Sunday, November 24, 2013

NEPAL: Major economic issues for Constituent Assembly II

The Constituent Assembly (CA) II election is almost over with the final tallying of 240 winners in the directly elected (first past the post) part. More will be decided based on proportional representation votes and nomination of 26 additional members by the political parties, filling in the CA II with 601 members. Hopefully, the CA II members will be able to iron out differences and deliver the Nepalese people an inclusive constitution.

Notwithstanding the political developments in the days ahead, below are some of the major economic challenges the CA II will have to deal with. At the outset, let me state that any economic and development narrative without migration and remittances, which are having profound impact at micro, macro and institutional levels, is incomplete. 

The figure below shows the sectoral contribution to GDP growth and GDP growth (basic prices).
Management of migration and remittances: Coherent policies to manage migration and remittances are missing despite these being the lifelines to the economy, which is struggling to grow beyond 5%. Nearly 1250 workers legally left the country each day for work overseas in FY2013. Both push and pull factors are at work here. Despite the high financial and human costs of migration for unskilled and low skilled works, there is little leverage (apart from fixing minimum wage for Nepalese workers in certain countries) Nepal has in terms of addressing these issues beyond its borders. The CA II members will have to come up with policies and strategies to better manage migration of Nepalese workers in such a way that it results in a win-win situation.

These may include: (i) wider publicity about the pros and cons of overseas migration for work; (ii) clarity on the total wage and income differences between overseas work and comparable jobs domestically; (iii) skills training to migrants in view of the jobs or sectors they will be working overseas (this will give them better clarity of the nature of work and will also help them fetch better salaries); and (iv) better facilitation in documentation (to prevent them from scams and agents who take a ‘cut’ from their income) and at the exit point (especially at the Tribhuvan International Airport). The overseas migrant workers (some of them cannot even fill out the necessary forms) need to be respected and provided appropriate assistance where necessary.
Regarding remittance inflows, which amounted to an estimated 25.5% of GDP in FY2013, the government will have to urgently explore how to better channel remittances to productive usages as almost 80% of it is used for daily consumption by households. Nepal cannot ride against the tide and will have to learn to live with high and persistent remittance inflows. The only option now is to leverage remittances to productive usages such as: (i) investment in infrastructure (including energy); (ii) high value agriculture production; (iii) commercial agricultural activities; (iv) industrial sector investment; and (v) high value service sector activities, among others. India and Israel have successfully raised billions of dollars by selling bonds targeted at expats and workers overseas. Similarly, the Philippines and other countries are doing good work in both raising awareness among migrants and channeling remittances to productive usages. 

Some of the policy options could be: (i) an attractive foreign employment bond; (ii) infrastructure bonds with guaranteed competitive yield; (iii) macroeconomic stability to reduce the cost of doing business and the promotion of SMEs; (iv) financial literacy; and (v) innovative measures such as providing loans without collateral to both migrants and remittance-receiving migrant households (but also without much downside risks to the creditor). An example from the Philippines: The central bank of the Philippines focused on increasing remittance inflows through formal channels by allowing Filipino banks to open branches in major employment destinations for Filipinos, reviewing fee structure for transaction, and promoting financial literacy at home and abroad among Filipino migrants. The financial literacy initiatives focused on the available investment opportunities for both remitting and recipient households, and the detection of financial scams.

Fiscal management (timely and full budget): The lack of political consensus in the CA I severely affected the budget process and negatively affected public expenditures, particularly capital expenditure (a mere 3.1% of GDP in FY2013). Higher quantum and quality of capital expenditure is crucial for inclusive and sustainable economic growth, and to ‘crowd-in’ private investments. The fiscal budget needs to be introduced well in advance and in whole. Piecemeal budgets equal to a percentage of previous year’s actual expenditure will hamper not only fiscal management, but also the potential for inclusive growth. 

The figure below shows total, recurrent and capital expenditures as a share of GDP.
On the same note, Nepal’s recurrent expenditure is rising so fast that the impressive tax revenue mobilization (15.3% of GDP in FY2013) is nearly equal to recurrent expenditures (15.2% of GDP in FY2013). Nepal needs to rationalize expenditures as well so that unproductive and wasteful expenditure items and subsidies are properly addressed. Some of the measures may  include: (i) timely and full budget; (ii) higher quantum of capital expenditure allocation and quality spending as well; (iii) rationalization of recurrent expenditure by taking out unproductive expenditure items form the Red Book; (iv) focused expenditure plan to address the binding constraints to inclusive growth; (v) rationalization of subsidies, particularly fuel subsidies; (vi) trimming the number of public employees, especially redundant staff hired without a specific work plan and due to pressure from political leaders; and (vii) reforming, including privatizing, the inefficient state-owned enterprises. Meantime, the tax net needs to be broadened instead of increasing cumulative tax rate each year. The ideal tax rate and system should be a function of the ability of citizens to afford tax payments without much difficulties, one that encourages additional enrollment in tax system, and one that entices domestic and foreign investments.

Load-shedding reduction: Load-shedding has been one of the most significant drags on economic activities in Nepal. The lack of electricity is identified as the second most problematic factor for doing business in Nepal, and 75.6% of firms consider it as a major constraint. About 50.5% of firms own or share a generator and it supplies, on average, 34% of electricity required by firms. The electrical outages cost firms, on average, 17% of annual sales. The adequate supply of electricity will be a major stimulant to economic activities and will potentially be a significant factor that helps push GDP growth beyond 5%. However, implementing reforms on this sector is also the hardest due to the strong lobby of interest groups and some sections in bureaucracy and political spheres.
Some of the measures, which may be politically unpalatable, include: (i) restructuring the Nepal Electricity Authority (NEA) so that it does not remain a dysfunctional behemoth with monopoly and monopsony powers; (ii) passing major reforms related to PPA; (iii) enticing private sector to develop power plants of all ranges (small, medium and large) by offering appropriate incentives, including sovereign risk guarantee and purchase of electricity in dollar terms, if required; (iv) promoting alternative and off-grid energy subject to budget constraints; (v) promoting cross border trade of electricity along with a PPA with India; and (vi) seeking a constructive role (as opposed to obstructive role) of employees and employees’ unions of NEA. If the NEA cannot be restructured, then its generation, distribution, and transmission functions could at least be unbundled to bring about transparency in operations and implement efficiency-enhancing reforms.  

Meaningful structural transformation: An unusual structural transformation is taking place right now, resulting in a growth trap of below 5%. Deindustralization process is ongoing well before the industrial sector's strengthening and the absorption of labor from agriculture sector. Labor moving out of agriculture is either going abroad for jobs or temporarily engaged in low value added, low productive service sector activities. The shift of workers and economic activities to less productive services sector activities instead of the industrial sector being a focal point for their absorption is not normal and doesn't contribute much to creating a strong foundation for the economy to take-off on a high and inclusive growth path. The low value added activities such as real estate and housing; wholesale and retail trade; hotels and restaurants; transport and storage, among others constitute almost 34% of GDP, which is equal to that of the agriculture sector’s share of GDP. The manufacturing sector’s share is only about 6.2% of GDP. In fact, the wholesale and retail trade, which is mostly based on imported goods, is larger than mining and quarrying; manufacturing; electricity, gas and water; and construction combined (i.e. the industry sector). Nepal’s industrial sector has been consistently underperforming; and for its income level, though the services sector’s contribution to GDP is relatively high, its impact on growth and employment generation is low. Furthermore, the increase in per capita income as countries get richer is initially associated with the expansion of industrial sector and then after a certain income level, its contribution starts to moderate. However, even with one of the lowest per capita incomes in Asia and the Pacific, Nepal’s industrial sector’s contribution seems to have tanked and consistently declining.
The intersection between the decline of agriculture sector and the 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.

A meaningful structural transformation to sustain a high and sustainable growth would require a strong industrial sector and high value added agriculture and services sector activities, with an employment-centric strategy to absorb the surplus labor. To promote higher productivity, high value-added production and high income generation, the agriculture sector requires adequate and appropriate commercialization, provision of necessary infrastructure and technology to link with the industrial sector, and promotion of agribusiness activities such as agro-processing, storage, and warehousing, among others. Similarly, for high productivity and value added services sector activities, there needs to be strong backward and forward linkages with the industrial sector along with the narrowing of skills gap required in the market, increase in R&D investment to promote innovation, and investment in education and health sectors to boost the capacity of the economy to sustain progress and prosperity. This would partly position and help sustain the industrial sector as an engine of inclusive growth.

Export competitiveness: Had it not been for remittances, Nepal would not have been able to afford such a high level of imports (over 25% of GDP against exports of about 5% of GDP). Exports are going down consistently. Sophistication of Nepal’s export basket is very low. The export items are still low-valued goods with high price elasticity of import demand. Nepal is losing competitiveness in its major export, i.e. garments. The main domestic factors include: (i) lack of adequate supply of infrastructure, including energy; (ii) political instability/strikes; (iii) labor disputes; (iv) lack of innovation by private sector; and (v)policy implementation paralysis.
Apart from addressing the supply-side constraints, the government needs to devise smart strategies to foster R&D investment, innovation, production of high-value added goods and services based on comparative advantage and endowment, and promote Nepalese items in the international market (this would also require active involvement of Nepalese embassies and consulates aboard). Other major initiatives on this regard could be to establish and operationalize Special Economic Zones (SEZs) and to implement the cash incentives scheme with goals to not only boost export revenue in dollars, but also to promote firms with high potential for export competitiveness and productive employment. Nepal also needs to take advantage of bilateral (especially with India) and regional treaties (SAFTA, BIMSTEC) and preferential treatment accorded to LDCs by the developed countries. Increasing capacity utilization of industries (on average, at just 60% right now) by lowering load-shedding and resolving labor disputes could be the starting points.

Labor disputes: Repeated labor disputes have been one of the most thorniest issues in Nepalese economy. Many multinationals closed down manufacturing plants precisely after the intensification of labor disputes. Nepal has too many labor unions, which largely act on behalf of the political parties. The bickering over wages and repeated revision of wages have positioned Nepal as the country with the highest minimum wage in South Asia. However, productivity hasn’t increased in proportion to the rise in wages. Note that, higher wages are not bad in itself if they are matched by a rise in productivity (so that firms remain competitive). Nepal’s labor unions needs to be guided more by the welfare of the workers, and less by the whims of the political leaders. Furthermore, they also need to be aware that with high productivity and competitiveness comes higher revenue, which would enable employers to raise wages and offer bonuses. It should be a win-win-win relation (government-industries-workers).
Taming high inflation:  With the government’s failure to clamp down on inflation, which is hovering above 8% since FY2009, people have built up expectations that prices will not come down in the near future (or say embedded expectations at a higher base). Inflation above 8% is becoming a ‘new inflationary normal’. For comparison, inflation was as low as 2.4% in FY2001. High inflation erodes people’s purchasing power, renders production uncompetitive, and discourages investment. It also forces government and firms to revise up wages, irrespective of the gains in revenue and productivity. In real terms, it makes people poorer in the absence of a proportional rise in income.
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 very fact that Nepal's currency is pegged to Indian rupee and over 60% of trade occurs with India means that 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. On the domestic side, persistent structural bottlenecks and supply-side constraints have contributed to keeping prices at a higher level. Notable supply-side constraints include the lack of adequate supply of electricity, transport bottlenecks, lack of raw materials leading to high import content of manufactured goods (further affected by depreciation of Nepalese rupee), inadequate supply of key inputs to boost productivity, administered fuel prices, wage pressures, distortions by middlemen  and strikes, among others.

Good governance: Governance is a never-ending issue. Transparency International repeatedly ranks Nepal as one of the most corrupt economies. According to the Enterprise Survey 2013, about 51.3% of firms expected to give gifts to secure government contract. Also, there is hardly any crosscheck on the quality of assets created with government (alternatively, tax payers') money. About 44.7% of manufacturing firms identified corruption as a major constraint in 2013. Major public sector reforms along with strengthening of the anti-corruption body are needed. Good governance and transparency of financial transactions have to be exemplified right from the political parties’ level to the lowest rungs of government bureaucracy and the private sector.

Of course, all of the economic issues cannot and will not be addressed by the CA II. However, it could play a vital role in preparing the ground for difficult policy and institutional reforms while exploiting the 'low hanging fruits'.