Salah El Serafy
Salah El Serafy is Senior Economist at the World Bank in Washington, D.C., but this article does not necessarily reflect the views of the Bank. The article also appears in FAO Forestry Paper No. 45, entitled Establishing pulp and paper mills
New pulp and paper industries in developing countries will inevitably lose money and face stiff competition from imports at the outset. This makes protectionist measures very tempting. The key question, however, is whether such measures, once adopted, can ever be removed. They can, but only if costs are brought down and in most cases this is not at all certain or even likely. Moreover, by adopting a policy of protectionism, argues Salah El Serafy, new pulp and paper industries would lose the numerous benefits accruing from free trade.
FREE TRADE OR PROTECTIONISM?: weighing the balance for pulp and paper
· Generally speaking, free trade offers greater opportunities for industrializing countries than protection. It brings in cheaper products and affords larger markets for the exporters and therefore economies of scale leading to price reduction. The forces of competition associated with free trade press the producers toward efficiency. Protection, by contrast, raises the cost of the protected goods to the users - whether consumers or producers - thus resulting in a loss of welfare to society as a whole, and further upsets relative prices whose function is to guide resource allocation.
The logic of infant-industry protection is that it is temporary, and that once the industry matures, free trade should be restored. A practical difficulty is that once protection is established, vested interests resist its removal to the detriment of the economy.
Pulp and paper is not an industry with strong backward and forward linkages with the rest of a developing economy, and therefore it is not likely to bring substantial benefits to other industries or trigger development of other sectors. Unless there are special factors that indicate that the initially high cost of this capital-intensive, fuel-absorbing and (usually imported) high-technology activity will fall as the industry matures, setting up such an industry behind protective walls will impoverish, not enrich, the country concerned.
Recent evidence suggests that countries that have adopted open-door policies and exposed their economies to international competition have fared better in terms of economic growth and balance-of-payment equilibrium than countries that have adopted protective policies.
But if protection is decided upon, it should ideally take the form of a direct subsidy which would not distort relative prices. Failing this, a tariff is preferable to quantitative restrictions, and low levels and uniformity of effective protection are preferable to high and divergent degrees of effective protection. A careful cost-benefit analysis, undertaken prior to establishing an industry, using prices reflecting true opportunity costs of inputs and outputs over the period of infancy as well as the period of maturity, would normally indicate whether or not protection was justified.
This article omits discussion of, but touches briefly on, irregularities in trade practices such as "dumping", and also the newly expounded proposition that free trade perpetuates the underdevelopment of the Third World - an apparent reformulation of the nineteenth-century justification for protection.
Developing countries, eager to industrialize, tend to give protection to their newly established industries in the belief that these industries, though initially unable to compete with the more established foreign industries, will one day be able to do so. The forms of protection are varied and are used singly or in combination, including outright prohibition of imports, quotas, tariffs, special exchange rates, and direct and indirect subsidies. Before the infant industry matures and protection is removed, the economy of the industrializing country is harmed, but such harm is tolerated in the expectation that it will be offset, or more than offset, by future benefits in terms of cheaper products, employment creation and export markets which would accrue to a mature industry. But the harm perpetrated on the export industry by protection is very seldom considered.
This article argues against protection generally, especially for an industry such as pulp and paper, which is capital-intensive and dependent on imported technology and feeds on highly specialized inputs. While it is not impossible that a newly established pulp and paper industry might one day stand on its own feet and become competitive without protection, I shall argue that it is generally unlikely. A developing country, planning to give protection to a nascent industry in the belief that the industry will eventually overcome its initial handicaps, should consider whether its costs can later fall sufficiently to offset the losses incurred during the years of nurturing the infant industry. Otherwise it should realize that it will be embarking on a loss-making endeavour with no certainty of ever realizing profits. It is necessary to elaborate the conditions that must be present before such an activity is encouraged, and to propose guidelines for protection that would minimize the cost borne by society during the formative years.
It was not an accident that free trade as a movement and a doctrine began in Britain around the first half of the last century, after the Industrial Revolution had taken root. The British classical economists identified the free interplay of market forces as the driving force behind the new productive processes, leading to specialization and higher productivity. Catering to a larger market afforded the producers the opportunity of realizing economies which competition forced them to pass on to their trade partners. They found no difficulty, therefore, in advocating the unhampered interaction of market forces, whether domestically or internationally.
Specialization among trading nations was viewed as increasing skills, enabling further division of labour, and tending to larger-scale production, more economies and reduced costs. Free trade would ensure competition and force the inefficient to give way to the more efficient so that costs and prices would come down, thus progressively enlarging the markets and bringing the product within the reach of greater numbers of people. Provided that expansion did not lead to the emergence of monopoly power - and if it did, the state would combat this by legislation - the advantages of free trade were almost self-evident. Conversely, interference with free trade would lead to inefficiency, smaller markets and higher costs and reverse the process of expansion.
Latecomers to industrialization, however, soon pointed out that free trade, as advocated by the already industrialized, would forever favour established industry over the interests of the newcomers, who might indeed have a latent comparative advantage that would find expression only after they had begun production. And since they would not be able to begin production and sell their product in the face of competition from the more efficient, older producers, the state should afford the new producers some transitory protection.
The essence of the doctrine of infant-industry protection is its temporariness, for once an industry has been established and given time to mature behind protective barriers, its costs would come down sufficiently for the barriers to be removed, and once again free trade would rule to the benefit of all. Protecting infant industry, therefore, was nothing more than a transitory suspension of the rules of the game until participants became equal and could compete.
In more recent times, the principles of international specialization associated with free trade have been further elaborated. The comparative advantage of market participants, which had been assumed by the earlier economists, was traced to its root causes such as their resource endowments. Countries tended to specialize in lines of activity that reflected these endowments. Brazil or Argentina, for instance, can specialize in livestock, Australia in mineral production, the Far Eastern countries in electronics, the Scandinavians and North America in pulp and paper - all according to their natural resource endowment, including human ingenuity, which adapts to and develops the natural endowment. This pattern of specialization changes constantly through the incessant search for new and more efficient processes, thus inducing countries to reduce or abandon older lines of production in favour of new ones. This brings diversity among nations and creates fresh opportunities for trade. All the time, new and efficient production replaces less efficient production, and the engine of free trade distributes the fruits of this progress among the participants in trade, whether buyers or sellers.
Recent evidence suggests that countries that have adopted open-door policies and exposed their economies to international competition have fared better in terms of economic growth and balance-of-payment equilibrium than countries that have adopted protective policies. Closing the door on outside competition isolates domestic industry, depriving it of the benefits of new ideas that are transmitted through international intercourse and fostering habits of thought and behaviour among the domestic industrialists that eventually lead to inefficiency.
SORTING WASTE PAPER IN COSTA RICA: how much is the economy stimulated?
In its modern form the pulp and paper industry is a process industry whose capital requirements are considerable in relation to the job opportunities it creates. Essentially simple, the process falls into two parts: the making of pulp, and the processing of pulp into paper.
The pulp-making stage requires a cellulosic base, in combination with chemical solvents as well as heat, in order to transform the raw material into pulp in a semi-liquid state before this is bleached, moulded and dried into various paper products. This stage, which depends on the availability of logs or similar raw materials (bagasse, rice stalks, cotton linters, other plant parts) which are usually bulky and expensive to transport, tends ideally to be located where a source of the raw material exists. Although in the process of preparing the raw material for production some parts less fit for processing may be burnt as fuel, the industry is quite intensive in energy use, which at present makes up about half of the variable costs of processing.
If protection is decided upon, it should ideally take the form of a direct subsidy which would not distort relative prices.
It is not sufficient just to rely on the intuitive belief that familiarity with the pulp and paper industry on the part of developing countries will inevitably reduce costs.
The paper-making stage is as intensive in capital and energy use as it is highly mechanized, and the technology is dominated by the old-established manufacturers. Typically, a capital investment of US$ 200000 or more is required per job created in this stage.
For practical reasons, the two stages of processing are integrated, often under one roof. Though it might appear to make sense to locate the pulp plants close to the sources of cellulose and the paper mills in the proximity of the final markets, there would certainly be no saving in transport cost. Besides, in order to get the pulp to the paper mill, further processing would be needed, using expensive energy to desiccate the pulp for transportation and later to liquefy it in the paper mills before processing it into paper. The cost involved in all this would be prohibitive. That is why the pulp and paper industry tends to be located close to the sources of logs in countries richly endowed with suitable forests.
The opportunity does, however, exist for some paper-processing to take place away from the sources of the raw material. Low-quality paper is often manufactured using recycled paper with the application of less advanced techniques which are usually labour-intensive. Local sources of cellulose can also be used as ingredients, either on their own or mixed with recycled paper. Such processing is usually profitable and needs no protection from the state against the importation of rival products. Besides, the product is usually of low value in comparison to transport costs and is very seldom traded internationally anyway. But the low value of the product makes also for low value added, and manufacturing this type of paper, though advantageous to the economy, would not bestow great benefits on the processing country. The bulk of the paper market, even in a developing country, is of relatively high quality, and this type of low-quality paper, though useful, is usually a small fraction of total consumption.
Start-up. A developing country, attempting to set up a modern, integrated pulp and paper industry under conditions where it is cheaper to import the paper, should give careful consideration to the rationality of this endeavour. If the costs of production are perceived to be high only initially and are projected eventually to fall, then the reasons behind the initial high cost and the sources of improved productivity in future must be discussed and analysed. It is not sufficient just to rely on the intuitive belief that familiarity with the industry will inevitably reduce costs. The country concerned will presumably already possess - or would in time develop - a large-enough market to sustain the plant size it has chosen. Countries with small populations and low per caput incomes do not usually have a sufficiently sizeable market to sustain a viable industry, and it is often wishful thinking to plan on exporting a product that does not already have the benefit of a large-enough domestic market. But even the availability of a market, though necessary, is certainly not sufficient. Already having a market would brighten the prospects for the new industry to have local sources of the pulp-making raw material, ideally as logs of appropriate quality to suit the available technology, but other suitable sources of cellulose may be acceptable in varying degrees, depending on the quality of the paper manufactured. The availability of trained managers, chemists and engineers, sources of fuel, labour, transport, and credit and maintenance facilities would be a distinct advantage. Without these, it is unlikely that a country would gain much "learning by doing", sustaining an initially losing industry that is lacking in the elements that usually enhance productivity and reduce costs.
It should be clear to whoever takes a decision to protect an industry on grounds of infancy that protection inevitably involves losses. These losses include not only the difference between cheap imports and high-cost domestic production but also the opportunities lost in forfeiting production because of higher prices in this as well as in other sectors as a result of the price distortions introduced by protection. If it can be clearly demonstrated that these losses will prove to be temporary and will be more than offset by future gains, then protection is warranted. Otherwise, there is no justification for protecting an industry that will forever generate losses.
Once a conscious decision has been made to set up an initially losing but eventually profitable pulp and paper industry, economic analysis teaches a set of rules that would optimize protection. On efficiency grounds, the best way to afford protection is by direct subsidy. A subsidy paid out of the public treasury to a newly established industry would at once be recognizable and measurable, so that the cost of infant-industry subsidization is known and subject to periodic review when the budget is set. In this way the level of the subsidy can be reduced in step with the maturation of the industry. This method has the advantage that domestic prices would not be altered by protection and is therefore superior, from the point of view of allocative efficiency, to other methods of protection.
Failing this, however, protection should take the form of a tariff rather than quantitative restrictions, and the level of the tariff should be as low as possible, commensurate with profitability, and should be reviewed periodically. For there is a tendency, once a protective tariff is in place, for political pressure by vested interests to perpetuate it. When costs are eventually reduced and the producers can realize profits without protection, the tariff loses its raison d'être.
Another rule derived from economic analysis is that the level of tariff should not be too much out of line with other protective tariffs, the aim being to equate as much as possible effective tariffs on all goods that are being protected. The concept of effective protection relates the tariff not to the price of the product but to the value-added content of this price. With value added in the production of pulp and paper being in the neighbourhood of 40 percent of the final price of paper, a 20 percent tariff levied on imported paper is equivalent to 50 percent effective protection A good policy rule is that as far as possible the levels of effective protection should be both low and convergent among various lines of industrial activity.
Protection through tariffs or quantitative restrictions on imports does raise domestic prices and therefore upsets the balance of relative prices that had developed from the interplay of supply and demand. Such "distortion" means that prices will tend not to reflect the wants of society or the costs of production, leading to costly misallocation of resources.
Any projection that the initial high cost of the industry will give way to lower costs and eventual viability must be carefully debated and scrutinized. Is it likely in the case of a processing industry like pulp and paper that mere familiarity with the productive process will reduce cost and increase productivity? The pulp and paper industry is not one that is so powerfully linked backwards and forwards with other industries that its development could lead to the growth of connected activities, thus creating external economies of production. In fact, it is much more likely that difficulties will develop after the industry has been set up, because of unfamiliarity with the machinery, inadequate maintenance, shortages of parts or essential ingredients or plain mismanagement. A projection that the new industry will get over its initial difficulties and be able to stand on its own feet when initially it is unable to do so will have to be proved by special reasoning. If such reasoning is not forthcoming, the best alternative is to refrain from setting up the industry altogether, for there is no point in creating an activity that would remain a drain on the economy, generating losses instead of surpluses.
I am aware that international prices of products and capital goods alike, which should form the basis of investment and other decisions taken by the developing countries, may sometimes fail to reflect the free interplay of market forces. They can also be the product of indivisibilities and elements of monopoly and are often subject to fluctuation or even to artificial manipulation, including the practice of "dumping". Such imperfections, where they exist, should be addressed in the calculations behind the protection policy before it is decided upon. But however imperfect the international markets may be, they often offer opportunities for gains to be realized by participants through trade.
Another point worth mentioning is the vocal opposition, coming from certain quarters, to the principle of free trade, even where international prices reflect true comparative advantage. International specialization among unequal partners, it is argued, would lead to the continued underdevelopment of the developing countries and would force upon them perpetual specialization in primary activities. The suggested alternative to free trade, in this regard, is economic isolation - hardly the path to growth for the smaller countries - and encouragement of trade among the developing countries. This alternative, although good in theory, is likely in practice to be of limited scope and benefit. In fact, it is a repetition of the nineteenth century's protection argument against free trade.
