Trade reforms, incentives on ground and firm performance in Ghana

33735 Regional Program on Enterprise Development Discussion Papers Trade Reforms, Incentives on Ground and Firm Performance in Ghana Tyler Biggs and Manju Shah RPED Paper No. 105 July 1997 The views and interpretations expressed in this study are solely those of the authors. They do not necessarily represent the views of the World Bank or its member countries and should not be attributed to the World Bank or its affiliated organizations  Ghana was one of the first African countries to initiate an IMF/World Bank- sponsored structural adjustment program. In 1983, the Government of Ghana (GOG) introduced its Economic Recovery Program after almost a decade of economic decline. The reform program encompassed both a stabilization program, designed to reduce inflation and achieve external balance, and an adjustment program, aimed at achieving higher rates of growth via a restructuring of economic incentives, export promotion and rehabilitation of infrastructure. The Recovery Program was phased over a number of years, with most of the reforms completed by the late 1980s. While growth rates in Ghana have picked up as a result of these reforms -- averaging about 5 percent real growth in GDP since 1988 -- the expected dramatic increases in exports and in local and foreign investment have yet to materialize. Two explanations have been put forth to account for this limited trade and investment response. The first thesis is that the reforms may not have gone far enough or deep enough to change the structure of incentives on the "ground" sufficiently to elicit a significant response. It might be that the reforms themselves were not sufficient or that the impact of the reforms have been muted by policy-imposed distortions in other areas -- for example, in the regulatory regime -- or by mid-level government bureaucrats not performing their jobs efficiently. The second working hypothesis assumes that incentives have changed sufficiently, but questions whether firms are able to respond, either because they do not have the necessary human or financial capital to do so, or because they are constrained by the institutional environment and poor infrastructure, or both. This study examines the first of these explanations; namely, whether or not, in the wake of government reforms, incentives on the ground have actually changed and by how much. A limited analysis is also made of firm responses to the incentive changes induced by the reforms. Unfortunately, without data on firms before and after the reforms, it is difficult to assess accurately the extent and direction of firm response. We begin the investigation with a review of the government's trade policy reform program. Ghana's Trade Policy Reforms* * This section is based on information from Chapter 6 of the "Trade and Exchange Rate Policy Study: The Case of Ghana" by Gabriel Castillo, 1995, and from World Bank Ghana Industrial Sector Review, 1985.  The process of trade reform in Ghana, which began with the Economic Recovery Program in 1983, took the better part of a decade to complete. During this period, the government radically devalued the currency and made significant changes in commercial policy. Reportedly, Ghana shifted from being one of the most inward-oriented countries in Africa, and perhaps the world, to one of the continent's most liberal trading regimes. The Exchange Rate The single most important problem in restoring economic balance at the start of Ghana's Economic Recovery Program was the grossly overvalued exchange rate. World Bank estimates in 1982 put the parallel market premium at 2100 percent. As Figure 1 indicates, it took government policy makers almost a decade to move from this highly overvalued fixed rate to a fully convertible floating currency. The movement of the parallel market premium in Figure 1 traces out the three phases of liberalization over the period. Phase one consisted of a maxi-devaluation in 1983, followed by frequent small adjustments over the next few years. Over this period, the government allocated foreign exchange via a system of licenses. By 1986, the exchange rate had adjusted significantly toward its equilibrium level, but government rationing of foreign exchange continued to produce a parallel market premium of about 100 percent. In addition, rent-seeking and shortages of critical imports continued to plague the economy In the second phase of the exchange rate reform, government shifted to an auction system, coupled with a fixed rate allocation, for official transactions. This dual rate system began operating at the end of 1986 and lasted several months until government unified both rates in early 1987. In effect, the auction system devalued the currency by a further 67 percent, But, in spite of the auction, a gap still remained between the official rate and the parallel market rate. -- 2 --  Figure 1 Parallel Market Premium -- PMP (Percent) and Real Exchange Rate -- Cedis/USD (1983-86 = 100) 420 390 PMP 360 1981 =877 1982=2,142 330 1983=768 300 RER 270 240 210 Index 180 150 120 90 60 30 PMP 0 1975 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 Year Source: World Bank (1996). African Development Indicators. Washington, DC. In the final phase of liberalization in 1988 and 1989, the buying and selling of foreign exchange was shifted to private forex bureaus and to banks. As a result, over the next few years, the parallel market premium virtually disappeared by 1991. In the end, Ghana's gradualist approach succeeded in attaining a fully liberalized foreign exchange system, a substantial real depreciation of the currency, and the elimination of the parallel market premium. Today, the liberalized exchange rate system continues. Commercial Policy At the start of the Government's Economic Recovery Program, both price and quantity measures were used to control trade. Price measures ranged from import tariffs to "special" taxes and "super sales" taxes, quantity measures included quantitative restrictions based on import licenses, bans on certain goods, as well as exchange controls. -- 3 --  The licensing system and exchange controls were governed by the Ministry of Trade's positive list, which specified the items allowed to be imported. Two types of licenses were issued based on this list -- specific licenses and special licenses. Specific licenses could be funded by foreign exchange at the Bank of Ghana at the official rate, while special licenses could only be financed through the parallel market. Thus, by 1983, goods imported via a special license were burdened by the extra cost of the parallel market premium of 2100 percent. Reform of this system of trade restrictions occurred gradually over the next seven years. The first cautious steps in reform were taken at the time of the maxi-devaluation in 1983. Tariffs were reduced and unified into three groups -- the new rates were 25 percent on raw materials, 30 percent on capital goods, and 20 to 30 percent on basic consumer goods and luxuries, respectively. However, a complex array of differential excise and sales taxes, exemptions and quotas still remained, which made effective rates of protection much higher than implied by these new nominal tariff rates. In parallel with the tariff reforms, a few quantitative restrictions were also lifted and replaced by equivalent tariffs. These first steps in commercial trade policy reform really only scratched the surface of the complex array of protective instruments, and had very little impact on the level of protection. It was not until the end of 1986 that additional reform initiatives were introduced. After a good deal of political in-fighting, the Ministry of Trade was forced to reorganize and the government streamlined the special import licensing program by replacing the positive list with a much shorter negative list. All goods not listed could be imported freely. Importers, even those dealing in consumer goods, were automatically granted licenses. Just about any product could be imported provided that the parallel market supplied the foreign exchange, which at the time placed an additional cost on imports due to the premium of about 46 percent. Over the next few years, a series of steps were taken to eliminate the implicit foreign exchange tax on imports under the special license program. First, imports of producer goods, raw materials, spares and capital goods were given automatic licenses and foreign exchange for their importation was allowed to be obtained from the central bank's foreign exchange auction. Next, more consumer goods were deleted from the -- 4 --  negative list. Shortly thereafter, in 1988, virtually all imported goods, with the exception of a short list of luxury items, became eligible for foreign exchange funding at the Bank of Ghana's auction. Finally, in 1989, the import licensing program was abolished and exchange control via the licensing system disappeared. In response to loud complaints from businesses hurt by the surge in imports under this new trade regime, the government began to backslide somewhat on the reforms over the next year. "Super sales" taxes of 75 to 500 percent were imposed primarily on imported products. In 1990, these taxes were lowered to 10 to 100 percent after much pressure from the donor community. In 1991, the taxes were dropped and sales and excise taxes across comparable imported and domestic products were unified. A new structure of nominal tariffs was also introduced in 1990, reducing the rates to 10 percent for raw materials, 10 percent for capital goods, and 20 percent for consumer goods (see Table 1). Some items, like agricultural imports and petroleum products were exempted from tariffs. Table 1 Import Tariffs, 1983