1. NS4540 Winter Term 2019 Import Substitution Chilean Case Study
Reys & Sawyer Chapter 6

2. Chilean ISI Case: Overview
Leland Johnson, Problems of Import Substitution: The Chilean Automobile Industry, Rand 1968
Chile attempted import substitution to conserve foreign exchange
Country did achieve high level of self-sufficiency in the semi-fabrication and assembly of consumer durables
Automotive sector good example of
Pitfalls that can arise when a country attempts to combine conflicting economic objectives with political ones in designing trade protection programs for favor a particular industry
The role that foreign exchange control can play in maintaining a chronic misallocation of resources in the industry, and
The manner in which general price inflation can further contribute to poor industry performance

3. Chile ISI in Autos I
Chilean government decided to prohibit continued import of fully assembled automobiles for ordinary domestic use
Forced firms to import only components and assemble them in Chile – anticipated this would increase value created in the sector as well as save foreign exchange
To increase further domestic VA the government developed a “national integration” program – assemblers would be obliged to use in each successive year increasingly large amount of Chilean components as substitutes for imports
Automakers not free to locate plants wherever they chose. Had to build in Arcia 1,000 miles north of Santiago near border with Peru
No assembler would have gone their voluntarily – no skilled labor, high transport costs

4. Chile ISI in Autos II Arcia
Selected largely on political considerations
Had belonged to Peru before War of the Pacific
Residents not happy and have from time to time threatened to secede and join Peru
Had also been center of extreme left-wing political agitation in Chile – backed Allende in elections
With the decline in economic (nitrates, other mining) activity in the region, unemployment quite high.

5. Chile ISI in Autos III
Number of curious phenomena surround the industry
Assembling cars became a seasonal business
Many firms produce no cars in the first four of five months of the calendar year
Production accelerates during second half of year
Some plants producing only four or five cars a day
One firm employed 200 workers during the peak in December and tried to retain 20 during slack season
Basic cause of seasonal pattern was difficulty of obtaining domestically produced components to comply with the national integration requirements
As integration requirements increased firms had to use items increasingly difficult to fabricate – doors rather than just batteries

6. Chile ISI in Autos IV

7. Chile ISI in Autos V
According to the law automobile was judged to meet the integration requirement for a given year only if it is completed before the end of the year
Any cars not completed have to bear the higher requirement in the next year
In interest of firms to finish as many cars as possible before the end of the year
Why did Chile have such difficulty in domestic fabrication of components?
Did not have adequate managerial talent, skilled labor or capital to comply with the national integration regulations
Problem complicated by fact assemblers unable to predict their components requirement early in the year because they didn’t know how much foreign exchange they would be allocated

8. Chile ISI in Autos VI
Costs of Import Substitution to Chile

9. Chile ISI in Autos VII
Wholesale price of a fully assembled compact imported into Chile would run to about $2,200, compared to the $1,200 cost of imported components
About $1,000 foreign exchange directly saved by substituting domestic assembly and locally fabricated components
Problem no exchange rate that reflects accurately the relative costs of foreign and domestic resources
If use government controlled 3 escudo dollar rate Chile would be using equivalent of $4,000 in local resources to save $1,000 dollar
If use black market 5 to 1 rate this falls to 2.4 dollars of local resources per dollar saved of foreign exchange
To the extent that domestic components have a foreign exchange content, Chile saves less than the $1,000 estimated above

10. Chile ISI in Autos VIII
On balance – over wide range of assumptions about exchange rates and import content of domestic production
Possible that two, three or even four dollars of local resources are being consumed for each dollar of foreign exchange being saved through the program
If so, Chile much better off importing fully assembled automobiles

11. Chile ISI in Autos IX In defense of Chile’s ISI program, two arguments
First the value of the automobile industry is greater than implied above – favorable externalities – training of labor force
Second in a learning process extending through time Chile will be progressively better able to undertake fabrication and assembly operations
What may be a comparative disadvantage in the short tun may not be so in the longer run.

12. Chile ISI in Autos X Foreign exchange problems
One factor that contributes to the seasonality of production as well as the proliferation of small-scale plants is the difficulty of obtaining foreign exchange for imports of components
Foreign exchange is provided by the Central Bank only for imports it approves
Exchange rate not allowed to fluctuate reflecting supply and demand
Demand for foreign exchange greatly exceeds supply at the overvalued rate
Plant managers usually don’t know more than a few months ahead how much foreign exchange they will have access
Hard to plan production runs

13. Chile ISI in Autos XI
In practice the Bank dribbles out a little foreign exchange to any producer able to meet the national integration requirements.
Relatively efficient producers are not able to drive the less efficient out of the market – normal competitive behavior
Means even the very inefficient firms can survive
Given the size of the domestic market probably need only three or four plants in Arcia rather than 20

14. Chile ISI in Autos XII
How does system work? Bank wants to avoid favoritism.
Bank committee meets periodically to consider applications for foreign exchange
Specifies that if the total value of foreign exchange requests in a given industry in a given month does not exceed more than 5% of the average monthly value of foreign exchange actually granted in the previous 12 months than the Bank must approve all requests of the individual firms
If the total value requested exceeds by more than 5% of the preceding 12 month average approve then Bank may accept or reject all requests – it cannot accept those of some firms and reject those of others
Uncertainty meant firms had to hold large inventories

15. Chile ISI in Autos XIII
Why not just let firms bid for foreign exchange and let the escudo weaken?
Rationale of a overvalued rate was to keep inflation down.
Views inflation as a cost push phenomenon when actually it was more of a demand driven problem
Probably better just to control the money supply and let the exchange rate float