Think Piece

Industrial Policy as a Tool of Development Strategy: Using FDI to Upgrade and Diversify the Production and Export Base of Host Economies in the Developing World

January 2015
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Traditional views of industrial policy have typically begun with trade protection as a strategy to promote the creation of infant industries, with the hope that the latter grow to become viable international competitors. Following Lin’s Comparative-Advantage-Following (CAF) model, this paper adopts a perspective quite at variance with the older trade-protection approach, starting instead with foreign direct investment (FDI) promotion to attract multinational corporations into sectors that bring the host country immediately to the frontier of technology, management, and quality control.

The focus on harnessing FDI—in particular in manufacturing and assembly—to promote broad-based development, complete with economic and social spillovers and externalities, assumes special importance in light of the discovery that developing countries that diversify and upgrade their production and export base enjoy more rapid growth and greater welfare gains than those that simply do more and more of what they have always done.

New data introduced in this paper shows that FDI in manufacturing offers target-rich opportunities for host governments that want to use it for structural transformation of the host economy.

But this paper follows Hausmann-Rodrik-Lin in pointing out that there are important market failures and tricky obstacles to attracting investors in higher-skilled and novel sectors in untried emerging market locales. So, how should industrial policy be designed in the contemporary period? What are the precise market failures and obstacles to using FDI to upgrade and diversify a would-be host’s production and export base? What are the corresponding public sector interventions needed to achieve success?

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