FDI policy and investment climate in Nepal

Ramesh Chitrakar evaluates FDI policy and investment environment in Nepal in a new ADB report (see chapter 7). The report is about intra-regional trade and investment in South Asia. Sadly, most of the chapters include South Asia as India, Pakistan, Sri Lanka, and Bangladesh (where did Nepal, Bhutan, Maldives and Afghanistan go?). It would have been really helpful if Nepal was also included in the chapter on textiles and clothing, which was Nepal's top export before 2005. The chapter dealing with Nepal has nothing new in terms of information but it is a nice aggregation of all the stuff that has been said about investment climate in Nepal in the past three years.

Here are some points from the report:

-Nepal's landlocked location, technological backwardness, and internal political conflicts have prevented it from fully developing its economy.

-To increase FDI, the government has introduced a "one-window" policy but it has not worked as there are too many procedures.

-Reducing savings-investment gap is one of the challenges of the government in terms of maintaining sound fiscal health.

Trade profile:

-Nepal's major trading partner is India (around 62% of total trade took place with India)

-Nepal's export to SAARC as a share of its total exports ranged from 53.9% in FY2003 to 72.5% in FY2007, and of this India's share ranged from 97.5% to 98.4%.

-After India, Nepal's largest export partners during FY2003-FY2007 were the US, Germany, UK, France, Italy, Canada, Japan, Bangladesh, and Spain.

-Imports from SAARC ranged from 53.9% to 67% as a share of total imports during FY2003-FY2007.

-Major countries from where Nepal imports are India, PRC, Indonesia, Singapore, US, UAE, Thailand, Japan, Malaysia, and Saudi Arabia.

-Nepal needs to diversify trade inside and outside SAARC, which is clearly its main market.

-It needs to sort out differences in trade agreements with India-- problems in sanitary and phytosanitary requirements; complex quarantine rules on agricultural products; uneven implementation and interpretation of trade treaty's measures by state governments in India; disagreements on customs clearance procedures for cross-border rail operations (Banlabandh Marg is of little use) [some of these issues have been addressed in a recently signed trade treaty between India and Nepal but some issues on CVD remain)

-To integrate fully in the WTO system, Nepal has to address its domestic and border regulatory constraints (red tape, public service delays, labor laws, and industrial relations)

-Textile and carpet sector has been hit hard by the end of MFA.

-Nepal's proximity to the PRC and India offers opportunities for trade.

Lack of competitiveness arises from geography, policy, and institutions; low productivity and poor business climate due to government instability, inefficient government bureaucracy, corruption, and inadequate supply of infrastructure; high transportation and energy costs, rigid and formal labor market, poor work ethic of the labor force, poor industrial relations, domestic conflict...

-limited backward linkages and unable to keep up with technological developments

Infrastructure: by mid-March 2007, total road length reached 17609 kms, of which 5222 kms were metaled, 4738 kms graveled, and 7649 kms fair-weather roads; 47 airports, with four under construction; costly and unreliable infrastructure, high transportation and transaction costs

Resource endowments: water and hydropower high potential; forest covers 42.4% of landmass and provides 79% of total energy consumption and more than 90% rural household energy needs; labor force is about 1.1 million but skilled labor force lacking with serious brain drain problem, low labor costs...

RTAs: SAFTA is expected to be beneficial as it offers a huge market access; it covers more than 4000 items, most of which are nontradable; need to bring services under SAFTA; Nepal has a special agreement with the PRC for reduced tariffs no trade with Tibet; member of BIMSTEC, which is expected to be finalized by 2017; has preferential access to the EU under the Everything But Arms initiative; not much hope from the WTO…

FDI: first concerted effort to attract FDI came in 1987 with the passage of the Industrial Policy and Industrial Enterprise Act; joint ventures but telecommunications, hydropower, and air transportation were not opened up; in 1992 it introduced the Foreign Investment and Technology Transfer Act and established Investment Promotion Board; then came the one-window policy act; double taxation agreements were signed with India, PRC, Austria, Korea, Mauritius, Pakistan, Sri Lanka, Norway and Thailand with more coming; investment protection agreements with France, Germany, and the UK.

-the flow of FDI has been pretty dismal; flowed mainly in tourism sector and manufacturing

-57 countries had made investments in Nepal by mid-November 2007, of which 39.3% of investments in terms of project costs, 36.4% in terms of total fixed costs, and 44.5% in terms of total FDI were made by SAARC countries (mainly from India).

-some firms closed due to hostile labor relations and unstable political environment with poor regulatory structure

-lately the government has opened up all sectors to FDI except for defense, cigarettes, bidi (a small hand-rolled, often flavored, cigarette), and alcohol

-100% repatriation of equity invested, dividends obtained from foreign investments, and amount received as payment are allowed

-No legal impediments in registering mortgages or repossessions... but, some of the incentives offered in 1992 are being rolled back like reinvestment allowance in the form of deductions from taxable income of up to 40% of investment in expansion or modernization (withdrawn in 2002) and corporate tax rebate of 10% for high local content was removed.

-Priority sectors include services, medicinal herbs, vegetable and flowering seeds production, honey production, hydropower, petroleum exploration, and natural gas exploration

-Business unfriendly legislations: the Labor and Trade Union Act enacted recently permits strikes and requires unions to be affiliated with political parties [it was a disaster decision!]; Bonus Act requires that workers get 10% of yearly profits as bonus regardless of improvements in productivity; Electricity Act has limited bonuses of workers to 2% of yearly profits in the hydropower sector; industrial strikes by labor unions are a major constraint; 50% of the manufacturing workforce is composed of casual workers, who earn the same wage as permanent workers, but who have less job security and fewer fringe benefits.

-Customs and transshipment delays can account for as much as 55% of the logistics costs of sending certain types of goods from Kathmandu to Kolkata, instead of 25% on average for other international routes; it also delays travel time by about 3 to 8 days

-SEZs projects were initiated in 2003 to attract FDI and achieve high economic growth; SEZs at various stages-- Bhairahawa EPZ (under construction); Birgunj, Panchkhal, and Nuwakot SEZs (pre-feasibility studies carried out); clothing processing zone to be established in Simara; studies for more SEZs in Nepalgunj, Kailali, and Kanchanpur.

-Bilateral investment treaties agreements with France (1983), Germany (1986), the UK (1993), Mauritius (1999); no such agreements with India, the US, and PRC; investment agreements in the pipeline with India, Belarus, Qatar, Russia, Sri Lanka, and Thailand; SAFTA and BIMSTEC offer opportunities; double taxation agreements and prevention of fiscal evasion with several countries

-In 2007, total employment provided by approved FDI projects exceeded 180,000 with manufacturing other than textile and clothing accounting for around 35% of this total, followed by T&C with around 20%, and tourism with 9%; No domestic firms have been displaced by foreign manufacturing, tourism, or financial firms.

Constraints: small domestic market and infrastructural problems due to geography (landlocked and mountainous); low labor productivity leading to higher production costs; delays at customs and transshipment to India's Kolkota port; high costs of transport and power; a rigid and formal labor market; lack of labor-employer cooperation; weak policy and institutions in the areas of taxation, investment, and trade promotion; conflict; poor work ethic of the labor force, corruption; weak trade facilitation

FDI potential: access to markets in India and China, India has guaranteed duty-free access to most Nepalese manufactures and an agreement is due with China to designate Nepal as a tourist destination; abundance of natural resources (agriculture sector has high potential; has five climate zones); low tariff rates and a liberal foreign exchange regime and accessibility of the bureaucracy; potential sub-sectors: agriculture, and agro-based industries, flowers and flowering plants, Pashmina (third-largest export item with a share of 10.4% of overseas exports in FY2007), tourism, health and health education, IT, freight forwarding, nursing homes, construction; could piggyback on $10 billion software export industry of India.

The quest for education: Exam on a playground!

What happens when the demand for education outstrips supply for education? Well, there won’t be enough teachers and rooms to fit them all! In the picture above, more than 1000 students from grade one to nine are giving mid-term exams out on the playground because of short supply of enough rooms for them to sit for exam. The students are from a high school in Gularia, Nepal.

The quest for education continues despite logistic hurdles!

Development impact of the Doha Round

There has been a lot of debate about the gains from the Doha Round. It was initially estimated that the developing countries would gain tremendously and would help them not only achieve development goals (especially poverty reduction) but also bridge the income gap with the developed world. However, the exact benefit of Doha Round is still debatable. Generally, analysts use models (like CGE) and simulate the likely Doha scenarios (the likely framework that would be agreed upon) to estimate the impact of policy changes in the future as against the situation in the base year. Integrating the service sector in the modeling is a daunting task and is highly speculative as there are not convincing models to move in that direction yet.

In 2005, a World Bank study put a bombshell on the overly optimistic estimations from gains from trade. The study showed that under the "likely Doha scenario", the global gains in the year 2015 would be just $96 billion, with only $16 billion going to the developing world. This means the developing countries would see a one-time increase in income of just 0.16 percent of GDP. Also, it showed that only 6.2 million people would be lifted above the $2 per day poverty line (it represents just 0.3 percent of those living in poverty worldwide). Worse, most of these gains would go to the developed world and those that goes to the developing world is largely distributed among few countries. Half of all the benefits are expected to flow to just eight countries: Argentina, Brazil, China, India, Mexico, Thailand, Turkey, and Vietnam. Furthermore, this study by Carnegie Endowment shows that total gains from trade to be between $32-55 billion, with rich nations getting $30 billion; middle income countries like China, Brazil and SA getting $20 billion; and poor countries getting $5 billion (about $2 per head).

Amidst the increasing momentum on resuming Doha trade talks, a study by the Peterson Institute for International Economics (PIIE) has shown that the Doha deal could deliver $300-700 billion in global welfare gains, with the benefits 'well-balanced' between the developing countries. In a new policy brief, Kevin Gallagher and Tim Wise argue that these assertions rest on "shaky assumptions, controversial economic modeling, misleading representations of the benefits, and disregard for the high costs of Doha-style liberalization for many developing countries." They wonder how the economists found another  $150-$350 billion in benefits for developing countries that the World Bank missed in 2005.

The gains in the new study from agriculture and non-agricultural market access (NAMA) are of the same order of magnitude as previous studies, about $100 billion, with the vast majority going to rich countries.

The new estimates for services, sectorals, and trade facilitation are highly speculative, use methodologies that are unproven, and assume far more ambitious outcomes than seem at all likely at this point.

Peterson finds high gains in services and sectorals because they assume that developing countries will make big concessions and that those same countries are big winners (from lower prices) even if they lose significant parts of those sectors to imports.

The estimates of $365 billion in gains from trade facilitation are particularly exaggerated, because they assume not only agreement on reforms but resources for the vast investments in infrastructure and human capital needed to make them happen.

The claims of “balance” are unfounded, as developing countries receive less than one-third of the projected income gains. Previous modeling has shown that many poorer regions, such as Sub-Saharan Africa, are projected to be worse off after an agreement.

As with most such projections, researchers disregard the costs of liberalization for developing countries. Tariff losses just from NAMA reforms are estimated at $64 billion, far more than the estimated gains to developing countries. As countries struggle to recover from the financial crisis, this is not the time to cut needed government revenues. Terms of trade for developing countries are projected to decline significantly, as they shift back toward primary production rather than forward toward industrial or knowledge-based development.

 

Their recommendations:

• The US and the EU should agree to honor WTO rulings that have found their subsidies for cotton and sugar to be in violation of existing trade rules that forbid exporting products at subsidized prices.
• The WTO should take positively "special safeguard mechanism" provision, especially granting poor countries some policy space on maneuvering tariffs in staple food items like rice, corn, and wheat. This was the main reason why the negotiations in 2008 failed.
• For manufacturing sector, "special and differentiated treatment" should be re-enshrined for developing nations.
• Real gains from trade facilitation can only be captured through significant investment in infrastructure and human capital. The existing "aid-for-trade" proposals are inadequate.
• There should be a moratorium on North-South preferential trade agreements because these deals exploit the asymmetric nature of bargaining power between developed and developing nations.

Elections and economy policy

We explore the impact of elections on the quality of economic policy and governance in developing countries. We argue that not only do elections likely have a positive structural effect on economic policy, but they may also have a disruptive cyclical effect. Elections introduce frictions; they are periodic events, the timing of which may affect politicians’ incentives to reform. We also argue that achieving accountability in developing countries requires more than elections. When the quality of the electoral process is poor, elections simply do not create the structural effect we would expect.

We introduce into our estimations proxies for the structural effect of elections (the frequency of elections) and for their cyclical effect (the number of years that separate each year from the nearest election). We find that elections in developing countries have both a cyclical and a structural effect on policy.

An election that is not “free and fair” is a broken technology; it cannot be expected to hold governments accountable to citizens. Hence, the overall conclusion from our analysis is that the frequency and conduct of elections matter. Our results suggest that elections are a key instrument in achieving accountability. But elections fail to achieve accountability if they are infrequent or uncompetitive.

That’s from Chauvet L. and P. Collier, 2009. More here.

Fig: Democracy, elections, and economic policy (82 developing countries, 1978-2004)

Links of Interest (11/20/2009)

China will become of the world’s largest economy in 2032 (but not in terms of income per capita!)

Forecasting macroeconomic developments (Also, see top-down versus bottom-up macroeconomics)

An interesting Turkish blog

Gambling on a sinking nation (remember a Cabinet meeting underwater in Maldives)

The effectiveness of fiscal and monetary stimulus in depression (In short, analysis of budgets and central bank policy rates for 27 countries covering the period 1925-39 shows that where fiscal policy was tried, it was effective.)

Chavez slams GDP methodology after his economy contracted in 3Q

The impact of the Doha Round on Kenya (Kenya’s GDP will boost by a 0.2 percent; it will see losses in the manufacturing and mining sectors but gain in agricultural and processed food sectors)

Zedillo Commission Report on reforming the World Bank

WDI now in Google search (try the new stuff; its cool; see a sample below)… also, try WB Data Visualizer (you can do similar stuff in Google Spreadsheet plus copy the code and use it elsewhere!)

Not satisfied playing with data? Try WB Data Finder (a sample below):

GDP growth (annual %) - 2008

Source: World Bank Data - Annual GDP Growth Rate

The lessons on reducing poverty from the BRICs

John Perkins on stopping terrorism (trade fairly!)

Global economic crisis and South Asia

Dipak Dasgupta, Lead Economist for South Asia at the World Bank lists four reasons that have helped South Asia's growth rate from plunging down drastically as a result of the global economic crisis, which took South Asia’s growth down by about 3 percentage points (from 8.6% in 2007 to 5.6% in 2009). The World Bank expects GDP growth to recover to nearly 7 percent per annum on average in 2010-2011.

1. Remittances held up much stronger in South Asia than in other regions. In Nepal, the reliance on remittances is the highest, and without these flows, growth in consumption would have collapsed.

2. The resilience of some key export-oriented sectors also helped. Garments in Bangladesh and IT software exports from India, for instance, have held up relatively well.

3. FDI inflows to South Asia suffered a decline during the peak crisis period but have since picked-up sharply in India, Pakistan and Sri Lanka.

4. Policy responded early in the crisis, helped by domestic factors such as the pre-election fiscal spending in India. The size of fiscal stimulus announced was over 3 percentage points of GDP in India and significant also in Bangladesh. Interest rates were lowered sharply in most South Asian countries.

Gupta argues that the region faces two big challenges: food price inflation and fiscal deficits.

Rather than lumping all South Asian countries in the same basket (because high growth from three countries among eight in South Asia jacks up the regional average), there is a need to differentiate the countries into two blocs: high growth countries (India, Bangladesh and Bhutan) and low growth countries that suffer from instability (Pakistan, Nepal, Sri Lanka, and Afghanistan). This way it is easier and accurate to get a clear picture of each country’s constraints on growth, business environment, macroeconomic stability, institutions, governance structure, and bureaucracy . This WB blog post does take a differential look as required, which is not common among South Asian analysts (who actually exclusively look at India and Pakistan and refer it as South Asia; there are six other countries that are member of SAARC!)

Anyway, below are trend of some economic indicators for Nepal (compared with South Asian average).

Institutions, Incentives, Poverty and Inequality

Daron Acemoglu explains why and how there is persistent inequality and what can be done about it (fix incentives and governments):

The question social scientists have unsuccessfully wrestled with for centuries is, Why? But the question they should have been asking is, How? Because inequality is not predetermined. Nations are not like children — they are not born rich or poor. Their governments make them that way.

Economist Jeffrey Sachs, director of Columbia University's Earth Institute, attributes the relative success of nations to geography and weather: In the poorest parts of the world, he argues, nutrient-starved tropical soil makes agriculture a challenge, and tropical climates foment disease, particularly malaria. Perhaps if we were to fix these problems, teach the citizens of these nations better farming techniques, eliminate malaria, or at the very least equip them with artemisinin to fight this deadly disease, we could eliminate poverty. Or better yet, perhaps we just move these people and abandon their inhospitable land altogether.

Jared Diamond, the famous ecologist and best-selling author, has a different theory: The origin of world inequality stems from the historical endowment of plant and animal species and the advancement of technology. In Diamond's telling, the cultures that first learned to plant crops were the first to learn how to use a plow, and thus were first to adopt other technologies, the engine of every successful economy. Perhaps then the solution to world inequality rests in technology — wiring the developing world with Internet and cell phones.

And yet while Sachs and Diamond offer good insight into certain aspects of poverty, they share something in common with Montesquieu and others who followed: They ignore incentives. People need incentives to invest and prosper; they need to know that if they work hard, they can make money and actually keep that money. And the key to ensuring those incentives is sound institutions — the rule of law and security and a governing system that offers opportunities to achieve and innovate. That's what determines the haves from the have-nots — not geography or weather or technology or disease or ethnicity.

Put simply: Fix incentives and you will fix poverty. And if you wish to fix institutions, you have to fix governments.