Views of a Nepali Economist

Challenges of the Nepali economy in the next few years

Nepali economy has had a rough ride in the past few years. The escalating Maoist conflict sent the economy into doldrums during 2006/07. The economy went into a further fragile state due to the worldwide financial crisis in 2007/08, the domestic liquidity crisis since 2009/10, and the real estate crisis since 2008/09. Although the economy has recovered substantially, growth has been poor when compared to neighbors, inflation has not stopped its goliath run, and jobs are hard to come by for un-skilled or semi-skilled youths. Now that the year 2011 is well behind us, let us look at some problems that the Nepali economy will have to face in the coming year and beyond.

Urbanization

Urbanization is a boon and a curse. On one hand, urbanization is an indicator of economic growth. On the other hand, it creates a crisis in terms of delivery of public service goods and services because of increasing demand for said goods and services that, in turn, constrain resources and create crisis in delivery.

The escalating war between the Maoists and the Nepali state resulted in a rapid internal migration of Nepalese citizens from rural areas to urban centers. One of the major problems that arose out of this internal displacement was the classic urban giantism problem in the Kathmandu Valley. Unlike cities in China or India, the urban giantism problem of Kathmandu and a few other cities was not because they provided more jobs and business opportunities, but because of safety and security that they provided to people’s lives and properties. Despite the end of the decade-long Maoist rebellion, that started this rapid urbanization phenomenon, the urbanization trend has not stopped. It is on the rise.

Like many other Least Developed Countries (LDCs), urban centers of Nepal receive disproportionately larger budget in terms of development than rural areas. They have more hospitals and schools. As a result, the rural-urban migration has resulted in the creation of slums and makeshift communities in Kathmandu and other urban centers in Nepal. This has made the poverty situation worse. In addition, the weak economy implies that the poor and the hungry that arrive in today’s urban centers and cities remain poor and hungry because the government cannot take care of their basic needs.

Urbanization is happening, and is unavoidable. But, proper mechanisms can be put in place through anticipation or progressive efforts. Basic amenities and services should be provided all over the country so that people do not flock to urban centers to receive such services and amenities. There aren’t enough roads connecting different places in Nepal. Rural areas need roads to stay connected with the rest of the country. Unless an inclusive approach is taken, Nepali cities will keep experiencing rapid urbanization and crowding.

The Remittance Economy

When the Maoist rebellion was at its throes in 2006, the state of Nepali economy was in a mess, and was on the verge of collapse. The one thing that saved the economy was remittance money flowing in from overseas. Thanks to remittance, the consumption did not wane, and the economy stayed its course. However, that does not mean remittance is always good.

The latest NLSS reported that 53 percent of Nepali households have at least one member working away from home, out of which 32 percent work in foreign countries. The reason why so many Nepalis go overseas for work is because our state cannot provide them with jobs. However, that is not the worst news to come out of NLSS-III. It is this: 79 percent of the total remittance received by Nepali households is spent on consumption, and only 2.4 percent is spent on capital formation activities.  That is, the remittance income that our country receives each year finances our consumption, and only a small fraction is actually invested in a useful manner.

Another fact: over 65 percent of those that go to work overseas are between the ages 15 and 29 while the rest are between the ages 30 and 44. This does not bode well for our own economic development. How can our economy foster if the best and the ablest of our labor force goes overseas to build some other country’s economy? And, it does not look like we are going to see an improvement in this regard. The Youth Charter designed by our very own National Planning Commission has 6 bullet-points to help the youths of this country. One of those bullet points says something to the effect of “to train and provide our youths with skills that will enable them to land jobs overseas”.

The Youth Charter designed by the NPC explicitly says that one of the best things it can do for our youths and our economy is to train and educate our youths just enough so that they can land overseas jobs as laborers. If that is the best our country can do for our youths, we have no hope. How about mentioning something like “to create jobs at home for our youths so they don’t have to toil as menial workers in lands with no laws”?

And, then, there’s something called the spoil effect that we have to deal with. A study in Kosovo has shown that remittance money sent by family members from overseas made the youths reluctant towards seeking higher education. It also reduced their incentives to work. Similar results have been observed in studies done in remittance heavy economies like the Philippines, Egypt and Somalia. The spoil effect, essentially, suggests that an easy availability of remittance money sent from abroad by family members distorts the work efficiency and working mentality of the recipient young family members. What good is our remittance economy if we risk losing an entire generation of our youths to poor education and poor skills due to the spoil effect?

Nepali Agricultural Decline

The share of agriculture in national GDP has been on a perpetual decline. Agriculture contributed 72 percent to the Gross Domestic Product (GDP) in 1975. Today, it contributes only about 30 percent to the GDP. The situation is dire due to the fact that we still lag behind in the adoption and use of technology in our agricultural practices. Agriculture in Nepal cannot compete with highly subsidized and technologically superior large producers like China and India.

This decline would not be worrisome in itself. But, the reason why agriculture’s decline is much more worrisome in our case is because 65 percent of our labor force is still engaged in agriculture.  This is not going to change soon because this labor force does not have the skills and education to get hired by other sectors. Nepali agricultural labor force is mostly uneducated/under-educated and unskilled/low-skilled. Most of this labor force lives in rural areas, and therefore, lacks basic education, training and healthcare.

Liquidity Crisis Will Return

As the NLSS-III showed, most Nepalis spent the remittance income on consumption and spent only a small fraction in capital formation activities. The same is true of any type of income, and not just remittance. So, one of the reasons why the Nepali financial system went through a liquidity crisis since late 2009 until late 2011 is because of the Nepali public’s reluctance in saving their money in banks and financial institutions (BFIs). However, the main culprits of the recent liquidity crisis are the banks themselves who used to have surplus money in their vaults, but gave it away recklessly to whoever came asking for it. And, those that came asking for it were the housing and the plotting people.

Nepal Rastra Bank (NRB) did its best to mitigate the crisis. It suggested bank mergers hoping that the merger would create a larger institution that would experience lower costs due to economies of scope and scale, increase in market power, diversification, and reduced operational expenses. The belief was that the newly created larger bank would free up vital cash and other resources to infuse more liquidity into the market while ensuring lower costs, maximum efficiency and stability. However, no conclusive evidence exists of such perceived gains occurring in real life.

The NRB also lowered the Cash Reserve Ratio (CRR) from 5.5 to 5 percent, and claimed that this move would infuse Rs 3-4 billion liquidity into the market in order to ease the liquidity crunch. However, the NRB's tactics of lowering the CRR was undertaken to provide the bankers an accounting gimmick that could free up some cash in order to show profit, however minimum, to their shareholders. Any cash that opened up due to lower CRR would simply be invested in acquiring government treasury bills to ensure that SLR remained at 15 percent. The move was a sham.

One move that could have mitigated the crisis was if the NRB had lowered the interest rates to make it easier to borrow money. However, NRB could not lower the interest rates without giving the impression of loosening its anti-inflationary stance. If the rates were lowered so much that it came close to being zero percent, it risked turning the liquidity crunch into a “liquidity trap”. Also, a low interest rate would mean that people would hoard cash in their homes instead of depositing in their banks since interest rates signal the returns they would get on their deposits. That would make the crisis even worse. In addition, a low interest rate would also cause capital flight from Nepal to India where Indian banks provided higher interest rates. The capital flight scenario was highly plausible given the constant pegging of NRs with IRs, the high volume of traffic crossing the border between India and Nepal, and the easiness of converting NRs into IRs.

The above reasons make the NRB’s monetary policies ineffective in its fight against financial crises like the liquidity crisis. In addition, economists, like Paul Krugman, believe that monetary policies should be pursued only if a financial disturbance has the potential to affect inflation or the real economy. It should not be pursued to solve a financial distress. The liquidity crunch that we saw recently in Nepal had the tendency to affect neither the inflation nor the real economy. Therefore, there is serious doubt as to whether the NRB’s policies mitigated the recent liquidity crunch or if it was just the market correcting itself. In either case, majority of loans provided by our banks are still in the real estate sector. Until the lending portfolio of our banks do not change, we will be going through another round of liquidity crunch in the coming couple of years.

(Copyright) Mukesh Khanal