Emerging market countries that manage to diversify and upgrade their production and export base grow more rapidly and enjoy greater welfare gains than those that do not. Foreign direct investment in manufacturing is concentrated in middle- and upper-skilled activities -- not lowest-skilled operations -- and thus offers many opportunities for structural transformation of the host economy. But the challenge of using FDI to diversify and upgrade the local production and export base is fraught with market failures and tricky obstacles. Contemporary debates about industrial policy as a development tool focus on how best to overcome these market failures and other difficulties.
This paper identifies the ingredients for what it calls “light-handed” industrial policy to address these obstacles. To a certain extent, emerging market hosts can carry out the policy interventions recommended here on their own. But the evidence presented in this paper shows that external support is often essential to success. Developed countries, development agencies, and multilateral financial institutions have crucial roles to play. The paper concludes therefore with policy implications for developing countries, developed countries, and multilateral financial institutions.