Pegged exchange rate between Nepali rupee and Indian rupee and competitiveness

This blog post relooks at some of the issues surrounding the pegged exchange rate between Nepali rupee and Indian rupee, and its impact on competitiveness. For an earlier posts on exchange rate, see these posts: Stay the course on exchange rate;  Q&A on exchange rate; confidence on the Indian rupee in Nepal; and services exports competitiveness.

Nepal has been maintaining a pegged exchange rate to the Indian rupee for a long time. The peg of NRs1.60= IRs 1.0 has not been revised since 1993. With the changing pattern of trade, especially exponentially rising imports and small volume of exports together with low productivity, there are calls to either change the peg or float it freely with all currencies.[1] However, in successive Article IV reports, the IMF has been arguing that maintaining exchange-rate peg to the Indian rupee should be the key near-term policy priority because “abandoning it now would create significant uncertainty given weakness in the banking sector, likely leading to deposit and capital flight”(IMF 2011). Meanwhile, there is already a depreciation of exchange rate in the informal market, which was quite visibly seen in the border areas (IRs 1.0 = between NRs 1.65 and NRs 1.68).

The main reason for the calls to change the exchange rate is that it does not reflect the changes in trade and economic fundamentals since the time India and Nepal opened up their economies in the early 1990s. Between FY1993 and FY2010, the average annual GDP growth rate of the Indian economy and Nepalese economy was 7.0 percent and 4.4 percent respectively (see Table). On an average, the Indian economy had sectoral growth in agriculture, industry and services of around 3 percent, 7.3 percent and 8.6 percent respectively. The Nepalese economy had sectoral growth in agriculture, industry and services of around 3.1 percent, 4.4 percent, and 5.3 percent respectively. The simple average annual growth rate of the major indicators shows that the sectoral growth in Nepal had been lower than in India, except for that in agriculture. The trade deficit widened from Rs 10.92 billion in FY1993 to Rs 177.12 billion in FY2010. This alarming rise in trade deficit has been the main concern and rationale for revising exchange rate so that exports are encouraged and imports discouraged.

Table: Changes in Nepalese and Indian economies, FY1993-FY2010

Average annual growth rate, FY1993-FY2010
	Nepal	India
Real GDP	4.39	7.03
Agriculture	3.14	3.03
Industry	4.13	7.30
Services	5.26	8.61
Exports	9.50	14.05
to India	22.27
Imports	15.24	14.35
from India	18.31
Inflation	6.90	7.10
Nepal's trade with India (Rs billion)
	FY1993	FY2010
Exports	1.62	39.99
Imports	12.54	217.11
Trade deficit	10.92	177.12
Exchange rate (NRs/IRs)
Nominal	1.6	1.6
Real	1.36	1.92

Source: ADB and NRB data

Looking at the evolution of exchange rate between Nepalese rupee and Indian rupee and that with the dollar, it is clear that the existing exchange rate of IRs 1 = NRs 1.60 was prevalent even in FY1965. But, the Nepalese rupee has been revalued and devalued as per the evolving nature of Nepal’s and India’s economies. On June 6, 1966 following the devaluation of the Indian rupee, the exchange rate of Nepalese rupee vis-a-vis the Indian rupee appreciated by 57.5 percent (IRs 1 = NRs 1.0125). On December 8, 1967 the Nepalese rupee was devalued by 24.8 percent (IRs 1= NRs 1.35). 

Following the realignment of currency on December 17, 1971, the exchange rates of the Nepalese rupee vis-a-vis, Deutsche Mark, Japanese Yen and Indian rupee were revised effective December 22, 1971 (IRs 1 = NRs 1.39). Then effective from October 9, 1975, the exchange rate of the Nepalese rupee vis-a-vis the US dollar was revised. The exchange rate of other convertible currencies was quoted daily with reference to the US dollar rate in the international currency market. On June 1, 1983, the exchange rate system pegged on US dollar and Indian currency was replaced by a basket of currency system. On November 30, 1985,[2] the Nepalese rupee was devalued against foreign currencies (IRs 1 = NRs 1.68).

On July 1, 1991 the Nepalese rupee was revalued against Indian currency by 1.8 percent. And, on March 4, 1992 the Nepalese rupee was made partially (65:35) convertible on current account. It was followed by a change in proportion to 75:25 on July 12, 1992. On February 12, 1993 Nepalese rupee was revalued against Indian rupee by 3 percent to NRs 1.60 for 1 IRs and Nepalese rupee was made fully convertible on current account.

Figure: Exchange rate between Nepalese rupee and Indian rupee and US dollar

 

Source: Quarterly Economic Bulletin April 2011, Nepal Rastra Bank

As mentioned earlier, the main rationale for the calls for the revision of exchange rate, whether going for fully flexible system or devaluing the exchange rate, is to narrow down widening trade deficit. The prevailing perception among some analysts and policymakers is that the existing peg has to be devalued—a deliberate downward adjustment to the official exchange rate—so that Nepal’s export price competitiveness is improved and hence exports boosted.[3] The computation of the real exchange rate[4] also corroborates this argument.

Rodrik (2008) showed that undervaluation of currency (i.e. a high real exchange rate) not only reduces trade deficit, but also stimulates economic growth in developing countries. The caveat of this finding is that the operative channel is the tradeable sector (mainly industry), which should have a pretty strong foundation so that it can benefit from the devaluation of exchange rate.[5] In other words, developing countries that can increase relative profitability of their tradables are most likely to achieve higher growth from currency devaluation. Unfortunately, at present, Nepal does not have a strong industrial base due to persistent structural constraints to economic activities (also see why is Nepal poor?).

Figure: Real and nominal exchange rates between NRs and IRs after 1993

 

Source: Author’s computation using data from WDI (for inflation) and NRB (for nominal exchange rate); RER= Real exchange rate; NER= Nominal exchange rate

Though the existing economic fundamentals and widening of trade deficit with India necessitate a devaluation of the exchange rate, it can only work if Nepal has the prerequisites in place for the export-oriented sectors to take off. The prerequisites are mostly related to addressing the supply-side constraints such as power outages, labor disputes, increasing cost of labor and raw materials, strikes, and policy paralysis in terms of implementing already committed provisions in Trade Policy 2009 and Industrial Policy 2010, among others. It is expected that addressing these constraints would lower cost of production, encourage innovation, and research and development, which will make exports competitive and substitute a portion of import demand by domestic production. 

However, given the current fluid political situation, it is easier said than done. Hence, it is wise to think of favorably revising the pegged rate after the political situation is stable and the basic prerequisites for industrial sector to take off are in place, i.e. after institutional and market failures are duly taken care of.[6] Maintaining a stable and competitive real exchange rate requires a “supportive policy environment which would include prudent macroeconomic policies, a strong financial sector, and credible institutions” (Yagci 2001). For a developing country with limited links to global financial markets, low diversified production base and export structure, underdeveloped financial markets, lack of monetary credibility, and prone to bouts of high inflation, staying put on the existing peg until the necessary foundations are in place seems to be a good option (see Caramazza and Aziz (1998) for the pros and cons of fixed or flexible exchange rate regimes).

Note that hastily devaluing the exchange rate would risk adverse impact on the already deteriorating trade deficit because of the J-curve effect. In the short run, a real devaluation might not necessarily reduce total import volume as export and import connections are confirmed in advance. It would mean that the value of the current import volume would be higher in terms of domestic currency, leading to adverse impact on balance of trade. In the long run, as import volume gets affected by increased relative prices, total imports might decrease. Hence, a real depreciation might cause more damage initially before the expected changes start to kick in, that also provided that Nepal already has the prerequisites for export-oriented sectors to take off. Additionally, if the share of intermediate goods and raw materials used in production of export items are high in imports or the share the import demand is pretty much price inelastic,[7] (such as demand for petroleum fuel and LPG) then a real devaluation of exchange rate might not necessarily lead to reduction in imports and trade deficit. A devaluation of exchange rate will work only if the prerequisites are in place and institutional and market failures taken care of.

References

Caramazza, Francesco, and Jahangir Aziz. Fixed or Flexible? Getting the Exchange Rate Right in the 1990s. Economic Issues 13, Washington, D.C.: International Monetary Fund, 1998.

Chinn, Menzie D. "A Primer on Real Effective Exchange Rates: Determinants, Overvaluation, Trade Flows and Competitive Devaluation." Open Economies Review, 2006: 115-143.

IMF. NEPAL Article IV Consultation. IMF Country Report, Washington, DC: International Monetary Fund, 2011.

Rodrik, Dani. "The Real Exchange Rate and Economic Growth." In Brookings Papers on Economic Activity, by Douglas Elmendorf, Gregory Mankiw and Lawrence Summers, 1-47. Washington, D.C.: Brokings Institution, 2008.

Sapkota, Chandan, and Adnan Kummer. "Exchange rate: Stay the Course." Republica, March 23, 2010: 6.

Yagci, Fahrettin. Choice Of Exchange Rate Regimes For Developing Countries. Africa Region Working Paper Series No.16, Washington, D.C.: World Bank, 2001.

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[1] For a discussion on the pros and cons of changing the peg, see Sapkota and Kummer (2010)

[2] Nepal initiated the Structural Adjustment Program.

[3] Technically, devaluation of exchange rate makes exports less expensive, and discourages imports, which could help reduce both trade deficit and current account deficit.

[4] Real exchange rate is computed as RER = e*(P_I/P_N), where e is the nominal exchange rate, which is adjusted by the ratio prices in India (P_I) to prices in Nepal (P_N). Here, prices mean consumer price index (annual growth rate). The decline in real exchange rate value is interpreted as an appreciation of the exchange rate (or loss of cost competitiveness of exports). The assumption is that the cost differential between Nepal and India are closely related with the relative price structures in the two economies. For a detailed discussion on computing various real effective exchange rates, see Chinn (2006).

[5] Furthermore, maintaining a devalued real exchange rate requires higher saving relative to investment, or lower expenditures relative to income. Rodrik (2008) lists various policy tools to achieve these: fiscal policy (a large structural surplus), income policy (redistribution of income to high savers through real wage compression), saving policy (compulsory saving schemes and pension reform), capital-account management (taxation of capital account inflows, liberalization of capital outflows), or currency intervention (building up foreign exchange reserves). With low saving rate, high consumption rate, restrictive capital account, and remittance-fueled forex reserves to the tune of Rs 263 billion (imports from India alone was Rs 262 billion in 2010/11), Nepal is not in a position to fulfill these conditions right now.

[6] Sapkota and Kummer (2010) argue that at present devaluation is “definitely a better case than revaluation but a weaker case than status quo”, i.e. staying the course with IRs 1 = NRs 1.60. Specifically, devaluation could increase inflation in a highly import-dependent economy and could spur currency speculation as the market would want to hold stronger currency against weaker currency of a nation with waning industrial base for fear of repeated devaluation to keep up with further weakening of economic fundamentals.

[7] The top imports from India such as petroleum and coal products; ferrous metals; chemical, rubber and plastic; mineral products; and machinery and equipments do not have substituting industries in Nepal and hence the demand for these products will see marginal impact even if the peg is devalued right now to make them expensive in terms of domestic currency.

New inflationary normal in Nepal?

The figure shows the monthly change in inflation, which is an aggregate measure of the change in prices of goods and services, in the last three years and the first seven months of FY2013 (ending 15 July 2013). The inflation in a month of a particular fiscal year is the change in prices in that month compared to the prices in corresponding month in the preceding year. In other words, inflation of 10.1% in mid-August of FY2010 means that on average prices of goods and services have increased by 10.1% compared to the prices in mid-August of FY2009. The most widely yearly inflation data is computed by taking the average of monthly inflation in a fiscal year (in the figure, it is mentioned as annual average in the legend). The Nepal Rastra Bank gives 46.82% weight to food prices and 53.18% to non-food and services prices while determining overall inflation.

The figure shows that inflation in the first five months of this fiscal year has been consistently higher, though in a decreasing trend, than the levels reached in corresponding months of previous years. Compared to previous year, it essentially means that households have been paying higher prices, in general, for all goods and services purchased this year. High inflation is eroding household’s, whose income hasn’t kept pace with the inflation rate, purchasing power and is especially hitting poorer households hard. With the government’s failure to clamp down on inflation, which is hovering above 8% since 2008/09, people have built up expectations that prices will not come down in the near future (or say embedded expectations at a higher base). Unfortunately, we are living in times where inflation above 8% is becoming a ‘new inflationary normal’. Just for comparison, inflation was as low as 2.9% in 2000/01.

Traditionally, high inflation has its roots on too much money chasing too few goods, i.e. when the demand for goods (backed by too much money in hands of people) outstrips supply of goods. The central bank controls the flow of money (by changing interest rates and imposing regulatory restrictions) in the economy. However, given the pegged exchange rate with India, Nepal Rastra Bank’s monetary policies have little traction on inflation in Nepal. Alternatively, an irresponsible government with a knack for higher spending also pushes prices higher (or rather helps keep prices high).

Now, the question is: what really is pushing prices higher? Several factors come into play here. The very fact that our currency is pegged to Indian rupee and over 60% of trade occurs with India means that the inflation in India will naturally affect prices here. Research shows that about one-third of the price variability in Nepal is determined by prices in India. The rest is determined by domestic factors, including prices of administered petroleum fuel.

First, inflationary expectations are embedded in people’s consumption behavior due to the incompetency of government to control rising prices. Wholesalers and retailers deliberately jack up prices, irrespective of market supply and demand, each year during festival season (Dashain and Tihar) and the prices hardly come down after the end of festivals. This behavior is also apparent immediately after bandas and temporarily disrupted distribution of essential items.

Second, middlemen are distorting prices and deliberately keeping them high. For instance, transportation cost and some leakages do not fully justify more than 50% increase in prices of fruits and vegetables after they reach Kalimati from Dharke of Dhading. Powerful politically affiliated middlemen and associations act both as monopsonists (only they purchase food from farmers), and monopolists (only they sell food to wholesalers), in effect depriving farmers of the true price by stifling competition and also burdening consumers with artificially inflated prices.

Third, the frequent hike in administered fuel prices, high transportation costs, and long load-shedding hours have increased cost of production, which is ultimately reflected in retail prices. It affects costs at production site, distribution chains, and retail stores. Fourth, the continually rising imports of goods, especially those from outside of India, and the depreciation of the Nepali rupee have further pushed up prices as non-food and services have more weight in determining overall inflation.

All of this shows the failure of government leadership to lower inflation and make people’s lives easier. The ineffective market monitoring against anti-competitive practices, control of supply chains and market distortions, and to some extent a rise in cost of production are associated with government leadership and governance structure in practice. Recently, we have had leaders favoring high budget spending (unproductive ones) and cash handouts along with lax market monitoring because the supplies (ranging from construction materials to food items) are essentially controlled by party associates, who rake in huge commission by distorting market incentives. At some point controlling inflation becomes a political economy issue rather than a pure economic issue in developing countries like Nepal due to political, institutional and regulatory weaknesses along with immature linkages between and within sectors.

In effect, Nepali economy is destined to have high inflation, and with it people’s lives will get harder each year. Unless the market distortions are dismantled, unproductive spending are checked, and a sound macroeconomic framework (that doesn’t depend on remittances for sustenance) is created, we will continue to have a high inflationary normal, i.e. high inflation will be a new normal and people will experience continued erosion of purchasing power.

NEPAL: Multidimensional headcount poverty falls to 44.2% in 2011 from 64.7% in 2006

There has been quite an interest in interpreting the latest findings from UNDP’s Human Development Report, which, based on multidimensional poverty index (MPI), noted that of the 22 countries analyzed in the latest report, Nepal was the top performer in reducing MPI poverty. The MPI headcount poverty fell from 64.7% in 2006 to 44.2% in 2011, an astounding 4.1 percentage points decline per year. The latest survey used for this analysis was NDHS 2011.

From South Asia region, Bangladesh was another start performer with MPI poverty reduction of 3.4 percentage points per year between 2005 and 2010. The MPI poverty rate in South Asia is highest in Bangladesh (58%), followed by India (54%), Pakistan (49%) and Nepal (44%).

According to the latest HDR, while Sri Lanka is in the high human development group, Maldives, India and Bhutan are in the medium and the remaining ones in South Asia (Bangladesh, Pakistan,  Nepal and Afghanistan) are in the low human development group. Nepal’s HDI value for 2012 was 0.463 (ranking was 157 out of 187 countries). Between 1980 and 2012, Nepal’s HDI value increased from 0.234 to 0.463, an average annual increase of about 2.2%.  When HDI value of 0.463 is discounted for inequality, the HDI falls to 0.304, a loss of 34.2% due to inequality in the distribution of the dimension indices.  The average loss in South Asia is 29.1%.

The MPI replaced the Human Poverty Index (HPI), which used country averages to reflect aggregate deprivations in health, education, and standard of living. However, incorporating ten indicators in these three broad categories, the multidimensional poverty index [MPI = incidence (deprived in at least one-third of the weighted indicators) * intensity (proportion of weighted indicators in which households are deprived)] captures overlapping deprivations (prevalence) and deprivations on average (intensity). It also can be used to compute depravations using disaggregated data at the sub-regional level.

The education (years of schooling and school attendance) and health dimensions (nutrition and child mortality) are based on two indicators each while the standard of living dimension is based on six indicators (cooking fuel, sanitation, water, electricity, floor and asset ownership). A person is multidimensionally poor if the weighted indicators in which he or she is deprived add up to at least 33.3%. Households with a deprivation score greater than or equal to 20% but less than 33.3% are vulnerable to or at risk of becoming multidimensionally poor.

The MPI headcount differs substantially from CBS’s and WB’s poverty estimate. This is because the last two estimates are based on (consumption based) monetary measures, but the MPI is based on ten indicators that reflect multidimensional deprivations. It requires a household to be deprived in multiple indicators at the same time. The MPI shows the interconnectedness among deprivations and combines several MDG indicators into a single measure. So, while 44.2% of the population lived in MPI poverty, an additional 17.4% were vulnerable to multiple deprivations. [Note that the * sign adjacent to 2011 for CBS’s data refers to the change in consumption aggregates used to compute poverty. Without this one, the poverty rate fell even steeply. See this blog post.]

The point here that whatever measure of poverty you look at, there has been a substantial reduction in poverty and as a share of population, headcount poverty rate is not the highest in Nepal (when compared to other countries in the region). For more on national poverty line, see this blog post. The explanatory story also remains more or less the same, i.e. remittances backed reduction along with provision (mostly access) of basic necessities. The MPI shows that improvement in asset ownership, electricity and nutrition contributed the most in reducing poverty (both among overall population as well as among poor only).

The pie chart below shows the contribution of different indicators to the MPI. Nutrition followed by years of schooling child mortality, cooking fuel, sanitation and assets among others had the largest contribution (not in reduction in poverty but in pushing households below poverty line).

Region-wise breakdown shows that MPI poor (% of regional population) was the lowest in Western region and highest in Mid-western and Far-Western. Western and Eastern regions had MPI poor below the national average.

Further sub-regional breakdown reveals a surprising trend: Terai region reduced poverty the most. The figure below ranks regions from poorest (far left) to least poor (far right) and shows the rate of poverty reduction of each region between 2006 and 2011. Far-Western Terai region (even though fourth in terms of MPI headcount poverty when compared to all sub-regions) saw the largest rate of poverty reduction. It is followed by Western Terai and Central Terai. Central Hill and Mid-Western Terai reduced multidimensional poverty the least.

Western Terai more than halved its poverty rate (67% in 2006 to 33.4% in 2011). Far-Western Terai and Eastern Terai also achieved significant reduction in poverty rate (from 82.3% to 50.1% and from 61% to 32.5% respectively). Headcount poverty in Western Terai, Eastern Terai, Western Hill, and Central Hill was lower than the national average of 44.2%.

Before closing off this long post, few things to keep in mind:

1. The MPI supplements $1.25 a day and national poverty measures by looking at deprivations across 10 indicators. It is not one versus the other.
2. All three measures of poverty show a drastic decline in poverty.
3. The outstanding performance (regional comparison) of Nepal may not remain so in the days ahead because survey data for all countries was not for uniform time period. As new survey data are available, the relative position of Nepal might also change. But, still the story is that there has been a drastic reduction in poverty.
4. Improvements in asset ownership, access to electricity and better nutrition contributed the most to reduction in poverty. The role of remittances in all of these is loud and clear. Rural roads (leading to price reductions), increase in rural wages, social expenditure, vibrant civil society and active women's participation are also stressed upon.[Still, since nutrition followed by years of schooling child mortality, cooking fuel, sanitation and assets are the factors keeping poor people poor, the policy focus should be on improving access to and availability of these basic services.]
5. Sub-regional poverty analysis shows that largest multidimensional poverty reduction occurred in Terai region.
6. For those interested in the Alkire and Ravallion debate on MPI and $1.25 a day, see this blog post. Here is a summary of MPI released in 2010. Most of the figures in this blog post comes from Alkire’s presentation and the Nepal chapter of the report and related datasheet.

Nepal’s fiscal cliff

Todd Schneider, IMF’s mission chief for Nepal, argues that the lack of a full budget and the expenditure for FY2013 thus far set at the actual expenditure in FY2012 is leading to a situation where real expenditure (i.e., accounting for inflation) is contracting while rising revenue mobilization is pulling off money from people’s hands and storing it in the savings account of the government.

The inability of the government to spend money when so much of development works—particularly those related to infrastructure, which helps boost productivity— need to be accomplished is simply exerting unnecessary inertia on Nepal’s growth engine. Consequently, high government savings are resulting in liquidity strain (not the only reason, but one of the main reasons) in the banking sector. All of these will surely hit growth rate, which is already restrained by expected low agriculture production due to unfavorable monsoon, which IMF expects not to cross 3%.

In effect, there is a real expenditure contraction. This could be Nepal’s unintended “fiscal cliff”, emanating, as usual, from the lack of political consensus and the inability to separate basic budgetary processes from political influence.

Excerpts from Todd’s article:

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The move back toward political cooperation and consensus could help address the sharp reduction in government spending that has arisen in the absence of a formal, detailed government budget for 2012/13—known in some circles as Nepal’s “fiscal cliff”.

There are several reasons for this regrettable state of affairs. First, the 2011/12 government budget was under-executed—particularly for investment spending where only about 73 percent of the budget was actually spent. This under-performance was then used as the base for the spending ordinance passed in late November 2012.

Second, the 2012/13 budget ordinance of Rs 351 billion is a nominal figure—taking no account of inflation. So if projections for year-end inflation turn out to be accurate, spending could fall by another 9 percent in real terms.

The lack of a full budget with line-item allocations has further dampened expenditures. The budget ordinance was politically expedient, but lacked the detail that would allow government ministries to spend—and spend wisely.

Consequently, more money is being taken out of the economy via tax than is being put in by expenditure. As a result, government deposits are rising at the central bank, and liquidity available to commercial banks has dropped, putting upward pressure on interest rates and challenging monetary policy.

[…]Quick executive action on an appropriation ordinance (to allow line ministries to spend) would be the first step. Speeding up the approval process for investment projects would also help. Looking ahead, another year of badly-needed economic growth should not be lost to infighting and indecision over the next budget. The risks are high given the short time left to hold elections and forge a new consensus government before the beginning of the 2013/14 fiscal year in July. Political cooperation is needed to put the budget above the political fray, manage government spending in line with existing national priorities, and “do business” as normally as possible. How this is to be done should be decided now, as the budget is being formulated. Transparency and an inclusive dialogue on budget priorities should be an integral part of political parties’ agenda for the next several months, with the common objective of starting 2013/14 with a full-year budget in place. This opportunity to step back from the edge of Nepal’s fiscal cliff should not be missed.

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Todd has hit the nail on the head here. Highly recommended article.

Even if we account for 10% inflation, the actual expenditure allocation should have been around Rs 396 billion (including Rs 7 billion for election and Rs 3 billion for rehabilitation of Maoist combatants). The budget allocation is usually higher than actual expenditure, probably around Rs 430 billion for FY2013.

The political parties need to reach a consensus that FY2014 budget will not end up having the same fate as FY2013 budget. If not, there will be even more real expenditure contraction (and even more steeper ‘fiscal cliff’). For the sake of accounting purpose as well, Nepal needs to present a full budget for FY2013 however late it is, and set the stage for a full budget for FY2014. More on these in later blog posts when I have free time.

Fostering competitive spirit among federal states

Milan Vaishnav of Carnegie Endowment explains the lack competition in good policy formulation, experimentation and implementation among Indian states in this article. He states: “Federalism, in theory anyway, creates a marketplace for public policy, in which the best policies eventually take hold and are replicated across units, while the worst are relegated to the dustbin of history.”

Excerpts from the article below:

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The nature of federal fiscal relations, the concentration of power in state capitals and the absence of a venue for cross-state exchange of ideas are all biased against a more competitive federalism in India. If India’s states are to truly serve as effective laboratories for improving public policy, they must be liberated from these institutional impediments. Institutions are notoriously sticky, yet there are a few signs of hope on the horizon. Notwithstanding incentives to the contrary, India’s states often do manage to spur policy experimentation—but it just is not always clear how these experiments add up. We have Chhattisgarh linking smart cards to the Public Distribution System, Andhra Pradesh evaluating the impact of contract teachers on primary education, Gujarat reforming electricity by linking higher user fees to guaranteed service provision—the list goes on. This demonstrates that state governments can take initiative and ministers are able to carve out space to experiment when the conditions are right. But the next step is much harder: fostering an environment of learning across states. One positive development in this regard is the Planning Commission’s recent proposal to streamline the number of centrally sponsored schemes while increasing the amount of flexibility that states have with respect to programming funds. According to the draft proposal, centrally sponsored schemes would set aside up to 20 percent of allocated funds (10 percent for flagship schemes) for “flexible spending” by the states, which would give them the space to encourage local experimentation.

Inadvertently, the recent reform to allow greater foreign direct investment (FDI) in multi-brand retail could also provide a learning opportunity for states. Although it was characterized as a defeat at the time, the center’s decision to allow states to decide whether to the implement the new FDI regulations will create, as it were, a “treatment” and “control” group. Those states standing on the sidelines waiting to see whether the adopters sink or swim will have a golden opportunity to learn from their peers. If this counts as a policy defeat, India may well need many more like it.

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Trade finance gap in Asia is estimated at $425 billion

Based on a survey conducted in the fourth quarter of 2012 to identify and quantify gaps in trade finance, the Asian Development Bank (ADB), in its latest brief, estimates that $1.6 trillion of demand for trade finance is unmet (Asia’s share of unmet global trade finance is $425 billion).

Furthermore, it estimates an increase of 5% in availability of trade finance could result in an increase of 2% in production and 2% more jobs. Trade finance affects trade volume, business expansion, and job creation.

For international banks, the main factors that was perceived to aggravate the trade finance gap are

• Previous dispute or unsatisfactory performance of issuing banks
• Issuing bank’s low credit ratings
• Low country credit ratings
• Basel regulatory requirements
• Issuing bank’s weak capacity
• Lack of dollar liquidity
• High transaction costs or low fee income

Does export promotion programs work in long term?

The evaluation of export promotion program in Tunisia shows that while beneficiaries initially saw faster export growth and greater diversification across destination markets and products, after three years the growth rates and the export levels of beneficiaries were not significantly different from those of non-beneficiary firms.

Excerpts from the paper by Cadot, Fernandes, Gourdon and Mattoo below:

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This paper evaluates the effects of the FAMEX export promotion program in Tunisia on the performance of beneficiary firms. While much of the literature assesses only the short-term impact of such programs, the paper considers also the longer-term impact. Propensity-score matching, difference-in-difference, and weighted least squares estimates suggest that beneficiaries initially see faster export growth and greater diversification across destination markets and products. However, three years after the intervention, the growth rates and the export levels of beneficiaries are not significantly different from those of non-beneficiary firms. Exports of beneficiaries do remain more diversified, but the diversification does not translate into lower volatility of exports. The authors also did not find evidence that the program produced spillover benefits for non-beneficiary firms. However, the results on the longer-term impact of export promotion must be interpreted cautiously because the later years of the sample period saw a collapse in world trade, which may not have affected all firms equally.

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Chart of the week: Favored channels of ODA delivery in fragile and non-fragile nations

Below is an illustrative chart (sourced from OECD’s publication Fragile States: Resource Flows and Trends) that shows the amount of aid money entering a country through various channels.

In Nepal, a large portion of foreign aid goes "non reported" and those reported are channeled through public sector, followed by NGOs, multilateral agencies, and others. No aid flowing through PPP (understandably so considering the lack of viable PPP institutional and regulatory frameworks). The report notes that Nepal is chronically under-aided (p.88, Box: 3.1).

NEPAL: Interesting flights data in FY2012

Here are interesting stats that I picked up from Sangam’s article in The Kathmandu Post:

• Domestic passenger movement dropped 0.55 percent to 1.575 million in 2012 (attributed to high domestic prices due to high fuel charges, less bandhs and more luxury coaches, slow economic growth and real estate activities, and low capital spending).
• The Nepali skies saw 70,877 flights in the review period, a drop of 10.49 percent.
• An average 195 planes took off and landed at TIA daily (Thats about 16 take offs and landing per hour if the domestic terminal opens for 12 hours a day).
• High fuel surcharge:
• Flying from Kathmandu to Bhadrapur now costs Rs 6,550 (Rs 3,250 fare and Rs 3,300 fuel surcharge), compared to Rs 4,200 in 2010.
• The normal airfare to Pokhara has soared to Rs 4,035 from Rs 2,500 two years ago. Fuel accounts for more than 30-35 percent of their overall operating cost
• Oligopolistic market:
• Buddha Air secured 60 percent of the market share among the seven commercial domestic airlines. The carrier flew 881,611 travelers in 2012, up 27.59 percent. Yeti Airlines took 28.74 percent.
• Yeti flew 452,806 travellers in 2012, a slim growth of 0.74 percent compared to 2011.
• Apart from these two rivals, all five airlines saw a negative growth.
• Collapse and irregular operation of struggling airlines like Agni Air, Guna Airlines and Sita Air benefited Buddha and Yeti.

Value added trade and global value chains

The global trade landscape is changing along with the development of sophisticated global value chains (intra-firm or inter-firm, regional or global). The gross trade figures hide the real value addition that takes place while a good or service is produced in a country or across countries. The WTO already has a website that details value added trade. Here is an earlier blog post based on it. Also, here is more on why value added is a better measure of trade.

In its latest report on global value chains, the UNCTAD argues that 80% of global trade takes place in value chains linked to transnational companies. It states that as much as 28% of gross exports is actually double counted due to non adjustment of value addition during each production process scattered across many countries. It also shows that production and trade of goods and services are linked at some stage.

It recommends developing countries to “engaging” in GVCs, “upgrading” along GVCs, and “leapfrogging” and “competing” via GVCs. The ideal outcome for developing countries would be to an increase in global value chain participation with higher value added goods and services. GVCs participation could help developing countries build their productive capacities (through technology dissemination and skill enhancement).

Excerpts from the latest UNCTAD report:

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GVCs make extensive use of services. While the share of services in gross exports worldwide is only around 20 per cent, almost half (46 per cent) of value added in exports is contributed by services sector activities, as most manufacturing exports require services (such as engineering work, software development, and marketing) for their production. In fact, a significant part of the international production networks of TNCs is geared towards providing services inputs, with more than 60 per cent of global foreign direct investment (FDI) channelled to services activities. By comparison, 26 per cent of FDI goes to manufacturing and 7 per cent to the primary goods sector. The picture is similar for developed and developing economies.

The majority of developing countries, including the poorest, are increasingly participating in GVCs. The developing-country share in global value-added trade increased from 20 per cent in 1990 to 30 per cent in 2000, and is over 40 per cent today. Again, the role of TNCs is critical, as countries with a higher presence of FDI relative to the size of their economies tend to have a higher level of participation in GVCs and a greater relative share in global value-added trade compared to their share of global exports.

GVC links in developing countries can play an important role in economic growth. Domestic value-added – that is, an improved capacity of an economy to produce a broader variety of goods, and goods of greater complexity – resulting from GVC trade can be very significant relative to the size of local economies. In developing economies, value-added trade contributes some 28 per cent to countries’ GDPs on average, as compared to 18 per cent for developed economies. Furthermore, there appears to be a positive correlation between participation in GVCs and GDP per capita growth rates. The economies with the fastest-growing GVC participation have GDP per capita growth rates some 2 percentage points above average.

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Female migrants and income thresholds

An interesting study based on household data in Sri Lanka by Sanjaya DeSilva. The author finds that while households with female migrants experience enhanced catching up in terms of income level, households with male migrants see their economic position strengthened. Also, remittances from female migrants are used for home improvements and farm and nonfarm assets accumulation. Excerpt from the study is below:

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Utilizing a nationally representative sample of households from Sri Lanka, this study examines gender differences in the long-term impact of temporary labor migration. We use a propensity score matching (PSM) framework to compare households with return migrants, households with current migrants, and equivalent nonmigrant households in terms of a variety of outcomes. Our results show that households that send women abroad are relatively poor and utilize migration to catch up with the average household, whereas sending a man abroad allows an already advantaged household to further strengthen their economic position. We also find that remittances from females emphasize investment in home improvements and acquisition of farm land and nonfarm assets, whereas remittances of men are channeled more toward housing assets and business ventures.

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