Saturday, May 16, 2009

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.


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.


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.


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.

[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.


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.

[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.


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.

[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.


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).