Vertical policies come in many varieties, but they must always induce firms to increase their productivity by acquiring new capabilities. There is no single recipe for vertical policies, as they depend on the binding constraints identified, and must take state capabilities and political incentives into account.

Case study of the Ethiopian leather industry

Brautigam et al.’s (2016) case study of the Ethiopian leather industry provides an example of a typical sequencing of steps in vertical industrial policy:

  1. Creating a high level focus on the sector – the potential of the Ethiopian leather sector was identified in a strategy document authored by Prime Minister Meles Zenawi himself.
  2. Attracting a lead investor – the Prime Minister invested time in attracting foreign investment, including several trips to China. As a consequence, Chinese shoe firms invested in Ethiopia.
  3. Build government capacity to support the sector – the government created the Leather Industry Development Institute (LIDI) and invested heavily in building its technical capacity.
  4. Strengthening business associations – the government’s strategy for the leather sector involved the establishment of a business-government forum across the meat, leather and leather products sectors (although this effort has not met expectations).
  5. Promoting industrial upgrading – measures included assistance for training and skill transfer, low-cost financing for investments in upgrading, and export taxes on semi-processed leather.
  6. Improving input supply – the government aimed to reconfigure the raw hides and skins sector and created a new Ministry of Fisheries and Livestock in charge of the task.

Although the Ethiopian leather industry has not been an unconditional success, and although no two industrial policies will ever be the same, the steps taken by the Ethiopian government resonate with some of the main guidelines of our framework, and shows the different types of measures that may be included in vertical policy.

A useful distinction can be made between passive policies, which only require action by the public sector, and active policies, which aim to induce changes in the behavior of the private sector. While active policies are potentially more effective, they require greater state capacity.

Examples of passive vertical policies:

  • Negotiating foreign market access.
  • Building bespoke infrastructure.
  • Setting up ‘one-stop shops’ for investors.
  • Public training programmes.

Examples of active vertical policies:

  • Preferential allocation of foreign exchange, conditional on export performance.
  • R&D subsidies.
  • Tax holidays for firms entering new sectors.

Special Economic Zones

In the past few decades, Special Economic Zones (SEZs) have become a popular instrument of industrial policy. There are different types of SEZs, including free trade zones, export-processing zones (EPZs) and hybrid types, but Thomas Farole and Gokhan Akinci[1] note that the most relevant for developing country governments are export-processing zones (EPZs) and large-scale SEZs combining residential, commercial, and industrial functions, such as those successfully used by China.

SEZs can exert five functions:

  1. Attracting FDI, which brings in new capabilities to the host economy.
  2. Increasing export earnings.
  3. Alleviating large-scale unemployment.
  4. As instruments for kickstarting a ‘dual-track’ economic reform process.
  5. An experimental role in testing policies to be later expanded to the entire economy.

SEZs can not only provide short-term benefits for the host economy, as they can be a platform for facilitating industrial upgrading. However, this is no easy task. At initial stages, the challenge consists of creating inviting conditions for foreign investors, particularly with regards to the affordability and reliability of infrastructure, the ease of business regulations, and a sufficiently productive labour force. Fiscal incentives, while helpful, are less important than these factors, and are not a sustainable way of continuing to attract investors.

From a longer-term perspective, the dynamic benefits of SEZs depend on the ability of the host economy to create linkages with the zones, allowing them to learn from international firms’ best practices and enabling the host economy to upgrade into higher-value added activities. It also requires a trained labour force to which skills can be transferred.

For low-income African countries with little industrial tradition, SEZs can be a convenient way of kickstarting the industrialization process, while avoiding some of the difficulties posed by the domestic business environment. As usual, the devil is in the details, and the design of an effective SEZ programme requires political commitment at the highest levels, as well as an institutionalized way of planning the programme and dealing with the obstacles that will inevitably arise. Perhaps more importantly, the government must be able to overcome entrenched interests and provide for the needs of foreign investors.

[1] Thomas Farole and Gokhan Akinci (2011) – “Introduction” in Thomas Farole and Gokhan Akinci (eds.), Special Economic Zones: Progress, Emerging Challenges, and Future Directions, Washington, DC: World Bank