Saturday, May 16, 2009

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.


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.

[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).