What reforms on Nepal’s economic policies are needed for accelerating development?

1. Introduction

Nepal is a developing country sandwiched between the two giant economies of the world: China and India. Nepal has emerged from a decade long civil war recently and it is in the process of writing a new constitution. In this context, Nepal’s political parties (there are more than twenty) and civil societies are actively debating which political system Nepal should adopt under its new constitution. However, a rather more important question – what economic policies should Nepal adopt under the new constitution, has rarely been discussed. There is no better time to start this discussion as the economy and the political system are strongly tied to each other. This question has become even more important after the massive Earthquake shook the country few weeks ago that claimed more than 8500 lives and destroyed several important infrastructures.

China has been enjoying exponential economic growth in recent decades despite the rising inequality between the rich and the poor. The Indian economy has also shown great potential for growth, although its GDP Per Capita is less than half than that of China. Nevertheless, India and China both can be the role models for Nepal for economic development.

The economy of Nepal has been more affected by the Indian economy than the Chinese economy for various reasons. First, unlike the Nepal-India border which is relatively loose and open, the border between Nepal and China is strongly regulated. Second, Nepal is connected to India through a denser road network – thanks to the flat Nepal-India border. In contrast, Nepal and China are geographically separated by the Himalayas. In addition, Nepal and India have fixed currency exchange rate and stronger social/cultural ties compared to China. More recently, the struggle between China and India on who should lead over the region has provided both opportunities and dilemma in Nepal.

This paper assesses the key development indicators of Nepal and compares them with that of its neighbors China and India. The paper attempts to answer two important questions commonly raised in the forums engaged in the debates about Nepal’s development. First, why Nepal has not been able to gain momentum in economic development despite the availability of natural and human resources? Second, what reforms in development policies could enable Nepal to catch up with India or China?

2. Diagnosis: evolution and current status of socioeconomic indicators

2.1 Gross domestic Product

gdpFigure 1. GDP per capita trend. Data source: Madisson Project. 

GDP is the total market value of goods and services produced in a country in a given year and is a widely used indicator of the economic health of a country. The trend of GDP for Nepal, India, and China is presented in Figure 1. The GDP per capita trend of Japan and South Korea, who have set model for economic development in Asia, is also presented for direct comparison. Japan and South Korea seem to have gained economic momentum right after the Second World War. Nepal appears to be crawling without any changes. India seems to rise slowly after 1980 when India introduced major economic policy reforms although these have been criticized. China appears to have gained momentum after 1979 with the rise of Deng Xiaoping, when the Chinese government introduced several economic growth reforms in 1979. The effect of the 1997 Asian financial crisis is noted in Figure 1 which seem to have affected South Korea more and Japan less while the rest of the countries seem not to be affected.

2.2 Human development index

hdiFigure 2. Human Development Index. Data source: UNDP.

HDI, proposed by Indian economist Amartya Sen and Pakistani economist Mahbub ul Haq in 1990, is a composite index of four statistics: life expectancy at birth, the adult literacy rate, a combined school enrollment ratio, and GDP per capita in purchasing power parity terms. The trend of HDI in Figure 2 shows that Nepal has fallen behind its neighbors although the trend is improving over time. Japan and Korea appear to have reached saturation in terms of HDI. Nepal and India’s HDI is even lower than that of Korea and Japan in 1980.

2.3 Poverty

The headcount index for China, India, and Nepal is presented in Figure 3, which shows that these countries do not seem very different in terms of poverty. The percentage of population living below $1.25 per day in Nepal has fallen to about 24% by 2010 which is comparable to that of India. China looks remarkably successful in bringing down this indicator to less than 10% by 2010.

povFigure 3. Poverty Headcount Index below $1.25/day (PPP). Data source: The World Bank.

2.4 Corruption

The corruption perception index data by Transparency International (Figure 4) shows that there may be a strong correlation between corruption and economic growth. For example, Japan is the least corrupt countries among the five countries being compared, and Nepal is the most corrupt country. This is generally consistent with the growth trend data in earlier GDP report with the exception that China seems to be more corrupt than India despite its higher GDP, although the difference is not very high.

corruptionFigure 4. Corruption Perception Index for 2014. Data source: Transparency International.

2.5 Foreign Aid

Nepal receives foreign aid from a number of donors. The major donors are The World Bank, Asian Development Bank, Japan, UK, and the US in order from largest to smallest. Nepal has received about $59.16 Billion in aid since 1952. Among the foreign aid received, the sectors receiving the funds are Education, Local Development, Health, Roads, and Drinking Water from highest to lowest. Foreign aid and grants constituted about 15% of the proposed budget in FY 2014/15.

In 2014, India received about $ 1.67 Billion, Nepal received about $ 0.8 Billion, and China received about $0.2 Billion.

aiddFigure 5. Timeline of foreign aid received by Nepal. Data source: AidData.

The timeline of annual amount of aid received by Nepal is presented in Figure 5. In general, the trend is increasing. The aid reduced around 1996 marking the start of civil war led by Maoists that lasted until 2006. After 2006, Nepal’s political situation became relatively more stable and donors support is increasing.

2.6 Foreign Direct Investment

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Figure 6. Timeline of Foreign Direct Investment as percentage of GDP. Data source: The World Bank.

Foreign direct investment (FDI) in Nepal as percentage of GDP is presented in Figure 6. FDI seems to have increased after around 2006 reaching a peak in 2010 after which it again decreased. FDI being less than 0.5% of GDP at present does not seem to be a large contributor in Nepal’s economy. This is one area where Nepal could potentially benefit in the future if an investment-friendly environment is created. In particular, the hydropower sector can benefit greatly from FDI given the current hiatus in developing large-scale hydropower projects due to the lack of investment capital.

2.7 Remittances

Total workers’ remittances received for the countries being compared is presented in Figure 7 below. The contribution to GDP from remittances for Nepal seems spectacular hitting more than 20% after 2010. This is consistent with the increasing trend of workers going abroad for work mainly in the Middle Eastern countries, Korea, India and other countries. For more developed countries like China, Japan and Korea, remittances appear to be a small fraction of the total GDP though large in total volumes. For India, remittances only contribute to about 3% of total GDP at present. The increasing trend of migrant workers in recent decades can be attributed to a multiple reasons including rising unemployment as a result of the Maoist-led civil war, increasing activities of manpower companies, and the swift development of information and technology that penetrated through the rural villages.

remi

Figure 7. Total workers’ remittances and compensation received as percentage of GDP. Data source: The World Bank.

3. Discussion

3.1 Politics and development paradigms

Two distinct theories have been proposed by two Nobel laureates Friedrich Hayek and Karl Gunnar Myrdal for development. Hayek’s economic development theory was more liberal and argued that free markets can solve many societal problems in their own. His arguments supported the strengthening of communities at the grassroots level. In contrast, Myrdal’s view was that the development effort would be largely ineffective unless there were regulations backed by compulsion. He basically promoted top-down state planning. For example, growth production requires machines, which individuals may not be able to purchase. For this reason, Myrdal supported more state intervention to help individuals and communities overcome market failures.

Nepal seems to be following both paradigms at different times. The presence of left wings groups represented by communist parties including the Maoists have been defending a more state oriented view like Myrdal’s while other political parties mainly the Nepali Congress have been defending a more capitalistic and free market economy. In Nepal’s context, as raised by many economists, the question is not whether more or less state but a better state. Political stability is a great challenge in Nepal. Although Nepal became a democratic regime some decades ago, there has been much turbulence in its political system. Nepal’s civil war led by Maoists between 1996-2006 severely hindered Nepal’s economic growth which can be seen in all the indicators of development presented above.

3.2 Internal Determinants

Resources

Nepal is not poor in terms of resources. There is huge potential for hydropower development but merely a small fraction of it has been harnessed. Currently the installed capacity of hydropower is about 600 MW while the demand is well above 900 MW. Load shedding up to 15 hours a day is common in winter seasons in Nepal. About 60% of the total population of Nepal does not have access to electricity as light source, let alone the luxury of appliances. Industrial development has not expanded in Nepal due to a lack of reliable power supplies. India is the sole supplier of fossil fuels in Nepal and the demand for petroleum products has been rising exponentially. Because of a poor supply chain, supply of petroleum products can be interrupted for several days in a year. The issue often becomes the agenda of politics for the opposition parties.

One of the major problems in Nepal’s hydropower development is that many rivers have been shared with India and there are numerous water rights issues between Nepal and India. Most recently, Nepal signed three major hydropower deals which, if implemented, can revolutionize Nepal’s industrial sector while fostering overall development. Nepal recently gave a green light to the GMR groups, an Indian company, for a historic 900 MW upper Karnali hydroelectric project worth a $1.4 billion. Nepal also signed PDA with India’s Satluj Jalvidyut Nigam Limited (SJVNL) for another 900 MW hydro project Arun III in November, 2014 (ekantipur). Similarly, Three Gorges Corps., a Chinese company was given orders to execute the 750 MW West Seti River hydropower project worth $1.6 billion. While these projects have shown hope in Nepal’s development, their implementation still seem very far off given the government’s lack of experience, geography- and weather-related barriers, and social and environmental problems. In addition, it is not clear how much Nepal will really benefit from these projects because the Project Development Agreement (PDA) may not be in favor of Nepal given the inequality of bargaining power between Nepal and India or China.

Tourism is yet another potential which is recently booming with the increase in publicity through various tourism activities such as the celebration of Visit Nepal Year 2011. Tourism contributed to about 8.2% of the total GDP in 2013. The tourism industry is one such sector where private entities have invested more than the government. However, the private sector has the tendency to focus on its own private gain and is not solely responsible for managing and preserving the common or public points of attraction. Government’s role is very important in preserving and managing such public purposes.

The agricultural sector is the backbone of Nepal’s economy and contributes about one-third of the gross domestic product. However, this sector remains traditional to date and the agricultural productivity is very low. If agricultural practices are modernized like what Deng did in China, agriculture could substantially enhance economic growth in Nepal and by reducing the dependency of Nepal on India.

Geography

Nepal is a landlocked country and has to rely on India for connecting to the rest of the world. Air transport has potential, but there is only one international airport in Nepal. Improvements in air transportation have helped other landlocked countries like Rwanda by allowing the country to increase exports. Nepal can also utilize air transportation in order to overcome its geographic constraints. Recently, China agreed on a proposal for Nepal to construct new roads connecting Nepal with Tibet. This should bring additional opportunities in Nepal’s economic growth given a very old history of trade practice between Nepal and Tibet among their people.

Corruption

Corruption is one of the major problems in developing countries including Nepal, India, and China. With Nepal’s score on the corruption perception index being the highest among the countries being compared, corruption is one of the major constraints in Nepal’s development. High corruption in Nepal can be attributed to a number of factors. First, although there are a number of acts and regulations meant to curtail corruption, these have been weakly enforced. Second, the salary and incentives of the civil service employees are very low which may have increased corruption. A better performance-based reward and punishment system could potentially reduce this problem. Third, a decade of political instability has restricted the effective implementation of existing anti-corruption policies. Nepal’s bureaucracy is resistant to change, which is in fact more powerful than the government. The corruption is highly institutionalized in Nepal within the bureaucracy. A commission for investigation of abuse of authority (CIAA) was formed after the establishment of democracy in Nepal in 1990. CIAA has been very effective in recent years for curtailing corruption. CIAA is often criticized for catching only the small fish while leaving the big fish responsible for more significant corruption untouched. The boom of NGO’s and media also have helped curtail corruption by raising awareness among the people. Despite the increasing anti-corruption activities, corruption has not reduced as expected. In this context, a stronger intervention at the political level may be an effective strategy in controlling corruption.

3.3 External Determinants

Regional Dynamics

Nepal’s economy cannot be isolated from its giant neighbors. India and China are fighting for leadership in the region. India has made good progress but is still substantially behind China. China’s remarkable recent economic growth stands on the foundation laid by Deng Xiaoping, who transformed/modernized agricultural sector first and then took on the industrial sector. Deng is considered “the architect” of a new brand of socialist thinking, combining the Communist Party’s socialist ideology with a pragmatic adoption of market economic practices. Deng starting in 1978 opened China to the international market. China is now the leading nation in exports and the second largest economy in the world. Nepal has an excellent chance of benefiting from both neighboring giants with appropriate policies in place. Diplomatic relations with both giants should be balanced and should not be inclined to either China or India, as both could be detrimental.

Foreign Aid and Investment

The trend of foreign aid is certainly increasing in Nepal as seen in Figure 5. Despite the increasing foreign aid over time, Nepal has not gained proportional momentum in development in terms of increasing growth, building capacity, and accelerating achievement of the Millennium Development Goals. As a result, aid effectiveness has been questioned by the international community.

Various foreign aid projects have been implemented in Nepal by donor agencies based on past experiences in different places. However, if something works in Africa, it may not necessarily work in Asia. While a proper monitoring and evaluation system in place can increase aid effectiveness in part, institutional capacity development of Nepal can only ensure the effectiveness of aid in the long run.

Trade and Finance

Nepal became the member of world trade organization in 2004 so its impact on Nepal’s economy has not been clearly seen yet. The membership can bring opportunities for Nepal in the sense that the Nepalese products and services will get access to global markets with equal treatment compared to other member states. However, it can also bring negative consequences by encroachment of foreign multinational companies that can shadow local enterprises. Although Nepal’s export has increased with the growth of carpet and garment industries after 2000, negative consequences have been observed recently—the import to export ratio has increased from 2.31 to 3.40 from pre accession period to post accession period. In this context, Nepal should focus on increasing exports which can potentially be achieved by formulating appropriate market policies and better connecting Nepalese market with Chinese/Indian as well as the global market through air and road network.

Microfinance activities are rising recently in Nepal with various micro credit institutions in place. The importance of microfinance was recognized by the government with the establishment of democracy and district cooperatives. The activities increased at the grassroots level with the introduction of microcredit and micro finance institutions proposed by Bangladeshi Nobel Laureate Muhammad Yunus. While microfinance’s role on economic development is not clear due to the lack of reliable data, it can certainly contribute in poverty reduction and in reducing inequality.

Remittances are booming in Nepal recently as shown previously but it does not appear to contribute to growth. Clemens and Mckenzie (2014) showed that GDP growth and remittance growth are uncorrelated. Remittance inflows are always associated with labor outflows and the net effect on growth is extremely challenging to measure.

4. Concluding Remarks

Nepal has a great potential for economic development despite being landlocked and vulnerable to weather-related calamities. Nepal can greatly benefit from its two economic giants through appropriate proactive diplomacy. Large markets of India and China as well as global market can be Nepal’s opportunity for export if appropriate trade policies are made while strengthening the connectivity with these markets through air and road network. Hydropower and tourism are the two most viable sectors, investment on which can foster rapid economic development. Implementation of some large-scale hydropower projects can potentially help the country cross the poverty line and push the country’s economic growth rate towards the double digit. Remittance should not be taken as an indicator of economic development and the present increasing dependency of Nepal’s economy on remittance may not result in economic development in the long run.

The author is grateful to Dr. Joshua Busby for helpful comments. This paper is the outcome of a class project of the course ‘International Development’ at the LBJ school of public affairs, UT Austin.

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