Saturday, August 31, 2013

Remittances recap

Chami and Fullenkamp neatly summarize the impact of remittances in the latest edition of Finance & Development magazine (highly recommended for those who are unaware of it).

Excerpts from the article:

[…]remittances can provide much-needed fiscal space—which allowed some countries to increase spending, lower taxes, or both, to fight the effects of the recent global recession.­

[…]governments can sustain higher levels of debt when the ratio of remittances to domestic income is high—which reduces country risk.

[…]By expanding the tax base, remittances enable a government to appropriate more resources and distribute them to those in power. At the same time, remittances mask the full cost of government actions. Remittances can give rise to a moral hazard problem because they allow government corruption to be less costly for the households that receive those flows. Recipients are less likely to feel the need to hold the authorities accountable, and, in turn, the authorities feel less compelled to justify their actions.

[…]Because remittances increase household consumption, fluctuations in remittance flows can cause changes in output in the short term. But a shock that reduces economic output is also likely to induce workers abroad to send more remittances home, which then has the effect of reducing output volatility.

[…]remittance flows increase the simultaneous occurrence of business cycles in remittance-sending and remittance-receiving countries.

[…]Remittance inflows can also facilitate the financing of investments by improving the creditworthiness of households, effectively augmenting their capacity to borrow. Remittances may also reduce the risk premium that lenders demand, because they reduce output volatility.­

[…]But if remittances are perceived to be permanent income, households may spend them rather than save them—significantly reducing the amount of flows directed to investment. […]many households save part of the remittances by purchasing assets such as real estate, which generally doesn’t increase the capital stock.

[…]evidence from the Philippines and from Mexico suggests that receiving remittances leads to increased school attendance. However, that extra education would likely have little effect on domestic economic growth if it simply makes it possible for the recipients to emigrate.­

[…]Remittances enable recipients to work less and maintain the same living standard, regardless of how the distant sender intended them to be used (say, to increase household consumption or investment). Anecdotal evidence of this negative labor effort effect is abundant, and academic studies have detected such an effect as well. Thus, remittances appear to serve as a drag on labor supply.

[…]remittances may enhance the efficiency of investment by improving domestic financial intermediation (channeling funds from savers to borrowers).[…]remittances may help GDP growth when the financial markets are relatively underdeveloped because remittances loosen the credit constraints imposed on households by a small financial sector.

[…]remittances can lead to real exchange rate appreciation, which in turn can make exports from remittance-receiving countries less competitive.

[…]When a positive effect of remittances on growth is found, it tends to be conditional, suggesting that other factors must be present for remittances to enhance economic growth. For example, some studies have found that remittances tend to boost economic growth only when social institutions are better developed.

­[…]unequivocally good for recipient households because they alleviate poverty and provide insurance against economic adversity.

[…]governments will have to strengthen or facilitate the channels through which remittances benefit the overall economy while limiting or weakening others.

[…]he government can take advantage of its increased borrowing capacity to finance improvements in infrastructure. One potential use would be to upgrade a country’s financial system at all levels, including improvements in the payment system, availability of banking services, and financial literacy.

[…]Policymakers must design programs that are responsive to the needs of individual households and that give recipients the proper incentives to use remittances productively. Promoting the acceptance of remittance income as collateral for private loans used to finance productive investments is one way to direct remittance income into growth-enhancing investments.­

For those interested, my earlier paper on remittances in Nepal is also along these lines and contextualized by keeping Nepal in perspective.

Wednesday, August 28, 2013

Economic growth and its determinants in the future

Dani Rodrik, in a new working paper titled The Past, Present, and Future of Economic Growth, argues that economic growth in the future hinges on (i) stable macroeconomic framework; (ii) economic restructuring and diversification; (iii) social protection; (iv) investment in human capital and skills;and (v) regulatory, legal and political institutions.

Excerpts from the paper below:

The future of growth is unlikely to look like its recent past. It may well be that the six decades after the end of World War II will prove to have been a very special period, an experience not replicated before or after. The rate of convergence between poor and rich countries is likely to fall considerably from the levels seen during the last two decades. Developing countries will probably still grow faster than advanced economies, but they will do so in large part because of the slowdown in growth in the advanced economies.

Ultimately, growth depends primarily on what happens at home. Even if the world economy provides more headwinds than tailwinds, desirable policies will continue to share features that have served successful countries well in the past. These features include a stable macroeconomic framework; incentives for economic restructuring and diversification (both market led and government provided); social policies to address inequality and exclusion; continued investments in human capital and skills; and a strengthening of regulatory, legal, and political institutions over time. Countries that do their homework along these dimensions will do better than those that do not.

Beyond these generalities, however, the main policy implication is that future growth strategies will need to differ from the strategies of the past in their emphasis, if not their main outlines. In particular, reliance on domestic (or in certain cases regional) markets and resources will need to substitute at the margin for reliance on foreign markets, foreign finance, and foreign investment. The upgrading of the home market will in turn necessitate greater emphasis on income distribution and the health of the middle class as part and parcel of a growth strategy. In other words, social policy and growth strategy will become complements to a much greater extent.

Wednesday, August 21, 2013

Manufacturing sector and the path to prosperity

The manufacturing sector’s role in structural transformation, high wages, job creation and stimulus to growth is pretty well-known as most of the advanced economies have taken off by first strengthening their manufacturing (and overall industrial) sector. However, most low income and emerging Asian economies have seen their services sector widen and manufacturing sector shrink, leading to low to modest growth and income rise—ultimately slowing productivity and structural transformation. Here is more on the importance of manufacturing sector and structural transformation.

Reiterating the importance of manufacturing sector, a latest ADB report asserts that it is impossible to bypass the manufacturing sector on the path to prosperity. It states that no economy has reached high income status without reaching at least 18% share of manufacturing in total employment for a sustained period.

Excerpts from the report:

The report notes that one group of economies—Hong Kong, China; Japan; the Republic of Korea; Singapore; and Taipei,China—rapidly industrialized to become high income countries, while another group of economies, including the People’s Republic of China (PRC), Malaysia, and Thailand, are transforming more slowly.

Other developing Asian nations, such as Bangladesh, India, Pakistan or the Philippines, are changing even more slowly, have created few manufacturing jobs, and are shifting from agriculture into services.

Services are the largest share of developing Asia’s output and agriculture remains the largest employer, providing an income for 700 million people.

Regional diversity means Asia’s economies require different policy priorities to promote transformation. Modernizing the agricultural sector is a key task in developing Asia, in particular for low income countries.

For middle income economies heavily dependent on labor-intensive sectors or currently bypassing industrialization, the focus should be on upgrading their industrial base. For these nations, good quality education is essential for industrial diversification and reducing the path-dependency nature of structural transformation.

For small island economies, industrialization may not be cost effective, and the future lies in becoming competitive in certain service sector niche markets.

For economic transformation, the report observed the following:

  • Agriculture needs to be modernized by deploying infrastructure, introducing technological improvements, developing agribusiness, and increasing linkages to global value chains.
  • Industrialization is a step that, in general, is difficult to bypass on the path to becoming a high-income economy.
  • The service sector is already the largest source of employment and this trend will continue.
  • Basic education of high quality matters for industrial upgrading and, in general, for the development of new industries that can compete internationally.
  • Although it is important for countries to exploit their comparative advantages, some form of government intervention may be necessary and unavoidable to expedite economic transformation.

[Nepal’s structural transformation is going to be slow as the industrial sector is already tanking. The projections for 2040 show: (i) projected growth rate of income per capita of 4.1%; (ii) share of elasticities of income per capita of –0.19 and –0.10 for output and employment, respectively; (iii) agriculture share of GDP about 20.1%; and (iv) share of agriculture employment in total employment of about 49.9%.]

Sunday, August 18, 2013

Unusual Structural Transformation: Is Nepal stuck in a low growth trap?

The sectoral value addition and its movement against per capita GDP in the chart above indicates that high growth in Nepal won’t be sustained unless the industrial sector is strengthened along with the promotion of high value agriculture production and services activities. Else, growth will continue to be determined by the monsoon (agriculture sector) and remittances-backed consumption demand of mostly imported goods (low productive, low value added services sector activities such as wholesale and retail trade, real estate and housing, among others).

Interesting observations:

  • While the decline of agriculture sector is accompanied by the increase of services sector in Nepal, it is the opposite in India and South Korea, where the decline of agriculture sector was accompanied by rise of industrial sector. The intersection of these trends occurred at US$323 per capita GDP (in 1972) in South Korea and US$ 465 per capita GDP (in 2001) in India. This probably reflects the early industrialization drive along with steady accumulation of human and institutional capitals in South Korea. 
  • Services sector tends to grow consistently in both India and South Korea. However, there is a sharp increase in India circa 1980.
  • In China, though the decline of agriculture sector is accompanied by the increase of services sector, the industrial sector contribution is mostly higher than the contribution of agriculture and services sectors.
  • In Nepal, the decline of agriculture sector is accompanied by the increase of services sector (mostly low-value added activities like real estate, retail and wholesale trade, transport, etc— the demand for which is directly related to the remittance-backed consumption demand of imported goods traded in these sectors, implying that employment generation and domestic value addition are pretty low). Meantime, the industrial sector is continuously tanking. The intersection between decline of agriculture sector and increase of services sector occurred at around US$219 per capita GDP. It was circa 1998, the time when Nepal benefited favorably for a short time period from the Nepal-India trade treaty of 1996 (no value addition requirement in manufacturing goods exported to India). However, this was also the time when the Maoist insurgency started to heat up, forcing large number of people to migrate out of rural areas. Meantime, the inclement investment climate led to closure of many firms in the industrial sector, resulting in loss of jobs, high value production and productive activities. Consequently, those who migrated to urban areas and new entrants to the labor force either opted to seek employment overseas or engage in low value added, low paying services sector activities domestically. The high inflow of remittances has further fueled this process.
  • While in high growth and emerging countries, industrial sector plays a focal role in sustaining the transition from low value added production and productivity to high value added production and productivity, this whole feature is missing in Nepal’s case. Hence, the transition from low value added and low productivity agriculture production to low value added and low productivity services sector activities. This is resulting in a low growth trap, that too sustained by remittances-backed consumption demand of imported goods and the resulting trading activities. There is little domestic value addition and growth multiplier.

Overall, the message is that the ongoing structural transformation of Nepali economy appears abnormal and the economy is stuck in a low growth trap (mostly below 5%) sustained by robust remittance inflows and the monsoon. The only way to break free of it is to tackle head-on the binding constraints to economic activities, especially in the industrial sector.

Monday, August 12, 2013

Remittances in Nepal: Boon or Bane?

Below is the abstract of a recent paper published in The Journal of Development Studies (authored by yours truly!) :) 

Nepal is one of the highest recipients of remittances (percentage of GDP) in the world. For a small land-locked economy battered by a decade-long Maoist insurgency (1996–2006), prolonged political instability, slow growth rate and large exodus of youths for employment overseas, high inflow of remittances bears a huge significance both at micro and macro levels. Exploring various facets of high migration and remittances, this article shows remittance-induced Dutch disease effects and policy laxity to improve investment climate in Nepal. Since it is costly to sterilise the impact of remittances each year, it might be prudent to learn to live with it and gradually channel remittances to productive usages with a goal to boost productivity.

Tuesday, August 6, 2013

Nepal 128th innovative nation (out of 142)

According to the latest Global Innovation Index 2013, Nepal has ranked 128 out of 142 countries. In GII 2012, Nepal ranked 113 out of 142 countries. This year’s GII used 84 indicators, including the quality of top universities, availability of microfinance, venture capital deals, to gauge both innovation capabilities and measurable results.

The GII 2013 is calculated as the simple average of two sub-indices. The innovation input sub-index gauges elements of the national economy which embody innovative activities grouped in five pillars: (1) Institutions, (2) Human capital and research, (3) Infrastructure, (4) Market sophistication, and (5) Business sophistication. The innovation output sub-index captures actual evidence of innovation results, divided in two pillars: (6) Knowledge and technology outputs and (7) Creative outputs.

Nepal’s ranking (out of 142 countries) in the sub-indices and the pillars within them are listed below:

  • Innovation input sub-index (129)
    1. Institutions (125)
    2. Human capital and research (130)
    3. Infrastructure (122)
    4. Market sophistication (123)
    5. Business sophistication (97)
  • Innovation output sub-index (123)
    1. Knowledge and technology outputs (127)
    2. Creative outputs (106)
  • Innovation efficiency ratio [Output sub-index by input sub-index] (77)

Now, why is innovation important for a struggling economy like Nepal? It is because to remain competitive (both in factor and product markets), Nepal has to innovate, which would mean finding new ways of doing business to enhance productivity and efficiency. It has been argued that innovation leads to a virtuous circle, i.e. once a critical threshold is reached, investment entices investment, talent entices talent, and innovation generates more innovation. This way the economy can remain competitive, create employment opportunities with high paying jobs, and attract a steady flow of new investments. The decline of exports and increasingly higher imports replacing domestic production have been a glaring feature of the lack of innovation in Nepali economy.

The urgent need is to focus on the enables for making the economy competitive, i.e. stable institutions (including political stability), adequate accumulation of human capital, adequate supply of infrastructure, and more investments in R&D both in public and private sectors.

Excerpts from the GII 2013 report below:

Switzerland and Sweden’s performance reflects the fact that both countries are leaders in all components (pillars) of the GII, consistently ranking in the top 25. The United Kingdom has a well-balanced innovation performance (ranking 4th in both input and output), in spite of a relatively low level of growth in labor productivity. The United States continues to benefit from its strong education base (especially in terms of top-rank universities), and has seen strong increases in software spending and employment in knowledge-intensive services. The US was last in the GII top 5 in 2009, when it was number one.

Through several of its analytical chapters, the 2013 edition of GII explores how innovation has benefitted from ‘local specifics’ in different parts of the world. One key message is that too many innovation strategies have been focused on trying to replicate previous successes elsewhere, like Silicon Valley in California. However, fostering local innovation requires strategies that should be deeply rooted in local comparative advantages, history and culture. They should be combined with a global approach to reach out to foreign markets, and attract overseas talent.

The creation of an environment that could unleash the potential for innovation for all in a sustainable manner is the way to unlocking the true, tangible potential of value creation; it will lay the groundwork for societal change and develop a framework for cohesive synergies through collaboration.

Saturday, August 3, 2013

How can money supply growth not increase when CRR and SLF are reduced?

The Nepal Rastra Bank (NRB) on 21 July introduced the monetary policy for FY2014 largely supporting the budget’s growth and inflation targets of 5.5% and 8%, respectively. Overall, the monetary policy is loose and there is a provision to increase directed lending to deprived and priority sectors (at least 12% of total credit to agriculture and energy sectors).

One of the interesting things about this year’s monetary policy is the unchanged money supply growth target in the face of a decline in cash reserve ratio (CRR) and Standing Liquidity Facility (SLF). The CRR has been reduced by 100 basis points to 5%, 4.5% and 4% for commercial banks, development banks and finance companies, respectively. Similarly, SLF for commercial banks, development banks and finance companies has been reduced to 12%, 9%, and 8%, respectively. In FY2013, SLF for commercial banks, development banks and finance companies was 15%, 12%, and 10%, respectively. The bank rate is unchanged at 8%. Despite these, the central bank has left unchanged money supply growth at 16%.

The reduction in CRR and SLF increases monetary base and then eventually money supply.

  • Monetary base = currency in circulation + reserves of banks in central bank
  • Money supply = currency in circulation + demand deposits

When you reduce CRR, banks’ reserves in the central bank goes down, allowing them to lend more, which, ceteris paribus, increases the magnitude of money multiplier (the ratio of money supply to monetary base). Even if you keep money multiplier unchanged but increase monetary base, money supply increases. Alternatively, the only way you could have a constant money supply is by reducing money multiplier to such an extent that the total value of money multiplier times the increased monetary base is unchanged from last year, i.e. it would result in constant money supply growth. This seems to be a pretty daunting task for the central bank to hold on to. With the rise in the number of migrants and the incentive to remit more money back home due to the depreciation of Nepali rupee, net foreign asset is set to increase. It means the central bank has to print more Nepali rupees to match the extra incoming dollars. This automatically leads to an increase in money supply. Or am I missing here something?

One argument is that the NRB plans to channel the extra expected increase in lending (due to reduced CRR and SLR) to productive sectors, where the absorption capacity is relatively higher and would exert weak demand-push inflationary pressures. But, irrespective of channeling more credit to productive sectors, the conundrum is: how is the central bank planning an unchanged money supply growth by reducing reserve requirements?