Textile Sector Of Pakistan: A Beneficiary Of Economic Distortions

A small but influential number of 'insiders' lobby for more favourable conditions to operate at the cost of a larger number of 'outsiders.' 

Textile Sector Of Pakistan: A Beneficiary Of Economic Distortions

The textile sector of Pakistan can be termed as a textbook case of having one distortion woven into another. An economic distortion introduced as an instrument of policy not only provide sthis sector with an advantage over other sectors, but also enables the bigger players of the textile sector to maximise their economic gains at the cost of smaller players.

One such distortion is the Duty Drawback of Taxes (DDT) - an ongoing export promotion policy of the Pakistani government primarily aimed at artificially supporting textile and apparel sector along with only a handful of products from leather, sports (mainly inflatable balls) and surgical goods sectors. DDT is a mechanism through which import duties levied on imported input products are refunded to the exporters. The refund is paid once the imported product (raw material or intermediary) is exported as a processed or finished good. 

A recent World Bank Study reveals that the product eligibility criteria under the DDT scheme are not aligned with the objectives of export growth or diversification.

According to the Ministry of Commerce’s SROs dated 18.10.2017 and 03.08.2018, DDT provides rebates to exporters only for a set of 'eligible' products with rates that vary between 2% (eligible products of processed fabric category), 3% (eligible products of made-up category), 4% (eligible products of garments category) and 7% (eligible products of leather and sports among others). 

Additional rates of up to 2% points are also available for exports reaching non-traditional destinations as enlisted in the above-referred SROs. Pakistan’s textile and apparel exports amount to around 60% of country’s total exports. 

According to the World Bank, the current DDT scheme in Pakistan, therefore, specifically applies to 54% of textile products which account for 78% of textile exports in terms of value. The scheme is subjected to specific conditions and targeted to specific products only. 

Thus, while the scheme is aimed at increasing exports, it also alters resource allocation in favour of some products and destinations rather than others creating a subset of distortions within the principal distortion of DDT itself.

A recent World Bank Study reveals that the product eligibility criteria under the DDT scheme are not aligned with the objectives of export growth or diversification. This is because those products eligible for rebates and those entitled to higher rebate rates tend to face relatively less dynamic global demand. For instance, for the period 2019–2020, the product eligibility for the rebate was not based upon the past export growth performance. 

Conversely, products not eligible for rebate within the textile sector of Pakistan have more dynamic global demand than the ones eligible for rebates or entitled to higher rebate rates under the said scheme. Besides, within eligible products for rebate, higher rebate rates are applied on less-sophisticated products. 

Finally, higher rates tend to target well established products within the textile sector and these are defined as products for which Pakistan already has a global presence and that are exported by many firms, discouraging entry into new export markets.

Moreover, those products eligible for higher rebates tend to be exported more over time and the ones with less or no eligibility are exported less creating another layer of distortion within the DDT. 

The World Bank study referred above betrays the idea that DDT schemes have induced an increase in exports of products eligible for the highest rebate rates, at the cost of non-eligible or lower-rate products. 

The DDT scheme was introduced in 2013 and up until 2015, Pakistan’s textile and garment export trends have been more or less cumulatively aligned with global exports. 

A small but influential number of 'insiders' lobby for more favourable conditions to operate at the cost of a larger number of 'outsiders'. 

However, paths started to diverge post 2015 with high-rate products, mostly garments, growing faster particularly from 2017. As a counterweight, the exports of low-rated and non-eligible products registered a decrease. The results suggest that largely, duty drawbacks incentivized strategic product choices, instead of encouraging overall exports.

There is more to it. The distortions are not always an outcome of a policy decision, but there is also a political economy dynamic attached to them characterized by insider-outsider model of development as put forth by the World Bank Study. 

A small but influential number of 'insiders' lobby for more favourable conditions to operate at the cost of a larger number of 'outsiders'. There are three determinants which provide considerable evidence that a product being eligible for DDT is an outcome of lobbying in the design of the schemes.

First, the products already being exported have an 80% higher chance of being eligible for DDT than the new products or those not yet being exported. It not only discourages diversification but also indicates the role of existing exporters (insiders) in lobbying for handouts keeping out potential exporters (outsiders). 

Second, if large textile exporters are exporting a particular product, the likelihood of the product to be eligible for DDT increases. 

Third, traditional textile products like garments tend to secure a larger portion of the allocated funds under DDT. Garment exporters account for about 27% of exports, but are eligible for 47% of these export subsidies i.e. 70% more than what would be expected with a random allocation of subsidies across products. 

In case of random allocation, products accounting for 27% of exports, would only be eligible for 27% of subsidies. Similarly, the top 20 largest exporters account for 19% of exports, and are eligible for 26% of subsidies.

What is the way forward? The government of Pakistan should aim for a policy revamp and start phasing out market distortive subsidies being doled out to the textile sector. In order to diversify Pakistan’s exports, there should in fact be a policy shift away from the sectors being subsidised by the government. The premise is simple. Whoever is competitive will stay in the market.

Over the last 75 years, despite various textile-heavy government subsidies and related exemptions, the sector has only been able to export a few textile and apparel products to a handful of destinations. 

Moreover, around 97% of Pakistan’s textile exports are cotton-based products with synthetic and wool-based products comprise a meagre 3% of exports. Global clothing demand has long shifted away from cotton-based textile and garment to synthetic fibre-based exports and that market size is ever growing. This implies that Pakistan’s textile exports are trying to capture a larger share of a dying market.

 Pakistan may consider bonded warehousing option which can be an alternative to DDT.

Furthermore, as per State Bank of Pakistan’s (SBP) figures, only two products on a four digit HS (Harmonized System) level 6302 (Bed Linen, Table Linen, Toilet Linen and Kitchen Linen), all extremely low value-added products, and 6203 (Suits, ensembles, jackets, blazers, trousers, bib and brace overalls, breeches and shorts (other than swimwear); men's or boys' (not knitted or crocheted)) make up around a whopping 45% (USD 7.5 billion) of total textile exports of Pakistan which shows that how concentrated Pakistan’s textile and apparel exports are. 

In addition, Pakistan may consider bonded warehousing option which can be an alternative to DDT. The imported input products can also be stored duty free or at preferential rates in bonded warehouses, where they can then be processed ready for export. 

It was bonded warehouse facilities which, inter alia, catapulted Bangladesh’s readymade garment export in 1980s and making it the world’s second largest garment exporter after China at present. By following this option, the negative repercussions associated with the DDT scheme namely market distortion, corruption and personal gain, discrimination against non-exporting processing industries and lower government revenues can be warded off. 

Finally, if at all, a DDT-like scheme continues to go on, it must be reformed. According to the above-mentioned World Bank Study, It should be reformed first by broadening the eligibility, second by reducing the average subsidy rate and third by conditioning the subsidies on export growth at the firm level. 

Under the current structure, export subsidies target traditional, well-established, and low-sophisticated products, and are biased in favour of larger firms that are more likely to obtain the subsidy than smaller firms that are also eligible. This induces a disincentive to diversify the export bundle, or increase product sophistication. Additionally, it also creates an incentive to misreport export consignments to secure high rates. 

The DDT schemes would have a greater impact if the incentive was 100% conditioned on export growth relative to the previous period, automatically making new exporters eligible, irrespective of which product they exported. This flexibility will also help exporters in light of the constant changes in global demand they face.