Real exchange rate and import substitution episodes: Evidence from a developing economy

We investigate the impact of the real exchange rate (RER) on the growth of import-substituting sectors using the quasi-natural experiment of Argentina’s large and lasting RER depreciation following the end of the Convertibility regime. To this end, we developed an episode detection algorithm to identify sectors with substantial import reductions from 2003 to 2008, while controlling for changes in aggregate income. Our analysis examines the theoretical transmission mechanisms through which the RER influences the performance of the tradable sector competing with imports. The results reveal three main findings: First, labor-intensive sectors showed a higher probability of occurrence of import substitution episodes during 2003–2008. This is in line with our expectations and the traditional trade theory, given that the RER should increase profitability in these kinds of sectors more. Second, we find that the higher level of the RER increases the probability of an import substitution episode when the sector shares a higher number of similar capabilities with sectors in which the country is already internationally competitive. Last, we find complementarities between the sectors with import substitution episodes and those that achieved the status of export surge episodes during the same period (2003–2008). In this sense, and in contrast to the traditional consensus view about import substitution policies, we do not observe any tension between developing sectors for the domestic market and the incentive to export growth when the level of the RER is used to promote growth and diversification in the tradable sector. • We examine how the real exchange rate influences the occurrence of import substitution episodes in a developing economy. • We develop an episode detection algorithm to identify significant reductions in sectoral imports while controlling for changes in aggregate income. • We find that a competitive and stable real exchange rate significantly boosts the likelihood of import substitution episodes in labor-intensive sectors. • Import substitution episodes are more frequent in sectors where the economy already possesses relevant capabilities. • Using the RER to promote growth and diversification in the tradable sector does not create conflicts between developing import-competing sectors and promoting export sectors.