Monday, October 27, 2014

Structural transformation and fundamentals: Where does Nepal stand?

Here is an interesting presentation by Prof. Dani Rodrik, who explores new growth strategies in the context of the increasing value added and employment shares of services sector. The main idea is that manufacturing activities still are more important than services sector activities in terms of sustained rise in income per capita, productivity and employment. Links to the new growth strategies presentation by other economists and practitioners here.

The combo (and modified) chart above depicts the nature of structural transformation, investment in fundamentals, and the resulting nature of growth rate in Nepal. While the ‘Asian Tigers’ had high investment in fundamentals and a rapid structural transformation, Nepal is seeing moderate investments in economic fundamentals and a very slow (meaningful) structural transformation, leading to a low growth trap. The challenge for Nepalese policymakers is to transition the economy from (3) to (4) in a generation’s time!

According to Rodrik, rapid structural transformation together with high investment in fundamentals results in rapid and sustained growth.

Fundamentals include:

  • Reasonably stable fiscal and monetary policies [At least indicator wise, Nepal has done reasonably well as revenue is increasing, budget deficit is below 2.2% of GDP and has ended up with surplus some times, public debt is below 30% of GDP, forex reserves are sufficient to cover almost 9 months of imports, current account and balance of payments are mostly in surplus, etc. Unfortunately, these have been possible not due to domestic economic activities, but due to low public expenditure absorption capacity and large remittance inflows]
  • Reasonably business-friendly policies [Nepal’s ranking in Doing Business and other cross-country comparable assessments has been improving. Investors complain more about lack of electricity rather than corruption and labor issues.]
  • Steady investment in human capital and institutions (important for sustaining growth post middle-income level) [As a share of budget, Nepal spends the most in education and spending in health is also one of the highest in the region. However, the expenditure efficiency is a different story.]

[So ‘investment in fundamentals’ is not too bad. But these have not emerged out of domestic economic activities. The relatively sound indicators are due to exogenous factors.]

Structural transformation includes:

  • Labor-absorbing as well as incrementally higher productivity activities (shift from agriculture to industrial activities as well as employment shares).
  • Later on productivity services activities, which would normally require skilled workforce (may create a symbiotic relationship between this and manufacturing, which would use the innovation from the latter to enhance productivity).
  • Unorthodox policies may also work: Export subsidization, protection of home markers, exchange rate management, value addition rules, SEZs)
  • A generally generous global context in terms of technology transfer, market access

[Here, Nepal has ended up with an unusual structural transformation. Most of the GDP growth is coming from non-tradable sectors such as construction, retail and wholesale trade and real estate and housing. The demand for the services sector activities are in turn driven by public expenditure and remittances (see the rise in services sector value added while a premature deindustrialization in the chart below). Tradable sectors such as manufacturing and high-value agriculture activities are not prominent. Worse, more and more workers are shifting to informal activities in services sector until they find jobs overseas. Addressing this will be one of the major economic challenges for the Constituent Assembly II, if the country wants to realize its goal of graduating from LDC status by 2022.]

Note: The first three charts agriculture, industry and services sectors valued added (% of GDP) to the log of per capita GDP of China, India, Nepal, Bangladesh, Japan and South Korea over 1960-2012. The last chart shows the evolution of sectoral value added with respect to log of per capita GDP. It shows that the decline of agriculture sector is accompanied by the increase of services sector while the industrial sector is already declining.

A meaningful structural transformation to sustain a high and sustainable growth in the post-LDC graduation era would require beforehand 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 (alternatively, it also means that fewer folks with high skills can be employed), 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.