Sri Lanka: The upcoming South Asian miracle

Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management, explains the promises of an upcoming South Asian miracle, i.e. Sri Lanka. The article below is adapted from Sharma’s article published in The Economic Times. It is based on his new book Breakout Nations: In Pursuit of the Next Economic Miracle.

After decisive end of a bloody civil war, Sri Lanka is on a path of robust growth with investment in infrastructure, readily available human capital, better investment climate, and building up of the prerequisites for high growth rate. The Sri Lankans will definitely enjoy a peace dividend that will be of envy to its regional partners like Nepal.

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Why Sri Lanka can be a breakout nation

Ruchir Sharma

I first visited Sri Lanka in 1997, shortly after a rebel bombing of the central bank headquarters had thrown the financial system into chaos. Military checkpoints made travelling around Colombo rather punishing, but the overwhelming impression was of a charming island and talented people trapped inside a seemingly endless civil war.

When I returned in 2011, the civil war had ended with surprising finality, and I took an extra day to see the country, including the huge territory that had been behind the lines of the Tamil rebels.

This should have been easy enough: the Tamil capital at Trincomalee is just 160 miles from Colombo - but the new highways were still being built, and the helicopter on offer was a single-engine job of the kind that routinely crashes in India. My accommodating hosts arranged for the air force to take me up in a twin-engined helicopter.

I've taken helicopters in many emerging markets when the road network is inefficient, normally a bad sign for the economy. But the aerial views of the multiple expressways under construction, the lush green plantations of the interior, and the new resorts facing the turquoise waters that drape the island helped convince me that Sri Lanka is no longer a land in waiting.

In the 1960s, Sri Lanka was billed as the next Asian growth miracle, only to be stymied by a tryst with socialism that played a direct role in igniting the civil war. During the war, Sri Lanka grew half as fast as South Korea and Taiwan and became another country in the long line of emerging-market disappointments.

Today, it seems that Sri Lanka's time has come. The civil war is over, the process of healing is under way, and there is every chance that Sri Lanka will become a breakout nation. Despite slowing sharply during the war years, the economy continued to grow at an average pace of nearly 5% even though it was running on one engine: the prosperous Western province where Colombo is located, and where the well-educated young population was producing strong growth in industries and services.

The North and East Provinces, which account for 30% of Sri Lanka's land and 15% of its population, were largely war zones. With the nation whole again, achieving 7% growth over the next decade should be well within reach.

Since taking office in 2005, President Mahinda Rajapaksa has been consolidating power in ways that critics see as the start of a family dynasty. For now, however, he is deploying his growing powers to ends that suggest he understands the fundamentals of growth, if not of democracy.

Rajapaksa's regime is working to trim the fat left over from the socialist experiments of the 1970s, including high taxes and government debts that still equal 80% of GDP. It is also bringing the vast swaths of formerly rebel-held territory back into play; the government has established vocational training centres and low-interest loan programmes, distributed boats and livestock, and begun building roads and bridges in the former war zone.

Banks are returning, big retail chains are setting up shop, and domestic airlines are flying to Jaffna and Trincomalee again. The flood of state spending drove growth in North and East provinces up to 14% in 2009 and 2010, and they are expected to grow at above 13% for several more years, making them the fastest-growing areas of the country.

The effects reverberate nationwide. On my helicopter trip, I visited some of the newly-renovated resorts, from the retro-chic Chaaya Blu in Trincomalee to the Cinnamon Lodge in Habarana, which lies in the 'cultural triangle' formed by Sri Lanka's three ancient cities.
It wasn't hard to imagine tourists, seduced by the country's raw appeal, coming in droves. While prices are not as dirt cheap as they were at the height of the war, they are still very low - $150 for a high-end hotel room - which means the Sri Lankan currency is still very competitive and attractive to foreign investors.

War-zone insurance rates that had made it too expensive to dock in Sri Lanka have disappeared, leading to a large increase in cargo traffic at the main port in Colombo. The government is pouring money into new terminals there, as well as new ports and harbours in formerly rebel-held regions.

The reintegration of the marginalised Tamils - with their high levels of educational achievement and English fluency - could provide a huge boost to a nation that multiple consulting firms already rank highly as a potential destination for multinationals looking to outsource customer service, IT and other back-office operations.

It would be a mistake to sugarcoat the post-war mood. The final stages of the war were highly controversial: charges of human-rights violations still fly against both sides.
There is evidence that Tamils, embittered by the bloody endgame of the war and suspicious of Rajapaksa, continue to leave the country. But many of those who remain seem determined to put the war memories behind them. I was surprised to see Tamils in Trincomalee working to attract Indian tourists to the 'Ravana trail'.

While to Indians Ravana was the devil incarnate, in Sri Lankan legend, he was one of the most powerful and inspired of ancient kings. The difference of interpretation is of no small magnitude in Sri Lanka, which has long feared domination by its much-larger neighbour.

But in Trincomalee locals say that as long as the 'Ravana trail' is drawing tourists, subjective spins on the myth don't matter.

It's only natural for nations to trade most heavily with their neighbours and, indeed, the success of east Asia has been driven in no small measure by the willingness of China, Japan, Taiwan and South Korea to leave old wars in the past, at least when they are cutting business deals.

In contrast, there is no region in the world with weaker trade among immediate neighbours than south Asia where trade within the region has stagnated at 5% of total trade with the world.

Sri Lanka could be the country to move the region toward a new trade regime. The government is proposing a grand deal that could unlock trade with India and provide a huge boost to the economy. The opposition comes from Sri Lankan businessmen fearful of Indian competition. But India welcomes the deal, in part as an opportunity to balance China's growing interest in Sri Lanka as a linchpin on its supply routes through the Indian Ocean.

Sri Lanka is only too happy to exploit its felicitous location in return for even a small share of China's gargantuan outbound investment; China is investing heavily in the Sri Lankan port at Hambantota, the home base of the Rajapaksa family.

There is some risk that the peace dividend could prove fleeting: a 2009 study by the US Agency for International Development found that 40% of nations that end a civil war will revert to violence within a decade. However, Sri Lanka's peace could well hold because of the decisive end to the war.

There is also a fundamental national consensus that the future should be decided based on what works, not on the ideological debates that retarded Sri Lanka's development for so long. By the late 1990s, even the main left-leaning party, the SLFP, was moving toward a more modern development model built on an open economy and trade liberalisation.

Over the course of its war, Sri Lanka grew its economy slowly but positively, by a total of 206%. The country now has economic and administrative momentum. The government can build prosperity without interruption by suicide bombers.

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What explains the decline in poverty in Asia and Nepal?

According to a recent report by the ADB:

• Increase in expenditure contributed to lower number of poor people below US$1.25 a day, i.e. income effect
• But, it was dampened to some extent by rising food and non-food prices
• The net effect seems to show that the increase in expenditure contributed more to offset the negative impact of rising food and non-food prices.

The annual reductions in the poverty headcount ratio have been impressive in Armenia (22.61%), Azerbaijan (13.31%), Bhutan (15.26%), urban areas of the PRC (15.98%), Fiji (13.31%), Kazakhstan (24.81%), Sri Lanka (11.01%), and Thailand (21.12%). In Nepal, the annual reduction in poverty was to the tune of 7.61% between 2003 and 2010.

In further decomposition of the contributing factors to poverty reduction, the researchers also consider the effect of population growth along with the income effect, food prices and non-food prices. The results show that 30.40 million people escaped poverty in developing Asia every year during the survey periods. The income effect was the most significant.

• If prices and populations had stayed the same, the increase in mean household income during the period would have helped 244.10 million poor escape poverty every year.
• In Nepal, if prices and populations had stayed the same, the increase in mean household income between 2003-2010 would have helped 2.80 million poor escape poverty every year. Keeping other factors constant, increase in population, food prices, non-food prices and income would have increased the number of poor by 0.1354 million, 0.8544 million, 0.8843 million and –2.80 million every year. The net effect on poverty would have been a decrease in poverty by 0.20 million every year between 2003 and 2010. Hail the migrants and remittance inflows!
• In Nepal, food prices and non-food prices contributed to increase in poverty by 5.15 percent and 1.09 percent respectively. But, the income effect decreased poverty by 14.86 percent, leading to a net effect of decline in poverty by 7.61 percent annually between 2003 and 2010.
• The recent food price increases have slowed poverty reduction.
• The income effect in rural India is the biggest.

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Explaining the change in the number of poor people (million)
Country	Change in number of poor due to				Net effect on poverty
	Population	Food price	Non-food price	Income
Bangladesh	0.70	5.51	5.89	-13.43	-1.33
Bhutan	0.00	0.01	0.01	-0.04	-0.02
India–Rural	3.31	40.37	45.38	-99.69	-10.63
India–Urban	2.55	13.22	13.42	-30.85	-1.65
Nepal	0.14	0.85	0.88	-2.80	-0.92
Pakistan	0.60	9.40	8.78	-18.99	-0.20
Sri Lanka	0.01	0.42	0.62	-1.33	-0.28

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For more on the decline in poverty, see here, here and here.

UNESCAP projects GDP growth rate to be 4.5% in FY 2011/12 in Nepal

Here are latest projections by UNESCAP in its Economic and Social Survey of Asia and the Pacific 2012:

• GDP growth is projected to be about 4.5% in 2012, thanks to political instability, frequent strikes in the country, persistent labor problems and severe electricity shortages. It argues that economic revival largely hinges on improved law and order, as poor security and political instability are limiting the government's capacity to spend money and boost rural income.
• Inflation remained close to being a double digit, 9.6% in 2011 and in 2010. Weak supply of food items kept inflation high while at the same time, the cost of production of both agricultural and industrial products rose due to severe electricity shortages and rising labor wages stemming from the Overseas migration of Nepalese workers.
• Budget deficit is estimated to be 3.8% of GDP.
• The growth rate of the economies of the Asia and the Pacific region is forecast to decline to 6.5 percent in 2012 with a slackening demand for the region’s exports in advanced economies and as a  result of higher costs of capital.
• Managing growth and inflation balance seems to be a challenge in the region. Coping high and volatile commodity prices, addressing high unemployment and coping with volatile capital flows are also challenges faced by policymakers.

Considering the large remittance inflows to the region and large out migration, the UNESCAP is batting for establishment of South Asian Migration Commission:

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Remittances from overseas workers are quite substantial and play a major role in the South Asian economies. Governments should consider some special and innovative institutional arrangements to protect migrants and provide social protection coverage. In this regard, a commission should be created to put forward a uniform stance of countries in South Asia to oversee migration and enhance its positive aspects. Once established, the South Asian Migration Commission could formulate the framework for a coherent and comprehensive response to the issues surrounding migration generally applicable to all the countries in South Asia . By looking into best practices regionally and internationally, the Commission could help in designing policies that harness the benefits of migration in the best possible way for all stakeholders and minimize their negative effects.

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It is a good idea to have a commission to look after migrants’ rights and working condition, and channeling remittances to productive sectors instead of in consumption of imported goods. However, I think a commission at the regional level is a bit out of sync with the need for it by other countries. Nepal needs it for sure, but others might not feel so strongly about the idea. In the top ten recipients of remittances as a share of GDP, Nepal (20% of GDP in 2010) is the only one from South Asia. In terms of total amount of remittance inflows, India, Pakistan and Bangladesh (US$58 billion, US$12 billion, US$12 billion respectively) come in the top ten list. Having such commission at the national level in countries like Nepal is a good idea if the goal is to see quick policy execution and coordination. At the regional level, it will take a long time and might not work as expected. For now, I think the recommendation should have been to set up such a commission at the national level for countries where remittances constitute more than 10 percent of GDP (or say more than domestic revenue as a share of GDP). In terms of share of GDP, remittances in Bangladesh, India, Pakistan, and Sri Lanka are 10.9 percent, 3.1 percent, 5.6 percent, and 8.3 percent respectively.

That being said, it would be wonderful if a regional commission is set up (again, politically it might not happen soon) because a significant share (53 percent) of South Asia’s remittances come from the six GCC countries. About 18 percent comes from the US, 12 percent from Western Europe, 11 percent from other high income countries, and 6 percent from developing countries. The figures related to those of 2010. A unified voice is wonderful idea, but not a realistic one in terms of the time needed to set it up and to make it functional. This idea deserves further exploration and vetting.

Back to growth rate, the Nepali government expects GDP growth rate to be 5 percent this fiscal year. In Global Economic Prospects (GEP) 2012, the World Bank estimated GDP growth rate to be 3.6 percent. It blamed law and order problems, and persistent and extensive infrastructure bottlenecks (electrical shortages are reflected in widespread load-shedding and unreliable delivery). It expected exports to be hit due to the sovereign debt crisis in the EU and slow growth prospects. Exports to Europe (in particular textiles and clothing) are more sensitive to a decrease in consumer demand. If you are curious about the current state of Nepali economy, see this presentation.

Load-shedding versus demand for alternative energy sources and equipment

So, how much alterative energy sources and equipment Nepal is importing due to load-shedding? According to FNCCI’s estimate it is Rs 35 billion last year and might reach Rs 100 billion this year. Now, it is an entirely wild guess. I will have to check out the figures out when I am free. But, the overall message is true: Load-shedding is increasing demand for diesel generators (which has doubled the demand for diesel, in turn incurring huge losses to NOC thanks to state subsidies), solar panels, batteries, invertors, and the equipment used in them.

Increasing imports of alternative energy sources and equipment means widening trade deficit, which is already at unsustainable level (about 22 percent of GDP). It will further drain forex reserves and increase deficit.  First, Nepal will have to cough up more forex reserves to finance imports (which in turn means spending the remittance income). Though reserves are at record level right now, it might surprisingly come down if growth of remittance inflows slowdown and imports rise unabated. It might put the balance of payments in the red again (happened in 2009/10 and 2010/11). Second, the increase in load-shedding hours means high demand for fuel to run generators. Since diesel and LPG are subsidized to such an extent that the NOC, which is helplessly left to shoulder the burden, is incurring loss of over Rs 1 billion each month. NOC officials estimate that at present diesel generated electricity is to the tune of 500 MW. Ultimately, the Ministry of Finance (MoF) will have to take care of the balance sheet mess of NOC. It will get reflected in the country’s expenditure-revenue sheet—meaning pressure to widen fiscal deficit (at 3.8% of GDP now).

Now, why would this trend persist despite such ominous situation? Because, households are barely feeling the pinch as a result of increasing remittance income (at 20% of GDP now—around US$4 billion).

Until I compute the actual figures, let me list the FNCCI’s guess of imports of goods that are imperfect substitutes of hydroelectricity.

• Generator: Rs 5 billion (imported from India, China, Taiwan, Vietnam, among others)
• Solar panel, electricity import from India and coal: Rs 4 billion
• Battery: Rs 5 billion

Solution to multiple macroeconomic problems: generate enough hydroelectricity!

Hunger Alleviation Fund

In a new report on food security and poverty in Asia, the ADB has recommended governments to set up a “hunger alleviation fund” and contribute 1% of GDP to the fund, which could be used when food prices growth beyond the reach of the poor. Furthermore, it recommends joint management of the fund with the private sector and encourage contributions by giving giving tax break incentives. It is already being followed in the developed countries. It bats for targeted subsidies to deliver help to those who need it most.

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Reducing food waste and storage losses could close the gap between supply and demand by 15-25% and a second Green Revolution – one that relies on biotechnology to increase food production – is needed. Weather-based crop insurance, as well as futures contracts that would give farmers a guaranteed minimum income for their crops, are other measures worth exploring, the report said.

“Policies should enable producers to calculate revenues in advance, providing enough incentive to boost production, and should include social security safety nets to protect consumers and give the most vulnerable sections of society the means to feed themselves,” Pierre Jacquet, chief economist with the Agence Française de Développement, said at the seminar Seven Billion and Growing : How will the World Feed Itself?

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To promote food security, the policy strategies outlined are:

• Safety nets and social protection programs
• Agriculture productivity
• Rural development
• Agriculture research
• Human capital investment

Earlier, in a working paper (Food Price Escalation in South Asia: A Serious and Growing Concern), Bruno Carrasco and Hiranya Mukhopadhaya of the ADB argued that “a spike in the cost of food staples like rice and wheat could push tens of millions more people into extreme poverty in South Asia but food subsidies targeted at the very poorest in the region would help them cope with still-high prices”. Low income households in South Asia spend more than 50 percent of their budget on food. It also notes that while Nepal and Sri Lanka would be less affected, although a further surge in wheat prices would be especially painful for Sri Lanka, which is completely dependent on imports of the staple and has already seen prices hit historical highs in recent years. More here. Larson et al. argue that storage can help ensure food security if the target is set high and reserves are adequate. Meanwhile, Gouel and Sebastien recommend an activist policy to stabilize the impact of high food prices. They argue that the optimal trade policy for a single low-income country is to subsidize imports when domestic availability is low and tax exports when world prices are high, which will benefit consumers at the expense of producers, because it reduces the likelihood of high prices. But, a pure storage policy might have an opposite effect: it raises the average domestic price because of the increased stock accumulation, and is detrimental to consumers. They argue that to protect consumers from food price volatility in an efficient way, storage policies need to be complemented by trade policies, which would provide some isolation from the world market.

Note that a study (Global Food Price Inflation and Developing Asia) by ADB showed that a 10 percent increase in food prices will increase the number of poor people (in millions) living below US$1.25-a-day by 3.8, 0.01, 22.8, 6.7, 0.6, 3.5, and 0.2 in Bangladesh, Bhutan, rural India, urban India, Nepal, Pakistan, and Sri Lanka, respectively.

Cost of informality to Nepali economy

Published in Republica, May 5, 2012, p.8.

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Cost of informality

The Ministry of Finance (MoF) and National Planning Commission (NPC) are busy sketching budget boundary for various ministries and allocating development expenditure for next fiscal year, which starts from July 16. The size of budget is expected to be over Rs 400 billion, up Rs 385 billion in 2011/12. The government meets its expenditure from domestic revenue, internal borrowing and foreign aid. The most important one here is domestic revenue, which is low at 15.2 percent of GDP (tax and non-tax revenue at 13.1 percent and 2.2 percent respectively of GDP). But, expenditure stands at 23 percent of GDP, with over half of it as recurrent expenditure. Hence, there is always a pressure to increase revenue to cover increasing expenditure. A slew of policy measures ranging from increasing taxes and customs tariff to widening tax net are implemented to achieve revenue target. However, a crucial aspect mostly ignored by policymakers is the inability to bring in informal sector inside the tax bracket and level the playing field for both formal and informal sector firms.

Now, you might be wondering what informality has to do with the economy at this point of time. Well, brining informal activities and transactions under the tax net would help increase tax revenue even when the existing tax rates are unchanged, create level playing field for formal sector firms, and boost industrial capacity and productivity. Informality is highest in services sector, particularly construction, wholesale and retail trade, hotel and restaurant, and real estate, renting and business activities, whose combined contribution to GDP is approximately 31 percent. Nepal Informal Survey 2009 shows that nearly half of informal firms produce or sell food and beverages and the rest engage in repairing, tailoring and furniture business, among others. Almost 67 percent of informal firms are in Central Development Region.

Firms operating in the informal sector have cost advantage as they avoid taxes and regulations, which the formal sector firms have to pay and abide by. They evade fiscal and regulatory obligations, including value-added tax (VAT), income taxes, labor market obligations (such as social-security deductions and minimum-wage requirements), and product market regulations (quality standards, copyrights, and intellectual-property laws).The evasion of taxes and infraction of regulations help them offset the cost of low productivity and small-scale production. [Here, let me emphasize that the tax evaders in the formal sector should not be spared in any pretext and be penalized according to the law.] The government should play an active role in bringing informal firms into the formal sector because even if the economy grows, it is less likely that the transition would happen automatically.

It is estimated that the size of informal economy (also termed “shadow economy”, which means all market-based legal production of goods and services that is deliberately concealed from public authorities) in Nepal was 37.5 percent of GDP in 2007, which is the third highest in South Asia. Sri Lanka has the highest size of shadow economy at 47 percent of GDP. No wonder formal sector investors complain that the biggest obstacle to investment climate in Sri Lanka is the unfair competition with large informal sector. A 2009 survey shows that 49.4 percent of firms compete against unregistered or informal firms and around 18 percent identify practices of competitors in the informal sector as a major constraint to doing business in Nepal. Furthermore, recent estimate of informal trade along the porous Nepal India border shows that the total value of informal imports of agriculture goods from India is approximately Rs 55 billion.

The large informal economy and trade means lower revenue receipts than the potential level, which would in turn heap additional burden on those who operate in the formal economy and also negatively impact economic growth. First, high degree of informality stifles economic growth rate, which has been suppressed below 5 percent. With ever-increasing expenditure, low tax receipts would mean either rise in taxes imposed on formal businesses or high internal borrowing. Raising taxes on formal businesses would discourage investors because they feel burdened when compelled to cough up extra money for the excesses of competitors in the informal sector. It means investment and employment generation below the potential level. Also, high internal borrowing would increase budget deficit, which stands at around 3.8 percent of GDP. Second, the high degree of informality means a weak industrial sector due to subscale and unproductive companies. Most of the informal sector companies cannot grow beyond a certain limit because of a lack of access to credit, marketing and managerial weaknesses, and absence of downstream linkages to both formal and informal firms. Worse, informal firms eat away market share of bigger and productive formal competitors as they have the advantage of avoiding taxes and regulations. It has been found that the informal companies operate at just half the average productivity level of formal companies in like sectors and have price advantage of over 10 percent. It distorts competition, leads to stunted growth of industrial sector, and restrains consolidation of firms that could have resulted in economies of scale and enhanced productivity. Also, labor rights are not guaranteed in the informal sector, workers are underpaid and working condition is much worse than in comparable formal sector firms. In 2009, average monthly salary in informal sector was Rs 3,944 while the formal manufacturing firms offered Rs 6,510 per month.

It in the interest of government to reduce informality, increase revenue by broadening tax net rather than increasing taxes on the formal sector firms only, and create a level playing field to foster competition among firms in same sectors. However, doing so is a Herculean task for the Inland Revenue Department, the main agency to collect taxes for the government, because of its limited capabilities and resources. The major driving forces toward informality are high direct and indirect taxes, the regulatory capabilities of government along with the state of formal economy, and labor market regulations. There is a disincentive to comply with all legal obligations because of poorly staffed and organized government enforcement agencies, weak penalties for noncompliance, and ineffective judicial system. In 2009, approximately 46 percent of informal firms did not get registered because they saw no benefit from it. Moreover, the high cost of operating in the formal sector deters willing informal firms to comply with formal sector regulations. These include red tapes, high tax burdens, inadequate supply of infrastructure, and meeting costly product quality and worker-safety regulations. For instance, one of the major reasons behind the high informal imports from India is the red tapes and hassles at custom points.

The government could reduce informality by reducing the cost and burden of meeting formal sector regulations and by offering enticing incentives to those that operate in the formal sector. Some of these could be strengthening enforcement of laws and regulations, eliminating red tape, and cutting prohibitively high taxes. It could also enhance its audit capabilities, make court systems fast and efficient, avoid giving tax amnesties, hike penalties for tax evaders, collaborate with financial institutions to maximize monetary transactions of firms, streamline regulatory burden, introduce electronic tax filing, and simplify tax codes. Importantly, it could initiate steps in liking informal sector with formal one so that more firms are covered in the tax net and more revenue is generated to cover rising expenditure.

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Petroleum product’s demand, supply, prices and never-ending queue at petrol pumps in Nepal

The long queue at petrol pumps, rationing of LPG, rising NOC’s losses due to increase in international prices on whose basis it purchases from the IOC, NOC’s inability of purchase enough fuel when the subsidy government is offering has to be shouldered by the corporation, and the MoF’s inability to either give sufficient funds to NOC or compel it to restructure (administration, leakages and prices) are recurrent issues. The web of interconnections among these baffles analysts and, as in many cases, beyond some point there is no logic to the fuel prices in market, losses to NOC and supply of fuel (thanks to politics!).

Anyway, here is how the prices of petroleum products are moving in Nepal. The increase in domestic prices do not entirely reflect the prices in the international market. On April 4, 1996, a liter of petrol cost Rs 31; Rs 40 on July 17, 1998; Rs 47 on October 14, 2000; Rs 67.25 on March 3, 2006; Rs 100 on June 9, 2008; Rs 77.5 on February 17, 2010; and Rs 120 now. The prices of diesel and kerosene have been fixed at the same rate since December 3, 2008, largely to stop adulteration. Currently, petrol and diesel prices are highest in Kathmandu and Surkhet (Rs 120 and Rs 89 per liter respectively). The lowest prices (Rs 118.50/L for petrol  and Rs 87.50/L for diesel) are in the border cities with India. [Fyi, POL means petroleum, oil and lubricants. One barrel is equivalent to 159 liters and 1 cylinder 14.2 kg.]

As of 2012-05-01, there is loss in sale of diesel and LPG, which are also the ones with the highest demand in the market. Before the prices were adjusted two months ago, the losses were even bigger than what are listed in the table below. The NOC currently owes Rs 23.17 billion to the government and various banks and financial institutions. Of the total loans, the NOC owes Rs 10.73 billion to the government, Rs 6.40 billion to the EPF, Rs 4.13 billion to the CIT and Rs 1.90 to banks and financial institutions.

Profit and loss as per IOC's rate as of 2012-05-01
Item	Price
Petrol (MS)	3.71/Ltr
Diesel (HSD)	-10.60/Ltr
Kerosene (SKO)	3.02/Ltr
LP Gas	-598.34/cyl
Aviation Turbine Fuel (JET A-1)	14.39/Ltr (Duty Paid)
Aviation Turbine Fuel (JET A-1)	19.73/Ltr (Bonded)
Estimated total loss as of May 2012	- 1.1447 billion

Also be clear that the retail price of POL is high also because of high tariff (VAT, road tax and other charges), insurance and transportation charges, leakages, and NOC’s administrative costs. See the table below for the breakdown of costs for petrol, diesel, kerosene and LPG.

NRs	Petrol/L	Diesel/L	Kerosene/L	LPG/cylinder
Buying price as of May 1, 2012 from Raxaul	73.94	77.55	76.38	1530.32
Tariff	33.55	14.78	2.04	241.84
Interest on NOC's loan	1.47	1.47	1.47	20.87
Transportation cost and insurance	2.15	2.15	2.15	105.81
NOC's administrative charge	0.50	0.50	0.50	7.10
Technical leakage	0.98	0.59	0.50	1.39
Dealer commission	2.74	1.75	1.97	56.00
Insurance and transportation charge of dealer	1.24	0.82	0.97	50.00
Total price	116.29	99.60	85.98	2013.34
Retail price in Kathmandu	120.00	89.00	89.00	1415.00
Total monthly sales (KL, cylinder)	17,000	65,000	6,000	1,200,000

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Load-shedding, petro demand and inflation

The link between international petroleum prices and inflation in Nepal has been strong since 2007, the same year when load-shedding increased substantially and demand for petroleum products skyrocketed. A recent study by the IMF economists showed that almost a third of the variability in domestic inflation can be attributed to the prices in India and movements of international oil prices. The study found that the responsiveness of food price inflation was significant and quick to spillovers from India’s food prices and the global oil price fluctuations before 2007. However, after 2007 the impact of fluctuating oil prices is more persistent than the spillovers of food prices prevalent in the Indian economy. Even though petroleum prices do not change readily in our economy as they do in the international market, the price fluctuations are seen directly and indirectly in the cost of imported inputs (and final products) used by agricultural, industrial and service sectors.

The consumption of diesel has increased by over 100 percent between 2007/08 and 2010/11 (from 3 lakhs KL to 6.5 lakhs KL). The increase in demand comes mainly from the industries as a result of drastic increase in load-shedding hours. The peak demand for electricity in 2007 and 2011 was 648.39 MW and 946.1 MW respectively. The available energy (NEA hydro, NEA thermal, purchase from IPP and India) in 2007 and 2011 was 3051.82 GWh and 3858.37 GWh respectively. While the average annual average growth of peak demand for electricity between 2007 and 2011 was 9.44 percent, the annual average growth of available energy was 6.98 percent. There is a huge electricity demand and supply gap (on an average the demand is 650-900 MW but supply is around 450 MW). Furthermore, driven by the increasing purchasing power and expansion of trading business (mostly commercial), thanks to remittances, the additional number of consumers has also drastically increased between 2007 and 2008 (from 1.3 million to 2.05 million). The increase in consumption of petroleum fuel (especially diesel and LPG) is inversely related to the supply of electricity (load-shedding hours) in Nepal.

Nepal imported about Rs 51 billion of petroleum products in 2009/10, which increased to Rs 75 billion in 2010/11 (a solid jump of about 45 percent). It is expected to surpass Rs 100 billion in 2011/12. Fyi, the total merchandise export of Nepal was just Rs 64 billion in 2010/11.

What is the solution?

Saving myself from repeating the same arguments on how to handle the situation, let me direct readers to my earlier detail piece on the sorry state of state-owned enterprises, including NOC. Brief points are listed below:

• Adjust domestic prices with international prices (find other means to rein in on the impact of rising petroleum prices on inflation—NRB, MoCS, MoF, and NPC need to step up their efforts)
• Minimize leakages, including offering freebies to staff and MoCS guys, and lay off unnecessary staff at NOC
• Minimize political meddling in management, and improve governance and accountability
• Let private players join the market
• End syndicates and cartels in fuel transport
• Increase storage facility, mainly to partially tame price volatility. The present storage capacity of 71,558 kiloliters is just enough for 15 days (based on the projected sales for 2009).

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This is what happens when you ration products that have high demand in the market—it leads to a thriving black market. Petrol in mineral water bottles!