Saturday, May 16, 2009

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.


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.