Monday, December 1, 2014

Labor productivity and structural transformation in Nepal (plus LDCs)

The latest LDC Report 2014 focuses on the linkages between structural transformation, economic growth and human development. It argues that economic growth “must be accompanied by structural transformation and the creation of decent jobs in higher-productivity activities”. It has came up with a new term: "LDC paradox", which refers to “the failure of the MDGs to recognize the need for a policy framework that generates transformative growth, and in the inability of the LDCs to achieve structural transformation”.

The report underscores that the post-2015 agenda (Sustainable Development Goals) should focus on structural transformation of LDCs towards a modern and diversified economy (higher value-added sectors and more knowledge-intensive activities) in order to reverse the decline in labor productivity and to increase employment. It recommends three specific policy measures:

  • Resource mobilization (to generate financing for productive public and private investment)
  • Industrial policy (to direct those resources into sectors and activities that promote structural transformation)
  • Prudent macroeconomic framework/policies(to support structural transformation rather than impeding it— mainly, public investment, credit, real exchange rate, and domestic demand)

Labor productivity growth is a crucial factor in determining the pace and pattern of economic growth— essentially a structural transformation (changes in composition of output, employment, exports and aggregate demand). Labor productivity is generally higher in countries that export more manufactured and mixed goods— reflective of the structure of the economies they have. Countries with sluggish growth tend to export more food and agriculture products.

Economic performance is based on two interrelated processes: labor productivity and structural change. Labor productivity growth is determined by: (i) innovations within sectors (increases in capital, new technology and knowledge), and (ii) shift of labor across sectors (from lower to higher productivity activities). Labor productivity growth can be decomposed into growth of labor productivity by sector and the growth of employment (demographic and labor market components).

For countries like Nepal economic growth should be characterized by a dynamic transformation of sectors and employment share— as opposed to the growth being propped up by monsoon rains and remittance-induced demand for imported goods. Nepal needs to boost productivity within sectors (shifting from lower value added agriculture and services activities to higher value added activities within the sectors), and productivity across sectors (shifting production/employment structure from agriculture to industry before jumping into services sector— this is the proven path for sustained rise in income per capita).

The report decomposes aggregate labor productivity into three main components:

  • Direct productivity growth effect (changes in aggregate output per sector due to increases in productivity within sector)
  • Structural/reallocation effect (changes due to movements of labor between sectors with different levels of output per capita)
  • Terms-of-trade effect (changes due to relative output prices between sectors)

Manufacturing sector is important for higher productivity gains emanating from intersectoral reallocation of labor. Also, higher aggregate output per worker is strongly associated with higher productivity in the industrial sector, and with the transfer of workers to this sector.

Here is how Nepal stands relative to other LDCs in South Asia (and People’s Republic of China, which is not a LDC but has transformed is economy drastically within a generation’s time): 

  • Productivity gains within sectors contributed more to aggregate labor productivity growth than structural effect (this is expected because due to the lack of domestic employment opportunities there is a large-scale out migration of workers each year, contributing workers’ remittances equivalent to about 28% of GDP, which finance either the imported goods traded in services sector or nontradable activities within the sector). Bhutan had more productivity growth coming from structural/reallocation effect because of the large shift of workers to industry sector (electricity falls under this) after the hydropower boom.
  • Nepal’s labor productivity growth is low compared to the regional economies (see the dots in the above chart) .
  • In direct productivity growth effect and reallocation effect, services sector contributed the most.
  • Relocation effects in agriculture is negative, reflecting its reduced share in employment because of the shift of workers to other high productivity sectors. It shows trade-offs between employment generation and labor productivity (inverse).
  • The highest level of employment growth is registered in services sector. However, these are mostly informal in nature with severe lack of productive capacities at the firm level (low level of capital and information technology). Employment growth in services sector is broadly at the expense of gains in labor productivity. The reallocation effects (agriculture to services sectors) added to overall productivity growth because average productivity is higher in services sector (even if underemployment is high).
  • Industry sector productivity (both within and across) is considerably low (most probably due to the crippling binding supply-side constraints).

More on structural transformation in Nepal here (interested folks can follow the links within the blog post as well). Briefly, 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.