Female instructor. | © World Bank
This blog post is the first in a series that is bringing the latest research to bear on the potential role industrial policy can, should, or shouldn’t play in government economic policy in low- and middle-income countries.
In both developed and developing countries, there is a renewed interest in industrial policy. Governments are moving beyond basic regulatory and macroeconomic strategies, actively providing direct support to firms in the forms of subsidies, grants, training, and other assistance. The goal is to help generate new jobs, foster innovation, improve productivity, and accelerate the development of new green technologies. However, skepticism remains, particularly in developing countries, where industrial policy often conjures images of unproductive, politically connected firms.
Empirical Evidence from Developing Countries
A recent working paper delves into whether such programs truly achieve their intended outcomes in developing countries. The debate has largely been based on theoretical arguments and anecdotes and lacks concrete evidence on whether these programs deliver their intended results.
Targeting and Additionality: More Than Just Picking Winners
A common refrain in policy discussions is “governments cannot pick winners”, implying that support often goes to firms with little potential. Another concern is the lack of “additionality,” that support merely enables firms to do what they would have done anyway.
Recent empirical evidence challenges these notions. For example, in a study of a large business plan competition in Nigeria, conditional on getting through an initial screening, we found that expert judges, machine learning models, and economic models all had very low ability to predict which firms would grow fastest over the next three years. It’s not about identifying the best firms, but about attracting those with high potential. Indeed, in that same Nigerian business plan competition, entrants were strongly positively selected on education and growth potential, and I find that the government support causally resulted in higher firm survival, more profits and innovation, and higher employment over the next five years.
The Reality of Additionality
New evidence suggests that concerns about a lack of additionality may often be overstated. For example, a directed lending program in India resulted in increased borrowing and production among targeted firms. Similarly, in Poland, grants for science-industry collaboration led to more collaboration and increased patenting, and firms provided with management consulting in Colombia used more consulting, improved their management practices, and increased employment.
The Risks of Political Capture
These benefits are contingent on good program design and on programs attracting the right firms. Many developing countries struggle with state capacity to implement these programs well, leading to political capture. In a study in six African countries, matching grant programs for innovation often faced low take-up due to political economy or capture issues. The European Commission mitigates these risks by setting rules on the use of state aid that help prevent individual countries and politicians doling out support as favors. Here there is a role for the World Bank or donors to help run independent project implementation units and write the eligibility conditions for these programs to separate firm selection from politicians.
Fostering, Not Suppressing Competition
Historically, infant industry approaches to industrial policy often involved shielding firms from competition through tariffs, exclusivity, and other measures, giving them few incentives to improve and innovate. Yet, our work in Colombia showed that the threat of Chinese import competition motivated Colombian firms to improve their management practices. Simply financing some firms to do more of what they were already doing can just result in them stealing business from unsupported firms. This is what happened in a subsidized loan program in China, where firms that got loans just used them to take market share from non-supported firms without changing what they produced. Supporting export- and innovation-oriented firms helps in producing novel products and growing markets. For example, business training in Kenya helped firms figure out new products to sell, growing the entire market, while supporting all private schools in Pakistan villages resulted in firms competing on improving quality, raising children’s test scores.
How can governments afford this?
In a post-Covid era of tight government budgets, there are also concerns about providing public financing to relatively well-off firm owners. However, these programs can become more financially sustainable once one considers the potential for higher tax revenue from firms, and lower public social benefits if firms hire additional workers. Governments can also consider giving innovation funding under a royalties model, in which successful firms pay a time-limited royalty back to the government.
Support and Evaluate
Despite well-founded skepticism, these examples demonstrate that government support can lead to higher productivity, more innovation, and job creation. However, innovation is complex and risky. Rigorous impact evaluations are vital for measuring impacts and making necessary adjustments, especially as new areas of government support such as the green agenda emerge.
Conclusion: A Path Forward
In conclusion, while direct government support to firms is controversial, the evidence suggests it can be effective with careful design and implementation. Programs must aim to attract innovative firms, foster competition, avoid political capture, and should be subject to continuous evaluation and improvement. For policymakers, the challenge lies in crafting policies that are financially sustainable and easy to apply to, as well as being willing to accept (and learn from) some failures along with the successes that come with risky innovation.
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