Saturday, April 24, 2010

Five reform agendas to kick-start Nepal’s growth

My latest piece is based on a simple set of crucial reforms that are needed to kick-start Nepal’s jammed growth engine. These reforms can be launched simultaneously or in any other form deemed appropriate and politically feasible.

Main point: “To achieve a 5 percent plus growth rate in an undeveloped but budding economy likes ours, it is necessary to start from something that will first lubricate the growth engine, then speed it up, then attain stability, and then ensure sustainability of growth rate.”


Five Reform Agendas

If someone asked you to enumerate five reform agendas that will kick-start Nepal's jammed growth engine and sustain five percent plus annual growth rate, what would be your response? Recently, I was asked this question. By considering the pattern of reforms in countries that have passed through the existing development state of our economy and the evolution of institutions, culture, reforms and constraints in Nepali economy, my non-exhaustive list of reform agendas were: (a) Infrastructure (electricity and roads); (b) contemporary industrial policy; (c) overhaul of education and healthcare sectors; (d) governance and regulations (financial and non-financial sectors); and (e) social safety nets.

Before explaining the rationale behind this hierarchy of policy reforms, let me be clear about two key assumptions. First, it postulates that political situation will eventually be stable. Second, as is the case with the emerging economies, an increase in economic growth rate will lead to poverty reduction.

When macroeconomic situation is in a mess, we need to first ensure that fundamental variables are promptly taken care of. We need to identify the most binding constraints on economic growth in order to tackle the most troubling aspect of the economy. Studies have shown that the most binding constraint right now is a lack of infrastructure, mainly roads and electricity. With the supply of electricity about five times less than the demand, it is not only difficult for entrepreneurs to start new business, but is equally hard for the existing firms to keep their machines running. Note that Nepal has the highest electricity tariff (dollar per KWh) and lowest electric power consumption (KWh per capita) in South Asia.

An inadequate transport infrastructure increases transportation and transaction costs, leading to loss of competitiveness. Nepal has the highest transportation costs and lowest road density in South Asia. Provision of good infrastructure facilities incentivizes domestic entrepreneurs, both agricultural and non-agricultural. It facilitates the rise of small and medium enterprises (SMEs), the main source of employment for people and revenue for entrepreneurs. It kick-starts the growth engine but won't guarantee speeding up of the engine fast enough.

For this to happen we need to prop up firms that can exploit economies of scale and expand markets abroad. A contemporary industrial policy (IP) that can 'lead the market' and 'follow the market' is required to speed up growth rate. South Korea adopted 'lead the market' principle, where it picked potential winners and promoted 'winning' industries. Meanwhile, Taiwan adopted 'follow the market' principle, where the state 'nudged' firms to upgrade their technologies through appropriate incentives, performance requirements and facilitation of transfer of technical knowhow and capital. Any such promotion of domestic industries should have industry-specific sunset clauses to eschew misallocation of resources, price distortion, and repression of incentives.

The state has to play a vital role in propping up markets when there is substantial underinvestment in promising sectors. Just setting up 'enabling' environment is not enough amidst information asymmetries and coordination failures in the market. In Nepal's case, the state could speed up the establishment of Special Economic Zones (SEZs), Export Processing Zones (EPZs) and Garment Processing Zones (GPZs); extend tax holiday in key industries; guarantee investment insurance in hydropower sector; facilitate export of labor services to growing middle-income countries facing shortage of manual and semi-skilled labor; subsidize loans and provide easy credit to strategic firms; train human resources; promote tourism; facilitate trade; create backward and forward linkages in the industrial sector; and borrow new technology to enhance efficiency and productivity, among others. 

A good industrial policy helps to stimulate the economy and speed up industrialization, leading to absorption of surplus agricultural labor in industrial sector. A potential source of investment in the short term could be remittances, if only the policymakers can figure out how to channel it into the productive sectors for investment rather than for consumption of imported goods and for investment in real estate sector.

For a vibrant market and a sustainable growth rate, it is equally important to ensure smooth supply of quality human capital. To make the previous two reform agendas sustainable, it is necessary to reform the existing Nepali education and health sectors. An education sector that is geared towards the need of the domestic and international markets is vital to fulfill the demand for human resources in rapidly growing sectors. The banking sector is already suffocating from a short supply of competent human resources. Given the immature state of our financial markets, there is a huge demand for educated, well-trained young professionals who are capable of analyzing market fluctuations and investments. Along with the education sector, we need to improve on the provision of health services, especially in rural areas. It will ensure a constant supply of healthy, competent human capital to the industrial sector.

With booming economic activity also comes complexity. Some agents in the economy always want to earn more profits than others, often by going roundabout established rules. To keep unhealthy competition and risky investment activities at bay, it is necessary to have good governance and regulations. Nepal's notorious public sector, which is infested with corruption culture, needs to be reformed. This will not happen overnight. But we can at least take corrective steps by empowering the Commission for Abuse of Authority (CIAA), the main corruption watchdog, with more manpower, expertise and funding so that it can spread its wings to all districts. Furthermore, having proper regulation in place for the rapidly growing financial markets, which usually is the main artery from where investment spending is pumped out into the economy, is essential. This helps to check malpractices in the public and private sectors, and the financial markets.

Finally, with booming economic activity and growth of financial markets, also come unpleasant and unintended outcomes: rise in inequality, which retards growth rate, and increase in vulnerability of poor people. This is why we need to have adequate safety nets, which can be funded by taxing the richest people in the highest income quintile. This has to be done without killing incentives of entrepreneurs. To uplift living standard of the lowest quintile and to stimulate rural economy, we need public work programs, conditional (or unconditional) cash transfer programs, short-term employment during lean agricultural season, and training programs aimed at graduating low-skill workers with updated skills consistent with market demand.

Let me emphasize that these reform agendas are not comprehensive. Depending on objectives, there could be an entirely different set of hierarchy of reforms. However, to achieve a five percent plus growth rate in an undeveloped but budding economy likes ours, it is necessary to start from something that will first lubricate the growth engine, then speed it up, then attain stability, and then ensure sustainability of growth rate. Drawing out a simple set of national reform agenda endorsed by all political parties despite their divergent ideology would do a lot in terms of generating high and sustainable growth rate in Nepal.

[Published in Republica, April 22, 2010, pp.6]