Firms need to have easy access to inputs at world market prices to be internationally competitive. Free trade—with no tariffs, no indirect taxes, no import or foreign exchange restrictions—is the ideal policy goal. However, development experience over the past five decades suggests that it takes time to achieve free trade. Therefore, giving free-trade status to exporters is a practical intermediate step for those countries that cannot make the move to free trade quickly. Free-trade status schemes have worked very successfully in the East Asian economies.
The specialized schemes—such as fenced private or public export processing zones (EPZs), nonfenced EPZs, special bonded manufacturing warehouses (BMWs)—are more widely used than economywide schemes in countries at early stages of development. These specialized schemes have been quite effective in providing fast duty-free and indirect-tax-free access to imported inputs for 100 percent export-oriented manufacturing firms in a number of developing countries. Economywide schemes—such as duty exemptions and drawbacks—are desirable complementary systems, especially as development advances. The specialized and the economywide schemes should be offered in parallel (as in the Republic of Korea and Taiwan, China) so that foreign or private firms can choose depending on their particular needs and the relative effectiveness of the schemes.
However, in many low-income countries, implementation of the economywide schemes has been flawed. Experience shows that without the proper development of the necessary instruments, institutions, and mechanisms, it is hard to apply economywide schemes effectively.
This Note reviews free-trade status schemes and raises some issues critical to more effective implementation of the economywide schemes.
A fenced EPZ, if well administered, can guarantee the quickest access to free-trade status for inputs and outputs, with minimum red tape. The flow of input and export product containers to and from an area is monitored by an around-the-clock customs presence. An enclave-like location and physical safeguarding of containers make it possible to bypass the normal customs and duty-free import procedures so that governments do not have to worry about misuse of duty-free imports. This advantage, together with other liberal policy settings (liberal foreign exchange regimes, unfettered profit repatriation) and the availability of rental factory buildings with supporting infrastructure services, means that most foreign companies prefer fenced EPZs to other modes of free-trade status. Furthermore, private initiatives in EPZ construction and management minimize the risk of low-quality investment—a problem that often occurs in public estates.
The private fenced EPZs in the Dominican Republic and other Caribbean countries have played a catalytic role in the growth of manufactured exports during the 1980s and 1990s. Applying the successful experiences of the Caribbean, Kenya established the first private fenced EPZ in Sub-Saharan Africa a few years ago, and now the zone is in full operation with twelve factories.
Mauritius has provided quick access to free-trade status and other policy regimes similar to fenced EPZs without requiring the enterprises with the EPZ licenses to be located in fenced industrial estates with around-the-clock customs presence. Mauritius allows the EPZ enterprises to bypass the normal customs and duty-free import procedures, relying primarily on the firms' self-declaration of input inflows and output outflows. Trust in the integrity of EPZ enterprises—which probably originates from having a small domestic market and from the honesty of the enterprises involved—has allowed the self-declaration-based system to work in Mauritius, and the recent success of exporters has depended largely on manufactured exports by 100 percent export-oriented nonfenced EPZ enterprises.
Bangladesh's success in exporting garments may be the best working example of the special bonded manufacturing warehouses. Exports from the 1,500 special BMW factories using imported fabrics and accessories have risen to $1.5 billion over the past fifteen years. The factories employ one million workers. This could not have been done without the effective implementation of the special BMW scheme.
The special BMW relies on spot checks of the 100 percent export-oriented factory inventories by customs officials. Transparent criteria for each inventory check are based on the pretabulated input-output (physical) coefficients (such as the fabric-garment conversion factor). Because of the transparent criteria, customs has been able to allow the speedy processing of imports and exports without having to use fenced EPZs or BMWs (sometimes called individual fenced EPZs because customs officials check the input and output containers going to and from a fenced, bonded factory).
There are two options—a duty exemption or a duty drawback system. A duty exemption system exempts exporters from paying duties or indirect taxes on imports used in export production. The exemptions are granted at the time of importation. In a duty drawback system, exporters get refunds of the duties and indirect taxes they have paid on imported inputs. There are two ways of making such refunds. Individual drawback systems refund the duties and indirect taxes paid by firms. Fixed drawback systems refund the estimated duties and indirect taxes that enter the cost of production of exports according to a preset schedule.
A review of schemes giving exporters free-trade status in fifty-five developing and formerly nonmarket economies shows that fewer than half have a legal framework or implementation regulations for their duty exemption or duty drawback schemes. (About 40 percent appear to have specialized schemes—fenced EPZs and BMWs.) In many low-income countries that operate the duty exemption or duty drawback scheme, or both schemes, there are significant implementation problems. Furthermore, almost all small producers and indirect exporters are excluded. This exclusion hinders backward linkages and the development of trading companies, two big factors in the East Asian success.
The Bank's policy advice and project work have emphasized the economywide schemes more than specialized schemes because the specialized schemes have the handicap of having to be location-specific and 100 percent export-oriented, and they need customs officials to be present. In addition, the Bank has been encouraged by the success of the economywide schemes in successful newly industrializing economies (NIEs) such as Korea and Taiwan (China). The share of exports covered by the economywide schemes during the 1970s was more than 80 percent in each of these two economies.
During 1981-90, there were forty-seven World Bank structural adjustment loans, industrial sector loans, and export development loans that included reforms for free-trade status administration for exporters as part of the loan components. About 80 percent of these projects required the effective implementation of the duty drawback or exemption schemes as project components. (Many of the projects are in low-income developing countries.) Around 75 percent of these components were either loan conditions or part of action programs required by the loans. Only about 25 percent provided technical assistance for implementation (or study) of the economywide duty-free import schemes.
Bank projects have helped to set up the right legal foundations. However, unlike a tariff reform, issuing a decree for the duty exemption and drawback schemes is only the first step. The work of developing proper instruments, institutions, and mechanisms for implementation and monitoring still needs to be done. As noted, in some cases the Bank has provided technical assistance, but one of the lessons from doing so is that advisors must have sound institutional and implementation experience—preferably in countries that have established a good track record in implementation. External technical assistance generally has failed to grasp the critical role of the pretabulated standard input-output coefficients and therefore has not helped with the task of estimating them.
The main challenge for economywide schemes is establishing a speedy and robust system to process the exemptions and drawbacks. There are only two ways for the authorities to achieve fast processing. The first is by not checking exporters' self-declared input-output coefficients. The second is through pretabulated standard input-output coefficients uniformly applied to all exporters.
The first is possible in a country where exporters have the technical ability to estimate accurate self-declared input-output coefficients and where the authorities can expect exporters to play by the rules, as in the Mauritius EPZ and Mexico's maquiladoras. In the second case, the most critical data required for the duty exemption and drawback schemes are the standard imported input-output (quantity) coefficients. The East Asian NIEs' effective implementation of the duty exemption and drawback schemes depended on this second option. Officials continually fine-tuned and updated the systems to ensure that they worked well. For example, even in the early 1980s, Korea and Taiwan (China) exchanged missions to study each other's experiences with standard input-output coefficients and other tools. India, too, chose the second option. While initially the Indian duty exemption scheme was not very effective, the more than 2,000 pretabulated standard input-output coefficients were a major factor contributing to an improvement in the way it operated.
The biggest cause of delays in the duty exemption or individual drawback procedures in most low-income developing countries is that the authorities apply ad hoc or discretionary checks of exporters' self-declared coefficients. In other words, they don't accept exporters' self-declared coefficients without dispute or they don't use transparent criteria based on pretabulated standard input-output coefficients. Even if the authorities handling the duty exemption or drawback recognize the importance of these coefficients, they normally do not have the skills or resources to estimate them.
Where they been successfully applied, as in East Asia, the economywide duty-free import schemes have made a big contribution to the success of manufactured exports. Furthermore, export success has led not only to economic growth but also to building momentum for trade liberalization. Therefore, effective implementation matters.
Close analysis of how the economywide schemes operate shows that to enhance the effectiveness of these policy tools, development assistance agencies need to deal properly with the institutional know-how and resource constraint issues—though governments themselves must be committed too, or even the best external support will not translate into results.
To deal with the cost of highly technical work, the Bank's current piecemeal approach based on the limited country-specific technical assistance resources for input-output coefficients could be replaced by pooled technical assistance resources for several low-income countries—to come up with the basic data set for standard input-output coefficients for key product categories. Only if such a data set is available will it be possible to construct meaningful country-specific variations and therefore client-specific coefficients.
At a broader level, the Bank's experience with free-trade status schemes raises a serious question about one of the basic premises of its efforts to improve development policy implementation through institution-building assistance. Do the current mechanisms of supplying technical assistance personnel for institution-building meet the objective of providing professionals who have both the requisite expertise accumulated through institutional experience in successful countries and the ability to translate these experiences into advice tailored to different country circumstances? A related question: When highly technical work such as input-output coefficients for duty-free import administration is involved, shouldn't the individual country-specific approach (using limited technical assistance resources) be replaced by an alternative approach that pools the technical assistance resources for several countries with similar characteristics?
In turn, Bank research should give higher priority to defining the specific institution-building tasks related to specific development policy implementation issues. The current interest in so-called institutional economics does not appear to have much practical value. Searching for the right answers to these questions should be part of the agenda for improving development effectiveness.
Yung Whee Rhee, Principal Economist, Private Sector Development Department, September 1994.
Comments are welcome. Please call the FPD Note line to leave a message: 202-458-1111; or contact Suzanne Smith, editor, Room G8105, The World Bank, 1818 H Street, NW, Washington, DC 20433, or at ssmith7@worldbank.org.