This a part of a series of analysis on growth diagnostics of the Nepalese economy. This blog post is about my assertion that bad infrastructure is the most binding constraint on economic activity in the Nepali economy. For discussion of other constraints see these blog posts. It would be helpful to read discussion about corruption after going over this constraint.
There is a strong case that bad infrastructure is hindering structural transformation and a shift to more productive activities in the Nepali economy. It has been shown that infrastructure provision improves productivity of private sector firms and contributes to output (Morrison & Schwartz, 1996). The availability of infrastructure also determines spatial distribution of agents (firms and labor) and assets in an economy. Using household surveys data, Jacoby (2000) has shown that providing extensive road access to markets would provide “substantial benefits” to both businesses and households (on average most of it going to the latter) in Nepal. He argues that apart from cheaper transportation costs arising from expanding rural roads, it also helps in facilitation of access to schools, health facilities, and increase in variety of consumer goods. Limao & Venables (2001) have shown that a deterioration of infrastructure from the median to the 75th percentile raises transportation costs by 12 percentage points and reduces traded volumes by 28 percentage points. By using shipping data (costs associated with shipping of export items), they have also shown that a median landlocked country has transport costs 55% higher than a median coastal economy but improving infrastructure to the level of 25th percentile among landlocked countries cuts this cost to 41% and similar improvement by a transit economy cuts costs to 48%.
Poor quality of existing infrastructure and virtual absence of linkage between production and manufacturing sites in the hilly and mountain areas have hindered structural transformation. Surplus production in the rural areas hardly makes it to the market. The existing poor quality of roads makes transportation of good goods from production site to manufacturing plants costly. Furthermore, except for a symbolic rail line from India to a border city in Nepal, rail service is nonexistent. Air service is also not readily accessible given the per capita income of Nepali people. Even if it were accessible, there are not enough airports linking various parts of the country. Out of 44 domestic airports, less than two-thirds are in operation and the quality of those that are in operation is frustratingly low. Nepal ranks 114 out of 133 countries in the quality of airports in Travel & Tourism Competitiveness Report 2009, which is published annually by the World Economic Forum. The transportation cost of ferrying surplus goods on aircrafts is tremendously high. It is precisely because of the absence of cheaper transportation means that high quality apples produced in the mountain areas like Mustang, Jomsom and Manang do not make it to markets in urban and semi-urban areas, where the demand for domestic apples is high.
This diagnostics study shows that poor quality infrastructure is the strongest binding constraint on growth. By all standards, Nepal ranks poorly in all international comparative indexes. Though total road network and percentage of paved roads are increasing in the past seven years (see Figure 1 and Figure 2), this does not mean that the supply of roads is at par with the demand. The fact that many rural communities are collectively investing in construction of unpaved roads (to link their communities with markets in urban and semi-urban areas) means that people are taking alternative measures to bypass the most binding constraint. This is consistent with one of the principles of binding constraints.
Source: CBS, Nepal in Figures 2007
Comparing total roads network (km) in low and low middle-income countries gives a clearer picture of the scope and quality of infrastructure in Nepal.
Source: Author’s calculation using WDI [Latest data available for total roads network (Km) and income per capita is for 2006 (constant 2000 US$)]
Figure 3 shows that the total roads network (km) in Nepal is frustratingly low when compared with similar per capita income. Burkina Faso, a landlocked country in Sub-Saharan Africa, has similar per capita income as Nepal’s but it far exceeds Nepal in terms of total roads network. Similarly, even poorer countries like Ethiopia, Zaire, and Malawi have better road networks than Nepal.
Not surprisingly, Nepal’s infrastructure rating is one of the poorest in the world. Figure 4 shows how Nepal’s infrastructure rating compares with ratings of countries in Sub-Saharan Africa and Asia. Even with similar GDP per capita, many countries have better quality infrastructure than Nepal. Out of 134 countries considered in the Global Competitiveness Report 2008-2009, Nepal ranks 132 in terms of infrastructure quality. It also shows that there is a strong relationship between infrastructure quality and income per capita.
Source: Author’s calculation using data for Infrastructure rating from Global Competitiveness Report 2008-2009 and GDP per capita 2006 (constant 2000US$) from WDI
The same report shows the low rating of Nepal’s transportation system when compared to regional counterparts. The quality and reach of roads, which is the most feasible mode of transportation in a landlocked country, is the lowest in the region.
Source: Global Competitiveness Report 2008-2009
In fact, Nepal’s quality of infrastructure is lower than what most of the factor driven economies have (see the cobweb Figure 5).
Source: Global Competitiveness Report 2008-2009
The GCR considers twelve sets of factors as the pillars of a competitive economy. Low income countries are considered factor driven, which is determined by institutions, infrastructure, macroeconomic stability, and health and primary education. Middle income countries are considered to be driven by efficiency. Factors that enhance efficiency are higher education and training, goods market efficiency, labor market efficiency, financial market sophistication, technological readiness, and market size. High income countries are considered to be innovation driven, which is caused by business sophistication and innovation.
New discoveries and innovation of exportable items are of no use if there is an absence of linkage between production site, manufacturing plant, and markets. This is precisely what is happening in Nepal. It is not that entrepreneurs and producers are not coming up with new ideas and marketable items that could be exported with comparative advantage. The lack of infrastructure is stymies this process and provides disincentives to would-be entrepreneurs. In this situation, new entrepreneurs and investors ‘follow the herd’, i.e. they invest in industries already existing in the economy, sometimes overcrowding investment in one particular sector. There seemed to be overcrowding of producers and investors in textile and garment industry. This has melted away after Nepali market share in the West was taken over by big players from India, and China, among others countries. Out of more than 1000 garment and textile firms, only 18 remain right now. Worse, half of those remaining are not operational. This industry alone has lost 90% employment (Sapkota, Times up for garment industry, 2008).
De’s (2009) estimation of transportation costs, which depends on the quality of transportation facility in a country, shows that Nepal has the highest transportation costs (trade-weighted) in South Asia. He argues that the cost is high partly because Nepal is a land locked country. However, just being landlocked does not justify transportation costs that are nearly triple than what is prevalent in India. High transportation costs discourage investment. Moreover, the existing industries tend to cluster around areas that have relatively good transport infrastructure. It is no wonder that key industries in Nepal are clustered around cities adjacent to the Indian border. More than 50% of the roads are concentrated in the Terai region. Though this has helped lower transportation costs to some extent for the existing firms, it has left major parts of the country deficient in industrial activity.
Source: De, 2009
Notice that the transportation costs for textile and clothing industry is the highest in the region. It is more than three times the cost prevailing in India. This is the same industry, which has suffered tremendous losses in recent years, thus exerting a downward shock in exports volume and revenue. The deficient supply of infrastructure and poor quality of the existing ones increase total costs of commodities, thus making Nepali products relatively expensive in the international market. This has led to declining price competitiveness of Nepali products, the outcome of which has cost the industrial sector heavily in recent years.
Source: Pyakuryal 2008
The distribution of roads network is highly unequal. New exportable products from hilly and mountain regions do not make it to the market because of the absence of connectivity. Surplus production of moderately high valued fruit products like oranges, leeches, apples and other items like mushrooms and yarshagumba (a highly valued medicinal herb found in high altitudes) do not make it to the market, despite having high demand, in the right time. By the time they are sold at stalls in the urban and semi-urban cities, half of the original surplus gets perished. This means that the farmers do not get the true value for the surplus they generate. It is not a coincidence that the central region, which has the highest road density and length of paved roads (km), has the highest number of the manufacturing firms. The spatial distribution of manufacturing sector is highly skewed in favor of the central development region primarily due to access to physical infrastructure, though in a limited basis. Liberalization had little effect on the spatial distribution of industries in Nepal (Sharma, 2000)- the reason for which can be traced back to bad infrastructure in the country.
If infrastructure, such as roads and ropeways, that decrease transportation costs and reduce delivery time are existent, then not only will there be an expansion of market for domestically produced goods, it can also be exported to nearby bordering cities of India and China. This will help generate extra revenue for the nation and also increase household income of the people living in the hilly and mountain regions. A study done by the Ministry of Information and Communication Services (MOICS) in 2004 found that if transportation time is reduced by 50%, then it would result in higher income through increased use of fertilizers and market access (Pyakuryal, 2008).
As shown in Figure 7, Nepal has one of the lowest road densities in the whole region.The road density in Nepal is slightly higher than in Afghanistan. The penetration and quality of transport infrastructure is essential for connectivity of market and production site and to encourage new entrepreneurs to actively engage in the discovery of new goods and services that have potential to give Nepal a comparative advantage in trading of such goods and services in the international market.
Source: IRF World Road Statistics 2008 (*data for India and Afghanistan refer to 2002 and 2004 respectively).
If a factor is a binding constraint, then the market price for the supply of that product is very high. It shows that for whatever the supply there is in the market, the consumers are willing to pay more than its normal value. Short supply even on the face of extremely higher prices means that the sector is resisting growth and relaxing this constraint would stimulate consumption and expenditure. This is true in the case of hydropower sector, another important infrastructure for the very survival of the industrial sector, in Nepal.
The country is reeling under shortage of electricity recently and it has already resulted in shedding of 50% of productivity in the industrial sector (Sapkota, Bust factors: Poor appropriability and load-shedding, 2009). Currently, electricity is supplied at most 8 hours a day. This is done in two phases. A frequent cut in electricity supply has led to inefficiency and decline in production and productivity. The annual production of electricity in the nation is 250 MW. However, the demand in Kathmandu itself is 225 MW. The total demand of electricity in the nation is 770 MW. This shows that there is a huge shortfall in supply of electricity.
Despite having high electricity demand, it is interesting to note that the supply has been very low for decades. People have been using alternative means of energy sources to meet their needs. The demand for inverters, generators, and solar girds has increased by multiple folds in recent years. This means that people are finding alternative means to bypass the constraint, implying that infrastructure (including transport and electricity) qualify to become the most binding constraint on economic activity/growth. Despite the heavy shortfall in supply, the electricity tariff in Nepal is one of the highest in South Asia. The tariff rate is almost double the rates prevailing in Bangladesh and India (see Figure 8). It is no wonder that Nepal’s per capita electricity consumption is the lowest in South Asia (see Figure 9).
Source: Adapted from Pyakuryal, 2008
Similarly, Nepal has the lowest telephone subscriber rate (per thousand) in South Asia for decades (see Figure 10).
The social return to investment in Nepal is the lowest in the region. According to the growth diagnostics decision tree, this is caused by poor geography, low human capital, or/and bad infrastructure. As will be shown later, poor geography and low human capital do not qualify to be as strong a constraint as bad infrastructure is. So, the main cause for low social returns to investment must be caused by bad infrastructure for similar reasons discussed above.
Source: Adapted from Campbell & Khan, 2008
All these facts and analysis are consistent with the hypothesis that bad infrastructure is the most strongest and binding constraint on economic activity in Nepal.
De, P. (2009). Trade transportation cost in South Asia: An empirical investigation. In D. D. Brooks, & D. Hummels, Infrastructure's Role in Lowering Asia's Trade Costs: Building for Trade (pp. 230-256). Cheltenham: Edward Elgar Publishing Limited.
Jacoby, H. (2000). Access to Markets and the Benefits of Rural Roads. The Econoimc Journal Vol 110 , 713-737.
Limao, N., & Venables, A. J. (2001). Infrastructure, Geographical Disadvantage, Transport Costs and Trade. World Bank Economic Review Vol 15, 451-479.
Morrison, C., & Schwartz, A. (1996). State Infrastructure and Productive Performance. American Economic Review Vol 86 , 1095-1111.
Pyakuryal, B. (2008). Removing Growth Strategies: Investigating the role of NRN. Global Nepali in Local Transformation (pp. 1-35). Janakpur: Non-Resident Nepali Association.
Sapkota, C. (2009, January 6). Bust factors: Poor appropriability and load-shedding. Retrieved February 9, 2009, from Myrepublica.com-News in Nepal: Fast, Full & Factual: http://myrepublica.com/portal/?action=news_details&news_id=887
Sapkota, C. (2008, August 19). Times up for garment industry. The Kathmandu Post , p. 4.
Sharma, K. (2000). Liberalization and Structural Change: Evidence From Nepalese Manufacturing. Center Discussion Paper No. 812 (pp. 1-27). New Haven: Economic Growth Center, Yale University.
Straub, S. (2008). Infrastructure and Growth in Developing Countries: Recent Advances and Research Challenges. WB Policy Research Working Paper 4460 , 1-54.
 For a summary of existing literature on infrastructure and growth in the developing countries see Straub, 2008
 However, Jacoby (2000) emphasizes that the “benefits would not be large enough or targeted efficiently enough to appreciably reduce income inequality in the population.”
 In the month of January, the industrial sector reported 20% cut in employment. It is estimated that 70000 jobs have already been axed due to the power crisis (Source: The Himalayan Times: http://thehimalayantimes.com/fullstory.asp?filename=aBXaza0sa2qzpla7Va0ua.axamal&folder=aBDasaian729&Name=Business&sImageFileName=&dtSiteDate=20090115)