Initial analysis of the economic impact of the Nepal earthquake

This blog piece is cross-posted on Asian Development Blog. Here is my earlier reflection on the Great Earthquake in Nepal.

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ADB’s initial analysis of the economic impact of the Nepal earthquake

Clearly the poorest in the country, with fewer resources to fall back on, will suffer the most from the disaster in a country where 25% of the population lives below the poverty line.

The 7.8 magnitude earthquake that rocked Nepal on 25 April and the many subsequent aftershocks have imposed a huge human and economic toll on the country, with over 5,000 deaths and some 11,000 injured. Millions of people have been affected in other ways.

Roads, bridges, water supplies, schools, hospitals, and homes in the main cities and in rural areas across more than two-thirds of Nepal’s 75 districts have suffered damage. Major roads to neighboring countries still seem usable though.

Clearly the poorest in the country, with fewer resources to fall back on, will suffer the most, and many will likely fall back below the government’s national poverty line of NRs19,261 per person per year (average 2010-11 prices). This is particularly the case in rural areas, where 27.4% of the population lives below the poverty line. Overall, 25% of the population in Nepal lives below the poverty line.

Estimating the exact economic cost will be an ongoing process, but these are our initial thoughts.

Economic growth. Nepal’s economy grew by an estimated 5.2% in fiscal year (FY) 2014 (ending 15 July 2014), its highest rate since the global recession. Production activities, especially in the service sector, have been severely disrupted by the earthquake mainly due to damage to physical infrastructure and distribution networks. Travel and tourism is likely to be badly hit with most key hotels shutting down for the coming few weeks in order to examine the structural integrity of their buildings. Although this sector’s direct and indirect contribution was only about 9% of gross domestic product (GDP) in FY2014, it is one of the fastest-growing sectors and has significant backward and forward linkages in terms of employment and production. Hence, the impact of the likely drop-off in tourism will be significant. In addition, banks and financial institutions are only partially operating, which will restrict the credit supply to businesses and households. In March, ADB had projected 4.6% growth for FY2015. We now estimate that the growth rate will decline to 4.2%. If the supply-side disruptions intensify in the coming weeks, then the growth forecast may be further downgraded to somewhere between 3% and 3.5%. Meanwhile, GDP growth is expected to rebound strongly in FY2016 given that a forecast of a better monsoon than in FY2015 should boost agricultural output and the anticipated accelerated expenditure on rehabilitation and reconstruction should boost economic activities.

Inflation. In March, ADB projected inflation to moderate to 7.7% for FY2015, down from 9.1% in FY2014. However, due to supply side constraints following the earthquake, we now see it edging up to 8% in FY2015. Food inflation is expected to remain in double digits as a result of high prices of cereal grains and vegetables following to the earthquake. A shortage of fuel and higher transportation costs may also cause non-food inflation to edge upward. Inflation is expected to tick down to around 7.3% in FY2016 after the shortage of food and non-food items has eased.

Fiscal balance. In the short run, capital spending will be slow due to the significant disruption in labor and financial flows, and contract awards. The implementation and disbursement of some ADB projects may face delays for this same reason. In the medium term, a lot of reconstruction work will depend on government approvals and the pace of project implementation. Nepal’s fiscal situation has been manageable in recent years, even registering a surplus equivalent to 0.1% of GDP in FY2013. As in FY2014, the country is expected to run a small fiscal deficit in FY2015 and FY2016. The country can comfortably afford to run a moderate fiscal deficit to finance reconstruction projects, which will also serve to stimulate the economy.

Current account balance. Another impact of the earthquake could be seen on workers' remittances. Official remittance inflows are expected to increase immediately following the earthquake (expecting such trend starting the last month of FY2015 and mostly in FY2016). Potential migrant workers might defer travel and instead stay with family members; some workers working abroad might come back to take care of family matters. The net flow is harder to predict at the moment but net remittances are not expected to change drastically from the levels forecast in the Asian Development Outlook 2015 (ADO 2015), of about 25% of GDP. The current account has remained surplus since FY2012 and was about 4.7% of GDP in FY2014. In line with the ADO 2015, the current account surplus is still forecast to decrease to about 2.7% of GDP. This is largely due to the already decelerating official remittance inflows (and not expecting to change drastically except for the last month of FY2015 plus higher non-oil import bill that is widening trade deficit). Accordingly, the balance of payments surplus will also fall in FY2015. Foreign exchange reserves will continue to be enough to finance over 9 months of import of goods and services.

The immediate priorities for the government will be to:

1. Manage relief and logistic operations effectively.
2. Smoothen institutional coordination in both the relief and reconstruction phases.
3. Conduct a detailed needs assessment of the rehabilitation and reconstruction of physical infrastructure and a corresponding timeline of events and milestones to fully utilize internal and external assistance.
4. Ensure good governance of the relief and reconstruction efforts.
5. Focus the next budget for FY2016 on relief, rehabilitation and reconstruction.
6. Continue ongoing and planned reforms to increase private sector investment.

Tremors and timidity in Nepal

I am safe for now. Thank you for your concern and support. Stayed in a makeshift camp/tent since Sunday. Hopefully, things will get back to normal, especially the aftershocks and availability of food, water and essentials.

25 April 2015 is going to be an unforgettable moment in life. The massive 7.8 magnitude earthquake (on the Richter scale) hit several places, including Kathmandu. I had just finished lunch at my colleague’s place when we felt the first jolt. It lasted for over a minute, which felt like over an hour of a terrifying jolt. We ran to an open space by the local river for safety. There aren’t many open spaces in Kathmandu due to unplanned and unregulated urban planning, and haphazard housing and construction. The next 48 hours were the most grueling ones as the strong and frequent aftershocks (on top of the occasional rain) created difficulties in finding proper shelter, water and food. The tremors continued well into at least Tuesday night, forcing people to stay outside in makeshift tents or whatever shelter they could find in open spaces.

The destruction caused by the earthquake and subsequent aftershocks is overwhelming. Public infrastructure is damaged and some villages are completely wiped out. Worse, thousands of people died and many more remain unaccounted for and injured.

The things that have cropped up in the last few days bear the hallmark of a weak bureaucracy, fractured political system and a deep rooted institutional inadequacy and incapacity to manage logistics and large-scale operations:

1. Nepal has not faced such a dire situation in recent history. The extent of human and physical destruction caused by the earthquake is unprecedented. Hence, the post earthquake logistical management has been chaotic within the government and a nightmare for the public. The state machinery and political leadership are simply incompetent to fully deal with the unfolding situation. They realize it, but seem unwilling to let folks with competence to take over the management of relief operations and logistics management. The same bureaucrats and politicians are trying to spearhead such efforts, which simply is beyond their capacity and experience. Hence, the chaos and sense of inadequacy despite the excellent effort made by the security forces with the limited resources they have. This is an extraordinary situation and the government needs to think outside of the box in terms of solution. Traditional ways of doing business and governance is not going to be effective.
   
2. The weaknesses related to institutional coordination is apparent after the earthquake. In the absence of effective local authorities/elected bodies, aid coordination and relief operations at the local level are in a disarray. The existing institutional coordination is fractured due to incompetent staff and over politicization. Senior government staff do not have prior experience to manage such situation. In fact, this is a long running problem as evidenced from the incapacity of government to fully spend capital budget each year. Addressing this will require hard reforms and the political leadership as well as the bureaucracy need to be positive as well as proactive. Right now decision making is too slow and operational management too weak.
3. Coordination of immediate external assistance and its delivery are below expectation. Despite the large amount of assistance being offered by development partners and countries, the government is simply unable to fully utilize them. The Indian government has been the most responsive on this front and the Nepalese people owe them a lot for their generosity not only for financial resources, but also logistical assistance and management of the situation. Nepal can learn a lot from such swift decision making and logistical coordination. Proper and timely management is as equally important as the adequacy of such assistance.
   
4. The rural villages are affected the most. Only a few active, young politicians have visited their constituency and coordinated relief operations. The political leadership seems ignorant to manage and coordinate within their own constituency. The rural folks in the affected areas need their support and presence till the last mile to cope with the aftermath of the natural disaster.
5. A major rehabilitation of physical infrastructure and relief to people is needed pronto. Roads are damaged and building are demolished. Livelihood opportunities of the poorest folks are wiped out. Dreams are shattered. Centuries old heritage is destroyed in seconds. Traditional ways of rebuilding and rehabilitating physical infrastructure is not going to work. It will require newer and smarter ways of delivering such infrastructure. The political class, government and bureaucracy need to realize this and work accordingly, opening up space for more competent folks to take over efforts related on this front. It includes mobilizing the external assistance for this purpose as well. Many folks felt the absence of government immediately after the earthquake. They should not feel the same and lose hope during the rehabilitation and reconstruction phase. They deserve much better and efficient political culture, government mechanism and bureaucracy.
   
6. Growth outlook for FY2015 is going to be downgraded from the estimated 4.6% (ADO 2015) due to the disruption in economic activities. If the reconstruction and rehabilitation efforts are swift and efficient, then growth may recover in FY2016. This would require the next budget to squarely focus on this priority. Equally important will be to ensure that the planning, design and delivery of such physical infrastructure are orderly and well coordinate with a strict timeline of milestones and accountability. Adopting international best practices without much institutional and internal resistance is going to be helpful.
7. This is the time for making a difference to the lives of the people, who deserve better governance, prosperity and political leadership. Proper planning and implementation of infrastructure projects (rehabilitation as well as new ones) will make a big difference in terms of generating new growth opportunities, employment and stability. This is not the time to get lost in the bureaucratic process and engage in political division of the available pie. Let competent and professionals (from within and outside of the government) take the lead role (given adequate incentives) in creating new and rehabilitating old physical infrastructure.
   
8. Again, kudos to the security forces (Nepal Army, Armed Police Force and Nepal Police) for their relentless work. We should be proud of them and also think of how best we can increase resources for them and modernize their services in the future.  Also, thanks to the leading assistance efforts by the Indian government. We have to emerge stronger and rebuild the cities and villages in a sustainable way.

Third highest remittance inflows (% of GDP) to Nepal in 2013

According to the latest Migration and Development Brief (No.24), official remittance inflows to Nepal reached 28.8% of GDP in 2013, which makes Nepal the third largest remittance recipient in the world. Migrants remitted an estimated US$5.9 billion to Nepal in 2014. The amount of remittance outflows was just US$28 million in 2013. In 2012 as well Nepal was the third highest recipient of remittances (which includes workers' remittances, compensation of employees, and migrant transfers). More on remittances in Nepal here and here.

 

South-South migration was 37% of total global migrant stock (247 million) and South-South remittances accounted for 34% of global remittance flows. The top five migrant destination countries are the US, Saudi Arabia, Germany, the Russian Federation and the UAE.

The uneven recovery in developed countries, lower oil prices and economic troubles in Russia, tighter immigration controls, and forced migration and internal displacement due to conflicts impacted remittance flows in 2014. The fall in oil prices did not affect remittance from Gulf Cooperation Council (GCC) members, especially to South Asian economies in 2014. Remittances could fall if oil prices stays low for extended period.

Top remittance recipients

As a share of GDP in 2013, the top five remittance recipients were Tajikistan (48.8%), Kyrgyz Republic (31.5%), Nepal (28.8%), Moldova (24.9%) and Tonga (24.5%). In 2010, Nepal was the sixth highest remittance recipient in the world.

In US$ term, India received $70.4 billion in 2014, followed by China ($64.1 billion), the Philippines ($28.4 billion), Mexico ($24.9 billion) and France ($24.7 billion).

In South Asia, while India received the highest amount of remittances, Nepal was the highest recipient as a share of its GDP. As a share of total remittance inflows to South Asia, India receives about 60.7% and Nepal 5.1%.

Remittance inflows	2013e (US$ million)	Share of GDP, 2012
Nepal	5,875	28.8
Sri Lanka	7,036	9.6
Bangladesh	14,969	9.2
Pakistan	17,060	6.3
India	70,389	3.7
Afghanistan	636	2.6
Bhutan	14	0.7
Maldives	3	0.1

Global outlook

• The weak economic growth in Europe, troubles in the Russian economy and the depreciation of the Euro and the Ruble will hit the growth rate of remittances in 2015.
• Officially recorded remittances to the developing world are expected to reach $440 billion in 2015, an increase of 0.9% over 2014. Global remittances, including those to high income countries, are projected to grow by 0.4% to $586 billion.
• Remittance flows are expected to recover in 2016 to reach $479 billion by 2017, in line with the more positive global economic outlook.
• South Asia is expected to see remittances growth of 3.7%, 4.7%, and 4.7% in 2015, 2016 and 2017, respectively, increasing remittance inflows to $120 billion, 126 billion and 132 billion over the same time periods. This is lower than the one estimated in 2014 report.
• As much as $100 billion in migrant savings could be raised annually by developing countries by reducing remittance costs and migrant recruitment costs, and mobilizing diaspora savings and philanthropic contributions from migrants.
• The stock of international migrants is estimated at 247 million in 2013 and is expected to surpass 250 million in 2015.

Identifying the growth hotspots in India

A new McKinsey Institute report identifies growth hotspots (or investable pockets of growth) in India for the next decade. It takes into account two main factors: urbanization rate (shows how fast the economy is growing) and the shape of income pyramid (shows how fast consumer class households are added). India has 29 states and 7 union territories – all different in terms of economic drivers and income level.

Goa, Chandigarh, Delhi and Pondicherry are classified as very high performing states and union territories. The per capita GDP of these states was twice the national average in 2012. 

Gujarat, Haryana, Himachal Pradesh, Kerala, Maharashtra, Punjab, Tamil Nadu and Uttarakhand have per captia GDP between 1.2 and 2 times the national average and are called high performing states. These represent large, prosperous, and fast growing states of India— in other words, India’s economic powerhouses.  The main attributable factors for this are the investment in human and physical capital, higher urbanization, relatively superior land use, and structural advantages (for instance, coastlines). All have good fiscal position and host high-skill industries like automobiles, petrochemicals, financial services, etc. Gujarat’s growth is led mostly by manufacturing sector. Tamil Nadu’s growth is driven by services sector and knowledge-intensive industries.

Very high performing and high performing states accounted for:

• 45% of India’s GDP in 2012
• 58% of India’s consuming class households (4 million in very high performing states and 14 million in high performing states). Consuming class households are those with household disposable income (at 2012 prices) ranging from INR 0.485 million and INR 1.7 million or/and above INR 1.7 million.
• Except for Kerala and Punjab, these states benefited from higher productivity of non-agricultural workforce (and hence higher consuming class). Kerala benefited from larger share of remittance inflows, and Punjab benefitted from strong agricultural production (India’s wheat basket)
• Households demand more consumer durables and automobiles, and also spend significantly higher share of income on transportation and recreation.

Although Bihar and Madhya Pradesh are low performing states, they will make good progress with the ongoing investment climate reforms, including developing industries and better performing legislatures. However, Bihar, Uttar Pradesh and Jharkhand will likely remain low performing states in 2025 due to high population growth rate.

Over 2012-2025, the high performing states are likely to account for:

• 52% of India’s incremental GDP growth
• Tamil Nadu, Gujarat, Kerala and Maharashtra are likely to be more than 50% urbanized by 2025 (against 38% average for whole of India). The rapid urbanization and the associated income growth will likely increase these states’ income to that enjoyed by global middle income countries in 2012.
  
• 57% of India’s consuming class (or 51 million) will be concentrated in these states. Consumer expenditure on non-food items will increase faster than the national average (education, health care, automobiles, personal products and recreation)

Finally, below is the map of potential growth hotspot cities in India.

Need for higher public capital spending to close infrastructure deficit in Nepal

Capital spending has been persistently weak, with both planned and actual spending languishing far below what is required to close the infrastructure deficit, which has been estimated to require capital spending equal to between 8.2% and 11.8% of GDP per year until 2020. Raising the amount and quality of capital expenditure is one of the country’s most pressing challenges. Accelerated capital spending is needed to scale up infrastructure investments and thereby attract the private investment needed for Nepal to attain higher economic growth that is both sustainable and inclusive.

Source: L. Andres, D. Biller, and M. Herrera Dappe. 2013. Reducing Poverty by Closing South Asia’s Infrastructure Gap. Washington, DC: World Bank.

In its provision and quality of infrastructure, Nepal is rated one of the least competitive countries in the world, ranked 132 of 147. Disaggregating aspects of infrastructure, Nepal’s ranking on the quality of electricity supply is 136, on air transport infrastructure 129, and on roads 115. These dismal figures indicate that Nepal needs more and better investment to foster innovation, make the economy competitive, and enhance the efficiency of markets for goods, labor, and finance. Gross fixed capital investment has to be raised to at least 30% of GDP from the current 22% to support higher economic growth. Higher public capital spending is crucial, as it is the catalyst for private capital investment.

Source: ADB/WB

Capital spending comprises government spending on, among other things, land, buildings, furniture and fittings, civil works, vehicles, and plant and machinery. The average planned capital expenditure in the past 4 years was 5.6% of GDP, but actual spending averaged just 3.3%. Given Nepal’s huge infrastructure financing needs, budgeted capital spending is insufficient in itself to bridge the infrastructure deficit in such critical sectors as energy, transport, water supply and sanitation, irrigation, and telecommunications. The government’s recent commitment to meet certain infrastructure needs by developing public–private partnerships is an encouraging sign that the gap can be closed. A worrying observation, though, is that project spending has averaged only 71% of budgeted allocations in the past decade, indicating that the government is unable to fully disburse allocated funds on time.

Note: Changed report system to Government Finance Statistics (GFS) 2001 in FY2012.  In FY2011, actual reporting was done based on GFS 2001, but budget allocation was done based on earlier GFS. Source: MOF/ADB

Efficient budget execution has been hampered by bureaucratic hassles over project approval and by such structural issues as the limited capacity of line ministries to prepare a pipeline of projects ready to implement. That projects are included in the budget despite lack of readiness has left large sums of money unspent at the end of each fiscal year. A project will face many problems in execution if it is launched without detailed design, clarity about land acquisition, project offices properly established and staffed with the required personnel, and detailed procurement plans. Further, delays affecting government ministries’ project approval and budget release, and inherent weaknesses in procurement processes, and contractors’ capacity and construction management, have hobbled implementation. Finally, the desired acceleration of capital spending has been hampered by political interference and by frequent staff turnover that weaken project planning and implementation capacity.

Source: World Economic Forum. The Global Competitiveness Report  2014-2015.

The government recently reached a number of decisions to tackle these challenges. It resolved to abolish or shorten some of the processes required for project approval at the National Planning Commission, require the advance submission of procurement plans for projects seeking approval, and provide better mechanisms for planning and monitoring projects to troubleshoot in a more effective and timely way critical issues that slow project implementation. The government is amending the existing Public Procurement Act to remove legislative hurdles for accelerated project implementation. Essential to boosting the quality and quantity of capital spending are prudent public finance management, better interministerial coordination, the elimination of political interference, better qualified and lower turnover of staff for project offices, careful planning and preparation, sound construction management, and more diligent project monitoring.

(Adapted from Asian Development Outlook 2015, Nepal chapter. It is also cross posted in Asian Development Blog)

Are economies facing reduced level and growth rate of potential output?

The latest World Economic Outlook (April 2015) by the IMF focuses on potential output growth. It argues that the world economy is facing a slower ‘speed limit’ (potential output growth) due to the impact of aging, lower capital and productivity growth. Hence, unless there are appropriate policy responses to foster innovation, productive capital investment and effective responses to aging, the major economies will have to ride on lower speed limits.

Potential output is a measure of an economy’s productive capacity with stable inflation and is affected by the supply and productivity of labor and capital. The slower capital accumulation and labor growth (due to ageing) have led to lower potential growth in advanced economies. However, in emerging economies, this is caused by slower total factor productivity growth. After the global financial crisis, both the level and growth rate of potential output has reduced.

Even if capital investment increases as economic conditions improve, labor growth may not be as rosier as population age and workers retire. This is going to impact potential output growth as well in both advanced and emerging economies. Furthermore, the productivity growth may be weaker than before as the previous drivers (past technological improvements and enhanced educational attainment) don’t have similar strong impact as before because the catch-up gap with advanced economies is already narrow. Hence, potential output in advanced economies will remain below pre-crisis level (despite an improvement over 2008-2014). But, emerging economies will see lower potential output than before.

Now, to raise potential output growth, pro-active policy measures may help. Some of these as outlined in the report are as follows:

• Encourage innovation and enhance productivity by high R&D investment
  • Strengthening patent system, tax incentives, appropriate subsidies
• Improve labor productivity by improving education quality
  • Focus on secondary and higher education
• Higher infrastructure spending
• Improved business conditions and more efficient product market
• More female participation in the labor market
• Fiscal policy effective to boost investment and capital growth. Monetary policy may also support aggregate demand.

The reasons behind Indian (and South Asian) children being short

Here is an abstract from a paper by Jayachandran and Pande titled “Why Are Indian Children So Short?”:

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India's child stunting rate is among the highest in the world, exceeding that of many poorer African countries. In this paper, we analyze data for over 174,000 Indian and Sub-Saharan African children to show that Indian firstborns are taller than African firstborns; the Indian height disadvantage emerges with the second child and then increases with birth order. This pattern persists when we compare height between siblings, and also holds for health inputs such as vaccinations. Three patterns in the data indicate that India's culture of eldest son preference plays a key role in explaining the steeper birth order gradient among Indian children and, consequently, the overall height deficit. First, the Indian firstborn height advantage only exists for sons. Second, an Indian son with an older sibling is taller than his African counterpart if and only if he is the eldest son. Third, the India-Africa height deficit is largest for daughters with no older brothers, which reflects that fact that their families are those most likely to exceed their desired fertility in order to have a son.

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