Report No. 19591-BD Bangladesh Trade...

Report No. 19591-BD

BangladeshTrade LiberalizationIts Pace and Impacts

November 23, 1999

Poverty Reduction and Economic Management UnitSouth Asia Region

CURRENCY EQUIVALENTS

The external value of the Bangladesh Taka (Tk) is fixed in relation to a basket ofreference currencies, with the US dollar serving as the intervention currency. The officialexchange rate on October 21, 1999 was Tk 49.35 per US dollar.

US$1 = Tk49.35Tk 1 = US$ 0.020

FISCAL YEAR

July 1 - June 30

Vice President: Mieko NishimizuCountry Director: Fred TempleSector Directors: N. Roberto Zaghal Marilou J. UyTask Leader: Tercan Baysan

ACKNOWLEDGMENTS

This report was prepared by a team led by Tercan Baysan. Other members of the core teaminclude: Charles Draper, Zaidi Sattar (South Asia); Kabir Hassan, Abdul Bayes, Ismail Hossain,Farida Khan (consultants). Data International, a Dhaka-based consulting firm, helped with theprocessing and tabulation of the survey data. Ziaul Ahsan (consultant with the Dhaka Office)assisted with the trade data, import levies, and with the tables/charts. Tyler Biggs, peer reviewer,and James Tybout provided advice on the design of the survey questionnaire. The reportbenefited from the comments of the peer reviewers Wahiduddin Mahmud and Tyler Biggs. JohnWilliamson, Shekhar Shah, and Kapil Kapoor provided valuable comments. Oxana Bricha andJennifer Manghinang assisted with the annexes/appendices, processed the report, helped with thecommunications. The report also reflects on the discussions that took place at a seminar held inDhaka on September 16, 1999.

The report is based on the background work carried out on Bangladesh's trade liberalization,formal and informal trade patterns, and on quantitative analysis that utilized the data collectedfrom a sample of over 150 firns. The survey work was carried out during July-October 1998 andincluded firms located in Dhaka, Chittagong, and Khulna. The results of the 1992/93 IndustrialStudy survey (ISS) carried out by the World Bank and the USAID were also used in the study.The report was prepared under the guidance of Pierre Landell-Mills, Fred Temple (CountryDirectors for Bangladesh), and Roberto Zagha and Marilou Uy (Sector Directors).

TABLE OF CONTENTS

Executive Summary ..................................................................... iNote to Readers .................................................................... ix

Chapter 1 Bangladesh's Trade Liberalization: Has It Been Too Fast? ......................................1A. Introduction .................................................................... 1

Approach, Methodology, and the Outline ................................................................2B. Progress in Trade Policy Reform .................................................................... 3

Introduction ................................................................... 3Trade Policy Reforrns in the 1990s: Was It Too Much, Too Fast ...........................3Anti-Export Bias Remains Significant ....................................................................7Pace of Bangladesh's Trade Liberalization: A Cross-Country Comparison ............8Comparison With the Rest of the World ..................................................................9

C. Other Accompanying Policy Changes .................................................................... 11Complimentary Policies .................................................................... 11Business Environment ..................................................................... 11Exchange Rate Management .............................................. . 12

D. Trade Liberalization and Economic Performance ............................................... 14E. Conclusions .............................................. 15

Chapter 2 Recent Trends in Foreign Trade ............................................... 19A. Introduction ............................................... 19B. Recorded Trade .............................................. 20C. Trade with India .............................................. 25D. Conclusions .............................................. 28

Chapter 3 Impacts of Trade Liberalization on Technical Progress and Efficiency inManufacturing Industries ........................................ 31

A. Introduction ........................................ 31B. Results ........................................ 33

Technical Efficiency ........................................ 33Total Factor Productivity Growth (TFPG) .............. .......................... 36Business Environment and Performance of the Surveyed Enterprises ................... 38Conclusions and Policy Implications ................................................................... 39

Appendix: Methodology, Data and the Sample Statistics ............................................................ 43

AnnexesAnnex I ................................................................................................................................................

Table A. 1 Trends in Average and Dispersion of Tariffs, FY91-99 ..................................... 49Table A.2 Trends in Average and Dispersion of Tariffs on Manufacturers, FY92-99 ....... 50TableA.3 Tax Incidence on Imports ............................................................. 51Table A.4 Effective Protection Rates (EPRs) in 40 Sectors in Bangladesh ........................ 52Table A.5 Protection Related Quantitative Restrictions on Imports, FY92-99 ................... 53Table A.6 Effective Exchange Rate for Exports (Unweighted) .......................................... 53Table A.7 Effective Exchange Rate for Exports (Weighted) .............................................. 54Table A.8 International Comparison of Tariff Regimes ................................................ ..... 55Table A.9 Bangladesh - Macroeconomic Developments in Openness, 1980-1998 ........... 56

Annex II .. Table B.1 Bangladesh's Recorded Commodity Trade, 1989/90-1997/98: Overview ........ 57Table B.2 Bangladesh's Recorded Commodity Trade with India: 1989/90-1997/98: ExportComposition .............................................................. 58Table B.3 Bangladesh's Recorded Commodity Trade with India: 1989/90-1997/98: ImportComposition ............................................................. 59Table B.4 Bangladesh's Recorded Commodity Trade with India: 1989/90-1997/98 ......... 60

Annex III...............................................................................................................................................A. Data Envelopment Analysis (DEA) ................................................ .......... 61B. Estimating Efficiency Indicators and Measuring Productivity Changes ........................ 63

List of Text Charts, Tables and BoxesList of ChartsChart A Structure of Tariffs, 1998/99 .............................................................. 4Chart B Average Tariffs in South Asia, 1998/99 .............................................................. 8Chart C REER for South Asia (1990=100) ............................................................. 12Chart D Bilateral RER for Sotuth Asia (1990=100) ............................................................. 13Chart E GDP and Industrial Growth ............................................................. 13Chart F Relative Technical Efficiency: 1992/93 and 1997198 ..................................................... 35Chart G Total Factor Productivity Change Between 1992/93 and 1997/98 and its

Decomposition ...................................................... 36

List of TablesTable 1.1 Trends in Nominal Protection, 1990/91 to 1998/00 ....................................................... 5Table 1.2 Phased Removal of Quantitative Restrictions, 1998/90 to 1998/99 .................................. 6Table 1.3 Effective Exchange Rates for Import Substitutes and Exports ......................................... 7Table 1.4 Falling Behind? Bangladesh's Share in World Exports, Selected Countries ................... 8Table 1.5 Average Tariffs and Top Rates in South Asia, 1998 ........................................................ 8Table I.6 Intemational Comparison of Tariff Regimes ....................................................... 9Table 1.7 Trade Liberalization and Economic Performance .14

Table II.1 Major Categories' Shares of Export and Import Totals and of GDP in Late1980s and 1990s .22

Table 11.2 REERs and RERs: India and Bangladesh (1990=100) .26

Table II.1 Technical Efficiency Measures: 1992/93-1997/98 .34Table 111.2 Decomposition of the TFP Change between 1992/93 and 1997/98 .34Table 111.3 Technical Efficiency Measures and Total Factor Productivity Change (TFPCH) in

Manufacturing Firms: 1993-1998. ...................... 40

List of BoxesBox 1.1 What Could Have Been Done Differently in Implenmenting Bangladesh's Trade

Liberalization? ..................................................... 10Box 1.2 Sequencing of Complementary Reforms ..................................................... 13Box 11.1 Domestic Industrialization Process and the Speed of Trade Liberalization .................... 24Box II.2 Trade Deficit with India ..................................................... 26Box 111.1 Micro-Level Findings and Macro-Level Inferences ..................................................... 38

Selected References .69

EXECUTIVE SUMMARY

Spurred by the significant trade liberalizationt of the 1990s, Bangladesh 's merchandise foreign tradehas nearly doubled in the 1990s, to 30 percent of GDP since the beginning of the decade. With thegrowing, though still incomplete, openness to international commerce have come signifi cant economicgains, notably an expansion of exports strong enouigh to cover imports and maintain the trade deficitat sustainable levels. Through its commendable progress in eliminating a sizable portion ofquantitative import restrictions and in reducing the average rate and dispersion of import tariffs,Bangladesh is restructuring its economiy. It has made a significant departure away from a highlyrestrictive system focusing on import substitution to a more dynamic, export-oriented structurealready competitive in global markets for ready-made garments, knitwear,frozen food, and leatherproducts.

Such a sharp change niaturally generates protest. In Banzgladesh, the criticism takes the form ofcontentions that trade liberalization has moved too fast and that it has 'flooded" markets with goodsfrom abroad, particularly from neighboring countries, which are hurting domestic industries andinhibiting Ban.gladesh 's industrialization. This report examines these concerns. Itfinds them to beboth widespread and generally unsupported by hard evidence.

The pace of Bangladesh 's trade liberalization, for instance, is comparable to that of many Asian andLatin American countries that are experiencing strong benefits from their reforms. W7hile faster thansome of its South Asian neighbors, Bangladesh has not movedfarther than Sri Lanka. Indeed, theremaining anti-export bias of trade policy is considerable. Some trade-related quantitativerestrictions still impede importflows. Also, the range between the top and the lowest tariff rates isstill very wide, with very high nominal protection rates applying to competingfinal goods.

Although more foreign goods are in fact available (some of them smuggled to skirt high protection), itappears that increased supplies of cheaper raw materials/intermediate inputs andfixed capital goodshave generally stimulatedfaster expansion in exports and stronger GDP growth to the benefit of theeconomy overall. As to firms that perform poorly in fields where activity is shrinking, the faultgenerally does not lie with trade reform but with failures to graduate from the comforting cradle ofhigh and long-standing levels ofprotection. Such enterprises are in the minority; in generalmanufacturing industries have been performing strongly, notwithstanding all sorts of constraints todoing business in Bangladesh. Mostfirms surveyedfor this study actually experienced sizableproductivity growth over a period offive years, suggesting that trade liberalization has had a positive,not a negative, impact in the manufacturing sector.

Introduction

1. After a start in the mid-I 980s, Bangladesh's trade liberalization effort picked up its pace in theearly 1990s as an important component of the country's structural reform program. Initial steps weread hoc and focused on the removal of quantitative restrictions (QRs), but in the early 1990s a morecomprehensive trade policy reform program extended its reach to both tariffs and non-tariff barriers,though without a pre-announced implementation schedule or phased program targets. Significantprogress has since been made in removing QRs and in reducing the maximum and average tariff rates.Since the mid-i 990s, however, movement toward a lower and uniform tariff rate has slowed due toconcerns for budgetary revenues, the balance of payments, and, in particular, possible adverse effectsof trade liberalization on import-competing industries. In this period as well, some business and

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government circles and researchers have criticized Bangladesh's trade liberalization for being too fastand for flooding domestic markets with foreign goods in amounts that harn local industries.

Trade Liberalization in the 1990s: Was it too Fast?

2. In contrast with the highly protectionist, inward-oriented stance of the early 1980s,Bangladesh's trade policy today is far less restrictive, and its anti-export bias, significantly lower.Since 1990/91: the coverage of protective QRs fell from 253 four-digit codes to 28, now affectingmainly textile imports; the maximum tariff rate dropped from 350 percent to 37.5 percent and the(unweighted) average tariff rate to around 17 percent. To put those gains in context, however,Bangladesh, it should be recalled, started with an extremely restrictive set of trade barrierscharacterized by pervasive QRs and prohibitively hign import tariffs on many finished consumergoods. Thus, a good deal of import "liberalization" in the early 1990s basically amounted to removingQRs (still incomplete) and tariff redundancy. Once existing tariffs became binding and foreigncompetition more effective, the process slowed down considerably.

3. Although much rationalization and simplification of the import regime remains to beaccomplished, Bangladesh has made substantial improvemenits in removing trade barriers and shouldbe given credit for dismantling most of its QRs. The current maximum tariff rate is fairly steep, and,given its 0-37.5 percent range, the existing import tariff structure still shows a high degree ofdispersion. The average rate is pulled down substantially because many non-competing imports, suchas locally unavailable raw materials and fixed capital goods, enter at zero or very low rates. On theother hand, to protect import-substituting domestic industries, competing imports carry high customsduty rates. These nominal protection levels are augmented further by the other protective levy (thelicense fee) and also by the protective incidence of the (supposedly) neutral taxes that are in factasymmetrically applied. In some cases, the VAT, a supplementary duty, and an InfrastructureDevelopment Surcharge significantly raise the nominal protection rates due to the cascading effects oftheir valuation base, thus further increasing the dispersion of nominal protection rates. In addition,many tariff exemptions/concessions as well as multiple rates for similar categories of goodscomplicate the nominal protection structure and create significant scope for discretionary decisions bycustoms officials.

4. The progressive lowering of trade barriers has reduced anti-export bias to the point that theratio of effective exchange rate for imports to that of exports, a measure of this bias, fell from 1.66 in1991/92 to 1.26 in 1995/96, and stayed at that level through 1998/99; (the FY00 changes may havelowered the bias only marginally). The remaining bias, however, is still substantial and, coupled withadditional costs stemming from infrastructure bottlenecks, corruption and unreliable law enforcement,it puts production for exports at a competitive disadvantage. While enclave-type arrangements (EPZsand the special bonded warehouses) provide duty/tax free access to imports and insulate a narrowrange of activities from business constraints, negative factors continue to hinder a large number ofpotential export activities.

5. Cross-country comparisons. Cross-country comparisons in trade liberalization, while usefulin providing an international perspective, should not be taken as criteria for determining the pace andsequencing of country-specific trade liberalization programs. In the present case, a broad perspectiveescapes the frequent tendency to compare Bangladesh's trade liberalization experience only with thoseof its neighbors. Except for Sri Lanka, South Asian countries--India in particular--have been veryslow to liberalize trade and thus offer poor comparisons. Measured against other liberalizing countriesof the world, Bangladesh's trade reforms over a period of 8-1 lyears do not appear unusually fast.Many countries in South East and East Asia and in Latin America and even some in Africa achieved

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significant cuts in average tariffs and reduced the spread between their lowest and maximum rates in5-8 years time. Most of them, moreover, have gained in both export and GDP growth. Havinghighlighted the broader international perspective on trade liberalization experience and the resultingpositive impacts, the report argues that Bangladesh's economic performance has also improved undertrade liberalization.

6. Accompanyingpolicy/institutional changes. Initial economic and institutional conditions of acountry embarking on trade liberalization are obviously crucial determinants of the scope, sequencing,and pacing of trade liberalization programs. Bangladesh's record of generally maintaining a soundmacroeconomic environment has been a positive factor in carrying out trade liberalization. Inaddition, specific actions such as the introduction of a VAT in the early 1990s as the centerpiece of atax reform, the unification of multiple exchange rates and the adoption of a "managed" flexibleexchange rate system have also contributed positively. Since its neighbor-competitors -- India,Pakistan, and Nepal-- and other South East and East Asian countries have depreciated their realeffective exchange rates and bilateral real exchange rates (vis-A-vis the US dollar) at much faster pacethan Bangladesh since 1990, Bangladesh's strong export performance and satisfactory macroeconomicbalances may not have paid the highest possible dividends. A more flexible exchange rate policymight have had stronger positive effects on potential exportables and could have contributed to exportdiversification.

7. Other missed opportunities include scoring more rapid progress in strengthening the financialsector, tackling infrastructure bottlenecks, addressing bureaucratic hurdles, and reforning the highlyinefficient state-owned enterprises. Together with external shocks and prolonged political uncertainty,these errors of omission have most likely made adjustments to trade liberalization more difficult andlimited its potential benefits.

8. Macroeconomic performance. Although the direct causal connection of trade liberalization toeconomic performance in general and to GDP growth in particular is difficult to quantify,Bangladesh's overall economic performance-- in terms of export, manufacturing sector and GDPgrowth rates, and extemal balances and sustainability-- appears stronger in the 1990s than in the1980s. That change provides some evidence that trade liberalization, far from being harmful, has, onthe contrary, contributed together with other market-oriented reforms and sound macroeconomicmanagement to improved macroeconomic performance. The increased availability of cheaper andhigher quality imported raw materials, intermediate inputs, capital goods and new technologies, aswell as enhanced competitive pressures have obviously been important factors in producing thesepositive results. (While it is not specifically analyzed in this report, it needs to be highlighted that,aside from these positive impacts listed above, the increased availability of cheaper and better qualitygoods under trade liberalization has mostly likely generated significant gains in consumer welfare aswell).

9. Recommendations. Trade liberalization is incomplete. Further progress requires moremeasures to rationalize and simplify the existing tariff structure:

A key policy objective should be to move from enclave-type arrangements (which helpcircumvent the restrictive import regime and constraints to doing business) to broader tradeliberalization with a view to lowering the dispersion of nominal and effective protection rates, aswell as eliminating the protective QRs. In this respect, the tariff rationalization measuresannounced with the FY00 Budget -- reducing the maximum customs duty rate from 40 percent to37.5 percent and the number of tariff slabs from 6 to 4, and harmonizing tariff rates on similargoods-- are welcome developments. The new tariffs hikes on some finished goods (e.g., paperpulp and silk), however, would increase their effective protection rates and send mixed signalsabout the future direction of trade policy.

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* In implementation, one of the major drawbacks of Bangladesh's trade reform program has beennot announcing the time table of the planned policy changes in advance. This has obviouslycontributed to the perception that trade liberalization was "too fast", since some the domestic firmswere caught unprepared. In the future, announcing the planned trade reforms in advance will givetime to the private sector to adjust.

* Improvements in the business environment would help enhance gains expected from freer trade byreducing the costs of doing business and strengthening supply response capacity of local firms(details are in the last section below).

Trends in Foreign Trade: Is Domestic Production Being Displaced by Foreign Goods?

10. An economy opened to foreign goods and competition through trade liberalization benefitsfrom that inflow and stimulus in increased investment activity, stronger export and overall economicgrowth, and greater efficiency in resource use. With sound fiscal/monetary and exchange rate policies,trade liberalization should lead to the balanced growth of exports and imports that is desirable foreconomic growth without destabilizing external accounts. Overall, Bangladesh is reaping many ofthose gains, but at the micro-level, some firms claim to be victims of liberalization. In reality, most ofthese are inefficient firms that have failed to improve their competitiveness despite long periods ofhigh protection. They find themselves under pressure, losing or even leaving markets, and sheddinglabor as the progressive removal of trade barriers establishes a more neutral incentive regime. Suchdisplacements are a function of inefficiency, not a basis for retreating from trade reform. As otheractivities become more profitable, new enterprises expand arnd generate new jobs, with the pacedepending on how conducive the business environment is in facilitating supply response. Onlywidespread production and job displacements would indicate adverse consequences of trade reformand would show up in poor sectoral and aggregate economic performances. Bangladesh has notexperienced such setbacks.

11. On the contrary, the trade liberalization of the 1990s has most likely been a positive factor inthe achievement of the relatively stronger macroeconomic performance observed so far. That progresshas accompanied a significant degree of opening up in external trade transactions in parallel with tradepolicy liberalization. The significant increase in the merchandise trade-GDP ratio (almost doubled) hasnot, however, led to an unsustainable trend in the merchandise trade deficit. With faster growth inexports, a much larger proportion of import costs are now covered by merchandise exports, which arealso more diversified than in the 1980s, though there is still a high degree of export concentration. Inthe external accounts, the trade deficit as a share of GDP has remained stable and sustainable.

12. At the commodity level, formal trade statistics indicate that increases in merchandise importsinduced by trade liberalization have concentrated in raw materials, intermediate inputs, and capitalgoods. The share of final consumption goods imports in total imports has remained stable, showing nosustained surge. As for the claim that domestic markets are "flooded" with foreign goods that displacedomestic production,

No widespread production displacement has occurred. Both the official statistics on productiontrends in manufacturing industries, as well as findings based on a survey of a sample of enterprisesindicate that most manufacturing activities have continued' expanding production, capacity, andalso employment. Not surprisingly, some enterprises in import-competing manufacturing sub-sectors--cotton textile, vegetable oil, paper, insecticides, rubber footwear, metal products, andsome machinery and products--have reduced output and ernployment levels. Despite a long periodof protection, these enterprises that apparently failed to improve efficiency and competitivenessnow feel the pressures of competition brought by trade liberalization and smuggling.

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* In this regard, it is difficult to agree with the proposition put forward by some observers that"Bangladesh's import-substitution strategy has not moved its industrialization process away fromexport-orientation and that, given Bangladesh's narrow industrial base and the large domesticmarket, what is needed is continued protection of the domestic producers until they capturedomestic markets, become efficient and start exporting. Trade liberalization should then follow".The evidence on this is clear. Despite the prolonged protection, most import-substitutingindustries have not become efficient enough even to compete at home let alone export--the textilesector is a very good example. Moreover, the significant anti-export bias has limited the scopeand depth of export orientation and diversification beyond those activities benefiting from theenclave arrangements. The experience of the recent decades suggests that what is needed is notcontinued high protection of final goods, but more operness for efficiency enhancement.

* The other important issue pertaining to the high protection levels is that they are encouragingsignificant levels of informal (unrecorded) imports, leaving the existing statutory protection levelspartially ineffective and causing substantial loss of customs revenues. But even without tradeliberalization, smuggled goods--entering Bangladesh free of duty or tax--would have undercutdomestic products and producers. Some of the surveyed enterprises in textiles, flour milling,vegetable oil, and salt specifically reported their difficulties competing with contraband.

13. Recommendations. One proven way of suppressing smuggling is to make it unprofitable. Toachieve that end, high tariffs on finished consumer goods need to be cut and QRs on textiles importsneed to be eliminated. Such changes would help divert informal trade into formal (official) channels,generate budgetary revenues, and also provide some "effective" protection to such products. Atpresent, high statutory protection deters legal imports while inducing the entry of smuggled goods thatavoid not only the protective duty but also the VAT which domestic producers must pay. Among thebeneficiaries of curtailed smuggling would be the producers of goods such as sarees and other textileitems, sugar, salt, pulses, bicycle and truck parts, fans, and toothpaste. To combat smuggling andunder-valuation, a range of likely measures to be taken in combination fall into three groups:

* First, thefiscal incentive should be reduced both by cutting customs duty rates and by makingbasic changes in the VAT administration to strengthen enforcement. The collection point for VATshould be moved as close as possible to the retail-end where smuggled goods would be taxedequitably with domestic products and legal imports.

* Second, determined policing efforts are needed, backed by strong political will. Governmentagents who now support and profit from smuggling activities must be compelled to discontinuetheir involvement and, if necessary, pursued and prosecuted along with the bootleggersthemselves.

* Third, to deal with technical smuggling, i.e. the under-valuation of imports that do pass throughofficial channels, the Government needs to contract reputable agents to operate an effective pre-shipment inspection (PSI) scheme in the short-term while it automates and otherwise modernizesthe Customs service itself. The introduction of the compulsory PSI system with the FY00 Budgetprovides an opportunity to move in this direction.

14. Recent developments in formal and informal trade show a sizable trade deficit in favor ofIndia, Bangladesh's largest import source. The proximity and competitiveness of Indian goods,Bangladesh's faster liberalization, as well as the much larger depreciation of the Indian real exchangerate since the mid- 1 980s are among the factors that explain this imbalance. Given that Bangladesh'soverall external trade balances are on a sustainable path, a large trade deficit with India is not, on itsown, detrimental. These or even larger deficits would have been observed with other countries in any

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case. Therefore, halting Bangladesh's broader trade liberalization or reversing it in response to India'sfailure to reciprocate Bangladesh's unilateral liberalization would be a harmful policy error.

15. Bangladesh's economy has generally benefited froml economic liberalization, increasingopenness, and moves toward neutrality of market incentives. In a period of strong liberalization andglobalization that has been sweeping most countries and markets (soon to include textiles) and withthe approaching round of WTO negotiations, linking Bangladesh's trade/industrial policies to those ofIndia would not be beneficial. Not possessing a vast domestic market, diverse resource base and muchmore diversified industrial sector, as India does, for high, sustained economic growth, Bangladeshneeds to rely on trade to a greater extent and to strengthen its export base. A more neutral incentiveregime with further reductions in the remaining anti-export bias--a policy path adopted by Sri Lankawith results that recommend its model to Bangladesh--would serve this objective.

Has Trade Liberalization Improved Efficiency and Productivity of Industries?

16. Trade liberalization--judging from the quantitative analysis of firm-level survey data, fromsurvey questionnaires, and from interview results--has not had any widespread adverse impact on theperformance of the surveyed finns. On the contrary, the majority of the enterprises appear to haveexperienced a positive total (factor) productivity growth between 1992/93 and 1997/98, averaging 29percent over a period of five years, about 6 percent annually. Without claiming direct causality, itcould be argued that the progressive reductions in trade restrictions must have played a positive role inthis outcome. By inducing competition, technological change and diffusion, and technical efficiencygains, the stimulus to trade has stimulated an increased productivity of inputs. When thesequantitative results are put together with the official statistics on the output performance ofmanufacturing industries, the resulting picture is generally positive, a refutation rather than asupport for the claim that trade liberalization in the 1990s harmed Bangladesh 's manufacturingindustries.

* During the period under study, export-oriented firms appear to have done better in improving theirtechnical efficiency relative to the best-practice (most efficient) firm(s) in their own sub-group,thus moving closer toward the maximum potential production. The closer initial convergence intechnical efficiency between the average export firm and the best performer(s) was to be expectedamong export-oriented firms that are normally exposed to more intensive competition andmarket/production knowledge.

* Firms competing with imported goods have generally lagged behind the most efficient finns intheir own sub-group in improving their relative technical efficiency in resource use. This disparitybasically reflects the shelter that protective trade barriers provide to inefficient enterprises as wellas to efficient, more dynamic, front-runner import competing firms. The results of interviewsindicate that firm-specific problems and business environment constraints also appear to have beenimportant factors in slowing down efficiency improvements and adjustments to tradeliberalization. Remarkably, however, the import-competing firms surveyed experienced strongerpositive technological progress, on average, than the export-oriented firms over the five-yearperiod. Their gains may stem from two factors: the larger initial technology gap with the outsideworld that is norrnal for import-competing firms and the stimulus that a less restrictive tradepolicy fosters for larger leaps in technological progress by the best-practice import-competingfirms. As a result, import-competing firms, on average, experienced larger totalfactorproductivity growth than export-oriented firms, even though many of the former failed to close thegap with the best practice firm(s).

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* Some import-competing firms--marked by inefficiency and high costs--in iron/steel metal works,engineering, rubber works, and cotton mills might have been adversely affected by tradeliberalization. Although such an outcome of foreign competition is to be expected, it is importantto emphasize that many of the manufacturing firms surveyed reported other internal and externalconditions--constraints to doing business, for example--as other important, contributing, negativeinfluences on their performance.

17. To shed further light on the importance of trade liberalization and to measure various aspectsof the business environment affecting the performance and capacity to respond to trade liberalizationof the enterprises surveyed, direct interviews were held and qualitative questionnaires were used.Following are some of the findings:

* Of the 74 enterprises that answered the question about impacts of trade liberalization, 30 percentfound trade liberalization helpful, 14 percent considered it harmful (mainly import-competingfirms in rubber industries, soap/detergent and metal works), while the majority indicated nosignificant perceived impact from trade liberalization. The latter group included some ready-madegarments firms, which had started benefiting from trade liberalization much earlier under theenclave arrangements.

* With respect to the key constraints to doing business in Bangladesh, only 4 percent of therespondents considered competition from imports as a primary impediment. On the other hand,21 percent of the respondents saw the lack of business support services (such as assistance infinding/using new technology and in product design as well as instrument calibration, advice forproductivity improvement and quality control testing, etc.) as the foremost problem. Otherobstacles cited were access to credit (20 percent), inadequate supply of infrastructure (13percent), corruption, theft and "toll" collection (18 percent). Shortage of skilled labor was alsostressed as another important constraint.

* Evidence from the "sick "firms and new enterprises surveyed also suggest that trade liberalizationhas not caused widespread hardships. Of the 12 "sick" firms that could be traced (out of a smallsample of 23), 5 of the 6 import-competing firms identified trade liberalization as having hurt theirperformance. But none of the firms interviewed pointed to trade liberalization as the sole sourceof their problems/ "sickness." They cited non-availability of finance and working capital,technical production problems, natural disasters, increased domestic competition, and managerialinexperience among the other important reasons for their problems.

* The 26 new entrants interviewed (10 export-oriented and 16 import-competing) regarded tradeliberalization as helpful, noting duty reductions on raw materials and capital goods. Export-oriented firms were generally more optimistic about their future, while import substitute producerswere more cautious. All, however, mentioned the business environment constraints noted aboveas the main hurdles they faced.

18. Recommendation. An important implication of these findings is that faster improvements inthe areas of infrastructure, financial sector reforms, business support services, customsadministration, law and order, and the reform of the state-owned enterprise sector would haveundoubtedly brought higher returns from the gradual removal of trade barriers. Indeed, addressingthese business environment problems will be the Government's most essential contribution to boostingindustrial development and, with it, economic growth and the reduction ofpoverty.

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NOTE TO READERS

This report on trade liberalization was discussed at a day-long seminar held in Dhaka onSeptember 16, 1999. With opening remarks on the report's findings, the Minister of Financeinaugurated the seminar and led the discussions in which other senior Government officials, as well asrepresentatives from the local Chambers of Commerce and hidustries, research institutions and thelocal universities took part. Journalists participated in a separate session.

Among the issues raised in the report and during these discussions, four drew the mostcomment. They include:

Pace and timing of trade liberalization. Some discussants argued--as the report anticipatesand rebuts, particularly in Box 11.1 of Chapter Two--that "slower" trade liberalization would have beenmore appropriate given the significant business environment constraints in Bangladesh and its verynarrow, starting manufacturing base. Trade liberalization and the accompanying changes, in this view,came too fast and without advance notice. In consequence, they contended that unprepared domesticfirms were damaged and made "sick" by foreign competition. Some participants argued thatBangladesh's industrialization started with the development of export-oriented activities, such asgarment manufacturing, and that its import-substitution strategy has not moved the process ofindustrialization away from this ongoing export-orientation. "In view of Bangladesh's large domesticmarket and very narrow manufacturing base," one remarked, "what is needed is to follow the EastAsian strategy of continued protection to domestic firms until they capture domestic markets, becomeefficient through domestic competition, and start exporting. Trade liberalization could then follow."The policy implication of this view is to go slow in future trade liberalization.

Sequencing of complementary reforms. Some participants held that Bangladesh should havemoved faster on improving the business environment by addressing infrastructure and financial sectorproblems, bureaucratic bottlenecks, and law and order problems before proceeding with tradeliberalization. Chapter 1 has a section dealing with this important topic, and Box 1.2 tackles thesequencing issue.

Micro-level findings and macro-level inferences. Several discussants, while commending thereport's micro-level quantitative analysis for filling an important gap in terms of enterprise-levelefficiency and productivity impacts of trade liberalization, felt that this analysis was not sufficient todraw conclusions about the effects of trade liberalization on the entire manufacturing sector and theeconomy as a whole. It was remarked that the assessment was incomplete; it did not cover cottageand small-scale industries and included no causality analysis.

In response, the report's team explained that the enterprise-level analysis is intended to provideevidence on efficiency and productivity impacts of trade liberalization on Bangladesh's manufacturingfirms, without attempting to draw macro-level conclusions or generalizations. Macro-level impactsare, however, assessed using the available macroeconomic performance indicators and the officialdisaggregated data on the manufacturing sector.

All three chapters of the study present the relevant evidence and assessments on this topic, andBox 11. 1 in Chapter 3 presents a more specific response to these comments.

Trade deficit with India. The topic of Bangladesh's large trade deficit with India attractedsignificant attention at the seminar with participants citing India's slower trade liberalization asbackground for questioning the wisdom of Bangladesh's tolerating a large trade imbalance with itsneighbor.

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In response, the report's authors and the study itself emphasize that a trade deficit with aparticular partner is not a concern as long as the overall trade balance is sustainable. Importing fromIndia, as one benefit of triangular trade, actually saves Bangladesh the higher costs it would have hadto pay for acquiring the same necessary imports from sources other than India. Finally, referring tothe report's recommendation on this issue, bilateral and multilateral policy dialogue was stressed asthe appropriate strategy to address Bangladesh's legitimate complaints.

The report weighs this issue in detail in Chapter 2, and Box 11.2 provides a summarizedresponse on the comments made at the seminar.

Chapter I BANGLADESH'S TRADE LIBERALIZATION:

HAS IT BEEN TOO FAST?

A. INTRODUCTION

1.1 Objectives and scope. As a general rule in developed and developing economies alike, thefewer the barriers to trade, the greater is competition in domestic markets, the more neutral are marketincentives, and the easier is it to obtain access to cheaper raw materials and modem machinery.Resources are allocated with greater efficiency. Patterns of production more closely match a country'scomparative advantage. The consequent export expansion in turn supports stronger overall economicgrowth. In Bangladesh, for example, the dramatic growth of ready-made-garment (RMG) and knitwearexports has created new jobs and stronger economic growth, results that testify impressively to thebenefits of a liberal trade regime, supported by a facilitating business environment.

1.2 In Bangladesh, trade liberalization has been an important component of structural reform effortssince the mid-1980s. Compared to the highly restrictive and inward-oriented nature of the trade regime inthe previous decade, today Bangladesh has a far less restrictive, more outward-oriented trade policyenvironment. This is a result of commendable progress made in eliminating a sizable portion ofquantitative restrictions (QRs) and in reducing the average rate and dispersion of import tariffs. With thereduction of prohibitively high tariffs, the trade reform has been successful in reducing substantially, ifnot completely removing, the tariff redundancy ("water-in-the tariff"'), thus bringing the statutorynominal protection levels into closer alignment with the observed differences between the world anddomestic prices. As a result, the anti-export bias of the trade regime has been cut significantly for exportactivities outside the export processing zones (EPZ) and special bonded warehouses (SBW), whichbenefit from duty/tax free access to imported inputs. Nonetheless, the remaining anti-export-bias of thetrade regime is still considerable.

1.3 Since the mid-1990s, the pace of tariff reform has slowed as the Government faced the greaterchallenge of tariff rationalization. That step requires confronting both the considerable dispersion aroundthe average rate and the numerous exemptions/concessions in the existing nominal tariff protectionstructure. Together with the use of discretionary "tariff values" for import valuation and multiple tariffslabs even at highly disaggregated level of commodity classification, these features render Bangladesh'stariff system complex and less than transparent. They give customs officials wide leeway fordiscretionary decisions and rent-seeking behavior. It is difficult to trace the impact of such a nominalprotection structure on the effective protection rates (EPRs), which are affected also by the effects ofsmuggling and of the remaining QRs on domestic prices.

1.4 Key factors in retarding tariff rationalization/simplification in recent years have been concernsover the possible adverse effects of further tariff cuts on budgetary revenues, on the balance of payments,and on import-substituting domestic industries. Both industrialists and policy makers have voicednegative reactions to trade liberalization. Some of common criticisms argue that:

* Bangladesh has liberalized its import regime "too fast";

* domestic markets are flooded with foreign goods, particularly from the neighboring countries;and

2 Chapter 1: Bangladesh's Trade Liberalization: Has It Been Too Fast?

* these developments have adversely affected domestic industries, slowing the growth of enterprisesthat must compete with imports, making some of them "sick," forcing the closure of others and,generally, inflicting damage on the economy.

1.5 This report examines these claims in the context of related developments in the economy inrecent years. Specifically, it reviews actual changes in the trade regime as well as othercomplementary/accompanying economic policy changes and dLevelopments in the business environmentthat have a bearing on the effectiveness of trade liberalization. Additionally, by looking at some relevantmacroeconomic and finn-level developments, the study seeks to identify the impacts of tradeliberalization to the degree that any such analysis can overcome the considerable difficulty of establishingcausality when so many other factors are also affecting economic performance and outcomes.

1.6 Bangladesh's policy debate about the pace and effectiveness of trade liberalization is important.This report is meant as a contribution to it and to the next phase of trade reforms. The tariff structure stillstands in need of considerable simplification and rationalization. Useful as it is to examine the contentionthat liberalization has gone too fast, it should also be helpful to identify bottlenecks in the businessenvironment that may be impeding the adjustment of manufacturing industries to changes in relativeprices and limiting their capacity to respond effectively.

Approach, Methodology, and Outline

1.7 Has Bangladesh liberalized its trade regime too fast? No established principle dictates the paceat which a country should push its trade reforms. Even though speed may well serve to preempt lobbyingefforts by protectionist groups, it is the country conditions' that are critical determinants not only of thepace, but also of the sequencing of reforms.2 This chapter exarmines those conditions-- the record withrespect to macroeconomic stability and the implementation of other accompanying structural reforrns aswell as improvements in the business environment. First, however, it reviews Bangladesh's tradeliberalization experience during the last decade and assesses its pace relative to the experience of othercountries in the region as well as those of other regions, including countries that have successfullyliberalized. The subsequent analysis of the broader economic and regulatory setting reflects the ampleevidence from international experience of the importance to successful trade liberalization of a soundmacroeconomic framework and a conducive/facilitating business environment resting on politicalstability, law and order, and other structural policy and institutional reforms. Chapter 2 then considersrecent trends in Bangladesh's foreign trade patterns--merchandise imports and exports, including tradewith India--and external current account balances, looking for evidence of a sudden worsening inexternal balances and the supposed "flooding" of domestic markets with foreign goods.

1.8 Has trade liberalization hurt manufacturing industries? This report seeks to analyze tradeliberalization's impact on Bangladesh's manufacturing sector in three different ways. The first is a micro-level study on production efficiency in input use and on productivity that uses firm-level survey data on"before" and "after" trade liberalization observations with respect to input, output, and costs for a sampleof manufacturing enterprises. Chapter 3 presents the results of this exercise with respect to technicalefficiency and total factor productivity effects. Second, the replies received to a questionnaire on the key

I Some of the key country conditions include: macroeconomic stability, soundness of the macroeconomicframework; business environment (availability of infrastructure, state of the bureaucracy, legallregulatoryenvironment goveming business entry/exit and flexibility of labor markets, availability of skilled manpower,health/efficiency of the financial sector), and the existing economic structure--the extent of diversification inproduction and the export-base.

The literature on the trade policy reform experience and lessons is rich. Some of the recent referencesinclude: Michaely, Papageorgiou, and Choksi (1991); Thomas, Martin, and Nash (1991); Dean, Desai, and Riedel(1994); Rajapatirana (1997).

Chapter :. Bangladesh's Trade Liberalization: Has It Been Too Fast ? 3

constraints to doing business in Bangladesh and the results of direct interviews with businessmen on thesame subject are assessed. Additionally, the latter chapter also includes the feedback obtained from asmall sample of the so called "sick" enterprises, focusing on the explanations offered for their ill health.The purpose of the latter two exercises is to identify the factors other than trade liberalization that haveaffected the performance of Bangladesh's manufacturing enterprises during the 1990s. Finally, Chapter 3reports on the impact of trade liberalization on business entry decisions, based on the informationgathered from interviewing a small number of "new" enterprises.

B. PROGRESS IN TRADE POLICY REFORM

Introduction

1.9 To set the stage for an analysis of reform's impact, it is useful to evaluate Bangladesh's progressin trade liberalization against the generally accepted concept of liberalization as a move towards "outwardorientation". The degree to which trade reforms achieve that orientation is often measured by movementtoward:

* neutrality of incentives between/within exportables and importables, and between export anddomestic sales, and between non-tradables and tradables;

• liberality, implying a definite reduction in the level of intervention in external transactions; and3* openness, as measured by the importance of trade in the economy.

1.10 Quite apart from the removal of anti-export bias, the essence of trade liberalization, as it iscommonly understood, lies in reducing the level of intervention and increasing reliance on the pricemechanism. In the specific case of Bangladesh and its progress to date in liberalizing trade, the relevantpolicy changes to be considered include lowering nominal tariff rates, removing QRs and/or export taxes,and exchange rate policy.

1.11 With regard to the degree of openness achieved, the macroeconomic record is unambiguous. Theshare of merchandise plus non-factor services trade in the economy, after remaining stable at around 19percent of GDP throughout the 1980s, has risen rapidly in the 1990s--to 33 percent of GDP in FY98.Exports that stagnated in the 4-6 percent range in the 1980s, rose to 12-14 percent of GDP in FY97-FY98,while imports rose from about 14 percent to 19 percent of GDP over the same period (Table A.9 in AnnexI). This growth in foreign trade in the 1 990s evidently owes most of its momentum to activity on theexport side. The sharp expansion in exports of ready made garments (RMG) and knitwear has also led tostrong expansion in imports of inputs such as fabrics and yam into RMG and knitwear production. Asdiscussed below, evidence indicates that "neutrality" and "liberality" have also marked the intensivephase of trade reforms in the 1990s.

Trade Policy Reform in the 1990s: Was it too much, too fast?

1.12 To reach the more outward-looking trade regime of the present, reducing the bias against exportsalong the way, Bangladesh has accelerated the pace of its reforms in the first half of this decade,emphasizing import tariff reductions and the removal of QRs. Very early in the 1990s, the top tariff rateswere drastically cut and QRs rapidly dismantled. At the same time, the Government introduced a unifiedexchange rate system by eliminating the "Secondary Exchange Market System" and adopted a moderately

3 The trade literature refers to several related concepts of "liberalization", mostly revolving around"neutrality" of incentives, "liberality", and openness. For an extensive coverage and references on this issue, see:Pritchett, L. (1991).

4 Chapter 1: Bangladesh 's Trade Liberalization: Has It Been Too Fast?

flexible exchange rate policy. In 1994, Bangladesh accepted the International Monetary Fund's ArticleVIII obligations, thus committing itself to current account convertibility.

1.13 The achievement of sufficient macroeconomic stability early in the decade facilitated the reformprocess. So did the switch from a fixed, over-valued exchange rate regime to a managed but moderatelyflexible regime that has so far prevented any significant appreciation of the real exchange rate. However,the tempo of trade policy reform has slowed significantly over the past couple of years. That hold-up,accompanied by some evidence of backtracking, appears to reflect a perception in the business and policymaking circles that reform came "too fast" and needs to be moderated by a new gradualism. 4

1.14 Counter to this viewpoint is the contention that most of the tariff cuts at the top end have resultedso far mainly in removing the "water-in-the-tariff' 5 and in bringing statutory tariff rates closer to theobserved differences between domestic and border prices. The evidence of the existence of the water-in-the-tariff is reflected in the low and flat imports of final consumer goods in the first half of the 1990s.Available information at the 8-digit level indicates that imports of most of the highly protected consumergoods in that period did not show a surge from their very low levels, and the observed insignificantimports of these items were probably associated with the accompanied baggage. In the second half of the1990s, however, imports of these goods started increasing as the high tariff rates were lowered further.

25 Chart A: Structure of Tariffs, 1999/00

20-

15 -

0

1i 10

5

00 5 15 25 37.5

Tariff Rates

1.15 The maximum tariff ("customs duty") rate was reduced from 350 percent in FY91 to 40 percentin FY99, while the (unweighted) average tariff rate fell from 89 percent to 20 percent over the sameperiod. Although the FY00 Budget theoretically cut the maximum tariff rate further to 37.5 percent, theretention of a "temporary" 2.5-percent Infrastructure Development Surcharge (IDS), means that the toptariff rate (inclusive of the IDS) remains at 40 percent, 6 a fairly high rate despite the significant drop inmaximum as well as average tariff rates. In fact, the average rate is pulled down substantially becausemany of the non-competing imports--such as locally unavailable raw materials and

4 For a detailed coverage of changes in Bangladesh's trade regirme, see: The World Bank, Bangladesh: TradePolicy Reform for Improving the Incentive Regime, October, 1996.

Tariff redundancy resulting from prohibitively high rates and srnuggling.6 Inclusive of the IDS. In FY99, the average (unweighted) tarifl rate was 20 percent, and it fell to about 17percent with the FY00 changes.

Chapter 1: Bangladesh 's Trade Liberalization: Has It Been Too Fast ? 5

machinery/equipment--enter at zero or very low rates (see Chart A). Competing imports, on the otherhand, face higher tariff rates; indeed, nearly 25 percent of tariff lines (mainly finished products) aresubject to the maximum tariff rate. In addition, these nominalprotection levels are augmentedfurther byother protective levies (such as the licensefee), as well as by the asymmetrical application of VAT, thesupplementary duty (SD), and the IDS, which are in principle protection-neutral taxes.7 Not only has theIDS become de facto an import tax only; in some cases VAT and SDs are levied only on imports, not ondomestically produced substitutes. In some instances SD rates levied on imports are higher than thoselevied on domestic production. Consequently, the unweighted average nominal protection rate--i.e.,including import tariffs, other protective taxes and the protective components of VAT and SD--hasremained much higher than the average tariff rate (Table 1. 1, and Table A. 1 in Annex I).8

1.16 Moreover, even with the significant decline in average tariffs that is mainly due to reduction inthe top rates, the dispersion of tariffs - from 0 to 37.5 percent -- has nevertheless remained high relativeto the average rate.9 As noted above, the latter range is further widened due to the other protective importlevies. This continuing pattern remains an important shortcoming of Bangladesh's tariff structure,interfering in the allocation of resources based on comparative advantage. On the reforn agenda, furtherreductions in tanrff dispersion is an important pnrority since both the uniformity and average level ofprotection are critical stimuli to greater efficiency in allocating and using resources. The other prioritystep that needs to be undertaken in further rationalizing the tariff structure is to eliminate the existingtariff exemptions and concessions, which complicate the tariff system, promote rent seeking behavior, andalso cause revenue losses that might be as large as I 1 percent of tax revenues collected on imports.

Table 1.1: Trends in Nominal Protection, 1990/91 to 1998/99(Figures are averages, %)

Manufactures All TradablesPre-reform, 1990/91:Unweighted 89.0 88.6Import-weighted 51.8 42.1Dispersion (CV) 72.4 71.9

In 1998/99:Unweighted 26.0 28.2Import-weighted 23.8 20.3Dispersion (CV) 68.3 66.6

Current status, 1999/00:Unweighted 24.2 24.7Import-weighted

Dispersion (CV) 84.1 76.8

Source: World Bank staff estimates.

7 The across-the board license fee is 2.5 percent, and serves as a protective tax. The supplementary duty (SD)rates are differentiated and applied in a non-neutral manner, and VAT is levied on imports of some textiles but noton domestically produced substitutes, and it has a cascading effect on the nominal protection rate. An import-discriminating Infrastructure Development Surcharge (IDS) of 2.5 percent has been in existence for the past twoyears only to be complicated in FY99 with a post-flood rehabilitation surcharge. The protective effects of all theseimport taxes are examined in detail in: The World Bank, "Review of the Indirect Taxation Regime", 1999.9 It fell from 89 percent in FY91 to 28 percent in FY99, and further down to 25 percent in FY00.

As measured by the coefficient of variation (CV). The CV provides a measure of deviations from theaverage value by normalizing these variations with the mean itself.

6 Chapter ]. Bangladesh ', Trade Liberalization: Has It Been Too Fast?

1.17 With the falling but still highly dispersed nominal tariffs, effective protection rates (EPRs) appearto have remained widely dispersed as well. Moreover, there has been a concerted effort to adjust the rateson input tariffs commensurate with drops in output tariffs in order to limit the fall in EPRs afforded toimport-competing goods. Crude estimates"0 of industry-wide EPRs indicate a gradual decline in averagelevels of effective protection--from 76 percent in FY92 to 29 percent in FY98 (Table A.4 in Annex I), butmost import-competing lines of production (e.g., textiles) continue to enjoy high EPRs. And theprevalence of high dispersion is evidence of the downward rigidity of protection levels and of the tacitacquiescence by authorities under heavy pressure from domestic protection lobbies.

1.18 Significant progress, however, has been made in reducing the importance of quantitativerestrictions as instruments of protection. In FY92, nearly 11.5 percent of the 10,000 tariff lines weresubject to QRs, compared to only 3.4 percent today. Less than one-half percent of current imports -mainly in the textile category - are restricted (Table I.2, and Table A5 in Annex I).

Table 1.2: Phased Removal of Quantitative Rest:rictions, 1989/90 to 1998/99

(Number of 4-digit H.S. Codes)FISCAL YEAR ; 0Total T Reasons Non4Trade

Banned Restricted Mixed Reasons1989-90 315 135 66 52 621990-91 239 93 47 39 601995-97 120 5 6 17 921997-2002 124 5 6 17 96

Source . Ministry of Commerce, Import Policy Orders for various years.

Anti-export Bias Remains Significant

l.19 Trade policy in the late 1980s, a period marked by a highly dispersed and anomalous tariffstructure, embodied an incentive system that favored production, for the domestic market over exports,protecting many inefficient import-substituting activities and creating a significant anti-export bias. Thereforms of the early 1990s, in contrast, aimed at lifting restrictions on foreign trade, gradually removingthe anti-export bias, and creating a neutral policy regime. The initended objectives were to enhancedomestic competition, remove price distortions and bring domestic relative prices into alignment withinternational prices so as to boost efficiency in resource use, spur activities that have comparativeadvantage, and encourage technological progress, innovation and diversification and thus generatedynamic gains.

1.20 These efforts have produced partial success in reducing the anti-export bias of the trade regime,as shown in Table I.3 below. The ratio of effective exchange rate for imports (EERm) relative to exports(EERx) is used as an indicator of the trade regime's anti-export bias--the higher the ratio above 1.00, themore intense is the bias against export activity." Although the structure of relative incentives for

'° Estimates are based on operative nominal import taxes, rather than being based on the observed differencesbetween T.he domestic and intemational prices. In the presence of water-in-the-tariff, EPRs calculated on the basisof statutory import levies may only give crude approximations.I I In the present context, for imports EERs refer to nominal exchange rates adjusted for (protective) importtaxes (and any scarcity premium that exchange controls may generate). For exports, EERs give the nominalexchange rate after adjustment for the existing export promotion schemes. Accordingly, for imports EERmrepresents domestic market value of imports worth one unit of foreign currency (US dollar, in the present case). Forexports, EERx represents domestic currency equivalent of proceeds from exports worth one unit of foreign currency.

Chapter 1: Bangladesh's Trade Liberalization: Has It Been Too Fast ? 7

production of import substitutes declined from 1.66 in FY92 to 1.26 in FY96, it remained essentiallyunchanged through 1997/98, and might have fallen only marginally following the FY00 tariff changes.While the EERx rose from 38.5 in FY92 to 46.3 in FY98, the EERm fell from 63.8 in FY92 to 51.9 inFY96. It then rose appreciably to 58.4 in FY98 (much of it not explained by the depreciation of thenominal exchange rate), suggesting some reversal of the trend in the last couple of years partly due to thenew protective levies. Thus, the structure of trade policy-induced incentives still remains skewed in favorof import-substitutes by about 26 percentage points (according to the1997/98 figure), a rough indicator ofthe degree of anti-export bias of the current trade regime. It is worth noting that the bias still remainslarger in the case of the 'final" consumer goods--the EERm/EERx ratio was 1.90 in FY92 and itfell onlyto 1.39 by FY98.

Table 1.3: Effective Exchange Rates for Import Substitutes and Exports12

Overall un-weighted Nominal

Fiscal year protective exchange EERm EERx EERm!/EERxrate rate

(- Taka per US$ -

1991-92 67.35% 38.15 63.84 38.53 1.6571992-93 55.37% 39.14 60.81 39.72 1.5311993-94 42.43% 40.00 56.97 40.48 1.4071994-95 31.32% 40.20 52.79 40.53 1.3021995-96 27.11% 40.84 51.91 41.25 1.2581996-97 26.85% 42.70 54.16 43.22 1.2531997-98 28.54% 45.46 58.44 46.25 1.263

Source: World Bank staff estimates (Table A.6 in Annex I).

1.21 In spite of this favoritism for the domestic market relative to exports, the latter, measured incurrent US dollars, have grown at a significantly high annual rate of 17 percent in the current decade.That achievement is largely due to the special environment created for export production, insulating itfrom the prevailing trade regime. Enclaves created under various export promotion schemes haveprovided certain-- but not all would-be -- exporters duty-free access to imported inputs. Special bondedwarehouses for the ready made garment (RMG) production/export and export processing zones,complemented by other factors such as export quotas under the Multi-Fiber Arrangement and exportfinancing through back-to-back L/C, have allowed Bangladesh to use its abundant labor resources todevelop an efficient RMG and knitwear industry, which accounts for over 70 percent of its gross exports.This impressive success has yet to be replicated in other industries, however, and Bangladesh's exportbase remains narrow. More importantly, over the past two decades, while many countries gained globalmarket share, Bangladesh's share of world exports has remained relatively unchanged'3 (Table 1.4). Andthe inefficient system of duty drawback available to exporters is neither sufficient to offset the anti-exportbias nor supportive of potential export activities. Further reform is required to continue reducing theobstacles to exporting and to move toward a neutral domestic incentive structure.

12 For more details on the estimnated EERs, including unweighted and weighted EERs for imports, see Tables

A.6 and A.7 in Annex I.13 In general, South Asian countries seemed to have lost relative ground in the world market for exports.

8 Chapter ]: Bangladesh's Trade Liberalization: Has It Been Too Fast?

Table 1.4: Falling behind?...Bangladesh's share in World Exports,

Selected Countries (percent)Country ~~~~1980 1990 1996

China/a 6.94 9.95 12.81Indonesia/b 7.20. 4.91 4.13Thailand 2.75 5.14 5.34Malaysia 4.76 5.67 6.65

Mexico 7.92 8.97 8.16Philippines 2.63 2.1:8 2.99India 4.85 4.29 3.73Sri Lanka 0.48 0.46 0.42Pakistan 1.53 1.36 0.85Bangladesh 0.38 0.45 0.42

Source: World Development Indicators, World Bank 1998; /a: 1982, /b: 1981

Pace of Bangladesh's Trade Liberalization: A C'hart B: Average Tariffs in South Asia, 1998/99

Cross-Country Comparison 40 . I1.22 Another way of measuring the speed and 30.depth of trade policy reforms in Bangladesh is to 25scompare its achievements to those in other 201liberalizing countries in South Asia, Africa and Latin '5f

America. Starting in South Asia, for which the most s*recent comparable information is available, data o. Ashow that Sri Lanka --starting in 1977 -- has gone the farthest, continuing on a path of steady liberalizationthroughout the 1980s and 1990s. Currently, SriLanka has a four-band (5, 10, 25, and 35 percent) GUnweighted *Import weighted

tariff regime, with the highest rate applying toagricultural products. Taking QR reform intoconsideration, Bangladesh stands next to Sri Lanka in terms of the pace of trade liberalization. As thefollowing table reveals, excluding Nepal, which has little domestic industry to protect, Sri Lanka andPakistan have the lowest top rate. However, in terms of average tariffs, Bangladesh would come afterNepal with the FY00 tariff reductions.

Table 1.5: Average Tariffs and Top Rates in South Asia, 1998/99

cou es Top rate IAwighted gort-wtdBangladesh 40 20.0 16.0

India 45 39.6 20.2Pakistan 35 21.3 20.7Sri Lanka 35 17.6 10.0

Nepal 80 14.0 9.6

Source: SASPR, World Bank


1.23 In fiscal year 1999, Sri Lanka, in addition to compressing its tariffs into four slabs,14 alsoabolished export taxes '5 and limited the application of QRs only to non-trade reasons.16 Sri Lanka is alsomoving away from a heavy reliance on import duties for revenue: in 1995, customs duties were only 21percent of total revenue (compared with 33 percent in Bangladesh) and 9.7 percent of actual imports (21percent in Bangladesh). Although Sri Lanka's trade system retains such drawbacks as the granting ofduty waivers and exemptions and the application of surcharges and markups in import valuation, themove to the four-tier tariffs and the elimination of QRs has made Sri Lanka's economy the most open inSouth Asia. Sri Lanka has also announced plans to move to a two-band regime (10 and 20 percent) in2000 and to a uniform tariff rate system ultimately.

1.24 In contrast and despite significant import liberalization and tariff reductions, India continues to behighly protectionist. Import bans and other pervasive across-the-board QRs mostly on consumer goodsstill restrict international competition generally and trade with other South Asian countries as well. Some200 agricultural, mineral, and metal items are subject to export restrictions. In the past two years,although the maximum import tariff rate has moved closer to that of Bangladesh, entrenched protectionistlobbies in India continue to mount powerful resistance to scrapping QRs. In the face of a general trend inSouth Asia toward removing remaining trade barriers, India is likely to bend to the wind of change soonerrather than later. Indeed, it recently entered into bilateral free trade agreements with Nepal and Sri Lankafor a phased removal of tariffs and QRs within the next three years or so. Negotiations with Bangladeshare under way for providing market access to a broad spectrum of items.17

1.25 Comparison with the Rest of the World. Although low in the South Asian context, Bangladesh'stariffs are still higher than the average in a number of Latin American and even some African countriesthat undertook trade reforms during the late 1980s and early 1990s (Table 1.6, and Table A.8 in Annex I).Bangladesh can, however, claim one of the sharpest reduction in tariffs over the reform period asmeasured by the ratio of average tariffs after and before reforms.

Table 1.6: International Comparison of Tariff Regimes

Region averages Avg. tariffs Avg. tariffs Tariff ratio*Pre-reforn Post-reformn

Bangladesh (1989, 1998) 94 21 0.22

South Asia (1985, 1998) 80 27 0.34

South East and East Asia 29 14 0.48(1984, 1998)Africa (1983, 1996) 41 31 0.76

Latin America (1984, 1998) 44 13 0.30

(*) Tariff ratio is the post-reform average tariffs over pre-reforn average tariffs.

Source: Dean, Judith M. et. al., World Bank (1994); Rajapatirana. (1997; the World Bank(1999b); Ng, Francis and Yeats, Alexander (1999); Table A8(Annex I).

14 The only exception is agricultural products which have a rate of 35 percent.15 Some export cesses and "royalties" remain on such items as coconut products, tea packets and bags, raw

hides and skins, and rubber.16 Exceptions are some agricultural products, certain used transport vehicles, and certain diesel engines.17 Reservations are strong in Bangladesh business circles over these free trade negotiations. Low expectations

about a positive result stem from recent experience of Bangladeshi exporters who reportedly faced insurmountablenon-tariff barriers (even though tariff concessions were offered) in seeking market access to India.

10 Chapter 1. Bangladesh'"s Trade Liberalization: Has It Been Too Fast?

1.26 South East and East Asia. Between 1985 and 1998 tra(ie policy in South East and East Asiabecame decidedly more liberal. No country in the region, with]in which the character and pace of tradeliberalization varied, moved toward more protectionism during this period. QRs were virtually eliminatedthroughout East Asia, although Vietnam and China still maintain import licensing which may be used asrestrictive instruments. Most countries in the region have reduced tariffs, Taiwan, South Korea, and thePhilippines most significantly. Exchange liberalization was evident as most of the countries that removedQRs also had little or no black market premium by 1992. Only four of the East Asian countries initiatedtrade reforms in 1985 with substantial real devaluations: China, Philippines; Indonesia and Vietnam."8

1.27 Latin America. Latin American countries introduced dramatic and significant trade reformsbetween 1985 and 1998. Trade liberalization was comprehensive, both removing import and exportrestrictions in the area of commercial policy and liberalizing foreign exchange markets. Concomitantwith the removal of QRs, Latin American countries effected significant reductions both in import tariffsand in their dispersion, resulting in average nominal tariffs that are the lowest for any developing region.Export taxes and restrictions were also reduced while support for exports expanded. At the same time,most countries reduced intervention in their foreign exchange market, unified exchange rates to do awaywith pre-reform multiple rates, and moved to managed floats or crawling peg systems'9 In sum, the LatinAmerican trade reforms could be characterized as a combinatioin of moves towards neutrality andliberality.

1.28 In terms of the content of reforms, trade liberalization iln Bangladesh and Latin America has takensimilar paths: removal of QRs, tariff cuts, and diminished intervention in foreign exchange markets. Thedifference lies in the pace of reforns and the extent of reductions in the average rate and dispersion oftariffs. For instance, Chile, Colombia, Peru and Argentina brought down their average tariffs to below 14percent between 1985 and 1998, notably farther and faster than Bangladesh, which did handle QRs andforeign exchange liberalization in a like manner. The Latin American pattern attribute of trade reformsthat combine neutrality and liberality also describes performrance by Bangladesh so far.

Box 1.1: What could have been done Differently in Implementing Bangladesh's trade Liberalization?

An imnportant shortcomning of Bangladesh's approach to trade liberalization has been the failure toannounce in advance the timnetable of planned changes in the trade policy. Had the Governnent announced inadvance the future program of tariff and non-tariff changes, the credibi.lity of the trade reforms would have beenenhanced, giving clear and convincing signal to the domestic firms about the intended outward- and market-orientation in the policy environment. This would have given more tirne to the local firms to adjust and respond. Ata serninar held in Dhaka on September 16, 1999 to discuss the report, many participants agreed with this view.

Indeed it could be argued that one of the reasons why Bangladesh's trade liberalization is perceived as fast-paced is perhaps in part due to the fact that the program was not pre-announced and, therefore, many firns in theprivate sector were caught unprepared. The policy implication of the foregoing is that in the future it would beadvisable to announce the planned changes in the trade policy well in advance.

18 For a detailed coverage of the trade liberalization experience of these cited countries, see, for example:Dean,J., Desai, S., and Riedel, J. ( 994); and Rajapatirana, S. (1997).

19 The exception is Brazil which continues to maintain significant exchange controls under a crawling pegsystem.

Chapter 1: Bangladesh's Trade Liberalization: Has It Been Too Fast? 1]

C. OTHER ACCOMPANYING POLICY CHANGES

1.29 Complimentary policies. Trade liberalization in Bangladesh did not stand alone. Rather, it wasone component of economic liberalization and market-oriented reforms that entered an intensive phaseearly in the 1990s. Although the New Industrial Policy of 1981 signaled a major shift to privateenterprise and away from the pattern of nationalization and public-sector dominance in the ownership andmanagement of industrial enterprises, actual change came slowly. Significant liberalization of theinvestment regime for domestic and foreign investors did not actually occur until early in the presentdecade, excluding only a few sectors deemed vital to national security from the reach of private investors.Notable steps in the sphere of de-regulation and market orientation included financial sectorliberalization, privatization of SOEs, and re-structuring and private sector participation in gas, power andtelecom sectors. With respect to macroeconomic policies, the Government initiated a major reform tobroaden the tax base and improve efficiency in taxation, The centerpiece of the tax reform effort, a value-added tax (VAT) introduced with the FY92 budget at a uniform rate of 15 percent at the manufacturer-cum-import level, largely replaced the earlier structure of differentiated sales taxes levied on imports andexcise taxes on domestic goods.

1.30 Partly because policymakers have lacked strong commitment and partly because such vestedinterests as trade unions, industrialists, and bank defaulters have strongly opposed, Bangladesh'seconomic reform goals remain unfulfilled at the end of the decade. The privatization program remainsstalled; many of the firms identified for privatization are still state-owned. The process of re-structuringgas and power utilities has also been slow, particularly in the matter of unbundling generation,transmission and distribution facilities, although the energy sector has been successful in attractingsignificant foreign investment. The same is true for the telecommunications sector. What has beenpainfully slow are the regulatory reforms, enactment of laws and rules for regulating businesses whichwere the exclusive preserves of public monopolies.

1.31 Business environment depends not only on declared laws and regulations but on their effectiveenforcement to safeguard contracts and on the continuity of policies that enable businesses to computerisks and returns with a measure of predictability. Measured by these criteria and even acknowledgingthe fair degree of liberalization that has been achieved, the Bangladesh business environment remainsunhealthy. Deep-rooted problems of governance and weak infrastructure services underminepredictability. An intrusive and inefficient bureaucracy acts as a drag on business and industry;substantial non-performing loans (approaching 50 percent of the outstanding loan portfolio when theinternational standards are applied) burden the financial sector; the legal framework is not geared to thefast pace of modern business; frequent congestion and work stoppages hinder the ports, which also haveamong the highest handling charges in the region,0 grossly inadequate, the telephone system is not up tothe challenge of a rapidly growing economy; power disruptions are frequent; law and order seems to beworrisome; and the politics is confrontational and often destructive of life and property. Together, thesefundamental weaknesses raise the cost of doing business in Bangladesh and constrain the growth ofdomestic and foreign private investment, hampering competition and diversification in the economy.These structural constraints clearly undercut the efficiency and productivity impacts of tradeliberalization.

20 A World Bank study estimated that handling charges for a 20-foot container were $640 in Chittagong,

compared with $220 in Colombo and $360 in Bangkok. For additional details on the business environ-ment, see:Bangladesh: Government That Works-Reforming the Public Sector, The World Bank, 1996; and Bangladesh: KeyChallenges for the Next Millennium, The World Bank, 1999a.

12 Chapter 1: Bangladesh's Trade Liberalization: Has It Been Too Fast?

1.32 One redeeming feature in this discouraging picture is the noticeable improvement inmacroeconomic management in the present decade. Evidence suggests that trade liberalization is easierto manage if it is preceded by or contemporaneous with macroeconomic stability--a necessary conditionfor higher growth performance. Bangladesh's critical macroeconomic indicators, such as fiscal andcurrent account deficits, inflation and interest rates, showed marked improvement early in this decade dueto prudent fiscal and monetary management and to the adoption of a moderately flexible exchange rateregime. In line with the evidence from other countries, the elirnination of QRs and reduction of importtariffs in Bangladesh has had little adverse impact on external current account deficits and on fiscalbalances. Thus, the relatively stable macroeconomic environment that has accompanied tradeliberalization has generally been supportive of business investrment. However, the political uncertainty ofthe recent years and the related frequent country-wide general strikes have adversely affected privateactivity and investment decisions.

1.33 Exchange rate management. Unlike the majority of developing countries with severelyovervalued currencies that have made and sustained a real depreciation as an integral part of stabilizationprograms and trade liberalization efforts, Bangladesh avoided a major real devaluation at the outset oftrade reforms 2' and adopted a different strategy. After unifying existing multiple exchange rates in 1992,the central bank has pursued a largely successful "managed but flexible" exchange rate policy22 tomaintain the competitiveness of exports while keeping domestic inflation at bay. Though the open-market exchange rate premium is not a foolproof indicator of trade liberalization, the fact that thesepremiums have been consistently low for a sustained period (only 1.75 percent during 1996-99) is oneindication of the effectiveness of exchange rate management.

Chart C: REER for South Asia150. (1990=100)*

140 IND

130.

X 120. PA

iio. ~~~~~~~~~~~~~~~~~~~~NPLX U 0. BGD

8 909w ~~~~~~~~~~~~~~~~~~~~~~~~~SRL

cg80.

70

60

50.

80 82 84 86 88 90 92 94 96 98

Year

* Increases represent depreciation

Nonetheless, whether we look at basket-weighted real effective exchange rates (REERs) or bilateral realexchanges rates (RERs), in terms of maintaining competitiveness, Bangladesh's exchange ratemanagement, with a real appreciation of about 4 percent in its REER during 1990-98, lagged behind thoseof India (which had a 35 percent real depreciation), Pakistan (w ith 19 percent real depreciation), andNepal (7 percent real depreciation)--Chart C. It also trailed some of the competing South East and EastAsian countries, including Indonesia, Malaysia, Thailand, and South Korea. In the case of Bangladesh, a

21 The presumption being that the currency was not terribly overvalued in the first place.22 The central bank has adopted a policy of mini-devaluations, with several small adjustments resulting in a

cumulative nominal devaluation of roughly 3-5 percent annually, as opposed to one-time major devaluation. On theother hand, the rate of domestic inflation has fluctuated between 3 percent and 9 percent since 1992/93.


modest real depreciation is noticeable in the early years of trade reforms through mid-19962 A similarpicture is also reflected by the bilateral RERs vis-A-vis the US dollar--see Chart D.

Chart D: Bilateral RER for South Asia(1990=100)*

160150140 IND

130a' 120 NPL

110 BGDa100 SRL

80 70.60

80 82 84 86 88 90 92 94 96 98

Year

* Increases represent depreciation

1.34 Although export performance has been strong and macroeconomic balances satisfactory duringthe 1990s, a more competitive exchange rate policy could have had positive effects on potentialexportables and contributed to export diversification. India's large real depreciation may partially explainwhy Bangladesh's merchandise trade deficit--formal and informal-- with India has been growing rapidly,faster than the pace of Bangladesh's import liberalization alone would justify (this is discussed in moredetail in Chapter 2). In any case, Bangladesh requires more than just a competitive exchange rate tofoster sustained export growth; structural constraints that inhibit supply response must be addressed on apriority basis.

Box 1.2: Sequencing of Complementary Reforms

Noting the business environment constraints and the resulting high costs of doing business, it has beenargued--and this was also stressed by several participants at the September 16, 1999 seminar --that Bangladeshshould have opted for a more gradual approach to trade liberalization thus giving more time for improvements in thebusiness envirom-nent to take place. While it is difficult to speculate on the counterfactual, it can, however, beargued that postponing or slowing Bangladesh's trade liberalization would not have guaranteed acceleratedstructural reforrns and improvements in the business environment. Yet slowing trade liberalization any furtherwould have left the country even farther behind the rest of the developing world in intemational competitivenesssince mnany developing countries had started opening up in the early 1980s and begun capturing market shares.Furthermore, it can be added also that, if anything, trade liberalization has probably intensified the pressure to startimplementing at least some of the priority structural reforms. By moving forward with trade liberalization,Bangladesh put in motion the needed adjustments in the economy toward outward-orientation without further delayand started realizing at least some of the expected gains.

It is, of course, very critical that the needed reforms and improvements in infrastructure, the financialsector, state-owned enterprises, public administration, business exit, and in law and order are accelerated to fosterbusiness confidence, promote private investment, and ease the ongoing adjustments to trade liberalization. Steps toreduce political uncertainty would also be important.

23 Note, however, that the preceding is just to highlight the real exchange rate policy that has been pursued by

the South Asian countries since 1990. It does not in any way imply that the RERs/REERs that prevailed in 1990were equilibrium rates.

14 Chapter 1: Bangladesh''s Trade Liberalization: Has It Been Too Fast?

D. TRADE LIBERALIZATION AND ECONOMIC PERFORMANCE

1.35 By any measure of openness--size of trade, removal of QRs, lowering of tariffs, black marketpremium of foreign exchange-- Bangladesh is a more open economy today than it was in the 1980s. Hasthis change made any difference to growth? Employment? Investment? Industrial or agriculturalperformance? Several recent cross-country studies have found a positive relationship betweenliberalization and economic performance . 24 Setting aside problems related to the formulation of a robustindex of openness, most studies have also found evidence of a positive correlation between liberalizationand productivity growth, a subject discussed in the next Chapter25

1.36 Though rigorous econometric evidence on Bangladesh is awaited, comparable data for the 1980sand 1990s suggest a positive stimulus to growth emanating from increased openness (see Table 1.7). Thathigher momentum--5 percent annual GDP growth compared to 4 percent in the previous decade -- couldbe linked to the market-oriented policy changes, including trade liberalization, that occurred early on.Sectoral GDP growth rates in both manufacturing and agriculture seem to have responded favorably,particularly in manufacturing, despite external shocks and extended political uncertainty in recent years.The annual average growth rate of manufacturing GDP reached 7 percent in the 1990s, which contrastssharply with the 3 percent observed in the 1980s. As elaborateid further in Chapter 2, manufacturingoutput has also grown at a higher annual average rate in the 1990s than in the 1980s also--at 8 percentthrough FY98, in contrast with 6 percent realized in the 1980s. Better output performance in the 1990s ofthe medium and large scale manufacturing sector still holds even when the fast growing RMG/knitwearand the declining export-oriented jute textile sub-sectors are excluded from the averages. In agriculture,one of the factors leading to the acceleration of growth in foodgrain productivity was the decision in thelate 1980s to liberalize trade in pumps and engines.26

Table 1.7: Trade Liberalization and Economic Performance

Postliberalization iiA0 0zio 0t00t00 t 0000 0 f ; j4 liberalization

Annual growth rates VbY1980s2av. FY90 F2 FY94 FY96 FY98 1990s avg.

Real GDP 4.0 70 5.0 3.8 5.0 5.6 5.0

Manufacturing 3.0 1.0 10.0 5.0 6.0 9.0 7.0

Agriculture 2.0 10.0 2.5 0.8 3.4 3.0 3.3

Exports (in nominal 7.0 37.0 25.0 4.0 8.0 12.0 17.0US$)

Source: World Bank staff estimates

1.37 Export growth has been phenomenal compared to any tlime in the past. Though the response ofdomestic investors was modest (except in RMG sector), still private investment as a share of GDP rose by2 percentage points between FY90 and FY98 to 13.6 percent.27 The liberalized trade and investment

24 Michaely, Choksi and Papageorgiou (1991); Grossman, G. and Helpman, E. (1991); Romer, P. M. (1992),Barro, R.J. and Sala-i-Martin, X. (1995), and Edwards, S. (1998).25 There are also studies, however, that reflect skepticism over the findings of these empirical studies on thegrounds of inappropriate measurement of "trade policy-induced opemness", weaknesses in the methodologies used,and failure to establish the direction of causality: Krugman, P. (1994); Rodrik and Rodriguez (1999).26 For further details of the trade policy on agricultural inputs and outputs and on the related issues, see:Shilpi, F. (1998a, 1998b); Mitchell, D. (1998).27 While there appears to be a slowdown in the growth rate of investment activity in the last couple of years,the reasons for this should not be attributed to trade liberalization but to other factors, including: the recent

Chapter ]: Bangladesh's Trade Liberalization: Has It Been Too Fast ? 15

regime has also given a boost to foreign direct investment, expected to reach $1 billion by 2000-- fromvery modest beginnings in the early 1990s.

1.38 By definition, trade liberalization erodes the protection enjoyed by inefficient domesticproducers, generally with the deliberate aim of opening the economy to greater foreign competition. Thenatural cost should be at least a short-term deterioration in the balance of payments, but Bangladesh didnot experience even that brief reversal. Instead, both the external current account deficits and reserveposition improved following trade reforms. Having averaged 4 percent in the 1980s, the current accountdeficits as a percentage of GDP declined to 2.7 percent in the 1990s. Import growth was evenlydistributed among intermediate, capital and final consumer goods without, contrary to popular belief, theeconomy being particularly 'flooded' with consumer goods. The pick up in exports, expanding at anannual average of 17 percent in nominal dollar terms until FY98, led to a substantial improvement in thebalance of payments position. Foreign exchange reserves rose from about $500 million in 1990 to S 1.8billion at the close of FY98. Indeed, as evidenced in reform episodes elsewhere, gross reservesaccumulated rapidly following trade reforns, rising to a peak of $3 billion in FY95 before decliningagain. Also, there has been no major adverse effects on budgetary revenues as a result of tariff cuts. Theratio of tariff revenues (CD plus the IDS) to GDP has remained stable around 2.3 percent in the 1990s. Itappears that the growth of imports and the introduction of the IDS have more than offset any potentialrevenue losses from tariff cuts so as to stabilize the tariff revenue-GDP ratio.

E. CONCLUSIONS

1.39 Begun in the second half of the 1980s with the dismantling of QRs, Bangladesh's tradeliberalization effort became more comprehensive in the early 1990s, covering protective QRs, importtariffs, other levies, and the exchange rate policy. Rather than speeding up, however, the process ofliberalizing imports slowed down in the mid- 1990s, without a satisfactory degree of uniforrnity inprotection being achieved. Given that incomplete degree of trade liberalization and the good economicperformance that accompanied it, Bangladesh can hardly be said to have liberalized its trade too fast.

* The significant part of import "liberalization" in the 1980s and early 1990s basically amounted tothe still incomplete removal of QRs and of water-in-the-tariff, particularly on final goods. Onceexisting tariffs became binding and foreign competition more effective, however, the processslowed down.

* Given its range of 0-37.5 percent, the current import tariff structure still shows a high degree ofdispersion. Additionally, the tariffs accord industries producing competing final goodssignificant protection, augmented further by other import levies as well as by the protectiveincidence of supposedly protection-neutral indirect taxes. The latter include the supplementaryduty, VAT, and the IDS; asymmetrically applied, they give rise to further cascading nominalprotection. Moreover, with tariff exemptions/concessions and low tariff rates on intermediatesand high tariffs on finished products, the effective protection rates are undoubtedly pushed upsubstantially on final goods, resulting in perhaps greater dispersion in EPRs. Indeed, this appearsto have been a deliberate policy in guiding tariff adjustments in recent years with textiles servingas a very good example of a high effective protection strategy partially offset in practice bysmuggling.

devastating floods and the resulting losses in incomes and jobs, which in turn most likely depressed domesticdemand; difficulties faced in obtaining bank credit as the banks have become more stringent in extending loans;increasing domestic political tension; and the slowdown in international trade in the aftermath of the Asian crisis.

16 Chapter 1: Bangladesh 's Trade Liberalization: Has It Been Too Fast?

* While Bangladesh appears to be one of the faster liberalizing countries in South Asia, behind SriLanka, the region in general and India in particular have lagged behind other regions, even behindsome countries in Africa, in improving the neutrality and liberality of their trade regimes. Indiaappears to have opted for slower integration into global markets. The vastness of India'sdomestic economy and the diversity of its resource base, however, make it a poor trade policymatch for its smaller neighbor. On the other hand, Sri Lanka, more comparable in economic sizeand long committed to global markets and the pursuit of export growth, has been steadilyliberalizing its trade regime. For Bangladesh, Sri Lanka offers valuable guidance to the tempoand content of trade liberalization, lessons that Bangladesh needs to follow so that a strongerexport base and more neutral incentives that further recluce remaining anti-export bias can supporthigher sustained economic growth.

* Going outside South Asia to weigh the experience of other liberalizing countries of the world,Bangladesh's reforms over a period of 8-10 years do not appear particularly fast. In South Eastand East Asia and in Latin America, many countries achieved significant cuts in average tariffsand reduced the range of their lowest and maximum rates over a period of 5 to 8 years.

1.40 The preceding observations are intended to make the point that Bangladesh's trade liberalizationwas not particularly fast. Indeed, accepting that it is difficult to establish satisfactorily whether the paceof Bangladesh's trade liberalization was appropriate or not, the report does not try to pass a definitejudgement on this matter. However, what the report establishes and argues is that the economy'sperformance has markedly improved under trade liberalization, providing also a good reason forcontinuing with the program to further rationalize and simplify the tariff structure.

* Although the precise causal role of trade liberalization in overall economic performance and ingrowth in particular is difficult to determine, available macro-level evidence at least suggests thatBangladesh's economic performance has improved in the 1990s as standard economic modelswould lead one to expect. (For micro-level impacts on manufacturers, see Chapter 3).

* For a country embarking on trade liberalization, initial economic and institutional conditions areobviously crucial determinants of the scope, sequencing, and pacing of trade liberalizationprograms. The soundness of the macroeconomic framework and of other economic policies aswell as the state of the business environment affect economic performance and the prospects ofrealizing expected gains from trade liberalization directly. The fact that Bangladesh has generallymaintained a sound macroeconomic environment has been a positive factor in carrying out tradeliberalization. However, the progress (despite a sufficiently long lead-time and availability ofexternal assistance) in strengthening the financial sector, tackling infrastructure bottlenecks,addressing bureaucratic hurdles, and reforming the SO.E enterprise sector has been slow. Togetherwith external shocks and the prolonged political uncertainty, this foot-dragging has most likelymade attempts to adjust and respond to trade liberalization more difficult, thus limiting thepotential benefits.

* Looking forward, the key objective of future trade reform should be to move beyond enclave-typearrangements to broader trade liberalization. The goal that enclaves realize only in part bycircumventing import restrictions and other impedimenits to doing business should be to lower thedispersion of nominal and effective protection rates and eliminate protective QRs as well as tariffexemptions/concessions. In this respect, the tariff rationalization measures announced with theFY00 Budget--reducing the maximum rate from 42.5 percent (inclusive of the ISD) to 40 percentand the number of tariff slabs from 6 to 4, and harmonizing tariff rates on similar goods--arewelcome developments. However, tariff hikes on some finished goods (e.g., paper pulp and silk)that would increase their EPRs give mixed signals about the future direction of trade policy.

Chapter ]. Bangladesh's Trade Liberalization: Has It Been Too Fast ? 17

Improvements in the business environment would help enhance gains expected from freer tradeby reducing the cost of doing business and strengthening supply response capacity of local firms.

1.41 Before proceeding to the next chapter, it is important to draw attention to an important aspect oftrade liberalization. This concerns the impacts on consumer welfare. Because of its very focussedagenda, no attempt is made in the report to look at the likely size of consumer welfare gains attributable totrade liberalization. Such gains, which are generally substantial, result from lower prices for traded goodsand increased choices that trade liberalization facilitates. Therefore, it is important to remember thesignificant benefits enjoyed by the consumers when the policy debate is carried out on the impacts oftrade liberalization.

Chapter 2 RECENT TRENDS IN FOREIGN TRADE

A. INTRODUCTION

2.1 If Bangladesh has not moved too fast in liberalizing trade, has liberalization nonethelessworsened external balances, flooding domestic markets with foreign goods and thus displacing domesticproduction? This chapter briefly examines those concerns, the claims made in some business circles thatdomestic markets are "flooded" with foreign goods that, by implication, are causing difficulties inexternal accounts and leading to the displacement of domestic production.

2.2 Among the expected consequences of trade liberalization are shifts in resource use towardactivities that exploit comparative advantage and improved production efficiency under the pressure ofenhanced competition. Long-protected and, yet, inefficient firms that cannot attain competitive strengthfind themselves under pressure. They lose markets or, if they are not viable under a more neutralincentive regime, go out of business, costing workers their jobs. Such contractions/displacements arenatural but not universal results of moving to freer markets, but they do not happen across-the-board anddo not go unbalanced by the parallel creation or expansion of job opportunities in the existing as well asin the new fields and activities. If widespread production/jobs displacements were to take place, suchadverse impacts would be reflected in poorly performing aggregate and sectoral growth rates, as well asin sluggish investment activity. As discussed in Chapter 1, this is not the situation in Bangladesh. Boththe overall and sectoral GDPs have registered higher growth rates in the 1 990s than in the 1 980s, and theoverall investment-to-GDP ratio increased by one percentage point, while the private investmentincreased by two percentage points from FY90 to FY98. (These aggregate and sectoral improvements arealso reflected in the firm-level findings discussed in Chapter 3).

2.3 If foreign goods were inundating domestic markets to the point that external balances weredestabilized, then export and import patterns would also show adverse and unsustainable trends inexternal trade and current account balances. What more often happens is that imports made possible bymarket-opening reforms facilitate higher investment activity, stronger export performance, more vigorouscompetition, greater efficiency and, in consequence, economic growth. When there is no sustained surgein imports (particularly of final consumer goods), trade liberalization, ceteris paribus, will not causedestabilizing developments in external accounts. In addition, to understand better the effects of tradeliberalization on the level and composition of imported goods, it is essential to make a distinction betweenlegal imports and foreign goods that are smuggled into the country. Since high protection encouragessmuggling, liberalization may actually reduce those inflows in favor of legal imports. Indeed, inBangladesh many goods that are still highly protected are reportedly being smuggled in from India. Itmay be that it is largely smuggled goods that are "flooding" the domestic markets.

2.4 To explore how these expected effects of trade liberalization have played out in Bangladesh, thischapter discusses the country's recorded (format) and also unrecorded merchandise trade in the formborder crossings with India.' In summary, it may be noted that:

* Bangladesh has become a much more open economy over the past decade or so, a process spurred atleast in part by trade liberalization. The ratio of formal merchandise trade (exports plus imports) toGDP almost doubled to 30 percent between FY90 and FY98.

Of course, the other channel through which unrecorded trade takes place is the under-valuation of shipmentsthrough the regular channels. This part of the unrecorded trade, which might be sizable, is covered only briefly heredue to the lack of information (see the end of the chapter).

20 Chapter 2: Recent Trends in Foreign Trade

* The trade deficit has remained sustainable in the range ojf 5-6percent of GDP, without showing anyupward trend. Growth of merchandise exports (in current US dollars) has exceeded that of imports.The latter have not shown any upsurges. Thus, while in the early 1990s exports financed less than 50percent of merchandise imports, they covered almost 70 percent by FY98. This is a case of favorablybalanced growth of exports and imports, indicating the healthy development in external tradebalances that theory suggests. In this regard, it is worth noting, as in the previous chapter, thesignificant parallels with Sri Lanka, which has gone further than other South Asian countries inoutward-orientation, and has benefited from more openness without facing unsustainabledevelopments in her external accounts.

* The expansion of merchandise imports was concentrated in capital goods, primary goods/rawmaterials and intermediates. These developments have rmost likely facilitated the growth in domesticproduction and exports. Capital goods consistently accounted for around 16 percent of Bangladesh'srecorded imports over the past six years, compared with only 7 per cent for final consumer goods The absence of a surge in final consumer goods imports partly reflects the fact that they are stillhighly protected.

* There appears to be sizable unofficial border trade with India, with perhaps only 25 per cent ofinward smuggling being covered by counter trade and the rest most likely being financed by workers'remittances (readily available in the hundi market). Many of the smuggled items "flooding" thedomestic markets compete with highly protected goods.

B. RECORDED TRADE

2.5 Exports. Formal exports have grown rapidly over the past decade, showing an average annualgrowth rate of about 17 percent (in current US dollars) and reaching over 12 percent of GDP by FY98,compared with only 5 percent of GDP at the beginning of the decade. The growth has been led by evenmore rapid expansion of woven ready-made garment (RMG) "cut, make and trim" assembly than hadalready occurred in the mid/late 1 980s and has been supplemented by a mushrooming knitwear industry.Woven RMG and knitwear together accounted for almost three quarters of total exports in FY98, justover twice their 36 percent share in FY89. Their annual growth over the decade averaged 27 percent ayear, compared with 7 percent for all other exports combined (see Tables B. 1 and B.2 in Annex II).

2.6 Beyond their very strong contribution to foreign exchange earnings, developments in theRMG/knitwear activities have several positive features in terms of efficient industrialization-- andpotential for improvement--especially when compared with the industries like jute and tea which used todominate Bangladesh's exports:

* While value-added may be modest on a unit basis (since the industry must import its fiber, yarn orfabric), it mainly comprises the factor - labor - with which Bangladesh is well endowed, rather thanscarce capital or complex technologies. Moreover, the labor can be harnessed efficiently in fairlysmall units that do not require highly sophisticated management skills.

* At least part of the industry--evidenced by Grameen Check--is supporting backward linkages whichinvolve small and micro enterprise, including rural weavers. The industry holds great potential forbackward linkages with upstream industries that could expand such ties to the RMG sector byimproving the quality and cost competitiveness of their products, an advance they failed to makewhen they were long sheltered by trade protection and ineffective public support programs.

2 This is according to the Customs data, which are "shipment" based. Due to the "leads and lags", tradestatistics based on "payments" show somewhat higher figures for the share of capital goods imports.

Chapter 2: Recent Trends in Foreign Trade 21

* A significant number of entrepreneurs now exposed in some way to world trade are gainingincreased experience in marketing along with knowledge of foreign markets, of information sources,of quality upgrading, product development, and ways to respond to changing demand patterns.

* This same entrepreneurial flourish demonstrates how well the Bangladesh private sector can respondto liberal trade policy - albeit confined to liberalization in the form of SBW/EPZ enclavearrangements designed largely for RMG/knitwear, rather than the more general trade liberalizationthat would have encouraged a range of exporters.

In summary, Bangladesh 'success in RMG/knitwear exports is strong evidence of both the economy'sconsiderable capacity to respond to emerging opportunities under a liberalized and supportive businessenvironment and of the scope for competitive activities based on the abundance of labor.

2.7 While aggregated statistics seem to show export concentration continuing, with theRMG/knitwear products accounting for over 70 percent of merchandise exports, it should be noted thatthe two sets of products are not homogeneous commodity categories. They offer significant scope fordiversification in product variety, design, quality, value-addition, and destination markets, far more thanjute/jute products and tea. In addition, unlike the 1980s, export levels (in current and constant US dollarterms) are rapidly rising--though from a low base-- in an increasing number of product categories. Theseinclude: frozen foods, specialized textiles, leather goods, agricultural products, other manufactures,chemical products, and engineering goods. Their export levels (in current US dollars) have registeredannual average growth rates ranging from 11 percent in the case of frozen foods to 75 percent in the caseof "other manufactures" during FY91-FY98 (see Tables B. 1 and B.2 in Annex II). Reducing coststhrough faster removal of the existing factor market, infrastructure, bureaucratic, and otherconstraints will undoubtedly enhance the pace and depth of this ongoing diversification.

2.8 Imports. Total legal imports have grown in current US dollars at an average annual rate of 12percent since 1989/90, much more slowly than exports' 17 percent. The $7.5 billion import bill in1997/98 was equivalent to almost 18 percent of GDP, compared with around 12 percent during 1989-1994. Again, however, much of the import growth was attributable to the enclave export activities. There-exportable inputs for the SBW units (mainly RMG/knitwear producers) and EPZ firms have grownmuch faster (22 percent annually) than non-enclave imports. The latter registered only a 9.4 percentannual average growth rate, compared with about 12.8 percent for non-enclave exports (see Tables B. 1and B.3 in Annex II for annual data).

2.9 The non-enclave imports comprise mainly raw materials, intermediates, capital goods, and othergoods not produced in Bangladesh -- as well as the final consumer goods that are alleged to have floodedthe market at the expense of domestic producers. During the 1990s, imports of final consumer goodshave remained around 6-7 percent of total recorded imports and 1 percent of GDP, without showing anysustained surge (Table 11.1). Their average annual growth rate was 10.8 percent, compared with 16.6percent for primary commodities, 15.7 percent for capital machinery and parts, 19 percent for othercapital goods (including vehicles), and 7.6 percent for non-enclave intermediate inputs (see Table B1.3 inAnnex II for annual data).3

3 Imports of final consumer goods fell (in current US dollars) significantly during two consecutive years in theearly 1990s (in 1990/91 and 1991/92), and subsequently over the period 1992/93-1994/95 there was a significantrecovery growth and expansion in these imnports, which then leveled off at around $0.5 billion (current) US dollarsduring 1995/96-1997/98.


Table 11.1: Major Categories' Shares of Export andImport Totals and of GDP in Late 1980s and 1990s

% Share of Total % Share of GDPExports or Imports

EXPORTS: 1988/89 19'97/98 1988/89 1997/98Readymade garments and knitwear 36.7 73.3 1.6 8.9Frozen foods (mainly shrimp) 11.0 :5.7 0.5 0.7Jute goods and raw jute 29.5 7.5 1.3 0.9Leather and leather goods 10.7 4.6 0.5 0.6All other exports combined 12.1 8.8 0.5 1.1

Total exports 100.0 100.0 4.3 12.2

IMPORTS:Primary commodities 19.6 18.2 1.7 3.2Intermediate inputs 42.2 27.4 3.6 4.9Capital machinery & parts 10.8 11.3 0.9 2.0Other capital goods 4.0 4.8 0.4 0.9Final consumer goods 8.9 6.6 0.8 1.2Enclave (B/B SBW + EPZ) estimated 14.4 31.7 1.2 5.6

Total imports 100.0 1)0.0 8.6 17.8

Compiledfrom NBR and Export Promotion Bureau data.

2.10 Several other aggregates also indicate that domestic production, including that based on importedcapital and material, was not adversely affected by liberalization-induced imports. Over the decade:

* real GDP has expanded by 5 percent annually-a better record than the 4 percent achieved in the1980s;

* the quantum index of medium- and large-scale domestic manufacturing doubled, reflecting anaverage annual growth rate of nearly 8 percent over a nine-year period;

* most manufacturing activities have registered significant expansion according to these officialquantum indices. Out of the 57 identified (4-digit level) manufacturing activities, only 18 that areimport-competing have shown output contraction in this period. Accounting for about 17 percent ofthe medium- and large-scale manufacturing sub-sector, these contracting activities included vegetableoil, cotton textile, jute textile, paper, insecticides, rubberfootwear, iron and steel basic industries,fabricated metal and some machinery and equipment.

At a more diaggregated level:

* 1997/98 evidence collected from a random sample of manufacturing firms (see Chapter 3) indicatethat employment levels had expanded in the majority of them; only 28 out of 90 enterprises reportedany employment decline-this despite the fact that two-thirds of the firms are import-competingand/or import-intensive. And,

* about half of the 90 firms, including many import-competing, reported undertaking investment forexpansion, diversification, quality improvement, and modernization/replacement. If these firms hadbecome unprofitable because of sustained losses due to tracle liberalization, they would have refrainedfrom investing.


2.11 These macro- and micro-level data and the findings do not support the proposition thatBangladesh's manufacturing production has been displaced generally and significantly by importsduring the 1990s. On the contrary, the import growth spurred by trade liberalization appears to havecontributed not just to export expansion but also to capital accumulation and thus to economic growth.While some import-competing firms may have been adversely affected by trade liberalization, by andlarge the economy in general and the manufacturing sector in particular seem to have performed stronglyduring recent trade liberalization. As elaborated in Section C below and Chapter 3, many of the surveyedimport-competing firms reported that trade liberalization was not necessarily the primary reason for theirproblems. They have been adversely affected by a number of other factors, including domesticcompetition, smuggled goods, financial and management difficulties, infrastructure bottlenecks, politicaluncertainty, and disruptions caused by hartals (or general strikes).

2.12 External trade balances. As detailed in Chapter 1, with trade liberalization Bangladesh'srecorded, formal external trade expanded significantly faster than the economy as a whole. Merchandisetrade alone grew from about 16 percent of GDP in 1989/90 to 30 percent of GDP by 1997/98. At thesame time, due to the faster growth of exports, the formal merchandise trade deficit has been fairlymoderate over the past decade, averaging 5.5 percent of GDP. An important positive development worthemphasizing has been the steady increase in the coverage of imports by exports: in 1997/98, merchandiseexportsfinanced 69 percent of imports, compared to less than 50 percent observed in the early 1990s(Table B. 1 in Annex II). The general improvement in the external current account since the early 1990sand the sustainability of the current account deficit are reflected in the decline since 1990/91 in the ratioof external debt to GDP from about 42 to below 38 percent, and in the debt service ratio from about 13percent to 8 percent.4

2.13 Bilateral trade imbalances. North America and the European Union are the largest customersfor Bangladesh's legal exports, each region taking around $2 billion or 40 percent of all 1997/98 exports(mainly garments of course, especially for North America). Japan and Hong Kong follow with around 2percent each. Neighbouring India, the largest source of Bangladesh's formal imports, now about $800million, buys only a paltry $65 million or 1.3 percent of its exports.

2.14 Indeed, Bangladesh has significant imbalances with most of its individual partners. Excludingthe mainly fabric imports for SBWs (but including their garment and knit exports), significant surplusesoccurred in 1997/98 and previous years with key export destinations: the U.S.A., Germany, France, andthe U.K. On the other hand, large formal trade deficits were recorded with India, China, and Japan, thecountries that are Bangladesh's main suppliers of raw materials, intermediates, capital goods, and finishedconsumer goods. Their proximity to Bangladesh and the availability of highly competitive imports fromthese countries make them preferable sources, in contrast with Europe and North America. Since Indiaand China also compete with Bangladesh for the same export markets, the range of goods Bangladeshcould export to them is inevitably limited. Apart from these seven partners (plus Canada with whichtrade was balanced), the main sources of imports are countries to which Bangladesh barely exports at all:Singapore (mainly entrep6t), Australia, South Korea, Malaysia, Indonesia, Saudi Arabia and Thailand,which together provide almost a quarter of Bangladesh's non-fabric imports.

2.15 Such imbalances are not necessarily a cause for concern. A country can have sizable bilateraltrade imbalances based on the proximity and competitiveness of the source markets, as well as the extentof complementarities/similarities among their tradables. As long as overall external trade balances remainsustainable and in line with a sound macroeconomic framework, even a large trade deficit with a giventrading partner is not detrimental in and of itself. In triangular trade-e.g., China, the U.S.A., and theMiddle East-a trade deficit with one partner is balanced against a surplus with the other. Bangladesh's

4 Also, the present value of Bangladesh's long- and medium-term official debt has declined from around 250percent of exports of goods and non-factor services in the early 1990s to about 158 percent recently, which isconsidered well within the sustainable range.


growing trade imbalance with India, however, carries political costs. Bangladeshi business circles havecriticized the Indian Government for not reducing the high protective QR/tariff barriers and at theGovernment of Bangladesh for liberalizing the trade regime too fast.

Box II.1: Domestic Industrialization Process and the Speed of Trade Liberalization

It has been argued, and also stressed by some of the participants of the September 16, 1999 seminar, thatBangladesh's trade liberalization in the 1990s was rapid because it started at a time when the manufacturing sectorwas still very narrowly-based and the business environment was far from being supportive and the policy changeswere introduced at a fast pace. The argument continues by claiming that, "as a result, most manufacturingenterprises, including a large number of small-scale and cottage industries were caught unprepared for the increasedforeign competition. This has created many 'sick' enterprises and slowed down investment, with adverse impactson Bangladesh's industrialization process. Slower trade liberalization would have avoided these adverse effects".An implication of this line of argument, as noted earlier, is that further trade liberalization should be significantlymore gradual. Some observers add further that "Bangladesh's industrialization process has been led by export-oriented activities, until the 1980s by the jute manufacturing, and since the 1980s by the fast expandingRMG/knitwear industry. As such, export orientation in Bangladesh has not been affected by the policy of insulating jdomestic markets, and that Bangladesh's import substitution strategy has not moved the industrialization processaway from export orientation. Given the large size of the domestic rnarket and the small industrial base, what isneeded is the protection of the domestic producers until they capture domestic markets, become more efficientthrough domestic competition, and start exporting, as was the case in Korea and Taiwan, where temporary supportalso helped the local firms".

First, it is difficult to accept the argument that Bangladesh's protracted import-substitution strategy has notadversely affected Bangladesh's export-orientation and potential export activities. It is true that the jute sub-sectorled the industrialization process, thanks to Bangladesh's comparative advantage and the stronger world demand forjute products until the 1980s. The RMG/knitwear sector has flourished despite the highly protectionist trade regimesinply because of the enclave arrangements that guaranteed these activities duty/tax free access to importedmaterials. However, it is also true that the Govermnent deliberately avoided broad-based trade liberalization for anextended period and the trade regime remained highly restrictive until the early 1 990s. This has discouraged thedevelopment of other potential export industries due to the significant anti-export bias, thus limiting the extent ofexport diversification. What the import-substituting policy has done, however, was to lead to the creation of manyinefficient activities and firms, which are now complaining about trade liberalization and blaming it for their"sickness". A legitimate question that needs to be raised is "why have these firms failed to improve their efficiencyafter such a prolonged period of protection and despite the fiscal/financial support?". One highly plausible answeris that this was because of the inward-oriented, protectionist policy which continued far too long. The Governmentis apparently providing some subsidies to these supposedly ailing enterprises to exit or adjust. The appropriatenessof such a policy needs to be reviewed, because most of these sick enterprises have performed very poorly despite all t

the support. Using budgetary resources to support unviable or poorly managed firms does not appear desirable.

Second, the import substitution strategy and the protectionist trade regime have a long history in Bangladesh, andvanous support programs have also been employed to promote domestic industries --including directed credit and fiscalincentives. Unlike East Asia, these policies have in general failed in promoting wide-scale efficient import substitutingindustries in Bangladesh. A very telling example is the textile industry, which still enjoys very high protection. Yet, asnoted above, it has not been able to become an efficient, competitive activity, and dismally failed in exploiting the hugedemand generated for its products by the RMG/knitwear sub-sector. Why should then Bangladesh try to maintain such apolicy that has so far not produced good results. The culprit is not trade liberalization. The prolonged protection,direct/indirect subsidies, and the unpaid bank loans have all allowed many inefficient firms to survive, and these are thepolicies that should perhaps be blamed for Bangladesh's slow and inefficient industrialization.

Third, as detailed in Chapter I and in this chapter, available aggregate evidence on GDP growth, investment activity,and macroeconomic balances, as well as the data on manufacturing GDP and output growth support the view that tradeliberalization has contributed to Bangladesh's improved economic performance in the 1 990s. Firm-level findings reportedin the next chapter show gains in productivity and efficiency under trade liberalization. As expected there are somedeclining activities and some contracting and exiting firms, but the general outcome for the 1990s is an improved overalleconomic performance. The evidence simply does not show wide-spread displacement of domestic production under tradeliberalization.


C. TRADE WITH INDIA

2.16 Official trade. Recorded imports from India generally comprise intermediate goods, notably thecotton yarn and cement that accounted for 10 percent and 8 percent respectively in 1997/98. When a ricecrop failure in Bangladesh occasions a surge in imports from India, emergency purchases such as those inthe second half of the 1990s tend to exaggerate the level of Indian sales. For example, in 1997/98Bangladesh imported over $200 million worth of rice from India, 27 percent of that year's total importsfrom India (Table B.4 in Annex II). After imports of rice, yarn and cement, the next 12 items accountedfor between 1 percent and 3 percent each (tyres and tubes, flat steel products, raw cotton, aluminum, dyes,nucleic acids, textile machinery, onions, coal, animal feed, transformers, and phosphatic fertilizer). Inother words, two-thirds of total purchases from India are spread over hundred of other goods. Of theimportant items in 1997/98, the first nine--along with soya oil, apples and occasionally salt and chilies -were relatively more important at the beginning of the decade.

2.17 Still, there is no denying the large imbalances in Bangladesh's trade with India. Someguesstimates of informal border trade indicate that Bangladesh's exports might be covering about 25percent of informal imports from India. For the formal trade the export coverage is only about 10 percentof merchandise imports from India. Although some observers find that ratio surprising, the reasonsbehind it are both various and obvious. For instance:

* India has a far larger, much more diversified industrial sector than Bangladesh. Even Indianproducers of consumer goods that are still highly "protected" by pervasive QRs can profit from legalexports to Bangladesh and elsewhere. India's large domestic markets either (a) support sufficientcompetition to yield product prices (and quality) much closer to world prices than implied by the(notional) import protection, or (b) facilitate discriminatory pricing practices for those firms seekingscale economies. They are able to sell abroad cheaper than at home and thereby both bring downtheir average costs and gain market shares abroad.

* Indian suppliers enjoy a great transport cost advantage over more distant sources, a geographical assetexacerbated by the high cost of sea transport to and handling in Bangladesh ports. Indian exporterscan use either land transport or coastal ships with lower opportunity costs than intemational vessels.

* By retaining QRs on many consumer goods, India has kept its markets closed to the type of consumergoods that Bangladesh might be able to produce and supply competitively. Bangladesh, by contrast,has dismantled its protective QRs on all official imports except textiles.

* Finally, India's real exchange rate has depreciated faster than Bangladesh's during both this and theprevious decade, making Indian exports more attractive to Bangladeshi importers and Bangladesh'spotential exports less competitive in Indian markets. India's real effective exchange rate (REER)depreciated by 35 percent during 1990-1998, while Bangladesh's appreciated by 4 percent. Similarly,India's bilateral real exchange rate (RER) vis-a-vis the US dollar depreciated by 33 percent over thesame period, far exceeding Bangladesh's 9 percent depreciation (see Table 11.2).

2.18 In reality, the large trade deficit with India does not appear to have any major adversemacroeconomic consequences and, if not with India, would probably have appeared, perhaps as evenlarger imbalances with any other trading partners that supplied Bangladesh the raw materials,intermediate inputs, capital goods, and essential food items that it needs and needed. In the case of someindividual items, tariff cuts in Bangladesh have most likely increased demand for such goods and alsotheir import from India. Cotton yarn is an example. Increased cotton yarn imports (both formal andinformal) might have adversely affected some domestic firms that have remained inefficient despite yearsof protection. Against this, cheaper and higher quality imported cotton yarn (and other textile inputs)have supported competitive downstream activities and their export performance.


Table II.2: REERs and RERs: India and Itangladesh (1990=100) \a

eeme 1 of: 0RS0i01980 1990 1996 1998 j

REER:India 54.1 100.0 132.7 135.1Bangladesh 90.8 100.0 105.6 96.3

RER (against $US):India 66.9 100.0 133.3 133.4Bangladesh 82.9 100.0 109.4 108.8

Source: International Monetary Fund. Ia . Increases represent depreciation.

2.19 To complain about a large and growing trade deficit with a single partner is legitimate,particularly when India, the exporter, does not reciprocate Bangladesh's unilateral liberalization.Halting or reversing the reform process, however, would be iniappropriate and more damaging than theimbalance itself. Bangladesh will gain by not linking its economic policies to the action or inaction ofany specific trading partner. Instead, its task is to follow the relevant example of Sri Lanka and addressthe internal obstacles to doing business in Bangladesh. Progress in that area would set the stage forBangladesh, when the MFA is eliminated in a few years time, to maintain and even expand her foreignmarket shares in the important RMG and knitwear activities. IHolding and enlarging its competitivereach will depend on improving its business environment and on ensuring that policy reversals do notjeopardize the competitiveness of these activities. More importantly, an improving business environment,a flexible exchange rate policy and a resumption of broader trade liberalization that cuts the remaininghigh dispersion in nominal and effective protection rates could hasten the badly needed furtherdiversification of domestic production and exports in areas where there is comparative advantage.

Box 11.2: Trade Deficit with India

The large and increasing trade deficit with India has attracted significant attention from Bangladesh's businessand government circles. It was also an important topic of discussion at the September 16, 1999 seminar. In thepreceding section it is argued that the large deficit in formal trade with India should not be a concern in and of itself,given Bangladesh's sustainable overall trade balances. This is a result of Bangladesh's own huge trade surpluseswith the U.S.A. and Europe. In fact, by being able to meet some of its sizable essential import needs from India,including rice during times of poor harvest, Bangladesh has obviously been able to lower its import costs due toIndia's proximity and competitive export prices.

Bangladesh has good reasons to complain about India's still high barriers to its potential exports, but it standsto benefit from using bilateral and multilateral policy dialogue options and avoiding any backtracking in its tradeliberalization program.

There is also the perception held by some circles in Bangladesh that trade liberalization is the cause of a largeinformal border trade deficit in favor of India. This is simply wrong. As elaborated below, one of the principalreasons for the sizable in-bound smuggling is the remaining high protection on imports of most consumer goods.

2.20 Border smuggling. The sizable unofficial border trade with India has been a subject of anumber of studies. A recent survey and analysis by Rahman, A. and Razzaque, A. (1 998)5 focused on justfive of the approximately 50 thanas with important border crossing points. Due to the small number ofpoints covered, the study's estimates of the inflows and outflows may not be extrapolated to provide

5 Rahman, A. and Razzaque, A. (1998), "Informal Border Trade between Bangladesh and India: an EmpiricalStudy in Selected Areas", for the Asia Foundation, administered by Democracy in Development, Inc., (July).


accurate national data. On the other hand, it examined the smuggling mechanisms and commoditycomposition in more detail than previous studies with wider reach (Gafur, Islam and Faiz, 1990 and19916; Bakht, 19967; and Alam and Cookson 19958). Thus, its data provide a basis to derive some"guesstimates" of the magnitude of the whole unofficial border trade in 1997/98 and the significantchanges in its structure and size since 1994.

2.21 The 1998 study estimates the annual value of unrecorded commodity imports through the fivesurveyed thanas at $185 million, suggesting that the value for the whole border could be at least as largeas the official US$800 million trade or even twice that amount. In sharp contrast, the five-thana estimatefor commodity exports including gold (the largest item) is only about $41 million, nationally perhapsbetween $0.2 and $0.5 billion. Suggesting a considerable increase in illegal trade since 1994, theseextrapolations also imply a much larger imbalance in unofficial border trade in favor of India. Thatdeficit must have been financed at least in part by sizable amounts of workers' remittances diverted fromofficial channels to the "hundi" market.

2.22 Recent findings also show a general similarity with the past composition of illegal imports aswell as a few changes. Cattle was and remains the largest category. Other important imports include:food items (sugar, rice, pulses, milk powder, spices, salt); textile products (sarees, shawls and cardigans,and thaan cloth); spare truck parts that now appear to have become a relatively more important categoryof smuggled goods; bicycles and parts; timber; phensidyle (increasingly used as a recreational narcotic);ceiling and table fans; and toothpaste. Less important items include various consumer goods such ascosmetics, toiletries, utensils, electrical products and various other items that are also produceddomestically. On the export side, gold appears to be the single largest commodity, accounting for one-third of the five center's exports. Just four other groups made up most of the rest: electronic goods andVCRs, other metals (copper and brass), hilsha fish, and high-count yarn (a re-export, perhaps leakedfrom SBWs).

2.23 This smuggling of sizable amounts of food items, some textiles and other manufactured goods(medicine, car and truck parts), and a few other consumer goods reflects the persistence of protection notthe liberalization of trade. While many of the foreign goods in Bangladeshi markets are smuggled, atleast some of them are items that continue to be subject to high protection against formal imports.Increased smuggling activity induced by high statutory protection levels is rendering the intendedprotection partially ineffective. It is not evidence of failure in trade reform. At a high cost in lostBangladesh customs revenues, Indian exporters profit from the informal border trade for the same set ofreasons that apply to official trade.

2.24 As to the impact of the contraband on domestic industries, adverse effects seem rather limited:

* First, a very substantial proportion--perhaps around two-thirds--of the smuggled goods is made up ofcattle, rice, pulses, sugar, timber, milk powder, and illegal drugs that do not compete with domesticmanufacturing industries, let alone with ones which could conceivably become internationallycompetitive.

* Textile goods not yet subject to official trade liberalization fall into a second large category--reportedly accounting for about one-quarter of the illegal traffic. Because of the high level ofprotection through QRs, "tariff values" (TVs), and/or high tariffs, "duty free" smuggled goods are

6 Ghafur, A., Islam, M. and Faiz, N. (1990), "Illegal International Trade in Bangladesh: Impact on the DomesticEconomy", Phases I, BIDS; Ghafur, A., Islam, M. and Faiz, N. (1991), "Illegal International Trade in Bangladesh:Impact on the Domestic Economy", Phases II, BIDS.7 Bakht, Z. (1996), "Cross Border Illegal Trade in Bangladesh: Composition, Trends and Policy Issues", BIDSfor the World Bank, (data for 1994).8 Alam, N. and Cookson, F. (1995), "Cross Border Trade with India", (mimeo).


able to compete with domestic production. If quantitative r estrictions on legal imports were removed,tariffs lowered, and VAT imposed effectively on all final domestic sales, the smuggling trade couldbe severely undermined and modest protection made effective.

* Most of the remaining bootleg items are concentrated in a very narrow range of products: truck parts,bicycles, fans, mustard oil, toothpaste, salt, and bicycle tires, whose Bangladesh producers comprise afairly small but vocal section of manufacturing. And for all the other smuggled manufacturedproducts --e.g., shaving and face creams, stainless utensils, and razor blades-- the volume of suchimports appears to be very small for each item relative to domestic production. Of course, many ofthe products in this third group are still subject to very high tariff/tax rates--in the 50-55 percentrange-- and/or inflated TVs when imported legally. Just as for textiles, lowering those tariffs andimposing VAT at the retail-end would probably benefit affected Bangladesh manufacturers byreducing incentives for smuggling.

2.25 Under-valuation. Much less is documented on the magnitude and composition of "technicalsmuggling" than is known/guesstimated about the unofficial border trade. Under-valuation allegedlytakes two forms: false declarations that go uncorrected by inefficient or corrupt Customs valuation staff;and, seemingly much less significant despite frequent allegations of its importance, "dumping" which isnot corrected by the prevailing "tariff values" system.

2.26 Strong anecdotal evidence supports the frequency of false customs declarations. The pre-shipment inspection (PSI) scandal that came to light in 1996/97 revealed scams with respect to imports ofsecond-hand cars and perhaps also edible oil and other items. Although much of the blame for the fraudfell on the importer-employed PSI agents, the disclosures suggest an established practice of under-valuation that predated the voluntary PSI scheme and adapted tco it. A general recognition of this cultureexplains the tenacity with which successive governments have retained the notorious tariff-value systemdespite its deficiency in combating pervasive importer efforts to evade high tariffs and taxes on imports.In fact, the system's malfunctioning shows that an inefficient or corrupt Customs administration can befar more damaging to the profit levels and competitive success of some relatively efficient import-substituting producers than trade liberalization. For example, unless the posted level of protection is verylow, a producer willing either to deceive or conspire with corrupt officials may be able to close down acompetitor by paying less than the due payment of duty and tax on its imported inputs. Indeed, rivalproducers may have more financial incentive to engage in such practices than the commercial importersof goods competing with domestic production.

D. CONCLUSIONS

2.27 Bangladesh's trade liberalization during the 1990s has opened its markets to goods from abroadand opened opportunities abroad for its manufacturers without p:roducing either an unsustainable trend inthe merchandise trade deficit or even a flood of imports harmful to domestic producers. On the contrary,as trade has risen in relation to GDP, exports have successfully covered a much larger proportion ofimports and the trade deficit, as a share of GDP, has remained stable. Moreover, the macroeconomicevidence discussed in Chapter 1 suggests that far from harming the economy, trade liberalization has, ifanything, most likely been a positive factor behind Bangladesh's relatively stronger macroeconomicperformance in the 1990s.

2.28 As the economy grew stronger, however, imports of final consumption goods as a share of totalimports remained stable. On the other hand, purchases of raw materials, intermediate inputs, and capitalgoods from foreign suppliers rose markedly indicating that trade reform stimulated the kind ofmerchandise imports that domestic manufacturers could use to produce added output for sale at home andabroad. Trade liberalization, in short, opened no floodgates to foreign goods that displaced domesticproduction. Instead,


* The macro-level evidence shows no widespread production displacement. Both the official statisticson production trends in manufacturing industries, as well as findings based on a survey of a sample ofenterprises indicate that most manufacturers have continued expanding production, capacity, and alsoemployment. Not surprisingly, some producers of cotton textile, vegetable oil, paper, insecticides,rubber footwear, basic iron/steel and metal products, and some machinery and products-- allenterprises in the import-competing manufacturing sub-sectors-- have reduced output andemployment levels. Despite a long period of protection, a subset of enterprises in these fields appearto have failed to improve their efficiency and competitiveness; many still try to operate with outdatedmachinery. These are the firms now feeling the sharpest competitive pressure from tradeliberalization and smuggling.

* Indeed, smuggled goods might have caused difficulties for some of these import-competing activities,given that the contraband comes in "duty/tax free". Some of the surveyed enterprises in textiles,flour milling, vegetable oil, and salt specifically noted having to compete with smuggled goods.

2.29 Those illegal imports can be traced to high protection levels, not to lower tariffs, a cause-and-effect relationship that indicates the relative ineffectiveness of existing statutory protection measures andcarries with it substantial losses of customs revenues. Eliminating QRs on textiles imports and reducinghigh tariffs on finished consumer goods would help divert illegal trade into official channels, generatebudgetary revenues, and also provide some nominal protection to such products. In this regard, thedecision to reduce the maximum rate with the FYOO Budget is a small step in the right direction. Veryhigh nominal protection deters legal imports while inducing the entry of smuggled goods that avoid notonly the protective duty but also the VAT which domestic producers must pay. Lower tariffs, byreducing the incentive for smuggling, could benefit the producers of goods like sarees, other textile items,sugar, salt, pulses, bicycle and truck parts, fans, and toothpaste, which would have at least some nominalprotection.

2.30 Measures that need to be taken in combination to combat smuggling and under-valuation fall intothree groups:

* First, thefiscal incentive should be reduced both through lowering high customs duty rates andthrough basic changes in the VAT administration. The latter requires both strengthened enforcementand moving the collection point as close as possible to the retail end so as to tax smuggled goodsequitably with domestic products and legal imports. Indeed, an effective retail-level VAT would be agood instrument to curtail smuggling.

* Second, determined policing efforts are needed, backed by strong political will. The Government'sown agents must be made to end the support they now provide to the illegal border trade, andsmugglers and their allies must be vigorously pursued and prosecuted.

* Third, to deal with technical smuggling, i.e. the undervaluation of imports that do pass throughofficial channels, in the short term the Government needs to contract reputable agents to operate aneffective pre-shipment inspection (PSI) scheme while it automates and otherwise modernizes theCustoms service itself. The introduction of the compulsory PSI system proposed in the FYOO Budgetwill provide an opportunity to move in this direction.

2.31 Recent developments in formal trade show a sizable trade deficit in favor of Bangladesh's largestimport supplier, India. Proximity and competitiveness of Indian goods as well as much fasterdepreciation of India's real effective exchange rate are among the factors that explain this outcome.Given that the overall external trade balances of Bangladesh are on a sustainable path, a large trade deficitwith India is not, on its own, detrimental to Bangladesh which would otherwise have incurred similar oreven larger deficits with other countries. Therefore, halting Bangladesh's broader trade liberalization orreversing it in response to India's failure to reciprocate Bangladesh's unilateral liberalization would not


be in the best interest of Bangladesh. Bangladesh's economy has generally benefited from economicliberalization, increasing openness, and moves toward neutrality of market incentives. In a period ofstrong liberalization and globalization that has been sweeping most countries and markets (soon toinclude textiles under the MFA), Bangladesh's trade/industrial policies should mirror those of Sri Lanka,not India.

IMPA CTS OF TRADE LIBERALIZATION ONChapter 3 TECHNICAL PROGRESS AND EFFICIENCYIN

MANUFACTURING INDUSTRIES

A. INTRODUCTION

3.1 The removal of trade barriers makes domestic markets more competitive, which in turn induceslocal firms to become more efficient in input usage. Improvements in technical efficiency could resultas firms reduce input wastage and increase capacity utilization, and exploit the available scaleeconomies' as markets expand. As a result, domestic firms could produce more with the given amountsof inputs and thereby reduce costs of production. Similarly, firms may intensify their efforts to useinputs in optimal proportions in line with the changing relative input prices, hence improve their internalallocative efficiency. Such production efficiency gains in input usage enable firms to "catch up" withthe efficient production frontiers, or catch up with the most efficient (or "best practice") firm(s) in theactivity/industry. Trade liberalization could also trigger shifts in resources towards activities whichbecome relatively more profitable as a result of tariff cuts and dismantling of QRs. By encouragingresource movements towards more profitable lines of production and more efficient firms, the removalof trade barriers could contribute to improvements in resource allocation efficiency and pave the way toproduction patterns more in line with the country's comparative advantage.

3.2 Another important channel through which the removal of trade barriers could benefit theeconomy is the increased availability of new technologies, new products/capital goods, andideas/knowledge about improved production processes, management, product designs, and quality. Byfacilitating the inflow of new technologies, improved machinery, knowhow, trade liberalization couldhelp generate gains in productivity through the employment of better and improved productiontechniques, through learning-by-doing, and increased opportunities for imitation/innovation. In short,freer trade could lead to productivity gains in the economy through technological changes/progress,which would make inputs more productive. Such expansion in production possibilities could beobserved by looking at the performance of the most efficient/dynamic and fast adjusting enterprises,which set examples and shift production frontiers outward by responding to and exploiting quickly thenew incentives and opportunities created by the removal of trade barriers. These two forces--technicalefficiency gains ("catching up" with the efficient production frontier) and technological progress(which shifts the efficient production frontiers)--together enhance the productivity of inputs, leading togrowth in total factor productivity.

3.3 The above description of the likely positive impacts of removing trade barriers needs to bequalified however. Productivity gains associated with the induced improvements in technical efficiencyat the firm-level and those resulting from technological changes will be moderated or curtailed due to:limitations on the mobility of factors of production caused by, e.g., highly restrictive labor laws andinefficiencies/weaknesses in the financial markets; a lack of well developed secondary markets forsecond-hand capital goods; regulatory constraints to market exit; and significant infrastructureconstraints and bureaucratic bottlenecks.3 Moreover, such business environment constraints might alsoaggravate the adjustment difficulties of those firms that have remained insulated behind high protectionwalls for a prolonged period and now are exposed to intensified competition. Particularly, those import-competing firms that are highly inefficient and slow to adjust due to their own internal inertia could facehigher dynamic adjustments costs as they try to contract their output/employment levels or try to exit themarket.

This refers to as "pure" technical efficiency.2 Refers to "scale efficiency".

For further details on country experiences and analysis, see: Michaely, et al. (1991), and Rodrik (1992).

32 Chapter 3: Impacts Of Trade Liberalization On Technical Progress And Efficiency In ManufricturingIndustries

3.4 The objective. The purpose of this chapter is to report on the findings of a quantitativeinvestigation carried out to examine the impact of trade libera.lization in the 1990s on the productivity ofmanufacturing enterprises. To this end, an attempt is made to examine the changes in technicalefficiency and technological progress experienced by a sample of manufacturing firms over the period1992/93 (pre-liberalization) and 1997/98 (post-liberalization), using firrn-level survey data for these twoseparate years on inputs, outputs, and costs. The information obtained from computations on technicalefficiency changes and technological progress is then used to construct indices of total factorproductivity (TFP) and to calculate changes in these indices to see which of the surveyed enterprises andgroups of activities experienced total factor productivity growth (TFPG) during this period.

3.5 The quantitative analysis described above is intended for finding out whether the expectedimpacts of trade liberalization on relative technical efficiency and TFP growth have been experienced inBangladesh, noting however that full "causality" can not be established in view of the diverse factorsaffecting business performance, as alluded to in the previous chapters. If the results show that most ofthe enterprises surveyed experienced positive TFPG, then it could be argued that in general tradeliberalization has benefited manufacturing enterprises, although some firms might have been adverselyaffected. The expectation is that export-oriented firms as well as more efficient import-competingenterprises would experience gains in relative technical efficiency and TFP, as they would be moredynamic, quick to adjust, and better conditioned in coping with competition. At the same time, it isexpected that inefficient import-substituting firms would be adversely affected as protection levels comedown. By failing to improve their relative efficiency, such inefficient firms will lag behind in catchingup with the more efficient and dynamic firms-- they may adjust by contracting, if not exiting the marketor switching to other activities.

3.6 Approach and the methodology. The survey data collected for 1992/93 and 1997/98 for asample of 120 manufacturing enterprises were used to calculate changes in technical efficiency and totalfactor productivity (TFP) of the surveyed firms; (computations were carried out only for 82 firms, forwhich comparable data could be established). To derive analytically more meaningful results, theenterprise-specific computations are carried out and presented on the basis of the categories of activitiesin which they are grouped. These categories are determined according to market-orientation (as well asimport-intensity) of the surveyed enterprises. Specifically, they include: export-oriented, import-competing, import-intensive, and non-traded production activities; (see Appendix at the end of thischapter for further details on the survey data and the methodology used).

3.7 First, for each of the two observation years (1992/93 and 1997/98), technical efficiencyindicators are calculated relative to the efficient production frontiers that are constructed from theenterprise data on actual input-output observations, which make up the production possibilities set. Theefficient frontier in each time period represents the "upper" boundary of the relevant production set ofthat period and it reflects the production performance of the most efficient ("best-practice") firn(s) andtheir technology. The quantitative technique used in estimating the relative technical efficiency andtechnological progress indicators does not assume any pre-determined production relationship, but itconstructs efficient production frontiers (envelopes) from the input-output relationships of the mostefficient firms;4 (technical details of the approach are given in Annex III). The "relative" technical

4 In short, the frontier represents the set of best-practice observations. This means that no other production unit (orlinear combination of units) produces as much or more of every output without changing the input quantities used; ( a similarinterpretation applies if we were to describe the frontier in terms of input-orientated efficiency).5 To carry out the computations involved in the construction of efficient production frontiers, in obtaining relativetechnical efficiency and technological progress indicators, as well as in deriving TFP changes, a non-parametric programmingmethod is applied. This activity analysis method is based on the approach developed and applied by Fare et al (1994), using alinear programming approach. The relevant technical details-- pertaining to the definitions of technical efficiency (and itscomponents, i.e., "pure" technical efficiency and scale efficiency), technological change, the TFP change as a product of the

Chapter 3: Impacts Of Trade Liberalization On Technical Progress And Efficiency In Manufacturing 33Industries

efficiency indicators that are calculated have a simple interpretation: if a firm in a given observationyear was operating at less than optimal possible efficiency, then the relative technical efficiencymeasure shows the ratio of the observed to maximum possible output. For example, if the computedrelative technical efficiency (TE) measure for a specific firm is 0.85, it indicates that this particular firmproduced only 85 percent of what is potentially possible maximum output; had it operated as efficientlyas the best-practice firm within the group, it would have raised its production by 15 percent of themaximum level or could have produced the same output level with less inputs. If the relative TEindicator equals 1, then this implies that the firm is efficient and already on the frontier.

3.8 A second exercise is carried out to calculate indices of TFP change between 1992/93 and1997/98, with a view to examining whether or not the trade liberalization might have led toimprovements in total factor productivity. Such enhanced productivity would result from technologicalprogress (technical changes) and gains in technical efficiency (due to the induced "catching up" with thebest practice firms). Trade liberalization would be a significant factor leading to technological changesby facilitating: greater access to new technology (embedded in imported machinery), know-how(through increased interaction with foreign markets and increased volume of trade), higher qualityimported inputs, and increased scope for imitation and learning-by-doing. And by exposing thedomestic markets to foreign competition, trade liberalization would induce firms to improve theirefficiency. In this process, best practice firms in the post-liberalization period would have been the onesresponding more quickly to greater access to imported inputs/capital goods, changes in the domesticrelative prices and to increased competition, and would have led the way in technological change during1992/93-1997/97 and in pushing the efficient production frontiers outward. It is worth noting that themost efficient firm(s) in 1992/93 and 1997/98 would not necessarily be the same ones; the methodologyused here finds the most efficient ones for each of the observation years on the basis of the enterprisesurvey data on inputs and outputs.

3.9 In the study, these quantitative results are complemented by the qualitative assessments andobservations made from direct interviews held with the owners/managers of the surveyed firms as wellas from responses received to questions related to the business environment.

B. RESULTS

Technical Efficiency

3.10 The results indicate that export-orientedfirms have in general improved their relative technicalefficiency, with the (unweighted) average indicator rising from 0.88 in 1992/93 to 0.95 in 1997/98 (seeTable I1I.1 and Chart F for aggregate results). Findings also show that the principal source of this gainis the improvements in relative scale efficiency--related to the scale of production. Compared to1992/93, in 1997/98 pure technical efficiency is showing only a slight regress relative to the mostefficient firm(s) of the later year. This outcome could be interpreted as indicating that export-orientedmanufacturing firns have generally adjusted faster in closing the relative gap with the best-practicefirmn(s) or the frontier, which itself also shifted outward. Note, however, that the export-orientedfirmshad smaller gap (closer convergence) with their own group efficiency frontier in 1992/93 than theimport-competing firms, and that in the subsequent years the stronger catching up has made thisconvergence even closer (Chart F). This finding is consistent with the expected outcomes. Havingbeen already exposed to export markets and intensive competition, it is expected that export-orientedfirms would have started with smaller gaps from the most efficient firms in their own sub-group, andthat they would in general show faster adjustments to changing relative prices and market competition.

latter two changes, the Malmquist productivity indices, and the formulation of the programming problems--are presented inAnnex III.

34 Chapter 3: Impacts Of Trade Liberalization On Technical Progress And Efficiency In ManufacturingIndustries

At the enterprise level, the results show that almost all firms in the export-oriented categoryexperienced improvements in their scale efficiency. With respect to the relative efficiency in inputusage (i.e., pure technical efficiency), two finns showed iimprovements (faster catching up with themost efficient firm(s)), while two others showed increasing relative gap, reflecting sloweradjustment and catching up. (For firm-level detailed results, see Table III.3).

Table III.1: Technical Efficiency Measures: 1992/93-1997/98[Relative to their own-group (separate)frontier]

Efficiency measures - TE PTE SE

Group (obs.) 4- 1993 1998 1993 1998 1993 19981. Market OrientationExport (8) 0.88 0.95 0.98 0.96 0.89 0.99Import (61) 0.81 0.65 0.87 0.77 0.93 0.85

Import competing (47) 0.81 0.66 0.87 0.80 0.93 0.83Import intensive (14) 0.84 0.63 0.88 0.67 0.96 0.94

Non-tradable (13) 0.89 0.72 0.93 0.76 0.96 0.962. Size

Small (27) 0.83 0.60 0.90 0.76 0.92 0.79Medium (38) 0.84 0.72 0.88 0.77 0.96 0.94Large (17) 0.81 0.79 0.91 0.88 0.89 0.90

3. CityChittagong (28) 0.81 0.77 0.87 0.80 0.94 0.96Dhaka (45) 0.83 0.64 0.90 0.77 0.92 0.83Khulna (9) 0.88 0.72 0.92 0.77 0.96 0.94

TE: technical efficiency; PTE: pure technical efficiency; SE: scale efficiency

Table 111.2: Decomposition of the TFP Change between 1992/93 and 1997/98[Estimated relative to separate (group-specific) frontier]

TFPCH TECHCH EFFCH PTECH SECHASl $2, W 153 G S 0:89 0R .9$'1. Market OrientationExport (8) 1.17 1.08 1.09 0.98 1.12Import (61) 1.29 1.57 0.82 0.89 0.92

Import competing (47) 1.34 1.59 0.84 0.93 0.90Import intensive (14) 1.12 1.47 0.76 0.78 0.98

Non-tradable (13) 1.39 1.72 0.81 0.82 1.002. Size

Small (27) 1.24 1.68 0.73 0.85 0.87Medium (38) 1.34 1.55 0.87 0.89 0.98Large (17) 1.27 1.30 0.98 0.96 1.01

3. CityChittagong (28) 1.45 1.52 0.95 0.94 1.02Dhaka (45) 1.22 1.56 0.78 0.87 0.90Khulna (9) 1.17 1.42 0.83 0.83 0.99

TFP: total factor productivity; TFPCH: total factor productivity change;TECHCH: technological change; EFFCH: efficiency change; PTECH: pure technical efficiencychange; SECH: scale efficiency change.

3.11 In contrast, import-competing and non-tradable goods enterprises have generally showndeclining technical efficiency relative to the best practice (or most efficient) firm(s) in their own-group,indicating that they have in general lagged behind the fast adjusting, best practice import-competing


firms during this trade liberalization period. In other words, the gap between the TE of an averageimport-competing firm and that of the best-practice import-competing firm(s)--or what is potentiallypossible in terms of efficient use of inputs--widened, although these firms might have neverthelessimproved their absolute efficiency over the period 1992/93-1997/98. Specifically, the results indicatethat relative to the best practice firm(s), average relative technical efficiency measure fell from 0.81 in1992/93 to 0.66 in 1997/98 for import-competing firms, and from 0.89 to 0.72 for non-tradable goodsfirms. A similar result holds for import-intensive enterprises, many of which are import-competing.

Chart F: Relative Technical Efficiency: 1992/93 and 1997/98

1,2 1Best Practice Firm(s)

1.4 Best Practice Firm(s)

1.2- 0.8 - O Export oriented1.0 -

. .... 0.5 , Import competing

O.: 0. E Import intensive0.4

0.202

0 0 0.0

1992493 1997-98

3.12 Why have import-competing and non-tradable goods producing firms shown slower adjustmentand catching-up with the most efficient firm(s) in their own sub-sectors during this period? As pointedout earlier, this should not be seen as an unexpected result. Many of these firms have remainedinsulated from intensive competition due to the trade barriers, and have survived despite their growinginefficiencies and obsolete machinery. With the reductions in trade barriers, these firms started facingcompetitive pressures-- some were already facing it from smuggled goods-and have had difficulty inachieving faster improvements in their TE in input use, thus regressing relative to more modem,dynamic and better managed enterprises in the same sub-sectors. (As elaborated below, the findingsindicate that the import-competing firms on average experienced faster technological progress, but somemanufacturing firms failed to keep up). Evidence collected from direct interviews indicate that otherfactors related to business environment have in general been more important in affecting theirperformance and thus also adversely affecting their response capacity to trade liberalization (these areelaborated on below).

3.13 It is worth emphasizing that not all import-competing and non-traded goods producing firmsexperienced declining relative TE. Indeed, 13 out 61 import-competing/import-intensive firms appearedto have shown gains in their relative TE (see Table 111.3). As detailed below, it is also important to notethat the majority of import-competing/import-intensive enterprises showed positive TFP growth duringthis period. This is an evidence of technological change and an indication of more efficient use ofinputs (in some cases) when compared to 1992/93.


Chart G: Total Factor Productivity Change Between 1992/93 and 1997/98 and its Decomposition

Total Factor Productivity Change Technological Change Efficiency Change

2.W0 2.00 2.00 l E Export oriented1.70-

5 1.75 1.7S 01 Import competing1.50 15

1.25 125- 125 X Import intensive

0.75O�75-0.75

0.0 0-0 0.50-

0.5 025--0.25L

0.00 .000

1992/93. 1997/98 1992/93 .1997)98 1992/93-1997)98

Total Factor Productivity Growth (TFPG)

3.14 Turning to changes in TFP over the period 1992/93-1997/98, results show that on average thesample finns experienced a TFP growth of 29 percent in five years (about 6 percent annually). Thiswould imply that in 1997/98 an average firm was more productive than in 1992/93, capable ofproducing more with the same amount of inputs (see Table 111.2 and Chart G). As noted earlier, thiscould have been due to many factors, including technological progress, learning-by-doing, betterquality inputs, induced improvements in management and teclnical efficiency. While not claiming fullcausality, it could be argued that trade liberalization has most likely induced at least some of thesepositive changes. Indeed, if the multitude of adverse developmnents that occurred during these five yearsare considered, trade liberalization could be credited for inducing TFPG in these surveyed finrs--andmost likely in the rest of Bangladesh's manufacturing industries. The TFP increases happened againstthe background of several negative developments in this period, including: floods, a prolonged politicalcrisis and the associated uncertainty, frequent hartals (general strikes) that crippled economic activity,disruptions at the country's lifeline Chittagong port, and frequent power cuts.

3.15 Computation results also show that the major force behind the TFP increase was technologicalchange, showing an average technological improvement of 53 percent among the surveyed firms.However, the relative technical efficiency--relative to the best-practice frontier--in general regressed,showing about 15 percent decline in five years. As explained earlier, this means that, on average, thesurveyed firms lagged behind in "catching up" with the frontier or with the efficiency of the best-practice firns. Nonetheless, the positive technological change was strong enough to create a sizableoverall TFP growth (Chart G).

3.16 In terms of specific groups, the surveyed export-orientedfirms, on average, showed an 8percent positive technological change and a 9 percent improvement in their relative technical efficiency,thus realizing more than 17 percent TFP growth in five years (or 3.5 percent annually). Individually,out of 8 surveyed firms in this group, all firms showed TFP gains, with only two showing deteriorationin technological change and only one firn indicating regress in relative technical efficiency.

3.17 The results show a much stronger--59 percent (above 11 percent annually)--averagetechnological improvement for the sampled import-competingfirms, and 47 percent improvement forthe import-intensivefirms (many of which are import-competing), and taken together an average 57percent increase (Table 111.2). At the same time, these firms experienced deterioration in their relativeTE, with the two groups jointly showing an average 18 percent decline in their relative efficiency

6 This is the change (between the two observation years) in how far the actual production is from the maximumpotential output--the latter being represented by the observed production of the most efficient firm(s) in the group.


which implies that between these two years they have lagged behind in moving toward the maximumpotential production. However, these two forces taken together still led, on average, to a significant 29percent increase in TFP among the import-competing and import-intensive firms. The latter TFPG islarger than what the export-oriented firms appear to have experienced.

3.18 This is not a surprising outcome however. In a liberalizing environment, it should not be seenas unexpected that viable enterprises in the hitherto protected/isolated sectors might show the largestleaps in technological change. This is because they would be the ones with the largest scope forsignificant technological improvements, as they have probably lagged significantly behind the ongoingtechnological advancements abroad. And a few, front-running, dynamic, best-practice firms could leadthe way in this process with the opening up of the economy and the increased opportunities to accessbetter technologies and know-how. On the other hand, due to longer exposure to the outside markets,export-oriented firms would normally show a much closer convergence to the available frontiertechnologies.

3.19 At the firm-level, all of the 61 import-competing/import-intensive firms experienced somedegree of positive technological change. And not all of them experienced deteriorating relative technicalefficiency between 1992/93 and 1997/98--over 21 percent (13 of them) showed improvements in theirrelative technical efficiency (Table 111.3). However, because of their poor performance in relativetechnical efficiency, 18 out of 61 (about 30 percent) firms in this groups showed declining TFP. Thesepoor performing firms are mostly in metal works, steel re-rolling/engineering, and rubber products.

3.20 The non-traded goods producing firms showed results with similar performance patterns asthose of import competing firms: positive technological change and deteriorating relative technicalefficiency. However, because of stronger technological improvements, 11 out of the 13 sampled firms(85 percent) in this group showed positive TFP growth between the two observation years, with theaverage TFPG in five years reaching 39 percent (almost 8 percent annually) for the sub-group. In termsfirm-size and location, the results do not reflect a clear pattern, though medium-size firms appear tohave done better in achieving larger TFP gains (34 percent on average, compared to 24 percent forsmaller ones), while those located in Chittagong experienced higher (45 percent) TFPG than thoselocated in Dhaka or Khulna, perhaps due to being in the principal port city of the country.

3.21 The survey data and observations made at the interviews provide additional evidence supportingthe generally positive impacts of trade liberalization implied by the TFP analysis. Among the sampledfirms only 28 of 90 reported a decline in employment, and this is despite the fact that the majority offirms included in the sample are import competing. The firms that experienced employment contractionwere mostly in jute mills, iron and steel, rubber works, spinning, cotton mills, rice mill, andsoap/detergent. But, only some of these 28 firms mentioned trade liberalization as one of the reasonsfor their problems. Most of them mentioned smuggled goods, domestic competition, decreased demand(such as jute products),financial problems, management issues, political crisis and hartals as sources oftheir problems, rather than singling out trade liberalization as the main culprit. Given that the majorityof the interviewed firms are import competing, the observation about the employment situation is anindication that there was no widespread contraction. Furthermore, 51 percent of the firms reportedundertaking investment recently for expansion, diversification, automation, quality improvement,modernization/replacement, and new machinery-a sign of positive expectations about the future.Indeed, 47 percent of the sample firms indicated higher profits, 31 percent less, and 22 percent reportedno change.

38 Chapter 3. Impacts Of Trade Liberalization On Technical Progress And Efficiency In ManufacturingIndustries

Box 111.1: Micro-Level Findings and Macro-Level Inferences

One questioxn that was raised at the September 16, 1999 seminar concemed the issue of whether themnicro-level evidence provided in the report on impacts of trade liberalization constituted a basis for macro-levelinferences. Also related to this, some participants argued that the situdy's assessment of imnpacts on themanufacturing sector was incomplete in that it did not cover the cottage/small-scale industries and that there is notmuch information on exits and new entries.

The fimn-level analysis of the report is intended to demonstrate that Bangladesh's trade liberalization hashad positive impacts on factor productivity growth, without making, sweeping generalizations. However, thereport uses (in Chapters 1 and 2) the available information on macroeconomic performance as well as the fairlydisaggregated official data on manufacturing industries to assess macro-level impacts of trade liberalization. Inaddition, the report includes some evidence on perceived impacts of trade liberalization on the so called "sick"finns. As discussed below, the feedback obtained from a sample of "sick" firms indicate that trade liberalizationwas not even a major reason for their problems. Beyond this, a more comprehensive coverage of closed and sickfirms was not undertaken in the study due to the information constraints faced and the high cost of tracing thesefirms. Nonetheless, the evidence provided in the report is adequate to argue that Bangladesh's trade liberalizationhas been successful in improving economic performance and that the manufacturing sector has not experiencedany wide-spread production displacement.

Business Environment and Performance of the Surveyed Enterprises

3.22 To shed further light to the question of how important trade liberalization has been in affectingthe surveyed enterprises and what aspects of the business environment might have affected theirperformance and their capacity to respond to trade liberalization, direct interviews were held andqualitative questionnaires were used. The following are some of the findings:

* Of the 74 enterprises that answered the question about impacts of trade liberalization, 30 percentfound trade liberalization helpful, 14 percent considered it harmful (mainly import competing firmsin rubber industries, soap/detergent and metal works), while the majority indicated no perceivedimpact from trade liberalization. The latter group included some RMG firms, which had startedbenefiting from trade liberalization much earlier under the enclave arrangements.

* With respect to the key constraints to doing business in Bangladesh, only 4 percent of therespondents considered competition from imports as their primary obstacle to pursuing theirbusiness activities. On the other hand, 21percent of the respondents saw the lack of businesssupport services (such as assistance in finding/using new technology and in product design as wellas instrument calibration, advice for productivity improvement and quality control testing, etc.) asthe foremost problem. This is followed by access to credit (20 percent), inadequate supply ofinfrastructure (13 percent), corruption, theft and "toll" collection (18 percent). Shortage ofskilled labor was also stressed as another important constraint.

* Evidence from the "sick "firms and new enterprises surveyzed also suggest that trade liberalizationhas not caused widespread hardships. Of the 12 "sick" finns that could be traced (out of a smallsample of 23), only the import competing firms (5 out of 6) identified trade liberalization as havingadverse effect on their performance. But none of the firms interviewed indicated trade liberalizationas the sole reason for their problems/"sickness". Non-availability of finance and working capital,technical production problems, natural disasters, increased domestic competition, and managerialinexperience are among the factors mentioned as being the other important reasons for theirsickness.


* The 26 new entrants interviewed (10 export-oriented and 16 import-competing) regarded tradeliberalization as helpful for their business, noting duty reductions on raw materials and capitalgoods. Export-oriented firms were generally more optimistic about their future, while importsubstitute producers were more cautious. However, they all mentioned the above cited businessenvironment constraints as the main hurdles faced in carrying out their business.

Conclusions and Policy Implications

3.23 To summarize:

* The evidence obtained from quantitative analysis, survey data, and the interviews does not indicateany widespread adverse impact on the performance of the sampled firms that can be attributed toBangladesh's trade liberalization. On the contrary--without claiming causality-- the majority of theenterprises appear to have experienced positive TFP growth between 1992/93 and 1997/98, and itcould be argued that the progressive reductions in trade restictions must have played a positive rolein this outcome by inducing technical efficiency gains, technological progress/diffusion, and thusenhanced productivity of inputs. When these quantitative results are put together with the publishedstatistics on the output performance of manufacturing industries, the resulting picture is a generallypositive development, which does not support the claim that trade liberalization harmedBangladesh's manufacturing industries.

* The export-oriented firms appear to have done better in improving their relative technical efficiencyand thus in further catching up with the best practice firm(s)--or moving toward the maximumpotential production. Import competing firms have generally lagged behind the most efficient firmsin improving their relative efficiency in resource use. Firm-specific problems and the businessenvironment constraints faced appear to have been factors in slowing down efficiencyimprovements and adjustments to trade liberalization. However, it is also worth noting that thesurveyed import competing firms, on average, experienced stronger positive technological changethan the export-oriented firms, perhaps reflecting the larger beginning technology gap and the scopefor larger leaps in technological progress. This in turn enabled the import competing firms toexperience larger TFP growth.

* Some import competing firms (in iron/steel metal works, engineering, rubber works, and cottonmill) might have been adversely affected by trade liberalization. This is an expected outcome oftrade liberalization: inefficient/high cost firms will suffer from increased foreign competition.However, it is important to highlight that many of the manufacturing firms surveyed listed otherinternal and external conditions--such as the cited constraints to doing business--as also importantfactors that adversely affected their performance.

* An important implication of these findings is thatfaster improvements in the areas of infrastructure,financial sector reform, business support services, the customs administration, and law and orderwould have undoubtedly led to stronger benefits from the trade liberalization effort. Indeed,addressing these problems will be the most critical undertaking that the Government can do toboost industrial development.


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Fnm43 (Theilenills) hliaka miiurn 0.939 0.749 L.0)0 0.820 0.939 0.913 1.051 1317 Q798 0.820 0.973

Fum44 (Clay) Dhaia Iiium 1.0Q) 0.612 'L.0QO Q803 1.0Q 0.762 0Q926 1.513 0.612 0.803 0.762Firm45 (ClIa) Elaa aidrn 1.0Q) 0.832 1.000 1.000 [.000 0.832 L172 1.409 0.832 1.0Q, 0.832

Fmn46 (TbrIas &WWkingsn&d) Eiima kmrn 0.653 0373 0.725 .397 0.90D 0.938 0.845 1.480 0.571 0547 1.044Fnm47 (aYtc ) lia Nlodiwn 0.813 OA55 0.831 0.504 0.978 0.903 0.867 1.548 0S60 0.607 0,923Fum48(Shae) Dhaka MQdizn 0.901 0.771 0.907 1.000 0.993 0.771 1.269 1.482 0.856 1.102 0.777Finn49 (ldicare) Dlaka MD&i=m 0.670 OS79 0.673 1.000 0.996 0.879 2.068 1.577 1.311 1.486 0.882Ffrm 50 (Soya) Dhaka Mv6iin 0.606 0.517 0.607 0.521 0.999 0.992 1A25 1.671 0.83 0.859 0.993Fnm 51 (Texileernils) lhiaka Large 0.700 0.514 0.953 0.804 0734 0.640 1.136 1.546 0.735 0.843 0.872Furn 52 (edis) Ebaka LIrge 1.03) 1.000 1.Q)O 1.000 1.000 1.000 1.621 1.621 1.000 103) 1.000Fnn53 (Meta) Khulr m n 1.03) OM80 1.000 .809 1.000 0.717 0.754 1.300 0580 0.809 0.717

Fnm54([Rice) Ehulim 1ium. 0.653 Q653 0.698 Q740 0.935 Q882 1.782 1.780 1.001 1.060 0.944Fmnm5siceMrills) Kium Large 0.607 0.402 0.746 0.419 0.814 0.959 1.074 1.622 Q662 0.562 1.178

veul . Q 06 WI661 .870 0797 9 933S 1591 03 0.929 0

Frnm 56 (ht& Scl) Chtag Mvdirn 0.633 Q343 0.664 0.362 0.953 0S48 Q927 1.710 0.542 0,545 0.994Finn 57 (Alwunrm ataguE NiRn lOO Q620 1.0I) Q635 1.000 0.975 0.824 1.329 0Q620 0.635 0.976Fmrm58Rfiiyy&Vergable rtuds) (hittag Lae 0,786 1.0 0.860 1.000 0.915 1.000 1.897 1.491 127 1.163 1.094Fin59(1mn&Seel) Cittagorg Large 0.564 OA98 0.659 Q545 0856 0.915 1A72 1.665 0.884 0.827 1.069

Fum60(VegableOils) ittag Lrge 0.825 0.919 0.832 0.919 0992 1.000 1.143 1.026 1.114 1.105 1.008Fim 61 (Steel) ittag Lage 1.0) OM20 1.000 0.931 .ODO 0S88 0.924 1.004 0.920 0.931 0.988

Firm 62 (Fx Lalka soall 0.795 0.336 0829 0.372 0,958 0.902 0.785 1.856 0.423 0.449 0.942FrTn63 (Meta) lEaka Small 1.03) 1.000 1.03) 1.000 1.OD 1.000 2.016 2.016 1.000 1.03) 1.000

Fim 64 (Ccmmal Rinnrt snioll 0.891 0.438 0.893 Q440 0.999 0Q995 0.709 1.444 0Q491 0.493 0.996Fnm 65 ([bb1) Ebaka sQu 0.886 Q478 0,923 0.520 0.959 0918 0.834 1.547 0S39 0.563 0.957Fimn66( aint&Ch iacaD Dlhaa 9mll 0.936 0.702 0,973 0.705 0.962 0.996 1.091 1.455 0750 0.724 1.036Fmn67( MFaRnture&FiXDtes) Etla MIIUnM 0.574 Q509 0.584 Q646 0983 0.788 1.298 1.463 .887 1.107 0.801Fmrn68 (Cotam) Laa Lae 0.751 OA59 1.0) 0.699 0.751 0.657 0.895 1.462 0.612 0.699 0.876Fim 69 (C(mnrls) Khulma IkMn 1.03) QS87 1,000 0.620 1.000 0.947 0.855 1.457 OS7 0.620 0.947

tan q.832 0 62671 0.953 .938 1.119 1 760 0.6 979


CNlhhtAeOoLk Qy 0000*000;0:XS0:0 0:0 10f:Aut;iSA;f0;);F:CR i; : t:0: 0 :X i :f Sam

FMTois) Qitt x ig n 0.875 1.000 0.965 1.000 0.907 1.OD 2.003 1.752 1143 1.036 1.103

Fn1n (Bids) Giah g NMxin 0.869 0.453 0.923 (461 0.942 OM 1A1 2689 (6as 0.52a) 1.042

Fbm72(Bid(s) Gi1 r N ihn as93 4663 0.912 a.s O.7" 0.93 191 2279 a742 0.732 1.014

EHm73(Eid) aitig Mhtv n 0896 0.6w0 1.00 0.709 s896 OM8 1.093 1.440 1759 0.709 1.071

Flm74(Eidcs) Quigag Ivdun 0.873 LO.O 0.950 1.OOD 0.919 1.000 1318 1.150 L146 1.052 1089

Fxnm75(fid&) cit Mvikn 0a696 a621 0a70s5 (4 0.987 Qs4s 1906 2137 0ass2 0.92 0.960Fhm76(Bid(s) aitgiig Nlun 0s29 (1386 0.871 0.431 0.952 0U% 0.984 2116 0.465 0.494 0941

Fdm77(ki&) Qaii g lkllzn 0701 0Qs7 0.717 0.602 a978 0.991 O063 2424 as1 0.840 1.013Him7~8 qvk~ B*Wing) auit g Iaqp ICCO0 1.000 1C00. 1.000 IAXLO 1.000 0.835 0.835 LOOO 1o03 L.3D

Fm79 (Ridcs) a I. law 0.967 V702 L.3 10 09 OL72Z 1224 1.686 (1726 1.(D) 0.726

Fn(BADk) 1jijn L.ao as67 1.033 0.70 LOO( 0Qss7 1065 1.228 (67 0870 0997

Fum8l (id) IQum N.axDn 1.033 0.663 1.033 0667 1.000 0Q995 13S6 2045 166k3 0667 a9s4

Eim582(Bdcs) Kium 1vizn 1.03) Q 778 1,.C0 Q779 1.00) 0.999 1.156 1.486 0.778 0.779 0.999

~~ 4 ~~~ 1.392 1 m 715 O.W ~ 995

te: Technical Efficiencypte: Pure Technical Efficiencyse: Scale Efficiency

TFPCH: Total Factor Productivity ChangeTECHCH: Technological ChangeEFFCH: Efficiency ChangePTECH: Pure Technical Efficiency ChangeSECH: Scale Efficiency Change

Chapter 3: Impacts Of Trade Liberaliation On Technical Progress And Efficiency In Manufacturing 43Industries

Appendix to Chapter 3

METHODOLOGY, DATA AND THE SAMPLE STATISTICS

1. Since the production technology of afully efficient firm(s) in a given industry is not known, inpractice it must be estimated from observations. Three main approaches have been applied in empiricalstudies on efficiency frontiers. One is an economic frontier approach, using a pre-defined productionfunction or a cost function. The second is a pararrmetric linear programming frontier approach. The thirdis a nonparametric frontier approach. Though each approach has its merits and shortfalls, the thirdapproach is employed here. It has several advantages. First, its data requirement is less than the otherapproaches; second, it does not require a priori specifications about the underlying technologies, and itdoes not assume that production is already taking place on the efficient frontier; third, it provides firm-level productivity indexes; and finally, it can easily identify sources of productivity growth.

2. The nonparametric frontier approach--Data Envelopment Analysis (DEA)--is designed toconstruct piece-wise linear production frontiers and then to compute the level of efficiency(inefficiency) that might be present in the production process. As a result, it provides meaningful scalarefficiency scores, which can serve as measures to gauge the efficiency of firms within a multipleoutput/input framework (see Annex III for technical details and explanations).

3. In the present context, the DEA frontier represents a set of efficient observations for which noother production unit (or linear combination of units) employs as little or less of every input withoutchanging the output quantities generated or produces as much or more of every output without alteringthe input quantities used. However, this approach abandons the possibility of determining the precisestatistical significance of results. Nonetheless, this technique has become a standard in efficiencystudies; (see Fare et al, 1994, for a recent application of the technique to the question of technicalefficiency and technological progress in affecting total factor productivity changes in 17 OECDcountries).

Empirical design for efficiency estimations

4. Two separate sets of annual efficiency frontiers are estimated specifically for the years 1992/93and 1997/98, using panel data on a sample of manufacturing firms. A key advantage of having paneldata is the ability to observe each firm more than once over a period of time. This is critical in acontinuously changing business environment, because the technology that is most efficient in one yearmay not be the most efficient in another year. And in a period of changing market incentives associatedwith, say, trade liberalization, firms may decide to change their production technologies. Furthermore,by examining two observation years, the problems related to not being able to take into account randomerrors in the DEA approach are alleviated, at least to an extent, by allowing an efficient (inefficient)firm in one year to be inefficient (efficient) in another year, assuming that the errors owing to luck ordata problems are not consistent over time.

Survey Data

5. The data used in this study are obtained from two (manufacturing industry) surveys. The first isthe 1992/93 Industrial Study (ISS) survey carried out jointly by the World Bank and the USAID. Itcovered over 1200 firms. The second is the 1997/98 survey carried out for this report. The latter surveyincludes a sub-sample (about 10 percent) of randomly picked firms from those included in the ISS


survey. Accordingly, the 1997/98 survey has about 120 firrns. However, for the efficiency/productivityanalysis, only 82 were found to have comparable/usable data.

6. To carry out a more meaningful analysis on the efficiency/productivity effects of tradeliberalization, the surveyed firms are classified by market-orientation and size, such that any discernabledifferences in response pattems to trade liberalization could be identified and analyzed. For this reason,firms are grouped as: export-oriented (those that are producing for export, such as RMG, leather, seafoods, and indirect exporters); those producing non-tradables (e.g., bricks, and some service activities);and import-competing (the rest of the sample firms). Firms that are producing import-intensive products(such as vegetable oil, apparels, iron and steel, aluminum works, printing and packaging, dyers, plasticproducts, medicine, etc.) are also identified separately to see if such firms responded differently to thedismantling of trade barriers. Thus, out of 82 firms, 8 are classified as export-oriented, 13 non-tradable,47 as import-competing, and 14 as import-intensive; (13 firms in the latter group are import-competing).In addition, firms are classified by size, as small, medium, anid large. The criterion used in the sizeclassification is based on the number of employees. However, depending on the nature of the productinvolved, different employment ranges are used in classifying firms by size; (this is approach is adoptedfrom the 1992/93 survey work). For example, in knitwear, a firm with less than 18 employees isclassified as "small", while in jute the relevant threshold figure is 366 employees. Of the 82 firnsincluded in the quantitative impact analysis, about 33 percent are small, 46 percent medium-size, andthe rest are large. Regarding their location, 55 percent of the firms are located in Dhaka, 34 percent inChittagong, and 11 percent in Khulna.

7. In computations, the input vector includes: labor, raw materials, andfixed capital. The amountof labor is measured by the number of full-time employees on the payroll. In effect, this amounts toassuming that the sample firms maintained the same skill cornposition in their employment between1992/93 and 1997/98. Material inputs are also treated as one composite input, since only one costfigure is available, and the GDP deflator is used to deflate the nominal material expenditure figures.Fixed capital stock is calculated by summing the value of machinery, transport equipment, and factorystructures/premises .

8. The survey data do not have disaggregated information on material input expenditures and ontheir unit prices, and reliable price deflators for various kinds of imported and domestically producedcapital goods are not available. These data limitations necessitated the use of only one deflator to findchanges in real magnitudes of material inputs and different kinds of fixed capital goods between the twoobservation years. This creates the possibility of an increased incidence of extreme observations. Forexample, a firm that experienced significantly different price changes than what is implied by the GDPdeflator between the observation years for its material inputs and/or fixed investment goods could easilyemerge as an "extreme" observation in terms of its technical efficiency. This could distort the results byaffecting the outcome on the "best practice" frontier. Therefore, given the sensitivity of the results toextreme observations, an effort is made to ensure that such outliers are excluded from computations. (Inthe computations, one such observation-- a firm producing leather products--had to be eliminated).

Grouping Sample Firms by Market-Orientation

9. As indicated above, in carrying out the quantitative analysis, the sample firms are grouped bytheir market-orientation to come up with analytically meaningful results. Consequently, firms that are

7 Land is excluded from the calculations to avoid any biases that speculative land holdings might cause inthe estimation results. Firm specific capital stock figures for 1992/93 are available, so are finn-specific investmentfigures for 1994 through 1997. The 1997/98 capital stock figures are derived applying the perpetual inventorymethod--using GDP deflators to obtain the real investment figures and depreciating the capital stock figures by 8percent per annum.


producing different products--and most likely using different technologies--are put together. Forexample, in the import-competing group there are firms producing textiles, metal products, rubbergoods, and soap and detergent. Of course, further sub-groupings of import-competing enterprises thatproduce similar goods with similar technologies could have been formed. But this would have naturallyrequired a very large sample of firms, so that a sufficiently large number of firms are included in eachsub-group in order to compute separate "best-practice" frontiers. Because of the very high cost of sucha large sample, the sample had to be restricted to 120 firms in the study. However, it is worth drawingattention to the fact that in practice firms producing similar products use different technologies, with thescale, vintage, and the level of sophistication of capital equipment changing from firm to firm,depending on firms' size, age, and the extent of modernization undertaken by them.

10. Tne approach adopted here is not expected to distort the results. This is because the technicalefficiency indicators and comparisons are based on relative performance--that is relative to thebenchmark frontiers computed from observations pertaining to the best practice (most efficient) firms.Consequently, the technical efficiency rankings among firms within the same product category will notbe affected since their efficiencies are all measured relative to the best-practice frontier. Similarly,comparisons of the relative technical efficiencies of firms producing different goods but included in thesame market-orientation category remain meaningful. Because, this is like simulating a situation whererelative efficiencies of many activities that can be used in the production of one composite good--call itan import-substituting product--are compared, as in the case of "activity analysis".

ANNEXES

Annex I 49

Table A.1: Trends in average and Dispersion of Tariffs, FY91-99(in percentages)

Description FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00

Average CD (unweighted) 88.6 56.7 46,8 35.8 25.4 22.2 21.5 20.7 20.2 16.7AverageCD(collection) 42.1 24.1 23.6 24.1 20.8 17.0 18.0 16.1 14.1Standard Deviation 63.8 40.7 30.7 24.5 19.2 16.5 16.3 15.4 14.6 13.7Dispersion (Coeff. of 72.0 71.9 65.6 68.2 75.6 74.4 7537 74.4 72.4 82.1Variation)Numberoftariffslabs 17 17 14 11 5 6 6 6 6 4Infrastructure dev -- -- -- -- -- -- -- 2.5 2.5 2.5

surchargeAverage License Fee 1.2 1.4 1.5 1.5 1.2 1.3 1.3 1.0 --

(collection)Top CD rate 350 350 300 300 60 50 45 42.5 40 37.5

Trends in Average Nominal Protection

Panel BAll Tradables Manufacturing Sector

(Un-weighted Rates) (Un-weighted Rates)Fiscal Year CDLF+1DS SD VAT Over-all CD+LF-IDS SD VAT Overall

1990/91 88.6 0.04 -- 88.6 89.0 0.04 -- 89.0

1991/92 58.1 0.05 9.2 67.4 58.1 0.05 9.7 67.81995/96 23.7 0.1 3.3 27.1 23.4 0.1 3.4 26.91998/99* 23.4 0.4 3.3 27.2 23.3 0.4 3.5 27.31999/00 19.5 2.2 3.0 24.7 19.2 2.5 3.2 25.0

* Postflood rehabilitation surcharge on supplementary duty inclusive

All Tradables Manufacturing Sector(Weighted Rates)* (Weighted Rates)*

Fiscal Year CD+LF+lDS SD VAT Overall CD+LF+IDS SD VAT Overall1990/91 42.1 0.0 -- 42.1 51.8 0.0 -- 51.8

1991/92 25.3 0.0 3.3 28.7 23.6 0.0 3.7 27.31995/96 18.2 1.4 2.7 22.3 19.0 2.1 3.1 24.11998/99 17.1 1.1 2.1 20.3 19.5 1.6 2.8 23.8

* Import-weighted rates unavailable for 1999/00CD =custom duty;LF = license fee;IDS = infrastructure development surcharge;SD = supplementary duty

50 Annex I

Table A.2: Trends in Average and Dispersion of I'ariffs on Manufactures, FY92-99(in percentages)

Customs Supplementary VAT CD+VAT+SD+IDSC License Fee

Description Duty Duty

FY 1999-00

Average (weighted)

Average (unweighted) 16.5 3.3 11.7 35.5 --

Coefficient of Variation 84.0 --

Maximum 37.5 270.0 15.0 2.5

FY 1998-99

Average (weighted) Jul-Jan99 15.8 4.1 13.3 35.2 1.2


Coefficient of Variation 73.9

Maximum 40.0 270.0 15.0 2.5

FY 1995-96

Average (weighted) 17.6 2.5 13.6 33.8 1.3


Coeff. of Variation 76.0

Maximum 50.0 350.0

FY 1991-92

Average (weighted) 22.5 0.8 12.1 35.4 1.1


Coeff. of Variation 72.4 --

Maximum 350.0 25.0

Annex 1 51

Table A.3: Tax Incidence on Imports(in percentages)

Customs fDutv Supplementary VAT CD±VAT±SD+CDSCDescription Dty

FY 1998-99Average (Weighted) Jul-Jun99 14.1 2.6 10.3 29.1Average (Unweighted) 20.2 2.2 13.1 39.2Coeff. of Variation 72.4Maximum 40.0 270.0 15.0FY 1997-98Average (Weighted) 16.1 2.4 11.8 32.3Average (Unweighted) 20.7 1.7 13.7 38.6Coeff. of Variation 74.4Maximum* 42.5 350.0 15.0FY 1996-97Average (Weighted) 18.0 2.2 12.9 33.1Average (Unweighted) 21.5 1.0 13.8 36.6Coeff. of Variation 75.7Maximum* 45.0 350.0 15.0FY 1995-96Average (Weighted) 17.0 1.8 11.8 30.6Average (Unweighted) 22.2 0.8 13.7 37.0Coeff. of Variation 74.4Maximum* 50.0 350.0 15.0FY1994-95Average (Weighted) 20.8 1.1 12.8 34.8Average (Unweighted) 25.4 0.7 14.0 40.5Coeff. Of Variation 75.6Maximum* 60.0 350.0 15.0FY 1993-94Average (Weighted) 24.1 0.5 14.5 39.1Average (Unweighted) 35.8 1.8 16.7 54.1Coeff. Of Variation 68.2Maximum* 300.0 350.0 15.0FY 1992-93Average (Weighted) 23.6 0.3 13.8 37.6Average (Unweighted) 46.8 1.5 18.9 67.1Coeff. of Variation 65.6Maximum* 300.0 350.0 15.0FY 1991-92Average (Weighted) 24.1 0.6 11.5 36.2Average (Unweighted) 56.7 0.7 22.3 79.6Coeff. of Variation 71.9Maximum* 350.0 25.0 15.0

Source: World Bank StaffEstimates.

52 Annex I

Table A.4: Effective Protection Rates (EPRs) in 40 sectors in Bangladesh(in percentages)

Effective rates, of protection:

Sl # Sector Name 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98 1998/99 1999/0001. Rice -8.0 0.9 2.4 -5.8 -5.7 -5.4 -5.3 -4.702. Wheat -3.9 8.5 11.0 2.0 2.2 2.6 2.8 0.203. Coarse Grains -4.9 -4.1 -0.8 -0.2 -0.2 0.1 0.1 0.404. Jute 64.4 67.2 30.6 31.8 32.0 32.4 32.5 26.805. Sugar Cane 68.4 71.3 14.2 14.8 15.0 15.2 15.2 15.806. Cotton 4.8 5.4 -2.0 -1.7 -1.7 -1.5 -1.5 -1.407. Tobacco 12.5 -0.9 10.2 11.8 12.1 11.1 11.3 12.208. Potato 58.9 60.4 48.8 36.7 35.7 26.9 24.5 23.109. Other Vegetable 71.7 43.6 44.5 32.1 32.2 32.1 32.1 26.910. Pulses 19.9 18.1 17.4 16.9 17.0 18.2 11.3 8.311. Oil Seeds 53.8 42.7 35.6 24.6 24.7 22.8 22.8 19.712. Fruits 58.2 60.5 44.9 40.2 39.9 38.1 36.3 33.113. Tea 82.7 85.1 66.0 48.7 48.8 46.4 43.4 41.014. Other Crops 64.9 40.4 41.5 28.3 28.6 28.1 27.2 22.515. Livestock 74.3 54.0 42.0 33.2 32.8 28.8 28.0 24.816. Fish 78.4 45.3 45.1 28.4 28.5 27.9 28.0 23.217. Forestry 38.8 32.7 23.9 22.7 22.9 19.7 19.2 16.918. Other Fruits 489.2 327.4 88.5 88.3 86.0 76.7 68.3 66.919. Edible Oil 74.8 46.5 39.6 55.6 53.7 41.4 35.3 35.020. SugarandGur 96.3 42.3 52.3 51.1 51.4 40.0 38.5 31.121. Salt 51.4 61.6 43.5 37.2 34.6 30.7 29.1 29.622. Yam 68.0 57.4 60.9 51.7 35.0 34.2 33.7 30.523. Cloth: Mill 189.7 147.5 131.6 98.0 110.2 86.2 78.2 72.724. Cloth: Handloom 157.7 128.5 114.6 87.6 94.9 75.5 68.8 64.625. Readymade Garments 237.2 130.0 84.1 53.7 57.4 65.4 60.5 58.926. Jute Textile 98.2 93.5 81.0 55.7 56.0 48.4 44.1 43.527. Paper 68.3 74.1 48.8 25.4 22.7 12.7 11.3 15.528. Leather and Leather 98.6 87.3 42.3 20.7 15.8 8.8 5.90 6.5

Products29. Chemical Fertilizer -5.6 -2.2 -5.0 -3.6 -3.0 0.4 0.5 0.630. Pharmaceutical 1.5 -2.2 -2.5 -2.6 -1.4 0.7 0.6 -1.731. Chemical 30.3 15.4 14.9 12.5 13.8 15.2 16.1 9.732. Petroleum Products 40.2 32.8 45.7 35.5 35.7 32.3 31.2 27.333. Cement 56.0 30.6 21.4 18.5 19.1 19.0 20.3 21.234. Steel and Basic Metal 40.9 27.2 27.4 25.1 24.6 25.0 25.1 19.535. Metal Products 52.7 43.3 25.1 25.8 27.0 18.2 17.3 15.436. Machinery 47.5 28.9 15.1 12.6 12.3 9.3 9.6 5.237. Transport Equipment 69.9 49.1 41.9 38.0 22.8 21.8 19.8 17.938. Woodand WoodProducts 124.0 81.0 48.1 47.3 47.3 32.9 32.9 31.839. Tobacco Products 133.6 69.9 89.7 85.0 86.7 81.9 74.7 68.540. Other Industries 72.7 65.1 38.5 37.3 29.6 21.9 21.0 19.9

a) Average ERP 75.7 56.7 40.6 33.0 32.4 28.6 26.8 24.5b) Standard Deviation (SD) 84.4 57.0 31.2 25.7 26.9 23.0 20.9 20.0c) Coefficient of Variation 111.5 100.6 76.9 77.7 82.6 80.4 78.2 81.6

Source: Latest estimates by Bangladesh Tariff Commission, based on 1992-93 Bangladesh 1-0 Table.

Note: These estimates, which uses the Bank's Sintia-1O procedure, could be regarded as crude estimates, notbased on observed but derived differences between international and domestic prices.

Annex I 53

Table A.5: Protection Related Quantitative Restrictions On Imports, FY92-99

Quantitative restrictions FY 91-92 FY 96-97 FY 98-99

T'ariff Imports Tariff Import Tariff Importslines (mil. US$) lines (mil. US$) lines (m. US$)

Totalno.ofHSCodes 5987 2618 6106 4796 6106 5113

Total no. of tariff lines 10238 -- 9649 -- 9855 --

BANNED 410 -- 14 -- 20 --

RESTRICTED 81 45.65 28 5.77 30 5.78

BANNED/RESTRICTED 688 62.93 293 11.40 288 16.84

TOTAL 1179 108.58 335 17.17 338 22.62

Percentage of total 11.52 4.15 3.47 0.36 3.43 0.44

Note: POL products are restricted mainly for non-trade reasons and their imports in FY1991/92 were $398million, in FY 1996/97 $464 mnillion, and in FY1997/98 $507 million. Imports above do not include POLproducts.

Table A.6: Effective Exchange Rates for Exports (Unweighted)

Cash-

Cash Export Interest interest Nominal

Fiscal Export Subsidy credit Interest rates (%) subsidy subsidy Exch. RateYear

(bil. Tk.) (bil. Tk.) (bil. Tk.) Export General Diff. (mil. Tk.) (% of exp.) in Taka EERx

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

1991/92 75.2 .025 11.8 9.6% 15.8% -6.2% 0.0097 0.0100 38.15 38.53

1992/93 88.0 .022 15.8 9.0% 17.2% -8.2% 0.0147 0.0149 39.14 39.72

1993/94 98.0 .078 18.0 9.0% 15.1% -6.1% 0.0112 0.0120 40.00 40.48

1994/95 13.1 .029 19.6 9.0% 13.1% -4.1% 0.0060 0.0082 40.20 40.53

1995/96 13.8 .045 19.3 9.0% 13.9% -4.9% 0.0069 0.0102 40.84 41.25

1996/97 16.6 .080 22.6 9.0% 14.3% -5.3% 0.0072 0.0121 42.70 43.22

1997/98 17.3 .020 22.7 9.0% 13.5% -4.5% 0.0059 0.0174 45.46 46.25

Effective exchange rate for Import substitutes:-

Imports Un-wveighted Protective Rates Overall NominalExch.

Fiscal Year (bil, Tk.) CC)LFi SD VAT | Protective Rate in Tk. EERm EERmEERx EERx/EERmiDS S rate

(1) (2) (3) (4) (5) (6) (7) (8) (8)1991/92 10.0 58.1% 0.05% 9.2% 67.4% 38.25 63.84 1.66 0.60

1992/93 10.7 48.3% 0.10% 6.9% 55.4% 39.14 60.81 1.53 0.651993/94 11.3 37.2% 0.04% 5.2% 42.4% 40.00 57.97 1.41 0.711994/95 16.1 27.5% 0.06% 3.8% 31.3% 40.20 52.79 1.30 0.771995/96 20.1 23.7% 0.13% 3.3% 27.1% 40.84 51.91 1.26 0.801996/97 20.5 23.3% 0.20% 3.3% 26.9% 42.70 54.16 1.25 0.801997/98 23.3 24.6% 0.32% 3.3% 28.2% 45.46 58.44 1.26 0.79

54 Annex I

Table A.7: Effective Exchange Rates for Exports (Weighted)

;:0 ; ;Cash Export Interest Cish-Interest :Nominal

Fiscal0 F.x14r PSubsidy cei i:nterest ratesaN (ssidy subsidy Exchb,RateYear

(bi I. Tk.) (bil. Tk.)_ (bil. 'rk.) Export General Diff. (mil. Tk.) (% of exp.J in Taka ER

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

1991/92 75.2 0.025 11.8 9.6% 15.8% -6.2% 0.0097 0.0100 38.15 38.53

1992/93 88.0 0.022 15.8 9.0% 17.2% -8.2% 0.0147 0.0149 39.14 39.72

1993/94 98.0 0.078 18.0 9.0% 15.1% -6.1% 0.0112 0.0120 40.00 40.48

1994/95 13.1 0.029 19.5 9.0% 13.1% -4.1% 0.0060 0.0082 40.20 40.53

1995/96 13.8 0.045 19.3 9.0% 13.9% -4.9% 0.0069 0.0102 40.84 41.25

1996/97 16.6 0.080 22.6 9.0% 14.3% -5.3% 0.0072 0.0121 42.70 43.22

1997/98 17.3 0.020 22.7 9.0% 13.5% -4.5% 0.0059 0.0174 45.46 46.25

Effective exchange rate for Import substitutes:-

Fiscal Imports Weighed Protctive Rats Overall - NomiaV

Year (bil Tk.) CD+LF+1D SD VAT protective Rate inr Ek.M ERm EERmEERx EERx/EER

S 00 f :ftt;;tS;-0yg ;;y ;f:fQ000-;0 jrate m00 lt:000000000 n(1) (2) (3) (4) (5) (6) (7) (8) (8)

1991/92 10.1 25.34% 0.00% 3.32% 28.67% 38.15 49.09 1.274 0.785

1992/93 10.7 25.00% 0.00% 3.23% 28.23% 39.14 50.19 1.263 0.791

1993/94 11.3 25.57% 0.00% 3.71% 29.28% 40.00 51.71 1.278 0.783

1994/95 16.1 22.25% 0.72% 3.15% 26.12% 40.20 50.70 1.251 0.799

1995/96 20.1 18.24% 1.40% 2.70% 22.34% 40.84 49.96 1.211 0.826

1996/97 20.5 19.32% 1.72% 2.98% 24.02% 42.70 52.96 1.225 0.816

1997/98 23.2 19.34% 1.80% 2.75% 23.89% 45.46 56.32 1.218 0.821

Annex 1 55

Table A.8: International Comparison of Tariff Regimes

Country Avg. tariffh Recent Avg. tariffs Tariff ratio*

Pre-reform (in percentages)

(in percentage)

South Asia 80 27 0.34

Colombia (1984, 1998) 61 12 0.20

Peru(1988, 1998) 66 13 0.20

Brazil (1987, 1998) 51 15 0.29

Costa Rica (1985, 1992) 53 15 0.28

Chile (1984, 1998) 35 11 0.31

Argentina (1988, 1998) 38 14 0.37

Uruguay (1987, 1998) 32 12 0.38

Venezuela (1989, 1998) 37 12 0.32

Mexico (1985, 1998) 24 13 0.54

Latin America 44 13 0.30

Madagascar (1988, 1996) 46 7.3 0.16

Kenya(1988, 1996) 40 14 0.34

Nigeria (1984, 1995) 35 29 0.83

Ghana (1983, 1996) 30 13 0.42

Egypt(1989, 1995) 47 28 0.59

Tunisia (1987, 1998) 33 30 0.91

Africa 41 31 0.76

China (1986, 1998) 38 18 0.47

Indonesia (1985, 1996) 27 13 0.48

Malaysia (1988, 1997) 17 9 0.53

Thailand (1989, 1998) 40 18 0.45

Philippines (1988, 1998) 28 11 0.40

Singapore (1989, 1996) 0.4 0.4 1.00

Taiwan(1984, 1994) 31 11 0.36

South Korea (1984, 1996) 22 9 0.41

South East and East Asia 29 14 0.48

(*) Tariff ratio is the recent average tariffs over pre-reform average tariffs.

Source: World Bank (1994, 1996) and Rajapatirana (I 997)

56 Annex I

Table A.9: Bangladesh-Macroeconomic Developments in Openness, 1980-1998

(million UFY8 FY8 FY82 FY3 FY4 FY85 FY86 FY87 FY88 FY89 FY90

Export of goods and 723 932 840 889 1033 1162 1043 1301 1486 1598 1903

non-factor services

Import of goods and 2622 2717 2759 2517 2544 2864 2587 2876 3252 3701 4156

non-factor services

GDPatmktprice 17441 19405 17484 16618 19052 21129 21025 23728 25764 27662 30200

Export/GDP 4% 5% 5% 5% 5% 5% 5% 5% 6% 6% 6%

Import/GDP 15% 14% 16% 15% 13% 14% 12% 12% 13% 13% 14%

Export+Import/GDP 19% 19% 21% 20% 19% 19% 17% 18% 18% 19% 20%

Exchange Rate (period 15.49 16.26 20.07 23.8 24.94 25.96 29.89 30.63 31.24 32.14 32.92avg.)

(million USS) FY91L FY2 FY93 FY04 FY95 FY96 FY97 FY98

Export of goods and 2113 2467 2906 3057 4144 4508 5083 5879

non-factor services

Import of goods and 3829 3932 4519 4693 6449 7614 7655 8049

non-factor services

GDPatmktprice 30746 31163 31934 33559 37614 40343 41345 42647

Export/GDP 7% 8% 9% 9% 11% 11% 12% 14%

Import/GDP 12% 13% 14% 14% 17% 19% 19% 19%

Export+Import/GDP 19% 21% 23% 23% 28% 30% 31% 33%

Exchange Rate (period 35.68 38.152 39.13 40.001 40.2 40.86 42.7 45.45avg.)

Annex II 57

Table B.1: Bangladesh's Recorded Commodity Trade, 1989/90 - 1997/98: Overview

Fiscal year: 89/90 90191 9W/92 92/93 .93194 94195 95196 96/97 917/98

US$mailion

Total exports 1524 1718 1994 2383 2534 3473 3883 4418 5161.2Estinated SBWexport(25%VA) 641 831 993 1164 1376 2070 1908 2107 2517.4ExportProcessingZone exports 34 48 68 110 103 205 278 370 539.0

Derivednon-SBW/EPZexports 848 839 932 1109 1055 1197 1696 1941 2104.7

Total imports 3226 3687 3445 3700 3970 5762 6612 6779 7514.2SBWBlB UCfabricimports 481 623 745 873 1032 1553 1431 1581 1888.1Export Processing Zone inports 32 40 63 85 121 197 261 402 493.7

Non-SBW/EPZ imports 2713 3024 2637 2742 2817 4013 4920 4796 5132.5

Total trade (X + M) 4750 5404 5438 6083 6504 9235 10495 11197 12675.4

Trade surplus or deficit(-) -1703 -1969 -1451 -1317 -1436 -2290 -2729 -2360 -2353.1SBW+EPZsurplus 162 216 253 316 326 526 494 495 674.7Non-enclave deficit -1865 -2185 -1705 -1633 -1762 -2815 -3223 -2855 -3027.7

Arnwalgrowdi mie (i pefrcetages)

Total exports . 18.0 12.7 16.1 19.5 6.3 37.0 11.8 13.8 16.8Estimated SBWexport(25%VA) 29.5 19.6 17.2 18.2 50.4 -7.8 10.4 19.5ExportProcessingZoneexport 112.5 41.2 41.7 61.8 -6.4 99.0 35.6 33.1 45.7Derivednon-SBW/EPZexport -1.1 11.1 19.0 -4.9 13.5 41.7 14.4 8.4

Total imports 44.0 14.3 -6.6 7.4 7.3 45.1 14.7 2.5 10.9SBWB/BIJCfablicimports 29.5 19.6 17.2 18.2 50.4 -7.8 10.4 19.5ExportProcessing Zone imports 113.3 25.0 57.5 34.9 42.4 62.8 32.5 54.0 22.8Non-SBW/EPZ imports 11.4 -12.8 4.0 2.7 42.5 22.6 -2.5 7.0

Total trade(X X+) 34.5 13.8 0.6 11.9 6.9 42.0 13.6 6.7 13.2

Trade surplus or deficit (-) 79.3 15.6 -26.3 -9.2 9.0 59.4 19.2 -13.5 -0.3SBW+EPZ surplus 32.9 17.5 24.7 3.2 61.2 -6.0 0.2 36.3Non-enclavedeficit 17.1 -22.0 -4.2 7.9 59.7 14.5 -11.4 6.0

Percent of GDP

Total exports 5.0 5.6 6.4 7.5 7.6 9.2 9.6 10.8 12.2Estimated SBW export (25%VA) 2.1 2.7 3.2 3.6 4.1 5.5 4.7 5.1 5.9Export Processing Zone exports 0.1 0.2 0.2 0.3 0.3 0.5 0.7 0.9 1.3Derivednon-SBW/EPZexports 2.8 2.7 3.0 3.5 3.1 3.2 4.2 °

Total imports 10.7 12.0 11.1 11.6 11.8 15.3 16.4 16.5 17.8SBWB/BlUCfabricimports 1.6 2.0 2.4 2.7 3.1 4.1 3.6 3.9 4.5ExportProcessing Zone inports 0.1 0.1 0.2 0.3 0.4 0.5 0.6 1.0 1.2

Non-SBW/EPZ imports 9.0 9.8 8.5 8.6 8.4 10.7 12.2 11.7 12.1

0.0 0.0Totaltrade(X+AM) 15.7 17.6 17.5 19.0 19.4 24.6 26.0 27.3 29.9

Trade surplus or deficit (-) -5.6 -6.4 -4.7 -4.1 -4.3 -6.1 -6.8 -5.8 -5.6SBW+EPZ surplus 0.5 0.7 0.8 1.0 1.0 1.4 1.2 1.2 1.6Non-enclave deficit -6.2 -7.1 -5.5 -5.1 -5.3 -7.5 -8.0 -7.0 -7.2

Memorandum Item: 30,190 30,755 31,165 31,934 33,560 37,614 40,304 41,036 42,322GDP in US$'million

58 Annex II

Table B.2: Bangladesh's Recorded Commodity Trade, 1989/90 -1997/98: Export Composition

Fiscal year; 89X90 91 910; 9/92 92/93 93/94 94195 95/96 96/97 97/98

M inifiian

Readymadegarments 609.3 735.6 1064.0 1240.5 1291.6 1835.1 1948.8 2237.9 2843.3Knitwear 14.8 131.2 118.6 204.5 264.1 393.3 598.3 763.3 940.3Frozen Foods 138.1 141.8 130.5 165.3 210.5 305.6 314.6 320.7 293.8Jute Goods 331.3 290.4 301.6 292.4 283.8 318.8 328.9 317.9 281.4Leather 178.9 134.3 144.5 147.9 168.2 202.1 211.7 195.5 190.3Othermanufactures 2.6 5.1 12.0 25.3 39.9 76.1 115.0 148.6 184.4Raw Jute 124.6 104.2 85.5 74.3 57.0 79.5 90.0 116.3 107.8Chemical products 22.8 39.7 24.9 55.0 53.9 107.3 98.5 108.5 74.2Specialized textile, house linen 4.3 23.2 18.4 29,0 31.8 32.9 41.3 52.0 58.2Leather goods 0.0 2.8 4.4 10.7 23.8 23.2 29.5 26.6 48.1Tea 39.3 43.2 32.4 41.1 38.2 32.8 33.4 38.1 47.5Agricultural products 10.5 7.9 9.7 14.5 15.5 12.5 21.5 28.7 39.1Engineeringproducts 11.5 6.2 9.5 17.5 3.6 9.8 15.0 16.1 19.6Naphtha,furnaceoil, bitumen 16.9 32.5 8.3 36.8 15.6 13.5 10.9 16.4 10.9Fish 7.6 5.6 4.1 5.7 10.8 5.9 3.6 5.1 6.5Handicrafts 5.2 5.2 8.7 5.4 7.3 6.5 6.4 5.7 6.0Others 0.9 1.9 3.8 7.5 9.9 11.6 10.4 15.3 4.6Sharkfins, fishmaws 0.9 1.1 1.0 3.7 0.7 4.1 1.0 2.0 2.4Electronics 0.0 0.0 4.8 0.8 2.5 1.3 1.6 1.9 1.7Stainless steel cutlery 0.0 0.0 0.1 0.2 0.1 0.4 0.6 1.5 0.8Animal casings 0.4 0.1 0.1 0.1 0.0 0.0 0.1 0.1 0.2Crude Fertilizer 0.5 0.5 0.6 1.6 4.2 0.0 1.6 0.0 0.1Total 1523.7 1717.6 1993.5 2382.9 2533.9 3472.6 3882.8 4418.3 5161.2

S:are of total flu(f pen': !g"

Readymade garments 40.0 42.8 53.4 52.1 51.0 52.8 50.2 50.7 55.1Knitwear 1.0 7.6 5.9 8.6 10.4 11.3 15.4 17.3 18.2Frozen Foods 9.1 8.3 6.5 6.9 8.3 8.8 8.1 7.3 5.7JuteGoods 21.7 16.9 15.1 12.3 11.2 9.2 8.5 7.2 5.5Leather 11.7 7.8 7.2 6.2 6.6 5.8 5.5 4.4 3.7Othermanufactures 0.2 0.3 0.6 1.1 1.6 2.2 3.0 3.4 3.6RawJute 8.2 6.1 4.3 3.1 2.3 2.3 2.3 2.6 2.1Chernical products 1.5 2.3 1.3 2.3 2.1 3.1 2.5 2.5 1.4Specializedtextile,houselinen 0.3 1.4 0.9 1.2 1.3 0.9 1.1 1.2 1.1Leather goods 0.0 0.2 0.2 0.5 0.9 0.7 0.8 0.6 0.9Tea 2.6 2.5 1.6 1.7 1.5 0.9 0.9 0.9 0.9Agricultural products 0.7 0.5 0.5 0.6 0.6 0.4 0.6 0.6 0.8Engineering products 0.8 0.4 0.5 0.7 0.1 0.3 0.4 0.4 0.4Naphtha, fumace oil, bitumen 1.1 1.9 0.4 1.5 0.6 0.4 0.3 0.4 0.2Fish 0.5 0.3 0.2 0.2 0.4 0.2 0.1 0.1 0.1Handicrafts 0.3 0.3 0.4 0.2 0.3 0.2 0.2 0.1 0.1Others 0.1 0.1 0.2 0.3 0.4 0.3 0.3 0.3 0.1Sharkfins, fishmaws 0.1 0.1 0.1 0.2 0.03 0.1 0.03 0.05 0.05Electronics 0.00 0.00 0.24 0.04 0.10 0.04 0.04 0.04 0.03Stainless steel cutlery 0.00 0.00 0.00 0.01 0.00 0.01 0.01 0.04 0.02Animal casings 0.03 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00Crude Fertilizer 0.04 0.03 0.03 0.07 0.17 0.00 0.04 0.00 0.00

Annex II 59

Table B.3: Bangladesh's Recorded Commodity Trade, 1989/90 - 1997/98: Import Composition

Fiscal ycar 89/90 90791 91/92 92193 93/94 94/95 95/96 96/97 97198

Exclding ,on-S8 Wbond. baggage and diplomatic USS$mion

1. Primary Commodity 694 1124 653 761 718 1166 1379 1164 1367.3a. Food & vegetable product 323 247 279 359 357 640 734 497 681.8b.Miningproducts 150 705 224 213 183 250 253 229 228.6c. Animals,forestry & other 221 172 150 188 177 276 392 438 456.9

2.1ntermediateInputs 1151 1125 1168 1163 1236 1592 1900 1962 2060.73. Capital Goods 602 539 647 575 564 839 1167 1169 1207.8

a. Capital machinery & parts 427 423 520 426 397 565 815 738 849.9b.Othercapitalgoods 176 115 128 149 167 274 352 431 357.9

4. Final Consumer Goods 266 236 174 241 300 413 470 501 496.6Subtotal non-enclave 2713 3024 2643 2740 2817 4011 4915 4796 5132.5

5. Enclave 513 663 802 961 1153 1752 1696 1982 2381.8a. B/B L/C SBWFabric 481 623 752 875 1032 1555 1435 1580 1888.1b. Export processing zone 32 40 50 85 121 197 262 402 493.7

Total recorded imports 3226 3687 3445 3700 3970 5762 6612 6779 7514.2

Share of total (in percent)

1. Primary Commodity 21.5 30.5 19.0 20.6 18.1 20.2 20.9 17.2 18.2a.Food&vegetableproduct 10.0 6.7 8.1 9.7 9.0 11.1 11.1 7.3 9.1b. Mining products 4.7 19.1 6.5 5.8 4.6 4.3 3.8 3.4 3.0c. Animals,forestry & other 6.9 4.7 4.4 5.1 4.5 4.8 5.9 6.5 6.1

2. Intermediate Inputs 35.7 30.5 33.9 31A 31.1 27.6 28.7 29.0 27.43. Capital Goods 18.7 14.6 18.8 15.5 14.2 14.6 17.6 17.2 16.1

a. Capitalmachinery&parts 13.2 11.5 15.1 11.5 10.0 9.8 12.3 10.9 11.3b. Other capital goods 5.4 3.1 3.7 4.0 4.2 4.8 5.3 6.4 4.8

4. Final Consumer Goods 8.2 6.4 5.1 6.5 7.6 7.2 7.1 7.4 6.6Subtotal non-enclave 84.1 82.0 76.7 74.0 71.0 69.6 74.3 70.8 68.3

5. Enclave 15.9 18.0 23.3 26.0 29.0 30.4 25.7 29.2 31.7a. B/B L/C SBW Fabric 14.9 16.9 21.8 23.7 26.0 27.0 21.7 23.3 25.1b. Export processing zone 1.0 1.1 1.5 2.3 3.0 3.4 4.0 5.9 6.6

Total recorded imports 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Annuagrowth rate (in percent)

1. Primary Commodity 36.3 62.0 -41.9 16.5 -5.7 62.5 18.3 -15.6 17.5a. Food & vegetable product 10.7 -23.4 12.9 28.8 -0.7 79.3 14.7 -32.3 37.1b. Mfining products 346.2 369.3 -68.2 -4.8 -14.0 36.6 1.2 -9.7 -0.2c. Animals,forestry &other 20.1 -22.3 -12.8 25.4 -5.8 55.4 42.2 11.6 4.4

2. Intermediate Inputs 4.8 -2.3 3.8 -0.4 6.2 28.8 19.3 3.3 5.03. Capital Goods 55.9 -10.6 20.2 -11.2 -2.0 48.9 39.0 0.2 3.3

a. Capital machinery & parts 51.5 -0.8 22.8 -18.1 -6.8 42.4 44.2 -9.4 15.2b. Other capital goods 67.4 -34.4 10.7 17.0 11.7 64.6 28.3 22.4 -16.9

4. Final Consumer Goods 14.5 -11.3 -26.1 38.3 24.7 37.6 13.7 6.7 -0.9Subtotal non-enclave 21.9 11.4 -12.6 3.7 2.8 42.4 22.6 -2.4 7.0

5. Enclave 3320.0 29.2 21.0 19.7 20.0 51.9 -3.2 16.8 20.2a. B/B L/CSBWFabric n.a. 29.5 20.7 16.4 17.9 50.6 -7.7 10.1 19.5b. Exportprocessing zone 113.3 25.0 26.1 68.9 42.0 63.0 32.6 53.6 22.8

Total recorded imports 44.0 14.3 -6.6 7.4 7.3 45.1 14.7 2.5 10.9

60 Annex II

Table BA: Bangladesh's Recorded Commodity Trade with India: 1989/90 - 1997/98

Panel A: Annual Imports Yalues: F0isc i: 0 year: 90191i 7. ;:91/92 D /93 0 93194 - 94/95 95/96 96/97 97/98:

Shipment, excluding back-to-back S'milion 200 261 363 590 883 714 779

growth rate 30.5% 39.1% 62.5% 49.7% -19.1% 9.1%

Source: Customs data on imports

Panel B: Top 15 importsfrom India in 1992-1998

Fiscal year: 91/92 ~~~~~ ~ ~~~~92/93 97198

$'million Share $'million Share $'million Share

Rice 211.1 27.1%

Cotton yam 15.3 8% 28.0 11% 78.0 10.0%

Portland, aluminous, slag, supersulphate, similar hydraulic cements 5.9 3% 22.7 65.7 8.4%

New pneumatic tyres & tube, of rubber. 10.7 5% 12.7 5% 20.8 2.7%

Flat-rolled products or iron or non-alloy steel. 21.7 8% 19.9 2.6%

Raw Cotton 5.0 2% 17.9 2.3%

Unwrought aluminium 8.7 4% 10.5 4% 16.7 2.2%

Synthetic organic colouring matter 4.5 2% 6.4 2% 13.3 1.7%

Preparations of a kind used in animal feeding 13.1 1.7%

Heterocyclic cmpnds w/ nitrogen hetero-atom(s); nucleic acids/salts 5.5 2% 12.2 1.6%

Machines and parts for preparing textile fibres 8.2 4% 12.0 1.5%

Onions 26.2 13% 10.6 4% 11.8 1.5%

Coal; briquettes, ovoids, sim. solid fuels manufactured from coal 10.4 4% 11.0 1.4%

Elec. transformers, static convtrs (e.g. rectifiers) and inductors 10.6 1.4%

Mineral or chemical fertilizers, phosphatic 10.3 1.3%

Soya-bean oil and its fractions, maybe refined, not modified 15.9 6%

Synthetic filament yam 5.1 2%

Apples, pears and quinces, fresh. 3.9 2 % 4.4 2%

Eggs 4.4 2%

Parts and accessories of vehicles 3.9 1 %

Chillies, dry 17.1 9%

Salt 13.8 7%

Insulated (including enamelled or anodised) wire, cable 6.0 3%

Parts and accessories of vehicles. 3.5 2%

Machines and mechanical appliances n.e.s. 3.3 2%

Aluminium stranded wire, cables etc. not elec. insulated. 2.5 1 %

Staple fibres 2.5 1 %

All other goods 67.5 34% 93.8 36% 254.1 32.6%

Total 199.5 100% 261.1 100% 778.6 100.0%

Annex III 61

THE METHODOLOGY

A. DATA ENVELOPMENT ANALYSIS (DEA)

Farrel (1957) posited that the overall cost (economic) efficiency (CE) of a firm can be decomposedinto two components: (1) technical efficiency (TE), which reflects the ability of a firn to generate maximumoutput from a given set of factors of production, and (2) allocative efficiency (AE), which reflects the ability ofa firm to use the factors of production in optimal proportions, given their respective prices. Many studies havealso decomposed the overall technical efficiency into two components, one due to pure technical efficiency(PTE) and one due to scale efficiency (SE).

The AE and TE concepts can be better illustrated under the assumption of constant returns to scale(CRS), thinking of a hypothetical firm, f which uses only two factors of production, say labor (L) and capital(K) to produce a single good, y, as in Figure 1. Whereas, the further decomposition of TE into its PTE and SEcomponents can be better depicted with one input (L) and one output (y) case relaxing the CRS assumption asin Figure 2.

If we know the unit isoquant (production technology) of the best-practice firm, such as I- I' in FigureI and On or prstuv in Figure 2, we can measure the overall cost and technical efficiency of our hypotheticalfirm f Isoquant 1- I' shows the whole set of technologically efficient combinations of K and L for producing agiven level of output, y, . Isoquants further to the right are associated with higher levels of output, those to theleft with lower levels of output. For instance, the output level corresponding to isoquant III- III, y3, is greaterthan y,.

The isocost line, as represented by c-c in Figure 1, shows alternative combinations of K and L that thefirm can buy for a given outlay. Obviously the slope of the isocost line reflects relative factor (input) prices.The least cost position is given graphically by the tangency point between the isoquant and the isocost line.Given the factor prices and available technology, the optimal combination in Figure 1 is at point e. Anyalternative combination of the inputs along the c-c'isocost line would bring about less output for the same cost.If the observed combination of inputs used by our hypothetical firm, f to produce y, is at pointf in Figure 1, itcan be seen that the firm is inefficient because the point e was shown above to correspond to the most efficientcombination of K and L to produce y,.

Figure 1. Cost Efficiency (CE) Figure 2. Technical Efficiency (TE)

II' I' III' yK lontie

U VCE=Oa/f t

b JJJ(y~~~~~~~~~~~~~~~) ~FT-n7tier

II (v2)0 c L 0 p L

CE =AE xTE TE = PTE xSECE = Oa/ Of TE '=km/kfAE = Oa/ Ob PTE = ks / kfTE = Ob / Of SE krn/ks

62 Annex III

In Figure 1, to demonstrate allocative and technical efficiency of the firm, a line is drawn from theorigin, 0, to the pointf (dotted line, O). Farrell proposes that the technical inefficiency (TIE) of the firm couldbe represented by the distance bf which is the amount by which K and L could be proportionally reducedwithout a reduction in output. Stated differently, the combination of K and L associated with point f shouldenable the firm to produce a level of output, y3, which is greater than y,. Efficiency (inefficiency) measures aregenerally stated in percentage terms. For example, the TIE of the firmf is represented by the ratio bf/ Of, whichreflects the percentage by which all inputs could be reduced. Thus the overall technical efficiency (TE) of thefirm is given by: TE = I - TIE = I - (bfl OJ) = Ob / Of TE will take a value between zero and one and a value ofone will indicate that the firm is fully technically efficient. For instance, if both firns b and f produce y. levelof output, the firm b which lies on the frontier is fully technically efficient, whereas f is not. If the TE of thefirmf is say 80%, then this implies thatf would be able to reduce the consumption of all inputs (K and L) by20% without reducing its output if it were operating on the frontier like the firm b.

Allocative efficiency (AE) stems from the right input combinations given input prices. If we alsoknow the input price ratio, represented by the isocost line c-cl we can also measure allocative (price)efficiency. The allocative efficiency (AE) of our hypothetical firm. operating atf is expressed as follows: AE =

Oa / Ob. The firmf is also allocatively inefficient since the distance ab represents the potential reduction inf 'sproduction costs that would occur if production were to occur at the allocatively (and technically) efficientpoint e, instead of at the technically efficient, but allocatively inefficient, point b. Hence, the distance abcorresponds to additional production expenses resulting from the suboptimal allocation of inputs.

The distance af can also be regarded as a potential for cost reduction. It shows the amount by whichthe total production costs of the firmf can be lowered by eliminating both technical inefficiency (the distanceb]) and allocative inefficiency (the distance ab). This gives rise to overall cost efficiency (CE) measure, whichis simnply the product of allocative and technical efficiency: CE == AE x TE, in other words, CE = (Oa / Ob) x(Ob / Of) = Oa / Of

The CRS assumption is only justifiable when all firms are operating at an optimal scale (i.e. onecorresponding to the flat portion of the long run average cost curve). However, firms in practice might faceeither economies or diseconomies of scale because of imperfect cornpetition, constraints on finance, etc. In1984, Banker, Chames and Cooper proposed an extension of the CRS model to account for variable retums toscale (VRS) cases. If one makes the CRS assumption when all finns are not operating at the optimal scale, thecomputed measures of TE will be confounded (contaminated) with scale efficiencies (SE). The VRSassumption, on the other hand, will provide the measurement of 'pure" technical efficiency (PTE), which issimply TE devoid of these SE effects. Further decomposition of TE into its PTE and SE components can beaccomplished by conducting both a CRS and VRS specification upon the same data. If there appears to be adifference in the two TE scores for a particular firm, then this indicates that the firm has scale inefficiency.Thus the scale inefficiency can be obtained from the difference between the VRS TE and the CRS TE score.

Figure 2 illustrates the decomposition of TE for one input (L) and one output (y) case by means ofCRS and VRS frontiers. Under both assumptions, the firm which operates at point f in Figure 2 is technicallyinefficient. Under CRS, the technical inefficiency of the point f is the distance mf, while under VRS thetechnical inefficiency would only be sf The difference between these two measures, ms, is attributed to scaleinefficiency, which simply indicates that the firmf can produce its current level of output with fewer inputs if itattains CRS. In Figure 2, CRS frontier is represented by On, and it simply depicts the optimal level of output,which can be obtained for given input levels. In other words, CRS frontier shows what is attainable and what isunattainable with the given technology, and thus the firms either lie on or below it. The constituents of overalltechnical efficiency (TE), PTE and SE, for the firmf can also be expressed in ratio form: PTE = ks / kf and SE= km / ks. The technical efficiency of the firmf is thus simply the product of PTE and SE: TE = PTE x SE(ks / k]) x(km / ks) = km / kf.

Annex III 63

B. ESTIMATING EFFICIENCY INDICATORS AND MEASURING PRODUCTIVITYCHANGES

Approach. As elaborated in the main text, trade liberalization induces domestic firms to improvetheir competitiveness through enhanced technical efficiency in input use as domestic markets are opened toforeign competition. Also, with the increased availability of new/modem capital goods, new products,information about new technologies, and increasing opportunities to imitate and innovate, domestic firms canundertake technological changes. These two impacts--improvements in technical efficiency and technologicalprogress--induced by trade liberalization create productivity gains in the economy as factors of productionbecome more productive.

To estimate the impact of trade liberalization on technical efficiency of domestic firms--i.e., on howefficiently inputs are being used as competition intensifies--a relative technical efficiency approach is used inthis study. Accordingly, for each of the two observation years, "efficient production frontiers" are constructedfrom the input-output observations of the best practice (most efficient) firms in each of the identified groups offirms.1 A (non-parametric) Data Envelopment linear programming model--described below--is used toconstruct these frontiers. The solutions of the model, where appropriately defined objective functions areoptimized subject to a set of constraints for each finn, identify the best-practice finns on the basis of thecriteria defined by the constraints.2 The latter group's input-output relations make up the "best-practice"production frontier. For each group, these frontiers constitute the "benchmark technology", and each firm'stechnical efficiency indicator is measured relative to the benchmark frontier of that particular observation year.

Shifts in the efficient production frontiers over the two observation years represent "technologicalprogress" facilitated (at least in part) by trade liberalization, while positive changes in relative "technicalefficiency" of each firm over the same period indicate improvements in "catching up" with the best-practicefinns. These two effects taken together--i.e., their product-give a measure of total factor productivity growth(TFPG). Here, the specific index used for measuring TFPG is the Malmquist index.

Measuring efficiency and productivity changes: the Malmquist Index3. There are two basicindexes in the literature to measure productivity change in decision making units (DMUs): the Tomqvist(1936) index and the Malmquist (1953). In order to investigate the impact of trade liberalization on firmproductivity, we choose the Malmquist productivity index, which is dubbed after Sten Malmquist, a Swedishecnomist and statistician. We measure productivity change as a geometric mean of two Malmquist productivityindexes. The Malmquist index is preferable to Tomqvist index in conducting productivity analysis because theformer unlike the latter uses exclusively quantity information and thus demands neither problematic priceinformation nor a restrictive behavioral assumption in its calculation. Also, unlike the latter index which istranslog, the former index can be obtained by utilizing a nonparametric approach, which yields deterministicindex numbers, yet does not necessitate a possibly unwarranted specification of production function.Furthermore, the Malmquist index has informational advantage over the Tomqvist index in the sense that itallows one to isolate catching up to the frontier (efficiency change) from shifts in the frontier (technologychange).

Within the context of consumer analysis, Malmquist (1953) used input distance functions to comparetwo consumption bundles, e.g., one observed in year t2 and one observed in year t,, with respect to a referenceset, e.g., indifference curve of a consumer. In this sense, his quantity index is a measure showing by whatfactor the quantities in year t, should be scaled to give a consumer the same utility in year t,. In 1982, Caves,Christensen and Diewert (henceforth, CCD) carried the Malmquist's idea to production analysis. When

' The production function of the best-practice (fully efficient) firm in an industry is not known in practice and thus must be estimated froma sample of observations on the firms operating in the industry. The data envelopment analysis (DEA) linear programming model, as amember of nonparametric frontier family, estimate a non-stochastic envelopment frontier over the data points such that all observed pointslie on or below the frontier.2 The constraints are defined so as to ensure that only the best practice firms lie on the efficient (benchmark) production frontier of thatparticular observation year. This mean that no other firm (or linear combination of firms) produces as much or more of every outputwithout changing the input quantities used; (or, put in terms of input-orientated efficiency, no other firm or linear combination firms usesas little or less of every input without reducing output levels).3 This section draws on Fare et al. (1994), summarizing the Malmquist productivity index approach they developed and applied to 17OECD countries to examine the relative importance of technological changes and technical efficiency gains in explaining TFPG in thesecountries.

64 Annex III

measuring the scale factor, CCD exploited the Shephard concept of distance functions. Unlike CCD, Fare etal. (1985) defined the Malmquist index by exploiting the relationship of distance functions to the technicalefficiency measures of Farrel (1957). Also, CCD demonstrated that the Tomqvist index is equal, under certainconditions, to the geometric mean of a pair of Malmquist indexes.4 However, CCD presumed that production isalways efficient, an assumption with which it is impossible to trace the sources of productivity growth. Fare etal. (1989) adapted the Malmquist index to the case of inefficient observations, which made it possible todecompose productivity change into its components.

As in Fare et al. (1994), we adopt the output-orientated Malmquist index to measure productivitychange. Consider that N, firms employ p inputs to produce q outputs for each time period t = 1, 2, ..., T.

Transformation of the vector of inputs, xt -e9 p, into the vector of outputs, y, eE q during the productionprocess is represented by the function, F,:

F, = (x, y): x canproducey at time t}, (1)which is simply the production possibilities set, the set of all feasible combinations of inputs and outputs, attime t.5 By forming the upper boundary (frontier) of F, the best-practices in the sample define the efficientproduction technology at time t. The frontier constructed, however, is not static but subject to change perhapsdue to innovation, shocks (crises), changes in the market structure and regulatory treatment of firms over time,or perhaps some other factors.

Letting that x, and y, represent the observed input and output vectors of a firm at time t, respectively,the Shephard (1970) output distance function relative to the technology existing at time t is defined as:

dt (xt, yt) = inf {b: (x,, y, / ,) f F}. (2)which gives a normalized measure of the distance from the location of a firm in the input/output space to theproduction frontier at time t in the hyperplane, where inputs are held fixed. Thus, the distance of a combinationof x, and Y, to the frontier can be as low as zero and as high as one if measured relative to the contemporaneoustechnology (i.e., 0 < dt (x,, yt) S 1), but it can be higher than one if measured relative to the technology ofanother period (i.e., 0 < dt+1 (x, y,) [< or >1 1).

Using a simple case of single-input/single-output and constant return to scale (CRS), Figure 3illustrates these concepts. Assume that in year t, a firn was observed at the combination (x,, y,), whereas inyear t+1, it was observed at the combination (x,+,, y,+,). In this multi-period setting, there are twocorresponding benchmark firms for both observations. The first year observation (xe, y,) can be compared with

either the efficient point on its contemporaneous frontier (x, y') or the efficient point on the next year

t+1~~~~~~~~~~~~~+frontier (x, , y,'+ ). Likewise, the second year observation (x,+,, y,+,) can be assessed with respect to either

the efficient point on its contemporaneous frontier (x,+>, y'++ I) or the efficient point on the previous year

frontier (x,t1 , y,'). When measured relative to their own contemporaneous frontiers, both observationsrepresent feasible but technically inefficient production points because they are interior to the frontiers.

However, the firm observed at t+I (x,,1, y,+i) does better than the benchmark efficient firm at t, (x,+1, y' I),i.e., the firm at t+l became able to produce more output, d, than the corresponding efficient firm at t would doin the previous year, e, with the same level of input, x,+,.

The conditions are that all second-order terms must be constant over time and the Lnderlying functional form for technology must betranslog.5F, is assumed to satisfy certain conditions which mnake it possible to obtain meaningful output distance functions (see Shephard, 1970).

Annex III 65

Figure 3. The Output distance functions and Malmquist output-orientated productivity indexY A

t+1~~~~~~~~F+f=yt+1 -f t+I ------------------ --- - ------ /

d=yt+1 .,. . 1 (x1÷1,y,+l)

d yt+ ____-_-------------- -7 /X+/ /,]

t+ I

e = Y l .. ./ .. .. ......

b=yi

0 xt x,+, x

Fare et al. (1994) specifies the output-orientated Malmquist total factor productivity change (TFPC)index, M, as the geometric mean of two Malmquist productivity indexes:

11/2

-M(Yr,xt+I;Ytxd = dt(XI+ Y,+d X dt+l (XI+] ,Y+) (3)d(xt,,y9) yt_d,+, _ xf_ y

(MI) (M2 )

The first term in the above equation (M2) represents the Malmquist productivity change indexobtained relative to the benchmark technology in period t, whereas the second term (M) represents theMalmquist productivity change index calculated relative to the benchmark technology in period t+]. Therepresentation of productivity change as geometric mean of these two output based Malmquist TFP indexes (M= (Mix M2)1f 2] precludes arbitrariness in choosing the reference technology. M defines the productivity of theproduction point (x,+,,r, y+) with respect to the production point (x,, y,) according to both years' technologies.M can attain a value greater than, equal to, or less than unity depending on whether the firm I experiencesproductivity growth, stagnation or productivity decline, respectively, between periods t and t- 1.

Fare et al. (1989, 1992) wrote the equation (3) in such a way that one can determine the sources of theproductivity change:

- ~~~~~~~~1/2

(yt+1 t+1t t t+1 t+1' t+1 x_ t( t+'Yt+ x t_ t t_d (x,y d (x y d (x ,y) (4)

t t t t+1 t+1 Yt t+1 t

TFPCH EFFCH TECHCH

When written in terms of output distances on the y-axis, the equation (4) takes the following form:

66 Annex III

Od ) (Ob). (Od/Oe ) (Oa/Ob 12

M(yt+ 1,xt+ 1;yt,x,) = (Of Oa OdT/Of) K Oa/Oc

M(yt+,,xt+z;y,,x,) = Od) x Oa) x Oe) x Obc (S)

TFPCH EFFCH TECHCH

In the above two forms, (4) and (5), the Malmquist Total Factor Productivity change index (TFPCH),M, is defined simply as the product of efficiency change (EFFCHY), how much closer a firm gets to the efficientfrontier (catching up), and technological change (TECHCH), how much the benchmark production frontiershifts at each firm's observed input mnix (innovation or shock). EFFCH index takes a value greater than 1 incase of efficiency increase, I in case of no efficiency change, or less than I in case of efficiency decrease,between periods t and t+l. Similarly, TECCH attains a value greater than 1 in case of technical progress, 1 incase of no change, or less than I in case of technical regress, between periods t and t+l.

In order to measure the productivity change, we obtain M utilizing a mathematical programmingtechnique, Data Envelopment Analysis (DEA). For the time being, we assume that CRS technology exists: allfirms are scale efficient, but later we will relax this assumption to decompose EFFCH in addressing scaleefficiency issues. To get M, we need the four component distance functions in the equation (3), which involvesfour linear programming (LP) problems for each firm in the sample.

First, d, (xt, y) is obtained solving the following CRS output-orientated LP:

[d, (xt, y )] = max) 0,

S. t.

- !YY i + Y Ž 0, (6)

xi( -XtA 2 O,

A2 Ž0,The remaining three LP problems, (7), (8), and (9), are simple variants of (6):

[dt+ (xt+,, y,+ )]- = maxo,A 0,

S.t.

-oYYi,1+- + YtJLA > 0, (7)

xit+l- Xt+]A i 0,

A Ž 0,

[dt(x,+,y,+,)]-l = max0,A ob,

S. t.

-OYyi+, + Y'A 2 O, (8)

xi,t+ I-XtA > 0,

A >0,

Annex III 67

[dt+1(xt,y)] = maxo,2 9,

S. t.

-9YYid + Y+ 1A > 0, (9)

xit -Xt+,Sl 2 O,

A2 0,where 's represent intensity variables showing at what intensity a particular activity (i.e., each firm) may beused in production. Also, 1 < 0 < x and 0 -I is the proportional increase in outputs that could be realized by thei'th DMU, with input quantities held constant. The 0 and 2's are likely to take different values in the abovefour LP's. Farrel technical efficiency (TE) index is given by 1/0 and attains a value between zero and one. InLP's (8) and (9), where production points are compared to technologies from different time periods, the t

parameter need not be > I, as it must be when calculating Farrel efficiencies. It may be that the point could lieabove the feasible production set. This will most likely arise in LP (8) where a production point from periodt+l is compared to technology in period t. If technical progress has occurred, then a value of 0 < 1 is possible.It could also possibly occur in LP (9) if technical regress has occurred, but this is less likely.

Finally, we can also decompose the technical change into scale efficiency and pure technicalefficiency components (EFFCH = PEFFCH x SCH). This requires the calculation of distance functions undervariable retums to scale (VRS) (instead of a CRS) technology, requiring us to solve two additional LPproblems (when comparing two production points). To achieve this, we simply repeat LP's (6) and (7) with theconvexity restriction (NI 'A=1) added to each. We then use the CRS and VRS values to calculate the scaleefficiency effect residually.6

6See Fare et al. (1994, p.75) for more on scale efficiencies.

Selected References 69

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