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Pakistan’s Export Bonus Scheme: The effect of Pakistan’s export incentive scheme on the external and domestic sectors of the economy

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1974
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Andreas S. Gerakis

When Pakistan (all references include East Pakistan, now Bangladesh) became independent in 1947, it inherited from its colonial past a foreign exchange and trade system based on an overvalued exchange rate and relying heavily on restrictions. Despite a subsequent devaluation, the rupee remained a substantially overvalued currency a decade after independence, owing largely to inflationary financial policies. As a result, Pakistan experienced severe foreign exchange difficulties in 1958, even though the authorities tightened controls on imports and applied a variety of incentive schemes for exports.

In the writer’s opinion, the best remedy for this situation would have been to devalue the rupee to its equilibrium level. Instead, the authorities introduced in early 1959 the Export Bonus Scheme (EBS) which had a number of unfavorable consequences on Pakistan’s economic development. With hindsight this decision now appears unfortunate, although it is quite understandable when viewed in its historical perspective. At the time it was taken, many less developed nations operated multiple rate systems in order, inter alia, to avoid the price effects, particularly on essential items of mass consumption, of an outright devaluation. Moreover, such systems were widely considered as a useful policy instrument in guiding the economy toward desired objectives. The EBS was destined to remain in effect for a long period. This too is regrettable in retrospect, but may be explained by the fact that multiple rate schemes create vested interests which cannot be eliminated without considerable dislocation; indeed, the longer these schemes last, the more difficult it becomes politically to rationalize the exchange rate structure.

In any event, the EBS is now a thing of the past having been discarded by Pakistan with the far-reaching foreign exchange and trade reforms in May 1972 (and by Bangladesh shortly after it seceded from Pakistan in December 1971). Nevertheless, a study of this scheme may be rewarding not only for its historical interest, but also for the guidance it can provide to other countries which might be considering similar policies.

Main features of the EBS

Under the provisions of the EBS, some exports (unless the context indicates otherwise, the terms exports, imports, exporters, and importers relate to both merchandise trade and invisibles) continued to receive the rupee equivalent calculated at the official rate (approximately US$1 = PRs 4.76 throughout the period covered here). However, for specified items the exporter was given, in addition, bonus vouchers amounting to a certain percentage of his receipts. For example, if Mr. A exported jute goods worth $10,000 he would be paid PRs 47,600 ($10,000 × PRs 4.76); however, he would also receive bonus vouchers equal to, say, 10 per cent of the value of the transactor i.e., $1,000. He could use these vouchers to finance his own imports or, alternatively, could cede them to others. A market developed in which vouchers were traded at a varying price, usually including a premium; thus, the voucher for US$1,000 might sell for PRs 5,000, i.e., for more than its face value at the official rate (PRs 4,760). This meant that the effective rate for the export involved was higher (more depreciated) than the official rate and that the exporter was in effect subsidized through the mechanism of the EBS.

The scheme provided that some imports could be effected at the official rate. However, for “bonus” imports, the importer had to pay the foreign exchange equivalent at the official rate and surrender vouchers equal to the entire value of the transaction. Toward the end of the period discussed, the authorities introduced a category of “cash-cum-bonus” imports, for which importers had to purchase from the central bank the foreign exchange equivalent at the official rate and procure vouchers in an amount equal to half the exchange cost involved.

This brief description indicates that at any given time the Government determined the number of effective rates of the EBS by setting bonus percentages for exports and imports. On the other hand, the actual level of the rates depended on the bonus percentages applied and the market-determined price of the bonus voucher. This price reflected underlying supply and demand conditions for export and import commodities as well as government regulations with respect to external transactions, including those relating to the EBS itself. The pattern of rates resulting from the scheme is illustrated in the table.

Looking at the way the EBS operated over the years, one notices the following three distinctive features. First, the scheme achieved a gradual devaluation of the exchange structure on both the export and the import side. However, once again, the devaluation did not go far enough to offset the pre-existing overvaluation of the rupee and the effects of continuing inflationary financial policies; this point is illustrated by the fact that, at the time of Pakistan’s foreign exchange reform in May 1972, the average effective rates for receipts and payments were in the range of PRs 6.60 to PRs 6.90 per U.S. dollar, i.e., considerably below the realistic unitary rate of PRs 11 per U.S. dollar introduced by the reform. Second, as shown in the table, the spreads between the various rates of the scheme were quite large. Third, the system was unstable in several respects. The number of rates tended to proliferate, particularly so for exports, with each round of proliferation being followed by an effort aimed at simplification. There were frequent shifts of items from one effective rate to another. In addition, the price of the bonus voucher and, therefore, the level of the effective rates fluctuated substantially.

The EBS was supplemented by stiff quantitative restrictions on imports subject to the official and the cash-cum-bonus rates, though an importer who wished to bring into the country quantities exceeding the quotas applicable to these two rates could do so at the bonus rate. At the latter rate Pakistanis could also import freely a number of other specified items not allowed at the official and cash-cum-bonus rates. However, imports of many items considered luxuries or in competition with domestic manufactures were banned. Tariffs at rates of up to 300 per cent were levied on the value of imports together with sales taxes and certain other charges of considerable magnitude. Moreover, the trade and exchange system included tight restrictions on invisible transactions and (in addition to subsidies) other incentive measures for exports, such as special quotas for imports of raw materials required in the production of goods for export.

Effective Exchange Rates Resulting from EBS(In Pakistan rupees per U.S. dollar)
Buying RatesSelling Rates
4.75Official rate

Most exports of primary commodities, most invisible receipts except remittances by emigrants.
4.80Official rate

Imports of capital and essential consumer goods; debt service; government imports and invisible payments; imports of some raw materials, including petroleum and lubricants; most private invisible payments.
6.51Official rate plus 20 per cent bonus

Exports of wool; receipts from aircraft and ship repairs, and a few other invisibles.
9.24Cash-cum-bonus rate

Most industrial raw materials and some private invisibles.
7.39Official rate plus 30 per cent bonus

Exports of most semiprocessed items, exports of most jute manufactures, and some other manufactures.
13.68Bonus rate

Unrestricted import of items on bonus list, many of which were nonessential consumer goods, and of all items which could also be imported at official rate and cash-cum-bonus rate; business travel and certain categories of travel for pilgrimage.
8.26Official rate plus 40 per cent bonus

Exports of manufactured items, including a few jute manufactures; remittances from emigrants and certain other

As of the end of May 1969 on the basis of a price for the bonus voucher equal to 185 per cent of its face value.

As of the end of May 1969 on the basis of a price for the bonus voucher equal to 185 per cent of its face value.

The balance of payments

Since the degree of devaluation was insufficient, Pakistan’s balance of payments difficulties continued during the period of the EBS, even though the country benefited from a rising volume of foreign assistance as well as an improvement in the terms of trade. These difficulties were reflected in the need to maintain stringent restrictions on foreign payments and in shortages of imported goods—particularly raw materials—which led to substantial underutilization of industrial capacity. The effects of the EBS on the principal categories of balance of payments transactions are considered below. Data later than fiscal year 1969/70 and calendar year 1970 are not taken into account since they are distorted by the consequences of political events.

Exports

According to customs returns, merchandise exports increased considerably from the equivalent of $278 million in the fiscal year 1958/59, to $687 million in 1969/70, i.e., at the relatively high rate of 8.6 per cent per annum; indeed there is some reason to believe that their actual growth is understated by these data (see below). No doubt this was a commendable performance and it should be credited to the modest degree of devaluation accomplished through the EBS, given that both the foreign demand for, and the domestic supply of, Pakistan’s exports are known to be price elastic. Of course, the premise that these price elasticities are high implies the conclusion that exports would have done even better with a more adequate devaluation.

The gains in exports were not, however, distributed evenly. While exports of primary products rose only marginally, those of manufactured, including semi-manufactured, goods increased by more than 18 per cent a year. The low (appreciated) effective exchange rates applicable to primary commodities meant unsatisfactory prices for farmers and discouraged production. The increase in output which did, in fact, occur—resulting from an expansion of the cultivated area and improved techniques—was absorbed by rising levels of domestic consumption and was also needed to provide the raw material base for the large exports of manufactured items. Needless to say, the discrimination against primary commodities involved in the multiple rate structure constituted a departure from the principle of comparative advantage. However, the Pakistan authorities were making a strenuous effort to diversify the economy and justified their foreign exchange policy on the grounds that it would promote industrialization.

One of the most serious disadvantages of this policy on primary commodities may be found in the case of jute. At the time of independence and even when the EBS was introduced a decade later, Pakistan dominated the world jute market. The unfavorable exchange rate applied to jute was responsible for a slow growth in both output and exports and, therefore, for high prices to foreign buyers in terms of foreign exchange. This encouraged production of jute or similar fibers in other countries and, more importantly, the appearance of a number of synthetic substitutes. Jute has now been displaced in many end uses by such competitors and its future prospects do not appear as promising as they might otherwise have been.

The impressive showing of exports of semiprocessed and processed manufactures was due to the subsidies they received through the foreign exchange system, ranging up to 90 per cent or more in some instances. In themselves, the effective rates resulting from these subsidies were not unduly high—perhaps never as high as Pakistan’s “equilibrium” exchange rate at various points in time—but, given the existing structure of multiple rates, the subsidization of industrial products was clearly excessive. The manufacturer was able, as indicated above, to procure his raw materials, particularly cotton and jute, at artificially low prices, and in effect received a cash payment on these materials, since his subsidy was calculated not on a value-added basis but on the total value of the export. Excessive subsidization had at least two undesirable consequences. In the first place, it led to a vicious circle of self-perpetuating inefficiency because the existence of high-cost firms made the authorities hesistant to unify the multiple rate system for fear of causing bankruptcies and aggravating the unemployment problem. Secondly, the large subsidies induced exporters to cut prices to foreign buyers in cases where world demand for their exports was not infinitely elastic. The result is said to have been that Pakistan did not earn much more, and in some instances earned less, foreign exchange than it would have if exporters had sold raw materials in unprocessed form.

It appears that Pakistan’s invisible receipts, which, like exports, are highly price elastic, increased substantially during the years of the EBS, with the largest gains being achieved in the categories subject to- the most depreciated rates, for example, remittances. The precise extent of these increases is not known, however; owing to malpractices described in a later section, invisibles are probably overstated in the available statistics.

Imports

The rising earnings from exports and invisibles were offset by the strong upward trend in payments for imports which was due, at least partly, to the low average import rate. So far as individual groups of imports were concerned, the biggest increases were recorded in those subject to the official rate of exchange and only modest tariffs—in particular, capital goods. A lesser, though significant, increase was registered in raw material imports which were not as favorably treated in the exchange and trade system as the former group. On the other hand, imports of “nonessential” consumer goods and of items competing with domestic production were quite small, since they were strongly discouraged by high effective rates of exchange, tariff protection, and import prohibitions.

Foreign aid and private investment

The deficit on the above transactions (including certain payments for invisibles) was covered by the net inflow of grants and loans from the Pakistan Consortium and certain non-Consortium countries. However, toward the end of the 1960s, and even more so in later years, difficulties arose as this net inflow of foreign aid became increasingly inadequate owing to the rapid growth in Pakistan’s debt service obligations. In retrospect, it would seem that Pakistan might have been better off if it had forgone part of the assistance made available to it on relatively unfavorable terms, i.e., some supplier credits and loans tied to imports for which the sellers charged unduly high prices. In fact, the authorities took specific measures to ensure the utilization of such aid by applying the official rate to the most expensive tied imports and by using compensatory tariffs and quantitative restrictions to discourage similar imports from more competitive sources. It may be interesting to note that the alleged need to absorb tied imports was frequently invoked as an argument against eliminating the official rate and unifying the exchange system.

Over much of the period of the EBS Pakistan enjoyed political stability, encouraged private enterprise, and provided significant incentives for the foreign investor. Despite these favorable factors, foreign private investment was on a very small scale. It would be incorrect to attribute this to any single cause, but it seems reasonable to assume that Pakistan’s exchange and trade policies played a part. Overvaluation of a currency is a deterrent to foreign investment as are uncertainties resulting from frequent changes in effective exchange rates and import restrictions.

Allocation of resources

Failure to achieve balance of payments equilibrium was not the only instance of resource misallocation attributable to the foreign exchange system. With its very high bonus rate for imports, high tariffs, and import bans, the system favored import-substituting consumer goods industries even more than it did the export industries discussed earlier. In spite of comprehensive controls on new investment, this led to the establishment of industrial capacity ill-suited to the country’s resources endowment. Much of this capacity could not be utilized because of the country’s balance of payments difficulties and consequent limited ability to import necessary raw materials and spare parts.

Since capital goods imports were at the official rate and paid relatively low tariffs, the EBS fostered the adoption of a capital-intensive technology clearly inconsistent with efforts to eliminate Pakistan’s substantial unemployment and underemployment. At the same time, the scheme prevented the establishment of a domestic capital goods industry, prospects for which were considered promising by both Pakistani and foreign experts. Such an industry would have had to compete with low-priced goods imported at the official rate, while at the same time having to procure part of its raw materials abroad and pay for them at more depreciated import rates.

Imports by the Government itself were also subject to the official rate and, as a result, the cost of these imports in rupee terms appeared much lower than if a realistic rate had been applied. This probably led the authorities to spend more abroad than was desirable in view of the competing requirements of the private sector as well as of the overall economic and balance of payments situation.

Income and income distribution

Of considerable interest were the effects of the EBS on income and the distribution of income. The underutilization of capacity and the misallocation of resources mentioned above suggest that this scheme may have acted as an impediment to economic growth in both the short and the long run. The EBS also tended to aggravate existing inequalities in income and wealth inasmuch as it discouraged labor-intensive development and bestowed large profits on importers, who were able to secure import licenses and sell their goods at prevailing scarcity prices, manufacturers of subsidized export products, and producers of import-substituting goods granted excessive protection. In addition, economists in East Pakistan complained that the EBS subsidized exports from their province less than those from West Pakistan and thus intensified the disparity in per capita income between the two regions of the country.

Abuses

Overvaluation, multiple rates, and restrictions inevitably lead to evasions and malpractices. Abuses in the issuance of import licenses are said to have been widespread. There was an active black market in foreign exchange mainly fed by proceeds from illegal exports, remittances, and tourist receipts. The market financed travel expenditures and capital flight, which at times consisted of speculative outflows inspired by rumors of impending devaluation.

Smuggling was on a large scale. It was profitable to illegally export jute, cotton, and other primary export commodities subject to the official rate as well as a number of items distributed by the Government at subsidized prices. The proceeds were left outside the country by Pakistanis wishing to build up balances abroad, or repatriated and sold in the black market; another lucrative alternative was to import banned or restricted goods which commanded high scarcity prices on the domestic market.

Two other forms of evasion are worth noting. Exporters sometimes under-invoiced exports of primary goods in order to surrender at the official rate less than the full amount of their foreign exchange earnings. They repatriated the difference as remittances and thus received a more favorable exchange rate. In cases in which exports were granted not only the bonus subsidy but certain other incentives as well, it was profitable to fake an export transaction—i.e., declare a fictitious export—and surrender to the authorities foreign exchange purchased in the black market.

Better to devalue

That the EBS was introduced and maintained over a long period of time is understandable but this scheme does not, on balance, deserve high marks in an objective appraisal. Certainly, it may be credited with accelerating the development of industrial exports, though at a cost in terms of inefficiency and, perhaps, foreign exchange earnings forgone. On the other hand, while failing to correct the disequilibrium in the balance of payments, the scheme contributed to the misallocation of resources, tended to slow down economic growth, aggravated existing inequalities in the distribution of income, and led to various malpractices and evasions of government regulations. The EBS proved an unsatisfactory substitute for an appropriately executed outright devaluation and unification of the exchange system.

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