toconsider the possibility of a modestachievement in this area. The reason isthat with reduced government interventiondeveloping countries will have to relymore heavily on TNCs for the skills andinputs required to assist in restructuring.32

This is not to say that they are not capableof developing competitiveness themselves.Experience has shown, especially in EastAsia, that TNCs can allow a quick andeasy entry into world markets.

There is scepticism on the part ofmany host national Governments aboutputting in place rules on investment. Thisdoes not mean that efforts should simplybe stalled. Instead, it means investigatingother avenues that simultaneously allowthe achievement of rules and theadvancement of developing countryinterests. One way to tackle this problemis to separate the contentious issue ofmarket access for foreign investors fromperformance requirements. Issues relatedto performance requirements could beconfined to the revision of the TRIMsAgreement, and market access for foreignfirms could be negotiated separately. Infact, this is the current WTO architecturein a limited area. The GATS deals withmarket access for foreign firms in theservice industries, while the TRIMsAgreement deals with certain performancerequirements. A GAI could extend thisconcept to other sectors, therebyexpanding the rules on commercial

32 For an excellent discussion of the package ofassets that TNCs can contribute to host developingcountries see UNCTAD (1995).

presence. Such an initiative would alsoallow developing countries to arguestrongly that the GAI framework could bebased on the positive list approach, as inthe GATS, to avoid renegotiatingcommitments.

Within the context of industrialpolicy initiatives a GAI would leave theGATT rules on goods intact and providean opportunity for developing countries todevelop rules on specific foreigninvestment issues, including incentives toattract foreign investors, mandatorylicensing and joint-venture arrangements,equity restrictions and perhaps even otherelements of transnational corporatepractice. GATT rules simply do not allowsuch possibilities. And, as shown in theAnnex, unless agreements use preciselanguage concerning their intent theapplication of agreements may lead tooutcomes different from those originallyintended.33

E. Performance requirements forforeign investors

Developing countries feelaggrieved over the outcome of the TRIMsAgreement. There are three issues here:(i) the extent to which these instrumentsare related to foreign ownership; (ii)extension of the list; and (iii) whetherS&D treatment should be accorded todeveloping countries.

On the first issue, despite claimsby developing countries that the TRIMsAgreement is specifically a foreign

33 In this paper we have not gone into the details ofnegotiating a GAI. However, negotiations on aGAI, if conducted within the spirit of the GATs –negative list and developing country provisions –would allow members to include rules on foreigninvestment policies that would enhance theirprospects for development.

30

investment issue, a WTO dispute paneltook the opposite view.34 It interpreted thetitle literally and concluded that:

“Contrary to India’s argument,we find that nothing in theTRIMs Agreement suggeststhat the nationality of theownership of enterprisessubject to a particular measureis an element in decidingwhether that measure iscovered by the Agreement.We therefore find withouttextual support in the TRIMsAgreement the argument thatsince the TRIMs Agreement isbasically designed to governand provide a level playingfield for foreign investment,measures relating to internaltaxes or subsidies cannot beconstrued to be a trade-relatedinvestment measure” (WTO,1999, p. 339, para. 14.73).

This means that as the TRIMs textnow stands, there is no scope forimplementing a performance requirement(based on the existing illustrative list) in adiscriminatory fashion. Measures that areprohibited are prohibited regardless ofownership. If developing countriesperceive that TRIMs on the illustrative listare required in order to meet otherobjectives and must be implemented inrelation to foreign firms, this will need tobe negotiated. The chances of success arelikely to be very slim, given that ameasure will be prohibited because itdistorts trade.

With regard to the second issue,extending the illustrative list will involveintensive negotiations. As it now standsthe list is very much a compromise in

34 For example, see Yousef (1999: 7).

relation to the initial negotiating positions.Furthermore, the investment provision ofthe North American Free TradeAgreement (NAFTA) and the draftMultilateral Agreement on Investment(MAI) contain longer lists. Somedeveloped countries will seek to extendthe list, while developing countries arelikely to oppose such an initiative. Theoutcome of the negotiations will bedifficult to predict since the negotiations,by definition, will revolve around thoseperformance requirements that are directlyto trade.

The most contentious area wouldbe the expansion of the list to includepolicies relating to technology transferbeyond straightforward equity restrictions.Joint-venture laws, licensing requirementsand patent requirements are all typicallyimplemented within the context ofexpanding local capacity throughtechnology transfer. These policies havean effect on the location decision ofTNCs. The extent to which they are trade-related and within the framework of thecurrent TRIMs agreement is questionable.If members want the TRIMs list to includethose policies, clear evidence of their tradeeffect will have to be provided. At thesame time, developing countries shouldnot be complacent about the success of thepolicies. There may be evidence tosuggest that they can achieve certaindevelopment objectives, but there is alsoevidence to suggest that alternativepolicies, namely liberalization, may resultin a more efficient outcome.

Performance requirements withinthe context of the GATS should also notbe ignored. Article XVI lists six measuresthat members are not allowed to maintainin sectors that they have inscribed. Thesemeasures are reasonably comprehensive,but are disciplined only if an inscriptionhas been made in that sector. For the

31

forthcoming negotiations developingcountries may wish to consider to whatextent they may want to delink thisconnection – that is, to have a stand-aloneprovision not allowing these measures.

With regard to the third issue,responding to developing countryconcerns within the context of TRIMsAgreement will not be easy. Somemembers have already indicatedperformance requirements as an importantcomponent of their development strategy.Furthermore, it is likely that somemembers that have notified provisionsunder the TRIMs Agreement may takeadvantage of its Article 5.3 and seek anextension of the transition period. Whilethese are predictable and negotiableelements, the real difficulty will beattempts to allow a specific carve-out forsome policies. For example, the “trafficlight approach” used in the Agreement onSubsidies and Countervailing Measurescould be followed in the TRIMsAgreement. Measures that directly affecttrade could be prohibited (red light), andthose that are critical for development,even though they affect trade directly,could be included in a permissiblecategory (green light). The actionablecategory (yellow light) could includepolicies upon whose precise effect ontrade members cannot agree.35

F. Special and differential treatment

The preamble to Article XVIII ofGATT 1947 recognizes both thepossibility for developing countries tohave protection for developing infantindustries and a mechanism for allowing

35 This format follows the proposal by Switzerlandduring the TRIMs negotiations. See Gibbs andMashayekhi (1998) for an account of the UruguayRound TRIMs negotiations.

such protection. This provision wascomplemented during later years withvarious other provisions. Within thecontext of industrial policy and S&Dtreatment the crucial negotiating issue willbe the extent to which policies that areprohibited under WTO rules will beallowed for developing countries.

Again, consider the case of localcontent protection. Here, a WTO panel(see Annex) has concluded that without adoubt the Indonesian policy contravenesArticle III of GATT 1947. Nevertheless,some members will take the position thatthe policy is critical. If this is the case, theonly way to handle the issue is to examinewhat the optimal length of time is for adeveloping country to achieve itsobjectives with the policy.36 A similarissue arises with respect to exportsubsidies. Developing countries maintainthat, despite their disadvantage incompeting with developed countries on abudget basis, export subsidies are neededin order to develop new markets.

Two other aspects of S&Dtreatment that need to be examined arehow to determine qualification for S&Dtreatment and the optimal transitionperiod.

• Qualification. The current approach toidentifying members that wouldqualify for S&D treatment is to use theUnited Nations classification of leastdeveloped countries. In the Agreementon subsidies and CountervailingMeasures, a criterion in terms of GNPper capita is used. Given the ad hocnature of some of these measures andthe specific nature of industrial policy,the new negotiations may want toconsider using performance-based

36 Or to conclude that it is a failure.

32

measures. These can be either exportor import measures.

• Extensions of transition periods. This

point has been repeated a number oftimes in this paper: the issue concernsthe appropriate length. For industrialpolicy exemption from obligations, itmay be useful to examine specificexemptions that fit the problems ofdeveloping countries. For example,the five-year period in the TRIMsAgreement does not seem to have beenderived from any empirical work, nordoes the gap of two years in thetransition period between developingand least developing countries.

A final area of negotiation is thepossibility of snap-back of protection. Forexample, Article XVIIIb allows for

members to bypass obligations andimplement tariffs to develop certainindustries. This could be another issuewithin the context of the MillenniumRound; however, it should be reviewedcarefully. Article XVIIIb has certainconditions attached to it, which havelimited its use. The effect of theseconditions has been to force developingcountries to consider about the rationalefor protection. Indeed, tariff bindings areone of the central and critical features ofGATT rules. Our view is that increasingprotection once it has been bound shouldbe avoided. The focus should be on twopoints: the criteria for determiningmembers that would be eligible for S&Dand the duration of eligibility.

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VI. CONCLUSIONS

In today’s competitiveenvironment developing countries areattempting to boost their competitivenessby selecting industries and products withthe potential for high growth and highvalue added. The debate on the role of theGovernment in achieving this objectivecontinues. The theoretical literaturesurveyed in this paper shows that the casefor government intervention is weak. Onthe other hand, there is empirical evidenceto show that some Governments have hada role in the export and growth success ofsome countries.

This paper has reviewed the extentto which the new disciplines on subsidies,local content protection, exportrestrictions and TRIPS reduce theflexibility of Governments. It has shownthat they are playing their expected role oflimiting the use of a number of policies.However, they do so in an ownership-neutral manner, in the sense that theyapply to both foreign and domestic firms.Also, they are not country-neutral, assome WTO members are exempted fromobligations. This is an acceptable way toprovide for the needs of developingcountries, but clearly more needs to bedone.

The rules themselves are quiteconsistent with the large body oftheoretical and applied work on trade andindustrial policy. Only those policies thatdirectly affect international trade byfavouring domestic products overimported products are included. However,there are a number of areas wheregovernment policies that directly affecttrade, such as export subsidies inagriculture and services and exportperformance requirements, are notincluded. These should be a priority for

the forthcoming negotiations eitherthrough existing agreements or, assuggested, within an investment rulesframework.

The effect of WTO rules is not somuch to exclude the role of government,but rather to shift its emphasis to thesupply side. Policies that are related toinfrastructure, human capital formation,innovation and diffusion of technology,capacity building and competition policiesare now critical for exportcompetitiveness. These policies need to becomplemented by a stable exchange ratethat does not penalize (or favour) exports.These are generic pro-developmentpolicies; that is, they are not confined toand do not favour particular industries orproducers.

Efforts to challenge the ownershipneutrality of WTO rules should not bemade within the context of applyingGATT rules, but within a GeneralAgreement on Investment. Thus, specificissues relating to foreign affiliates, such asmarket access, and their performance andbehaviour, can be addressed with specificpolicies.

The point on which to close isaddressing the problem facing developingcountries as they try to compete in a newmore globalized and competitiveenvironment. The empirical body ofevidence with strong theoretical supportshows that selective industrial policiesresult in more losers than winners.Nevertheless, the political economy oftrade policy makes it difficult fordeveloping countries to agree to bindpolicies within multilateral rules. Theway to handle this problem is to examineways in which special and differential

34

treatment can account for the diversity ofdeveloping countries, in terms of boththeir levels and their objectives. Clearly, auniform 5-year transition period for allpolicies does not take into account thedifferent speeds at which developingcountries can adjust to a new regime. Thepaper has suggested that this differentialshould be examined further within thecontext of an “appropriate” transition timeor perhaps even a performance-basedmeasure such as the degree ofdiscrimination towards imports oreffective rate of assistance.

At the same time, clogging theWTO mechanism with various S&D

provisions that will never be implementedis not the way to go. Those making a casefor further S&D provisions may want toconsider an omnibus approach to thisissue. As with a GAI, such an approachwould target the specific nature of theproblem, which is the difficulty thatdeveloping countries are having withrespect to their WTO obligations. Thiswould include addressing their perceptionthat the Uruguay Round results werebiased against them. It is consistent withevolution of WTO rules highlighted in thispaper – ownership-neutral rules that havea direct effect on international trade.

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Yu, E. S. H. and C. C. Chao (1998). “On investment measures and trade”, The WorldEconomy, Global Trade Policy Issue, 21: 549–561.

39

Table 1Policies and measures to promote exports in Asia

TYPE OF India Malaysia Bangladesh Philippines Thailand Republic Singapore Indonesia Hong Kong Japan

MEASURE of Korea (China)

1. MEASURES AFFECTING

PRODUCTION

Industrial development

Policy

General y y n y y y y n y y

Specific/industry targeting y y y y y n y y n na

- strategic/domestic y y y y n n y y n na

- export industry na na y y y n y n na na

Support measures

- import protection fall y na y y n n y n n

- price controls fall y na n na n n y n na

- investment regulations fall na na fall na n n fall n na

- credit subsidies/facilities y y y na y y y y y y

- manpower training na y y y na y y na y y

Investment incentives

Deregulation y y na na partly y na y na na

Tax concessions

- holiday/exemptions y y y y y y y na na na

- reduced rates y y y y y y y na na y

- accelerated depreciation na y n n n y y na na y

Production subsidy

- input subsidy y y y n y y n y na y

- assistance for R&D y y y y y y y y y y

- pricing and marketing

arrangements y y y y y y n y na na

- regional assistance y y y y y y y n na y

Adjustment assistance y y n n y y y n y y

2. MEASURES AFFECTING

EXPORTS

Export incentives

- duty drawback & taxes y y y y y y y y y n

on imported inputs

- export finance y y y y y y y y y y

- export insurance & guarantees y y y y y y y y y y

- export quality management y n n y y n n y y n

- export processing zones y y y y y y y y n n

- export performance.requirements y n y n y n n n n n

- export cash subsidies n n y y y n n n n n

- export cartels n n n n n n n n n y

- export promotion organizations y y y y y y y y y y

Other measures affecting exports

- registration requirements y y y y n n n n n n

- export licensing y y y y y y y y y y

- export prohibitions y y y minimal n y y y y y

- export taxes/levies y y y n y n n y y y

- minimum export prices y n y n on two n n n n

- export quotas y n MFA MFA,others

MFA,others

n n y n y

- voluntary restraints MFA MFA,others

MFA MFA,others

MFA,others

n y y MFA y

Source: Singh (1996, annex II).y=yes; n = no;

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Table 2Evolution of industrial policies in East Asia

1950s 1960s 1970s 1980s 1990s

1950-1958 1959– 1967– mid-1980s

Japan IS EO Liberalization Deregulation

Trade & forex

1953-1957 1958-1980 1981– 1986–

TaiwanProvince ofChina

IS EO Liberalization

1961-1972 1973-1979 1980– 1990s

Republic of EO EO Liberalization Internationalization

Korea IS (Heavy (trade, investment, Deregulation sinceIndustry) finance) mid-1980s – innovation

oriented

1961-1971 1971-1986 1986–

Thailand IS IS (capital goods EO

beginning 1981)

Some EO Technology-intensive

industries

1950-1970 1971-1985 1986–

Malaysia Moderate IS continued Liberalization

IS Added EO EO

1967-1973 1974-1985 1986–

Indonesia Stabilization Strong IS Liberalization

Beginning IS EO

1950– 1980s 1990s

Philippines IS Continued IS Liberalization Continue Liberalization

(political (strengthened political

instability) stability)

1965-1976 1977-1978 1980s 1990s

China Defence/Industry Plant Coastline Infrastructure

(heavy Importation Liberalization High technology

industrialization) (light indus-

tries)

1950s 1960s 1990s

Singapore IS (still part of EO Strategic independence

Malaya) (high technologyand services)Regionalization

1950– 1979– 1990s

Hong Kong EO (laissez-faire, education, Improved Upgraded support

(China) infrastructure, institutional institutional for technology

support) support for

industry

Source: table 1.1 in Masuyama, Vanderbrink and Chia (1997).IS = import substitution; EO = export orientation.

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ANNEX

WTO Dispute Panel case on Indonesia:Certain measures affecting theautomobile industry

The range of tools employed bycountries in the name of industrial policyis so broad and comprehensive that ataxonomy of such tools against WTO ruleswould prove to be cumbersome. Inpractice, industrial policy is not pursuedwithin the context of selecting oneparticular tool for one particular objective;typically, a range of tools are used.

A simple way to examine howWTO rules affect industrial policy is toexamine a case where a WTO member’sindustrial policy has come under scrutinyfrom a WTO Dispute Panel ruling. Such acase has just been completed. On 2 July1998 a Dispute Panel reported its findingson Indonesia with regard to theautomobile industry.37 The case isreviewed in this section in order to seehow Indonesia’s objectives in itsautomobile industry were affected byWTO rules and the Dispute Panel’sinterpretation of these rules. Lessons arethen drawn with a view to assessing theirimplications for the forthcomingnegotiations.

Indonesia’s automobile policy

The basic issues are Indonesia’stax and tariff treatment of completelybuilt-up units (CBUs) of motor vehiclesthat are imported into Indonesia. Theseunits are subject to an import duty rate and

37 The document is listed as WT/DS54/R;WT/DS55/R; WT/DS59/R; WT/DS64/R. It can beretrieved from the WTO document disseminationsystem.

when the product is sold it is subject to asales tax. While import duties and salestax are by themselves not actionable,Indonesia had in place a scheme whichallowed an exemption from these dutieson the basis of the local content – thehigher the local content, the greater theexemption.

The policy was complicated by thefact that the specific programme todevelop the national industry reliedheavily on an inter-firm agreementbetween an Indonesian company (PTTimor Putra Nasional) and a Republic ofKorea company (Kia). The agreementincluded the supply of CBUs until localassembly capabilities were expanded.This was facilitated by an exemption fromtariff duties.

Objectives of the national automobileprogramme

Indonesia’s objectives for itsnational automobile programme can belisted as follows:38

• To improve the competitiveness oflocal companies and strengthen overallindustrial development;

• To develop the capacity of multiple-source automobile parts andcomponents;

• To encourage the development of theautomobile industry and theautomotive component industry;

• To bring about major structural changein the automobile industry;

38 WTO (1999, p. 341, para 14.78). These aresummary objectives listed by Indonesia in asubmission to the Dispute Panel.

42

• To encourage the transfer oftechnology and contribute to large-scale job creation;

• To encourage automobile companiesto increase their local content,resulting in a rapid growth ofinvestment in the automobile industry.

Precise statements of the objectivescan be found in the various legislativechanges. They include:39

• Supporting and promoting thedevelopment of the automobileindustry and/or the componentindustry;

• Further strengthening domesticindustrial development;

• Further promoting thedevelopment of the automobileindustry and/or domesticallyproduced components;

• Promoting the growth of theautomobile industry;

• Development of the nationalautomobile programme is aimed atimproving the nation’s self-reliance.

Interestingly enough, none of theabove is consistent with the World Bankdefinition of industrial policy. In sum, thestatements refer to the desire to expand thedomestic production of an industry that isunable to compete without assistance. Ofthe above statements, the last one is themost telling and is at the root of much ofthe developing country anxiety aboutWTO rules. Indonesia had the intention ofshifting into a large-scale industry withconsiderable potential for domesticlinkages. The issue at stake is to whatextent WTO rules can allow such atransition. One interpretation of the impact

39 WTO (1999, p. 339–341). The precisereferences to the government decrees can be foundin that document.

of WTO rules is that it is not“development-friendly” in that it does notallow members the opportunity toimplement policies that may have apositive impact on industrial restructuring.We shall return to this issue below.

Policies

The policies put in place by theIndonesian Government to develop self-reliance are the standard policies requiredto support a weak and infant sector:subsidies to lower the cost of production,local content restrictions to force domesticsourcing of inputs, and protection toincrease the market in which the productis sold.

The Indonesian Government didnot document the list of subsidies.However, it asserted that there was still anissue with respect to the claims of Japan,the European Union and the United Statesin relation to:

• Import duty exemption and a salestax exemption on CBUs from theRepublic of Korea;

• Import duty exemptions on partsand components used or to be usedin the assembly of automobilesTimor in Indonesia;

§ Luxury sales tax exemption.

WTO rules affected by the nationalautomobile programme

The three complainants (EuropeanCommunities, Japan and the UnitedStates) were concerned about the totaleffect of the Indonesian policies. Inparticular, their concerns was in thefollowing areas:

43

• Discrimination in favour ofimports from the Republic ofKorea;

• Discrimination in favour ofdomestic goods over importedgoods;

• Bias in the tax system in favour ofdomestically producedautomobiles.

Their concerns also applied toother areas, most notably those covered bythe Agreement on Subsidies andCountervailing Measures and theAgreement on Trade-related Aspects ofIntellectual Property Rights (annextable 1).

Ruling

The panel ruled on the measures inthe following manner:40

• Local content measures linked tothe sales and customs duty benefitswere inconsistent with Article 2 ofthe TRIMs Agreement.

• The sales tax discrimination underthe national automobileprogramme violated Article III:2.

• The arrangement with the Republicof Korea violated Article I.

• The European Communities haddemonstrated that the use ofspecific subsidies caused seriousprejudice within the meaning ofArticle 5(c) of the SCM.

• The United States had notdemonstrated serious prejudiceunder Article 5c.

• Indonesia had not violated Article28:2 of the SCM.

• The United States had notdemonstrated that Indonesia had

40 WTO (1999: 397).

violated Articles 3, 20 or 65:5 ofthe TRIPS Agreement.

State of play41

On 21 October 1998 the partiesinformed the Director-General of theWTO that they had agreed on anarbitrator. This was after agreement couldnot be reached on a “reasonable time” forthe implementation of the ruling. Thepositions on what constituted a“reasonable time” were interesting.Article 21:3 (c) states that a reasonableamount of time should not exceed 15months. Indonesia, citing its economicdifficulties, claimed that the full period of15 months was required. In particular, itidentified the hardship that compliancewith the WTO rules was going to involve.

The United States and theEuropean Union expressed particularlystrong views, citing the fact that structuraladjustment was a normal course ofcompliance with WTO rules. Hence, therewas no scope for citing Indonesia’sparticular circumstances as the reasons fora lengthy transition period. Indonesia alsohad to consider internal consultations tocomply with the ruling. This meant notonly abolition of the measures prohibited,but also developing a package that couldmeet Indonesia’s initial objectives andalso be WTO-consistent. In the end, thearbitrator accepted Indonesia’s positionand awarded a 12-month period.

On 15 July 1999 Indonesiainformed WTO members that it had put in

41 This section is drawn from the following WTOdocuments: WT/DS54/15, WT/DS55/14WT/DS59/13, WT/DS64/12 (7 December 1998);WT/DS54/17, WT/DS55/16, WT/DS59/15,WT/DS64/14 (4 June 1999); WT/DS54/17 add.1,WT/DS55/16 add.1, WT/DS59/15 add.1,WT/DS64/14 add.1 (15 July 1999).

44

place policies to comply with the ruling ofthe WTO Dispute Panel.

Lessons

There are a number of insights andimplications for developing countries andfor the forthcoming negotiations. Theseare set out only briefly below since theyare taken up in the text.

• Local content protection isunambiguously trade-distorting,which means that any attempt bydeveloping countries to carve outlocal content protection would befutile. At best, they would have totry to negotiate an extendedtransition period.

• Lack of knowledge and capacity –the series of initiatives undertakenby Indonesia were nothing short ofextraordinary. In the first place,some of the policies in disputewere implemented after the WTO

was established. Second,Indonesia tried to notify thesemeasures under the TRIMsAgreement to benefit from thetransition period after the expiry ofthe notification period. Initiativessuch as these support the argumentthat developing countries requiretechnical assistance to implementthe WTO multilateral tradeagreements.

• An obligation is an obligation:

once the Indonesian policies werefound to violate WTO rules theyhad to be brought into lineimmediately. The position of theUnited States and the EuropeanUnion was quite extreme. Bothargued that “structural adjustment”was not a defence for a longertransition period. This positionmeans that prospects for anextended transition period will insome cases depend very much on anegotiated outcome.

45

Annex table 1Alleged breaches of multilateral trade agreements by Indonesia’s

national automobile programme

GATT 94 I:1 Most favoured nationIII:2 National treatment on internal taxation and

regulationIII:4 National treatment on like productsX:1X:3(a)

Publication of national laws

TRIMs 2 National treatment and quantitative restrictionsSCM 1 Definition of a subsidy

2 Specificity3:1 Prohibition27 Special and differential treatment of developing

country members28(2) Standstill on arrangements

TRIPS 3 National treatment20 Other requirements65 Transitional arrangements

Source: WTO (1999).

47

UNCTAD Study Series on

POLICY ISSUES IN INTERNATIONAL TRADE AND COMMODITIES

No. 1 Erich Supper, Is there effectively a level playing field for developingcountry exports?, forthcoming.

No. 2 Arvind Pangariya, E-commerce, WTO and developing countries, 2000.

No. 3 Joseph Francois, Assessing the results of general equilibrium studies ofmultilateral trade negotiations, 2000.

No. 4 John Whalley, What can the developing countries infer from theUruguay Round models for future negotiations?, 2000.

No. 5 Susan Teltscher, Tariffs, taxes and electronic commerce: Revenueimplications for developing countries, 2000.

No. 6 Bijit Bora, Peter J. Lloyd, Mari Pangestu, Industrial policy and the WTO,2000.

No. 7 Emilio J. Medina-Smith, Exports and economic growth: Is the export-ledgrowth hypothesis valid for developing countries?, forthcoming.

No. 8 Christopher Findlay, Service sector reform and development strategies:Issues and research priorities, forthcoming.