The Bangladesh economy : some policy issues

Abstract

Bangladesh is a poor country that has not performed well in economic terms since independence. It was hoped that industrialization would lead to rapid growth, but protectionist import-substitution policies failed to deliver industrial development. Following the trend toward identifying policy problems as being key to growth, this study sets out to examine the effects of foreign exchange and trade policies on industrial development. An ORANI-type computable general equilibrium model, CGE-B89, for the Bangladesh economy (on a 1989 database) was developed for policy analysis. The model was simulated for an exogenous inflow of foreign aid to estimate the shadow exchange rate. It was then simulated for changes in the official exchange rate, money supply, tariffs and export subsidies. Simulations were designed for the short-run in identical economic environments. For each simulation two alternative assumptions about the labour market were made: fixed nominal wages in the presence of involuntary Keynesian unemployment and aggregate employment fixed by the exogenous supply of labour. The macroeconomic and sectoral effects were analysed, and the aggregate welfare gain (or loss) was evaluated for each exogenous change. Harberger's fundamental equation of applied welfare economics (Harberger 1971) was used to disaggregate the change in welfare, due to a small change in an exogenous variable, into the direct welfare impact of the change and indirect gains (or losses) from alleviating (or exacerbating) distortions in all other markets. To apply Harberger's fundamental equation, it was necessary to extend his analysis to allow for intermediate goods, terms of trade effects, indirect taxes on consumption and intermediate inputs, production subsidies, exchange controls and wage rigidity (for simulations in which changes in involuntary Keynesian unemployment are allowed). In the case of shadow price of foreign exchange, the direct effect on welfare of a costless increase in foreign exchange availability of US$1, due to increased foreign aid, is the value of US$1 at the official exchange rate (taka 32.14). The indirect effects equal the sum, across all distorted markets, of the change in distorted activity multiplied by the excess of marginal social benefit of that activity over its marginal social cost. For example, in the case of tariffs, the marginal social benefit of an extra unit of imports is domestic price, while the marginal social cost is the world cif import price (exogenously given in the model). Therefore the gap between the marginal social benefit and marginal social cost is the amount of the tariff, and the indirect benefit of additional foreign aid in alleviating tariff distortions is the tariff times the rise in imports due to the increased foreign aid availability. In the case of Keynesian unemployment, the indirect benefit is the difference between wage and the disutility of labour (assumed to be zero in the model) times the change in employment. With rigid nominal wages in the presence of involuntary Keynesian unemployment, the indirect effect on welfare of a costless increase in foreign exchange availability was estimated to be more than 30 per cent of the official exchange rate. This percentage also measures the extent by which the shadow exchange rate exceeded the official exchange rate. The shadow exchange rate was 15 per cent above the official exchange rate when the nominal wages were flexible and aggregate employment was fixed at the base-year level. Model results suggested that the inflow of foreign aid would raise households' welfare at the expense of reduced production in the tradable sectors. Foreign aid inflow would cause a fall in the real exchange rate, defined as the ratio of the price of tradable goods to the price of nontradable goods. Production of most of the importables and exportables would decline against a substantial expansion in the nontradable sectors. In a small open economy with a unified exchange rate and no exchange controls, a devaluation of the exchange rate increases the money stock through the Hume mechanism. But such a causality does not take place in an economy confronting exchange controls under a dual exchange rate system (involving an exogenously fixed official exchange rate and the market determined secondary exchange rate). In such an economy, changes in money supply and changes in the official exchange rate may be viewed as two separate policy tools to affect the secondary exchange rate premium, and hence implicit taxes on imports and exports. Production and consumption decisions in the economy are thus influenced. The study explored the consequences of two instruments for exchange rate unification: devaluation of the official exchange rate and a contraction of the domestic money supply. Simulations of the devaluation of the official exchange rate and increases in money supply have suggested that a devaluation of approximately 2 per cent or a contraction of domestic money supply by 2 to 2.5 per cent would unify the exchange rates. When aggregate employment is fixed, devaluation and money supply contraction would both reduce the aggregate implicit taxes on exports, and would lead to a deterioration in the international terms of trade. As a result, welfare would fall. In other words, unification of the exchange rates in the absence of optimal export taxes is estimated to be welfare worsening. A nominal contraction (or expansion) degenerates (or produces) a Keynesian stimulus under conditions of sticky nominal wages. As a result, a contraction in the domestic money supply would be welfare worsening, and a devaluation which is equivalent to a monetary expansion would be welfare augmenting in conditions of wage rigidity. But a 2 per cent devaluation, which would unify the exchange rates, would raise households' welfare, albeit by only 0.14 per cent of the base-year GDP at market prices. An equiproportional reduction of tariffs was found to be welfare improving. Both exports and GDP at market price rose. Simulation results, however, suggested that the welfare gains from a 10 per cent equiproportional reduction in tariffs were quite small as a proportion of base-year GDP: only 0.11 per cent under the assumption of nominal wage rigidity and 0.02 per cent under the exogenously fixed aggregate employment assumption. Simulation results also showed that the equiproportional reduction of the Export Performance Benefit entitlement rates was welfare worsening. The simultaneous reductions in the Benefit entitlement rates and tariffs by the same percentage, however, were welfare augmenting. All exports except jute experienced a rise. This seemed to reveal the inadequacy of the Benefit Scheme in overcoming the deleterious effects of nominal protection on exports. The results also showed that the elimination of subsidies under the Benefit Scheme had to be accompanied by a reduction in nominal protection to raise welfare and exports.