Industrial Policy Conditionalities: From Mandates to Menus

Modern industrial policy is evolving its approach to conditionalities: the conditions or requirements attached to government support to advance a wider objective. The intention of conditionalities is to tie government support to a business under its industrial policy to the meeting of wider objectives, such as increasing foreign investment, increasing manufacturing output, or wider social considerations such as regional development or increasing employment. However, not all conditionalities are created equal.

There are three problems that governments face when introducing conditionalities.

1. Governments face uncertainty. As they seek innovation and economic transformation, governments do not know which technologies or businesses will succeed and scale.
2. Businesses are not homogenous. They have different capabilities, positions in value chains, and appetites for risk. They may not all respond to the same conditions.
3. There is a trade-off between ambition and participation. A government may have clear objectives, but if the conditionalities are too hard for businesses to meet then the objective may not be met. Conversely, if conditionalities are set too low, then the desired objective may be unfulfilled.

This article shows that strict conditionalities have, historically, been used with mixed levels of success as they do not fully respond to the above challenges. Some countries are moving from mandates to menus in their conditionalities. They are offering multiple options for compliance which creates more flexibility and pathways for successful outcomes to emerge. Because they are relatively new, there is not yet much evidence on how well menu-based conditionalities work, however they may be a promising method of responding to the three key problems.

Strict conditionalities

Historically, many countries mandated strict conditions, often related to building national champions or using local content. Governments offered subsidies to a single domestic business to scale and required international businesses to manufacture locally or partner with domestic businesses. However, in some cases, governments picking winners led to inefficiencies, which undermined the legitimacy of industrial policy.

Strict conditionalities can be successful. In the 1970s, South Korea offered subsidies, low interest loans, and various fiscal incentives to promote exports in the strategic sectors of steel, nonferrous metals, shipbuilding, machinery, electronics, and petrochemicals. The government closely monitored export performance, and withdrew support where companies were not performing as intended. This resulted in the rapid growth of companies such as Samsung and Hyundai, which became internationally competitive. More recently, during the COVID-19 epidemic, the UK government funded early research and development of the AstraZeneca vaccine, but required that the company would produce the vaccine on a non-profit basis during the epidemic, and that profits would be reinvested in medical research.

Conversely, strict conditionalities have also been used unsuccessfully. In the 1980s, Brazil introduced an informatics law to promote the development of national informational technology companies. Imports of many types of information technology equipment required government approval and were, generally, not approved, where the government assessed that domestic companies could produce similar equipment. A variety of fiscal incentives were offered to Brazilian information technology companies, including exemptions from import taxes provided the company maintained a net positive balance in its transactions in foreign currencies. However, combined, the exclusion of foreign manufacturers and lack of exposure to competition hindered the development of a globally-competitive Brazilian microcomputer industrial sector at the technological frontier.

Case studies

As countries renew their adoption of industrial policy, some countries are adopting increasingly sophisticated conditionalities that respond to these problems by creating menus of conditionalities, offering multiple ways of complying with the government’s requirements. This allows governments to maintain ambition but offers flexibility to businesses on how they comply with the conditionalities. This increases the governance challenge for governments to monitor and assess compliance, but if done effectively, it allows state learning from observation of which conditionality pathways businesses choose. Case studies from Indonesia, Brazil, and Morocco demonstrate some different approaches.

Indonesia demonstrates the traditional approach of robust, strict conditionalities based around resource nationalism. In 2009, the government introduced greater controls over the mining sector and reinforced this in 2020 with a ban on the export of nickel ore and in 2023 with a ban on the export of bauxite ore. In effect, this sets a strict condition that multinational companies wanting access to Indonesia’s critical minerals must refine the minerals domestically. Similarly, it applied local content rules to the manufacturing of electric automobiles, solar PVs, hydropower, and geothermal equipment. These were initially set on renewable energies at around 40% but reduced as the government learned about the realistic level of local content achievable. In return, the government offered fiscal incentives through income tax deductions and accelerated depreciation on investments. To facilitate technology transfer, battery manufacturers in Indonesia must partner with the state-owned Indonesia Battery Corporation, but the nature of the partnerships is “foggy”, and it is unclear whether IBC takes equity stakes in the partnerships.

Brazil has introduced some options into its conditionalities related to attracting multinational manufacturing of vehicles. Companies are allowed but disincentivized from importing disassembled vehicles by a 35% import tax. For companies relocating their vehicle manufacturing to Brazil, the MOVER automobile policy offers an additional tax credit on imported production equipment and tax exemptions on goods exported.

MOVER  introduced new standards for vehicles produced in Brazil, which, if met, have a tax reduction of 1-2% for electric and hybrid vehicles. If vehicle parts are not manufactured locally, companies have the option to join MOVER and benefit from the reduced tax rates provided that they invest 2% of the customs value of the imported parts into research and development (R&D).

MOVER shows an evolution of how Brazil offers incentives for relocating manufacturing and mitigating greenhouse gas emissions by setting R&D and innovation spending as the “price” of businesses not manufacturing locally.

Morocco has shown an evolution of approach to conditionalities by introducing a menu of options. Its Industrial Acceleration Plan, 2014-2020, offered concessionary land grants and fiscal incentives if companies have investment projects of at least $20 million, provided they operate in special economic zones and export 85% of their production. Its tenders for wind and solar electricity generation incorporated “soft” local content requirements, which gave preference to bidders that meet the local content requirements, but do not mandate it. The Investment Charter, 2022, offers further flexibility by incorporating a menu of conditionalities tied to fiscal incentives. Investors must invest $5.5 million (MAD 50 million) and create 50 permanent jobs, or, if not meeting the investment threshold, must create 150 jobs. It offers additional incentives to investors that employ women, invest in prioritized regions, and use sustainable practices such as using recycled water and renewable energies, or improving energy efficiency.

This “menu” of compliance pathways enables Morocco to balance two competing objectives that often undermine industrial policy. On one hand, it maintains discipline and ambition, continuing to push firms toward export competitiveness and deepening domestic value chain linkages. On the other hand, it broadens participation by allowing firms with different capabilities and risk profiles to engage with the Investment Charter.

This approach also illustrates a broader focus on system-building rather than picking winners in its industrial policy. Incentives are a part of a multi-pillar system of support, including logistics and transport infrastructure, industrial zones, workforce development, and demand support. The menu-based conditionality framework supports this by aligning business behavior with complementary activity across the system of industrial policy support.

Takeaways

Menu-based conditionalities offer another way of tying government support in their industrial policy to wider economic and social objectives. The introduction outlined three problems faced by governments, which menu-based conditionalities respond to:

1. Menu-based conditionalities represents another way of reducing information asymmetries between governments and businesses. By producing a menu, the government reveals its strongest policy preferences but offers flexibility.
2. The response by different businesses to conditionalities provides a feedback loop for governments to understand what are their most binding constraints. This can allow governments to better understand existing business capabilities, confidence, and appetite for risk in a new sector or market. 
3. The remaining challenge will be to ensure that the government uses the information revealed in businesses’ responses to set the conditions at the right level which balance ambition with participation. They must also exercise sufficient autonomy by monitoring that businesses do meet the conditions and withdraw support if they do not. With appropriate governance, the menu-based approach can inform what incentives the government should offer on its next wave of industrial policy conditionalities.

The menu-based conditionality approach has implications for governments and businesses. Governments need a realistic assessment of whether they have the right governance procedures to effectively manage conditionalities, what their policy priorities are, and what is the right level to set conditions at. With a menu-based approach, a wider range of small and medium-sized businesses should consider participating in the targeted industrial sector, and whether the wider range of conditionalities improve the commercial case for them to engage in a new industrial area. For businesses, the most attractive industrial policy environments may not be the biggest subsidies, but those that offer a flexible and credible conditionality framework.