PRI Quarterly Policy Briefs on Bangladesh Economy · considered autonomy, naively though. Quasi-fiscal operation or policy-based lending to preferred sectors or groups is not part

PRI Quarterly Policy Briefs onBangladesh Economy

June 2013

Policy Research Institute of Bangladesh (PRI) Department for International Development (DFID)

Volume IV

ii

PRI Quarterly Policy Briefs on Bangladesh Economy June 2013

Foreword

The Government aims at becoming a middle income country by 2021, and improving further by 2041. Thiswould require sustained development at a high rate - say 7-8%, structural change and improvement, goodinstitutions and right kind of policies.

Knowledge is a critical input for achieving the goals that the Government has set. An independent think-tankcan make significant contribution to this national enterprise by independent analysis and realistic advice.

The present edition of PRI Quarterly Policy Brief moves in that direction. It addresses the issues of the bankingsector, the capital market, and export.

Banks play a critical role for the economy, making efficient allocation of financial resources to the sectorswhich are socially important. The nationalized banks, by and large, are the only institutions which lend forinvestment. The foreign banks and private banks are lukewarm to lending for investment; they prefer trade, importand export in particular, which has much less risk. The criteria for judging performance of the two types of banksneed to be differentiated by their lending strategies and attitude to risk.

Autonomy of central bank is recognized. However, while talking about autonomy of central bank, it isnecessary to separate its core function from the non-core or subsidiary functions. Monetary policy is its core function,which it ought to - and does actually - pursue with independence. Government's deficit financing could impactmonetary policy, but for decades deficit has remained stable at a low level. Disagreeing with the government is oftenconsidered autonomy, naively though. Quasi-fiscal operation or policy-based lending to preferred sectors or groupsis not part of the core monetary policy. In performing these tasks, the central bank acts as an agent of thegovernment or takes on a policy-related political function.

The stock market should function better to play its role in the development of the economy. However, thestock market may not get adequately strong unless the underlying assets are also in good shape. Stock marketanywhere in the world has a speculative element; an efficient market would contain within limit the speculativeelement and make the necessary corrections.

There is excessive dependence on export of RMG in terms of product as well as market. It is absolutelynecessary that there are initiatives for diversification.

RMG has grown very fast and the factory structures sometimes neglected safety standards. This needs to beremedied. RMG is essentially a global phenomenon; remedies of deficiencies also need coordinated global efforts.Compliance has a cost; and if each importer or group of importers defines its own standards, compliance gets muchmore complex and costly. ILO, the governments of the exporting country and of the importing countries, should jointo establish uniform - or at least compatible - standards. There is a need to provide accessible funds for financing thecost of compliance. More research is needed to identify the global contact-points.

Wage and productivity as well as the trade union practices are important areas for research and policy. Itseems that not enough has been done in these areas, especially for development of healthy industrial relations.While ILO embraces tripartite arrangement in industrial relations - the government, the employer, and the workers -other players also have entered the field who are not trade unions or institutions committed to professional researchin labor economics and trade union. This is a new phenomenon whose impact on trade unionism and industrialpeace should be examined carefully.

PRI deserves commendation for undertaking serious policy research addressing many of the relevant issues.

Dr. Mashiur RahmanEconomic Adviser to the Hon'ble Prime Minister

Government of the People's Republic of Bangladesh

iii


Contents

Summary: .................................................................................................................................. v

I. Banking Sector in Bangladesh: Progress, Challenges and Agenda for Reforms........ 1

Overview .............................................................................................................................1

Progress with Banking Sector Reforms ...............................................................................1

Challenges and Concerns ....................................................................................................2

An Agenda for Reforms.......................................................................................................3

II. Post-Correction Bangladesh Stock Market: Market Developments and Policy Issues5

Introduction and Background .............................................................................................5

Is Bangladesh Stock Market Behaving Differently from Others? ........................................5

Are Regulatory Reforms to Govern the Stock Markets Progressing Well? .........................8

Concluding Observations and Policy Recommendations ....................................................9

III. A Review of Tobacco Taxation in Bangladesh and Some Proposals......................... 11

Background .......................................................................................................................11

Real price in decline ..........................................................................................................11

Increase in consumption of low quality cigarettes ...........................................................12

Policy Recommendation and Rationale ............................................................................13

IV. Promoting Export Diversification by addressing Anti-Export Bias in FY2013-14Budget .......................................................................................................................... 16

Introduction ......................................................................................................................16

Scope of the Paper ............................................................................................................16

Vulnerability from Export Concentration..........................................................................16

Trade Policy Bias as Key Constraint...................................................................................17

Anti-Export Bias of the Incentive Regime and Trade Policy ..............................................18

Recommendations ............................................................................................................21

iv


List of Tables

Table 1.1: Indicators of Health of the Banking Sector (Percent) ........................................... 1

Table 2.1: New Issue of Shares and Bonds Since 2009........................................................... 8

Table 2.2: Key Policy Actions and Current Status of Reforms under the Second CapitalMarket Development Program of ADB.................................................................. 9

Table 3.1: Current Structure of Tobacco Pricing Slab .......................................................... 13

Table 3.2: Estimated Price and Revenue Effects of an Uniform Tax Rate Structure........... 13

Table 3.3: Price and Revenue Estimates from Additional Specific Excise Duty onCigarettes and Biri ................................................................................................ 14

Table 3.4: Prices of Low and High Quality Brands in Selected Countries ........................... 14

Table 3.5: Tax Structure and Most Popular Brand Cigarette Prices in Selected Countries 14

Table 4.1: Recent Trend in Nominal Protection in Bangladesh ........................................... 18

Table 4.2: Summary of Range of ERPs and Average ERPs 2012 .......................................... 20

List of Figures

Figure 1.1: Indicators of Growth of Banking Activities.......................................................... 1

Figure 1.2: Growth of Private Banking, 2001-12.................................................................... 2

Figure 2.1: Developments in the DSE Index and Turnover.................................................... 5

Figure 2.2: Comparison of Shanghai and Dhaka Stock Exchange Indices............................ 5

Figure 2.3: Kuwait and Dhaka Stock Exchange Index............................................................ 6

Figure 2.4: Kuwait Stock Exchange......................................................................................... 6

Figure 2.5: P/E Ratio at DSE ..................................................................................................... 6

Figure 2.6: P/E Ratio in 2012.................................................................................................... 7

Figure 2.7: DSE Turnover as % of Market Cap (20 Days MA) ................................................. 7

Figure 2.8: Turnover as % of Market Cap in 2012 .................................................................. 7

Figure 2.9: Net Portfolio Investment (Million USD) ............................................................... 7

Figure 3.1: Market share of Biri and Cigarette ..................................................................... 11

Figure 3.2: Cigarette Price in Real Terms .............................................................................. 12

Figure 3.3: Cigarette Price in Nominal Terms....................................................................... 12

Figure 3.4: Market Share of segments .................................................................................. 12

Figure 3.5: Revenue loss due to tax policy: .......................................................................... 12

Figure 4.1: Export Concentration Trends (FY1980-2012).................................................... 16

Figure 4.2: Average NPR on Import Categories FY 00-13 .................................................... 19

v


Summary:

I. Recommendations for stimulating theprogress of the banking sector included:

Autonomy of the Bangladesh Bank (BB) toensure: sound management of MonetaryPolicy; staying away from government-directedcredits; ensuring sound supervision of banksand avoiding/disallowing political involvementin the decision-making body of financialinstitutions; and exercising extreme prudencein granting new bank licenses

Implementing a banking supervision strategyentailing: supervision of both public andprivate banks through the same standardizedbest practice norms; ensuring compliance withregulatory standards and ethical governance;improving the reporting standardssubstantially.

Avoiding conflict of interest by preventing thegovernment from being both a producer ofbanking services and also a regulator of theseservices.

Restricting the lending capability of lossmaking public banks if those banks cannot beprivatized.

II. Recommendations for addressing policyissues related to the post-correctionstock market included:

Upgrading accounting and auditing standardsto enhance market confidence.

Establishing an Independent FinancialReporting Council to adopt and monitorinternational accounting and auditingstandards as well as license accountants andauditors.

Developing an organized investors' basethrough a robust mutual fund industry andmonitoring how the sector responds to thesteps already taken.

Completing demutualization of stockexchanges to segregate ownerships,management and trading rights of members,and thereby improve the overall governancestructure of the two stock exchanges inBangladesh.

Issuance of treasury bills and bonds at marketrates to develop a liquid bond market and amarket-based yield curve.

Regulatory measures, such as investmentregulations and recapitalization measuresshould be adopted to revitalize the insurancesector.

A comprehensive review of taxation of thestock market is long overdue. At the momentthe tax regime applicable for the stock marketis full of inconsistencies due to ad hocmeasures and not in line with internationalbest practices.

Finally, the government should stop the annualritual of “allowing black money into the stockmarket.” Stock market should not painted asthe playground for legalizing illegally obtainedor undeclared money.

III. Recommendations Regarding Taxationof Tobacco Products in Bangladesh:

It is well established that the most effectivemeans to discourage tobacco smoking isthrough sharply higher prices. As discussed inthe note, there is still significant room for priceincrease in the tobacco industry, which shouldbe done in the form of increased taxes,particularly at the lower end, so thatconsumption is discouraged and sizableresources are directed to the governmentcoffers.

Through uniform ad valorem supplementaryduty and a specific excise tax, the governmentwould be able to minimize tax avoidancethrough down-trading and extract higherrevenue from tobacco.

It is in the best interest of the people as well asthe government for biri to be priced out of themarket owing to the extensive harm thisrudimentary form of tobacco does to thesmokers. Besides, if the price of biri is increasedthrough additional excise duties and a uniformtax band, the producers may find it in theirinterest to shift to producing low endcigarettes rather than biris, while consumersmay opt for the latter as well.

These measures will also help to rationalize thedistortion that exists in the current tax andpricing structure and also help to movetowards the mixed tax structure instead of thecurrent ad valorem system.

vi


These recommendations should be seen as amodest first step. In the upcoming budgets,stronger follow up measures must be taken tocontinuously discourage the use of tobaccoproducts.

IV. Recommendations for promotingexport diversification by addressinganti-export bias of the tariff structure:

Trade policy bias against exports must beeliminated. A major challenge in the budget ofFY2013-14 will be to address the issue of anti-export bias in the tariff structure because ithurts emerging and potential exports, thusserving as a policy constraint to exportdiversification. It is imperative that theunusually high ERP for import-substituteproduction needs to be scaled down. Theprocess needs to start with the FY2013-14budget by reversing the growing wedgebetween output and input tariffs.

Efficiency of customs administration must beimproved. All exports must be brought withinthe fold of automated clearance mechanismthat is equipped with state of the art hardwareand software.

Efficiency of import-export procedures needsto be improved. Modernization of importclearance by installing the latest machinery andequipment along with IT software is absolutelycritical to achieve export diversification.

Transparency and efficiency of behind-the-border services – such as modern banking andfinancial institutions -- need to be brought inline with those of trading partners andcomparators.

Availability and quality of transportinfrastructure and services. Improving tradelogistics – road, rail, river and air transport --will definitely enhance competiveness ofexports.

Availability and use of IT. Export success alongwith export diversification calls for rapidlyinstalling state of the art IT equipment and

software for handling activities at the ports butalso inland for as much of the behind-the-border activities as are related to trade.


1

I. Banking Sector in Bangladesh: Progress,Challenges and Agenda for Reforms

Sadiq Ahmed

Overview

A review of international experience suggests that prudentbanking regulations including a sound and rigorouslicensing procedure are essential for the health of thefinancial system. The outcome of lax regulatory frameworkcan be devastating, as graphically illustrated by the globalfinancial crisis of 2008 that has severely affected theindustrial countries. The world’s largest economy, the USA, isstill on the recovery path after 4 years of intense pain causedby the financial sector turmoil. Developing countriesincluding Bangladesh need to pay serious attention to thisexperience in designing and managing their own emergingfinancial sector. The role of prudential regulations and thecapacity of the regulator to monitor and implement themare of fundamental importance for a healthy financialsystem.

The objective of this policy note is to review the progresswith reforms in the banking sector in Bangladesh, highlightthe challenges and identify specific reforms that arenecessary to address those challenges. Given theimportance of a healthy banking sector for the overall healthof the economy, it is imperative that the Government payscareful attention to the key issues and challenges andaddress those concerns quickly as festering problems in thiscritical sector could seriously hurt development progress.

Progress with Banking Sector Reforms

Bangladesh’s experience with promoting the financial sectorsuggests a mixed record of performance. On the wholeBangladesh has done well in the banking sector, despiterecent unfortunate developments in the area of publicbanking. But, the performance in developing the stockmarket is weak.

Banking reforms started in early 1980s, but it gatheredmomentum in the 2000s. Overall, these reforms have paidoff handsomely in terms of most indicators of bankingperformance (figure 1.1). Thus, broad money (M2) to GDPratio, which is often used as an indicator of the depth of thefinancial sector, has risen from 12% in 1980 to 57% in June2012. Total bank credit as a share of GDP has grown from14% to 55% over the same period. Importantly, the share ofprivate credit to total credit has expanded from 36% to 82%.In the absence of a well developed capital market, thegrowth in private credit has played a major role insupporting the expansion of the private sector inBangladesh.

Figure 1.1: Indicators of Growth of Banking Activities

Source: Bangladesh Bank

Much of the serious reforms that impacted on the qualityand health of the banking sector happened after 1999. Theprogress in this aspect of the banking sector is indicated inTable 1.1. The quality and stability of the banking sector hasimproved, as reflected by the sharp decline in the share ofnon-performing loans (NPLs) from a high of 41% in 1999 to7.2% in June 2012. This is a major positive development forthe banking sector, although there are some seriousconcerns about the portfolio quality of the public banks thatare not properly reflected in the numbers as discussed later.Improvement was also made in meeting capital adequacyrequirements that is based on a more realistic measure ofrisk. The industry-wide risk-weighted capital adequacy ratioexceeded 11% as of June 2012. Profitability of banksmeasured against rate of return on assets and equity hasalso increased, especially in the private sector.

Table 1.1: Indicators of Health of the Banking Sector(Percent)

Indicators1999 (Pre-

ReformBaseline)

June 2012(Latest

Available)Share of Non-Performing Loans:Overall

41.1 7.2

Share of Non-Performing Loans:Private Banks

27.1 3.8

Share of Non-Performing Loans:Foreign Banks

3.8 3.2

Share of Non-Performing Loans:State Commercial Banks

45.6 13.5

Share of Non-Performing Loans:Public DFIs

65.0 23.8

Risk-weighted Capital Ratio: Overall 7.4 11.3Risk-weighted Capital Ratio: PrivateBanks

11.0 11.4

Risk-weighted Capital Ratio:Foreign Banks

15.8 21.5

Risk-weighted Capital Ratio: StateCommercial Banks

5.3 11.2

Risk-weighted Capital Ratio: PublicDFIs

5.8 -4.3


0

20

40

60

80

100

M2/GDP C/GDP PC/C

Perc

ent

1980 2012


2

The coverage of the banking sector also compares favorablywith the neighboring countries of India and Pakistan eventhough Bangladesh is a significantly smaller economy. Thenumber of banks has grown from 17 in 1980 to 47 as of June2012 and the number of branches expanded from 4067 to8146 over the same period. However, much of formalbanking is concentrated in the urban sector.

The three main factors that contributed to this improvementare greater competition, better regulations and improvedsupervision. The opening up of the banking sector to privateenterprise was perhaps the most dominant factor. As aresult of this competition the share of private banks in totalassets has grown from 42% in 2001 to 72% in June 2012;commensurately, its share of total deposit has expandedfrom 43% to 69% over the same period (figure 1.2).

Figure 1.2: Growth of Private Banking, 2001-12


This changed the character of the banking industry ascompetition amongst private banks and between privateand public banks caused a massive increase in financialresource mobilization, introduction of new financialproducts and substantially better service to customers.While still catching up with international standards,nevertheless intense competition in retail banking hascaused a huge improvement in banking services not only interms of faster turn-around time for transactions but also interms of access to modern banking facilities such as ATMs, e-banking, credit/debit cards, wire transfers, etc.

Importantly, this transformation was instrumental inimproving the health of the banking sector. Thus, to a largeextent the improvement in total banking sector NPLshappened due to the rising share and much better portfolioquality of the private banks. Within private banks, foreignbanks performed better in terms of NPLs. Furthermore,foreign banks substantially surpass the Basel II risk weightedcapital guidelines, making them the safest banks in theindustry.

Banking regulations have been progressively tightened inthe context of implementation of BASEL I and II guidelines.Efforts have also been made to improve the supervisioncapacity of the regulator, the Bangladesh Bank, through arange of technical assistance from the IMF and the WorldBank.

Challenges and Concerns

Notwithstanding this progress, a number of seriousconcerns remain in the banking sector.

First, there are sharp differences in the performance ofbanks, especially between private and public banks. Forexample, the NPL of private banks in June 2012 was only3.8%; it was 13.5 % for public commercial banks and 23.8 %for public specialized development banks. The reportedNPL numbers likely understate the true portfolio qualityproblems in the public banks because they do not accountfor the effects of the recently discovered scams and thequality of accounting standards are uncertain. Even if onewere to ignore the potential threat to banking stabilitybecause of implicit government bailout, large NPLs of publicbanks pose a major fiscal risk.

Second, the definition of NPLs used in Bangladesh so fardoes not fully accord with the international norms. Thestandard international definition for NPLs was scheduled foradoption from July 2012. This will likely adversely affect theNPL results for 2013. Similarly, the accounting standardsfollowed in measuring and weighting capital, assets andrisks in the public banks are not fully consistent with BASEL IIdefinition. It is therefore likely that the true NPL of thebanking sector is under-stated while the capital adequacy isover-stated.

Third, there are important issues relating to the corporategovernance of banks. Due to political connections andinfluences some private banks are able to bypass standardsrelating to fit and proper criteria for bank board andmanagement. Importantly, public banks are not within thepurview of the supervision of the Bangladesh Bank. As such,there are serious concerns about the quality of the boardand top management of these banks. Furthermore, theircompliance with prudential regulations is weak.

Fourth, not withstanding progress, the capacity andflexibility of Bangladesh Bank to supervise the bankingindustry and implement prudential measures are oftenconstrained. Owing to lack of autonomy, Bangladesh Bankoften cannot withstand political pressure that compromisesprudential management. Similarly its operational flexibilityis inadequate. For example, it does not have wage settingflexibility and as such cannot hire quality staff. As a result,banks are sometimes able to bypass prudential standardsfor liquidity ratios, compliance with credit/deposit ratios,exposure to stock markets, compliance with capitaladequacy and accounting standards.

0

10

20

30

40

50

60

70

80

PrA/TBA PrD/TBD

Perc

ent

2001 2012


3

Finally, the experience of the past few years has shown thatthe lack of autonomy of the Central Bank is particularlyconstraining in regards to the conduct of sound monetarypolicy and the granting of licenses for new banks. Monetarypolicy was overtly expansive during FY10-12 partly owing topressures from the Government to pump liquidity in thestock market and the financing of Treasury operations. Thisled to considerable damage to underlying economicoutcomes including the fueling of inflation, contributing toasset price bubble and putting pressure on the exchangemarket during those years. Similarly, undue Governmentpressure has forced Bangladesh Bank to issue several newlicenses to new private banks at a time when most analystsbelieve new banks were not needed as they would tend tosubstitute the services provided by existing banks andcontribute to solvency and/or liquidity problems of existingbanks.

Thankfully, corrective monetary policy actions over the past15 months or so have tended to offset some of theseadverse effects, particularly in the area of inflation andexchange market. Also, in the area of new bank licenses, theBangladesh Bank management approached this politicalchallenge as professionally as possible by laying down morestrict performance criteria than in the past for the selectionof the new banks. Yet, these experiences are illustrative ofthe risks of political interventions in the conduct of thefunctions of the Central Bank that must be averted toestablish a healthy banking system.

In this environment of an unfinished banking reform agendaand significant downside risk, the recent unfortunatescandals involving the state-owned banks raisesconsiderable concern and anxieties. Several questionsemerge about the health of the banking sector and theunderlying regulatory regime.

First is the issue of how the recent scams in the public banks,especially the Sonali bank scandal involving the plunderingof an estimated 360 billion taka by a hitherto unknown butnow infamous entity called the Hallmark Group, affects thefinancial health of the banking sector. The second questionconcerns the implications of this incidence for the adequacyof banking safeguards in Bangladesh. A final question is theappropriateness of the banking oversight arrangements inBangladesh. Let’s review each of these issues in some detail.

The impact of the unfortunate and despicable Sonali bankscandal on the financial health of the banking sectordepends upon the strength of the Government’s responseto this case. If the Government responds swiftly and inaccordance with the law of the country with no-holds-barred, then Bangladesh should be able to ride over theproblem with minimal damage. But if the response is weakand uncertain, the potential long-term downside risk to thehealth of the banking sector is huge. If the Hallmark groupescapes lightly, the associated moral hazard issue can have acrippling effect on the banking sector. This will provide

adverse incentives to a host of potential predators to feedon the public banks. The Government is therefore stronglyadvised to move swiftly and with resolve to nip thisdangerous incident right in the bud before it becomes veryugly and cancerous.

Regarding the implications for the adequacy of bankingsafeguards, there are two inter-related issues. First is theadequacy of internal controls within the Sonali bank andother public banks. And second is the adequacy of thesupervisory effort of the Bangladesh Bank.

The transfer of taka 36 billion from a small branch of theSonali bank is a mind-boggling event. The Sonali bankBoard and the Managing Director both denied having anyknowledge of these transactions. If this is really true, it raiseshuge concerns about the lack of internal controls. There isan urgent need for the Bangladesh Bank to do a full reviewof the internal control mechanisms of all the public banksand ensure that all loopholes including those related totransactions recording, accounting standards and approvalmechanisms are immediately secured.

Regarding the supervision arrangements in the BangladeshBank, the immediate question is how did this scam prevailfor so long without detection in the supervision reports ofthe regulator? There could be many possible reasons.Whatever they may be, the event does indicate a seriousgap in the supervision arrangement that must be carefullyreviewed and quickly rectified.

An Agenda for Reforms

At the very top of the reform list is the need for autonomy ofthe Bangladesh Bank. The Government should carefullyreview the issue of the independence of the BangladeshBank and the amount of autonomy it wants to convey to theregulator. A fully autonomous regulator that can hire qualitystaff it needs, procure the technology it requires tostrengthen its effectiveness, and implement prudentialnorms without the fear of political influence is essential toprevent the Hallmark type scams in the future. Anautonomous Central Bank is also necessary to conductsound monetary policy management and to exercise utmostprudence in such matters as the licensing of new banks andthe use of directed credits. Recent experience withgovernment interventions in these matters is illustrative ofthe critical importance of establishing an autonomousCentral Bank in Bangladesh.

The Government should also rethink the strategy for thesupervision of public banks. The weakly performing publicbanks with a huge amount of infected portfolio are a seriousthreat to the soundness of the banking sector. In addition toefforts to improve their performance, these banks must bebrought under the regulatory supervision of the BangladeshBank and must be required to comply with all prudentialnorms, including certification of the bank boards and senior


4

management as per the approved fit and proper criteria.The Government must understand that it cannot both be aproducer of banking services (as owner) and also a regulatorof these services. This is a serious conflict of interest thatmust be corrected.

Over the longer term the Government should also reassesswhether it really needs be in the business of providingbanking services. There is plenty of international evidencethat publicly owned banks do not perform well in anenvironment of weak governance. The quality of portfolioinevitably gets tainted owing to political interventions thatare inconsistent with sound banking decisions. The firstbest option is to privatize the state-owned banks.Unfortunately, this is not a politically palatable option inBangladesh. There are also other practical problemsincluding union pressure against privatization and,additionally, finding sound buyers who are untainted bypolitical favors is a major challenge.

In a political environment where privatization is notimminent, there is a second-best approach that might work.Public banks tend to have an unfair advantage in mobilizingdeposits because of the perception of state guarantees andde-facto immunity from effective supervision. Because ofthese concessions, state-owned banks are able to stay floateven with very poor loan portfolios. The adverseimplications of these improper privileges for efficientlending decisions could be tackled by taking away thelending functions of these banks. If such banks are allowedto only hold government paper, their deposit growth wouldbe indirectly limited and sounder banks would intermediatemore flows. Importantly, the deposits mobilized will be safeand not exposed to risks of the type presented by the recentSonali bank scam.

Such lending restrictions are akin to a “dual banking system”with “narrow banks” that are likely to remain state-owned(and only allowed to gather deposits to invest ingovernment paper) and conventional private sector banks.No new laws are required because the government asowners of the public banks could take this decision.

The idea of narrow bank is not a new one and merits seriousattention1. At the least the Government might ask theBangladesh Bank to review this option carefully and providea technical proposal. The Government must understand thatit faces a very tight fiscal situation owing to the burden ofenergy subsidies and it cannot absorb yet another fiscalshock from a potential liquidity crisis in public banksemerging from an overload of infected portfolio.

1 A more detailed analysis of the idea of narrow banks as a serious policyoption is contained in Sadiq Ahmed, Marilou Uy and S. Ramachandaran(2003). “South Asian Banking and Finance: Growth with Festering Problems”South Asia Region Internal Discussion Paper IDP-186, The World Bank:Washington D.C.


5

II. Post-Correction Bangladesh Stock Market:Market Developments and Policy Issues

Ahsan H. Mansur

Introduction and Background

Bangladesh stock market has been passing through aturbulent period in recent years. Following a bull run thatstarted in second half of 2009, the stock price index asmeasured by DGEN Index reached a peak of 8919 inDecember 2010. Market turnover as percentage of marketcapitalization also surged from the very low level of about19% in 2006 to about 114% at its peak coinciding with thesurge in the DGEN Index. Market capitalization also surgedfrom 5.5% of GDP in 2005 to more than 46% of GDP at itspeak. Like all bull runs and the associated bubble, the stockprice bubble in Bangladesh also came to an end inDecember 2010. In the midst of the correcting phase, theGovernment had announced a number of initiatives tosupport the stock market and used sizable amounts ofpublic funds to support the market without any visibleimpact. The DGEN Index declined and currently stands ataround 3600 level (Figure 2.1). At the same time the marketremains volatile, directionless, and the daily value/volume oftransactions have plummeted. The market sentiment is alsosuffering from continued overhang arising out of unsettledBO accounts of retail market participants. More recently, theongoing political turmoil and hostilities may also have takena toll on the market.

Figure 2.1: Developments in the DSE Index and Turnover

The state of stock market has intensified pressures forimproved governance through market reforms both interms of legal/ regulatory and operational aspects. There arealso continued pressures for further governmentintervention to support the market throughsupporting/floating of government sponsored funds (likeBangladesh Fund) and other forms of reliefs in the contextof the forthcoming budget.

The purpose of this policy note is to assess thedevelopments in the stock market in the context of other

markets which have gone through similar corrections inrecent years and determine whether Bangladesh stockmarket is behaving very differently from others who hadgone through similar bubble and burst phenomenon. Thepurpose is to determine whether Bangladesh market isindeed passing through a phase which is very different fromothers under similar circumstances. The observations madein the paper would shed light whether the pessimismprevailing in the market or expressed by market participantsis justified. This will also set the stage for assessing the needfor special interventions, if any, as demanded by certainmarket participants. We also take note of reforms initiated toimprove governance of the stock market and assess its paceof implementation.

Is Bangladesh Stock Market Behaving Differentlyfrom Others?

Both in market commentaries and press reports on marketdevelopments we hear much about the dismal situation inthe Bangladesh stock market in terms of lacklusterperformance of the index and the market turnover. Ofcourse, much of the analysis is colored by the recent stockmarket boom and the associated surge in the index anddaily turnover. There is still high expectation in manyquarters about the stock price index bouncing back to muchhigher levels because of the perception that the stocks areunder-valued. There are also regular complaints about thecollapse in the level of market activity measured in terms ofdaily turnovers.

Often market participants fail to understand the extent ofadjustments that follow a major market correction followingthe bursting of the stock market bubble. An examination ofthe stock markets in developed and emerging marketsindicates a clear pattern of adjustment in the stock priceindex and other related market activities. A simplecomparison of DSE daily index with the daily Shanghai stockmarket price index reveals how similar is the pre- and post-correction developments in the two stock markets.

Figure 2.2: Comparison of Shanghai and Dhaka StockExchange Indices

(Peak Index=100)

12/5/2010, 8919

2/6/2012,3616 3610

036912151821242730

02000400060008000

10000

1-Ja

n-09

1-Ju

n-09

1-N

ov-0

9

1-Ap

r-10

1-Se

p-10

1-Fe

b-11

1-Ju

l-11

1-De

c-11

1-M

ay-1

2

1-O

ct-1

2

1-M

ar-1

3

Turnover (20 Days MA) DGEN Index

Source: Dhaka Stock Exchange

10

30

50

70

90

t+13

…t+

12…

t+10

…t+

956

t+81

6t+

676

t+53

6t+

396

t+25

6t+

116

t-24

t-16

4t-

304

t-44

4t-

584

t-72

4t-

864

Shanghai DSE

Source: Dhaka Stock Exchange and Yahoo Finance


6

Despite the marked differences in the size and depth of thetwo markets and the dynamism of the two economies, itappears that DSE Index increased faster than the Shanghaiindex and the pace of correction of the DSE Index has beenslower than the Shanghai index. The slower adjustment inthe case of DSE Index may be attributable to efforts by thegovernment to stem the decline in stock prices throughmarket interventions, which helped push up the indextemporarily but without much lasting impact on the overalldirection of the market index. Seen in this way, governmentinterventions—in the form of market interventions by ICBand state-owned banks, announcement of theestablishment of Tk 50 billion Bangladesh Fund or theincentive package announced by the Prime Minister—simply delayed the adjustment and prolonged the agony.When compared with the Shanghai market it may appearthat DSE Index may not have fallen enough and furtherminor adjustments may not be ruled out or would not beinconsistent with developments in other countries withsimilar situation or in similar phase of adjustment.

A comparison with the Kuwaiti bubble and burst episodealso reveal a similar scenario. Once again we may note thatthe Kuwaiti index dropped much faster (in 152 days) thanthe DSE Index which reached its bottom after 275 days.However, the kind of movement we observe following themajor corrections are quite similar despite wide differencesbetween the two markets in terms of market characteristicsand the fundamentals driving the two markets anddifferences in their timing.

Figure 2.3: Kuwait and Dhaka Stock Exchange Index(Peak Index=100)

A comparison of the DSE and Kuwait stock markets alsoindicates how market turnovers have collapsed in the postcorrection period and generally came down to levelsprevailing before the start of the bull runs or at the earlystages of their bull runs. Markets are different in terms ofmarket liquidity and the turnover ratios, but what isnoticeable is that with increase inflows of liquidity turnoverratios increase with the surge in the stock price indices, andas the liquidity and the price indices collapse, so does theturnover ratios. In both DSE and Kuwait stock markets the

turnover ratios increased by 8-10 times before tumblingback to their respective normal levels.

Figure 2.4: Kuwait Stock Exchange

As regards valuation, certainly the average current Price-Earning (P/E) Ratio at 10.6 is certainly much more attractivefrom investors’ perspective compared with the average P/ERatio of 30.6 at its recent peak in February 2010 (Figure 2.5).In 2012, the average P/E Ratio of the DSE was 12.1. It iscertainly true that stocks traded in DSE are much cheaper atthe moment relative to their recent past levels.Nevertheless the valuation issue should be looked at bothfrom temporal and international perspective. On bothcriteria the current average P/E ratio is not an outlier:

Figure 2.5: P/E Ratio at DSE

DSE average P/E ratios are not low compared withthe P/E Ratios observed in the period prior to thebeginning of the recent bull-run in the DSE. TheP/E Ratios generally ranged between 10 to 18during 2005-06.

An international comparison with a wider range ofmarkets indicates that the average P/E Ratio of 12.1for the DSE in 2012 was very similar to the levelsobserved in Singapore and Shanghai stock markets(Figure 2.6). In fact, the P/E ratio for Hong Kong at10.5 was significantly below the DSE level.

10

30

50

70

90

t+80

0t+

664

t+52

8t+

392

t+25

6t+

120

t-16

t-15

2t-

288

t-42

4t-

560

t-69

6t-

832

t-96

8t-

1104

t-12

40t-

1376

DSE Kuwait

Source: Dhaka Stock Exchange and Kuwait Stock Exchange

050100150200250

0

5000

10000

15000

20000

17/0

6/20

0128

/04/

2002

4/2/

2003

15/1

1/20

0323

/08/

2004

30/0

5/20

0525

/03/

2006

30/1

2/20

068/

10/2

007

14/0

7/20

0820

/04/

2009

25/0

1/20

103/

11/2

010

11/8

/201

1

Turnover (20 Days MA) All Share Price Index

Source: Kuwait Stock Exchange

Feb-10, 30.58Nov-

10, 29.71

Mar-13, 10.61

05

101520253035

Jan-

05

Sep-

05

May

-06

Jan-

07

Sep-

07

May

-08

Jan-

09

Sep-

09

May

-10

Jan-

11

Sep-

11

May

-12

Jan-

13

Source: Various issues of Monthly Reviews, Dhaka Stock Exchange


7

Figure 2.6: P/E Ratio in 2012

Market dynamism is generally measured in terms of marketactivities like the value of daily turnovers or volume ofbuys/sales. Thus most market participants and analysts areconcerned about the sharp fall in daily turnover to less thanTk. 2 billion in recent weeks compared with the all time peakof Tk. 30 billion in late 2010. The marked decline in daily DSEturnover needs to be examined more carefully to determinewhether the decline is indeed unusual for the size of themarket measured in terms of market capitalization.

In order to filter the volatility in daily turnover due to variousreasons we measured the 20-day moving average for DSEdaily turnover as percent of market capitalization for alonger period. It is noteworthy that, despite smoothing outthrough the moving average method, the ratio has beenquite volatile and broadly followed the trend in the DSEIndex. Both of these phenomena are also observed in othermarkets that passed through similar boom and burst. Whatis important is that despite the steady decline, the turnoverratios are still comparable with its levels recorded during2004-06 and before when the market was functioning in astable environment.

Figure 2.7: DSE Turnover as % of Market Cap (20 DaysMA)

In addition to looking at the turnover to marketcapitalization ratio over time for Bangladesh, we alsocompared the annual market turnover as percent of marketcapitalization for 2012 for a selected number of countries.

Certainly for 2012, the annual turnover ratio for DSE at 42percent compares very favorably with most of the regionalcomparators. Even if we allow for some further reduction inthe daily value of DSE turnover (in Taka terms), given thatthe market capitalization may have also declined further inrecent weeks, the decline in the turnover ratio would bemodest and would still be in the region of mid to high 20s.This will still put the turnover ratio for DSE in the sameleague as Malaysia and Karachi and above many otherregional comparators.

Figure 2.8: Turnover as % of Market Cap in 2012

Do We Observe Green Shoots of Recovery in theBangladesh Market?

Foreign portfolio investment is generally considered to be agood indicator for market valuation and futureperformance/outlook for the stock market. Developments innet foreign portfolio investment position in Bangladesh alsopointed to future developments in the stock market in theperiod leading up to the peak of the bubble and thereafter.In the period up to October 2007, the increase in the stockprice index in DSE was primarily driven by marketfundamentals and attractive valuation.

Figure 2.9: Net Portfolio Investment (Million USD)

The dual positive characteristics of the market helped attractforeign portfolio investment in the DSE through October

8.010.5

12.0 12.1 12.315.0 15.0 15.9

17.4 18.4

0

5

10

15

20Ka

rach

i

Hong

kong

Sing

apor

e

Dhak

a

Shan

ghai

Mal

aysia

Thai

land

Colo

mbo

Bom

bay

Phili

pine

s

Source: Various issues of Monthly Reviews, Dhaka Stock Exchange

6-Dec-10, 0.73

0.000.100.200.300.400.500.600.700.80

9-Ap

r-13

6-N

ov-1

228

-May

-12

28-D

ec-1

117

-Jul-1

114

-Feb

-11

14-S

ep-1

012

-Apr

-10

10-N

ov-0

99-

Jun-

0913

-Jan-

0929

-Jul-0

828

-Feb

-08

19-S

ep-0

722

-Apr

-07

16-N

ov-0

64-

Jun-

0614

-Nov

-05

20-Ju

n-05

8-Fe

b-05

12-S

ep-0

4

Source: Dhaka Stock Exchange

9 1015

26 2733

39 42

60

010203040506070

Bom

bay

Colo

mbo

Phili

pine

s

Kara

chi

Mal

aysia

Sing

apor

e

Hong

kong

Dhak

a

Thai

land

Source: Monthly Reviews, January 2013, Dhaka Stock Exchange

-486

248

-500-400-300-200-100

0100200300

Jan-

07

Jul-0

7

Jan-

08

Jul-0

8

Jan-

09

Jul-0

9

Jan-

10

Jul-1

0

Jan-

11

Jul-1

1

Jan-

12

Jul-1

2

Jan-

13

Monthly 12 Months Cumulative



8

2007, with the 12-month cumulative net inflow increasing to$148 million in October 2007. As the market continued tosurge and market became increasingly over-valued, foreignportfolio investors started to pull out of Bangladesh marketand 12-month cumulative net withdrawal from DSE peakedto $486 million by April 2010. It is believed that by the timethe stock price index peaked in December 2010 virtually allforeign portfolio investment was pulled out of the market.During October 2008 through December 2010, every monthsizable amounts were withdrawn from the stock market(except 2 months) as foreign portfolio investors bookedtheir capital gains and waited for the market correction.

As the market correction was largely over by April 2011,portfolio investors started coming back to the market fromMay onwards. Every month, except one, new money pouredinto the stock market on a net basis and by June 2012 the12-month cumulative net investment increased to $269million. Monthly inflows continued and new netinvestments continued to be made every month throughJanuary 2013.

We consider this noticeable turnaround in net portfolioinvestment as the early signs of market recovery becauseforeign portfolio investors are being attracted in increasingnumbers by the prevailing stock price valuations and thepositive macroeconomic and growth outlook.

The other area where we notice the green shoots is in thenumber of IPOs and the total amount raised through IPOsduring the post correction period. In 2011, in the immediateaftermath of market correction, 9 IPOs were launched byenterprises to raise Tk. 13.8 billion. The number ofenterprises floating IPOs in 2012 increased marginally to 10and the total amount raised decreased to Tk. 7.7 billion. Thenumber of new issues bounced back significantly in the firstquarter of 2013 with 7 enterprises issuing IPOs in theamount of Tk. 6 billion.

Table 2.1: New Issue of Shares and Bonds Since 2009Number of

ScriptsSum of Size of the IPO (In

Million Taka)2009 11 6,358

Share 11 6,3582010 6 4,516

Bond 1 400Share 5 4,116

Of which BookBuilding

1 1,656

2011 10 14,074Bond 1 300Share 9 13,774

Of which BookBuilding

2 7,948

2012 10 7,743Share 10 7,743

2013 Q1 7 6,024Share 7 6,024

Total 38,715Source: Bangladesh Bank

Are Regulatory Reforms to Govern the StockMarkets Progressing Well?

The recent stock market debacle exposed the inadequaciesin the stock market operations and the prevailing policiesand practices. The report prepared by ADB identified“government tutelage over the capital markets” as the mostcritical problem “holding back sector development andconstrains responsible institutions from carrying out theirmandates effectively.” Combined with strong vested interesthave resulted in entrenched status quo.

There is a general degree of convergence among thepractitioners and market analysts about the key problemsfacing the capital markets, which are:

Limited SEC capability in areas of regulation,surveillance, and enforcement

Limited financial stability oversight and policycoordination between SEC, Bangladesh Bank andMOF

Weak regulation, governance and operation ofstock exchanges

Small institutional investor and mutual fundindustry: underdeveloped insurance industryserving only 1%-2% of population; nascent mutualfund segment of the financial sector

Limited supply of bonds and equities

The key recommendations were:

Demutualization of stock exchanges Enhanced coordination between regulators to

enhance financial stability Enhancing institutional investor demand and

promote the mutual fund industry Enhancing supply and demand of equities and

bonds

A review of reform measures under consideration indicates aslow pace of implementation and a mixed picture, althoughmore than 2 years have passed since the bubble busted inlate 2010 (Table 2.2). In particular, delays have beenexperienced in submitting the draft Demutualization Act toparliament and the Banking Control Act (BCA); and there isnot much progress in submitting a new Financial ReportingAct containing the provisions for establishing anindependent Financial Reporting Council. The governmentshould use its political capital to steer these draft lawsthrough Parliament. Reforms which could be implementedthrough administrative circulars—such as devolving oftreasury bills and amending the Mutual Fund Rules—arealready in place.


9

Table 2.2: Key Policy Actions and Current Status ofReforms under the Second Capital Market Development

Program of ADBPolicy Actions StatusSubmission to Parliament ofamended BCA with theobjective to contain risksposed by equity marketsthrough consolidatedsupervision.

Got cabinet approval on13th March 2013

Submission to Parliament ofFRA Bill to include establishan independent FinancialReporting Council (FRC)

Not Submitted

Establish a special tribunal forcapital market related cases.

MoF has requested theMinistry of Law andParliamentary Affairs to setup a special tribunal tohandle stock market-related cases.

Submission to Parliament ofDemutualization Act. (SECand MOF-BFID)

Has been placed inparliament on 3rd March

BB to devolve at a yield whichis the average of allsubmitted bids by thePrimary Dealers (PDs) andnon-PDs in an auction,excluding outliers.

Circular published on 3 Oct03, 2012

Amend Mutual Fund) Rules toallow asset managementcompanies greaterinvestment flexibility.

Amended in March 2013

Source: Asian Development Bank; Bangladesh Bank; BangladeshSecurities and Exchange Commission; Daily Star; and Financial Express.

Concluding Observations and PolicyRecommendations

Following a major correction, DSE stocks are found to beappropriately priced and the decline in daily marketturnover is also in line with what we observe in manyhealthy and stable stock markets in our region. Marketvolatility measured in terms of movements in the DSE Indexand the average turnover are still high, but not out of linewith market volatilities observed in other markets which hadgone through similar corrections and were at the samestage (i.e., two years after the start of market correction).

Government’s efforts to stop the decline in the DSE Indexdid not predictably bring any positive result. Theinterventions temporarily pushed the index upward, butresumed the declining trend soon thereafter ignoring thebumps. Government interventions only delayed the processof market correction, thereby prolonging the agony withoutany real gain and sizable financial losses for the public sectorfinancial institutions.

The observed volatilities notwithstanding, there are positivesigns which I characterize as the green shoots indicatingfuture market recovery. Foreign portfolio investment hasbeen increasingly noticeable attracted by proper valuation,macroeconomic stability and growth potential of theeconomy. Increasing numbers of IPOs are also taking place,as more and more companies are approaching the stockmarket for funding their growing operations and expansionprograms. We however must caution that the recentintensification of political tensions and hostilities may stallor even reverse the gained observed in the period up toJanuary for foreign inflows and up to March 2013 for newIPOs.

The period after the bursting of the bubble is normally thebest time to launch carefully thought through reforms. Inthe case of Bangladesh the reform agenda has largely beenidentified, but the central issue is to implement the reformagenda without further delay. The key elements of thereform agenda include the following:

Complete the demutualization of stock exchangesto segregate ownership, management and tradingrights of members and convert the two exchangesinto commercially and professionally runorganizations. Improved governance structure willhelp develop the market and attract new investors.It is regrettable that more than 2 years after it is stillnot done.

Enhancing supply and demand for equities overtime will require restoration of confidence through: Upgrading of accounting and auditing

standards to enhance market confidence Establish an independent Financial

Reporting Council to adopt and monitorInternational Accounting Standards (IAS)and International Standards of Auditing aswell as license accountants and auditors

Establish an Audit Committee to supervisecompanies’ internal controls, accountingpolicies, and compliance with IAS

Developing an organized investor base through arobust mutual fund industry will require goingbeyond what has been done so far and observehow the sector responds to the steps already taken.Making the playing field even by requiring ICBfunds to be fully compliant with all mutual fundregulations will be important in this regard.

Government should issue treasury bills and bondsat market rates and thereby develop a liquid bondmarket and reliable yield curve. This will requirebasically stopping the policy of devolvement byBangladesh Bank. Enhancing liquidity will require


10

increasing the average size and reopening existingones. Development of the corporate bond marketwill also require: (i) improving the regulatoryprocess for private placements by balancinginvestor protection with ease of approval; (ii)abolishing the transaction taxes on bonds; and (iii)elimination of stamp duty to help catalize asset-backed securities.

A comprehensive review of taxation of the stockmarket is long overdue. Such a comprehensivereview should treat taxation of income from thestock market in the same manner as any otherincome and at the same time getting rid ofinefficient taxes and double taxation of income ifthat exists. At the moment the tax regime is full ofinconsistencies due to ad hoc measures and not inline with international best practices.

Finally, the government should stop the annualritual of “allowing black money into the stockmarket.” Stock market should not be painted as theplaying ground for legalizing illegally obtainedmoney.


11

III. A Review of Tobacco Taxation inBangladesh and Some Proposals

Ahsan H. Mansur

Background

Bangladesh is one of the most profitable tobacco markets inthe world, with annual sales of around one billion dollars.Recent higher growth in tobacco manufacturing industryhighlights that the prevalence of tobacco use is increasing,especially among poor. These evidences point to thedangerous effects of tobacco consumption on public healthin general and particularly on the low income families. Themain reason for the sharp growth in smoking in Bangladeshand in particular at the lower end is the steady decline in theprice of tobacco and biri in real terms in recent years. In thelast decade or so, there has been a decisive change inconsumption pattern, with smokers shifting from ‘biris’ to‘cigarettes’. This is a positive sign for the health of smokersand for sustaining tax revenue from tobacco products eventhough smokers are clearly shifting more to the low qualitysegment of cigarettes. It may however be observed that thepace of reduction of market share of Biri in volume termshas markedly slowed down in recent years withcorresponding impact on tax collection from cigarettes.

Figure 3.1: Market share of Biri and Cigarette

To reduce the demand for tobacco, excise tax increases andthe resulting higher prices are considered authenticmeasures that governments do adopt across the globe aspart of an overall strategy to reduce tobacco consumption.The higher excises generally induce some smokers to quit,reduce the volume of consumption by those who continueto smoke, prevent others from starting, and reduce thenumber of ex-smokers who resume smoking. A part of thehigher tax revenue from tobacco products is also used tofinance anti-smoking awareness campaigns.

In the current fiscal year there has also been a large shortfallin supplementary duty from tobacco products, which

contributed a significant shortfall in the overall NBR revenuecollection. This new development has also made us reviewthe policy and practices with respect to tobacco products inBangladesh.

This note discusses how the prevailing tax structure fortobacco has encouraged a rapid growth of cheaper lowquality cigarettes in recent years. It finds that: (i) real price ofcigarettes have remained virtually unchanged for lowerquality brands in recent years; (ii) consumption of lowquality cigarettes have increased faster than any othersegment creating a potential public health disaster for thepoor over the long run; and (iii) the change in thecomposition of cigarette consumption from middle tocheaper brands has contributed to a loss of revenue and theconsequent slower growth in revenue from the tobaccoindustry. Based on the considerations which are describedbelow in greater detail, a number of specific proposals areoutlined in the final section. We strongly believe that, todiscourage tobacco consumption and in parallel attaininghigher tax revenue from the tobacco industry, thegovernment should consider rationalizing thesupplementary duty structure on cigarettes in the upcomingbudget.

Real price in decline

The taxation policy has been successful in raising thenominal prices of cigarettes over the past few years. As it canbe seen from the figure below (see Figure 3.3) nominalprices have increased across all segments since FY 07. Thesteepest rise can be noticed in the premium and high endsegments where cigarette prices have increased by around70%. In the medium and low segment nominal prices havein comparison recorded a much smaller increase.

A closer look at Figure 3.2 would highlight the weakness ofthe tobacco taxation policy. While nominal prices haveincreased over the past four years, the real prices have beenlargely unchanged for the lower segments. The prices of lowsegment remained consistently low, while the premium,high and medium has been on the rise comparatively. Thishas resulted in a wider price gap, leading to high volumegrowth of the low segment cigarettes with buyers shiftingfrom the medium segment to the lower one. As thepurchasing power of smokers increased, thedisproportionate taxation policy meant that in most casesthe tax on tobacco was not able to serve its intendedpurpose: to discourage people from smoking. As a result,Bangladesh has continued to see an increase in its smokingpopulation. In terms of loss in government revenue it hasbeen seen that the shift of consumption pattern frommedium to low segment has led to a loss of BDT 2300 crorein FY12 alone. This is a significant figure and can have a verypositive outlook for the government exchequer if it iscaptured in the tax net.

72%

71%

70%

66%

64%

63%

60%

52%

49%

48%

47%

28%

29%

30%

34%

36%

37%

40%

48%

51%

52%

53%

0

0.2

0.4

0.6

0.8

1

2001- 02

2002- 03

2003- 04

2004- 05

2005-06

2006-07

2007-08

2008-09

2009-10

2010-11

2011-12

Biri Vol Cig Vol


12

Figure 3.2: Cigarette Price in Real Terms

Figure 3.3: Cigarette Price in Nominal Terms

Increase in consumption of low quality cigarettes

As highlighted above, Bangladesh has seen a very stronggrowth in the consumption of cigarettes. This growth hasbeen led predominantly by the Low value segment in themarket (Figure: 3.4).

Figure 3.4: Market Share of Segments

Among the competing segments it can be seen that themedium segment traditionally had largest market share.However over the last four years, the Low segment hasstarted to increase its dominance. At the top end of themarket, represented by the premium and high qualitybrands, the share has remained more or less stable. Themedium segment has taken a massive hit and this can bevery strongly attributed to the pricing structure in themarket. With little or no tax increases over the past fouryears the low value segment was able to capture not onlythe new entrants but also to pick up existing customers whoare down trading from the higher end segments. This isalarming on two fronts: i) the government’s anti smokingpolicy via its taxation policy is being defeated and ii) theincrease number of smokers in the low value segment isresulting in a huge loss of revenue for the government.

Figure 3.5: Revenue Loss Due to Tax Policy:

Overall revenue in absolute terms shows an increasingpattern from FY2007 to FY2011 (Figure: 3.5). In absoluteterms it can be seen that all segments have significantlycontributed to the government exchequer. However, whatis concerning is the fact that despite controlling over 50% ofthe market, revenue from the low segment was only 20% ofthe overall tobacco revenue. In FY12, the low segmentaccounted for 60% of the overall market whilst contributingonly 25% of the overall tax revenue from tobacco. The

2005-06

2006-07

2007-08

2008-09

2009-10

2010-11

26% 37% 43% 52% 55% 59%

51% 41% 35% 30% 27% 24%18% 17% 16% 12% 12% 11%5% 5% 6% 6% 6% 6%

Low Medium High


12









2010-11

2011-12

59% 60%

24% 23%11% 11%

6% 6%

Premium


12










13

medium segment had the maximum revenue share of 31%with 23% market share. High and premium contributed 20%and 23% respectively to the revenue share while holding11% and 6% of the market share, respectively in FY12. Acloser look at the growth in revenue over the past two years(Figure: 3.5) shows that total revenue growth has been only13.9% so far in FY11 which is lower than the 25.8% achievedin the previous year. The single largest contributing factorfor the slowdown in revenue is attributable to the poorperformance in the Medium segment. As highlighted earlier,smokers have down traded to the low segment due to itsattractive pricing and consequently depriving thegovernment of much needed revenue.

Another potential tax revenue generator for the tobaccoindustry is the biri segment. While the trend of consumptionshows that a more than 50% smokers have now shifted tocigarettes from biris; biris still constitute 47% of the volumeshare of the tobacco industry. However, such a significantsegment of the industry only generates 2% of the totalrevenue contribution by the industry as of FY12. This posesa similar problem like the low segment of cigaretteswhereby the tax revenue generated is not indicative of theactual market share of the product.

Policy Recommendation and Rationale

As part of the overall strategy to reduce the consumption oftobacco related products, it can be argued that the currenttobacco taxation policy must be revisited. Currently, it canbe observed that the tax structure follows a multi-layer advalorem taxation policy (See Table: 3.1). When this structurewas put in place, it was believed that such a system wouldencourage people to move away from bidi to cigarettes. Inthis report, it can be seen that the major beneficiary of sucha system has been the low segment which not only pickedup new entrants, but was also able to pick up consumerswho were down trading from the higher segment due theirattractive pricing.

Table 3.1: Current Structure of Tobacco Pricing Slab(Inclusive of 15% VAT*)

Brand of Cigarettes Tax Rate (Excise*)(%)

(Price In taka/10sticks)

Premium 76 66+High 74 35.20 – 39.50Medium 71 24.75 – 25.25Low 54 12.10 – 12.30Biri 35 -

Such a system has constantly encouraged the consumptionof low quality cigarettes and but has also had detrimentaleffect on the revenue collection of the government.

In order to rectify such a situation it is therefore proposed:

1. Across all segments, a single uniform ad valoremrate tax structure be established in the first stage.

This would increase revenue for the governmentwhile increasing the price of the lower segments soas to curb down-trading from the mediumsegment. According to FY12 figures, if a 76% exciserate is applied to all segments, the governmentwould receive BDT 53.4 billion in additionalrevenues. The current system of giving preferentialtax rates for lower quality brands cannot bejustified on the ground of equity. It is irrational tojustify lower taxes on the low segment to keep theprices affordable for the low-income group ofconsumers because that would cause excessivelyharmful impact on their health. There is no moraljustification to provide preferential tax rates for thepoor smokers so that they are encouraged tosmoke more. For this reason, a uniform tax rate onall segments could be justified on administrativeefficiency and revenue grounds. Such a policywould also uphold the ultimate goal of reducingtobacco consumption.

Table 3.2: Estimated Price and Revenue Effects of anUniform Tax Rate Structure

Curr

ent T

ax ra

tes

(%)

Pric

e in

BD

T/10

Stic

ks

Uni

form

Tax

Rat

e (%

)

New

Pric

e un

der U

nifo

rmRa

te

No.

of 1

0 st

ick

pack

s

Tax

Reve

nue

unde

r cur

rent

tax

(BD

T in

bill

ions

)

Tax

Reve

nue

unde

r uni

form

tax

(BD

T in

bill

ions

)

Add

. Rev

enue

from

Uni

form

Tax

(BD

T in

bill

ions

)

Premium

76 66+ 76 66+474

million23.76 23.76 0

High 7435.20

–39.50

7635.9-40.29

869million

25.41 26.61 1.2

Medium

7124.75

–25.25

7625.99-26.51

1.817billion

32.57 36.61 4.04

Low 5412.10

–12.30

76 14.76-154.74

billion31.48 54.04 22.56

Biri 355(25

Sticks) 76 7.057.1

billion12.43 38.04 25.62

Total Revenue 125.6 179.1 53.4

2. For premium, high and low segments an additionaltax of 0.50 taka/stick should be imposed over time.In the medium segment an additional tax of 0.20taka/stick should be imposed to reduce downtrading from medium to low. This additionalspecific excise taxes need not be imposed rightaway but rather could be done gradually in two orthree phases.

3. The aim of the additional specific tax in the case ofbiri is to encourage low-end smokers to move up tocigarettes and encourage biri producers to


14

eventually shift to producing low segmentcigarettes. Biri as an indigenous cottage industryhas lived beyond its normal eclipse througheconomic development. Bangladesh today reallydoes not need an industry like biri which providesextremely low wage and the working environmentis very unhealthy. Biri as an industry is survivingonly because of its virtual tax exempt status; and itsvery low price due to low taxation poor families arebecoming more addicted to smoking and exposedto harmful after effects.

Table 3.3: Price and Revenue Estimates from AdditionalSpecific Excise Duty on Cigarettes and Biri

Uni

form

Tax

Rate

(%)

Pric

e un

der

Uni

form

Rate

Add

. Exc

ise

Dut

y /1

0st

icks

(BD

T.)

New

Pri

ceaf

ter

Add

.Exc

ise

Dut

y (in

BDT)

Tax

Reve

nue

unde

r Add

.Ex

cise

dut

y(B

DT

inbi

llion

s)

Premium 76 66+ 5 71+ 2.37

High 76 35.9-40.29 5 40.29-45.29 4.345

Medium 76 25.99-26.51 2 27.99-28.51 3.634

Low 76 14.76-15 5 19.76-20.0 23.7Biri (25Sticks) 76 7.05 5 12.05 35.5

Total 69.549

4. When looking from an international perspective, itis evident that Bangladesh cigarette prices in boththe low and higher segments are cheaper than theprices in comparator nations, as shown in the tablebelow. Even with both proposed changes, the newprices will be below the comparator countries andwill simply make Bangladesh cigarette prices closerto other countries, but still well below the levelsrecorded by WHO for India.

Table 3.4: Prices of Low and High Quality Brands inSelected Countries

Price of cigarettes in USD ($)(Pack of 20 Sticks)

Figures for 2010 Low-costBrand

Marlboro orcomparable

brand

Malaysia 2.20 3.14

Thailand 0.93 2.42

Philippines 0.44 0.87

Pakistan 0.33 0.80

China 0.30 2.37

Bangladesh 0.21 1.51

India 1.51 2.11Source: WHO Report on the Global Tobacco Epidemic 2011 and Author’sown calculation

5. A closer look at the tax structure on cigarettes inother countries indicates that specific excise dutyon cigarette widely used by most countries. As amatter of fact, most nations use a combination ofad valorem and specific excise duty along with VATto tax tobacco products. Amongst the nations weexamined, Bangladesh seems to be the lonecountry with tax on tobacco being applied only onad-valorem basis (both VAT and supplementaryduty).

Table 3.5: Tax Structure and Most Popular BrandCigarette Prices in Selected Countries

Figures for 2010 Price of most popularcigarette (pack of 20)

Taxes on this Brand(% of Retail Price)

Coun

try

and

Cige

rrat

eBr

and

In D

omes

ticCu

rren

cy

In U

SD @

Offi

cial

Exch

ange

Rate

Tota

l tax

es

Spec

ific

Exci

se

Ad

Valo

rem

Exci

se

VAT

Malaysia (Dunhill)MYR

10 $3.14 52 38 10 5

Thailand (Krong Thip)THB58 $1.80 69 2 60 7

Phillipines(Hope/Fortune)

PHP22 $0.48 63 52 0 11

Pakistan (Gold Flake)PKR

28.10 $0.33 62 37 11 15

China (Baisha) CNY 5 $0.74 41 1 25 15Bangladesh ( StarFilter King)

BDT33 $0.48 68 0 53 15

India ( Gold Flake) INR 70 $1.51 46 28 0 17Source: WHO Report on the Global Tobacco Epidemic 2011

6. It is well established that the most effective meansto discourage tobacco smoking is through sharplyhigher prices. AS discussed above, there is stillsignificant room for price increase in the tobaccoindustry, which should be done in the form ofincreased taxes so that the additional funds aredirected to the government coffers. In Bangladeshthe Government sets both the price band and thetax rates which is contrary to general economicprinciples as well as makes the tax system and theunderlying pricing structure subject tomanipulation and political pressures. Throughuniform ad valorem supplementary duty and aspecific excise tax, the government would be ableto minimize tax avoidance through down-tradingand extract higher revenue from tobacco. Ofcourse, the proposed specific excise does notnecessarily need to be introduced with the uniformtax band and can be gradually implemented inphases.


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7. To prevent the flooding of the domestic marketwith discounted raw tobacco it is also proposedthat the tax on the export of raw tobacco beabolished so that more raw tobacco is exported outof Bangladesh and lesser amount is available forhome consumption.

8. As for the biri industry, there are 117 factories inoperation whose combined production isapproximately 7100 crore sticks of biri annually.There are 84 different brands in circulation with aapproximate monthly production of 590 croresticks in total. It is in the best interest of the peopleas well as the government for biri to be priced outof the market owing to the extensive harm thisrudimentary form of tobacco does to the smokers.Besides, if the price of biri is increased throughadditional excise duties and a uniform tax band, theproducers may find it in their interest to shift toproducing low end cigarettes rather than biris,while consumers may opt for the latter as well. Thebiri industry employs 65,000 full-time workers at awage rate of BDT 100 per day. When the country isgenerating 1.7 million new jobs annually, it will bepossible to absorb these workers into the jobmarket at better wages as well as workingconditions in case the biri factories close downoperations. These measures will also help torationalize the distortion that exists in the currenttax and pricing structure and also help to movetowards the mixed tax structure instead of thecurrent ad valorem system.

These recommendations are not the final steps but shouldrather be seen as a modest first step. In the upcomingbudgets, stronger follow up measures must be taken tocontinuously discourage the use of tobacco products.


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IV. Promoting Export Diversification byaddressing Anti-Export Bias in FY2013-14

Budget

Zaidi Sattar

Introduction

Over the past two decades, Bangladesh has emerged as thesecond largest readymade garments {RMG} exporter in theworld after China. Driven by this one product group, exportshave averaged comfortable double digit growth for theentire period. Prospects for sustained high exportperformance are bright, though vulnerabilities remain. Oneprimary source of vulnerability arises from “exportconcentration” characterized by the extreme reliance ofexport earnings on just one product – RMG.

The problem has been duly identified by analysts andpolicymakers alike, and the need for export diversification iswell recognized by the government which, to be fair, hasmade it a cornerstone of trade policy. But, judging from therecord thus far, results are modest. Though the number ofexport products has increased over time, the share of RMGin the export basket has remained steady at 75-79% for thepast decade. This is partly due to the approach taken toaddress the challenge, which has been to identify productswith strong past growth record or assessment of potentialcomparative advantage using some indicator like revealedcomparative advantage (RCA), and to include these amongthe “thrust sectors” in industrial or export policy to givethem all kinds of support in preference to other sectors notso identified.

The emphasis of trade or industrial policy based on theprinciple of thrust sectors has its merits and demerits. It is afact that RMG was never a thrust sector at its inception threedecades ago. Most recently, ship building has emerged as aviable and prospective export sector to everyone’s surprise.The thrust sector approach is largely a post facto device todistribute public resources rather than an effective criteria todiversify production or exports going forward.

What is missing in this approach is a proper diagnostic ofwhat generates the momentum for export concentration inone product to the exclusion of others. To be sure, anystrategy for export diversification should not createconditions to stem the existing momentum associated withthe lead product but contain adequate incentives togenerate momentum for the emergence and expansion ofother products. PRI research2 in the past year has revealedthat, in the ultimate analysis, it is a matter of relativeincentives that determine resource allocation across

22012 PRI study for the World Bank, “Assessment of Effective Rates ofProtection 2012.Survey of selected manufacturing enterprises”.

competing activities in production for domestic sales orexports. It also established that while non-RMG exportssuffered from significant anti-export bias of incentives(resulting in exports of a product being less profitable thanits domestic sales propped up by high protection), RMGsector – being a 100% export-oriented sector -- was largelyimmune to it. The consequence of this structure of relativeincentives seemed to accentuate the uni-product exportconcentration.

Scope of the Paper

This paper primarily seeks to provide a diagnostic of thetariff-related constraints to export diversification byexamining existing incentive regimes in the manufacturingsector, and identification of trade policy biases, besidestaking note of the standard issues of cost-competitivenessand inadequacies of trade infrastructure. While making astrong case for eliminating anti-export bias for non-RMGexports by rationalizing the tariff structure, we believe thepaper highlights some critical barriers related to exportdiversification that were not raised or adequately discussedin the past. The forthcoming budget for FY2013-14 might bea good opportunity to take some of the recommendationsfor tariff adjustments on board.

Vulnerability from Export Concentration

Export concentration is not a new phenomenon forBangladesh. For many decades prior to the emergence ofRMG exports, jute and jute goods dominated the exportsector making up 70 percent of exports in 1981. In the post1990 period, however, RMG exports had overtakenBangladesh’s traditional exports and, by the close of the1990s, export concentration emerged afresh, with RMGexports reaching a share of 77-80 percent.

Figure 4.1: Export Concentration Trends (FY1980-2012)

In terms of international trade, Bangladesh aptly fits thedescription of a small open economy that is a price taker inthe world market, for its exports as well as imports.Consequently, it must face the consequence of adverse

0.0

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100.0

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FY95

FY00

FY01

FY02

FY03

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FY05

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rt sh

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Jute & Jute Goods(% of Total export)RMG (% of Total export)Mfg export as % of Total Export


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movements in its terms of trade (TOT), stemming fromexogenous price shocks in its imports or exports. Typically,such exogenous TOT shocks have originated in adversemovements in the prices of imports such as petroleum, foodgrains, and raw materials, such as cotton – a major import ofBangladesh’s textile sector. Research shows that TOT shocksor variability have adverse impacts on GDP growth. Fordeveloping countries like Bangladesh, external demand(quantity) shocks appear as a more serious threat. Suchshocks are the outcome of cyclical movements in theeconomies of North America and the European Union, thedestinations to which bulk of Bangladesh’s exports aredirected. The income effect of these cyclical movements isto stimulate export revenues from trading partners in boomtimes with its negative counterpart in contractionaryperiods. While a developing country cannot escape fullyfrom the adverse effects of a global crisis, a diversifiedexport market can help soften the impact considerably. IfNorth America and Euro zone countries embark on austeritymeasures to resolve their fiscal and debt problems, it couldmean lower demand for developing country exports acrossthe board. This is illustrated, for example from the 2012experience when the export growth in nominal US dollarsdipped to only 6%, as compared with a target of 14% in theSixth Plan, owing to the adverse effects of the EuropeanDebt crisis. The saving grace, in such scenarios, might bedemand from the emerging market economies (Brazil, India,and China) and Japan. Together, these economies add up toa market size that is roughly equal to that of the EU or NorthAmerica. Geographical diversification – one morecharacteristic of export diversification – into these potentialand sizable export markets could help stabilize exportrevenues in times of crises or cyclical movements in thetraditional markets in developed countries.

Trade Policy Bias as Key Constraint

A wide range of constraints undermine Bangladesh’sprospects to diversify its export base. These constraints canbe categorized into several themes like (a) AdverseIncentives for Export Diversification, (b) Role of CostCompetiveness, (c) Ease of Doing Business, (d)Availability ofSkills, (e) FDI inflows into export sectors, and many more.This paper mainly focuses on a scarcely discussed issue oftrade policy bias arising from adverse incentives, whiletaking note of some of the standard issues like costcompetitiveness and ease of doing business.

Incentives for Exports versus production for domesticsales

This concerns the attractiveness of investors to go intoexports vis-à-vis domestic production. The main incentivepolicies arising from the trade regime relate to exchangerate management and the tariff structure.

Exchange rate management: Exchange rate is acritical determinant of export incentives and as

such sound exchange rate management is veryimportant for maintaining exportcompetitiveness, particularly for non-RMGexports. RMG exports are partly shielded fromexchange rate movements because of the specialimport credit system (back-to-back LC) thatcovers import costs from export proceeds so thatany nominal exchange rate depreciation affectscosts and returns proportionately. As a long-termstrategy for export diversification, theappropriate exchange rate management wouldbe to avoid rigidity or real appreciation of REER; amoderately depreciating REER would work betterto sustain competitiveness of exports, particularlynon-RMG exports.

Tariff structure and relative incentives:Perhaps the single most important determinantof export competitiveness is the incentive regimeemerging from trade policy. Bangladesh likeother South Asian countries started with anautarkic trade policy regime with a host ofquantitative restrictions and high tariffs. Thiscomplex system of anti-trade and anti-exportregime slowly got dismantled, especially since1990. Yet, as analyzed in detail in the nextSection, a substantial anti-export bias of the tradepolicy remains due to a structure of tariffs thatraise profitability of domestic sales relative toexports, particularly for firms engaged inproduction both for domestic and externalmarkets, thus serving as a hindrance to non-RMGand emerging exports.

Cost Competitiveness

Except for RMG, for most of the products that Bangladeshexports, it faces a virtually infinitely elastic demand curve.Bangladesh is a very small player in the global market fornon-RMG exports and its presence or absence does notcreate any impact on the world price of that product. Whilethere may be tariff or non-tariff barriers in individualcountries, these are likely to apply uniformly for allexporters. So, for all practical purposes, Bangladesh is aprice taker in the global non-RMG export market. Marketaccess to these products is by and large limited by costcompetitiveness of Bangladeshi suppliers.

The enabling environment for trade is a key determinant ofcost competitiveness of exports. In recognition of itsimportance considerable attention is now being paid byvarious countries to this factor. Globally, several indicators ofthis enabling environment have been prepared that areregularly updated on an annual basis to track progress


18

relative to competitors. Two commonly used indicators arethe Enabling Trade Index (ETI) and the Trade LogisticsPerformance Index (LPI). In addition, Bangladesh doespoorly on most of the indicators included in this index, butscores especially low on transport. This is not surprising astransport and power have emerged as serious constraints tomanufacturing sector in general. Export competitiveness issharply reduced by the high transaction costs relative tocompetitors related to transport services as well as theinefficiencies of custom procedures.

Ease of Doing Business

The regulatory environment for doing business in a countryis yet another indicator of broad-based exportcompetitiveness. The regulatory regime can raise thetransaction cost of doing business and hurt exports. In thehighly competitive global markets the ability to respondswiftly and timely to business opportunities andcommitments can be critical factor underlying exportcompetitiveness. Importantly, the regulatory environmentis a major determinant of FDI inflows that can alsosubstantially influence the domestic supply capacity torespond to the world export markets. Historically, thebusiness environment of South Asia has been intrusive withhigh transaction costs. Deregulatory efforts in South Asiancountries, especially in Bangladesh and India, started inearnest only since the 1990s. While progress has beenmade, there is still a long way to go. In terms of specificregulatory constraints, investors in Bangladesh face aparticularly difficult challenge in getting electricity; inregistering property; and in enforcing contracts.Bangladesh, however, does a good job in protectinginvestors. On the whole, despite a series of deregulatoryreforms since the 1990s, the overall business environment inBangladesh is difficult relative to competitors that tends toincrease the transaction cost and lowers competitiveness.Considerably more progress is needed for making theBangladeshi investment climate much more attractive forattracting foreign investment and improving exportcompetitiveness.

The important point is that while these constraints could begeneric to all exports, they hurt non-RMG exports andemerging or potential exports even more thus inhibitingtheir expansion.

Anti-Export Bias of the Incentive Regime and TradePolicy

This section provides in-depth analysis of the critical role ofthe anti-export bias in trade policy as a constraint to exportdiversification. Bangladesh like other South Asian countriesstarted with an autarkic trade policy regime with a host ofquantitative restrictions and high tariffs. This complexsystem of anti-trade and anti-export regime slowly gotdismantled, especially since 1990. Yet, a substantial anti-export bias of the trade policy remains. While quantitative

restrictions have been largely eliminated and customsduties reduced and simplified, tariff reforms, incompletethough they are, have stalled in recent years. Over the past13 years, average custom duty has come down; but averagenominal rate (NPR) has not, due to the emergence of para-tariffs, such as supplementary and regulatory duties. What isstriking is the growing wedge between output and inputtariffs resulting in higher effective protection (ERP) fordomestic producers at a cost to non-RMG exporters, inparticular, who face anti-export bias in export expansionand diversification.RMG firms, being 100% export-oriented,are immune to this bias of the tariff regime, thanks to theduty-free regime they operate in.

Structure of Nominal Tariffs

The analysis of relative incentives for exports and domesticsales would have to begin with an analysis of nominalprotection to various categories of products imported underthe tariff and import tax regime. It turns out that withprogressive trade openness, and virtual elimination of trade-related QRs, tariffs on imports are now the single mostimportant determinant of trade protection. Whereas tariffsand quantitative restrictions (QR) together determined theextent of openness or restrictiveness of trade policy in the1990s and before, the QR slate has been wiped pretty muchclean since FY2005, leaving tariffs as the main instrument oftrade policy and protection. The tariff structure has beensimplified by moving to only four non-zero tariff slabs – 3%,5%, 12% and 25%. Although the average customs duty hascome down over the past 13 years, the average nominalprotection rate (NPR) shows mixed trend (Table 4.1). Itinitially declined between FY01 and FY09 and then startedrising again over FY10-FY13.

Table 4.1: Recent Trend in Nominal Protection inBangladesh

FiscalYear

Un-weightedAverage

CD

Averagepara-tariff

AverageNPR

TopCD

Rate

TopNPR*

FY 01 21.10 7.13 28.54 37.5 59FY 02 21.02 8.11 29.43 37.5 43FY 03 19.91 6.51 26.42 32.5 52FY 04 18.82 10.29 29.11 30 53FY 05 16.31 10.22 26.5 25 60FY 06 15.49 10.97 26.47 25 72FY 07 14.85 9.42 24.27 25 69FY 08 15.93 6.20 21.94 25 72.5FY 09 13.82 6.26 20.08 25 72.5FY 10 13.67 10.21 23.88 25 79FY 11 13.55 10.20 23.74 25 79FY 12 13.57 13.39 26.96 25 88FY13 13.87 14.72 28.93 25 116

Source: NBR Tariff database and PRI staff estimates; (*) Excludes highNPR on automobiles (where revenue objective dominates), alcoholicbeverages, tobacco (demerit goods).

Two aspects of the tariff structure and its trend areparticularly noteworthy:


19

(a) proliferation of para-tariffs, and

(b) perceptible divergence between the top NPR rate (whichmoved up since FY01) and the average NPR, and a growingwedge between output and input tariffs.

The Proliferation of Para-Tariffs

A close examination of para-tariffs and their trends will givethe reader a fair understanding of the emergence andproliferation of this rather ad hoc instrument of trade andtariff policy and how they are affecting relative incentivesbetween production for exports and domestic sales. Thesepara-tariffs comprise mainly of two taxes: a regulatory dutyand a range of supplementary duties.

Regulatory Duty (RD): The RD is charged under TheCustoms Act 1969, at a rate set every year with the budget.However, it has the character of a temporary measure thatexpires at the end of the year and has to be renewed thefollowing year. The RD rate for FY2012/13 is 5% appliedalmost uniformly on all products subject to the top rate of25%, thus making the effective top CD rate to be at least30%, if not higher, when SD is applied. The base forcomputation of RD is the same as CD, i.e. assessable value(AV) of imports. For all practical purposes, RD is an additionalCD applied on all goods subject to the highest CD rate of25%. Historically, RD has been applied intermittently, havingbeen eliminated in some years in response to therequirement for simplification of the tariff structure underWorld Bank’s budget support facility, Development SupportCredit, but re-emerging once the obligation was no longerbinding.

Supplementary Duty (SD): SD was introduced in 1991under the VAT Act, and was meant to be a trade-neutral tax.However, increasingly it has come to be applied in a non-neutral fashion, i.e. it is not applied equally on imports aswell as domestic sales. Indeed it has become an expedientinstrument of protection through its differential application(higher rates on imports; lower or zero rates applied toimport substitutes). The VAT authority also issuesexemptions on SD through SROs. SD was applied as apercentage of “assessable value” (AV) but, from 1997-98, SDis levied on the basis of duty paid value (assessable valueplus customs duty plus regulatory duty), adding complexityto the computation and creating the scope for malfeasance,which serves as a trade inhibiting factor.

Likewise, RD is now seen to be used on an ad hoc basis everyyear, only on imports subject to the top CD rate of 25%,aimed primarily to raise protection to domestic industries,though NBR hopes it will generate extra revenue. The factthat there is hardly any objection from the producercommunity against these applications testifies to theirfavorable impact on protection. So far, such rampant use ofpara-tariffs seems to have escaped attention of WTO TradePolicy Review, since cross-country tariff comparisons

available in UNCTAD’s COMTRADE database do not haveinformation on para-tariffs. However, information on para-tariffs is being compiled and could soon become an irritantin multilateral trade discussions.

Growing wedge between output and input tariffs

A closer examination of the structure of tariffs reveals thatthe decline in average NPR was due primarily to thereduction in tariffs on basic raw materials, capital goods andintermediate inputs, while the top CD rate remained flat at25% since FY05, topped up by generous supplement oflevies (RDs and SDs)– para-tariffs. The proliferation of paratariffs has indeed been a major negative feature of the tradepolicy regime in Bangladesh. Its growing significance isevident from Table 4.1. Amazingly, it now contributes tomore than 50% to the value of the average NPR in FY2013.

A review of the trends in nominal protection rates of importcategories (Figure 4.2) shows that in the recent past theaverage NPR for input categories have been decliningrapidly while that of final consumer goods remainedpractically flat if not increased. This trend could besymptomatic of the priority demand for higher revenue. Butthe pressures created by domestic producers of consumergoods seeking higher effective protection by holding on tothe higher rates on final consumer goods while depressingrates on imported inputs used in the production processhave also had their impact on tariff trends. The net outcomeof this process is higher effective protection to domesticproducers over time. Also notable are the prohibitively highNPRs on consumer goods that are domestically produced(e.g. 116% in FY2013). Such high rates, if effective, constitutede facto import bans (e.g. biscuits are subject to 200% NPR).

Figure 4.2: Average NPR on Import Categories FY 00-13

Source: NBR Tariff database and PRI staff estimates

Implications for Resource Allocation: Effective Rates ofProtection (ERP)

All the protection analysis in the recent past has been doneon the basis of nominal protection, which is estimated from

0

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the prevailing tariffs and para-tariffs on imports. On anaverage, we are aware that overall NPR has trendeddownwards for the past two decades, except in the last fewyears. But producers know very well that profitability is afunction of relative protection on outputs and inputs. Theyknow that higher tariff protection on inputs undercutprotection on outputs. Hence, economists have devised analternative but more precise measure of the incentive toproducers arising from the relative weight of tariffs onoutputs and inputs. That is the measure of effective rate ofprotection (ERP). ERP – a measure of effective incentives to afirm producing a traded product – increases with highertariffs on output or lower tariffs on inputs, and decreaseswith lower tariffs on outputs or higher tariffs on inputs.

A summary of ERP results is shown in Table 4.2. The ERPcomputations across products and firms now reveal thateffective protection rates far exceed NPRs by wide marginsbecause average input tariffs are well below output NPRs,ranging from over 100% for agro-based products like fruitjuice, to over 300% for such products as bicycles and plasticchairs. Barring a few products like carbon rods and jutetextiles, which are intermediate products, most ofmanufacturing in Bangladesh is concentrated on consumergoods production, all of which have

Table 4.2: Summary of Range of ERPs and Average ERPs2012

Sub Sectors Range Average ERPFootwear 214%--342% 273%Jute Textiles 33%--125% 76.5%Agro-based industry 4.5%--381% 187%Light Engineering 117%--386% 219.5%Ceramics 190%--239% 214.9%Pharmaceuticals 9.4%--20.6% 3.1%Electrical Products 1.6%--272% NADomestic Garments&Embroidery

5.75%--51% 25%

Plastic Products 86.8%--483% 259.8%Source: PRI estimates based on industry survey

output NPR rates between 50-100% (200% for biscuits!). Theobserved low ERPs for jute textiles are mainly because ofredundancy of nominal tariffs due to Bangladesh’s strongglobal competitiveness in this product, while low (barelypositive and even negative for some generic drugs)observed ERPs for pharmaceuticals are due to low outputNPRs designed by Drug Policy (Drug Control Act of 1982restricted imports and capped prices) to keep domesticprices low but with strong controls on competing importswhich are essentially banned with a view to achieving self-reliance – a goal that was mostly achieved as the countrynow produced nearly 95% of all drugs demanded locally.

The protection situation is quite the reverse in the case ofproduction for export, even for firms that produce both forthe domestic market and exports. Since producers have nooutput protection in export markets, export ERPs are

typically zero when imported inputs are duty exempt viamechanisms such as SBW or duty drawback. Often cashsubsidies compensate for duty drawback or SBW. In caseswhere transaction costs undermine the full extent of dutydrawback reimbursement or when there are domesticallysourced inputs and cash subsidy does not fully compensatefor the duty-inclusive prices, export ERPs could be modestlynegative. In the case of footwear and leather, thelongstanding export prohibition on wet blue leather – a keyraw material for finished leather – serves as a substantialsubsidy by keeping domestic price of this key inputdepressed below world prices, and the resulting ERP couldthen be significantly positive. All said, export ERPs are foundto be zero, modestly negative, or modestly positive.

Thus when relative incentives between domestic productionand exports are considered, it is clear that production fordomestic sales has a significant advantage over exports.What is disconcerting is that, in a regime of non-uniformtariffs, incentive from protection is non-uniform without anyrationale for why some sub-sectors receive heavier effectiveprotection than others. Again, this sort of protective regimereveals significant anti-export bias which raises the questionwhy firms export at all when profitability is so much higherin the domestic market for the same product. The enormoussize of the export market, potential scale economies,Bangladesh’s labor cost advantage for globalcompetitiveness, and higher revenues from larger sales, alltaken together might provide the justification for firms toengage in exports either entirely or in addition toproduction for domestic sales.

The support policies for export, such as cash subsidies, andmechanisms to provide duty-free inputs through dutydrawback or bonded warehouse facilities, are not enough tomatch the augmented profitability resulting from generallyhigher protective tariffs on outputs and lower protectivetariffs on inputs. It is important to note that there is no clearevidence that cash incentive scheme has been effective inexpanding exports or promoting its diversification.Originally intended to offset tariffs on imported inputs, itswidespread use by firms (e.g. jute textiles) with smallproportion of imported inputs makes it a wasteful exportincentive besides creating the scope for over-invoicing ofexports – an avenue for corruption. This practice could alsobe cited as GATT-illegal by competitors.

Overall, the ERP estimates confirm the existence ofsignificant anti-export bias of the tariff and incentive regime.In these circumstances, it is a fair question to ask why theseenterprises export at all when profitability is higher in thedomestic market. One answer is that there are positiveprocessing margins still in exports, but processing marginsare far greater in domestic sales. Those who recognize thevastness of the export market and future potential can stillfocus on being competitive in exports to gain greater futuresales/profits. In comparison, domestic market is limited andfuture economies of scale also limited.


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Studies on firm level effective rate of protection (ERP) doneby PRI indicate that effective protection as been on the risethroughout the past decade for most of the sub-sectorsunder study. Bangladesh is known to possess highprotective tariffs, especially on consumer goods, byinternational standards. Declines in average NPR in the pastdecade has been largely due to reduction in input tariffsrather than output tariffs. The ERP computations acrossproduct and firms reveal that effective protection rates farexceed NPRs by wide margins because average input tariffsare well below output NPRs, ranging from over 100% onagro-based products, to over 300% for such items asbicycles and plastics. Barring intermediate goods, mostconsumer goods production in Bangladesh have outputNPR rates between 50-100% (200% for biscuits!).

As producers have no output protection in export markets,export ERPs are typically zero when imported inputs areduty exempt via mechanism such as SBW or duty drawback.ERP estimates for exports from the study found ERP to bezero, modestly negative, or modestly positive. This indicatesthat the mentioned support policies and facilities for exportare not enough to match the augmented profitabilityresulting from the input–output tariff ‘imbalance’. It is clearthat production for domestic sales has a significant relativeadvantage over exports. This sort of protective regimereveals significant anti-export bias which raises the questionwhy firms export at all when profitability is so much higherin domestic market.

The RMG sector is 100% export oriented. So question ofchoice between exports and domestic sales does not ariseso that anti-export bias is not an issue. The problem of anti-export bias is relevant for firms that engage in productionfor exports and domestic sales.

Recommendations

Policies and institutions that favor export expansion will alsobe conducive to export diversification. Bangladesh isprobably a unique case where this proposition might nothold. This is because the high reliance on RMG exports hasput in place institutions and policies that give high priorityto this sector resulting in an asymmetry of policy supportthat accentuates the existing uni-product exportconcentration, on the one hand, and also hinders theemergence and growth of non-RMG exports. Given the sizeof the global market for textiles and clothing, Bangladesh’sstrong market position in RMG is unlikely to diminishanytime soon. Given that (a) China is moving away frombasic garments to high-value products, (b) Japan, thesecond largest apparel market in the world, has opened upto Bangladeshi garment exports, and (c) emerging marketsare becoming significant buyers of Bangladeshi garments,McKinsey and Company3 project that Bangladesh RMG

3Mckinsey & Company (2011). “Bangladesh’s Readymade GarmentsLandscape: The Challenge of Growth”.

exports will double by 2015, and triple by 2020.Nevertheless, the case for diversifying Bangladesh’s exportbasket in the interests of reducing vulnerability fromindustry-specific shocks has been made.

The following policy and institutional mechanisms need tobe put in place if export diversification is to be attainedwithin a reasonable period:

Trade policy bias against exports must beeliminated. As for the trade policy regime, PRIresearch in the past year has highlighted the factthat the tariff structure is generally skewed in favorof import-substituting activities with a substantialanti-export bias. Because of the essentially “freetrade enclave” created for RMG production – a100% export-oriented industry – it is not affected somuch by the anti-export bias of the incentiveregime as are other exports. However, in recentyears, the government has taken some steps toselectively provide such facilities like SBW(previously restricted for 100% export-orientedfirms like RMG) to exporting firms that satisfy acritical minimum export volume, thus mitigatingsome of the anti-export bias. We find that anincreasing number of non-RMG exporting firms arenow making use of this facility which is theprincipal means by which the dis-incentives from ahigh-tariff regime can be mitigated. This processneeds to be sustained and made more effective.Nevertheless, a major challenge in the forthcomingbudget of FY2013-14 will be to address the issue ofanti-export bias in the tariff structure because ithurts emerging and potential exports, thus servingas a policy constraint to export diversification. It isimperative that the unusually high ERP for import-substitute production needs to be scaled down.The process needs to start with the FY2013-14budget by reversing the growing wedge betweenoutput and input tariffs.

Efficiency of customs administration. Atransparent and efficient customs administration isideal for export success. Again, it is not enough toprovide green channel clearance for RMG cargowhile leaving the remaining exports at the mercy ofan archaic and incompetent customsadministration. All exports must be brought withinthe fold of automated clearance mechanism that isequipped with state of the art hardware andsoftware.


22

Efficiency of import-export procedures. It wouldbe foolish to think that improving tradeinfrastructure means focusing on rapid clearance ofexport cargo. Export and imports are intricatelylinked so that export performance dependscritically on simplification of import procedures aswell. Modernization of import clearance byinstalling the latest machinery and equipmentalong with IT softwares is absolutely critical toachieve export diversification.

Transparency and efficiency of behind-the-borderservices. Besides providing the support of modernbanking and financial institutions to trade,industrial and investment policies need to bebrought in line with those of trading partners andcomparators so that a dynamic export sector can besustained for the long-term.

Availability and quality of transport infrastructureand services. Improving trade logistics willdefinitely enhance competiveness of exports. First,land and sea ports must be equipped with state ofthe art facilities – container depots, gantry cranes,IT-enabled port clearance services, etc. -- for rapidclearance of import-export cargo. Road, rail, river,and air transports linking the hinterland to theports must be developed to the highest level ofsophistication so that transaction time and costsare minimal, to ensure export competitiveness.

Availability and use of IT. Export success alongwith export diversification calls for rapidly installingstate of the art IT equipment and software forhandling activities at the ports but also inland for asmuch of the behind-the-border activities as arerelated to trade. Export competitiveness in the 21st

century is as much a matter of producing at thelowest cost as it is about producing with thesupport of the best and latest technology. In thisregard, it is critical to run and stay with the latestversions of hardware and software, or else exportsuccess could be short-lived.

Documents

PRI Quarterly Policy Briefs on Bangladesh Economy · considered autonomy, naively though. Quasi-fiscal operation or policy-based lending to preferred sectors or groups is not part