Sunday, May 30, 2010

Nepal’s Industrial Policy 2010: Good but inadequate reform

My latest piece is about the new industrial policy 2010 of Nepal. Nepal desperately needed an updated industrial policy to reflect the changes the national and the world economies have gone through in the past two decades. Here is my argument for why the industrial policy of 1992 should be changed. Here and here are my initial reaction when the cabinet endorsed the new industrial policy two weeks ago. Read the full text of Nepal’s industrial policy 2010 here.

Industrial Policy 2010: Good but inadequate reform

Despite the never-ending political uncertainty, something good happened in the economic policy front. A long-awaited industrial policy (IP) to buttress the domestic industrial sector was endorsed by the government two weeks ago. This new IP replaced the outdated IP of 1992.

The main objectives of the new IP are to promote industrial activity, increase employment generation, and boost per capita income. The government hopes to increase contribution of the industrial sector to the economy and expects a reduction in poverty. Though the new IP has numerous progressive and encouraging policy agendas, it is also riddled with loopholes and inconsistencies. It looks like a typical government document formulated without adequate consultation with associated parties and without prior appraisal by independent agencies.

The new IP makes it clear that the 1992 IP did not do a good job in promoting the industrial sector. The contribution of the industrial sector to GDP is decreasing, especially after the start of Maoist insurgency. Furthermore, it is paradoxical that the annual growth rate of the industrial sector is declining after the implementation of the 1992 IP. The dream of laying out a foundation for structural transformation, thus absorbing surplus agricultural and unemployed labor in the industrial sector, has remained a fairly tale.

Let me start with some of the salient features in the new IP. It promises flexible labor policy, including the ‘no-pay-for-no-work’ principle. It allows easy exit from business for promoters, freeing them from long-term labor and other liabilities. Tax and income rebate incentives and easy credit are offered to export-oriented firms. It promises tax holidays for 10, 7, and 5 years to firms that invest respectively in highly underdeveloped (21 districts), undeveloped (15 districts) and less developed (24 districts) areas. As always, it aims to promote Special Economic Zones (SEZs) and institute ‘one-window’ policy for all industrial activities.

It aims to promote value-added industries and facilitate supply and adoption of new technology to increase production and productivity. The government promises to purchase goods that are produced by domestic firms if there is 30 percent value-addition in the final product. Furthermore, it offers to establish a bunch of bureaucratic organizations to promote trade. It aims to upgrade technical and skill-related aspects of the existing administrations related to the industrial sector.

Great! It looks like a good IP, at least better than the previous one.

However, there are some inconsistencies and poorly-formulated plans that are worth mentioning. The document is indecisive in identifying the priority sectors, is ambiguous, and might distort incentives instead of enhancing them. Let me explain.

Despite numerous incentives, the IP is not clear if the overall strategy is either to ‘lead the market’ or to ‘follow the market’ or to do both. There is a danger that it might end up being an import-substituting policy in some sectors rather than promoting and sustaining competitive-edge of our industries. This is evident from the government’s willingness to impose anti-dumping duty and countervailing duty (CVD) on imports. If we injudiciously impose tariff and non-tariff barriers, then other countries might follow suit, especially on our exports. It will have negative impact on some sectors, as was seen when India imposed CVD, which it repealed recently, of 4 percent on Nepali exports. The most troubling aspect is the absence of sunset clauses in most of the proposed incentives. It might foster the dependence of the industrial sector on seemingly perennial concessions from the government.

There is no clear-cut identification and preference of industries based on national priority. The whole exercise looks like a spray-gun strategy trying to encompass everything under the roof of the industrial sector. Since the economy is resource constrained, both financially and in human capital, it should have promoted the industries that matters the most. It means tackling the binding constraints head on.

Our biggest constraint on economic growth is a lack of infrastructure, chiefly transport, energy and communication. The IP should have given utmost priority to addressing this constraint. This sector would be an obvious ‘winner’ with very little distortion of incentives. Why? Because domestic demand for infrastructure, energy and communication is higher than supply, offering a huge potential profitable markets. Moreover, there is tremendous demand for energy from neighboring Indian states. Bhutan is following this strategy and is growing at a phenomenal rate. There is no reason why we cannot do it.

The proposed “one-village-one-product” strategy seems nonsense, politically-charged and populist policy. It is a catchy slogan which basically means one village specializing in one product. This discounts the possibility of creating synergies among production processes and techniques, i.e. very little possibility for economies of scale and harmonization of products and production structure. How are we going to decide a product each village will specialize in? Similarly, will there be enough resources, financial and human capital, to bring about such specialization? This kind of open-ended and wooly strategy dilutes the very purpose of having a well-directed, specific and incentive-enhancing IP.

It offers varying incentives to industries willing to operate in less developed districts. This will not lead us much far because businesses, by nature, try to concentrate in places where their counterparts and complementary industries are operating. A firm will be disinclined to operate in less developed districts despite offer of good incentives, which might not offset the increase in cost of production incurred by operating in less developed areas. Simply constructing roads up to factory sites won’t suffice for the promotion of industries in rural areas.

Furthermore, rather than coming up with brand new programs, it would had been better to upgrade or overhaul the existing ones such as the promotion of the IT park, expediting the establishment of SEZs, and importing technologies to update the outdated technological base of the industrial sector.

There are endogenous and exogenous variables contributing to the decline of the industrial sector. The endogenous variables are utter ignorance and lack of domestic firms to increase price and quality competitiveness of products, and a habit of doing business under other’s tutelage rather than their own intellect and sound management. The business community relied more on concessions, of various nature and degree, derived by coaxing politicians rather than banking on their own ability to discover the potential to intrude and expand in new markets. This habit and nature of doing business became self-reinforcing once the nexus between business community and politicians became stronger. Additionally, it choked product specialization and diversification, further necessitating the need to seek political blessing for survival in the competitive market. It was evident from the failure of numerous export-oriented firms, the most infamous being the textiles and garment industry.

The most binding constraints on industrial activity are the exogenous variables such as lack of infrastructure and energy, deficient human resources, deteriorating labor and industrial relations, political instability and policy inconsistency. The state has to address these constraints decisively. Else, the IP’s effectiveness will be very minimal.

[Published in Republica, May 29, 2010, pp.6]