Interesting number

The number of births in a year in India = the total population of Nepal = 27 million

This is probably the most pessimistic (but realistic) description of India:

INDIA is a land of bright promise. It is also extremely poor. About 27m Indians will be born this year. Unless things improve, almost 2m of them will die before the next general election. Of the children who survive, more than 40% will be physically stunted by malnutrition. Most will enroll in a school, but they cannot count on their teachers showing up. After five years of classes, less than 60% will be able to read a short story and more than 60% will still be stumped by simple arithmetic.

Is it time for the death of Chinese growth model?

Michael Pettis argues that the fiscal stimulus enacted in the Asian economies, particularly China which is providing a “steroid-fuelled” growth, will potentially boost growth in the short term but their growth model is not sustainable.

One of the consequences of the Asian development model has been that production outgrew consumption for decades. When a country produces more than it consumes, it must run a trade surplus to export its excess capacity. The Asian model consequently required high and rising trade surpluses that allowed Asian producers to produce far in excess of what Asian consumers could afford to absorb.

But there cannot be trade surpluses without trade deficits elsewhere. A fundamental requirement for the Asian model was that foreigners were able to run the requisite trade deficits. In practice, only the US economy and financial system were large and flexible enough to play this role. The Asian model, in other words, implicitly involved a massive bet on the willingness and ability of the US to continue to run large and rising trade deficits.

The assumption that implicitly underlay the Asian development model – that US households had an infinite ability to borrow and spend – has been shown to be false. This spells the end of this model as an engine of growth. The sooner Asian policymakers accept this and force through the necessary economic and political changes, the less painful the transition will be. Unfortunately this does not seem to be happening.

Many Asian nations are using fiscal stimulus to prop up export-based sectors. Is exports-based growth model still the answer to higher GDP per capita in developing and emerging nations? As the main buyers (US and the EU) are cutting back consumption expenditure and the governments ‘required’ to maintain fiscal balance down the road (deficits can’t go forever), will the exports-based growth obsessed nations find customers to buy their goods and services? Also, will domestic demand in the developing countries be strong enough to prop up GDP growth rate? Is the exports-based growth model still relevant for the low income countries? And, is the model nearing death for emerging nations? Interesting questions that need answers!

Here is Szirmai arguing that the manufacturing sector still matters for growth and catch up in the developing countries.

Manufacturing sector and growth

According to Szirmai, the manufacturing sector still matters for growth and catch up in the developing countries because of the following reasons:

• First, there is an empirical correlation between the degree of industrialisation and per capita income in developing countries.
• Second, productivity is higher in the manufacturing sector than in the agricultural sector.
• Third, a further aspect of the structural change bonus argument focuses on the dynamics of sectors. Manufacturing is assumed to be more dynamic than other sectors. A transfer of productive resources to more dynamic sectors contributes to growth.
• Fourth, the transfer of resources from manufacturing to services provides a structural change burden in the form of Baumol’s disease.
• Fifth, compared to agriculture, the argument runs that the manufacturing sector offers special opportunities for capital accumulation.Capital accumulation can be more easily realised in spatially concentrated manufacturing than in spatially dispersed agriculture. This is one of the reasons why the emergence of manufacturing has been so important in growth and development.
• Six, the manufacturing sector offers special opportunities for economies of scale, which are less available in agriculture or services.
• Seven, the manufacturing sector offers special opportunities for both embodied and disembodied technological progress.
• Eight, linkage and spillover effects are stronger for manufacturing than for agriculture or mining. Linkage effects refer to the direct backward and forward linkages between different sectors.
• Finally, as per capita incomes rise, the share of agricultural expenditure in total expenditure declines and the share of expenditure on manufactured goods increases (Engel’s law).

That said, he argues that the role of manufacturing sector on growth is weakening, especially in the industrialized nations. The strongest contributions are found in the period 1950-1973, when there were special opportunities for absorption of mass production techniques by developing countries. In the advanced economies, the role of services has become much more important.

Financial crisis and the academic economics

Here is a critical assessment of the stuff we learn in econ in light of the financial crisis.

The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession. Over the past three decades, economists have largely developed and come to rely on models that disregard key factors—including heterogeneity of decision rules, revisions of forecasting strategies, and changes in the social context—that drive outcomes in asset and other markets. It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, “systemic crisis” appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession.

This failure has deep methodological roots. The often heard definition of economics—that it is concerned with the ‘allocation of scarce resources’—is short-sighted and misleading. It reduces economics to the study of optimal decisions in well-specified choice problems. Such research generally loses track of the inherent dynamics of economic systems and the instability that accompanies its complex dynamics. Without an adequate understanding of these processes, one is likely to miss the major factors that influence the economic sphere of our societies.3 The inadequate definition of economics often leads researchers to disregard questions about the coordination of actors and the possibility of coordination failures. Indeed, analysis of these issues would require a different type of mathematics than that which is generally used now by many prominent economic models.

We believe that economics has been trapped in a sub-optimal equilibrium in which much of its research efforts are not directed towards the most prevalent needs of society. Paradoxically self-reinforcing feedback effects within the profession may have led to the dominance of a paradigm that has no solid methodological basis and whose empirical performance is, to say the least, modest.

They argue that economists have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. And, this time they failed to do just that. They argue that there was some sort of “academic moral hazard”. Also, Rodrik argues that the failure has to do more with ideology-wrapped economists than economics itself. See this one about economics crisis under heterogeneity as well.

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.

Property rights protection in Nepal

This a part of a series of analysis on growth diagnostics of the Nepalese economy. For discussion of a set of constraints on economic activity in Nepal see this post. Also, see this column and this blog post.

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Nepal’s standing on protection of property rights and rule of law index are satisfactory but they are still not up to the standard to clear doubts and uncertainty from potential investors and entrepreneurs. The CPIA property rights and rules based governance rating for Nepal is not that encouraging for an economy that is aspiring to grow at a double-digit growth rate, which never happened in the past five decades. Frequent encroachment on business property and establishment of extralegal camps on industrial complex by politically affiliated youth wings and unions have scared investors.

Figure 1

Its rating on property rights and rules based governance is 3, which is the median score. Based on this index, Nepal compares favorably with other countries that have similar per capita income. Though protection of property rights might not necessarily be a strong constraint at present, a lack of improvement in this front might scare away potential investors who do not what to assume too much risk. To attract more FDI and encourage domestic entrepreneurs, Nepal has to have a score well above 4.

In the rule of law front, Nepal’s standing is discouraging. In terms of enforcing rule of law, 71% of the countries rate better than Nepal. Only 29% of the countries have worse rule and law situation than Nepal.

Figure 2

Source: World Governance Indicators 1996-2007

The rule of law in Nepal deteriorated since 1996, the year when the Maoists started an armed rebellion. After a decade of civil war and finally an end to rebellion in 2006, there was a slight improvement in the rule of law. However, the complication generated by youth wings and trade unions and eruption of fresh violence in the Terai region led to deterioration of the rule of law. Though this seems to be a concerning factor, it still is not the binding constraint.

Since it is not strong enough yet to deter investment and dampen entrepreneurial activity, property rights cannot be the binding constraint on economic activity.