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ECONOMIC SCENE
 
Anatomy of policy shortcomings
Trade policies and the current account
M A Taslim
12/26/2005
 

          A major macroeconomic concern in an inflationary situation is that the current account balance would worsen. The rising price level would reduce competitiveness of domestic goods relative to imported products. As a result, imports would rise and exports, fall to such an extent that the trade balance and the current account could move into a deficit. The opening up of a current account deficit would put pressure on international reserves of the country. The domestic currency would become vulnerable and could depreciate. A depreciated currency would raise import costs and give an upward push to domestic prices and inflation. An important question is then whether the Government has done enough to improve the current account balance on a long term basis or taken measures to prevent unwarranted depreciation of the currency. This would require looking at the individual accounts of the current account.
The current account balance has four accounts: trade balance, service balance, income balance and current transfer balance. The sum of these balances gives the overall current account balance. Hence, an improvement in the overall balance will require an improvement in one or more of these accounts.
Trade balance shows the net merchandise export of the country, i.e. merchandise export less import. The trade balance of Bangladesh has always been in deficit. Over the years the deficit has grown and reached $3.6 billion by 2004-05. An improvement in the trade balance requires either increasing the rate of growth of export to offset the increase in imports, or reducing import requirements below the export earnings through substituting import for domestic production. The former is a proactive policy that is sometimes referred to as export-led industrialisation (growth) strategy while the latter, more of a reactive knee-jerk policy, is widely known as import substitution industrialisation (ISI) strategy of economic growth.
Soon after emergence as an independent country, Bangladesh, following the examples of most other developing and socialist countries, opted for ISI strategy of economic growth. The economy was fenced tightly in by very high tariff and non-tariff barriers as domestic businesses jostled to create and exploit a captive market. ISI strategy has performed poorly in just about all the countries that embraced it. On the other had, a few East Asian countries that went against the tide to adopt an export-led growth strategy performed spectacularly well. Their example influenced many countries including Bangladesh to abandon ISI and adopt a more liberal trade regime.
Bangladesh started the process of trade liberalisation in the early eighties, but ideological and administrative inertia and stiff business resistance slowed the process. It was not until the early 1990s that Bangladesh engaged seriously in trade liberalisation. This incidentally coincided with the establishment of the first truly elected government of the country. The results of liberalisation were very encouraging. Economic growth increased markedly and the export sector boomed. Despite the positive outcomes, the pace of liberalisation was not maintained due to strong lobby pressures of the import-competing industries and the inability of the government to raise requisite revenue from direct taxes and other sources. While it is true that the economy liberalised trade considerably, what is also true that almost all other countries of the world [including all in the South Asian Association for Regional Cooperation (SAARC) region] liberalised at an even faster pace with the result that Bangladesh is still one of the most heavily protected country in the world. This has happened despite the fact that Bangladesh has adopted the concept of export-led growth strategy many years ago.
A consequence of high trade protection to import-competing industries is that there is a pronounced anti-export bias in our trade policies, i.e. export industries are actually disprotected. A good example of this is the ready made garments (RMG) industry, which is almost entirely export-oriented. The principal inputs for the products of this industry are yarn and fabric. However, these two products have been among the most heavily protected import products. The high cost of procurement of fabric severely reduced the export competitiveness of the RMG industry.
To give respite to RMG, the government introduced a duty drawback system in the early 1980s. Bureaucratic corruption, inefficiency and transaction costs did not allow the benefits of the system to be fully reaped. It was abandoned and replaced by a bonded warehouse system. Although it was a very substantial improvement over the previous system, bonded warehouse also imposed some costs on the RMG industry. Another policy that systematically hurt the interests of the export industries including RMG was the maintenance of an over-valued currency.
These policies contributed to a reduction in the competitive strength of these industries. With the phasing out of the Multi-Fibre Arrangement (MFA) regime at the beginning of 2005, the international apparel market has become intensely competitive. Even a small loss of efficiency will now have a relatively large impact on the export performance of the sector. We are already witnessing a reduction in the exports of the woven RMG sector, which is heavily dependent on imported fabric. Unless the government acts expeditiously on the policy front to ensure that the woven RMG industry, which is still the largest export earner, can readily procure quality inputs at international prices, the growth potential of RMG will not be realised. The industry could even decline after 2008 when China enters the market in full force. The adverse consequence of such a decline on the national economy cannot be overstated.
The telltale signs are already emerging. Woven RMG exports declined by more than 9.0 per cent during July-August 2005 relative to the corresponding period in 2004. This was instrumental in pulling down the growth rate of total exports during July-August 2005 period to only 3.4 per cent. Bangladesh will not be able to maintain even the current growth rate with such a low export growth. If the growth rate of the economy falls, the nation cannot attain the Millennium poverty reduction goals.
Anomalies in the tariff structure whereby some raw materials and intermediate products carry higher tariffs than the final products also discourage exports and even domestic production. Value Added Tax (VAT) and other taxes are sometimes imposed in a manner that discourages domestic production. For example, although electronics have been officially designated as a thrust sector, many of its products, such as UPS, IPS and Voltage stabilisers, are discriminated against by the existing tariff and tax structure. Producers of these and others products find it difficult to compete even in the domestic market let alone export to the international market. These industries are reportedly contracting rapidly and may soon disappear altogether. It is hard to believe that the government is permitting the demise of industries that appears to have significant comparative advantage.
Such anomalous tax policies occur if taxes are determined by lobby pressures. Those who have greater access and influence over the government succeed in having the taxes that protect their interests. It seems that import-competing industries and importers always had a greater influence on tariff and tax policies than the export industries, and hence government policies tend to have an anti-export bias. Unless this bias is reversed, it will cost the nation dearly in the emerging competitive world.
The service balance of the current account records transactions in commercial services such as freight and insurance. Bangladesh has run a deficit in the service balance for a long time. It is noteworthy that the deficit in the service account has increased at a faster pace than that in the trade account. Service credit has remained virtually unchanged since the beginning of this millennium, but service debit has increased by nearly one-third.
Worldwide, the service sector is growing at a faster rate than the goods sector, and service trade is growing in importance. Although more than half of the country's gross domestic product (GDP) originates in the service sector, there is no coherent policy regarding service trade. The government has received over the years a number of requests from various countries under the provision of GATS of the World Trade Organisation (WTO) for offers of its service industries to be opened up. But no assessment has been made of the large categories of service industries in order to determine which may be opened up for trade under GATS and what Bangladesh could demand in return. The state of the service industries is very poor in Bangladesh; the country needs foreign investment in many of its service industries to raise the quality of services. High quality services will not only help to reduce the deficit in the service balance, but also contribute to increasing the efficiency and competitiveness of the overall economy. Hence, Bangladesh needs to work out both a strategy for the accelerated growth of the service industries and a strategy for negotiations under GATS to ensure a productive outcome at the WTO that will promote the growth of the service sector of the country and increase its share in the world service trade.
International payments for factor services, such as interest and dividends on foreign investment, are recorded in income balance. This has always been in deficit, and the deficit is likely to increase in the foreseeable future as the country attracts more foreign investment and aid. There is little likelihood of improving the current account by generating a surplus in the income balance, nor is it desirable to do so at this stage of our development. Neither a reduction of foreign investment in the country nor a flight of domestic capital to overseas is desirable. The deficits in this account will have to be offset by surpluses elsewhere.
The current transfer balance records foreign grants and remittances by Bangladeshi workers employed overseas. Foreign grants have dwindled over time and hardly make any significant contribution to the current account. Remittances from workers employed overseas, on the other hand, have increased steadily. Overseas employment is now the single largest source of employment outside of agriculture; it engages a larger workforce than the ready-made garments industry. It is also the largest net foreign exchange earner of the country. Without the remittances Bangladesh's balance of payments would have been in a dismal state and much of its development would have ground to a halt.
Despite the overwhelming importance of overseas employment in the national economy, it hardly receives much attention of the government. The intending migrants, most of whom are rural-based and poor, have few skills and go overseas for menial jobs at very low wages. They are swindled by private manpower agents and exploited by foreign employers. Government officials frequently turn a blind eye to their plight and harass them whenever an opportunity arises. Despite the fact that a little training would have allowed them to earn a higher income and thereby increase the remittances, there is inadequate facility to offer training to the intending migrants. They are forced to pay enormous fees for obtaining jobs overseas. These fees sometimes exceed the net value of the contracts. Many of them experience immense hardship and sometimes even face death in foreign land. Notwithstanding the adverse environment, they sent home nearly $4.0 billion in remittances last year, which is equivalent to over 6.0 per cent of GDP. The remittances were instrumental in maintaining the health of the balance of payments as well as the economy.
The harassment (as well as low exchange rate) that the recipients of the remittances are subjected to forces the migrants to send part of their earnings though informal channels such as hundi. Some people estimate that the migrants sent $2.0-3.0 billion through informal channels. And yet the government provides inadequate help or cooperation to these people. This is particularly galling in view of the amount of supplication and hobnobbing the government engages in with the donor agencies for only a few hundred million dollars. The Ministry of Finance (MoF) provides hundreds of million of taka as cash incentives to a handful of rich industrialists ostensibly to encourage exports of a few hundred million dollars. But it did not provide any incentive to millions of poor migrants to encourage their efforts and attract remittances of an additional few billion dollars. It has been suggested that if the government had provided only one taka per dollar of remittance sent through official channels as incentive, it could have added perhaps over a billion dollar to the current transfer balance. The reserves could have improved by a similar amount and the need for balance of payments support from the donors would be less. A subsidy of this magnitude would have cost about Tk. 5.0 billion (500 crore) -- less than that provided to only the textile industrialists in the early 2000's.
Almost all of our blue-collar workers go to the Middle-Eastern and Asian countries at fairly low wages under bilateral contracts. Negotiations at WTO under Mode 4 of GATS have opened up a small widow of opportunity for the LDCs to send workers to western countries for temporary employment. Many of these countries suffer from acute shortage of blue-collar workers and certain categories of technical workers. The wage rate is 10-20 times higher than that in the Arab or Asian countries. Hence, even a small intake of workers could yield a large pay-off. However, to realise this opportunity the government would have to engage in very hard negotiations with the developed countries. This cannot be done without good knowledge of the supply and demand situation of each category of service providers in the country and overseas, qualification requirements to assess training needs and adequate provisions for obtaining requisite qualifications. Despite repeated suggestions, the government is yet to move on the issue. A good opportunity for (labour) service export and employment overseas thus remains to be explored.
During the last two decades, the government has taken several measures to liberalise the economy and promote exports. These have reaped significant gains for the economy. The government needs now to consolidate the gains to provide a platform for accelerated growth of the economy. This would require removing the last vestiges of import-substitution policies so as to make the industries with real export potentials competitive in the international market. This is all the more important in a globalised world where it has become increasingly difficult and costly to protect an inefficient industry. If export industries suffer a loss of competitiveness due to adverse (tax) policies of the government, they would be unable to survive in a global market that has already become intensely competitive, and will be even more competitive in the future. The cost of policy mistakes has risen very substantially; by the same token the rewards of putting in place the right policies have also increased. It is up to the government to steer the economy in the right direction.
The policies described above are the long term policies to improve the current account; these are also the relatively more difficult policies. If the government chooses to take a myopic view, it may shun the difficult polices and resort to the short-term blunt policy of applying a monetary brake. This will ease the balance of payments situation by reducing aggregate demand. While this policy may improve the current account in the short-term it also reduces the growth rate of the economy and could compromise the longer term structural improvements of the balance of payments.
The difficulty that the country is now facing in respect of the current account and the consequent tight monetary policy provide a good class room example (for economics educators) of the phenomenon of 'crowding out'. The opening up of a half-billion dollar deficit in the current account in 2004-05 and dwindling reserves are largely the making of the government fiscal actions. The budget balance of the government has worsened by 0.4 per cent of GDP between 2003-04 and 2004-05 (Bangladesh Orthonoitic Shomikkha 2005, Ministry of Finance). The incremental deficit alone had worsened the current account by about $250 million. Together with 'errors and omissions' this would explain most of the deficit in the current account incurred in the last fiscal year. The remedy sought through the tightening of monetary policy, however, would reduce private demand to accommodate the increased budget deficit. In other words, higher government deficit (spending) would in effect crowd out private spending. This is not desirable in view of the low productivity of government spending. (This is the third instalment of the write-up with its theme, 'Anatomy of Policy Shortcomings.' The writer is Professor of Economics, University of Dhaka and former chairman, Bangladesh Tariff Commission)

 

 
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