45 THE WORLD BANK BANGLADESH Development Series Poverty Reduction and Economic Management Unit SEP. Ba g a desh S for Susta.ned Growth ÿþBangladesh: Strategy for Sustained Growth Bangladesh Development Series Paper No. 18 The World Bank Office, Dhaka July 2007 www.worldbank.org.bd/bds M Document of the World Bank The World Bank World Bank Office Dhaka Plot- E-32, Agargaon, Sher-e-Bangla Nagar, Dhaka-1207, Bangladesh Tel: 880-2-8159001-28 Fax: 880-2-8159029-30 www.worldbank.orq.bd The World Bank 1818 H Street, N.W. Washington DC 20433, USA Tel: 1-202-473-1000 Fax: 1-207-477-6391 www.worldbank.orq All Bangladesh Development Series (BDS) publications are downloadable at: www.worldbank.orq.bd/bds Standard Disclaimer: This volume is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. 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Illustration Credits: Front cover (from left): Andrew Biraj, Photo Courtesy of BEPZA and UCEP Back cover (from left): Andrew Biraj CURRENCY EQUIVALENTS Taka (Tk) US $1.00 = Tk 69.86 (July 9, 2007) GOVERNMENT'S FISCAL YEAR July 1-June 30 ABBREVIATIONS AND ACRONYMS ADP Annual Development Plan JSAN Joint Staff Advisory Note ASYCUDA Automatic System for Customs Data KDA Khulna Development Authority ATC Agreement on Textiles and Clothing LDC Least Developed Country BBS Bangladesh Bureau of Statistics LF License Fee BERC Bangladesh Energy Regulatory Commission LFPR Labor Force Participation Rate BEPZA Bangladesh Export Processing Zones Authority LFS Labor Force Survey BPDB Bangladesh Power Development Board LGED Local Government Engineering Department BRAC Bangladesh Rural Advance Commission LIC Low Income Country CAR Capital Adequacy Ratio MFA Multi Fiber Arrangement CAS Country Assisting Strategy MTBF Medium-Term Budgetary Framework CDA Chittagong Development Authority MOU Memorandum of Understanding CEACR Committee of Experts on the Application of NCBs Nationalized Commercial Banks Conventions and Recommendations NGO Non-Governmental Organization CIB Credit Information Bureau NHA National Health Accounts CMI Census of Manufacturing Industries NPLs Non-Performing Loans CPA Chittagong Port Authority NPSEB National Private Sector Survey of Enterprises in CPD Center for Policy Dialogue Bangladesh CPI Consumer Price Index NSS National Savings Schemes CRF Clean Report of Findings PCBs Private Commercial Banks DEDO Duty Exemption and Drawback Office PGCB Power Grid Corporation of Bangladesh DESA Dhaka Electricity Supply Authority PL Post Larvae DESCO Dhaka Electricity Supply Corporation PRS Poverty Reduction Strategy DFIs Development Financial Institutions PSI Pre-Shipment Inspection DPHE Department for Public Health Engineering PTA Preferential Trade Agreement DTI Direct Trader Input PWD Public Works Department DWMB Dock Workers' Management Board QRs Quantitative Restrictions EBA Everything But Arms R&D Research and Development EPZ Export Processing Zones RAJUK Rajdhani Unnayan Kartripakkha FAO Food and Agriculture Organization RD Regulatory Duty FCBs Foreign Commercial Banks RDA Rural Development Academy FCLs Full Container Loads REB Rural Electrification Board FDI Foreign Direct Investment REER Real Effective Exchange Rate FPMU Food Policy Monitoring Unit RMG Readymade Garment FSRFD Fisheries Sector Review and Future Development SAARC South Asian Association of Regional Cooperation FTA Free Trade Agreement SAFTA South Asian Free Trade Area GDP Gross Domestic Product SAPTA South Asian Preferential Trade Area GSP Generalized System of Preferences SD Supplementary Duty HDC Human Development Center SEC Securities and Exchange Commission HSC Higher Secondary Certificate SIMA Statistical Information Management & Analysis HYV High Yielding Variety SME Small and Medium Enterprise IASNF Integrated Annual Survey of Non-Farm Activities SPS Sanitary and Phyto-Sanitary IBRD International Bank for Reconstruction and SSC Senior Secondary Certificate Development SSG Ship-to-Shore Gantry TEU Twenty-foot ICA Investment Climate Assessment Equivalent Unit ICB Investment Company of Bangladesh TFP Total Factor Productivity ICDs Inland Container Depots UN United Nations ICESCR International Covenant of Economic, Social VA Value Added and Cultural Rights VAT Value Added Tax ICFTU International Confederation of Free Trade Unions WASA Water and Sewerage Authority IDSH Infrastructure Development Surcharge WB World Bank IPOs Initial Public Offerings WBI World Bank Institute IPP Independent Power Producer WDI World Development Indicators IRO Industrial Relations Ordinance WTO World Trade Organization ISO International Standards Organization Vice President Praful Patel, SARVP Country Director Xian Zhu, SACBD Sector Director Sadiq Ahmed, SASPR Sector Manager Ijaz Nabi, SASPR Task Leader Sandeep Mahajan, SASPR iii TABLE OF CONTENTS Acknowledgement ...................................................... xi F orew ord ................................................................................................................................................... xiii Executive Summary ..................................................... xv Overview: Strategy for Sustained Growth .............................................................................. 1 I. Introduction..................................................................................................................... 1 II. The Record of Growth and Development .............................................................. 3 III. Transition to Middle-Income Country Status: Issues and Challenges................ 15 IV. Concluding Remarks and Summary Policy Recommendations.......................... 39 Chapter 1: Firm-Level Productivity in Bangladesh Manufacturing Industries ........... 41 I. Introduction and Main Findings.......................................41 II. The Significance of Total Factor Productivity in Output Performance of the Manufacturing Sector ............................................... 44 III. TFP Trends in Manufacturing Industries ......................... ...... 44 IV. Insignificant Role of Allocative Efficiency of Resources Within an Industry .......... 47 V. Determinants of Firm-Level TFP..................................... 48 VI. Conclusions.................. ...................... .......... 54 Chapter 2: Accelerating Income Growth in Rural Bangladesh ................... 55 I. Introduction.................. ...................... .......... 55 II. Agriculture Sector Performance: Trends and Issues........................ 55 III. The Rural Non-Farm Sector......................................... 64 IV. Implications for a Rural Growth Strategy......... ............... ...... 65 Chapter 3: The Labor Market: Trends, Characteristics, and Challenges 69 I. Introduction.................. ...................... .......... 69 II. Labor Market Trends in Bangladesh............................. 70 III. Employed Labor Force Characteristics.................................. 75 IV. Earnings from Paid Employment...................................... 81 V. Determinants of Employment and Real Wages: An Analytical Approach.... ..... 82 VI. An Overview of Labor Laws and Regulations in Bangladesh................. 84 VII. Challenges Ahead ....................... ................. 86 Chapter 4: Trade Liberalization and Export Competitiveness 89 I. Introduction.................. ...................... .......... 89 II. Trends in Trade Policy and the Anti-Export Bias .............................. 89 III. Trade Liberalization in Bangladesh: Impact and Remaining Challenges..... ..... 95 IV. Towards Growth-Supporting Trade Policy Strategy ................ ........ 97 Chapter 5: Urban Development and Economic Growth in Bangladesh 101 I. Urbanization and Urban Concentration in Bangladesh: A Process of Rapid Transformation 101 II. Urban Concentration in Bangladesh: Extent, Causes, Benefits, and Costs .... .... 102 v III. Urban Management Structure and Financing and Delivery of Local Amenities......... 108 IV. Policy Options To Improve the Contribution of Cities to Economic Growth: Improving Management of Cities and Removing Policy Distortions.. .................. 111 Chapter 6: Sub-National Income and Expenditure Dynamics in Bangladesh: Insights from the Macro-GDP and Micro-Survey Data ........................ 115 I. Introducing the Theme ................................................ 115 II. Income, Growth, and Inequality Variations Across Bangladesh ............... 116 III. Correlates of Sub-National Expenditure Dynamics.......................... 120 IV. Discussion of Results and Implications for Policy ........................ 123 Chapter 7: Governance and Growth: the Bangladeshi Conundrum ...............................125 I. In tro d u ctio n .................................................................................................................. 12 5 II. D oes G overnance M atter to G row th? .......................................................................... 125 III. Bangladesh's M ixed Record of Governance ............................................................... 127 IV. Unbundling Governance in Bangladesh: Some Strengths........................................... 129 V . C hallenges in C ore G overnance................................................................................... 131 V I. C o n clu sio n ................................................................................................................... 13 6 Chapter 8: Creating a More Efficient Financial System 137 I. Introduction.................. ...................... .......... 137 II. The Structure and Recent Performance of the Banking Sector in Bangladesh............ 137 III. Bangladesh's Financial System in International Comparison ................. 139 IV. Finance Development and Growth in Bangladesh: Is there a Link? ....... ........ 142 V. Finance as Key to Faster Economic Development: Cross-Country Evidence............. 143 VI. Three Pillars of an Effective and Stable Financial System........................... 145 VII. The Evolving Role of the Government in Bangladesh's Financial System................. 147 VIII. A Financial Sector Reform Agenda For Bangladesh....................... 151 IX. Conclusions.................. ...................... .......... 153 Chapter 9: Infrastructure and Growth: a Focus on Power and Trade Facilitation 155 I. Power Sector: Weak Governance, Poor Outcomes......................... 155 II. Trade Facilitation and Growth .......................................... 165 vi List of Tables Table 1 Progress on Key Social Indicators ........................................ 5 Table 2 Growth Rates of Output Components ....................................... 7 Table 3 GDP Levels and Growth by Division ............................. ......... 8 Table 4 Population Dynamics of the Largest Agglomerations .................. ........ 9 Table 5 A Hypothetical Scenario of Bangladesh's Transition of MIC Status ..... ................ 15 Table 6 Satisfaction with Services ............................................ 22 Table 7 Investment Climate Survey ............................................ 24 Table 8 Cost of Starting a Business in Bangladesh and Comparator Countries ... .............. 25 Table 9 Structure of the Banking System (end-2005) ....................... .......... 33 Table 10 Performance Measure in the Banking Sector........................... 34 Table 11 Cross-Country Comparisons of Technology and Knowledge Related Measures ............ 37 Table 2.1: Bangladesh: Agricultural Growth, 1981-2005 .......................... ..... 55 Table 2.2: Bangladesh Agricultural Land and Labor Productivity, 1980/81 to 2004/05 ..... .....56 Table 2.3: Bangladesh: Area, Yield and Production of Rice and Wheat, 1981-2005 .. ............58 Table 2.4: Bangladesh: Area, Yield and Production of Major Crops, 1981-2005 ...... .........60 Table 2.5: Projection of Fishery Sector Output (tons) .....................................62 Table 2.6: Bangladesh: Access to Services and Credit by Micro, Small and Medium Enterprises 65 Table 3.1: Ratio of Female Population to Total Population .......................71 Table 3.2: Unemployment rate among labor force by level of education and sex .. ...............74 Table 3.3: Employed Person by Status of Employment, Gender and Locality (Percent) .................77 Table 3.4: Number of Workers by Status and Sector ...................................78 Table 3.5: Educational attainment of the economically active labor force: 1996 to 2003................78 Table 3.6: Formal and Informal Employed Labor Force by Sector ........................80 Table 4.1: Average Protection Rate in Bangladesh........................................................................... 90 Table 4.2: Evolution of Import Restrictions 1991-2006 ................................................................... 91 Table 4.3: Bangladesh: Tariff Escalation and Cascading Impacts of Para-Tariffs on Total Nominal Protection ........................................ .........92 Table 4.4: Estimates of Anti-Export Bias Based on Effective Exchange Rates for Imports...... And Exports.......................................................94 Table 4.5: Average MFN tariffs in South Asia and Other Select Developing Countries..................95 Table 5.1: Population Growth of the Largest Agglomerations ........................... 103 Table 5.2: Urban Concentration in Comparator Counties (% .................................... 103 Table 5.3: Specialization Index................... ....................... ..... 106 Table 5.4: Satisfaction with Services (% of surveyed households).....................................................107 Table 5.5: Providers Responsible for Delivering Urban Services.......................................................110 Table 5.6: Reductions in Central Government Transfers.....................................................................111 Table 6.1: GDP Levels and Growth by Division .............................. ...... 117 Table 6.2: Between and Within-Group Decomposition of Theil Index of Inequality at District-Level .................................................... 120 Table 7.1: Investment Climate Survey.............. .................... ........... 129 Table 7.2: Cost of Starting a Business in Bangladesh and Comparator Countries ....................129 Table 8.1: Structure of the Banking System (end-2005) ....................... ......... 137 Table 8.2: Performance Measure in the Banking Sector .................................... 138 Table 8.3: Banking and Non-Banking Indicators for Bangladesh in International Comparison........ 139 Table 9.1: Collection Rates ......................................... .........160 Table 9.2: Average Costs and Billing Rates ............................. ........ 160 vii List of Figures Figure L.a Per-Capita GDP: Bangladesh Vs. Median LIC ..................3... ..........3 Figure 1.b Per-Capita GDP: International Comparisons ...............3.... .............3 Figure 2 Trends in GDP Per-Capita ..................................... ........ 4 Figure 3 International Volatility Comparisons (1990-05) ...............6... ...........6 Figure 4 Urbanization in Bangladesh ............................................9 Figure 5 Sources of Growth .................................................. 10 Figure 6 Public-Private Breakdown of Investment ........................ .............. 11 Figure 7 Trends in Investment and Savings ...................1....................1 Figure 8 Agriculture Sub-Sectors Growth......................................... 18 Figure 9 Unweighted Average Nominal Protection ..................................... 20 Figure 10 Evolution of Import Restrictions........................................ 20 Figure 11 Average Tariff Protection (2002-04) ................................ ..... 21 Figure 12 Export to GDP Ration (2004-05) .................. ................ 21 Figure 13 Long-Term Fiscal Trends ....................... ............... 27 Figure 14 Electric Power Consumption.......................................... 29 Figure 15 Percentage of Managers Ranking Power .. .................................... 29 Figure 1.1: M anufacturing Sector's Share in GDP............................................................................ 41 Figure 1.2: Median Firm-Level TFP Growth, Output and Input Growth (1999-2003)............ 46 Figure 1.3: Decomposition on Industry-Level TFP.......................................................................... 47 Figure 1.4: Firm Size and Average Productivity are Negatively Correlated................... 51 Figure 1.5: Inverted-U Shaped Relationship Between Firm Age and Average Productivity........ 51 Figure 2.1: Bangladesh: Real Prices of Rice and Wheat, 1980-2003........................ 59 Figure 3.1: Age-W ise Demographic Trends in Bangladesh...................................................................71 Figure 3.2.a: L abor Force Trends.............................................................................................................72 Figure 3.2.b: A ge Profile of Labor Force .............................................................................................. 72 Figure 3.3.a: Changes in LFPR over Tim e............................................................................................ 73 Figure 3.3.b: A ge-LFPR R elationship .......................................................................................................73 Figure 3.4: Job Creation Vs. New Labor Force Entrants........................................................................74 Figure 3.5.: Distribution of Employment by Broad Sector: 2003 ........................... 75 Figure 3.6: Gender Decomposition of Labor Across Sectors............................. 76 Figure 3.7: Real Wage Trends in Major Sectors (1991 normalized to 100)................... 81 Figure 3.8: Ratio of Urban Wage Rate to Rural Wage Rate for Major Economic Sectors ......... 82 Figure 5.1: U rbanization in B angladesh .............................................................................................. 101 Figure 5.2: M arket Accessibility across Urban Centers .......................................................................104 Figure 6.1: District-Level Variations in Per Capita GDP (FY96-00) and Expenditure G row th R ates (FY 92-05)....................................................................................................118 Figure 6.2: District-Level Variations in Per Capita GDP (FY00) and Expenditure Level (FY05) ..... 118 Figure 6.3: Per Capita GDP Growth Across the Old Districts .............................................................119 Figure 6.4: Initial Expenditure Level and Subsequent Expenditure Growth Over.............. 120 Figure 6.5: Initial Gender Inequality Measures and Expenditure Growth Over 1992-2000 ........ 121 Figure 6.6: Large-farm Landholding and Growth...............................................................................121 Figure 6.7: Initial Inequality and G row th ............................................................................................122 Figure 7.1: G overnance and G row th ................................................................................................... 126 Figure 7.2: Bangladesh governance Indicators 1998 and 2004.......................................................... 128 Figure 8.1: Financial Sector Penetration .............................................................................................140 Figure 8.2a: Sources of Firm Financing: Share of Working Capital........................ 142 Figure 8.2.b: Financing Obstacles: Access to and Cost of Financing ........................ 142 Figure 8.3: Financial Development, Investment and Income in Bangladesh over Time.......... 143 Figure 8.4: GDP Per Capita Growth and Private Credit: Cross-Country .................... 144 viii Figure 8.5: The Interaction of Government Guarantees and Supervisory Approach .... ......151 Figure 9.1: Electricity Consumption in 2005 (kwh per capita) ................. ........156 Figure 9.2: Installed Capacity and Available Supply ....................................156 Figure 9.3 Electricity Sales Trends by customer Type................... ........156 Figure 9.4: Percentage of Managers Ranking Power Shortages as a Major Constraint.................157 Figure 9.5: Power Sector Institutional & Ownership ....................................158 Figure 9.6: Operational Performance of the Power Sector ..................................154 Figure 9.7: Predicted Demand-Supply of Natural Gas.................... .......... 161 List of Boxes Box 1: Unbundling Governance in Bangladesh: A Mixture of Strengths and Weaknesses..... 26 Box 1.1: A Note on Firm-Level Data Used for Productivity Calculations ....... ........ 42 Box 2.1: Role of Government in Agro-Food System and Agro-enterprise Development.....67 Box 4.1: Trade Protection: Its Impact on Anti-Export Bias and Export Competitiveness ...........93 Box 6.1: Regionally Disaggregated Data: Macro GDP vs. Micro Expenditure Data.................116 Box 8.1: Three Different Approaches to the Role of Government in Financial Service Provision .......................................... .....148 Box 8.2: Bank Privatization Process: Lessons from International Experience ..... .......152 Box 9.1: Vision Statement and Policy Statement: Formal Objective of Power Sector Reform.162 Box 9.2: GoB's Three Year Road Map for Power Sector Reform: 2006-08....... ......164 Box 9.3: Chittagong Port................................................170 References........................................................ ....... 173 The Annexes and Statistical Annexes are made available on a CD-Rom attached to this report ix 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 Rahman (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 Bricha processed the report at various stages, and Mehar Akhter Khan, Joyce Mormita Das, and Mildred Gonsalvez helped coordinate mission activities. The report was produced by Aniqah J. Khan. A team of students from the Economics Department of Jahangirnagar University, led by Professor Abdul Bayes, did a commendable job in undertaking a comprehensive firm-level survey for the report. Alfred Friendly assisted with the preparation of the Executive Summary. 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 Xian Zhu (Country Director, Bangladesh). The peer reviewers were Jim Hanson (formerly World Bank), Professor Siddiq Osmani (University of Ulster), and Manuela Ferro (World Bank). The team is deeply appreciative of the valuable guidance from Dr. Quazi Mesbahuddin Ahmed (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 gratefully acknowledges 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; Bangladesh Bank. Mr. Allah Malik Kazemi, Deputy Governor, Bangladesh Bank, and Mr. Jafar Ahmed Chowdhury, Acting Member, GED, and their respective teams provided additional guidance during discussions of the "Green Cover" version of the report. A number of individuals provided very useful comments at various stages. These include Ahmad 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 IMF's 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. xi FOREWORD Economic growth has proven to be the most potent force globally in the fight against poverty and an important contributor to faster human development. Bangladesh's own development record mirrors the international experience. The poverty rate declined steeply, from 58 percent in 1992 to 40 percent in 2005, a period over which income growth has picked up markedly, and impressive progress has been made on many key human development indicators despite serious weaknesses in governance, notably corruption. As argued in this report, Bangladesh: Strategy for Sustained Growth, Bangladesh can reasonably aspire to join the ranks of middle-income countries within a decade, by 2016, or soon thereafter. This will require raising GDP growth to and sustaining it at an ambitious 7.5 percent or more; a challenging target with precedence in the dynamic economies of East Asia. With much-improved economic funda- mentals and successful implementation of many first-generation reforms, Bangladesh seems well placed for such performance. Its young, rapidly growing labor force and an entrepreneurial private sector would also be conducive. However, these in themselves will not suffice and the next stage of policy challenges is likely to be much more demanding and will require deeper and more complex policy innovations. This report focuses on three long-term transitions essential to more rapid, sustained, and employment generating growth: (i) a shift in the economic structure from agriculture to labor-intensive manufactur- ing; (ii) deepening of integration with global markets wherein internationally competitive Bangladeshi firms would be plugged into global supply chains, and; (iii) unleashing the growth potential of the major urban centers, Dhaka especially. The reform agenda in support of these transitions entails continuation of macroeconomic stability and deepening of financial sector and external trade reforms. It is also essential to rebalance the policy focus toward structural areas that have received far too insuf- ficient attention. These include economic governance, urban management, infrastructure (especially power, ports, and transportation), and market-oriented vocational skills and quality secondary and tertiary education. Bangladesh has shown an impressive capacity to tackle major development challenges with remark- able and innovative policy responses. It is our sincere hope that the country will find the necessary political commitment to continue that performance and realize its economic potential. Sadiq Ahmed Xian Zhu Sector Director Country Director Poverty Reduction and Economic Management World Bank Office South Asia Dhaka xiii 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 (by 2016) or some time soon after. It has the necessary assets: much-improved economic fundamentals; success in implementing many first-generation reforms; a young, rapidly growing labor force; and an established entrepreneurial culture. Despite the widely acknowledged and critical weaknesses in governance, Bangladesh also has an impressive record of achievement, especially in harnessing sound economic and social policies to pioneering social entrepreneurship. 3. To pick up pace in the development marathon, Bangladesh will need to deepen its industrial base, 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. II. 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 international basket case." Thirty some years later, doubts and doubters have been disproven. Life expectancy in Bangladesh has risen from 50 to 64 years. Population growth rates of 3 percent a year have been halved. Unemployment that 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 Development Goal 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 strongest engine for raising living standards and reducing poverty. 5. Thanks to that motor, Bangladesh's real (inflation-adjusted) per-capita Gross Domestic Product (GDP) has more than doubled since 1975. Until 1989, however, GDP growth per-capita ran 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 deregulation that produced per-capita GDP growth of 3.3 percent. Not xv Bangladesh: Strategy for Sustained Growth 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-income country (LIC). 6. The economic advances during the 1990s, when productive reforms coincided with political democratization, underpinned and benefited from progress on human development. A steep decline in the poverty rate - from an estimated 70 percent in 1971 to 58 percent in 1992 and 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 Grameen Bank - winner of the 2006 Nobel Peace prize along with its founder, Prof. Mohammad Yunus - and the Bangladesh Rural Advance Commission (BRAC). 7. Impressive as progress has been, Bangladesh still faces 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. Deconstructing 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-term pattern of just 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 force between 1996 and 2003. 10. Despite that success and although real wages increased across all economic sectors, the income of self-employed workers - almost half the 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 1990 are physical and human capital, the latter measured in terms of the quality of the workforce, its size and skill 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 xvi Executive Summary 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 measures propelled both private 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 closer to its market rate; * Trade and exchange liberalization, including tariff cuts, reduction of quantitative restrictions, exchange-rate unification and continued preferential arrangements for 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-sector reforms, especially by continuing programs to spread small- scale irrigation, widen access to small diesel engines, and liberalize fertilizer markets. 13. These and other policy initiatives jump-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 fruits of Bangladesh's early emphasis on social development to support sustained high rates of economic growth. 14. With most of those first-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 skills shortages - along with lackluster agricultural performance and limited success in attracting FDI in manufacturing act as brakes on growth. Only by confronting these and other constraints can Bangladesh grow rapidly enough to achieve MIC status by 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 10 years (assuming GNI growth equals GDP growth). 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) if it raised per-capita growth to 6 percent, implying GDP growth at a challenging but not impossible 7.5 percent. There is international precedence for such performance - 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 more productively. It will also need to increase the investment rate by more than 5 percentage points, relying on higher domestic savings. Three mutually reinforcing long- term transitions would be integral to achieving these outcomes: (i) a shift from agriculture 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; xvii Bangladesh: Strategy for Sustained Growth a commercially viable energy sector that supports the economy's vast energy needs; deeper and more efficient financial sector; and, a greater emphasis on the quality of education and labor skills. 17. Shifting 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 agriculture sector. 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 attention to: (i) Addressing burgeoning energy supply constraints that undercut productivity. A 1 percent increase in number of power outages in a year reduces the productivity of the average firm by 10 percent. (ii) Improving Bangladesh's attractiveness to FDI. Quite 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 energy production, but not in manufacturing, where FDI brings significant productivity gains - firms with any level of foreign ownership are found to be 10 percent more productive on average than firms that are wholly domestically owned. (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 improves over time, as valuable experience is gained in export markets. (iv) Building human capital. Higher-education levels and experience of managers benefit productivity, a survey finding that highlights the importance of improving access to quality tertiary education, while consolidating earlier 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 Bangladeshi manufacturing firms. (vi) Strengthening law and order. Private investors often cite protection payments, for example, as harmful to firm productivity, and the analytical results support that assessment. 19. A drive to boost industrial productivity 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 HYV rice variety in the aman season. 20. Ultimately, raising real agricultural incomes will require diversification 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 shrimp farmers' past difficulties in meeting importers' sanitary and phyto-sanitary quality requirements and 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 addition to research and extension support from the government. 21. The government's important but limited role in promoting agricultural diversification includes a significant expansion in agricultural research and extension efforts. Additionally, institutional reforms to increase the stability of funding and strengthen research management are crucial as is sustained public investment in rural marketing infrastructure (particularly roads, bridges and telecommunications). xviii Executive Summary 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 acceleration of GDP growth over the same period 23. Nonetheless, substantial further 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 infrastructure bottlenecks to exporting are severe. The resulting anti-export bias 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, compares unfavorably with that of other Asian economies. 24. Moreover, RMG exports account for about 75 percent 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 drawbacks to be paid. Half the applications remain pending even after two years. 25. To diversify its trade base and improve export competitiveness, Bangladesh needs a well- thought out sequence of trade liberalization measures. Key elements of such strategy would 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 introduction of a pre-announced medium- and long-term schedule of tariff reductions offers a useful model. * Merger of para-tariffs with the customs duty, in order to have one tariff rate for each tariff line. * Elimination of all end-user tariff exemptions and concessional tariffs. * Levying VAT on both domestic production and imports of the same product, thus eliminating its protectionist impact while improving fiscal revenues. * Ensuring full and immediate implementation of the new duty drawback and bonded warehouse scheme and quick payment of rebates under the duty drawback system. 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 administrative power 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 estate prices skyrocket as traffic congestion worsens and infrastructure decays. 27. Weak governance is the fundamental underlying cause of poor urban management. Because Bangladesh is among the most centralized countries 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-source revenue on the property tax and associated fees for water, lighting and conservancy. Because of administrative and technical shortfalls, these taxes prove inadequate to cover most spending requirements, forcing city governments to rely on central government xix Bangladesh: Strategy for Sustained Growth transfers that often account for half of their revenues. Such grants typically come tied to pre-specified projects. Adding little to local capacity or autonomy, they are also proving increasingly unreliable. 28. The urban management challenge, therefore, is twofold: the first relates to improving access to and the quality of basic services and infrastructure in Dhaka and other major metropolitan areas, and the second to improving prospects 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 service providers 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 computerizing billing to strengthen collection machinery at the same time. Crucially, they will need to build stronger links between 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 communications are likely to make cities more attractive to investment and reduce excessive concentration in 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 govermment-owned Municipal Development Funds (MDF) appear to be steps in the right direction. IV. Enabling the 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, strengthen the financial sector, and narrow the acute skill gaps. 31. Strengthening Governance is Essential: The first 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, Bangladesh is widely perceived by potential investors - foreign and domestic - as an expensive and risky place to do business. Weak governance, in short, undermines prospects for the accelerated growth Bangladesh seeks. 32. The toughest challenges lie in the core governance areas - the confrontational nature of politics, flawed revenue administration and financial 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 most judicial and law enforcement institutions - courts, police and prosecutors - are consistently rated poorly in citizen surveys. While domestic entrepreneurs learn how to survive the system, foreign investors unfamiliar with Bangladesh and armed with many other investment choices see such failures as serious deterrents. xx Executive Summary 33. Only strong political leadership supported by a constituency that demands change can advance reforms that cut across a wide range of institutions and threaten powerful 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 similar tests 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, monetary policy, 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 on fiscal management is more mixed. Higher public spending and 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 since been contained below 50 percent of GDP, but poor tax collection - among the weakest in the world - could imperil the higher allocations for essential social sector and infrastructure development. 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 losses pose an emerging fiscal risk. SOE losses - 80 percent of them by the Bangladesh Petroleum Corporation (BPC) - for FY06 are estimated to have increased to about Tk 45 billion (US$670 million), or 1.1 percent of GDP, almost 8 times their level in FY04. The sizable level of outstanding SOE 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, authorities need to step up efforts to contain SOE losses, mainly through efficient and cost-reflective pricing of energy products, while steadily improving tax mobilization. 36. Overall fiscal 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 months of import cover) compared with US$1 billion in FY02. 37. Overcoming Infrastructure Constraints: Inadequate energ 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 labor problems, 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 160 kwh of electricity per-capita, among the 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 xxi Bangladesh: Strategy for Sustained Growth 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 subsidies in 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 restructuring the industry so that the BPDB's share of generation drops to 60 percent from 86 percent in FY99 while various autonomous companies take over all of BPDB's transmission assets, 9,000 km of its rural distribution lines, and parts of the key Dhaka market. 41. With an estimated US$1.5 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 could be 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 procurement process 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 efficient container ports. 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 sustainability needs to be ensured. 43. The hold-ups at the Chittagong port can be traced largely to complex clearance and customs procedures and deficient 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 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. Resistance to change comes from workers who gamer substantial income from speed payments and from the absence of incentives - or competition from private service providers - for current employees to improve their performance. 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 contractor could open the way for modernizing container-terminal operations to take advantage of the recently procured SSGs and RTGs. This measure seems to have the highest immediate pay-off. xxii Executive Summary Effective use of the equipment will involve computerization, restructuring of the workforce, and close interaction with shipping lines, all very difficult measures under the current public-sector management. 45. Additionally, service providers whose defaulting actions reduce the port's efficiency should face elevated penalties stringently enforced; customs clearance processes 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, diversified to exploit inland waterways, and perhaps to separate, as India has, container-unit train services placed under commercial management from the less profitable and 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 control, 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 governance have 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 operational and financial performances. 47. Nonetheless, major challenges remain. After 20 years of systemic distress, 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 reform process initiated since 2001 has moved move away from 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 domestic bank has been allowed to 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 ongoing move 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 simultaneously relying more on market participants to monitor and discipline banks. 50. Addressing Skills Shortages in the Labor Market: Under the right conditions, labor - often viewed as Bangladesh's most precious resource - could power the kind of rapid transition toward prosperity that resource-poor East Asian economies have made. Its relative abundance of labor endows Bangladesh with a comparative advantage in production of labor-intensive goods, but that advantage only translates into global competitiveness when it rests on a foundation of high productivity. The efficiency of the labor market and the quality of the labor force are important components of the overall productivity xxiii Bangladesh: Strategy for Sustained Growth 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 hinders the formation of an effective mechanism to resolve labor disputes. 52. A focus on market-oriented vocational skills 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 showing that 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 seems questionable. The low quality of the vocational education and training (VET) system is reflected by its low capacity utilization and pass rates and further by the weak demand for its graduates. V. Conclusion: Summary policy recommendations 53. Economic growth has proven to be the most potent force in the fight against poverty. 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 sharp acceleration in per-capita GDP growth. 54. Despite serious weaknesses in governance, corruption most notably, Bangladesh has achieved good growth since 1990. What some observers call 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 successfully partnering 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 sustainability is 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 capacity to implement policy innovations. There is every reason to believe it can continue that performance xxiv Executive Summary 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 trends in agriculture Place special emphasis on addressing the emerging quality and productivity concerns in the shrimp industry, especially inland aquaculture, where Bangladesh has long-term comparative advantage. In addition to research, information, and extension support the government can assist by taking measures to improve post-harvest handling and marketing and distribution of better quality fish seeds. Expand agricultural research and extension efforts in rice as well as high valued crops, livestock and fish. Implement phased increases in expenditure on agricultural research. Establish an endowment Trust Fund and carry out necessary institutional reforms to increase stability of funding and to strengthen research management. Improve marketing infrastructure (particularly roads, bridges and telecommunications) to promote growth of non-crop agriculture, including the poultry and fish sub-sectors, as well as the rural non-farm sector. Create a more favorable environment for private investment, especially in warehouses and cold storage facilities, to reduce storage losses and price risk for highly perishable fruits and vegetables. Provide a growth-friendly institutional environment, by setting and enforcing transparent and consistent "rules of the game" for agro-food system and agro- enterprise development. Strengthen export Place continued emphasis on unilateral trade liberalization. competitiveness by phased and * Establish establishment of a low and uniform tariff rate (by FY12) as the key transparent ultimate objective, to be preceded by the following measures: liberalization of the trade regime * Unify all para-tariffs and merge these with the CDs (by FY09) * Reduce the maximum tariff rate to 15% by FY10. This would, of course, require parallel progress in expanding the base of VAT and direct taxes, while the tax administration is further strengthened. * Eliminate all end-user tariff exemptions/concessional tariffs (FY09 budget) * Discontinue protective use of VAT (FY09 budget) * Lobby strongly in the USA for duty-free entry of RMG exports, already extended to LDCs in Africa under the Africa Growth & Opportunity Act (AGOA). Improve efficiency of the duty drawback system, to ensure quick payment of rebates. Work with regional partners to ensure full use of 'regional cumulation' allowed by the EU towards meeting the latter's 'rules of origin' conditions. In particular, ensure that in any regional PTA/FTA "rules of origin" are liberal, simple, transparent and uniform. XXV Bangladesh: Strategy for Sustained Growth Address skills Improve labor skills to make them more relevant to market needs. constraints * Consolidate gains in primary and secondary education with emphasis on improving the overall quality and removing urban-rural disparity in quality * Improve the quality and market relevance of the vocational education and training (VET) system (see the Bangladesh Vocational Education and Training System: An Assessment, World Bank 2006, for an elaboration of the following) o Develop a policy framework, in coordination with the private sector, clarifying roles & responsibilities of various VET agencies (immediate). o Make available information on training programs and facilitate regular and independent impact evaluations of training programs (immediate). o To improve overseas employability of workers: allow accreditation from internationally recognized agencies; strengthen linkages between VET system and overseas employment agency (immediate) o Allow greater autonomy for VET institutions (immediate) o Set-up an autonomous Board of VET (3-5 years) o Develop a Qualifications Framework to establish uniform course assessment requirements and course entry prerequisites (3-5 years) o Support demand-driven and employer-financed initiatives such as the Chittagong Skills Development Center (CSDC) (3-5 years) Address weaknesses in Strengthen institutional arrangements for public expenditure, financial management, Bangladesh's core and procurement, using the agreed PFM indicators as benchmarks. Specifically: governance areas that matter directly for * Implement the Action Plan to strengthen public financial management future sustained growth * Deepen and mainstream the MTBF being piloted in 14 ministries * Complete computerization of public accounting system * Ensure timely completion of the PAC strengthening project. * Implement the Procurement Law and ensure compliance with its rules Strengthen revenue mobilization by deepening the tax administration modernization program. Specific actions would include: * Develop new functional areas in NBR, including taxpayer services, audit, ICT * Reorient NBR composition along functional lines, starting with its Board * Improve HR policies and procedures to ensure more professional and competitive recruitment and promotion, training, compensation, and career development * Undertake periodic taxpayer surveys to measure progress. Xxvi Executive Summary * Establish unique taxpayer identification numbers for both Income Tax and VAT * Undertake necessary legislative reforms to correct major tax policy distortions Improve quality and efficiency of the civil service. Strengthen the personnel management system, ensuring a more merit and performance based system of promotions, a strategic use of postings and transfers, a revised compensation package, particularly for the senior cadres of the civil service who are relatively poorly paid. Address the pricing Address the critical issue ofpricing ofpower and gas: and governance issues in power generation * Immediate increases in power and gas prices to at least cover all operating costs and gas production, needed to attract * Reinstate the pricing formulae that ensure automatic price adjustments, and adopt private investment a credible timeline to increase power prices to full cost recovery and gas prices to into the sector its economic value * Hardwire budget support to cover utilities' losses in the transition period Address the governance issues afflicting the power sector * In generation procurement, appoint internationally reputed 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 operationalize the Energy Regulatory Commission * Implement the recently adopted financial recovery and restructuring plan Improve the Implement necessary policy and institutional reforms at Chittagong port, necessary to functioning of the attract much needed investment in the port's physical capacity Chittagong port and carry out * Handover management of port to experienced private contractor complementary measures to * Modernize the container terminal (especially computerization and restructuring strengthen trade of workforce) to take full advantage of the SSGs and RIGs facilitation * Increase penalties on service providers for creating congestion Implement complementary trade facilitation measures * Increase customs bonded facilities, including road-based and ICDs, in the Dhaka region * Improve inter-connection transport infrastructure, especially by modernizing the Bangladesh Railways as per current agreement with development partners Xxvii Bangladesh: Strategy for Sustained Growth Deepen and make Successfully complete the ongoing restructuring of the NCBs, with the eventual more efficient the objective of divestment over the medium term (3 years) financial system * Set objective performance benchmarks in the managers' contracts, linking performance with future pay scale and continued employment (immediate) * Introduce government-funded VRS to rationalize NCB staffing sizes (immediate) * Ensure divestment of each NCB to a strategic buyer, particularly by: o reducing government share in divested NCBs to virtually nil; o resolving SOE bad debt ahead of the divestment With respect to private sector banks, move away from system of implicit guarantee to applying the existing limited explicit deposit insurance for depositors, while simultaneously relying more on market participants to monitor and discipline banks. The following concrete steps can be considered: * Develop objective criteria for bank licensing, to de-politicize the process * Subject all banks to special audits to assess their long-term viability * Resolve non-viable banks, preferably through market-based solutions such as M&A or purchase and assumption * Review and reform as necessary the legal framework for bank failure resolution Strengthen regulatory & supervisory frameworks for capital & insurance markets * Strengthen information disclosure, by ensuring timely and accurate filing of annual audited financial statements by incorporated companies. * Review and reform as necessary legal impediments to the SEC's ability to carry out its oversight role, while weaning it away from excessive intervention in certain areas - prescribing dividend payouts, interfering in selection of CEOs etc Maintain the past To ensure continued fiscal sustainability: record of macroeconomic * Reinstate the pricing formulae for energy products. Align energy prices to full stability and cost recovery levels, and earmark budgetary resources to cover energy SOE sustainability losses in the interim * Improve tax collection (reform measures are noted above) * Strengthen debt management capacity, especially the recording of contingent liabilities Ensure continued monetary prudence with more flexible use of interest rates. Continue reliance on market-based mechanisms in foreign exchange markets Xxviii OVERVIEW BANGLADESH: STRATEGY FOR SUSTAINED GROWTH' I. Introduction 1. This is a report on the growth performance and potential of Bangladesh. The report argues that the 1st 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) weaknesses in governance. 2. The primary objective of the report, however, is to draw attention to the 2nd and current phase of Bangladesh's economic development - ensuring a speedy transformation to middle-income country (MIC) status. For that, the much-improved economic fundamentals and successful implementation of 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 govermment's Poverty Reduction Strategy (PRS),2 Bangladesh must not only pursue actively a range of second generation policy 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 productivity performance of the economy (the efficiency with which capital and labor are used to produce output), and thereby ensure long-term sustainability of 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 (especially those related to the power sector, ports, and transportation), deepening and making more efficient the financial sector, and addressing acute skills 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 reduction are built. It also rightly stresses the 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 1 This report was prepared prior to the emergence of the political turmoil in October 2006. Nonetheless, given its particular focus on the longer-term development agenda facing Bangladesh, the relevance and validity of the report's analyses and conclusions should not be affected by the recent political events. 2 Unlocking the Potential: National Strategy for Accelerated Poverty Reduction, Government of People's Republic of Bangladesh, 2005. 1 Bangladesh: Strategy for Sustained Growth Joint Staff Advisory Note (JSAN)3 observes, a well thought-out process of growth acceleration is 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. 3 Joint IDA-IMF Staff Advisory Note on the Poverty Reduction Strategy Paper, December 2005. 2 II. The Record of Growth and Development 11.1. A Synopsis of the Development Record 6. Starting out as desperately poor, with much of the institutional and physical capital obliterated by the 1971 war for liberation, Bangladesh was written off by many international observers. Henry Kissinger famously prophesied Bangladesh's economic future as "an international basket case." Extremely weak initial conditions and various vulnerabilities offered plenty to worry about. Summing up the conditions then, a World Bank report in 1972 noted:4 Even under the best of circumstances, Bangladesh constitutes a critical and complex development problem. The population is poor (per-capita income of $50 to $70 - a figure which has not risen over the past 20 years), overcrowded (population density is nearly 1400 per square mile) and becoming more so (population is growing at 3 percent per annum), short-lived (life expectancy at birth is well under 50 years), in many cases unemployed (perhaps 25-30 percent), and largely illiterate (under 20 percent literacy rate). Furthermore, most of the population (90 percent rural) 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 discrimination was prevalent: there were only 958 females for every 1,000 males in 1970, which then was lower than in India, Pakistan, Nepal, and Sri Lanka in the region. 7. Bangladesh's development record has been a remarkably positive one, especially when viewed through the prism of the weak initial conditions and surrounding pessimism. Thirty some years later, life expectancy has risen to 64 years (comparable to neighboring India's), population growth has dropped to 1.5 percent (resulting from 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 1,000 males in 2005 - more than in India and Pakistan. Figure La : Per-Capita GDP: Bangladesh Vs. Median LIC Figure L.b: Per-Capita GDP: International Comparisons 1900 1800 1700 6000 Z 1600 D4000 ii 1500 E a200 1400- Note: Included LICs are the 2] countries whose per-capita GNI in 1975 was at or below US265, the cut-offfor LICs eligibility used by IDA in 1975. Source: World Development Indicators, BBS, and World Bank staff calculations. 4 Bangladesh: Reconstructing the Economy, Report No. SA35, the World Bank, 1972. 3 Bangladesh: Strategy for Sustained Growth 8. Income growth has been crucial in raising living standards and reducing poverty. 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, 9. Rwanda (Figure L.a).5 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). 10. Strong economic growth has been mostly a Figure 2: Trends in GDP Per-Capita post-1989 phenomenon. Abstracting from the post independence turmoil, since 1976, the growth process 2 200 4 exhibits two distinct phases (Figure 2). The first 1 3 phase spans the years 1976-1989 and was a period of E 160 -2 - positive but mediocre 1.2 percent average per-capita D growth, benefiting from sporadic reform episodes - 14-o 1 mostly related to domestic market deregulation 1 0 (including for agricultural inputs and outputs) and ( divestment of state control from some state 100 enterprises. In comparison, the median country 80 -2 growth across the globe was 1.7 percent, while the 1975 1980 1985 1990 19 20 2005 per-capita GDP of even the median LIC (among the 21 Real Per-Capita GDP (right a)ds) who classified as LICs in 1975) caught up slightly Real Per-Capita Grov& (left ads) with Bangladesh (Figure L.a). The second phase BBS and WorldBank staff calculations 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 1 990s. 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 increasing trend in the second phase, averaging 3 percent in the 1 990s and close to 4 percent in the 2000s. 11. Growth has both underpinned and benefited from substantial progress on human development. Growth acceleration since 1990 has been accompanied by faster progress on poverty reduction and some human development measures. After a virtual stagnation in the 1 980s, the poverty rate fell from 58 percent in 1992 to 49 percent in 2000 and further to 40 percent by 2005; 6 one of the fastest rates of poverty reduction in the region. In other areas, secondary school enrollment remained stalled at about 20 percent between 1975-90, but has since increased to 43 percent; access to sanitation facilities has doubled since 1990, and; child malnutrition rates (by weight), have been reduced considerably after showing little progress in the 1 980s, although Bangladesh still has a lot of distance to cover on this one. 12. Much of the social sector progress started in the first two decades after independence, well before the growth acceleration, a feature that is somewhat unique to Bangladesh. This owes to good social policies and innovative social programs pioneered by world famous nongovernental 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 5 Among the 21 countries that fell under IDA's LIC classification in 1975 were Bangladesh, China, Haiti, India, Indonesia, Nepal, Pakistan and 14 Sub-Saharan African countries. 6 Tepoverty statistics are from various rounds of Household Income and Expenditure Survey (HIES). 4 II. The Record of Growth and Development Commission (BRAC), partnered with government agencies and international donors. As a result, 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 LICs. Table 1: Progress on Key Social Indicators Then Now School enrollment, secondary (% net) 19 (1990) 43 (2005) School enrollment, primary (% net) 71(1990) 93 (2004) Fertility Rate 6.1 (1972) 3.0 (2005) Immunization, DPT (% of children ages 12-23 months) 1 (1980) 88 (2005) Immunization, measles (% of children ages 12-23 months) 1 (1982) 81(2005) Improved sanitation facilities (% of population with access) 20 (1990) 39 (2004) Life expectancy at birth, total (years) 45 (1972) 64 (2005) Malnutrition prevalence, weight for age (% of children under 5) 68 (1983) 48 (2004) Mortality rate, under-5 (per 1,000) 239 (1970) 73 (2005) Mortality rate, infant (per 1,000 live births) 145 (1970) 54 (2005) Source: World Development Indicators, World Bank 13. 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 US$10,843.8 Its population of over 140 million is compactly packed in a land area of 147,570 sq. 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, particularly among women. Child malnutrition rates are among the highest in the world and maternal mortality rates, albeit lower than in India, Pakistan, and Nepal in the region, are among the highest in the world outside of Sub-Saharan Africa. 11.2. Main Characteristics of the Growth Process 14. 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) striking 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 accompanying employment creation. A brief description of each follows. 7 For elaboration of this, see Bangladesh Development Policy Review: Impressive Achievements But Continuing Challenges, World Bank, 2003. 8World Development Indicators. 9 The Financial Times, 2007, "Bangladesh Plight Serves As Warning to World," February 1. 5 Bangladesh: Strategy for Sustained Growth Remarkably Low Volatility of Growth 15. An impressive feature of the growth process has Figure 3: International been its remarkable and improving stability. The standard Volatility Comparisons (1990-0 deviation of per-capita GDP growth fell from 1.6 over 1976- 4 1989 phase to 0.7 over 1990-2005. In fact, the standard 35 deviation 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.10 Furthermore, Bangladesh is among the handful of countries that have avoided even a single year of negative per-capita growth since 1990. The achievement .2 4.5 of low volatility is all the more creditable given Bangladesh's exposure to natural calamities. An impressive Bangladesh SouthAsia OECD LIC Average record on strengthening disaster management and Average Average macroeconomic stability are the likely factors in achieving Note: LICs are ctries that classified as such in 1989. Source: WB staff calculations and World Bank data the low growth volatility. 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 inflicted more physical damage, the human and economic loss from it was much lower." The good record on macroeconomic stability is discussed later. Broad-Based Nature of Growth 16. Growth has also been broad-based, although the sectoral composition is shifting away from agriculture, as is common for developing economies during periods of sustained high growth. Manufacturing sector growth has improved to about 7 percent since 1991, compared with 5 percent in the 1980s (Table 2 ), benefiting from better performance by both small-scale and 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 insignificant amount in early 1980s to $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 emergence and 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 from a much smaller base than garments. As a result, the merchandize exports to GDP ratio increased from 7 percent in 1991 to 18 percent in 2006 and the share of manufacturing in merchandize exports from 67 percent in 1981 to over 90 percent. 17. 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 (remittances through 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. 10 Ramey 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. " The 1998 Floods in Bangladesh: Disaster Impacts, Household Coping Strategies, and Response, International Food Policy Research Institute, 2001. 6 II. The Record of Growth and Development Table 2: Growth Rates of Output Components 1981-85 1986-90 1991-95 1996-2000 2001-2006 1981-2006 Growth Rates (%) GDP Growth 3.7 3.7 4.4 5.2 5.6 4.6 Agriculture Sector Growth 2.7 2.4 1.6 4.9 2.8 2.9 Industrial Sector Growth 5.7 5.9 7.5 6.4 7.8 6.7 Manufacturing 4.7 5.3 8.2 5.6 7.4 6.3 - large & medium scale 4.4 5.4 8.4 5.5 7.3 6.3 - small scale 5.4 4.9 7.7 5.9 7.7 6.4 Construction 6.4 5.6 6.3 8.8 8.4 7.1 Services Sector Growth 3.7 3.8 4.6 4.8 5.8 4.6 Wholesale and Retail Trade 4.6 4.4 5.4 6.0 6.7 5.5 Transport, Storage, & Communications 5.6 3.7 3.5 5.7 7.3 5.2 Shares of GDP at Producer Price (%) Agriculture Sector 31.7 31.2 27.6 25.7 21.5 27.6 Industrial Sector 21.3 21.2 23.4 25.3 26.8 23.6 Manufacturing 14.1 13.3 14.6 15.6 16.0 14.7 Construction 5.8 5.8 6.3 7.2 8.0 6.6 Services Sector 47.0 47.6 49.0 49.0 51.7 48.9 Wholesale and Retail Trade 13.0 12.5 12.5 12.8 13.6 12.9 Transport, Storage, & Communications 10.8 9.9 9.6 8.8 10.2 9.8 Source: Bangladesh Bureau of Statistics. 2006 data are provisional. 18. 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 2000s has fallen to its long-term trend of just 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 - which is half of GDP - has mostly mirrored GDP growth. Not only have GDP and services grown at 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 1981-2006 was 1.0, compared with 1.8 for the industrial sector and 2.4 for agriculture. Sub-National Variations 19. Per-capita GDP 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.12 Furthermore, the growth acceleration at the national level since 1990 was experienced in varying degrees by each of the 6 Divisions. It was most pronounced in the Sylhet Division, where per-capita growth accelerated by 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 FY00, per-capita GDP of the most well-off Division (Dhaka) was about 50 percent higher than that of the least well-off Division (Sylhet). 12 It must be noted that data at the Old District level are fairly unreliable. For one, these are based on the 1968 SNA, whereas the 1993 SNA is currently being used. The District level data address some of these quality concerns. 7 Bangladesh: Strategy for Sustained Growth Table 3: GDP Levels and Growth by Division Aggregated From 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 FY00 FY00 FY96-00 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 3.0 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 2.3 1.6 2.9 2.4 Source: BBS, and Staff calculations 20. GDP data for the next administrative level, the District, are available only for the FY96-00 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, FY92-05.13 As 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 expenditure growth rates, on the other hand, varied widely, between -4.8 to 6.2 percent, over FY92-05. There is also considerable dispersion in both GDP and expenditure levels of the Districts. In FY00, 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-half times that of the least well-off District (Gaibandha) in FY00. 21. 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 expenditure inequality, 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 150 years without considering the correlates.14 Growth Process Led by Major Urban Centers: Growing Primacy of Dhaka 22. Although still predominantly rural, Bangladesh is undergoing a rapid transformation toward urbanization (Figure 4). Growth in the country has been led by its urban centers, especially the 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 quarter to almost one-half. 13 Although expenditure data are not representative at the District level, these are tightly correlated with GDP data across districts. Still, the District level aggregations for expenditure are to be interpreted with caution. 14 At the Divisional level, expenditure growth over FYOO.-05 was significantly faster in the top 3 Divisions (in terms of their per-capita expenditure level in FY00) than the bottom three, leading to increased divergence in living standards between the two groups and slower progress on poverty reduction in the latter. 8 II. The Record of Growth and Development Figure 4: Urbanization in Bangladesh 200 Urban Population (%) 180 160 40 r 140- 35 6 100w Ru,ral 25- m 120 -* -Total 2 03 4C 100 10 22 5 1 0 Source: UN World Urbanization Prospects and World Bank staff calculations 23. Urbanization has 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 from 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 12 million residents, and its "urban primacy" level (share of total urban population) exceeds that of most global comparators.'5 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, making it the 6th largest city in the world (it is currently the 1 1' largest) and the 3rd largest in Asia by 2015.16 Chittagong, Khulna, and Rajshahi have each experienced a more-than-five-fold increase in population since 1970. Table 4: Population dynamics of the largest agglomerations (population figures in thousands) City Population Population Population Population Population Annual Growth Rank (2000) (2000) (1990) (1980) (1970) (1970-2000) Dhaka 1 12300 6619 3248 1474 7.1% Chittagong 2 3581 2265 1333 693 5.5% Khulna 3 1426 972 622 310 5.1% Rajshahi 4 1016 517 238 105 7.6% Data Source: Global Cities Database http://www.econ.brown.edu/faculty/henderson/worldcities.html 24. The population trends, not surprisingly, mirror the concentration of economic opportunities in these 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 employment7 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 considerably higher in Dhaka and the other large metropolitans relative to the rest of the country. A Positive Record on Employment Creation, Skill Levels Remain Low 25. An overall positive record on employment creation has accompanied GDP growth (Chapter 3). 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 with other 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. Ahmed et al. Mimeo, World Bank 2006. 17 Dhaka Urban Poverty: Land and Housing Issues, Draft paper, World Bank, 2005. 18 The labor force data are to be interpreted with caution given the considerable quality issues. 9 Bangladesh: Strategy for Sustained Growth Female labor force participation is on the rise, increasing from 16 percent in 1996 to 26 percent in 2003. Real wages increased across all major economic sectors between 2000-2004, rising by close to 30 percent in manufacturing, indicating some tightening of the labor market despite rapid growth in labor supply. 26. Nonetheless, 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 2000-03 period. 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 picking 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 literacy rates and generally poor quality of education and worker training, that are also not particularly relevant to market needs.'9 11.3. Factors Underlying GDP Growth 27. Accumulation of physical capital and (quality- adjusted) labor has been instrumental in the growth Figure 5: Sources of Growth acceleration since 1990, with some contribution from 8.0 total factor productivity (TFP) growth (Figure 5). Capital stock growth picked up from an average rate of 4 percent over 1980-89 to 6.6 percent over 1991-06. Growth rate of 4.0 effective labor - measured as a combination of the labor force and education levels of the working-age population - 2.0 also improved up by almost one-half percentage points in 0.0 the latter period. While better access to education played a role, the dominant factor in this increase was labor force 198-9 199M6 growth. Average annual growth of TFP (the efficiency GOP growth Figue 5 Sorce of GrockGt with which capital and labor are used to produce output) Ei Labor (quality adjusted) Growth 19 TF growth picked up from virtually zero in the ten years prior to 1990 Source: BBS and staffecalculations to 0.4 percent since .20 To be sure, a lot of caution 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 1990 is a robust conclusion across all plausible variations in assumptions (see Table 1 in Annex 1). 28. 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 FY06 was accompanied by a concomitant increase in the gross domestic savings rate, from 13 percent to 20 percent (Figure 7). 19 The Bangladesh Vocational Education and Training System: An Assessment, World Bank 2006. 20 In the absence of reliable labor force data that are also comparable across time, 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 1 980s, the ILO and the US Census Bureau each report corresponding growth of 3.4 percent, about one percentage point higher than in the 1980s. The TFP estimates shown here use the ILO data. The increase in TFP growth since 1990 would be close to 1 percentage point if WDI data were used instead. 10 II. The Record of Growth and Development Figure 6: Public-Private Breakdown of Investment Figure 7: Trends in Investment and Savings 28-28 82 84 86 88 90 92 94 96 98 00 02 04 06 8 -__ Total Investment Rate 8 4 8 8 9 2 9 6 9 0 0 4 0 ----- Public Investment Rate 224- 20-0- 88- ~82 84 86 88 90 92 94 96 98 00 02 04 06 ---- Private Investment Rate - Total hvestment Rate --- Gross Domestic Saving Rate Source: BBS and World Bank staff calculations 29. Labor force growth has been strong despite declining population growth (from 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 labor force and, more recently, from sharp increases in the female 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 working-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 increased by just 17 percent. 30. The initial surge in private investment and the improvement in TFP growth 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 implementation of a fresh wave of macro and structural reforms. Key measures included: * Improved macroeconomic stabilization: CPI inflation fell from 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 15 percent 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 11 percent 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, increased to 12.4 percent by FY95. 21 Bangladesh: Recent Economic Developments and Priority Reform Agenda for Rapid Growth, World Bank 1995. 11 Bangladesh: Strategy for Sustained Growth * Launching 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 interest rate bands in 1997 and finally withdrawal 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 stimulus to private investment in the 1990s, as shown in Chapter 8. * Deepening of agriculture 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. Deregulation and privatization of public tubewells in the 1980s contributed to 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. 31. 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 1990s, 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 significant crowding 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 competitive pressures, loosen government control, and tighten prudential regulations and regulatory quality. Trade liberalization has been further 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 availability until recently of preferential markets for garment exports. 32. Earlier emphasis on social development was also an important factor in sustaining the higher growth. As noted earlier, progress 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 organizational management. The state also wisely created the space for the emergence of effective partnerships 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 education being allocated significant parts of the budget. 33. 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 12 II. The Record of Growth and Development acknowledged micro-credit programs have also made significant contribution with their emphasis on underprivileged women. 34. Having completed an array of first generation macro and structural reforms, Bangladesh is now confronted with some emerging structural issues 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 agricultural 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-mentioned (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 Bangladesh has even done rather well. Nonetheless, in a number of important areas governance is significantly lagging overall development and (if unaddressed) risks becoming a gradually tightening noose around the growth process, particularly in the next development phase - the country's transition to middle-income status. 13 III. Transition to Middle-Income Country Status: Issues and Challenges 111.1. A Scenario of Rapid Growth to Achieve MIC Status 35. 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 1990s to 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 6 percent, 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 1997 East Asian crisis. A possible hypothetical scenario of Bangladesh's transition to MIC status by 2016 is outlined in Table 5. Table 5: A Hypothetical Scenario of Bangladesh's Transition to MIC Status 22 1990-2006 2006-16 Per-capita GDP Growth (%, period average) 3.3 5.9 Capital Stock Growth (%, period average) 6.6 8.6 Labor (quality adjusted) Growth (%, period average) 3.7 3.6 TFP Growth (%, period average) 0.4 2.0 Investment Rate (%, end of period) 25 31 Source: BBS, Barro-Lee (2000), and World Bank staff calculations 36. 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 II of the report. In addition, capital accumulation will need to accelerate, with the investment rate needing to increase by over 5 percentage 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 relatively low 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) - estimated at close to 1 percent 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 important role. 37. Continued strong labor force growth would be conducive, although a far greater emphasis on improving labor skills would be needed. As before, a special focus on women's advancement would bring considerable growth dividends. Only about one-quarter of the working-age women participate in the labor force, compared with at least double that in advanced economies. Educational attainment of the labor force should increase as a result of the higher-school enrollment rates over the past decade. 22 The TFP calculations in this table are based on the methodology described in Annex 1. Further, the share of capital in output is assumed at 0.35 and future growth rates of labor force and education levels are assumed to equal the average rates since the early 1990s. 15 Bangladesh: Strategy for Sustained Growth 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 Three Key Transitions 38. The above scenario needs to be mapped into a real agenda for 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 features seem 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 significantly more open to investment and trade, where Bangladeshi firms will be plugged into global supply chains and the country will figure prominently on global investment maps. * A middle-income Bangladesh will be far more urbanized than it is today, with a diverse set of dynamic urban centers emerging as viable alternatives to Dhaka, benefiting from much improved urban governance. Transition 1: Facilitating Sectoral Shifts: From Agriculture to Manufacturing and Services 39. In common with nearly all developing countries, Bangladesh's growth has been accompanied by a shift in output composition away from 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 manufacturing, and agriculture would continue losing its share even if it does well: it is hard to envision agriculture outperforming manufacturing and services on a sustained basis under any high-growth scenario. It seems more plausible that manufacturing sector would be the one picking up the slack, given its relatively low share in GDP (17 percent) and also its strong growth momentum since the early 1990s. 40. 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 tremendous pressure 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 sector and by improving its competitiveness and preparing it for growing globalization. 23 The Government's PRS highlights another major transformation with implications for long-term growth: the evolution of the meso-economy (rural market centers). This incorporates formal and informal activities in services, trade, construction and small industries that are rapidly expanding in the rural market centers. The transition, no doubt critical, is still not sufficiently understood. Its analytical underpinnings need to be deepened for incorporating it into the mainstream growth story. 16 III. Transition to Middle-Income Country Status: Issues and Challenges Improving Productivity in the Manufacturing Sector 41. Chapter 1 estimates the TFP offive major manufacturing industries over the 1999-2003 period using a firm-level survey of about 700 firms conducted for this report. The industries covered were ready-made garments, textiles, pharmaceuticals, food, and leather/footwear - together these account for about 70 percent of the manufacturing sector and therefore give a good account of the sector. 24 42. Analysis shows that the average annual (median) TFP growth over 1999-2003 was positive in four out of the five manufacturing industries under consideration - garments being the lone exception.25 Within the garment sector, the average growth in the sweaters sub-sector was positive and relatively quite high. The results also show that allocation of resources within the pharmaceuticals, leather/footwear, and textiles industries during the sample period 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 insignificant in determining the overall productivity performance at the industry level, which is largely shaped by productivity at the firm-level. 43. Careful econometric analysis identifies the factors that affect firm-level TFP performance, taking into account differences in firm characteristics - such as location, industry, age, and size. The results suggest that in order to strengthen TFP performance of manufacturing firms, the following measures would 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 1 percent increase in number of power outages in a year reduces the TFP of the average firm by 10 percent. (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 1 percent - but not in manufacturing, where the potential for productivity gains is significant. Results show that firms with any level of foreign ownership are 10 percent more productive on average than firms that are wholly domestically owned. (iii) Phasing out the high anti-export bias is important. For this, it would be essential to further lower and streamline tariffs, improve trade facilitation, and tackle behind-the-border barriers to competitiveness. Results show that firms that export majority of their output are about 10 percent 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 consolidating earlier 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 advanced technologies, 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. 24 The survey team comprised students of the Department of Economics, Jahangirnagar University, who worked under the supervision of Professor Abdul Bayes. 25 The median TFP growth rate in an industry and in any given year is the growth rate such that half the firms in that industry and year have lower TFP growth rates and the other half have higher TFP growth rates. 17 Bangladesh: Strategy for Sustained Growth Such certifications guarantee the use of internationally recognized technical standards (e.g., ISO quality certifications) and are an important means of acquiring state-of-the-art technological know-how. (vi) The poor 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 found to be negatively associated with protection payment by a firm relative to its sales, a proxy measure of law and order problems. (vii) Interestingly, results find firm 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 corporate management deficiencies in the country. Improving Productivity in the Agriculture Sector 44. Growth performance in agriculture has picked up 9 Figure 8 Agriculture Sub-Sectors Growl across its major sub-sectors in recent years, with the 1991-2000 important exception of the fishing sub-sector (Figure 8). As a result of the decline in fishing sub-sector growth - 1.8 5 percent in the 2000s compared with 8.2 percent during the 2 1990s - overall agriculture sector growth has deteriorated Z001-0b somewhat. Meanwhile, the agriculture sector is under 2 significant pressure to improve its productivity due to a 1 shrinking land base. In fact, the total land area sown is 0 expected to decline at an even faster rate in the coming years. tlrticulture Faning Related Agriculture Chapter 2 covers the key trends and sectoral issues. Source: BBS and StaW Calculations 45. The decline in fishing sub-sector growth was mainly caused by falling output levels of open water capture fisheries - 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. Aquaculture fisheries, on the other hand, have shown strong growth - 10 percent growth over the last decade - and continue to hold considerable promise. Shrimp production, in particular, has considerable potential, given its signi~ficant export potential. Significant potential for productivity improvements exists - for instance, current productivity in shrimp production (100- 150 kgs/hectare) is far below that of Thailand (4-7 tons/hectare), the world's leading shrimp exporter. Growth would have to come mainly from productivity gains as total pond area is not expected to increase significantly. 46. Bangladesh has a comparative advantage in rice production, particularly in the aman season, when there are few profitable alternatives on flooded land, the economic potential of which needs to be more fully 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 HYV variety of rice to the aman crop (where HYV is being used in only half of the area) holds most promise for improving rice productivity. 47. 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. Shrimp production 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 18 III. Transition to Middle-Income Country Status: Issues and Challenges also have a role to play.26 They would need to adhere to self-imposed standards and the recognition and acceptance of third-party certification process by importers and regulatory agencies in importing countries. Further, farmers would need to adopt semi-intensive and intensive methods of shrimp farming in place of the prevalent practice of extensive methods. 48. 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 (agricultural research and extension) system is weak and suffers from inadequate and unstable funding, inefficient allocation and use of resources, weak management, and ineffective institutional arrangements for coordination of research. 27 Significant scaling up of public spending on research along with institutional reforms to increase the stability of funding and to strengthen research 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 fruits 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 seeds need to be improved, in addition to research and extension support from the government. Transition 2: Trade Liberalization and Export Competitiveness 49. Starting in 1991, Bangladesh marked a clear departure from the highly protectionist, inward- looking import substitution policies of the earlier decades. Considerable, albeit uneven,28 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 15 percent in FY07, and the top CD rate from 350 percent in FY90 to 25 percent at present. Also, trade-related quantitative restrictions (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 IMF's Article VIII), and adoption of a floating exchange rate. These reforms have sought to enhance competition and reduce anti- export bias and incentives for import substitution.29 Chapter 4 covers the trade liberalization agenda. 50. Trade liberalization and the resulting increase in export orientation - with merchandize exports to GDP ratio increasing from 6 percent in 1990 to 18 percent 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 26 Bangladesh: Growth and Export Competitiveness, World Bank, 2005. 27 Revitalizing the Agricultural Technology System in Bangladesh, World Bank, 2005. 28 The trade liberalization drive suffered a temporary setback in the FY96-02 period, with a hiatus, even some reversal, in the reform process, before it was rejuvenated in FY02. The number of HS 4-digit items subject to QRs increased from 111 in the 1993-95 Import Policy Order (IPO) to 122 in the 1997-02 IPO: this has subsequently been cut to 15 items, only 3 of which are for protection purposes. Similarly, the average rate of nominal protection increased from 31.9 percent in FY96 to 33.4 percent in FY98, before being brought down to 24.3 percent in FY07. 29 Ahmed and Sattar (2003). 30 Bangladesh: Trade Liberalization-Its Pace and Impacts, World Bank, 1999. 19 Bangladesh: Strategy for Sustained Growth through the use of the special bonded warehouses, offered back-to-back letters of credit, and shielded exporters from business environment weaknesses by developing Export Processing Zones (EPZs). A duty drawback system was also implemented for those exporting less than 100 percent. Figure 9: Unweighted Average Nominal Protection Figure 10: Evolution of Import Restrictions 80 (Number of items in control list at HS-4 level) 140 70 - 120 122 60- 50 -100 40 80 67 30 60 20 40 10 20 0 0 . C 0 0 8 (0 FY00 (IPO 1997- July 2004 (from July 2005 (from L- >- I' L>_ 02) IPO 2003-06) IPO 2003-06) 111CID OPara tariff - Average nominal protection HOverall QRs ETrade-related QRs Source: Bangladesh Bank and Staff Calculations 51. Nonetheless, a substantial agenda for 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 1990s, which 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 strengthening their export competitiveness (Figure 12). 31 Four kinds of para-tariffs have been used: Infrastructure Development Surcharge (IDSC), VAT, Supplementary Duty, and Regulatory Duty (removed in FY05). The FY08 budget proposes to merge the IDSC with the CDs. 20 III. Transition to Middle-Income Country Status: Issues and Challenges Figure 11: Average Tariff Protection (2002-04, %) Figure 12: Exports to GDP Ratio (2004-05, %) 30 140 25 120 20 100 15 80 0 60 40 5 20 0T .C C L C o CU C C C M . C 3 a= flZ C 5 0 Sources. Fig 11: World Bank (2004): Trade Policies in South Asia: An Overview. Fig 12: WDI indicators. 52. Moreover, the export base is heavily concentrated in RMGs - RMG exports account for about 75 percent of merchandise exports - where the extent of the anti-export bias is much lower. 32 Enclave arrangements and a duty drawback system can reduce the anti-export bias but do not offset it entirely. While the bonded-warehouse system and EPZs provide exporters duty/tax free access to inputs, they do not offer shelter from the broader disincentives caused by high levels of protection and anti-export bias. Moreover, the Duty Exemption and Drawback Office (DEDO) is extremely inefficient: it takes a minimum of six months for drawbacks to be paid, with half the applications still pending after two years. 53. In order to diversify her trade base and improve export competitiveness, Bangladesh needs to implement a well-thought-out sequence of trade liberalization measures. The country would need to accept that the process of increasing economic integration at the global level is likely to persist, intensifying competitive pressures among nations. Beyond that, global competition for Bangladesh's main export, RMG products, itself has stiffened with the phase-out of the global export quotas. Low wages notwithstanding, competitiveness of Bangladeshi exporters is undercut by low productivity, higher input costs, perceptions of poor product quality, inefficiencies in trade facilitation and long lead times, and weaknesses in the domestic business environent; areas where many of Bangladesh's main competitors for RMG exports (e.g., China, India, Sri Lanka, Vietnam) are generally doing better. In order to maintain her position as a leading RMG exporter and also to diversify her export base, Bangladesh would need to strengthen her export competitiveness by addressing each of these critical areas of concern. 54. Key elements of the reform strategy to liberalize the trade regime would include: * A continued emphasis on unilateral trade liberalization and a somewhat cautious approach to the current fashion of regional and bilateral trade agreements. * Establishment of a low and uniform tariff rate in not so distant future. Interim reform steps would include further simplification of the import tax regime, and reduction in the dispersion and average level of nominal (and thus effective) protection, preferably through a pre-announced medium- and long-term schedule of tariff reductions (as was done by India recently) * Merger of para-tariffs with the customs duty, in order to have one tariff rate for each tariff line. * Elimination of all end-user tariff exemptions and concessional tariffs. * Discontinuation of protective use of VAT by ensuring that it is levied both on domestic production and imports of the same product. 32 Shrimp export has also shown considerable promise, with a two-and-a-half fold increase in value since 1990. But, most of this increase was over the FY90-97 period. Since then, problems with meeting intenational quality and phyto sanitary standards and low productivity stages have resulted in a virtual stagnation in shrimp exports. 21 Bangladesh: Strategy for Sustained Growth * Ensuring a well functioning duty drawback system such that rebates are paid quickly. The full implementation of the new duty drawback and bonded warehouse scheme is needed immediately. * 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 agreements to services trade and investment. Transition 3: Managing the Net Benefits of Rapid Urbanization 55. The process of rapid, largely Dhaka-centric, urbanization underway in Bangladesh (described briefly in Section 1), 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 service delivery bottlenecks. The challenge before policymakers in Bangladesh is to strengthen urban management to avail of the agglomeration benefits, while avoiding policies that contribute to over- concentration and its negative effects. Chapter 4 covers the issue in some depth. 56. The urban management situation in Dhaka and, to a lesser extent, Chittagong, Khulna, and Sylhet typify these challenges. Economic returns from 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 striking manifestation is 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 world.34 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 deemed viable by investors because of the high costs. Table 6: Satisfaction with Services (% of surveyed households) Services Dhaka Chittagong Khulna Rajshahi Police 2 0 1 2 Land Registration 2 1 10 4 Transport 7 3 19 6 Electricity Services 8 2 12 2 Judiciary 8 1 2 5 Health Care 11 4 18 9 Garbage Disposal 15 10 12 10 Sewerage/Sanitation 17 16 11 16 Education 21 5 28 12 Drinking Water 27 9 11 8 Source: Proshikha (2002) 33 Production typically benefits from being located in densely populated urban areas that provide a pool of skilled workers and a network of complementary firms with backward and forward linkages for supply chains, knowledge flows, and a critical mass of consumers. World Development Report 1999-2000, World Bank, Washington, D.C. 34 Ahmed et al, World Bank mimeo, 2006. 22 III. Transition to Middle-Income Country Status: Issues and Challenges 57. Urban management is even weaker in the smaller cities, retarding their emergence as viable urban alternatives. Out of the 522 urban areas identified by 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 administrative capacity in local governments, creating dependence on fiscal transfers from the center.35 58. The fundamental underlying cause of the poor urban management record is weak governance, manifest in various forms: the lack of decentralization and 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 govermment, 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. 59. Furthermore, responsibilities are fragmented among the large number of central and local agencies, often with overlapping functions and little coordination. In Dhaka, for example, currently, 16 organizations are directly involved with service provision and another 30 have indirect responsibilities, all with little coordination. An additional problem is the failure of national land development markets which, together with lack of fiscal decentralization, prevents land developers and local governments from actively developing alternate urban locations and spreading development across the urban hierarchy. 60. Weak fiscal and administrative capacity at local levels limits city governments' ability to deliver even the small subset of responsibilities entrusted them. Importantly, city governments do not have buoyant tax handles. Their main own revenue source is the property tax and associated fees for water, lighting and conservancy imposed on the same base, collectively called the 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 government 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 grant per Pourashava has steadily declined over the last decade. 61. The urban management challenge is twofold. First, to improve access to and quality of basic services and infrastructure in Dhaka and other major metropolitans. Second, to improve the prospects 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 govermments, 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 govermments first need to step up collection from existing tax bases, for which training of the appraisers and computerization of billing are likely to prove useful. However, these efforts can succeed only if the link between local taxes and quality of public services is strengthened. 62. 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 communications networks - that 35 Chowdhury (2004); Bangladesh Municipal Finance Management Sector Study, 1998, World Bank. 23 Bangladesh: Strategy for Sustained Growth 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 maintaining access to markets and their suppliers. As smaller cities improve provision of public goods and services, locations further 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 turn, 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 funding of US$70 million from the World Bank to provide financial support to Pourashavas for infrastructure development and service provision. The fund requires Pourashavas to improve performance on many counts before becoming eligible to apply for its resources. 111.3. The Enabling Environment for Making the Key Transitions 63. The management of these consequential long-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 skill gaps. These, in turn, are described below. Strengthening Governance and the Regulatory Environment 64. 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 governance matters and how it influences growth. For example, while the research shows that property rights are important to 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-growth nexus. Chapter 7 pushes the envelope in that particular direction for Bangladesh. 65. 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 from the 2003 Investment Climate Survey further bear these concerns out, showing the bureaucracy as delivering in some areas and not in others (Table 7). Table 7: Investment Climate Survey Indicator Bangladesh South All Asia Countries Senior Mgmt time spent dealing with regulation requirements (% time) 4.2 8.1 8.2 Officials' interpretation of regulations, predictable (% agree) 78.6 52.5 46.9 Economic and regulatory policy uncertainty (%) 44.3 23.2 30.5 Firms expected to give gifts in meetings with tax inspectors (% of firms) 85.8 44.3 21.7 Unofficial payments for firms to get things done (% of sales) 2.5 1.6 2.4 Value of gift expected to secure government contract (% of contract) 4.3 2.2 3.0 Corruption as a major or severe obstacle (% of firms) 57.6 25.3 29.9 Confidence in the judiciary system (% of firms) 17.02 48.5 56.7 Crime, theft and disorder a major or severe obstacle (% agree) 39.0 15.0 19.7 Losses due to crime (% of sales) 0.6 0.6 1.5 Tax administration a major or severe obstacle (% of firms) 49.7 22.4 25.9 Customs and trade regulations a major or severe obstacle (% of firms) 41.9 24.8 16.8 Source: World Bank and Bangladesh Enterprise Institute, Improving the Investment Climate in Bangladesh, 2003. 24 III. Transition to Middle-Income Country Status: Issues and Challenges 66. Information from the World Bank's Doing Business 2006 database is also not encouraging (Table 8) overall. There are 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 subject to 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 among the 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. Exporters need a lot of signatures, which take a long time (35 days on average, compared with 20 days in China) and undercuts competitiveness of Bangladeshi exporters. Recovering a loan in a bankruptcy can take up to 4 years and cost up to 8 percent the value of the estate. Table 8: Cost of Starting a Business in Bangladesh and Comparator Countries Starting a Business Registering a Property Enforcing Contracts Export Procedures Pocedues Tine Cost Procedues Tine Procedures Tire Cost Documents Signatures Time (days) (US$) (nuter) (days) (number) (days) (%ofdebt) (number) (numnber) (days) Bangladesh 8 35 358 11 363 29 365 21.3 7 15 35 China 13 48 175 3 32 25 241 25.5 6 7 20 India 11 71 383 6 67 40 425 43.1 10 22 36 aaysia 9 30 972 4 143 31 300 20.2 6 3 20 Pakistan 11 24 146 5 49 46 395 35.2 8 10 33 Sri Lanka 8 50 105 8 63 17 440 21.3 8 10 25 Thaland 8 33 155 2 2 26 390 13.4 9 10 23 LIC Vedian1 10 44 372 6 71 34 390 31 8 13 43 Source: Doing Business Indicators 2006, World Bank. 67. The "Bangladesh Paradox" of good growth despite weak governance is then frequently posed as a serious puzzle. Put sharply, how has Bangladesh managed to increase its per-capita GDP close to 90 percent since 1980, while Haiti (ranked equally low by the Transparency International index of corruption in 2004) has seen its per-capita GDP halved over the same period? 68. 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 governance in Bangladesh does produce a mixed bag of goods (Box 1), which may help resolve the popular paradox. 69. 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 acceleration of 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 governance systems as well as in sectoral governance in critical sectors will be essential. 70. 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 consequences for the economy. Bangladesh is not unique in its confrontational politics; 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 25 Bangladesh: Strategy for Sustained Growth view of investments in developing countries tend to stay away from what they see as a high risk environment which has a significant impact 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 macroeconomic discipline. * Successive governments have been relatively good at making wise public expenditure choices. * Recognized its limitations, the state has created space and forged partnerships with NGOs and the private sector to help deliver social services. * The state has greatly improved its capacity to manage natural disasters. * Successive governments 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 * Confrontational politics and the high cost of election finance have severe economic consequences. * Governance challenges also severely impede public financial management. * Major problems in tax administration (poor taxpayer services, lack of transparency in collection, inadequate audit and enforcement, and protracted taxpayer disputes) yield low revenue collection. * Financial accountability is weak with flawed (albeit improving) procurement processes, poor financial controls and inadequate external checks and audits. * Serious governance weaknesses in key sectors such as power (which is in a near state of crisis) and financial sector (which has seen recent improvements) * Surveys show that the public in general views the civil service as being low quality, which further feeds this vicious cycle of poor governance. * Finally, the justice sector has also been a source of weakness, although the Supreme Court and the senior judiciary are exceptions to this rule. Source: World Bank, Country Assistance Strategy for Bangladesh for the Period FY-06-09, 2006. 71. Governance challenges also severely impede public financial management. There are major shortcomings in tax administration (poor taxpayer services, lack of transparency in 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 expenditures and lack of effective checks and balances. Financial accountability is also weak with flawed procurement processes, poor financial controls and inadequate external checks and audits, although recent measures to adopt an international good-practice procurement law and strengthen the Public Accounts Committee (PAC) are major steps in the right direction. Bangladeshis in general view the civil service as being low quality, which further feeds this vicious cycle of poor governance. 72. Another major core governance area in need of urgent attention is the rule of law, 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 successful resolution. 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 greatly deterred by these failures. 26 III. Transition to Middle-Income Country Status: Issues and Challenges 73. Addressing the governance challenge will require strong political leadership and emergence of a constituency that demands change. The reform agenda is large and cuts across a wide range of institutions and threatens powerful vested interests. Developing a strategic, sequenced approach that relies on success in a few key areas to generate momentum and demand for reform in other areas will be crucial. Summoning the political will to do this will not be easy, and will itself depend on strong political leadership and a public that demands reforms and shows lower tolerance for weak governance. Continuing Sound Macroeconomic Management 74. 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-side shocks due to natural disasters resulted in inflation rates in the teens in the 1970s and 1980s. The record on monetary management since 1990 has 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 single digits. 75. The record on fiscal management is more mixed. Figure 13: Long-Term fiscal Trends 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 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 2 46 percent of GDP. Benefiting also from good growth, public 1 44 sector debt has since been kept under 50 percent of GDP. 42 Broad allocation of public expenditures has been quite 1992 1994 000 2002 2004 sound, with 60 percent of expenditure accounted for by Public Debt to GDP, % (right ayis) health, education, social protection, rural development, Fiscal Deficit to GDP, % and infrastructure and a relatively small allocation of (1.1 -Itrs amn rmBde oGP percent of GDP, which is less than half the regional average) 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 infrastructure development that are needed for sustained growth. 76. 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$670 million), or 1. 1 percent of GDP, compared with Tk 27 billion (0. 7 percent of GDP) in FY05, and just Tk 6 billion in FY04. The Bangladesh Petroleum Corporation (BPC) alone accounted for more than 80 percent of these losses because of inadequate pass-through of the recent increases in global energy prices to domestic consumers. The other major loss making SOEs are Bangladesh Power Development Board (BPDB), Biman, the national airline, and BClC, the public sector chemicals corporation. A hike in power prices in March 2007 and in fuel prices in April 2007 should help curtail losses at the BPDB and substantially at the BPC. 77. The losses of the SOEs have exacerbated the fragiities at the Nationalized Commercial Banks (NCBs), which are directed to provide loans to these agencies. The capital shortfall in the NCBs amounts 36 Bangladesh Public Expenditure Review, World Bank, 2003. 27 Bangladesh: Strategy for Sustained Growth to about Tk 68 billion (around 1.5 percent of GDP), which adds to the fiscal risk and makes future divestment of these banks more expensive for the government. 78. Reflecting these large contingent liabilities, together with the weak revenue mobilization, the recent debt sustainability jointly prepared by the World Bank and the IMF assessed the risk of debt distress to be "moderate". Accordingly, to ensure continued public debt sustainability, authorities would need to step up their efforts to contain SOE losses with cost-reflective pricing and enhanced operational efficiency while steadily improving tax mobilization. 79. The external debt situation is fairly benign, benefiting from a number offactors. Overall fiscal and monetary prudence has helped contain excess demand, particularly since 2002. Temporary slackening of macroeconomic management had led to a build up of external pressures by end-2001: the current account deficit rose to over 2 percent of GDP in FY01 and foreign exchange reserves fell to a precarious level of US$ 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 US$4 billion (2.6 months of import cover). The situation was further aided by the free floating of the taka/US$ 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 external public debt distress to be "low". Addressing Infrastructure Constraints: Emphasis on Power and Trade Facilitation 80. Infrastructure bottlenecks related to power and trade facilitation (ports and transportation) are severe in Bangladesh and place a major (and growing) drag on economic performance (Chapter 9). Only about 35 percent of the population - four-fifths of urban population and one-fifth of rural population - has access to network power, and load-shedding to those with access is rapidly increasing. Firm level 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 merchandise trade, is highly inefficient. Moreover, transport networks connecting the ports with the hinterland are underdeveloped and beset with logistical problems. Power Sector: Weak Governance, Poor Outcomes 81. 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 160 kwh of electricity per-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 experienced load shedding during peak times of as much as 2,800 MW. 82. The 203 Investment Climate Assessment survey confirms the concern about power at the firm level. Electricity supply easily topped the list of "major or severe obstacle" with 73 percent of firms citing it as a major obstacle to investment (Figure 15), versus 38 percent in the region. The average firm interviewed experiences power losses for 2 of every 3 days in a year, versus one in five days in the region. 37 World Bank and IMF, 2006, Bangladesh: Joint Fund- World Bank Debt Sustainability Analysis (DSA). 28 III. Transition to Middle-Income Country Status: Issues and Challenges 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 lot 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.38 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 1.8 percent of them own a generator.39 Figure 14: Electric Power Consumption (kwh per-capita) Figure 15: Percentage of Managers Ranking Power as Major Constraint Malaysia Bangladesh Thailand Pakistan China Indonesia China India India Pakistan Indonesia Sri Lanka Malaysia Bangladesh 7 0 500 1000 1500 2000 2500 3000 0 10 20 30 40 50 60 70 80 Source: World Devlopment Indicators Source: Inestment Climate Assessment of Bangladesh: WB and BE 83. Not surprisingly then, 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 fluctuations often put the pumps out of order. 84. Most of Bangladesh's power sector problems are rooted in a long history of badly run government power enterprises and governance weaknesses, which also undermined the 1990s initiative to encourage private power generation. Half a dozen independent power producers (IPPs) 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. 85. Part of the government's response to power shortages has been increasing the 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 reforms the country can experience major gas shortages as early as the next decade. 86. Also critical are political economy factors that have caused under-pricing of energy products. In 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 cents/kWh, 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, 38 Promoting the Rural Non-Farm Sector in Bangladesh, World Bank, 2004. 39Ibid. 29 Bangladesh: Strategy for Sustained Growth ultimately, is covered from the budget. An important consequence of under-pricing of power, therefore, is crowding out of productive public expenditure. 87. The government is beginning to address some of these constraints, although the pace of reforms has been uneven and slow on account of inadequate prioritization, resistance by 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 important initial implementation measures include: * Bangladesh Energy Regulatory Commission (BERC) was established in 2004, and is expected to play the lead role in setting tariffs, issuing licenses and providing regulatory oversight. * The industry structure has been changed noticeably, leaving BPDB with 60 percent of generation (compared to 86 percent in FY99) and 30 percent of distribution. Major steps include: " horizontal unbundling of BPDB's distribution activities into four regional entities: one each for the West Zone, Northwest Zone, South Zone, 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 transmission assets; o creation of Ashuganj Power Station Company Limited (APSCL) to takeover the 724MW Ashuganj Power Station, and; o transfer of 9,000 km of distribution lines from BPDB to the more efficient Rural Electrification Board (REB). * Management in PGCB, DESCO, and APSCL has been contracted competitively from the market. Both PGCB and DESCO are now profit-making enterprises. * Three distribution 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. Corporatization of BPDB is also being studied. * A Captive Power Policy was adopted in FY06 with the objective of tapping potential captive capacity into the public grid. * Arrears to major power utilities companies have been reduced, from 8 months equivalent of receivables in end-FYO3 to less than 3 months. * A financial restructuring and recovery plan (FRP), 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 sector more appealing to private investors and also allow a more gradual adjustment of tariffs. 88. Recent government-commissioned studies indicate that new investment of US$1.5 billion may be needed annually in the foreseeable 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 commitment to cost-reflective pricing in power and to economic costing of natural gas, including reinstatement 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 30 III. Transition to Middle-Income Country Status: Issues and Challenges 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, appointment of internationally reputed advisors would help address the worst of the transparency issues. To address corruption in 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-politicizing the rural electrification program and putting law and order resources behind managers seeking to enforce payment from delinquent customers. * Implement complementary reforms, particularly corporatization and financial 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 determining future tariff increases. Trade Facilitation and Growth 89. Trade facilitation shortfalls are assessed to be a major bottleneck to Bangladesh's export competitiveness. 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 shrinking order cycles in the post-ATC world, the costs to Bangladesh's external competitiveness from related distortions are mounting and it is essential that they be tackled on a priority basis. 90. Various inefficiencies and high shipping and port costs at the Chittagong port - 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 72nd out of the 75 ports it rated. Average container dwell time was reported at 18 days compared to 10-12 days for other ports in the region. 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 Chittagong port 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 12 private 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. 91. What is causing the malaise at Chittagong Port? Clearance procedures at the ports and customs are complex and the port lacks physical and logistical capacity. The documentation needed for 40 Bangladesh: Growth and Export Competitiveness, World Bank, 2005. 41 Trade facilitation involves procedures for import-export transactions at ports, efficiency of transport networks linking ports with hinterland, logistics services, and implementation of food safety and quality standards. 42 www.textileandapparel.com/story/2005/12/8/20246/8014. 43 Asian Development Bank, Chittagong Port Trade Facilitation Project. 44 "Improving Trade and Transport Efficiency - Understanding the Political Economy of Chittagong Port", Bangladesh Development Series Paper No. 6, The World Bank Office, Dhaka, December 2005. 31 Bangladesh: Strategy for Sustained Growth 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 specter of such an inspection is sufficient to elicit informal payments. 92. Moreover, a number of physical constraints add to the costs. Chittagong's is not a deep-sea port, and transshipment via the Singapore/ Tanjung Pelapas and Colombo ports add to shipping costs 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 modern logistics tracking system. Furthermore, most containers arriving 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 this 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 containers because of their large size, while movement of containers by rail is slow and greatly constrained by the limited infrastructure. Second, importers must provide a bank guarantee to remove the container from the port unless shipped to the Dhaka Rail inland container depots (ICDs) - although the larger freight forwarders can make do with a company guarantee. Third, there are no customs facilities for clearing cargo near where most of the importing production units are located. 93. A recent World Bank report45 finds the situation a classic example of the 'tragedy of the commons' in that individual stakeholder interests predominate to the detriment of overall port interests and those of the national economy. Lack of incentives for those providing port services and of transparent competition in private service provision contribute to 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 coordinate and steer through a radical reform program. 94. 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 innovations and operational practices are still quite limited. 95. 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 conditions for much needed investment in the port's physical capacity. The following measures appear to be key:47 Modernize the container terminal operations, to 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 interaction with the shipping lines. Such modernization will benefit from the recent measures to engage 45 Ibid. 46 Bangladesh: Growth and Export Competitiveness, World Bank, 2005. 47 Although the reform agenda focuses on the Chittagong port, the malaise affecting other, smaller ports, including Mongla port, is of a similar nature and, therefore, much of the reform agenda is also be applicable to these. 32 III. Transition to Middle-Income Country Status: Issues and Challenges private berth operators and depoliticize the labor force. These need to be sustained and deepened, and complemented with handover of the port management to an experienced private contractor. * Increase the penalties on service providers for creating congestion. Stakeholders currently 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 clearance processes. As noted, a relatively high proportion of imports are inspected by customs despite having in place a PSI system. While the introduction of the ASYCUDA++ system should help improve selectivity, some remaining incentive distortions faced by customs officials need to be tackled. 96. Other complementary key reform measures needed to improve trade facilitation include: * Increase customs bonded facilities, 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-makers should further consider more fully exploiting the inland-water transport network. Creating a Deeper and More Efficient Financial System 97. Financial sector development is critical for sustained growth and poverty reduction. Well developed financial systems ease the exchange of goods and services by providing payment services, help mobilize and pool savings from 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 literature.48 Time series evidence in Chapter 8 corroborates these findings for Bangladesh. 98. 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 (FCBs). 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: Structure of the Banking System (end-2005) Bank Types Number of Number of % of Industry % of Industry Banks Branches Assets Deposits NCBs 4 3386 37 41 DFIs 5 1342 10 6 PCBs 30 1643 46 46 FCBs 9 41 7 7 Total 48 6412 100 100 Source: Bangladesh Bank Financial Sector Review, May 2006 99. 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 48 See, for example, Goldsmith (1969), Levine (1997), King and Levine (1993) and Rajan and Zingales (1998). 33 Bangladesh: Strategy for Sustained Growth 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 important milestone for banking sector reforms, should provide impetus for and set a useful precedence in following through with the rest of the NCBs. 100. Performance in the banking sector has responded well to the reform measures. Especially robust has been the response of private banks, which have dramatically increased their 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: Performance Measure 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 numbers are without adjustment for actual provision and interest suspense. * Negative CAR for NCBs in 2005 because of negative capital of Agrani bank Source: Bangladesh Bank Quarterly, various issues. 101. 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 comparator countries and increasing consistently, 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 capitalization is below 10 percent 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 Prize. 102. With the reform process initiated since 2001, the government has sought to move away from 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 49 Applying one of the criterion for a systemic banking crisis, gross NPL ratio of more than 10 percent of aggregate loan portfolio, the Bangladeshi banking sector has been in one since 1983. 34 III. Transition to Middle-Income Country Status: Issues and Challenges for a more market-based supervision by introducing some important measures towards market-based supervision. 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 separate list of approved auditors for banks. 103. 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 enabling approach. For instance, the institution has not been immune from political interference in the bank licensing process. Fortunately, the practice has 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 failing banks. 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 supervisory oversight and certain regulatory restrictions and enjoy regulatory forbearance. The situation is also not helped by an environment of weak contract enforcement and poor accounting and auditing standards. 104. 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 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-politicization of entry of banks, market monitoring of banks, and reform of the exit process would be key. The licensing process has to be put on objective, non-political basis. Most importantly the government would need to move away from the implicit guarantee system to applying the existing limited explicit deposit insurance for depositors, while simultaneously relying more on market participants to monitor and discipline banks instead of micro-managing financial institutions. This redefinition 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 essential element in the overall governance reform agenda. 105. Financial sector reforms in Bangladesh, in fact, may be viewed as being at the heart of the country's anti-corruption agenda50 and can help catalyze broader governance 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 106. Labor it is often said is Bangladesh's most precious 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 50 As the famous bank robber Willie Sutton is claimed to have said: "because that's where the money is", when asked why he robbed banks. 35 Bangladesh: Strategy for Sustained Growth depends on a host of factors that affect productivity. As a corollary, measures to improve the productivity performance can be expected to stimulate labor-intensive manufacturing, as was the case for garments. 107. The overall productivity and competitiveness of an economy depends, among other things, upon the efficiency of the labor market and the quality of the labor force. Oppressive labor market regulations are often enough to put the brakes on growth even if other everything else falls into place. A skilled and well-trained labor force, on the other hand, makes for more productive workers and enables greater technology adaptation and spillovers. Taking it a step further, a well-developed knowledge economy infrastructure, including the availability of workers with the requisite skills and training, promotes innovation and adaptation of cutting-edge global technology. 108. On balance, labor laws and regulations in Bangladesh do not appears to be serious hindrances to the functioning 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 from government restrictions that the International Labor Organization's (ILO) Committee of Experts on the Application of Convents and Recommendations has deemed excessively restrictive. 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 intervention and, if at all, in what shape and form. 109. 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.5' Because 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, appears essential in addition to consolidating earlier gains on primary education. 110. Other key identifiable distortions in the labor market include: * 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 III and IV) public sector jobs. Not only does this lead to rationing of the high premium public sector jobs, it also distorts wage signals across 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, 51 For detailed discussion of skills and training shortages in Bangladesh and underlying policy and institutional constraints, see The Bangladesh Vocational Education and Training System: An Assessment, World Bank, 2006. 36 III. Transition to Middle-Income Country Status: Issues and Challenges 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 improve this. * 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 could be speeded up. 111. Advancement of a domestic knowledge economy that promotes innovation and helps adapt cutting edge global technologies and information is critical for productivity growth. Not only is this the emerging consensus in the economics literature,52 evidence of the linkage can be traced even for Bangladesh. The far reaching effects of knowledge and technological 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 technologies tend to improve TFP performance, although only in the presence of absorptive capacity in the form of R&D activity. 112. Given the importance of a more developed knowledge economy for 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 assessment of this area would be an important topic for future analytical work in Bangladesh. Table 11: Cross-Country Comparisons of Technology and Knowledge Related Measures Innovation System Bangladesh India Pakistan LIC Average Science and Engineering Enrollment Ratio, 1998-2003 (as % of tertiary enrollment students) 13.08 20.08 .. 19.25 Scientific and Technical Journal Articles Per Million Population, 2001 1.33 10.73 1.99 3.42 Royalty and License Fees Receipts (US$ millions) Per Million Population, 2003 0.03 0.03 0.05 0.12 High-Technology Exports as% of Manufact Exports, 2003 0.03 4.75 1.15 2.88 Tertiary Enrollment (% gross), 2002 6.24 11.44 2.77 8.24 Information and Communication Technology Internet Users Per 10,000 people, 2004 20.04 323.7 127 236.35 ICT Expenditure as% of GDP 2003 2.7 3.7 7.3 5.84 International Telecommunications, Cost of Call to US ($/3 min), 2003 2.1 3.2 .. 4.24 Phones Per 1000 People, 2004 (mainlines + mobile phones) 34.4 84.4 62.9 83.35 Computers Per 1,000 Persons, 2004 11 12.1 4.2 15.91 Sources: UNESCO, WDI, ITU, and World Bank's KAM database. 52 E.g. Romer (1986, 1990), Grossman and Helpman (1991), and Coe and Helpman (1995) 37 IV. Concluding Remarks and Summary Policy Recommendations 113. 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 - including the majority of those in Sub-Saharan Africa - where growth failed to take off, saw minimal reductions and, in some cases, even increases in poverty. Bangladesh's own experience 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 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 poverty rate to under 25 percent by 2015. 114. Bangladesh has achieved good growth despite a record of weak governance - cross-country perception-based indicators usually 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 weaknesses and strengths such as the positive resolve that produced a series of first generation macroeconomic and structural reforms which stimulated the 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, successive Bangladeshi governments have also played an important part. 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 successfully 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 confrontational nature 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 which political party is in power. 115. 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 ensure that 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 strengthening tax 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 productivity growth, seen as being necessary for sustained long-term growth. 116. Specific policy recommendations are summarized in the matrix at the end of the Executive Summary. Most of the recommendations are underpinned by analytical work in the various chapters of this report and/or in other recent World Bank economic reports. 39 CHAPTER 1: FIRM-LEVEL PRODUCTIVITY IN BANGLADESH MANUFACTURING INDUSTRIES I. Introduction and Main Findings 1.1 The manufacturing sector has been a major driver of GDP growth in Bangladesh. The sector recorded an impressive 7 percent average annual growth over the 1991-2005 period, increasing its share in GDP from 13 percent to 16 percent, compared with just 5 percent average growth in the 1980s. Manufacturing exports, garment exports especially, have been the major part of the story: these now account for over 90 percent of total exports, up from 67 percent in 1981 and 80 percent in 1991. Ready- made garment (RMG) exports, increased from an insignificant amount in early 1980s to US$2.5 billion (6 percent of GDP) in FY96, and further to US$7.9 billion (13 percent of GDP) in FY06. A number of other products, such as ceramics, pharmaceuticals, and food products have also experienced strong growth over the last decade, although from a much smaller base than garments. 1.2 Continued dynamism in the manufacturing sector would be important for Bangladesh's transition to middle-income status. Given the still modest share of manufacturing in GDP, there is considerable scope for the sector to lead the growth process for quite some time. A comparison with the East Asian economies that successfully made the transition from low- to middle- income status highlights the scope for this increase (Figure 1.1). Figure 1.1: Manufacturing Sector's Share in GDP (percent) 45 40 - 35 - 2003 30 - 1970 1990 25 - 20 - 1980 15 1 10 5- 0 Bangladesh China Indonesia Malaysia Thailand 1.3 Significant challenges would need to be overcome for the manufacturing sector to fulfill its potential. For one, the mainstay of manufacturing activities, the garments sector (which accounts for about 40 percent of manufacturing), is facing growing competition in global markets due to the dismantling of the quota restrictions that were in place, first under the Multi-Fiber Agreement (MFA) system and then under the Agreement on Textiles and Clothing (ATC) system.' Furthermore, special arrangements for the garment sector - in the form of bonded warehouse and EPZ facilities - may have helped the sector escape some of the businesses environment weaknesses that are endemic in Bangladesh, but, at the same time, this has also led to excessive concentration of manufacturing activities in garments, which is a source of vulnerability for the economy (see Chapter 4). To unleash the full potential of the Competition for garment exports is expected to intensify even more after 2008, when the remaining shackles on Chinese garment exports to the US are removed. 41 Bangladesh: Strategy for Sustained Growth manufacturing sector and to achieve greater diversification, it would critical that the competitiveness of the Bangladeshi manufacturing sector be strengthened considerably. Box 1.1: A Note on Firm-Level Data Used for Productivity Calculations The analysis in this chapter uses data from a firm-level survey conducted for this report between November 2004 and September 2005. The survey was conducted by students of the Jahangirnagar University under the supervision of Prof. Abdul Bayes also of the same University. The survey covered a total of 682 firms in five industries: pharmaceuticals, food, ready-made garments, leather/footwear, and textiles. After the elimination of firms with data problems, the sample was cut to 575 firms, each firm having at most 5 years of production data - from 1999 till 2003. Annex 1 provides a detailed description of the data problems encountered. The majority of firms in the sample belong to the garments industry reflecting the importance of the sub-sector in manufacturing in Bangladesh. Within garments, 86% of the surveyed firms belong to the woven sub-sector, 21% to the knitwear sub-sector, and 13% to the sweater sub-sector. Most firms have more than 50 workers, although the size distribution varies significantly across industries. The sample comprises relatively young firms-more than half the firms were less than 10 years old while a third were 10 to 20 years old. About one-half of the firms were located in Dhaka while 17 percent were located in Chittagong (excluding the EPZs). However, the location of firms differs across industries: e.g., firms in the leather/footwear and pharmaceuticals industries are mostly concentrated in Dhaka. The table below summarizes the main characteristics of the surveyed firms based on the data for 2003. The survey produced a wealth of information on production variables, firm characteristics, and aspects of the business environment - these are summarized in Annex Table 1. Size Distribution (% of Firms) Industry Number of Firms Small Medium Relatively Large Very Large Extremely Large (<10 workers) (10-50 workers) (50-150 workers) (150-500 workers) (>500 workers) Pharmaceuticals 51 5.9% 15.7% 45.1% 33.3% Food 88 1.1% 12.5% 44.3% 33.0% 9.1% Garments 276 0.4% 0.7% 48.6% 50.4% Leather/Footwear 24 4.2% 20.8% 33.3% 29.2% 12.5% Textiles 136 2.2% 16.9% 44.1% 36.8% Total 575 0.4% 4.0% 13.9% 44.0% 37.7% Age Distribution (% of Firms) Industry <5 Years 5-10 Years 10-20 Years 20-40 Years > 40 Years Old Old Old Old Old Pharmaceuticals 15.7% 11.8% 29.4% 29.4% 13.7% Food 26.4% 10.3% 35.6% 25.3% 2.3% Garments 27.5% 27.5% 35.9% 8.3% 0.7% Leather/Footwear 8.3% 25.0% 54.2% 12.5% Textiles 29.4% 27.2% 27.2% 11.0% 5.2% Total 25.6% 22.7% 32.8% 15.3% 3.7% Location (% of Firms) Industry Dhaka Export Chittagong Dhaka Processing Chittagong Export Khulna Other Zone Processing Zone Pharmaceuticals 72.6% 5.9% 21.6% Food 28.4% 39.8% 4.6% 27.3% Garments 62.3% 4.7% 15.9% 9.8% 7.3% Leather/Footwear 87.5% 4.2% 4.2% 4.2% Textiles 29.4% 1.5% 9.6% 3.7% 55.9% Total 51.3% 2.8% 16.7% 5.6% 0.7% 23.0% 1.4 This chapter seeks to deepen the understanding of the factors that impact the productivity and, therefore, the competitiveness of the manufacturing sector in Bangladesh. The chapter tracks the total factor productivity (TFP) performance of five major manufacturing industries over the 1999-2003 period 42 Chapter 1: Firm-Level Productivity in Bangladesh Manufacturing Industries based on a firm-level survey that was done exclusively for this report (see Box 1.1). The industries covered were ready-made garments, textiles, pharmaceuticals, food, and leather/footwear - together these account for about 70 percent of the manufacturing sector and therefore give a good account of the sector. 1.5 Analysis shows that the average annual (median) TFP growth over 1999-2003 was positive in four out of five manufacturing industries under consideration - garments being the lone exception.2 Within the garment sector though, the average growth in the sweaters sub-sector was positive and relatively quite high. Employment generation was positive across the five industries, with annual growth rates of jobs varying between 0.7 percent in the food sector and 3 percent in the pharmaceuticals sector. Additionally, there was a sharp decline in the capital stock in all industries, likely reflecting build-up of excess capacity during the 1990s followed by a period of consolidation. 1.6 Analysis also shows that allocation of resources within the pharmaceuticals, leather/footwear, and textiles industries during the sample period was inefficient: in these industries, on average, firms that were less productive received a higher share of their industry's output. However, this phenomenon is relatively insignificant in determining the overall productivity performance at the industry level: firm- level productivity is the dominant force for that. 1.7 Econometric analysis is used to determine factors that impact firm-level TFP performance, taking into account differences in firm characteristics - such as location, industry, age, and size. The results suggest that in order to strengthen TFP performance of manufacturing firms, the following areas would need particular attention: (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 1 percent increase in number of power outages in a year reduces the TFP of the average firm by 10 percent. (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 1 percent - but not in manufacturing, where the potential for productivity gains is significant. Results show that firms with any level of foreign ownership are 10 percent more productive on average than firms that are wholly domestically owned. (iii) Phasing out the high anti-export bias is important. For this, it would be essential to further lower and streamline tariffs, improve trade facilitation, and tackle behind-the-border barriers to competitiveness. Results show that firms that export majority of their output are about 10 percent 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 consolidating earlier 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 advanced technologies, which results show as having a positive impact on productivity of Bangladeshi manufacturing firms. Quality certifications, too, 2 The median TFP growth rate in an industry and in any given year is the growth rate such that half the firms in that industry and year have lower TFP growth rates and the other half have higher TFP growth rates. 43 Bangladesh: Strategy for Sustained Growth 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., ISO quality certifications) and are an important means of acquiring state-of-the-art technological know-how. (vi) The poor 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 found to be negatively associated with protection payment by a firm relative to its sales, a proxy measure of law and order problems. (vii) Interestingly, results find firm 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 corporate management deficiencies in the country. II. The Significance of Total Factor Productivity in Output Performance of the Manufacturing Sector 1.8 What matters more for output performance - factor accumulation or TFP growth? By-and- large, there is an emerging consensus in the literature that TFP growth plays a more significant role, especially for explaining cross-country differences in GDP growth.3 The topic is more than just academic: it holds significant implications for policymakers - should their focus be on accumulation of capital (in other words, saving and investment) or on technology infusion via R&D, FDI, and higher- quality labor force? 1.9 What is the evidence on this from the firm-level data used in this chapter? A straightforward measure to determine the relative significance of firm-level TFP growth in output growth would be TFP growth/sales growth. The median value of this measure for each industry is presented below: Leather/ Total Pharmaceuticals Food Garments Footwear Textiles Manufacturing TFP Growth/Sales Growth 73 4572 (%) of the median firm Source: Firm-level data collected for this report and staff calculations As per this measurement, 20 percent of manufacturing sector output growth is accounted for TFP growth. But this measure does not account for output and TFP differences among firms. A more accurate assessment of the role of TFP growth in output growth would be provided by answering the following: if output growth of firm is higher than the sample average, then how much of that higher growth is attributable to TFP growth? For this, we run a regression of sales growth of each firm on TFP growth of the firm. The coefficient on TFP growth from this regression is 0.85, suggesting that 85 percent of the variation in sales growth may be attributable to TFP growth. While this figure may be on the high side, it does illustrate that TFP plays a major role in shaping output growth. This is also consistent with the findings of the cross-country studies noted above. III. TFP Trends in Manufacturing Industries Increasing TFP trends over 1999-2003 1.10 This section presents trends in firm-level productivity performance of five major manufacturing industries in Bangladesh: these are readymade garments, textiles, pharmaceuticals, 3 For example, Klenow and Rodriguez-Clare (1997) and Easterly and Levine (2000). 44 Chapter 1: Firm-Level Productivity in Bangladesh Manufacturing Industries food, and leather/footwear. Productivity here is measured by the unobservable firm-level TFP that is estimated under specific assumptions about the production function (Annex 1.2 explains the methodology used in obtaining the TFP measures). The firm-level survey for this exercise provides us with information on output (measured by sales) and inputs - which include labor, material, and capital - that is needed for estimating the production function. To adjust for the effect of inflation, we deflate sales by price levels. An important advantage of our analysis relative to the literature is that we deflate sales by firm-level prices rather than the industry-level prices that are often used. 1.11 Figure 1.2 presents the median TFP trends for each of the five industries.4 The main results may be summarized as follows: * In all industries except garments, the average annual (median) TFP growth over the 1999-2003 period was positive. Average growth in the garments sector as a whole was marginally negative over the period. With an average annual growth of 1.3 percent median TFP growth in the leather industry was the highest. * There is considerable variation within the garments sector. While the average of the annual median TFP growth in both the woven and knitwear (excluding sweaters) sub-sectors was negative over the 1999-2003 period, in the sweaters sub-sector it was positive and relatively quite higher. * Each sector and each garment sub-sector exhibited positive median TFP growth in 2002 and 2003, with the sole exception of a 0.7 percent decline in the leather industry in 2002. * The pharmaceuticals and garments sectors and knitwear (excluding sweaters) and woven subsectors recovered with positive median growth in 2002 and 2003 after recording negative median growth in TFP in 2000 and 2001. * The textiles sub-sector was the only sector or sub-sector with positive median growth in each of the four years under consideration. * Each sector displayed positive trends in employment generation. Employment creation was particularly strong in the pharmaceuticals and garments industries, with number of employees growing annually at 2-3 percent per year. * The sharp decline in the capital stock in each sector is striking. In each sector, the capital stock declined at an annual rate of at least 5 percent - the annual rate of decline was 9 percent in the case of the leather industry. This reflects relatively small investments by firms over the sample period, which is also consistent with the stagnation of the private investment rate (in the 15.5-15.8 percent range) over 1999-2001 at the national level. There has been a sharp pick-up in national private investment since 2002, which the firm-level data presented here do not reflect. It is possible that strong growth in national private investment at the rate of 13 percent per annum over 1992-1999 may have led to some excess capacity, which then resulted in the subsequent slowdown. 4 There are several ways to capture TFP dynamics at the industry level after estimating TFP at the firm level. One is the weighted-average TFP for firms in an industry-where the weights are assigned as per the firm size however measured. While giving the most accurate picture of the aggregate industry trends, by definition this measure is biased toward the performance of the larger firms. Alternatively measures include the unweighted-average TFP across all firms and TFP of the median firm. We prefer here the median TFP because it both gives equal weight to all firms - which seems more appealing from a policymaker's perspective - and is also more robust to presence of extreme values, unlike the simple average measure. Nonetheless, the summary TFP performance calculated by the other two methods is reported in Annex Table 1.3. 45 Bangladesh: Strategy for Sustained Growth Figure 1.2: Median Firm-Level TFP Growth, Output and Input Growth (1999-2003) Pharmaceuticals Industry Food Industry 0 Q - - - ---- -- - - - ------- - ----------- ----------= 2000 2001 2002 2003 2000 2001 2002 2003 Med. TFP Gr. - -4- - Med. SlesGr. - Med. TFP Gr. - - Med Sales Gr. ---- Med. Employment Gr. Med. Materials Gr. ----- Med. Employment Gr. - I Med. Materials Gr. -------- Med. Capital Stock Gr. ----I---- Med. Capital Stock Gr. Garments Industry Garments - Knitwear Me.TF - -- - Med Sae Gr MeinTFr - - - - Meia Sae Gr - - - -. mploy en ·- -- -- ria . - ------- - -E p -·- - - -- n M a G --0 --- M a G . - M Garments - Gaet - Woe 2000 2001 2002 2003 2000 2001 2002 2003 Med. TFP Gr. --*-- Med. Sales Gr. - Median TFP Gr. --*-- Median Sales Gr. ---- Med. Empoyrment Gr. - + Med. Materials Gr. -- -- Median Employment Gr. Median Materials Gr. -------- Med. Capital Stock Gr. ----A---- Median Capita Stock Gr. Garment - Sweater Garment - Woven 2000 2001 2002 2003 2000 2001 2002 2003 Meda TFP Gr. - - Med.a Sales Gr. - Med. TP Gr. - - - Med. Sales Gr. ----Med. Employment Gr. ---+ -- Med.anMaterials Gr. - --- Med. Employment Gr. ---+--- Med.a Materials Gr. --- - --- Med. Capital Stock Gr. ------- Med. Capital Stock Gr. Sorc: ir -lve dTaxi collected fo hsrpr n tf ac Latns ower nusr r46 - ~ ~4 -. --. ---- COC -------------- 2000 2001 2002 2003 2000 2001 2002 2003 ---Med,r Tl P Mr. ---4- Med.a Sales Gr.-.- Med, Tl P Gr. -- Media. Seie. r. -* Med. Employmenrt Mr. +.Medi. Materials Mr. Med. Employment Mr. 1...+ Media. Materials r. ---- -- -Med. Capital Stock Mr. - ----- Med. Capital Stock Mr. Sore ilvldta coletefoti -eor an staf acuain e -. 46 Chapter 1: Firm-Level Productivity in Bangladesh Manufacturing Industries IV. Insignificant Role of Allocative Efficiency of Resources Within an Industry 1.12 Productivity in any given industry in any given year may grow (decline) because its firms become more (less) productive and/or because output is reallocated towards the more (less) productive firms. In fact, industry level productivity (weighted-average TFP of all firms in the industry) can be broken into two components: (i) industry-level unweighted-average TFP and (ii) a term measuring the covariance between firms' shares in total sales and firms' TFP. The covariance term measures allocative efficiency: if it is positive, then the more productive firms in the industry have higher market shares and the allocation of resources is efficient.5 Figure 1.3: Decomposition of Industry-Level TFP Pharmaceuticals Industry Food Industry 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 Weighted Avg. TFP Unweighted Avg. TFP Weighted Avg. TFP Unweighted Avg. TFP Reallocation Reallocation Garments Industry Textiles Industry 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 Weighted Avg. TFP Unweighted Avg. TFP Weighted Avg. TFP Unweighted Avg. TFP Reallocation Reallocation Leather/Footwear Industry 1999 2000 2001 2002 2003 [ Weighted Avg. TFP Unweighted Avg. TFP SReallocatin Source: Firm-level data collected for this report and staff calculations 5 This positive statement has no normative content. There may be reasons why a reallocation of output to less productive firms that are, e.g., more socially or environmentally responsible, could increase economic welfare. Here, we consider only the efficient allocation of resources (output) to their more productive use. 47 Bangladesh: Strategy for Sustained Growth 1.13 As seen in Figure 1.3, the industry-level TFP patterns are explained mostly by the firm-level TFP performance, not by the allocative efficiency of output across firms in any of the industries. 1.14 Other key features of the analysis include: * In the garments industry over the entire period, and in the food industry since 2001, the allocative efficiency has made a positive contribution to industry-level productivity. * In the pharmaceuticals, textiles, and leather/footwear industries, allocative efficiency has made a negative contribution to industry level productivity. This inefficiency in these three industries may be related to the lack of competition - including import competition - or to ineffective bankruptcy rules and the lack of markets for used capital that prevent the exit of less productive firms. V. Determinants of Firm-Level TFP 1.15 This section identifies the factors that impact the level and growth offirm-level productivity in Bangladesh. Annex 1.2 provides more details on the econometric methodology used in identifying the determinants of TFP performance.6 Specifically, the chapter considers the impact on firm-level TFP of (i) human capital, (ii) global integration, (iii) technology, (iv) finance, and (v) other factors impacting business environment. In addition, this section also assesses the role of firm size and age. Various measures are constructed in each of these areas using firm-level data survey mentioned in Box 1.1. A brief description of each factor follows. 1) Human capital here is measured by the education level and years of experience of the firm's managers, and by education-based as well as occupation-based measures of workforce skills. As shown in Annex Table 1.5, there is quite a bit of variation in the human capital characteristics within our sample of firms. In pharmaceuticals, food, and textiles industries, more than 70 percent of the firms are run by managers with post-graduate education, compared with only 54 percent in garments and 42 percent in leather/footwear. At the same time, the lower educational achievement of managers in the leather/footwear industry is somewhat compensated for by their longer work experience. Among the workers, only a small percentage is college-educated - ranging from only 3 percent in the footwear/leather industry to 24 percent in the pharmaceuticals industry. This reflects the low levels of education attainment in Bangladesh: 2.6 years on average for the population as a whole in 2000 according to the Barro and Lee (2000) statistics and 4.2 years for the working-age population as per the 2003 Labor Force Survey (Chapter 3).7 In contrast, skilled workers represent more than 60 percent of the workforce in all industries except the pharmaceuticals industry where the share is only 44 percent.8 2) Global integration occurs because of foreign ownership or by trading across borders. Annex Table 1.6 shows the corresponding summary statistics. Foreign-owned firms represent about 10 percent of the sample. The ownership composition does not vary much across industries, 6 Existing literature suggests a list of policy variables that could potentially impact firm-level productivity, including export orientation, level of foreign ownership, human capital and training, and the investment climate. Many of these policy-relevant factors have also been considered in the macro literature to explain differences in GDP growth across countries. In testing for these policy variables in a single unified framework, the analytical work here, in fact, is a step over the existing literature where different strands of policy variables are generally tested for separately. 7 Data on average educational achievement of the workforce in the manufacturing sector is not available. 8 A worker is classified as skilled here if he or she falls into any of the following categories - professional, technical, administrative, managerial and skilled production workers. 48 Chapter 1: Firm-Level Productivity in Bangladesh Manufacturing Industries except for the leather/footwear industry where a significantly smaller proportion (4 percent) is foreign-owned. Export orientation on the other hand varies significantly across industries. While almost all firms in the garments industry and 92 percent of the firms in the leather/footwear industry are exporters, only 26 percent of firms in the pharmaceuticals industry are. In the garments and leather/footwear industries, most of the firms are majority exporters, i.e., they export over half their output. In contrast, in the pharmaceuticals industry there are no majority exporters. Finally, firms in the garments and footwear/leather industries have, on average, a much longer experience in export markets than firms in other industries.9 3) Technology here is measured by (i) the percentage of machinery that is computerized; (ii) the vintage of the capital stock (percentage of machinery less than 5 years old); (iii) whether or not the firm has any staff working on R&D activities; and (iv) whether or not the firm has been awarded one or more quality certifications (e.g., ISO).10 Annex Table 1.7 shows summary statistics for the technology-related measures. In the garments and footwear/leather industries, only a fraction - less than a tenth - of machinery is computerized. In contrast, in the pharmaceuticals industry it is much higher at 42 percent. While in the garments and textiles industries almost half the machinery is less than 5 years old, only 16 percent of the machinery is in the leather/footwear industry. In the pharmaceuticals industry about 70 percent of the firms have staff engaged in some form of R&D activity, while the ratio is less than 20 percent in all other industries. Finally, the percentage of firms with one or more quality certifications varies substantially across industries: it is highest in the pharmaceuticals industry (40 percent) and lowest in the leather/footwear industry (8 percent). 4) Several measures are used to assess the role of financial intermediation (Annex Table 1.8). Over 60 percent of the firms report having an outstanding bank loan in each of the industries except garments where the ratio is only 30 percent. More than 60 percent of firms report having an overdraft credit line. Furthermore, between 16 percent (garments) and 49 percent (leather/footwear) of the firms use financing from banks and other financial intermediaries to cover any part of their working capital, and the range is between 6 percent (leather/footwear) and 38 percent (textiles) for financing investment." 5) The business environment corresponds to the institutional, policy, and regulatory environment in which firms operate. While previous studies have mostly relied on managerial opinions and perceptions about the business environment, our measures have the advantage of including mostly objective measurements. Bureaucratic efficiency is measured by the number of days needed to clear customs for imports and exports and the percentage of weekly time spent by managers dealing with regulation capture. The number of power outages suffered and whether or not a firm has a generator capture the reliability of the public infrastructure. Whether or not a firm pays bribes to "get things done" and the share of sales paid as bribes are used as measures of corruption. Finally, security payments or protection payments as a share of firm sales capture potential crime. 12 9 We use detailed information to construct the export experience variable. The firm survey asks the year since when a firm has exported, whether and in which year the firm has interrupted exports and if the firm interrupted exports, in which year exports restarted. 10 Another measure of technology is the percentage of imported machinery. However, we do not use it in the regressions since it exhibits little variation across firms: 90% of firms import 100% of their machinery. 1 Financial intermediaries here include leasing companies, special development banks, and any other public financing agency. 12 In the survey questionnaire, (i) "get things done" was explained as bribes needed for firms to resolve issues related to customs, taxes, regulations, and services, (ii) security expenses cover security guards, alarm and security systems, and (iii) protection payments are those to organized crime to prevent violence. 49 Bangladesh: Strategy for Sustained Growth Annex Table 1.9 shows summary statistics for the business environment measures. Between a fifth to a quarter of managers' time is spent in dealing with regulation and bureaucracy. Power outages appear to be a major problem for all industries, especially so in the food and leather/footwear industries where firms on average suffer 560 and 885 power outages, respectively, per year. In face of the frequent power outages, it is not surprising that more than 80 percent of firms in all industries own a generator. There is evidence of high levels of corruption in the interactions of Bangladeshi firms with government officials and the bureaucracy. More than 85 percent of the firms indicated that firms in their industry needed to pay bribes to government officials to get things done. Such bribes amount to 1.3 percent of sales on average in the garments industry, double of that in the other industries. Finally, firms spend minimal resources on security expenses and protection payments. 1.16 In addition, we also test for the impact of the size and the age of firms on their productivity. Studies for the US have found that firms generally enter an industry with a small size and low productivity. Firms that survive grow and converge quickly to the average size and productivity in the industry. Developed country studies have also analyzed the relationship between firm age and firm productivity. These hypotheses are yet to be tested broadly for developing countries though. Ours is the first such analysis for Bangladesh. What determines TFP levels in Bangladesh? 1.17 This section reports the findings of econometric analysis of the determinants offirm-level TFP for the period 1999-2003, as reported in Annex Tables 1.10 and 1.11. Annex 1.3 discusses some important econometric problems encountered in the estimations and how and to what extent these were tackled in the analysis. * Firm size and productivity are inversely related. We adopt the size classification used in the Bangladesh Census of Manufacturing Industries (CMI), according which: small firms have less than 10 workers, medium firms have between 10 and 50 workers, and large firms have more than 50 workers. We further divide the large firm category into 3 sub-categories: relatively large firms have between 50 and 150 workers, very large firms have between 150 and 500 workers, and extremely large firms have more than 500 workers. As seen in Figure 1.4, relative to the extremely large-sized firms, firms of smaller sizes are more productive.13 Medium-sized firms are the most productive firms - on average 32 percent more productive than extremely large-sized firms.14 Thus, contrary to findings for developed economies, in Bangladesh the larger firms are not the most productive. Although it is not possible to verify at this point, this may be because of the severe corporate management deficiencies and the resulting dearth of qualified middle managers in Bangladesh which become increasingly binding as the firm size increases, preventing exploitation of available economies of scale.'5 13 This is contrary to the predictions of theoretical models of industrial dynamics with firm heterogeneity that predict that more productive firms are larger (e.g., Jovanovic (1982)). This is confirmed by empirical studies for developed economies. 14 These findings are robust across different specifications. These findings also hold true if we use capital stock as the measure of firm size: i.e., firms with larger capital stocks have lower TFP. " Our sample is skewed towards larger firms as it includes only a few small firms (those with less than 10 workers). The small firms included are likely to be particularly efficient since they have survived and are part of the same business associations as the "bigger players" in their industry. Thus, the focus of our findings on size and TFP 50 Chapter 1: Firm-Level Productivity in Bangladesh Manufacturing Industries Figure 1.4: Firm Size and Average Productivity Are Negatively Correlated 140 120- 100- 80- 60- 40- 20- 0 - - Firm size Firm size Firm size Firm Size Firm Size 500+ between 150- between 50- between 10- between 1-10 500 150 50 TFP of firms' sized 500+ normalized to 100 Source: Firm-level data collected for this report and staff calculations * An inverted U-shaped pattern is seen in the relationship between firm age and productivity. The most productive firms are those that are either 10-20 years old or 20-40 years old, followed by firms that are 5-10 years old, then by firms that are more than 40 years old, and finally by firms that are less than 5 years old (Figure 1.5). This inverted U-shaped life-cycle pattern suggests that firms start at low TFP while they are young, and then improve their productivity, through learning-by-doing, engaging in innovation, and participation in international markets. Figure 1.5: Inverted-U Shaped Relationship Between Firm Age and Average Productivity 120 115 110 105- 100 95 90 Age of firm Age of firm Age of firm Age of firm Age of firm less than 5 between 5 between 10 between 20 oxer 40 years years and 10 years and 20 years and 40 years TFP of firms aged less than 5 years normalized to 100 Source: Firm-level data collected for this report and staff calculations * Power supply problems lower significantly the firm TFP. Specifically, if a firm belongs to an industry and location that has 1 percent more power outages than another industry-location, then its TFP is lower by almost 10 percent. The economic cost of the power sector problems that have resulted in large nation-wide deficiencies in power supply are therefore extremely high. * Human capital has a positive impact on firm productivity. Firms with more skilled workers (where skilled workers group includes professional, technical, administrative, managerial and skilled production workers) and firms with a higher fraction of college-educated workers are should be on the comparison across size categories for medium-sized and particularly for large-sized firms (i.e., those with more than 50 workers). 51 Bangladesh: Strategy for Sustained Growth found to be more productive, significantly so in the case of skilled workers. Firms with more experienced managers and with managers with post-graduate education have higher TFP - 3 percent higher TFP in the case of firms whose managers hold a post graduate degree. These results point out to the importance of human capital development - a dimension lagging behind in Bangladesh despite sustained improvements over the last couple of decades - for the performance of manufacturing firms. In particular, it highlights the significance of access to quality tertiary education to prepare more qualified management cadres. * Global integration has a positive impact on firm productivity. o Foreign ownership has a positive impact on firm TFP. Firms with any fraction of foreign ownership are about 10 percent more productive than firms without foreign ownership.16 The usual benefits of foreign ownership - arising from both the tangible assets (e.g., better technology) and the intangible assets (e.g., better access to distribution and marketing channels and networks) - are likely to be at play here. o Exporting has a positive impact on firm TFP. Firms that export the majority of their output are about 11 percent more productive on average compared with firms that don't. The TFP advantage of exporters may be due to technology transfers received from foreign buyers as well as the possibility that exporters improve their own technological capabilities in order to exploit profitable opportunities in export markets.17 Productivity in exporting firms also benefits from having to adopt stringent technical and quality standards of developed markets, coping with tighter time pressures, and having to face more stringent competition in general. Further, exporters face several challenges that likely result in learning-by-exporting and consequent improvements in firm TFP. To capture the learning-by-exporting effect we test for the effect of the number of years that a firm has exported. Results confirm the positive of learning-by-exporting effect on TFP. * Research and development has a positive impact on firm productivity. Firms with staff engaged in R&D activities have higher TFP. However, we do not simply interpret R&D literally as activities that bring breakthrough patentable innovations. Given the very low overall R&D levels in the country,18 it is more meaningful to ask how successful are the R&D staff in adaptation of technology and production processes to local conditions. In confirmation of this, we find that although firms with a larger percentage of new machinery (a measure of new technology) have lower TFP, that effect is counteracted when the firm has staff engaged in R&D activities. Even stronger results are obtained when the technology measure is the percentage of computerized machinery. Computerized machinery is associated with significantly higher TFP (about 16 percent higher) if the firm is engaging in R&D activity; the effect of computerized machinery on TFP is negative in itself. These findings suggest that more advanced technologies tend to improve TFP performance but only in the presence ofsignificant absorptive capacity. Similarly, quality certifications are positively and significantly associated with firm TFP. Such certifications guarantee the use of internationally recognized technical standards (e.g., ISO quality certifications) and are an important means for firms to acquire state-of-the-art technological know-how and raise their capability to compete on global markets. 16 This finding is obtained in regressions that control for industry, location, and year dummy variables, therefore it is not driven by macroeconomic fluctuations (i.e., the fact that business cycles in the FDI-sending countries make some years more prone to foreign investment), nor by a composition effect (i.e., the fact that certain industries are more prone to receive FDI), and it is also not driven by a location effect (i.e., the fact that FDI firms are more likely to locate in certain regions such as EPZs). 17 Westphal (2002) documents the latter possibility for firms in Taiwan. 18 R&D expenditures represent only 0.03% of GDP in Bangladesh, compared to 0.7% in China and India, and 0.2% in the Philippines. 52 Chapter 1: Firm-Level Productivity in Bangladesh Manufacturing Industries * Potential for crime dampens TFP performance. Firms making larger protection payments are significantly less productive than other firms. We assume that larger protection payments to be "spared" from organized crime are a proxy for an environment with more potential crime. In unreported regressions, we also find a negative effect of the ratio of security expenses to sales when that variable is the proxy for potential crime. * No clear relationship between financial intermediation and firm TFP. Firms with an overdraft facility or credit line have higher TFP, but this relationship is not statistically significant. In contrast, firms with access to a bank loan have significantly lower TFP. Qualitatively similar findings are obtained in the regressions that test only for the impact of using the overdraft facility or with access to a bank loan along with some basic control variables.19 In unreported regressions, we do find a positive correlation between the percentage of working capital financed by banks and related institutions and firm TFP. These intriguing findings likely have to do with the inefficiencies of the banking sector in Bangladesh and deserve a more detailed analysis. However, they should by no means be taken as evidence that access to external finance is not relevant for firm performance. * Some counterintuitive results emerge in looking at the linkage between TFP and corruption/red tape. For example, the percentage of management time spent on dealing with regulations is found to be positively correlated with TFP. This could easily be because better performing firms are more visible to public officials which makes them more subject to inspections or visits from officials. Moreover, firms with higher TFP may also be more involved in activities - such as firm expansion, exports, etc. - that require permits and/or meetings with officials. Similarly, we find that firm TFP is higher in industries and locations where firms pay a larger percentage of their sales in bribes to get things done. Again, even though counterintuitive, it is quite plausible that this is because firms with higher TFP can afford to pay larger bribes to cut through bureaucratic hassles. Finally, the number of days needed to clear customs for imports does not seem to impact firm TFP. What determines TFP growth in Bangladesh? 1.18 Results of the econometric estimations of the factors that affect the change in TFP between 1999- 2003 are presented in Annex Table 1.12. Summary results follow: * There is strong evidence of conditional TFP convergence. Results show consistently and significantly that firms with lower initial TFP level tended to grow faster. Over time, this process would lead to convergence in firms' TFP to the average TFP in the firms' industry and location. * The size of the firm is inversely related to TFP growth. Medium-sized and large-sized firms are found to have significantly higher TFP growth than extremely large-sized firms. A possible interpretation is that smaller firms may be more flexible in adapting to shocks. Or, it could be that corporate management deficiencies become more binding as the firm gets larger, inhibiting its growth. Since the TFP level too was found to be inversely related to firm size, it seems that the gap between smaller and larger firms in terms of their productivity is widening over time. 1 There is widespread evidence of a correlation between firm size and access to finance. In fact, size is often used as a proxy for financing constraints (see, e.g., Beck, Demirgti-Kunt, and Maksimovic (2005)). The finding that firms with access to a bank loan have lower TFP is unchanged, however, when we estimate our regressions excluding size but including the other basic controls. Thus, the negative effect of the loan dummy variable is not driven by the potential correlation between firm size and access to finance. 53 Bangladesh: Strategy for Sustained Growth * We find an inverse relationship between firm age and TFP growth. Older firms have lower TFP growth than firms that are less than five years old. Although not significant, the findings on age are similar to those obtained for firms in African countries.20 * Global integration is associated with faster TFP growth. Firms that export majority of their output seem to enjoy faster TFP growth. In fact, being a majority exporter increases TFP growth by 0.7 percentage points per year on average. Learning-by-exporting seems to be at play here as firms with more experience in exporting are also those with higher TFP growth. Foreign owned firms also seem to have higher TFP growth, although this particular result is statistically not significant. * Firms with more skilled workers have significantly faster TFP growth. Also, firms with higher levels of external training have higher TFP growth. * Degree of red tape hurts TFP growth. Firms whose managers spend a larger percentage of their time dealing with regulation have lower TFP growth rates. A 10 percentage point increase in percent of managers' time spent on regulation can lower TFP growth by 2.5 percentage points. VI. Conclusions 1.19 The findings of this chapter highlight several important areas of policy relevance in which improvements are likely to bring large benefits for firm-level productivity in Bangladesh. The importance of accelerating infrastructure development stands out starkly. In addition, policies to promote human capital formation at various levels, incentivize R&D activities by firms, and encourage use of quality certifications hold significant potential in terms of improving productivity in manufacturing activities. Deepening of global integration by both promoting export orientation among manufacturing firms and enabling foreign ownership of manufacturing activities in Bangladesh is another high pay-off reform area. 1.20 Finally, the analytical work in this chapter points to the benefits of systematically collecting information for the manufacturing sector. The Government would be well advised to institutionalizing again a comprehensive and regular census of manufacturing firms in Bangladesh. 20 Van Biesebroeck (2005) 54 CHAPTER 2: ACCELERATING INCOME GROWTH IN RURAL BANGLADESH I. Introduction 2.1. Bangladesh has enjoyed major successes in rural development, in both agriculture and the non-farm sector. Agricultural output has grown at an average rate of 2.9 percent since 1980, outpacing population growth and allowing the country to strengthen its food security and make a significant dent on rural poverty. In particular, rice production - which accounts for two-thirds of total value added of crops - has more than doubled since independence as a result of public and private investments in irrigation, dissemination of improved seeds and fertilizer, and a policy environment that maintained incentives for domestic production. At the same time, significant investments in roads contributed to the development of well-functioning markets for major agricultural products. The rural non-farm sector - employer of 40 percent of rural workforce - has also been growing fast, at over 4 percent per year since the early 1990s. 2.2. However, the rural sector is faced with a number of emerging challenges in order to sustain good performance. Agriculture is under pressure to improve its productivity due to a shrinking land base. As urban development continues, area cultivated has declining steadily. As a result, total area sown has also declined, and, in fact, the rate of decline is expected to accelerate. Furthermore, agricultural diversification is lacking, with potential in higher-end products largely unexploited: agriculture production is dominated by crops which, in turn, are largely rice based. The rural non-farm sector is faced with a number of structural constraints that (if unaddressed) risk undermining its future growth prospects. Sharp productivity increases in both agriculture and rural non-farm sector are necessary to support sustained high growth and faster poverty reduction. This calls for the next generation of agro reforms and addressing the major investment climate constraints faced by rural enterprises. II. Agriculture Sector Performance: Trends and Issues 2.3. Agriculture sector growth has been 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 has since fallen to its long-term trend of just under 3 percent in the 2000s (Table 2.1). In common with other fast growing developing countries, the rest of the economy has outpaced the agriculture sector, resulting in a decline in the sector's share in (producer price) GDP, from 30 percent in 1990 to 20 percent in FY06. Table 2.1: Bangladesh: Agricultural Growth, 1981-2005 All Agriculture Crops Livestock Forestry Fish Growth Rates 1981-90 2.5 2.7 2.1 2.7 2.3 1991-95 1.6 -0.4 2.4 2.8 7.9 1996-00 4.9 4.1 2.6 4.4 8.6 2001-06 2.8 2.6 5.1 4.8 1.8 1981-06 2.9 2.3 2.9 3.5 4.5 Share of GDP at Producer Price (%, period average) 1981-90 31.5 23.1 3.5 1.6 3.2 1991-00 26.7 16.2 3.4 2.0 5.1 2001-05 21.9 12.6 2.6 1.8 4.9 1981-05 27.6 18.2 3.3 1.8 4.3 Source: Calculated from BBS data. 55 Bangladesh: Strategy for Sustained Growth 2.4. The sector is dominated by crops, although fish production has gained considerable share since the 1980s. Crops account for about 60 percent of agricultural GDP (AGDP), compared with 73 percent in 1980. The slack was mostly picked up by fisheries, the fastest growing sub-sector in agriculture, which saw its share increasing from 10 percent to 23 percent in AGDP over the 1980-2000 period, benefiting especially from the high growth in the 1990s (Table 2.1). Fish production growth has slackened significantly since 2001, however, resulting in fisheries' share in AGDP falling to 21 percent by FY06. The livestock sub-sector (including poultry) has seen a small decrease in its share in AGDP since 1980 (from 13 percent of AGDP to 12 percent), while forestry has doubled its share to 8 percent. 2.5. Intensifying land pressures are a major constraint on agricultural growth. Owing to extremely high population density (one of the highest in the world) and rapid urbanization, the net cultivable area declined by an average rate of 2 percent per year in the first half of the 1990s and by close to 1 percent in the second half, as potential agricultural land was diverted to other uses such as housing, roads, and industrial development (Table 2.2). The net area sown has also been on a decline, albeit at a more gradual pace, resulting in an increase in the ratio of net area sown to total cultivable area from 85 percent in FY90 to 95 percent in FY03. With less than 5 percent of total cultivable land not sown, further shrinkage in cultivable land would lead to an almost equivalent decline in net area sown. Table 2.2: Bangladesh Agricultural Land and Labor Productivity, 1980/81 to 2004/05 Net Cultivable Net Area Sown Crop VA VA (Tk bn Land 1996 prices) /Net Million Hectares Million Hectares (Tk bn 1996 prices) Area Sown (mill. Hectare) 1981-90 9.5 8.6 212.3 24.8 1991-95 9.0 7.9 243.5 30.9 1996-00 8.4 7.9 261.4 32.9 2001-06 8.6 8.1 314.1 38.8 1981-06 9.0 8.2 251.2 30.6 Average Annual Growth 1982-90 0.5 -0.2 2.5 2.7 1991-95 -2.1 -1.5 1.0 1.1 1996-00 -0.7 1.0 1.8 3.1 2001-06 -0.1 -0.1 2.6 2.7 1982-06 -0.4 -0.2 2.0 2.5 Source: BBS and Ministry ofAgriculture. Note: Data on cultivable area and area sown are available only through 2002. Data for these variables for 2003 through 2006 assume no changes relative to 2002. 2.6. Land productivity has been improving since the early 1980s (Table 2.2) due to increased productivity/hectare of individual crops, increased multiple cropping, and, to some extent, a shift to higher valued crop production.21 Given that net cultivable land and net area sown have reached their limits, future improvements in the crop sector performance will depend mainly on productivity growth. 21 There is no statistical evidence that land fragmentation has significantly lowered total factor productivity in Bangladeshi crop agriculture. Econometric evidence from Pakistan suggests that plot size does not affect productivity there, controlling for crop choice and other factors (Pakistan Poverty Assessment, World Bank (2002), and; Pakistan Rural Factor Markets: Policy Reforms for Growth and Equity, World Bank (2004),). The Green Revolution agricultural technology (improved seeds, irrigation and fertilizer) is to a large extent scale-neutral (i.e. there are little or no economies of scale in increasing farm size), particularly for the major grains (rice, wheat, maize). Some scale economies may exist in marketing, particularly of highly perishable fresh fruits and vegetables. There is evidence of economies to scale in aquaculture, however, particularly in coastal areas where the need to coordinate the timing of water flows may make large farms more efficient than small farms. 56 Chapter 2: Accelerating Income Growth in Rural Bangladesh For one, this will require continued improvements in rice yields, especially in the aman season when the HYV rice variety is used only in half the sown area. Ultimately though, raising real agricultural incomes will require more 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, where productivity performance in recent years has fallen well short of potential. Crops Sub-Sector 2.7. Sustained growth of crops production - rice and wheat, in particular - in the 1980s and 1990s enabled Bangladesh to achieve its food grain production targets. Growth in foodgrain production has outpaced population growth, eliminating the so-called "food gap" (calculated as the difference between the amount of foodgrain required to meet the consumption target of 454 grams of foodgrain per person per day and net domestic production) by FY00. However, growth has slowed down considerably since FY02, averaging 1.8 percent per year over FYO2-06, compared with an average 2.4 percent over FY81- 01. This was essentially on account of a slowdown in growth of rice production, a sharp decline in wheat production (which fell by 12 percent per year, on average, over the FYO2-05 period), and continued poor performances of other crops such as jute, sugarcane, pulses, and oilseeds. 2.8. Diversification of crop production to non-rice crops, especially the higher value added ones, is important, but is being held back by a number of factors. Marketing constraints including shortage of cold storage facilities and a functioning cold chain, lack of grades and standards, insufficient processing capacity and, to some extent, weak consumer demand related to low incomes and consumer preferences remain a major impediment. Transport bottlenecks also slow delivery of fresh vegetable products and lead to reduced quality and sales price. Rice and Wheat Production 2.9. Rice production, which accounts for two-thirds of crops value-added of doubled between 1980 and 2005, growing at an average rate of 3 percent per year. Growth has been on a declining trend, however, falling from an average 3.7 percent during the 1980s to 2.7 percent in the 1990s and further to 1.9 percent in the 2000s. Growth was also quite uneven in the 1990s; averaging -1 percent a year in the first half of the decade (due to droughts and problems with fertilizer supply and distribution) and a whopping 6.6 percent in the second half. 2.10. Growth in rice production has been underpinned by improvements in land productivity, as the land area under cultivation has not changed much. In fact, most of the increase in rice production since 1980 has been on account of the winter season (January-May) boro crop (Table 2.3).22 Traditionally, the main rice crop in Bangladesh was the monsoon season aman crop (August-December), which depends almost entirely on rainfall and regular seasonal flooding of rivers and streams. Following the liberalization of imports of diesel engines and pumps for tubewell irrigation and expansion in fertilizer in the 1980s and with growing use of high yielding varieties of rice (HYV's), the area planted to boro increased sharply.23 The boro area has almost quadrupled since 1980, replacing the lower yielding aus rice crop (April-August) in many areas. In the meanwhile, as a result of concomitant productivity improvements, boro production has increased almost six-fold. The area planted to aman crop, in the meanwhile, has shrunk by about 10 percent and although its yield has improved the rate of improvement has been declining. 22 The dates of planting and harvest of the aman and other rice crops given in this section are indicative; actual dates vary slightly across Bangladesh. 23 Ahmed 2001. 57 Bangladesh: Strategy for Sustained Growth Table 2.3: Bangladesh: Area, Yield and Production of Rice and Wheat, 1981-2005 Annual Average Growth Rates 1981-90 1991-2000 2001-05 1981-90 1991-2000 2001-2005 Aus Production (th tons) 2992 1900 1781 -0.78 -3.27 -2.38 Area (th ha's) 2906 1655 1204 -2.75 -4.94 -5.23 Yield (tons/ha) 1.03 1.15 1.48 1.94 1.73 2.81 Aman Production (th tons) 7920 9127 10886 3.02 1.81 -0.59 Area (th ha's) 5872 5683 5593 -0.30 0.13 -1.49 Yield (tons/ha) 1.35 1.61 1.95 3.07 1.39 0.77 Boro Production (th tons) 4100 7745 12517 10.20 6.33 4.70 Area (th ha's) 1666 2863 3877 8.46 3.99 2.17 Yield (tons/ha) 2.46 2.71 3.22 1.58 2.16 2.46 Total Rice Production (th tons) 15011 18772 25184 3.71 2.75 1.86 Area (th ha's) 10444 10201 10682 0.33 0.24 -0.62 Yield (tons/ha) 1.44 1.84 2.36 3.36 2.46 2.46 Wheat Production (th tons) 1092 1400 1403 2.26 7.85 -11.64 Area (th ha's) 572 699 684 4.36 3.68 -7.61 Yield (tons/ha) 1.91 2.00 2.05 -1.88 4.04 -4.50 Total Production (th tons) 16103 20172 26587 3.56 3.00 1.07 Area (th ha's) 11016 10900 11367 0.46 0.44 -1.07 Yield (tons/ha) 1.46 1.85 2.34 3.06 2.52 2.12 Source: Staff calculations from BBS data. 2.11. Production of wheat (the second largest crop) has also seen a substantial increase since the early 1970s, although production levels have declined sharply after peaking in FY99 (Table 2.3). Wheat production increased from an average of about 100 thousand tons per year during FY70-75, to an average of more than 1.8 million tons in FY00, due to a seven-fold expansion in area and a doubling of wheat yields. Production growth was especially rapid in the 1970s (37 percent per year), as area increased by 19 percent per year and yields rose by 15 percent per year, and also in the 1990s when production increased by 83 percent and area under cultivation by 39 percent. In recent years, however, area under wheat production has declined from a peak of 0.9 million hectares in FY99 to only 0.6 million hectares in FY05, as area planted to boro rice, maize and potatoes expanded. In the meanwhile, per acre yield has dropped by more than 20 percent since FY99, resulting in halving of wheat output since then. 2.12. The long-term increases in rice and wheat production have resulted in declining domestic prices (Figure 2.1.).24 From the late 1970s to the early 1990s, real rice prices fell by about 30 percent. 24 Imports of rice over these periods were rather small (about 250 thousand tons per year in the 1980s and 700 thousand tons per year in the 1990s (Dorosh, 2001). 58 Chapter 2: Accelerating Income Growth in Rural Bangladesh Real rice prices have, more or less, leveled off since, although with substantial fluctuations. Nonetheless, real incomes of farmers who adopted new technology, particularly those who increased their area planted with boro rice, have improved in general. Farmers unable to adopt the new technology because of lack of irrigation, appropriate drainage or other constraints, particularly in southern and northeastern parts of Bangladesh, however, may have experienced declines in real incomes.25 Lower real prices would also have directly benefited consumers of rice, a staple for the majority. Moreover, the increased size of the rice harvest and the more even seasonal spread between the monsoon season (aman) rice crop and the winter season boro crop have helped prevent large spikes in price following years of drought or floods that damaged the aman crop.26 In addition, private sector rice imports (made possible by trade liberalization in the early 1990s) have added to price stability in years of poor rice harvests (FY95, FY98 and FY99), by keeping domestic prices from rising above the cost of imports.27 Figure 2.1: Bangladesh: Real Prices of Rice and Wheat, 1980-2003 28 _____________ 26 _____________ 24 ______________ 22 ______________ 18 ___________ 16 Real Rice Price 14 I- Ar 10 Y 8 1 v i___________ Note: Prices are deflated using the non-food Dhaka middle-income Cost of Living Index (and the national CPI after June 1998). Source: FPMU data and author's calculation. 2.13. Despite the improvements, rice yields in Bangladesh remain substantially lower than in the East Asian economies, although better than in India and Pakistan. Wheat yields, on the other hand, are significantly lower than both the South Asian and East Asian comparators. Average rice yields in Bangladesh are about 5 to 10 percent higher than in India and Pakistan, but 45, 20, and 25 percent lower than in China, Vietnam and Indonesia, respectively (FAO production data). Wheat yields in Bangladesh are about 30 percent lower than in India, 15 percent lower than in Pakistan, and are less than half of those in China. Rice cultivation in Bangladesh lacks the water control (in aus and aman seasons) and warm temperatures (in winter/boro season) enjoyed in the East Asian countries. In addition, fertilizer use is significantly lower than in China. Bangladesh, however, had higher yield growth of both rice and wheat over the 1980-2003 than India and Pakistan. 25 See Ahmed (2001) and Arndt et al (2002). 26 In addition, changes in cropping pattems resulting from an increase in minor irrigation and availability of modem varieties have reduced the susceptibility of Bangladesh agriculture to floods by leading to a reduction in deepwater (broadcast) aman rice, grown on flood-prone land during the monsoon season; and greatly increasing the quantity of rice produced within five to six months of any damaged monsoon season rice harvest (Hossain, Bose and Chowdhury, 2001; del Ninno, Dorosh, Smith and Roy, 2001; Chowdhury and Haggblade, 2000). 27 See Dorosh (2001). 59 Bangladesh: Strategy for Sustained Growth 2.14. Sustained increases in rice production through yield improvements are needed to keep real prices from rising, as well as to free up land for diversification into high-valued crops. The comparisons with the East Asian economies suggest that significant scope for further improving rice productivity exist. Apart from aman rice, few crops can be profitably grown on flooded land during the monsoon season (jute is an exception in some areas). Since only about half of the aman crop (53 percent in FY04) is cultivated with HYV varieties, (compared with 95 percent of boro), continued expansion of HYV cultivation in the aman season is one potential source of further rice productivity and production growth. In the winter season, many crops compete with boro rice, and greater diversification of agricultural production has the potential to increase rural incomes and lead to increased consumption of non-foodgrains in the citizens' diet.28 Table 2.4: Bangladesh: Area, Yield and Production of Major Crops, 1981-2005 Annual Average Growth Rates 1981-90 1991-2000 2001-2005 1981-90 1991-2000 1991-2005 Maize Production (th tons) 2 3 307 15.01 0.79 46.10 Area (th ha's) 3 3 55 6.19 -1.04 26.64 Yield (tons/ha) 0.76 1.05 5.66 8.30 1.85 15.36 Jute Production (th tons) 977 879 819 -0.06 -1.05 -0.89 Area (th ha's) 658 514 437 -0.95 -2.06 -2.12 Yield (tons/ha) 1.49 1.71 1.87 0.90 1.03 1.25 Sugarcane Production (th tons) 6970 7312 6642 0.32 -0.70 -1.05 Area (th ha's) 166 179 165 1.62 -1.03 -1.07 Yield (tons/ha) 41.99 40.83 40.20 -1.28 0.33 0.03 Pulses Production (th tons) 430 500 348 12.03 -2.09 -3.64 Area (th ha's) 619 666 449 11.19 -3.15 -4.36 Yield (tons/ha) 0.69 0.75 0.78 0.76 1.09 0.75 Oilseeds Production (th tons) 424 462 281 6.84 -0.20 -3.91 Area (th ha's) 496 544 365 8.15 -1.68 -3.81 Yield (tons/ha) 0.85 0.85 0.77 -1.21 1.50 -0.10 Potatoes Production (th tons) 1115 1715 3376 0.55 8.37 9.66 Area (th ha's) 107 153 251 0.00 6.30 6.99 Yield (tons/ha) 10.59 11.11 13.44 0.55 1.95 2.50 Source: Staff calculations from BBS data. Note: Data for jute, sugarcane, pulses, oilseeds and potatoes are through 2003/04. 28 Note also that there remains a substantial yield gap between national average yields and experiment station results ranging from 29 percent for boro to 53 percent for aus (Revitalizing the Agricultural Technology System in Bangladesh, World Bank, 2005). Part of this yield gap is due to improved management, which may require increased labor and other inputs that are not necessarily financially optimal from the farmers' perspective. 60 Chapter 2: Accelerating Income Growth in Rural Bangladesh Other Crops 2.15. Maize production has expanded by nearly 100 times in the past seven years (Table 2.4), with area cultivated and production increasing from only 2.8 thousand hectares and 2.6 thousand tons in FY98 to 102 thousand hectares and 230 thousand tons in FY05. Maize production has benefited from dissemination and adoption of highly profitable hybrid seeds (essentially all maize in Bangladesh is now planted with hybrids) and ample domestic demand for poultry feed. Production is concentrated in the northwest corner of Bangladesh (Thakurgaon, Panchogarh, Dinajpur, Nilphamari) and in parts of western Bangladesh (Kushtia and Jessore). 2.16. Potato production increased by 7.0 percent per year from FY90 to FY04. Area planted to potatoes surged by 120 thousand hectares (an 80 percent increase) in FY99 after the opening of the Jamuna bridge that helped connect potential growing areas around Bogra with the Dhaka market. Since then, area under cultivation has remained steady, but production has continued to increase due to yield increases; yield increased by 28 percent between FY99 and FY03. 2.17. In contrast, area and production ofjute, sugarcane, pulses and oilseeds have declined over the last 15 years. Area planted to jute, once a major export of Bangladesh, declined by an average of 0.9 percent per year between FY90 to FY04. Likewise, area planted to sugarcane declined by an average of 1.1 percent per year. The declines in pulses (3.6 percent per year) and oilseeds (3.9 percent per year) were even steeper, as there has been little improvement in technology in these crops, unlike in rice, wheat, maize and potatoes. Non-Crop Agriculture 2.18. Non-crop agriculture, fish and poultry in particular, has shown good growth since the early 1990s and continues to hold significant potential for growth, although there are emerging concerns that need to be addressed. The fish sub-sector, nearly 80 percent of which derives from inland water (i.e. rivers, ponds, flood plains, etc.), grew at a rapid pace of 8 percent per year during the 1990s, but then experienced a major setback in 2001 with a 4.5 percent decline in output; growth has since recovered somewhat to about 3 percent. In the 1990s, fish output was buoyed by doubling of frozen food exports (mostly shrimps) during the first half of the 1990s. Shrimp exports - the second largest source of foreign exchange and employer of about 600,000 workers - fell during FY96-99 due in large measure to problems in meeting sanitary and phyto-sanitary (SPS) requirements of importers, and remained at the FY96 level through FY03. It also appears that expansion of the poultry industry may be slowing down on account of subdued demand and high cost of feed. Fish and Shrimp29 2.19. Fish production has increased rapidly since the early 1990s, mainly due to increases in aqua- culture (fish raised in ponds); output of the capture fisheries sub-sector has stagnated. Within this basic division between aqua-culture and capture fishing, there are also substantial differences in the types of fish, production growth rates, and distribution of benefits between inland aquaculture (fresh water fish ponds) and brackish-water aquaculture (mainly shrimp), and between inland capture fisheries (rivers, floodplains, ox-bow lakes and the Sundarbans) and marine capture fisheries (including both trawling, i.e. Industrial coastal fishing and artisanal, i.e. small-scale fishing) (Table 2.5). The aquaculture sub-sectors 29 This section is based largely on the World Bank Bangladesh Water CAS (2005), supplemented with material from other major studies on fish and shrimp in Bangladesh, including Collis (2004), Revitalizing the Agricultural Technology System in Bangladesh (World Bank 2005), Cato and Subasinge (2004), and Dobson and Quader (2004). 61 Bangladesh: Strategy for Sustained Growth (inland and brackish water) have the potential for significant sustained growth. Capture fishing, by contrast, is likely to continue to stagnate. Table 2.5: Projections of Fishery Sector Output (tons) 2002 2012 (estimate) Annual change (mt/year) (mt/year) (%) Inland aquaculture 850,000 1,465,744 5.6 Coastal aquaculture 94,580 129,597 3.2 Inland capture fisheries 750,419 606,919 -2.1 Coastal/marine capture fisheries 589,500 501,689 - 1.6 Total 2,284,499 2,703,949 1.5 Source: Fisheries Sector Review and Future Development (FSRFD); World Bank Bangladesh Water Country Assistance Strategy 2005. Aquaculture Fisheries 2.20. Production of both inland and brackish-water aquaculture has grown rapidly since the early 1990s - at over 10 percent per year. Most of the growth has derived from utilization of existing ponds and established technologies. Relatively high growth rates are expected as long as internal prices remain stable and shrimp exports are not reduced. Projections by a Fisheries Sector Review and Future Development (FSRFD) study suggest medium term growth rates of 5.6 and 3.2 percent per year for inland and coastal aquaculture, respectively (Table 2.5). 2.21. Inland aquaculture is the largest source offish production amongst the various fisheries sub- sectors, production in 2002 stood at an estimated 850,000 tons with over 80 percent from small holder- pond polycultures. (Other areas of importance include seed production, pen and cage culture and commercial aquaculture.) New ponds continue to grow at a rate of 2 percent or more per year. Small pond carp polycultures will continue to offer the greatest potential for expansion and increased production within the sector. Fresh water shrimps (golda) are cultivated by about 105 thousand farmers, with total production of about 10 thousand tons,30 about 1 percent of total inland aquaculture production by weight. Integrated rice-aquaculture systems have proven highly productive, although on an, as yet, limited scale. 2.22. Brackish-water aquaculture produces shrimp, prawn and fish, and is expected to double its small base (almost 95,000 tons in 2002) over the next decade, although much depends on the ability to meet SPS requirements of importers. Tiger shrimp (bagda) produced by this technique comprise most of Bangladesh's shrimp exports. 2.23. There is a strong need and, fortunately, significant potential remains for improving productivity in shrimp production. Since total pond area is not expected to increase significantly, major increases in total shrimp production will have to come through increased productivity per hectare. Current productivity in Bangladesh shrimp production (100-150 kgs/hectare) is far below that of Thailand (4-7 tons/hectare), the leading shrimp exporter.31,32 Raising productivity is possible through increased support of extension, improved pond construction, better hatchery and water management, reduced Post Larvae (PL) mortality, and improved stocking ratios. Most important are improvements in post harvest handling to raise quality and safety of the final products, issues of major concern to international buyers (see Annex Table 2.1). 30 Collis (2004), p. 89. 31 Dobson and Quader, 2004. 32 Collis (2004) reports a somewhat higher average yield of 214 kgs/hectare in 2001/02 (See Table 9). According to the Bangladesh Shrimp Foundation, yields in Bangladesh are about 250 Kg/ha compared to 1000 Kg/Ha in India. 62 Chapter 2: Accelerating Income Growth in Rural Bangladesh 2.24. Key issues in the sub-sector - particularly for poorer farmers - are (i) availability of information, (ii) extension support and (iii) quality of available fish seed and access of the poor to production units. Landless and marginal farmers and the fish seed industry will require additional investment and technical support. Government-NGO partnerships have proven to be the most effective means for promoting and improving smallholder aquaculture. Capture Fisheries 2.25. Open water capture fisheries - a major income source for the rural landless poor - have been in decline in recent years. Catches of the critically important hilsa, Indian Salmon, the major carps (Rui, Catla, Mrigal and Kalabaus) among others have declined precipitously. Production losses in inland capture fisheries have been on account of habitat loss, reduced dry season flows and unregulated over- fishing as wetlands and other aquatic resources are lost to infrastructure, agriculture, urbanization and increasing pollution. Portions of the marine capture fisheries - inshore coastal and tiger shrimp capture - are also experiencing a decline, which is especially worrisome as the sub-sector is a primary source of income and nutrition for at least half-a-million households in the coastal region and also employs about 0.4 million poor in seasonal shrimp larvae collection. 2.26. Key issues for the sustainable use and preservation of the capture fisheries include maintenance of dry season flows, protection of key aquatic habitats, creation and maintenance of fish sanctuaries, limitation to further disruption of migratory pathways and avoidance of further pollution and chemical degradation. In addition, the future of the sub-sector will require a reduction of fishing effort. Recent small scale efforts have shown that communities working with local governments are capable, with technical and other support, of managing local resources in a sustainable manner. Livestock and Poultry 2.27. There has been virtually no growth in the number of large animals (mainly cattle and dairy cows) since the early 1980s. This is a significant loss to the rural economy. High cost of feed and fodder, and productivity and animal losses from disease are major constraints on production. In addition, shortage of veterinary personnel and equipment to prevent and treat infectious diseases contributes to high mortality rates of animals.33 Increasing the number of improved breed cattle appears to be a priority for raising productivity in the sector. 2.28. The formal sector commercial dairy market is growing rapidly and increasing its relatively small market share, while the markets for meat remain almost entirely in the informal sector. As recently as 2000, the informal sector accounted for more than 95 percent of total milk marketed. In recent years, however, formal sector enterprises have established chilling centers, and milk collection networks linked to village milk co-operatives. BRAC Dairy now sells 40-45,000 liters of milk per day, equivalent to 20 to 25 percent of the commercial milk market.34 2.29. In contrast to large livestock, the poultry sector, particularly chickens and eggs, has seen good growth. Chicken meat and egg production each rose by 6 percent per year between 1986 and 1996. Figures for later years vary widely according to source. FAO data indicate a slowdown in growth since 1997, while BBS figures indicate an average annual growth rate of 6.7 percent from 1995 to 2000. Estimates from the Bangladesh poultry association suggest growth rates closer to those of BBS. Urbanization and rising incomes are the major forces driving increased demand for poultry products in 33 Control of disease is complicated by the unregulated cross border import of livestock from India (Alam (1997)). 34 Sales of other processed products such as yoghurt and flavored milk are also increasing rapidly, and account for about 20 percent of BRAC Dairy's sales. (Source: interviews with BRAC Dairy, 2005). 63 Bangladesh: Strategy for Sustained Growth Bangladesh. Since most commercial demand is concentrated in major urban centers, poultry production on the approximately 65,000 commercial farms is largely a peri-urban activity. 2.30. Indications are that expansion of the poultry industry may be slowing down, as it confronts lingering concerns. According to the Bangladesh Poultry Association, operators of about 800 - 1,000 medium-sized poultry farms have appealed to the government for assistance with servicing their outstanding debt from commercial sources. Demand fluctuations (related to consumer fears surrounding the Asian bird flu) are reported as major reasons for some recent failure of poultry operations. 2.31. High costs of maize and soybean meal have also slowed growth in recent years and also threaten the competitiveness of the poultry sector in the medium-term.35 Informal estimates by the Poultry Association suggest that imports (about 60 percent from India) account for about half of total annual use of maize as poultry feed.36 Partly as a result of the transportation and marketing costs involved in importing, maize prices in Bangladesh are about 30 percent higher than in India and also higher than in other maize exporting countries, putting domestic poultry producers are at a disadvantage. It is estimated that higher costs of feed add about 20 percent to the production cost of layers and 8 percent to the production cost of broilers relative to the producers in India.37 III Rural Non-Farm Sector38 2.32. The rural non-farm sector accounts for more than 40 percent of all rural employment and more than half of rural household income, and is growing fast. The RNF sector here is defined as all activities located in villages, rural towns, and peri-urban areas excluding the primary production of crops, fish, trees, and livestock. The number of non-farm enterprises increased from about 2 million in FY90 (BBS Integrated Annual Survey of Non-Farm Activities (IASNF)) to about 4 million in 2003 (National Private Sector Survey of Enterprises in Bangladesh (NPSEB)). Annex Table 2.4 describes the main characteristics of the micro, small, and medium enterprises, including those in the rural areas. These data also suggest that employment in rural non-farm activities increased from 5 million to 9 million over the same period. As in many other developing countries, wholesale and retail trade is the most common non- farm activity, with about 57 percent of rural firms engaged in this sector. Another quarter of the enterprises in rural areas are manufacturing firms. 2.33. A number of key investment climate weaknesses are holding back the growth potential of the rural non-farm sector. The micro, small and medium (MSM) enterprises in non-farm sector, (which constitute almost all of the rural non-farm enterprises) appear to be lacking access even to basic factors of production and services (Table 2.6). Only 31 percent of rural enterprises reported having utility connections, compared with 60 percent in urban metropolitan areas.39 Moreover, only about 2 percent of the MSM firms have own generators40 and only 1.5 percent have access to a phone. About one quarter of rural enterprises said they had access to formal credit, which was significantly higher than for the urban areas. The widespread and rapidly growing availability of micro-enterprise lending by NGOs appears to be the driving force behind the higher access in rural areas. 3 High cost of medicines and vaccines imported from the European Union and the Unites States also contribute to high costs of poultry production in Bangladesh. 36Note that official data seriously under-report maize imports. 3 See Quasem and Islam (2004), p. 348. 38 This section is based on Promoting the Rural Non-Farm Sector in Bangladesh, World Bank, 2004. 39 The estimate of utility connection may be an under estimate as it is derived from responses of the enterprises about their expenses for utilities. 40 This compares to 72% of in the Investment Climate Assessment (ICA) Survey, 2003, which collected information on larger firms located in Dhaka and Chittagong. 64 Chapter 2: Accelerating Income Growth in Rural Bangladesh Table 2.6: Bangladesh: Access to Services and Credit by Micro, Small and Medium Enterprises Rural Other urban Peri-urban Metropolitan Total Enterprises with Access to Services (%) Utility Connection 31.49 59.65 57.05 59.88 40.00 Generator 1.81 3.96 3.40 4.15 3.00 Phone 1.51 5.94 4.54 9.79 4.00 Registered 13.20 37.93 22.05 41.78 21.11 Association Member 16.21 25.08 16.04 21.95 18.41 Access to Credit (%) None 41.25 47.03 54.62 49.06 43.74 Informal 22.23 20.96 27.23 32.86 23.71 Formal* 24.62 20.02 9.89 11.02 21.45 Both 11.90 11.99 8.27 7.06 11.10 *Formal includes micro-lending by NGOs. Source: the Rural Non-Farm Sector in Bangladesh, World Bank, 2004; WB Staff estimates based on NPSEB (2003). 2.34. Average labor productivity of rural MSM firms is estimated at only about 60 percent that of urban firms. Estimates of total factor productivity (TFP) are broadly similar across regions and sectors, but difference among firms within a particular region and/or sector spear to be large. Analysis shows that access to markets, access to services and to formal finance, education of the proprietor and access to a network for contract enforcement are all statistically significant determinants of TFP, after controlling for 41 other firm characteristics. It is worrisome, therefore, that more than half of the firms covered by the NPSEB reported lack of access to finance as the biggest problem in starting an enterprise, and about 44 percent of firms reported it as the biggest problem in running an existing firm. Floods and disasters, availability of electricity, and road conditions were also identified in the NPSEB as severe problems by at least a third of respondents. IV Implications for a Rural Growth Strategy 2.35. Agricultural growth remains crucial for rural poverty reduction in Bangladesh, and rice production will continue to play an important role. The development strategy should neither neglect nor over-emphasize the rice sector, however. Bangladesh has a comparative advantage in rice production, particularly in the aman season, when there are few profitable economically viable alternatives to rice cultivation on flooded land, the economic potential of which needs to be exploited. Even though urbanization and related shifts in diets are mitigating factors, growth in overall population and rural incomes can be expected to lead to increased demand for rice. Background projections for this report suggest that total demand for rice is likely to increase by 30 to 40 percent over the next two decades, even with constant real prices. The emphasis would have to be on improving productivity, which would also free up resources for use for non-rice crops.42 For this, expanding the use of the HYV variety of rice to the aman crop (where HYV is being used in only half of the area) holds most promise. 41 For further details on the TFP calculations see Promoting the Rural Non-Farm Sector in Bangladesh, World Bank, 2004, Vol II., pp. 46-48. 42 Development of shorter-season rice varieties and greater use of mechanization could permit expansion of non-rice crop area and production (mainly in the winter season) while maintaining adequate domestic rice production. Shortage of water in the winter season and problems of flooding and drainage in the monsoon season are perennial issues that remain unresolved in many regions of the country. Increasingly frequent localized water shortages (declining water tables) in the winter season add to the costs of irrigation and reduce the profitability of boro rice in some regions, favoring the production of less water-intensive crops. 65 Bangladesh: Strategy for Sustained Growth 2.36. Ultimately, raising real agricultural incomes in Bangladesh will require more diversification into higher-valued crops and increased output of the fishing, poultry, and livestock sub-sectors. Analysis of comparative advantage suggests that in the winter season, production of most non-rice crops (including wheat, pulses, potatoes and many vegetables) is economically efficient.43 Marketing constraints including shortage of cold storage facilities and a functioning cold chain, lack of grades and standards, insufficient processing capacity and, to some extent, weak consumer demand related to low incomes and consumer preferences, remain a major constraint, however. Transport bottlenecks also slow delivery of fresh vegetable products and lead to reduced quality and sales price. Promoting development of more vertically integrated marketing systems through NGOs (e.g. BRAC), private firms (including supermarkets) through improvements in road and electricity infrastructure, and in local governance can help spur the necessary private investments. Medium-term prospects for the poultry sector and the commercial dairy sector are also good, benefiting from rapid urbanization and rising per capita incomes. The country needs to be vigilant against outbreaks of poultry diseases (including the Asian bird flu), and provide improved veterinary services, in general. 2.37. Bangladesh appears to have a long-term competitive advantage in inland aquaculture. Even if past declining trends for inland and marine capture fisheries continue, as is expected, fish production as a whole can still be expected to grow as long as inland and coastal aquacultures continue to do well. In addition to research, information, and extension support from the Government, growth in aquaculture will need improvements in post-harvest handling and marketing and distribution of better quality fish seeds. Coastal shrimp and prawn aquaculture are typically profitable and practitioners are, for the most part, able to finance their own activities - special attention is needed, however, to protect the rights of small farmers and landowners, particularly in coastal areas. Although much of the direct income from production accrues to the land-owners, there are still major pro-poor employment and income effects in the provision of inputs (e.g. capture of wild shrimp post-larvae (PLs) by poor households) and processing. Shrimp exporters also have a role to play.44 First, they will need to adhere to self-imposed standards and the recognition and acceptance of third-party certification process by importers and regulatory agencies in importing countries. Second, in the medium-term, farmers need to adopt semi-intensive and intensive methods of shrimp farming in place of the prevalent practice of extensive practice. 2.38. The Government's role in promoting agricultural diversification is important, albeit limited. In particular, a significant expansion in agricultural research and extension efforts is needed in rice as well as high value added crops, livestock and fish. Bangladesh currently spends only about 0.2 percent of agricultural GDP on agricultural research, compared to an average of 0.6 percent of agricultural GDP for all developing countries. Given the importance of agriculture and also the potential for future productivity gains, a medium term target of 2.0 percent of agricultural GDP seems appropriate. Establishment of an endowment Trust Fund, and institutional reforms to increase stability of funding and to strengthen research management, (including renewed efforts at prioritizing research) could substantially increase the effectiveness of public research and extension expenditures.45 2.39. In addition to agricultural research and extension, public investments 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 risk for non-rice crops, particularly highly perishable fruits and vegetables, and improve farmer incentives for expanded production. Government also has an important 43 Shahabuddin and Dorosh (2004). 44 Bangladesh: Growth and Export Competitiveness, World Bank, 2005. 45 Revitalizing the Agricultural Technology System in Bangladesh. Bangladesh Development Series (paper no. 7), World Bank. 2005. Dhaka, Bangladesh: World Bank office. 66 Chapter 2: Accelerating Income Growth in Rural Bangladesh role in providing a growth-friendly institutional environment "rules of the game" for agro-food system and agro-enterprise development (see Box 2.1 for relevant lessons from a recent study for India). Box 2.1: Role of Government in Agro-Food System and Agro-enterprise Development Setting and ensuring enforcement of transparent and consistent 'Rules of the Game' * Establish and enforce rules which define and allocate property rights (i.e. property and bankruptcy laws; intellectual property rights; zoning regulations). * Establish and enforce rules which define permissible and non-permissible forms of cooperation and competition (i.e. licensing laws, laws of contract and liability, company and cooperative laws; anti-trust laws). * Establish and ensure compliance with bio-safety, food safety, worker safety, and sanitation regulations. * Negotiate favorable terms for access to international markets and ensure fair practices on the part of international trading partners. Addressing market failures * Ensure that the country is protected from the harmful introduction/spread of plant pests and animal diseases. * Ensure the availability of (production, price, industry) information and statistics to facilitate market activity and to monitor market progress. * Invest in or facilitate risk management instruments for agribusiness system participants (e.g. futures contracts, options, negotiable warehouse receipts, crop insurance). * Compensate for unbalanced power relationships within the agribusiness system by monitoring potential abuses of market power, by providing training and information, and/or by supporting organizational development among weak participants. * Compensate losers in structural reform processes through safety nets and other transitional targeted programs. Building physical and knowledge capital * Invest in social overhead infrastructure, especially that related to transport, and energy. * Invest in knowledge-building to accelerate the agribusiness learning process and better enable the emergent private sector to participate/compete (i.e. R&D; academic/technical training). * Facilitate development of agricultural marketing facilities (i.e. marketplaces; wholesale markets). Source: India Re-energizing the Agricultural Sector. World Bank. 2004. Report No. 27889-IN. 2.40. Improved marketing infrastructure will also promote growth of non-crop agriculture, including the poultry and fish, as well as the rural non-farm sector. Meeting the growing demand for meat and eggs deriving will require steady increases in the supply of day-old chicks and feed (currently largely based on imported maize). Extension efforts are needed to ensure that poor rural households have access to technology in production and processing.46 2.41. Policies and investments outside the agricultural sector are also key to promoting non-farm growth. There is an urgent need to improve rural access to finance and electricity. Although, large farmers have access to formal credit and poor households can often obtain micro-credit, small and medium farmers have difficulty obtaining credit for production activities. Similarly, small rural non-farm enterprises report access to credit as a major constraint to establishing and operating a firm. Furthermore, the experience of Latin America and the Caribbean suggests that improvements in education, transport infrastructure, and engines of non-farm growth that promote female employment can be important components of a successful strategy to promote non-farm growth and rural poverty reduction.47 46 Sen (2003). 47 Berdegue, Reardon, Escobar (2000), and India Re-energizing the Agricultural Sector, World Bank. 2004. Report No. 27889-IN. 67 CHAPTER 3: THE LABOR MARKET - TRENDS, CHARACTERISTICS AND CHALLENGES I. Introduction 3.1. Labor it is often said is Bangladesh's most precious 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. Of course, global comparative advantage does not automatically translate into global competitiveness, which depends on a host of factors that affect productivity. Productivity in Bangladesh does suffer from a number of problems that are highlighted in the other chapters of this report. Are there inefficiencies in the labor market itself which undercut overall productivity of the economy? This chapter assesses the key labor market trends and characteristics in seeking to answer this. 3.2. Creating productive employment opportunities for a rapidly growing labor force clearly is a major challenge for the Bangladeshi economy. Its substantial labor force of about 50 million is growing at a rapid 3 percent per year - adding just under 2 million workers each year.48 The rapid labor force growth derives from two main sources: the demographic transition which is resulting in a surge of youthful entrants into the labor market, and; the sharp increase in female labor force participation since the mid-1990s. Expectedly, given Bangladesh's low development level, almost half the labor force is still in the agriculture sector and three-quarters are in rural areas. At the same time, the labor force appears to be in the midst of transitioning from rural to urban areas, consistent with the overall economic shift that is discussed in Chapter 5, and from agriculture to rural non-farm activities. 3.3. Despite the considerable pressures, labor market outcomes have been generally favorable. For one, most new entrants between 2000 and 2003 (the years in which the latest available Labor Force Surveys were conducted) were able to find a job, keeping the unemployment rate at about 4 percent. However, this is slightly tempered by the fact that the entrants were partially accommodated by sharing some of the existing jobs, as indicated by a decline in the average hours worked per week per worker in all economic sectors during 2000-03. Rising real wages across the major economic sectors provide further evidence of labor market tightening despite the rapidly growing labor supply. 3.4. At the same time though, some important aspects of the labor market deserve closer 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 levels of the self-employed workers (who account for almost half the workforce) appear to have declined over the 2000-03 period. 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 picking up - in fact, data for the 2000-2003 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". 3.5. 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, as highlighted by the fact that almost 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 48 The 2002-03 Labor Force Survey (LFS) estimated the labor force size at 46 million. It also estimated the annual increase in labor force at over 1.5 million, which would imply a labor force of over 50 million today. 69 Bangladesh: Strategy for Sustained Growth the relevance of their skills is questionable. The low quality of the vocational education and training (VET) system is reflected by its low capacity utilization and pass rates and also by the weak demand for its graduates. A tracer study shows that less than 10 percent of VET graduates were employed over two years after the survey, while close to half the graduates took at least a year to find a job, and this in an economy where skills are deemed to be acute shortage. Not only that, wages of VET graduates apparently are lower than those of graduates from the general education system.49 3.6. Other key identifiable distortions in the labor market include: * 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 sharper at the lower-end (classes III and IV) public sector jobs. Not only does this lead to rationing of the high premium public sector jobs, it also distorts wage signals across the economy. * Another segmentation is between urban and rural areas: Econometric analysis in this chapter 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, 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 improve this. * Female workers continue to face considerable barriers. 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 could be speeded up. 3.7. On balance, labor laws and regulations do not appears to be serious hindrances to the functioning of the labor market, although worker rights need better protection. 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. Overall, firms retain considerable flexibility to hire and fire, as 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 from government restrictions which the ILO's Committee of Experts on the Application of Convents and Recommendations has deemed excessively restrictive. 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 recent impasse in the RMG sector over worker demands for higher minimum wages highlights the costs of the latter problem. It is not clear though whether the resolution to this is government intervention and, if at all, in what shape and form. II. Labor Market Trends in Bangladesh Long-term Demographic Trends: Transition to a Younger, More Gender-Balanced, and More Urbanized Population 3.8. Bangladesh's population has almost tripled since 1960 - increasing from 52 million inhabitants to over 140 million. Female population has grown faster than male population, reflecting the impressive underlying improvements in gender parity, with the share of female population in total 49 The Bangladesh Vocational Education and Training System: An Assessment, World Bank, 2006. 70 Chapter 3: The Labor Market: Trends, Characteristics, and Challenges population increasing from 47 percent in 1960 to 49 percent in 2005, slightly higher than in India and Pakistan. Bangladesh has experience the biggest increase in the ratio in the South Asia region since 1960 (Table 3.1). This is an impressive, if somewhat underreported, achievement that benefits from increasing empowerment of females in the social sphere - female primary enrollment rates are higher than male enrollment rates, for example. The rapid urbanization of the population is discussed in Chapter 5. Table 3.1: Ratio of Female Population to Total Population 1960 1970 1980 1990 2000 2004 Bangladesh 47.3 47.9 48.2 48.5 48.8 48.9 India 48.4 48.3 48.2 48.4 48.6 48.7 Nepal 49.8 49.8 49.5 49.6 50.3 50.4 Pakistan 47.8 48.1 48.3 48.4 48.5 48.5 Sri Lanka 47.7 48.1 48.5 48.8 49.1 49.2 Source: World Development Indicators, World Bank 3.9. The growth of the working-age population has outpaced that of the population as a whole. While total population has increased by about 70 percent between 1980-2005, working-age population (those in the 15-64 age group) practically doubled - increasing from 44 million in 1980 to 86 million in 2005. Demographic factors such as increased life expectancy and markedly lower infant mortality have offset the slowdown in population growth (from 2.5 percent in the 1980s to about 1.5 percent), resulting in working-age population growth remaining largely unchanged at about 3 percent per annum.50 Under-5 mortality rates fell from 205 per 1,000 live births in 1980 to 77 in 2004; one of the fastest rates of decline in the developing world.51 Life expectancy at birth increased from 49 years to 64 years over the same period. The labor dividends from the ongoing demographic transition are expected to continue for a considerable, although at a declining rate. The growth rate of working-age population is expected to slow down to 2 percent a year in the coming years. Still, more than one-third of the population is currently under the working age, a sizable pool to feed robust labor supply growth. Under certain baseline assumptions, the working-age population is expected to increase by 65 percent by the year 2040.52 Figure 3.1: Age-Wise Demographic Trends in Bangladesh -#-Total Population -.-Population aged 0-14 --Population aged 15-64 -x-Population aged 65+ Source: World Development Indicators, World Bank 50 Working-age population estimates vary by source. While the World Bank's WDI data show average 2.7% growth during the 1990s (virtually the same as in the 1980s), the ILO and the US Census Bureau each report the growth rate at about 3.4 percent, about one percentage point higher than the average growth reported by the ILO for the 1980s. 51 Even so, Bangladesh still has long ways to go. Just to meet its MDG, Bangladesh needs to lower the U-5 mortality rate to 48 by 2015. After that a target rate of 15 - the current rate of Sri Lanka - or less can be set. 52 The precise demographic assumptions - regarding birth and death rates, population growth, fertility rates, infant and child mortality, and life expectancy - can be found in the World Bank's SIMA database. 71 Bangladesh: Strategy for Sustained Growth Labor Force and Employment Trends A rapidly growing labor force 3.10. The 2003 LFS estimated the size of the economically active population, or the labor force, to be 46.3 million - or about 57 percent of the working-age population (Figure 3.2.a) . Reflecting the predominantly rural population in Bangladesh, 76 percent of the labor force resided in rural areas. The female labor force was estimated at about 10 million, or 22 percent of the total labor force. Consistent with the demographic trends, survey results showed the labor force to be quite young, with over half the workers falling in the 15-34 age group (Figure 3.2.b). Figure 3.2.a. Labor Force Trends Figure 3.2.b. Age Profile of Labor Force 20 3 Female 20 0 Male 1996 Source: Bangladesh Labor Force Surveys (various years) 3.11. The labor force has grown at a fast pace, reflecting both the rapidly increasing working-age population and, more recently, sharp increases in the female labor force participation rate (LFPR). As the working-age population increased by over 11 million between 1996-2003,54 the labor force increased by over 10 million (Figure 3.2.a); 4.6 million between 1996-2000 and another 5.6 million between 2000- 2003, with average annual labor force growth of 3.6 percent over the 1996-2003 period. Consistent with the overall population patterns, the labor force is also becoming increasingly urbanized - urban labor force's share in total increased from 23 percent to 24.5 percent over 1996-2003. 3.12. The female labor force almost doubled in size between 1996-2003 to 10 million, while the male labor force grew by just 17 percent. The female labor force grew at an astounding annual rate of 14 percent over 1996-2000, which then slowed down a bit but still remained high at 7 percent during the 2000-2003 period. The LFPR increased sharply for females in urban and rural areas, and in both areas the increase was more pronounced in the 1996-2000 period than the 2000-2003 period (Figure 3.3.a). Almost 4 million additional female workers entered the labor force during 1996-2003 due to the increase in the female LFPR alone. Nonetheless, because of the low starting base, the female labor force remains less than a third of the male labor force of 36 million. In the meanwhile, the male LFPR remained virtually unchanged over 1996-2003. 53 The LFS also counts those aged 65+ years as being part of the labor force. This group, with 2.3 million persons, comprises just 5% of the total labor force though. 54 The increase in the population aged 15+ during the 1996-2003 period was 11 million as per the LFS and 15 million as per the World Development Indicators. 72 Chapter 3: The Labor Market: Trends, Characteristics, and Challenges Figure 3.3.a Changes in LFPR Over Time Figure 3.3.b: Age-LFPR Relationship 199620 -*-Urban Male --Rural Male -1- Urban Female -.- Rural Female Source: Bangladesh Labor Force Surveys (various years) 3.13. The age patterns of LFPRs differ considerably between male and female workers (Figure 3.3.b). The male age-LFPR relationship has an inverse-U shaped pattern. The youngest and oldest male workers have the lowest LFPR. LFPR for males in the 30-54 age group was close to 100 percent and over 97 percent for the 55-59 age group. Two-third of males work even after the age of 64. LFPR for those in the 15-19 year age-group was only 50 percent, reflecting in part school enrolment. The LFPR pattern is almost identical for rural and urban males, with the LFPR of urban youth being lower, reflecting differences in school enrolment. The age-LFPR relationship for female workers shows a different pattern and also some urban-rural variation. For one, the female LFPR is significantly lower than the male LFPR for all age groups. The urban female LFPRs are higher for all age groups except the 15-19 age group, as girls in urban areas are more likely to be enrolled in school. LFPRs for both rural and urban females drop precipitously from the 15-19 age group to 20-24 age group, from about a third for urban females and 40 percent for rural females to around one-quarter for both, most likely because of marriage. For rural females, the LFPR then remains virtually constant till age 39, while for urban females it increases a bit in that interval. The LFPRs for both groups decline from the 40-44 age group onward. Employment and underemployment trends 3.14. The Bangladeshi economy added 5.3 million (9.5 million) new jobs over the 2000-2003 (1996- 2003) period. This is a sizable number, although it still falls short of the 5.6 million (10.2 million) new entrants into the labor force. As seen in Figure 3.4, new jobs for females kept pace with the increase in female entrants in the labor force during the 2000-2003 period, whereas half-a-million new male entrants into the labor force were not accommodated. A further breakdown reveals that 2 million new jobs were created in urban areas, where the labor force increased by 2.1 million, while 3.3 million new jobs were created in the rural areas, where the labor force increased by 3.5 million. 73 Bangladesh: Strategy for Sustained Growth Figure 3.4: Job Creation Vs. New Labor Force Entrants ~) 0 0 EE z z z Source: Bangladesh Labor Force Surveys and World Bank Staff calculations 3.15. Unemployment rates in Bangladesh, as in the majority of the LICs, have been consistently low. Standard definitions of unemployment consider any person of age 15 years or above as unemployed if he or she did not work at all during the preceding week of the survey and was actively looking for work. As per this definition, 2 million persons, or 4.3 percent of the labor force, were unemployed in 2003 (Table 3.2). The unemployment rate increases with the education levels of the labor force, reflecting the fact that the more educated workers have higher reservation wages and are less willing to compromise on the quality of the job they accept. Also, those who go for higher studies often come from more well-off backgrounds and can afford to hold-off working longer. At 8.3 percent, the unemployment rate was the highest among the 20-24 age group. Table 3.2: Unemployment rate among labor force by level of education and sex Bangladesh Urban Rural Both Male Female Both Male Female Both Male Female sexes sexes sexes Per cent Total 4.3 4.2 4.9 5.0 4.6 6.2 4.1 4.0 4.4 No education 3.4 3.4 3.6 3.2 3.1 3.5 3.5 3.4 3.6 Class I-V 3.3 3.1 4.3 3.3 2.9 4.5 3.4 3.1 4.2 Class VI-VIII 3.9 3.8 4.3 4.3 3.9 5.6 3.8 3.8 3.7 Class IX-X 5.6 5.7 5.2 6.2 6.3 6.0 5.3 5.4 4.8 SSC, HSC & 7.8 7.0 11.7 8.7 7.7 12.9 7.2 6.6 10.7 equivalent Degree & 9.5 8.1 17.4 7.7 6.2 14.7 12.0 10.6 22.8 above Others 9.6 8.9 15.7 9.0 5.7 31.2 10.0 11.0 0.0 Source: Bangladesh Labor Force Surveys (various years) 3.16. The open unemployment estimates based on the standard definition of unemployment besides being exceptionally low do not change much over time and as such are not very informative. By focusing on only those who did not work at all, the unemployment indicator misses the inefficiencies in the labor market that affect the majority of the labor force who are looking for more substantial work hours. For this reason, the underemployment rate is considered a more meaningful indicator of the labor market condition. 74 Chapter 3: The Labor Market: Trends, Characteristics, and Challenges 3.17. Unfortunately, data quality and definitional problems preclude a meaningful assessment of the underemployment trends in Bangladesh. The LFS considers as underemployed anyone who is part of the labor force but did not work for at least 35 hours a week, regardless of whether or not the person was willing to work for 35 hours or more. Furthermore, comparability between the 2000 and the 2003 surveys is rendered difficult by the fact that while the former was conducted on a rotating basis covering the entire year, the latter was conducted only during the months of October and November - a slack period for agriculture, which would result in overestimation of underemployment. Therefore, even though the 2003 LFS reports an increase in underemployment over the 2000-03 period, from 16.6 percent in 2000 to 37.6 percent in 2003, it is not at all clear whether this is reflects actual increase rather the seasonality in data collection and/or the fact that female workers - who are increasing their share in the labor force - often tend not to look for full-time work to balance competing work pressures at home. III. Employed Labor Force Characteristics Sector composition of the employed labor force 3.18. The agriculture sector has the highest share of the employed labor force, as in other most other low-income economies. In 2003, despite accounting for just 21 percent of GDP, agriculture sector accounted for 52 percent of the labor force, up from 49 percent in 1996 (Figure 3.5). The increase in agriculture's share over 1996-2003, as suggested by the LFS results, is counter-intuitive though as it came at a time when agriculture's share in GDP fell from 25 percent to 21 percent. It is also in sharp contrast with recent analytical work (based on a separate survey of rural population) that shows a rising role of non-farm activities in rural employment.55 On balance, the evidence is more compelling that the employment share of agriculture has been declining over time, as would be expected from the sector's diminishing role in the overall economy. Figure 3.5: Distribution of employment by broad sector: 2003 35% Constrution i11 3% Industry 10% Source: Bangladesh Labor Force Surveys and World bank Staff calculations 3.19. Gender decomposition of labor across sectors provides additional insight into the sectoral mobility of labor. Almost 90 percent of the male workers are either in agriculture (50 percent) or services (38 percent): the share of male workers in industry (manufacturing and mining) and construction, which combine for a quarter of the GDP, is thus only about one-tenth. Their share in agriculture declined over the 1996-2003 period (Figure 3.6), while the share of the female workers increased substantially - from 28 percent in 1996 to 59 percent in 2003. Again, these trends derived from the LFSs are likely overstating the increasing trends of female participation in agriculture. Nonetheless, these trends may well be highlighting the lower mobility of female labor out of agriculture than of male labor. That would 5 Mahabub Hossain (2004). 75 Bangladesh: Strategy for Sustained Growth suggest that the positive aspect of increasing female labor force participation is, at least partially, being offset by the fact that their entrance is mostly in the agriculture sector (including livestock production), which is not only the least productive and remunerative sector in the economy but in which women's involvement usually takes the form of unpaid family work which does not give them direct access to income and may not be a particularly effective means of empowerment. Figure 3.6: Gender Decomposition of Labor Across Sectors "ll 0 -n Source: Bangladesh Labor Force Surveys (various years) 3.20. A more detailed breakdown of the labor force by industry (4 digit BSIC level) is shown in Annex Table 3.3. After agriculture, wholesale and retail trade is the next most significant category, employing about 14 percent of the labor force, while manufacturing accounts for one-tenth. There are some interesting gender and urban-rural difference within these two categories. Wholesale and retail account for 21 percent of the workers in urban areas, which is twice the category's share in rural areas. It also accounts for 26 percent of urban male workers and 14 percent of rural male workers, which, in each case, is about eight times the category's share of female employment. It is quite telling that, despite the significant decline, manufacturing sector's share of female employment - in both urban and rural areas - is more than twice its share of male workers. For the urban sector at least, this in large part reflects opportunities for female workers in garments manufacturing. Female participation in rural manufacturing deserves more analysis. Status of employment 3.21. The self-employed workers constitute the largest group, by far, of any employment status category (Table 3.3), accounting for 45 percent of the employed labor force. 56 This is true not only for rural areas where family based subsistence agriculture has been traditionally the main economic activity but also for urban areas where it is likely being driven by the large share of male employment in wholesale and retail trade. Another 18 percent classify as unpaidjfamily workers: thus family or own source of employment contributes about two-third of the labor force. The breakdown by gender for these two categories is informative. Almost half the male workers classify as self-employed whereas only a quarter of female workers do. On the other hand, almost half the female workers classify as unpaid family workers, which is up from 19 percent in 1996 (Annex Table 3.5), while only one-tenth of male workers do. Among the 34 percent who classify as hired workers, employees are more common in urban 5Self employment as a percentage of non-agricultural employment (data for the latest available year between 1990-2000) in idia and Pakistan was 37 and 43 percent (HDC 2004), respectively, compared to 44 percent in Bangladesh. Share of paid workers (regular and casual) in total employment in India were 37 and 46 percent respectively among men and women, compared to 35 percent and 20.0 percent in Bangladesh. 1995-96 data (HDC 2004) shows that agriculture contributed 67, 47 and 42 percent of employment in India, Pakistan and Sri Lanka respectively. The comparable figure for Bangladesh was 48 percent. 76 Chapter 3: The Labor Market: Trends, Characteristics, and Challenges areas and day laborers in rural area. As would be expected, regular salaried employee jobs are mostly in the non-agriculture sector while the agriculture sector mostly creates jobs in the categories of self- employed, day laborer, and unpaid family workers. Table 3.3: Employed person by status of employment, gender and locality (Percent) Bangladesh Urban Rural Status of employment Both Both Both Male Female Male Female Male Female Sexes Sexes Sexes Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Employee 13.7 13.8 13.4 23.7 24.4 21.6 10.5 10.5 10.5 Employer 0.4 0.4 0.2 0.6 0.7 0.3 0.3 0.4 0.1 Self-employed 44.8 50.6 24.5 41.2 47.1 21.6 45.9 51.6 25.5 Day laborers 20.0 22.9 9.6 15.6 17.3 10.1 21.4 24.7 9.5 Unpaid family worker 18.4 9.9 48.0 15.0 7.6 39.3 19.4 10.6 51.0 Domestic worker 0.6 0.1 2.5 1.1 0.1 4.3 0.5 0.1 1.8 Apprentice 0.9 1.0 0.6 1.3 1.3 1.2 0.8 0.9 0.4 Others 1.2 1.2 1.2 1.4 1.4 1.6 1.1 1.1 1.1 Source: Bangladesh Labor Force Survey 2003 3.22. The income and poverty situation of self-employed workers in rural areas may have worsened during 2000-2003. If we consider monthly income of taka 2,000 (roughly 1 US$ a day) cut-off for poverty, about half of the self-employed fell below this level in 2003 (Annex Table 3.10), up from 42 percent in 2000. About 35 per cent of the urban self-employed and 55 per cent of the rural self-employed fell below the cut-off point in 2003, compared with 40 percent and 43 percent in 2000. The worsening condition of the rural self-employed would be even more pronounced if inflation during this period is taken into account. It is hard to be conclusive about this worsening pattern, however, as the survey data on income from two LFSs are not strictly comparable. 3.23. The number of regular salaried jobs declined over the 2000-2003 period (Table 3.4), and the only reason this did not lead to increasing casualization of labor was that the day laborers declined even faster. The number of regular employees fell in all major sectors except industry where it saw a small increase. The number of day laborers on the other hand fell markedly in agriculture but increased in all other sectors. The reduction in salaried jobs affected the female workers much more severely - the number of female employees fell by 20 percent and the number of female day workers by 40 percent (Annex Tables 3.8 and 3.9). This was offset by an increase of about 75 percent for unpaid family workers and about 15 percent for self-employed. The number offemale unpaid family workers, in fact, increased more than five-fold between 1996-2003, with most of the increase occurring in rural areas. The increase in unpaid workers was mostly accounted for by the agriculture sector and, to a much lesser extent, by the industrial sector. The unpaid family worker category, just 12 percent of total employment in 2000, accounted for two-third of the increase in employment between 2000-2003 and all of the increase in female employment. 77 Bangladesh: Strategy for Sustained Growth Table 3.4: Number of Workers by Status and Sector 2003 Data (thousands) Total Employee Employer Self-Employed Day Laborer Unpaid Worker Total 44322 6083 169 19849 8851 8139 Agriculture, Forest and Fisheries 22931 317 45 10548 5343 6555 Industry 4523 1666 24 928 1073 612 Construction 1541 87 6 341 1051 9 Services 15327 4013 94 8032 1384 963 Change between 2000 and 2003 (thousands) 1/ Total 5343 -450 72 1679 -639 3450 Agriculture, Forest and Fisheries 3147 -418 28 1994 -1888 3308 Industry 493 75 9 -280 259 210 Construction 446 -30 -7 35 426 -25 Services 1257 -77 42 -70 564 -43 1/ The aggregate of changes in individual categories is less than the total change. This is because of additional categories in the 2003 LFS that were not there in the 2000 LFS Source: Bangladesh Labor Force Surveys (1999-2000 and 2002-03) Educational Attainment of Labor Force 3.24. Improving the quality of the labor force, particularly its literacy levels, is crucial for an economy that wants to place itself on the path to development and modernity. Basic literacy and primary/secondary schooling are essential to productivity of almost any sector, while good quality higher education plays an important role in the economy's transformation away from primary activities. 3.25. In Bangladesh, the educational attainment trends of the labor force are somewhat disheartening. Half of the employed labor force is functionally illiterate and another 17 percent does not have education beyond class five (Table 3.5). On average, the employed labor force has only 4 years of schooling; 4.2 years on average for male workers and 3.2 years for female workers (Annex Table 3.11). The percentage of the labor force with no education, in fact, has increased over the period covered by the last three LFSs; from 47 percent in 1996 to 50 percent in 2003. This is driven by the decline among male workers, urban and rural; female literacy ratios, both urban and rural, albeit still considerably lower than male has been stagnant at about 41 percent. Urban literacy rates (64 percent) are considerably higher than rural (45 percent), for both male and female workers. Table 3.5: Educational attainment of the economically active labor force: 1996 to 2003 Level of education 2002-2003 1999-2000 1995-1996 For both sexes (changes between) Both Male Female Both Male Female Both Male Female 2003 & 2000 & sexes sexes sexes 2000 1996 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 +3.5 - No education 50.1 48.0 57.6 46.6 42.1 58.7 46.6 44.3 58.8 -7.5 0.0 Class I-V 16.8 17.4 14.9 24.3 25.4 20.4 23.3 26.4 19.2 -1.2 +1.0 Class VI-VIII 10.8 11.0 10.1 12.0 13.1 8.0 9.2 9.6 7.0 +3.1 +2.8 Class IX-X 8.6 8.9 7.6 5.5 5.8 4.3 6.4 6.9 4.9 +3.1 -0.9 SSC/HSC & 9.0 9.6 6.8 8.5 9.0 6.5 8.9 9.0 7.4 -0.4 -0.4 equivalent Bachelors degree 4.6 5.0 3.0 4.1 4.6 2.0 3.6 3.8 2.8 +0.5 +0.5 or above Source: Bangladesh Labor Force Surveys (various years) 78 Chapter 3: The Labor Market: Trends, Characteristics, and Challenges 3.26. Education attainment varies considerably across sectors. The average education of employed persons disaggregated by sector, status of employment, gender and location are presented in Annex Tables 3.11-13. Agriculture (especially fishing) and transport sectors employ workers with the lowest average education, while the labor force in public administration, health and education services, and modem sectors like electricity-power, finance and real estate have substantially higher educational attainment. It is discouraging though to see that almost half of the workers in the manufacturing sector have no education, which likely adversely impacts the sector's productivity. 3.27. Data for technical training and vocational education are similarly discouraging. Out of a labor force of 44 million, the 2003 LFS estimated that only 58,000 (53,000 males and 5,000 females), or a little over 1 percent of the labor force, had technical training or vocational education, and even among those, the relevance of their skills seems questionable. 3.28. There is still hope as past trends in educational attainment of workers are expected to improve. With rising school enrolment, labor force entrants with school education tends to decline in the initial phase. This trend is likely to be reversed after the interval taken to complete school education. In fact, in Bangladesh, during the last three years there has been a small increase in the percentage of labor force with class IX and above education. It would be reasonable to expect that within the next few years the percentage of school educated labor force will increase because of the rapid increase in school enrolment since the early nineties. 3.29. A more intractable problem has to do with the poor quality of education and pre-employment training. An important shortcoming is the gap between the skill types demanded by the market and those being supplied by the system is perceived to be still fairly wide. Studies have found education quality to have also deteriorated (CAMPE and UPL 2001). Furthermore, the quality divide between urban and rural areas is wide and, worryingly, appears to be worsening. Addressing the urban-rural gap would have to be at the heart of any government plan to address the skills shortages in the economy. 3.30. The low quality of the vocational education and training (VET) system is reflected in the low capacity utilization and pass rates: in both vocational education and vocational training institutions, close to half the student capacity remains unutilized, and pass rates in standardized tests have also dropped significantly in recent years. This is further corroborated by the weak demand for the graduates from the VET institutions. A tracer study shows that less than 10 percent of individuals who graduated in 2003 from these were employed over two years after the survey, while close to half the graduates took at least a year to find a job. Moreover, the wages for VET graduates appear to be lower than those received by graduates from the general education system.57 Formal and informal employment 3.31. The informal sector is estimated to account for close to 80 percent of the employed labor force. Furthermore, the sector's share increased slightly over the 2000-03 period, accompanied by a decline in both private and public sector formal employment (Table 3.6). All economic sectors experienced an increase in informal jobs. Private formal sector job increased considerably in industries (manufacturing, mining, and utilities). These increases came at the expense of public sector jobs which declined across the board, and in private formal jobs in construction and services. 5 The Bangladesh Vocational Education and Training System: An Assessment, World Bank, 2006. 79 Bangladesh: Strategy for Sustained Growth Table 3.6: Formal and Informal Employed Labor Force by Sector 2003 Data (thousands) Change between 2000 and 2003 (thousands) Informal Private Formal Govt. Informal Private Formal Govt. Total Sector Sector Sector Total Sector Sector Sector Total 44322 35078 7368 1877 5343 5749 14 -419 Agriculture, Forest & Fisheries 22931 21714 1163 54 3146 3085 172 -111 Industry 4030 1748 1956 326 493 154 516 -177 Construction 1541 1290 202 49 446 624 -141 -37 Services 15327 10172 3531 1625 1258 1886 -533 -94 Source: Bangladesh Labor Force Surveys (1999-2000 and 2002-03) 3.32. The formal/informal breakdown of employment needs cautious interpretation. For one, data on formal/informal distribution are difficult to interpret because of underlying definitional problems. Formal jobs are considered to be better in terms of job security, fringe benefits and pension schemes etc. Nonetheless, for an LIC like Bangladesh, it may be difficult to clearly distinguish formal from informal jobs and pinpoint their implications for worker benefits. In such a situation, even the formal sector employees may not get the benefits that are typically associated with the formal sector. Many formal sector enterprises may give jobs that are more closely associated with the informal sector. Besides, many employees in the RMG sector in Bangladesh do not get an appointment letter even though they may work for enterprises that are registered and fall under the formal sector. On the other hand, many enterprises may not obtain the required registration etc. for qualifying as formal sector, because they do not have an incentive to do so. The distinction for the labor market in Bangladesh is made even more blurry by the fact that the LFS reports do not include a definition of the formal employment. Moreover, the workers may not know whether their employer has formal registration when interviewed for the survey. Bangladeshi migrant workers 3.33. International migration is a major source of gross national income and foreign exchange in Bangladesh. It is estimated that between 1976 and 2004, a total of 3.7 million workers migrated abroad, and at present about 3 million people of Bangladeshi origin are living and working abroad (MoF)." This constitutes 6.5 per cent of the present labor force within the country (Annex Tables 15-16). The growth rate of fresh migration has declined since the early 1990s, with negative growth recorded for 2001 to 2003. Even so, 241 thousand workers - about one-half percent of the domestic labor force - migrated to work abroad in 2003. 3.34. The net benefits from migration appear to be positive for Bangladesh. The benefits from migration are clear - in the form of higher income and foreign exchange. Are there any associated costs, especially due to brain drain and shortages of critical skills? It seems unlikely that that is the case in Bangladesh, given its excess supply of labor, especially unskilled labor, a category under which majority of the emigrants fall. The share of the unskilled workers, in fact, has also risen since 1990 (Annex Table 17), from 40 percent of all migrants in 1990 to 54 percent in 2003. 3.35. The Middle East is the favorite destination of emigrants - accounting for over 90 percent of emigration (Annex Table 18). Saudi Arabia alone accounts for almost two-third of emigration, but only about 40 percent of total remittances because of the low-skill emigrants it attracts. The U.A.E. and Kuwait are the other preferred destinations: together, these three countries account for almost 90 percent of all emigrants. The USA has a small share of immigrants from Bangladesh (less than 5 percent), but accounts for 15 percent of the remittances because of the higher skill level of emigrants there. 58 This does not take into account the estimated millions of unrecorded migrants, majority believed to be India. 80 Chapter 3: The Labor Market: Trends, Characteristics, and Challenges IV. Earnings from Paid Employment Wage trends 3.36. Real wages in the manufacturing sector have risen quite sharply (Figure 3.7) as per the BBS data.59 The real wage index for the sector increased by over 30 percent between 2000 and 2005. Real wages increased in the other sectors as well, albeit at a slower pace; by 23 percent in the agriculture sector and by 7 percent in construction.60 Real wage trends in agriculture turned a corner in 2000, after virtually stagnating in the 1990s. Figure 3.7: Real Wage Trends in Major Sectors (1991 normalized to 100) Manufacturing sector wages Agriculture sector Construction wages Source: BBS Data and World Bank Staff calculations 3.37. Real wage growth in the manufacturing sector exceeds the sector's labor productivity and output growth. While real manufacturing wages increased by 32 percent over 2000-2005, real manufacturing output per worker increased by no more than 20 percent.61 This disparity could arise from any combination of: a premium on certain skill sets not readily available; informational problems that prevent matching of jobs with available workers with the right skills, and; wage setting by collective bargaining. Other than collective bargaining, which doesn't seem to be prevalent in Bangladesh (Section VI), the first two forces are likely to be at play. There is some evidence of the skills premium increasing in the engineering industry. For instance, the ratio of the daily wage rate for a "skilled" fitter in the engineering sector to that of an "unskilled" fitter increased from 1.40 in 2000 to 1.72 in 2005. 3.38. The disparity between real wage and labor productivity trends appears even more glaring for the agriculture sector. While real wages in the sector increased by 23 percent over the 2000-05 period, real output increased by just 13 percent. In order for labor productivity changes alone to justify the real wage increases, labor force in agriculture would have had to fall by 10 percent over the five year period. While labor has been flowing out of agriculture, the pace is likely to have been slower than that. It is possible that part of the wage increase in agriculture was simply catching up with the productivity 5 A nation-wide price index for the industrial sector has been used to convert the nominal indices into real indices for general, manufacturing and construction. To deflate nominal agriculture wages, price deflators for agriculture from the national accounts are used. 60 The LFS data, on the other hand, show agriculture sector wages to have declined during 2000-2003, in large part because the 2003 survey was conducted during the lean agriculture season of October-November, while the earlier survey was spread over the year. 61 This is assuming that the annual labor force growth in manufacturing was 3 percent, about the same as the overall labor force growth. The increase in output per worker in manufacturing over the 2000-05 period would be accordingly lower than 20 percent if the labor force growth in the sector was higher than 3 percent. 81 Bangladesh: Strategy for Sustained Growth improvements seen in the 1990s which were then accompanied by real wage stagnation. The adjustment would have occurred over the 2000-05 period because of the significant tightening of the labor market in manufacturing which trickled to other sectors, including agriculture. Two other important factors likely also contributed. One, certain high wage segments of agriculture - e.g. commercial poultry, high value crops etc. - deepened over the latter period, as shown in Chapter 2. Second, the forms of labor employment or features of contract are changing. Piece rate and contract jobs are beginning to substitute time rate or daily employment. Piece rate jobs are given for specific work and usually a group leader is involved in the negotiation. The employer does not supervise the laborers. This form reduces supervision cost and raises the intensity of work. Thus productivity and wage rates tend to benefit. Rural-urban wage differential 3.39. The LFS data show significant rural-urban wage disparity in 2003; the weighted average rural wage rate was only 62 per cent of urban wage rate (Annex Table 19): the divergence was 40 percent for males and 33 percent for females. The disparity between rural and urban wages stands even after accounting for the cost of living differences: cost of living in urban areas is estimated to be about 25 percent higher than in rural areas. Wage disparities in agriculture and services seem to be driving this (Figure 3.8). Urban wages for the agriculture sector were about 30 percent higher, while the wage gap in services varied between 22 percent (trade) to 65 percent (finance). In the manufacturing sector, urban wages are about 20 percent higher than rural wages, which mainly reflects the difference in cost of living. Figure 3.8: Ratio of Urban Wage Rate to Rural Wage Rate for Major Economic Sectors (Percent) 2000 2003 Source: BBS Data and World Bank Staff calculations 3.40. The overall rural-urban gap remained virtually unchanged between 2000 and 2003, with offsetting changes across different sectors. The rural-urban wage divide became worse in the agriculture sector and improved dramatically in mining and also in the manufacturing and construction sectors between 2000 and 2003. The disparity didn't change much in most services sub-sectors, except personnel services where it became considerably worse. V. Determinants of Employment and Real Wages: An Analytical Approach Determinants of employment levels: cross-sectional variations 3.41. This section seeks to identify analytically the factors that affect weekly hours of employment in the major sectors. Key results from the regression reported in Annex Table 20 are: 82 Chapter 3: The Labor Market: Trends, Characteristics, and Challenges * The size of landownership tends to increase employment levels. Here two offsetting effects would be at play. Bigger size of landownership can positively affect productivity and hence boost employment from the demand side. On the other hand, it can negatively affect employment from the supply side by reducing incentives to work. On balance, it appears that the positive demand side impact dominates. * Workers training has a positive and significant effect on the hours of employment, likely reflecting an increased demand for their higher skill levels. * Worker's education lowers the hours of employment. This is consistent with Table 3.2 which shows an positive relationship between unemployment and education. This likely reflects the higher reservation wages of the more educated and the substantial the gap that studies have found between the skills being demanded by the market and those being supplied by the system. * Urban areas provide more hours of employment even after controlling for worker characteristics and sectors of employment. This likely reflects both demand and supply side factors. On the supply side, urban workers need to put in longer hours to cope with the higher cost of living and, for the large number of migrants, to be able to send remittance money back home to rural areas. On the demand side, productivity in urban areas is higher because of agglomeration economies and other benefits mentioned in Chapter 5. * Among the various statuses of employment, hired employment is associated with more hours of employment than self-employment - more so for the 'salaried employees' than wage laborers who are often hurt by seasonality of their work. Unpaid family workers and employers tend to put in fewer hours than the self-employed. * The manufacturing and construction sectors provide more hours of employment than agriculture. The trade and transport and communication sub-sectors provide more hours of employment that agriculture, but the rest of the services sector provides fewer hours. * As would be expected, the relationship between hours of employment and age of the worker has an inverse U-Shape. Hours of employment increase with age up to a certain age and decline after that. This is also consistent with Figure 3.3b that shows a similar relationship with LFPR and age for male workers. * Other worker and household characteristics also affect hours of employment. Males and heads of the family worker longer hours. Having more dependents in the households also increased the number of hours of employment. 3.42. The determinants of hours of employment are quite similar for the self-employed and for paid workers (Annex Tables 21 and 22). The coefficients on workers' education and training are not significant for the self-employed, while land ownership is not significant for either category. Determinants of wage rates 3.43. Section IV showed rural-urban and sectoral differences in wage rates. It left out the micro characteristic such as human capital differences and household characteristics that could further help explain wage differences among workers. This section jointly assesses the role of all these factors that can affect wage earnings from paid employment. Regression results using 2002-2003 LFS data are presented in Annex Table 23, and show that: * The public sector pays 32 percent higher wages, on average, compared to the private sector after controlling for all other factors, including skills and location. The premium for public sector is 83 Bangladesh: Strategy for Sustained Growth well recognized in Bangladesh,62 which results in rationing of these jobs to a few fortunate ones and also distorts wage signals in the rest of the economy. * Urban wages are about 11 per cent higher. This captures the urban-rural differences in the cost of living as well as higher productivity in urban areas. * Human capital - i.e., workers' training and years of schooling - tend to improve wages. This is only to be expected in an economy in which skill levels are still visibly quite low. * Male wages are about 40 per cent higher than female wage rate, even after controlling for education and other worker, location and employment characteristics. Gender bias in remuneration is not unique to Bangladesh; even developed countries report evidence of it. Like the rest of the world, it is an important ongoing challenge for Bangladesh. Wage disparities perpetuate economic inefficiency - not to mention the social inequity they perpetuate. * Salaries of regular employees are about 20 percent higher than irregular employees and day laborers. This confirms that the workers in the former category are relatively more empowered to bargain their position. The higher remuneration also comes in addition to the better working conditions, including substantially higher job security. * Asset endowment - proxied here by size of land ownership - tends to improve wages. This likely has to do with the higher reservation wage of land owners. Those with bigger size land would be willing to work outside of it with better compensation. Why the employers would be willing to link pay with the size of landholding of the worker, everything else being the same, needs more analysis. Possibly, the enhanced social standing that comes with a larger land endowment improves the workers' bargaining power as well. * Differences in wages also exist among various sectors. Relative to the agriculture sector, the wage premium is 17 percent in manufacturing, 32 percent in constructions, and anywhere from 2 percent to 30 percent in services. * The relationship between workers age and wage rates has an inverse-U shape. Initially, wages increase with age up to a certain age, after which they decline with age. VI. An Overview of Labor Laws and Regulations in Bangladesh63 3.44. The Right of Association: Bangladesh's Constitution guarantees freedom of association, the right to join unions, and, with government approval, the right to form a union. With the exception of workers in the railway, postal, telegraph, and telephone sectors, civil servants are forbidden to join unions. The ban also applies to the military and police. Some public sector employee groups, such as teachers and nurses, although forbidden to join unions have joined associations which perform functions. 3.45. The Industrial Relations Ordinance (IRO), 1969, provides that any worker or employer has the right to form a union/association without previous authorization. But such a union/association cannot function as a trade union without being registered under the law, which requires a 30 percent participation in the union before it can be registered, and a union may be dissolved if membership falls below this level. The ILO's Committee of Experts on the Application of Conventions and Recommendations (CEACR) finds such requirements to be excessively restrictive and has requested that the government amend these. Additionally, the International Confederation of Free Trade Unions (ICFTU) has expressed 62 See, for example, Bangladesh Public Expenditure Review, World Bank, 2003. 63 Sources: U.S. (i) State Department Country Report on Economic Policy and Trade Practices in Bangladesh, 1998. (ii) Fair Labor Association, 2004 Annual Report. (iii) Board of Investment, Bangladesh. 84 Chapter 3: The Labor Market: Trends, Characteristics, and Challenges concerns that workers trying to establish a trade union are not protected by law, and as a result, are subject to severe resistance from employers and government to prevent formation of the union. 3.46. Bangladesh has ratified seven of the eight fundamental ILO conventions. In 1972 Bangladesh ratified both fundamental ILO Conventions concerning freedom of association: Freedom of Association and Protection of the Right to Organize (Convention No. 87, and Right to Organize and Collective Bargaining (Convention 98). However, when Bangladesh ratified the International Covenant on Economic, Social and Cultural Rights (ICESCR), it entered a reservation on articles 7 and 8, which guarantee the right of everyone to form trade unions and join the trade union of their choice. The reservation indicated that there would be some limitations placed on workers' freedom of association. 3.47. In 2002, there were about 6,300 registered trade unions, most with political affiliations, with less that 2 million worker members (less than 5 percent of the workforce). The relatively low level of union membership reflects the informal nature of vast majority of economic activity and the mentioned restrictions that apply to the formal sector. 3.48. The Right to Bargain Collectively: Collective bargaining by workers is legal under the condition that their unions are legally registered as collective bargaining agents. In case of multiple registered unions in an establishment, a collective bargaining agent is determined by the Registrar of Trade Union - a position given to the Director of Labor of the government - through a secret ballot for a term of two years. Collective bargaining occurs occasionally in large private enterprises but is generally not seen in small private enterprises. 3.49. Right to Strike: Strikes are common in Bangladesh and are recognized in the 1969 IRO as a legitimate avenue for addressing unresolved grievances. The IRO permits the govermment to bar strikes for three months in any sector deemed "essential." These include utilities (electricity, gas, oil and water etc.), hospital and ambulance services, fire brigade, railways and the national airline Biman, and ports. Mechanisms for conciliation, arbitration and labor court dispute resolution were also established under the 1969 IRO. 3.50. The ILO Committee of Experts has objected to the following provisions of the IRO on the grounds that these restrict workers' right to defend their economic interests through strikes: * the need for three-quarters of the members of a workers organization to consent to a strike; * the government's power to prohibit a strike if it lasts more than 30 days or to prohibit a strike at any time if it is considered prejudicial to the national interest; and * penalties (which include imprisonment) that may be imposed if workers participate in an industrial action that is deemed by the government to be unlawful. 3.51. Prohibition of Forced Labor: The constitution prohibits forced or compulsory labor. The Factories Act and the Shops and Establishments Act, both passed in 1965, set up inspection mechanisms to guard against forced labor, but resources for enforcement are scarce. Nevertheless, the practice of forced labor is believed to be quite limited. 3.52. Minimum Age for Employment of Children: Bangladesh has laws that prohibit labor by children. The Factories Act bars children under the age of 14 from working in factories. The enforcement of these rules is quite inadequate though and the application of the rules to informal sector activities such as agriculture and domestic help - where majority of child labor is found - is not clear. As per the 2000 LFS data, over 5 million, or 20 percent of the population in the 0-14 age group, was working. 3.53. In July 1995, Bangladesh garment exporters signed an MOU that has virtually eliminated child labor in the garment export sector. Under the MOU, schools and a stipend program were established for 85 Bangladesh: Strategy for Sustained Growth displaced child workers. By November 1998, hundreds of schools serving thousands of former child workers were in operation. A system of fines and possible suspension of import/export privileges exists, and a monitoring system has been set up by the ILO. 3.54. Acceptable Conditions of Work: Regulations regarding minimum wages, hours of work and occupational safety and health are not strictly enforced. The legal minimum wage varies depending on occupation and industry. It is generally not enforced in the private sector. The garment sector has witnessed prolonged worker agitation over dissatisfaction over minimum wage rates which have not changes for several years. The impasse carries on unresolved, highlighting the significant economic cost of not having in place a functioning mechanism to resolve labor disputes in the formal private sector. In the public sector, wages and fringe benefits of the workers are determined on the recommendation of the National Pay Commission established from time to time. Sometimes private industries follow the public sector wages & salary structure for their workers. 3.55. Leave & holidays of the workers & employees are regulated by the Factories Act, 1965 and shops Establishment Act, 1965. The law sets a standard 48-hour workweek with one mandated day off. A 60- hour workweek, inclusive of a maximum 12 hours of overtime, is allowed. The Factories Act of 1965 nominally sets occupational health and safety standards. The law is comprehensive but appears to be largely ignored by many employers. Freedom of Association in Export Processing Zones in Bangladesh 3.56. In 1980, the Bangladesh Export Processing Zones Authority Act 10 was enacted. It provided for the establishment of the Bangladesh Export Processing Zones Authority, (BEPZA), which is the official arm of the government responsible for the creation, development, operation, management, and control of export processing zones (EPZs). Under the BEPZA Act the government may exempt an EPZ from as many as 16 laws, including the Industrial Relations Ordinance (IRO). In 1986, the government declared, in accordance with the BEPZA Act, that the IRO was not applicable in the EPZs. The declaration effectively suspended the rights of workers in EPZs to freedom of association and collective bargaining. 3.57. Mostly under pressure from the U.S., in 2004 the Parliament of Bangladesh passed a bill granting limited workers' association rights in the country's export processing zones (EPZs) effective from November 1, 2006. Under the 2004 Bill, trade unions of a particular EPZ can form a federation, but there cannot be more than one federation in an EPZ. The federations will not be allowed to form a single national body or join any national trade union, political party or its labor front. VII. Challenges Ahead 3.58. A rapidly growing labor force presents a critical development challenge for Bangladesh. Its labor force is projected to increase by 10 to 20 million over the next decade - 10 million if the female LFPR does not change and 20 million if female LFPR increases to 40 percent. Creating productive employment opportunities will clearly be an imperative for poverty reduction and even sustained economic growth in Bangladesh, as rightly recognized by the Government's Poverty Reduction Strategy (PRS). Labor market regulations in Bangladesh do not appear that encumbering, especially relative to India, as is also bome out by various investment climate survey results which show that hiring/firing rigidities are not among the main concerns of employers. More effective enforcement of the existing labor market policies is needed, nonetheless, especially to protect worker rights. Instrumental for meeting the govermment's employment generation objective will be sustained productivity and output growth across all major economic sectors (an agenda covered in the rest of this report); deeper and more focused government attention to enhancing worker skills, particularly by strengthening the higher education and VET systems and making them more responsive market needs; improved urban management to facilitate rural-urban migration; and, continued 86 Chapter 3: The Labor Market: Trends, Characteristics, and Challenges emphasis on gender empowerment to allow greater mobility of female workers to more productive employment opportunities. 87 CHAPTER 4: TRADE LIBERALIZATION AND EXPORT COMPETITIVENESS I. Introduction 4.1 Starting in 1991, Bangladesh marked a clear departure from the highly protectionist, inward-looking import substitution policies of the earlier decades, with tangible benefits to GDP growth. Considerable, albeit uneven, progress has since been made on liberalizing the trade and exchange regimes. Trade tariffs have been significantly reduced and rationalized, with the unweighted average customs duty (CD) falling from 100 percent in FY85 and 74 percent in FY92 to 15 percent in FY07, and the top CD rate from 350 percent in FY90 to 25 percent. Trade-related quantitative restrictions (QRs), which covered 21 percent of HS 4-digit tariff lines in FY90, have been 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, and adoption of a floating exchange rate policy. 4.2 Despite good progress, a substantial agenda for deepening trade liberalization and strengthening export competitiveness remains. Although the average CD 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. As a result, the average nominal protection in Bangladesh is the highest in the region and among the highest in the world. Furthermore, trade facilitation procedures are cumbersome and infrastructure bottlenecks to exporting are severe. The resulting anti-export bias has leveled off at around 20 percent since the late 1990s, which works against the emergence of new exports 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. Moreover, the export base is heavily concentrated in the readymade garment (RMG) sector - which accounts for 75 percent of merchandise exports - where the extent of the anti-export bias is much lower. 4.3 The potential net benefits from further opening up the trade regime are high for - certainly higher than for the larger emerging economies such as China and India. In fact, even these larger economies are now moving decisively down the trade liberalization track to reap its benefits. The impressive growth performance of many successful East Asian economies was shaped in large part by their ability to integrate into the global supply chains at early stages of development. At the heart of their increased integration was lowering of trade barriers and anti-export bias and improving trade facilitation. Gradually, with economic development, strengthened domestic competitiveness, and improved labor skills these economies moved up the quality ladder toward higher-end production chains, achieving unprecedented GDP growth in the process. A broad strategy along those lines holds tremendous potential for Bangladesh.64 This chapter presents an overview of the trade policy trends in Bangladesh and makes some policy recommendations that would help strengthen the country's global competitiveness. The trade facilitation aspect of competitiveness is covered in Chapter 9. II. Trends in Trade Policy and the Anti-Export Bias Overview of Trade Policy Trends Since Early 1990s 4.4 Considerable, albeit uneven, progress has been made on trade and exchange liberalization since 1991. Reform measures have included tariff cuts and rationalization, removal of trade-related QRs, adoption of a unified exchange rate system, switching from a fixed to a more flexible exchange rate regime, and current account convertibility. These have been accompanied by complementary measures to 64 This combination of trade policy reforms and strengthening domestic competitiveness also appears to be the best policy response to the challenges and risks emanating from the phasing out of the ATC quotas in January 2005. 89 Bangladesh: Strategy for Sustained Growth liberalize the domestic economy and improve market orientation: contributing to the improved growth since the early 1990s. 4.5 More substantial progress on trade liberalization measures was made during the first half of the 1990s. During this period, import tariffs were cut significantly through a 'tops down' approach of reducing the maximum CD rate while also reducing the number of tariff slabs. As a result, the (unweighted) average protection rate fell from 73.6 percent in FY92 to 32.4 percent in FY96 and the dispersion of tariffs declined by over 60 percent (Table 4.1). The number of QRs fell significantly in the 1993-95 Import Policy Order (IPO) relative to the 1991-93 IPO (Table 4.2) Table 4.1: Average Protection Rate in Bangladesh (MFN Rates, including concessional rates in %) 1 1991/92 1995/96 2003/04 2004/5 2005/06 2006/07 Unwei2hted average Customs Duty (CD) - MFN rates only 70.6 28.7 18.8 16.3 15.5 14.9 Industrial products/a 69.7 28.4 18.0 15.6 14.7 14.0 Agricultural products1' 76.6 30.1 22.6 19.6 19.4 19.1 Unweighted total protection rate -MFN rates only C 73.6 32.0 29.1 26.5 26.5 24.3 Industrial products 73.2 31.9 26.8 25.4 25.3 22.4 Agricultural products 76.6 32.4 39.8 32.1 32.4 31.3 Standard deviation of total protection 41.9 15.9 25.9 25.5 27.1 22.6 (based on MFN tariff lines) Tariff lines subject to protective SD and VAT Supplementary Duty .................... 49 13 691 1066 1031 1043 VAT .............................. 426 373 727 582 600 601 Unweighted avg. CD - MFN rates, adjusted for tariff exemptions/concessions 57.6 22.6 15.6 13.5 12.4 11.8 Industrial products 55.9 21.5 14.6 12.6 11.4 10.8 Agricultural products 73.5 29.4 22.2 19.3 18.9 18.7 Unweighted total protection rate - MFN rates, adjusted for tariff exemptions/concessions 60.2 25.1 23.7 21.4 20.7 18.9 Industrial products 58.7 24.0 21.2 19.9 19.1 17.3 Agricultural products 73.6 31.6 38.9 31.4 31.6 30.5 Percentage and the number of tariff lines with 93.3 86.1 72.5 70.1 70.8 69.4 international tariff peaks (total protection rate >15%) (6233) (5810) (4983) (4699) (4746) (4649) / 1: Averages reported here are based on 8-digit 6877 tariff lines and the MIFN tariffs, and do not reflect 'preferential' tariffs. / a: Harmonized System (HS) Chapters 25-97; / b: HS Chapters 01-24. / c: 'Total protection' incorporates, in addition to customs duty, the protective effective of the para-tariffs. Source: Trade Policies in South Asia: An Overview, World Bank, 2004; Bangladesh's Import Policies, World Bank, 2005. 4.6 The trade liberalization drive slowed down considerably during the FY97-99 period, with even some instances of reversal. The average rate of nominal protection rose slightly over the period and the number of HS 4-digit items subject to QRs increased from 11I in the 1993-95 IPO to 122 in the 1997-02 IPO. Resistance by domestic protectionist lobbies, the heavy reliance on customs revenues, and concerns about the slow progress in addressing domestic business environment weaknesses played a key role in the slow down. Many openly worried that Bangladesh was perhaps opening up too much, too fast. These fears turned out to be unfounded, however.65 Bangladesh had started the trade policy reforms from prohibitively high protection levels to begin with, and a significant portion of the initial tariff cuts essentially amounted to eliminating 'water-in-the-tariff (i.e., tariff redundancy) in the case of final products. More importantly, trade liberalization was accompanied by sustained strong performance of the export sector and the economy in general. The BOP was also not overwhelmed by a surge in imports 65 This point is forcefully made by Bangladesh: Trade Liberalization: Its Pace and Impact, World Bank, 1999. 90 Chapter 4: Trade Liberalization and Export Competitiveness during periods of import liberalization, as many had predicted: in fact, export growth outpaced import growth during these periods. 4.7 Trade liberalization was partially revived during FYOO-FYO2, and picked up pace in FY03. The average CD was cut from 26.6 percent in FY99 to 21 percent in FY02, and further to 14.9 percent in FY07. The decline in average nominal protection was more modest, however, because of increased use of other protective import levies, or para-tariffs (see below) - nominal protection fell from 32.4 percent in FY99 to 24.3 percent in FY07. In the meanwhile, the number of QRs has been lowered to 15 (Table 4.2), of which only three are protection-related (poultry, eggs, and salt), and on these GoB has obtained waivers from WTO until 2009. More significantly, the long-standing import bans on many textile products have also been removed, strengthening the competitiveness of the critical garment manufacturing sector. TABLE 4.2: EVOLUTION OF IMPORT RESTRICTIONS 1991-2006 Section 1.03 IPO IPO IPO IPO Section 1.02 IPO Section 1.04 2003- 1991-93 1993-95 1995-97 1997-02 06 (iulyft) Number of items in the control 193 111 120 122 48 list at the HS 4-digit level (15.6%) (9.0%) (9.7%) (9.8%) (1.4%) Number of trade-related items in 79 19 27 28 3 the control list at the HS 4-digit (6.4%) (1.5%) (2.2%) (2.2%) (0.3%) level Source: WTO Trade Policy Review, Bangladesh 2000; IPOs various years. 4.8 A pattern of increasing reliance on para-tariffs for protection has emerged over the last decade, to the detriment of trade openness. Since the mid-i 990s, the Government has increasingly relied on the para-tariffs for protection as well as revenue purposes, partially offsetting cuts in CDs.66 Four types of para-tariffs have been put to use: Infrastructure Development Surcharge, Regulatory Duty, Value Added Tax (VAT), and Supplementary Duty (SD).67 The Regulatory Duty, introduced in FY01, was later removed in FY05. The 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 FY96.68 These developments have led to an increase in the dispersion of total tariff protection, from 15.9 percent in FY96 to 22.6 percent in FY07. Moreover, introducing protection through the back door - i.e., through increased use of para-tariffs - increases the scope for lobbying pressures by protectionist groups and for corruption. 4.9 Especially worrisome is the recent widespread use ofSDs, which have become a key instrument of trade protection. SDs now cover 1,043 tariff lines, up from 356 tariff lines in FY03. The increased reliance on their use was most visible in the FY05 budget. Then, in a far-reaching move, the Government reduced the maximum CD rate from 30 percent to 25 percent, moved from a four to a three non-zero tariff slab system, and eliminated the Regulatory Duty. But it also further increased the number of tariff lines 66 For a detailed discussion on the protective application of the para-tariffs, see: Trade Policies in South Asia: An Overview, Chapter 3; and Bangladesh's Import Policies, World Bank, 2005. 67 In principle, both the SDs and VAT are supposed to be protection-neutral taxes. In practice, however, the SDs are levied mostly on only imported products, and when applied on domestic goods, the rates are generally lower. Furthermore, because the SDs are applied on the landed value plus CD, it has a cascading effect, with protection rates rising further with higher CD rates. Similarly, VAT has been used to provide extra protection to certain import competing industries (e.g., imports of textiles are subject to the general VAT rate of 15 percent, but domestically produced textiles are subject to a special lower VAT rate of 2.5 percent). 68 This was despite the elimination of the License Fee in FY03, an across-the-board import tax of 2.5% of the assessable value, and also the removal of the Regulatory Duty (of varying rates) in FY05. 91 Bangladesh: Strategy for Sustained Growth subject to SDs, from 691 in FY04 to 1,066 (Table 4.1), offsetting much of the impact of the other liberalization measures. 4.10 There is significant tariff escalation in the import duty structure, with the CD rates rising according to the stages of processing. This means that the effective rates of protection for import substituting final products are considerably higher than the nominal tariff protection on these products. This escalation is magnified by the imposition of the SDs whose duty-base includes landed costs plus CD. For example, given the general maximum tariff rate of 25 percent in FY05, with an SD rate of 25 percent, total nominal protection for tableware products reached 84 percent.69 The calculations for major commodity categories presented in Table 4.3 show tariff escalation as well as the cascading impacts of para-tariffs since FY92. Moreover, because of a plethora of end-user specific CD concessions, tariff policies have discriminated against the domestic production of certain products that were not favored, such as intermediate material and components.70 Table 4.3: Bangladesh: Tariff Escalation and Cascading Impacts of Para-Tariffs on Total Nominal Protection Unweighted Average Rates (based on MFN tariffs only, %) Description CD CD+DS+RD P-SD /* P-VAT /* Total Nominal Protection from FY +LF /* Protection para-tariffs (%) 06-07 Basic raw materials 9.3 12.8 0.9 0.0 13.7 31.7 06-07 Intermediate inputs 12.3 16.1 1.1 -0.1 17.2 28.2 06-07 Capital goods 9.2 13.1 1.7 0.1 14.9 38.7 06-07 Final consumer goods 20.2 24.1 8.5 3.3 35.8 43.6 06-07 Overall 14.9 18.7 4.3 1.3 24.3 38.8 03-04 Basic raw materials 12.1 15.9 0.2 0.2 16.2 25.6 03-04 Intermediate inputs 16.9 20.8 1.4 0.3 22.5 25.0 03-04 Capital goods 12.0 15.9 3.1 0.2 19.2 37.8 03-04 Final consumer goods 24.0 30.5 6.3 3.3 40.2 40.3 03-04 Overall 18.8 23.8 3.7 1.6 29.1 35.4 95-96 Basic raw materials 14.9 17.4 -0.1 0.1 17.4 14.4 95-96 Intermediate inputs 26.3 28.8 0.0 0.9 29.6 11.3 95-96 Capital goods 20.6 23.1 -0.2 0.2 23.0 10.5 95-96 Final consumer goods 35.9 38.4 -0.3 1.4 39.4 9.1 95-96 Overall 28.7 31.2 -0.2 0.9 31.9 10.1 91-92 Basic raw materials 38.1 40.6 -1.1 0.3 39.8 4.3 91-92 Intermediate inputs 62.2 64.7 -0.9 1.3 65.1 4.5 91-92 Capital goods 62.3 64.8 -0.4 0.2 64.6 3.6 91-92 Final consumer goods 87.6 90.1 -2.1 3.2 91.1 3.9 91-92 Overall 70.6 73.1 -1.3 1.8 73.6 4.0 /* CD: Customs Duty; DS: (Infrastructure) Development Surcharge; LF: License Fee; RD: Regulatory Duty; SD: Supplementary Duty; VAT: Value-Added Tax. P-SD: Protective component of SD; P-VAT: Protective component of VAT. Source: Staff calculations. 69 For more examples of product specific tariff escalation by stages of processing, see: Trade Policies in South Asia: An Overview, page 64, Table 3.17. 70 These calculations are based on the protection levels made 'available' by import duties. In practice, statutory tariffs may not reflect the actual price differences between domestic and international prices due to illegal border trade and smuggling through official channels. However, it is important to stress that such informal trade is induced, in part, by high protection rates, and it is the structure of protection shaped and made available by the statutory duties that is going to affect medium- and longer-term production decisions. 92 Chapter 4: Trade Liberalization and Export Competitiveness Anti-Export Bias Remains High 4.11 Anti-export bias, measured here as the ratio of (average) effective exchange rate for imports (EERm) to that of exports (EERx), is often used as an indicator of the trade regime's anti-export bias.' The higher is the ratio above 1.0, the higher the bias against export activities, and the more damaging it is for export competitiveness. Box 4.1 discusses the various channels through which trade protection impacts the anti-export bias. Box 4.1: Trade Protection: Its Impact on Anti-Export Bias and Export Competitiveness 4.2 Enhancing Bangladesh's export competitiveness depends crucially on reducing the anti-export bias of the trade regime, which, in turn, is shaped by the level of trade protection. The tariff structure impacts the anti-export bias through several channels: * Duties levied on imports of final goods raise their domestic relative prices, thereby increasing the profitability of import substitutes relative to exports. This diverts resources towards inefficient production for the domestic market, away from the production of exports. For example, the very high protection (nearly 100 percent) afforded to the ceramics industry e.g., tableware - reflected in much higher domestic prices of ceramics products relative to their export prices - appears to be discouraging production for exports. * An escalating tariff structure raises the effective protection for an import substitute above the nominal protection that the same import substitute receives from import duties and other protection. This means that the value-added (processing margins) involved in production for the domestic market will exceed the value-added that would have existed in the absence of any protection, by proportionately more than the nominal protection of the final product. This further increases the anti-export bias. * With import demand being curtailed under high protection, import-related (ex-ante) demand for foreign exchange is also curtailed, enabling the country to maintain a lower exchange rate (i.e., a lower domestic currency price for foreign currency) than otherwise. This then translates into lower domestic currency proceeds for export. * Exporters sell in competitive world markets and cannot pass on higher production costs to buyers. Thus, import duties paid on imported inputs increase their production costs and cuts into their profit margins and make them less competitive globally. * Even if there is a duty/tax rebate system, these are generally very inefficient and slow, and even the delayed collection of rebates have associated costs (e.g., bribes). Enclave arrangements, such as the bonded-warehouse scheme used by the RMG sector and export processing zones (EPZ), provide speedy duty-free access to imported inputs, but they serve only specific/limited activities and, as such, they are not substitute for extended periods for broader and deeper trade liberalization. 4.12 Reflecting the patterns of trade liberalization, the anti-export bias fell significantly in the first half of the 1990s, and has leveled off at a relatively high rate since the late 1990s (Table 4.4). This holds for both the average import effective exchange rate based on the MFN rates only (column 9) as well as with the import EERs that also reflect end-user tariff concessions/exemptions (column 10). The lack progress in the latter period was on account of declining amount of direct cash support and other forms of explicit subsidies (such as provision of subsidized credit) for exporters, which offset the reductions in average nominal protection. The increased use of the para-tariffs has also contributed to the high levels of 71 EERs for imports refer to nominal exchange rates adjusted for (protective) import levies and any scarcity premium that exchange controls may generate. The EERm here indicates the domestic currency cost of one US$ worth of imports. For exports, EERx represents the exchange rate after adjusting for existing export promotion schemes (direct export cash subsidies, subsidized export credits etc.). Thus, EERx represents domestic currency equivalent of proceeds from exports worth one US$. 72 A ratio of 1.0 would imply a trade policy that is neutral towards exporting and import substituting production. 93 Bangladesh: Strategy for Sustained Growth anti-export bias by holding back the reduction in nominal protection. With the extent of average bias remaining at about 20 percent, the structure of incentives created by the trade policy still favors the production of import substitutes and constitutes a significant barrier to the emergence of new export areas and to the expansion of exports that are not benefiting from enclave arrangements cited below. Table 4.4: Estimates of Anti-Export Bias Based on Effective Exchange Rates for Imports and Exports Fiscal Imports Average total Average tota Nominal EERm EERm1' EERx Year (in billion protection rate protect. rate Exchange rate Anti-Export Bias tk) (%) la 0 /b (Tk/US$) EERm/ EERml/ EERx EERx (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) 1991-92 134.5 73.6 60.1 38.15 66.24 60.94 38.53 1.72 1.58 1992-93 159.3 60.5 49.6 39.14 62.83 58.45 39.76 1.58 1.47 1993-94 167.7 45.9 38.1 40.00 58.36 55.14 40.50 1.44 1.36 1994-95 234.6 37.5 28.5 40.20 55.29 51.64 40.52 1.36 1.27 1995-96 283.0 31.9 25.1 40.84 53.89 51.04 41.24 1.31 1.24 1996-97 305.4 31.6 24.8 42.70 56.20 53.27 43.17 1.30 1.23 1997-98 341.8 33.1 26.2 45.46 60.53 57.37 46.06 1.31 1.25 1998-99 384.8 32.4 25.6 48.06 63.64 60.34 49.10 1.30 1.23 1999-00 421.3 29.4 22.7 50.31 65.09 61.72 51.82 1.26 1.19 2000-01 503.7 28.5 23.4 53.96 69.36 66.56 55.50 1.25 1.20 2001-02 490.5 29.4 24.0 57.43 74.33 71.24 59.19 1.26 1.20 2002-03 559.2 26.4 21.6 57.90 73.20 70.42 59.68 1.23 1.18 2003-04 642.6 29.1 23.7 58.94 76.10 72.88 60.74 1.25 1.20 2004-05 809.0 26.5 21.4 61.39 77.66 74.51 62.81 1.24 1.19 2005-06 892.2 26.5 20.7 67.08 84.84 80.95 68.01 1.25 1.19 /a: Average (unweighted) total protection based on MFN rates only, and the corresponding EERm is given in column 6. /b: Average (unweighted) total protection based on MIFN rates adjusted for end-user concessions and exemptions-the corresponding EERm is given in column 7. The latter also reflects duty-free access to imported inputs provided to 100 percent RMG exporters. 4.13 Bangladesh has managed to insulate certain activities- most notably the RMG sector - from the anti-export bias, through the bonded-warehouse and Export Processing Zones (EPZs). Furthermore, exporters without access to the duty-free bonded warehouse system or EPZs (because they are not 100 percent exporters) and required to pay import duties or domestic taxes on imported inputs, can benefit from the existing duty drawback system managed by the Duty Exemption and Drawback Office (DEDO). While such enclave type arrangements provide cheaper access to certain types of exporters, they do not offer shelter from the broader disincentives caused by high protection listed in Box 4.1. 4.14 Moreover, the DEDO suffers from weak governance and inefficiencies. Exporters experience significant delays in payments of tariff/tax rebates, despite various attempts to strengthen the DEDO through staff training, new technical staff, and strengthened reimbursement procedures. This is partly due to the complexity of the existing import duty regime and a very lengthy duty drawback process involving the determination of input-output coefficients and the submission of 18 documents by direct exporters (even more documents are required in the case of indirect exporters). It takes a minimum of six months for drawbacks to be paid; 50 percent of applications are not disposed of in two years. 4.15 Securing both the continued success of the RMG sector and export diversification will require sustained efforts to reduce the anti-export bias through further trade reforms, along with measures to address the key behind-the-border investment environment bottlenecks discussed elsewhere in this report. 94 Chapter 4: Trade Liberalization and Export Competitiveness Bangladesh Lags the Rest of the World on Trade Openness 4.16 While trade liberalization occurred in fits and starts in Bangladesh, stronger and more decisive commitment to trade liberalization was seen in majority of the rest of the world. As a result, Bangladesh lags behind on most measures of trade openness (Table 4.5). Even after the reduction in nominal protection in the FY07 budget, Bangladesh has the highest level of trade protection in the region, which itself is the most trade restrictive region in the world. Other South Asian countries, particularly India and Pakistan, have cut their protection levels far more aggressively in recent years, while Sri Lanka started its trade liberalization in the late 1970s and has continued to maintain much lower protection levels (except for the agricultural products). In fact, in 2004, only 4 countries in the world had higher average nominal protection than Bangladesh, and it is unlikely Bangladesh's rank has improved since. Trade liberalization did lead to an increase in Bangladesh's trade-to-GDP ratio - from 20 percent in 1990 to 38 percent in 2005. However, since trade liberalization was a common phenomenon across the globe over the period, Bangladesh's global rank on the measure did not change by much. Among the 140 countries for which comparable data are available for 1990 and 2004, Bangladesh ranked 135t in 1990 and slipped to 137th by 2004 in terms of the trade to GDP ratio.73 Table 4.5: Average MFN tariffs in South Asia and other select developing countries All products (134 countries) Agriculture (134 countries) Average tariff (%) Rank Year Average tariff (%) Rank Year Morocco 33.4 1 2002 Morocco 53.6 1 2002 Tunisia 30.2 3 2002 Turkey 51.6 2 2001 Bangladesh 26.5 5 2004-05 Tunisia 44.7 4 2002 Iran 23.9 7 2002 Korea 43.5 5 2002 Nigeria 23.4 8 2002 India 40.1 7 2004-05 India 22.2 10 2004-05 Iran 35.7 9 2002 Pakistan 18.5 19 2002-03 Bangladesh 32.1 10 2004-05 Egypt 18.4 20 2002 Sri Lanka 28.1 12 2003-04 Nepal 18.0 22 2003-04 Mexico 25.7 14 2002 Mexico 16.2 30 2002 Nigeria 23.0 25 2002 Vietnam 15.0 32 2001 Pakistan 22.6 26 2002-03 Ghana 14.7 34 2000 Ghana 20.2 37 2000 Thailand 14.7 35 2002 Vietnam 19.7 40 2001 Sri Lanka 13.4 42 2003-04 Nepal 19.6 42 2003-04 Turkey 12.6 47 2001 Egypt 18.2 46 2002 Korea 12.6 48 2002 China 17.9 50 2002 Brazil 12.3 51 2002 Thailand 16.2 56 2002 China 12.3 52 2002 Colombia 15.9 59 2003 Argentina 11.8 62 2001 Argentina 12.3 85 2001 Colombia 11.7 63 2003 Brazil 11.7 90 2002 Malaysia 8.8 86 2002 Philippines 10.5 101 2003 Indonesia 7.2 99 2002 S. Africa 10.2 104 2001 Chile 7.0 101 2002 Indonesia 8.4 115 2002 S. Africa 6.4 106 2001 Chile 7.0 119 2002 Philippines 5.1 120 2003 Malaysia 3.0 129 2002 Median 11.2 Median 15.1 Mean 11.7 Mean 16.7 4.17 Source: World Bank (2004): Trade Policies in South Asia: An Overview, page 35. III. Trade Liberalization in Bangladesh: Impact and Remaining Challenges Growth has Benefited from Trade Liberalization 4.18 The intended objectives of Bangladesh's trade policy reforms initiated in the early 1990s were to foster trade integration, enhance domestic competition, and align domestic relative prices with 73 Source: World Development Indicators, World Bank. 95 Bangladesh: Strategy for Sustained Growth international prices. The expectation was that these developments would promote efficiency in resource use and encourage technological progress and diffusion and thus generate dynamic gains and higher productivity growth. This reasoning drew on the widespread agreement that in the long-run economies with liberal trade policies and greater openness show stronger economic growth and overall development performance, based on supporting evidence from numerous cross-country studies and country case studies.74 Has trade liberalization in Bangladesh brought with it the intended consequences of growth and efficiency gains? 4.19 Trade liberalization and the resulting increase in export orientation in Bangladesh since the early 1990s has certainly coincided with and very likely contributed to faster GDP growth. This is supported by evidence at the micro and macro levels. Chapter 1 of this report shows that export orientation and productivity across manufacturing firms in Bangladesh are positively correlated. A similar conclusion was reached by a previous World Bank study. At the macro level, too, growth performance, especially of manufacturing sector and exports, has improved considerably since 1991, benefiting from the trade reforms.76 4.20 A large part of the growth response of exports came from the RMG sector, which, in addition to preferential access to developed country markets, benefited from far deeper trade liberalization than did the rest of the economy. The Government moved early to avail of the opportunities presented by the 'reserved' import markets under the Multi Fiber Arrangement (MFA) and more recently under the Agreement on Textiles and Clothing (ATC) until its complete removal in January 2005 and by the Generalized System of Preferences (GSP) and 'Everything But Arms' programs in the European Union markets. It expanded the use of 'special bonded warehouses' to facilitate quick duty-free access to imported inputs for the 100 percent exporters, offered back-to-back letters of credit, and established EPZs to bypass some of the business environment weaknesses besetting the rest of the economy. Authorities also substantially lowered tariffs on imports of raw materials and capital equipment for most finished products. Several other industries, that had the potential to show a similar growth response, were held back by the slow pace of trade liberalization. 4.21 The positive experience of the RMG sector is testament to the benefits of reducing protection levels while improving business environment and trade facilitation. It reflects the capacity of the Bangladeshi private sector to respond to the new opportunities and the significant positive externalities created through the learning-by-doing process, as evidenced by the emergence of a new generation of entrepreneurs in Bangladesh. Important Challenges Remain Because of the Uneven Nature of Trade Liberalization 4.22 The impressive success of the RMG sector is yet to be replicated in other industries, and Bangladesh's export base remains narrow. As noted, in large part this is because trade liberalization has been much slower in reaching the non-RMG sectors. If anything, Bangladesh's RMG experience demonstrates that relying on enclave-type arrangements to facilitate export growth in a specific economic activity, while postponing broader and deeper trade liberalization, can even backfire in some ways by creating significant concentration of the export base. Today, knitwear and woven-based RMG exports 74 Dollar and Kraay (2002) and (2004), Michaely, Papageorgiou, and Choksi (1991), Winters, McCulloch, and McKay (2004). There are also studies reflecting skepticism over the findings of cross-country studies on the grounds of inappropriate measurement of 'trade policy-induced openness', weaknesses in the methodologies used, and failure to establish the direction of causality: Rodriguez and Rodrik (2000). However, the latter is in turn criticized for ignoring the findings of the country case studies: Srinivisan and Bhagwati (1999). ' The Bangladesh- Trade Liberalization: Its Pace and Impacts, World Bank, 1999, Report No. 19591-BD. 76 Ahmed and Sattar (2003) make the case that the improved growth performance since the early 1990s was in significant part due to the trade reforms. 96 Chapter 4: Trade Liberalization and Export Competitiveness account for 75 percent of Bangladesh's merchandise exports and directly employ 1.8 million workers (90 percent being women), and indirectly another 0.8 million workers in the accessory industries. In this post ATC era, with the abolishment of the quota system, such heavy economic concentration presents significant vulnerabilities that need to be recognized. 4.23 In order to diversify its trade base and improve export competitiveness in general, Bangladesh needs to develop and implement a well-thought-out sequence of trade liberalization measures. The country has to accept the reality of increasing global economic integration that is likely to persist, intensifying competitive pressures among nations. Beyond that, global competition for Bangladesh's main export, RMGs, itself has stiffened with the phase-out of the textiles and clothing export quotas. Low wages notwithstanding, competitiveness of Bangladeshi exporters continues to be undercut by low productivity, higher input costs, perceptions of poor product quality, inefficiencies in trade facilitation and long lead times, and weaknesses in the domestic business environment; areas where many of Bangladesh's main competitors for RMG exports (e.g., China, India, Sri Lanka, Vietnam) are generally doing better. In order to maintain its position as a leading RMG exporter and also to diversify its export base, Bangladesh would need to strengthen its export competitiveness by addressing each of these critical areas of concern. IV. Towards Growth-Supporting Trade Policy Strategy 4.24 Over the last two decades, Bangladesh has followed a unilateral approach as the principal avenue to liberalize its trade policy, while remaining active in the ongoing WTO multilateral trade negotiations, particularly as a leader in the Least Developed Country (LDC) coalition under the Doha Development Round. However, in the area of 'offers' in agricultural and non-agricultural trade, Bangladesh has opted for a strategy of keeping the coverage of its 'tariff bindings' very low (at 13 percent of all tariff lines so far). Furthermore, the bound rates have also been kept significantly above the applied rates for both agricultural as well as for manufactured products.77 In any case, given Bangladesh's prohibitively high protection rates in the early 1990s, trade liberalization through unilateral actions (of course, in a manner that is consistent with the multilateral system of the GATT principles) and not waiting for the multilateral trade negotiations as a key instrument of Bangladesh's own tariff rationalization efforts seems to have been the right strategy. 4.25 Bangladesh and the other South Asian countries have also been actively involved in the negotiations of various regional 'preferential trade agreements' (PTAs) and in discussions ofpotential bilateral free trade agreements (FTAs). Quite apart from general opening up through unilateral trade liberalization particularly since the early 1990s, South Asian countries view increased cooperation and trade among themselves as a key objective. This was reflected in the signing by the member nations of the South Asian Association of Regional Cooperation (SAARC) - Bangladesh, Bhutan, India, The Maldives, Nepal, Pakistan, and Sri Lanka - of the South Asian Preferential Trade Area (SAPTA) Agreement in 1993, which became operational in December 1995. The actual exchange of preferences has been quite limited, partly due to the hostilities between India and Pakistan, and the impact of this initiative on Bangladesh trade liberalization and trade openness has been minimal. 4.26 More recently, the worldwide proliferation of PTAs has led to a change in thinking in the region, especially in India but also in other South Asian countries, which have all begun to negotiate a series of PTAs of their own. As in other regions, these efforts particularly intensified in the aftermath of the failed September 2003 Cancun Ministerial meet. The South Asian Free Trade Area (SAFTA) Agreement was signed in January 2004, with the ultimate objective of turning South Asia into a full- 7 For details, see: Trade Policies in South Asia: An Overview, World Bank, 2004, Report No. 29949. In FY04, the simple average of bound tariff rates was 188 percent - 197 percent for agricultural products and 50 percent for manufactured products. 97 Bangladesh: Strategy for Sustained Growth fledged FTA with the internal liberalization beginning in January 2006. This agreement has come in the wake of a bilateral FTA agreement between India and Sri Lanka in 1998 that became operational on March 1, 2000. At the same, there is an ongoing discussion between India and Bangladesh on a possible bilateral FTA. Outside the region, Bangladesh is discussing details of an FTA with Malaysia.78 4.27 The potential costs of PTAs/FTAs need to be carefully evaluated. Given that South Asia is the most protected regions of the world, Bangladesh faces considerable risks of adverse 'trade diversion' effects from regional PTA/FTA agreements. This is because such (multilateral and bilateral) preferential trading arrangements may lead to shifting of the source of imports away from least cost/most efficient third countries to higher cost members countries. In addition, a loss of customs revenues could also result.79 It is therefore critical that Bangladesh continues to reduce the high protection levels with unilateral trade policy reforms by reducing the average level and dispersion of import tariffs, with a particular effort to dismantle the existing para-tariffs. This strategy will also enable Bangladesh to better manage its 'regional integration' objectives by helping to minimize the adverse 'trade diversion' effects. 4.28 Specific recommendations are listed below, first with respect to the unilateral trade liberalization strategy, and then on the key elements of a strategy toward potential FTAs, assuming that the Government is determined to remain a member of the SAFTA and finalize the ongoing bilateral discussions with a view to signing FTA agreements. 4.29 Recommendations for the future unilateral trade liberalization program: * Establish a low and uniform tariff rate in not so distant future - the key ultimate objective of the future trade reforms. And these interim reform steps will need to include further simplification of the import tax regime, and reduction in the dispersion and average level of nominal (and thus effective) protection, preferably through a pre-announced medium- and long- term schedule of tariff reductions (as done recently by India). * Unify all para-tariffs and merge these with the CD, with the result of having one tariff rate for each tariff line (in one-to-two years); * Following the practice of the last decade, a 'tops down' tariff reduction approach could be maintained. Accordingly, gradually reduce the maximum tariff rate (after the merging of all para-tariffs with CDs) to 20 percent over the next two-three years, followed by a new maximum tariff rate of 15 percent by, say, 2010. This would, of course, also require parallel progress in expanding the base of VAT and direct taxes, elimination of the numerous tax exemptions, and further strengthening of tax and customs administration; * Eliminate all end-user tariff exemptions/concessional tariffs; * Discontinue protective use of VAT by ensuring that it is levied both on domestic production and imports of the same products (in one year); * Eliminate all the remaining quantitative restrictions/bans that are for protective purposes, such as those applying on imports ofpoultry, cartons, and salt. Replace them with appropriate tariffs (in one year); * To maximize benefits from the EU's GSP/EBA preference programs extended to the LDCs, resist objections raised by the textile sector to the use of 'regional cumulation' allowed by the EU 78 For further details and analysis, see: Baysan, Panagariya, and Pitigala (2004); Trade Policies in South Asia: An Overview, Chapter 5, (Volume II), World Bank, 2005; Global Economic Prospects: Trade, Regionalism, and Development, World Bank, 2000. 79 For details, see: Baysan, Panagariya, and Pitigala (2004). 98 Chapter 4: Trade Liberalization and Export Competitiveness towards meeting the latter's 'rules of origin' conditions. This will help Bangladesh's RMG exports in the EU markets; and * Lobby strongly in the USA for duty-free entry for its RMG exports, since such a preference has already been extended to the LDCs in Africa under the Africa Growth and Opportunity Act. * Since many export items do not benefit from the duty-free access to imported inputs through the bonded warehouse and EPZ schemes, it is critical to ensure a well functioning duty drawback system such that rebates are paid quickly. To this end, the full implementation of the new duty drawback and bonded warehouse scheme is needed immediately. 4.30 Recommendations for the regional track to trade liberalization through free trade area (FTA) agreements:80 * First, continue with unilateral trade liberalization to minimize the likely adverse trade diversion effects, the key elements of which are listed above. * Both for the SAFTA and for any bilateral FTA that might be signed: o minimize sectoral and/or product exception from such FTA agreements; o have clear rules against tariff-rate quotas; o have 'rules of origin' that are liberal, simple, transparent, and uniform for all products; o extend such agreements to services trade and investment; * It would be desirable if countries in the region use the instrumentality of SAARC to promote economic cooperation in areas other than trade, de-linking those with cooperation on trade under SAFTA. Using the SAFTA instrumentality to promote trade and other agendas could face the risk of each being held hostage to the progress in the other. Specific areas of regional economic cooperation where the SAARC forum could be used include: infrastructure; trade facilitation; and harmonization of technical and sanitary and phytosanitary (SPS) standards in line with the standards of the major export markets. 80 For an analysis of economic arguments on the topic, see Baysan, Panagariya, and Pitigala (2004). 99 CHAPTER 5: URBAN DEVELOPMENT AND ECONOMIC GROWTH IN BANGLADESH I. Urbanization and Urban Concentration in Bangladesh: A Process of Rapid Transformation 5.1 Bangladesh, a predominantly rural country, is undergoing a transformation toward urbanization at a remarkable pace. Its urban population has grown at a yearly average rate of 6 percent since independence, at a time when the national population growth was 2.2 percent. As a result, urban population has grown six-fold, compared with a 70 percent increase in rural population. As per recent UN data, about 35 million people, or approximately 25 percent of Bangladesh's population, currently live in urban areas, compared to only 8 percent at the time of independence: the number is projected to cross 80 million by the year 2030 (Figure 5.1).81 The share of urban activities in GDP increased from 26 percent in 1972-73 to over 42 percent by 1998-99,82 a period over which agriculture sector's share in GDP fell from 60 percent to 26 percent. Figure 5.1: Urbanization in Bangladesh 200 Urban Population (%) 180 - 160 40 0140 35 - 120 -30 E -*-Total 1 100 -- Rural 25 75 80 -- Urban 20 60 15 40 10 20 5 0 0 0 0 0 0 0 0 LO 0 LO) (0 1- 00 O) 0 0 V %0 4 I'l 'l ( ,l e 2 21 N 04 C14 ON Data Source: UN World Urbanization Prospects 5.2 Urbanization has been more concentrated in the largest cities. More than half the urban population lives in the four largest cities (see Table 5.1). Dhaka, the national capital, is the largest of these with 12 million residents:83 an eightfold increase in its population since 1970. Its population is projected to reach a staggering 22 million by the year 2015 according to UN estimates.84 This would make Dhaka, currently the world's 11th largest city, the 6t largest city in the world and 3rd largest in Asia by 2015. The next three largest cities - Chittagong, Khulna, and Rajshahi - are also growing rapidly, each having experienced at least a five-fold increase in population since 1970 (ten-fold increase the case of Rajshahi). At the other end of the size spectrum are about 300 smaller urban areas, which account for just 4 percent of the urban population.85 Economic activity is just as concentrated in the largest metropolitan areas. 5.3 Urbanization and concentration of it in the largest cities is a byproduct of economic development, a phenomenon hardly unique to Bangladesh. Developed countries, almost by definition, 81 Urban growth in Bangladesh is considerably higher than its South Asian neighbors - urban populations in both India and Pakistan have grown at about 3 percent annually since the 1970. Similarly, urban population growth in Brazil has increased by 3.7 percent a year since 1970. 82 Center for Policy Dialogue (CPD) (2001). 83 This is about one-third of the national urban population. 84 Ahmed et al., mimeo, World Bank, 2006. 85 Chowdhury (2004). 101 Bangladesh: Strategy for Sustained Growth have already made the transition to having a vast majority of their population living in cities. Similarly, as the emerging economies, including Bangladesh, have moved up the development ladder, the share of urban activities in GDP has increased and a rapid shift toward urbanization has resulted. Fast growing economies such as Korea and Malaysia, in fact, have doubled their urbanization rates to 65 and 80 percent, respectively, since 1970. 5.4 The urbanization process has important implications for productivity and growth prospects of a country, and the associated opportunities and challenges require careful management. Production typically benefits from being located in densely populated urban areas that provide a pool of skilled workers, a network of complementary firms that provide backward and forward linkages for supply chains, opportunities for knowledge flows, and a critical mass of consumers.86 Presence of economies of scale and scope that arise in the early development stages generates increasing returns, with benefits for growth and productivity. At the same time, concentration of urbanization in a few large cities without concomitant improvements in their governance and infrastructure also carries associated costs in the form of congestion, pollution, and transport and services bottlenecks. After a point, the costs tend to dominate and decreasing returns set in, resulting in lower GDP growth, as shown by recent cross-country studies.87 Accordingly, policies to manage this challenge need to first ensure strong governance of the larger cities to benefit from their dynamism and agglomeration economies, while also creating a level playing field for the smaller cities, to enable their emergence as viable urban alternatives. The latter focus is important to reduce concentration pressures on the larger cities and spread the agglomeration benefits more widely. 5.5 In this context, two aspects of the urbanization process in Bangladesh seem quite relevant. First, from a production perspective, how can the net benefits from urban concentration be maximized? Second, from a consumption perspective, how can cities overcome administrative and fiscal constraints to provide services that are valued by households and firms? The two issues are necessarily intertwined. The first involves national level policies such as expenditure on inter-regional transport network and decentralization that shape the patterns of urban concentration and have a bearing on demand for urban services. The delivery of city services, itself along with improvement of other aspects of urban city management (such as revenue mobilization), works to reduce the costs of urban concentration and hence improve the net benefits of urban concentration. Additionally, improvement of urban services in the smaller cities has the spillover effect of alleviating pressures on the largest cities. To address these issues, it seems important to examine more closely the costs and benefits of urban concentration in Bangladesh, including the factors driving it, and also the structure of urban management (including division of responsibilities at the national and local levels) that guides the extent to which individual cities can innovate. The rest of this chapter is organized along such lines. II. Urban Concentration in Bangladesh: Extent, Causes, Benefits, and Costs Urban Concentration in Bangladesh 5.6 As already noted above, the process of urbanization in Bangladesh has been rapid and uneven: it has been much more concentrated in the largest cities, especially Dhaka (Table 5.1). The four largest cities - Dhaka, Chittagong, Khulna, and Rajshahi - account for over 60 percent of the urban population, up from 48 percent in 1970. One-third of the urban population resides in Dhaka alone. Dhaka, Chittagong, and Rajshahi have each outpaced national urban growth. The urban concentration trends, not surprisingly, largely mirror the concentration of economic opportunities in these cities. Most major industrial activities and auxiliary businesses services are concentrated in the largest cities. Dhaka alone 86 World Development Report, World Bank, 1999-2000. 87 For example, Henderson (2003). 102 Chapter 5: Urban Development and Economic Growth in Bangladesh accounts for 80 percent of the garments industry-the mainstay of manufacturing in Bangladesh." In Dhaka and Chittagong, about one-tenth of the labor force is engaged in the garments industry, which is over seven times the national average (Annex Table 5.1). 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 considerably higher in the four largest cities relative to the rest of the country. At the same time, and not surprisingly, the share of population in the largest cities engaged in primary activities is significantly lower than in the rest of the country. Table 5.1: Population growth of the largest agglomerations City Population Population Population Population Population Annual Growth Rank (2000) (2000) (1990) (1980) (1970) (1970-2000) Dhaka 1 12300 6619 3248 1474 7.1% Chittagong 2 3581 2265 1333 693 5.5% Khulna 3 1426 972 622 310 5.1% Rajshahi 4 1016 517 238 105 7.6% Mymensingh 5 328 189 108 N.A. - Comilla 6 307 135 126 86 4.2% Note 1: Population in thousands; Note 2: Data are for agglomerations; Data Source: Global Cities Database http://www.econ.brown.edu/faculty/henderson/worldcities.html 5.7 The degree of urban concentration in Bangladesh appears to be higher than in many of its comparators. A straightforward measure of urban concentration is primacy, or the share of the largest city in the total urban population in the country. In Bangladesh, Dhaka's primacy rate is about 32 percent, which is significantly higher than in neighboring South Asia countries (See Table 5.2) and is also high relative to countries with similar land areas - for example, primacy is 21 percent for Bulgaria and 23 percent in Korea. However, Dhaka's primacy seems in line with countries such as Honduras when these were at similar levels of economic development. Table 5.2: Urban concentration in comparator counties (%) South Asia Region Per capita Incomes Land area Historic Incomes Country Primacy Country Primacy Country Primacy Country Primacy India 5.72 Cameroon 22.48 Bulgaria 20.84 Colombia (1975) 20.16 Pakistan 21.94 Mongolia 56.27 Guatemala 20.09 Honduras (1985) 35.48 Senegal 43.53 Korea 23.28 Armenia (1995) 50.85 Kyrgyz Republic 45.50 Honduras 27.25 Turkey (1975) 21.63 Data Source: WDI Tables, SIMA Causes of Urban Concentration: Market Access, Agglomeration Economies, and Policy Biases 5.8 Analyses for other large developing countries have identified the following factors as being key to firms' location choices across sub-national regions:89 (i) the quality and cost of complementary utility services, including electricity, water and telecommunication; (ii) market access, or the geographical reach, given existing transport infrastructure; (iii) agglomeration economies as measured by the presence of firms in own industry and of firms in related industries; (iv) labor and other regulations; and (v) access to serviced land. Due to data limitations, for the case of Bangladesh we restrict ourselves to assessing the 88Dhaka Urban Poverty: Land and Housing Issues. Draft paper, World Bank, 2005. 89 Lall, Venables, and Redding (2005). 103 Bangladesh: Strategy for Sustained Growth role of market access and agglomeration economies, in addition to that of major policy biases toward the largest cities. The Role ofMarket Access 5.9 Regional variation in market access, the distance from and the size and density of market centers in the vicinity of the firm, is an important factor leading to urban concentration.90 Firms are attracted to areas with better market access, which leads to concentration of production in these areas.91 In the case of Brazil, India, and Indonesia studies have found market access to be the most important factor in determining where firms locate.92 Market access and urban concentration appear to be closely linked also in Bangladesh. Figure 5.2 shows market access - which is a combined function of road network and its quality, travel speeds, and population density - to be the highest around the Dhaka metropolitan area. As one moves out of the corridors that link Dhaka to other major urban centers, market access drops off quite rapidly. This does not, however, establish in any way that market access causes urban concentration in Bangladesh. It may well be that urban concentration, arising from other factors, is leading to higher market access. A more reasonable reading would be that market access and urban concentration reinforce each other in Bangladesh. Figure 5.2: Market Accessibility across Urban Centers Ac-cessibility index Source: Deichmann 2003 The Role ofAgglomeration Economies 5.10 Agglomeration economies are another major reason why industrial and commercial activities tend to cluster. The benefits of agglomeration economies take two forms. Firms benefit from co-locating with other firms in the same industry: a phenomenon also known as localization economies. Firms also benefit from presence of complementary activities or urbanization economies.93 Firms that produce intermediate goods will tend to locate close to producers of the final good (a forward linkage). 90 The classic gravity model is commonly used in the analysis of trade between regions and countries (Evennet and Keller (2002)). It states that the interaction between two places is proportional to the size of the two places as measured by population, employment or some other index of social or economic activity, and inversely proportional to some measure of separation such as distance. 91 Davis and Weinstein (2003) show that good market access has a magnified effect on location decisions because firms will locate in the larger market and export (bearing transport costs) to the smaller ones, rather than vice versa. 92 Deichmann et. al, 2005; DaMata et. al. 2005; Lall and Mengistae (2005). 93 World Development Report, World Bank, 1999-2000. 104 Chapter 5: Urban Development and Economic Growth in Bangladesh Downstream firms, similarly, will gain from locating close to their suppliers (a backward linkage). These linkages can also serve as a channel for information transfers. Firms that are linked through stable buyer- supplier chains often exchange ideas on how to improve the quality of their products or on how to save production costs. 5.11 Do agglomeration economies explain urban concentration in Bangladesh? It is highly likely that the concentration of garment activities in Dhaka and Chittagong generate localization economies, a draw for newcomers in the sector. To test whether the largest cities in Bangladesh also provide more opportunities for urbanization economies, we calculate a population-weighted specialization index, with the expectation that lower the value of the index for a given city, the less specialized is the city and greater is the presence of urbanization economies in that location. The index is calculated at the district level, using data from the 2003 Labor Force Survey. 5.12 We first group the districts into three size categories. The first category consists of the Dhaka metropolitan area with a population of more than 5 million. The second consists of the cities of Chittagong, Rajshahi and Khulna metropolitan areas, which have populations more than 500,000 but less than 5 million. The third category consists of all the other districts.94 The index is measured as follows: k sj = s .E)2 j=1 where Ej is the share of industryj in national employment, siy is the share of industryj in total employment of agglomerationi, and the sum is over k industries locally. The index measures for each industry how much the local production share differs from the national share. If all industries mimic the national share the index has a value zero and the city is perfectly diverse. A highly specialized city would have an index approaching two. 5.13 Estimates of the specialization index suggest a more significant presence of urbanization economies in the largest cities. As seen in Table 5.3, relative to the smaller cities (size less than 500,000), the index has a lower value for the four largest cities in Bangladesh, suggesting diversified economic structures in these cities. This, together with the concentration of the major economic activities such as garments production and organized business services in these cities, reflects scope for both aspects of agglomeration - localization economies and urbanization economies - in the largest cities. A somewhat surprising finding, however, is that Dhaka is more specialized than the next three cities on both specialization measures.95 On the other hand, the small and medium size cities appear to be more specialized, consistent with empirical evidence for other countries which similarly find smaller urban centers to be specializing in production activities such as food and beverages, textiles, shoes, or pulp and paper products, among others.96 Therefore, while there is scope for localization economies for the smaller cities in Bangladesh, the scope for urbanization economies is much more limited compared with the 94 Rural parts of the district have been excluded. 9 Much of Dhaka's excessive specialization comes from the fact that it diverges from the national share of agriculture employment (11 percent vs. 60 percent nationally) giving it a high overall index, and its share of garments employment is twice the national share, thereby giving it a high value in the manufacturing index. 96 Henderson et. al 2001. 105 Bangladesh: Strategy for Sustained Growth larger metropolitans. This appears to be another likely reason behind the uneven pace of different-sized cities in Bangladesh. Table 5.3: Specialization Index City Size Manufacturing Overall 5 million + (Dhaka) 0.19 0.28 500,000- 5 million (Chittagong, Khulna, Rajshahi) 0.07 0.2 less than 500,000 0.4 0.5 Data Source: Labor Force Survey, 2003 The Role of Policy Biases 5.14 Policy bias and resulting favoritism also aid urban concentration. In a centralized governance structure, as in Bangladesh, the national govermment tends to favor one or two cities, typically the national capital (Bangkok, Dhaka, Mexico City, Jakarta, or Seoul) or certain financial/commercial capitals (Sao Paulo), over others. Such favoritism often involves disproportionate allocation of public expenditures toward the favored cities. These cities also receive disproportionately high levels of public services, while hinterland cities are restricted in their ability and autonomy to deliver public service.97 Favoritism can also involve the national government choosing not to invest sufficiently in interregional transport and telecommunications, so hinterland cities are less competitive locations.98 Both forms of policy bias are visible in Bangladesh. Policy bias can also take the form of restrictions in capital markets, export/import markets, and licensing of production rights, all favoring firms that locate in the national capital, although there is no direct evidence of this in Bangladesh. An additional problem in Bangladesh is the inefficient functioning of the national land development markets which, together with lack of fiscal decentralization, prevents land developers and local governments from actively developing alternate urban locations and spreading development across the urban hierarchy. Negative Externalities Arising from Excessive Urban Concentration 5.15 While market access, agglomeration economies, and policy biases influence location decisions of firms towards large cities, excessive urban concentration in the absence of concomitant improvements in urban management and infrastructure carries associated economic costs. Such costs are becoming fairly evident in the major urban areas of Bangladesh, especially Dhaka. Real estate in Dhaka has gotten out of reach for most, rapidly worsening traffic congestions have increased commute times substantially, Dhaka's infrastructure is being stretched to the limit, and citizen ratings of most urban services border on complete dissatisfaction. 5.16 The cost of real estate in Dhaka has reached astonishing levels. Residential land values in prime locations of Dhaka are higher compared to those found in developed countries.99 For example, the Bangladesh Institute of Planners estimates that land in Dhanmondi, among the more expensive areas in Dhaka, is Tk 3,500/ft2 or roughly US$50. Similarly, land in Gulshan is priced at Tk 3,194 /ft2 and Baridhara at Tk 3,000 /ft2. Even in peripheral areas of Dhaka, such as Uttara, Pallabi, and Shyamali, land 9 However, it is quite likely that there are increasing returns in the provision of many public goods. For instance, if a country is to build 100 miles of paved roads, it may be efficient to build most of it joined together in a dense network rather than scattered around. In this case an, 'favoring' large cities in public expenditure and provision may be an efficient allocation of resources. 98 Recent literature confirms the importance of inter-regional discrepancies in influencing urban concentration. Henderson (2003) finds that investment in national roads and highway systems significantly reduces national urban primacy. Gallup, Sacks, and Mellinger (1999) and Rosen and Resnick (1980) find similar results for investments in waterways and railways. 9 Seraj and Afrin (2003) 106 Chapter 5: Urban Development and Economic Growth in Bangladesh costs over Tk 1,500/ft2 (over US$20). Consider in comparison the land prices (in) in the cities of the United States (whose per capita income in purchasing power prices is about 20 times higher): US$13/ft2 in Boston; US$14/ft2 in Chicago; US$30/ft2 in Los Angeles; US$11/ft2 in Miami; US$32/ft2 in New York; US$26/ft2 in San Diego; and US$64/ft2 in San Francisco.100 The situation is not that much different in other metropolitans in Bangladesh. Land prices in Khulna have been estimated to be similar to those in Dhaka, and are about 15 percent lower in Chittagong.101 The least expensive middle class housing in the country is estimated at about Tk 700,000, which is more than 10 times the median income. 5.17 Dhaka's high land prices stem from the topographical features that limit its supply of land as well as from poor land management. Dhaka is located in a flood plain and surrounded by rivers which periodically flood the lowlands around the city. This creates scarcity of developable land, reflected in the city's high population density of about 20,000 persons per square kilometer, going up to 100,000 persons in some parts.102 The land constraint imposed by the natural features is exacerbated by poor land management by the Rajdhani Unnayan Kartripakkha (RAJ-UK), the regional planning and development agency. Since its formation in 1959, RAJUK has developed serviced parcels sufficient only for 16,000 housing units, or less than 400 units per year. At the same time, the area within its jurisdiction has added more than 6 million people-roughly 1 million households.103 Thus, the one public agency responsible for housing infrastructure, and with the means to assemble parcels, has been able to meet one 1-2 percent of demand for serviced land. 5.18 Infrastructure and service bottlenecks in the major urban areas have become just as acute. In a 2002 consumer satisfaction survey (Table 5.4),104 less than 20 percent of households in each of the four metropolitan areas expressed satisfaction with almost any urban major service. Police, land registration, public transport, electricity, and especially judiciary were rated very poorly. In Chittagong, only 5 percent of the respondents were satisfied with the quality of education and 4 percent with the quality of health care. Table 5.4: Satisfaction with Services (% of surveyed households) Services Dhaka Chittagong Khulna Rajshahi Police 2 0 1 2 Land Registration 2 1 10 4 Transport 7 3 19 6 Electricity Services 8 2 12 2 Judiciary 8 1 2 5 Health Care 11 4 18 9 Garbage Disposal 15 10 12 10 Sewerage/Sanitation 17 16 11 16 Education 21 5 28 12 Drinking Water 27 9 11 8 Source: Proshikha (2002) 100 Glaeser and Gyorko (2003) 101 Housing Finance Reforms in Bangladesh, South Asia Finance and Private Sector, World Bank, 2004. 102 Islam (2004). 103 Housing Finance Reforms in Bangladesh, South Asia Finance and Private Sector, World Bank, 2004. 104 The survey was conducted in 2002 by Proshikha (a Bangladeshi NGO) and the Public Affairs Center (Bangalore, India). Six satisfaction-related response options were provided to the households ranging from strongly satisfied to strongly dissatisfied. These were aggregated into three groups: (i) "satisfaction", which represented the share of respondents strongly satisfied and moderately satisfied with any particular service; (ii) "dissatisfaction", which represented the share of respondents strongly dissatisfied and moderately dissatisfied with any particular service; and (iii) "ambivalent", which represented the share of respondents marginally satisfied and marginally dissatisfied. 107 Bangladesh: Strategy for Sustained Growth 5.19 Firm surveys, too, reflect deep dissatisfaction on the part of business owners and executives with infrastructure and access to land in the main cities.105 Firms in Dhaka and Chittagong were equally unhappy with the quality of electricity supply, reporting power interruptions of about 250 days per year. Forty percent of firms interviewed in Dhaka reported access to land as a severe constraint to business expansion. 5.20 Until recently, Dhaka ranked among the world's most polluted cities, with emissions from vehicles with two-stroke engines (baby taxis, tempos, motor-cycles) and trucks and buses being the main contributors to air pollution. However, with the phasing out of two-stroke engines on December 31, 2002, air quality has improved quite dramatically. PM2.5 concentration in Dhaka declined from 250 micrograms/m3 prior to the phase-out to 150 micrograms/m3 on Jan 2, 2003.106 However, the overall welfare effects of this policy is not clear as the phase out baby taxis are likely to be used in other cities and increase emission levels in those places. Growth Implications of 'Excessive' Urban Concentration 5.21 The relationship between urban concentration and growth appears to have an inverse-U shape, for given levels of income and urban governance and infrastructure. As noted, concentration of resources in early stages of development is useful and improves efficiency as economies of scale and scope help get the most out of scarce resources. At the same time, the economic costs - congestion, overburdening of infrastructure etc. - also begin to rise with increasing urban concentration, more so in absence of good urban management. In fact, recent research suggests that there is an optimal range of urban concentration relative to the quality of the country's urban governance and infrastructure.'07 As show by Henderson (2003), for example, deviations from this optimal point lead to productivity and growth losses. 5.22 Primacy of Dhaka is considerably higher than the "optimal" primacy level suggested by Henderson's cross-country estimations. At Bangladesh's income level and urbanization scale, Henderson's estimates suggest an 'optimal' primacy rate of around 21 percent for Dhaka, whereas it is about 32 percent, or more than two standard deviations higher than the optimal. This implies a loss of at least two percentage points in annual GDP growth. This likely overstates the case, but does make the point that excessive concentration of economic activity in one city, Dhaka, relative to its level of governance and infrastructure, could have serious growth costs for the nation as a whole. III. Urban Management Structure and Financing and Delivery of Local Amenities 5.23 In the previous section, we considered the benefits from agglomeration economies and the costs associated with excessive urban concentration. To be sure, the extent of the negative externalities is related to the quality of the city management. If cities suffer from bad management and inadequate resources, then that will only add to the bottlenecks in infrastructure and service provision, resulting in diminishing returns from urbanization setting in sooner. On the flip side, better management of cities can help contain the costs of increasing concentration, prolonging the period of net benefits from urbanization. The quality of urban management in smaller cities also matters - the higher is the quality, the lower will be the concentration pressures on the major cities. What is the structure and state of urban management in Bangladesh? 105 The Bangladesh Enterprise Institute and the World Bank carried out the investment climate survey, covering 1001 firms in Dhaka and Chittagong. 106 Details on air quality issues are at http://www.cleanairnet.org/caiasia 107 For example Wheaton and Shishido (1981), and Henderson (2003). 108 Chapter 5: Urban Development and Economic Growth in Bangladesh 5.24 Out of the 522 urban areas identified by the 1991 Census Commission, only 295 urban centers have urban local governments. The six largest cities have a city corporation status, while 289 other urban centers have Pourashava or Municipality status. Pourashavas are further classified into four categories based on their own source revenue potential. These are Special Category Pourashavas (only 2 in number), Category I Pourashavas (61), Category II Pourashavas (46), and Category III Pourashavas (190). In centers with no local government, urban infrastructure and services are provided by the field administration of the central government through its line ministries.108 5.25 City governments in Bangladesh do not have much autonomy to develop economic development programs or design and provide most public services. There is considerable vertical imbalance where most 'urban' functions are the responsibility of the central government. This includes all utility services, housing and land development, secondary and higher education, and economic development planning. Several national ministries are responsible for the management of the 'urban sector'. The Ministry of Local Government, Rural Development and Cooperatives (MLGRDC) and the Ministry of Housing and Works (MOHW) share the responsibilities of developing and providing urban services and infrastructure through the Local Government Engineering Department (LGED) and the Department of Public Health Engineering (DPHE) respectively. Urban development authorities such as RAJUK are part of the MOHW. Local autonomy is further stifled by the fact that local governments have little or no choice on the staffing, nor do they have control over the wages for their employees. Further, key personnel at the local levels are central government employees with limited accountability to residents. 5.26 City corporations and Pourashavas are responsible for delivering a set of generic public services, which leaves little scope for competition among them to attract investment and labor. Table 5.5 summarizes various responsibilities of local governments and other service providers along with their main revenue sources.109 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 administrative capacity at the local levels, creating dependence on fiscal transfers from the center.110 5.27 City governments are unable to ensure satisfactory delivery even of the small subset of responsibilities entrusted them, due to their weak fiscal and administrative capacity. Importantly, they do not have buoyant tax handles, which limits their own-source revenues. The main own-source revenue for Pourashavas is the property tax and associated fees for water, lighting and conservancy that are imposed on the same base, collectively called the holdings tax. The base of the property tax is the 'annual value' (or rent) of buildings and lands, as is common in many other countries."' Rebates on the 108 Chowdhury (2004). 109 There are only small differences between the responsibilities of a City corporation and a Pourashava. However, in case of Dhaka and Chittagong city corporations, water supply and sewerage, planning and development responsibilities have been given to special development authorities (RAJUK for Dhaka, CDA for Chittagong, and WASA for both Dhaka and Chittagong). Water supply is a local government responsibility for the Pourashavas. 110 Asaduzzamar (1996), Chowdhury (2004), and Bangladesh Municipal Finance Management Sector Study, Infrastructure Operations Division, South Asian Region World Bank, 1998. "1 The tax on land and buildings is imposed at a maximum rate of 7% of the tax base (the annual value); and government regulations also set the maximum rates for the other parts of the holdings tax, at 3% for the lighting rate, 7% for the conservancy rate, and 10% for the water rate, giving a maximum combined tax rate of 27%. This overall rate of taxation is similar to, if slightly higher than, other countries with an annual value system of property taxation Bangladesh Municipal Finance Management Sector Study, World Bank, 1998. 109 Bangladesh: Strategy for Sustained Growth annual taxable value are offered to owner occupied properties to deduct mortgage costs as well as for maintenance expenditures.112 Table 5.5: Providers responsible for delivering urban services Name of Agencies Main Services Sources of Finance City Corporations Sanitation, solid waste disposal, road Property taxes, conservancy, building and maintenance, street lighting, lighting and water rates, fees, traffic signaling, parks, playground, fines, rental income, poverty alleviation, slum improvement government grants, donor funds. Pourashava Sanitation, solid waste disposal, Road Property taxes, conservancy, building and maintenance, Street lighting, lighting and water rates, fees, traffic signaling, parks, playground, fines, rental income, poverty alleviation, slum improvement, government grants and donor Planning, etc funds. Water and Sewerage Authority Drinking water supply and sewerage Water tariffs, loans, grants (WASA) in Dhaka and Chittagong from govt. and donors Development Authorities: Planning and development of physical From sale of lands and RAJUK, CDA, KDA, RDA infrastructure government grants Department of Environment Environment Control Government budget Specialized authorities: Civil works, Housing, physical Government budget and PWD, NHA, DPHE & LGED Development donor's grant and aid Source: Chowdhury (2004) based on different sources 5.28 Weak administrative capacity and strong political interests limit the extent to which local governments can tap an expanding tax base and enforce compliance with taxes. In principle, property tax collection should be sufficient to finance delivery of services expected of local government. This, however, is not the case. While the tax base is scheduled for revaluation every five years, the reassessments are seldom performed in practice. The administration of the stagnant tax bases is also fraught with problems. The rate of tax collection across Pourashavas is low - between 2000 and 2002, only 29 percent of smaller Pourashavas collected more than 50 percent of their estimated holding tax. Further, only 25-30 percent collected more than 50 percent in arrears.113 Moreover, in many local governments, the assessed base and taxable values are recorded by hand, which increases the potential for rent seeking and limits the potential for regular updates.114 Growth in revenues from the property tax is further limited when local politicians make promises of not raising tax rates (as was done in the 1990s). Finally, the linkage between taxes and the receipt of public services is extremely weak, which lowers tax payer confidence and willingness to pay property taxes. 5.29 In the absence of strong own source revenues, most local governments (especially Pourashavas) rely on central government transfers. These transfers often account for 50 percent of local govermment revenues. However, such grants, in turn, depend on the central government's own fiscal wellbeing; thus their reliability as source of municipal revenues is limited. There has also been a steady decline in grant allocation per Pourashava over time. With additional Pourashavas being created on a regular basis, total govermment grants per Pourashava fell by more than half between 1996 and 2002 (Table 5.6). This has adversely affected the ability of municipalities, especially the smaller ones, to provide services to their citizens. 112 Maintenance rebates are offered regardless of whether the resident or the landlord has incurred these expenditures. 1" Similar problems of low collection rates and incomplete assessments of the property tax are seen in Indian cities. 114 Bangladesh Municipal Finance Management Sector Study, World Bank, 1998. 110 Chapter 5: Urban Development and Economic Growth in Bangladesh Table 5.6: Reductions in central government transfers Government grants to Pourashavas 1996-2002 Average Govt. FY Total Municipal No. of Grants for Year Govt. Grants (million) Pourashava Pourashavas (million) 1996 1200 133 9.02 1997 1050 160 6.56 1998 1150 181 6.35 1999 1250 213 5.87 2000 1300 226 5.75 2001 1300 252 5.16 2002 1200 276 4.35 Source: Ministry ofLocal Government, GoB, Dhaka; Chowdhury (2004) 5.30 The transfers from the central government to urban local governments are mainly in the form of: (a) specific transfers for investment expenditures identified in the Annual Development Plan (ADP); (b) block grants to finance local expenditures; and (c) revenue budget transfers to finance recurrent expenditures, mainly salary subventions for municipal employees (City Corporations are not given salary subvention grants). Grants to local governments in support of the ADP are declining. In the year 1997/1998, City corporations and Pourashavas received 0.82 and 0.86 percent of total ADP grants respectively, and these figures fell to 0.63 and 0.74 percent by 2001/2002. Two important issues in the context of ADP allocations are not clear. First, the mechanism and criteria by which ADP block grants are allocated across different types of local governments are not defined. Second, the rationale for centralized administration of the bulk of ADP block grants is unclear. Further, even when ADP grants are locally administered, they are pre-committed to specific sectors, which constrains innovation at the local level. IV. Policy Options To Improve the Contribution of Cities to Economic Growth: Improving Management of Cities and Removing Policy Distortions 5.31 The urban management challenge is twofold. First, to improve access to and quality of basic services and infrastructure in Dhaka and other major metropolitans. Second, to improve the prospects for the smaller cities to emerge as viable urban alternatives. Cutting across both challenges 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 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 computerization of billing would be useful. However, these efforts can succeed only if the link between local taxes and quality of public services is strengthened. 5.32 A multi-pronged holistic approach is necessary to effectively tackle urban management problems of the severity and scope seen in Dhaka.115 Strengthening the city's governance structure is the foremost priority, and would involve addressing the mentioned issues of decentralization, capacity and resource constraints, and fragmentation of responsibilities and accountabilities among the various agencies. Some specific recommendations follow: "15Ahmed et al., mimeo, World Bank, 2006. 111 Bangladesh: Strategy for Sustained Growth * Strengthen the role of the Dhaka City Corporation (DCC) in urban management and improve inter agency coordination between the DCC and various development authorities in charge of infrastructure development and service provision. The DCC does not manage the use of public land nor does it have power over public utility companies that are operating within its jurisdiction. There are more than 16 government/autonomous organizations directly involved with urban development in Dhaka, with another 30 other organizations having indirect roles."6 Many of these are line ministries of the central govermment who have very little accountability to the elected local government. * Improve DCC's own-source revenues. Dhaka's property tax base has not been reassessed for over 10 years. Furthermore, data from the Bangladesh Bureau of Statistics show that in 2001 the DCC collected holding tax from only 180,000 households out of the 1.1 million holdings in its jurisdiction. It is critical to address fundamental issues of updating property tax rolls, computerizing billing and collection systems, and strengthening enforcement. * DCC has recently tried to initiate self-assessment of the holding tax to reduce administrative costs, which should be promoted. The self-assessment system not only reduces the costs of administration and reporting, it also reduces opportunities for informal agreements arrangements between homeowners and appraisers. According to municipal finance experts and local government officials, self-assessment system could increase property tax revenues by 40 percent." However, implementation of the self-assessment program has been stalled following a High Court stay order in response to petitioners who argued that the program did not have provisions of appeal in case of dispute over assessment. Civil society organizations have also opposed the self-assessment system in absence of a guaranteed link to public service standards. 5.33 In addition to improving governance of Dhaka, it is also important to consider options for enhancing the potential for other cities as viable investment destinations. As in the case of Dhaka, the emphasis should be on improving the governance structure of these cities - a multifaceted agenda involving development of their administrative capacity, strengthening of their own-revenues, and greater autonomy over local matters such as utility services, crime prevention etc. 5.34 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 networks - that 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 movement are guided by objective measures of urban management. Investments in inter-regional transport and communications are likely to make the smaller cities more attractive to private economic activity and reduce excessive concentration in the largest cities.118 To be really effective, concomitant improvements in local infrastructure and service provision 116 Center for Policy Dialogue (CPD) (2001). "7 Chowdhury (2004). 118 While infrastructure links may enhance productivity and, in combination with complementary investments, attract firms to smaller cities in the hinterland, these investments can also have unintended consequences. In particular, inter-regional transport networks provide firms in the larger cities easier access to lagging-region markets, in competition with local producers. Higher transport costs for these large-city producers are often more than made up for by their inherent advantages such as economies of scale, better know-how and lower unit cost of production. This could result in a flow of resources and opportunities out of the lagging region. 112 Chapter 5: Urban Development and Economic Growth in Bangladesh within the smaller cities would also be important,119 which, in turn, will require better governance of these cities and large public investments by the local govermments.120 5.35 The recently initiated Municipal Development Funds (MDF) appears to be a useful way to address the large investment needs of the local governments. The MDF, a government-owned company, was established in 1998 with initial funding of US$70 million from the World Bank to provide financial support to Pourashavas for infrastructure development and service provision - including, water supply, roads, drainage, sanitation, solid waste disposal, street lighting, development of office complexes and community centers. The fund explicitly requires Pourashavas to improve performance on many counts before they become eligible to apply for its resources. In particular, holding tax collection rates need to cross 50 percent of estimated revenues; the municipality's accounting system should be converted to a double-entry system; office management and accounts should be computerized; and local stakeholders should be involved in choice of projects. Currently, around 100 municipalities have applied for MDF. An important implementation issue relates to development of the Pourashavas' capacity to enable them to quality for the MDF. Otherwise, the less developed Pourashavas with weaker capacity risk being left behind. 5.36 Finally, land and housing market reforms also need to be addressed to accommodate new and existing demand. RAJUK's limited capacity as a land servicing agency needs to be enhanced - its mandate needs to be updated and performance improved. At present physical constraints in land availability are worsened by widespread public ownership of land, poor land record maintenance, costly registration procedures, and unclear property rights. These issues will need to be addressed to improve the ability of cities to accommodate growth. 5.37 In sum, Bangladesh would need to unleash the enormous economic potential of its major urban centers to ensure sustained high growth rates. While special attention is warranted toward Dhaka, which would remain an important engine of growth, a more enabling environment is needed other urban centers to emerge as viable alternatives to Dhaka. This will require long-term collaborative efforts of central and local governments, development agencies, international donors, the private sector, and local communities. The main strategic issues that can help start-off the process include: * Building on agglomeration economies in large metro areas by improving management of 'urban' functions and promoting inter-agency coordination among service providers; * Reducing vertical imbalances (in responsibilities and revenue generation) and building local capacity. * Improving local fiscal capacity and linking improvements to service delivery (the MDFs appear to be a useful idea). * Improving attractiveness of alternate locations through regional transport improvements. * Reducing growth constraints from land supply and infrastructure bottlenecks. 119 Paul Krugman (1991). 120 Recent empirical evidence on Brazil (DaMata et. al (2005)) shows that along with national policies such as regional transport networks and education quality, local matters such as land use, zoning, and crime reduction, too, are important for a city's growth. 113 CHAPTER 6: SUB-NATIONAL INCOME AND EXPENDITURE DYNAMICS IN BANGLADESH: INSIGHTS FROM THE MACRo-GDP AND MICRO-SURVEY DATA I. Introducing the Theme 6.1 Bangladesh is geographically a small country with ethnically much more homogenous population than other countries in South Asia. Nonetheless, historically it is marked with considerable regional differences in dialect, custom, agrarian relations and social development.121 Although the presence and persistence of differences in human development indicators in the country are often discussed,122 regional differences in income and other economic indicators are less known. This chapter seeks to advance the understanding of the regional income and expenditure differences. 6.2 Income differences at the sub-national level matter in large part because of their impact on income growth at the national level. For one, the growth potential of a nation would not be fulfilled if any of its major geographical/administrative units lags its own potential. Lagging regions also create clear demarcations between the "haves" and the "have-nots," which, over the longer run, can sow the seeds for social conflict and jeopardize sustainability of good growth at the national level. 6.3 The main policy challenge, however, is to unleash the growth potential of each region, and not pursuit of regional equality as a goal of intrinsic worth in itself Single-minded pursuit of regional equality can, in fact, be counterproductive - it is likely to retard the better performing areas without necessarily lifting up the lagging ones. Similar to nations, regions, too, grow toward their own economic potentials, which depend on a host of economic and social factors - some in the control of policy makers and some not. Also, as economies grow and diversify there is a tendency to reap the benefits of agglomeration economies, spatial externalities, and increasing returns to scale leading to the formation of large urban/industrial clusters and regional specialization, with implications for increasing spatial divergences.123 The growth potential of the poorer regions would very much depend on informed policy choices that encourage them to benefit from the "externality-generating" activities, and facilitate flow of resources (especially manpower) to the parts of the country that are economically more dynamic. 6.4 This chapter seeks to shed light on the sub-national differences in the levels and growth of income and expenditure in Bangladesh, although within the confines of fairly restrictive data limitations. The chapter also identifies some factors correlated with cross-district differences in per- capita expenditure growth over FY1 992-2005. Specifically, expenditure growth is found to be negatively correlated with the initial levels of expenditure inequality, gender disparity, and large landholdings, and positively correlated with the degree of urbanization and access to electricity. Also, in general, districts with lower per-capita expenditure experienced faster expenditure growth, implying mild regional convergence in per-capita expenditure, although the speed of convergence was quite slow; the estimated time to full convergence is about 90 years. 6.5 These result are indicative at best, as the expenditure data are not representative at the district level. Nonetheless, per-capita expenditures and per-capita GDP are tightly correlated across districts for 121 Two Bengals had historical differences in geography and subsequent social formations (Eaton (1997); Khan (2002)). However, the significant differences were observed even within Eastern Bengal, especially in terms of agrarian systems (Bose (1986)); between agrarian frontiers and settled territories (Ludden (2004)); and in respect of customs and traditions (Roy 1988). 122 BIDS (2001); Sen and Ali (2004); World Bank 2004. 123 Rosenstein-Rodan (1943); Krugman (1992); Hoff (1998); Jalan and Ravallion (1998); Kanbur and Venables (2005). 115 Bangladesh: Strategy for Sustained Growth the years for which comparable data are available. In light of that, there is some value in identifying the policy and institutional correlates - that are representative of the individual districts - of district level expenditure patterns. The exercise adds another dimension to better understanding the nature of the aggregate growth process in Bangladesh. Still, the analysis presented here is not developed enough to be able to be translated into a concrete policy message. II. Income, Growth, and Inequality Variations Across Bangladesh 6.6 Bangladesh is divided into six Divisions, each Division is sub-divided into Districts or Zilas: there are 64 such Districts in all. The average population of each District is about 2 million with an average land area of about 2,250 sq.km. The Districts are further sub-Divided into Thanas (for rural areas) and one or more Pourashavas or Municipalities: in all, there are 289 Pourashavas and 6 City Corporations (Chapter 5). Thanas are sub-divided into Unions and Unions into Villages.124 6.7 Two sets of data are used here in this chapter. One is the District-level macro GDP data from the 2000 Statistical Yearbook of the BBS. The other is the micro-level "consumption expenditure" (henceforth "expenditure") data derived from the Household Income and Expenditure Survey (HIES) and aggregated at the District level. Box 6.1 provides more details on the two data sets. GDP data are also used for the 20 Old Districts for longer inter-temporal comparisons. Box 6.1: Regionally Disaggregated Data: Macro GDP Vs. Micro Expenditure Data Regional income or expenditure level or growth data are difficult to come by in Bangladesh - the state of affairs for social indicators or agriculture production data is better. The BBS published GDP data at the level of the 20 Old District level between FY1982-99, but discontinued that subsequently. The BBS recently also published GDP data for the 64 Districts during 1996-2000, but then discontinued that as well. The GDP data, therefore, do not allow for any detailed analysis of growth trends at the subnational level. The use of micro data on "consumption expenditure" aggregated at the District level then becomes a potentially important avenue for exploring growth dynamics. Their main advantage over the GDP data is that they cover a longer period, FY92 to FY05, deriving from the HIESs done in FY1992, FY2000, and FY2005. The micro-level expenditure data are preferred over micro-level income data from the same data source because of lower measurement error (see, Deaton 1997). One problem, however, is that the district level aggregates are not representative of the districts in a statistical sense. Even under the best of circumstances, when micro expenditure data are, in fact, representative at the regional level, it is difficult to reconcile them with the national accounts (see Deaton and Kozel 2005 for a survey of issues in the Indian context). As a result, the regional rankings of GDP and micro expenditure data seldom match closely. The reconciliation problem can be even more pronounced for growth rates (see, for example, Azzoni et al (2005) for evidence on Brazil). Not surprisingly then there is less than one-to-one correspondence in the rankings of Districts by GDP and micro expenditure data. Nevertheless, there is significant congruence. The Spearman rank correlation between the GDP and expenditure rankings for the 64 Districts is 0.43 for the year 1996 and 0.38 for 2000. Similarly, the correlation coefficient between District-level GDP and expenditure is 0.80 for 1996 and 0.71 for 2000. GDP and Expenditure Variations at the Divisional Level 6.8 Per capita GDP growth in the 1980s and 1990s was strikingly similar across the 6 Divisions (Table 6.1) - Dhaka, Chittagong, Khulna, Barisal, Sylhet, and Rajshahi. As per aggregated Old Districts data, annual Divisional growth varied in a narrow 1.8-2.8 percent range across the Divisions over the 124 "Role of UNDP in Promoting Local Governance and Decentralization in Bangladesh" Report of the Initial SPPD Scoping Mission, 2002. 116 Chapter 6: Sub-National Income and Expenditure Dynamics FY83-99 period. Similarly, as per aggregations from District level GDP data, Divisional growth in the second half of the 1990s varied within an even narrower band of 2.7-3.1 percent.125 Another noticeable feature is that the growth acceleration at the national level since 1990 was experienced in varying degrees by each of the 6 Divisions. It was most pronounced in Sylhet, where per-capita growth accelerated by over 3 percentage points during the FY90-99 period compared with the FY83-89 period. Dhaka and Chittagong, with 2 and 1.3 percentage point acceleration, respectively, also saw a significant pick-up in their growth rates. On the other hand, growth in Barisal improved by a small amount. At the same time though, a fair amount of dispersion is seen among the Divisions in their per-capita GDP levels. In FY00, the per-capita GDP of the most well-off Division (Dhaka) was about 50 percent higher than that of the least well-off Division (Sylhet). Table 6.1: GDP Levels and Growth by Division Aggregated From District Level Data Aggregated From "Old District" Data GDP per capita GDP Share in GDP per capita (current prices) Total (%) growth GDP per capita growth Division FY00 FY00 FY96-00 FY83-89 FY90-99 FY83-99 Dhaka 22303 37.7 2.9 1.3 3.3 2.4 Chittagong 18128 19.3 2.8 1.7 3.0 2.5 Khulna 17875 11.6 3.1 2.6 3.0 2.8 Barisal 15383 5.8 3.0 2.1 2.2 2.2 Sylhet 14886 5.2 2.7 0.0 3.1 1.8 Rajshahi 15174 20.4 3.4 1.8 2.6 2.3 National 18511 100 2.3 1.6 2.9 2.4 Source: BBS, and Staff calculations GDP and Expenditure Variations at the District Level 6.9 GDP data for the next administrative level, the District, are available for a relatively short period of FY96-00, although additional insights can be obtained from District-level expenditure data from the HIES, since they cover a longer period, FY92-05.126 As in the case of the Divisions, per-capita GDP growth was relatively uniform across the Districts. Almost 90 percent of the Districts experienced average growth in the 3-5 percent range during FY96-00, none of the Districts experienced negative growth and only two experienced growth of over 5 percent (Figure 6.1). The per-capita expenditure growth rates, on the other hand, were much more varied, with average annual growth varying between -4.8 and 6.2 percent over FY92-05. Almost one-fifth of the Districts recorded negative expenditure growth over this period, while another one-fifth recorded positive but less than 1 percent growth (Figure 6.1). 125 It must be noted that the data compiled by BBS at the level of the 20 "old districts" are of fairly weak quality. For one, these are based on the 1968 SNA, whereas the 1993 SNA is currently being used. The District level data, on the other hand, address some of these quality concerns. 126 Although expenditure data are not representative at the District level, these are tightly correlated with GDP data across districts. Still, the District level aggregations are to be interpreted with caution. 117 Bangladesh: Strategy for Sustained Growth Figure 6.1: District-Level Variations in Per Capita GDP (FY96-00) and Expenditure Growth Rates (FY92-05) 35 14 30 12 t5 25 10 20 5 8 0 06 15 6 0 40 E E = 10-= 4 5 2 0 0 2%-3% 3%-4% 4%-5% 5%-6% Negative 0% - 1% 1% - 2% 2% - 3% 3% - 4% Over 4% Aerage Annual Per Capita GDP Growth Average Annual Per Capita Exp GroAwth (1992-05) Source: BBS, HIES and Staff Calculations 6.10 Considerable dispersion in both GDP and expenditure levels can be seen among the Districts. In FY00, the average per-capita GDP of the top five Districts was about two-and-a-half times that of the bottom five Districts. Per-capita GDP of Dhaka, the most well-off District, was three-and-a-half times that of the least well-off District (Gaibandha) in FY00. Moreover, as seen in Figure 6.2, in FY00, per- capita GDP in three-fifths of the Districts was less than Tk.16,000, while only four Districts - Dhaka, Gazipur, Narayanganj, and Chittagong - had per-capita GDP of over Tk. 25,000. The ratio of the top and bottom five Districts in terms of per-capita expenditure was also close to 2.5 in FY00 and in FY05. In FY05, per-capita expenditure in only three Districts was over Tk. 20,000, while in three-fifths of the Districts it was less than Tk. 14,000. Annex Table 6.1 shows GDP and expenditure level and growth information for all Districts for which such data are available. Figure 6.2: District-Level Variations in Per Capita GDP (FY00) and Expenditure Levels (FY05) 25 25 20 20 15 15 ,8 0 10 E E z 5 z 5 0 - 0 - Over 20000- 18000- 16000- 14000- 12000- Over 18000 to 16000 to 14000 to 12000 to 10000 to 9000 to 25000 24999 19999 17999 15999 13999 20000 19999 17999 15999 13999 11999 9999 Per-capita GDP in FY00 (current Taka values) Per-Capita Expenditure in FY05 (current Taka %alues) Source: BBS, HIES and Staff Calculations 6.11 Growth patterns across Districts show mild evidence of convergence in expenditure levels. In general, as also discussed later, Districts with lower initial expenditure levels in FY92 saw higher growth in their per-capita expenditure over the FY92-05 period. Comparisons between the richest and poorest Districts were even more striking. Average per-capita expenditure growth in the 5 Districts with the lowest per-capita expenditure in FY92 - Patuakhali, Gopalganj, Gaibandha, Netrokona, and Tangail - was 3.9 percent, compared with an average growth of 0.8 percent in the 5 Districts with the highest per- capita expenditure - Dhaka, Nilphamari, Sylhet, Chittagong, and Narayanganj. Furthermore, while six of 118 Chapter 6: Sub-National Income and Expenditure Dynamics the top 10 Districts in FY92 (in terms of per-capita expenditure) experienced negative growth over the FY92-05 period, each of the bottom 10 Districts experienced positive growth. GDP Growth Variations at the Old District Level 6.12 The growth acceleration at the national level in the 1990s appears to have been shared across much of the country (Figure 6.3). Per capita GDP growth was higher in the FY90-99 period compared with the FY83-89 period in 14 out of the 20 Old Districts. All 6 Old Districts which experienced a growth slowdown in the latter period were among the seven fastest growing Old Districts in the FY83-89 period. Furthermore, the three slowest growing Old Districts in the FY83-89 period experienced the fastest acceleration in their per-capita growth in the latter period. Figure 6.3: Per-Capita GDP Growth Across the Old Districts 5.00 -ca ta GDP growth, 1983-89 4.00 GDP growth, 1990-99 3.00 2.00 1.00 S0.00- -1.00 -2.00 -3.00 4.00 Source: HIES and Staff Calculations How "High" is Regional Inequality? 6.13 To estimate spatial inequality, we consider the contribution of variation in per capita expenditure across Districts to per capita expenditure variation across all individuals. 127 This assesses to what extent regional inequality in Bangladesh accounts for the total inequality (i.e. inequality in the inter-personal income) in the country. The matter assumes special significance for the 1990s when the standard measures of inequality such as Gini index show sharp rise both for expenditure and income data. 128 6.14 The Theil index of inequality is well-suited for the analysis and is calculated in Table 6.2. 129,130 Three results are noteworthy. First, as with the conventional Gini index, the Theil measure of inequality shows a sharp increase in inter-personal inequality in expenditure during the 1990s. Second, both within- District and between-District components of interpersonal expenditure inequality rose during this period with slightly higher pace of increase recorded for the latter. Third, and more importantly, the contribution of between-District inequality to total interpersonal inequality was relatively modest - between District 127 On this, see Kanbur and Venables (2005). 128 See, World Bank 2003 and Osmani et al (2003) for trends based on expenditure data; Khan and Sen (2004) for trends based on income data. 129 See, Bourguignon (1979); Cowell (2000); Conceicao and Ferreira (2000); Elbers et al (2005). 130 The measure used here is Theil L or mean log deviation. This belongs to the general entropy class of inequality measures, with the aversion parameter to inequality among the poor being set to zero. 119 Bangladesh: Strategy for Sustained Growth inequality accounted for only about 17 percent of total inequality in FY00.131 In short, the bulk of the total interpersonal inequality is explained by within-District inequality.132 Table 6.2: Between and Within-Group Decomposition of Theil Index of Inequality at District-Level Level of Decomposition: 64-District 1991/92 1999/2000 Number of Sub-Groups 61 63 Within-Group Inequality 0.11 (85%) 0.16 (83%) Between-Group Inequality 0.02 (15%) 0.03 (17%) Total Inequality 0.13 (100%) 0.19 (100%) Source: HIES and Staffcalculations Note: Figures in parentheses represent percentage contribution of each component of inequality to total inequality. III. Correlates of Sub-National Expenditure Dynamics 6.15 In this section we test for the correlations between cross-District per-capita expenditure growth over FY92-05 and available policy and institutional variables. The choice of the variables is essentially dictated by data availability - for instance, a notable omission is a proxy for saving/investment across the Districts as the relevant data are not available. District level GDP data are not used since they cover just four years - FY1996-2000. Key Bivariate Relationships Figure 6.4: Initial Expenditure Level and Subsequent Expenditure Growth 6.16 Districts with lower per-capita expenditure in 8 FY92 experienced faster subsequent growth in per-capita 1"M 0) 6- expenditure. This is consistent with the predictions of standard neo-classical growth models, as per which S" 4 regions would converge toward a (more-or-less) common 2 steady-state under conditions of similar production w functions and economic conditions shaping growth. In 0- this case, Districts that are further away from the steady F state, i.e., the poorer regions, would grow faster by 2 (D -4 - accumulating faster the factors of production, and vice o versa for the richer regions. A pattern of mild -6- unconditional convergence in expenditure level may be 8.8 9.0 .2 .4 9.6 9.8 10.0 seen in Figure 6.4. Perhaps, the lack of ethnic Real Per Capita Exp in 1992 (natural log) fragmentation along caste-ethnicity lines combined with Sorce HIES and Staffcalculations high population density fostered faster "geographic diffusion", especially in terms of information/knowledge diffusion. There are many such examples of fairly rapid spread of new "technology" such as from Green Revolution,133 fertility control,134 and microfinance group formation, which could have contributed to this observed convergence.135 Homogeneity of population also allows greater mobility of labor within the country, which, through remittances, fosters faster convergence in expenditures across geographical units. It is important to note, 131 This is similar to what has been reported for some of the African and Latin American countries such as Madagascar, Mozambique and Ecuador (in all these countries the matched contribution was restricted to 20-25%) but much lower than other larger economies such as Russia (33%). See Kanbur and Venables (2005). 132 Analysis of inequality in interpersonal income per se goes beyond the scope of the present paper. Factors contributing to rising inequality as seen through the prism of income source-decomposition analysis has been discussed elsewhere (see, for instance, Khan and Sen (2001); Khan and Sen (2004)). 133 Ahmed et al (2000). 134 Amin and Basu (2000), and Dev et al (2004). 135 Morduch and Aghion (2005). 120 Chapter 6: Sub-National Income and Expenditure Dynamics however, that the convergence rate indicated by the relationship in Figure 6.4 is very slow: it would take close to 150 years for the Districts to converge fully to a single level of per-capita expenditure at the indicated pace. Figure 6.5: Initial Gender Inequality Measures 6.17 Districts with higher gender inequality 9 8 n E Grqwth -00 experienced slower growth. Conceptually, gender inequality can affect growth through two principal 6 6 transmission mechanisms. With higher gender 4 inequality, especially in human capital, there is less o o likelihood of female voice and female agency, o leading to high fertility and high population growth regime, which in turn, has adverse impact on the subsequent per capita income growth.136 The 0) - second channel is through malnourished mothers Source: HIES and Staff Calculations. (resulting from gender biases) having malnourished E -6. children, who then tend to have poor schooling < 20 40 60 80 100 120 140 160 performance, which can lead to lower future Male advantage in adult literacy rate (1991) productivity, thus depressing the rate of long-term growth.137 As a proxy for gender inequality we use initial male advantage in adult literacy rates.'38 Gender inequality measured as such is seen to be negatively and significantly correlated with subsequent growth in per-capita expenditure (Figure 6.5). One implication of this is that the recent progress in reducing gender inequality in schooling (through incentive schemes) and in child mortality holds promise for long-term growth in Bangladesh. 6.18 Initial inequality in landownership is Figure 6.6: Large-farm Landholding and Growth negatively correlated with growth.139 Feudalism in land 9 8 - 0)R (s . = - . relations has been identified as a particularly sclerotic 6 factor negatively influencing investment in new 4 technology in agriculture and slowing down the pace of a) broad-based human development.140141 Bangladesh, however, saw semi-feudalism only in patches: in the 0 0 traditional Jotdari belt of North Bengal corresponding to upper Rangpur and Dinajpur districts in the Rajshahi Source. HIES, m938 Agicltr Cesu division; in the haor areas of the Sunamganj basin of the " and Staff calculations Sylhet division; and in some parts of the South where -6 "reverse tebhaga " prevailed.142 Even so, as seen in 136 See, Eastwood and Lipton (1998). 137 See, Glewee and King (2003); Osmani and Sen (2004). 138 This is measured as 100*(male adult literacy rate in 1991 - female adult literacy rate in 199 1)/(female adult literacy rate in 1991). 139 See, Alesina and Rodrik (1994); Deininger and Square (1996); World Development (2005). 140 See, Sobhan (1992) for a cross-country survey. 141 There is a large-body of old-generation "mode of production" and new-generation "growth" literature on this subject. World Development Report, World bank, 2006, provides a useful survey on why high land inequality matters. See, Easterly 2000 on the long-term impact of feudalism on growth in Pakistan; Bardhan 1996 on the general importance of land-reform for faster progress in agricultural technology and human development; Dreze and Sen (2000) on contrasting regional growth experiences in the context of India. 142 "Reverse tebhaga" corresponds to the system where tenants are supposed to give two-third share of the produce to the landlord although the costs of production were entirely borne by them. This has become much less common these days even in the once-prevalent Southern pockets. 121 Bangladesh: Strategy for Sustained Growth landholding" (i.e. with land-size greater than 7.5 acres according to the 1983/84 Agricultural Census) is negatively correlated with expenditure growth at the District level. 6.19 Initial expenditure inequality is negatively 0 igure 6.7: Initial Inequality and Growth associated with expenditure growth. The literature is R (sq.) -036 increasingly looking at the possible adverse influence of 6 high initial income (expenditure) inequality on the rate 2 of subsequent growth as well as on the pace of future CL poverty reduction.143 Initial inequality can reduce -a growth by adversely affecting investment in human 2 0 0 capital. Initial inequality can also increase credit r constraints by reducing access to collateralizable asssets, 2E thus adversely affecting potential investment. Further, 2 4- high initial inequality may lead to low poverty- 6 Source: HIES hd Staff Calculations responsiveness of growth creating social unrest or < .00 .05 .10 .15 .20 .25 political tensions, which in turn, may generate Initial expenditure inequality, 1991 investment uncertainty, depressing growth. In some circumstances, especially in democracies (though not typically an empirical regularity in the context of developing countries), high initial inequality can lead to electoral pressures "from below" on the part of have-nots for additional poverty-transfers likely to be financed through greater distortionary taxation on the rich investors. This, in turn, can have negative impact on productive investment and growth. The inequality measure used in this exercise relates to "mean log deviation" (see, Annex Table 6.3). Figure 6.7 shows a significant negative relationship between initial expenditure inequality and subsequent growth. Sub-National Expenditure Dynamics: Results of the Multivariate Analysis 6.20 Each of the variables noted above is also significantly correlated with per-capita expenditure growth in a multivariate regression analysis - with per-capita expenditure growth as the dependent variable and the rest as explanatory variables (Annex Table 6.2). As predicted, and consistent with the bivariate relationships seen above, expenditure growth is negatively and significantly correlated with initial levels of expenditure, gender inequality, asset inequality, and income inequality. In addition, we also include in the regression access to electricity and degree of urbanization in 1991 as explanatory variables, although in separate regressions since the two are highly correlated. The coefficients for both access to electricity and degree of urbanization are positively and significantly correlated (at the 99 percent level) with expenditure growth in the multivariate regression. It is worth noting that both variables vary considerably across Districts. In 1991, access to electricity varied from just 2 percent in the Kurigram district to 69 percent in the Dhaka district. Similarly, the degree of urbanization varied from only 7 percent in the Gopalganj district to 88 percent in the Dhaka district. 6.21 Results further indicate the presence of "conditional" regional convergence: i.e., Districts with lower initial per capita expenditure tended to have higher growth in expenditure per capita. However, the speed of convergence is quite slow- the estimated time for full convergence in per-capita expenditure is about 90 years. 143 Ray (1998) surveys the literature on the effect of inequality on growth. Ravallion (1997) and (2000) discusses impact of inequality on poverty reduction. 122 Chapter 6: Sub-National Income and Expenditure Dynamics IV. Discussion of Results and Implications for Policy 6.22 This chapter highlighted the considerable (although not unusual in any sense) spatial variability in GDP and expenditure levels and in expenditure growth in Bangladesh. Results presented in the chapter indicate that the level of inequality between Districts accounts for less than one-fifth of the total inequality in the country: interpersonal inequality accounts is the main contributor to that. The chapter also showed expenditure growth at the District level to be negatively correlated with initial levels of gender disparity, expenditure inequality, and asset inequality, and positively correlated with initial access to electricity and degree of urbanization. It further showed some evidence that Districts with lower initial per capita expenditure, in general, appear to have grown somewhat faster, indicating mild convergence in expenditure per capita among the Districts. Any convergence among Districts is quite slow, however. Unconditional convergence - the rate at which convergence would take place without addressing the major policy and institutional differences among Districts - could take more than 150 years. Policy support for the lagging regions, therefore, is clearly quite important for shared growth within the country. 6.23 Is there, then, a role for "regional policy" that can help accelerate convergence among sub- national units? If so, what forms it should take? Unfortunately, analytical limitations at this stage prevent us from making a clear leap from identifying factors that are correlated with and possibly impact regional growth to elaborating clear policy choices that would address growth constraints at the regional level. Sub-national income dynamics are also shrouded in economic and political complexities that need to be further explored. Particular consideration has to be given to the information, resource, and capacity constraints within which policy makers operate. Our emphasis at this stage was simply to highlight the differences in sub-national income and expenditure dynamics and provide a preliminary assessment of the possible causes, in order to also better understand the growth process at the national level. 123 CHAPTER 7: GOVERNANCE AND GROWTH: THE BANGLADESHI CONUNDRUM144 I. Introduction 7.1 Bangladesh's impressive record of economic growth and social change has been achieved despite weak governance, particularly high levels of corruption and a perceived worsening of regulatory quality. Bangladesh is thus an outlier in cross-country studies which relate governance to economic growth. What explains this relatively strong performance despite apparently poor governance? And would this performance be better and more sustainable if governance were better? This chapter attempts to grapple with these questions. Although there are no clear answers, the cost to growth and social development from poor governance is clear enough. 7.2 The chapter begins with a brief overview of whether governance matters to growth. It summarizes what we know about the quality of governance in Bangladesh. Governance is then unbundled in an effort to demonstrate that Bangladesh's governance also has some positive aspects to it although these often not recognized by observers. The chapter then focuses on the negative aspects that adversely affect growth. It concludes by arguing that building on its many successes and addressing these negative governance factors could help remove some of the constraints that are preventing Bangladesh's growth performance coming closer to its faster growing neighbors. II. Does Governance Matter to Growth? 7.3 Research over the last decade has shown increasingly compelling evidence that good governance matters to long-run growth. This research has included economic history studies of development over the last millennium as well as cross-country studies that have tested the statistical relationship between governance and growth.145 One study shows that absolutist governments were associated with slow growth of cities in the 800 years preceding the industrial revolution.146 Large cross- country studies have shown that political instability adversely affects property rights,147 and that subjective assessments of political risk to overseas investors provided by commercial firms are closely associated with lower investment and growth rates.148 7.4 These statistical relationships do not say much about the direction of causality. Governance may have simply improved as income levels increased. More recent studies have attempted to address this weakness. A recent comprehensive study asks what the independent contribution of geography, integration and institutions is to the cross-national variation in income level, and concludes that institutions trump everything else. Once institutions are controlled for, global integration has no direct effects on incomes, while geography has at best weak direct effects.149 A recent World Bank staff report also attempts to address the causality issue by measuring long-term growth during periods entirely 144 This chapter draws on a discussion of the Govemance conundrum in the recent World Bank Group's "Country Assistance Strategy for the People's Republic of Bangladesh for the Period FY-06-09", Report No. 35193 dated February 6, 2006, Washington D.C. 145 Govemance is broadly defined in these studies to mean the exercise of power through the country's economic, social and political institutions. These include the processes by which govemments are chosen and replaced, held accountable and monitored, the capacity of govemment to formulate and implement policies and manage resources efficiently, and the respect with which citizens hold the institutions that govern social and economic interactions among them. 146 De Long, J. Bradford and A. Shleifer (1993). 147 Barro, Robert (1991). 148 Knack, S., and P. Keefer (1995). 149 Rodrik, D., Subramanian, A., and F. Trebbi (2002). 125 Chapter 7: Governance and Growth subsequent to when the quality of governance assessments were made (Figure 7.1). The strong relationship between governance and growth remains, and is not very sensitive to whether developed countries are included in the sample or not, although it becomes slightly weaker if countries in the East Asia and Pacific Region are excluded. Figure 7.1: Governance and Growth Governance and Growth, 1982-2002 08 CHN .06 CI 04 K R 04 I 00BG YP TUN 0 CHL HOYs Z AR FO BGR ZAF -.oe * 11I O m C 4 E O SLE -.04 0~ ZAR co -066 -20 -10 0 10 20 30 ICRG index (residual) Note: The scatterplot in Figure 7.1 shows the partial relationship between the quality of governance in 1982 and income growth in the subsequent two decades (controlling for schooling levels and initial income levels) for all countries for which data was available except 22 developed countries. (Global Monitoring Report, World Bank, 2006). 7.5 The conclusions reached by these studies are not uncontested. The studies rely heavily on subjective indicators, since objective indicators that measure constrained behavior are almost by definition impossible to find. And objective indicators that measure intent but not practice are meaningless.150 It is also argued that subjective indicators are prone to ideological biases and overgeneralizations on the part of businessmen surveyed. The effects of recent incidents may overly affect judgments by citizens and businessmen. And those surveyed are often part of a small group of "country watchers" who tend to talk to each other and are influenced by each other. Moreover, respondents to such surveys may confuse cause and effect. A strong growth performance may lead some to assume strong underlying governance (as with East Asia during the 1980s and early 1990s), while ignorance about strong development gains in countries that are not the focus of much international attention except during times of crises may lead to the opposite conclusion (e.g., Bangladesh). Moreover, indicators typically used, such as the protection of property rights, may be unduly influenced by non- institutional factors such as the emergence of civil unrest. 7.6 However, there is steady progress in improving the quality of governance data and particularly in the design of questionnaires eliciting the views of businessmen and citizens to reduce the noise in the data. Moreover, the users of this data are well aware of these issues and have been taking increasing pain to deal with the underlying concerns through a range of statistical techniques.51 Above all, perceptions become the reality, influencing as they do behavior and, particularly, investment decisions of foreigners, and therefore need to be taken seriously. 7.7 That we have evidence that governance matters to growth however tells us little about why it matters and how it influences growth. The cross-country studies have failed to establish a causal link 150 See Weyland, Kurt (2003). See Kaufmann, Daniel, Kraay, Aart and Mastruzzi, Massimo (2006). 126 Chapter 7: Governance and Growth between particular forms of institutions and economic growth. As academic Dani Rodrik observes, "we know that growth happens when investors feel secure, but we have no idea what specific institutional blue prints will make them feel more secure in a given context".152 Certainty of property rights is clearly important to investors, but this implies nothing about the form that property rights should take.153 Problems of identifying appropriate policy prescriptions are accentuated by less than full transparency in the criteria, information sources and methodology used by risk assessment firms. For example, it is possible that countries are only downgraded for violations of property rights that the risk assessors deem to be harmful to growth. If so, an exclusive emphasis on the security of (all) property rights might actually reduce growth in the (admittedly few) developing countries with growth-oriented high-capacity governments that might otherwise re-allocate rights in ways that are favorable to long-run growth.154, 155 7.8 Understanding individual country contexts and how institutions work in particular historical and cultural settings is important to understanding better the governance-growth nexus. This chapter is an attempt to improve our understanding of this relationship in the particular context of Bangladesh, where the economy has seen an impressive growth performance despite poor governance. III. Bangladesh's Mixed Record of Governance 7.9 Bangladesh's strong growth and macro-economic performance highlighted in Volume I of this report contrasts sharply with the relatively poor perceptions of governance in the country. In the most recent governance data set released by the World Bank Institute (WBI) for 2005,156 Bangladesh scores poorly on all six indicators, ranking between the bottom seventh to thirty-second percentile among some 210 countries (Figure 7.2). Bangladesh's percentile rankings were, respectively, 6.6 for political stability, 14.9 for regulatory quality, 19.8 for rule of law, 7.9 for control of corruption, 21.1 for government effectiveness, and 31.4 for voice and accountability. Within the South Asia region, with at a confidence level of least 90 percent, Bangladesh fared worse than India on each of the six indicators and Sri Lanka on rule of law and control of corruption, and better than Nepal and Pakistan on voice and accountability. 7.10 A comparison of the point estimates for these indicators over time suggests that Bangladesh's performance has worsened on all six indicators between 1998 and 2005. However, because of large, though declining, margins of error, there is not enough evidence to conclude that Bangladesh's governance has become better or worse, except in the case of political stability, where it is possible to say at a 90 percent confidence interval that there was a perceived decline. On both control of corruption and regulatory quality, there is at least 70 percent chance that there was deterioration over time 152 Rodrik, Dani (2006). 153 Rodrik, et al (2002), cite the experience of China and Russia: China retains a socialist legal system, while Russia has a formal property rights regime in place. Yet Russia scores lower than China in property rights indicators. Credibly signaling that property rights matters is more important than having formal property rights on paper, they conclude. 154 Khan, M (2002). 155 For example, land reforms in Taiwan and Korea are often credited in part for their subsequent economic success. 156 The increased awareness of the importance of institutions to development outcomes has been accompanied by a large body of work to measure the quality of governance in different countries. The WBI has developed a set of indicators aimed at capturing these broad dimensions of governance. These indicators aggregate a large number of surveys of businesses, citizens and experts both within and outside countries to measure performances in six key dimensions of governance: voice and accountability, political stability, government effectiveness, regulatory quality, rule of law and control of corruption. 127 Bangladesh: Strategy for Sustained Growth Figure 7.2: Bangladesh Governance Indicators 1998 and 2004 CaMTAOiM ErrMLWIU SM W Source: Kaufmann D., A. Kraay, and M Mastruzzi 2006: Governance Matters V: Governance Indicators for 1996-2005. 7.11 While these data rely on perception-based surveys, the storyline that emerges is reinforced by the data emerging from surveys on Investment Climate (done jointly by the World Bank and the Bangladesh Enterprise Institute) and Doing Business (done by the World Bank) that rely on opinions based of those actually engaged in business in Bangladesh. While subjective bias is likely even here, the information collected also records specific data on costs associated with governance. * Investment climate survey data from 2002 (Table 7.1) show the bureaucracy delivering in some areas and not in others. Senior management time spent dealing with requirements of regulations is a modest 4 percent, just over half the regional average, while enterprises on average find a much higher level of consistency of officials' interpretation of regulations than in South Asia or all countries surveyed. Yet, Bangladesh enterprises report almost twice the level of concern with economic and regulatory policy uncertainty than in South Asia as a whole. Similarly tax administration was seen as a major or severe obstacle by half the firms surveyed, double the global average and more than double the South Asian average, while customs and trade regulations also received poor ratings with 42 percent of firms seeing this as a major or severe obstacle. * Corruption is clearly a major concern. Some 58 percent see corruption as a major obstacle, as against a global average for the survey of 30 percent and a South Asia region average of 25 percent. Corruption is thus the second most important source of concern for investors in Bangladesh. Some 86 percent of firms expect to give gifts in meetings with tax inspectors, almost twice the level for South Asia as a whole * Lack of confidence in the judiciary among Bangladeshi enterprises at 83 percent of the firms surveyed was the lowest rating among all countries surveyed. Crime, theft and disorder were seen as a major or severe obstacle by 39 percent of firms, again substantially higher than in the region as a whole (15 percent) and globally (20 percent), although the actual cost of such losses was around the South Asia average (0.6 percent of sales). 128 Chapter 7: Governance and Growth Table 7.1: Investment Climate Survey Indicator Bangladesh South All Asia Countries Senior Mgmt time spent dealing with regulation requirements (% time) 4.2 8.1 8.2 Officials' interpretation of regulations, predictable (% agree) 78.6 52.5 46.9 Economic and regulatory policy uncertainty (%) 44.3 23.2 30.5 Firms expected to give gifts in meetings with tax inspectors (% of firms) 85.8 44.3 21.7 Unofficial payments for firms to get things done (% of sales) 2.5 1.6 2.4 Value of gift expected to secure government contract (% of contract) 4.3 2.2 3.0 Corruption as a major or severe obstacle (% of firms) 57.6 25.3 29.9 Confidence in the judiciary system (% of firms) 17.02 48.5 56.7 Crime, theft and disorder a major or severe obstacle (% agree) 39.0 15.0 19.7 Losses due to crime (% of sales) 0.6 0.6 1.5 Tax administration a major or severe obstacle (% of firms) 49.7 22.4 25.9 Customs and trade regulations a major or severe obstacle (% of firms) 41.9 24.8 16.8 7.12 Information from the World Bank's Doing Business 2006 database is also not encouraging (Table 7.2) overall. There are 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. Once firms are established they are subject to frequent visits from a variety of government agencies (some 17 a year on average in 2003 compared to some 7 a year in India in 2004). The number of procedures and their time requirement for registering a property is among the 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. Exporters need a lot of signatures, which take a long time (35 days on average, compared with 20 days in China) and undercuts competitiveness of Bangladeshi exporters. Recovering a loan in a bankruptcy can take up to 4 years and cost up to 8 percent the value of the estate, with the recovery rate a low 24 cents on the dollar. Table 7.2 Cost of Starting a Business in Bangladesh and Comparator Countries Starting a Business Registering a Property Enforcing Contracts Export Procedures Procedures Time Cost Procedures Time Procedures Time Cost Documents Signatures Time (days) (US$) (number) (days) (number) (days) (%ofdebt) (number) (number) (days) Bangladesh 8 35 358 11 363 29 365 21.3 7 15 35 China 13 48 175 3 32 25 241 25.5 6 7 20 India 11 71 383 6 67 40 425 43.1 10 22 36 Malaysia 9 30 972 4 143 31 300 20.2 6 3 20 Pakistan 11 24 146 5 49 46 395 35.2 8 10 33 SriLanka 8 50 105 8 63 17 440 21.3 8 10 25 Thailand 8 33 155 2 2 26 390 13.4 9 10 23 LIC Median 10 44 372 6 71 34 390 31 8 13 43 Source: Doing Business Indicators 2006, World Bank. IV. Unbundling Governance in Bangladesh: Some Strengths 7.13 How has Bangladesh enjoyed such relatively strong economic outcomes with such poor governance? The mixed record of governance shown above suggests however that Bangladesh has enjoyed governance successes in some key areas. There are at least five areas where Bangladesh has unquestionably demonstrated a capacity for good governance. 7.14 First, the state created space for the emergence of what is a vibrant domestic private sector. It has done this in part by increasingly introducing macroeconomic discipline, as evident from low inflation rates, fiscal deficits and external indebtedness, thus reducing the crowding out of private sector investment. One aspect of the enhanced macroeconomic discipline is the improved fiduciary regulation of commercial banks by Bangladesh Bank. The Government has also had some success in reducing the 129 Bangladesh: Strategy for Sustained Growth non-performing loans of nationalized commercial banks (NCBs), a major source of weak governance, by capping new lending to private borrowers, enforcing a ban on loans to defaulters, closing 100 bank branches. These measures have resulted in a sharp fall in the share of the NCBs in total bank lending; from 70 percent in 2000 to under 40 percent today (see Chapter 8 for details). In addition, the state has opened up the economy through trade liberalization, although, as argued in Chapter 5, there remains a strong anti-export bias confronting Bangladeshi producers. Nevertheless, from a long term perspective, trade liberalization and the successful encouragement of garments exports have led to a near doubling in the share of trade in goods in GDP since 1990, contributing to an enlarged role for the private sector. 7.15 Second, successive governments 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. These remittances, which amount to over US$6 billion a year (including those through informal channels), have in turn stimulated domestic demand in the country side, and financed growth inducing investments in land, agricultural inputs, human capital and business start-ups. 7.16 Third, Bangladeshi governments have been relatively good at making wise public expenditure choices. Military spending has been kept under check, and at 1.1 per cent of GDP, is less than half the regional average, leaving fiscal space for pro-poor spending. It has also financed rural infrastructure, particularly roads connecting about 1,400 of 2,100 growth centers and markets and thus also contributing to the significant increase in non-farm incomes. Government budgets have also ensured a sustained if still modest injection of public funds for health and education that have increased the quality of human capital and contributed to the significant strides in attaining the Millennium Development Goals (MDGs). 7.17 Fourth, the state has recognized its limitations in meeting the strong demand for public services and has created space and forged partnerships with NGOs and the private sector to help deliver social services. Unlike many developing countries where the state crowds out civil society or co- opts NGOs, Bangladesh has seen the emergence of effective partnerships between large, effective NGOs and the state to deliver micro-credit and to provide education and health services. Bangladeshi NGOs account for just under a tenth of health and education spending. But they have also emerged as major social enterprises with considerable capacity to deliver a range of developmental services that have contributed to both growth and human development. The state has also pragmatically encouraged the private sector to help provide secondary and tertiary education. 7.18 Fifth, the state has greatly improved its capacity to manage natural disasters. The macro- economic impact of natural disasters has been considerably reduced. The 1998 flood for instance was far more severe than that of 1988. But per-capita GDP growth stood at 3 percent in FY99, whereas a decade earlier per-capita GDP growth was negative in the flood year.157 The factors contributing to this improvement include the reduced dependence on farm income, early warning systems, the construction of cyclone shelters, and better relief efforts including reduced leakages in food distribution, allowing private sector imports of food, and well targeted Voluntary Group Feeding systems. The response capability of civil administrations has improved markedly and public campaigns to educate households on food and water safety precautions during floods and cyclones have proved effective. NGOs play a major role in disaster prevention, recovery and relief, and an alert opposition and free press have motivated successive governments to respond promptly to disasters. 7.19 What is clear from the above is that the State has played a significant role in the growth that Bangladesh has enjoyed. It has done that by not crowding out the private sector and civil society, by delivering with some effectiveness key services, such as macroeconomic management, human 157 See Sen, B. (2004). 130 Chapter 7: Governance and Growth development and disaster prevention, and providing a certain degree of continuity in government policies despite changes in government. These positive governance aspects arise from recognition by the state of its weak implementation capacity and stepping back from its role as a producer to that of regulator and facilitator. While the stepping back has contributed to a strong private sector response and has been crucial in the delivery of essential services where NGOs and the private sector have stepped in, the government's capacity to regulate and facilitate is uneven and governance issues have been a serious impediment to delivering on these new roles. 7.20 However, these positive governance aspects are somewhat overwhelmed by the significant weaknesses in a number of other governance areas. The weaknesses lie principally in the country's core governance systems: its politics, the way it funds elections, the way it manages its public finances including revenues and expenditures, the way it delivers public services and the legal and judicial services it provides its citizens, all of which have a profound impact on development and economic growth. There are serious sectoral governance challenges as well which have an adverse impact on growth. These are discussed in Chapters 8 for the financial sector and in Chapter 9 for the infrastructure sector. V. Challenges in Core Governance 7.21 The most serious and difficult governance challenge lies in the political domain where confrontational politics and the high cost of election finance have severe adverse economic consequences. Governance challenges also severely impede public financial management. There are major shortcomings in tax administration (poor taxpayer services, lack of transparency in collection, inadequate audit and enforcement, and protracted taxpayer disputes) and the resulting low revenue collection creates a chain of disincentives to good governance, from low salaries to civil servants to inadequate operations and maintenance expenditures and lack of effective checks and balances. Financial accountability is weak, with flawed procurement processes, poor financial controls and inadequate external checks and audits. Essential infrastructure is not properly maintained for lack of resources and leakage, while the state has little or no capacity to finance infrastructure investments. This in turn leads to a reliance on private provision of infrastructure, which is poorly managed and regulated by the state resulting in a serious infrastructure crisis. Bangladeshis in general view the civil service as being of low quality, which further feeds the vicious cycle of poor governance. Finally, the justice sector has also been a source of weakness. Although the Supreme Court and the senior judiciary are exceptions to this rule, the poor state of the lower judiciary, the police and the prosecution services means that the citizen's first encounter with the justice sector tends to be a disappointing one. Above all, the courts have difficulty enforcing contracts and enforcing the rule of law, two essentials to creating an enabling environment for the private sector. These issues are discussed in more detail below. Political competition 7.22 Political power has been concentrated in two major parties - the Awami League and the Bangladesh Nationalist Party - that have dominated Bangladesh's politics since independence. A first-past-the-post system of elections results in large stable majorities for governments. A constitutional amendment that forbids members of political parties from voting against their parties in Parliament reduces the importance of Parliament as a check on the executive. The lack of inner party democracy prevents these parties from being held accountable by their grassroots. The strong centralization of the state in Bangladesh precludes the sharing of effective political power through local governments. 7.23 The outcome is a system in which the winner takes all in elections and the loser has difficulty reconciling to the loss. Bitter relations between the two parties lead to frequent confrontations, which often shift to the streets. Frequent hartals, or work stoppages, are one consequence, which according to a 131 Bangladesh: Strategy for Sustained Growth UTNDP report costs the economy some 3-4 per cent of GDP annually. The dependence of political parties on muscle power results in the criminalization of politics and increasing political violence. Fundamentalist groups which appear to have a rather modest public following have nevertheless exploited this dissension among the secular parties in recent years to pursue their own agenda. 7.24 Bangladesh is not unique in its confrontational politics; developed and developing nations have shown this tendency. But the fractiousness contributes to political uncertainty and to perceptions of political instability for outside investors who may not always understand that much of this tends to be "sound and fury, " signifying little. Potential foreign investors taking a long-term view of investments in developing countries tend to stay sway from what they see as a high risk environment which has a significant impact on growth. The answer lies in a number of political reforms that improve the quality of political competition in Bangladesh, including strengthening the role of Parliament and parliamentary committees including ensuring an effective role for the opposition in the work of parliament, decentralization of power to local governments, requiring inner party democracy for political parties contesting elections and strengthening civil society watch dogs of the political process. These changes can only come if the people of Bangladesh demand it and cannot be imposed from outside. The high cost of elections 7.25 Elections in Bangladesh, like in many democracies, tend to be a costly affair, and certainly cost much more than the Tk 500,000 that election rules permit for each parliamentary candidate. Parties and individuals wanting to get elected must raise funds to fight elections and this opens the door to undue influence of money on public policy. Moreover, because actual expenditures on elections exceed prescribed limits they result in a lack of transparency about the source of such funds and blur the line between a parliamentarian's public and private use of such funds. State capture resulting from the incurring of debt to vested interests distorts trade and industrial policies and erodes competition. Public funding of elections, reducing the cost of fighting elections through limited free access to TV and radio for candidates, and requiring transparency relating to donations for elections will help. Enforcing existing laws requiring candidates to declare their assets and liabilities will be critical. Low revenue mobilization 7.26 Bangladesh's revenue effort has been weak, and for the past several years it has stagnated. With a population of 140 million, the country has only 1.4 million registered tax payers and 300 businesses registered for its value added tax. Total tax revenue is a low 8.5 percent of GDP. This reflects the low elasticity of revenues with respect to income growth due to a heavy dependence on import taxes (45 percent of total tax collections) and numerous exemptions, tax holidays and preferences. It also reflects a tax administration that is weak and open to corruption. Investment climate surveys show that half the firms see tax administration as a major or severe obstacle to investment, almost double the average for all countries surveyed, and 42 percent of firms see customs administration in the same way, more than double the average for all countries surveyed. It takes as much as 11 days for imports to clear customs, nearly twice as long as the average country surveyed. While customs has seen some improvement of late, shippers still face cumbersome processes including large number of approval processes (15 signatures for exports on average and 38 for imports) and many opportunities for face to face contacts with customs and tax inspectors and staff which create opportunities for rent seeking. Tax administration is complicated by a cumbersome management system that lacks clear direction and leadership and an organizational structure based on type of tax which tends to duplicate functions (such as audits and collection) and undermine the exchange of information. This forces taxpayers to deal with different units on similar issues, with little scope for redress. 132 Chapter 7: Governance and Growth 7.27 Apart from the direct disincentive effects for potential investors, governance issues in tax and customs administration raise the cost of doing business in Bangladesh and erode the country's competitiveness. They also reduce the resources available to the state to pay adequate salaries to civil servants, meet operations and maintenance (O&M) expenditures, and finance much needed infrastructure for growth. Low provisions for salaries and wages and O&M feed the vicious cycle of corruption which constitutes an across the board tax on growth. 7.28 The National Board of Revenue (NBR) is embarking on a reform program to address these issues. The govermment has established Large Taxpayer Units for Income Tax and VAT to help improve tax collection and reduce the costs of dealing with the NBR. A strategic development plan has been recently approved aimed at raising revenue collections, organizing the NBR along functional lines, and ensuring that all businesses are treated uniformly and equitably. 7.29 A comprehensive tax administration modernization program is being developed by GoB. The modernization program will include developing new functional areas such as tax payer services, audit functions to detect underreported income and collection enforcement. These new functions will be piloted by the Large Taxpayer Units for income tax and VAT, and will be supported by reengineering processes and automation. The NBR's composition will be strengthened and based on functional lines. Human resource policies and procedures will also be improved to ensure more professional and competitive recruitment and promotion policies, training, compensation and career development. The NBR will also be encouraged to work with exporter and taxpayer associations to ensure that the quality of service improves and to make the NBR more client-friendly. Periodic surveyors of taxpayers, exporters and the general public will monitor perceptions of the NBR's progress in addressing the concerns of its clients. Public financial accountability 7.30 A recent World Bank review of institutional arrangements for public expenditure, financial management and procurement revealed the need to significantly strengthen Bangladesh's public financial management. Key links in the chain of public financial accountability are flawed: * A serious weakness is the lack of a strategic planning process reflected in the routine over- programming of the annual development plan. This results in the reliance on discretion rather than rules, creates opportunities for rent-seeking and leads to too many under funded projects, implementation delays and chronic under expenditure. Budget planning is fragmented between recurrent and investment budgets and preoccupied with inputs rather than outputs and outcomes, resulting in weak performance orientation. All these contribute to weakening the impact of public investment on growth and development. * Weaknesses in budget execution related to poor accounting practices, including reliance on manual systems which weaken accountability and transparency, and reporting delays. All these contribute to leakages reducing the effectiveness of budgetary spending. State-owned enterprises do not use international accounting standards. This contributes inter alia to a lack of transparency about contingent liabilities in the budget. * Weak internal and external controls is reflected in the lack of accounting information and proper financial controls in line ministries, delays in the publication of audited reports, unsatisfactory quality of the external audit function and ineffective parliamentary oversight over the entire budget process. A new Anti-Corruption Commission has so far not been able to make an impact as an additional weapon in the government's armory against corruption. 133 Bangladesh: Strategy for Sustained Growth 7.31 The Government has begun to address some of these weaknesses. It has strengthened strategic budget planning by expanding the medium-term budget framework (MTBF) approach. The MTBF approach has been introduced on a pilot basis in ten ministries (6 in FY06 and 4 in FY07), and there are plans to cover another four ministries in the FY08 budget. This will bring MTBF coverage to more than 65 percent of total budgetary expenditure. The emphasis at this initial stage has been on better integration of the revenue (recurrent) and development (investment) budget planning processes at the center and line ministries, by unifying the budget preparation process and issuing an integrated budget ceiling for line ministries. The MTBF approach has also given more flexibility to the line ministries in their spending allocation decisions, and has encouraged the substantive involvement of senior officials in the budget formulation process, which otherwise was considered routine work and typically undertaken by lower- level officials. Despite such progress, the process is still in its infancy, and needs to be significantly deepened before it can produce tangible gains in linking policies and budgets and contribute to better budget and service delivery outcomes. 7.32 To strengthen budget execution, serious efforts are being made to improve the accuracy and timelines of expenditure and strengthen internal and external accountability, audit and scrutiny. A customized computerized accounting system has been rolled out 60 district accounts offices and 49 chief accounting offices. In early FY07, the Ministry of Finance and Planning issued a circular notifying the Government's decision to adopt the International Public Sector Accounting Standards (IPSAS) cash standards for accounting. Several government agencies have started implementing this circular. The Government has also reduced a major conflict of interest by separating out the internal and external audit functions. To strengthen the internal audit function, the Government has prepared a Public Expenditure Management Manual and the Internal Control Manual, and taken steps consistent with the manuals, including separation of cash management from debt management. The time lag for final audited accounts has been reduced from two to one year. The Comptroller and Auditor General (C&AG) has introduced performance and entity based audits on a pilot basis and is planning to roll them out across various government units. Audit committees are being formed in ministries, and the Government remains committed to making the C&AG functionally and administratively independent 7.33 Reform efforts have also sought to strengthen the transparency of fiscal information and key institutions of accountability in public financial management. To this end, GoB developed baseline ratings of the core PFM functions in early 2006 and more recently prepared a comprehensive, medium- term, rolling Public Financial Management Improvement Plan (PFMIP) that lays out a series of second- generation PFM reforms. Among the initial implementation measures, the FY07 Budget Summary, for the first time, included an explanatory note that listed all explicit and counter guarantees provided by the Government against liabilities of SOEs; these amounted to US$2.5 billion (4 percent of GDP). Furthermore, in FY07, GoB began setting up a technical support unit for the Public Accounts Committee (PAC) in the Legislature and developing a system of information that would increase the transparency of its decision-making, once the elected Parliament returns. The PAC had made good progress in reducing the backlog of audited accounts for discussion, and its deliberations were beginning to be followed by the press in Dhaka, until the Parliament was dissolved in October 2006. Transparency and competitiveness of public procurement 7.34 A key element in strengthening public financial management is making public procurement much more competitive and transparent. Bangladesh, like many developing countries faces significant challenges in improving its public procurement, which typically has been subject to considerable delays, lacks transparency and is open to collusive practices. It is widely regarded as being the single most important source of leakage of public funds in Bangladesh. Reducing opportunities for corruption in procurement will significantly enhance the effectiveness of public expenditures, reduce the costs of public infrastructure and donor financed projects and contributes to faster growth. Recognizing this, the 134 Chapter 7: Governance and Growth Govermment has initiated a number of reforms in the area. Despite strong resistance from powerful vested interests, the previous Parliament adopted a new law on public procurement in July 2006, with many provisions that are in line with well-accepted international practices. The Government is now finalizing the rules to implement the law, and in the interim is using the regulations that were the precursor for the law. The regulations have introduced new standard bidding documents that significantly reduce the layers in the procurement approval processes. The Government has also put into place a unique procurement performance tracking and monitoring system and is piloted it in a few agencies. 7.35 Moving ahead, strong compliance monitoring, not just by the Central Procurement Technical Unit, which manages the Govermment's procurement process, but also by civil society and NGOs through procurement watch activities will be crucial to effective implementation. Systematic outreach to potential bidders in the business community, including civil works contractors, consultants and suppliers, will be necessary to explain the new law and seek their cooperation in making it a success. Quality of the civil service 7.36 At the root of the failure of the state to contribute effectively to growth, as in many countries, is a civil service that is politicized, poorly paid and poorly managed. Bangladesh's civil service today is inadequately trained, hierarchical and secretive and subject to political influence. Lack of accountability contributes to poor service delivery, the deterioration in regulatory quality and many of the problems discussed above in public financial management and revenue mobilization. 7.37 Numerous commissions and reviews have addressed these concerns, and the Government has acted on some of the recommendations. The size of the public service and the wage bill has been successfully contained. A career planning wing of the Ministry of Establishment was created to focus on career planning and effective deployment of Class I officers. A training policy has been announced and training is now a criterion for promotion of officers. Key to further reform will be strengthening the personnel management system, ensuring a merit and performance based system of promotions toward which initial steps have been taken, a strategic use of postings and transfers to strengthen capacity and match available skills to requirements, a revised compensation package, particularly for the senior cadres of the civil service who are relatively poorly paid for their level of responsibilities. The rule of law 7.38 The rule of law is central to the growth process. While Bangladesh's Constitution has provided for all the formal requirements of a society based on the rule of law, in practice the system fails to deliver, as is evident from the low confidence in the judicial system cited above. With the possible exception of the Supreme Court, all the key pillars of the justice sector are weak, inefficient and prone to corruption. Law and order is perceived to be weak. 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. In part it reflects the emphasis placed on maintaining a modicum of public order and protecting the wealthy rather than preventing, detecting and investigating crime. A weak prosecution service and an inefficient and allegedly corrupt lower court system contribute to the lack of justice. 7.39 For ordinary citizens, access to justice is impeded by the high costs of the system and the low probability of a successful resolution. For businesses, the inability to enforce contracts promptly and to secure property rights, particularly for land, greatly raises the cost of doing business in Bangladesh. Creditor and minority shareholder rights are well protected under the law, but enforcing these rights is another matter. But as is noted in Chapter 8 on the financial sector, lenders and borrowers must deal with a flawed collateral system. Unreliable land records, high fees and fraud hamper land titling. And as noted below, registering a property is cumbersome, and enforcing a contract through the courts is costly. 135 Bangladesh: Strategy for Sustained Growth Bankruptcies are not an easy solution to corporate distress. It takes 4 years on average to shut a business down, and you may recover 24 cents on the dollar, better than the regional average of 20 cents, but much lower than the 44 cents that are recovered in Pakistan and Thailand or even the 40 cents recovered in Uganda. While domestic entrepreneurs learn how to survive the system and absorb its high costs, foreign investors unfamiliar with Bangladesh and with plenty of other places to invest in are greatly deterred by these failures. 7.40 Comprehensive but well sequenced reforms of the justice sector are long overdue. The Govermment has begun modestly with a program to strengthen court administration and reducing delays through an automated case management information system, strengthened judicial training, upgrading facilities and other human resource needs in five pilot districts and the Supreme Court. Important steps have also been taken to separate the judiciary from the executive. DFID, Japan and UNDP are helping with police reforms. But more comprehensive reforms will be crucial if the failure to ensure the rule of law and protect property rights is not to prove a serious impediment to the acceleration in growth that is the topic of this report. Improving the regulatory environment 7.41 The formal hoops that new businesses must jump in Bangladesh may be relatively modest (Table 7.2), but the red tape is more formidable in practice than it is on paper. The high informal regulatory costs are especially worrying in the post-ATC environment where garments exporters must compete with low cost producers in China, India, and Vietnam. Adding even a few cents to the price of a garment can cause business to go elsewhere given the competitiveness of markets. The Government recognizes this and is working to streamline the regulatory process and strengthen its regulatory policy capacity. Industrial zoning programs are being considered to insulate investors from some of the constraints they face operating in Bangladesh. The Board of Investment, the Bangladesh Export Processing Zones Authority, the Registrar of Joint Stock Companies and other regulatory institutions are strengthening their capacity to support investors and simplifying their procedures. VI. Conclusion 7.42 Bangladesh has enjoyed good growth since the early 1990s despite weak governance. Growth has accelerated slightly in recent years, but as is argued elsewhere in this report, diversification of the economy and improving the environment for foreign direct investment will be central to bringing Bangladesh's performance closer to its neighbors in the region. Like Indonesia and other South East Asian countries in the early 1990s, Bangladesh is likely to soon discover that it is fast growing out of its current institutional environment. While governance may have been adequate to cope with an economy breaking out of stagnation and poverty, it is increasingly proving a barrier to the acceleration of growth that is needed to push Bangladesh firmly on the path of middle income status and poverty reduction. And yet, from a political economy perspective, the fact that growth has been adequate and rising reduces the pressure on political leaders to address the governance issue. 7.43 Addressing the governance challenge will also not be easy. The governance agenda is large and cuts across a wide range of institutions and threatens powerful vested interests. Developing a strategic, sequenced approach that relies on success in a few key areas to generate momentum and demand for reform in other areas will be crucial. Summoning the political will to do this will not be easy, and will itself depend on strong political leadership and a public that demands reforms and shows lower tolerance for weak governance. 136 CHAPTER 8: CREATING A MoRE EFFICIENT FINANCIAL SYSTEM 1. Introduction 8.1 Creation of a deeper and more efficient financial system can be considered a sine qua non for sustaining high growth and attaining the middle-income country status that is desirable for Bangladesh. It is reasonably clear that this will require a substantial change in the role of government - from an operator and arbiter in the financial system to a facilitator role. This implies not only divestment from the nationalized commercial banks (NCBs), a laudable reform process that is underway, but also de- politicization of the licensing process and a market-based framework for resolving bank failure. Most importantly, the government would need to move away from the implicit guarantee provided to depositors and owners to applying the existing limited explicit deposit insurance for depositors, while simultaneously relying more on market participants to monitor and discipline banks instead of micro- managing financial institutions. This redefinition of government's role also applies to other segments of the financial system, such as capital markets and the micro-finance sector, and should be seen as an essential element in the governance reform agenda and in the movement from a relationship-based economy to a market- and arms-length economy. II. The Structure and Recent Performance of the Banking Sector in Bangladesh 8.2 Financial intermediation in Bangladesh, as in majority of the developing world, is heavily dominated by commercial banks. As of end-2005, the banking sector comprised four groups of "scheduled banks" (see Table 8.1): four NCBs, five government-owned development financial institutions (DFIs) (specialized banks that deal in "development financing"), thirty private commercial banks (PCBs), and nine foreign commercial banks (FCBs). While there are a number of investment banks, merchant banks, leasing and finance companies, insurance companies, and stockbrokers, these are small in comparison. As of December 2001, the banking sector accounted for 89 percent of the country's financial assets.158 The story of the banking sector, therefore, is largely also the story of the financial sector in Bangladesh. Table 8.1: Structure of the Banking System (end-2005) Bank Types Number of Number of % of Industry % of Industry Banks Branches Assets Deposits NCBs 4 3386 37 41 DFIs 5 1342 10 6 PCBs 30 1643 46 46 FCBs 9 41 7 7 Total 48 6412 100 100 Source: Bangladesh Bank Financial Sector Review, May 2006 8.3 Immediately after independence, the Government decided to nationalize the banking sector. The legacy of that move carried on for several decades. Although two of the six NCBs were privatized in the 1980s and private banking was permitted, Bangladesh started out the 2lt century with a banking system dominated by government-owned banks and several weak privately-owned banks. 8.4 The structure of the banking sector has evolved quite remarkably since 2001, benefiting from some bold reforms that have sought to deemphasize the role of the NCBs, strengthen competitive pressures, loosen government control, and tighten prudential regulations and regulatory quality (See Annex 8.1 for a chronology of major banking sector reforms). The structural shift is most visible in the 158 Financial Performance and Soundness Indicators ofSouth Asia, World Bank, 2004. 137 Bangladesh: Strategy for Sustained Growth declining share of the NCBs in the industry's total assets, from 54 percent in 1998 to 37 percent in 2005, mirrored by the increase in the share of the PCBs, from 27 percent in 1998 to 46 percent in 2005. In 2004, for the first time, the combined share of the NCBs and DFIs in total banking sector assets was lower than the combined share of the PCBs and FCBs. Similar trends can be seen for bank deposits and loans; with the PCBs and FCBs increasing their market share at the expense of the NCBs and DFIs. 8.5 A number of key performance measures in the banking sector have responded positively to the recent reforms (Table 8.2). The Capital Adequacy Ratio (CAR) of banks increased from 6.7 percent in 2001 to 8.3 percent in 2006, mainly due to sharp increases in the CARs of FCBs and DFIs; the CAR of the NCBs fell over the period. The non-performing loans (NPLs) to total loans ratio improved considerably for all categories of banks, responding to restructuring measures, improved lending practices, and strengthened loan recovery drives. The gross NPL ratio of the NCBs fell from 46 percent in 1999 to 23 percent in 2005. Underlying the history of the high NPLs in the NCBs and DFIs are the problems of weak management, constant political interference, and problems of corruption and directed lending; issues which are beginning to be addressed under the ongoing reforms. The PCBs managed to cut their gross NPL ratio to 5 percent by 2006, down from an astounding 33 percent in 1998. There is substantial variation in performance among the PCBs though, with several older ones having been under intensive Bangladesh Bank care for over a decade due while others have maintained healthy balance sheets positions. 159 Table 8.2: Performance Measure 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 numbers are without adjustment for actual provision and interest suspense. * Negative CAR for NCBs in 2005 because of negative capital of Agrani bank Source: Bangladesh Bank Quarterly, various issues. 8.6 Despite the recent improvements, the banking sector, having been plagued by systemic distress over the last 20 years, is only beginning to emerge from a crisis situation and has a long road ahead to full recovery. Applying one of the criterion for a systemic banking crisis, gross NPL ratio of more than 10 percent of aggregate loan portfolio, Bangladesh has been in one since 1983 - with gross NPLs standing at 13.1 percent in 2006 and NPLs net of loan provisions at 7.1 percent of total loans.160 In addition, provisioning by the NCBs and the problem PCBs has typically fallen well short of requirement. The required to actual provisioning ratio for the banking sector as a whole fell from 60 percent in 2001 to 41 percent in 2004, before recovering a bit to 48 percent in 2005. With a provision maintenance ratio of about 25 percent and a provisioning shortfall equaling Tk. 40 billion, the (in)solvency situation was the worst in NCBs. The FCBs were the only category that met its provisioning requirement in 2005. 159 There were several waves of PCBs licensed at different points in time, referred to as generations. The first generation of PCBs was licensed during 1972 and 1989, the second during 1991 and 1996 and the third between 1999 and 2001. 160 Other criteria commonly used to identify a systemic banking crisis include: (i) emergency measures were taken to assist the banking system (such as bank holidays, deposit freezes, blanket guarantees to depositors or other bank creditors), (ii) large-scale nationalizations took place, or (iii) the fiscal cost of the rescue operations was at least 2 percent of GDP. Compare Demirguc-Kunt and Detragiache (2005). 138 Chapter 8: Creating a More Efficient Financial System III. Bangladesh's Financial System in International Comparison 8.7 The level of development of Bangladesh's banking system is comparable with other South Asian countries and higher than the average for low-income countries, although on some important indicators of banking efficiency and solvency Bangladesh lags many comparators. Other segments of the financial system, such as the insurance sector and the stock market are substantially less developed in Bangladesh than in the comparator countries. Both the banking system and stock markets are less developed and less efficient in Bangladesh than in East Asia. 8.8 As seen in Table 8.3, in 2004, on all three financial intermediation development indicators used - Private Credit to GDP ratio, Liquid Liabilities to GDP ratio, and Bank Deposits to GDP ratio - Bangladesh performed worse than India, but better than Indonesia, Pakistan, the average for South Asian countries, and the averages for low-income countries. Not surprisingly, it fared worse than the average for East Asian countries whose financial systems have by now recovered from the 1997 crisis. On a positive note, Bangladesh's loan-deposit ratio stood at an exceptionally high 80 percent, i.e. four-fifths of banks' deposits were intermediated into private sector loans. This is even higher than the East-Asian average. One of the reasons for this is that the Government directly competes with banks through the National Savings Schemes (NSS), which go straight into its budget, leaving limited need for direct bank loans to the Government.161 Table 8.3. Banking and Non-Banking Indicators for Bangladesh in International Comparison (2004) Panel A - Banking Sector Indicators Loan-Deposit Liquid Private Bank Overhead Net Ratio Liabilities/GDP Credit/ Deposits/GDP Costs Interest GDP Margin Bangladesh 0.801 0.389 0.274 0.342 0.026 0.026 Indonesia 0.540 0.433 0.210 0.389 0.031 0.048 India 0.641 0.616 0.328 0.511 0.022 0.032 Nepal 0.367 0.021 0.033 Pakistan 0.748 0.469 0.257 0.344 0.021 0.028 Low Income 0.656 0.294 0.147 0.220 0.058 0.077 South Asia 0.677 0.486 0.269 0.402 0.024 0.031 East Asia & Pacific 0.712 0.544 0.402 0.456 0.026 0.041 Panel B - Non-Banking Sector Indicators Stock Market Value Stock Market Life Insurance Premium Non-Life Insurance Traded/GDP Turnover Ratio Volume/GDP Premium Volume/GDP Bangladesh 0.016 0.365 0.004 0.002 Indonesia 0.107 0.430 0.006 0.007 India 0.548 1.137 0.024 0.006 Nepal 0.004 Pakistan 0.769 3.268 0.002 0.004 Low Income 0.096 0.720 0.009 0.007 South Asia 0.273 1.239 0.009 0.005 East Asia & Pacific 0.223 0.311 0.017 0.011 Source: Financial Structure Database, Beck, Demirguc-Kunt and Levine (2000). Data are revised up to 2004. 161 These NSS are mostly for 3-5 years of maturity and their sale is restricted to individuals. Their rate of return is significantly above that of bank deposits, especially since there seems a very low penalty for early liquidation. At the end of 2004, there were Tk 349 billion outstanding NSS, but only Tk 182 billion outstanding government papers. 139 Bangladesh: Strategy for Sustained Growth 8.9 Comparisons of operational efficiency paint a mixed picture. The NPL ratios in Bangladesh are significantly higher than in the comparator countries. In 2002, the gross NPL ratio of the banking sector stood at 28 percent, compared with 9 percent in India, 16 percent in Pakistan, and 14 percent in Sri Lanka. Despite the reductions since, Bangladesh has not yet caught up with these comparator countries. On the other hand, overhead costs and net interest margins - measures of inefficiency in the banking system - are at comparable levels with other South Asian and East Asian countries and significantly lower than the average for low-income countries (Table 8.3). 162 8.10 Comparisons with other countries in the region and low-income countries suggests that banking penetration in Bangladesh is adequate for the level of financial and economic development. Here, we use a new database on access to and use of banking services, compiled from regulatory entities and public information for the years 2003/2004 and discussed in Beck, Demirguc-Kunt and Martinez Peria (2005). Bangladesh has 47 bank branches per 1,000 square kilometer which is significantly higher than in comparator countries (Figure 8.1). Bangladesh's demographic branch penetration, four branches per 100,000 people, is at similar or higher levels than in Pakistan, Nepal and the average low-income country, but significantly below the level observed for India, Indonesia and Sri Lanka. ATM penetration of less than one ATM per 1,000 square kilometer and per one million people is significantly lower than the comparator countries with the exception of Nepal. The number of loan and deposit accounts per capita is higher than in Pakistan and the average low-income country, while the average loan size and deposit account size relative to GDP per capita - negative indicators of outreach - are below the levels in Pakistan and the average low-income country. While these indicators are only for the formal banking sector, the limited data available for the microfinance sector suggest that access to and use of formal financial services is higher than in many comparable countries. Bangladesh has the highest microfinance penetration in the world (borrowing clients constitute 13 percent of total population), twice that of Indonesia, which has the second highest penetration rate.163 Figure 8.1: Financial Sector Penetration Branch Penetration Across Countries ATM Penetration Across Countries Branches per ATMs per 1,000 1,000 sq km sq km N India 0 Indonesia 0 Indonesia E Sri Lanka N Sri Lanka NepalNea Number of E Pakistan Number of ATMs Nepal branches per Bangladesh per 100,000 E Pakistan 100,000 people E Low Income Countries people Bangladesh E Low Income Countries 0 10 20 30 40 50 0 2 4 6 8 10 12 162 Overhead costs are banks' total operating costs relative to total assets while net interest margins are net interest revenue (i.e. interest revenue from loans minus interest costs from deposits) relative to total earning assets. 163 Honohan (2004). 140 Chapter 8: Creating a More Efficient Financial System Loans/Deposit per Capita Across Countries Ratio of Loan/Deposit Size to Income Ratio Across Countries U Pakistan Number of Bangladesh Deposits per U Low Income Countries 1000 People Average Deposit Size/GDP per Capita Number of E Pakistan Average Loan Loans Per 1000 Bangladesh Size/GDP Per People Low Income Countries Cap 0 50 100 150 200 250 0 5 10 15 Source: Beck, Demirguc-Kunt and Martinez Peria (2005) 8.11 Other segments of the financial system in Bangladesh are significantly less developed than the banking system, and this disparity stands out relative to comparator countries. There is a small but growing non-bank financial sector comprising leasing and finance companies. The stock market is a small, inactive and stagnant market. Stock market capitalization relative to GDP stands at about 5 percent, and the turnover ratio - trading relative to capitalization - is lower than most comparator countries. The shares of financial institutions - mandated by law to list - dominate the Dhaka stock exchange;164 in December 2006, they constituted 55 percent of market capitalization. There were only two Initial Public Offerings (IPOs) of non-financial companies in 2005 and none in 2004. There are few incentives for a firm to go public, and stocks of a typical company are rarely traded freely.165 8.12 Long-term contractual savings institutions are virtually absent and even their miniscule presence does not serve the societal purpose of promoting long-term saving. The insurance sector is small and inefficient - in 2004, life and non-life insurance penetration (premiums relative to GDP) stood at just 0.4 percent and 0.2 percent, respectively, below the average for both low-income and the South Asian country averages (Table 8.3). Not only that, life insurance companies undertake reverse maturity transformation, i.e. transform long-term liabilities into short-term assets, such as bank deposits, which can be partly explained by the reluctance to issue long-term savings instruments that would have to compete with the NSS. There are few private pension funds and mutual funds whose development is most likely also prevented by the existence of the NSS that offer rates above deposit interest rates in the banking sector. Both the pension and mutual fund industry are dominated by public pension schemes and by the Investment Company of Bangladesh (ICB) that also holds a large part of the shares on the Dhaka Stock Exchange.166 Unlike private funds, ICB is not subject to Securities and Exchange Commission (SEC) supervision and has fewer restrictions on its activities, so that private institutions do not face a level playing field.167 This lack of privately owned institutional investors has negative repercussions for corporate governance and stock market liquidity. 8.13 The picture painted by the aggregate indicators is confirmed by firm-level indicators of financing patterns. Firms in Bangladesh finance a lower share of their working capital and new 164 There is a second smaller stock exchange in Chittagong. 165 Sobhan and Werner, 2003. 166 It is estimated that ICB holds 20% of shares through their mutual funds and own accounts as brokerage firm (Asian Development Bank, 2004) 167 Sobhan and Werner (2003). 141 Bangladesh: Strategy for Sustained Growth investment with retained earnings than firms in Pakistan and the average firm in low-income country, but more than in other comparator countries (Figures 8.2.a and Annex Figure 8.2). Differentiating by sources of external finance, Bangladeshi firms finance a larger share of working capital and new investment with banking credit, while private equity and the sales of stocks play a miniscule role. At the same time though, Bangladeshi firms view access to external finance and cost of external finance as bigger obstacles than firms in Pakistan, Sri Lanka, Indonesia and the average firm in the average South Asian or East Asian country or, for that matter, in the average low-income country (Figure 8.2.b).168 Figure 8.2a: Sources of Firm Financing: Figure 8.2b: Financing Obstacles: Access to Share of Working Capital and Cost of Financing * Internal funds : Equity and sale of stock------- * ~~40 Eqit an s.l sfsucO No Obstacle; 1 = Minor Obstacle; 2 = Moderate Obstacle; _ a Trade credit (supplier or custorner credit) 4 Major Obstacle; 4 Vert Severe Obstacle 100% Informal sources 080% Conmmercial bank loans (local and foreign) 3.00 o Other sources 60% - - 3.00 -IAccess o Financ 20% 1.00 0%d 'g-~ '3e 0.0 Source: Investment Climate Assessments IV. Finance Development and Growth in Bangladesh: Is there a Link? 8.14 Financial development indicators, such as Private Credit to GDP, Total Deposits to GDP and M2 to GDP display rising long-term trends in Bangladesh, suggesting financial sector deepening (Figure 8.3 and Annex Table 8.2). As seen in Figure 8.3, the year 1991 marked a turn-around in financial sector performance, resulting from the Financial Sector Reform Program (FRSP) that was initiated in that year and aimed at moving the financial system to a more market-based one. Reductions in interest rate controls and credit quotas were among the major changes under the FRSP. It is important to note, however, that the FSRP led to a more quantitative improvement in the financial development indicators: i.e., although, for example, the volume of credit increased in the first phase, the quality of lending did not necessarily improve. As noted in Section II, the qualitative shift occurred as a result of the reforms started in 2001. 16' Although these are subjective assessments, that Beck, Demirguc-Kunt and Levine (2006) find that in countries where firms report higher financing obstacles, industries that depend more on external finance grow relatively more slowly and investment resources are reallocated more slowly as demand changes across industries. Also, Beck, Demirguc-Kunt and Maksimovic (2005) find a significant negative impact of financing obstacles on firm growth. 142 Chapter 8: Creating a More Efficient Financial System Figure 8.3: Financial Development, Investment and Income in Bangladesh over Time 40 400 35 350 30 -300 20 -200 15 -X 150 10 X X 100 5 50 1976-1980 1981-1985 1986-1990 1991-1995 1996-2000 2001-2005 -o--cr_y ---dep y -A-ni2_y -x-i_y --*-y_pcap cry is Private Credit to GDP, dep_y is total deposits to GDP, m2_y is M2 to GDP, i_y the investment-GDP ratio and y_pcap income per capita in current USD. Source: Bangladesh Bank and authors' calculations. 8.15 Financial development has been positively correlated with and very likely has contributed to the rising income levels. Figure 8.3 shows the positive correlation between the financial development indicators and the investment to GDP ratio as well as GDP per capita. Use of econometric tim-series techniques - that are elaborated in Annex 8.2 - shows that not only is financial development positively correlated with investment and income in Bangladesh, it also seems to have positively impacted the two: i.e., higher levels of financial development have caused higher levels of investment rate and per-capita GDP. Results show that a one percent increase in the ratio of private credit to GDP led to a 0.15 percentage point increase in the investment rate and a 0.22 percent increase in per capita income. The finding of a positive impact of financial development on per capita income is after controlling for the indirect impact through investment activity, suggesting that financial development likely enhanced both the level and efficiency of investment.169 8.16 The positive relationship between financial development, investment, and per capita income is driven by the post-FSRP period of 1991 to 2005. The econometric results reported in the previous paragraph hold only for the 1991-2005 period and not for the pre-FSRP period of 1976 to 1991. This is consistent with the cross-country evidence discussed below and carries some important policy conclusions. Specifically, a financial system that relies heavily on nationalized banks, interest rate controls and directed credit, as was the case in pre-FSRP period, cannot be expected to fulfill its important role in channeling society's savings into investments and fostering economic growth. V. Finance as Key to Faster Economic Development: Cross-Country Evidence 8.17 The positive impact offinancial development on income levels in Bangladesh is consistent with economic theory as well as cross-country evidence. Financial markets and institutions arise to alleviate market frictions that prevent the direct pooling of society's savings and channeling to investment projects. Well developed financial systems ease the exchange of goods and services by providing payment services, help mobilize and pool savings from a large number of investors, acquire and process information about enterprises and possible investment projects, thus allocating society's savings to its 169 The results also show a positive and significant relationship between investment and per capita income. In the long-run a 1 percentage point increase in the investment-GDP ratio is shown to increase per capita income by 0.2%. 143 Bangladesh: Strategy for Sustained Growth most productive use, monitor investments and exert corporate governance and help diversify and reduce liquidity and intertemporal risk.70 8.18 A well-established body of evidence corroborates that countries with better developed financial systems Private Credit: Cross-Country experience faster economic growth.171 Annex Table 8.1 and Figure 8.4 summarize this evidence; countries with higher levels of credit to the private sector relative to GDP experienced higher per capita growth rates over the period 1980 to 2003.172,173 [Note that the positive relationship between private credit and growth shown in Figure 8.4 is CL after controlling for the standard growth regressors such as V education, government consumption, trade, black market premium, inflation, and population growth.] This relationship is not only statistically, but also economically significant. Results in Annex Table 8.1 suggest that a doubling of private sector lending to GDP ratio in Bangladesh over the period 1980-2003, from 22 to 44 percent, would have resulted in 0.7 percentage higher GDP growth per year.174"75 Other measures of financial development, such as M2 to GDP or the turnover ratio in stock markets yield similar results.'76 8.19 Financial development is not only pro-growth, but also pro-poor. Annex Figure 8.1 shows the negative relationship between Private Credit and the average annual change in Headcount - the share of population living on less than one dollar a day - over the period 1980-2000. 177 Note that the relationship represented in Annex Figure 8.1 is after controlling for the effect of average economic growth suggesting that financial intermediaries help the poor also by improving the inequality situation.'7 8.20 Bigger is not always better in financial development, however! For financial development to positively impact growth, an enabling policy environment is essential. Private credit is not a policy variable itself. A rapid increase in private sector lending not supported by macroeconomic stability and the contractual and informational framework discussed below can result in fragility and banking crises, as experienced by many countries over the past 30 plus years, with associated costs in the form of lost growth and worsened poverty situation.'79 170 Levine, 1997 and 2005. 17 1 To be sure, there is also a feedback of faster economic growth on the development of the financial system. 172 Private Credit to GDP is a standard measure of financial intermediary development and is the ratio of claims by deposit money banks and other financial institutions on the private, domestic non-financial sector relative to GDP. Private credit to GDP was 173% in the U.S. in 2003, but only 2% in Mozambique. a The set of explanatory variables follows a standard regression set-up from the finance and growth literature, for example, as used in Beck, Levine and Loayza (2000). r Such counterfactuals have to be interpreted with caution as the coefficients indicate marginal effects from which we are extrapolating to discrete changes. Further, this counterexample serves an illustrative purpose; it does not actually tell us how to achieve higher growth rates. neg The relationship between financial intermediary development and economic growth is not only robust to controlling for other factors that are associated with economic growth, but to controlling for the reverse causation from faster economic growth to financial development and to the relationship being driven by a third factor. 176 Levine r Loayza and Beck (2000); Beck and Levine (2004). p v As shown by Beck et al. (2004), this relationship is robust to controlling for characteristics such as government consumption, inflation, openness and population growth, as well as for reverse causation and simultaneity bias. 178 Changes in poverty can be decomposed into economic growth and changes in income inequality (Bourguignon, 2004). Kraay (2006) shows that the larger part of poverty changes can be explained by economic growth. 179 Demirguc-Kunt and Detragiache (1999); and Caprio and Klingebiel (1997). 144 Chapter 8: Creating a More Efficient Financial System VI. Three Pillars of an Effective and Stable Financial System80 8.21 This section discusses the three building blocks - macroeconomic stability, contractual framework, and informational framework - for a sound and effective financial system and benchmarks Bangladesh in those areas. Bangladesh has made impressive progress in securing macroeconomic stability, but still has a long way to go in building the contractual and informational framework. Macroeconomic stability 8.22 Macroeconomic stability is a prerequisite for financial development and a first building block for an effective financial system. A low and stable rate of inflation provides incentives for financial rather than non-financial forms of savings. It is also conducive to long-term contracting and thus long- term savings and investment. Economic theory predicts and cross-country studies have shown that countries with lower and more stable inflation rates have more rapid banking sector and stock market development.181 This is illustrated in Annex Figure 8.3, which plots Private Credit to GDP over the period 1980 to 2003 against the average annual inflation rate for the same period for a cross-section of countries. Similarly, a lower fiscal deficit can enhance financial sector deepening by avoiding crowding- out of private sector lending and investment. As discussed in Volume I of this report, macroeconomic stability has been an area of strength for Bangladesh, with inflation rates having stayed in single digits for almost two decades now and the fiscal deficit and debt situation well under control. Contractual framework 8.23 Financial contracts depend on the certainty of legal rights of borrowers, creditors and outside investors and the predictability and speed of their fair and impartial enforcement. Private property rights and enforcement of contracts - both vis-d-vis other private parties and vis-d-vis the government - are thus a second crucial pillar of an effective financial system. Savers will relinquish control over their savings only if they can be sure to receive principal and contracted interest in return. Similarly, outside financiers - be they equity or debt holders - will only be willing to invest in companies and projects if their legal claims and rights are upheld. Critical in the relationship between minority shareholders and controlling shareholders and management are often problems of looting and tunneling, i.e. the possibility for the controlling shareholder to remove assets outside the firms, and the remedial actions that the legal system offers minority shareholders against them.182 This points to both creditor rights and minority shareholder rights as being critical for external financing, as well as the role of corporate governance in both financial institutions and non-financial corporations. 8.24 An effective legal system is an important feature of the contractual framework as it provides timely, efficient and impartial resolution of insolvent borrowers through the efficient liquidation of unviable enterprises and the rehabilitation of viable businesses. International comparisons have provided ample evidence for the critical role of legal system efficiency and its different elements for financial sector development.183 The effect of legal system efficiency on financial intermediation is illustrated in Annex Figures 8.4 to 8.6, which show the positive relationship between creditor rights and private credit to GDP, the negative relationship between the time it takes to enforce contracts and private credit to GDP and the positive relationship between better protection of minority shareholder rights and the market capitalization in stock markets. 1so This and the following section draw heavily on Beck (2006). 181 Boyd, Levine and Smith (2001). 182 Johnson et al. (2000). 183 La Porta et al. (1997); see overview in Beck and Levine (2005). 145 Bangladesh: Strategy for Sustained Growth 8.25 While Bangladesh has made some progress in the contractual framework over the past years, there is still significant room for improvement. Corruption is widely regarded a major problem in the country (Chapter 7). Although creditor and minority shareholder rights are relatively strong on the book, their enforcement is weak. Lenders and borrowers have to deal with an ineffective collateral system for movable and immovable assets. Land titling is hampered by poor and unreliable records, high fees, and fraud. The movable collateral regime is effectively available only for limited liability companies, as these are the only ones that can register charges with the Registry of Joint Stock Companies.184 This effectively excludes most of the small and micro enterprises from using such assets as collateral. These problems have increased reliance of lenders on personal guarantees from company directors. The bankruptcy legislation is rarely used in practice as a tool to resolve corporate distress, with less than half of the cases in the two bankruptcy courts actually being declared bankrupt at the end of the process.85 This is partly due to the stigma attached to bankruptcy and possible criminal prosecution of bankrupt debtors.'86 While some progress has been made with the recent introduction of the money loan courts and alternate dispute resolution mechanisms that allow a faster and less bureaucratic enforcement of claims, it is still too early to say whether these reforms have significantly impacted the availability and cost of loans. Further, appeals to the high court still pose a major bottleneck to the quick resolution of claim resolution because of the delays involved.187 8.26 The deficiencies in the contractual framework are reflected in cross-country benchmarking. The 2006 Doing Business Indicators rank Bangladesh 147th out of 153 in terms of days needed to register a property, 76th out of 155 on days needed to enforce a contract, and 101st out of out of 144 on days needed to close a business. Informational framework 8.27 Financial markets and institutions arise due to information asymmetries that prevent direct interaction between multiple savers and investors. Accordingly, effective financial intermediation depends on tools to reduce these information asymmetries. The informational framework is thus a third crucial pillar for effective financial intermediation. International experience has shown that credit information sharing is important to reduce adverse selection problems and foster competition in the financial system. Credit registries have an important role to play as they can dramatically reduce the time and costs of obtaining such information from individual sources. They are especially important for SMEs as their creditworthiness is harder to evaluate and they have less visibility and transparency relative to large enterprises. International comparisons show that countries with better developed systems of credit information sharing enjoy higher levels of financial development and their firms report lower financing obstacles.188 Annex Figure 8.7 illustrates the positive relationship between the efficiency of credit information sharing and Private Credit to GDP. 8.28 Bangladesh has a well functioning public Credit Information Bureau (CIB), established in 1992 and housed in the Bangladesh Bank. It collects data on a monthly basis from all banks and financial institutions that are regulated and supervised by Bangladesh Bank on all borrowers. While there is no unique borrower identifier, the wealth of information of individual borrowers seems to allow a relative good match. All financial institutions are required by law to obtain information about a borrower from the CIB before granting or renewing a loan. This provision was introduced in the effort to reduce NPLs in the banking system. 184 Meagher (1998). 18 Asian Development Bank, 2004. 186 Sobhan and Werner (2003). 187 ibid. 188 Japelli and Pagano (2002); Love and Mylenko (2003); Djankov et al. (2005), and Miller (2003) for an overview. 146 Chapter 8: Creating a More Efficient Financial System 8.29 While the CIB has a long and positive track record, several shortcomings of the existing financial informational system should be noted. First, the system is still limited by the lack of computerization. Second, banks effectively obtain current information only about existing borrowers, but not about past payment performance. This is an important omission in the CIB's function as it prevents borrowers from building "reputation collateral", which would allow them to use their track record as reference in future loan applications. Third, only financial institutions participate in the information sharing agreement, other non-financial institutions such as utility companies, which are a source of valuable credit information about customers in other countries are excluded. Further, the minimum threshold of Tk 50,000 (US$700) excludes small and opaque enterprises. While technical problems are certainly recognized, a move towards including all borrowers irrespective of the size of their loans should be envisioned in the medium-term. Another important step would be to link the existing CIB to the credit registry to be created for micro-finance institutions (MFIs). Finally, private institutions should be allowed to provide credit information services, for which the necessary legal provisions would need to be changed. While it seems unlikely that such an industry would immediately flourish, it can become an important element in the move from a relationship-based economy to an arms-length economy, which relies on numerous information brokers, including credit rating institutions and credit registries. 8.30 Similarly, more accurate and transparent financial statements can help reduce information asymmetries between borrowers and lenders. Financial statements that give an accurate picture of a firm's financial situation reduce screening and monitoring costs for financial institutions and increase the efficiency of resource allocation. Cross-country comparisons have shown a positive association of more transparent and comprehensive accounting standards with higher levels of financial development.'89 Similarly, transparent and more informative financial statements lower information costs for investors and can foster stock market development and liquidity.190 8.31 The quality of financial statements in Bangladesh, however, is undermined by weak accounting and auditing practices, due to institutional weaknesses in regulation, compliance, and enforcement of standards and rules.191 While all incorporated companies must file annual audited financial statements with the Registrar of Joint Stock Companies, there is no effective enforcement of the timely and accurate filing. A review of published financial statements revealed numerous compliance gaps. There is limited accounting and auditing capacity and numerous violations of professional ethical standards. While listed companies are subject to additional oversight by the SEC, there are legal and judicial constraints to effective enforcement of this oversight. Further, there seems little confidence in the financial reports issued by companies with no or perverse price effects of such announcements.192, 193 More importantly, the costs of going public seem to surmount their benefits, as public firms are subject to more scrutiny by tax authorities. VII. The Evolving Role of the Government in Bangladesh's Financial System 8.32 What is the appropriate role for the government in the development of the financial system, in addition to providing its three essential pillars described above? Should it leave it all to the markets, take it upon itself to provide financial services, or seek to enable markets by addressing market failures and reducing market frictions? As described in Box 8.1, it is evident from global experiences that the 189 Levine, Loayza and Beck (2000) and La Porta et al. (1997). 190 Levine (2003). 191 Investment Climate Assessment, World Bank, 2003 192 Asian Development Bank, 2004. 193 Sobhan and Werner (2003) even quote the example where a bank's stock price increased after irregularities in its lending practices became public, most likely due to manipulating transactions in the market. 147 Bangladesh: Strategy for Sustained Growth (relatively new) market enabling approach is generally the most attractive option for government intervention. What has been the approach adopted in Bangladesh? Box 8.1: Three Different Approaches to the Role of Government in Financial Service Provision The role of the government in financial service provision has been controversial. While most economists agree by now on the role of government in providing a stable monetary environment and the contractual and informational frameworks, the government's roles as provider, regulator, and supervisor of financial service remains moot. Three different approaches to the government's role have been applied: The laissez-faire approach: This approach sees no role for government involvement in the financial system. Market discipline rules the relationship between banks and depositors and between banks and borrowers. A modified laissez-faire approach stresses the importance of macroeconomic stability and the contractual and informational framework and sees a role for government in providing these necessary elements. The laissez- faire approach has been criticized for ignoring market imperfections and failures that lead to a breakdown of bank-depositor and bank-borrower relationships as envisioned in theory. From market to government failures: Government solutions to overcome market failures rely on two crucial assumptions. First, governments know better than markets; second, governments act in the best interest of society. Both assumptions find little empirical support. Bureaucrats as bankers have failed almost everywhere, but especially in developing countries; economies with a higher share of government-owned banks typically have lower levels of financial development, more concentrated lending and lower economic growth and are more likely to suffer systemic banking sector fragility (La Porta et al, 2001; Barth, Caprio and Levine, 2004). High NPLs in these systems often result in banking crises (Barth, Caprio and Levine, 2004; Caprio and Martinez Peria, 2003), at large costs to the budget. Further, the negative impact of government-owned banks spreads often beyond these institutions and adversely affect governance and efficiency of private banks as well. Enabling markets - a new approach: According to this approach, rather than replacing market failures with government failures, policies need to address market failures directly by reducing market frictions. Cross- country comparisons show that countries with lower entry barriers into the financial system, fewer restrictions on banking and a higher share of foreign-owned banks, each resulting from lowering of market frictions by governments, have more competitive banking systems (Claessens and Laeven, 2004; Beck, Demirguc-Kunt and Maksimovic (2004), Demirguc-Kunt, Laeven and Levine (2004); Beck, Demirguc-Kunt and Levine (2006b). This is not a laissez-faire approach; rather, it relies on the government to enable and develop markets. The approach relies on private institutions to provide financial services efficiently but takes into account their incentive structure. It sees a critical role of the government in ensuring a competitive and contestable financial system. The approach envisions monitoring and disciplining of banks by private actors, together with a role for effective government intervention in troubled institutions. It also argues for strengthening the independence and accountability of regulators to protect them against political and regulatory capture and, a careful, incentive compatible designing of deposit insurance where it already exists. It sees an important role for the government in avoiding segmentation in the financial sector through expanding access to the payment system or the credit information sharing system beyond the commercial banks to bank-like institutions such as cooperatives or regulated microfinance institutions can help the financial system cater to marginal customers in all financial 8.33 The role of the government after independence was a highly interventionist one, following the examples of many other developed and emerging economies.194 Through nationalization of banks it hoped to enhance mobilization of savings, direct credit to "priority sectors", and make financial services affordable for larger parts of the population. Through interest rate controls it hoped to reduce lending costs, while credit quotas were supposed to guarantee flow of financial resources to priority and underserved sectors, such as agriculture. Through specialized institutions, such as agricultural banks and industrial development finance companies, the government hoped to provide more financial resources to these sectors. As in many other countries, deposit insurance was introduced to prevent bank runs and 194 See Fry (1988) for a discussion of these policies and numerous examples in other countries. 148 Chapter 8: Creating a More Efficient Financial System protect small savers. Essentially, in doing all these, the government completely rejected the laissez-faire approach and sought to replace it with a model based on government discipline. 8.34 Things didn't quite turn out as intended - market failures were soon replaced by government failures. This is also similar to the experience of other countries that attempted the public control approach: bureaucrats as bankers have failed almost universally, but especially in developing countries (Box 8.1). By 1990s, it was clear that the highly interventionist approach had left a profound mark in the form of an inefficient state-dominated banking sector which fostered a culture of non-payment, provided excessive rents to private banks and distorted resource allocation at all levels; controlled interest rates that had nothing to do with risks and returns, resulting in gross misallocation of resources and large losses for the banking sector, and; political interference in most aspects of banking operations and supervision. By the late 1990s, the situation had come to such a pass that a 1998 World Bank report noted that "The three institutional pillars of banking - a strong regulatory system, well managed banks, and an effective court system - have crumbled to such a point that the banking institutions cannot be relied upon ensure the safety of deposits and efficiently allocate credit, their two most important functions. In a more difficult environment, the banking system could become Bangladesh's Achilles Heel." 8.35 Starting in 2001, the government began pulling back the banking sector from this brink by moving it toward a more market enabling approach. As described in Box 8.1, this approach recognizes the existence of frictions in financial markets which prevent their full functioning and calls for government intervention to create the conditions for a competitive and contestable system. Initial actions on reducing controls on the interest rates and credit quotas were undertaken under the FSRP in 1991,195 but it wasn't until 2001 when a more substantial reform program was begun leading to qualitative improvements in the banking sector performance, as reported in Section II. 8.36 Authorities have embarked on a wide-ranging restructuring and divestiture program for the NCBs. 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 are in the process of being 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 restructuring and divesture process, however, has been much slower than envisaged because of political interference, resistance from labor unions, and judicial roadblocks. Nonetheless, the expected successful divestment of Rupali Bank, in itself an important milestone for banking sector reforms, should provide impetus for and set a useful precedence in following through with the rest of the NCBs. 8.37 Further, since 2001, Bangladesh Bank has followed international "best-practice" recommendations to strengthen bank regulations and supervision. Key measures include (see Annex 8.1 for a more complete set of banking reforms): * The capital adequacy ratio was raised from 8% to 9% of risk-weighted assets and the minimum capital requirements from Tk 400 million (US$6 million) to Tk 1 billion (US$15 million). * Loan classification, rescheduling, and provisioning rules were tightened and single exposure and large loan limits introduced. * Risk management guidelines were issued. 195 Starting with the FSRP in the early 1990s, the government abolished most interest rate controls, with the exception of loans supporting export activities. Banks were asked to report reference lending interest rates for different sectors. Individual lending rates could only move within a band of 1.5 percentage points above and below this reference rate. Further, credit directives for privately owned banks were withdrawn, although government- owned banks were still expected to lend to priority sectors. 149 Bangladesh: Strategy for Sustained Growth * Measures to improve corporate governance were introduced. The number of board members in a financial institution was restricted to a maximum of 13; the term of a director was restricted to six years; shareholding by a single shareholder was limited to 10 percent of capital and only one member from a shareholding family could sit on the board; banks had to establish audit committees; limitations on divided payout were imposed as well as on expenditures for automobiles and travel expenses for executives. Responding robustly to the ensuing conducive environment, private banks have dramatically increased their market share and turned around their operational and financial performance, as noted in Section II. 8.38 Certain amount of political capture of Bangladesh Bank, however, continues to vitiate market discipline and works against its move toward the market enabling approach. Bangladesh Bank has not been immune from political interference in the bank licensing process, often having to follow "recommendations" of the political class to allow new banks into the system. Fortunately, the practice has ceased in recent years. Nonetheless, 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 failing banks. 8.39 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;196 weak banks are referred to the Problem Bank Monitoring Department within Bangladesh Bank where they are subject to special supervisory oversight and certain regulatory restrictions and enjoy regulatory forbearance.197 8.40 On its part, the Bangladesh Bank has sought to compensate for the lack of market discipline (induced by the implicit guarantee) by taking a somewhat interventionist approach to supervision. For example, in order to expand outreach, it requires banks to open three banks in rural areas for every branch opened in an urban area. It has also issued job and task descriptions for board members and CEOs and made the appointment of a CEO subject to its approval. However, the resulting heavy-handed regulation has its own costs. For example, banks can get around the branching requirement by opening new branches just outside the urban areas - given that the urban areas in Bangladesh are still growing, soon these branches will be inside the urban area. This particular regulation, therefore, only causes sub- optimal allocation of bank branches. Regulations such as for branch opening or prescribing bonuses and benefits for board members and executives cause additional transaction costs and cause inefficiencies in banks' operations. Vetting the appointments of new CEOs by Bangladesh Banks seems rather in the old tradition of operating a financial system than regulating it. Similar governance measures can, in fact, benefit the NCBs and were even expanded to cover them, but there is no enforcement for the NCBs. 8.41 Figure 8.5 illustrates the interaction of the government guarantee and supervisory approaches. On the horizontal axis is the degree of government guarantee and on the vertical axis the degree of supervisory intervention. In the past, absence of both market and supervisory discipline resulted in easy abuse by banks and high risk of fragility, placing Bangladesh in the South East corner. Since 2001, with the reform measures noted above, Bangladesh Bank has thus opted for the supervisory intervention approach (North East comer). Given the continuing explicit and implicit guarantee, politicization of licensing and the absence of exit of weak banks, this approach can avoid any "open" failures, but comes at huge efficiency cost - such as large interest rate spreads and sub-optimal allocation of resources - and involves high and increasing contingent losses for the government. Further, bank owners face incentives 196 The only bank to be closed was BCCI. The bank was restructured and reopened as Eastern Bank. 197 Pubali Bank spent 10 and National Bank 3 years under the intensified supervision of the Problem Bank Monitoring Department. 150 Chapter 8: Creating a More Efficient Financial System to take aggressive credit risks, with little incentive for depositors or other creditors to exercise any market discipline in the presence of the implicit guarantee. This can explain the fragility in the banking system even beyond government-owned banks in the 1990s. Figure 8.5: The Interaction of Government Guarantees and Supervisory Approach -U 0 DBangladesh CD Divestiture