IMPORT PROTECTION, THE MANUFACTURING SECTOR AND THE CURRENT ACCOUNT

IN AUSTRALIA

by ANDREW MARKS*

1. Background The relationship between (effective) import protection and the current

account has centered on the balance of trade. For example, theory and international evidence have comprehensively demonstrated that the costs (such as protection-induced inefficiency in production and hence an infer- ior export performance) of protection have exceeded the major benefit of lower import growth) e.g. see Dongas (1976), Balassa (1977) and Kruger (1975). The Australian experience is harmonious with this result as indi- cated by reports such as The Coombs Task Force (1974), Jackson Committee (1975), White Paper (1977), Crawford (1979), Pappas, Evans and Koop (1990) and O.E.C.D. (1972, 87).

Furthermore, strategic trade theory, as pioneered by Spencer and Brander (1983), Heloman and Krugman (1983) and Brander and Spencer (1985), also highlights the relationship between import protection and the balance of trade. In particular, temporary import protection and assistance measures such as subsidies for exporters, will assist in promoting manu- factured exports in an imperfectly competitive international market due to barriers to trade, the possession of technical advantages and the benefits of economies of scale by some international firms. In the Australian context, the Australian Manufacturing Council (1991), Hart (1991), Whiteman (1991) and others support the important role which strategic trade theory can play in promoting manufactured exports. However, the Industries Commission (1989, go), takes the opposite view by emphasising the numerous hazards involved with targeting assistance measures.

Whilst the relationship between protection policy and the external account has centred on the balance of trade, as indicated above, the objec- tive of this paper is to focus the analysis on the income component of the current account. This relationship has not been explored in Australia, with the need to do so highlighted by the fact that the net income deficit (as a

* The author would like to thank Dr A. Chowdhury and Prof. A. Dasgupta for their useful comments. Needless to say any errors or omissions are the responsibility of the author. This paper was also presented at the 22nd Conference of Economists, Murdoch University, Perth. 1993.

52

percentage of GDP) has generally constituted the largest component of the overall current account deficit in Australia, a phenomenon displayed by the following diagram for the period 1960/61-1992/93.

DIAGRAM 1 Components of Current Account

PERCENTAGE OF G.D.P.

1960/61 1965/66 1970/71 1975/76 1980/81 1985/86 1990/91 YEAR

- BALANCE OF TRADE + NET SERVICES

A NETINCOME -6- NET UNREQUITTED TRS.

The other interesting dimension of diagram 1 has been the tendency for a relative contribution of the net income deficit to generally rise since the mid 1970s. This result is consistent with Daniels (1992) who highlights a similar trend over the period 1973-1989. Consequently, it would seem appropriate to analyse the effects of sustained high import protection on the income component of the current account.

The paper is organised as follows: Section 2 provides an overview of the factors explaining the inflow of foreign investment in the manufacturing sector as a means to analysing the relationship between protectionism and its impact on the income component. Section 3 examines the negative influence of import protection on the income component of the current account, whilst the following section provides a quantitative measure of this effect. Section 5 briefly canvasses the relatively more important reasons for the implementation of the sustained high levels of import protection policy. Finally, section 6 provides a brief analysis of the policy implications of the results of the paper.

53

2. Import Protection and Foreign Investment Foreign investment plays the important role of supplementing domestic

saving thereby raising overall investment and hence economic growth. One of the earliest theoretical models formulated to explain the inflow of foreign investment was that of Mundell (1957). It constitutes a two country, two commodity and two factor model to highlight a positive rela- tionship between import protection, the relative rate of return and foreign capital inflow when barriers to trade are imposed. The Brigden Report (op. cit.) provides evidence to the effect that tariffs were encouraging a higher rate of return and hence foreign (and domestic) capital inflow into the Australian manufacturing sector for the first three decades of this century. With the high import protection strategy maintained up to the early 1970s in Australia, this implied that protection-induced capital inflow can also be expected to increase the supply of foreign capital thereby reducing the rate of return over time. Indeed, Johns (1967) reinforces this point by revealing data which highlights the general trend for the profitability on direct foreign investment to fall in Australia in the representative period 1955/56-1965/66. This trend is also likely to constitute a proxy for the rate of return in the manufacturing sector due to the high proportion of direct foreign investment which had traditionally flowed into this sector. However, at the same time as the rate of return was falling, the magnitude of direct foreign investment diverted into the manufacturing sector exhi- bited a general rising trend. These phenomena are illustrated in Table 1.

TABLE 1 _ _ _ ~ ~ ~

Year Apparent Profitability on Direct Foreign Investment Direct Foreign Investment in the Manufacturing Sector

($MI

1955156 19 5615 7 195 7/58 1958159 1959160 196016 1 1961162 196 2/63 1963164 196465 196 5/66

11.2 10.3 9.9 10.7 10.5 8.9 6.4 7.7 7.6 7.0 6.3

n!a 147 122 130 170 243 113 249 218 247 205

Source: B.I. Johns (1967), “Private Overseas Investment in Australia Profitability & Motiva- tion”, Economic Record, Vol. 43, No. 102, p.237 and ABS Cat. No. 5305 “Foreign Investment in Australia” - various issues.

The rising levels of direct foreign investment within the context of a declining trend in the rate of return on capital in the manufacturing sector

54

appears to be critically related to the protection issue. For example, The Vernon Report (op. cit.) emphasised that the relatively high tariff wall in itself may not have encouraged direct foreign investment, but rather the fact that once established, foreign firms had access to the Tariff Board which they believed could be influenced to readily raise import protection on request. Furthermore, Hogan (1967) reveals that the most important motive for British direct foreign investment in the early decades of the post WWII period was the incentive provided by the sustained levels of high import protection to establish Australian operations so as to overcome the loss of export sales. Moreover, Brash (1966) explains the inflow of U.S. direct foreign investment as principally the produce of both strong economic growth and sustained high levels of import protection.

The various dimensions of import protection which have been discussed appear to have constituted a critical element in attracting a rising level of direct foreign investment to the manufacturing sector over time. Despite this, the proportion has exhibited a genera1 falling trend with subsequent stabilisation at lower levels. These phenomena are depicted in diagram 2.

90

8o

70

50

40

30

20

10

DIAGRAM 2 % of Direct Foreign Investment

-. - ‘L

v\/\ \r\

b/q/!hJ - -

- I

foreign investment. Furthermore, the expectation created of lower import protection after the Vernon (op. cit.) revelation of the excessive protection related costs to this sector, is also likely to have stifled the growth and hence profit outlook, thus further retarding the inflow of direct foreign investment. This appears to have combined with the previous factor to explain the more pronounced decline in the period of the mid 1960s to the early 1970s. The general tendency for the proportion of direct foreign investment to stabilise in the period after the early 1970s appears to be fundamentally explained by the transition phase of moving from high to low import protection. In particular, although this policy change is likely to have created a conducive environment for restructuring in order to improve export competitiveness, this would have simultaneously slowed manufacturing activity as the relatively less efficient firms contracted. Direct capital inflow appears to have thus adjusted to this new situation where the manufacturing sector exhibits a slower rate of growth in a more liberalised environment.

It is also important to include a brief analysis of portfolio and institu- tional investment (defined as investment in shares, corporate bonds and loans to Australian controlled companies) because, like direct foreign investment, it also has implications for the net income component of the current account. In particular, overseas borrowing of this type will also involve regular payments overseas in the form of not only dividends, but also interest. Despite the general trend of a rising level of portfolio and institution1 investment in the manufacturing sector in the period 1973/74-1992/93 (data is unavailable prior to this period), the proportion diverted into this sector has exhibited a similar behavioural pattern as direct foreign investment. This is illustrated below in diagram 3.

DIAGRAM 3 % of Portfolio & Institutional Investment

DIVERTED INTO MANUFACTURING

1973/74 1975176 1977178 197918D 1981182 1983184 1985186 1987188 1989/90 1991192 YEAR

56 Source: ABS. Cat. No. 5305. “Foreign Investment in Australia” - various issues.

More specifically, the proportion of portfolio and institutional invest- ment has declined up to 1977/78, although steeply (particularly as com- pared to the more general decline of direct foreign investment up to 1972/73) and subsequently stabilised at lower levels (although direct foreign investment stabilised at higher levels). The former difference may possibly be explained by the fact that given the high degree of mobility of portfolio and institutional investment, changes in flows can be quicker and more pronounced in response to changing economic climate. The latter phenomenon may possibly be explained by the fact that, once foreign investors have established domestic operations, continued investment is required (in the form of new capital, the adoption of new technology etc.) in order to maintain competitiveness. Apart from these differences, the general behaviour of these two different types of foreign investment appear closely synchronised, thereby indicating that the same fundamental factors are likely to have been impacting.

3. Import Protection, Income Payments and the Current Account The high levels of total foreign investment in the manufacturing sector,

apart from having the favourable impact of expanding output and employ- ment growth, have also augmented the capital account, which in turn has worked to offset the traditional current account deficit. However, Penrose (1956) emphasised that the preoccupation of the authorities with attempts to encourage foreign capital into Australia, and in particular to the manu- facturing sector, in order to extract these benefits would simultaneously lead to the problem of servicing the income payable overseas from this source: a phenomenon which would ultimately be reflected in a worsen- ing current account deficit. Particular emphasis was attached to the pro- tection-induced inward orientation of the manufacturing sector which would restrict the export revenue growth to cover the investment income payable overseas. Arndt (1957) reinforced this concern by highlighting the potential servicing difficulties that would arise because the manufacturing sector’s growth relied primarily on import replacement, rather than exports. However, as the Treasury (op. cit.) highlights, the limited export growth was also the product of foreign subsidiaries in Australia being restricted and in some cases completely prohibited (by the parent company) from the pur- suit of export activities. The Vernon Inquiry (op. cit.) into the Australian economy focused on the potential magnitude of the servicing problem from the excess reliance on foreign investment for the economy as a whole (i.e. its ability to meet the dividends, interest, other payments overseas deriving from the excess reliance on direct and portfolio and institutional investment), although this situation can be principally applied to the manufacturing sector due to its ability to attract a disproportionately large inflow of foreign capital. Indeed, this report had stated:

‘As investment continues, Australia builds up an increasing liability for the remit- tance of dividends and other payments overseas and its future ability to service these charges from export earnings and import replacement must be considered. ” (P.274)

57

Despite the recognition of a potential servicing problem and the adverse impact on the current account, Vernon nevertheless ignored the need for specific measures to accelerate the manufacturing sector’s export orienta- tion. This criticism carries additional weight because of the earlier “warn- ing signals”, emanating from Penrose (op. cit.) and Arndt (op. cit.).

4. The Manufacturing Sector’s Servicing Burden Foreign investment, whether in the form of direct or portfolio and insti-

tutional investment, impacts on the balance of payments via numerous avenues. For example, when either type of foreign investment occurs, it is normally associated with capital inflow, thereby impacting on the capital account (in the form of an unofficial credit transaction). Furthermore, whilst the former can generate foreign exchange via net export growth, the latter can finance the expansion of domestic industry through capital inflow, initially impacting on the capital account and ultimately on the balance of trade via promoting net exports. However, an adverse impact occurs on the net income component when interest, dividends and other income is paid overseas to foreign investors. This section will not concen- trate on the different effects of foreign investment on the balance of pay- ments, but rather focus on gauging the manufacturing sector’s ability to service the income payable overseas from direct foreign and portfolio and institutional investment in the manufacturing sector, for the period 1979/80-1992/93 (data on income payable overseas from portfolio and institutional investment is unavailable prior to 1979/80 thereby restricting the time period covered). This exercise is undertaken because of the poten- tial to lead to a further deterioration of the net income and hence current account deficit.

The ratio of investment income payable overseas from these two types of foreign investment in the manufacturing sector (defined as the income deriving from direct foreign investment in the form of interest, reinvested earnings, dividends and remitted profits of branches, and the income payable from portfolio and institutional in the form of interest and divi- dends to manufacturing output will be used. It is interesting to note that the measure of manufacturing output captures numerous favourable effects of foreign investment. These include those highlighted by Dunning (1993), such as the generation of foreign exchange via export and import replacement activities. Furthermore, he provides evidence of foreign investment enhancing the export capabilities of domestic firms. This occurs, for example, when they collaborate in the production of goods and components for export purposes. All these effects are captured by the denominator, with the result that it improves the manufacturing sector’s ability to pay income overseas deriving from direct foreign and portfolio and institutional investment. The behaviour of the manufacturing sector’s servicing burden based on income payable on these two types of foreign investment for the period 1979/80-1992/93 is illustrated by Diagram 4.

58

DIAGRAM 4 Manufacturing Sector‘s

SERVICING BURDEN d

7

6

5

4

3

2

1 1979/80 1981/82 1983184 1985186 1987188 1989/90 1991192

YEAR Source: ABS Cat. No. 5303, “Foreign Investment in Australia” and ABS Cat. No. 5203,

‘Australian National Accounts, National Income and Expenditure”.

The above diagram represents a situation where the rate of growth of investment income payable overseas from direct and portfolio and institu- tional investment in the manufacturing sector, has generally exceeded the rate of growth in output of this sector. The former case basically reflects the protection-induced accumulation of large amounts of both direct and indirect foreign investment in the past which has led to rising levels of investment income payable overseas. The relatively slower growth in manufacturing output has fundamentally been the result of the inflow of foreign investment into a sheltered sector. This is a critical result because the prolonged high protective environment not only encouraged the inflow of foreign capital, but simultaneously provided a disincentive to export, thereby leading to an excess reliance on import replacement activity to conserve foreign exchange.

Sharper focus is also required on the low, but nevertheless deteriorating situation of servicing the income payable overseas from the manufacturing sector. In particular, this burden has more than doubled within the rela- tively short period of the fourteen years to 1992/93. It is of paramount importance to emphasise that this deterioration has basically occurred from the mid 1980% a period which also coincides with a significant improvement in this sector’s export (e.g. see Garnaut (1991) and Athukorala (1995)) and hence output performance.

This situation thus indicates the possibility of an aggravation of the ser- vicing burden if an even more rapid rate of growth of manufactured (net) exports cannot be achieved in order to offset the expected rising level of

59

investment income payable overseas over time. This goal however may be difficult to achieve.

The adverse impact of the deterioration of the manufacturing sector’s servicing burden in relation to meeting the income payable overseas, on the current account, can be gauged by initially examining the contribution of investment income payable overseas from this sector to total income debits. This is depicted by Table 2.

TABLE 2 Ratio of Investment Income to Total Income Debits

Year (1) (21 (1) (2) Investment Income Total Income Debits

Payable from the Manufacturing Sector

$M $M

1979180

1980181

1981182

1982183

1983184

198485

1985186

1986187

1987188

1988189

1989190

1990191

1991192

1992193

69

730

997

70

1268

1560

1770

1795

2832

3680

3827

2570

2549

3563

3715 25.4

3641 26.5

4075

4168

6700

8636

10229

11815

14559

17979

31.1

16.9

26

23

22.3

20.1

26.9

27.0

21953 22.2

22138 14.1

20045 16.2

19818 25

Source: ABS Cat. No. 5305, “Foreign Investment in Australia” - various issues and ABS Cat. No. 5303, “Balance of Payments” - various issues.

The above table indicates that an appreciable 20-25 percent, on average, of total income debits derive from the investment income payable from the manufacturing sector (except in the recessionary years of 1982/83 and 1990/91-91/92 when profits and hence investment payable overseas have fallen sharply). Consequently, given this situation, the deteriorating ser- vicing burden of this sector implies a sizeable negative impact on the level of income debits and hence net income deficit. However, the critical point is not so much the negative impact on the level of income debits, but rather the fact that the general inward orientation of the manufacturing sector has not allowed for sufficient offsetting (net) export revenue growth, thereby ultimately leading to a widening current account deficit. Despite

60

the difficulty of further accelerating manufactured export growth, pressure nevertheless exists for policies to achieve this goal so as to prevent a further deterioration of the current account problem from this source. Measures to combat the other factors contributing to the large net income deficit, as well as to improve the balance of trade and net services compo- nents, are therefore needed in order to ensure that inroads are made at reducing the external deficit at a satisfactory rate.

5. The Political Economy of Import Protection The negative impact of sustained high levels of import protection on the

income component of the current account necessitates the need to briefly canvass some of the important factors contributing to this policy stance. The Brigden Report (op. cit.) recognised the important role of protection- induced expansion of manufacturing activity in supporting stronger than otherwise growth in output, employment and hence real wages in the economy. Consequently, rapid improvements in prosperity encouraged the authorities to extend the high import protection strategy into the post WWII period, despite the offsetting costs associated with the external competitive disadvantage. The extension of protection beyond WWII in Australia, was, however, not only the product of rising economic pros- perity. Special interest groups such as those in the manufacturing sector which were benefiting, particularly in the form of high profits, lobbied strongly for preserving the high import protection structure. Furthermore, pressure to maintain the status quo in relation to protection levels also emanated from trade unions who sought to protect employment and hence real wage levels; with additional support from those states benefiting most from import replacement industrialisation.

In the Australian context, Anderson’s (1980) empirical investigation has also revealed the “politics” of protection to have been an important factor in influencing both overall, as well as relative differences in protection levels among manufacturing industries. Moreover, Ratnayake (1993) analyses the determinants of inter industry variation of tariff protection in the Australian manufacturing sector within a cross section framework (using a simultaneous equations model). He reveals that factors such as profit levels, degree of competition from developing countries and histori- cal protection levels have been imporant considerations in determining lobbying pressure on government and hence relative protection levels. Warhurst (1992) also emphasises the importance of the political nature of industry assistance decisions in the Australian manufacturing sector. Consequently, lobbying has constituted an important factor in explaining the difficulties associated with switching emphasis from import substitu- tion industrialisation to lower protection. According to Woronoff (1992), this situation is in sharp contrast to the five successful East Asian economies of Japan, Singapore, Korea, Taiwan and Hong Kong, which began shifting emphasis away from import replacement activities and towards a more liberal trade regime in a shorter time period than Australia.

61

Chowdhury and Islam (1993, p.87) highlight the ability of these govern- ments to insulate themselves from rent seeking groups (primarily via the manipulation of the financial system) as being of significant importance in explaining this phenomenon. Indeed, they argue:

“internal factors like the absence of strong distributional coalitions and political leadership committed to growth appear to be more important, i f not crucial, in aflecting a country’s external tmde and economic growth. ”

6. Policy Implications and Conclusions The purpose of this paper has been to provide an analysis of the impact

of sustained high levels of import protection on the income component of the current account. The results indicate this component to have been adversely affected because of the difficulty of the manufacturing sector to export at a sufficiently rapid rate to offset the rising remittances of interest, dividends and other payments overseas. Consequently, this has aggravated the net income and hence current account deficit. It should be emphasised that this outcome was fundamentally the product of the strategy used to promote industrialisation, i.e. sustained high levels of import protection. The high protection levels therefore not only encouraged the inflow of for- eign capital, but also created a disincentive to operate efficiently and hence export. Therefore, there is a need to continue to reduce import pro- tection in order to minimise these negative influences. The May Economic Statement’s (1988) objective of reducing the average tariff level for the manufacturing sector to 5 percent by 1996 constitutes a step in the right direction.

However, the deeply ingrained inefficiencies of this sector arising from the prolonged period of high protection and the competitive disadvanage arising from the non existence of a “level playing field” on the interna- tional market, requires assistance measures in order to cushion the impact of the stronger import competition. This approach is likely to provide the opportunity for a more effective response by the manufacturing sector. Towards this end, the assistance measures in the form of accelerated depreciation allowances, grants for investment purposes, etc. as provided in “Building A Competitive Australia” (1991) and “One Nation Economic Package” (1992) constitute important complementary measures. Furthermore, the various micro-economic reform measures of the past decade, such as the deregulation of markets, education and training reforms, tax and public sector reforms, etc. are all important indirect assis- tance measures. Consequently, the improved performance of manufac- tured exports will work towards offsetting the investment income payable overseas and hence combat this sector’s deteriorating servicing burden, and ultimately the current account deficit. An improved manufacturing export performance will simultaneously diversify the export base thereby easing the terms of trade induced-income losses which have characterised the Australian economy. Measures to ensure that other sectors also

62

generate sufficient export revenue in order to offset investment income payable overseas will also be important. Finally, policies to also promote the export of services will buttress attempts at combating the external deficit.

Attempts however to accelerate the manufacturing sector’s export orien- tation will also be characterised by numerous offsetting costs. For example, some firms will not successfully respond to the challenge of stronger import competition, thereby contracting and hence accentuating unem- ployment. The rising unemployment will compel the government to increase expenditure on unemployment benefits. When combined with the lower tariff revenue and the expenditure on the various assistance measures, this will have an adverse impact on the budgetary position thereby applying upward pressure on interest rates. These short run costs nevertheless can be more than offset in the medium to long run. For example, the improvement in manufacturing exports will improve both the current account and employment levels. Furthermore, the higher levels of economic activity will increase taxation revenue thus improving the budgetary position and the outlook for lower interest rates.

Failure to further improve the manufacturing sector’s export perfor- mance will result in a deterioration of its ability to service the income to foreigners deriving from direct and portfolio and institutional investment, thereby further widening the net income and hence current account deficit. The importance of reducing the current account deficit is high- lighted by the O.E.C.D. (1994) which depicts Australia’s external deficit (as a percentage of G.D.P.) to have been substantially above the O.E.C.D. average since the early 1980s. This situation has been sustaining a signifi- cantly tighter than otherwise macroeconomic policy stance, thus con- straining the economy’s overall output and employment performance.

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