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Anatomy of policy shortcomings
Foreign investment and international reserves
M. A. Taslim

          THE Minister for Finance can justifiably claim credit for implementing the trade liberalisation measures that helped accelerate the growth of the economy. Although the measures were suggested by the World Bank (WB) and others for a long time, no one before him was willing to take the political risk associated with enforcing liberalisation. He took the plunge and it clicked; all praise for him.
In the process, he has notched up two other records that have not drawn much attention. First, the liberalisation policies that he pursued tremendously increased trade with India. During his tenure as the Finance Minister of the first Khaleda Government, the volume of Indo-Bangla trade increased by more than 600 per cent. From a modest supplier, India became a very substantial source of imports of Bangladesh within just four years. During the entire Hasina regime, trade with India stagnated; but since the second Khaleda Government took over, trade with India boomed again. It nearly doubled to more than $2.0 billion, further increasing Bangladesh's reliance on India as a source of imported products particularly foodstuff and raw materials. The Bangladesh economy is now fairly well integrated to the Indian economy with many of the essential prices in the domestic market strongly influenced by price movements in India. The closer economic relation might be helpful in reducing tensions between the two countries.
Second, no other Finance Minister of the country has been able to run surpluses in the current account. During the last twenty-five years, the current account of the balance of payments has been in surplus in only six years -- thrice during the first and thrice during the second Khaleda Government. As a result of these surpluses, the Finance Minister has been able to build up the international reserves of the country after they had reached critically low levels. When the first Khaleda Government was installed, the international reserves stood at considerably less than a billion dollar. Within four years, the reserves had been built up to more than $3.0 billion. At the time the second Khaleda Government took the reigns of the country the reserves had been depleted to about $1.0 billion, or just about one and half months' import payment requirements. The Finance Minister again built the reserves up to more than $3.0 billion in less than three yeas. The surpluses in the current account were helpful in augmenting the reserves.
The Finance Minister seems to have taken to heart the IMF advice that the reserves should be kept at above $3.0 billion or about four months' import payments. In order to build up the reserves he seems to have consciously adopted a policy of pushing the current account to a surplus. In other words, he regarded a surplus in the current account as essential for increasing reserves. Hence a close correlation was maintained between the additions to reserves and the surplus in the current account. The Finance Minister's policy of running a current account surplus in order to build up international reserves is unarguably superior to running a current account deficit and depletion of reserves as happened during the tenures of other ministers. The latter is clearly not sustainable and sooner or later will impose unpalatable adjustment burden on the economy.
However, this is not to say that the current policy is the best available policy option for a poor country like Bangladesh. While building up certain minimal amount of reserves is certainly desirable, a current account surplus is neither necessary nor sufficient for increasing the international reserves. This seems to have been not clearly understood.
The current account records the nation's foreign exchange earnings from, and expenditures on, current transactions. The current account balance can be shown to be equal to the excess of the nation's disposable income over expenditures (demand). Hence, it may be viewed as akin to household saving. Just as household saving does not necessarily show up in the bank accounts of the household (it may decide to invest the saving elsewhere), a current account surplus also may not augment the reserves of the central bank. For example, if the country runs a current account surplus, but some business people invest more than this amount in overseas enterprises, the reserves would decline. Similarly if the government pays off debt with the surplus, reserves will not increase. Hence, it is not possible to say that there will always be a one-to-one or even a positive relationship between the current account surplus and the international reserves.
If a poor country such as Bangladesh wishes to achieve a high growth rate, it may not be desirable to run a current account surplus since such a surplus may hinder the acceleration of the growth rate. In the early stages of development, most of the capital goods and much of the intermediate inputs and raw materials needed for both export and import substituting industries as well as non-tradable product industries have to be imported. It so happens that one needs to invest about five taka in capital goods in order to produce one taka worth of a final good. Even if much of the final good is exported, initial import requirements will exceed export receipts. Only after a period when imported capital goods are paid off and the country has acquired a substantial capital base, export industries will have net foreign exchange earnings. Until this happens the country will run a deficit in the current account. Hence, throughout early stages of industrialisation a developing country is more likely to be in a deficit situation. In this situation, any effort to reduce the deficit will also decelerate the growth rate.
It is in this light that one should read the recent 'advice' of IMF to the Finance Ministry. The acceleration of investment activities (essential for higher growth) in the country has caused an increase in imports and imparted an excess demand pressure in the economy leading to a deficit in the current account for the first time during the tenure of this Government. This is likely to depreciate the currency. The 'advice' was to put in monetary brakes to decelerate the economy. But this also means that the economy cannot attain the growth rate required to quickly reduce poverty. The accelerated growth requirement of poverty reduction would appear to be contradictory to the health of the current account in an essential way!
How do we resolve the contradiction? If we look at the experience of other countries that have grown robustly without suffering from reserve problems, the shortcomings of our policies will become evident. A large number of countries such as India, Malaysia, Indonesia, the Philippines and Thailand have run fairly large deficits during the period from 1975 to 2000, and yet built up very considerable reserves. India, for example, posted large deficits in the current account every year during the period from 1980 to 2000. These deficits amounted more than 87 billion dollars. Despite this enormous cumulative deficit, international reserves of India increased from only seven billion dollars to about thirty eight billion dollars during the same period. This apparently contradictory result was achieved by encouraging inflows of foreign investment that more than compensated for the current account deficits.
All these countries have built up their considerable reserve through the same means i.e. foreign investment. The cases of Korea and Singapore are interesting. Both countries suffered from current account deficits during the early years when they could be regarded as developing countries. But as their economies matured, their deficits turned into surpluses. Singapore's current account was in deficit in all but one year during the period from 1975 to 87, but since then it had surplus always. Even when Singapore was running current account deficits, its reserves increased five-fold from three billion to over fifteen billion dollars. Australia is a good example from the developed world. It has consistently run current account deficits during the 25-year period from 1975 to 2000, totalling a staggering 277 billion dollars. And yet its reserves increased from less than three to more than eighteen billion dollars during the same period. Again it was foreign investment that made it possible to build up the international reserves despite the deficits (all figures from International Financial Statistics).
The policy failure of Bangladesh lies in the inability or unwillingness of the country to attract foreign investment. It relied instead on foreign aid to meet its development need. The reliance on foreign aid has certain invisible costs. A number of economists of the country believe that foreign aid had a perverse influence on the saving effort and investment performance of the economy.
They have shown that foreign aid discouraged both public and private savings, and it also had negative influence on local investment. It was not until foreign aid dried up in the nineties that the country increased its own saving effort. Investment also picked up.
More than half of the government's development budget is now financed from domestic resources. This is a marked turn around from the almost total dependence on foreign aid. However, total investment is still much below the required level for accelerated growth. The government should proactively seek to bridge this development gap by foreign investment.
The less is the dependence on foreign aid, the better is the outcome for the country. Foreign aid is utilised in projects chosen by donors. Their choices may not always be the optimal choice for the country. There is less accountability and transparency in aid-financed projects leading to large leakages. Indeed foreign aid has allegedly supported a great deal of corruption in the country (see for example, Salim Rashid, Rotting from the Head). Another unattractive feature of foreign aid is that it builds up a debt burden for the future generation without equivalent compensation in terms of increased capital stock.
Foreign investment is undertaken by private business people from overseas either on their own or jointly with local entrepreneurs. The choice of the investment project is determined by profit criterion. If the markets are competitive and there are no significant externalities, their choices are likely to be optimal. Unlike in the case of aid, the investment funds brought in by overseas businessmen do not add to the debt burden of the economy. Foreign investors can take out funds only if they earn profits and thus impose no burden on the economy. If much of the output of the foreign firm is exported, there is a net gain in foreign exchange receipts, which helps the balance of payments.
Foreign investment is the most effective conduit of transfer of technology and access to the global market. Domestic entrepreneurs can learn from them and improve their performance. The technology of local industries improve and they gain a foothold in the global market. The downside is that foreign investors may corrupt the government to cut costs and increase their profits unethically. This is especially true in the case of extractive industries such as gas and industries with toxic effluent. Some firms in these industries have caused enormous damage to the environment and resource base of the host developing economies. They may also form cartels or resort to transfer pricing to earn excessive profits. Hence, to reap the full benefits of foreign investment, the government needs to be vigilant and put in place appropriate regulatory measures such as competition policy. If Bangladesh can encourage significant inflow of foreign investment, especially in manufacturing and service industries, it will not only bridge the development gap, but also solve the balance of payments problem. Without an infusion of foreign investment, Bangladesh is likely to run into reserve crises periodically. The government has not been so far able to attract significant foreign investment, despite the fact that several high-powered foreign teams visited the country in the recent past to explore investment opportunities. Rumour has it that they have been discouraged by corruption and the sorry state of infrastructure.
The failure of the government to give the first private Export Processing Zone (EPZ), the Korean EPZ in Chittagong permission to function has been interpreted as a sign of unreliability of government policies. This is very damaging to the prospect of inflow of foreign investment. In order to avoid such outcomes, the government needs to carefully consider its policies and actions with regard to foreign investment. (This is the fourth instalment of the write-up with its theme -- Anatomy of Policy Shortcomings -- under the revised arrangement. The writer is Professor of Economics, University of Dhaka and former chairman of Bangladesh Tariff Commission.)



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