Viewpoint The World Bank FPD Note No. 20 September 1994 Free-Trade Status for Exporters Yung Whee Rhee Firms need to have easy access to in- and the economywide schemes should puts at world market prices to be inter- be offered in parallel (as in the Republic nationally competitive. Free trade- of Korea and Taiwan, China) so that with no tariffs, no indirect taxes, no foreign orprivatefirms can choose de- import orforeign exchange restric- pending on theirparticular needs and tions-is the ideal policy goal. How- the relative effectiveness of the schemes. ever, development experience over the pastfive decades suggests that it takes However, in many low-income coun- time to achieve free trade. Therefore, tries, implementation of the economy- giving free-trade status to exporters is a wide schemes has been flawed. Experi- practical intermediate step for those ence shows that without the proper countries that cannot make the move development of the necessary instru- tofree trade quickly.l Free-trade status ments, institutions, and mechanisms, it schemes have worked very successfully is hard to apply economywide schemes in the East Asian economies. effectively. T-he specialized schemes-such as This Note reviews free-trade status fencedprivate orpublic exportprocess- schemes and raises some issues critical ing zones (EPZs), nonfenced EPZs, to more effective implementation of the special bonded manufacturing ware- economywide schemes.2 houses (BMWs)-are more widely used than economywide schemes in coun- Specialized free-trade schemes tries at early stages of development. These specialized schemes have been Enclave quite effective inprovidingfast duty- A fenced EPZ, if well administered, free and indirect-tax-free access to im- can guarantee the quickest access to ported inputsfor 100percent export- free-trade status for inputs and out- oriented manufacturingfirms in a puts, with minimum red tape. The number of developing countries. Econo- flow of input and export product con- mywide schemes-such as duty exemp- tainers to and from an area is moni- tions and drawbacks-are desirable tored by an around-the-clock customs complementary systems, especially as presence. An enclave-like location and development advances. The specialized physical safeguarding of containers ) --D Private Sector Development Department * _ J Vice Presidency for Finance and Private Sector Development make it possible to bypass the normal customs and accessories have risen to $1.5 billion over the past duty-free import procedures so that governments do fifteen years. The factories employ one million not have to worry about misuse of duty-free im- workers. This could not have been done without the ports. This advantage, together with other liberal effective implementation of the special BMW policy settings (liberal foreign exchange regimes, scheme. unfettered profit repatriation) and the availability of rental factory buildings with supporting infrastruc- The special BMW relies on spot checks of the 100 ture services, means that most foreign companies percent export-oriented factory inventories by cus- prefer fenced EPZs to other modes of free-trade sta- toms officials. Transparent criteria for each inventory tus. Furthermore, private initiatives in EPZ construc- check are based on the pretabulated input-output tion and management minimize the risk of low-qual- (physical) coefficients (such as the fabric-garment ity investment-a problem that often occurs in conversion factor). Because of the transparent crite- public estates. ria, customs has been able to allow the speedy pro- cessing of imports and exports without having to The private fenced EPZs in the Dominican Republic use fenced EPZs or BMWs (sometimes called indi- and other Caribbean countries have played a catalyt- vidual fenced EPZs because customs officials check ic role in the growth of manufactured exports during the input and output containers going to and from a the 1980s and 1990s. Applying the successful experi- fenced, bonded factory). ences of the Caribbean, Kenya established the first private fenced EPZ in Sub-Saharan Africa a few Economywide schemes years ago, and now the zone is in full operation There are two options-a duty exemption or a duty with twelve factories. drawback system. A duty exemption system exempts exporters from paying duties or indirect taxes on Self-declaration imports used in export production. The exemptions Mauritius has provided quick access to free-trade are granted at the time of importation. In a duty status and other policy regimes similar to fenced drawback system, exporters get refunds of the duties EPZs without requiring the enterprises with the EPZ and indirect taxes they have paid on imported in- licenses to be located in fenced industrial estates puts. There are two ways of making such refunds. with around-the-clock customs presence. Mauritius Individual drawback systems refund the duties and allows the EPZ enterprises to bypass the normal indirect taxes paid by firms. Fixed drawback systems customs and duty-free import procedures, relying refund the estimated duties and indirect taxes that primarily on the firms' self-declaration of input in- enter the cost of production of exports according to flows and output outflows. Trust in the integrity of a preset schedule. EPZ enterprises-which probably originates from having a small domestic market and from the hones- A review of schemes giving exporters free-trade sta- ty of the enterprises involved-has allowed the self- tus in fifty-five developing and formerly nonmarket declaration-based system to work in Mauritius, and economies shows that fewer than half have a legal the recent success of exporters has depended largely framework or implementation regulations for their on manufactured exports by 100 percent export- duty exemption or duty drawback schemes. (About oriented nonfenced EPZ enterprises. 40 percent appear to have specialized schemes- fenced EPZs and BMWs.) In many low-income Transparent spot checks countries that operate the duty exemption or duty Bangladesh's success in exporting garments may be drawback scheme, or both schemes, there are signif- the best working example of the special bonded icant implementation problems. Furthermore, almost manufacturing warehouses. Exports from the 1,500 all small producers and indirect exporters are ex- special BMW factories using imported fabrics and cluded. This exclusion hinders backward linkages 2 and the development of trading companies, two big and therefore has not helped with the task of esti- factors in the East Asian success. mating them.4 The World Bank's project experiences The key problem in economywide schemes The Bank's policy advice and project work have The main challenge for economywide schemes is emphasized the economywide schemes more than establishing a speedy and robust system to process specialized schemes because the specialized the exemptions and drawbacks. There are only two schemes have the handicap of having to be location- ways for the authorities to achieve fast processing. specific and 100 percent export-oriented, and they The first is by not checking exporters' self-declared need customs officials to be present.3 In addition, input-output coefficients. The second is through the Bank has been encouraged by the success of the pretabulated standard input-output coefficients uni- economywide schemes in successful newly industri- formly applied to all exporters. alizing economies (NIEs) such as Korea and Taiwan (China). The share of exports covered by the econo- The first is possible in a country where exporters mywide schemes during the 1970s was more than have the technical ability to estimate accurate self- 80 percent in each of these two economies. declared input-output coefficients and where the authorities can expect exporters to play by the During 1981-90, there were forty-seven World Bank rules, as in the Mauritius EPZ and Mexico's maqui- structural adjustment loans, industrial sector loans, ladoras. In the second case, the most critical data and export development loans that included reforms required for the duty exemption and drawback for free-trade status administration for exporters as schemes are the standard imported input-output part of the loan components. About 80 percent of (quantity) coefficients.5 The East Asian NIEs' effec- these projects required the effective implementation tive implementation of the duty exemption and of the duty drawback or exemption schemes as pro- drawback schemes depended on this second op- ject components. (Many of the projects are in low- tion. Officials continually fine-tuned and updated income developing countries.) Around 75 percent of the systems to ensure that they worked well. For these components were either loan conditions or example, even in the early 1980s, Korea and Tai- part of action programs required by the loans. Only wan (China) exchanged missions to study each about 25 percent provided technical assistance for other's experiences with standard input-output co- implementation (or study) of the economywide efficients and other tools. India, too, chose the sec- duty-free import schemes. ond option. While initially the Indian duty exemp- tion scheme was not very effective, the more than Bank projects have helped to set up the right legal 2,000 pretabulated standard input-output coeffi- foundations. However, unlike a tariff reform, issuing cients were a major factor contributing to an im- a decree for the duty exemption and drawback provement in the way it operated. schemes is only the first step. The work of develop- ing proper instruments, institutions, and mecha- The biggest cause of delays in the duty exemption nisms for implementation and monitoring still needs or individual drawback procedures in most low- to be done. As noted, in some cases the Bank has income developing countries is that the authorities provided technical assistance, but one of the lessons apply ad hoc or discretionary checks of exporters' from doing so is that advisors must have sound in- self-declared coefficients. In other words, they don't stitutional and implementation experience-prefera- accept exporters' self-declared coefficients without bly in countries that have established a good track dispute or they don't use transparent criteria based record in implementation. External technical assis- on pretabulated standard input-output coefficients. tance generally has failed to grasp the critical role of Even if the authorities handling the duty exemption the pretabulated standard input-output coefficients or drawback recognize the importance of these co- 3 efficients, they normally do not have the skills or tution-building meet the objective of providing pro- resources to estimate them. fessionals who have both the requisite expertise accumulated through institutional experience in suc- Implications for tbe World Bank cessful countries and the ability to translate these Where they been successfully applied, as in East experiences into advice tailored to different country Asia, the economywide duty-free import schemes circumstances? A related question: When highly have made a big contribution to the success of man- technical work such as input-output coefficients for ufactured exports. Furthermore, export success has duty-free import administration is involved, led not only to economic growth but also to build- shouldn't the individual country-specific approach ing momentum for trade liberalization. Therefore, (using limited technical assistance resources) be re- effective implementation matters. placed by an alternative approach that pools the technical assistance resources for several countries Close analysis of how the economywide schemes with similar characteristics? operate shows that to enhance the effectiveness of these policy tools, development assistance agencies In turn, Bank research should give higher priority to need to deal properly with the institutional know- defining the specific institution-building tasks related how and resource constraint issues-though govern- to specific development policy implementation is- ments themselves must be committed too, or even the sues. The current interest in so-called institutional best external support will not translate into results. economics does not appear to have much practical value. Searching for the right answers to these ques- To deal with the cost of highly technical work, the tions should be part of the agenda for improving Bank's current piecemeal approach based on the development effectiveness. limited country-specific technical assistance resourc- es for input-output coefficients could be replaced by ' The GATT Agreement on Subsidies and Countervailing Measures pooled technical assistance resources for several continues to recognize that free-trade status for export activities does low-income countries-to come up with the basic not constitute an export subsidy as long as it is properly administered. A more detailed paper by the author is under preparation. data set for standard input-output coefficients for 3 See World Bank, Export Processing Zones, Policy and Research Series key product categories. Only if such a data set is 20 (Washington, DC, 1992). available will it be possible to construct meaningful I The input-output coefficients are also an important checking device country-specific variations and therefore client- against export subsidies in the Uruguay Round Agreement on Subsi- dies and Countervailing Measures. specific coefficients. 5 Another important requirement for the duty exemption scheme is bank guarantees covering the duty liabilities in the case of failure to fulfill At a broader level, the Bank's experience with free- the export obligations. This is a very real problem for some coun- tries-for example, the Philippine government has recently eliminated trade status schemes raises a serious question about the dutv exemption scheme because of the trouble it has had enforc- one of the basic premises of its efforts to improve ing bank guarantees. development policy implementation through institu- tion-building assistance. Do the current mechanisms Yung Whee Rhee, Principal Economist, Private Sector Development of supplying technical assistance personnel for insti- Department This series is published to share ideas and invite discussion. It covers financial and private sector development as well as industry and energy. The views expressed are those of the authors and are not intended to represent an official statement of Bank policy or strategy. @ Printed on recycled paper. Comments are welcome. Please call the FPD Note line to leave a message: 202-458-1111; or contact Suzanne Smith, editor, Room G8105, The World Bank, 1818 H Street, NW, Washington, DC 20433, or Internet address ssmitheworldbank.org. 4