World Development, Vol. 16, No. 12, pp. 1419-1439, 1988. 0305-750X/88 $3.00 + 0.

00
Printed in Great Britain. fQ 1988 Pergamon Press plc

Foreign Exchange Regimes and Industrial Growth

in Bangladesh

JOSEPH J. STERN and RICHARD D. MALLON

Harvard Institute for International Development, Cambridge, Massachusetts
THOMAS L. HUTCHESON*
World Bank, Washington, DC

Summary. -Foreign exchange regimes have been found to play an important role in implement-
ing trade and industrial development strategies in many developing countries. The economic in-
centives provided to export-oriented and import-substituting industries can be measured by the
real effective exchange rate (REER) for imports and exports. Such measures are develooed for
Bangladesh. The REER for exports’and imports increased by around 72 and 82%, respectively,
over the period 197>74 to 1976-77. From 197677 to 1984-85. the REER for imoorts fell bv
nearly 10% while the REER for exports declined by 6%, although the exchange rate for non-
traditional exports fared somewhat better. The REER for both imports and exports appears to
have recovered somewhat since 1984-85, but the paper concludes that while trade and industry
policies in Bangladesh have become less “inward-looking,” the exchange regime is still biased in
favor of import-substituting industrialization. Substantially stronger export incentives than exist
at present would be necessary to remove this bias.

1. INTRODUCTION at promoting and diversifying exports. More re-

cently many countries, again including Bangla-
Management of the external sector involves desh, have become more “outward-looking.”
consideration of trade-offs among multiple and This shift in policy has provided a wealth of new
potentially conflicting objectives. On the one empirical evidence on the results of different
hand, there is a need to encourage the expansion trade and industry development strategies re-
of exports and to take advantage of improved ported in numerous comparative and individual
technology and capital inflows so that rapid eco- country studies published since 1970.’ Almost
nomic growth is not inhibited by shortages of without exception these studies strongly suggest
capital, know-how, or foreign exchange. On the that undue reliance on import-substituting poli-
other, there is a need to provide incentives for
efficient import substitution to save foreign ex-
change and to strengthen national self-reliance.
*This paper was prepared while the authors served as
These different objectives have been incorpor-
consultant, senior project advisor, and advisor on
ated in development strategies which have been industrial studies respectively, to the Trade and Indus-
labelled as either “outward-looking,” usually trial Policy Reform Programme, Government of the
taken to mean that importance is given to provid- People’s Republic of Bangladesh, Dhaka. The views
ing incentives for the development of the export expressed here are, however, solely those of the
sector, or as “inward-looking,” defined as a strat- authors.
egy focused primarily on the development of We would like to thank our colleagues in Bangladesh
import-substituting industries. In fact, however, who read and commented on earlier drafts of this
paper. In particular, Dr. Abdur Rab, Dr. K. M. Matin,
successful development seems to require a care-
Dr. S. R. Osmani, Prof. A. Rashid, and Kamal
ful combination of the two.
Ahmad. Fred Eaton provided research assistance. We
In most developing countries, including Ban- hope that in responding to their comments, sugges-
gladesh, early industrialization efforts focused tions, and criticisms we have improved our analysis and
primarily on fostering import substitution, with removed errors of logic. However, the authors claim
little attention initially given to policies aimed full responsibility for any remaining errors.

1419
1420 WORLD DEVELOPMENT

ties fails in its objectives of developing a dynamic prices. During the earlier period of more rapid
industrial sector or ‘of narrowing the balance of industrial growth the share in current prices rose
payment gap. Rather, after an initial period of significantly, whereas in constant prices it has
rapid industrial growth, bottlenecks are created hardly changed at all. In contrast, during the sub-
that eventually block further expansion, a situa- sequent period, the shares remained relatively
tion commonly referred to as the “exhaustion of stable in both current and constant prices. This
easy import-substituting opportunities.” finding is consistent with the hypothesis that dur-
The experience of Bangladesh appears to be ing the earlier period government policy relied
consistent with these findings, even though the more heavily on increasing the real effective ex-
country has been independent for less than a change rate for imports to protect domestic pro-
decade and a half. The average rate of growth of ducers against import competition than it did
the manufacturing sector slowed markedly after during the subsequent period, a hypothesis that is
1978/79 although there is some indication that in accord with the analysis in Section 3 of this
another period of accelerated growth may have paper.2
started in 1983/84 despite a temporary setback in Initial heavy reliance in Bangladesh on policies
1985/86. The official industrial production index, to promote import substitution at virtually any
shown in Table 1, does not accurately reflect the cost also seems to have produced results consist-
rate of growth because of under-reporting and ent with other findings of the comparative inter-
the outmoded weighting system used, but recent national and country studies mentioned above.
attempts to correct for these shortcomings do not As can be seen in Figure 1, Bangladesh’s industry
fundamentally alter this conclusion. and trade policies predictably did not bring about
Perhaps the most interesting statistic in Table any increase in the share of exports in manu-
1 is the contrast between the shares of manu- facturing production until recently when policies
facturing in total GDP in current and constant became less “inward-looking.” Furthermore,

Table 1. Manufacturing secfor growfh (percent)

Share of
Annual changes in industrial manufacturing in
production index total GDP
Old New New Current Constant
weights* weightst data$ pricess prices11

1974175 -2.4 6.2 0.8 6.7 10.5

197.5176 7.5 10.3 8.4 7.6 10.0
1976177 8.4 11.5 13.4 8.2 10.3
1977178 9.6 12.6 11.4 9.1 9.8
1978179 6.3 1.8 7.7 9.2 10.7
Average J.j 8.5 &3u 10.3
1979180 0.0 2.7 5.2 9.9 10.7
1980/81 0.2 7.2 7.9 9.8 10.6
1981/82 0.0 3.5 0.0 9.7 10.7
1982/83 -4.9 -7.2 0.9 9.7 10.2
1983/84 4.4 10.7 13.1 8.8 10.1
Average 1.5 3.4 2 u 10.5
1984/85 3.5 8.3 10.1
1985/86 -2.0 . 8.1 9.8
1986187 8.3 7.5 10.0
Average j.J &J 10.2

Sources: *Bangladesh Bureau of Statistics.

tAbraham (1984).
$Aksoy (1985).
BWorld Bank (1985a). Tables 2.1 and 2.2 and World Bank
(n.d.), Tables 2.1 and 8.1.
I/Constant 1972/73 market prices.
 FOREIGN EXCHANGE AND INDUSTRIAL GROWTH 1421

40

36

32

26

24

$ 20

16

12
/

011975/76
’ I
1977/76
I
1979160
I
1961/62
I
1963/64
Years
0 Exports / Production 0 Imports/Absorption

Figure 1. Imporlance of foreign trade in domestic production and absorption of manufactures

despite the emphasis of policy on promoting im- policies become more “outward-looking,” new
port substitution, the share of imports in total export-oriented firms are frequently set up to
apparent domestic absorption of manufactured take advantage of special incentives that permit
goods appears to have increased significantly them to import modern equipment and input re-
up to 1982. This seemingly paradoxical effect quirements, often at concessionary tax rates or
of policies aimed precisely at producing the duty free. Because existing firms, catering for the
opposite result also has precedents in other domestic market, still cannot export directly or
countries. supply inputs to export-oriented firms at com-
Although it can be misleading to generalize on petitive prices, new industrial exports tend to
the basis of the experience of other countries, it have little local content, generating lower net
may be useful to consider the relevance for Ban- foreign exchange earnings than would have been
gladesh of some of the reasons why heavy reli- possible if government policy had not promoted
ance by other developing countries on “inward- development of a dual industrial structure. The
looking” trade and industry policies have had export garment industry in Bangladesh is a good
limited success. Perhaps most important is the re- example of this phenomenon.
latively small size of domestic markets in these Because opportunities for substituting imports
countries which prevents many industries from of final consumer goods tend to be exhausted
capturing potential economies of scale. Even rather quickly, and because import-substituting
though Bangladesh has a population of about 100 development strategies usually favor establish-
million, non-agricultural income, which gener- ment of “basic” industries, “inward-looking”
ates most of the purchasing power for manu- policies are then aimed at promoting domestic
factured goods, is only 2.5% as large as that of production of intermediate products. Since these
Brazil and barely 0.6% of that of Japan, two products often rely more heavily on scale econo-
countries which have a population of similar size, mies and enjoy even less comparative advantage
yet neither of which considers itself large enough than most final consumer goods, nominal protec-
to forego the advantages of specialization and of tion rates tend to escalate with the introduction
scale economies made possible by international of each new stage of domestic production. The
trade.” Smaller, poorer countries, can afford result is that user industries become increasingly
even less to forego these advantages. non-competitive, and that input costs represent a
In most cases the expansion of import- rising share of the value of manufacturing output.
substituting industries soon tends to be con- In Bangladesh, for example, the rising cost of in-
strained by limited domestic demand. Since their puts relative to the price of outputs resulted in a
relatively high costs usually make exporting un- fall in the share of value added in the gross value
profitable, these industries are also often saddled of manufacturing output from about 50% in
with substantial idle capacity. This factor, plus 1973174 to 33% in 1981/82.
the lack of competitive pressure to improve oper- New domestic production of intermediate pro-
ating efficiency and product quality, dooms them ducts is often so import-intensive that it gener-
to remain “infants who never grow up.” When ates negligible net foreign exchange savings.
1422 WORLD DEVELOPMENT

Policymakers then discover that far from reduc- ence of Bangladesh we describe below. Exchange
ing the demand for foreign exchange, import- rate policies and export development are analy-
substitution industrialization has made their zed in Section 2 while the relation between ex-
countries even more dependent on imports. Most change rates and import-substitution policies is
final consumer goods have already been substi- reviewed in Section 3. A brief summary of find-
tuted, so the only way to cut imports in lean years ings concludes the paper.
is to reduce purchases of raw materials and inter-
mediate products required to maintain the level
of production. For this purpose quantitative reg- 2. EXCHANGE RATES AND EXPORT
ulations are frequently introduced to allocate PROMOTION POLICIES
scarce foreign exchange. With the exchange rate
no longer relied on to balance supply and de- Before entering into an analysis of export
mand, real exchange rates are allowed to fall promotion policies, it will be useful to see what
further, discouraging export expansion and has actually happened to Bangladesh exports
diversification. over time. Table 2 summarizes the data, shown in
Introduction of more outward-looking policy greater detail in Appendix Table A2, on total,
strategies therefore almost always involves cur- traditional and non-traditional exports, in US
rency readjustments and some relaxation of dollars at current prices. The most striking fea-
import restrictions. International experience ture of this table is the increase in the share of
indicates that such policy changes do not usually non-traditional exports, especially since 1978/79.
produce dramatic turnabouts. Because socio- Almost all of these exports can legitimately be
political considerations impede drastic restruc- considered manufactures, with the bulk consist-
turing or the phasing out of older industries that ing of ready-made garments and processed food.4
may no longer be economically viable under the A number of policy measures helped stimulate
new strategy, a dual industrial structure is cre- this growth. The exchange rate, and in particular
ated in which competitive and non-competitive the real trade-weighted exchange rate, de-
firms continue to exist side by side with few, if preciated while other incentive measures, such as
any, transactions between them. The older firms export performance licensing (XPL), access to
may continue to stagnate while the newer firms bonded warehouses, and concessionary credit
struggle to gain a foothold in competitive mar- and duty rates were given to exporters. All of
kets, a task which usually takes time. these incentives serve to increase the taka earn-
This scenario seems consistent with the experi- ings of every unit of exports. The impact of these

Table 2. Exports: Traditional and non-traditional*

Share of
non-traditional
Traditional Non-traditional exports
Total (US $ millions; current prices) (percent)

1973174 97.40 90.23 7.17 7.4

1974175 102.38 91.86 10.52 10.3
1975176 181.25 163.94 17.31 9.5
1976177 217.76 196.08 21.68 10.0
1977178 234.35 212.02 22.33 9.5
1978179 314.46 275.69 38.77 12.3
1979180 359.01 315.01 44.00 12.3
1980/81 374.93 323.08 51.85 13.8
1981/82 404.41 330.72 73.69 18.2
1982/83 588.17 429.70 158.47 26.9
1983/84 657.38 509.09 148.29 22.6
1984/85 849.02 596.72 252.30 29.7
1985/86 799.11 499.79 299.32 37.5
1986/87 1,073.98 570.61 503.37 46.9

Sources: Appendix Table A2 for data for 1973/74-1984/85. Data for

1985/861986/87 from Export Promotion Bureau and Bangladesh
Bureau of Statistics.
*Data in takas converted to US$ at the 1986/87 exchange rate.
 FOREIGN EXCHANGE AND INDUSTRIAL GROWTH 1423

various measures can be combined to yield a real Table 3. Export exchange rates: 1973174-1987188
effective trade-weighted exchange rate, which (taka/US$)
measures the real earnings per unit of exports.
Because of data limitations, the real effective ex- Trade-weightedt
change rate only includes export taxes and the Nominal* Nominal Real
subsidy provided through the XPL scheme.
Other export incentive measures are reviewed 1973174 7.97 7.97 7.97
and their impact assessed. 1974175 8.88 8.79 7.45
Consider first movements in the exchange rate. 1975176 15.05 14.46 12.90
The nominal exchange rate, expressed in terms 1976177 15.43 14.47 14.07
of taka/US$, has moved from Tk 7.97/$ in 1973/ 1977178 15.12 14.63 13.74
74 to Tk 30.47/$ in 1987/88, an increase in the 1978179 15.22 15.15 13.68
1979180 15.49 15.39 13.71
value of the dollar relative to the taka, of some
1980/81 16.26 15.47 13.63
282%. But the nominal exchange rate tells only 1981/82 20.07 17.04 14.88
part of the story and the least interesting part at 1982/83 23.80 17.97 15.72
that. The taka may appreciate against some cur- 1983184 24.94 17.38 14.94
rencies even as it depreciates against the dollar, 1984185 25.96 16.04 12.68
an outcome especially likely in an era of floating 1985186 29.68 18.56 14.44
exchange rates. To measure the total impact of 1986187 30.07 19.27 14.72
movements in the various exchange rates, one 1987/88$ 30.47 20.29 16.33
needs to develop an index of the trade-weighted Percentage changes
exchange rate which provides a better measure of 19731741987188 282.3 154.6 104.9
what a representative exporter actually earns 1973/74-1979180 93.6 93.1 72.0
than does the nominal taka/dollar exchange rate. 1979/8@1987/88 96.7 31.8 19.8
As shown in Table 3, the appreciation of the US
dollar against other currencies during much of *Economic Trends (Dhaka: Statistics Department,
the period covered meant that the trade- Bangladesh Bank, various issues).
weighted exchange rate has depreciated substan- tThe nominal trade-weighted exchange rate is based on
tially less than the nominal taka/dollar exchange an index applied to the actual 1973/74 exchange rate, of
a weighted average of the exchange rates for Bangla-
rate. More important, while the taka depreciated
desh’s major export trading partners, with the weights
fairly substantially over the period 1973/74 to reflecting their share in total exports for the period
1979/80, the trade-weighted exchange rate has 1979-82. The real trade-weighted exchange rate is the
depreciated much less since then. Despite the nominal trade-weighted exchange rate deflated by a
common perception of a rapid continued depre- weighted average of consumer price indices (1980 =
ciation of the currency, the reality facing expor- 100) for the major export trading partners, relative to
ters is of a more modest decline. the consumer price index in Bangladesh. See Appendix
While the nominal trade-weighted exchange Table A5 for trading partner weights. All data from
IMF, International Financial Statistics (various issues).
rate provides a better measure of the incentive to
*July-December 1987 data only.
exports than does the unweighted exchange rate,
the attractiveness of exporting also depends on a
number of other factors. First, account must be
taken of price than es in Bangladesh relative to ciation of the exchange rate has been relatively
its trading partners. 5 To the extent that inflation moderate. In fact, the real, price deflated, trade-
is higher (lower) in Bangladesh than in its trading weighted exchange rate for 1987/88 stood at
partners, exports become less (more) competi- about the same level it was five years earlier.
tive. Since inflation in Bangladesh has generally The incentive to export depends on the total
exceeded the weighted average inflation rate in returns earned per unit of exports, which is a
countries that buy its exports, the real (price de- function not only of the exchange rate but also of
flated) trade-weighted exchange rate depreciated export taxes paid net of subsidies received.6 In-
by about one-third of the nominal exchange rate. corporating the effect of duties and subsidies
Put differently, part of the taka devaluation did yields a real effective exchange rate (REER). Be-
not provide an additional incentive to Bangla- cause export policies differ in their treatment of
desh exporters but served to offset the erosion in “traditional” and “non-traditional” exports, real
their competitive position resulting from the effective exchange rates have been calculated
higher rates of domestic inflation relative to the separately for these two export categories as well
inflation in importing countries. In short, once as for total exports.
relative price movements are taken into account, Some traditional exports are subject to export
the incentive to export provided through a depre- duties which reduce the receipts earned by expor-
1424 WORLD DEVELOPMENT

ters of such commodities. Export duties paid are The entitlement rates have varied over time. In
deducted from total export receipts in calculating 1979/80 and 1980/81 four rates were in effect
a real effective exchange rate (REER). The use ranging from 10 to 40%; in 1981182 there were
of export duties can be justified in cases where an only two rates (40 and 60%); in 1982/83 and 1983/
economy is able to exert market power. There is 84, there were three rates (40, 60, and 80%);
some doubt whether in fact the long-run price while in 1984/85 the entitlement rates were 60,
elasticities facing Bangladesh justify an export 80, and 100% .9 The value of exports under XPL,
duty on such traditional exports as raw jute and classified by entitlement rates is shown in Table
tea. In any event, export duties, which peaked at 4. By 1984/85, the last year for which detailed
4.4% of the value of traditional exports in 19791 data are available, some 37% of all exports were
80, have declined to less than 1% in 1986187.’ covered by the XPL scheme.
The second measure included in the calculated The premium earned by selling XPL certifi-
real effective exchange rate is export perform- cates is determined by the percentage difference
ance licensing (XPL), now renamed export per- between the WES and the official exchange rate.
formance benefit (XPB). XPL(XPB) is a means This premium, also shown in Table 4, has varied
of increasing the returns to exporters. The over time but has trended downward. When the
rationale for an XPL/XPB system (or some premium fell to only 1.4% in 1982/83, the value
variant thereof) is that the import tariff system to exporters of the XPL scheme declined by some
inevitably introduces a bias against exports. This 70% even though the total value of exports
occurs because on the output side export activi- covered by XPL rose substantially in that year
ties are unprotected since exports, by definition, over the previous year. Both the premium rate
are sold at world prices. At the same time traded and the value of XPL certificates subsequently
inputs into the production of exports are pur- rose until 1984/85 but since then the value of the
chased at a price reflecting their cif value plus premium has declined.
import taxes paid plus the value of a scarcity pre- In general we would argue it is important that
mium for those commodities subject to quantita- exchange rate management prevent a repetition
tive controls. Protection also raises the cost of of the sharp decline in value of XPL to ex-
non-traded inputs and factors of production. porters, such as occurred in 1982183, because
Consequently, the effective protection afforded frequent and sharp changes in the returns to ex-
export activities is generally negligible or even porting are not likely to induce investors to
negative.s An import duty drawback scheme, undertake such activities. While the “Export
which is in use in Bangladesh but which operates Policy Order: 1984/85” listed four items as eli-
poorly, or use of a “bonded warehouse” scheme, gible for the new 100% XPL entitlement rate; in
which works better but covers only a few items, 1985/86 the list was expanded to 45 items and this
as well as the export performance licensing was further expanded to 72 items in 1987/88. The
scheme, all serve to partially offset the bias coverage of XPB benefits has therefore increased
against exports. but at the same time the premium has been al-
Exporters of commodities covered by the XPL/ lowed to decline to less than 5% in 1987188.
XPB scheme receive, in addition to the local The benefits of the XPUXPB scheme,
currency equivalence of their expott earnings, together with export duty payments, can be
certificates whose face value depends upon the readily incorporated into the real trade-weighted
specific entitlement rate applicable to the com- exchange rate to yield a real effective trade-
modity in question. The total benefits conferred weighted exchange rate. Such exchange rates
upon an exporter through the XPWXPB scheme have been calculated separately for traditional,
depend upon his entitlement rate (z), the pre- non-traditional, and total exports and are shown
mium @), expressed as the percentage difference in Table 5. Comparing the real effective ex-
between the Wage Earner’s Scheme (WES) rate change rate for non-traditional exports with the
and the official exchange rate, which is paid when real trade-weighted exchange rate (Table 3) it be-
the certificates are encashed, and the value of ex- comes apparent that the XPL/XPB benefits yield
ports (X). The taka earnings (7) resulting from only a marginally higher (9.0% in 1984/85) return
exporting one taka worth of a commodity under to non-traditional exports. Despite the expansion
the XPUXPB scheme is given by: of the XPL/XPB scheme and the increase in
the average entitlement rate, changes in the
T=X+zpX (1) real effective exchange rate are dominated by
changes in the real trade-weighted exchange rate,
or and the depreciation in that rate has been modest
in recent years. On balance one is led to conclude
T=X(l + zp) (14 that the exchange rate incentives provided to
 FOREIGN EXCHANGE AND INDUSTRIAL GROWTH 1425

Table 4. Exports under XPL (taka millions)

Entitlement rate
(percent) 1979/80 1980/81 1981182 1982/83 1983/84 1984/85

10 46.3 90.0
20 669.7 627.5 - -
30 29.7 36.1
40 1,243.l 1,062.6 1,371.4
60 1,365.B
80 -
100 -

Total XPL exports 1,988.8 i1 816.1 2,737.2

Analysis
1. XPL exports/total
exports (percent) 18.1 15.8 22.1
2. Average entitlement
rate (percent) 32.4 31.4 50.0 59.3 57.5 59.7
3. Exchange rate:
Official (TMUS$) 15.59 16.26 20.07 23.80 24.94 25.96
WES (Tk/US$) 19.21 20.11 22.79 24.12 27.16 29.29
4. WES premium over
official rate
(percent) 24.0 23.7 13.6 1.4 8.9 12.8

exports been modest.

conclusion subject one the
real exchange does
include impact such as holi-
access bonded back-to-back
of more access imported
for special products, in-
rate which available
exporters. such raise real
to the effective
rate calculated understates full
tive to We add,
that quantitative of
export-promoting recently
by concluded “. . export
tives sizeable on a in-
activities as garments,
leather leather some
ized etc., most activities not
from various) . Going
Rab that those pro-
which from to ware-
and LC receive
moderate relative import-
1426 WORLD DEVELOPMENT

substituting industries, .so that exporting as a tion of whether the increased export earnings
whole continues to receive less assistance than represent an increase in import capacity. Clearly
import-substituting activities.i’ the depreciation of the nominal exchange rate
Export promotion policies have had a further has increased the local currency cost of imports,
shortcoming. They have biased exporters against reducing the import capacity of taka export earn-
using domestically produced tradable inputs, be- ings. In addition, one also needs to adjust for the
cause XPWXPB is given on gross export receipts erosion in the purchasing power of exports
and, until recently, provided no incentive to re- caused by world inflation. To derive a measure
ducing the import content of such exports. Simi- of real import capacity, current priced foreign
larly, access to bonded warehouse facilities, or to exchange earnings, expressed in dollars, are de-
duty drawbacks, is an incentive only to the extent flated by an index of world inflation. The resul-
that the exporter uses imported inputs. An ex- tant import capacity measure is shown in Table 6.
porter who purchases domestically produced in- Bangladesh’s capacity to import has increased,
termediate inputs, which embody imports on although at a far slower rate than the increase in
which duties have been paid, will find himself at a the nominal value of exports would suggest. The
cost disadvantage vis-ri-vis an exporter with most significant conclusion that can be drawn
access to a bonded warehouse, whose intermedi- from this table is that almost the entire improve-
ate inputs bear no taxes, or vis-d-vis an exporter ment in the capacity to import has come from the
who purchases imported intermediates but re- expansion in non-traditional exports.
ceives a duty rebate.12
Incentives have recently been introduced to try
to encourage backward linkages of export indus- 3. EXCHANGE RATES AND IMPORT-
tries. Domestic suppliers to export producers SUBSTITUTION POLICIES
have in some cases become eligible for XPB en-
titlements, while other export incentives, such It is quite understandable that import-sub-
as subsidized credit, have been authorized for in- stitution policies in Bangladesh should focus
direct, or “deemed,” exporters through a system on the manufacturing sector. While agricultural
of inland back-to-back letters of credit. These products, chiefly foodgrains, account for a sub-
new incentives, however, are applied selectively stantial share of total imports in poor harvest
and depend to a considerable extent on adminis- years, sometimes as much as 30%, manufactured
trative fiat. goods consistently represent between 45%
Creation of a general incentive for backward and 55% of total merchandise imports. Dom-
integration would clearly be an improvement estic production of the other major import cat-
over present policies. Such an incentive could be egory, crude materials and petroleum products,
created through suitable modifications of the is limited by the country’s natural resource en-
XPB scheme. First, XPB for bonded warehouses dowment and is thus less susceptible to import
could be granted on a net export basis. By being substitution.
related to net exports the XPB would provide an As in the case of export promotion, a number
incentive for all export firms to increase their use of policies can also be used to stimulate develop-
of local inputs and to reduce their purchases of ment of import-substituting industries. The most
imported inputs. Since net exports are less than common policies to protect local producers from
gross exports, the percentage rate for a net- import competition are concessionary rates of
export XPB would need to be higher than current duty on imported inputs, subsidized loans from
XPB rates to achieve the same incentive effect. development finance institutions, income tax ex-
For example, if the WES premium were about emptions, and discount prices for the purchase of
10%) an XPB rate of 200% on net exports would land, buildings, and public utilities. Only the first
be needed. For exporters who do not use bonded two policies are directly affected by the foreign
warehouses, an incentive for backward integra- exchange regime and are therefore analyzed in
tion could be created by offering a gross-export this paper.
XPB sufficiently high to enable the exporter to The nominal amount of protection local manu-
give up duty drawback privileges. Finally, for facturers receive in relation to non-traded goods
administrative simplicity, exports should be is determined mainly by the foreign exchange
assigned to one of a small number of XPB slabs rate, the level of taxes on competitive imports,
on the basis of world price value added and on and quantitative regulations such as bans,
the import duties paid when giving up access to quotas, and other restrictions on imports of com-
duty drawback. peting goods. All of these factors can in principle
Before turning to an analysis of import struc- be incorporated into a single measure: the real
ture and controls, it is worth addressing the ques- effective exchange rate (REER) for imports. This
 FOREIGN EXCHANGE AND INDUSTRIAL GROWTH 1427

Table 6. Import capacity: Bangludesh* ($ million)

Non-
Traditional traditional Total
exports exports exports Deflator

1973174 346.9 27.6 374.5 100.0

1974175 267.3 30.6 297.9 118.6
1975176 262.0 27.7 289.7 127.3
1976177 291.6 32.2 323.9 133.5
1977178 283.6 29.9 313.4 151.5
1978179 321.2 45.2 366.4 172.7
1979180 328.0 45.8 373.8 189.9
1980181 316.0 50.7 366.7 192.6
1981182 265.1 59.1 324.2 190.3
1982183 296.2 109.1 405.1 186.8
1983184 339.5 97.9 437.4 184.4
1984185 370.7 156.9 527.6 189.9
1985186 287.8 172.7 460.5 188.6
1986187 321.8 284.2 606.0 190.0
Percentage change
1973174-1986187 -7.2 929.7 61.8 -

*Totals may not add up due to rounding.

Source: Exports in million takas converted at the nominal ex-
change rate from Table 3 and deflated by the manufacturing unit
value index (cif) for exports to developing countries from World
Bank (1986), p. 45. Deflators for 1984185 to 1986187 have been
estimated by the authors.

Table 7. Composition of imports

Crude Share of
materials manufactures
Food and and fuels? Manufactures+ in total
beverages* (taka millions) Total (percent)

1977178 5,730 4,565 7,921 18,216 43.5

1978179 3,702 5,229 12,796 21,727 58.9
1979180 8,019 4,697 15,589 28,305 55.1
1980181 5,455 11,339 20,494 37,288 55.0
1981182 8,620 9,597 20,512 38,729 53.0
1982I83 10,717 13,187 21,361 45,265 47.2
1983184 12,052 14,638 24,184 50,874 47.5
1984185 14,897 14,623 23,513 63,033 53.2

Source: Bangladesh Bureau of Statistics.

*Food and beverages = BSTC 0 (food & live animals)
1 (beverages & tobacco)
4 (animal, vegetable oils and fats)
jCrude materials and food = BSTC 2 (crude materials - inedible)
3 (fuels & lubricants)
SManufactures = BSTC 5 (chemicals)
6 (manufactures)
7 (machinery)
8 (misc. manufactures)
9 (other commodities)
JBSTC = Bangladesh Standard Trade classification and corresponds roughly
to SITC-R codes.
1428 WORLD DEVELOPMENT

rate is estimated in a way similar to that used in lar vis-ri-vis other currencies while the effect of
calculating the REER for exports. In estimating the decline in average import taxation was offset
the REER for imports the trade weights corres- by the increase in the share of imports purchased
pond to the share of major trading partners in under the WES at a premium over the official
providing imports while the deflator is the ratio rate of exchange.
of consumer price indices in those trading partner In 1981/82 and 1982/83 the REER rose as the
countries vis-&vis the consumer price index in nominal exchange rate was raised faster than the
Bangladesh. Further adjustments are made to in- difference in the inflation rates between Bangla-
corporate the effects of import taxation and the desh and its trading partners and the increasing
premium paid on WES imports. over-valuation of the US dollar. In the subse-
Both the nominal and the real effective taka/ quent two years this movement was reversed: the
dollar exchange rates rose substantially between REER fell back to below the 1976/77 level as the
1973/74 and 1976/77 and then remained relatively decelerating rate of the taka/dollar movement
stable at the new level until 1980/81. During this was overwhelmed by differential inflation rates
period the effect of the higher rate of inflation in and the steady rise in the value of the US dollar
Bangladesh relative to its trading partner coun- against other currencies. Since then the nominal
tries was offset by the fall in the value of the dol- exchange rate has depreciated but because of the

Table 8. import exchange rates: 1973174-1987188 (taka/US$)

Trade-weighted? Real
Nominal* Nominal Real effectivet

1973174 7.97 7.97 7.97 9.72

1974175 8.88 8.80 7.41 8.69
1975176 15.05 14.57 12.76 15.22
1976177 15.43 14.78 13.97 18.23
1977178 15.12 15.22 13.69 17.79
1978179 15.22 16.11 13.62 18.07
1979/80 15.49 16.56 13.49 17.11
1980/81 16.26 16.96 13.40 17.35
1981/82 20.07 19.61 14.99 18.55
1982183 23.80 21.95 16.22 19.88
1983/84 24.94 21.98 15.34 19.13
1984/85 25.96 21.17 13.07 16.42
1985186 29.68 24.56 14.18
1986/87 30.07 25.57 13.69
1987/88§ 30.47 27.42 13.80
Percentage change
1973/74-1987/88 282.3 244.0 73.2
1973/74-1979180 94.4 107.8 69.3 76.0
1979/8C-1984/85 67.6 27.8 73.1 -4.0
1979/8@1987/88 96.7 65.6 2.3

*Economic Trends (Dhaka: Statistics Department, Bangla-

desh Bank, various issues).
tThe nominal trade-weighted exchange rate is based on a
weighted index, applied to the actual 1973/74 exchange rate, of
the exchange rate for Bangladesh’s major import suppliers,
with the weights reflecting their share of total imports over the
period 1979-82. The real trade-weighted exchange rate is the
nominal trade-weighted exchange rate deflated by a weighted
average of consumer price indices (1980 = 100) for the major
import trading partners, relative to the consumer price index
in Bangladesh. See Appendix Table A5 for trading partner
weights. All data from IMF, International Financial Statistics
(various issues).
$See Appendix Table A4.
PJuly-December 1987 data only.
 FOREIGN EXCHANGE AND INDUSTRIAL GROWTH 1429

relatively higher inflation in Bangladesh com- goods declined between 1979 and April-June
pared to its trading partners, the real (price 1984. They estimated that overall wholesale
deflated) trade-weighted exchange rate has trade margins on imports into Bangladesh fell
appreciated marginally. from 60% to 35% during this period. These trade
To put the matter differently: the currency margins include “normal” wholesale markups
readjustment of 1981/82 raised all taka/dollar ex- and therefore exaggerate the size of the scarcity
change rates shown in Table 8 to higher levels, premia, but there is no reason to doubt that they
but the REER rose much less than the nominal reflect a substantial fall in scarcity margins be-
rate and continued to lag significantly behind it tween these years.
during subsequent currency adjustments. In fact, Another factor not taken into account in the
by 1984/85 the REER had fallen back to well be- estimation of the REER for imports is the influ-
low the 1981/82 level. The main reason for this ence of tied foreign aid and barter trade. Imports
outturn is that the effect of the higher rate of in- financed from these sources are likely to be more
flation in Bangladesh relative to its trading part- expensive than goods purchased in the open mar-
ner countries was not offset this time by changes ket but no empirical study has yet been carried
in the value of the dollar vis-ci-vis other curren- out on this subject in Bangladesh. The share of
cies; instead the worldwide appreciation of the imports financed under tied aid and barter trade
dollar reinforced the depressive effect of rela- has not changed very much during the period
tively high domestic inflation on the REER. under review, so it can reasonably be assumed
Thus, during the period 1976177 to 1984185 the that the omission of this factor in the estimation
real effective taka/dollar exchange rate fell by of the REER for imports does not seriously bias
9.9% compared to an increase of 68% for the the trend.14
nominal rate. On balance then, it is likely that the cost of im-
The REER estimates in Table 8 do not take porting has increased by less than the REER for
into account the influence of quantitative import imports in Table 8 in recent years to the extent
restrictions (QRs). Import bans, quotas, and that scarcity premia on imported goods have de-
other restrictions drive a wedge between border clined, although imports other than those
and domestic market prices that is larger than the financed by foreign aid and under barter agree-
difference between border and landed costs. This ments are now negotiated through the WES mar-
difference is generally referred to as the “scarcity ket. The cost of importing would actually have
premium.” Given the heavy reliance by govern- fallen somewhat faster since 1976/77 than indi-
ment on QRs to ration foreign exchange, scarcity cated by the real effective exchange rate if it had
premia can be expected to be quite significant, been adjusted for the fall in the average premium
although on average they have probably declined estimated by Bhuyan, Haq, and Rashid. This
since 1982 as a result of some relaxation of im- finding could be interpreted as representing a re-
port regulations made possible by increases in the duction in the general level of government assist-
REER and as a result’of a shift in policies as ance to import-substituting industries were it not
enunciated in the New Industrial Policy (NIP). for the fact that the overall average REER does
Before June 1982, industrial importers were not accurately reflect the level of assistance in-
required to submit production figures, informa- dustries actually receive in Bangladesh. The
tion on ex-factory prices, and the recommenda- reason is that taxes, subsidies, concessions, and
tion of sponsoring authorities before being QRs tend to be tailor-made for individual indus-
permitted to import, and prior permission from tries or products, even for individual producers
various government agencies was necessary to or users of each product. The penchant for “fine
purchase a large number of specific products. tuning” also affects export promotion policies but
These regulations were partially relaxed during nowhere nearly as much as it influences the level
1982/83, and more imports were allowed with of protection provided different industries pro-
fewer restrictions through the WES market. In ducing for the home market.
1983/84, industrial importers were no longer An idea of the great complexity of industrial
required to obtain import licenses and certain import policies in Bangladesh can be obtained by
limitations on “Pass Book” entitlements were re- comparing statutory and observed nominal rates
moved. Further reforms have been carried out in of protection shown in Table 9. Statutory rates
subsequent years, although the severity of quan- are those legally established for customs duties
titative regulations still depends a great deal on plus sales and other taxes on competitive
administrative discretion. imports.
Indeed a study by Bhuyan, Haq, and Rashid13 Observed rates represent estimates of actual
found that the scarcity margins between domestic differences between domestic and border prices.
market prices and the landed cost of imported Large differences between the two indicate either
1430 WORLD DEVELOPMENT

Table 9. Nominal rates of protection for selected industries

(percent)

Statutory Observed

1. Textiles and garments

Cotton yarn 67 17 to 33
Specialized yarn 67 to 85 49 to 76
Gray cotton shirting 155 80
Gray polyester shirting 155 100
Gray polyester suiting 155 100
Men’s shirts (blended) 385 180
Men’s trousers (blended) 385 160
2. Agro-industries
Jute goods 0 0
Packet tea 155 14
Sugar 245 48
Canned pineapple juice 245 60
Vegetable ghee 85 80
Soybean oil 20 20
Cigarettes 505 -33
3. Rubber products
Bicycle tire: 2-ply 145 53 to 512
4-PlY 145 148 to 892
Bicycle tube 145 13 to 125
Sandals 205 354
4. Pulp, paper, and board
Pulp 37 18 to 37
Paper 145 40 to 45
Newsprint 105 31
Duplex board 145 82
Packaging materials 145 61
5. Basic steel
M.S. billet 85 70
Shipbreaking products 50 22
M.S. rods using:
a) CSM billet 115 90
b) Imported billet 115 90
c) Ship scrap 115 90
M.S. heavy plate 73 73 to 115
M.S. thin plate 73 73 to 115
CGI sheet 85 81

that statutory rates are fixed at prohibitively high the point. For example, the regulations state that
levels (and that imports may be entering the CI sheets of up to 26 BWG containing zinc coat-
country illegally or at concessionary rates) or that ing of 1.26 oz per square foot can be imported
protection is provided mainly by quantitative im- under a uniform entitlement of Tk 1 lac (100,000)
port restrictions. In either case our estimates of per registered WES importer on the basis of
movements in the REER are not likely to accu- district-wise quotas allocated according to popu-
rately reflect changes in the level of protection in- lation; or, that MS sheet and plate (hot rolled) is
dividual industries actually receive unless all importable by recognized industrial units up to
other factors, including the enforcement of QRs annual entitlements registered in their “Pass
and the granting of tax concessions, remain the Books” except for recognized manufacturers of
same - a rather unlikely outcome. agricultural implements, who can import as much
Since it is very difficult to make valid generali- as they want. Imports of many kinds, specifica-
zations about such a complex system of import tions, models, and brands of machinery and
controls, a few specific examples may be more to equipment are prohibited unless specifically
 FOREIGN EXCHANGE AND INDUSTRIAL GROWTH 1431

authorized by designated government agencies. tive protection to domestic industry without the
Thus second-hand clothing is importable only help of QRs because it had been allowed to de-
under WES subject to a complicated system of teriorate at least until 1984/85. If government
quotas. And QRs, if they effectively exclude really wishes to rationalize and simplify import
competitive imports, make it extremely difficult policies and to rely more on decentralized de-
to measure the level of protection domestic pro- cisionmaking and markets to allocate resources,
ducers actually receive because of differences in it will have to pay much more attention to move-
product quality. Users of bicycle and rickshaw ments in real effective exchange rates for imports
tires, for example, claim that the imported article and exports, both in absolute terms and in rela-
is anywhere from two to four times more durable tion to each other.
than domestic substitutes.
No conclusion can, of course, be reached on
the impact of a foreign exchange regime on 4. SUMMARY AND CONCLUSIONS
development of import-substituting industries
without taking into account the treatment of in- Foreign exchange regimes have been found to
dustrial inputs because effective rates of protec- play a critical role in implementing trade and
tion depend on the relation between nominal industry development strategies in developing
rates of protection on outputs relative to those on countries. The economic incentives provided
inputs. Analysis of this subject would, however, by many government policies used to promote
take us far beyond the limits of this paper. Suffice export-oriented and import-substituting indus-
it to say that policies affecting imports of locally tries can be measured by real effective exchange
produced inputs are just as complicated as those rates (REERs) which incorporate the effects of
affecting other competitive imports, but the taxes, subsidies, relative rates of inflation, and
treatment of imported inputs that do not com- changes in the relative values of trading partner
pete with domestic production is much less currencies. An initial effort has been made in this
restrictive. The net result of this highly differen- paper to assess their impact on industrial growth.
tiated set of policies is that the effective rate of The estimated REERs for exports and imports
protection import-substituting industries in for the period 1973/74 to 1984/85 are compared in
Bangladesh receive ranges from negative to infin- Figure 2.
ity, with an astonishingly large number of them The REERs for exports and imports increased
apparently saving little or no foreign exchange by around 72 and 88%, respectively, between
for the country. ’ 1973174 and 1976177, but since then they have fol-
The most important policy implication of this lowed a rather indeterminate course despite the
analysis is not that the measurable REER for im- progressive rise in the nominal taka/dollar ex-
ports does not matter very much because of so change rate during most of the latter period. The
much other noise in the system. It is that the main reason is that the increase in the nominal
REER may not provide the desired level of effec- exchange rate was little more than sufficient to

23 4

xi, , , , , ,
1973/74 I975176 1977/ 78 1979mo 1981/92 I993/84

Y@XS
0 Nominal oFfI IrTvclts l REER non - tmditiond exports .REER tmditiwal exports

Figure 2. Nominal nnd real effective exchange rates.

1432 WORLD DEVELOPMENT

compensate for the depressing effect of the Equally important for promoting more viable,
higher rate of inflation in Bangladesh relative to dynamic industrial growth would be the adoption
its trading partner countries and the decline in of policies more conducive to the development of
the value of these countries’ currencies vis-r&v& an integrated manufacturing sector in Bangla-
the US dollar. As a result, between 1976/77 and desh. Although this objective is assigned priority
1984/85 the REER for imports fell by nearly 10% in the NIP, actual policies tend to work in the
and while the REER for exports fell by around opposite direction. Until recently the XPL/XPB
6%) non-traditional exports fared somewhat bet- scheme provided no incentives for the backward
ter, in part because of the introduction of the integration of export production and other ex-
XPL/XPB scheme. These modest changes con- port promotion policies, such as back-to-back
trast strongly with public perceptions, based on LCs, use of bonded warehouses, and duty draw-
nominal exchange rate movements, that there backs, provide a strong inducement for export in-
has been a sharp devaluation of the taka. dustries to remain import-intensive. The same is
Before drawing any conclusions from these true of policies generally relied on to promote de-
figures, it is first necessary to consider what influ- velopment of import-substituting industries.
ence other factors that are difficult to quantify Concessionary rates of duty are given for import-
may have had on the effective exchange rates. ing capital goods,16 thereby discouraging
The most important policies not quantified in the development of the engineering sector, and
analysis of the incentives provided to exports are domestic producers of intermediate goods enjoy
back-to-back LC and bonded warehouse privi- high levels of protection regardless of whether
leges. Had it been possible to quantify the effects they save any foreign exchange.
of these measures, our estimate of the incentive It is probably fair to conclude that Bangla-
given to non-traditional exports in recent years desh’s new trade and industry policies have been
would have been higher. The main factor left out grafted onto a foreign exchange regime that is
of our calculation of the REER for imports is the still basically “inward-looking.” Industries that
influence of QRs, which raise domestic prices of are exclusively export-oriented but relatively
imported goods above their duty-paid landed import-intensive will probably continue to ex-
costs. This difference, or scarcity premium, ap- pand so long as special incentives are extended to
pears to have declined in recent years, so that new producers and products.” High cost import-
instead of falling marginally after 1979 the REER substituting industries are likely to remain so,
for imports may have actually declined more. and without major changes in policy these indus-
Neither of these adjustments would fundamen- tries are unlikely to develop close linkages with
tally alter the main conclusions that can be drawn export-oriented firms. They will probably have to
from our estimates. continue to struggle for a piece of the highly
Government trade and industry policies have domestic market where real purchasing power is
indeed become less “inward-looking” to the ex- increasingly constrained by the escalation of
tent that they provide stronger incentives for the industrial costs and prices. An unfortunate out-
expansion of non-traditional exports. Neverthe- come of this modest shift toward a less “inward-
less, the foreign exchange regime is still biased in looking” policy may well be that it will be held
favor of import-substituting industrialization, responsible for creating the problems generated
although perhaps less so than it was a few years by the existence of a dual industrial structure.
back. Substantially stronger export incentives
than exist at present would be necessary to re-
move this bias.

NOTES

1. See, for example, Little, Scitovsky, and Scott relative prices-of tradables vs. non-tradable goods and
(1970), which includes individual studies on six coun- services, since the domestic terms of trade between
tries; Balassa and associates (1971), which also in- manufactures and agricultural goods actually fell
eludes studies of six countries; Donges (1976); Bhag- slightly during this period.
wati (1978), and Krueger (1978), along with separate
volumes on 10 developing countries; the World Bank 3. Data taken from World Bank (1985). Data refer
studies (1980a, 1980b, 1983, and 1984); and Adams to 1983.
and Klein (1983) which includes the results of studies
on 11 developed and developing countries. 4. It would be interesting to present a constant price
series for exports as well, but no price deflators are
2. The increase in the share of manufactures in cur- available that accurately reflect the composition of new
rent price GDP was mainly due to the increase in the non-traditional exports. The physical volume of total
 FOREIGN EXCHANGE AND INDUSTRIAL GROWTH 1433

exports, however, appears to have grown more slowly 11. Ibid.

than real GDP during the period, so that despite the
relatively rapid expansion of non-traditional products
it cannot be said that Bangladesh entered a phase of 12. The duty drawback is recognized as being an
export-led growth. administrative nightmare that does not work well. But,
even if it were improved and extended to the domestic
5. If purchasing power parity (PPP) determined all supplier of inputs to exporters, it would still encourage
exchange rates among Bangladesh’s trading partners, such suppliers to import their inputs.
then movements in the cross-exchange rates would re-
flect relative price changes and thus obviate the need to 13. Bhuyan, Haq and Rashid (1985).
calculate a trade-weighted exchange rate or a trade-
weighted price deflator. Our assumption is that PPP
does not fully explain cross-exchange rate movements. 14. A directive in the 1mpor1 Policy Order: 1985186
obliging importers to use barter exchange allocations
6. Consideration of import duty rebates is omitted before they are able to use other sources of financing,
since we wish to compare the incentive to exports under and making barter exchange non-transferable, may in-
existing policies against a “no-tax” situation. Viewed in crease the cost of barter imports significantly.
this way, import duty rebates represent an offset to
duties paid on imported intermediates and thus provide 15. That import-substituting industries save little or
no additional benefits over a “no-tax” situation. no foreign exchange is a rather common phenomenon
in many countries. An obvious example is the assem-
7. The 1985186 Tea Policy notes the “export duty on bler of imported CKD parts who has to pay about as
tea has been abolished to make Bangladesh tea much for them as it would cost to import the finished
more competitive in the world market,” (p. 1). a step product. Any industry that relies almost exclusively on
that will further reduce export duties. imported inputs, a quite common situation in Bangla-
desh, runs the same risk.
8. The average effective rate of protection for export
activities has been calculated at 1.5% compared to an
average rate of effective protection of almost 50% for 16. However, the 1987/88 Budget Message
import-substituting activities. See TIP (October 1985). announced that concessionary rates would no longer be
given to imports that compete with domestically pro-
9. Stern (1984, 1983). duced capital goods.

10. Rab (1985) provides a fuller analysis of these 17. The recent creation of a Duty Drawback and Ex-
various incentive measures. His analysis shows that the emption Office (DEDO) to facilitate duty-free access
primary assistance to exports is the XPUXPB system by exporters to imported inputs represents another step
which is included in the real effective exchange rate. in this direction.

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