Understanding Reform

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Third Draft

Understanding Reform: The Case of Bangladesh

A. K. M. Atiqur RahmanManzur Alam Tipu

DRAFT REPORT PREPARED FOR GLOBAL DEVELOMENT NETWORK (GDN) ONTHE REFORM EXPERIENCE OF BANGLADESH UNDER THE UNDERSTANDINGREFORM PROJECT

Institute of Development, Environmental, and Strategic Studies (IDESS)North South University

12 Kemal Ataturk Avenue, Banani, Dhaka 1213, BangladeshPh: 988 5611-20 ext. 157 email: [email protected]

Fax: 880-2-882-3030


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I. Introduction:

When Bangladesh started its journey as a newly independent state in the early 1970s itwas one of the poorest countries of the world. In 1972 the per capita income of Bangladesh wasa meager 190 USD (at 1995 constant dollar). Henry Kissinger, the then Secretary of State of theUS termed Bangladesh as a bottomless basket for aid programs. The prospect for achievingeconomic progress with Bangladeshs extremely adverse conditions that included frequent naturaldisasters, extremely high population density, very little human or physical capital and naturalresources, and poor governance appeared bleak. In one of the earliest book on Bangladeshseconomy by international authors Faaland and Parkinson (1976) termed Bangladesh as a testcase for development with the intended meaning that if economic development were possible inBangladesh it should be possible everywhere else on the planet. After three decades of strugglewith adverse circumstances and experimentation with socialism in the initial few years andsubsequently with varieties of reforms Bangladesh today presents a case of being a success in anumber of social and economic fronts while frustration remain about not nearing the enormouspotential she has for attaining growth and elimination of poverty in a short period of time.

While many of the low income countries of the world achieved little or no growth duringthe 80s and the 90s decades Bangladesh experienced per capita GDP growth of more than 2.5%or more per annum. Per capita income, since independence, has risen more than three-fold, andincome poverty has been reduced by almost half. Some improvements in the humandevelopment indicators, such as the 100% primary school enrollment with 1:1 ratio of boys togirls; children immunization coverage, reduction in population growth rate, and reduction ininfant mortality exceed the rates progress of most developing countries (Temple, 2003). Inaddition to these concrete progress measured by various development indices, Bangladeshsachievement in the hosting the largest NGO network of the world with various innovations indevelopment interventions, its success in apparel exports and its innovation of caretaker form ofgovernment to ensure fair elections have also given good reasons to feel optimistic about thefuture of the country.

Despite these successes, Bangladesh remains one of the poorest countries in the worldwith a per capita income of around 400 US dollars. Still more than half of its population living onless than one dollar a day income, 60% of children suffering from malnutrition and a largeportion of the population is exposed to drinking arsenic contaminated water. Bangladesh hasbeen ranked as the most corruption infested country for the last four years successively in termsof the Corruption Perception Index (CPI) published by the Transparency International. Extremelyconfrontational politics often degenerating into general strikes with street fighting resultingmassive disruptions to economic activities often raises doubts about sustainability of the progressBangladesh has achieved. Indeed, no discussion about Bangladeshs economic development orreforms fail to place the issue of governance at the center. Reforming institutions of governancefor establishing rule of law and the capacity for building institutions for delivering goodgovernance remains the focus of future reform efforts.

Bangladesh is one of the first 35 countries which adopted Bretton Woods institutionsponsored Structural Adjustment Program (SAP). It started with World Bank structural andsectoral adjustment loans (SALs and SECLs) in 1980. IMF introduced three-year structuraladjustment facility (SAF) in 1986 in Bangladesh that had been followed by extended structuraladjustment facilities (ESAF) in the early 1990s. Since then funding from IMF and the World Bankhas been provided under the umbrella of SAP. All reform programs received extensive donorassistance with a focus of building a better market economy with special attention to preventinghuman disasters. While the reform programs were being implemented with varying pace andvarying emphasis at different points of time, the polity had also been becoming increasingly more


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open and democratic, with encouragement from the donor countries. The aim of the paper, inaccordance with the Understanding Reforms Project (URP), is to address three fundamentalquestions centering the reform experience in Bangladesh: why, what kind and how well? Thefirst question leads us to explain why or what factors led Bangladesh to begin the journey on thepath of market oriented reforms. The second question leads us to explain what factors accountfor some of the observed successes and failures of the steps taken towards establishing a more

market oriented and a more open economy. The third question leads us to evaluate theoutcomes and to draw implications for future reform efforts.

1.2 Methodology and Hypothesis

The methodology adopted by the URP is unique at least for studying the Bangladeshsreform experience. Previous studies on Bangladeshs reform experience have given ampledescription of the reform inputs and outcomes. In one study politico-economic setting of thecountry has also been described in addition to presenting some discussion and analysis of thereform programs and economic and social performance (Ahmed 2003). Our attempt at viewingthe whole reform program as a game of strategic interactions between stakeholders within the

context of initial conditions and settings of the polity will hopefully provide a fresh perspective onthe ways through which context matters in the past and future reform efforts in Bangladesh.

While several studies looked at particular parts of the reform process such as impact oftrade liberalization on firm efficiency (World Bank, 1999) and productivity impact of agriculturalinput usage (Ahmed, 2000), this study looks at reform in a holistic approach. Although we shalldiscuss reforms under different sectors, e.g., agricultural reform, (international) tradeliberalization and privatization, under separate headings the focus is on the of steps that, takentogether, impacted on the creation of a more market oriented environment in the country. Thenarrative will particularly focus on the institutional and the politico-economic analysis of thereform experience.

The following set of hypotheses will guide the research:

1. Disastrous failure of the state controlled economic management and unavailability ofdomestic resources at the disposal of autocratic rulers makes them easy compliers ofdonor demands for democratic as well as market oriented reforms.

2. In the absence sufficient state capacity the donors have to take the drivers seat in thereform process.

3. A state with weak institutions of governance can nevertheless derive significant economicbenefits from acts of simple deregulation and liberalization.

4. When a program of divestiture is carried out to gain political legitimacy withoutconsidering efficiency reasons, undesirable results can ensue due to wrong sequencing.

5. A government of a clientilist system may achieve decent macroeconomic performancewhen foreign aided projects are significant means of distributing clientilist favors andgovernments internalizes the understanding that foreign is contingent uponmacroeconomic balance.

6. A clientilist system contributes towards in weakening general governance by formal rulesbut it may be able to issue bold executive orders in favor or against markets.


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7. However, a clientilist system may leave room for paternalistic kind of government and

NGO interventions for poverty alleviation.

8. A clientilist system without apparent lack of capacity institution building is sustained byan electorate that do not voice a demand for formal rules for government but inclined to

make arbitrary demands.

The paper is divided in three chapters. The first chapter consisting of three sectionsnarrates the historical background, i.e., the politico-economic and institutional context ofeconomic reforms in Bangladesh. Chapter two is about the implementation stage of the reformsand thus geared to answering the question: what kind of reform? In this chapter we narrate theinputs, outcomes and effects of agricultural reform, trade liberalization, privatization of SOEsfollowed by discussion of reform measures in the financial sector and in the fiscal and monetarymanagement. In chapter three we present our assessment of the impact of the reform process(i.e., how well) in the economy as a whole and devote a separate section on analysisng theinstitutions of governance and draw implications for second generation reforms. At the end ofthe chapter brief concluding remarks are made.


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Chapter II

The Background and Context of Reforms

This chapter is divided into three sections. Section I gives an account of the historicalbackground of the countrys economy and polity. Section II describes how the country started itsexperimentation with socialist economic policies after its birth as an independent country soon tobe reversed following a devastating economic crisis. In section III we discuss changes in thepolity and the emergence of a parliamentary form of government with elections held under ainnovative system of non-partisan caretaker government.

2.1 Historical Background

Although Bengal enjoyed prosperity in ancient times, hunger and famine becamecommon to Bengal since the merchants of East India Company took over the ruling powers in

Bengal in the middle of the eighteenth century. Contrasting the want, famine, and mortality inBengal, that was prosperous in the past, and the increasing prosperity in North America AdamSmith wrote: the difference between the genius of the British constitution which protects andgoverns North America, and that of the mercantile company which oppresses and domineers inthe East Indies, cannot perhaps be better illustrated than by the different state of thosecountries.1 During the East India rule and the direct British rule, although Calcutta prospered,East Bengal, later to become East Pakistan and then Bangladesh, was to remain mired in poverty.In April 1947, the year the British left India, Bengals last British Governor, Sir Frederick Burrows,predicted that East Bengal was condemned to turn into the greatest rural slum in history.2

In a book written for introducing Bangladesh to the outside world James Novak (1995)

states that the most significant event of Bangladeshs history that had left the most indelibleimpression in the psyche of Bangladesh, is the Great Bengal Famine of 1943, when millions of

people died of hunger and starvation and related diseases. He states that the leaders ofBangladesh could never forget the humiliation of human dignity when people fought with streetdogs for food on the streets of Calcutta. Later we shall we shall see that an event of devastatingfamine played a crucial role in starting the reform process and the threat of food shortage wasalways in the back of the mind of the government leaders who negotiated reform package withthe donors since the devastating famine of 1974.

When Pakistan was created from British India in 1947, people of East Pakistan nurtured ahope that their prosperity, lost centuries ago, would return soon. Pakistan government followedprivate sector led strategy of industrialization through import substitution for achieving rapiddevelopment. This strategy had built in bias in favor of industrial and urban development againstagriculture and rural development. Although East Pakistan had the larger share of votes, thepolitical and economic power was concentrated in favor of West Pakistanis due to greaterpresence in the military and the civil bureaucracy, better educational attainment, and also priorpresence of an industrial entrepreneur class. Although jute, the largest export earner ofPakistan, was grown in East Pakistan, jute mills and jute export was controlled by the westPakistanis. Industrial development and urbanization in East Pakistan was low to begin with, andthe gap between West and East Pakistan became far bigger due to unequal pace development inthe two wings of the country. Even the industries that were set up in the East Pakistan were

1 Smith, (1776), pp. 72-73.2 Quoted in Lapierre and Collins (2002), p. 136.


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mostly controlled by West Paksitani entrepreneurs. The unequal development, even thoughprivate sector led, engendered by the import substituting industrialization strategy that involved agreat deal of state support and sponsorship created a deep sense of disparity among the EastPakistani citizens. People developed widespread dislike not only for West Pakistanis but alsoagainst the rich and the capitalists in general. The appeal of Awami League (AL), calling forregional autonomy and increased independence of economic management, received widespread

support among the Bengali masses. Although Awami League (AL), led by Sheikh MujiburRahman, was essentially a middle class party in nature, it incorporated many of the socialistideals of the European Fabian socialism of the 1940s.

When Bangladesh achieved its independence from West Pakistani rule, through a bloodyliberation war, there was a widespread support for nationalization of industries including banking,insurance and foreign trade3. Although the new government suffered from an acute shortage ofpeople experienced in general administration, the government took over the job of runningindustrial and major commercial enterprises. For a country that would have been dependent oninternational assistance even under normal circumstances (i.e., with private sector managementof the economy), the assumption of economic management of all major business activities by aninexperienced government manned by scantly educated officials and led by politicians with noknowledge of statecraft was destine to lead the country to a major crisis immediately after its

birth.

2.2 The Crisis and the Beginning of Reforms

When Bangladesh was created there was very few bureaucrats with the experience atthe highest level of administration. There were not enough people with the requisite educationalbackground and experience to fill the vacant posts even in general administration. There wasalmost none in the government with the managerial expertise for running industrial orcommercial enterprises. Still an ideologically driven young group of economists led thegovernment to impose stifling government control on the economy by creating severalgovernment corporations and agencies to run the economy.

Since well-educated bureaucrats were short in supply, factory managers and officialsresponsible of vital economic functions were recruited from political cadres who had littleeducations had little experience other than in the field of politics. Many of the managers of thestate owned enterprises (SOEs) got themselves involved in outright theft and looting. Peoplewith political power or with connections with the highest levels of government got busy in rentseeking and smuggling. With little taxes and other revenue flowing to the exchequergovernment resorted to inflationary deficit financing to conduct its operations. The domesticeconomic crisis assumed critical magnitude with adverse movements the international economicsituation; namely increases in the price of Bangladeshs main imports, i.e., oil and food, anddownward movements in the price of Bangladeshs main export, jute. Unable to finance theimport of desperately needed food, while the US insisted on the cancellation of jute export toCuba as a precondition for the delivery of food aid from the US, the new government became

witness to a severe famine in 1974.

It is interesting to note that while people became disillusioned with the promises madeby Awami League (AL), the ruling party, and its economic planners there was no mass agitationby the hungry people. While the imposition of socialist planning on Bangladeshs subsistence

3 Major sectors that were left to the private management were agriculture, construction, andinternal trade. None of these sectors were also free from widespread intervention of theinefficient government machinery.


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economy was responsible for most of economic miseries, the most vocal protests against theAwami League (AL) regimes mismanagement came from students and political parties calling foreven more hard-line and purer form (i.e., free from the corruption) of socialist rule. Mujib (thePrime Minister of the country at that time) responded to the protests by imposing one party ruleand ban on all newspapers except four government-owned national dailies. Those calling forpurer forms of socialism faced arrests and other forms of repression while the silent majority

most of whom were too poor and too illiterate to either to understand the difference betweensocialism and free markets, or even articulate their dissatisfaction. A very small minority ofpeople who opposed socialist policies refrained from expressing their views for fear ofpersecution by both the government as well the opposition who were even more militantproponents of socialism.

A small group of young military officers capitalized on the widespread dissatisfaction atthe mismanagement of the economy and the autocratic rule who were themselves frustrated dueto increasing marginalization of the well armed but ill-paid armed forces. A couple of coups andcounter coups in 1975 resulted in the installation of General Ziaur Rahman, who imposed martiallaw in the country.

The task before the government after the removal of Mujib was to ensure enough food

availability. Since the country was suffering from chronic food deficit, the most important taskbefore the rulers was to ensure the supply of adequate food from international donors. WhileMujib government was reluctant to engage with the western countries because of its socialistleanings, the immediate job of its successor was to mend relations with the US as quickly aspossible. The positive reception of the overthrow of Mujib by the military shown by the publicwho once idolized Mujib as the father of the nation, convinced all subsequent governments, bothpopularly elected and non-elected, that continuance of political power required support from themilitary as well as the international donors.

The reversal of statist doctrinaire approach to economy ended and a slow process ofeconomic reforms began with the installation of Gen Ziaur Rahman government. However, moreimportant than the policy reversals was to restore order in the government machinery. Since thebase of power of Zia was the military, he had to end the policy of marginalizing the military andbring it at the center of power while at the same time ensure that no one from the armed forcesthreaten his own political authority. Zia also had to start the process of legitimizing his power byorganizing popular elections and contest in it by forming his own political party. Bans on politicalparties and newspapers previously imposed by Mujib was withdrawn. While Mujib regime reliedon its own political cadre while marginalizing both military and the civil bureaucracy, andcondemning all persons connected with Pakistani rule, Zia tried to consolidate his rule by seekingadvice from experienced civil bureaucrats earned their experience in connection with the formerPakistani government. He formed his own political party by combining former Pakistan MuslimLeague leaders and also leftist politicians of pro-China orientation. Only people left out from hisparty were AL leaders and pro-Moscow leftist political leaders. Economic policy advice wassought from civil bureaucrats, donors and other local economists leaving out the architects of theMujibs socialist program. As a result of these policies and good agricultural harvest the economy

re-gained stability and the Gross Domestic Output reached the 1969 levels i.e., the highest levelof output achieved prior to the independence of Bangladesh.

Why the political party that brought independence with overwhelming and dedicatedsupport of the general masses became autocratic while a military general who rose to powerwithout any election comes to restore multiparty democracy is seems odd and deservesexplanation. AL, led by Mujib although was successful in organizing an emotion charged political


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institution. The military emerged as a relatively more honest and disciplined institution fordelivering basic governance and established the confidence among the people that it can govern.

When General Ershad took power, after Zias overthrow in a coup in 19815, he also haddemocratize himself by offering general elections in 1983 which he was elected by massive votesagain by ensuring that he could keep famine at bay and thus in total control of the situation.

Therefore one can see the instrumental role played by the donors in instituting multipartydemocracy in Bangladesh, a role made so effective due to the well-recognized vulnerability ofBangladeshs economic situation. Had Bangladesh possessed rich natural resource deposits andfar lesser population, perhaps the governments could afford, like some of the governments ofcountries in the African continent, to be more authoritarian by ignoring the internationalcommunity by delaying democratization and perhaps they could also afford to delay theimplementation of donor prescribed reforms.

Democracy (in the sense that governments attain legitimacy by getting elected bypopular vote) in Bangladesh, has achieved certain degree of consolidations in Bangladesh due totwo reasons in addition to donor preference for giving aid to countries with democraticallyelected governments6. The first of these two reasons is the high level of interest that generalmasses take in the election ritual; perhaps because this is one occasion when otherwise

powerless people feel that they count for something. Second reason is a unique Bangladeshiinstitutional innovation, which is the practice of holding national elections under a non-partisancaretaker government. The creation of this institution, under which all three national electionssince 1991 has been held, has ensured free and fair elections ensuring legitimacy of the electedgovernments.

The emergence of the institution of caretaker government is reflects both negative aswell as positive aspects of the polity. On the one hand it reflects that the credibility of theexisting government institutions is low. While Indias election commission has been performingthe job of conducting elections in a vastly spread out country with little doubts about itsimpartiality and efficiency, Bangladesh had to make changes in the constitution to recognize thevulnerability of the civil administration to partisan pressure7. Similar problems of credibility alsoafflict the judiciary underlying the uphill battle Bangladesh faces in establishing institutions ofgood governance.

One the other hand it reflects that people are innovative enough to be able to createinstitutions that can address the failure of the existing institutions. Very importantly it shows thatthe politicians of the country are capable to create a set of laws and submitting to those laws forresolving conflict. However there are reasons to believe that it was an isolated and anexceptional instance of institutional innovation. So far both political parties have hailed the

5 Ershad came to power by a bloodless coup in 1982 by removing democratically elected Sattar,who led the government for few months after the assassination of Zia.6 It is widely believed that the reason the military in Bangladesh today refrains from taking over

the political power, despite the ability to do so, is the clear message that the donors, US inparticular, that the international aid and other concessions might be significantly reduced for amilitary government. Although Pakistani military can still take the risk due to the countrysstrategic importance and greater domestic resource base, Bangladesh is to poor to impart thatkind of confidence to its Generals.7 After a series of widely reported rigging of elections held under the BNP government ((1991-1996) AL led highly disruptive agitation movement with the contention that it is not possible tohold fair elections under a partisan government. It resulted in a constitutional amendmentmaking the provision of a non-partisan caretaker government, for a three month term headed bya former chief justice, to hold elections at the end of each political governments five-year term.


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caretaker government system when they won the elections held under it and questioned itsintegrity and called for its reform when they lost.

With a credible system of holding free and fair elections Bangladeshs has establisheddemocratic form of government but its polity remains clientilist that privileges rent seeking andcorruption. The poverty and illiteracy of the population and lack of a tradition for formal rules of

governance that translates into lack of capacity or demand for building institutions for deliveringgood governance. Thus the early history of the people explains the roots of the clientilist systemand its resilience, understanding of which is would be the key to understanding reforms in itsdeep level.

The clientilist polity of Bangladesh with little capacity for building institution andpropensity for undermining formal rules in favor of exercising discretionary authority in all affairsof governance nevertheless is capable of producing few good outcomes. Majority of these so-called reforms were accomplished by executive orders majority of which originated from series ofmeetings held between donors and high officials of the government.


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Chapter III

Inputs, Outcome and Effects and Political Economy of Reforms

in Major Sectors

The initial thrust of reforms in Bangladesh came as response to mitigate chronic foodshortage and extreme mismanagement of the state controlled sectors of the economy. Asmentioned earlier, after the state managed economy collapsed and aid was desperately neededfor the survival of an extremely vulnerable population, the new leaders installed by a militarycoup was never had any socialist predilection and were desperately looking for any alternate wayout. The main concerns of the aid agencies was primarily humanitarian and there was no granddesign for creating a market economy at that point of time.

The first goal of reforms in the agricultural sector was to bring Bangladesh out of the

constant threat of famine. Reforms in agricultural sector, with donor assistance, with the goal ofattaining food self sufficiency was embraced by the government whole heartedly. Privatizationinvolving divestiture of state owned enterprises also started early. Reforms in all other sectorsreceived attention in the 80s with greater comprehensiveness in the 90s under the StructuralAdjustment package.

Section 2.1 discusses agricultural reforms, section 2.2 discusses trade liberalization,section 2.3 discusses privatization, section 2.4 discusses financial reforms, and section 2.5discusses reforms in fiscal and monetary management. Reform measures under these separateheadings constitute parts of an overall process of market oriented reforms.

2.1 Reforms in the Agricultural Sector

In the early 70s almost entire input distribution system in agriculture and a significantpart of food grain distribution was under government control. A parastatal with the name ofBangladesh Agricultural Development Corporation (BADC) was in charge of purchasing and re-selling all major agricultural inputs including chemical fertilizer, pesticides and irrigationequipment with the complete exclusion of the private sector. Public Food Distribution System(PFDS), originally set up in 1943 during the Great Bengal Famine and expanded rapidlyafterwards, was geared to price stabilization, farm price support, providing food to the poor aswell as certain priority groups. Both the input distribution and the public food grain distributionsystem (PFDS) tolled a heavy amount of fiscal pressure because of huge subsidy associated withthese.

2.1.1 Agricultural Reform I nputs and Outputs

Reform process in agriculture started in the mid 1970s, although major reforms in thissector has been implemented in 1980s and 1990s. Major inputs in the agricultural reform inBangladesh have been the following:

Gradual reduction in subsidy in agricultural input Gradual reduction in the role of BADC in supplying, managing, and marketing agricultural

inputs and equipment


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Reduction and/or abolition of licensing requirement for private trading of agriculturalinputs and equipment

Reduction of the role of the government in the output market and limit its role inproviding safety nets and price stabilization

Extension of trade liberalization policy in both input and output market of agriculture,i.e., opening up of agricultural input imports and import of food grain to private sector in

the 90s.

Outcome of the reform in agriculture was very positive. First, budgetary pressure hasdeclined due to reduction and elimination of subsidy that was evident even the early 1980s.Subsidy in fertilizer reduced from 48 per cent in 1979 to 23 percent in 1982 (Osmani andQuasem, 1990). The impact of subsidy reduction on fertilizer prices was partially offset by theprice reduction effect arising from increased competition among the traders in the liberalizedprivate sector. Gradual privatization of fertilizer distribution had generally ensured timely supplyof fertilizer to the farmers and a better spatial integration of fertilizer market.

Reform outcome is more pronounced in case of irrigation equipment. With thewithdrawal of import restrictions and removal of standardization restrictions, there had beensubstantial reduction in initial investment cost of irrigation equipment. Econometric analysis by

Ahmed (2000) showed that the adoption of seed-fertilizer-irrigation based HYV is driven byexpansion of irrigation, while wider spread availability of fertilizer at reasonable price playedsupporting role.

Liberalization of import of food grains resulted in expansion in food import by privateimporters and reduction in import of food by the government. While up to 1992, bothcommercial import of food and food import under food aid were made directly by thegovernment, by the end of 1990s entire commercial import of food was made by the privateimporters. Private import of food helped the goal of achieving food price stabilization despitelimited role of PFDS after the reform.

2.1.2 Political Economy of Agricultural Reform

Reforms in agriculture have resulted in a most remarkable feat, which is bringingBangladesh out of the shadow of famine. This is an area of reform where reforms consisted ofsome easy de-regulating steps resulting in win-win outcomes. The sequencing of de-regulationswas the key, which was planned carefully by the donor agencies with full cooperation from thegovernment. Attainment of food selfsufficiency which was the government objective was alsohelped by donor assistance in flood embankment, irrigation, research and extension projects.

There are several reasons behind this achievement. First, the political will. The reasonfor the political will has been explained before: it was clear to every government that a necessarycondition for retaining political power in Bangladesh was ensuring adequate food supply. Achieving food self-sufficiency was in every governments priority target. Governments knewthat increasing food production required construction of embankments, adoption of HYV and

widespread use of modern inputs such as mechanical irrigation, chemical fertilizers andpesticides. Government knew that subsidizing these inputs was too costly but didnt know howto come out of the subsidy program without disrupting production. Donor assistance was criticalin this regard since they not only provided funds for expensive constructions such as floodprotection embankments but also showed the government how to use the market to achieve itsgoals through right sequencing. Bangladesh followed the sequence of privatizing agriculture


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market starting from retail trade towards wholesale and apex trade that is consistent with thesequencing strategy as suggested by Mackinon (1993).8

Reforms were gradual because the extreme poverty of the peasants ruled out any big

bang approach. Since there were no big farming lobby and almost all farmers were essentiallypoor none had any entrenched interest in the previous policies. Only group of losers was the

high officials of BADC who saw their power curtailed. Since the government at the top level wasconvinced, with arguments and aid conditionality, these high officials of BADC could not put upvery effective resistance.

The sequencing of agricultural reform was such that gains of reform were almostimmediately visible for peasants. Since greater competition among private traders could offsetthe effect of withdrawal of subsidy on input prices there were no losers, hence government didnot have to worry about creating extra safety nets. On the public food distribution side, thewithdrawal was very slow and the raising of food prices under public distribution advanced inparallel with the increase of peoples purchasing power. Hence the urban population hardlynoticed the discontinuation of government subsidy through PFDS.

The distributional impact of market oriented agricultural reforms were not significant

because most peasant farmers were subsistence farmers. For centuries they were familiar withflood and drought and even starvation. Liberalization of agricultural inputs made modern inputscheaper9 and thus reduced their vulnerability to vagaries of nature. While subsistence farmerswere better off with more production, liberalization of trade created employment as well asbusiness opportunities hitherto non-existent. Hence it was a win-win deal for all.

Liberalized market for agriculture input was functioning pretty well until mid 1994 beforefalling into a crisis in early 1995. Prices of fertilizer skyrocketed in peak season due to a shortageartificially created by government appointed dealers of fertilizer10. The crisis sparked a riotcausing the death of some 17 people when police opened fire on peasants demonstrating forfertilizer. In our view this crisis reflected the absence of appropriate institutions (e.g., anti-trustlaws and competition authority to enforce fair play in the market) to support free marketoperations. Biggest traders in Bangladesh often get together and create artificial crisis of someinelastic consumer commodities to reap windfall profits. It is often alleged that some of thesebusinessmen who engage in such activities also maintain good contacts with highest levels ofgovernments. When crisis of other commodities such as sugar and cooking oil occur, peoplesuffer and government popularity decline but crisis in these commodities never sparked a riot.Fertilizer crisis sparked a riot because it is a life and death issue for many peasant farmers andno government can ignore the life death matters of the predominant occupational group of thepopulation. Government responded to the crisis in its habitual ad hoc manner by increasingsurveillance and telling all the dealers that dealership would be cancelled if there is any more ofsuch crisis. All successive governments of Bangladesh demonstrate from this kind of ad-hocismand excessive reliance on executive orders reflecting a lack of capacity for institution building forlong term solutions. We have discussed the origin of such low capacity in section on historicalbackground and this issue will be further discussed in chapter three.

8 For more on the actual sequencing and the role of government and donors see Ahmed, R. et al(2000).9 Even though studies suggest that quoted price before and after reforms remained same,competition among private traders made the availability easier and that is why the use of moderninputs increased substantially after market liberalization.10 It should be noted that although fertilizer trade is fully privatized, production of main fertilizeris carried out in government owned factories. Only government-appointed dealers can buyfertilizers from government owned factories.


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2.2 Trade and External Sector Reform

Like most of the other developing countries, Bangladesh used to maintain a veryprotective trade policy. Import substituting strategy with high tariff and non-tariff protection

along with overvalued fixed foreign exchange regime gave rise to over capitalization and creationof excess capacity (Ahmed, 1978). Government responded to current account deficit anddeteriorating terms of trade with extensive quantitative restrictions (QRs) and high levels ofcustoms tariff. Bangladesh faced considerable difficulty to pay for her imports with a narrowexport base forcing it to seek IFI assistance quite often.

2.2.1 Inputs and Pace of Trade and External Sector Reforms

Bangladesh took her first tentative steps toward liberalization, under the directive of IMF,through devaluation of the currency by a staggering 58% (1975) and later by a further 10%(1979). During the mid 1980s import liberalization process was initiated under he the ImportProgram Credit (IPC) of the World Bank. Although the government officials and local economistswere against the conditionalities imposed by IFIs, government faced with balance of paymentcrisis could not refrain from taking conditional loans from IFIs.

The prescription for trade liberalization from donors was only very grudgingly acceptedas a condition for receiving aid by the government under balance of payment crisis. Governmentbureaucracy was extremely slow to implement the trade liberalizing prescriptions.Implementation of the trade policy reform was accelerated in the early 1990s perhaps reflectingthe combination of influences of the fresh attitude of a newly elected government, waves ofchange in the world especially of the liberalization moves in neighboring India in 1991 and alsocloser monitoring and supervision by the IFIs.

Top customs duty (CD) rate came down from 350 per cent to 35 per cent. Tariff slabshas been reduced from 24 to 17. Average CD, numbers of slabs, dispersion in tariff all marked

sharp decline. A moderately flexible exchange rate policy was adopted since mid 1979 with theexchange rate being pegged with a basket of currencies of the main trading partners. In 1994,the government accepted the obligations embodied in IMF article VIII, making the Takaconvertible for current account transactions. Exchange rate had been adjusted periodically basedon changes in Bangladesh Banks Real Effective Exchange Rate (REER) along with considerationsof foreign exchange reserve situation, inter-bank market exchange rate, unofficial exchange rate,and overall macroeconomic situation. Governments management of the exchange rate hadbecome so flexible since 1994 that when Bangladesh adopted a fully floating exchange rateregime on May 2003, the exchange rate remained largely stable around the old governmentdetermined rates.

Some have criticized that that Bangladeshs trade liberalization proceeded too fast.However, a cross country comparison, as documented in a World Bank study (World Bank, 1999)

shows that the pace of liberalization was not that fast as many of the comparable countriesproceeded even at a faster rate. Although the pace of reform was not as fast as alleged by thecritics, it is also true that trade liberalization in the 1990s has been quite fast compared toliberalization and reforms in other sectors in Bangladesh.

2.2.2 Outcome and Political Economy of Trade Liberalization

Like the reforms in agriculture policy trade policy reform was largely an IFI assistedprogram with an almost win-win outcome. The challenge for the IFIs was that the planning and


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finance ministry officials could not understand how balance of trade could improve when importsare made easier. There was also reluctance of many government employees in the tax andcustoms department who saw their carefully planted patterns of graft dangerously threatened.Protests came from the political parties in the opposition11, as they voiced the populist argumentthat such import liberalization would turn this country to a market of foreign commodities erodingself-reliance. Same sort of populist criticism also came from left leaning economists, intellectuals,

and some civil society think tanks. Businessmen and Chambers were also critical of tradeliberalization policy as they feared of growing competition in the industry and reducing the rentsthat emanated from trade restrictions.

However, as the finance minister himself got convinced through numerous meetings withIFI officials, the lower level officials could not drag their feet longer. The material of the FinanceMinisters speech outlining liberalizing moves triggered countrywide general strike by theopposition. Later on the businessmen and the chambers realized that their fear of tradeliberalization was unfounded. Most of the chamber leaders who were engaged in internationaltrade found that with trade liberalization their businesses grew many-fold. The growth in theirbusiness resulted from increase in consumer's purchasing power due to fall in the price ofimported goods. Many new traders got involved with import businesses as cost of importssignificantly went down.

One of the biggest losers were in the whole trade liberalization process were inefficientSOEs that were operating behind high tariff walls. However some private entrepreneurs werequick and efficient enough to set up more efficient factories in businesses, such as textilemanufacturing where SOEs dominated, that were capable of competing under a liberalizedenvironment. The biggest growth under the liberalized environment was experienced by thetextile exporters who experienced nearly 13% growth throughout the decade of 90s. Howevereven before the larger liberalization of the 90s, textile units were already enjoying specialprivileges, such as duty drawback scheme and special bonded warehouse facilities, thattantamount to operations under a complete free trade environment12. Liberalization in the othersectors of the economy helped the growth of textile exports in an indirect way.

After the implementation of major waves of trade liberalization in the first half of 1990s,the position of a group of critics started to change. As the finance minister saw that the direwarnings from his officials about serious the fall of revenue after liberalization did not materializewhile the balance of payments situation improved, he felt more confident about IFIrecommendations in favor of liberalization. The quick falsification of about the dire consequencesof trade policy reform especially on the balance of payment forced most of the intellectualdefenders of protectionism to limit themselves to criticizing the pace and sequencing of tradeliberalization. These intellectuals used some of the negatively affected manufacturing enterprisesin the public as well as the private sector in support of their argument against the pace ofliberalization. Most of their criticism emanate from the extra-ordinary importance they attach tothe word industrialization which to them is synonymous with development perhaps reflecting the

11 In Bangladesh virtually there is no deep difference in terms of stated economic policies amongthe two main political parties. Since the major trade liberalizing push came during the regime ofBangladesh Nationalist Party (BNP), the opposition party Awami League started saying thingsthat they thought would arouse negative sentiments against the ruling party. If BNP had been inthe opposition they would have opposed trade liberalization voicing the same arguments.12 One of the significant factor for the growth of textile exports in Bangladesh was the specialGSP and the quota system practiced by the developed countries. Without GSP and quota it isdoubtful that trade liberalization alone could help Bangladesh make its presence felt in theinternational market.


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emphasis placed in the textbooks of development economics of the 40s and 50s decade(Bhattacharya and Titumir 2001).

The key to success of trade policy reform was that it was very easy to implementbecause it hardly made any demand for increased administrative capacity. Since Bangladeshibusinessmen had far greater exposure to trading business than manufacturing entrepreneurship

they had little trouble availing themselves of the opportunities made available by the increasedopenness. There was no powerful lobby or a industrial entrepreneurial class with entrenchedinterest in protectionism because most Bangladeshis are either peasants or traders withmanufacturing output contributing to less than 15% of GDP. Businessmen could easily takeadvantage of greater opportunities for trading, encouraged by eased up trade restrictions. Themanufacturing units that operated under trade restrictions were mostly owned by government,where worker jobs were not immediate threatened because of their status as governmentemployees enjoying job security. These SOEs were shut down at a much later stage and workerswere offered generous golden handshake with financial support from the IFIs.

2.3 Privatization of SOEs

2.3.1 Background and t he Sequence of Privatization

After the political change in 1975, the government dropped its commitment to socialismand emphasized upon the role of private entrepreneurship. The Government under Ziaur Rahmanwanted to hand over the nationalized SOEs in jute sector to their original owners and 247enterprises were privatized under this effort during 1979-80. However, the process stopped asthe Bangladesh Jute Mills Corporation (BJMC) turned in profit that year13.

The most dramatic and sweeping privatization attempts were carried out between 1982-86, during the first half of the General Ershads rule. Enterprises that were brought under directownership of the GOB from Bangladeshi owners were released for sale to private buyers, andthus the process of denationalization started in this period. Within months after the

announcement of a New Industrial Policy the military regime of General Ershad startedtransferring the ownership of 222 industrial firms along with few hundred commercial enterprisesfrom the public sector to private sector. By 1986 the share of the public sector in the totalindustrial-sector assets fell from 85 percent to roughly 40 percent. Before the massivetransformation of the Eastern European Countries, Chile and Bangladesh had been declared champion performer in the world of privatization or divestiture (Berg, 86)14. Since then theprivatization has proceeded at lot slower pace. In the 90s Bangladesh ranked the of slowestamong the countries in South Asia in the area of privatization.

Through a process of privatization, denationalization and disinvestment and privatizationthe number of public sector enterprises has come down from their peak of 416 in 1976/77 to 146in 1990/91, and to 116 in 1999/00. Share of public sector in the total asset of the industrial andfinancial sector also declined. While about 90% of industrial asset were owned by the public

sector during the early 70s, only about one third of the industrial asset is currently owned by thegovernment. Despite donor proddings

13 Proponents of retaining SOEs used this profit earning instance to argue that enterprises underthe state management is also capable of being efficient. The profits of BJMC was due to atemporary surge in demand in the world market rather than any sustained improvement inefficiency.14 The only other country that had undertaken such dramatic and far-reaching privatization effort in thedecade of the 80s was Chile (see Humphrey, p. 92).


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2.3.2 Political Economy of Privatization

The most important reason behind the dramatic privatization program of Bangladesh isprobably explained by a negative reason, the disastrous failure of the public sector. Public sectorfailed immediately after take over not only because of the classic incentive problem but also

because there was acute shortage of managerial expertise or experience. The economic crisisresulting from severe mismanagement of the state-controlled economy made it clear to almosteveryone, except some economists and left-wing political parties that private sector has to bebrought back to take the leading role in the economy.

A deep sense of injustice and betrayal also created a powerful force comprising of theformer Bengali owners who were dispossessed by the nationalization drive. As the statecontrolled economy got into deeper and deeper crisis, this group also started a concertedcampaign to further discredit the state controlled economy and bringing back the private sectordominance. When General Ershad, after coming to power in 1982, was looking for some alliesfrom the elite section of the society to back his military regime the dispossessed industry ownerswere a natural choice. The most sweeping phase of the denationalization program carried outduring the 1982-86 period could be interpreted as a drive for gaining legitimacy, by General

Ershad who came to power by a military coup, through correcting a perceived act of injustice tothe former owners of industrial enterprises.

Among all the reform programs in different sector of Bangladesh, the privatizationprogram was most internally driven. It was driven by failure of SOEs and by the need to gainpolitical legitimacy rather than any conviction, in the political leadership or in the academia,about the efficacy of the private sector. Although the donors always maintained that a marketeconomy with private sector dominance was better than a state controlled economy, during the80s they were directly involved with the reform of the sector corporations, the controlling unitsof the SOEs15. From 90s donors encouraged privatization through intellectual arguments andproviding funds for golden handshake but there was no serious pressure from the donors forembarking on privatization in the industrial sector.

The staunchest opponents of the privatization program always came from the employeesof the SOEs. The left wing political parties and few academicians were diehard critics of theprivatization program. The academic arena was clearly dominated by economists and otherintellectuals who were in favor of greater state control of the economy. Whenever the rulingpolitical party came forward with a privatization move, the potential losers would always go tothe opposition party for ready political support.

Although almost most people agreed that state control was not taking the economyforward and there had been a good number of supporters of privatization program, there werefew, if any, passionate supporters of privatization program. The most vocal academics werepassionate antagonists of the privatization initiative and always saw privatization as a conspiracyof the world capitalists represented by the World Bank and the IMF. The workers opposed

privatization for fear of losing job in an economy, with more than one third of the labor forcefacing unemployment or underemployment, where every single job in the modern formal sectorwas deemed too precious. Bureaucrats were fearful of losing control and thereby a more limitedscope for graft. Although business chambers in general showed support for privatization inpublic, privately many of them were also fearful of facing competition. The vast majority of thepopulation living in rural areas were passive about the whole privatization issue. The

15 In the agricultural sector, however, donors got directly involved in the liberalization andprivatization measures with a great deal of success, as discussed above.


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government itself was not confident about its capacity to implement a successful privatizationprogram. Therefore, except for a brief period, none of the governments showed a non-vacillating commitment toward privatization program.

2.3.3 Outcome and Effects of Privatization

Just as the nationalization drive was not well planned privatization was also not very wellplanned and was not carefully sequenced. Apart from gaining political legitimacy in the case ofGeneral Ershad, for all successive post-Mujib governments privatization meant getting rid of theloss making enterprises through divestiture. After divestiture government thought its job wasfinished and never considered what kind of institutional support and private sector supportingenvironment it must create for the efficient functioning of the economy. For instance, althoughgovernment privatized jute mills, the privatized mills were required to pay government mandatedwages and purchase raw jute at government mandated procurement price. When the privatesector went for financing to the state controlled financial sector it found that government ownedenterprises were to receive loans on a priority basis and their loan applications were disqualifiedfor reasons for which government was more responsible. While there were variousadministrative support for the SOEs the private sector were to negotiate through an inefficientand corrupt bureaucracy. When the private sector jute mills tried to win foreign buyers through

aggressive price-cutting over the price offered by Bangladesh Jute Mills Corporation (BJMC), theywere accused of shortchanging greater national interest.

Due lack of capacity of the government for handling16 post privatization situation divestedenterprises found themselves in various troubles. Since government had almost monopolycontrol over financial institutions and officials of those institutions were either inefficient orcorrupt, privatized enterprises saw that that the easiest way for them to survive was to becomeactive players in the game of rent seeking and corruption. Defaulted loans started accumulatingin development financial institutions (DFI) as well as nationalized commercial banks (NCB) athigher rate after privatization.

Several studies were conducted by both supporters (e.g., Dowlah, 1997) and critics ofprivatization (e.g., Sobhan and Ahsan 1984) and all of them focused on the profit and losssituation of the divested enterprises themselves ignoring the question of larger economy wideefficiency gains. For example, when an enterprise was found closed after divestiture it wasnecessarily assumed by both groups as indicating a negative result for privatization, forgettingthe all important questions whether the whole economy gained or lost in terms of allocativeefficiency17.

In general the studies carried out on the post-privatization performance of the divestedenterprises reveal the following: some privatized enterprises show improved profits or reducedlosses while some others show the opposite, some privatized enterprises also show improvedcapital and labor productivity (Rahman, 2000) and introduction of new goods while others showincreased loan default, closure and even complete disappearance (Sen, 1997; Akram, 1998).Almost all studies found that employment declined in the divested enterprises and it affected

mainly white-collar workers reflecting the class bias of clientilism under governmentcontrol(Bhaskar and Khan, 1995)18. There is also little dispute that a good number of divested

16 As discussed above government could not provide them a level playing field with SOEs andwith each other.17 See Tipu (2002) for a more detailed analysis of this point.18 Bhashkar and Khan (1995) interprets the loss of white collar jobs as evidence of clientilism ofgovernment towards the section of society that supplies white collar workers, since it is therelatively better off section of the society that is more well connected with the government.


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enterprises defaulted on loans borrowed from the government owned financial institutions. Whilethe debt default problem has been interpreted by some as a proof that government shouldnthave embarked on privatization (Akram, 1998), some have interpreted as a consequence of aninefficient governments excessive control of the financial sector (Humphrey, 1992; Tipu, 2002).

The debt default crisis shows that there has been a problem of sequencing. Debt default

crisis could have been avoided had financial sector could have been reformed into an efficientsector prior to embarking on massive divestiture. However, building an efficient financial sectorcalls for greater financial management capacity in the central bank and other public regulatoryinstitutions. On the other hand divesture and deregulation only calls for one firm executiveorder. As will be discussed below Bangladesh has shown greater success in the areas requiringexecutive orders but continues to struggle with institution building and even maintaining theintegrity of good institutions derived from the past.

Even though the divested enterprises show mixed performance, it can probably beargued that the impressive rate of growth that Bangladesh has achieved in the last two decadeshas been led by the private sector. Although all divested enterprises did not benefit directly fromprivatization, the private sector friendly environment signaled by the privatization programappear to have convinced the private sector to undertake investment and productive activities

with energy and enthusiasm. Despite the poor planning and poor implementation of theprivatization program by an inefficient bureaucracy, the relatively strong performance of theprivate sector and the economy as whole, although below its potential, appear as a surprise tomany observers. (Humphrey, 1992).

2.4 Financial Sector Reform

Bangladesh inherited an undeveloped and un-diversified financial system, with the pre-dominance of commercial banks that were nationalized with the Presidential Order of 1972. Till1982, all the financial institutions were kept under the ownership as well as regulatory control ofthe government. Financial repression was the norm in the early days. Interest rates were

heavily regulated and credits were mostly directed towards so-called priority sectors and thepublic enterprises with little concern for risk and profitability. Bank branches increased mainly tosatisfy demands for employment for the educated youth. A huge proportion of the asset profilesof the financial institutions became overdue. All these had been reflected through decline in theprofitability of the nationalized commercial banks (NCBs). Rapid expansion of credit createdinflationary pressure, although the overall private investment was not stimulated.

With the policy change of the government regarding the role of private sector after thepolitical change in 1975, IMF took a strong role in monitoring the supply of money by establishingits office inside the Bangladesh Bank (BB), i.e., the central bank premises.

In 1989, first steps towards deregulation of interests rates were taken. In 1992, under thestructural adjustment package, the interest rate bands were removed from all but three of the

lending sectors and banks were allowed to fix lending interest rate on their own judgment.However the practice of regulating interest rates for some priority sectors remain intact.

Since the private sector was growing and NCBs could hardly keep pace, the pressure forallowing local private banks to finance increasing activities of the growing private sector built up.The government decided to allow the operation of local private banks and to denationalize twoout of six NCBs in 1982. Number of private commercial banks (including 2 denationalizedcommercial banks) stood at 40 by the year 2000. A good number of leasing, insurance and alsomerchant banks also sprang up taking advantage of the deregulated environment.


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A major reason for proliferation of private sector banks is a guarantee of huge profits in

an undiversified and a protected financial market. No domestically owned bank has ever beenclosed down even after piling up bad loans. On the other hand the central bank never lets anybank go without cash for fear of bank run. BBs capacity to monitor and verify the financialactivities of commercial banks, despite pouring of good quantity of donor funding on financial

management, remains weak. Reliance on executive orders and the practice of ad hoc measuresis endemic in all public institutions and therefore any improvements in the loan default scenario islikely to be temporary. The interest rate dispersion, i.e., the gap between lending and depositrates, in Bangladesh is very high and this high dispersion has so far resisted all reform attemptsto minimize the default risk of lending.

While a majority of the domestically owned private commercial banks are widely reportedto be engaged in insider lending and various other irregular practices causing the amount ofinfected portfolio to swell, the foreign commercial banks have been the best performers in termsof conceding least quantity of defaulted loans. One of the reasons for the success of the foreignbanks has been their prudent management and greater respect for laws and official regulations.Foreign banks have also played the role of supplying the best quality human resources at the topmanagement levels of the local banks and other local business organizations. On the contrary

local banks are not only able to utilize their knowledge of weaknesses of the governmentinstitutions and use various informal relationships to their advantage. For promoting betterfinancial discipline an impartial government determined to achieve quick market oriented reformscould let the foreign banks expand their operations while restricting the operations of those localbanks that are not performing well. However for a politically elected government lettingpolitically connected people to open new banks and continue operations gets a higher prioritythan bearing the short term political costs of letting foreigners earn the easy profits.

Liberalization of capital markets resulted in a surge in the inflow of foreign equity fundsin the early and mid 90s. The inflow of foreign funds gave rise to a speculative bubble in 1996that burst within few months. The burst of the speculative bubble brought forward reports ofsevere mismanagement and manipulation in the stock market. Despite widespread reports ofillegal collusion, cheating and fraud by the stockbrokers not a single person could be convictedresulting in loss of confidence in the capital market. It is a common knowledge almost allauditing firms can be paid to sign any amount of false accounting information. Donors havefinanced technical assistance projects for improving the institutional capacity for capital marketregulations that has clearly not been enough to bring back credibility of the capital marketoperations.

2.5 Fiscal and Monetary Management Reform

In the initial years, the government had to rely on deficit financing because the newgovernment demonstrated little awareness of fiscal or monetary discipline. Naturally there wasexcessive growth in domestic money supply that fueled inflation. With little capacity and

awareness in the government about needs of fiscal and monetary discipline IMF had to play astrong role when the government asked for a bailout.

Since those inflationary years of the 70s (i.e., 19.3% during 72-80 period), themacroeconomic area of the became an area of strength of the government, lauded by the WorldBank and other external observers. Why a government with no substantial improvement inadministrative capacities or significant reforms in institutions goes on to be applauded as one ofthe best performers in the area of macroeconomic management (Temple, 2004) appears to be apuzzle. A plausible reason appears to be the disastrous failure of the first post-independence


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government impressed all subsequent governments to be sensitive to the IFI demands. Since itis relatively easier for IMF to monitor and negotiate monetary growth with a government with avery centralized and powerful executive branch, macroeconomic management has emerged as anarea of strength for Bangladesh economy19.

The most significant achievement in the fiscal area under the structural adjustment

program was the introduction of trade neutral value added tax (VAT). VAT has been the majorinstrument through which government could offset the loss of revenue from trade liberalization.We have shown above that the people who vocally opposed trade liberalization moves weredefeated by the failure of their prediction of dire consequences in government revenue earningsand balance of payments consequences. Therefore credit must be given to this aspect of thepackaging or clustering of the structural adjustment package.

It should be noted that Bangladesh has one of the worlds lowest tax GDP ratios. Donorshave provided a good deal of technical assistance in enhancing government capacities forimproving tax collection. Government eagerness to improve its revenue collection is increasingsince foreign aid is declining over the years while government expenditure is growing.Corruption in the tax administration, lack of capacity for efficient design of tax policy, the generaltendency among the top politician to the lowest individual for evading rules are difficult for

donors to solve. Reforms in the tax administration, (thanks to IFI conditionality as parts ofstructural adjustment package and PGRF) as well as improvements in per capita incomes haveresulted in a very slow but continuous improvement of tax-GDP ratio over the years. This areacan improve further with an overall improvement in the capacity of the civil bureaucracy. Overallimprovement in the governance institutions of governance would be essential for ensuring thatthe pressure for generating more revenue does not result in imposition of excessive burdens onthe honest individuals and the politically weak groups. Weak governance along with a pressurefor earning more revenues result in a tendency to spare those individuals who can bribe the taxmen or can use informal connections with the political or administrative high-ups.

Besides good macroeconomic management (i.e., low deficits, sustainable debts and lowinflation) analysts have praised the composition and targeting of the public expenditure (Temple,2004; Ahmed, 2004). Public expenditure has been termed pro-poor even with lot of systemicinefficiencies. The pro-poor bias of the budget is perhaps a combination of a humanitarian focusof international donors and a democratic polity with clientilist tendencies. Natural disasters andpoverty of Bangladesh has received a great deal of international attention and hence povertyfocused projects have received greater donor funding. It is rational for government agencies andNGOs to focus on those projects that are likely to draw maximum donor funding. Moreover, asSen and other economists (Quibria, 2004) as pointed out that democracy and a free press is themost potent weapon for fighting famine and other worst form of human sufferings, Bangladeshdemocratic polity and free press has had positive influence for a pro-poor bias of publicexpenditure. This bias is not contradictory to clientilist government since with a pro-poor focusgovernment can award the procurement contract to favorite individuals and groups whilesatisfying the donor concerns at the same time.

19 In addition to IMF monitoring, a sustained fall in the velocity of money, which is yet to beexplained, has also been responsible for the low rates of inflation with a increasing growth rate ofmoney supply in recent years.


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Table 2.5.1: Some Facts on of Fiscal Sector Performance

FY81-90 FY91 FY92FY93 FY94FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02

Tax GDP ratio (%) 5.4 6.2 6.5 7.3 7.1 7.9 7.3 7.9 7.7 7.4 6.8 7.8 7.8

Direct tax as % of tax Revenue 6.6 7.0 6.5 6.7 6.7 6.4 7.0 6.4 6.7 7.4 7.2 6.4

VAT as a % of tax revenue -- -- 21.6 27.7 28.1 29.5 30.6 31.5 31.3 30.27 31.6 31.5 31.7

Growth of revenue 14.1 15.4 21.7 16.2 11.0 15.7 9.2 10.5 9.5 4.9 8.4 13.2 14.5Growth of Current Expenditure 17.7 8.5 8.1 7.7 7.5 12.6 14.7 6.1 15.7 15.6 10.0 12.0 9.8

Social Sector Expenses as a %of total public Expenditure 18.53 20.4 22.2 23.5 25.9 24.7 25.4 24.7 23.9 23.7 23.8 23.9

Share of Domestic Finance in ADP (%) 25.0 26.2 35.8 43.0 42.3 48.9 45.3 41.5 49.5 52.4 48.7

Growth in M2 (%) 21.6 12.1 14.1 10.6 15.4 16.1 8.3 10.8 10.2 12.8 18.6 16.6 13.1

Table 2.5.1 presents some measures of fiscal performance in the 90s under twodemocratically elected regimes (i.e., the 91-96 period was ruled by BNP while the 96-01 period

was ruled by AL. It is evident that tax-GDP ratio has increased in the 1990s. Share of publicexpense on social sector has increased over time. While growth of public revenue was lowerthan the growth of current expenditure throughout 80s, revenue growth rates started exceedinggrowth of current expenditure. Dependence on the foreign aid also has been substantiallyreduced as evidenced by increased shared of internal financing of Annual Development Plan(ADP).

Although in terms of manifesto and explicit pronouncements there seems to be almost nodifference between the two major political parties, BNP and Awami League, the fiscal picturereveals interesting difference between the two parties. Donor advice and conditionalities weremore readily accepted by the BNP government and the fiscal balance did mark an improvementduring the BNP regime (1991-1996) and again (2001-present). AL has demonstrated moreconfidence on its own group of left leaning intellectuals with a preference for bigger government

and less respect for donor prescriptions. AL tried to satisfy its supporters with more recruitmentin government jobs and dishing out more purchase contracts to its favored group of businessmen(or commission agents) often disregarding financial balance situation and ignoring warnings fromthe donor agencies. Although BNP has shown identical tendencies20 but it has demonstrated lessconfidence on the left leaning intellectuals and has been more willing to listen to donor advice.By succumbing to extreme clientilist pressures within the inner circle of power Awami Leaguewent on spending hard cash on expensive defense items such as Mig-29 and frigates with noapparent disregarding the donor warnings. Disregard for donor warnings resulted in reducedflow of foreign aid leading to precariously low levels of foreign currency reserves at the end of Awami Leagues tenure. BNP governments assurance to satisfy donor conditionalities anddemonstration improved fiscal performance have resulted in greater inflow of foreign aidbolstering foreign exchange reserves in the recent years. This kind of reluctance of grass rootsbased political parties to implement donor prescriptions and the relatively more faithfulimplementation by the ones with military and autocratic roots while none really understands andowns these packages could explain why military governments were favored by some intellectualsin the past.

20 All political parties that have been in power have demonstrated very similar clientilisttendencies. The predominant mode of distributing clientilist favor has been family ties andrelationship established through informal and illegal financial transactions (i.e., bribes andcampaign contributions).


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The importance of planning by the IFI about appropriate packaging and clustering ofreform programs is hard to overemphasize, especially because the capacity to understand theobjective of reforms and adjust it to the local circumstances is scarce among the administrativepersonnel responsible for implementation of reform programs. While we have mentioned thepackaging of VAT with reduction in import tariffs as an instance of right clustering there is at leastone instance of inappropriate packaging of reform measures. Recently under Poverty Reduction

and Growth Facility (PRGF) program, IMF asked the government of Bangladesh to set up anindependent debt management office. One of the authors of this report was asked to write a paperon debt management strategy for the ministry of finance as a consultant. It was found thatcurrently the BB, the central bank, automatically monetizes the debts incurred by the government.There is no plan in the horizon that government would either give any independence to the centralbank or put any limit on automatic debt monetization. Under these circumstances, it is difficult tosee the productivity of the aid money that is spent on creating a separate debt management officewith several officers and staff, with practically nothing to do. There was no one within thegovernment to question the use of setting up such an office, since aid money enables thegovernment greater discretion at least in the short run.


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Chapter III

Aggregate Economic Performance and the Issues forInstitutional Reforms

In this chapter we first discuss the aggregate performance of the economy in relations tothe reforms in the areas discussed above. Next we discuss the institutional context of thestructural reform and implications for second generation reforms. We then discuss the Thischapter is divided in two sections. Section 3.1 narrates the aggregate economic performanceand section 3.2 presents summary and conclusions of the paper.

3.1 Reforms and Aggregate Economic Performance

While explaining the history of economic growth in Bangladesh, Mujerie and Sen (2002)classified the growth dynamics in four phases (Box 3.1.1). According to their scheme, ensuing

macroeconomic crisis in the 1980s led to the compulsion for undertaking a range of stabilizationprogram at the end of 1980s. Implementation of these programs resulted in a new phase ofdevelopment during the period of 1989-93 that may be termed as formation of favorable initialconditions in terms of improved macroeconomic fundamentals and also improvements ineducational attainments. The subsequent period exhibited much improved performance both interms of higher economic growth and faster pace of social development. Mujerie and Sensapproach is based on simple judgment about observed growth rates that nevertheless seems tobe a convenient periodization for organizing the observed growth experience.

Box 3.1.1: Periodizaion of Growth in Bangladesh

Up to 1981/82: Period of reconstruction and recovery amidst political turbulence21 1982/82-1988/89: Period of slow economic growth with growing macroeconomic

instability 1989/90-1992/93: Period of crisis driven economic reforms and formation of favorable

initial conditions (i.e., macro stability) 1993/94-1999/00: period of higher economic growth and faster social development

especially in the rural areas

Source: Mujeri and Sen (2002)

Table A2 in the appendix shows that current account balance, gross budget deficit, andinflation all came down to a low level by the early 1990s. Real exchange rate also came close tounity during this period (Rahman and Basher, 2001). Thus, the country achieved notable

macroeconomic balance during the early 1990s. The country also had notable achievements insocial indicators of development (appendix table A1) by this period. The period was followed by ahigher rate of growth, although the growth rate did not reach very high levels.

We attempted to find a structural break on the trend growth path of GDP andinvestment. According to our estimates, FY 1992 appears as the structural break point in the

21 Starting from mid 70s till the establishment of the institution of caretaker government in 1991,the threat of a cycle of military coups and counter coup always haunted the political scene.


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trend growth path of GDP, and FY 1994 appeared is the break point for trend growth path ofindustrial GDP. Structural break in the trend growth path of investment appeared at 1990 (tableA4)22. Thus, it seems that macroeconomic stabilization and trade liberalization created a precondition for achieving higher economic growth. Slow progress in educational attainment andimprovements in other social indicators and perhaps unaccounted transmission23 of higher Indiangrowth and liberalization around the same period could also play an important role in fostering

growth rate in the subsequent period after stabilization.

Table 3.1.1: Test of Structural Break in the Trend Growth Path of Macro Variables

Break point in thetrend growth path

F-statistics Periodconsidered

GDP 1992 112.75 1982-2001

Industrial GDP 1994 20.17 1982-2001

Investment 1990 36.56 1982-2000

Inflation rate could be a comprehensive indicator of macroeconomic stability in a leastdeveloped country like Bangladesh. We estimate a simple model of inflation incorporating bothstructural and monetarist factors. The model includes growth in M2/GDP ratio and the food gapas a percentage of total consumption as the regressor.24 Estimated regression results is reportedin table 3.1.2. Both the variables appear statistically significant. It is important to note here isthat the inflation rate in the 1990s is lower than that of earlier periods by about 2.5% even aftercontrolling for the usual determinants of inflation. The negative coefficient of the dummyvariable substantiate further that the reform measures of the 90s has successfully contributed inbringing price level stability.

Table 3.1.2: Inflation in B angladeshDependent Variable: Inflation measured by GDP deflator

Model 1 Model 2

Intercept -0.053(-0.05)

2.86(2.09)

Growth in (M2/GDP) 0.334

(6.07)

0.239

(4.08)Food-gap as a % of itsrequirement

0.239(3.79)

0.186(3.22)

Dummy for the periodafter 1990

-2.479(-2.73)

Adjusted R-Square 0.70 0.78

Durbin-Watson 1.74 2.38

Source: Authors estimate with data from different sources

While stabilization had been important for growth, donor conditionality and IFImonitoring appears to be the strongest influence against unsustainable pattern of publicspending and the resultant macroeconomic imbalance. Successive governments, especially thosewith military roots (e.g. BNP, and Ershads Jatiya Party) have, so far been more effectively

22 We tried to find out the structural break in the trend growth path for the period FY 1982 to FY 2002 byconducting an F test considering all possible years for structural break. F statistic attaints is highest valuewhen 1992 was used as the break point.23 In addition to formal trade Bangladesh has significant informal trade with India which isestimated to be several times the volume of formal trade (Rahman and Rahman, 2001).24In Bangladesh expenditure on food counts a lions share of household budget and increase in food pricehave strong affect on price index. Hence, food gap is used as a determinant of inflation in our regressionmodel.


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the early 1990s, overall trend growth rate in the period FY 1991-02 could not reach the targetrates because of the lower growth of the manufacturing sector in the later years.

Sustainability of the recent growth performance remains questionable (Rahman, 2003)for the following reasons. First, the process of industrial growth has been discontinuous as it fellin the second half of 1990s. While GDP growth was propelled by manufacturing growth with a

stagnant agriculture during the first half of the 1990s, the growth in the second half of the 1990sis accounted for by the impressive growth in agriculture with stagnant manufacturing. Lack ofstable pattern of growth in manufacturing lowers the confidence in the future sustainability of theaggregate growth rate. Second, savings, investment, and private investment as percentage ofGDP have stagnated in the recent years despite after a noticeable growth in the early to mid1990s. Third, growth accounting exercise shows that TFP growth (Table A9) decelerated in thesecond half of 1990s, implying a declining of dynamism in the economy. Fourth, apparel sectorthat accounts for about 25% of manufacturing value addition, 33% of manufacturingemployment, 20% of annual investment (Bhatacharya and Rahman, 2000), and has a stronglinkage effect on other economic activities will face a serious uncertainty after 2004 withcomplete phasing out of MFA. Any deceleration of this sector will seriously affect employment,investment, export and the growth of the manufacturing sector as well as of GDP.

Investment must be stimulated for accelerating growth. A recent survey by BangladeshEnterprise Institute (BEI) and the World Bank shows that investment climate is very poorcompared to other countries in Asia because of poor quality infrastructure, poor governance,corruption, excessive intervention by bureaucracy, high cost of financing, economic policyuncertainty, and lack of adequate skilled manpower (World Bank and Bangladesh EnterpriseInstitute, 2003). Bank lending rates remains high reflecting high default-risk premium.

Figure 3.1.1

Savings and Investm enr as % of GDP

0

5

10

15

20

25

1980

-81

1983

-84

1986

-87

1989

-90

1992

-93

1995

-96

1998

-99

2001

-02

SAV

INV

PRIVINV


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Figure 3.1.2

Annual Growth Rate of Investment at constant price

-5

0

5

10

1520

25

1981

-82

1984

-85

1987

-88

1990

-91

1993

-94

1996

-97

1999

-00

2002

-03

INV

PRIVINV

3.2 Issues for Reforming Institutions of Governance

There is a widespread consensus that Bangladesh has a great potential to achieve fargreater successes in economic and social fronts but reaching its potential is contingent onensuring good governance. It appears as surprising to many that in terms of social indicatorsBangladesh has surpassed India, although in terms of good governance Bangladesh lags farbehind.

The major institutions of governance of Bangladesh was inherited from Pakistan whichinherited those institutions from the British colonial administration27. The positive aboutinheriting these institutions was that these institutions are suitable for supporting a very efficientgovernance with a market based economy. Unlike many other TCs where these institutions hadto be built from scratch, Bangladesh could use these organizations with little modifications.However the trouble with these institutions was that these were built a very astute group ofstatesmen with a very clear purpose of holding the people of colonized under the ruleof themother country not for servingthe people of the colony. It has been noted by historians thatwhen the British left India, the leaders of both Pakistan and India scrambled to fill the positionsleft vacant rather than embarking on the job the job ofre-orientingthe those institutions to servethe needs of the free countries.

The colonial government ruled the country with a civil bureaucracy manned by extremelywell-educated well-trained and knowledgeable and well-paid officers with lot of powers vested onthem. During the colonial days native youth who received modern education dreamed to obtain

a lower level job within the civil administration. National politicians who were elected to office asministers under the British rule longed for some authority to distribute these lucrative jobs to thesteadily increasing number of educated youth who did not find jobs due to a stagnant economyunder the British rule. After the independence of India and Pakistan, while in India the civilbureaucracy maintained its grip on the administrative affairs of the country, in Pakistan the

27 The civil bureaucracy, the military, the judiciary, can be cites as being the most importantinstitutions of governance left by the British colonial government. The legislative branch ofgovernment is built in the model of British Parliamentary democracy


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military overtook the leadership due to better pay and training, thanks to generous aid from theUS for the Pakistan military during Johnson administration. After the independence ofBangladesh, the leadership demonstrated little understanding or regard for maintaining thequality of this very important institution. In addition to the lack of respect for among theleadership of the new country for the rules and laws governing those institutions there wassevere scarcity of quality personnel to fill the gap. While jobs were given to political cadres in

these institutions the nominal salary was hardly adjusted with the spiraling inflation. While theprivate sector adjusted prices and salaries with changes in the general price levels public sectorsalaries got depleted in real terms. As a result subsequent generations of educated youth nolonger considered public sector job as their best possible option, their first option becamemigration to foreign countries or obtaining an opportunity in the private sector. Although manyother countries face similar problem, Bangladeshs civil service has become almost dysfunctionalgiving rise to a long tradition of corruption and rent seeking as the most practiced business byanyone possessing some of power in the government. The erosion of capacity and integrity ofthe civil service serves imparts further legitimacy to the clientilist politicians for usingdiscretionary directives as the predominant mode of governance.

While the governments have used the institution of civil bureaucracy as a tool forclientilism and weakened it considerably, the military has remained relatively well organized and

less corrupt. A major reason for the military to maintain it integrity was that the recruitment inthe military always remained strictly professional and even during military rule chain of commandwas not broken and discretionary powers were enjoyed only at the top level. The military alsomaintained relatively better salary and benefits. During the elections under the caretakergovernment the military has performed a highly appreciable role of being a neutral lawenforcement agency. When minor elections are held under a partisan government candidateswho are not favored by the ruling party invariably calls for military presence since the homeministry administered police force has never been able to act without being influenced andcorrupted. Reformation of governance in Bangladesh could well use the organization of themilitary of as a model for re-organizing various organizations of civilian wings of the government.The current ruling government has achieved considerable success in improving the deteriorationof law and order situation by constituting a new police force titled RAB (for Rapid ActionBatallion) by using the o

Understanding Reform

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