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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
 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.