The irony of private sector involvement in infrastructure sector in SSA

Kate Bayliss finds that by encouraging private sector involvement (by reducing their risk exposure) in utility provision in Sub-Saharan Africa, risks are simply transferred to governments, taxpayers, and end-users. Private sector is supposed to bet on risks, make smart investment and profit from it. However, it seems that the private sector engagement in utility provision in the developing countries is leading to a situation where benefits are reaped by them while risks are being heaped upon consumers and taxpayers.

a plethora of donor initiatives have emerged with the aim of bringing private investment into the region, and these too focus on reducing risk for the private sector. As a result, on offer to the private sector are the least challenging and most lucrative aspects of delivery, which are tightly ring-fenced and bound by guarantees. In industrialised economies, discussions of the merits of PSP highlight the importance of transferring risk to the private sector in order to generate efficiency gains. In contrast, as regards attracting PSP into utilities in SSA, the focus is on reducing the risk to which the private sector is exposed. But this risk is not reduced, it is transferred. As a result, African governments, taxpayers and end-users bear high levels of risk in order to accommodate the priorities of investors.

A review of the Nepali economy under the Maoist-led administration

In the last day of his role as prime minister, the Maoist premier Prachanda claimed that his administration gave “utmost importance to economic transformation” and made “major contribution to economic revolution”. Unlike his boss, former Finance Minister Dr. Baburam Bhattarai was a bit modest in laying claims about economic progress achieved under his leadership. In assessing the economic policies and progress under the Maoist administration, it is unclear how the dismal performance, especially in encouraging private sector and utilizing development expenditures, amounts to or leads to “economic revolution”.

The most successful and significant achievement of the previous administration was to ensure governance and accountability in revenue collection, which increased by 40 percent in the first ten months of the current fiscal year, for which credit goes to Dr. Bhattarai’s policies on taxation. Given the institutional intransience for good governance at customs and government agencies, many people, including myself, were skeptical about revenue targets of Dr. Bhattarai, who, with good leadership and ‘carrot and stick’ approach, was able to beat all pessimistic expectations. Under his leadership, the Inland Revenue Department was more vigilant than ever in curbing leakages, streamlined and cleaned up the mess in the department, and offered extra incentives to customs personnel for better performance.

The other commendable policies initiated by Dr. Bhattarai were loan waiver of heavily indebted farmers and the Youth Self-Employment Program (YSEP). These programs were well-intentioned but the execution was not all that clear. Overall, the huge demand for loans by youths and partial relief received by some of the poorest farmers was worth the policy experimentation.

Not all the program and policies of the previous administration were productive. The drive for more revenue generation and implementation of VDIS led to savings flight as nervous investors and savers searched for safer vaults abroad. While this policy was unpopular in the business community, the government, instead of trying to find a common path, wasted more than three months going head-on-head against the businessmen, whom it saw as “feudalist and bourgeois classes”. At a time when there was a desperate need for normalization of tension between the private sector and the government, this incident led to souring of relationship and fostered distrust between the two.

Fond of making bombastic, populist and unrealistic claims and a tendency to look backwards in the age of globalization, the Maoists government miserably failed in convincing the private sector, foreign investors, and development agencies that their Marxist/socialist model was worth trying. Filled with pompous slogans, socialist ideas and the aim to develop “national capitalism”, Dr. Bhattarai’s budget was not well received by the private sector. They, along with the development agencies, repeatedly asked him to be clear about government’s position on the role of private sector and in general the economic system. Trying to treat private sector and cooperatives in equal footing by bringing Investment Board and Cooperative Board under the Economic Council was probably the most dubious plan. Instead of streamlining of disaggregated economic activities, it led to more chaos and confusion in the industrial sector. Also, the plan to revive moribund, sick industries with the aim of increasing employment and channeling their production for government’s use was a blunder. The drumbeat of double-digit growth rate without assessing ground realities and workable economic policies perplexed people.

The most devastating and counterproductive policies were to let YCL make a mockery of contract enforcement, destabilize the already feeble industrial sector, and turn a deaf ear to dire call for industrial security. By implicitly supporting the activities of its militant cadres, the Maoist administration showed double standards in dealing with the private sector. Some of the Maoist ministers even endorsed and defended the extralegal occupation of industrial districts by YCL cadres, forced donation campaign, and threat to life and property of businessmen, whom they see as ‘feudalists’. The government engaged in multiple rounds of discussion with businessmen but did not budge on the call for disciplining YCL cadres and taming disruptive activities of trade unions. This led to closure of several garment firms, jute mills, and multinational companies, among others. The Maoists administration backtracked only after it was threatened of noncooperation by the opposition parties; it was not because it was responding to the concerns of the private sector.

Later on, the Maoist government was busy cleaning its own mess. Too focused on controlling and finding a way out for its disruptive cadres, it was helpless in supplying the most needed essential services in rural areas. For instance, it was powerless when more than one-third of the population was under the threat of starvation at the height of the global rise in price of food and commodities, and when major forests were on fire. Moreover, the government also did not do enough to manage safe return of IDPs.

With regards to macroeconomic management, the administration’s performance was very disappointing. The price level initially rose above 14 percent due to rise in food, fuel and commodity prices in the global market. However, as prices of these items declined globally, they were too sticky in the Nepali market, leading to inflation rate of above 10 percent. The government was unable to manage shortage of goods, which was created artificially by holding back inventories. The export sector continued to lose its grip in international market and trade deficit is rising. The supply of fuel was severely affected due to frequent closure of the main highway linking the Valley and Terai. The government had to bail out cash-strapped, debt-ridden NOC two times. Still, the nation lacks a plan to close big hole in NOC’s balance sheet. On top of that, there is no immediate plan to bridge the wedge (of 500 MW) between demand for and supply of electricity in the economy. Worse, domestic and foreign investors are not yet convinced of secure investment, rule of law, and respect for property rights in the infrastructure and hydropower sectors.

The Maoists also failed to mobilize development expenditure, leading to very few development programs being implemented—a point even Dr. Bhattarai has conceded. So far, only 27 percent of total capital expenditure has been spent. Meanwhile, achieving the targeted economic growth rate is now a fairy tale!

The economy is far from being transformed. There were some successes in revenue collection and welfare programs. However, there were even more problems-- industrial relations deteriorated, allocated development money remained unspent, investors and donors remained skeptical of Maoists policies, price level spiraled upwards, and there was a severe shortage of energy, which further crippled the industrial sector, among others.

Links of Interest (05/27/2009)

From manufacturing to services to land in developing countries now (to ensure smooth food supply to rich countries’ consumers!)

Dambisa Moyo and Easterly respond to Sachs’s ironies

Serving the poor through (subsidized) markets

New database on nutritional impact

US trade policy for development: further open up markets to exports from poor countries

Feeble domestic demand is a dragging down EU markets

Need to think about the upcoming debt crisis in 2015

In this One Page, Paul Ladd argues that it is time to think about restructuring debt that the developing countries will owe to the international financial institutions as they will be forced to borrow money, due to the global financial crisis, to meet domestic development expenditure. Putting an international mechanism in place for sovereign debt restructuring now will help avoid situations the culminated to multiple rounds of debt reliefs such as HIPC and MDRI in the past.

If developing-country debt problems come to a head once again—including because of how the international community is responding to the current economic crisis—we will need a new way of addressing the problem. A second round of debt relief schemes based on creditor largesse will lack credibility. The scene is set once again for an idea that almost reached fruition in 2003, albeit in an imperfect form. An international mechanism for sovereign debt restructuring, which includes provisions for temporary moratoria on debt servicing, could provide a better means of restructuring unpayable debts in a way that is fairer, more transparent and more efficient for the creditors, the indebted country, and its population.

To be effective and comprehensive, however, any such arbitration mechanism would need to cover the claims of the World Bank and IMF. These are not covered by the recent introduction of “collective action clauses” in sovereign bonds.

The time to put in place such a mechanism is before a new debt crisis emerges, not when the waters start to get choppier. Otherwise, 2015 may be remembered as the year that a new debt crisis emerged, rather than the year in which we celebrate achieving the MDGs.

The scourge of poverty

This news is very disturbing:

Jashuli Bista, 26, who was living an impoverished life in Sunkada VDC of the district on Friday, killed her daughters, four-year-old Ramkala and eight-month-old Ramita, before she hanged herself to death.

Bista had been raising her daughters all alone as her husband Min Bahadur Bishta had gone to India for work.

This story is also very troubling. A woman is stripped naked and beaten up by a group of stupid men in the middle of Kathmandu.

Sachs’ take on Moyo and Easterly

Sachs has finally responded to Dambisa Moyo’s new book Dead Aid, where she basically follows on Easterly’s line of argument that aid is hurting Africa more than it is helping them.

The debate about foreign aid has become farcical. The big opponents of aid today are Dambisa Moyo, an African-born economist who reportedly received scholarships so that she could go to Harvard and Oxford but sees nothing wrong with denying $10 in aid to an African child for an anti-malaria bed net. Her colleague in opposing aid, Bill Easterly, received large-scale government support from the National Science Foundation for his own graduate training.

I certainly don't begrudge any of them the help that they got. Far from it. I believe in this kind of help. And I'd find Moyo's views cruel and mistaken even she did not get the scholarships that have been reported (Easterly mentioned his receipt of NSF support in the same book in which he denounces aid). I begrudge them trying to pull up the ladder for those still left behind. Before peddling their simplistic concoction of free markets and self-help, they and we should think about the realities of life, in which all of us need help at some time or other and in countless ways, and even more importantly we should think about the life-and-death consequences for impoverished people who are denied that help.

Recently Paul Kagame, President of Rwanda, wrote an op-ed for the Financial Times praising Moyo's fresh thinking. This is extraordinary. His government has depended on aid for more than a decade. Nearly half the budget revenues currently come from aid. Rwanda currently imports around $800 million of merchandise each year, but only earns $250 million or so in exports. So how does it do it? Aid, of course, helped to pay for around $450 million of the imports. Without foreign aid, Rwanda's pathbreaking public health successes and strong current economic growth would collapse. Kagame's op-ed did not help FT readers to understand this.

At some level, the works of Sachs and Easterly (and Moyo) are more ideological than practical (I think Sachs is little bit more practical!). Easterly is in an all out war with economists who favor some form of government intervention and industrial policy (such as Sachs, Rodrik, and Collier). Easterly’s work is more in line with Hayek’s and free-market views and Sachs’ is more interventionist. These two are reviving the 1940’s back-and-forth argument between Hayek and Keynes (and later followed by Hayek and Samuelson) and applying them in the development field. And now we know who was right in the epic ideological battle between the centrists and the rightists.

Interesting number

The number of births in a year in India = the total population of Nepal = 27 million

This is probably the most pessimistic (but realistic) description of India:

INDIA is a land of bright promise. It is also extremely poor. About 27m Indians will be born this year. Unless things improve, almost 2m of them will die before the next general election. Of the children who survive, more than 40% will be physically stunted by malnutrition. Most will enroll in a school, but they cannot count on their teachers showing up. After five years of classes, less than 60% will be able to read a short story and more than 60% will still be stumped by simple arithmetic.

Is it time for the death of Chinese growth model?

Michael Pettis argues that the fiscal stimulus enacted in the Asian economies, particularly China which is providing a “steroid-fuelled” growth, will potentially boost growth in the short term but their growth model is not sustainable.

One of the consequences of the Asian development model has been that production outgrew consumption for decades. When a country produces more than it consumes, it must run a trade surplus to export its excess capacity. The Asian model consequently required high and rising trade surpluses that allowed Asian producers to produce far in excess of what Asian consumers could afford to absorb.

But there cannot be trade surpluses without trade deficits elsewhere. A fundamental requirement for the Asian model was that foreigners were able to run the requisite trade deficits. In practice, only the US economy and financial system were large and flexible enough to play this role. The Asian model, in other words, implicitly involved a massive bet on the willingness and ability of the US to continue to run large and rising trade deficits.

The assumption that implicitly underlay the Asian development model – that US households had an infinite ability to borrow and spend – has been shown to be false. This spells the end of this model as an engine of growth. The sooner Asian policymakers accept this and force through the necessary economic and political changes, the less painful the transition will be. Unfortunately this does not seem to be happening.

Many Asian nations are using fiscal stimulus to prop up export-based sectors. Is exports-based growth model still the answer to higher GDP per capita in developing and emerging nations? As the main buyers (US and the EU) are cutting back consumption expenditure and the governments ‘required’ to maintain fiscal balance down the road (deficits can’t go forever), will the exports-based growth obsessed nations find customers to buy their goods and services? Also, will domestic demand in the developing countries be strong enough to prop up GDP growth rate? Is the exports-based growth model still relevant for the low income countries? And, is the model nearing death for emerging nations? Interesting questions that need answers!

Here is Szirmai arguing that the manufacturing sector still matters for growth and catch up in the developing countries.

Manufacturing sector and growth

According to Szirmai, the manufacturing sector still matters for growth and catch up in the developing countries because of the following reasons:

• First, there is an empirical correlation between the degree of industrialisation and per capita income in developing countries.
• Second, productivity is higher in the manufacturing sector than in the agricultural sector.
• Third, a further aspect of the structural change bonus argument focuses on the dynamics of sectors. Manufacturing is assumed to be more dynamic than other sectors. A transfer of productive resources to more dynamic sectors contributes to growth.
• Fourth, the transfer of resources from manufacturing to services provides a structural change burden in the form of Baumol’s disease.
• Fifth, compared to agriculture, the argument runs that the manufacturing sector offers special opportunities for capital accumulation.Capital accumulation can be more easily realised in spatially concentrated manufacturing than in spatially dispersed agriculture. This is one of the reasons why the emergence of manufacturing has been so important in growth and development.
• Six, the manufacturing sector offers special opportunities for economies of scale, which are less available in agriculture or services.
• Seven, the manufacturing sector offers special opportunities for both embodied and disembodied technological progress.
• Eight, linkage and spillover effects are stronger for manufacturing than for agriculture or mining. Linkage effects refer to the direct backward and forward linkages between different sectors.
• Finally, as per capita incomes rise, the share of agricultural expenditure in total expenditure declines and the share of expenditure on manufactured goods increases (Engel’s law).

That said, he argues that the role of manufacturing sector on growth is weakening, especially in the industrialized nations. The strongest contributions are found in the period 1950-1973, when there were special opportunities for absorption of mass production techniques by developing countries. In the advanced economies, the role of services has become much more important.

Financial crisis and the academic economics

Here is a critical assessment of the stuff we learn in econ in light of the financial crisis.

The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession. Over the past three decades, economists have largely developed and come to rely on models that disregard key factors—including heterogeneity of decision rules, revisions of forecasting strategies, and changes in the social context—that drive outcomes in asset and other markets. It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, “systemic crisis” appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession.

This failure has deep methodological roots. The often heard definition of economics—that it is concerned with the ‘allocation of scarce resources’—is short-sighted and misleading. It reduces economics to the study of optimal decisions in well-specified choice problems. Such research generally loses track of the inherent dynamics of economic systems and the instability that accompanies its complex dynamics. Without an adequate understanding of these processes, one is likely to miss the major factors that influence the economic sphere of our societies.3 The inadequate definition of economics often leads researchers to disregard questions about the coordination of actors and the possibility of coordination failures. Indeed, analysis of these issues would require a different type of mathematics than that which is generally used now by many prominent economic models.

We believe that economics has been trapped in a sub-optimal equilibrium in which much of its research efforts are not directed towards the most prevalent needs of society. Paradoxically self-reinforcing feedback effects within the profession may have led to the dominance of a paradigm that has no solid methodological basis and whose empirical performance is, to say the least, modest.

They argue that economists have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. And, this time they failed to do just that. They argue that there was some sort of “academic moral hazard”. Also, Rodrik argues that the failure has to do more with ideology-wrapped economists than economics itself. See this one about economics crisis under heterogeneity as well.

Growth diagnostics of the Nepali economy

These are a collection of blog posts related to growth diagnostics of the Nepali economy, which I finished in April 2009. I will post a link to the full paper later.

Nepal’s growth story:

1. What’s holding back growth in Nepal?
2. Reality about Nepal’s GDP growth rate
3. Five decades of Nepal’s growth story
4. Nepal’s export dynamics

Binding constraints:

1. Bad infrastructure as the most binding constraint on economic activity in Nepal
2. The state of corruption in Nepal

Incompatible constraints:

1. Macroeconomic stability and macroeconomic risks in Nepal
2. Property rights
3. Education (human resources) sector in Nepal
4. Is “self-discovery” an issue in the Nepali economy?
5. What about coordination externalities? [Product space, comparative advantage and Nepal’s export sector]
6. Labor and business regulations in Nepal
7. Taxes, revenues and expenditures in South Asia
8. Cost of finance in Nepal (Bad international finance, Low domestic savings, and Poor intermediation)

Policy implications:

1. Policy implications of growth diagnostics of the Nepalese economy
2. Growth strategies for Nepal

Policy implications of growth diagnostics of Nepali economy

This blog post is related to earlier posts, where I discuss the constraints on economic activity in the Nepali economy. These policy implications are related to the growth diagnostics of the Nepalese economy, a paper I finished writing on April. Also, see this column and this blog post.

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This growth diagnostics exercise indicates that Nepal has failed to attain a high and sustained growth rate mainly due to poor performance in the exports sector. GDP growth rate below 2.5% is sustained primarily by favorable output in the agricultural sector, caused chiefly due to favorable climate. However, sustained growth rate above 2.5% is determined by the export sector, whose performance is dependent on prices prevalent in the international market. Since 1997, exports as a percentage of GDP are declining due to lack of price competitiveness in the international market and domestic supply bottlenecks. Worse, the export sector has few ‘nearby’ products to shift productive activities to in the case of unfavorable international price shock.

The economy has not been able to upgrade its productive activities due low proximity in sectors other than the garment and textile industries, where the existing capacity has already been exhausted. There are no nearby products to move in to in the agricultural sector even though some of the products in this sector are being exported with comparative advantage. There is some scope in the manufacturing of small machinery and electricity circuits industry. The question is: why is the manufacturing sector not able to produce these goods despite a potential for production of exportable items with comparative advantage?

As the above analysis shows, the main constraint behind the growth of the most important sectors in the economy lies in deficient supply of transport infrastructure and a lack of appropriability due to microeconomic risks such as corruption. These are dragging down the pace of structural transformation in the economy. Considering the effect of relaxation of these two constraints on economic activity in the short term, it is argued that relaxing bad infrastructure constraint would produce bigger change in the objective function (i.e. growth rate) than relaxation of corruption, which is an institutional matter and takes a long time to change this constraint.

Using the logic of practicability in the short term, bad infrastructure was identified as the most binding constraint on growth. To make this assertion, other constraints such as microeconomic risks, macroeconomic risks, cost of finance, human capital, and poor geography were shown as nonbinding constraints (or not as strong as bad infrastructure and corruption) on growth.

Nepali economic reform has to focus on relaxing the most binding constraints to produce the biggest effect on growth in the short term. However, this does not mean that other constraints are not important. The sequencing of reforms has to be done in such a way that relaxation of the two identified constraints should be on the high priority list, at least in the short term.

High tariff rates and transportation costs are eroding competitiveness of products produced by the industrial and agricultural sector. Apart from the deficient supply of roads transport, the country is reeling under an acute shortage of electricity. At present, there are over 15 hours of power cuts. Lack of energy is contributing to loss of productivity in the existing manufacturing industries. The current environment is one where the only activities that can survive have to be un-intensive in infrastructure (both transport and electricity). This means that the government should invest heavily on roads and air transports, hydroelectricity, and communication sectors.

Relaxation of the infrastructure constraint has to be done systematically keeping in mind three key issues: (i) the composition of infrastructure investments (new investments or maintenance; public or private investment; operational or capital expenditures), (ii) sequencing (marked based reforms such as privatization, introduction of competition and regulatory innovations), and (iii) the relevance of different sub-sectors. Lower than optimal levels of maintenance expenditures will result in higher operation costs for private capital goods that depend on infrastructure and for running such infrastructure facilities.

While devoting resources to relax the most binding constraint on growth (i.e. bad infrastructure), the government also has to make sure that the economy is equipped with the necessary conditions to convince investors of profitable investment. This means other strong constraints such as corruption and labor regulations are duly taken care of. A stringent action on governance reform is needed along with relaxation of labor market rigidities to propel private investment in the infrastructure and other productive sectors.

The government should engage in public private partnership and let foreign investors invest in the infrastructure sector under the Build-Own-Operate- Transfer (BOOT) provision. Similarly, it should also offer tax incentives to private and foreign investors in hydroelectricity investment. Designing policies to channel remittances inflows into the hydroelectricity sector might also be fruitful in relaxing this constraint in the short term.

There is a need to strengthen the regulatory regime and reform the existing labor regulations. The Commission for Investigation of Abuse of Authority (CIAA), the administrative regulatory watchdog, should be bestowed with more independence, funding, and authority. Moreover, the labor regulations, especially hiring and firing provisions should be made business friendly. The absence of connectivity and weak regulatory structure have been preventing industrial transformation to more productive activities, i.e. exploitation of ‘nearby’ machinery and electricity products, which could be exported with comparative advantage, is not occurring.

The government alone cannot relax the constraints- the private sector needs to get on board in this process. Here the issue is not about whether the government should intervene or let the private sector flow in its own spirit. The real issue is: what would help relax the constraints in the immediate term so that growth can be sustained in the medium and long term? Without the private sector, the government will not do a good job in identifying what needs fixing within the infrastructure sector and regulatory structure.

On the other hand, without the government the private sector will also not be willing to incur huge overhead costs associated with investment in infrastructure. Similarly, it alone cannot solve the myriad labor issues that are bedeviling the industrial sector right now. The government is in a position to build missing forward and backward linkages for the industrial sector. It can be done through the establishment of special economic zones (SEZ), garment procession zones (GPZ) and one-window-policy for all business transactions.

As argued earlier, though this analysis identifies the two constraints as the most binding on growth for immediate and medium term, it should not be interpreted that other factors like macroeconomic issues are trivial. Though the prevailing inflation rate does not pose as the strongest constraint right now, it will nevertheless be damaging if it spirals up in the coming years. Similarly, the economy might be in short supply of human resources if it grows above 5% for more than five consecutive years.

It might be hard to bridge the gap between domestic demand for and supply of human resources by importing skilled workforce from India because the Indian economy itself will be absorbing more of them in the coming years, provided that their economy grows at the current rate of over 7%- which is a likely scenario. Similarly, the rising population growth rate might pose as a debilitating factor in dragging down the growth rate of GDP per capita in the coming years. The obscure economic policies of the Maoists, who are the governing party right now, regarding the role of the private sector might scare away domestic and foreign investors. Note that the issues discussed here are not comprehensive and are just a cautionary note.

In short, Nepal’s export sector has huge potential for growth if the two binding constraints- bad infrastructure and corruption- are relaxed in the immediate term. It will not only allow structural transformation but also create new opportunities for the industrial sector to produce products that are competitive in the international market, which could help sustain growth rate above 5%. To attain a double-digit growth rate, it is very important to relax the most binding constraint—bad infrastructure. Attracting new investment in road and air transport infrastructure can be done by relaxing some of the business and labor regulatory issues.

Making the most out of this opportunity is the key to sustained growth in Nepal. Quick relaxation of these constraints could lead to acceleration of the rate of shift to productive activities in the agricultural sector, which already has products that are exported with comparative advantage, and the machinery industry, which is a promising one given the existence of high proximity between products in this sector. Tapping these opportunities and letting the promising sectors flourish seems key to high and sustained economic growth in Nepal. This can be done by relaxing the most binding constraints, which will produce the biggest bang for a reform buck in the immediate term.

Property rights protection in Nepal

This a part of a series of analysis on growth diagnostics of the Nepalese economy. For discussion of a set of constraints on economic activity in Nepal see this post. Also, see this column and this blog post.

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Nepal’s standing on protection of property rights and rule of law index are satisfactory but they are still not up to the standard to clear doubts and uncertainty from potential investors and entrepreneurs. The CPIA property rights and rules based governance rating for Nepal is not that encouraging for an economy that is aspiring to grow at a double-digit growth rate, which never happened in the past five decades. Frequent encroachment on business property and establishment of extralegal camps on industrial complex by politically affiliated youth wings and unions have scared investors.

Figure 1

Its rating on property rights and rules based governance is 3, which is the median score. Based on this index, Nepal compares favorably with other countries that have similar per capita income. Though protection of property rights might not necessarily be a strong constraint at present, a lack of improvement in this front might scare away potential investors who do not what to assume too much risk. To attract more FDI and encourage domestic entrepreneurs, Nepal has to have a score well above 4.

In the rule of law front, Nepal’s standing is discouraging. In terms of enforcing rule of law, 71% of the countries rate better than Nepal. Only 29% of the countries have worse rule and law situation than Nepal.

Figure 2

Source: World Governance Indicators 1996-2007

The rule of law in Nepal deteriorated since 1996, the year when the Maoists started an armed rebellion. After a decade of civil war and finally an end to rebellion in 2006, there was a slight improvement in the rule of law. However, the complication generated by youth wings and trade unions and eruption of fresh violence in the Terai region led to deterioration of the rule of law. Though this seems to be a concerning factor, it still is not the binding constraint.

Since it is not strong enough yet to deter investment and dampen entrepreneurial activity, property rights cannot be the binding constraint on economic activity.

Is self-discovery an issue in the Nepali economy?

This post should be viewed in relation with other blog posts on growth diagnostics of the Nepalese economy. It a part of a series of analysis on growth diagnostics of the Nepalese economy. For discussion of a set of constraints on economic activity in Nepal see this post. Also, see this column and this blog post.

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Low appropriability arising from market failures such as information externalities/“self-discovery” could potentially be a factor constraining growth[1]. Markets in an economy might fail to discovery or shift to new productive activities despite strong price signals such as loss of price competitiveness in the international market or unfavorable terms of trade. A lack of self-discovery arises if countries fail to follow price signals and shift production of goods and services accordingly. For instance, a shock in international prices of primary export items of a country should serve as price signal to public and private sectors that it now needs to shift production to more favorable goods and services, which potentially could be exported with comparative advantage.

In the case of Nepal, the terms of trade is declining since 2000. This price signal has failed to induce entrepreneurs to shift to new productive activities. The list of top five primary export items[2] has hardly changed since the downward fall in TOT. Could this be a sign of a lack of self-discovery? This should be seen in the light of the availability of infrastructure in the country because shift to new productive activities might itself be hindered by the lack of basic infrastructure that would help reduce transportation and transaction costs. This means that self-discovery itself could be a function of the available basic infrastructures like road and transports, communication and electricity. This is what seems to be the case with Nepal’s inability to discover and shift to new productive activities.

Even if new comparatively advantageous goods and services are discovered, they might not make it to the market due to lack of basic infrastructure. This means that if a country already has a stock of high-value exportable goods and services relative to its income level[3], the case for lack of self-discovery might be weak. It is not that Nepal does not have high-value exportable goods and services. The irony is that despite having high-value goods, they hardly make it to the international market. For instance, yarsagumba[4], a high-value herb and medicinal plant found at high altitudes, is hardly exported to markets where its final price is high. Why is this the case? It is because of the lack of infrastructure, chiefly road transport. It is not surprising that most of the yarsagumbas harvested during its peak growing season are smuggled to the bordering Tibetan and Indian markets.

Similarly, hundreds of tones of surplus apple produced at high altitudes go wasted due to lack of infrastructure to transport them to the urban areas, where its demand and price are very high. The price of imported apples is lower than the price of the domestically produced apples that have to be transported from the mountain regions to the urban market. High transportation costs in the case of domestically produced apples accounts for its high price in the domestic market as opposed to lower price of imported apples.

Horticulture could be another promising sector for the economy, as is the case with cutflower market in Colombia. It can be argued that one of the main reasons why this sector is not making headway despite huge international market potential is due to lack of appropriate infrastructure, which limits transportation of final goods and distribution of fertilizers and machinery required for high yield. Moreover, an acute lack of cold storage facilities has led to stymied development of the dairy industry.

Tourism is another sector that has one of the highest potentials to increase growth rates. Nepal is famous for its mountains (eight of the ten highest peaks in the world are in Nepal) and its rich flora and fauna. The basic necessity for this industry is transport infrastructure. The country has 44 domestic airports, of which only two-thirds are operational, and one international airport. The poor quality of Nepal’s tourism infrastructure is reflected in the low rankings (118 out of 133 countries) in the Travel and Tourism Competitiveness Report 2009. The rankings in the quality of air transport infrastructure and ground transport infrastructure are 114 and 125 respectively.

This shows that there is a huge potential in the agro-processing and tourism sector. Since the economy already has the potential stock of high-valued exportable goods and services, lack of self-discovery cannot be a binding constraint on growth.

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[1] See (Hausmann & Rodrik, Economic Development as self-discovery, 2003)

[2] (i) Carpets, (ii) Garments, (iii) Jute goods, (iv) Pulses, and (v) Raw jute and jute cuttings

[3] Hausmann and Rodrik call this export sophistication and use EXPY index to quantify the sophistication of a country’s export basket. It represents the income level associated with a country’s export package. A low EXPY value for a country means that it exports goods typical of countries poorer than itself. Constructing EXPY for all the countries for comparison with Nepal’s export sophistication is beyond the capacity of and resources at the author’s disposal. However, by using other available resources, I still argue that lack of self-discovery is not a binding constraint on growth of the Nepali economy.

[4] Note that there are some restrictions on its harvesting. But, systematically and lawfully trading in this good could earn Nepal substantial foreign exchange.

Labor and business regulations in Nepal

This a part of a series of analysis on growth diagnostics of the Nepalese economy. For discussion of a set of constraints on economic activity in Nepal see this post. Also, see this column and this blog post.

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The fact that manufacturing sector is losing competitiveness both in the domestic and international market at a time when there is an increase in urban population and improvement in educational attainment suggest that the current labor market rules and regulations are playing a role in constraining economic activity in the economy. In fact, one of the standard indicators for measuring business regulation and labor activity, Doing Business Indicators, shows that the quality of business regulations is bad and the country is mired with red tape and labor restrictions.

If the current trend of political interference continues, then labor and business regulations will be the most binding constraint in the coming years. Politically indoctrinated labor unions and youth wings are at loggerheads with the industrial sector right now. They have been demanding higher minimum wages, which was revised in 2009. The tension between the youth wings and labor unions and industries has led to closure of many firms. Worse, this has forced multinational companies to close down factories and has aided capital flight from the country. Colgate Palmolive, a multinational company, was forced to shut down operation due to labor disputes. Meanwhile, due to labor disputes and energy shortage, industrial productivity has declined by over 50%.

In WB’s Doing Business ranking, Nepal has slipped in ranking by 10 positions from 111 to 121 between 2008 and 2009 (see Figure 1). This means that the cost of doing business in Nepal is rising, particularly due to complex labor disputes. Note that this has been a recent phenomenon, especially after various youth wings and unions started forcefully closing down factories demanding higher minimum wages and better working conditions. As stated earlier, this could potentially be the strongest constraint in the future but it still is not strong enough to qualify as the binding constraints as bad infrastructure and corruption did in our earlier analysis.

Figure 1

Source: Doing Business Report 2008 and 2009

Nepal has one of the most cumbersome hiring and firing practices in the world. The difficulty of hiring index and firing index are the highest in the region. Firing provision is very rigid and employers are required to hire temporary workers as permanent after 245 days of work. This has fostered disincentives among investors. Hiring regulations have slightly improved in the last four years but it is still considered unfriendly to business. There has been no attempt to ease firing regulations. Nepal’s firing index is the highest in South Asia (see Figure 3).

Figure 2

Figure 3

Source: Doing Business Reports

Starting a business is also not that easy in Nepal. There has been hardly any improvement in this front in the past four years. It still takes 7 procedures[1] and 31 days to start a business. These figures have not changed since 2004. The cost of starting a business remains pretty high but the good news is that it is decreasing in recent years.

Table 1

Source: Doing Business Reports

Labor and business regulations (inflexibility of the labor market and industrial relations) do not necessarily threaten the economy as the most binding constraints because most of them are being relaxed since 2004. The existing labor dispute is a recent phenomena and it is expected to subside in the coming months because the government has already revised the minimum wage, the main cause of conflict between the unions and the private sector. Change in the labor regulations has not have a substantial effect on industrial productivity and GDP growth rate. Hence, labor and business regulations do not qualify to become the binding constraint on growth.

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[1] The seven procedures are: (1) Verify the uniqueness of the proposed company name, (2) A professional verifies and certifies the memorandum and articles of association, (3) Buy a stamp to be attached to registration form, (4) File documents with the Company Registrar’s Office, Department of Industry, (5) Make a company seal/rubber stamp, (6) Register with the Inland Revenue Office, the Ministry of Finance, and (7) Enroll the employees in the Provident Fund.

Nepal’s export dynamics

This a part of a series of analysis on growth diagnostics of the Nepalese economy. For discussion of a set of constraints on economic activity in Nepal see this post. Also, see this column and this blog post.

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Since Nepal opened up its economy in the early 1990s, trade volume has increased tremendously (see Table 1). Exports per capita consistently increased since 1991 up until 1996, the year when the Maoists’ launched armed rebellion against the state. The apprehension of an all-out state assault against the rebels and the uncertainty surrounding the Maoists activities partly led to export collapse in 1997. This was a supply side issue because Nepali investors were unable to produce goods and services, despite consistent demand from the global market, as they were doing prior to the start of rebellion. The main reasons for this can be attributed to uncertain surrounding private appropriability of returns to investment arising mainly from corruption and a lack of and poor quality of existing infrastructure. Additionally, frequent closure of the only highway (due to political conflict) that connects the valley with the bordering Indian states disrupted supply chain, leading to loss of demand in subsequent years.

Table 1

Source: Economics Survey, MOF 2006

The other factor that contributed to export collapse was partial phase out of quota restrictions under the Multi Fiber Agreement (MFA), under which Nepal was enjoying free access to the Western garment and textile markets while emerging nations like China and India faced quota restrictions. Adjustment occurred in subsequent years and exports per capita began to incline, though at a slower rate until 2001.

Figure 1

Source: Author’s calculation using WDI; LXPCCUS$= Log of export per capita in current US$; LYPCC2KUS$ = Log of income per capita in constant 2000 US$

However, export recovery has not reached the peak attained in 1997. The third phase of abolition of quota restrictions under the MFA contributed to tremendous loss of markets abroad. Nepali exporters were losing price and quality competitiveness in the international market. The year 2004 came as a respite after three years of export recession. However, this relief was short-lived because 2005 marked the end of all quota restrictions under the MFA, leading to further loss of markets abroad. This happened because of increasing competition triggered by the entry of big players in the international market from emerging nations like India, China, Cambodia and Vietnam, among others. They were no longer bounded by quota restrictions in the Western markets. Moreover, high inflation (to the tune of 11% in 1998) contributed to loss in price competitiveness of Nepali exports.

Thus began a tragic trend of a recessionary Nepali export sector, which is mostly dominated by textile and garment industries. Exports collapse after 1997 had a mixed impact on GDP growth rate. In fact, GDP growth rate increased in 1998 and reached 6.10% in 2000. The steep fall in exports in 2001 also partly dragged down GDP growth rate. More weight on the fall in GDP growth rate in this period was caused by a collapse in agriculture production.

Figure 2

Source: WDI

The collapse in exports alone cannot explain the low and stagnant growth rate in the previous decades. Even when exports were rising during 1975-1981 period, GDP growth rate declined more than an increase in previous period. The decline in exports in 1984 brought down GDP growth rate by a significant percentage point, while a slight increase in exports in 1985 increased the GDP growth rate by more than 9%. This should not be alarming because the rise in GDP growth rate by such a margin is just a recovery from a previous plunge and the rise was partially fuelled by improvement in agricultural production. The steep incline in exports during 1991-1996 did not increase GDP growth rate in the same proportion. In fact, there were four instances of growth decline and just one instance of growth increase during this period. Moreover, the increase in growth rate in 1994 was lower than the peak reached in 1984. At best, exports have a weak drag on GDP growth rate in Nepal.

It is because exports did not have a strong drag on GDP growth rate that it fluctuated by so much in the past five decades. There were nineteen instances of increase in GDP growth rate and twenty-five instances of growth collapses in the past five decades ( the remaining being growth stagnation). This alone shows GDP growth rate in Nepal was never sustained and extremely fluctuating. This fluctuation will continue until sectors other than agriculture put heavier weight on the production function of Nepali economy[1].

No country has prospered without transiting to an economy that is largely dependent on the industrial and service sectors (demand emanating from both foreign and domestic consumers). In this light, Nepal will also not see a sustained increase in growth rates until the economy moves from the current structure of production. If the export sector (mostly high valued exports that contribute more revenue to Nepali industries) is so important in the growth process, then why is it not growing as in its neighbors? What is dragging down the progress of export-based industries in the industrial and service sectors? Before answering this question, it is helpful to shed some light on the first question.

Consider a situation where a country has just discovered a market that it can cater to with few resources. Taking advantage of the exclusivity of knowledge of and access to the market, the country begins production of goods (possibly high valued ones) aimed at consumer of the new market. Initially, the country uses its best resources and courts in industries to produce a limited set of products that are of demand in the new market, i.e. it follows price signal. Over time, exporters from other countries as well begin to sell similar products in the market. Greater access to the same market for producers from other countries fosters competition (both price and quality). Since the first country exclusively focuses on production of a narrow set of goods and basks on special access facility (like preferential treatment and quota free entry), it forgets about other potential goods and services, which could help it expand the set of exportable items. Unfortunately, it is too late before it realized that its industries are becoming inefficient and had risked focusing on a narrow set of exportable items, leading to loss of markets abroad and crash of domestic export-based industries.

This situation is analogous to what is going on with Nepal’s export sector. The export sector is marked by a limited set of goods and services (see the product space). Textile and garment products, which once were the highest generator of foreign exchange, dominate the set of Nepal’s export basket. Since the 1970s, the garment and textile industry attracted significant domestic investment because of duty free, quota free access to the Western markets. Germany and the US are the two biggest markets for Nepali garment and textile sector. There was quota restriction for all countries but low income ones. However, by signing MFA, under the WTO regime, the member countries agreed to phase-out quota restriction, in four phases, in their markets. The first phase began in 1990 and after the final phase in 2005, the MFA ended, opening the world market for textile and garment to producers from all over the world.

Table 2

Source: Adapted from Adhikari & Weeratunge, 2007

The first two quota phase-outs did not affect Nepali exporters that much. In fact, exports grew until 1997. Buoyed by healthy exports and increasing revenue, this sector either did not diversify intentionally or did not have an incentive to do so because of the absence of “nearby” products (see product space). When exports began to fall rapidly, the government and the exporters realized that they were losing competitiveness in the international market. Neither the government was able to help nor the producers were able to find new exportable products that could substitute for the loss of market and revenue from garment and textile sector. This means the Nepali export industry could not shift to production of new productive activities after the international price and quantity shock in garment and textile markets. Thus began a sustained export collapse (see Figure 2).

What caused the limited number of exportable items in the export basket and what prevented addition of new exportable items in the production function of Nepal? The producers knew that price and quality competitiveness of the products they were making was decreasing. Moreover, exogenous shocks to international prices in Nepal’s primary export sectors led to deterioration in terms of trade and decline in export earnings (see Figure 3). Even the continuing unfavorable terms of trade did not give incentives to producers to seek new items with better export prices.

Figure 3

Despite the terms of trade shock, there has been no significant movement to new exportable items with higher export prices. When the country’s main export items faced international price shocks, there were/are few “nearby” high valued products to exploit in the production process. In fact, garment and textiles were the only high valued products that were exported with comparative advantage. There were no “nearby” products which could be produced using the already installed capacity of the garment and textile industries, leading to a lack of upgrading from production of one product to another (see discussion on coordination externalities).

On top of this, the unfavorable exchange rate, which consistently appreciated over the past four decades, should have served as a signal to investors that their products were becoming uncompetitive in the international market. The exchange rate system is fixed as the Nepali currency is pegged with the Indian currency. The fluctuations in the Indian exchange rate against the dollar affects Nepali exchange rate. The appreciation of Nepali currency against the dollar meant higher cost of finished exported items. This had also contributed to declining demand and competitiveness of Nepal’s export items. It seems that this signal was ignored by producers and government. Even when the exchange rate began to depreciate beginning 2002, there was hardly any improvement in the exports sector.

Figure 4

Source: WDI

Nepal enjoys an open border with India, which also is its largest trading partner. It usually exports agricultural and budget manufacturing goods to India. The range of market for Nepal’s exports is very narrow as 94.5% of exports go to four countries (considering the EU market as one bloc). A marginal shock in prices of the manufacturing goods in these main four markets rattles the whole export industry in Nepal. Nepal imports far more than it exports to India, leading to alarmingly high level of trade deficit. However, the fluctuation in exports (% of GDP) comes primarily from changes in demand from the Western economies, mainly the US and the EU.

Table 3

Source: WTO International Trade Statistics, 2008

The inability to diversify the export basket with other high valued items has already taken a toll in the economy. Now, the question is: what is preventing diversification of exportable items? Also, what is preventing discovery of new exportable or high valued items? Why is the country so reliant on a limited range of items? Is it due to information externalities (self-discovery)? Is it coordination failures? As will be shown later, both self-discovery and some form of coordination failures are a result of two other strong constraints, namely poor infrastructure and low appropriability arising from micro risks such as high corruption and poor property rights. Previous studies of the Nepali manufacturing sector showed that the reasons behind its sluggish productivity and growth are a lack of human resources and deficient infrastructure. However, this study will show that the existing level of human resources does not qualify to be a stronger constraint on the growth of manufacturing sector (and hence the overall growth rate) than bad infrastructure.

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[1] This analysis is based on the assumption that for a high and sustained growth rate, the industrial and service sectors have to play a vital role in the production function of the Nepali economy. So, this study does not focus much emphasis on the agricultural sector because a sustained high growth rate of over 7% is unthinkable without transition from an agricultural based economy to an industrial based economy, which would constitute surge in exports, increase in FDI, and policy interventions to sort out coordination failures and information externalities. It is also considering analysis only from 1960 onwards, which means the complete isolation during the autocratic Rana regime (up until 1951) is not incorporated in this analysis.

Macroeconomic stability and risks in Nepal

This a part of a series of analysis on growth diagnostics of the Nepalese economy. For discussion of a set of constraints on economic activity in Nepal see this post. Also, see this column and this blog post.

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Could macroeconomic (financial, fiscal, and monetary) issues such as balance of payment crisis, an acceleration of inflation and a debt crisis, and exchange rate volatility be constraining economic growth in Nepal? Are these the current constraints on growth?

It might have been a binding constraint on growth during the 1970s but at present it is hard to make a case that macroeconomic risks are the most binding constraints on growth in Nepal. The current account balance started deteriorating since 1977, reached its lowest point (-8.65% of GDP) in 1994, and after 2001 it has continued to improve. For the past seven years, the current account balance has been positive with slight fluctuations.

Figure 1

Source: WDI

The high current account deficit during the 1980s and 1990s did not negatively affect GDP growth rate. In fact, GDP growth rate increased during these years and reached its peak in 1984. The growth rate in the 1980s was sustained by pumping in large sum of government money as development budget. This resulted in high inflation and budget deficit. Meanwhile, overvalued exchange rate resulted in balance of payment deficit. Faced with macroeconomic instability, the government approached major multilateral donors for assistance. This brought in the Structural Adjustment Program (SAP) in Nepal. In more than a decade, the SAP policies did little to bring about a structural shift in the economy—roughly, the same percentage of people engage in the agricultural sector then and now. This is similar in the case of the industrial sector. The agricultural sector’s contribution to GDP has declined by approximately one percentage points a year.

The high inflation rate and frequent fluctuations in general price level seem to be risky for the economy. Inflation rate peaked to 19% in 1974, 18% in 1986 and 17% in 1992. In 2008 it hovered around 10%. It is expected to be above 10% in 2009.

Figure 2

Source: WDI

Though inflation was a worrisome issue during 1980s and 1990s, it decreased substantially from a high of 17% in 1992. The country enjoyed a healthy growth rate of more than 5% during 1991-1995, implying that the decrease in inflation rate along with liberalization, deregulation and privatization of key sectors aided GDP growth rate. This also means that high volatility in price level might have been a strong constraint on growth before 1992 because a relaxation on this constraint produced a large effect on GDP growth rate (our objective function).

The inflation rate has been rising in the past three years. This should not necessarily pose as a strong constraint because the recent rise in general price level is triggered by rising food and commodity prices in the global market. Almost all the developing countries experienced rise in general price level in 2008. Moreover, inflation rate in Nepal tends to follow the inflation rate in India because of close integration of the two economies, easy currency convertibility in local markets, and fixed exchange rate between the Indian and Nepali currency.

Figure 3

Source: Author’s calculation using WDI; (SD= Standard Deviation; Avg= Average)

As seen in Figure 3, Nepal’s current account balance has satisfactorily improved in the past decade and is not that different from what regional economies have. In addition, inflation rate has declined in Nepal in the past decade and now it is in line with the rate prevailing in regional counterparts. The variation in current account deficit and inflation rate (as shown by standard deviation in the above figure) is also declining. It is more or less at the level prevailing in SAARC[1] nations.

This shows that current account deficit and inflation rate do not pose as the most binding constraints on medium and long term growth in Nepal. As will be shown later, debt level and exchange rate also do not pose to be strong constraints.

All of these suggest that macroeconomic stability is not a binding constraint on growth in Nepal.

Macroeconomic risks

Despite frequent bouts of coups and change in government, investment in the economy seems to be improving since 2001. However, the rate of improvement is still not satisfactory and it falls well short of fixed capital formation (% of GDP) reached in 1996.

Figure 4

Source: WDI and University of Maryland Polity IV Project; Polity2 index goes from -10 (autocracy) to 10 (democracy)

As seen in Figure 4, even though political climate improved between 1998 and 2001, investment nosedived and FDI (net inflows) also suffered a decline. However, as political stability deteriorated after 2001 and stagnated at a low level between 2000 and 2005, gross fixed capital formation surprisingly began to increase. On the contrary, FDI continued declining. This means that at least domestic investors perceived the political changes as not threatening to the business sector. This might be a result of business sector getting accustomed to political instability and the process to get things done, often taking alternative means like complying to the armed faction’s demand for donation in return for security and noninterference on business dealings. This is a signal that the political changes were not perceived as threatening to economic activity, at least to the domestic investors.

Nepal is also as one of the least volatile developing economies in terms of private foreign capital flows (see Table 1). The degree of volatility to private capital flows in Nepal is one of the lowest when compared to other developing countries. This has spared the Nepali financial system from international fluctuations in capital inflows and outflows.

Table 1

Source: Adapted from (Dailami, et al., 2000)

As argued earlier, though rapidly rising inflation rate pose a serious problem in the immediate period, this should be seen in the light of the global price fluctuations in 2007 and 2008. Before 2007 inflation rate in Nepal, though high, was improving (see Figure 2). In 2008, the inflation rate shot up to approximately 10%, which is a result of rising fuel, food, and commodity prices in the international market. The alarming rise in inflation rate recently has little to do with domestic monetary policies. The effect of these kind of exogenous shocks tend to subside over time and is expected to lower pressure on Nepal’s general price level in 2009/10. However, if producers and retailers take this price rise as an excuse to permanently keep prices of food and commodities artificially high, then the resulting price level could threaten soundness of Nepal’s macro economy. As for now, money supply is comparatively lower than in previous decade and M2 growth (a key indicator used to forecast inflation) is not that high to cause serious concerns on inflation rate. In other words, the recent rise in inflation rate has little to do with domestic money supply; the current rise in price level is caused by exogenous factors, mainly rise in global fuel, food, and commodity prices.

Figure 5

The exchange rate against the dollar also seems to be depreciating in recent years. This is at least providing the struggling exports sector some badly needed relief. The Nepali currency is pegged with the Indian currency. Due to increasing volume of trade between these two countries and mounting current account deficit in trade with India, the monetary authorities sometimes find it hard to satisfy the demand for Indian currency in the domestic market. However, with comfortable foreign exchange reserve worth US$ 3.1 billion (38% of GDP) in 2008, this should not pose as an immediate threat to the economy.

In addition, as will be shown later, the national debt (though still high) has been decreasing in the last couple of years. This by itself should not pose as a major risk on the soundness of the economy. As for savings, it has been consistently increasing and the domestic economy is fuelled by increasing remittances, which accounts for around 18% of GDP. The surplus in current account balance amounted to 1.67% of GDP in 2006. Furthermore, as compared to other low income countries in the world, the macroeconomic stability score/rating for Nepal is pretty high (see Figure 6).

Figure 6

Source: Authors calculation using data for macroeconomic stability from Global Competitiveness Report 2008-2009 and for log of income per capita (constant 2000 US$) from WDI

These findings are inconsistent with the hypothesis that macroeconomic risks are the binding constraint on economic activity.

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[1] SAARC stands for South Asian Association for Regional Cooperation. It has eight members namely Nepal, India, Bangladesh, Pakistan, Bhutan, Maldives, Sri Lanka, and Afghanistan (inducted in 2007).

What’s holding back growth in Nepal?

My latest column is related to the growth diagnostics paper I wrote for honors thesis in economics. I argue that bad infrastructure is the most binding constraint on economic activity in Nepal. I will post the full diagnostics paper in a series of blog posts later. So far these are the discussion on some of the constraints.

Almost all the medium- and long-term development strategy papers floated so far specified economic growth as the most important objective in the economy. The finance ministers presented fiscal budgets accordingly and promised to devote resources based on his administration’s economic philosophy. For instance, last year the finance minister presented the fiscal budget with a goal to attain double-digit growth rate in three years, something that is hard to attain given labor and energy problems and the fact that even during the heydays of liberalization the economy did not witness a double-digit growth rate. What is ironic is that almost all the finance ministers trumpeted high economic growth rate as the main objective without first diagnosing what is actually holding back growth, i.e. the set of binding constraints on economic activity.

Nepal has few resources but numerous economic and political problems. Hence, trying to solve all the problems using limited stock of resources might not produce the best synergistic effect. For instance, the spray-gun approach tried in the past did not produce growth rate as expected by the policymakers. A smarter strategy would have been to devote a proportionally high amount of resources in relaxing the binding constraints, which could have led to a large positive effect on growth rate.

The main issue here is to identify the most binding constraints on economic activity and to design a set of policies that, once targeted on these constraints at any given point of time, would produce the biggest bang for the reform buck. This would not only help construct a hierarchy of the strongest constraints, but also identify the most binding one so that economic policies designed to relax it would produce a favorable change in growth rate. Following this line of policy-oriented approach, a growth diagnostics of the Nepali economy (done by this author in collaboration with Prof. Sinan Koont, Dickinson College, PA) shows that bad infrastructure is the most binding constraint on economic activity.

That being said, it does not mean that other constraints like human resources, macroeconomic stability (financial, monetary and fiscal), microeconomic risks (property rights, corruption and taxes), coordination failures and information externalities (self-discovery) in the market, low savings, and poor intermediation are of no importance. What it really means is that these constraints are not as strong as bad infrastructure is, if our objective is to bring the largest change in growth rate in the short term, i.e. improvement in the supply of infrastructure (relaxing the binding constraint) would produce the largest positive change than relaxation of other constraints.

Read the full column here.

 

Five decades of Nepal’s growth story

This a part of a series of analysis on growth diagnostics of the Nepalese economy. For an earlier post on GDP growth rate in Nepal, see this blog post. For discussion of a set of constraints on economic activity in Nepal see this post.

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For more than five decades, the economic growth rate in Nepal has been rocky and unstable. The average growth rate in the past decade was approximately 3.8%. The economy had more bouts of growth decelerations than accelerations. There were nineteen instances of an increase in GDP growth rate and twenty-five instances of growth collapses in the past five decades (the remaining being growth stagnation). There were no instances of sustained growth rate above 5% for three consecutive years in the past five decades.

The only period when growth accelerated for two consecutive years is between 1967 and 1969. Besides this and an instance of growth stagnation at 2% between 1961 and 1963, the economy experienced a proportional growth decline for every growth increase, implying that the increase is a mere attempt of recovery from a fall in previous period. In sum, the Nepali economy can be seen as one marked by sustained growth failure in the past five decades. This is reflected in similar rocky trend in growth rate of GDP per capita in the past five decades (see Figure 2).

Nepal’s GDP growth rate has never exceeded the 10% mark. The highest growth rate recorded so far is 9.6% in 1984. This is not surprising because the sudden rise in growth rate was just a recovery from three years of recession in previous consecutive years. The growth rate plummeted from 8.3% in 1981 to -2.98% in 1983. It then shot up to 9.6% in 1984 and then nosedived to 1.69% in 1987, marking three consecutive years of recession. The growth rate increased for one year to 7.48% in 1988 and then again fell down to 4.3%. The growth rate has never reached its peak level of 1984. The average GDP growth rate in the past five decades was 3.57%.

Figure 1

Source: WDI

The medium and long term growth rates[1] have fluctuated between 2.5% to 5.2%. The average growth rate was 2.52% during 1961-1970, 2.11% during 1971-1980, and 4.75% during 1981-1990, which was the most prosperous decade so far. Note that this happened before Nepal adopted an open economic policy. The country implemented a new industrial policy in 1992, thus engaging in liberalization, privatization and deregulation of many sectors, following the popular dictates of the Washington Consensus[2]. Accordingly, GDP growth rate increased to 5.26% during 1991-1995. This period also saw relatively low variation in GDP growth rate fluctuation.

It is argued that Nepal’s economy in the 1990s had a poor growth performance despite reasonable macroeconomic stability because of a lack of good governance and political instability(Khatiwada & Sharma, 2002). The Maoist insurgency started in 1996 and began to take a toll on foreign and domestic investments (more in detail later). The successive governments were unable to fully spend allocated development expenditure. Meanwhile, recurrent and general expenditure hiked, leaving little impact on economic growth. During 1991-1996, the growth rate was 5.26%. This decreased to 4.03% during 1996-2006. The growth rate in 2007 was 3.2%.

Figure 2

Figure 3

Source: WDI

In short, the economic growth has been very at a low level as compared to its neighbors and countries having similar income per capita (see Figure 4). The economy had more number of growth collapses than recoveries in the past five decades.

Figure 4

It is tempting to argue that the tremendous volatility in growth rates in Nepal might be caused by tumultuous political situation and frequent instances of coups and fleeting democracy. However, as is seen in Figure 5, government changes and coups had little impact on the trend of overall growth rate. The trend in Polity2 index[3] is inconsistent with the trend in growth collapses and recoveries.

Figure 5

Nepal was under the autocratic Panchayat structure beginning 1962, the year when the then King Mahendra usurped political power and outlawed political activity. This continued until 1980, when the next King Birendra loosened restrictions on political activity in the country. This can be seen on Figure 5 as a flat -9 (autocracy) and then an improvement by seven points to -2. After a general revolution, a multi-party system of governance was instituted in 1990. This is reflected in the Polity2 index as an improvement with an index value of 5. Though there were frequent changes in government, it did not have a strong effect on the overall index until 2001, the year when King Birendra, along with his family members, was murdered during the Royal Palace massacre. After 2001, King Gyanendra assumed the throne and staged a coup in 2002. A revolution led by major political parties overthrew the King and abolished monarchy system in 2006.

As shown in Figure 5, the Polity2 index nosedived to -2 after the political upheaval in 2001. This is also the same year the Maoists militias, who launched an armed rebellion against the monarchy and “feudal” system in 1996, attacked an army base, thus marking a full-fledged civil war/conflict between the rebels and the state. The armed Maoists rebellion came to an end after the monarchy was abolished in 2006. This is the only time period (2001-2005) when the impact of political change is seen on GDP growth rate, which never crossed the 6.10% mark after 2000. Notice, that in all other periods except for 2001-2005, the change in political structure did not have any relation with the trend in GDP growth rate. As stated above, this implies that a frequent political change was not a strong constraint on medium and long term growth in Nepal.

This leads us to two questions: (i) what is constraining growth rate in Nepal? and (ii) what factor(s) are posing as strong constraint(s) on sustained growth rate? This is where we apply the growth diagnostics approach to figure out the most binding constraint(s) on economic activity in the Nepali economy.

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[1] For simplicity, medium term is defined as 5 years and long term is defined as above 5 years.

[2] Nepal adopted a more liberal trade policy in 1992 with the objectives of: (i) enhancing the contribution of trade by promoting both internal and external trade with increased private sector participation, (ii) diversifying trade with the promotion of backward linkages, (ii) expanding trade on a sustained basis to reduce imbalance, and (iv) coordinating trade with other sectors. The current account was made fully convertible in 1993.

[3] Polity2 is a composite index that measures the quality of democracy in a country. It ranges from -10 (autocracy) to 10 (democracy). Specifically, score of -10 means hereditary monarchy, -10 to -6 means autocracies, -5 to 5 means anocracies (societies where central authority is weak or nonexistent), 6 to 10 means democracies, and 10 means consolidated democracy.