UN/ESCAP Bangkok 30 September 2009

Nepals Binding Constraints to Growth

Bishwambher Pyakuryal Professor of Economics Tribhuvan University

I. Introduction
Sequencing of Nepals political changes: first democratic movement in early 1990; second peoples movement in 2006, and declaration of Federal Democratic Republican State on Wednesday, May 28, 2008. Overemphasis of political restructuring has overshadowed the need for economic restructuring. ADB, DFID, and ILO-supported initiative in diagnosing growth constraints and identifying opportunities in Nepal is just completed.

II. Issues for assessing growth constraints

Inability to produce export products and failure to maintain real exchange rate regime with IC The gross foreign exchange reserves Rs. 212.6 billion (US$ 3.1 billion) compared to Rs. 165.1 billion in mid-July 2007 The workers remittances rose by 42.5 per cent (Rs. 142.7 billion) by contributing to 17.4% to the GDP. Its contribution in gross foreign exchange reserves is approximately 33 per cent. Such growth is encouraging but not sufficient to replace Nepal's dependency on foreign loan.

II. Issues for assessing growth constraints Contd.

Cost Competitiveness Indicators Table 1: Index of Cost Competitiveness Indicators of Nine Asian Countries, 1999
COUNTRY Nepal India China Bangladesh Indonesia Thailand Sri Lanka Malaysia Philippines LABOR COST PER WORKER (A) 100 130 180 110 120 480 160 960 600 VALUE ADDED PER WORKER (B) 100 205 271 130 276 390 195 909 742 UNIT LABOR COST (C) 100 81 72 90 87 94 105 93 93

Note: A = average labor cost per worker manufacturing, B = value added per unit of labor, C = labor cost per unit of output manufacturing according to the internationally accepted definition of the U.S. Department of Commerce.

II. Issues for assessing growth constraints Contd.

Deteriorating trade & diversion of foreign exchange reserve The ratio of merchandise trade deficit to GDP is 20.0% (Rs. 165.3 billion) Trade deficit w/India is 64 per cent of the total merchandise trade (Rs. 105.9 billion) Import upsurge from India is 24.7% against just 3.5% from other countries Increased import and purchase of IC worth 70,602.53 million by selling US$

II. Issues for assessing growth constraints Contd.

Increasing debt liability, and cut back in public sector investment The country is experiencing a diversion of resources from productive sectors and fulfilling the terms of increasing debt liability The budgetary allocation shows a cut back on public sector investment and inadequate infrastructure development to attract potential investors The low infrastructure expenditure can be said as the single most important macro constraint on Nepal's economy.

III. Reason for identifying growth constraints

Nepal government has adopted expansionary fiscal policy in the budget 2009/10. First, there is a need to reconcile between inflationary economic forces and expansionary fiscal policy. Secondly, this situation necessitates diagnosing growth constraints and possibilities for increasing future investments.

IV. Selected Growth Constraints

It is advisable to find out the likely constraints for growth before making investment decisions. If Nepals infrastructure is a constraint to growth, then we need to find out what infrastructure e.g. power, transportation, telecommunications etc. are relatively important constraints to growth?

IV. Selected Growth Constraints.Contd

(a) Low investment rate In 1995, Nepals investment rate (25.2%) was very close to India (26.2%). Bangladesh (19.1%), Pakistan (18.5%) and Sri Lanka (24.2%) were lagging behind Nepal. But, since 2007, only Pakistan is lagging behind Nepal.

IV. Selected Growth Constraints.Contd

Fig1: Investment Rate of Nepal from 1975-2006 (% of GDP)
30 25 20 15 10 5 0

InvestmentRate (% ofGDP)

Source: Economic Surveys, MOF

IV. Selected Growth Constraints.Contd

(b) Low domestic savings rate Domestic Saving Rate is lowest in South Asia and it is almost one third of Bhutan. The highest Gross Domestic Saving was in 2000 (15.17 percent of GDP). It is interesting to note that GNI per capita increased by more than fifty percent from the year 1995 to 2006 (WDI, 2008) but Gross Domestic Saving decreased from 14.8 percent in 1995 to 9.4 percent in 2006 indicating the fact that low domestic saving rate is one of the major constraints for growth.

IV. Selected Growth Constraints.Contd

Fig 2: Gross Domestic Saving 1975-2006 (% of GDP)
16 14 12 10 8 6 4 2 0

GrossDomesticSaving(%ofGDP)

GDP: Gross Domestic Product Source: Economic Survey (various issues), MOF

IV. Selected Growth Constraints.Contd

Although there is deficit trade balance, current account surplus is maintained cause of large amount of workers remittance, which increased by 23.9 percent annually from 1991-2006. From the year 2000-2006, remittance was 75 percent of trade balance and 89 percent of saving-investment gap. For two consecutive years from 2000, remittance exceeded the savinginvestment gap. It indicates that saving is not a problem for Nepalese economy. But decline in remittance inflow may seriously affect the economy.

(c) Investment Constraints

(i) Labor and Technology Nepals total factor productivity growth rate is about fifty percent of India, which has contributed negatively. Table 2: Total Factor Productivity- Nepal Vs India
Period Growth Rate Nepal Growth Rate Adjusted 1.34 1.47 0.14 0.64 0.91 Growth Rate India Growth Rate Adjusted 0.57 2.64 2.02 2.90 2.08

1980-1984 1985-1989 1990-1994 1995-1999 19802000

0.57 1.24 2.27 0.14 1.11

0.58 2.63 2.01 2.90 2.08

Source: APO Note: Growth rate adjusted for business fluctuations

(c) Investment Constraints.contd

Nepalese manufacturing sector is dependent on India for skilled labor. ILO study reports that manufacturing sector hires about 15 percent of total skilled labor force from India. Similarly, Nepal's position in the Labor related regulation is also poor in comparison to other south Asian countries. Table 3: Comparison of Labor-Related Regulations with Regional Countries
Difficultyof Rigidityof HiringIndex hoursIndex Afghanistan 0 Bangladesh 44 Bhutan 0 India 0 Maldives 0 Nepal 67 Pakistan 78 SriLanka 0 Firingcosts Rigidityof Nonwage Difficultyof Employment LaborCost(% (weeksof wages) ofsalalry) firingIndex Index 40 30 23 0 0 20 40 35 0 104 0 20 7 1 10 20 70 30 17 56 0 0 0 0 9 20 70 52 10 90 20 30 43 11 90 20 60 27 15 169

Investment Constraintscontd.
ii. Infrastructure Infrastructure in Nepal is one of the poorest and Road density is smallest in the region. Road density is least in Midwestern region. Population to road ratio is highest in Western Development Region. In other words, in this region more people use fewer roads. Distribution of road network is highly unequal. More than fifty per cent of the total road network is concentrated in Terai. See Table 4 and Fig. 3 below:

Investment Constraintscontd.
Table 4: Road Network in Three Geographic Regions
Region Total Length of Roads (Km) Population Influenced Per Km. of Road (Nos.) Road Density (Km./100 sq.Km)

Mountain

742

2274.743

1.431962

Hill

7590

1350.608

12.38719

Tarai

8504

1318.492

24.9978

Source: Calculated from DoR, 2006

Investment Constraintscontd.
Fig 3: Road Network in Three Geographic Regions

Source: Calculated from DoR, 2006

Investment Constraintscontd.
Figure 4: Density of the total road network (Km.roads / square Km. land area)-2003*

Source: IRF World Road Statistics *Data for India and Afghanistan corresponds to 2002 and 2004respectively

Investment Constraintscontd.
Nepal study shows that if transportation time is reduced by fifty per cent, then it may result in higher income through the increased fertilizer use and yield (MoICS, 2004). Other important constraint is electricity tariff, which is one of the highest in South Asia.

10

Investment Constraintscontd.
Figure 5: Electricity Tariff ($/KWh, 2000)
Bangladesh 0.041

Pakistan

0.065

Sri Lanka

0.079

India

0.043

Nepal

0.093

Source: MOICS, 2004

Investment Constraintscontd.
The overall infrastructure situation for attracting investment is very dismal. Expensive and irregular electricity, small and low quality road network, expensive and deficient transportation are some of the examples. Infrastructure quality score shown in the Figure 6 reveals that Nepal, in fact, has the poorest infrastructure in comparison to other South Asian neighboring countries. Highest possible score is seven out of which Nepal secures only 1.9. Nepal's position with this score is 119 out of 125 countries in the world.

11

Investment Constraintscontd.
Both quality and expenditure for infrastructure is very low. Nepal spends < 1% of total GDP on infrastructure against 4.8 percent of India. Study shows that Nepal needs to invest US$ 3.44 billion (12.22 percent of GDP) for the period of 2008-2012 in order to achieve eight per cent growth rate.
InfrastructureQuality Score

Fig 6: Infrastructure Quality Score of South Asian Countries

Bangladesh India Nepal Pakistan Srilanka 1.9

2.3 3.3

3.4 3

http://siteresources.worldbank.org/INTEXPCOMNET/Resources/2.01_Overall_Infra structure_Quality.pdf

Investment Constraintscontd.
In terms of telecommunications, Nepal has lowest number of telephone subscriber per 100 people in South Asia. Fixed line and mobile phone subscribers (per 100 people) in 2006 remained at 5.9244 for Nepal. It was 18.6356 in India; 36.6930 in Sri Lanka; 24.9911 in Pakistan and 12.9911 in Bangladesh. Although Nepal ranks lowest in the region in terms of subscriber per 100 people, study shows telephone doesnt seem to be a constraint to investment and growth.

12

Investment Constraintscontd.
iii. Political Stability and Governance
Governance indicator, as published by World Bank is deteriorating. It may be due to frequent change in government during last one and half decade. Table 6: Governance Indicators for Nepal, Percentile Rank (0-100)
Governance Indicators Voice and Accountability Political Stability Government Effectiveness Regulatory Quality Rule of Law 1996 46.4 26.9 36 22.9 51.4 1998 42.3 23.6 36 31.7 52.9 2000 43.3 14.4 40.8 28.3 44.8 2002 24.5 6.7 37 31.7 42.4 2003 25.5 5.3 34.1 33.2 37.1 2004 2005 18.3 2.9 22.3 31.2 32.4 13.9 1.4 15.2 25.9 23.8 2006 2007 Region Avg. 15.4 22.6 28 2.9 21.8 26.3 33.3 2.9 21.8 26.7 31 19.3 36.5 31.9 38.3

Investment Constraintscontd.
Similarly frequent bandh is deteriorating smooth functioning of business sector.
Figure 7: Number of Days of Bandh (Excluding Indefinite Bandh)
City District Region Country 36

24 21 13 9 1 8 4 7 9 5 2 3 5 4 5 3 2 3 2 2 4

21 13

September

December

February

August

October

March

April

July

April,2007

January,2008

Source: Various News Papers Note: This chart doesn't include Bandh called for indefinite period. District: One district Region: Two or more district City: City or part of highway in one district e.g. Bhairahawa-Sunauli highway

November

Total

June

June

May

May

13

Investment Constraintscontd.
Fig 8: Share of Bandh for City to Country (Excluding Indefinite
Country 5% City 25%

Region 42% District 28%

Source: Various News Papers

(V) Conclusion & Recommendations

Overall macroeconomic positions look OK. The challenge is to sustain growth against the existing constraints of poor infrastructure, underperformance of agriculture, inadequate skills and technology and unsatisfactory corporate and political governance. Major task is to ensure equity to make growth inclusive. The Heritage Foundation's Index of Economic Freedom uses relatively objective scoring system to rate countries on a 1-to-5 (good-to-poor) scale, under a series of headings. Nepal rates poorly on investment-related indicators: capital flows and foreign investment (4, high barriers), property rights (4, low-level of protection), and regulation (4, bureaucratic delays, inefficiency, and pervasive corruption), contributing to an overall score of 3.5.

14

(V) Conclusion & Recommendations.contd

Review shows, investors demand the revision of the rigid Labor Act, 1992 to avoid labor market rigidity. Other equally important acts such as Bankruptcy and Mergers Act should be enacted without further delay to reduce investor's risk. It is important for the government and private sector to find out the reasons why increased FDI has not been very significant in the growth of Nepalese GDP in absolute as well as in the relative sense (http://ideas.repec.org).

(V) Conclusion & Recommendations.contd

The value of Nepals new Human Empowerment Index (HEI) is 0.463 (including social, economic and political indicators into a composite index of empowerment). The economic empowerment is lowest at 0.337, which reflects the low level of income, limited access to productive assets and lack of gainful employment opportunities (Nepal HDR, 2004). Gross domestic savings rate in Nepal is low but total savings rate is higher than investment rate indicating the possibility of generating additional resources for investment.

15

(V) Conclusion & Recommendations.contd

Banks are holding more funds than they are required to, however, investment in larger infrastructure projects suffers as there is a limited access to international financial markets. The survey of foreign affiliates in Nepal shows that majority of the projects with capital participation from developed countries are small-scale projects with individual investors. There is a predominance of JVIs even when 100 per cent equity ownership is allowed. This is the area to be investigated.

(V) Conclusion & Recommendations.contd

The draft Industrial Policy, 2002; Industrial Development Perspective Plan: Vision 2020 and Foreign Investment Policy, 2002 are relatively better designed. In the revised policies, provision for enhancing NRNs involvement in Nepals development initiatives be ensured. The new government should get rid of weaker administrative practices and conservative attitudes towards business.

16