ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Preference Erosion

It is hoped that the World Trade Organisation's Doha round of negotiations will result in significant reductions in tariffs on agricultural and industrial goods and services. However, least developed countries fear that tariff reduction deals amongst developed countries may erode the preference margin they enjoy as far as their exports are concerned. How will this "erosion of preference" affect Bangladesh's exports?

Notes

Preference Erosion

Impact on Exports of Bangladesh

It is hoped that the World Trade Organisation’s Doha round ofnegotiations will result in significant reductions in tariffs onagricultural and industrial goods and services. However, leastdeveloped countries fear that tariff reduction deals amongstdeveloped countries may erode the preference margin they enjoyas far as their exports are concerned. How will this “erosion ofpreference” affect Bangladesh’s exports?

M A TASLIM

A
successful conclusion of the World Trade Organisation’s (WTO) Doha round of negotiations is likely to result in substantial reductions in the bound tariffs on both industrial and agricultural products. This will be welcomed by many countries, which have negotiated long and hard in the Non-Agricultural Market Access (NAMA) and agricultural negotiations for a more open trade environment. However, it is causing serious concern among the least developed countries (LDCs); they fear that any tariff reduction deal among the more affluent countries might leave them high and dry. Currently, virtually all the exports of LDCs that satisfy the rules of origin get duty-free access to all developed countries except the US, which provides duty-free access to only a select group of LDCs under the African Growth Opportunities Act (AGOA). For the LDCs that receive duty-free treatment, the applied most favoured nation (MFN) rate is an approximate measure of the preference that its exports receive in the developed country markets.1 Any reduction in the MFN rates reduces the margin of preference they currently enjoy. Since these countries may not be fully competitive in the international market due to weaknesses in their productive capacity and other constraints, the erosion of preference due to a reduction in the MFN tariff rates will have an adverse impact on their export performance, especially of those LDC relying on the export of manufactured products. Some indications of this are already evident. Lesotho, a least developed African country benefited greatly from the AGOA preferences. A large clothing manufacturing industry developed there to take advantage of the quota-free and duty-free access to the US market. However, the abolition of the Multi-Fibre Agreement (MFA) quota regime on January 1, 2005 has taken a heavy toll on the industry as some foreign companies withdrew from the country. Within a short time Lesotho lost nearly a quarter of the total employment in the industry. This is a very hard blow to a poor country with few resources and a massive HIV/AIDS problem to cope with [UNCTAD 2005].

Trade Preferences and Export Performance

The fear of falling exports due to an erosion of preferences in a quota-free world is also a matter of serious concern to Bangladesh. Its export basket, unlike that of most of the LDCs, contains mostly manufactured products (92 per cent). A single manufactured product, viz, clothing or readymade garments, account for more than 75 per cent of the total merchandise export of the country.2 The global clothing market was a highly protected market under the MFA quota regime until 2005. A large number of small countries including Bangladesh had found it relatively easy to enter the market by virtue of quota restrictions. The end of the quota regime has greatly intensified competition in the clothing markets of the developed countries. The more efficient apparel producing developing countries such as China and India with very strong upstream and downstream industries are coming out as winners in this intensely competitive market.

Bangladesh has already started feeling the pinch of the abolition of quotas. Although the dire predictions of experts of some multilateral organisations that the country may lose 25 per cent or more of the market has proved to be overly pessimistic so far, prices received by exporters have considerably declined. One mitigating factor has been the imposition of stiff restrictions on Chinese exports of textile and apparel products to the EU and US. This has given Bangladeshi exporters a temporary reprieve such that a healthy growth of apparel export could be maintained. The full impact of cut-throat Chinese competition will not be felt until 2008 when the restrictions will be withdrawn. If the margin of preference that Bangladesh enjoys in the developed country markets (except US) were to be reduced as a result of a successful conclusion of the Doha round, the resulting reduction in competitiveness will no doubt have a negative impact on the export performance of the country. If this is not offset by other factors and there is a substantial reduction in exports, the consequent loss of jobs could destabilise the fragile democratic structure of the country built up painstakingly over the last one and half decades and much of the social and economic attainments could be reversed.

An important question is how the export performance and welfare of the country will be affected by preference erosion due to a successful outcome of the Doha round. Although it is most unlikely that there would be an immediate elimination of tariffs of products of export interest to the LDCs, large reductions such as one-third or one-half are possible. Such reductions are bound to have some adverse impact on the LDC export of products that benefit from preferential treatment. The precise magnitude of the effects is uncertain but there are several estimates. Some of these indicate some reduction in welfare while others predict an increase. This paper does not go into any detailed estimate but rather provides some indication of the possible outcome in the short term on the basis of the past performance of the economy.

Since most of the exports of Bangladesh, as well as exports under the generalised system of preferences (GSP), comprise readymade garments, the impact of erosion

Economic and Political Weekly June 9, 2007 of preference on the export of garments will, to a large extent, determine the overall impact on total exports. Two types of garments are distinguished – knitwear (HS 61) and woven garments (HS 62). Until the 1990s, woven garments comprised the bulk of textile exports of the country. In recent years, there has been a strong growth in knitwear production and export such that now, it contributes nearly half of the total apparel export. The pattern of growth of knitwear and woven garments exports tells an interesting story about the effect of preferences on export performance. During the last several years, there has been very little growth in woven apparel export. Between 1997-98 and 2005-06, it grew at an annualised rate of only 4.6 per cent. During the same period knitwear export grew at the rate of 18.3 per cent. The EU is the principal market for knitwear where nearly 80 per cent of the total export is sent. US absorbs only about 14 per cent. Apparel exports to US do not get GSP treatment such that Bangladeshi exports have to be sent on an MFN basis. This puts Bangladeshi exports at a disadvantage as a number of its competitors such as Mexico and Lesotho get duty-free access under North American Free Trade Agreement (NAFTA) and AGOA. Although the EU offers duty-free access to all LDC products (but arms) under the everything but arms (EBA) initiative, the rules of origin are sufficiently stringent so that woven garments manufactured from imported fabric fail to gain originating status. Only a small fraction of woven garments (25 per cent) that are manufactured from domestic fabric qualify for EBA duty-free treatment. The rest 75 per cent are sent on an MFN basis. However, some of the major competitors of Bangladesh such as India and Pakistan do not face any problem in satisfying the rules of origin as all these countries have well developed domestic textile (fabric) industries. Their exports are entitled to a duty rebate of 20 per cent of the MFN rate. Thus, woven garment exports of Bangladesh are also disadvantaged in the EU market. This is one of the major causes of the poor performance of woven garment exports. During the period 2000-01 to 2004-05, GSP woven apparel export to the EU grew by 15.7 per cent but the non-GSP woven apparel export grew by only 2.8 per cent. Knitwear exports, on the other hand, satisfy the EU rules of origin as knit fabric is almost entirely domestically procured. Hence, knitwear exports enjoy duty-free access to the EU market. This gives substantial advantage (12 and 9.6 per cent depending on the competitor) to knitwear exports of Bangladesh. Knitwear exports to the EU have been growing at a very fast pace as mentioned earlier.

Clothing exports to Canada also showed spectacular growth since it granted dutyfree access to LDC exports. Exports from Bangladesh to Canada during 1997-98 to 2001-02 had remained virtually constant at slightly over $ 100 million. Canada granted duty-free entry to LDC with flexible rules of origin in 2003. Exports from Bangladesh to Canada jumped by 141.4 per cent in 2003 and by 60.1 per cent in 2004. It increased by 17.9 per cent in 2004-05 and

5.2 per cent during 2005.3 The quadrupling of exports in just three years following the granting of duty-free access (after near zero growth during the four previous years) can be explained only by the utilisation of this special preference given to LDC exports by Canada.

Possible Effect of Preference Erosion

The rather poor performance of woven exports to the EU relative to that of knitwear and the surge in exports to Canada since it accorded duty-free access to LDC exports provide a good indication of the possible impact of preference erosion on the exports of the economy. If the export items to the EU that currently enjoy dutyfree entry were to receive no preferential treatment, their growth performance would not be much higher than that of the woven garments and other exports that currently do not qualify for duty-free access. Hence, the growth rate of the exports that are sent on an MFN basis provide a conservative estimate of what could be expected to be the growth rate of all exports if none were to receive any preferential treatment. The fact that many LDCs that currently enjoy duty-free benefits will also have their preferences reduced or eliminated with the reduction or elimination of MFN duties will not have much positive impact on the export volume of Bangladesh as they are not significant players in the export market for products that are of interest to Bangladesh. Hence, one could reasonably assume that if the preferences were withdrawn (fully eroded), the rate of growth of exports of Bangladesh to the EU would most likely be not much greater than the rate of growth of woven garment exports. In the case of Canada exports would most likely fall back to their original profile.

The impact of a reduction in the MFN duty will not be the same in all markets. Bangladesh hardly gets any preference in the US market – total export under the US GSP being about 1.5 per cent of total export to the US. Hence, MFN duty reduction by US will not have an adverse impact on the export of Bangladesh to US. Indeed, it will raise the competitive strength of Bangladeshi apparel. Bangladesh will most likely increase exports to US if the MFN duties are reduced. The other GSP giving countries – Japan, Australia, Norway, Switzerland and

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    Economic and Political Weekly June 9, 2007

    New Zealand – take in only a small fraction of the total exports of Bangladesh and hence, MFN duty reduction by these countries would have a small impact on the country’s total export volume in the near future.

    The high growth rate of knitwear and woven garments clearly indicate that the growth rate of exports that enjoy GSP benefits far exceed the growth rate of exports on an MFN basis. Indeed, the GSP exports essentially drove the growth rate of total exports. Non-readymade garments (RMG) exports fared much worse and have grown even less than the growth of woven RMGs during the last one and half decades. The evidence would seem to suggest that if all exports were without any preference (quota or tariff), export growth rate would fall to 7-8 per cent whereas if all exports received duty-free access, the growth rate could be in excess of 20 per cent. If Bangladesh were to lose the preference margin due to reductions in MFN duties, the growth rate of total exports could therefore decline by about 4-5 per cent. However, there could be a large decline in the initial export. If Bangladesh were to lose the 12 per cent (or 9.6 per cent against GSP receiving developing countries) price advantage it currently enjoys in the EU market, the current level of exports could decline by about $ 1,100 million for changes in the terms of trade alone (assuming elasticity to be 4). Similarly, Bangladesh could lose another $ 250 million in exports to Canada. The global change in exports will be less as one could also expect a fairly large increase in export to the US market if it reduces MFN duty to zero. Exports to US could rise by about $ 700 million (assuming elasticity to be lower at 2 since Bangladesh is in the same situation as its major competitors in the US market). Thus, the net loss due to preference erosion could be about $ 650 million. How much of this loss could Bangladesh exporters make up through productivity improvements and market expansion is a moot point.

    Ironically, the main reason why global liberalisation may raise exports of some countries is precisely that most of their exports are deprived of the promised preferences. Only about a third of the total exports of Bangladesh receive GSP. The rest are sent on an MFN basis, which essentially implies that these are discriminated against vis-à-vis both domestic producers of the importing countries and the exporters in preference receiving countries (such as NAFTA). A reduction of the MFN rate due to liberalisation reduces the discrimination against Bangladeshi exports and hence may raise its exports to some extent.

    It should be clearly understood that such a reduction of discrimination will not raise exports in the way preferences can. This is also borne out of the very recent export performance of the country. It is highly significant that while preferential exports of apparel to the EU have grown during the 2002-03 and 2004-05 period by 29.3 per cent, non-GSP apparel exports grew by only 3.8 per cent. Globalisation could probably increase the exports of non-GSP clothing items by a few percentage points but GSP exports will likely fall to the same level as well. Since most of the exports do not receive GSP benefits, the expansion in non-GSP exports may cause a small increase in total exports in the initial years but total export will grow slowly henceforth.

    On the other hand, if all exports had received duty-free access, the growth rate of exports could be well over 20 per cent. Such an export growth is essential to achieve a high rate of economic expansion. Without an acceleration in the economy’s growth rate, the country cannot appreciably reduce poverty and consequently cannot achieve the Millennium Development Goals. If the country could attain high growth, it would be able to climb out of the cesspool of poverty in a fairly short time. By not providing GSP and greater market access, the developed countries (especially US) have deprived Bangladesh of the opportunity of releasing its population from the curse of poverty. This is the real the cost of not granting preference. This will also be the cost of erosion of whatever preferences are now being allowed.

    Remedial Measures

    What should be done to improve market access of the LDCs in the face of a real possibility of a reduction of MFN tariffs under NAMA of the Doha round? Such a reduction will erode whatever little preferences LDCs enjoy currently. The gains from more liberalisation will not compensate the losses from the erosion of preferences. The LDC trade ministers seem to be apprehensive of the consequences of preference erosion. This is reflected in demands contained in paragraphs 1,3, 4 and 5 of the declaration of the fourth trade ministers’ meeting at Livingstone, Zambia

    on June 25-26, 2005 [WTO 2005]: Binding commitment on duty-free and quota-free market access for all products from LDCs to be granted and implemented immediately, on a secure, long-term and predictable basis, with no restrictive measures introduced; The need for non-debt creating financial resources from international organisations and bilateral partners, for adjustment required in LDCs as a consequence of changes in the multilateral trade rules. Incorporation of special provisions in the modalities to maintain preferences until such time as all domestic and export subsidies are removed that affect LDC commodities, complemented by compensatory and transitional measures to allow LDCs to fully prepare their commodity industries for open and fair competition;

    The importance given to unrestricted market access by the LDC ministers is evident. The first thing that should be done under the present circumstances is that the rich countries should honour their pledges made at the WTO, United Nations Conference on Trade and Development (UNCTAD) and other international fora for providing duty-free and quota-free market access to LDC exports. Assuming that it will take a few years to phase in the reduction in MFN duty following an agreement under the Doha round, if such preferences were immediately granted, LDCs will have an opportunity to benefit from the preferences during the transitional period, and also have time to prepare to phase in the erosion. To make the already existing regulations for preferential access of LDC exports meaningful, they must be complemented by flexible rules of origin. The only reason why Bangladesh has not been able to fully utilise duty-free access into the EU market is that the EU preferential rules of origin are too stringent for LDC to satisfy. Rules of origin are an essential part of preferential access; they should be designed in a manner that the LDC can actually comply with. The Hong Kong ministerial unfortunately failed to provide duty-free access to LDCs. Its ambiguous commitment to provide dutyfree access to 97 per cent of the tariff lines by 2008 may not substantially alter the situation for many LDCs including Bangladesh. It has become obvious that US is opposed to providing market access to the apparel-dependent LDCs of Asia.

    The trade ministers of LDCs demand the strengthening of the existing preferential schemes and the incorporation of

    Economic and Political Weekly June 9, 2007 provisions in the modalities to address the erosion of preferences but they do not suggest any modalities to achieve this objective. However, they evidently do not want any scheme that will increase their debt burden or reallocation of existing assistance funds. Hence, the IMF’s suggestion to embed any compensatory financing of preference erosion into the existing medium term adjustment and programme financing facilities would be contrary to their expectations [WTO 2003].

    The design of facilities for reducing the impact of preference erosion is a difficult task and will need extensive research and consultation with the affected parties. Here, two possible remedial measures are mooted. LDCs export very few products. For example, the only product of real interest to Bangladesh is clothing. Since the LDC export products are so few, it might be possible to make an exception in the case of such exports and not reduce the MFN duty drastically, say, for a 10-year period. Developed countries would probably not object to agreeing to the proposition but developing countries with textile interests such as India and Pakistan might be reluctant to accept such a proposal. Indeed Pakistan opposed the LDC proposal for duty-free access to developed country markets at the Hong Kong ministerial.

    Another solution to the problem of preference erosion is the provision for import subsidies on products imported from LDCs. This would be the preferred option of economists as subsidies granted to imports from LDCs that constitute a negligible fraction of the total imports of developed countries do not distort prices and the production structure of the world in the way that tariffs do.4If import subsidies on imports from LDCs are given at the same rate as existing tariffs, it duplicates the effect of duty-free access. There is no budgetary implication for the subsidy granting country since the tariffs collected are redistributed as subsidy. However, if the duty on the product is less than the import subsidy or zero, the subsidy will require budgetary outlay in the grantor country. The current tariff rates may be regarded as the base level for subsidies. When tariffs are reduced by a certain amount, the subsidies should be increased by the same amount in order to leave the preference margin unchanged.

    It is the declared objective of virtually all development partners of Bangladesh to promote the rapid growth of a liberalised economy. Accelerated growth of exports and diversification of the export basket are essential for achieving this end. Several organisations including the World Bank have undertaken projects to directly promote the diversification of the export basket of the country but without any positive outcome so far. The objective could be more easily achieved through a general import subsidy. As there are only a few products that have large tariffs, producers in Bangladesh have an incentive to produce and export these products. Industrial products (other than textile and leather products) usually carry very low tariffs in developed countries. This acts as a disincentive for the production and export of these industrial products. Import subsidies that equalise preferences on all exports of LDCs would take away the advantage of exporting particular products, and promote diversification of the export basket and the economy.

    Another option that has been mooted is the lump sum payment of financial compensation to LDCs in proportion to the losses due to erosion of preferences. This is perhaps the easiest for the preference granting countries to implement and the most attractive to the governments of the LDCs but it is also the least desirable from the perspective of LDC economic development. The real victims of preference erosion are the exporters; financial payments to the LDC governments do not ensure receipt of the money by those who bear the losses. Even if the payments to them were ensured that does not reverse the reduction of incentives in their export activities unless the payments could be tied to the level of exports. In this case, it would be very similar to import subsidies, and hence, much better handled at the grantor’s end. If no such support is provided, the existing export industries that are the victims of preference erosion will decline or even disappear with consequent impact on income and unemployment. Whether the compensatory funds provided by developed countries would help these countries to readjust and grow new export industries is a moot question. Past experience with adjustment programmes does not inspire much confidence in the possibility of such an outcome.

    Epilogue

    It should be mentioned that trade preferences are only transitional measures to help the growth of LDC economies. These must not be regarded as substitutes for the development of supply capacity at home. The major economic problem of LDCs is that they have a rather narrow and weak supply base that cannot take full advantage of the opportunities opened up by a more open world economy. A rapid growth of supply capacity will require appropriate domestic policies. The international community could expedite the building of supply capacity in LDCs by providing adequate financial and technical assistance and greater market access. The latter is of crucial importance as supply capacity cannot be quickly developed or if developed, cannot be sustained without market access. Trade preferences must, therefore, go hand in hand with the development of supply capacity in LDCs. On their part, LDCs must undertake to carry out necessary reforms in order to ensure that they can actually utilise the window of opportunities opened up by preferential trade regimes.

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    Notes

    [This is a substantial revision of a paper read at the 52nd Session of UNCTAD, October 2005. The author gratefully acknowledges, without implicating, the comments and suggestions made by participants of that session.]

    1 If the competing countries are developing countries receiving the generalised system of preferences (GSP), then the difference between the MFN and GSP rates shows the margin of preference.

    2 The data used in this paper are sourced mostly from ministry of finance, Bangladesh Economic Survey 2006 and Export Promotion Bureau.

    3 Industry Canada, Trade Data Online, August 2006.

    4 Limao and Olarreaga (2005) suggest that there would be considerable gains to both developed countries and the LDC from a switch to import subsidies from the existing preference system.

    References

    Limao, N and M Olarreaga (2005): ‘Trade Preferences to Small Developing Countries and the Welfare Cost of Lost Multilateral Liberalisation’, mimeo.

    UNCTAD (2005): ‘Erosion of Preferences for the Least Developed Countries: Assessment of Effects and Mitigating Options’, Trade and Development Board, 52nd Session, TD/B/52/ 4, August 4.

    WTO (2003): ‘Communication from the International Monetary Fund’, WT/TF/COH/ 14, February 14.

    – (2005): ‘Fourth Trade Ministers’ Meeting at Livingstone’, Zambia, WT/L/614, July 7.

    Economic and Political Weekly June 9, 2007

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