Report No. 38289-BD Bangladesh Strategy for Sustained Growth (In Two Volumes) Volume II: Main Report June 26, 2007 Poverty Reduction and Economic Management Sector Unit South Asia Region Document of the World Bank CURRENCYEQUIVALENTS Taka (Tk) US $1.OO =Tk 71.02 (April 5,2006) GOVERNMENT'S FISCAL YEAR July 1-June 30 ABBREVIATIONSAND ACRONYMS ADP Annual Development Plan JSAN Joint Staff AdvisoryNote ASYCUD1A Automatic Systemfor Customs Data KDA Khulna DevelopmentAuthority ATC Agreementon Textilesand Clothing LDC Least Developed Country BBS BangladeshBureau of Statistics LF LicenseFee BERC Bangladesh Energy RegulatoryCommission LFPR Labor Force Participation Rate BEPZA Bangladesh Export ProcessingZones Authority LFS Labor Force Survey BPDB BangladeshPower DevelopmentBoard LGED Local GovernmentEngineeringDepartment BRAC Bangladesh Rural Advance Commission LIC Low IncomeCountry CAR CapitalAdequacy Ratio MFA Multi Fiber Arrangement CAS CountryAssistingStrategy MTBF Medium-Term Budgetary Framework CDA ChittagongDevelopmentAuthority MOU Memorandumof Understanding CEACR Committeeof Expertson the Applicationof NCBs Nationalized CommercialBanks Conventionsand Recommendations NGO Non-GovernmentalOrganization CIB Credit Information Bureau NHA National HealthAccounts CMI Censusof ManufacturingIndustries NPLS Non-PerformingLoans CPA ChittagongPort Authority NPSEB National Private Sector Surveyof Enterprisesin CPD Center for Policy Dialogue Bangladesh CPI ConsumerPrice Index NSS National SavingsSchemes CRF Clean Report of Findings PCBs Private CommercialBanks DEDO Duty Exemption and Drawback Ofice PGCB Power Grid Corporation of Bangladesh DESA Dhaka ElectricitySupplyAuthority PL Post Larvae DESCO Dhaka ElectricitySupplyCorporation PRS Poverty Reduction Strategy DFIs DevelopmentFinancial Institutions PSI Pre-Shipment Inspection DPHE Departmentfor Public Health Engineering PTA PreferentialTrade Agreement DTI Direct Trader Input PWD Public Wo~ksDepartment DWMB Dock Workers' ManagementBoard Qh Quantitative Restrictions EBA EverythingBut Arms R&D Research and Development EPZ Export ProcessingZones W U K Rajdhani Unnayan Kartripakkha FA0 Food and AgricultureOrganization RD RegulatoryDuty FCBs Foreign Commercial Banks RDA Rural DevelopmentAcademy FCLs Full Container Loads REB Rural ElectrificationBoard FDI Foreign Direct Investment REER Real EffectiveExchange Rate FPMU Food Policy MonitoringUnit RMG ReadymadeGarment FSRFD Fisheries SectorReviewand Future Development SAARC South Asian Association of Regional Cooperation FTA Free TradeAgreement SAFTA South Asian Free Trade Area GDP Gross Domestic Product SAPTA South Asian Preferential Trade Area GSP GeneralizedSystemof Preferences SD SupplementaryDuty HDC Human Development Center SEC Securitiesand ExchangeCommission HSC HigherSecondaryCertificate SIMA Statistical InformationManagement& Analysis H W High Yielding Variety SME Small and Medium Enterprise IASNF Integrated Annual Surveyof Non-Farm Activities SPS Sanitary and Phyto-Sanitary IBRD InternationalBank for Reconstructionand SSC Senior SecondaryCertificate Development SSG Ship-to-ShoreGantry TEU Twenty-foot ICA Investment ClimateAssessment EquivalentUnit ICB Investment Companyof Bangladesh TFP Total Factor Productivity ICDs Inland ContainerDepots UN United Nations ICESCR InternationalCovenantof Economic,Social VA Value Added and CulturalRights VAT Value Added Tax ICFTU InternationalConfederationof Free Trade Unions WASA Water and SewerageAuthority IDSH InfrastructureDevelopmentSurcharge WB World Bank IPOs Initial Public Offerings WBI World Bank Institute IPP IndependentPower Producer WDI World DevelopmentIndicators 1RO Industrial RelationsOrdinance WTO World Trade Organization IS0 InternationalStandardsOrganization Vice President PrafulPatel, SARVP Country Director : Xian Zhu, SACBD SectorDirector SadiqAhmed, SASPR SectorManager : Ijaz Nabi, SASPR Task Leader SandeepMahajan, SASPR TABLE OF CONTENTS Executive Summary ..................................................................................................................................... i Bangladesh: Strategyfor SustainedGrowth ............................................................................................ 1 I. Introduction...................................................................................................................... 1 I1 . The Record of Growth and Development:An Overview................................................... 2 I11. Transitionto Middle-IncomeCountry Status:Issues and Challenges............................. 12 IV. ConcludingRemarks and Summary Policy Recommendations....................................... 34 Annex 1: Growth Accounting To IdentifySources Of Economic Growth ...........................................36 List of Tables Table 1: Progresson Key SocialIndicators..........................................................................................4 Table 2: GrowthRates of Output Components....................................................................................6 Table 3: GDP Levels and Growthby Division..................................................................................... 7 Table 4: PopulationDynamics of the Largest Agglomerations............................................................8 Table 5: A Hypothetical Scenarioof Bangladesh's Transitionof MIC Status................................... 12 Table 6: Satisfactionwith Services................................................................................................... 19 Table 7: Investment Climate Survey .................................................................................................. 21 Table 8: Cost of Startinga Business in Bangladeshand Comparator Countries................................ 22 Table 9: Structureof the Banlung System (end-2005) ....................................................................... 30 Table 10: Performance Measure in the Banhng Sector .......................................................................31 Table 11: Cross-Country Comparisonsof Technologyand Knowledge Related Measures.................34 List of Figures Figure 1.a: Per-Capita GDP: BangladeshVs.Median LIC ......................................................................2 Figure 1.b. Per-Capita GDP: InternationalComparisons.........................................................................2 Figure 2: Trends in GDP Per-Capita...................................................................................................... 3 Figure 3: International Volatility Comparisons(1990-05)....................................................................5 Figure 4: Urbanization in Bangladesh ................................................................................................... 8 Figure 5: Sourcesof Growth.................................................................................................................. 9 Figure 6: Public-PrivateBreakdown of Investment............................................................................. 10 Figure 7: Trends in Investment and Savings...................................................................................... 10 Figure 8: Agriculture Sub-sectorsGrowth........................................................................................ 1 5 Figure 9: Unweighted Average Nominal Protection............................................................................ 17 Figure 10: Evolution of Import Restrictions......................................................................................... 17 Figure 11: Average Tariff Protection(2002-04)....................................................................................18 Figure 12: Exportto GDP Ration (2004-05) ........................................................................................ 18 Figure 13: Long-Term Fiscal Trends.................................................................................................. ,., 24 Figure 14: Electric Power Consumption................................................................................................ 26 Figure 15: Percentage of Managers Ranking Power.............................................................................. 26 List of Boxes Unbundling Governancein Bangladesh:A Mixture of Strengthsand Weaknesses.............23 Acknowledgements This report was prepared by a team comprising: Sandeep Mahajan (task team leader and lead author), Tercan Baysan, Thorsten Beck, Paul Dorosh, Ana Margarida Fernandes, Somik Lall, Binayak Sen, and Alan Townsend (World Bank), Rushidan Islam (BIDS), K. Sarwar Lateef (consultant),and Md. Habibur Rahrnan (Bangladesh Bank). At all stages, the report has benefited tremendously from advice and support from Dr. Shankar Acharya (ICRIER), who was senior advisor to the team. Zahid Hussain and Mustafa Zakir Hussain contributed useful background pieces for the report. Mushgan Siddique provided invaluable research assistance support, Sanjana Zaman prepared the statistical tables, and F.M. Ziaul Ahsan provided additional analytical input. Oxana Bncha processed the report at various stages, and Mehar Akhter Khan, Joyce Mormita Das, and Mildred Gonzalves helped coordinate mission activities. A team of students from the Economics Department of Jahan~magarUniversity, led by Professor Abdul Bayes, did a commendablejob in undertaking a comprehensivefirm-level survey for the report. Alfred Friendly assisted with the preparation of the ExecutiveSummary. The report was prepared under the guidance of Sadiq Ahmed (Sector Director, SASPR), Ijaz Nabi (Sector Manager, SASPR), and Christine Wallich (previous Country Director, Bangladesh), and Xiang Zhu (Country Director, Bangladesh). The peer reviewers were Jim Hanson (formerly World Bank), Professor SiddiqOsmani (Universityof Ulster), and Manuela Ferro (World Bank). The team is deeply appreciative of the valuable guidance from Dr. Quazi Mesbahuddin Ahrned (former Member, General Economics Division, Ministry of Planning), the main government counterpart for the report, and Dr. Shahabuddin M. Hossain (former Advisor to the Governor, Bangladesh Bank). The team also gratefullyacknowledges the useful feedback from senior government officials of General Economics Division (GED) and IMED, Ministry of Planning; Finance Division and Economic Relations Division, Ministry of Finance; Ministry of Industry; Ministry of Education, and; BangIadesh Bank. Mr. Allah Malik Kazemi, Deputy Governor, Bangladesh Bank, and Mr. Jafar Ahrned Chowdhury, Acting Member, GED, and their respective teams provided additional guidance during discussions of the "Green Cover" version of the report. A number of individualsprovided very useful commentsat various stages. These include Ahrnad Ahsan, Syed M. Ahsan (Resident Advisor, Bangladesh Bank), Maitreyi Das, Elena Glinskaya, Prof. Wahiduddin Mahmud (Dhaka University), Deepak Mishra, Tom Rumbaugh and others in the IMFYs Bangladesh team, Zaidi Sattar, Vinaya Swaroop, Hassan Zaman, and participants in workshops held in the World Bank's Dhaka office in December 2005 and October 2006. BANGLADESH STRATEGY FOR SUSTAINED GROWTH EXECUTIVE SUMMARY I. Introduction 1. If Bangladesh were a long-distance runner, its supporters would be applauding the speed and stamina that have brought it from the back of the pack to a place within sight of the leaders. At the same time, they might be wondering when Bangladesh will get its second wind and propel to the head of the field. That challenge is the subject of this report on Bangladesh's record of growth, its potential for more rapid growth, and the policies which can help the nation realize its potential. 2. The premise of the report is that Bangladesh, given a second wind, could join the ranks of middle-income countries (MICs) within a decade @y 2016) or some time soon ajier. It has the necessary assets: much-improved economicfundamentals; success in implementingmany first-generation reforms; a young, rapidly growing labor force; and an established entrepreneurial culture. Despite the widely acknowledgedand critical weaknessesin governance, Bangladesh also has an impressiverecord of achievement, especially in harnessing sound economic and social policies to pioneering social entrepreneurship. 3. To pick up pace in the development marathon, Bangladeshwill need to deepen its industrialbase, further its economic integration with global markets, and unleash the growth potentials of its major urban centers, Dhaka especially. Reform measures essential to these objectives include continuing macroeconomic stability, with emphasis on strengthening tax mobilization and tackling energy sector losses; deepening financial sector and external trade reforms; and rebalancing the policy focus toward hitherto neglected structural areas - economic governance, urban management, infrastructure(especially power sector, ports, and transportation),and labor skills -that are especially important for strengthening factor productivity. Progress in these and other areas can bring the kind of sustained,rapid growth which the government has put at the center of its poverty-reduction strategy. 11. Growth and Development:An Overview 4. Background: Desperately poor when it won its independence in 1971, over-populated, and reeling from overwhelming war damage to its institutional and physical capital, Bangladesh looked to become, as Henry Kissinger forecast, "an internationalbasket case." Thirty some years later, doubts and doubters have been disproven. Life expectancyin Bangladeshhas risen from 50 to 64 years. Population growthrates of 3 percent a year have been halved. Unemploymentthat ran at 25-30 percent has shrunk to 4 percent. Child mortality rates of 240 per 1,000 births have been cut by 70 percent. Literacy has more than doubled, and Bangladesh is on track in meeting its Millennium DevelopmentGoal on gender parity, having already achieved the goal in primary and secondary schooling. These and other gains, aside from being the result of targeted government efforts and exemplary social entrepreneurship, owe a primary debt to income growth, the strongestengine for raising living standards and reducingpoverty. 5. Thanks to that motor, Bangladesh's real (inflation-adjusted)per-capita GrossDomestic Product (GDP) has more than doubled since 1975. Until 1989,however, GDP growth per-capitaran at a positive but mediocre average yearly rate of 1.2 percent. Where reform episodes had been sporadic in that first, slow phase of growth, the second phase, the period since 1990, while deepening some earlier market deregulation and privatization measures, saw a new wave of reforms in the areas of macro stabilization, trade liberalization,and financial deregulationthat produced per-capita GDP growth of 3.3 percent. Not only is that rate almost triple the previous average; it is also more than double that of the median country worldwide and three times that of the median low-incomecountry (LIC). 6. The economic advances during the 1990s, when productive reforms coincided with political democratization, underpinned and benefitedfrom progress on human development. A steep decline in the poverty rate -firom an estimated 70 percent in 1971to 58 percent in 1992and to 40 percent in 2005 - is in large measure due to accelerated income growth in the last decade and a half. It and the advances in health, education, and population growth, however, also reflect the sound social investments made in Bangladesh's first two decades and innovative social programs, exemplified by world-renowned organizations such as the Grarneen Bank -winner of the 2006 Nobel Peace prize along with its founder, Prof. Moharnrnad Yunus -and the Bangladesh Rural Advance Commission (BRAC). 7. Impressive as progress has been, Bangladesh stillface great challenges. Its per-capita GDP in 2005 in purchasing power parity (PPP) terms was just under US$2,000 compared to India's US$3,486, China's US$6,572, and Malaysia's US$10,843. Adult illiteracy persists at 50 percent, and both child malnutrition and maternal mortality rates are among the world's highest. Strong, sustained growth has produced remarkable advances. To move Bangladesh into the company of MICs, economic growth must become even stronger. 8. Deconstructinn Growth: Among the unusual and significant features of Bangladesh's economic growth are its notable and improving stability and its broad-based nature. Although hit hard and often by cyclones and floods, Bangladesh, remarkably, is one of a handful of countries to have avoided even a single year of negative per-capita growth since 1990. Across districts and economic sectors - manufacturing, construction, and services - the pace of growth has largely mirrored that of GDP. Only agriculture, whose share of GDP has dropped from 30 percent in 1990 to 20 percent, has turned in an uneven performance: lackluster growth in the first half of the 1990s, a relatively strong rate of 5 percent in the last half, and a return in the 2000s to its long-termpattern ofjust under 3 percent. 9. Unsurprisingly,the country's urban centers,foremost among them Dhaka, have led growth. In terms of population, cities have grown at roughly three times the speed of overall population. Dhaka, with 12 million inhabitants, has seen an eight-fold increase in its population since 1970 and is estimated to be one the two fastest growing mega cities in the world. Lagos, Nigeria is the other. Not least because of the surge in readymade-garment (RMG) exports and the directly related housing construction boom, urbanization has been accompanied by job creation strong enough to accommodate over 10 million new entrants to the work forcebetween 1996and 2003. 10. Despite that success and although real wages increased across all economic sectors, the income of self-employed workers-almost halfthe workforce -declined between 2000 and 2003. With skill levels critically low, moreover, the 8 percent unemployment rate among 20-24 year olds is uncomfortably high. Joblessness runs even higher among workers with higher secondary or degree education. Economic expansion, in other words, has not yet lifted the generally poor quality of education and worker training. 11. Explaining Acceleration of Growth Since 1990: Three factors go into picking up the pace of growth. The two that have played the dominant role since 1990are physical and human capital, the latter measured in terms of the quality of the workforce,its size and slall levels. The third factor,the efficiency of production technology, as measured by total factor productivity (TFP), also contributed by growing at a slightly faster pace than in the 1980s. The pick up in physical capital accumulation - a 6.6 percent average growth rate over 1991-2006,compared to 4 percent in the preceding decade -was led by private investment and financed principally by higher domestic savings. The acceleration in human capital growth was largely on account of the strong increase in the size of the labor force. A demographic transition has brought a surge in youthful entrants to the labor force, where, more recently, women have sharply increased their presence. 12. The lesson of the 1990s is that broad-based, market-oriented reforms and macro stabilization measurespropelled bothprivate investment and technology infusion. The key reforms included: Stabilization efforts that tamed inflation, sharply reduced the current account deficit and significantly devalued the taka to bring it closerto its market rate; Trade and exchange liberalization, including tariff cuts, reduction of quantitative restrictions, exchange-rate unification and continuedpreferential arrangementsfor garment exporters; Relaxation of such restrictions as licensing requirements on private investment while opening telecommunications, power, and domestic aviation to the private sector; Initiation of financial sector reforms such as interest rate deregulation and abolishment of credit quotas-measures that eased private-sector access to credit; and Building on earlier agriculture-sectorreforms, especially by continuingprograms to spread small- scale irrigation, widen access to small diesel engines,and liberalize fertilizermarkets. 13. These and other policy initiativesjump-started growth in the 1990s. Their continuation has sustained good growth since. Lasting fiscal and monetary prudence, bolder banking sector reforms and continued trade liberalization have combined with the h i t s of Bangladesh's early emphasis on social development to support sustained high rates of economicgrowth. 14. With most of thosefirst-generation reforms soundly in place, a new set of challenges require deeper and more complex policy innovations. Emerging structural issues - critically weak economic governance; overburdened port, power, and transportation facilities; urban congestion and mismanagement; acute slulls shortages - along with lackluster agricultural performance and limited success in attractingFDI in manufacturingact as brakes on growth. Only by confronting these and other constraintscan Bangladesh grow rapidly enough to achieve MIC statusby 2016 or some time soon after. 111. Gathering Speed: Scenario for Rapid Growth 15. Bangladesh, with per-capita gross national income (GNI) of $470 in 2005, could become a middle-income country - defined by the International Development Association (IDA) as one with per- capita gross national income (GNI) of $875 -by 2023 if the average per-capita GDP growth holds at the 3.5 percent level of the last 10years (assumingGNI growth equals GDP growth). The transition to MIC statuswould be put on hold for another 5 decades if per-capita growth slipsback to the 1percent rate seen in the 1980s. Or, Bangladesh could become an MIC within a decade (by 2016) if it raisedper-capita growth to 6percent, implying GDP growth at a challenging but not impossible 7.5percent. There is international precedence for such perfonnance - GDP growth in China has averaged over 9 percent since 1975, while Korea and Thailand each attained 8 percent growth for two decades before the 1997 East Asian crisis. 16. To make the rapid transition to MIC status, Bangladesh will need, above all, to employ its resources (labor and capital) much moreproductively. It will also need to increase the investment rate by more than 5 percentagepoints, relying on higher domestic savings. Three mutually reinforcing long- term transitions would be integral to achievingthese outcomes: (i) a shift fi-omagriculture to industry and services; (ii) deepening of integration with global markets; and (iii) emergence of diverse dynamic urban centers. The management of these transitions, in turn, will require better economic governance and business environment without which FDI will continue at low levels; continued macroeconomic stability; a commercially viable energy sector that supports the economy's vast energy needs; deeper and more efficientfinancial sector;and, a greater emphasison the quality of educationand labor skills. 17. shift in^ the Sectoral Balance from Agriculture to Manufacturing and Services: This transition, already underway in Bangladesh, as in other developing countries, would be driven by a globally competitive private manufacturing sector and a productive, diversified, and commercially-oriented agriculturesector. 18. Improving the productivity of the manufacturing sector, according to analysis of a survey of some 700 firms in 5 major manufacturing industries carried out for this report, will require particular attentionto: (i) Addressing burgeoning energy supply constraints that undercut productivity. A 1percent increase in number of power outages in a year reduces the productivityof the average firmby 10percent. (ii) Improving Bangladesh's attractiveness to FDI. Qulte low historically (less than 0.5 percent of GDP for the most part), FDI has picked up recently in extractive industries (coal and gas), telecommunications, and energyproduction,but not in manufacturing,where FDI brings significant productivity gains - firms with any level of foreign ownership are found to be 10 percent more productiveon averagethan firms that are wholly domesticallyowned. (iii) Phasing out the high anti-export bias. By further lowering and streamlining tariffs, improving trade facilitation and tackling other behind-the-border barriers to export competitiveness, manufacturing firms stand to gain. The results show that firms that export majority of their output are about 10 percent more productive on average. Results also show that the benefit of being an exporter improvesover time, as valuable experienceis gained in export markets. (iv) Building human capital. Higher-education levels and experience of managersbenefit productivity, a survey finding that highlights the importance of improving access to quality tertiary education, while consolidatingearlier gains at the primary and secondary levels. (v) Responding to the lagging knowledge economy. New measures are needed to encourage the application of greater innovation and the adoption of more advanced technologies. Survey results show both having a positive impact on productivity of Bangladeshimanufacturing firms. (vi) Strengthening law and order. Private investors often cite protection payments, for example, as harmful to firmproductivity,and the analytical results support that assessment. 19. A drive to boost industrialproductivity needs to be matched by initiatives to do the same for agriculture. Targets for initial action are the underperforming (but high potential) fishing sub-sector and rice production, where only half the cultivated area uses the H W rice variety in the aman season. 20. Ultimately, raising real agricultural incomes will require diversiJcation into higher-valued crops and increased output of the livestock and fishing sub-sectors. Bangladesh needs to especially capitalize on its long-term competitive advantage in inland aquaculture by overcoming shnmp farmers' past difficultiesin meeting importers' sanitary and phyto-sanitary quality requirementsand assisting them in adopting semi-intensive and intensive methods of shrimp farming. To raise productivity of inland aquaculture, the post-handling and marketing and distribution of better quality fish seeds need to be improved, in additionto research and extension support from the government. 21. Thegovernment's important but limited role inpromoting agricultural diversification includes a significant expansion in agricultural research and extension efforts. Additionally, institutional reforms to increasethe stabilityof fundingand strengthen research management are crucial as is sustained public investment in rural marketing infrastructure (particularlyroads, bridges and telecommunications). 22. Liberalizing Trade and Spurring Export Competitiveness: The considerable, if uneven, progress Bangladesh has made since 1991 has brought tariffs down, eliminated trade-related quantitative restrictions and import licenses, unified exchange rates, and instituted a floating exchange-rate policy. Largely driven by the success of the RMG sector, the resulting increase in export orientation - with merchandize exports to GDP ratio increasing from 6 percent in 1990 to 17 percent in 2006 - has very likely contributed to the accelerationof GDPgrowth over the sameperiod. 23. Nonetheless, substantialfurther reforms are needed to deepen trade liberalization and boost export competitiveness. While the average customs duty rate has been steadily reduced by cutting the general maximum rate, a rampant increase in the use of other protective levies (para-tariffs) in the last decade has offset so many of the gains that average protection levels are the highest in the region and among the highest in the world. Furthermore, trade facilitation procedures are cumbersome and infkastructurebottlenecksto exporting are severe. The resulting anti-exportbias has leveled off at a high level, which works against the emergence of new exports activities. Unsurprisingly, Bangladesh's export orientation,albeit much higher than in 1990,comparesunfavorablywith that of other Asian economies. 24. Moreover, RMG exports accountfor about 75percent of merchandise exports, reflecting the much lower anti-export bias institutionalized in enclave arrangements and a duty drawback system. They reduce but do not entirely offset the bias, and the Duty Exemption and Drawback Office (DEDO) for those who are not 100 percent exporters is so inefficient that it takes a minimum of six months for drawbacksto be paid. Half the applicationsremain pending even after two years. 25. To diversifi its trade base and improve export competitiveness, Bangladesh needs a well- thought out sequence of trade liberalizationmeasures. Key elementsof such strategywould include: A continued emphasis on unilateral trade liberalization matched by caution in pursuing the current fashion of regional and bilateral trade agreements. Establishment of a low and uniform tariff rate sooner rather than later, following interim reform steps that further simplify the import tax regime and reduce the dispersion and average level of nominal (and thus effective)protection. India's recent introductionof a pre-announced medium- and long-term scheduleof tariff reductions offers a useful model. Merger of para-tariffs with the customsduty, in order to have one tariff rate for each tariff line. Eliminationof all end-usertariff exemptionsand concessionaltariffs. Levying VAT on both domestic production and imports of the same product, thus eliminating its protectionist impact while improving fiscalrevenues. Ensuring full and immediate implementation of the new duty drawback and bonded warehouse scheme and quickpayment of rebates under the duty drawbacksystem. 26. Making the Most of Rapid Urbanization: Careful management is needed to balance the major opportunities and equally large challenges for Dhaka-based economic activity. Dhaka's economic dynamism makes it a magnet for migrants, while a combination of national institutional arrangements, such as centralization of political and administrativepower in the city, and public expenditure allocation decisions - as in Dhaka-centric investment in transport - augments its special appeal. At the same time, the city's already stretched service provision and infrastructure are under mounting stress and vastly unresponsive. Real estateprices skyrocket as traffic congestionworsens and infrastructuredecays. 27. Weakgovernance is thefundamental underlying cause of poor urban management. Because Bangladesh is among the most centralized counties in the world, local autonomy suffers, major capacity and resource constraints build up, and city management structures are loosely defined and fragmented. Denied buoyant tax handles, cities depend for own-sourcerevenue on the property tax and associated fees for water, lighting and conservancy. Because of administrativeand technical shortfalls, these taxes prove inadequate to cover most spending requirements, forcing city governments to rely on central government transfers that often account for half of their revenues. Such grants typically come tied to pre-specified projects. Adding littleto local capacity or autonomy, they are also proving increasinglyunreliable. 28. Theurban management challenge, therefore, is twofold: thefirst reIates to improving access to and the quality of basic services and infrastructurein Dhaka and other major metropolitan areas, and the second to improvingprospects for the smaller cities to emerge as viable urban alternatives. Cutting across both is the need to devolve key services to city governments, together with clear delineation of duties and accountability chains between the federal and city governments, among the various agencies involved with urban management functions, and between serviceproviders and citizens. This devolution has to be carefully sequenced so that improvement in city governments' ability to perform is matched by enhancing their own revenue sources and building their technical and administrative capacity. Local governments will first need to increase revenues from existing tax bases, training appraisers and computerizingbilling to strengthen collection machinery at the same time. Crucially, they will need to build stronger linksbetween the taxes they exact and the quality of public services they deliver. 29. Bangladesh needs a well-reasoned and carefully considered national strategy to bring more balance and energy to urban development across the country. Such a strategy would seek to remove policy biases that work against the emergence of smaller cities, misdirecting public expenditure allocations and public investments in transport networks. It should also create incentive structures and competitive pressures among cities such that public and private investment and labor flows respond to objective measures of city management. Investments in inter-regional transport and communicationsare likely to make cities more attractive to investmentand reduce excessive concentrationin the largest ones. To be really effective, improvements in inter-regional transportation need to be accompanied by improvements in local infrastructure and service provision, which will require significant additional resources. Toward this, recently initiated efforts such as the government-owned Municipal Development Funds @&IF) appearto be steps in the right direction. IV. Enablingthe Key Transitions 30. The three key transitions discussed above are long-term endeavors. To ensure their success Bangladesh will need to strengthen economic governance, maintain macroeconomic stability, improve infrastructure,strengthenthe financial sector, and narrow the acute skill gaps. 31. Strenatheninn Governance is Essential: Thefirst steps need to tackle the governance-related problems that foster regulatory uncertainty, corruption, crime and disorder, and distrust of the judiciary. Despite laudable progress in maintaining macroeconomic discipline to foster a vibrant private sector, in making wise public expenditure choices, and in forging partnerships with NGOs and the private sector, Bangladeshis widely perceived by potential investors- foreign and domestic-as an expensiveand risky place to do business. Weak governance, in short, undermines prospects for the accelerated growth Bangladeshseeks. 32. The toughest challenges lie in the core governance areas - the confrontational nature of politics, flawed revenue administration andfinancial accountability, and distrust of supposed rule-of- law guarantors. The fractiousness of Bangladeshi politics contributes to political uncertainty and heightens perceptions of economic risks among investors, especially foreigners. The low revenue effort that stems from weak administration creates a chain of disincentives to good governance, from low salaries for civil servants to inadequate operations and maintenance expenditures. Flawed procurement processes, poor financial controls and inadequate external checks and audits reflect weaknesses in financial accountability. The quality of civil service and mostjudicial and law enforcementinstitutions- courts, police and prosecutors - are consistently rated poorly in citizen surveys. While domestic entrepreneurslearn how to survive the system, foreign investors unfamiliar with Bangladesh and armed with many other investment choices see such failuresas seriousdeterrents. 33. Only strongpolitical leadership supported by a constituencythat demands change can advance reforms that cut across a wide range of institutions and threatenpowerful vested interests. It will be essential to develop a strategic, sequenced approach so that successes in a few key areas generate momentum and demand for even broader reform. Summoning the necessary political will is a major challenge,but Bangladesh has proved equal to similartests in the past. 34. Continuing Sound Macroeconomic Management: One such demanding responsibility that Bangladesh has generally met with strength is macroeconomic management. At least since 1990, monetarypolicy, for example, has broadly supported growth. By keeping tight control on reserve money growth and permitting more flexible interest rates, monetary managers have held inflation rates to single digits. The record onfiscal management is more mixed. Higher public spendingand increased reliance on costlier domestic commercial borrowing in the FY99-02 period began to escalate the government's interest obligations. Fiscal prudence was soon restored, however, by lowering the deficits to under 4 percent of GDP and limiting commercial borrowing to under 2 percent of GDP. Public sector debt has sincebeen contained below 50 percent of GDP, but poor tax collection -among the weakest in the world -couldimperilthehigherallocationsforessentialsocialsectorandinfrastructuredevelopment. 35. Large losses incurred by energy-sector state-owned enterprises (SOEs) - due to underpricing of energy products in domestic markets - and the resulting impact on the NCBs that are directed to finance these lossespose an emergingfiscal risk SOE losses - 80 percent of them by the Bangladesh PetroleumCorporation (BPC)-for FY06 are estimated to have increased to about Tk 45 billion &JS$670 million), or 1.1percent of GDP, almost 8 times their level in FY04. The sizable level of outstandingSOE liabilities, which are contingent liabilities for the budget, together with the weak revenue mobilization, make the risk of debt distress"moderate". To keep public debt in line, authoritiesneed to step up efforts to contain SOE losses, mainly through efficient and cost-reflective pricing of energy products, while steadilyimproving tax mobilization. 36. Overallfiscal and monetary prudence has helped contain excess demand, particularly since 2002, and kept the assessed risk of external public debt distress "low." Disciplined macroeconomic management together with stronger growth in exports and remittances and a pick-up in concessional and other long-term capital inflows over the last 4 years have restored external balances that were precarious at the end of 2001. The current account deficit has stayed under 1 percent of GDP, and reserves now stand at over US$4 billion (2.6 monthsof import cover) compared with US$1 billion in FY02. 37. Overcominn Infrastructure Constraints: Inadequate energy supply, congested ports and underdeveloped transport networks connecting the ports with the hinterland impose a major (and growing) drag on economic performance. Firm-level surveys consistently cite access to power among the top obstacles to investment. Trade facilitation, critical for export competitiveness, cannot proceed strongly as long as Chittagong port, which handles nearly 85 percent of the country's merchandise trade, is plagued by laborproblems,poor management, and lack of equipment. 38. The most serious and immediate of the infrastructure constraints - with perhaps the most damaging impact on productivity and investment - is the widespread and growing shortage of electricity. In 2005, the power sector generated 160kwh of electricityper-capita, amongthe lowest levels in the world. Only about 35 percent of the population has access to network power, and outages during periods of peak demand are scoring historic highs and growing fast. The average firm interviewed experienced power losses 2 of every 3 days in a year, and most reported sharing or owning a generator, raising their electricity costs by half. 39. A long history of political interference has produced badly-run government power enterprises and undermined the 1990s initiative to encourage private power generation. Legitimate private investors are reported to have been put off by the interference of vested interests in technical evaluations and by rumors about particular parties having been chosen for political reasons. Part of the government's response to power shortages - increasing the supply of natural gas at highly subsidized rates -risks depleting gas reserves and bringing on major gas shortages as early as the next decade. To deflect shortage-induced political discontent, the authorities have been maintaining artificially low tariffs, a costly and unsustainable expedient. The Bangladesh Power Development Board (BPDB) gives bulk buyers annual subsidiesin excess of US$100 million. 40. Unevenly and slowly and against the resistance of various vested interests, the government is beginning to address some power-sector shortcomings. Among the important initial implementation measures undertaken are establishing the Bangladesh Energy Regulatory Commission (BERC) in 2004 and restructuringthe industry so that the BPDB's share of generation drops to 60 percent fi-om86 percent in FY99 while various autonomous companies take over all of BPDB's transmission assets, 9,000 km of its rural distributionlines, and parts of the key Dhaka market. 41. With an estimated USS1.5 billion in new investment needed annually to build utility-scale plants that can catch up with demand, Bangladesh needs to address the critical issue of efficient pricing as a priority, Since public resources are in no position to finance such projects, large-scale private investment in gas exploration and production and in gas-fired power generation is required. To attract it, Bangladesh must immediately raise power and gas prices to cover, at a minimum, all operating costs and adopt a credible timeline to increase power prices to full cost recovery levels and gas prices to economic value. Well-targeted subsidies couldbe used to protect the poor from the tariff increases. Over the longer term, addressing the major governance problems, especially the lack of transparency in the procurementprocess for new power plants, in the sector is a must. 42. Bangladesh's drive toward export competitiveness is hostage to major bottlenecks - from customs procedures in the ports to inefficient transport networks and even the administration of food safety and quality standards. The Chittagong port, which handles about 85 percent of the country's merchandise trade flow, ranks among the world's least efficientcontainerports. Average container dwell time there is reported at 18 days compared to 10-12 days for other ports in the region, and container handling costs are estimated to be four times higher than in Colombo and twice as high as in Bangkok. No doubt, the engagement of private berth operators, crackdown on union activity among dockworkers, and restructuring of the labor force since January 2007 has improved many of the performance measures. According to officials, efficiency at the port has improved by about 30 percent because of these measures. These are welcome improvements whose sustainabilityneeds to be ensured. 43. The hold-ups at the Chittagongport can be traced largely to complex clearance and customs procedures and dement physical and logistical capacity. The documentation needed for customs is lengthy and must be submitted in hard copy. Even with the required Pre-Shipment Inspection (PSI) system now in place, customs continues to check 5-10 percent of the shipments that have a CRF (Clean Report of Findings) and up to 100 percent of the packages in these consignments. In addition to the resulting delays, the mere prospect of such an inspection is sufficient to elicit informal payments. Although the port handles about 400,000 containersper year, only recently has it procured fixed container handling equipment such as ship-to-shore gantry (SSG) cranes and rubber-tired gantries (RTGs); and that too in insufficient quantity. Resistance to change comes from workers who garner substantial income from speed payments and from the absence of incentives- or competition from private service providers -forcurrentemployeestoimprovetheirperformance. 44. Introducing private service providers could serve as a catalyst for the requisite policy and institutional reforms at Chittagong port. Handing over management of the port to an experienced private contractorcould open the way for modernizing container-terminal operationsto take advantage of the recently procured SSGs and RTGs. This measure seems to have the highest immediate pay-off. Effective use of the equipment will involve computerization, restructuring of the workforce, and close interactionwith shippinglines, all very difficult measures under the currentpublic-sectormanagement. 45. Additionally,service providers whose defaulting actions reduce the port's efficiency should face elevated penalties stringently enforced; customs clearanceprocesses should be modernized for efficiency; the number of customs bonded facilities, including road-based and inland container depots (ICDs), in the Dhaka region should be increased; and interconnection transport infrastructure should be modernized, diversifiedto exploit inland waterways,and perhaps to separate,as Indiahas, container-unittrain services placed under commercial management from the less profitableand time-sensitive railway services. 46. Creating a Deeper and More Efficient Financial Sector: Bold banking reforms adopted since 2001 have deemphasized the role of the NCBs, strengthened competitive pressures, loosened government conirol, and tightened prudential regulations and regulatory quality. Although political interference, resistance from labor unions, and judicial roadblocks have slowed restructuring and divestiture, measures to bring the capital adequacy ratio up to international norms, to tighten loan classification, to issue risk guidelines, and to improve banks' corporate governancehave already brought positive results. In response, private banks have dramatically increased their market share to over 50 percent of banking sector assets and turned around their operationaland financialperformances. 47. Nonetheless, major challenges remain. After 20 years of systemic disbess, the sector is only beginning to emerge from crisis and has a long road ahead to full recovery. Despite improvements,non- performing loan (NPL) ratios remain precariously high in the NCBs and development banks, while provisioning by the NCBs and the problem private banks has typically fallen well short of requirement. The non-bank segment of the financial system, with the important exception of microfinance, is grossly underdeveloped. 48. The reformprocess initiated since 2001 has moved move awayfrom heavy intervention in the banking sector to more emphasis on bringing market forces into play. Bangladesh Bank, despite political interference in the bank-licensing process, has made some important progress toward market- based supervision. In addition to setting higher disclosure and auditing requirements for financial institutions, it maintains a separate list of approved auditors for banks, requires them to go public and - along with non-bank financial institutions (NBFIs) - to publish their annual financial statements in newspapers. Still, thanks to undue political influence, troubled banks enjoy such protection that no domesticbank has been allowedto fail. 49. All in all, an effective long-term expansion of the financial system will require a more substantial change in the role of the government,from an operator and arbiter to a facilitator. The ongoingmove to a privately-owned financial system -along with the redefinition of government's role in capital markets and micro-finance - is an important one, although international experience also advises caution (but not necessarily delay) in the privatization process. To move forward, Bangladesh should de- politicize the entry of banks by subjecting licensing to objective, non-political standards, institute market monitoring of banks, and reform the exit process. Most importantly, the government needs to move away from implicit guarantees against failure to the use of existing, limited, but explicit deposit insurance, while simultaneouslyrelying more on market participantsto monitor and disciplinebanks. 50. Addressing Skills Shortages in the Labor Market: Under the right conditions, labor - often viewed as Bangladesh's most precious resource - could power the lund of rapid transition toward prosperity that resource-poor East Asian economies have made, Its relative abundance of labor endows Bangladesh with a comparativeadvantage in production of labor-intensive goods, but that advantage only translates into global competitivenesswhen it rests on a foundation of high productivity. The efficiency of the labor market and the quality of the labor force are important componentsof the overall productivity and competitiveness. Oppressive labor market regulations are often enough to put the brakes on growth even if everything else falls into place. 51. On balance, Bangladesh's ineffectively enforced labor laws and regulations are less of a hindrance to the functioning of the labor market than are deficiencies in protecting worker rights. Overall, labor laws and rules are relatively light, and firms retain considerable flexibility to hire and fire. At the same time though, lack of organized union activity in the formal private sector, where only about one worker in twenty is covered,has its down sides, especially since it arises from government curbs that International Labor Organization (ILO) experts have decried for being excessively restrictive. Such limited union activity handicaps workers' ability to engage in collective bargaining and protect their rights, and hindersthe formation of an effectivemechanism to resolve labor disputes. 52. Afocus on marketkwiented vocationalskills and good quality secondary and tertiary education are essential not just to consolidate earlier gains in primary education but to boost productivity and, with it, global competitiveness. Skilled and well-trained workers, now in acutely short supply in Bangladesh, are more productive workers and better able to adapt superior greater technology. Not only are the education levels among the workforce low - only four years of schooling on average - but the education and vocational training systems are also not geared toward market needs. Productivity suffers heavily when even this scarce human capital is not properly utilized, as highlighted by data showingthat almost one-fourth of the unemployed - 30 percent in the case of women - hold an SSC, HSC or higher degree. Furthermore, just over 1 percent of the labor force has had technical training or vocational education, and even among those, the relevance of their skills seemsquestionable. The low quality of the vocational education and training (VET) system is reflected by its low capacity utilization and pass rates and furtherby the weak demand for its graduates. V. Conclusion:Summary policy recommendations 53. Economic growth hasproven to be the mostpotent force in thefight againstpoverty. Mirroring experience across the globe, Bangladesh's own record bears out the significance of growth for poverty reduction: the poverty rate has fallen by close to 20 percentage points since the early 1990s,benefiting from a sharpaccelerationin per-capita GDP growth. 54. Despite serious weaknesses in governance, corruption most notably, Bangladesh has achieved good growth since 1990. What some observerscall the "Bangladesh paradox" actually reflects a mixture of weaknesses and strengths such as the positive resolve that produced a series of first-generation macroeconomic and structural reforms. They, in turn, stimulated the positive growth response. Successive Bangladeshi governments have maintained the initial momentum, allowing - unlike their counterparts in most of the developing world - sufficient space for social organizations to evolve and flourish, with both sides often successfullypartnering to deliver essential social services such as primary and secondary education, family planning, and primary healthcare. Moreover, the major political parties, despite their acrimonious relationship, have not shown fundamental disagreements over the course of economic reforms. The pace of the reforms may be gradual,but their sustainabilityis not in doubt. Bangladesh's challenge is not to jumpstart growth but to maintain and, to the extent possible, accelerate it. The country can reasonably strive to become an MIC in a decade or sometime soon after; thereby ensuring that the government will meet its goal of reducing the poverty rate to 25 percent by 2015. To win that next stage of the development marathon, Bangladesh will need to tackle a new set of challenges with deeper political commitment. The measures that are needed - detailed in the report and summarized below - are not simple steps, nor easy ones. Bangladesh, though, has already shown an impressive capacityto implement policy innovations. There is everyreason to believe it can continuethat performance. Specific Policy Choices for Making the Transition to MIC Status Objective Recommended Policy Measure Reverse the declining Expand the use of the HYV variety of rice to the aman crop. productivity growth Place special emphasis on addressingthe emerging quality andproductivity concerns in trends in agriculture the shrimp industry, especially inland aquaculture, where Bangladesh has long-term comparative advantage. In addition to research, information, and extension support the governmentcan assist by taking measures to improvepost-harvest handling and marketing and distribution of better qualityfish seeds. Expand agriculturalresearch and atension efforts in rice as well as high valued crops, livestockandfish. Implement phased increasesin expenditure on agricultural research. Establish an endowment Trust Fund and carry out necessary institutional reformsto increase stabilityof fundingand to strengthenresearch management. Improve marketinginfrastructure(particularly roads, bridges and telecommunications) to promote growthof non-crop agriculture, includingthe poultry and fish sub-sectors, as well as the m l non-farm sector. Createa morefavorable environmentforprivate investment,especially in warehouses and cold storagefacilities,to reduce storagelosses and price risk for highly perishable h i t s and vegetables. Provide a growth-friendly institutional environment,by setting and enforcing transparent and consistent"rules of the game" for ago-food systemand agro- enterprise development. - - - - ~ ~ - - - Strengthen export Place continued emphasison unil~teraltrade liberalization. competitivenessby Establish establishmentof a low and uniform tariff rate (by FY12) as the key phased and ultimateobjective, to be preceded by the followingmeasures: transparent Unify all para-tariffs and merge these with the CDs (by FY09) liberalizationof the Reduce the maximum tariff rate to 15%by FYlO. This would, of course, require trade regime parallelprogress in expanding the base of VATand direct taxes, while the tax administration isfurther strengthened. Eliminate all end-usertariffexemptions/concessionaltariffs (FY09budget) Discontinue protectiveuse of VAT (FY09budget) Lobby strongly in the USA for duty-free entry of RMG exports, alreadyextended to LDCs in Afiica under the Africa Growth & Opportunity Act (AGOA). Improve eflciency of the duty drawback system, to ensure quick payment of rebates. Workwith regionalpartners to ensurefull use of 'regionalcumulation' allowed by the EU towardsmeetingthe latter's 'rules of origin' conditions.Inparticular, ensure that in any regional PTAQTA "rules of origin" are liberal, simple,transparent and uniform. Improve labor skills to make them more relevantto market needs. Address skills Consolidate gains in primary and secondaryeducation with emphasis on constraints improving the overall qualityand removing urban-rural disparityin quality Improve the qualityand market relevance of the vocational education and training (VET) system (see the Bangladesh VocationalEducation and Training System: An Assessment, World Bank 2006, for an elaboration of the following) o Develop a policy kamework, in coordinationwiththe private sector, clarifying roles & responsibilities of various VET agencies (immediate). o Make availableinformationon trainingprograms and facilitateregular and independent impact evaluations of training programs (immediate). o To improveoverseas employabilityof workers: allow accreditationfrom internationallyrecognized agencies; strengthen linkagesbetween VET system and overseas employment agency(immediate) o Allow greater autonomy for VET institutions(immediate) o Set-upan autonomousBoard of VET (3-5 years) o Developa QualificationsFrameworkto establish uniformcourse assessmentrequirements and course entryprerequisites (3-5 years) o Supportdemand-drivenand employer-financedinitiatives such as the Chittagong Skills Development Center (CSDC) (3-5 years) Address weaknessesin Strengtheninstitutional arrangementsfor public expenditure,financial management, Bangladesh?score andprocurement, using the agreed PFM indicators as benchmarks. Specifically: governance areas that Implement the Action Plan to strengthenpublic financialmanagement matter directlyfor Deepen and mainstreamthe MTBF being piloted in 14ministries future sustained Completecomputerizationof public accounting system growth Ensure timely completion of the PAC strengtheningproject. Implement the ProcurementLaw and ensure compliancewith its rules Strengthenrevenuemobilization by deepeningthe tax administration modernization program. Specificactionswould include: Developnew functionalareas inNBR, includingtaxpayer services, audit, ICT Reorient NBR compositionalong functionallines, startingwith its Board Improve HR policies and procedures to ensuremore professional and competitive recruitment and promotion,training,compensation,and career development Undertakeperiodic taxpayersurveysto measureprogress. Establishunique taxpayer identificationnumbers for both Income Tax and VAT Undertakenecessary legislative reformsto correct major tax policy distortions Improve quality and efficiency of the civil service. Strengthenthe personnel management system, ensuringa more merit and performance based systemof promotions, a strategic use of postings and transfers, a revised compensationpackage, particularly for the senior cadresof the civil service who are relativelypoorly paid. Address the critical issueof pricing ofpower and gas: Address thepricing Immediateincreases in power and gas prices to at least cover all operatingcosts andgovernance issues Reinstate the pricing formulaethat ensure automaticprice adjustments,and adopt inpower generation a credible timeline to increase power prices to full cost recovery and gas prices to andgasproduction, its economic value needed to attract Hardwirebudget support to cover utilities' losses in the transition period private investment Address thegovernanceissues afflicting thepower sector into the sector In generationprocurement, appoint internationallyreputed transaction advisors Empower utility managers to run fully commercial operations. Put law and order resources behind managers to enforce payments from delinquent customers Implement other complementary reforms: Corporatize the power sector entities Fully operationalizethe Energy RegulatoryCommission Implementthe recently adopted financialrecoveryand restructuringplan Improvethe Implement necessary policy and institutional reforms at Chittagong port, necessary to functioning of the attract much neededinvestment in theport's physical capacity Chittagongport and Handovermanagement of port to experiencedprivate contractor carry out + Modernize the container terminal (especially computerization and restructuring complementary of workforce)to take full advantage of the SSGs and RTGs measuresto Increasepenalties on serviceproviders for creating congestion strengthentrade Implement complementary tradefacilitation measures facilitation Increase customs bonded facilities,including road-based and ICDs, in the Dhaka region Improve inter-connection transport infrastructure, especially by modernizing the BangladeshRailways as per current agreementwith developmentpartners Deepen and make Successfully completethe ongoing restructuring of theNCBs, with the eventual more efficient the objectiveof divestmentover the medium term (3 years) financial system Set objective performancebenchmarks in the managers' contracts, linking performance with futurepay scale and continuedemployment(immediate) Introduce government-funded VRS to rationalizeNCB staffing sizes (immediate) Ensure divestmentof eachNCB to a strategicbuyer, particularly by: o reducinggovernmentshare in divestedNCBs to virtuallynil; o resolving SOEbad debt ahead of the divestment With respect toprivate sector banks, move awayfrom system of implicit zuarantee to xii applying the misting limited explicit deposit insurancefor depositors,while simultaneously relying more on marketparticipants to monitor and discipline banks. The followingconcrete steps canbe considered: Develop objective criteria forbank licensing, to de-politicizethe process Subject all banks to special audits to assess their long-termviability Resolve non-viable banks, preferably through market-based solutions such as M&A or purchase and assumption Review and reform as necessarythe legal frameworkfor bank failureresolution Strengthen regulatory& supervisoryframeworksfor capital & insurance markets Strengtheninformationdisclosure,by ensuringtimely and accurate filing of annual audited fmancialstatementsby incorporatedcompanies. Review and reform as necessarylegal impedimentsto the SEC's abilityto carry out its oversightrole, while weaning it away fromexcessiveinterventionin certain areas-prescribing dividendpayouts, interferingin selection of CEOs etc Maintain thepast Toensure continuedfiscal sustainability: record of Reinstate the pricing formulaefor energyproducts. Align energyprices to full rnacroeconomic cost recovery levels, and eannarkbudgetaryresourcesto cover energySOE stability and losses in the interim sustainability Improvetax collection (reformmeasures are noted above) Strengthendebt management capacity,especiallythe recordingof contingent liabilities Ensure continuedmonetaryprudence with more flexibleuse of interestrates. Continue reliance on market-based mechanisms in foreign exchangemarkets xiii I. Introduction 1 . This is a report on the growth performance and potential of Bangladesh. The report argues that the 1" phase of Bangladesh's development - rising from the post-independence desolation and establishing a positive development record - has been a success. The country has clearly come a long way since independence in 1971 and its future is anchored in far stronger fundamentals than the pervasively bleak conditions then. Good economic and social policies and pioneering social entrepreneurship, partnered under innovative institutional arrangements, have contributed immensely to the successes attained. These have also enabled the country to cope with some critical (and widely reported) weaknessesin governance. 2. The primary objective of the report, however, is to draw attention to the zndand current phase of Bangladesh's economic development - ensuring a speedy transformation to middle-income country (MIC) status. For that, the much-improved economic fundamentalsand successful implementationof an array of first generation reforms augur well, as do a young,rapidly growing labor force and an established culture of entrepreneurship. But the challenges ahead are also major. To sustain and improve her good growth record, needed to achieve the poverty reduction objectives set forth by the government's Poverty Reduction Strategy(PRS): Bangladeshmust not only pursue activelya range of second generationpolicy reforms (i.e., deepen the first generation reforms), but also rebalance the policy focus toward key structural areas where progress has been lagging. As the report shows, this is needed to stimulate the productivityperformance of the economy (the efficiencywith which capital and labor are used to produce output), and therebyensure long-term sustainabilityof growth. 3. In tracing Bangladesh's path to MIC status, it is useful to first envision a middle-income Bangladesh and work backward from there. Three complementary features seem inextricable from that vision. Namely, an economy with (i) much higher degree of industrialization; (ii) deeper and better- managed global integration, and; (iii) rapid urbanization, with Dhaka continuing to be an important engine of growth and emergence of a more diverse set of dynamic urban centers as viable alternatives to Dhaka. 4. What is needed then is a deepened understanding and careful management of the mutually reinforcing transitions within each of these areas. Policymakers would also need to nurture an enabling environment to support the key long-term transitions. In particular, by strengthening economic governance, ensuring continued macroeconomic stability, addressing the burgeoning infrastructure constraints (especiallythose related to the power sector,ports, and transportation),deepeningand making more efficientthe financialsector,and addressingacute slulls shortages. 5. The government's PRS document appropriately places economic growth at the center of its strategic and policy focus - growth is the first of the three elements (human development and better governance are the other two) that constitute the policy triangle on which the PRS's vision and strategic agenda for poverty reductionare built. It also rightly stressesthe importance of outward-oriented,private sector-led growth, thriving on macroeconomic stability, improved governance, promotion of technology, a stronger small and medium enterprise (SME) sector, and agricultural diversification. However, as the 'This report was prepared prior to the emergenceof the political turmoil in October 2006. Nonetheless, given its particular focus on the longer-termdevelopmentagenda facing Bangladesh, the relevance and validity of the report's analyses and conclusionsshould not be affected by the recent political events. Unlockingthe Potential: National Strategyfor Accelerated Poverty Reduction, Government of People's Republic of Bangladesh, 2005. Joint Staff Advisory Note (JSAN)~observes, a well thought-outprocess of growth accelerationis missing in the PRS. The systematic piecing of a strategy for sustained economic growth in this report is an effort to narrow some of that analytical gap. 11. The Record of Growth and Development: An Overview 11.1. A Synopsis of the DevelopmentRecord 6. Starting out as desperatelypoor, with much of the institutional andphysical capital obliterated by the 1971 warfor liberatio~i,Bangladesh was written off by many international observers. Henry Kissinger famously prophesied Bangladesh's economic future as "an international basket case." Extremely weak initial conditionsand various vulnerabilitiesoffered plenty to worry about. Summing up the conditionsthen, a World Bank report in 1972noted:" Evenunder the best of cifcurnstances, Bangladeshcmstitvtesa critical and complex developmentproblem. The popuiationis poor (per-capita incomeof $50 to $70-a figure which has not risen over the past 20 years), overcrowded (population density is nearly 1400per square mile) and becoming more so (populationis growing at 3 percent per annumf, short-lived (lifeexpectancy at birth is well under 50 years), in many casesunemployed(perhaps25-30 percent),andlargelyilliterate(under 20 percent literacyrate). Furthermore, most of the population (90 percent ma]) lived below subsistence, with the poverty rate estimated at over 70 percent, child mortality was extremely high at about 240 deaths for every 1,000 children, and gender discriminationwas prevalent: there were only 958 females for every 1,000males in 1970,which then was lower than in India, Palustan, Nepal, and Sri Lanka in the region, 7. Bangladesh's development record Itas been a remarkablypositive one, especially when viewed through the prism of the weak initial conditions and szrrrounding pessimism. Thirty some years later, life expectancyhas risen to 64 years (comparableto neighboring India's), population growth has dropped to 1.5 percent (resulting &om a reduction in the fertility rate from 7 children in 1972 to 3), literacy has more than doubled, child mortality has been cut by 70 percent, unemployment is down to 4 percent, poverty incidence has fallen to 40 percent, and about a quarter of the population lives in urban areas. Bangladesh is on track in meeting its Millennium Development Goal (MDG) on gender parity, having already achieved the goal in primary and secondary schooling. There were an estimated 978 females for every 1,000males in 2005 -more than in India and Pakistan. Figure 1.a: Per-Ca~itaGDP: Bangladesh Vs. Median LIC Figure 1.b: Per-Capita GDP: International Comparisons Note: Included LICs are the 21 countries whose per-capita GNI in 1975 was at or below US265, the cut-offfor LICs ehgibility used by IDA in 1975. Source: World Development Indicators, BBS, and World Bank staff calculations. Joint IDA-IMF Staff Advisory Note o n the Poverty Reduction Strategy Paper, December 2005. Bangladesh: Reconstmcting the Economy, Report No. SA35, the World Bank, 1972. 8. Income growth has been crucial in raising living standards and reducingpoverty. Since 1975, Bangladesh's per-capita gross domestic product (GDP) has more than doubled in real Taka value and increased by close to 90 percent in constant PPP US$ terms, outpacing most other low-income countries (LICs). In 1975, Bangladesh's per-capita GDP was just 6 percent higher than that of the median LIC, Rwanda (Figure l.a).' By 2005, the margin relative to the median country in the same group had increased to 50 percent. Six out of the 21 countries that classified as LICs in 1975 saw a decline in their per-capita GDP and another 8 saw a smaller increase than did Bangladesh. Of course, some other LICs did much better: since 1975, China's per-capita GDP has increased almost ten-fold, Indonesia's over three-fold and India's over two-and-a-half fold (Figure 1.b). Figure2: Trends in GDP Per-Capita 9. Strong economic growth has been mostly a post-1989 phenomenon. Abstracting fiom the post 220 5 independence turmoil, since 1976, the growth process ? 200 4 exhibits two distinct phases (Figure 2). The first ,80 3 5 '" phase spans the years 1976-1989 and was a period of positive but mediocre 1.2 percent average per-capita 2 2 growth, benefiting from sporadic reform episodes - & 9 $40 1 3 mostly related to domestic market deregulation " 0 (including for agricultural inputs and outputs) and $ Irn lo divestment of state control from some state $ -1 lm enterprises. In comparison, the median country 80 -2 growth across the globe was 1.7 percent, while the 197s 1980 198s 1990 1~195 2000 2005 percapita GDP of even the median LIC (amongthe 21 -RealPer-CapitaGrwlh(leftaxis) GDP(righta&) who classified as LICs in 1975) caught up slightly Real Per-Capita with Bangladesh (Figure 1.a). The second phase BBS and World Bank staffcalculations begins in 1990, deriving from deepening of the earlier reforms plus a new wave of reforms in the areas of macro stabilization,trade liberalization,and financial deregulation. The latter phase also coincided with political democratization in the early 1990s. Per- capita GDP growth almost tripled, to 3.3 percent, in the latter period, more than double that of the median country across the globe and three times that of the median LIC. In fact, growth has been on an increasingtrend in the secondphase, averaging 3 percent in the 1990sand close to 4 percent in the 2000s. 10. Growthhas both underpinnedand benefitedfrom substantialprogress on human development. Growth accelerationsince 1990has been accompanied by faster progress on poverty reduction and some human development measures. After a virtual stagnation in the 1980s, the poverty rate fell from 58 percent in 1992 to 49 percent in 2000 and further to 40 percent by 2005;~one of the fastest rates of poverty reduction in the region. In other areas, secondary school enrollmentremained stalled at about 20 percent between 1975-90,but has since increased to 43 percent; access to sanitation facilitieshas doubled since 1990, and; child malnutritionrates (by weight), have been reduced considerably after showing little progress in the 1980s,althoughBangladeshstill has a lot of distance to cover on this one. 1I. Much of the social sector progress started in the first two decades aBer independence, well before the growth acceleration, afeature that is somewhat unique to Bangladesh. This owes to good social policies and innovative social programs pioneered by world famous nongovernmental organizations (NGOs) and community-based organizations, such as Grameen Bank (winner of the 2006 Nobel Peace prize along with its founder, Prof. Mohammad Yunus) and the Bangladesh Rural Advance Commission (BRAC), partnered with government agencies and international donors. As a result, Among the 21 countriesthat fellunder IDA'SLIC classificationin 1975were Bangladesh,China, Haiti, India, Indonesia,Nepal, Pakistan and 14Sub-SaharanAfrican countries. 6The poverty statisticsare fiom variousrounds of Household Income and ExpenditureSurvey(HIES). progress on most human development indicators (see Table 1) has been even more impressive than income growth on many counts and also stands out in comparison with most ~ 1 ~ s . ~ Table 1: Progress on Key Social Indicators Then Now Schoolenrollment,secondary(% net) 19(1990) 43 (2005) Schoolenrollment, primary (% net) 71 (1990) 93 (2004) Fertility Rate 6.1 (1972) 3.0 (2005) Immunization, DPT(% of children ages 12-23months) 1(1980) 88 (2005) Immunization,measles (% of childrenages 12-23months) 1(1982) 81(2005) Improved sanitationfacilities(% of populationwith access) 20 (1990) 39 (2004) Life expectancyat birth, total (years) 45 (1972) 64 (2005) Malnutritionprevalence, weight for age (% of childrenunder 5) 68 (1983) 48 (2004) Mortalityrate, under-5 (per 1,000) 239 (1970) 73 (2005) Mortalityrate, infant (per 1,000live births) 145(1970) 54 (2005) Source: WorldDevelopment Indicators, WorldBank 12. Despite the good development record, the remaining challenges are daunting. In 2005, Bangladesh's per-capita GDP in current PPP terms was only US$1,997 (or US$420 at market exchange rates), compared with India's US$3,486, China's US$6,572, and Malaysia's ~~$10,843.'Its population of over 140 million is compactly packed in a land area of 147,570sq. km.,one of the highest population densities in the world; over 2 million people are added to this each year. Almost half of the country's population lives near sea level and 40 percent of its land area is flooded for three months each year, exposing large parts of the population and land to the threat of global climate change and resulting rise in sea levels. In fact, few other countries are as imperiled by climate change.9 Close to 60 million people still live in deprivation, two-thirds of them caught in extreme poverty. The level of human development remains low despite the tremendous progress since independence. Adult illiteracy is persistent at about 50 percent and falling slowly, particularlyamong women. Child malnutrition rates are among the highest in the world and maternal mortalityrates, albeit lower than in India, Palastan, and Nepal in the region, are among the highest in the world outside of Sub-Saharan Ahca. 11.2. Main Characteristics of the Growth Process 13. The long-term growth process in Bangladesh displays at least five key characteristics: (i) remarkable stable growth; (ii) broad-based growth, spread over a number of major economic activities; (iii) strilang uniformity in regional GDP growth in the 1980s and 1990s, although regional expenditure growth has varied quite a bit and substantial differences remain in income and expenditure levels; (iv) significant urban-rural differences, with the largest urban centers (especially Dhaka) driving the growth process, and; (v) a relatively good record on accompanyingemployment creation. A brief description of each follows. For elaborationof this, see Bangladesh Development Policy Review: Impressive Achievements But Continuing Challenges, World Bank, 2003. World Development Indicators. TheFinancial Times, 2007, "Bangladesh Plight ServesAs Warning to World," February 1. Remarkably Low Volatility of Growth 14. An impressive feature of the growth process has been its remarkable and improving stability. The standard deviation of per-capita GDP growth fell from 1.6 over 1976- 1989 phase to 0.7 over 1990-2005. In fact, the standard devialion in the latter period was the lowest in the world (Figure 3). It is quite likely that low volatility has had a positive impact on long-term GDP growth, and even on income distribution." Furthermore, Bangladesh is among the handful of countriesthat have avoided even a single year of negative per-capita growth since 1990. The achievement of low volatility is all the more creditable given Bangladesh's exposureto natural calamities. An impressive record on strengthening - - disaster management - and macroeconomic stability are the likely factors in achieving [ ~ ~ { ~ the low growth volatlhty. Progress on disaster management is brought out by comparing the two major floods in 1998 and 1988: even though the former lasted longer, was more far reaching, and inflictedmore physical damage, the human and economic loss from it was much lower." The good record on macroeconomicstabilityis discussedlater. Broad-Based Nature of Growth 15. Growth has also been broad-based, although tlze sectoral composition is shifting away from agriculture, as is common for developing economies during periods of sustained high growth. Manufacturing sector growth Itas improved to about 7percent since 1991, compared with 5percent in the 1980s (Table 2),benefiting from better performanceby both small-scaleand large- and medium-scale enterprises. Manufacturing exports, especially of ready-made garments (RMGs), have played a crucial and catalytic role: RMG exports increased from an insignificantamount in early 1980sto $2.5 billion (6 percent of GDP) in FY96 and $7.9 billion (13 percent of GDP) in FY06. The impact of the RMG sector boom has been much more far-reaching. For one, the sector has catalyzed the emergenceand growth of a number of ancillary industries. It has also contributed to rural growth - and female empowerment - through its recruitment of a large number of female workers from poor rural backgrounds. A number of other products, such as ceramics,pharmaceuticals, and food products have also experienced strong export growth over the last decade, although fi-om a much smaller base than garments. As a result, the merchandize exports to GDP ratio increased from 7 percent in 1991to 18percent in 2006 and the share of manufacturingin merchandize exports from 67 percent in 1981to over 90 percent. 16. Construction,too, has been booming since the mid-1990s, fueled by the strong manufacturing sector growth and the large amounts of remittance inflows, coming primarily from the Gulf countries. Remittances through formal channels have more than doubled since 2001, from US$1.9 billion to almost $5 billion in FY06 (remittancesthrough informal channels are estimated to be at least half of that), which is about 8 percent of GDP and half of merchandize exports. These increases are linked to stricter enforcement of money laundering activities (within Bangladesh and internationally) and higher global fuel prices which have benefited the Gulf region where majority of Bangladeshi emigrants are based. ' ORarney and Ramey (1995) and Hnatkovska and Loayza (2005) confirm the negative impact of volatility on GDP growth. Laursen and Mahajan (2005) show a negative impact of volatility on income inequality. Tile I998 Floods in Bangladesh: Disaster Impacts, Household Coping Strategies, and Response, International Food Policy Research Institute, 2001. Table 2: Growth Rates of Output Components 1981-85 1986-90 1991-95 1996-2000 2001-2006 Growth Rates (%) GDP Growth 3.7 3.7 4.4 5.2 5.6 AgricultureSectorGrowth Industrial Sector Growth Manufacturing - large & mediumscale - small scale Construction ServicesSector Growth Wholesale and Retail Trade Transport,Storage, &Communications Sharesof GDP at ProducerPrice (%) AgricultureSector 31.7 31.2 27.6 25.7 21.5 Industrial Sector 21.3 21.2 23.4 25.3 26.8 Manufacturing 14.1 13.3 14.6 15.6 16.0 Construction 5.8 5.8 6.3 7.2 8.0 ServicesSector 47.0 47.6 49.0 49.0 51.7 Wholesaleand Retail Trade 13.0 12.5 12.5 12.8 13.6 Transport,Storage,&Communications 10.8 9.9 9.6 8.8 10.2 Source: BangladeshBureau of Slntisrics. 2006 data areprovisional. 17. Agriculture sector growth has been more sporadic. The sector recorded relatively good growth of about 5 percent in the second half of the 1990s, recovering from weak performance in the first half. Growth in the 2000shas fallen to its long-term trend ofjust under 3 percent. Agriculture's share in GDP, in the meanwhile, has fallen from 30 percent in FY90 to under 20 percent. Growth in the services sector -whichishalfofGDP-hasmostlymirroredGDPgrowth. Not onlyhaveGDPandservicesgrownat an identical average rate of 4.6 percent since 1980(considerably lower than service sector growth of over 7 percent in India), year-on-year movements in the two series have been highly correlated. Growth in services is also marked by extremely low volatility: the standard deviation of services sector growth over 1981-2006was 1.0,comparedwith 1.8for the industrial sector and 2.4 for agriculture. Sub-National Variations 18. Per-capita GRP growth in the 1980s and 1990s was strikingly similar across the 6 Divisions (Table 3) - Dhaka, Chittagong, Khulna, Barisal, Sylhet, and Rajshahi. Annual Divisional growth obtained from Bangladesh Bureau of Statistic's (BBS) Old Districts data varied in a narrow 1.8-2.8 percent range across Divisions over FY83-99. Similarly, Divisional growth aggregated from BBS's district-level data, varied between 2.7 and 3.1 percent in the second half of the 1990s.I2 Furthermore, the growth acceleration at the national level since 1990was experienced in varying degrees by each of the 6 Divisions. It was most pronounced in the Sylhet Division, where per-capita growth acceleratedby over 3 percentage points over FY90-99 compared with the FY83-89 period. Dhaka and Chittagong Divisions experienced with 2 and 1.3 percentage point acceleration, respectively. Nonetheless, a fair amount of dispersion is seen among the Divisions'per-capita GDP levels. In FYOO, per-capita GDP of the most well-off Division (Dhaka) was about 50 percent higher than that of the least well-offDivision (Sylhet). -- l2It must be noted that data at the OldDistrict level are fairly unreliable. For one, these are based on the 1968SNA, whereas the 1993SNA is currentlybeing used. The District level data address some ofthese quality concerns. Table 3: GDPLevels and Growth by Division AggregatedFrom District Level Data Aggregated From "Old District" Data GDP per-capita GDP Share in GDP per-capita (Tk, current prices) Total (%) growth GDP per-capita growth Division FYOO FYOO FY9640 FY83-89 FY90-99 FY83-99 Dhaka 22,303 37.7 2.9 1.3 3.3 2.4 Chittagong 18,128 19.3 2.8 1.7 3.O 2.5 Khulna 17,875 11.6 3.1 2.6 3.0 2.8 Barisal 15,383 5.8 3.0 2.1 2.2 2.2 Sylhet 14,886 5.2 2.7 0.0 3.1 1.8 Rajshahi 15,174 20.4 3.4 1.8 2.6 2.3 National 18,511 100 23 1.6 2.9 2.4 Source: BBS, and Staffcalculations 19. GDP data for the next administrative level, the District, are available only for the M96-00 period, although additional insights is provided by District-level expenditure data from the Household Income and Expenditure Surveys (HIES), since they cover a longer period, ~ ~ 9 2 - 0 5As . ' ~in the case of the Divisions, per-capita GDP growth was also relatively uniform across the Districts. Almost 90 percent of the Districts experienced average growth in the 3-5 percent range over FY96-00, none experienced negative growth and only two experienced growth of over 5 percent. The per-capita expendituregrowth rates, on the other hand, varied widely, between -4.8 to d.dpercenf,over FY92-05. There is also considerable dispersionin both GDP and expenditurelevels of the Districts. In FYOO, the average per-capita GDP and the average per-capita expenditure of the top five Districts were about two- and-a-half times those of the bottom five. Per-capita GDP of Dhaka, the most well-off District, was three-and-a-halftimes that of the least well-off District (Gaibandha) in FYOO. 20. Analytical work in Chapter 6 identifies some correlates of cross-District differences in expenditure growth over FY92-05. The chapter finds expenditure growth at the District level to be negatively correlated with the initial expenditureinequality, gender disparity,and large landholdings,and positively correlated with the degree of urbanization and access to electricity. Also, Districts with lower per-capita expenditure, on average, experienced faster expenditure growth, implying mild regional convergence in per-capita expenditure, although the speed of convergence suggested by the results is quite slow: the estimated time to full convergence is about 90 years after accounting for the mentioned correlates of growth, and about 150years without consideringthe correlates.14 GrowthProcess Led by Major Urban Centers: GrowingPrimacy of Dhaka 21. Although still predominantly rural, Bangladesh is undergoing a rapid transformation toward urbanization(Figure 4). Growthin the country has been led by its urban centers, especiallythe largest ones (see Chapter 5 for details). Urban population has grown at an annual rate of about 6 percent since independence; compared with 2.2 percent population growth at the national level. About 35 million people, or a quarter of the population, currently live in urban areas, compared to only 8 percent at independence: the number is projected to cross 80 million by 2030. Over the same period, the share of urban activities in GDP is estimated to have increased from a quarterto almost one-half. l3Although expendituredata are not representativeat the District level, these are tightly correlated with GDP data across districts. Still,the District level aggregationsfor expenditureare to be interpreted with caution. 14At the Divisional level, expendituregrowth over FY00.-05 was significantlyfaster in the top 3 Divisions(in terms of their per-capita expenditure level in FYOO) thanthe bottom three, leadingto increased divergencein living standardsbetween the two groups and slowerprogress on poverty reductionin the latter. Figure 4: Urbanization in Banglades11 Lkban Population(%) I I ' I Source: UN World Urbanization Prospects and WorldBank staff calculations 22. Urbanizatiorzhas been more concentrated in the largest cities. The four largest cities -Dhaka, Chittagong, Khulna, and Rajshahi - account for over 60 percent of the urban population, up fiom 48 percent in 1970 (see Table 4). Dhaka, the national capital, has seen an eight-fold increase in its population since 1970. The city accounts for a third of the urban population with its 12million residents, and its "urban primacy" Ievel (share of total urban population) exceeds that of most global corn para tor^.'^ Furthermore, as per UN estimates, it is the fastest growing mega city in the world (along with Lagos, Nigeria), a pace at which its population would be close to 22 million by the year 2015, rnakrng it the 6" largest city in the world (it is currently the 11' largest) and the 3rdlargest in Asia by 2015.'~Chittagong, Khulna, and Rajshahi have each experienceda more-than-five-foldincrease in population since 1970. Table 4: Populationdynamicsof the largest agglomerations(population figures in thousands) 1 II Rank City Population Population Population Population Annual Growth f 1 (2000) I1(2000) I1 (1990) I Population I1 ] (1980) (1970) 11(1970-2000) Dhaka I 1 1 12300 1 6619 3248 1474 I 7.1% Chittagong 2 3581. 2265 1333 693 5.5% KhuIna 3 1426 972 622 310 5.1% Rajshahi 4 1016 517 238 105 7.6% Data Source: Global Cities Database http:'/wwu econ.brown edu~facul@~henderson~uorldcities.html 23. Thepopulation trends, not surprisingly, mirroi-the concentration of economic oppop.tunitiesin tltese cities. Most major industrial activities and auxiliary businesses services are concentrated in the largest cities. Dhaka alone accounts for 80 percent of the RMG output and half of manufacturing sector employment1' and a tenth of its labor force is engaged in RMG industry - over seven times the national average. If this is linked to availability of complementary businesses services, then the data bear that out as well - the representation of business services, particularly finance and real estate, in employment is also considerablyhigher in Dhaka and the other large metropolitansrelative to the rest of the country. A Positive Record on Employment Creation,Skill LevelsRemainLow 24. An overallpositive record on employment creation has accompanied GDPgrowth (Chapter3). According to the 2002-03 Labor Force Survey (LFS), the economy created 5.3 (9.5) million new jobs between 2000-2003 (1996-2003), accommodating most of the 5.6 (10.2) million entrants into the labor force. In common w~thother developing countries, open unemployment is quite low at about 4 percent.'8 For example, primacy levels of the largest cities in India, Pakistan, and Korea are 6%, 22% and 23%, respectively. '6Ahmed et al. Mimeo, World Bank 2006. Dhaka UrbanPoverty: Land and Housing Issues, Draft paper, World Bank, 2005. l8The labor force data are to be interpreted with caution given the considerable quality issues. Female labor force participation is on the rise, increasing from 16 percent in 1996to 26 percent in 2003. Real wages increased across all major economic sectorsbetween 2000-2004,rising by close to 30 percent in manufacturing, indicatingsome tightening of the labor market despite rapid growth in labor supply. 25. Nonetlieless, some important aspects of the labor market deserve more careful attention. The unemployment rate is 8 percent for the 20-24 year olds and even higher for those with higher secondary or degree education. The income of the self-employed workers (almost half the work force) appears to have declined over the 2000-03period. Furthermore, the formal sector comprises only about a fifth of the labor force (although this ratio is higher than in India) and shows no signs of pichng up in fact, data for - the 2000-03 period show a decline in the formal sector's share. The share of "unpaid family workers" in the workforce increased over the 2000-03 period at the expense of all other job statuses except "employers". Above all, skill levels remain critically low, owing to low literacyrates and generally poor quality of education and worker training, that are also not particularly relevant to market needs.19 11.3. Factors Underlying GDP Growth 26. Accumulation of physical capital and (quality- adjusted} labor has been instrumental in the growth acceleration since 1990, with some contribution from totalfactor productivity (TFP} growth (Figure 5). Capital stock growth picked up fkom an average rate of 4 percent over 1980-89 to 6.6 percent over 1991-06. Growth rate of effective labor - measured as a combination of the labor force and education levels of the working-age population - also improved up by almost one-half percentage points in the latter period. While better access to education played a role, the dominant factor in this increase was labor force growth. Average annual growth of TFP (the efficiency I DGDPgrowth tal Stock Gmwth with which canital and labor are used to ~roduceoubutl / 88 Labor (quaiity aeusted] Growth #Qrowth 1 1 1 , picked up from v~rtually7cro in the ten years prior to 1990 !.~3P?-~f_s?~Epla9-?~_---- - . to 0.4 since.20TO be sure, a lotof cakon is warranted in interpreting TFP estimates because of data quality problems and the lack of information on the precise assumptions to deploy in calculating TFP. Nonetheless,the slight pick up in TFP growth since 1990is a robust conclusion across all plausible variations in assumptions(see Table 1 in Annex 1). 27. Capital accumulation has been led by private investment and financed principally by gross domestic savings. Figure 6 shows the breakdown of investment by its private and public components, with the total and private investment rates moving in almost complete synchronization after 1990. The increase in the investment rate from 17 percent in FY90 to 25 percent in FYOG was accompanied by a concomitantincreasein the gross domestic savingsrate, from 13percent to 20 percent (Figure 7). l9TheBangladesh VocationalEducation and TrainingSystem: An Assessment, World Bank 2006. 20In the absence of reltable labor force data that are also comparable across bme, to calculate TFP growth we use working-age population (15-64 age group) as proxy for labor force, although estimates of even that vary by source. While the WDI database shows average working-age population growth of 2.7 percent during the 1990s and 2.8 percent in the 1980s,the ILO and the US Census Bureau each report corresponding growth of 3.4 percent, about one percentage point hlghex than in the 1980s. The TPP estimates shown here use the ILO data. The Increase in TFP growth since 1990would be close to 1percentage point if WDI data were used instead. Figure 6: Public-PrivateBreakdownof Investment Figure 7: Trends in Investment and Savings Z88 .-..--TotallnveslmentRate PublicInvestmentRate Private mstment Rate I -Total hvesbnentRate GmssDomeslicSavimRate I Source: BBS and WorldBank staff calculations 28. Labor force growth has been strong despite declining population growth (fiom 2.5 percent in the 1980s to 1.5 percent in recent years) because of the demographic transition that is resulting in a surge of youthful entrants into the laborforce and, more recently,from sharp increases in thefemale labor force participation rate (LFPR). Demographic factors such as increased life expectancy and markedly lower infant mortality have helped offset much of the slowdown in population growth, resulting in fairly robust worlung-age population growth. Furthermore, as a result of the increase in female LFPR, from 16 percent in FY96 to 26 percent in FY03, the female labor force almost doubled in size during these seven years, while the male labor force increasedby just 17percent. 29. The initial surge inprivate investment and the improvement in TFPgrowth that supported the growth acceleration in the 1990s were propelled by broad-based market oriented reforms and macro stabilization measures. These involved deepening of the reforms initiated in the previous decade and implementationof a fresh wave of macro and structuralreforms. Key measures included: Improved macroeconomic stabilization: CPI inflation fell fiom an average rate of 10 percent during 1985-1990 to 4 percent during 1991-94, while the current account deficit as a share of GDP fell from 7 percent to 2.7 percent and fiscal deficit from 7.6 percent to 6.2 percent. 21 The sharp reduction in the current account deficit allowed foreign exchange reserves to improve from an import cover of 2 months in FY90 to 8 months in FY94. Furthermore, the taka was devalued by 15percent against the US dollar over FY91-92 to bring it closer to its market value. Easing of trade and exchange restrictions: The pace of trade liberalization was accelerated and preferential arrangements for garment exporters were continued to avail of the special access to developed country 'markets offered by the Multi-Fiber Agreement (MFA) quota system. The "Secondary Exchange Rate System" was abolished to unify the exchange rate system and most exchange controls on current account transactions were removed. Export performance responded immediately. After stagnating at about 5-6 percent of GDP between FY85-90, exports to GDP ratio increased to 11percent by 1995. Relaxation of several restrictions on private investment in the Industrial Policies of 1991 and 1992, including licensing requirements for private investment, and opening up of telecommunications, power generation, and domestic air transport to the private sector. Partly in response to this stimulus, private investment, having declined from 11.8 percent of GDP 9.8 percent between FY85-90, increasedto 12.4percent by FY95. '9angladesh: Recent Economic Developments and Priority Reform Agendafor Rapid Growth,World Bank 1995. Launchinp of the Financial Sector Reform Program (FSRP): Controls on interest rates were relaxed with the launching of the FSRP in 1990, followed by replacement of the controls with interestrate bands in 1997and finallywithdrawal of the bands in 1999. In addition,credit quotas were abolished to reduce the directed lending. With easing of credit constraints faced by the private sector, private credit to GDP ratio increased from 15 percent in FY93 to 21 percent in FY95, after having increased by just 2 percentage points since FY85. This provided another major stimulusto private investmentin the 1990s,as shown in Chapter 8. Deevenina of aficulture reforms. Further liberalization of input and especially output markets was carried out in the early 1990s, building on the significant progress of the 1980s. In 1987, restrictions on import of small diesel engines were lifted followed by removal of import duty in 1989. Deregulationand privatizationof public tubewells in the 1980scontributedto rapid spread of small-scale irrigation and provided the irrigation needed for adoption of the HYV rice crop in winter. Furthermore, fertilizer markets were liberalized in 1980s. Even though these measures could not prevent the poor performance of the rice crop in the first half of the 1990s,they laid the foundation for the recovery that followed in the latter half. 30. Successful and sustained macroeconomic stabilization (lower inflation and smaller internal and external imbalances), played an important part in nurturing the good growth. Since the early 1 9 9 0 ~inflation has not touched the two-digit mark, broadly reflecting responsible monetary and fiscal ~ policies. Fiscal prudence has kept public borrowing in check and prevented any significantcrowding out of private investment. Fiscal and monetary discipline, together with periodic real exchange rate adjustments, has helped keep the external sector more-or-less in balance. At the same time, improvements in disaster management have contained the economic loss from natural calamities. Since the early 2000s, growth has been further aided by the advent of some bold banking sector reforms that have sought to deemphasize the role of the public sector banks, strengthen competitivepressures, loosen government control, and tighten prudential regulations and regulatory quality. Trade liberalization has beenfurther deepened, albeit at an uneven pace. From the demand side, important impetus has been provided by sharp increases in worker remittances - that have also helped maintain macro balances by offsetting a declining trend in foreign aid - and the availabilityuntil recently ofpreferential marketsfor garment exports. 31. Earlier emphasis on social development was also an importantfactor in sustaining the higher growth. As noted earlier, progess on a number of human development areas preceded the growth take- off in early 1990s, enabling a more robust growth response to the aforementioned market-oriented reforms. Underlying the various social development successes were conducive public policies that complemented the tremendous work of the NGOs and community-based organizations, many of which are world leaders in their fields in terms of innovative ideas and organizationalmanagement. The state also wisely created the space for the emergenceof effectivepartnerships between large, well-functioning NGOs and relatively weak public agencies to deliver education, health services and micro-credit. Furthermore, the government pragmatically encouraged the private sector to deliver secondary and tertiary education. Government expenditure priorities, too, were broadly supportive, with health and educationbeing allocated significantparts of the budget. 32. GDP growth has further benefited from the good progress on women's advancement. The mentioned increase in participation of women has been an important factor behind the strong labor force growth. Furthermore, the success of the garment sector - a major contributor to the overall growth performance - has been shaped by female workers, mostly from rural areas, who constitute about 90 percent of the sector's workforce. More fundamentally, an early focus on female education - through female stipend programs for school enrollment, for example - improved the productivity of the female workers and contributed to better health and education of children and lower fertility rates. The widely acknowledged micro-credit programs have also made significant contribution with their emphasis on underprivileged women. 33. Having completed an array of first generation macro and structural reforms, Bangladesh is now confronted with some emerging structural hues that will require deeper and more complex reforms. The finding on low TFP growth, which has shown only a mild response to the reform efforts, is worrisome. The finding is consistent, nonetheless, with the report's assessments of tightening infrastructure constraints (especially power, ports, and transportation), lackluster agncultural growth (especially a sharp drop in the critical fisheries sub-sector), increasing urban congestion pressures and weak urban governance and infrastructure, significant remaining trade barriers, limited success in attracting FDI into manufacturing, stresses in the financial sector, and acute skills shortages. Afflicting each of these is the oft-rnentioned (for Bangladesh) weak governance. Interestingly, as elaborated later, closer inspection reveals that governance is not as universally poor as is commonly believed: on some aspects Bangladeshhas even done rather well. Nonetheless, in anumber of importantareas governance is significantly lagging overall development and (if unaddressed) risks becoming a gradually tightening noose around the growth process, particularly in the next developmentphase - the country's transition to middle-income status. III. Transitionto Middle-IncomeCountry Status: Issues and Challenges 111.1. A Scenarioof Rapid Growthto AchieveMIC Status 34. At US$470, Bangladesh's gross national income (GNI) per-capita in 2005 (calculated by the World Bank's Atlas method) was a little over half the US$875 cut-off for MIC classification used by IDA. The challenge for Bangladesh is to build on the growth momentum since the early 1990sto close this gap as soon as possible. If the country's per-capita GDP grows at 3.5 percent (assuming GNI growth equals GDP growth), the average rate in the last ten years, it would take until 2023 to attain MIC status (as per the 2005 IDA classification). The transition to MIC status would be put on hold for another 5 decades if per-capita growth slips back to the 1 percent rate seen in the 1980s. Or, Bangladesh could become an MIC within a decade (by 2016) ifper-capita growth could accelerate to 6percent, implying GDP growth at a challenging (but not impossible) 7.5 percent. There is international precedence for such performance - for instance, average per-capita GDP growth in China has been close to 8 percent since 1975, while Korea and Thailand each attained per-capita growth in excess of 6 percent for two decades before the 1997East Asian crisis. A possible hypothetical scenarioof Bangladesh's transition to MIC statusby 2016 is outlinedin Table 5. Table 5: A Hypothetical Scenario of Bangladesh's Transition to MIC statuszz [ 1990-2006 12006-16 Per-capita GDP Growth (%, period average) 3.3 1 5.9 capital Stock Growth(%, average) 6.6 Labor (quality adjusted) Growth(%, period average) 3.7 TFP Growth(%, period average) 0.4 Investment Rate (%, end of period) 25 Source: BBS, Burro-Lee (2000), and WorldBank staflcalculations 35. The key requirement to attain this hypothetical scenario (or something close to it) is a far stronger performance of TFP. Progress on this will be predicated upon tackling the structural constraints summarized below and discussed in detail in Volume I1 of the report. In addition, capital 22The TFP calculations in this table are based on the methodologydescribed in Annex 1. Further, the share of capitalin output is assumed at 0.35 and future growth rates of labor force and educationlevels are assumed to equal the average rates sincethe early 1990s. accumulation will need to accelerate, with the investmentrate needing to increaseby over Spercentage points. Demographic trends would be conducive, with a rising share of working-age population tending to raise household savings rates, as has happened in India and other countries. Increases in domestic savings would also depend upon improvements in the financial system. The budget is unlikely to be a major source of additional savings, as budget deficits are running at relativelylow levels of 3-4 percent of GDP and pressure for higher public expenditure is likely to intensify even as revenue generation catches up from its current low levels. It would be important, however, to tackle the emerging losses of the energy sector state-owned enterprises(SOEs)-estimatedat close to 1percent of GDP in FY06 -to make space for private investment and more productive fiscal spending. FDI would also need to pick up, although that would require better economic governance and business environment. Remittances and donor support would continue to play an importantrole. 36. Continued strong laborforce growth would be conducive,although afar greater emphasis on improving labor skiIls would be needed. As before, a special focus on women's advancement would bring considerable growth dividends. Only about onequarter of the working-age women participate in the labor force, compared with at least double that in advanced economies. Educational attainmentof the labor force should increase as a result of the higher-school enrollment rates over the past decade. However, more emphasis on improving the quality of education and reducing its rural-urban divide, and making it more market relevant would be crucial. 111.2. Managing ThreeKey Transitions 37. The above scenario needs to be mapped into a real agendafor reforms. For this, it is useful to first envision a middle-income Bangladesh and work backward from there. Drawing on the major structural transformations already at play in Bangladesh and experiences of other successful developing countries, three inter-connected featuresseem integral to that vision:23 A middle-income Bangladesh will have reached a more advanced stage of her transition out of agriculture and into manufacturing and services. This would be driven by a globally competitive private manufacturing sector and a productive, diversified, and commercially- oriented agriculture sector. A middle-income Bangladesh would be significantlymore open to investment and trade, where Bangladeshi firms will be plugged into global supply chains and the country will figure prominently on global investmentmaps. A middle-income Bangladesh will befar more urbanized than it is today, with a diverse set of dynamic urban centers emergingas viable alternativesto Dhaka, benefiting from much improved urban governance. Transition 1: FacilitatingSectoralShifts:From Agricultureto Manufacturingand Services 38. In common with nearly all developing countries,Bangladesh's growth has been accompanied by a shift in output composition awayfrom agriculture and in favor of manufacturing and services. During the low-growth period of the 1980s, the sectoral shares did not change much. However, the sectoral shift has been quite noticeable since 1991 (Table 2), coinciding with higher growth. Looking ahead, high growth performance under any scenario would be underpinned by services and l3 The Government's PRS highlightsanother major transformationwith implicationsfor long-termgrowth: the evolution of the meso-economy(rural market centers). This incorporatesformal and informal activities in services, trade, constructionand small industriesthat are rapidly expanding in the rural market centers. The transition, no doubt critical, is still not sufficientlyunderstood. Its analyticalunderpinningsneed to be deepenedfor incorporating it into the mainstream growthstory. manufacturing, and agnculture would continue losing its share even if it does well: it is hard to envision agnculture outperforming manufacturing and services on a sustained basis under any high-growth scenario. It seems more plausible that manufacturingsector would be the one piclung up the slack, gven its relatively low share in GDP (17 percent) and also its stronggrowth momentum since the early 1990s. 39. A key factor in Bangladesh's expected sectoral transformation would be robust factor productivity performance. Sustained strong future growth depends on it. There are also compelling reasons at the sectoral level. No matter how rapid the transition, agriculture will continue to play a dominant role for quite some time. The sector accounts for over half of the total employment, which is not expected to dissipate soon. The sector is also under tremendouspressure due to a declining land base. Productivity growth is important,therefore, to maintain good growth and generate more productive jobs. Productivity growth would also help sustain and accelerate past trends of good growth in the industrial sectorand by improving its competitivenessand preparing it for growingglobalization. Improving Productivityin the ManufacturingSector 40. Chapter I estimatesthe TFPoffive major manufacturing industries over the 1999-2003period using a Jirm-level survey of about 700firms conductedfor this report. The industries covered were ready-made garments, textiles, pharmaceuticals, food, and leatherlfootwear- together these account for about 70 percent of the manufacturing sectorand therefore give a good account of the sector.24 41. Analysis shows that the average annual (median) TFPgrowth over 1999-2003 was positive in four out of the manufacturing industries under consideration - garments being the lone exception.2 Within the garment sector, the average growth in the sweaters sub-sector was positive and relatively quite hgh. The results also show that allocation of resources within the pharmaceuticals, leather/footwear,and textiles industries during the sampleperiod was inefficient:in these industries,on average,firms that were less productive produced a higher share of their industry's output. However, this phenomenon is relatively insignificantin determiningthe overall productivityperformance at the industry level, which is largely shapedby productivityat the firm-level. 42. Careful econometric analysis identifies the factors that affect firm-level TFP performance, taking into account differencesinfirm characteristics-such as location, industry, age, and size. The results suggest that in order to strengthen TFP performance of manufacturing firms, the following measureswould be important: (i) The rapidly emerging energy supply constraints will need to be addressed. Results show that power supply problems are costing firms dearly in terms of TFP losses. A 1percent increase in number of power outages in a year reduces the TFP of the average firm by 10percent. (ii) Concerted efforts are necessary to improve Bangladesh's attractiveness to FDI, the level of which has been quite low (less than 0.5 percent of GDP for the most part). FDI has recently picked up in extractive industries (coal and gas), telecommunications,and energy production - increasing FDI's share in GDP to about 1percent -but not in manufacturing,where the potential for productivity gains is significant. Results show that firms with any level of foreign ownership are 10percent more productive on averagethan firms that are wholly domesticallyowned. (iii) Phasing out the high anti-export bias is important. For this, it would be essentialto further lower and streamline tariffs, improve trade facilitation, and tackle behind-the-border bamers to competitiveness. Results show that f m s that export majority of their output are about 10percent " The survey team comprisedstudents of the Departmentof Economics, JahangirnagarUniversity, who worked under the supervisionof Professor Abdul Bayes. 25The median TFP growth rate in an industry and in any given year is the growthrate such that half the firms in that industry and year have lower TFP growth rates and the other half have higher TFP growth rates. more productive on average. This advantage to exporters may be due to technology transfers from foreign buyers and having to adopt the stringent technical and quality standards of developed markets, and from coping with tighter time and competitive pressures. As further shown by the results, the benefit of being an exporter also improves over time as valuable experience is gained in export markets. Export orientation of firms not only increases TFP levels, but also TFP growth rates. (iv) Human capital deficiencies will need to be tackled. Results show that firm productivity improves with various measures of human capital. Higher-education levels and experience of managers in particular benefit productivity of firms, highlighting the importance of improving access to quality tertiary education,while consolidatingearlier gains on primary and secondary education. (v) Policies would need to develop the knowledge economy to strengthen the basis for more innovative activities and adaptation of more advancedtechnologies, which results show as having a positive impact on productivity of Bangladeshi manufacturing firms. Quality certifications,too, are found to improve firm productivity, and the application of these needs to be strengthened. Such certifications guarantee the use of internationally recognized technical standards (e.g., IS0 quality certifications) and are an important means of acquiring state-of-the-art technological know-how. (vi) Thepoor law and order, often cited as major concerns by private investors in Bangladesh, will need to be improved. Results show that these hurt firm productivity: firm TFP is fowd to be negatively associated with protection payment by a finn relative to its sales, a proxy measure of law and order problems. (vii) Interestingly, results findfirm size and productivity to be negatively correlated - the youngest and oldest among the surveyed firms were the least productive. This suggests that Bangladeshi firms in general are unable to benefit from economies of scale. Although hard to prove at this point, it may be partly reflecting the severe corporatemanagement deficiencies in the country. ImprovingProductivityin the Agriculture Sector 43. Growthperformance in agriculture has picked up across its major sub-sectors in recent years, with the important exception of the fishing sub-sector (Figure 8). As a result of the decline in fishing sub-sector growth - 1.8 percent in the 2000s compared with 8.2 percent during the 1990s - overall agriculture sector growth has deteriorated somewhat. Meanwhile, the agriculture sector is under significant pressure to improve its productivity due to a shrinking land base. In fact, the total land area sown is expected to decline at an even faster rate in the comingyears. Chapter2 coversthe key trends and sectoral issues. 44. The decline in fishing sub-sector growth was mainly caused by falling output levels of open water capturefisheries - a major income source for the poor. Catches of important fish types such as Hilsa, the Indian Salmon, the major carps (Rui, Catla, Mrigal, and Kalabaus) have all declined precipitously. For inland capture fisheries this has occurred mainly due to habitat losses, reduced dry season flows, and unregulated over-fishing. Future prospects for capture fisheries continue to be bleak. Aquaculturefisheries, on the other hand, have shown strong growth - 10percent growth over the last decade - and continue to hold considerable promise. Shrinlp production, in particular, has considerable potential, given its significant export potential. Significant potential for productivity improvements exists -for instance, current productivity in shrimpproduction f 100-150kgshectare) is far below that of Thailand (4-7 tonshectare), the world's leading shnmp exporter. Growth would have to come mainly from productivity gains as total pond area is not expected to increase significantly. 45. Bangladesh has a comparative advantage in riceproduction, particularIy in the aman season, when there arefew profitable alternativesonflooded land, the economicpotential of which needs to be morefully exploited. Per-acre rice yields in Bangladesh, although higher than in India and Pakistan, are considerably lower than in the East Asian economies, suggesting unexploited opportunities to improve productivity. Expanding the use of the H W variety of rice to the aman crop (where H W is being used in only half of the area) holds most promise for improvingrice productivity. 46. Ultimately, raising real agricultural incomes will require diversification into higher-valued crops and increased output of the livestock and fishing sub-sectors. In particular, Bangladesh would need to better avail of its long-term competitive advantage in inland aquaculture. Shrimpproduction in the past has suffered due to difficulty in meeting the sanitary and phyto-sanitary quality requirements of importers, which would need to be addressed for exploiting future growth potential. Shrimp exporters also have a role to play.26They would need to adhere to self-imposed standardsand the recognition and acceptance of third-party certification process by importers and regulatory agencies in importing countries. Further, farmers would need to adopt semi-intensiveand intensivemethods of shrimp farming in place of the prevalent practiceof extensivemethods. 47. The government's role in promoting agricultural diversification is important, albeit limited. Certainly, a significant expansion in agricultural research and extension efforts is needed. Currently, technology (agriculturalresearch and extension)system is weak and suffers from inadequateand unstable funding, inefficient allocation and use of resources, weak management, and ineffective institutional arrangementsfor coordinationof research.27 Significant scaling up of public spending on research along with institutional reforms to increase the stability of funding and to strengthenresearch management are crucial. Moreover, sustained public investment in rural marketing infrastructure (particularly roads, bridges and telecommunications)combined with a favorable environment for private investment (e.g. in warehouses and cold storage facilities) are needed. This would reduce storage losses and price fluctuations for non-rice crops, particularly highly perishable h i t s and vegetables, and improve farmer incentives for expanded production. Government also has an important role in providing a growth- friendly institutional environment and setting and enforcing transparent and consistent "rules of the game" for agro-food system and agro-enterprise development (Chapter 2, Box 2.1). To strengthen productivity of inland aquaculture, the post-handling and marketing and distribution of better quality fish seedsneed to be improved, in additionto research and extension support from the government. Transition 2: Trade Liberalization and Export Competitiveness 48. Starting in 1991, Bangladesh marked a clear departurefrom the highlyprotectionist, inward- looking import substitutionpolicies of the earlier decades. Considerable, albeit uneven:' progress has been made since on liberalizing the trade and exchange regimes. Trade tariffs have been significantly reduced and rationalized, with the unweighted average customs (CD) duty falling from 100 percent in FY85 and 74 percent in FY92 to 15percent in FY07, and the top CD rate from 350 percent in FY90 to 25 percent at present. Also, trade-related quantitativerestrictions (QRs), which covered 21 percent of HS 4- digit tariff lines in FY90, have been virtually eliminated, and import licenses are no longer needed. Foreign exchange liberalization has included unification of exchange rates, removal of most foreign exchange restrictions for current account transactions (in conformity with the IMF7sArticle VIII), and Bangladesh: Growth and Export Competitiveness, World Bank, 2005. 27Revitalizing theAgricultural TechnologySystem in Bangladesh, World Bank, 2005. The trade liberalizationdrive suffereda temporarysetback in the FY96-02 period, with a hiatus, even some reversal, in the reformprocess, before it was rejuvenated in FY02. The number of HS 4-digit items subject to QRs increasedfkom 111in the 1993-95Import Policy Order (IPO) to 122in the 1997-02IPO: thls has subsequentlybeen cut to 15items, only 3 of which are for protectionpurposes. Similarly, the averagerate of nominal protection increased from 31.9 percent in FY96 to 33.4 percent inFY98, before being brought down to 24.3 percent in FY07. adoption of a floating exchangerate. These reforms have sought to enhance competition and reduce anti- export bias and incentives for import substit~tion.~~ Chapter 4 covers the trade liberalizationagenda. 49. Tradeliberalization and the resulting increase in export orientation -with merchandize exports to GDP ratio increasingfrom 6 percent in 1990to 18percent in FY06 -has very likely contributed to the growth acceleration since the early 1990s. The firm-level evidence presented in Chapter 1 and earlier World Bank studies support this.30 The growth impact of trade liberalization has been largely driven by the success of the RMG sector though, where the government moved early to avail of the opportunities presented by the MFA and more recently the Agreement on Textiles and Clothing (ATC) quota systems. More specifically, it provided 100-percent exporters duty-free access to raw materials and machinery through the use of the special. bonded warehouses, offered back-to-back letters of credit, and shielded exporters from business environment weahesses by developing Export Processing Zones (EPZs). A duty drawback systemwas also implemented for those exporting less than 100percent. Figure 9: Unweighted Average Nominal Protection Figure 10: Evolutionof Import Restrictions (PO200506) !PO 2003-06) I CD UParataf~ffA v e r a g e nom~nalprotecttan Source: Bangladesh Bank and Staff Calculations 50. Nonetheless, a substantial agendafor deepening trade liberalization and strengthening export competitiveness remains. While the average customs duty rate has been steadily reduced by cutting the general maximum rate, a rampant increase in the use of other protective levies (para-tariffs) in the last decade has offset much of that (Figure 9).3' Para-tariffs now cover about 20 percent of tariff lines and account for just under 40 percent of total nominal protection provided by the statutory import duties, as opposed to 10 percent in FY96. Consequently, and the significant reductions in customs duties notwithstanding, average protection levels are the highest in the region and among the highest in the world (Figure 11). Furthermore, trade facilitation procedures are cumbersome and infrastructure bottlenecks to exporting are severe, as discussed later. As a result, the anti-export bias has leveled off at about 20 percent since the late 1990s7which works against the emergence of new export activities and expansion of the export activities to non-enclave areas. Unsurprisingly, Bangladesh's export orientation, although much higher than in 1990, compares unfavorably with other Asian economies that have moved more decisively in lowering trade protection and strengtheningtheir export competitiveness (Figure 12). Ahrned and Sattar (2003). 30Bangladesh: Trade Liberalization-Its Pace and Impacts, World Bank, 1999. 3'Four kinds of para-tariffshave been used: InfrastructureDevelopmentSurcharge (IDSC),VAT, Supplementary Duty, and RegulatoryDuty (removed in FY05). 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For any regional or bilateral agreement, it would be important to: minimize sectoral or product exemptions; have clear rules against tariff-rate quotas; have "rules of origin" that are liberal, simple,transparent,and uniform, and; extend such agreementsto servicestrade and investment. Transition3: Managing the Net Benefits of Rapid Urbanization 54. Theprocess of rapid, largely Dhaka-centric, urbanization underway in Bangladesh (described briefly in Section I), offers major opportunities and challenges, which need careful management. The increasing returns to investment that typically arise from urban agglomeration can be an important stimulus for economic growth and productivity.33 At the same time, uneven patterns of urbanization, characterized by excess concentration in the largest cities without concomitant improvement in their governance and infrastructure carry associated costs in the form of congestion, pollution, and transport and servicedeliverybottlenecks. The challengebefore policymakersin Bangladeshis to strengthenurban management to avail of the agglomeration benefits, while avoiding policies that contribute to over- concentrationand itsnegative effects. Chapter 4 coversthe issue in some depth. 55. The urban management situation in Dhaka and, to a lesser extent, Chittagong, Khulna, and Sylhet typijj these challenges. Economic returns fiom Dhaka-based urban activities are clearly quite high, as reflected in the city's economic dynamism which continues to be a magnet for migrants from elsewhere in the country. In addition to the agglomeration benefits, a combination of national institutional arrangements and public expenditure allocation decisions - for example, in the form of Dhaka-centric public investment in transport network - has contributed to the special appeal of Dhaka. At the same time, the costs of urban concentration in Dhaka are rising sharply, putting even more stress on the city's (already stretched)service provision and infrastructure. A strikingmanifestationis the sky- rocketing real estate prices - already among the highest in the world! Moreover, traffic congestion is getting worse by the day and provision of infrastructure and urban services lags demand by a significant margin in Dhaka and other major metropolitans (Table 6). Firm surveys reflect similar dissatisfaction with infrastructure and access to land in Dhaka and Chittagong. Not surprisingly, Dhaka is consistently ranked as one of the least livable cities of the The economic toll from these rising costs is also likely to be significant, as they increase the hurdle rate for new investments: i.e., many potentially high- return projects would not be deemedviable by investorsbecause of the high costs. Source: Proshikha (2002) 33Productiontypicallybenefits fiombeing located in denselypopulated urban areas that provide a pool of skilled workers and a network of complementary firmswith backward and forward linkages for supply chains, knowledge flows, and a critical mass of consumers. WorldDevelopment Report 1999-2000,World Bank, Washington, D.C. 34Abmed et al, World Bank mimeo, 2006. 56. Urban management is even weaker in the smaller cities, retarding their emergence as viable urban alternatives. Out of the 522 urban areasidentifiedby the 1991 Census Commission, the six largest cities have a city corporation status and only 289 of the remaining urban centers have Pourashava or Municipality status, and the capacity and resource constraints of the latter are much more severe than in the metropolitans. It also seems that by creating many small Pourashavas, the government has not carefully considered scale economies in service provision or the implications of limited fiscal and administrativecapacityin local governments,creatingdependenceon fiscaltransfers from the center.35 57. Thefundamental underlying cause of thepoor urban management record is weak governance, manifest in various forms: the lack of decentralizationand local autonomy, major capacity and resource constraints, loosely defined and fragmented city management structures, and absence of a coherent national urban strategy. Bangladesh is among the most centralized countries in the world. Even where local governments have been established, they have neither the autonomy nor the capacity to develop economic policy or design and provide most public services. These functions lie mostly with the central govemment, which is responsible for not only the provision of basic services (police, fire protection, housing development), utilities, and higher education,but also their regulatory oversight. 58. Furthermore, responsibilities are fragmented among the large number of central and local agencies, ofCen with overlappingfunctions and little coordination. In Dhaka, for example, currently, 16 organizationsare directly involvedwith serviceprovision and another 30 have indirectresponsibilities,all with little coordination. An additional problem is the failureof national land development markets which, together with lack of fiscal decentralization, prevents land developers and local governments from activelydevelopingalternateurban locationsand spreadingdevelopment across the urban hierarchy. 59. Weakfiscal and administrative capacity at local levels limits citygovernments' abiliiy to deliver even the small subset of responsibilities entrusted them. Importantly, city governments do not have buoyant tar handles. Their main own revenue source is the property tax and associated fees for water, lighting and conservancyimposed on the samebase, collectively calledthe holdings tax. In principle, the property tax should meet majority of their spending requirements. In practice, their ability to raise property taxes is constrained by administrative and technical shortfalls. City governments then need to rely on central govemment transfers for up to half of their revenues. These grants are typically tied to pre-specified projects and as such don't add to local capacity or autonomy. They are also proving increasingly unreliable: average grantper Pourashava has steadilydeclined over the last decade. 60. The urban management challenge is twofold First, to improve access to and quality of basic services and infrastructurein Dhaka and other major metropolitans. Second, to improve theprospects for the smaller cities to emerge as viable urban alternatives. Cutting across both is the need to devolve key services to city governments, together with clear delineation of duties and accountability chains between the federal and city governments,among the various agencies involved, and between the service providers and the citizens. This has to be carefully sequenced with improvements in city governments' ability to perform, particularly by enhancing their own revenue sources and building their technical and administrative capacity. To improve own revenues, local governments first need to step up collection from existing tax bases, for which training of the appraisers and computerizationof billing are likely to prove usehl. However, these efforts can succeed only if the link between local taxes and quality of public servicesis strengthened. 61. A carefully thought-out national urban development strategy is needed for more balanced urban development across the country. This would seek to remove policy biases - such as those in public expenditure allocations and public investments in transport and communicationsnetworks - that 35 Chowdhury (2004);Bangladesh Municipal Finance Management Sector Study, 1998, World Bank. work against the emergence of smaller cities, and to create incentive structures and competitive pressures among cities such that (public and private) investment and labor flows are guided by objective measures of city management. New investments are likely to help firms de-concentrate from the largest cities and locate in their peripheries, while still maintainingaccess to markets and their suppliers. As smaller cities improve provision of public goods and services,locations fhther away from large metropolitan areas will start becoming attractive. To be effective, better infrastructure and service provision within these areas need to accompany improvements in inter-regional transportation, which, in tum,will require large public investments and significant resources. Toward this, recently initiated efforts such as the Municipal Development Funds (MDF) appear to be steps in the right direction. The MDF was established in 1998 with initial hnding of US$70 million from the World Bank to provide financial support to Pourashavas for infrastructure development and service provision. The h d requires Pourashavas to improve performance on many countsbefore becoming eligible to apply for its resources. 111.3. The EnablingEnvironment for Makingthe Key Transitions 62. The management of these consequentiallong-term transitions will be shaped by some key cross- cutting reforms - particularly, measures to strengthen economic governance and the regulatory environment, ensure continued macroeconomic stability, address infrastructure constraints (especially power, ports, and transportation), deepen and make more efficient the financial sector, and address acute slall gaps. These, in turn, are described below. StrengtheningGovernance and the Regulatory Environment 63. Research over the last decade has shown increasingly compelling evidence that good governance matters to long-run growth. It tells us little though about why governancematters and how it influences growth. For example, while the research shows that property rights are importantto investors, it implies nothing about the form these should take. Understanding individual country contexts and how institutions work in particular historical and cultural settings is important to understanding better the governance-growthnexus. Chapter7pushes the envelope in that particulardirection for Bangladesh. 64. The issues of governance, corruption and related matters have been major and growing areas of concern in Bangladesh. Cross-country (perceptions-based) indicators of governance,such as the ones developed by World Bank Institute (WBI), generally find low and, in some areas, even declining governance standards in Bangladesh. Results fiom the 2003 Investment Climate Survey further bear these concernsout, showingthe bureaucracy as deliveringin some areasand not in others (Table 7). Table 7: InvestmentClimateSurvey Indicator IBangladesh I South I All I Source: WorldBank and Bangladesh Enterprise Institute, Improving the Investment Climate in Bangladesh, 2003. 65. Information from the World Bank's Doing Business 2006 database is also not encouraging (Table 8) overall. Thereare more procedures involved and it takes more time to start a business in China than in Bangladesh, and yet the associated cost in China is half that in Bangladesh. Firms are established are subjectto frequent visits from a variety of government agencies (some 17 a year in 2003 compared to 7 a year in India in 2004). The number of procedures and their time requirement for registering a property is amongthe highest in the world -it takes less than one-fifth as much time to register a property in the median LIC as in Bangladesh. Bangladesh does a bit better on contract enforcement, where the number of procedures, time, and cost involved are each lower than in India, Pakistan and the median LIC. Exportersneed a lot of signatures,which take a long time (35 days on average, compared with 20 days in China) and undercuts competitivenessof Bangladeshi exporters. Recovering a loan in a bankruptcy can take up to 4 years and costup to 8 percent the value of the estate. Table 8: Cost of Startinga Businessin Ban~ladeshand Com~aratorCountries statingaWsiness I FaegsteringaRapertyI EI-& ingC a t t a 3 ~ I m- l%c&msI~mI cost I~oceckresI Time I ~ncec~resTime1 Cost IDDarnentsIsi~ln?SlTime I I(d;ys)lcuss, -(clays) - 1 8 1 3 5 1 358 35 Chi-rr 13 48 175 lnda 11 71 383 w 9 33 972 F%kish 11 24 146 S i b 8 50 105 Th;ilad 8 33 156 ucmm 10 44 m 6 1 71 Source: Doing Business Indicators 906, WorldBank, 66. The "BangladeshParadox" of good growth despite weak governance is thenfrequently posed as a seriouspuzzle. Put sharply,how has Bangladeshmanaged to increaseits per-capita GDP close to 90 percent since 1980,while Haiti (ranked equally low by the TransparencyInternationalindex of corruption in 2004) has seen its per-capita GDP halved over the sameperiod? 67. A possible resolution to this conundrum is that governance in Bangladesh may not be uniformly weak across the board, particularly in key areas of economic management that interface with the forces of growth. Unbundling of governancein Bangladeshdoes produce a mixed bag of goods (Box I), which may help resolvethe popular paradox. 68. While such analysis helps reconcile Bangladesh's good growth record with weak governance, there is little doubt that improvements in key dimensions of governance will be necessary to carry through the second generation reforms, strengthen the investment climate, and lower the cost of doing business. Like Indonesia and other South East Asian countries in the 1990s,Bangladesh is likely to soon discover that it is growing out of its current institutional environment. The governance situation may have been adequate to cope with an economy breaking out of stagnation and poverty, it is very likely a barrier to the accelerationof growth (as recognized in the government's PRS) needed to push Bangladesh firmly on the path of middle income status and poverty reduction. Tackling weaknesses in the core governancesystemsas well as in sectoral governancein critical sectorswill be essential. 69. The most serious and difficult of the core governance functions has to do with the political domain where confrontational politics and the high cost of election financing have pernicious consequencesfor the economy. Bangladesh is not unique in its confrontationalpolitics; developed and developing nations have shown this tendency. But the fractiousness contributes to political uncertainty and to perceptions of political instability to outside investors who may not always understand that much of this tends to be "sound and fury, signifying nothing". Potential foreign investors taking a long term view of investments in developing countries tend to stay away from what they see as a high risk environment which has a significantimpact on growth. Box 1:Unbundling Governance in Bangladesh: A Mixture of Strengths and Weaknesses Five Unquestionable Areas of Strength + The state created space for the emergence of a vibrant private sector through macroeconomicdiscipline. + Successivegovernmentshave been relatively good at making wise public expenditurechoices. Recognized its limitations, the state has created space and forged partnerships with NGOs and the private sectorto help deliver social services. + The statehas greatlyimprovedits capacity to manage natural disasters. + Successivegovernments have encouraged the migration of Bangladeshi workers to West Asia and other destinations, and created a domestic economic environment that has encouraged these workers to remit large sums of money to Bangladesh. Significant Governance Weaknesses Confrontationalpolitics and the high cost of election fiance have severe economicconsequences. Governancechallenges also severelyimpede public financialmanagement. + Major problems in tax administration (poor taxpayer services, lack of transparency in collection, inadequateaudit and enforcement, and protracted taxpayer disputes) yield low revenue collection. + Financial accountability is weak with flawed (albeit improving) procurement processes, poor ftnancial controls and inadequate externalchecks and audits. + Serious governance weaknesses in key sectors such as power (which is in a near state of crisis) and financial sector (whichhas seenrecent improvements) + Surveysshow that the public in general views the civil service as being low quality, which fixther feeds this vicious cycle of poor governance. + Finally, the justice sector has also been a source of weakness, although the Supreme Court and the seniorjudiciary are exceptionsto this rule. Source: World Bank, CounhyAssistance Strategyfor Bangladeshfor thePeriod FY-06-09,2006. L 70. Governance challenges also severely impede public financial management. There are major shortcomings in tax administration(poor taxpayer services, lack of transparencyin collection, inadequate audit and enforcement, and protracted taxpayer disputes) and the resultant low revenue effort creates a chain of disincentives to good governance, from low salaries to civil servants to inadequate operations and maintenance expendituresand lack of effective checks and balances. Financial accountabilityis also weak with flawed procurement processes, poor financial controls and inadequate external checks and audits, although recent measures to adopt an internationalgood-practice procurement law and strengthen the Public Accounts Committee (PAC) are major steps in the right direction. Bangladeshis in general view the civil serviceas being low quality,which further feedsthis vicious cycle of poor governance. 71. Another major core governance area in need of urgent attention is the rule oflaw, central to the growth process. With the possible exception of the Supreme Court, all the key pillars of the justice sector are weak, inefficient and prone to corruption. The police are held in little confidence. In part this is a matter of staffing: its 80,000 complement makes the force quite the smallest in the sub-continent in relation to population. A weak prosecution service and an inefficient and allegedly corrupt lower court system contribute to the lack of justice. For ordinary citizens, access to justice is impeded by the high costs and the low probability of a successfulresolution. For businesses, the inability to enforce contracts promptly and to secure property rights, particularly for land, greatly raises the cost of doing business. While domestic entrepreneurs learn how to survive the system, foreign investors unfamiliar with the country and with plenty of other places to invest in are greatlydeterredby these failures. 72. Addressing the governance challenge will require strongpolitical leadership and emergence of a constituency that demands change. The reform agenda is large and cuts across a wide range of institutions and threatens powerhl vested interests. Developing a strategic, sequenced approach that relies on successin a few key areas to generate momentum and demand for reform in other areas will be crucial. Summoningthe political will to do this will not be easy, and will itself depend on strong political leadership and a public that demandsreforms and shows lower tolerance for weak governance. Continuing Sound Macroeconomic Management 73. Macroeconomic management has generally been an area of strength for Bangladesh. Monetary policy has broadly supported growth while doing a good job of containing inflation. Monetary management prior to 1990, in fact, was quite problematic, with money supply growth far in excess of nominal GDP growth. This and frequent supply-sideshocks due to natural disastersresulted in inflation rates in the teens in the 1970sand 1980s. The record on monetary management since 1990has been positive, with tighter control on reserve money growth and more flexible interest rate management which, together with decontrol of interest rates, resulted in positive real interest rates, keeping inflation rates in singledigits. 74. The record onftscal management is more mixed Figure 13: Long-TermfiscalTrends Fiscal sustainability came under some stress in the FY99- 6 54 02 period because of scaled up public spending and 52 increased reliance on the more expensive domestic commercial borrowing which put interest payment on a 4 50 rising trend (Figure 13). Fiscal prudence was soon 48 restored, however, with the deficit being lowered to under 4 percent of GDP and commercial borrowing capped at 2 46 percent of GDP. Benefitingalso .fromgood growth, public I 44 sector debt has since been kept under 50 percent of GDP. Broad allocation of public expenditures has been quite 0 42 1992 1994 1996 1998 2000 2002 zoo4 sound, with 60 percent of expenditure accounted for by Public Debt to GDP. % (right ads) health, education, social protection, rural development, -FiscalDeficittoGDP.% ----InterestPaymentfromBudgettoGDP.% and infrastructure and a relatively small allocation of (1.1 percent of GDP, which is less than half the regional a;erage) to defense. The quality of expenditure at project level is a concern, however.36 Moreover, a poor tax collection record (tax collection equals 8.5 percent of GDP), among the weakest in the world, is not consistent with the higher allocations for social sector and infrastructuredevelopment that are needed for sustainedgrowth. 75. The main source offiscal risk are the large losses and unpaid liabilities of the SOEs, especially those in the energy sector. SOE losses for FY06 are estimated at about Tk 45 billion (US$670 million), or 1.1 percent of GDP, compared with Tk 27 billion (0.7 percent of GDP) in FY05, and just Tk 6 billion in FY04. The Bangladesh Petroleum Corporation (BPC) alone accounted for more than 80 percent of these losses because of inadequate pass-through of the recent increases in global energy prices to domestic consumers. The other major loss making SOEs are Bangladesh Power Development Board (BPDB), Biman, the national airline, and BCIC, the public sector chemicalscorporation. A hike in power prices in March 2007 and in fuel prices in April 2007 should help curtail losses at the BPDB and substantiallyat the BPC. 76. The losses of the SOEs have exacerbated thefragilities at the Nationalized CommercialBanks (NCBs), which are directed to provide loans to these agencies. The capital shortfallin the NCBs amounts 36Bangladesh Public Expenditure Review, World Bank, 2003. 24 to about Tk 68 billion (around 1.5 percent of GDP), which adds to the fiscal risk and makes future divestment of these banks more expensivefor the government. 77. Reflecting these large contingent liabilities, together with the weak revenue mobilization, the recent debt sustainabilityjointly prepared by the World Bank and the IMF assessed the risk of debt distress to be "m~derate".~'Accordingly, to ensure continued public debt sustainability, authorities would need to step up their efforts to contain SOE losses with cost-reflective pricing and enhanced operationalefficiencywhile steadily improving tax mobilization. 78. Theexternal debt situation isfairly benign, benewngfrom a number offactors. Overall fiscal and monetary prudence has helped contain excess demand, particularly since 2002. Temporary slackening of macroeconomic management had led to a build up of external pressures by end-2001: the current account deficit rose to over 2 percent of GDP in FYOl and foreign exchange reserves fell to a precarious level of US$ 1 billion (or 1 month of import cover) by end-2001. More disciplined macroeconomic management together with stronger growth in exports and remittances and a pick-up in concessional and other long-term capital inflows have since restored external balances. The current account deficit has stayed under 1 percent of GDP and reserves now stand at over USM billion (2.6 months of import cover). The situation was further aided by the free floating of the takaKJS$ exchange rate in 2003. Even prior to the free float though, periodic devaluations and low inflation rates ensured that loss of external competitiveness from real exchange rate appreciation was limited. External debt equals 30 percent of GDP, down from 45 percent in FY95 and 34 percent in FY02, most of which is concessional loans from international donors; the external debt servicing ratio is only 5 percent. Recognizing these benign external conditions, the joint Bank-Fund debt sustainability analysis assesses the risk of externalpublic debt distress to be "low". Addressing Infrastructure Constraints: Emphasis on Power and Trade Facilitation 79. Infrastructure bottlenecks related topower and tradefacilitation (ports and transportation) are severe in Bangladesh and place a major (and growing) drag on economicperformance (Chapter 9). Only about 35 percent of the population -four-fifths of urban population and one-fifth of rural population -hasaccesstonetworkpower, andload-sheddingtothosewithaccessisrapidlyincreasing. Firmlevel surveys consistently reveal access to power as being among the top obstacles to investment. Trade facilitation, critical for export competitiveness, is also not faring well. Chittagong port, which handles nearly 85 percent of the country's merchandisetrade, is highly inefficient. Moreover, transport networks connectingthe ports with the hinterlandare underdeveloped and beset with logisticalproblems. Power Sector:Weak Governance, Poor Outcomes 80. The most serious and immediate of the infrastructure constraints - with perhaps the most damaging impact on productivity and investment - is the widespread and growing shortage of electricity. In 2005, the power sectorgenerated 160kwh of electricityper-capita, among the lowest levels in the world (Figure 14). It is estimated that only about 35 percent of the population has access to network power. Moreover, load shedding - the practice of cutting off customers during periods of peak demand -is at historic highs and growing fast. While peak demand exceeds 5,000 MW, the country has experiencedload shedding duringpeak times of as much as 2,800 MW. 81. The 203 Investment ClimateAssessment survey confirms the concern aboutpower at thefirm level. Electricity supply easily topped the list of "major or severe obstacle" with 73 percent of firms citing it as a major obstacleto investment (Figure 15), versus 38 percent in the region. The average firm interviewed experiencespower losses for 2 of every 3 days in a year, versus one in five days in the region. 37World Bank and IMF, 2006,Bangladesh: Joint Fund-WorldBank Debt Sustainability Analysis (DSA). This necessitated reliance on expensive captive power generation: 71 percent of firms shared or owned a generator (versus 56 percent of firms in the region), which added an estimated 50 percent to their electricity costs. Lack of access to power is a Iot more constraining for rural enterprises. A recent survey found only 32 percent of rural firms with access to electricity compared to 60 percent in urban areas.3g For those fortunate enough to have access, reliability is a major issue -power outages and surges are all too frequent. This, again, affects the rural enterprises more as only 1.8percent of them own a generator.39 82. Not surprisingly theft, the growing power shortages hit the economy hard. Evidence in Chapter 1 shows that productivity of manufacturing firms is seriously impaired by power supply disruptions. The developing power crisis also adversely affects agriculture production: power shortages hurts irrigation of the boro crop, as irrigation pumps run mainly on power, while power voltage fluctuationsoften put the pumps out of order. 83. Most of Bangladesh's power sector problems are rooted in a long history of badly run governmentpower enterprises and governance weaknesses, which also undermined the 1990s initiative to encourage private power generation. Half a dozen independent power producers (PPs) were established in the late 1990s adding up to about 1,260MW. But since then no new deal has been closed. Underlying this failure is alleged interference in the technical evaluations by vested interests and rumors about particular parties having been chosen for political reasons. Potential investors are also put off by the BPDB's growing financial shortfalls and the resulting problems in meeting its financial obligations. 84. Part of the government's response to power shortages has been increasing tite supply of natural gas, at highly subsidized rates and with scant regard to sustainability and costs. This policy stance, unless corrected, is likely to prove fatally flawed. Bangladesh is running out of natural gas, for commercial rather than geologic reasons; projections show that without significant power and gas sector refonns the country can experience major gas shortages as early as the next decade. 85. Also critical arepolitical economyfactors that have caused under-pricing of energyproducts. h common with many other developing countries, Bangladeshi authorities, unable to provide adequate services, have sought to deflect political pressures by maintaining artificially low tariffs. Average retail power tariffs are around 3.4 c e n t s m , quite low by international standards and insufficient to cover costs. About US$1 billion in accumulated power sector debt is not serviced by the utilities, which, 38Promoting the Rum2 Non-Farm Sectorin Bangladesh,World Bank, 2004. 39~bid. ultimately, is covered from the budget. An important consequence of under-pricing of power, therefore, is crowding out of productive public expenditure. 86. The government is beginning to address some of these constraints, although the pace of reforms has been uneven and slow on account of inadequateprioritization, resistanceby various vested interests, and lack of clear political support. The government's 2000 Vision Statement and Policy Statement sets forth reasonable objectives, and its implementation strategy is laid out in the recently adopted "road map" for the years 2006-08. Some importantinitial implementation measures include: Bangladesh Energy Regulatory Commission (BERC) was established in 2004, and is expected to play the lead role in settingtariffs, issuing licenses and providingregulatory oversight. The industry structure has been changed noticeably, leaving BPDB with 60 percent of generation(compared to 86percent in FY99) and 30 percent of distribution. Major stepsinclude: o horizontal unbundling of BPDB's distribution activities into four regional entities: one each forthe West Zone, Northwest Zone, SouthZone, and Central Zone; o creation of the Dhaka Electric Supply Company Ltd (DESCO) out of DESA assets to cover parts of the key Dhaka market; o creation of the Power Grid Company of Bangladesh (PGCB) to handle all of BPDB's transmissionassets; o creation of Ashuganj Power Station Company Limited (APSCL)to takeover the 724MW AshuganjPower Station,and; o transfer of 9,000 krn of distribution lines from BPDB to the more efficient Rural ElectrificationBoard (REB). Management in PGCB, DESCO, and APSCL has been contracted competitively from the market. Both PGCB and DESCO are now profit-making enterprises. Threedistribution companies -DESCO, West Zone, Northwest Zone -have been corporatized. Corporatization of the remaining three - DESA, South Zone, and Central Zone - is planned over the next three years. Corporatizationof BPDB is alsobeing studied. A Captive Power Policy was adopted in FYO6 with the objective of tapping potential captive capacity intothe public grid. Arrears to major power utilities companies have been reduced, from 8 months equivalent of receivables in end-FY03 to less than 3 months. A financial restructuring and recovery plan (FM), prepared by a group of reputable international consultants, has been adopted by the government in principle, and initial implementation of the plan has begun. Debt restructuring under the FRP is expected to make the sectormore appealingto private investorsand also allow a more gradual adjustment of tariffs. 87. Recent government-commissioned studies indicate that new investment of US$I.5 billion may be needed annually in theforeseeable future to develop the gas and power sectors. Most reasonable forecasts suggest that Bangladesh would need at least one utility-scale plant in the 500 to 700 MW range every year to catch up with demand. Attracting large-scale private investment in gas exploration and production and in gas-fired power generation will be key - clearly, the public sector is not in a position to undertake investment of the needed magnitude. But to achieve that, it would be important to: Address the critical issue of efficient pricing as a priority item. The way forward on pricing must involve: (i) explicit commitmentto cost-reflectivepricing in power and to economic costing of natural gas, includingreinstatement of the pricing formula that ensures automatic pass-through of future fuel and foreign exchange related costs; (ii) adoption of a credible timeline to increase power prices to full cost recovery levels and gas prices to its economic value, and; (iv) hard- wiring of budget support during the transition to full price adjustment. Over the longer run, address governance problems in the sector. In generation procurement, appointmentof internationallyreputed advisors would help address the worst of the transparency issues. To address corruptionin service delivery and in network expansion,it would be important to commercialize the utility companies and fully support and empower their managers. That will mean de-politicizingthe nual electrification program and putting law and order resources behind managers seeking to enforcepayment from delinquentcustomers. Implement complementary reforms,particularly corporatization andfinancial restructuring of power sector entities and strengthening of the BERC, which would each be meaningful and achievable only in the aforementioned framework of price reform, better governance, and clear investment requirements stemming from gas exploration and production and power generation programs. Efficient and cost-reflective pricing would also be the cornerstone of implementing the FRP, the first-phase steps of which would include reconciliation of inter-company arrears, restructuring of balance sheets, and analytical inputs for determiningfuturetariff increases. Trade Facilitationand Growth 88. Trade facilitation shortfalls are assessed to be a major bottleneck to Bangladesh's export A recent study finds that Bangladesh's garments exports could increase by 30 percent if various capacity constraints at the port are addressed.42 With tightening margins and ever shrinlung order cycles in the post-ATC world, the costs to Bangladesh's external competitiveness from related distortionsare mounting and it is essential that they be tackled on a priority basis. 89. Variousineflciencies and high shipping andport costs at the Chittagongport - which handles nearly 85 percent of the country's merchandize trade flow - continue to undermine the country's international competitiveness. The port ranks among the world's least efficient container ports - the 2001-02 Global Competitiveness Report ranked it 72ndout of the 75 ports it rated. Average container dwell time was reported at 18days compared to 10-12 days for other ports in the region.43 Similarly,the average wait time for a loaded import container was found to be 20-25 days compared with international standards of 4 days for imports and 2-3 days for exports.44 Moreover, container handling costs in Chittagongport are estimated to be four times higher than in Colombo and twice as high as in Bangkok. No doubt, many of these performance measures have improved in recent months - since January 2007 - in large part because of the crackdown on union activity among dockworkers and retrenchment of about 4,000 workers under the heavily unionized Dock Workers' Management Board (DWMB) that was declared defunct. Many of the retrenched workers have been hired back by the 12private berth operators asked to takeover port operations in place of the old stevedoring system. According to officials, efficiency at the port has improved by about 30 percent because of these measures. These are welcome improvements in the labor efficiency at the port, although the sustainability of the new structure put in place on an experimental basis remains to be seen. 90. What is causing the malaise at Chittagong Port? Clearance procedures at the ports and customs are complex and theport lacksphysical and logistical capacity. The documentationneeded for 40Bangladesh: Growthand Export Competitiveness,World Bank, 2005. 4'Trade facilitationinvolves procedures for import-exporttransactionsatports, efficiencyof transportnetworks linkingports with hinterland,logisticsservices, and implementationof food safety and qualitystandards. 427~ww.textileandapparel.com/story/2005/12/8/20246/8014. 43Asian Development Bank, Chittagong Port Trade FacilitationProject. 44"ImprovingTrade and Transport Efficiency-Understandingthe Political Economy of Chittagong Port", BangladeshDevelopment SeriesPaper No. 6,The World Bank Office,Dhaka, December2005. customs is lengthy and must be submitted in hard copy. Even with the required Pre-Shipment Inspection (PSI) system now in place, customs continues to check 5-10 percent of the shipments that have a CRF (Clean Report of Findings) and up to 100 percent of the packages in these consignments. In addition to the resultingdelays,the mere specter of such an inspection is sufficientto elicit informal payments. 91. Moreover, a number of physical constraints add to the costs. Chittagong's is not a deep-sea port, and transshipment via the Singapore1Tanjung Pelapas and Colombo ports add to shippingcosts and lead-time. Although the port handles about 400,000 containers per year, only recently has it procured fixed container handling equipment such as ship-to-shore gantry (SSG) cranes and rubber-tired gantries (RTGs); and that too in insufficient quantity. The port also lacks an effective and modem logstics tracking system. Furthermore, most containers aniving at the port are unstuffed and shipped as break- bulk in ten-ton trucks even though they are FCLs (Full Container Loads) and should be delivered directly to their destinations or to a customs facility near that destination. There are three main reasons for ths practice. First, the interconnecting infrastructure (rail and trucking), including and especially along the critical Chittagong-Dhaka corridor, is unable to carry the container load. Road transport, which handles bulk of the load, cannot carry containersbecause of their large size, while movement of containersby rail is slow and greatly constrained by the limited infrastructure. Second, importers must provide a bank guaranteeto remove the container from the port unless shipped to the Dhaka Rail inland containerdepots (ICDs) - although the larger freight forwarderscan make do with a company guarantee. Third, there are no customs facilities for clearingcargonear where most of the importingproductionunits are located. 92. A recent World Bank report5finds the situation a classic example of the 'tragedy of the commons' in that individual stakeholder interestspredominate to the detriment of overallport interests and those of the national economy. Lack of incentives for those providing port services and of transparentcompetitionin private serviceprovision contributeto the resistance to change. Moreover, the substantial incomes to workers from speed payments add to the resistance. One estimate shows that bribes and related costs account for about one-eight of the total port-related expenses for imports and about one-tenth for exports, not including duties and taxes.46 Chittagong Port Authority (CPA), on the other hand, lacks the legal authority to coordinateand steer through a radical reformprogram. 93. There is some evidence that the CPA management is beginning to take up a more proactive role. In addition to the earlier mentioned measures to improve labor efficiency and break the hold of union activity, it has introduced some private contractors for operations such as internal container distribution,running of the new road truck terminal,and rail container loading. It has proposed a separate concession arrangement for the operation and management of the new Moorings Container Terminal, which will provide five new dedicated container berths with 22 hectares of back-up land. However, the scope and reach of such institutional innovationsand operationalpractices are still quite limited. 94. To carry out the requisite policy and institutional reforms at Chittagong port, it would be important to let private service providers be the catalysts, thereby also improving the conditionsfor much needed investmentin theport'sphysical capacity. The followingmeasures appear to be key:47 Modernize the container terminal operations, to take advantage of the recentlyprocured SSGs and RTGs. This measure seems to have the highest immediate pay-off. Effective use of the equipment will involve computerization, restructuring of the workforce, and close interaction with the shipping lines. Such modernization will benefit from the recent measures to engage 45Ibid. 46Bangladesh: Growth andExport Competitiveness,WorldBank, 2005. 47Although the reform agenda focuses on the Chittagong port, the malaise affecting other, smallerports, including Mongla port, is of a similarnature and, therefore, muchof the reformagenda is alsobe applicableto these. private berth operators and depoliticizethe labor force. 'Theseneed to be sustained and deepened, and complementedwith handover of the port management to an experienced private contractor. Increase the penalties on service providers for creating congestion. Stakeholderscurrently do not face adequate penalties against defaulting actions that reduce the port's overall efficiency - even the limited penalties that are there on paper are not imposed uniformly. Improve efficiency of customs clearanceprocesses. As noted, a relatively high proportion of imports are inspected by customs despite having in place a PSI system. While the introductionof the ASYCUDA* system should help improve selectivity, some remaining incentive distortions faced by customs officialsneed to be tackled. 95. Other complementarykey reform measures needed to improve tradefacilitation include: Increase customs bondedfacilities, including road-based and ICDs, in the Dhaka region. Improve interconnection transport infrastructure. Bangladesh can also consider emulating India in separating container-unit train services from the less profitable and time-sensitive ones and placing them under commercial management. Decision-makersshould further consider more fully exploiting the inland-water transportnetwork. Creatinga Deeper and More EfficientFinancial System 96. Financial sector development is critical for sustained growth and poverty reduction. Well developed financial systemsease the exchange of goods and servicesby providingpayment services,help mobilize and pool savings fiom a large number of investors, acquire and process information about enterprises and possible investment projects, thus allocating society's savings to its most productive use, monitor investments and exert corporate governance and help diversify and reduce liquidity and inter- temporal risk. The importance of a deeper and more efficient financial sector for growth and productivity performance of an economy has been empirically well established in the ~iterature.~'Time series evidencein Chapter 8 corroboratesthese findings for Bangladesh. 97. Financial intermediation in Bangladesh, as in majority of the developing world, is heavily dominated by commercial banks. The sector comprises four groups of "scheduled banks" (Table 9): four nationalized commercial banks (NCBs), five government-owned development financial institutions (DFIs), thirty private commercial banks (PCBs), and nine foreign commercial banks PCBs). While there are a number of investment banks, merchant banks, leasing and finance companies, insurance companies, and stockbrokers,these remain small in comparison with the banking sector. Table 9: Structureof the Banking System (end-2005) 1 1 1 ;1 BankTypes Numberof Number of %of Industry %of Industry i0 ;; Banks Branches Assets Deposits 2: ;; PCBs FCBs Total 48 6412 100 100 iource: Bangladesh Bank Financial Sector Review, May 2006 98. Since 2001, Bangladesh has embarked on bold banking reforms, most prominently by deemphasizing the role of the NCBs, strengthening competitive pressures, loosening government control, and tightening prudential regulations and regulatory quality. Key measures on the latter 48See, for example, Goldsmith(1969), Levine (1997), King and Levine (1993) and Rajan and Zingales (1998). include increase in the capital adequacy ratio to international norms, tightening of loan classification, issuance of risk guidelines, and improvements in corporate governance of banks. Loan growth restrictions have been imposed on the four NCBs. Divestment of Rupali Bank, an NCB, to a strategic buyer is now close to being finalized. The three other NCBs have been corporatized and two of these would be partially privatized in the coming years; in the fourth NCB, the Sonali Bank, the government intends to sell only a minority share. The expected successful divestment of Rupali Bank, in itself an importantmilestone for banking sectorreforms, shouldprovide impetus for and set a useful precedence in followingthrough with the rest of the NCBs. 99. Perfomance in the banking sector has responded well to the reform measures. Especially robust has been the response of private banks, which have dramaticallyincreasedtheir market shared and turned around their operational and financial performances. While the share of the NCBs in the total assets fell from 54 percent in 1998 to 37 percent in 2005, PCBs and FCBs increased their share to over one-half by 2004. Similar trends are seen for bank deposits and loans: with PCBs and FCBs gaining market share at the expense of the NCBs and DFIs. Furthermore, NPL ratios have declined markedly since 2001 across all four groups, while capital adequacy ratios have noticeably picked up for the DFIs and FCBs (Table 10). Table 10: PerformanceMeasure in the Banking Sector Capital to risk weighted assets ratio Ratio of gross NPL to total loans Bank Type 2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006 NCBs 4.4 4.2 4.1 4.3 4.1 -0.4* 1.1 38.6 37.0 33.7 29.0 25.3 21.3 22.9 DFIs 3.2 3.9 6.9 7.7 9.1 9.2 9.5 62.6 61.8 56.2 47.4 42.9 34.9 33.7 PCBs 10.9 9.9 9.7 10.5 10.3 9.2 9.8 22.0 17.0 16.4 12.4 8.5 5.6 5.4 FCBs 18.4 16.8 21.4 22.9 24.2 25.1 22.7 3.4 3.3 2.6 2.7 1.5 1.3 0.8 Total 6.7 6.7 7.5 8.4 8.7 7.3 8.3 34.9 31.5 28.0 22.1 17.6 13.5 13.1 Note: NPL numbersare without adjustment for actual provision and interest suspense. * Negative CAR forNCBs in 2005because ofnegativecapitalof Agranibank Source: Bangladesh Bank Quarterly, various issues. 100. Nonetheless, major challenges remain. In the banking sector, the problem is not so much size and depth, which are more or less at par with comparatorcountriesand increasingconsistently,but rather quality and efficiency. The sector, having been plagued by systemic distress over the last 20 years, is only beginning to emerge from a crisis and has a long road ahead to full recovery.49 The NPL ratios, despite improvements, remain precariously high in the NCBs and DFIs, while provisioning by the NCBs and the problem PCBs has typically fallen well short of requirement. Among the PCBs themselves, there is considerable variation in performance, with several older PCBs having been under intensive Bangladesh Bank care for over a decade, while others show healthy balance sheets. The non-bank segment of the financial system, with the important exception of microfinance, is grossly underdeveloped. The stock market is small (market capitalizationis below 10percent of GDP) and inactive, and long-term savings institutions such as insurance companies and pension funds are virtually absent. On the other hand though, Bangladesh has the highest microfinance penetration in the world and is home to some of the world's leading microfinance institutions, including the Grameen Bank, winner of the 2006 Nobel Peace h z e . 101. Withthe reformprocess initiated since 2001, the government has sought to move awayfrom an heavy interventionist approach in the banking sector to a more market enabling one; which global experiences tell us is generally the most effective option. Bangladesh Bank has laid the first fundaments " Applying one of the criterion for a systemicbanking crisis, grossNPL ratio of more than 10percent of aggregate loan portfolio,the Bangladeshi banking sectorhas been in one since 1983. for a more market-based supervision by introducing some important measures towards market-based supe~sion.Importantly, it has made it mandatory for banks to go public and for banks and non-bank financial institutions (NBFIs) to publish their annual financial statements in newspapers It has also set higher disclosure and auditing requirements for financial institutions than faced by non-financial corporations,and maintains a separatelist of approved auditorsfor banks. 102. Nonetheless, lack of autonomy and certain amount of political capture of Bangladesh Bank continues to vitiate market discipline and works against its move toward the market enablingapproach. For instance,the institutionhas not been immune frompolitical interferencein the bank licensingprocess. Fortunately, the practicehas ceased in recent years, but the past practice has resulted in a number of weak PCBs, plagued by insider lending and other owner abuses. Political capture of the regulatory entity also prevents proper resolution of failingbanks. Although there is an explicit deposit insurance scheme, it has not been used. Rather, Bangladesh Bank has extended an implicit guarantee to all banks. Over the past years, no domestic bank has been allowed to fail; weak banks are referred to the Problem Bank Monitoring Department within Bangladesh Bank where they are subject to special supervisoryoversight and certain regulatory restrictions and enjoy regulatory forbearance. The situation is also not helped by an environment of weak contract enforcementand poor accountingand auditingstandards. 103. All in all, an effective long-term expansion of the jinancial system will require a more substantial change in the role of the government,from an operator and arbiter to afacilitator. The ongoing move to a privately-owned financial system is an important one, although international experience also advises caution (but not necessarily delay) in the privatization process: a failed privatization process can be worse than government ownership. Privatization is also not a panacea, as privatizing into a non-competitive environment will not necessarily bring intended benefits. Moving forward, de-politicizationof entry of banks, market monitoring of banks, and reform of the exitprocess would be key. The licensingprocess has to be put on objective, non-political basis. Most importantlythe governmentwould need to move away from the implicit guaranteesystemto applyingthe existinglimited explicit deposit insurance for depositors, while simultaneously relylng more on market participants to monitor and discipline banks instead of micro-managing financial institutions. This redefmition of the government's role applies also to other segments of the financial system, such as capital markets and micro-finance, and needs to be seen as an essentialelement in the overall governance reform agenda. 104. Financial sector reforms in Bangladesh, infact, may be viewed as being at the heart of the country's anti-corruptionagenda50and can help catalyze broadergovernance reforms in the rest of the economy. A proper and transparent divestiture process of the NCBs and de-politicization of financial sector regulation and supervision can be a model for the redefinition of the government's role in the economy at large. An autonomous and accountable Bangladesh Bank can be a model for institutional reform in other government entities. Finally, reform of corporate governance in banks can pave the way for similar measures in the non-financial sector. Addressing Labor Market Issues: Focus on Skills Shortages 105. Labor it is open said is Bangladesh's mostprecious resource. This precious resource,under the right conditions, has the potential to unleash a rapid transition toward prosperity, as the East Asian economies have shown without having the benefit of a natural resource bounty. A relative abundance of labor provides Bangladesh with a comparative advantage in production of labor-intensive goods. But global comparative advantage does not automatically translate into global competitiveness, which 50As the famous bank robber Willie Sutton is claimed to have said: "because that's where the money is", when asked why he robbedbanks. depends on a host of factorsthat affect productivity. As a corollary, measuresto improve the productivity performance can be expected to stimulatelabor-intensivemanufacturing,as was the case for garments. 106. The overall productivity and competitiveness of an economy depends, among other things, upon the efficiency of the labor market and the quality of the laborforce. Oppressive labor market regulations are often enough to put the brakes on growth eyen if other everythingelse falls into place. A slulled and well-trained labor force, on the other hand, makes for more productive workers and enables greater technology adaptation and spillovers. Talung it a step further, a well-developed knowledge economy infrastructure, including the availability of workers with the requisite slulls and training, promotes innovationand adaptation of cutting-edgeglobal technology. 107. On balance, labor laws and regulations in Bangladesh do not appears to be serious hindrances to thefunctioning of the labor market, although worker rights need better protection (see Chapter 3 for details). Laws and rules are relatively light and, if anything, suffer from ineffective enforcement - certainly there are no signs of the draconian labor regulations seen in India. Firms retain considerable flexibility to hire and fire, which is also confirmed by the Investment Climate Assessment and Doing Business survey results. At the same time though, lack of organized union activity in the formal private sector, where only about one worker in twenty is covered, also has its down sides, especially since it arises fiom government restrictions that the International Labor Organization's (ILO) Committee of Experts on the Application of Convents and Recommendationshas deemed excessivelyrestrictive. Such limited union activity handicaps workers' ability to engage in collective bargaining and protect their rights, and hinders the formation of an effective mechanism to resolve labor disputes. The impasse in 2006 over garment workers' demand for higher wages highlights the problem. It is not clear though whether the resolution to this is government interventionand, if at all, in what shape and form. 108. A particular concern afflicting the labor market is acute skills shortages. Not only are the education levels among the workforce low, the education and vocational training system are not geared toward the market needs. On average, the employed labor force has only 4 years of schooling. It is a major loss to productivity when even this scarce human capital is not properly utilized: only about one- fourth of the unemployed hold a SSC, HSC or higher degree. Furthermore, just over 1 percent of the labor force has had technical training or vocational education, and even among those, the relevance of their skills seems questionable.51Because of its poor quality, the vocational education and training (VET) system suffers from low capacity utilization and pass rates and weak demand for its graduates. Econometric results in Chapter 3 find that workers training tends to improve demand for labor and also workers' wages. A focus on market oriented vocational skills and good quality secondary and tertiary education,therefore, appearsessential in additionto consolidatingearlier gains on primary education. 109. Other key identifiabledistortionsin the labor market incl de:U\ There is a clear segmentation of the public and private job markets - this is apparent in the considerable wage premium (over 30 percent) for public jobs, after taking into account worker characteristics such as education, skill, gender, etc. Analyses have shown the disparity to be arising from the lower-end (classes 111and IV) public sector jobs. Not only does this lead to rationing of the high premiumpublic sectorjobs, it also distortswage signalsacross the economy. Another segmentation is between urban and rural areas: Econometric analysis in Chapter 3 shows that urban areas provide more employment opportunities(more hours of employment)and a significant wage premium. The barriers to rural-urban mobility of labor - that would also be productivity improving - likely have to do with the shanty living conditions in the cities, '' Fordetailed discussionof skills and training shortagesin Bangladeshand underlying policy and institutional constraints, see The Bangladesh VocationalEducation and Training System: An Assessment, World Bank, 2006. 33 especially for fresh migrants and the poor, and the higher cost of living. An urban agenda of the sort discussed in Chapter 5 would work to improvethis. Female workers continue to face considerable barriers in the labor market. Improvements notwithstanding, only a quarter of working-age females participate in the labor force and wages for female workers are significantly lower than for male workers with similar characteristics. This emanates mostly from the social barriers commonly seen in developing countries, but it is hard to imagine a path of rapid development, if three-quarters of females are not there to participate in and shape it. The solutions of more education and female empowerment are happening but couldbe speeded up. 110. Advancement of a domestic knowledge economy that promotes innovation and helps adapt cutting edgeglobal technologies and information is criticalfor productivity growth. Not only is this the emerging consensus in the economics literat~re;~evidence of the linkage can be traced even for Bangladesh. The far reaching effects of knowledge and technologcal dissemination are powerfully illustrated in the profound impact that adaptation and expanded use of the HYV variety of rice have had on rice productivity. Further, results in Chapter 1 show that R&D activities improve productivity of Bangladeshi manufacturing firms, and that more advanced technologes tend to improve TFP performance,although only in the presence of absorptive capacity in the form of R&D activity. 111. Given the importance of a more developed knowledge economyfor productivity, its current low level is surely a critical constraint on productivity. As seen in Table 11, Bangladesh lags her comparators on a number of indicators capturing the essence of the innovation system and information and communication technology. A more in-depth assessmentof this area would be an importanttopic for futureanalyticalwork in Bangladesh. Table 11: Cross-Country Compariso 1geRelatedMe Lsures Innovation System Pakistan LIC Average Science and EngineeringEnrollment Ratio, 1998-2003(as% of tertiary enrollmentstudents) Scientific and TechnicalJournal Articles Per Million Population,2001 Royalty and LicenseFees Receipts (US$ millions) Per Million Population,2003 High-Technology Exportsas %of Manufact Exports, 2003 Tertiary Enrollment(% gross),2002 Information and Communication Technology InternetUsers Per 10,000people, 2004 20.04 ICT Expenditureas %of GDP 2003 2.7 InternationalTelecommunications,Cost of Call to US ($13 min), 2003 2.1 Phones P a 1000People, 2004 (mainlines+mobilephones) 34.4 ComputersPer 1,000Persons, 2004 11 Sources: UNESCO, WDI,ITU, and WorldBank S KAM database. IV. ConcludingRemarks and SummaryPolicy Recommendations 112. Economic growth has proven to be the most potent force in the fight against poverty. Across the globe, examples abound of countries-most notably, the East Asian Tiger economies-that achieved high GDP growth over sustained periods and made visible dents in their poverty rates. Conversely, economies -includingthemajorityofthosein Sub-SaharanAfrica wheregrowthfailedtotakeoff,sawminimal - 52 E.g. Romer (1986, 1990),Grossman and Helpman (1991), and Coe and Helpman (1995) reductions and, in some cases, even increases in poverty. Bangladesh's own experience bears out the significanceof growth for poverty reduction: the poverty rate has fallen by close to 20 percentagepoints since the early 1990s,benefiting from a sharp acceleration in per-capita GDP growth. Recognizing this, the government's PRS rightly seeks acceleration of GDP growth in order to meet its stated objective of reducing the povertyrate to under 25 percent by 2015. 113. Bangladesh has achieved good growth despite a record of weak governance - cross-country perception-based indicatorsusually place Bangladesh at the bottom of the league on corruption and other governance measures. Viewed by some observers view as the "Bangladesh paradox", this dichotomy actually reflects a mixture of weahesses and strengthssuch as the positive resolve that produced a series of first generation macroeconomicand structuralreformswhich stimulatedthe good growth response. No doubt, the growth response to these reforms was reinforced by an early focus on human development, with Bangladesh's world-class indigenous NGOs and community organizations playing a crucial role. However, successiveBangladeshi governments have also played an importantpart. For one, and in sharp contrast with their counterparts in majority of the developing world, they allowed sufficient space to the social organizations to evolve and flourish, with both sides often successfilly partnering to deliver essential social services such as primary and secondary education, family planning, and primary healthcare. The state further contributed by broadly prioritizing the social sectors in budgetary allocations. It is also worth noting that despite the bitter confrontationalnature of the politics, the major parties have not shown fundamental disagreements over the course of economic reforms, which has ensured sustainability of the reforms: reforms may be gradual in pace, but essentially without any major backtracking, no matter whch politicalparty is in power. 114. The growth challenge facing Bangladesh today is a positive one. It is not about jumpstarting growth, as in a number of other LICs, but rather about sustaining the good growth record, and, to the extent possible, accelerating it. The country can reasonably strive to become an MIC in a decade or sometime soon after; which would also ensurethat the government's poverty reduction goal -of reducing the poverty rate to 25 percent by 2015 - will be met. However, as argued in this report, fast-paced convergence to MIC status is unlikely without deepening of the industrial base and of economic integration with global markets, and unleashing of the growth potentials of the major urban centers. The reform agenda in support of these transitions, discussed at some length in the report, entails continuation of macroeconomic stability, with emphasis on strengtheningtax mobilization and tackling energy sector losses, deepening of financial sector and external trade reforms, and rebalancing the policy focus toward hitherto neglected structural areas: economic governance, urban management, infrastructure (especially power sector, ports, and transportation), and labor skills. The latter would be especially important for more robust factor productivitygrowth, seen as being necessary for sustainedlong-term growth. 115. Specific policy recommendations are summarized in the matrix at the end of the Executive Summary. Most of the recommendationsare underpinned by analytical work in the various chapters of this report and/orin otherrecent World Bank economicreports. ANNEX 1: GROWTHACCOUNTING TO IDENTIFY SOURCESOF ECONOMIC GROWTH Here we develop a growth accounting framework to estimate the contributions of capital (physicaland human), labor, and total factor productivity (TFP)to long-term growth. Let us assume that the standard neoclassical constant-returns-to-scale Cobb-Douglas production function describesoverall production in Bangladesh;i.e., A is the Solowresidual and represents total factor productivity (TFP). Y symbolizesreal GDP, K stands for physical capital stock, E for effective labor or quality-adjusted labor, a is the share of capital stock in output under perfect competition,y is the returns to scale, and t is the number of years since the initial period 0. E equals L*H, where L is the total labor force and H, a measure of human capital based on education stocks and returns on education, adjusts for the quality of the labor force.53 Following Ghosh and Kraay (2000), we define H = eO.lS,where Sis the average years of schooling per worker, and 0.1 is the returns to education that is consistent with estimates for Bangladesh and with estimates found in the literature for other countries (e.g., Klenow and Rodriguez-Clare (1997)). By using the exponential form for calculating human capital, we assume that human capital grows faster at higher levels of education:a fact confirmed by studies in the field. The initial stock of capital in 1973 is derived using the capital-output ratio from Nehru and Dhareshwar(1994). The data are then extended through 2000 using the perpetual inventory method. 2. Kt = (I - geometric depreciation rate, K,, + Gross Capital Formation (t - I ) Data on gross capital formation are fiom the WB's SIMA database. The data on S, the average years of school attainment by population aged 15 years or more, are from the updated Barro-Lee (2000) database on education attainment. The frequency of the Barro-Lee database is every 5 years and their numbers for 2000 are projections. We fill in the five year periods using the assumption of a constant geometricgrowth rate within that period. From (I), the growth rate of A (TFP) may then be written as where g(X)indicates the annual growthrate of variableX. We set the annual depreciation rate at 4 percent. The derived annual TFP growthrates under different assumed values of yand a are shown below. GDP Capital Stock Labor (quality TFPGrowth cu=O.25, (v=O35, cu=O.45, (v=O.35, cu=0.35, y= Growth Growth adjusted)Growth y= 1.0 y= 1.0 y= 1.0 y= 0.8 1.2 1980-89 3.22 4.04 2.82 0.09 -0.03 -0.15 0.62 -0.68 1990-06 5.04 6.51 3.69 0.64 0.36 0.08 1.30 -0.57 53Previousdetailed studies(e.g. Young (1994))have shown educationto be by far the most important element in accountingfor differencesin labor quality. A more accurateproxy for human capital would also include human capital developmentdue to learning-by-doing, but lack of data precludes this here.