NEPAL: Macro snapshot of FY2014 budget

Finance Minister Shanker Prasad Koirala introduced a timely and full budget for FY2014 on Sunday. Shunning populist slogans, programs and policies, the budget prioritized hydropower and energy development; agriculture productivity and commercialization; physical infrastructure development; access to social education, health, drinking water and sanitation; tourism development; investor-friendly environment; export promotion; and good governance.

FY2014 budget targets
GDP growth (%)	5.5
Inflation (%)	8
Budget allocation for FY2014
	Rs billion	%
Budget allocation	517.2	100
Recurrent	353.4	68.3
Capital	85.1	16.5
Financial provision	78.7	15.2
Projected total revenue	429.5	100
Revenue	354.5	82.5
Foreign grants	69.5	16.2
Principal repayment	5.5	1.3
Budget surplus (+)/deficit (-)	-87.7
Deficit financing	87.7	100
Foreign loans	43.7	49.8
Domestic borrowing	44.0	50.2

The total budget for FY2014 is Rs 517.2 billion, with Rs 353.4 billion for recurrent expenditures, Rs 85.1 billion for capital expenditures, and Rs 78.7 billion for financial provision. The total budget allocation for FY2014 is 27.8% higher than FY2013 budget allocation and 41.1% higher than the revised estimate of total expenditure in FY2013.

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The projected total revenue is Rs 429.5 billion, with 82.5% of it coming from tax revenue, 16.2% from foreign grants, and 1.3% from principal repayment. This leaves the government with Rs 87.7 billion of budget deficit, whose financing would come from foreign loans and domestic borrowing of 49.8% and 50.2%, respectively, of the deficit.

The table below provides income and expenditure snapshot of the FY2014 budget and the FY2013 revised estimate. Due to the lack of timely full budget and the inability to spend allocated money in time along with high revenue mobilization, there was net savings in FY2013.

FY 2014 budget targets	FY2014 BE	FY2013 RE
GDP growth target (%)	5.5	3.6
Inflation target (%)	8	9.9
Income and Expenditure FY2014
	Rs billion	Rs billion
Projected total expenditure	438.5	311.7
Recurrent	353.4	258.1
Capital	85.1	53.6
Projected total revenue	424.0	337.6
Revenue	354.5	295.7
Foreign grants	69.5	41.9
Surplus (-)/deficit (+)	14.5	-25.9
Projected financing	-14.5	23.5
Net loan investment	24.5	12.8
Net share investment	7.2	9.3
Net foreign loans	-27.4	-0.7
Net domestic borrowing	-18.8	-2.0

Some macro related points to consider (for more, see Economic Survey 2013 as well):

• Recurrent expenditure allocation is really high. It is barely equal to tax revenue target. The growth in FY2014 budget allocation (BE) is 40.7%  over FY2013 revised estimate (RE). Rationalization of recurrent expenditures has to be thought of seriously.  Grants to local bodies and social service constitute 42% of recurrent expenditure, followed by compensation of employees (25%), use of goods and services (15%), and social security (15%). The allocation for compensation of employees, use of goods and services, grants, and social security increased by 30.4%, 88.3%, 40.6%, and 12.9%, respectively, compared to the revised estimate of respective expenditures in FY2013.

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Note: FY2014 nominal GDP at producers’ prices assumed to be 14.7% (average of FY2012 and FY2013) higher than FY2013 provisional data. Revised estimate of revenue in FY2013 is higher than revised estimate of expenditure because of the inability of the government to spend the allocated budget in time, thanks to the lingering political uncertainties and delay in bringing out a timely and full budget.

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• Capital allocation has remained around 16.5% of budget allocation, but problems always arise during implementation. More challenges would prop up both scale and quality fronts in the run up to the CA elections (and possibly local body elections).
• Revenue target is 20% in FY2014, down from 21% between FY2013RE and FY2012. Given the weakening currency and a potential slowdown in imports (due to depreciation, but we will have to see remittances growth to see the net impact), revenue target might be challenging. The existing reforms have to be sustained and its reach expanded to increase tax net and tax base.
• Allocation for financial provision has been equal to or higher than capital expenditure. It includes internal loan investment, domestic share investment, and external (borrowing) amortizations and domestic (borrowing) amortization. This probably has direct relationship with the government’s continuous pumping in of money in public enterprises (last year only 2 of the 37 PEs gave dividends and 21 operated in losses) as well as high debt servicing as a result of higher borrowing. The combined loss of NOC and NEA was Rs 19.5 billion (1.27% of GDP in FY2012).
• Domestic borrowing is getting larger than external borrowing. Interest on domestic borrowing (except for T-bills) is higher than interest on concessional loans from multilateral banks because the interest rate is usually pre-determined (much higher than market rates) before auction. Higher domestic borrowing might also impact liquidity situation in the banking sector. As a share of estimated FY2014 GDP, planned deficit financing is about 4.5% of GDP (2.2% of GDP foreign loans, and 2.3% of GDP domestic borrowing).
• Growth target is ambitious and inflation target is conservative. The recent depreciation of the rupee (except against Indian rupee) might dampen not only revenue mobilization, but also exert pressures on prices as more than 50% weight in CPI index comes from non-food and services, which are mostly imported. Also, market prices will see upward pressures coming from the hike in salary and allowance of public employees. It is mostly going to be ‘push’ factors, complemented by the persistent supply-side constraints.

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The blocks refer to the share of functional expenditure in total expenditure (including financing). The numbers (in Rs ‘000) is the amount of budget allocation or expenditure.

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The blocks refer to the share of expenditure item in total economic affairs functional expenditure heading. The numbers (in Rs ‘000) is the amount of budget allocation or expenditure.

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Performance of the Nepali economy in FY2013

The Finance Ministry has published Economic Survey 2012/13. One of the most interesting things in economic survey each year is that it reports the progress on several economic and development fronts (though the latest stats do not cover the entire 12 months of the running year).

The real sector data comes from the CBS, which usually publishes provisional figures well before the economic survey is published.  The Central Bureau of Statistics (CBS) released its annual national account estimate on 5 April 2013, projecting GDP at basic prices to grow at 3.56%, down from 4.48% revised estimate for FY2012 (fiscal year ends on 15 July). The CBS projects services sector to grow by 6.03%, industry sector growth to further drop to 1.49%, and agriculture sector to grow by a mere 1.31%.

The sharp drop in agriculture growth is attributed to the unfavorable monsoon and shortage of chemical fertilizers during peak paddy planting season. The industry sector continues to be beset by persistent supply-side as well as structural constraints, including power outages, labor disputes, low productivity, high cost of raw materials and production, inadequate investment climate reforms, lack of innovation and research and development, corruption, and political instability. High services sector growth is supported by demand backed by high remittance inflows.

GDP_NEPAL	FY2011	FY2012R	FY2013P
GDP growth rate (basic prices)	3.85	4.48	3.56
Primary Sector	4.48	4.98	1.31
Secondary Sector	4.4	2.96	1.49
Tertiary Sector	3.42	4.51	6.03
Composition of GDP (%)
Primary Sector	37.37	36.31	35.32
Secondary Sector	14.94	14.30	14.35
Tertiary Sector	47.69	49.39	50.33

Some useful stats (provisional) from the ES (FY2013):

Real sector (GDP growth has declined; domestic savings are down but national savings are up due to high inflow of remittances; so is per capita GNDI)

• Per capita GDP: US$717
• Per capita GNI: US$721
• Per capita GNDI: US$926
• Gross domestic savings: 9.3% of GDP
• Gross national savings: 38.4% of GDP
• Gross fixed capital formation: 21.2% of GDP
• Total population: 27.2 million
• Inflation: 10.6%

Fiscal sector (revenue growth has declined; government expenditure growth has increased; tax revenue has increased; budget deficit is up; external loans are up)

• Revenue growth: 18.5%
• Revenue: 17% of GDP
• Tax revenue: 14.8% of GDP
• Government expenditure: 23.8% of GDP
• Budget deficit: 3.7% of GDP
• Domestic borrowing: 2.2% of GDP
• External loan: 1.5% of GDP
• Public debt: 30.1% of GDP
• Outstanding domestic debt: 12.4% of GDP
• Outstanding external debt: 17.6% of GDP (or 103.6% of revenue; 587% of exports)

Monetary sector (total credit growth down; growth of credit to private sector up; money supply decreased)

• Total credit growth: 8.9%
• Growth of credit to private sector: 15.6%
• Money supply (M2) growth: 6.2%
• Total loans: 63.7% of GDP
• Total loans to private sector: 55% of GDP
• Money supply: 70.6% of GDP

External sector (export growth down; import growth up; trade deficit up; tourism income growth down; remittance income growth down; current account surplus down; balance of payments surplus down)

• Merchandise export growth: 4.2%
• Merchandise import growth: 20.4%
• Merchandise trade deficit growth: 23.5%
• Merchandise export: 4% of GDP
• Merchandise import: 29% of GDP
• Merchandise trade deficit: 24.9% of GDP
• Tourism income growth: 4%
• Tourism income: 1.7% of GDP
• Remittances growth: 19.6%
• Remittances: Rs 430 billion (22.4% of GDP)
• Current account balance: 1.4% of GDP
• Balance of payments: Rs 11.8 billion
• Foreign exchange reserve: Rs 453.6 billion (10.2 months of goods import or 8.7 months of import of goods and non factor services).

The annual comparison is more revealing when the full year fiscal sector, monetary sector and external sector data are released around end of August. Right now, the data is good to observe any interesting as well as alarming trends.

Performance of public enterprises (PEs) in FY2012:

• Of the 37 PEs, 15 made profit and 21 made loss. One did not do any transaction. 8 PEs that earned profit last year made losses this year.
• Total loss incurred by PEs reached Rs 3.49 billion in FY12, compared to profit of Rs 6.69 billion recorded a year earlier.
• NOC and NEA reported loss of Rs 9.52 billion and Rs 9.94 billion, respectively, in FY2012. Combined loss is 1.27% of GDP in FY2012.
• The government has recently decided to pay off the staff of Janakpur Cigarette Factory (Rs 2 billion needed) and is considering doing the same at Nepal Drugs Company in order to liquidate them.
• Pension related obligations increased by 25.9% to Rs 21.2 billion from Rs 16.8 billion a year earlier.
• Political interference and growing unionization are eroding competitiveness
• Excess number of staff needs to be downsized and productivity boosted to remain relevant and financially afloat.

Highlights from Nepal’s Three Year Interim Plan FY2014-FY2016 Approach Paper

The government has come up with a draft approach paper of the upcoming Three Year Interim Plan (TYIP) FY2014-FY2016. It was endorsed by the National Development Council on July 6. The NPC will publish a final version of the approach paper before the Finance Minister unveils the budget for FY2014. It will be the third interim plan (previously, TYIP FY2008-FY2010 and TYIP FY2010-FY2013) as the country is unable to have a full five year plan due to the protracted political transition. The NPC publishes a detailed TYIP after few months of the approach paper’s, which needs to be endorsed by the cabinet, publication.

The upcoming plan has a vision of graduating Nepal from LDC category to a developing country status by 2022. It is consistent with the Istanbul Plan of Action, an outcome of the UNLDC IV meeting held in Istanbul on 9-13 May 2011. More analysis on this specific issue in later blog posts, but for now the major highlights.

Growth rate: The government is targeting an average annual growth rate of 6.0% over the next three years, with agriculture sector growth and non-agriculture sector growth targeted at 4.5% and 6.7%, respectively. Surprisingly, while the NPC has listed targeted growth rate for all sub-sectors , it is missing in the case manufacturing activities, which have seen a consistent decline over the last few years.  Instead, it is combined with mining and quarrying and the combined growth target is 4.7%. Mining and quarrying itself was growing at over 5% in the last few years. Probably, the NPC is not expecting much growth in manufacturing sector as it is still plagued with persistent structural bottlenecks and supply-side constraints. 

The highest growth at the sub-sectoral level is targeted for community, social and personal service related activities, followed by hotel and restaurant; transport, storage and communication; education; electricity, gas and water; and health and social work (all above 7.5% growth rate). While real estate and commercial activities, and financial intermediation are expected to register growth rate of over 6%, wholesale and retail trade growth is estimated at 5.5%. Note that most of these are driven by remittances-backed demand. In essence, this plan doesn’t aim to change much (wrt economic fundamentals required for promoting high-productivity and jobs-generating activities), but let the economic activities be driven by exogenous factors (mainly remittances sent from abroad).

Poverty and social development: The government is targeting to reduce proportion of population living below the national poverty line to 18% from 25.2% in FY2011 and an estimated 23.8% in FY2013. The targets for maternal mortality rate (per 100,000 birth) is 134 from 229 in FY2013, net enrolment rate at primary education target is 100% from 95.3% in FY2013, and area under forest cover is targeted at 40%, marginally up from 39.6% in FY2013.

Similarly, the targets for population with access to drinking water, sanitation, and electricity are set at 96%, 91% and 87%, respectively. They were 85%, 32% and 67%, respectively, in FY2013. Furthermore, the government targets to add 668 MW by FY2016 (major contribution coming from the completion of 456 MW Upper Tamakoshi hydropower project). It is targeting cent percent telephone (including mobile) access by FY2016. While aiming to construct 3,000 kms of road, the government is also targeting to link all district headquarter by road transport.

Investment: Of the total investment required to realize the growth rate, the government is expecting the private sector to contribute 68.7%. The government is expecting 100% private sector investment in real estate, rent and commercial services, and construction. The contribution of private sector in total investment is expected to be over 90% in manufacturing (here, mining and quarrying is missing!); construction; wholesale and retail trade; hotel and restaurant; and real estate, rent and commercial activities. Now, if the government is expecting major investment to come from private sector to support economic activities, then it should have explicitly laid out the steps it will initiate to ensure an investor-friendly environment. Apparently, this is missing or even if it will be laid out in the final version, there are ample reasons to doubt its effective implementation. No wonder, the plan has received lukewarm response from the private sector.

Overall, the government is targeting total investment of about 25.8% of GDP by FY2016, with private and public sector contributing 17.7% of GDP and 8.1% of GDP, respectively. While about 4% of GDP is expected to be invested in agriculture and industry sectors each, the investment target in services sector is about 17.5% of GDP over the next three years. Highest investment of 6.1% of GDP in expected in transport, storage and communication sub-sector. 

The incremental capital output ratio (ICOR) has been maintained at 4.9 (think of it as investment as a share of GDP divided by GDP growth rate). It shows the level of inefficiency of capital investment, largely contributed by the lack of prerequisites (energy, roads, ICT, quality of human resources, among others) to ensure productive and efficient investments. The highest ICOR is for electricity, gas and water (22), followed by health and social work (8.9); transport, storage and communication (8.7); hotel and restaurant (7); community, social, personal service related activities (6); real estate and commercial activities (5.5); and financial intermediation (5.5).

Priorities:

• Hydro and other energy development
• Agriculture productivity, diversification and commercialization
• Road and other physical infrastructures
• Social sector: basic education, health, drinking water and sanitation
• Tourism, industry and trade
• Good governance

Expenditure and revenue: The government is targeting average annual revenue growth (FY2013 constant price) of 13.8%. Based on the assumption that at the end of FY2013, revenue will be 17% of GDP, the government is targeting revenue of 21.1% of GDP by FY2016. However, looking at the numbers provided in the draft approach paper, the revenue target is set at 18.4% of GDP in FY2014, 19.6% of GDP in FY2015 and 20.8% of GDP in FY2016. It indeed is ambitious and even if the revenue growth targets (growth at current prices are usually higher than growth at constant prices) are met, it will be hinged not on domestic economic activities, but on taxes (customs, excise, VAT) on imported goods and services, which in turn are a function of remittances. Foreign grants are expected to be between 3.28% of GDP and 3.33% of GDP.

The size of budget is estimated at 26.9% of GDP in FY2014, 28.0% of GDP in FY2015 and 29.1% of GDP in FY2016. Recurrent expenditure is estimated at 17.1% of GDP  in FY2014, 17.1% of GDP in FY2015 and 16.6% of GDP in FY2016 (surprising that it would decline in FY2016 without justification!). Meanwhile, capital expenditure is estimated at 5.0% of GDP in FY2014, 5.5% of GDP in FY2015, and 4.1% of GDP in FY2016 (not expected to recover to the level reached in FY2009) . Given the delays in unveiling a full budget and implementation bottlenecks, capital spending target is already ambitious.

Domestic borrowing is expected to be below 2.3% of GDP and foreign loans 2.8% of GDP. To finance expenditure, the government is aiming to seek more loans from major multilateral and bilateral development partners and reduce the share of domestic borrowing. It will have implications on debt sustainability.

Financing conundrum: Capital, lending and merger in Nepal

An explanatory analysis, by Rupak D Sharma, about the issues surrounding the regulatory requirement to increase capital, financing (earning) requirement to increase lending, and at the same time ensuring higher cash dividends for shareholders. The message is that, as of now, consolidation of BFIs is the most viable path for a competitive and healthy banking sector. 

Excerpts from the article:

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[…]sudden hikes in interbank rates – which clearly indicate credit tightness in the banking sector -- could precipitate a decline in private sector investment, make the banking and financial sector unstable, and eventually affect the real economy.

[…]commercial banks need to maintain a capital buffer -- known capital adequacy ratio -- of 10 percent. These ratios -- which are measures of the amount of capital held by banks and financial institutions in relation to risk-weighted credit exposures -- stand at 11 percent for development banks and finance companies.

[…]these buffers ultimately protect the interest of depositors, who park hard-earned money in banking institutions, and prevent financial risks from building up in the country’s banking system.

[…]however, the level of these buffers at banks and financial institutions has been gradually declining. The average capital adequacy ratio of commercial banks stood at 11.30 percent as of mid-April, according to Nepal Rastra Bank’s latest report. Although the figure shows holding of an extra 1.30 percentage points of capital fund by commercial banks, the discomforting part is the regulator’s instruction to maintain a capital buffer of at least 11 percent to be able to distribute cash dividend to shareholders.

[…]banks are currently operating with very little extra capital, which is constricting their ability to lend.

[…]Although one may argue there is not much credit demand these days due to the not-so-encouraging investment climate, banking institutions will gradually need to stimulate lending to meet the country’s target of attaining a seven percent growth rate till 2022 to graduate from the category of least developed country to developing country. And data shows there is ample room for credit expansion, as lending of banks and financial institutions as a percentage of GDP currently stands at only 59.2 percent.

[…]if the regulator asks banks to raise paid-up capital to, say, Rs 5 billion within the next three years, and to Rs 10 billion within next seven years, then this technique might not work for all, as many may not be able to earn such huge profits in such a short period of time.

[…]other options for raising capital, such as, asking promoters to inject cash, mergers, or leveraging -- that is issuing corporate bonds.

[…]Currently, many promoters are not as enthusiastic about putting money from their own pockets as return on equity is gradually declining. At the end of the third quarter of the current fiscal year, the average annualized return on equity of commercial banks stood at 14.75 percent as against around 20.66 percent around three years ago. This is because of fierce competition.

[…]This leaves banks and financial institutions with the only option of merger to raise capital, which is probably the fastest way of meeting the minimum regulatory capital requirement.

[…]merger of institutions with very little free capital would only expand the balance sheet size of the consolidated units without addressing the problems that can raise the specter of credit crises and ultimately destabilize the financial sector and the economy.

[…]This, however, does not mean mergers are ineffective in solving many problems faced by banking institutions, as they can expand single obligor limit that allows lenders to give bigger-sized loans to single parties. Mergers can also reduce operating cost, including fixed costs like salaries.

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For a brief note on the financial sector vulnerability, see the policy challenge section of Asian Development Outlook 2013 Nepal chapter.

Poverty by district in Nepal

Based on the recent household surveys and census data, the CBS has come up with Small Area Estimation of Poverty 2013 in Nepal. A general trend is that while the (rural) Far West and Mid West districts have the highest proportion of population living below the poverty line, the Terai districts have the highest number of poor people below the poverty line. The poverty line is fixed at Rs 19,261 (both food and non-food).

According to the latest figures, Bajura has the high percentage of district population (64.1%) living below the poverty line, followed by Kalikot (57.9%), Bhajhang (56.8%), Humla (56%) and Darchula (53%). The districts with the least proportion of poor as a share of the respective district’s population are Kaski (4%), Illam (7.3%), Lalitpur (7.6%), Kathmandu (7.6%) and Chitwan (8.9%). Note that at the national level, the poverty rate is 25.2% of the total population.

Now, do not get confused with the percentage of poor with the number of poor. For instance, while poverty rate in Bajura is 64.1% of that district’s population (134,062), the number of poor people below the poverty line is 85,934. Similarly, while Kathmandu has poverty rate of 7.6%, the number of poor people in Kathmandu is 128,298.

Overall, Nepal has 6,588,664 number of poor people living below the poverty line (25.16% of 26,187,059 = 6.59 million). Kailali has the highest number of poor (257,204), followed by Saptari (251,643), Rautahat (227,340), Siraha (219,656), and Bara (203,348). The least number of poor people are in Manang (2,150), Mustang (4,634), Rasuwa (13,311), Terhathum (147,17), and Dolpa (184,98).

Comparing the progress between 2001 (based on NLSS II) and 2011 (based on NLSS III), the data shows that poverty (% of respective district population) declined in 55 districts, but increased in 19 districts. Twenty districts were able to reduce poverty by over 20 percentage points.

The largest reduction in poverty happened in Panchthar (down from 52.5% in 2001 to 11.4% in 2011 = 41.1 percentage points), followed by Rolpa, Illam, Dhankuta and Khotang. Poverty increased the most in Bajura (by 16.8 percentage points), followed by Manang, Darchula, Jumla and Humla. While Kathmandu and Bhaktapur saw increase in poverty by 3.2 and 3.8 percentage points, respectively, Lalitpur saw a decline in poverty by 2.5 percentage points.

 

Now, the following comparison (at the district level) will be interesting. I will try to write separate blog posts when I have more free time as these tend to have growth and development policy implications:

• Percentage point decline in poverty, and remittance inflows and per capita remittance receipts
• Percentage point decline in poverty and migration/absentee population
• Percentage point decline in poverty and changes in education and health services
• Percentage point decline in poverty and aid concentration
• Percentage point decline in poverty and per capita public expenditure
• Percentage point decline in poverty and provision of infrastructure (electricity, roads, telephone)
• Percentage point decline in poverty and change in real estate and housing prices
• Percentage point decline in poverty, and agriculture production and agriculture productivity
• Percentage point decline in poverty and industrial value added production

More on these and poverty gap and poverty severity by district in later posts.

Cartels everywhere

I am posting the following observation on this blog because a lot of people had strong opinion about it. Context: Water association called for a strike and halted water supply since Thursday (withdrawn on Sunday).

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A toxic mix of entrepreneurs, politicians and politico-entrepreneurs guided by quick gains from business and politics = Continuation of cartels and syndicates, though illegal, who bring the government to its keens and force it to backtrack decisions made in the interest of the public. As a result, you have cartels running the show from essential items to luxury goods supply:

(i) Water cartels shutting down supply because the government is trying to enforce strict standards; (ii) Petro cartels halting supply because the government isn't increasing commission and is monitoring their businesses for regulatory compliance; (iii) Gold cartels pulling down shutters because the government is inspecting their businesses in order to stop adulteration and to make them comply with weighing standards; (iv) Truck cartels halting vehicle movement because they are not allowed to charge three times the normal fare; (v) Taxi cartels calling for sudden chakka jam because they are not allowed to rig meters and charge astronomical fares to travelers; (vi) Veggie cartels shutting down veggie supply because the government wants to lower middlemen commission and regulate the market for any wrongdoing; (vii) Bus cartels vehemently opposing new vehicle addition to specified routes even though a majority of the existing ones are best suited for scrap works; (viii) Construction cartels resorting to violence in districts to win contracts for public construction, which are hardly constructed to the standard.

Few examples of how the cartels run the political and economic spheres in Nepal. Meantime, the government is just trying to adjust to these, without an urge to go hard on them.

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Sourced from Facebook.

The importance of a strong manufacturing sector for structural transformation

Dani Rodrik writes:

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Except for a handful of small countries that benefited from natural-resource bonanzas, all of the successful economies of the last six decades owe their growth to rapid industrialization. If there is one thing that everyone agrees on about the East Asian recipe, it is that Japan, South Korea, Singapore, Taiwan, and of course China all were exceptionally good at moving their labor from the countryside (or informal activities) to organized manufacturing. Earlier cases of successful economic catch-up, such as the US or Germany, were no different.

Manufacturing enables rapid catch-up because it is relatively easy to copy and implement foreign production technologies, even in poor countries that suffer from multiple disadvantages. Remarkably, my research shows that manufacturing industries tend to close the gap with the technology frontier at the rate of about 3% per year regardless of policies, institutions, or geography. Consequently, countries that are able to transform farmers into factory workers reap a huge growth bonus.

To be sure, some modern service activities are capable of productivity convergence as well. But most high-productivity services require a wide array of skills and institutional capabilities that developing economies accumulate only gradually. A poor country can easily compete with Sweden in a wide range of manufactures; but it takes many decades, if not centuries, to catch up with Sweden’s institutions.

Consider India, which demonstrates the limitations of relying on services rather than industry in the early stages of development. The country has developed remarkable strengths in IT services, such as software and call centers. But the bulk of the Indian labor force lacks the skills and education to be absorbed into such sectors. In East Asia, unskilled workers were put to work in urban factories, making several times what they earned in the countryside. In India, they remain on the land or move to petty services where their productivity is not much higher.

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Important message: A meaning structural transformation would require “an industrialization drive, accompanied by the steady accumulation of human capital and institutional capabilities to sustain services-driven growth once industrialization reaches its limits.”

Cautionary note:

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But this time-tested recipe has become a lot less effective these days, owing to changes in manufacturing technologies and the global context. First, technological advances have rendered manufacturing much more skill- and capital-intensive than it was in the past, even at the low-quality end of the spectrum. As a result, the capacity of manufacturing to absorb labor has become much more limited. It will be impossible for the next generation of industrializing countries to move 25% or more of their workforce into manufacturing, as East Asian economies did.

Manufacturing industries will remain poor countries’ “escalator industries,” but the escalator will neither move as rapidly, nor go as high. Growth will need to rely to a much greater extent on sustained improvements in human capital, institutions, and governance. And that means that growth will remain slow and difficult at best.

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