Don’t rescue dying industries

Don’t rescue dying industries

The South African government has just announced plans for a new rescue package for its ailing apparel industry, which is to include direct subsidies, raising import tariffs by as much as 45%, seeking WTO permission to impose additional anti-dumping duties, directing state-owned financial institutions to free up credit to manufacturers, an aggressive “Buy South African” policy for government procurement, and a range of cash and fiscal incentives to producers and exporters.  It is a huge mistake.

There is no question that the industry is suffering. Textiles and apparel companies provide over 14% of total manufacturing employment, and account for over 3.5% of GDP.  But sales, employment, and, especially, exports, are on the skids. The industry shed 2,200 jobs in the first two months of 2009, and the largest garment manufacturer in the country reported a loss for the second half of 2008, but the industry has been in decline for much longer. Employment dropped 17% in 2007, well before the current economic crisis, a function of factories closing or dropping out of the formal sector and operating as unregistered companies paying their workers under the table. Overall industry sales and employment are down nearly 50% from their peak in 2002 and 2003. Job and revenue losses may be paltry compared to the hemorrhaging of the American car industry, but in an emerging economy with over 30% unemployment and a fragile political situation, they matter.

South Africa is hardly alone in trying to save its textile and garment industry. Spain and Portugal have announced bailout packages of €800 million and €850 million, respectively. China is providing massive state support and India is offering export incentives. Mauritius and Nigeria have also pledged cash support to their textile companies. They are not alone.

The striking thing about this is that in so many of the countries whose governments are prepared to increase protectionism and ladle out subsidies, the textile and apparel industries have been in decline for several years. The current economic crisis has certainly accelerated the collapse, but in South Africa the industry reached peak employment in 2003 and exports peaked in 2002. Nigeria’s once-vibrant textile industry has been all but wiped out by a crippling lack of electricity to run its factories. Mauritius, whose garment industry has enabled it to advance from a poor agrarian economy to a middle-income manufacturing one over the past 30 years, is no longer a cheap labor manufacturing location. It has outsourced many of its cut-and-sew operations to nearby Madagascar and has moved into products and services that add far more value than labor-intensive garment production, just as Hong Kong did with China at around the same time.

The South African rescue package highlights a weakness at the heart of the international trade system. Most of the measures it proposes – though they are highly protectionist – are legal under WTO rules. Negotiations at the WTO are focused mainly on “bound” tariffs: the maximum import duty that can be imposed on a given product. This is often substantially higher than the applied tariff, giving countries the latitude to raise import duties without breaking the rules. Though export incentives and subsidies are for the most part banned, rich and poor countries have devised a slew of techniques to skirt these prohibitions without formally violating the regulations.

Support for free trade in most countries has always been tenuous, and never more so than when a structural decline or an economic crisis threatens profits and jobs. Politicians, who ought to know better, pander to the misguided protests of their constituents rather than showing some leadership and explaining why – however counter-intuitive it may seem – raising protectionist barriers will only make things worse. The argument shouldn’t be that hard to make. After contracting sharply in the second half of 2008, trade is forecast to drop in 2009 by three percent according to WTO projections, or five percent according to the IMF’s gloomier outlook. A senior WTO official recently warned that world trade could contract by another eight percent – $1 trillion – if all countries were to raise their import tariffs from to the maximum (bound) tariffs allowed under WTO rules. This would turn what is still a recession from which we could recover in the next year or so into a deep depression that could last a decade or more.

I don’t expect politicians the world over to sacrifice their short term political interests to do the right thing in a time of crisis, or to think much past the next election. I stopped writing letters to Santa Claus many years ago.  But attempts to rescue dying industries or companies with protectionist barriers and subsidies no not work, have never worked, and cannot work. At most they give temporary respite that only postpones the day of reckoning and makes the collapse more devastating when it finally occurs. This breathing space also prevents companies from making the radical changes in strategy that just might allow them to survive. It was obvious last autumn when the U.S. government gave billions to save General Motors and Chrysler from insolvency that both companies would be back in a matter of months asking for even more money, and so it proved.

Mass production of T-shirts and jeans is a matter of razor-thin margins, in which the difference between profit and loss is often measured in fractions of a cent in unit costs. Slight differences in the cost of wages and benefits, electricity, water, and transport can translate into millions of dollars of revenues and profits gained or lost. Powering your plant with a diesel generator, as companies in Nigeria must do, more than doubles your energy cost. The average sewing machine operator in South Africa makes $10 to $15 a day, compared to as little as two dollars in Haiti or Vietnam.

South Africa is a middle income country, and can no longer compete at the bottom end of the market. The industry must either get out of the garment industry altogether or move into higher value, higher margin products. Brioni, the Italian men’s suit maker whose prices start at around $5,000, does not need to worry how much more it pays its workers than a Chinese sweatshop operator. Insulating the South African industry from the hard choices it needs to make will only hasten its demise.

If the politicians and bureaucrats promoting South Africa’s textile industry bail-out package were only wasting their own country’s finances and hurting its own competitiveness it would be sad but not cataclysmic. But this new policy only encourages others to follow suit and contributes to a destructive protectionist spiral.

This is a time for someone – anyone – to show some leadership, but as world leaders run for cover it seems less likely than ever. This week’s G20 summit produced solemn pieties about the need to preserve free trade, even though nearly every country present has already broken previous promises to refrain from increasing trade protection. Despite pledges to conclude the Doha round of trade talks, an actual deadline for doing so continues to recede into the future.

I would think about writing a letter to Santa Claus, asking him to do something, but by the time next Christmas rolls around it may be too late.

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4 Comments

Alice » 14 Jul 2009 »

Mr. Krakoff-

I have read many of your articles related to protectionism. My question is: How can businesses and governments build support for open markets? I do understand your point of not investing in dying industries and investing in infastructure, but how can these two ensure that the markets remain fluid? In what ways can we protect “open” markets?

    Chip Krakoff » 14 Jul 2009 »

    Alice, this is a great question, and a very hard one. Free trade hasn’t much of a popular constituency, which is why populist politicians and pundits attack it so aggressively. It is easier to blame sneaky foreigners and their unfair trade practices, pursue anti-dumping cases, and ladle out subsidies to inefficient companies – and it tends to win a lot more votes – than to confront the sources of declining competitiveness in one industry or another and to do something about it, either by forcing companies to compete without protection and subsidies or by letting those industries shrink or die, making room for new, competitive ones. President Obama, to his credit, has defended free trade and has refrained from acting on some of the protectionist promises he made – e.g., to renegotiate NAFTA – on the campaign trail.

    My answer to your question, though it may not be feasible politically, is to: 1) recommit to the WTO and push for genuinely free trade, which means giving up some of our cherished agricultural and industrial subsidies; 2) stop protecting and subsidizing industry and agriculture, forcing American companies to compete domestically and internationally. This probably means a lower corporate tax rate (right now we have the second-highest in the OECD), while at the same time getting rid of all the tax breaks and incentives and loopholes that make up a big chunk of the 10,000-plus pages of the U.S. tax code. This would be a good start, anyway.

Alice » 30 Jul 2009 »

My apologies for the late response. The reason why I asked so many questions was because I was approached with the question: What are some ways businesses and governments build support for open markets? I cannot help but wonder how this can be done if Obama is approaching greater protectionist measures in the wake of the financial meltdown. How can both international governmental and nongovernmental institutions begin to discuss open markets, when food prices are going up, garment industries and manufacturing industries disappearing, and piracy increasing? Perhaps, auto company mergers can be an example of open markets.
To respond to your comments, I do not think lower corporate taxes will make much of a difference since many companies are escaping to tax-haven countries and re-establishing their headquarters abroad. Look at what has been happening in NYC since Giulliani: big corporation received tax breaks to stay in downtown and midtown Manhattan; however, more relocated to Queens and Jersey City while eliminating jobs and outsourcing abroad.

    Chip Krakoff » 31 Jul 2009 »

    Alice,

    Another very pertinent comment. I have written previously in this blog – “Why Do Capitalists Hate Capitalism?” http://www.emergingmarketsoutlook.com/?p=198#more-198 and “the Problem with Capitalism” http://www.emergingmarketsoutlook.com/?p=141#more-141 – about why many businesses and governments do not support open markets. Established businesses fear that opening markets will expose them to more competition from foreign companies or upstart domestic ones. Politicians win more votes with protectionist rhetoric than by supporting free trade and liberalized markets.

    Regarding taxation, countries have two main options: the first, to have high tax rates but then give all sorts of concessions and breaks to industries or companies they want to favor; and the second, to establish lower tax rates and eliminate most of the subsidies and loopholes. The first, which is what we have in the U.S., has created a lobbying industry worth about $2.5 billion at the federal level and who knows how much more at state and local levels. Many, if not most, companies in the U.S. pay far less than the average 39.3% combined federal and state corporate income tax and many also get breaks on state and local property taxes, so their effective tax rate may be quite low. But working the political system to lower your tax rates is expensive (only big companies can afford it) and uncertain (plenty of anti-business lobbying groups also have huge influence). What government gives in special favors it can also take away.

    The trend in much of the world has been for countries to lower corporate tax rates – from the mid-teens to the low twenties seems to be the sweet spot – and to simplify their tax systems so that more businesses pay their fair share. If your basic tax rate is low enough and the system transparent enough there is no need to move to an offshore tax haven, as Halliburton did when it moved to Dubai. In any case, I doubt that relocating from Manhattan to Queens has much to do with tax rates. Class A office space in the suburbs rents for less than half of what it does in Manhattan.