Can Nepal become a middle-income country by 2030?

May be, but it depends on the pace of reforms and how fast it is able to break the low growth, high migration equilibrium, according to a latest report by the World Bank. Nepal’s performance so far can be summed up as: impressive decline in absolute poverty rate (proportion of population below $1.90 a day, 2011 PPP), low growth grate (below 5%), large-scale out-migration for work, and huge inflow of remittances that is popping up revenue growth, consumption demand and more. Also, see this paper on remittance in Nepal: boon or bane.

A business-as-usual scenario (BAU) and the resulting GDP growth would lead to per capita income (GNI) of $958 in 2030 (short of $1025 benchmark for lower middle income country as per the WB definition). However, under a reform scenario (investment and productivity improve until 2021 and then level off), per capita income level will breach the lower-middle income threshold in 2027. The exercise comes out of a classic neoclassical growth model (growth accounting/long-term trend [steady state] analysis). 

The WB recommends a “systematic assault” to break the inferior equilibrium through:

• Breaking policy barriers (ramp up public investment, promote competition, trade integration)
• Building new sources of growth (mainly hydropower)
• Revitalizing existing sources of growth (reform agriculture)
• Investing in people (take advantage of the demographic dividend and invest in skills of youths)

Here is an earlier analysis (Macroeconomic Update August 2013, ADB) on prospects for graduation from LDC category by 2022. Also, here is a piece on rapid economic transformation to be a middle-income country by 2030. Here is a econ-political analysis on why is Nepal poor. And, here is a short piece on low growth trap and the unusual structural transformation. 

Four binding constraints to growth in Nepal

The government and MCC have jointly published the constraint analysis report, which identifies four main binding constraints to economic growth in Nepal:

1. Policy implementation uncertainty
2. Inadequate supply of electricity
3. High cost of transport
4. Challenging industrial relations and rigid labor regulations

The analysis draws on the ‘growth diagnostics’ methodology developed by Hausmann, Rodrik and Valesco in Harvard, and builds on an earlier similar study jointly done by ADB/DFID/ILO, which also found similar constraints to economic activities in Nepal.  I had also followed the same methodology in 2009 and came up with similar constraint (mainly inadequate supply of infrastructure, including transport). 

The constraint analysis points out that protracted political transition and instability results in policy implementation uncertainty, rigid labor regulations and challenging industrial relations, and reduced government effectiveness and capital expenditures (the last one in turn leads to inadequate supply of electricity and high cost of transport). 

Below are the major highlights of the report:

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Policy implementation uncertainty: Frequent changes in government leadership have resulted in policy implementation that has been unpredictable for firms in Nepal. While much of Nepal’s bureaucratic structure and policy documents have remained the same, changes in leadership of a ministry often leads to significant shifts in the implementation of government policy. This lack of continuity and predictability of policy implementation is consistently cited by firms as a major constraint to making investments in Nepal.

Inadequate supply of electricity: Nepal suffers from the worst electricity shortages in South Asia. Only half of the demand for electricity can be met by the nation’s grid. This results in load shedding of up to 18 hours a day during the dry winter months, when hydropower generation is low. The low availability of electricity creates significant costs for businesses which have to run generators on expensive imported fuel.

High transport costs: Nepal ranks 147th out of 155 countries in the Logistics Performance Index (World Bank LPI). While Nepal’s rugged terrain and landlocked geography contribute to this poor performance, the high of cost transportation in Nepal is also driven by poor quality and quantity of roads, a lack of competitiveness in the trucking sector, and by costly customs procedures. The result is that transporting goods within Nepal and reaching international markets is expensive and unreliable

Challenging industrial relations and rigid labor regulations: Nepal’s labor code is complex. Implementation of the code and mediation by the government between labor and business is both challenging and inadequate. The Federation of Nepalese Chambers of Commerce and Industry (FNCCI) Employers’ Council summary report identifies three primary reasons why the labor code needs revision: poor implementation, protracted court rulings, and long firing. These difficulties appear to alter the hiring and firing practices of firms in costly ways that include firm size remaining small to avoid the difficulties of labor negotiations. However, evidence from focus group discussions in Nepal suggest that these issues are improving and thus the team has categorized this constraint as less severe

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Will Nepal graduate from LDC category by 2022?

[This blog post is adapted from the issue focus of Nepal’s Macroeconomic Update, August 2013, published by the ADB.]

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GRADUATION FROM LDC CATEGORY

Background

The government’s recently approved approach paper to the Three Year Plan (TYP) FY2014-FY2016 envisions uplifting Nepal from the current Least Developed Country (LDC) category to a developing country status by 2022. In the previous TYP FY2010-FY2013, the government had targeted graduation by 2030. The rapid increase in the country’s per capita gross national income (GNI) as well as significant progress on key social indicators has encouraged the government to aim for this ambitious target, which is incidentally in line with the Istanbul Programme of Action (IPoA), 2011-2020, an outcome of the United Nations Least Developed Country (UNLDC) IV meeting held in Istanbul on 9-13 May 2011. The IPoA aims to enable half (24 out of the 48) of the LDCs meet the criteria for the graduation by 2020. It also recommends LDCs to integrate the IPoA into their national and sectoral development programs and strategies.

LDCs are low-income countries suffering from the most severe structural impediments to sustainable development. They benefit from special support measures from the donor community and preferential treatment in trade agreements. They get preferential market access to developed countries and are provided special non-reciprocal treatment in regional and bilateral trade agreements. The European Union provides duty-free access to imports of all products from LDCs under its ‘Everything but Arms’ (EBA) initiative. Furthermore, the Enhanced Integrated Framework (EIF)—a multi-donor, multi-agency program—assists LDCs in boosting their trade related capacities, including operational support to national implementation arrangements related to trade strategy, preparing and updating the Diagnostic Trade Integration Study, and supporting activities on mainstreaming trade. Meanwhile, the bilateral donors have pledged to provide official development assistance (ODA) equal to 0.7% of their GNI. Some donors such as Japan even provide concessional loans with a 0.01% interest rate and a 40-year repayment period (including a 10-year grace period). Similarly, multilateral development banks provide grants and concessional lending to LDCs.

Criteria and Process for Graduation from LDC Status

Graduating from the LDC category requires progress on three indicators relating to the income-generating capacity of a LDC, its stock of human capital, and its structural vulnerability to exogenous shocks. Specifically, the following criteria are considered[1]: (i) Low-income criterion (based on a three-year average estimate of per capita GNI [World Bank Atlas method[2]] higher than $1,190); (ii) progress in Human Assets Index (HAI), which comprises (a) nutrition (percentage of population undernourished), (b) health (mortality rate of children aged five years or under), and (c) education (gross secondary school enrolment ratio and adult literacy rate); and (iii) progress on Economic Vulnerability Index (EVI), which comprises (a) population size, (b) remoteness, (c) merchandise export concentration, (d) share of agriculture, forestry and fisheries in gross domestic product (GDP), (e) share of population living in low elevated coastal zones, (f) instability of exports of goods and services, (g) victims of natural disasters, and (h) instability of agricultural production.

After determining threshold levels for each of the criteria every three years, the Committee for Development Policy (CDP) reviews the progress made by LDCs and recommends a country for graduation[3] from the LDC category provided that the country is eligible at two successive triennial reviews. At least two of the three criteria or per capita GNI higher than twice the threshold (and with a high probability that it will be sustained) must be met to be eligible for graduation. Following the recommendation by CDP and subsequent endorsement by the UN Economic and Social Council (ECOSOC), the UN General Assembly (GA) takes note of it[4], three years after which a country will graduate from the LDC category. So far, Botswana, Cape Verde and the Maldives are the only countries that have graduated from LDC category. Samoa is set to graduate in January 2014. While Tuvalu and Vanuatu are recommended for graduation, Angola and Kiribati met the criteria for graduation once and will be reviewed again in 2015.

The latest thresholds for graduation from the LDC category are (i) per capita GNI of $1,190 or more, (ii) HAI of 66 or more, and (iii) EVI of 32 or less. At least two of the three criteria must be met to qualify for graduation. Alternatively, a country also qualifies for graduation if its GNI per capita is $2,380 or more, irrespective of its HAI and EVI scores. The graduation thresholds are usually 20% above the per capita GNI threshold for inclusion, 10% above the HAI threshold for inclusion, and 10% below the EVI threshold for inclusion. 

Prospects for Graduation

Although Nepal has already met the EVI criterion, it still has to either increase its per capita GNI by US$770[6] or HAI score by 6.17 before 2015 to be eligible for consideration for graduation. This is because eligibility conditions should be fulfilled during two successive triennial reviews, and the CDP will now review the progress only in 2015. After the review, Nepal will have to sustain the progress through 2018, the next triennial review, only after which the CDP will recommend for graduation. It will then be endorsed by ECOSOC and the UN GA takes note of it (between one and three years). Then only can Nepal graduate by 2022, provided that a transition strategy is prepared for implementation and the thresholds do not change.[7] An alternative path for Nepal’s graduation would be for it to increase its per capita GNI by US$1,960 well before 2022, irrespective of its progress on the HAI and EVI threshold requirement. Overall, substantial efforts would be needed for Nepal to graduate from the LDC category by 2022 particularly in the income front. Nevertheless, an encouraging certainty is that the country will be making clear and substantial progress towards graduation.

Post-LDC Graduation Scenario

The post-graduation scenario will also remain challenging, mostly arising from the implications of the loss of LDC status and associated benefits such as development assistance and preferential treatments in international trade. The concessional lending as well as market entry preferences accorded to Nepali exports in several developed and emerging economies will most likely be eroded. Therefore, prior to the graduation, Nepal needs to strengthen the pre-requisites required to support a stable and high growth rate and continue the momentum on the social development front. It calls for: (i) full and productive utilization of the available development assistance and trade preferences to tackle supply-side constraints, promotion of high value exports, and search for niche markets abroad; and (ii) reorientation of the ongoing structural transformation to strengthen the industrial sector’s and high value production’s contribution to GDP, which will help stabilize the growth rate, raise the income level and create high paying jobs.

The available resources and assistance to tackle the most binding constraints to economic activities have to be effectively utilized with an objective to sustain high growth and rapid poverty reduction. Meanwhile, the challenging task is to make the GDP growth more responsive to industrial sector growth and the high value agriculture production and services activities instead of the less productive and low value agriculture and service sector activities. At the core of it, political stability and good governance are the necessary conditions to effectively make this happen. Overall, the challenges to adequately meet the pre-requisites for high growth and a sustained development path in the post-graduation era are: (i) structural bottlenecks (low quality human resources and deficient skills, weak backward and forward linkages, fragmented value chains, negligible research and development investment, distorted labor market characterized by high minimum wages and low productivity, and policy inconsistencies, among others); and (ii) supply-side constraints (the lack of adequate supply of electricity, transport bottlenecks, lack of raw materials leading to high import content of manufactured goods, inadequate supply of key inputs to boost productivity, and political disturbance, among others).

There is also a need to reorient the ongoing process of structural transformation, especially considering the production disruption caused by the decade-long civil conflict, the exodus of migrant workers, and Nepal’s accession to the WTO. 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 in the post-LDC graduation era.[8] 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[9] 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 (Figure 4). 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 have been consistently declining (second chart in Figure 4).

Figure 4: Sectoral value added, per capita GDP and structural transformation

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.

Source: NRM staff estimates based on data from World Development Indicators.

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, 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.[10]

Conclusion

A high and sustainable growth and development in the post-LDC graduation era would require the effective utilization of the current resources to create the pre-requisites for the economy to take off on a high, inclusive, employment-centric and sustainable growth path. Furthermore, there is a need to reorient the ongoing structural transformation to ramp up industrial sector activities and to promote higher value and productive agriculture and services activities.

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Notes:

[1] These are reviewed every three years by CDP. The latest review was done in 2012. The next triennial review will take place in 2015.

[2] The Atlas method is used by the World Bank to estimate the size of economies in terms of gross national income (GNI) in US dollars. According to the World Bank, ‘a country's GNI in local (national) currency is converted into US. dollars using the Atlas conversion factor, which uses a three-year average of exchange rates to smooth effects of transitory exchange rate fluctuations, adjusted for the difference between the rate of inflation in the country (using the country's GDP deflator), and that in a number of developed countries (using a weighted average of the countries' GDP deflators in SDR terms). The resulting GNI in U.S. dollars is divided by the country's mid-year population to obtain the GNI per capita.’ For more: http://go.worldbank.org/IEH2RL06U0

[3] Inclusion in the LDC category requires lower thresholds for all the three criteria: GNI per capita of $992 or less, HAI of 60 or less and EVI of 36 or more. All three criteria must be met.

[4] It is expected that the recommendation for eligibility by CDP, the endorsement by ECOSOC and the UN GA taking note of it happen within three years. It might take longer if the UN GA delays taking note of the endorsement by ECOSOC.

[6] Based on data from the 2012 triennial review, which used 2008-2010 average GNI per capita (US$420). The latest three year average (2010-2012) GNI per capita of Nepal is US$616.7 (Atlas method), which means GNI per capita has to increase by at least US$573 to reach the respective threshold for graduation.

[7] For more, see http://www.unohrlls.org/en/ldc/164/

[8] Asia 2050: Realizing the Asian Century provides strategies on how to avoid the middle income trap as per capita income rises along with economic advancement. See: ADB. 2011. Asia 2050: Realizing the Asian Century. Manila: Asian Development Bank.

[9] According to industrial classification, manufacturing is a part of industrial sector, which also comprises of mining and quarrying; electricity, gas and water; and construction.

[10] For this to happen, the country needs to tackle head-on the binding constraints to industrial sector growth, including amicable resolution of labor disputes to create a win-win situation for both workers and employers, and the promotion of FDI to not only increase investment but also to impart critical knowledge and expertise on advanced technologies, innovations, and entrepreneurship.

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.

How globally connected is Nepal?

A report released last month, DHL Global Connectedness Index (GCI) 2012, ranks Nepal 133 out of 140 countries, the same as last year’s ranking, in terms of global connectedness or globalization. Nepal has the lowest ranking in South Asia region. In South Asia, India is steadily improving connectedness, ranking 62 out of 140 countries, followed by Sri Lanka (rank 75), Bangladesh (rank 91)and Pakistan (rank 102).

The report notes that Nepal has higher breadth (98th) than depth (137th). Among Nepal’s component level depth ranks, its highest is on outbound international students (41st) and its lowest is on merchandise exports (140th). Over half of Nepal’s merchandise exports goes to India and has a trade pillar ranking of 136 out of 140 countries (also read the changing narrative of the state of Nepal’s globalization).

Depth measures how much of a country’s activities or flows are international versus domestic by comparing the size  of its international flows with relevant measures of its domestic economy (usually as a share of GDP). Breadth complements depth by looking at how broadly the international component of a given type of activity is distributed across countries (usually diversification of sources for the scores in the pillars).

They are based on scores in four pillars, namely trade, capital, information and people. The depth dimension provides Nepal’s outward and inward depth scores and ranks at the component and pillar levels. Using the same pillars as in depth, the breadth dimension considers the intra-regional share of each Nepal’s flows. The components of trade are merchandise trade (% of GDP), services trade (% of GDP); capital components are FDI stock (% of GDP), FDI flows (% of GFCF), portfolio equity stock (% of GDP) and portfolio equity flows (% of GDP); information components are speed of internet bandwidth, cost of international phone calls, cost of printed publications trade; and people components are migration (% of population), tourists departure and arrival per capita, international students.

The Netherlands retained its 2010 position as the world’s most connected country. Of the top ten most connected countries in 2011, nine of them are located in Europe, which is the world’s most connected region. Meanwhile, Sub-Saharan Africa is the least connected region today, but Sub-Saharan African countries averaged the largest increases in connectedness over the past year, with their gains driven primarily by the trade pillar.

GCI measures the depth and breadth of countries’ trade, capital,  information, and people flows. Twelve distinct components  of connectedness are incorporated across those four pillars. Overall, richer countries tend to have deeper and broader global connections than poorer countries. Smaller countries tend to lead on depth while larger countries tend to lead on breadth.

In the latest Global Information Technology Report 2012 as well Nepal ranked poorly at 128 out of 142 countries in terms of network readiness. Insufficient development of ICT infrastructure has limited its ability to leverage information and communications technologies to boost country competitiveness. It has stifled entrepreneurship and innovation.

Exports sophistication of Nepal

Finally, I have a stable internet connection at my place, at least for now (for how long? don’t ask!) I will now be updating this blog more frequently than during the past two weeks.

This blog post is an extension to my previous piece about the future of Nepal’s exports. I remain optimistic that exports will rebound if non-economic constraints are addressed. It is based on this paper by Jesus Felipe et al. The position of Nepal in ranking of each of the indicators discussed below is shown with a red pointed arrow in the figures.

Among the 96 non-high income countries, Nepal ranks 33 while China and India rank second and third, respectively. For a country with this level of income per capita, Nepal’s standing is not bad at all. The exports sector is still capable of rebounding. There is no need to excessively fret about curbing imports just because exports are declining. With right policies in place, we can produce new products with high exports potentials and export with comparative advantage, thus inducing further structural transformation. With the existing state of capabilities, Nepal is expected to grow at an average annual rate of the average annual growth rate of 5.49-6.69 percent over the period 2010-2030.

In the “Index of opportunities”, Nepal ranks third in South Asia with a score of 0.4729, following India and Malaysia with scores of 0.8590 and 0.6822 respectively. The higher the score, the better the potential to undergo structural transformation. Everything else remaining the same, a ten percent increase in the value of the index yields 0.31 percentage points of additional growth. Among the 96 non-high income countries, Nepal’s rank is 33 while China’s and India’s second and third respectively.

Among the 96 non-high income countries, Nepal has a score of 0.4112 in the sophistication level of the export basket, called EXPY. It is calculated as the weighted average of the sophistication of the products exported by a country. Generally, countries with high EXPY tend to have high per capita income. A 10 percent increase in EXPY at the beginning of the period raises growth by about half a percentage point, according to ADB economist Jesus Felipe.

 

For its given level of income Nepal already has a pretty impressive level of sophistication of exports basket, although it has to be improved to if we want to enjoy the same level of export sophistication and future India and China have. With the existing state of capabilities and export potential, the average annual growth rate is projected to be between 5.49 and 6.69 percent between 2010 and 2030.

Furthermore, in EXPY-core, another measure of exports sophistication which looks at the core of the product space (machinery, chemical and metals). Nepal has a score of 0.5926 in EXPY-core. Note that even though the exports basket of Pakistan, Sri Lanka and Bangladesh are less sophisticated than ours, they nevertheless have high EXPY-core score, meaning that their exports sector has high-valued products that constitutes a major portion of the overall exports basket. No wonder they have higher exports market and high income per capita. Given Nepal’s income level, the EXPY-core score is not that bad but it can be improved further.

 

In terms of diversification of exports, Nepal has the second highest score (0.4032) in South Asia, following India (0.8611). Diversification is measured by the absolute number of products that a country exports with comparative advantage. Between 2001 and 2007, Nepal exported, on average, around 100 products with comparative advantage. Meanwhile, China and India exported 257 and 246 products, respectively.

Looking closer at the diversification of core products (diversification-core) only, Nepal has a score of 0.221 and exported less than 25 products with comparative advantage. In this category, China and India exported with comparative advantage 89 and 81 products, and had scores 0.9496 and 0.8611, respectively. Generally, except for heavily natural resource dependent nations, countries with high income per capita tend to have higher degree of diversification.

In order to gauge the level differentiation of products exported with comparative advantage, the authors constructs share-core score, which shows the number of commodities with revealed comparative advantage in the core as a ratio of the total number of commodities in which that country has comparative advantage. Nepal scores 0.3569, the third best in South Asia,  in share-core category. China and India scored 0.6497 and 0.6148, respectively. To increase per capita income, Nepal has to acquire more capabilities, “both by increasing the absolute number of core commodities with comparative advantage and by shifting the composition of products with comparative advantage towards core commodities.”

 

The uniqueness of products exported by a country also matters in ensuring sustainability of exports sector and in undergoing the resulting structural transformation. In terms of uniqueness of exports, termed standardness, Nepal has a score of 0.5219, while China and India have 0.7917 and 0.9352, respectively. The standardness level of Nepal is better than that of countries with the same income level. Nepal has a good degree of exports uniqueness and diversification. This is an encouraging news for the listless, demoralized exports sector.

Policymakers and investors want to know the probability of producing new products and exporting them with comparative advantage. This can be figured out from “open forest” analysis in the product space. It provides a measure of the (expected) value of products that could be potentially exported with comparative advantage. We can figure out how far products currently not exported with comparative advantage are from the ones that are exported with comparative advantage and are within nearby range of existing production capacities of an economy. It is easier to produce “nearby” products than a product that is “far away” because the capabilities to produce similar but slightly differentiated products already exists in the economy.

Nepal has a score of 0.2041 in “open forest” dimension of the Index of Opportunities. It is among the lowest among the South Asian countries. The low score indicates the fact that the industrial sector needs revamping of its capabilities to produce goods that are sophisticated and are within close range of each others capital and resources requirements. Poland, India, Turkey, China, and South Africa have one of the highest open forests among developing countries.

My point: The exports sector is not done yet and there is no need to resort to widespread import curbing measures, especially in daily consumption goods. We can increase exports if we could judiciously and decisively address non-economic constraints ailing the industrial sector and implement highly targeted and appropriate industrial and trade policies. The product level analysis of sophistication of our exports basket reaffirms this conviction.

The Future of Nepal’s exports

My latest op-ed is about the future of Nepal’s exports. I will post an extended version of this article in next blog post. I am a bit optimistic about the future of Nepal’s exports industry.

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Future of Nepal’s exports

Everything ain’t good, but everything ain’t bad either

The prevailing perception among policymakers and analysts is that we are in an economic mess, the exports sector is doomed to fail, and imports will keep on imploding. With total merchandise exports and imports amounting to Rs 55.37 billion and Rs 343 billion, respectively, trade deficit has swelled to Rs 287.62 billion in the first eleven months of this fiscal year. The BOP deficit stands at around Rs 15 billion. The momentum of decline in exports and surge in imports looks unabated.

With no hopes of increasing exports, the idea of import-substituting policies, which is expected to at least curb imports and lower deficit, is seen as the policy of last resort. As I have argued before, these are convenient conclusions (see Convenient conclusions?, Republica, July 14) fostering misguided policy because if we can address non-economic constraints-- bandas, destructive activities of militant youth wings and combative labor unions, donation campaign, supply-side constrains, and power shortages--, then Nepal could see an increase in exports.

Curious why I remain optimistic than most of the pundits in Kathmandu? Allow me to explain. In South Asia, Nepal has one of the highest potentials for growth in the exports sectors. It could potentially export many new products with comparative advantage, if the right constraints on promotion, production, and accumulation of capabilities of key products are timely addressed.

A new study (As you sow so show shall you reap: From capabilities to opportunities) published by the Asian Development Bank (ADB) corroborates this view. It analyzes product spaces of 130 countries and ranks them on the basis of “Index of Opportunities”-- which is based on a country’s accumulated capabilities to undergo structural transformation and captures the potential for further product upgrading, growth, and development. A product space shows a graphical representation of all products exported in the world.

The good news is that the future of Nepal’s export industry and the economy’s potential to undergo structural transformation is not all that gloomy as has been portrayed by analysts. In the index, Nepal ranks second in South Asia with a score of 0.4729, following India which has a score of 0.8590. The higher the score, the better the potential to undergo structural transformation. Everything else remaining the same, a ten percent increase in the value of the index yields 0.31 percentage points of additional growth.

Among the 96 non-high income countries, Nepal ranks 33 while China and India rank second and third, respectively. For a country with this level of income per capita, Nepal’s standing is not bad at all. The exports sector is still capable of rebounding. There is no need to excessively fret about curbing imports just because exports are declining. With right policies in place, we can produce new products with high exports potentials and export with comparative advantage, thus inducing further structural transformation. With the existing state of capabilities, Nepal is expected to grow at an average annual rate of 5.49-6.69 percent over the period 2010-2030.

Ranking among 96 non-high income countries

Country	EXPY	EXPY-core	Diversification	Diversification-core	Share- core	Standardness	Open forest	Index of opportunities	South Asian countries rank	Non-high income countries (96) rank
India	0.6486	0.9328	0.9287	0.8611	0.6148	0.7917	0.8759	0.859	1	2
Nepal	0.4112	0.5926	0.4032	0.2214	0.3569	0.5219	0.2041	0.4729	2	33
Pakistan	0.3447	0.8006	0.48	0.1053	0.1421	0.4485	0.4379	0.4551	3	37
Sri Lanka	0.3259	0.8535	0.4279	0.1023	0.1546	0.4957	0.3657	0.4326	4	44
Bangladesh	0.2768	0.782	0.2386	0.0519	0.1387	0.2348	0.201	0.3576	5	73

The index is composed of seven indicators. Among the 96 non-high income countries, Nepal has a score of 0.4112 in the sophistication level of export basket, called “EXPY” and calculated as the weighted average of the sophistication of the products exported. Generally, countries with high EXPY tend to have high income per capita. A 10 percent increase in EXPY at the beginning of the period raises growth by about half a percentage point, according to a study by the ADB economist Jesus Felipe. For its given level of income, Nepal already has a pretty impressive level of sophistication of exports basket, although it needs enhancement if we want to enjoy the same level of sophistication as India and China have.

Furthermore, in “EXPY-core”, another measure of exports sophistication which looks at the core of the product space (machinery, chemical and metals), Nepal has a score of 0.5926. Note that even though the exports basket of Pakistan, Sri Lanka and Bangladesh are less sophisticated than Nepal’s, they nevertheless have high EXPY-core score, meaning that their exports sector has high-valued products that constitute a major portion of exports basket. No wonder they have higher exports revenue and, consequently, higher income per capita than Nepal’s. Nepal needs to improve on the exports of EXPY-core products.

In terms of exports diversification, Nepal’s score is 0.403, the second highest in South Asia. Diversification is measured by the number of products that a country exports with comparative advantage. Between 2001 and 2007, Nepal exported, on average, around 100 products with comparative advantage. Meanwhile, China and India exported 257 and 246 products, respectively. Looking closer at diversification of core products (“diversification-core”) only, Nepal has a score of 0.221 and exported less than 25 products with comparative advantage. In this category, China and India exported with comparative advantage 89 and 81 products, and had scores 0.9496 and 0.8611, respectively. Nepal’s score is not that discouraging given its income level.

The uniqueness of products exported by a country also matters in ensuring sustainability of exports sector and structural transformation. In terms of uniqueness of exports, termed “standardness”, Nepal has a score of 0.5219, while China and India have 0.7917 and 0.9352, respectively. Again, the standardness level of Nepal is better than that of countries with the same income level. Nepal’s good position in exports uniqueness and diversification is encouraging news for the listless, demoralized exports sector.

Policymakers and investors want to know the possibility of producing new products that could be exported with comparative advantage. “Open forest” analysis provides the answer. It basically shows how easy it is to produce “nearby” products than the ones that are “far away”. The capabilities to produce similar but slightly differentiated products (“nearby”) already exist in the economy and policies can be designed to facilitate this process. Nepal has a score of 0.2041, one of the lowest in South Asia, in “open forest” dimension of the index. It indicates the fact that the industrial sector needs revamping of its capabilities to produce goods that are sophisticated and are within close range of each others’ capital and resource requirements.

The exports industry is not done yet. There is no need to resort to widespread import curbing measures, especially of daily consumption goods. Exports can be increased if we could judiciously and decisively address non-economic constraints ailing the industrial sector and implement highly targeted and appropriate industrial and trade policies to augment capabilities. The product level analysis of sophistication of our exports basket reaffirms this conviction.

[Published in Republica, August 1, 2010, pp.6]

New measure of structural transformation: Index of Opportunities

Abdon, Felipe and Kumar have used Hidalgo et al. (2007) and Hausmann et al. (2007)’s concept of product space to come up with an “Index of Opportunities” (full paper here), which captures the potential for further upgrading production, economic growth, and development. It is based on a country’s accumulated capabilities (human and physical capital, legal system, institutions, etc.) to undergo structural transformation.

The idea is that “in the long run, a country's income is determined by the variety and sophistication of the products it makes and exports, and by the accumulation of new capabilities.” Hidalgo and Hausmann have shown that structural transformation occurs when countries grow sustainable by continually upgrading production structure, i.e. redeploying existing production structure to produce (upgraded) new products. It is related to “nearby goods”, “proximity”, and “open forests” concepts used in product space analysis. It is also used to see if coordination failures are binding constraints to growth while doing growth diagnostics of an economy. (An interesting idea that I have used to do growth diagnostics of the Nepalese economy).

Anyway, back to the new Index of Opportunities. It includes:

• Exports sophistication (EXPY--a weighted average of the income level of the products exported, where the latter is calculated as a weighted average of the GDP per capita of the countries that export a given product)
• Sophistication of the core commodities (machinery, chemicals and metals)
• Overall diversification (the number of products in which the country has acquired revealed comparative advantage)
• Diversification of core products (the number of core products in which the country has acquired revealed comparative advantage)
• Share of complex capabilities (the ratio of the number of core commodities with revealed comparative advantage to the total number of commodities with revealed comparative advantage)
• Standardness/uniqueness of the export basket (how many countries export the same product; this measure of uniqueness of the export basket has been called “standardness”)
• Open forest (measure of the potential for further structural change. This variable provides a measure of the (expected) value of the goods that a country could potentially export, i.e., the products that it currently does not export with revealed comparative advantage)

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“We estimate cross-country regressions of each of the seven indicators on the level of GDP per capita. Each indicator has two components that enter the construction of the Index. One is the actual value of the indicator, which captures the actual capabilities. The other one is the residual from the regression of the indicator on GDP per capita. This shows whether a country is a positive or a negative outlier given its income per capita. The residual obtained in each case is considered a “reward” or a “penalty”, respectively. A lower value of standardness is considered better. In this case, therefore, a negative residual corresponds to a reward and a positive residual to a penalty. We use highly disaggregated trade data covering 779 products for the years 2001-2007.

We rescale all seven indicators and the residuals such that they lie between 0 (minimum value) and 1 (maximum value). With all the seven indicators (and their residuals) scaled to lie between 0 and 1, and an increasing value corresponding to an improvement, we averaged the fourteen components to obtain the Index of Opportunities.”

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The result shows that China has the highest score, followed by India, Poland,Thailand, and Mexico. Nepal stands at number 33 with an index of 0.4729.

The authors use the index to predict average annual economic growth rate between 2010-2030. For instance, the average annual growth rate of Nepal between 1990-2007 was 4.33 percent. Based on the index, growth projection, average annual growth rate, for Nepal, between 2010-2030 is 5.49 to 6.61 percent. For the same timeframe, China’s is 10.34 and 4.15 to 5.12 percent and India’s is 6.47 and 5.78 to 7.07 percent. Their result is pretty close to the one done by Uri Dadush and Benn Stancil (2010) from Carnegie Endowment.

The conclusion is that countries (such as China, India, Poland, Thailand, Mexico, and Brazil) that have diversified and increased the level of sophistication of their export baskets have accumulated a significant number of capabilities, allowing them to perform well in the long run. For countries that have not done so yet, they will have hard time having structural transformation. The authors vouch for “soft” industrial policies advocated by Harrison and Rodriguez Clare (2010). [Soft industrial policies promote collaboration among government, industry, and cluster-level private organizations with an aim to directly increase productivity. It basically seeks to directly address coordination failures that keep productivity low in existing or promising sectors rather than engage in direct interventions that might distort prices. This is like facilitating the process that already looks promising but is not realizing its full potential, rather than instituting one all anew whose success is unclear.]

I am not sure how much impact this index will have but it does not add much new information than EXPY and PRODY analysis developed by Hausmann et al.. It just reaffirms the results that are already there (it reaffirmed the conclusion of the product space analysis and the projections done by Dadush and Stancil). Nevertheless, a series of interesting papers and one more index to look at export-led structural transformation. Also, read the papers I have linked to. The whole concept is amazing!

Five reform agendas to kick-start Nepal’s growth

My latest piece is based on a simple set of crucial reforms that are needed to kick-start Nepal’s jammed growth engine. These reforms can be launched simultaneously or in any other form deemed appropriate and politically feasible.

Main point: “To achieve a 5 percent plus growth rate in an undeveloped but budding economy likes ours, it is necessary to start from something that will first lubricate the growth engine, then speed it up, then attain stability, and then ensure sustainability of growth rate.”

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Five Reform Agendas

If someone asked you to enumerate five reform agendas that will kick-start Nepal's jammed growth engine and sustain five percent plus annual growth rate, what would be your response? Recently, I was asked this question. By considering the pattern of reforms in countries that have passed through the existing development state of our economy and the evolution of institutions, culture, reforms and constraints in Nepali economy, my non-exhaustive list of reform agendas were: (a) Infrastructure (electricity and roads); (b) contemporary industrial policy; (c) overhaul of education and healthcare sectors; (d) governance and regulations (financial and non-financial sectors); and (e) social safety nets.

Before explaining the rationale behind this hierarchy of policy reforms, let me be clear about two key assumptions. First, it postulates that political situation will eventually be stable. Second, as is the case with the emerging economies, an increase in economic growth rate will lead to poverty reduction.

When macroeconomic situation is in a mess, we need to first ensure that fundamental variables are promptly taken care of. We need to identify the most binding constraints on economic growth in order to tackle the most troubling aspect of the economy. Studies have shown that the most binding constraint right now is a lack of infrastructure, mainly roads and electricity. With the supply of electricity about five times less than the demand, it is not only difficult for entrepreneurs to start new business, but is equally hard for the existing firms to keep their machines running. Note that Nepal has the highest electricity tariff (dollar per KWh) and lowest electric power consumption (KWh per capita) in South Asia.

An inadequate transport infrastructure increases transportation and transaction costs, leading to loss of competitiveness. Nepal has the highest transportation costs and lowest road density in South Asia. Provision of good infrastructure facilities incentivizes domestic entrepreneurs, both agricultural and non-agricultural. It facilitates the rise of small and medium enterprises (SMEs), the main source of employment for people and revenue for entrepreneurs. It kick-starts the growth engine but won't guarantee speeding up of the engine fast enough.

For this to happen we need to prop up firms that can exploit economies of scale and expand markets abroad. A contemporary industrial policy (IP) that can 'lead the market' and 'follow the market' is required to speed up growth rate. South Korea adopted 'lead the market' principle, where it picked potential winners and promoted 'winning' industries. Meanwhile, Taiwan adopted 'follow the market' principle, where the state 'nudged' firms to upgrade their technologies through appropriate incentives, performance requirements and facilitation of transfer of technical knowhow and capital. Any such promotion of domestic industries should have industry-specific sunset clauses to eschew misallocation of resources, price distortion, and repression of incentives.

The state has to play a vital role in propping up markets when there is substantial underinvestment in promising sectors. Just setting up 'enabling' environment is not enough amidst information asymmetries and coordination failures in the market. In Nepal's case, the state could speed up the establishment of Special Economic Zones (SEZs), Export Processing Zones (EPZs) and Garment Processing Zones (GPZs); extend tax holiday in key industries; guarantee investment insurance in hydropower sector; facilitate export of labor services to growing middle-income countries facing shortage of manual and semi-skilled labor; subsidize loans and provide easy credit to strategic firms; train human resources; promote tourism; facilitate trade; create backward and forward linkages in the industrial sector; and borrow new technology to enhance efficiency and productivity, among others. 

A good industrial policy helps to stimulate the economy and speed up industrialization, leading to absorption of surplus agricultural labor in industrial sector. A potential source of investment in the short term could be remittances, if only the policymakers can figure out how to channel it into the productive sectors for investment rather than for consumption of imported goods and for investment in real estate sector.

For a vibrant market and a sustainable growth rate, it is equally important to ensure smooth supply of quality human capital. To make the previous two reform agendas sustainable, it is necessary to reform the existing Nepali education and health sectors. An education sector that is geared towards the need of the domestic and international markets is vital to fulfill the demand for human resources in rapidly growing sectors. The banking sector is already suffocating from a short supply of competent human resources. Given the immature state of our financial markets, there is a huge demand for educated, well-trained young professionals who are capable of analyzing market fluctuations and investments. Along with the education sector, we need to improve on the provision of health services, especially in rural areas. It will ensure a constant supply of healthy, competent human capital to the industrial sector.

With booming economic activity also comes complexity. Some agents in the economy always want to earn more profits than others, often by going roundabout established rules. To keep unhealthy competition and risky investment activities at bay, it is necessary to have good governance and regulations. Nepal's notorious public sector, which is infested with corruption culture, needs to be reformed. This will not happen overnight. But we can at least take corrective steps by empowering the Commission for Abuse of Authority (CIAA), the main corruption watchdog, with more manpower, expertise and funding so that it can spread its wings to all districts. Furthermore, having proper regulation in place for the rapidly growing financial markets, which usually is the main artery from where investment spending is pumped out into the economy, is essential. This helps to check malpractices in the public and private sectors, and the financial markets.

Finally, with booming economic activity and growth of financial markets, also come unpleasant and unintended outcomes: rise in inequality, which retards growth rate, and increase in vulnerability of poor people. This is why we need to have adequate safety nets, which can be funded by taxing the richest people in the highest income quintile. This has to be done without killing incentives of entrepreneurs. To uplift living standard of the lowest quintile and to stimulate rural economy, we need public work programs, conditional (or unconditional) cash transfer programs, short-term employment during lean agricultural season, and training programs aimed at graduating low-skill workers with updated skills consistent with market demand.

Let me emphasize that these reform agendas are not comprehensive. Depending on objectives, there could be an entirely different set of hierarchy of reforms. However, to achieve a five percent plus growth rate in an undeveloped but budding economy likes ours, it is necessary to start from something that will first lubricate the growth engine, then speed it up, then attain stability, and then ensure sustainability of growth rate. Drawing out a simple set of national reform agenda endorsed by all political parties despite their divergent ideology would do a lot in terms of generating high and sustainable growth rate in Nepal.

[Published in Republica, April 22, 2010, pp.6]

What is wrong with the Nepali economy?

The Under-Secretary at Ministry of Finance, Yoga Nath Poudel, in Nepal questions the increase in tax revenue, limited public services and low saving.

The underlying problem is the conflict between the large demands for investment and paucity of domestic savings. Lowering taxes, reducing public sector prices and improving infrastructure and education could lower public revenue in the short run; but it is the only avenue to save the country from being doomed to sink to the bottom of development failures. Rigorously stringent measures may not be politically feasible at this time, but the government can contain expenditure at a sustainable level so that the incoming government may not have to bear the unsound scale of expenditure. The times demand that we hammer out a plan of action that will not further burden the governments to come after the new constitution is written.

The questions is: if you lower taxes, where will the revenue come from to fund the existing meager public goods. Reducing public sector prices is not politically feasible. The tax revenue has been increasing with no increase in tax rates. How is it possible? Stemming corruption and loopholes in tax collection could be the two reasons. Another might be the incentives provided to tax collectors and tax payers to do fulfill their responsibilities as required. If revenue is higher than recurrent expenditures, then there is something wrong with the bloated public sector. Trimming its size is one evil option. Also, rather than nominal increase in revenue, we need to look at real increase in revenue.

The economy is in a bad shape-- expenditures are higher than revenues; huge balance of trade deficit; strain in exchange rate; balance of payments deficit in more than four decades; strains in fixed exchange rate between Indian rupee and Nepali rupee; decline in remittances; tightening of overall liquidity; real estate bubble; strained financing in the productive sectors; huge unemployment problem in the rural as well as urban areas; population growth rate that matches real GDP growth rate; low development expenditures; high recurrent expenditures; double-digit inflation rate; low productivity; demise of garment industry; slackness in total production in the agricultural sector; increasing migration from the rural areas to the urban areas; the inability of the economy to absorb new labor force entering the labor market, thus triggering massive exodus of talented citizens; inequality is increasing … the economic situation is as gloomy as it could get!

But, there are positive signs waiting to show up in the economy, if only there is improvement in law and order; political stability; restraint in YCL and similar organizations disruptive activities; restraint in militant trade unions; a selective industrial policy; (improvement in infrastructure) … Notice that almost all of these are largely related to political factors. The economic fundamental are still strong but the political fundamentals are constraining them and nipping their growth.

Growth diagnostics of the Nepali economy

These are a collection of blog posts related to growth diagnostics of the Nepali economy, which I finished in April 2009. I will post a link to the full paper later.

Nepal’s growth story:

1. What’s holding back growth in Nepal?
2. Reality about Nepal’s GDP growth rate
3. Five decades of Nepal’s growth story
4. Nepal’s export dynamics

Binding constraints:

1. Bad infrastructure as the most binding constraint on economic activity in Nepal
2. The state of corruption in Nepal

Incompatible constraints:

1. Macroeconomic stability and macroeconomic risks in Nepal
2. Property rights
3. Education (human resources) sector in Nepal
4. Is “self-discovery” an issue in the Nepali economy?
5. What about coordination externalities? [Product space, comparative advantage and Nepal’s export sector]
6. Labor and business regulations in Nepal
7. Taxes, revenues and expenditures in South Asia
8. Cost of finance in Nepal (Bad international finance, Low domestic savings, and Poor intermediation)

Policy implications:

1. Policy implications of growth diagnostics of the Nepalese economy
2. Growth strategies for Nepal

Policy implications of growth diagnostics of Nepali economy

This blog post is related to earlier posts, where I discuss the constraints on economic activity in the Nepali economy. These policy implications are related to the growth diagnostics of the Nepalese economy, a paper I finished writing on April. Also, see this column and this blog post.

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This growth diagnostics exercise indicates that Nepal has failed to attain a high and sustained growth rate mainly due to poor performance in the exports sector. GDP growth rate below 2.5% is sustained primarily by favorable output in the agricultural sector, caused chiefly due to favorable climate. However, sustained growth rate above 2.5% is determined by the export sector, whose performance is dependent on prices prevalent in the international market. Since 1997, exports as a percentage of GDP are declining due to lack of price competitiveness in the international market and domestic supply bottlenecks. Worse, the export sector has few ‘nearby’ products to shift productive activities to in the case of unfavorable international price shock.

The economy has not been able to upgrade its productive activities due low proximity in sectors other than the garment and textile industries, where the existing capacity has already been exhausted. There are no nearby products to move in to in the agricultural sector even though some of the products in this sector are being exported with comparative advantage. There is some scope in the manufacturing of small machinery and electricity circuits industry. The question is: why is the manufacturing sector not able to produce these goods despite a potential for production of exportable items with comparative advantage?

As the above analysis shows, the main constraint behind the growth of the most important sectors in the economy lies in deficient supply of transport infrastructure and a lack of appropriability due to microeconomic risks such as corruption. These are dragging down the pace of structural transformation in the economy. Considering the effect of relaxation of these two constraints on economic activity in the short term, it is argued that relaxing bad infrastructure constraint would produce bigger change in the objective function (i.e. growth rate) than relaxation of corruption, which is an institutional matter and takes a long time to change this constraint.

Using the logic of practicability in the short term, bad infrastructure was identified as the most binding constraint on growth. To make this assertion, other constraints such as microeconomic risks, macroeconomic risks, cost of finance, human capital, and poor geography were shown as nonbinding constraints (or not as strong as bad infrastructure and corruption) on growth.

Nepali economic reform has to focus on relaxing the most binding constraints to produce the biggest effect on growth in the short term. However, this does not mean that other constraints are not important. The sequencing of reforms has to be done in such a way that relaxation of the two identified constraints should be on the high priority list, at least in the short term.

High tariff rates and transportation costs are eroding competitiveness of products produced by the industrial and agricultural sector. Apart from the deficient supply of roads transport, the country is reeling under an acute shortage of electricity. At present, there are over 15 hours of power cuts. Lack of energy is contributing to loss of productivity in the existing manufacturing industries. The current environment is one where the only activities that can survive have to be un-intensive in infrastructure (both transport and electricity). This means that the government should invest heavily on roads and air transports, hydroelectricity, and communication sectors.

Relaxation of the infrastructure constraint has to be done systematically keeping in mind three key issues: (i) the composition of infrastructure investments (new investments or maintenance; public or private investment; operational or capital expenditures), (ii) sequencing (marked based reforms such as privatization, introduction of competition and regulatory innovations), and (iii) the relevance of different sub-sectors. Lower than optimal levels of maintenance expenditures will result in higher operation costs for private capital goods that depend on infrastructure and for running such infrastructure facilities.

While devoting resources to relax the most binding constraint on growth (i.e. bad infrastructure), the government also has to make sure that the economy is equipped with the necessary conditions to convince investors of profitable investment. This means other strong constraints such as corruption and labor regulations are duly taken care of. A stringent action on governance reform is needed along with relaxation of labor market rigidities to propel private investment in the infrastructure and other productive sectors.

The government should engage in public private partnership and let foreign investors invest in the infrastructure sector under the Build-Own-Operate- Transfer (BOOT) provision. Similarly, it should also offer tax incentives to private and foreign investors in hydroelectricity investment. Designing policies to channel remittances inflows into the hydroelectricity sector might also be fruitful in relaxing this constraint in the short term.

There is a need to strengthen the regulatory regime and reform the existing labor regulations. The Commission for Investigation of Abuse of Authority (CIAA), the administrative regulatory watchdog, should be bestowed with more independence, funding, and authority. Moreover, the labor regulations, especially hiring and firing provisions should be made business friendly. The absence of connectivity and weak regulatory structure have been preventing industrial transformation to more productive activities, i.e. exploitation of ‘nearby’ machinery and electricity products, which could be exported with comparative advantage, is not occurring.

The government alone cannot relax the constraints- the private sector needs to get on board in this process. Here the issue is not about whether the government should intervene or let the private sector flow in its own spirit. The real issue is: what would help relax the constraints in the immediate term so that growth can be sustained in the medium and long term? Without the private sector, the government will not do a good job in identifying what needs fixing within the infrastructure sector and regulatory structure.

On the other hand, without the government the private sector will also not be willing to incur huge overhead costs associated with investment in infrastructure. Similarly, it alone cannot solve the myriad labor issues that are bedeviling the industrial sector right now. The government is in a position to build missing forward and backward linkages for the industrial sector. It can be done through the establishment of special economic zones (SEZ), garment procession zones (GPZ) and one-window-policy for all business transactions.

As argued earlier, though this analysis identifies the two constraints as the most binding on growth for immediate and medium term, it should not be interpreted that other factors like macroeconomic issues are trivial. Though the prevailing inflation rate does not pose as the strongest constraint right now, it will nevertheless be damaging if it spirals up in the coming years. Similarly, the economy might be in short supply of human resources if it grows above 5% for more than five consecutive years.

It might be hard to bridge the gap between domestic demand for and supply of human resources by importing skilled workforce from India because the Indian economy itself will be absorbing more of them in the coming years, provided that their economy grows at the current rate of over 7%- which is a likely scenario. Similarly, the rising population growth rate might pose as a debilitating factor in dragging down the growth rate of GDP per capita in the coming years. The obscure economic policies of the Maoists, who are the governing party right now, regarding the role of the private sector might scare away domestic and foreign investors. Note that the issues discussed here are not comprehensive and are just a cautionary note.

In short, Nepal’s export sector has huge potential for growth if the two binding constraints- bad infrastructure and corruption- are relaxed in the immediate term. It will not only allow structural transformation but also create new opportunities for the industrial sector to produce products that are competitive in the international market, which could help sustain growth rate above 5%. To attain a double-digit growth rate, it is very important to relax the most binding constraint—bad infrastructure. Attracting new investment in road and air transport infrastructure can be done by relaxing some of the business and labor regulatory issues.

Making the most out of this opportunity is the key to sustained growth in Nepal. Quick relaxation of these constraints could lead to acceleration of the rate of shift to productive activities in the agricultural sector, which already has products that are exported with comparative advantage, and the machinery industry, which is a promising one given the existence of high proximity between products in this sector. Tapping these opportunities and letting the promising sectors flourish seems key to high and sustained economic growth in Nepal. This can be done by relaxing the most binding constraints, which will produce the biggest bang for a reform buck in the immediate term.