Local Content Requirements: Measures Intended to Boost Domestic Industry Boomerang to Bring Failure

Since 1947, when the post-World War II multilateral trading system came into existence, trade liberalization has incrementally rendered the traditional tools of protectionism ineffective. Governments, through both domestic reform and global and regional trade agreements, have reduced and eliminated tariffs and quotas, leading to increasing levels of international trade across all economic sectors along with decades of global prosperity.

However, as we noted in the opening blog in our series, many governments around the world, to respond to domestic political pressures, are using forced localization measures as a means of protectionism. One popular forced localization measure is the local content requirement (LCR). Many international economists agree that LCRs do not help the economy maintaining them, since they lower productivity, increase prices, lead to social welfare loss, and divert investment, leading to stagnation rather than economic growth and development. Many international economists agree that LCRs do not lead to economic growth or development for the country imposing these restrictions—instead they backfire, resulting in lower productivity, increased consumer prices, and lost investment in local industries.

What are LCRs? They are rules that a company must derive a certain amount of the final value of a good or service from domestic firms, either by purchasing from local companies or by manufacturing or developing the good or service locally. Governments use LCRs in an attempt to protect and develop domestic industries. The logic is faulty but simple: every good or service requires inputs, and requiring companies to purchase those inputs from domestic companies develops those industries – how could this be bad for an economy? Unfortunately, the reality is not so simple.

When considering whether to comply with an LCR, companies must consider the costs of sourcing locally. Modern goods and services are the result of complex, global business networks which companies develop in multiple locations around the world to tap innovation, maximize cost efficiencies, and be responsive to supply and demand. If regulations require a company to establish part of its business network in a specific location with costs higher relative to the global market, then that company must raise its prices to factor in the new costs, change product features to adjust to those costs, or exit the market altogether. LCRs also act to force out international small and medium size enterprises (SMEs), which cannot afford higher costs. Domestic SMEs find that they cannot buy the latest goods and services that they need to grow. The results are higher prices and fewer choices for consumers, less investment and development for the economy, and reduced growth and innovation all around.

Unfortunately, LCRs in the global economy have grown to 146 active measures in 2015. Indonesia, for example, has a law requiring all 4G-capable smartphones to be made of at least 30% locally produced content and 4G wireless modems to be 40% local content. Even more onerous, Nigeria’s Guidelines for Nigerian Content Development in Information and Communications Technology (ICT) require all ICT hardware to be 50% local content and tack on multiple other forced localization measures. Both of these measures clearly state that their respective objectives are protecting and developing domestic industries. Local Indonesian companies have already indicated that they cannot comply with the requirement, and we expect local Nigerian companies to have similar problems. The downside of these measures will likely be high costs of compliance, decreased competition with smaller companies exiting the market, and less innovation over time – none of which will serve to develop a vibrant tech sector.

There are multiple international trade agreements that already prohibit governments’ use of these measures: the WTO Agreement on Trade Related Investment Measures (TRIMs, Articles 2.1, 2.2), the General Agreement on Tariffs and Trade (GATT, Article III:5) — and new agreements, such as the Trans-Pacific Partnership (TPP, Article 9.10.1(b)), do so as well. Despite these agreements, the use of LCRs continues to grow.

Governments imposing LCRs do not want to hear complaints about their negative economic consequences, opting instead to look for policy alternatives for attracting investment and development. The Asia-Pacific Economic Cooperation (APEC) forum produced such a set of alternatives in 2013 – the APEC Best Practices to Create Jobs and Increase Competitiveness. Notably LCRs are not included in APEC’s recommendations.

We encourage governments to turn to these best practices when considering how to develop their domestic technology industries and focus on high return investments, such as education and infrastructure, that provide ample labor forces and reduce the cost of doing business. They should also take steps to ease the movement of goods and services over their borders and create clear and consistent regulations that align with global industry practices to reduce uncertainty for investment and build confidence in the rule of law. With these reforms, as opposed to LCRs, governments can effectively encourage growth, investment, and development in their economy.

Forced Localization Blog Series Table of Contents:

Public Policy Tags: Forced Localization