Structural transformation and fundamentals: Where does Nepal stand?

Here is an interesting presentation by Prof. Dani Rodrik, who explores new growth strategies in the context of the increasing value added and employment shares of services sector. The main idea is that manufacturing activities still are more important than services sector activities in terms of sustained rise in income per capita, productivity and employment. Links to the new growth strategies presentation by other economists and practitioners here.

The combo (and modified) chart above depicts the nature of structural transformation, investment in fundamentals, and the resulting nature of growth rate in Nepal. While the ‘Asian Tigers’ had high investment in fundamentals and a rapid structural transformation, Nepal is seeing moderate investments in economic fundamentals and a very slow (meaningful) structural transformation, leading to a low growth trap. The challenge for Nepalese policymakers is to transition the economy from (3) to (4) in a generation’s time!

According to Rodrik, rapid structural transformation together with high investment in fundamentals results in rapid and sustained growth.

Fundamentals include:

• Reasonably stable fiscal and monetary policies [At least indicator wise, Nepal has done reasonably well as revenue is increasing, budget deficit is below 2.2% of GDP and has ended up with surplus some times, public debt is below 30% of GDP, forex reserves are sufficient to cover almost 9 months of imports, current account and balance of payments are mostly in surplus, etc. Unfortunately, these have been possible not due to domestic economic activities, but due to low public expenditure absorption capacity and large remittance inflows]
• Reasonably business-friendly policies [Nepal’s ranking in Doing Business and other cross-country comparable assessments has been improving. Investors complain more about lack of electricity rather than corruption and labor issues.]
• Steady investment in human capital and institutions (important for sustaining growth post middle-income level) [As a share of budget, Nepal spends the most in education and spending in health is also one of the highest in the region. However, the expenditure efficiency is a different story.]

[So ‘investment in fundamentals’ is not too bad. But these have not emerged out of domestic economic activities. The relatively sound indicators are due to exogenous factors.]

Structural transformation includes:

• Labor-absorbing as well as incrementally higher productivity activities (shift from agriculture to industrial activities as well as employment shares).
• Later on productivity services activities, which would normally require skilled workforce (may create a symbiotic relationship between this and manufacturing, which would use the innovation from the latter to enhance productivity).
• Unorthodox policies may also work: Export subsidization, protection of home markers, exchange rate management, value addition rules, SEZs)
• A generally generous global context in terms of technology transfer, market access

[Here, Nepal has ended up with an unusual structural transformation. Most of the GDP growth is coming from non-tradable sectors such as construction, retail and wholesale trade and real estate and housing. The demand for the services sector activities are in turn driven by public expenditure and remittances (see the rise in services sector value added while a premature deindustrialization in the chart below). Tradable sectors such as manufacturing and high-value agriculture activities are not prominent. Worse, more and more workers are shifting to informal activities in services sector until they find jobs overseas. Addressing this will be one of the major economic challenges for the Constituent Assembly II, if the country wants to realize its goal of graduating from LDC status by 2022.]

Note: The first three charts agriculture, industry and services sectors valued added (% of GDP) to the log of per capita GDP of China, India, Nepal, Bangladesh, Japan and South Korea over 1960-2012. The last chart shows the evolution of sectoral value added with respect to log of per capita GDP. It shows that the decline of agriculture sector is accompanied by the increase of services sector while the industrial sector is already declining.

A meaningful structural transformation to sustain a high and sustainable growth in the post-LDC graduation era would require beforehand a strong industrial sector and high value added agriculture and services sector activities, with an employment centric strategy to absorb the surplus labor. To promote higher productivity, high value-added production and high income generation, the agriculture sector requires adequate and appropriate commercialization, provision of necessary infrastructure and technology to link with the industrial sector, and promotion of agribusiness activities such as agro-processing, storage, and warehousing, among others. Similarly, for high productivity and value added services sector activities (alternatively, it also means that fewer folks with high skills can be employed), there needs to be strong backward and forward linkages with the industrial sector along with the narrowing of skills gap required in the market, increase in R&D investment to promote innovation, and investment in education and health sectors to boost the capacity of the economy to sustain progress and prosperity. This would partly position and help sustain the industrial sector as an engine of inclusive growth.

Nepal’s industrialization and global value chain

Here is an abstract from a recent ADB economics working paper by Yurendra Basnett and Posh Raj Pandey:

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The world’s trade landscape is being shaped by global value chains, which present new opportunities as well as challenges to developing countries. While large developing countries are leveraging the benefits of global value chains, smaller economies have been less successful. In this paper we examine the constraints faced by Nepal, a land-locked least developed country, in participating in global value chains. We find that weak and ineffective industrial policy has led to de-industrialization, which in turn has reduced productive capacity. The high cost of transport and energy, inadequate provision of public goods and low levels of investment reduce the country’s ability to participate in global value chains. As a land-locked country, Nepal is dependent on regional neighbors for access to global markets. Shallow regional integration, the prevalence of non-tariff barriers, and inefficient transit trade further disadvantage Nepal.

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Manufacturing-led growth is still more powerful than services-led growth in low-income countries

Dani Rodrik is skeptical that “a services-led model can deliver rapid growth and good jobs in the way that manufacturing once did”. Excerpts from a recent article on why productivity gains in services sector activities are self-limiting and mostly lower than in manufacturing sector. It has to do with the nature of services activities, which are mostly low value added, low productivity and non-tradable type in low-income countries.

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Two things make services different from manufacturing. First, while some segments of services are tradable and are becoming more important in global commerce, these typically are highly skill-intensive sectors that employ comparatively few ordinary workers.

Banking, finance, insurance, and other business services, along with information and communications technology (ICT), are all high-productivity activities that pay high wages. They could act as growth escalators in economies where the work force is adequately trained. But developing economies typically have predominantly low-skilled labor forces. In such economies, tradable services cannot absorb more than a fraction of the labor supply.

That is why, for all of its success, the ICT sector in India has not been a primary driver of economic growth. By contrast, traditional manufacturing could offer a large number of jobs to workers straight off the farm, at productivity levels three to four times that in agriculture.

In today’s developing countries, the bulk of excess labor is absorbed in non-tradable services operating at very low levels of productivity, in activities such as retail trade and housework. In principle, many of these activities could benefit from better technologies, improved organization, and greater formalization. But here the second difference between services and manufacturing comes into play.

Partial productivity gains in non-tradable activities are ultimately self-limiting, because individual service activities cannot expand without turning their terms of trade against themselves – pushing down their own prices (and profitability). In manufacturing, small developing countries could thrive on the basis of a few export successes and diversify sequentially through time – t-shirts now, followed by the assembly of televisions and microwave ovens, and on up the chain of skill and value.

By contrast, in services, where market size is limited by domestic demand, continued success requires complementary and simultaneous gains in productivity in the rest of the economy. Focusing on a few sectors yields no quick winning opportunities. Growth therefore must rely on the much slower accumulation of economy-wide capabilities in the form of human capital and institutions.

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2014 Noble Prize in Economic Sciences for Jean Tirole

The 2014 Noble Prize in Economic Sciences is awarded to French economist Jean Tirole of Université Toulouse 1 Capitole “for his analysis of market power and regulation”.

Here is the Nobel committee’s brief on his work and here is the detailed explanation. His main theoretical contributions is related to the understanding and regulation of industries with a few powerful firms (oligopoly), which influence prices, volume and quality. His research has helped governments to design regulations "so that large and mighty firms will act in society's best interest" and that there is a need to ensure that different industries may require different regulations. Other important issues that has Triole’s contributions in microeconomics are market failures, oligopoly, asymmetric information, game theory, competition regulation and industrial organization, procurement theory and optimal contracts. More on the depth and breadth of his work is outlined here and here.

Excerpts from the Nobel committee's brief:

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Price caps can provide dominant firms with strong motives to reduce costs – a good thing for society – but may also permit excessive profits – a bad thing for society. Cooperation on price setting within a market is usually harmful, but cooperation regarding patent pools can benefit everyone involved. The merger of a firm and its supplier may lead to more rapid innovation, but it may also distort competition.

To arrive at these results, a new theory was needed for oligopoly markets, because not even extensive privatization creates enough space for more than a small number of firms. There was also a need for a new theory of regulation in situations of assymetric information, because regulators often have poor knowledge of firms’ conditions.

Tirole’s research would come to build upon new scientific methods, particularly in game theory and contract theory. There were great hopes that these methods would contribute to practical policy. Game theory would aid the systematic study of how firms react to different conditions and to each other’s behavior. The next step would be to propose appropriate regulation based on the new theory of incentive contracts between parties with different information. However, even though many people could see the research questions, they were difficult to solve.

Jean Tirole’s research contributions are characterised by thorough studies, respect for the peculiarities of different markets, and the skilful use of new analytical methods in economics. He has penetrated deep into the most central issues of oligopolies and assymetric information, but he has also managed to bring together his own and other’s results into a coherent framework for teaching, practical application, and continued research. Tirole’s emphasis on normative theories of regulation and competition policy has given his contributions great practical significance.

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Export growth in South Asia

Here are two interesting charts from a recent WB’s South Asia Economic Focus Fall 2014 showing export growth in South Asia.

Nepal’s merchandise exports grew by just 3.2% over 2000-2013, the lowest in the region. India’s exports grew by 17.5%. Nepal clearly could not benefit from the increase in competitiveness as a result of depreciation of the currency. It raises few (mundane) issues:

1. Despite favorable external condition (fairly strong external demand and recently the increase in competitiveness due to currency depreciation), the country could not boost exports as a result of the binding supply-side constraints, most notably the inadequate supply of infrastructure (energy, roads, irrigation, etc), recurring strikes and political instability. Some structural issues such as low labor productivity, lack of skilled manpower and policy implementation paralysis are also at play here. These have affected services export as well (most notably tourism).
2. Nepal imports a lot of raw materials and intermediate goods as inputs to produce final products for export. A depreciation of currency tends to escalate input cost and hence the cost of the final product. This, added to the increase in cost of production due to supply-side constraints, makes exports less competitive.
3. Exports to India account for almost 60% of total exports. Nepal has pegged its currency to the India rupee since 1993. It might have also resulted in low export growth as the country could not take full advantage of the relative increase in competitiveness arising from depreciation against convertible currencies.

Another interesting part of the report is the analysis on Dutch disease, which is potentially seen in Afghanistan, Bhutan, Maldives, and Nepal— all due to the massive foreign exchange inflows that are relatively independent from international trade, resulting in appreciation of real effective exchange rate. An earlier paper on remittances and Dutch Disease is here (presentation slides here), which shows an appreciation of REER, growth in real wages and declining manufacturing sector.

The report forecasts South Asia’s regional growth to be 6.0% in 2015 and 6.4% in 2016, largely driven by higher growth rates in India. Indian economy is forecast to grow at 5.6% in 2015. Nepal's GDP is expected grow by 4.5-5% in 2015. ADB forecast FY2015 growth at 4.6% in August 2014 issue of Macroeconomic Update.

The disproportionate impact of inflation on small firms

Here is an abstract from a recent WB working paper that argues that inflation disproportionately reduces investment by small firms, which obviously have lower cash flows, because it erodes the value of their accumulated savings (= investment eventually).

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In countries with limited access to finance, firms accumulate retained earnings to finance indivisible investment projects. McKinnon (1973) illustrates that when cash is used as a primary store of value, inflation may discourage investment as it increases the cost of accumulating retained earnings. This paper formalizes this argument in a dynamic framework and provides a simple calibration of the model that suggests sizable effects of inflation on investment. The mechanism is particularly relevant for small firms, as firms with lower cash flows must accumulate retained earnings for longer periods of time to meet the price of indivisible investment goods. Consistent with the model, empirical evidence suggests that inflation disproportionately reduces investment in small firms.

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State of manufacturing establishments in Nepal

This blog post is adapted from Macroeconomic Update, August 2014, Vol.2, No.2.

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The Central Bureau of Statistics (CBS) released the findings of National Census of Manufacturing Establishments (NCME) 2011/12 in June 2014. The census is carried out every five years and it covers all manufacturing firms engaging 10 or more persons.

The manufacturing census shows an increase in the number of light manufacture activities, but a decline in the number of slightly heavier manufacturing activities, indicating the impact of load-shedding in scaling-up and sustaining higher valued-added industrial activities. Between 2006/07 and 2011/12, the number of operating manufacturing establishments increased by 18.3%, mostly contributed by the growth of food and beverages; tobacco products; apparel; leather; leather products and footwear; wood products; chemical and chemical products; rubber and plastic products; non-metallic mineral products; fabricated metal products; machinery and equipment; and furniture manufacturing. Meanwhile, textiles; printing and publishing; basic metal; and transport equipment saw a decline in the number of manufacturing establishments.

The increase in the number of light manufacturing establishments has also increased the number of employees by 14.8%, reaching 194,989 employees in 2011/12. However, the average number of employees per manufacturing establishment has declined to 48 in 2011/2 from 57 in 2001/02.

Compared to the last NCME, wages and salaries nearly doubled, reaching NRs16.4 billion. With value of inputs totaling NRs241.8 billion and value of outputs totaling NRs322.6 billion, the total value addition reached NRs80.0 billion— a 97% growth between 2006/07 and 2011/12.

The efficiency of manufacturing establishments in the use of inputs seems to be eroding as evidenced from the increase in inputs as a percentage of output, and a decline in output input ratio. Input as a percentage of output stood at 75 in 2011/12, one percentage point higher than in 2006/07. Similarly, output input ratio was 1.33 in 2011/12, lower than 1.36 in 2006/07. A better measure of the efficiency of the use of inputs is value-added output ratio, which discounts the effect of inflation. Value-added output ratio is consistently decreasing, reaching 0.25 in 2011/12 from 0.37 in 1991/92— indicating that the manufacturing firms are using inputs more inefficiently and are incurring increasing cost of inputs as well.

Labor productivity (value added per employee) increased to NRs414,000 in 2011/12 from NRs241,000 in 2006/07. However, labor productivity growth was 71.8%, lower than wages and salaries growth of 104.4% (or growth of wages and salaries per employee of 78.1%) over the same period. At an annualized average rate, while labor productivity grew by 11.4% over 2007-2012, wages and salaries increased by 12.2%.

The number of districts with manufacturing establishments has dropped to 64 in 2011/12 from 67 in 2006/07. About 88% of the manufacturing firms are located in 23 districts, with the top five being Rupendehi, Kathmandu, Morang, Sunsari, and Parsa.

About 40.7% of total manufacturing firms reported that they have not been able to fulfill market demand, primarily due to the underutilization of capital arising from load-shedding, lack of raw materials, labor shortages, lack of finance and lack of skilled manpower. Furthermore, about 84.7% of firms reported that the lack of electricity was having impact on their operations. 

Overall, manufacturing sector has been weakening over the past several years. Its share of GDP declined to an estimated 5.6% in FY2014 from 8.2% of GDP in FY2002. The average growth rate has been a mere 3.2% in the last five years.