Critical Development Constraints Nepal’S Pace of Growth and Poverty Reduction Has Lagged Behind That of Other South Asian Countries

Nepal

Critical Development Constraints

Country Diagnostics Studies

Nepal: Critical Development
Constraints

ISBN 978-971-561-803-8 Publication Stock No. RPT090743

Cataloguing-In-Publication Data ADB, DFID, and ILO.
Nepal: critical development constraints.
Mandaluyong City, Philippines: Asian Development Bank, 2009.

1. Economic development. 2. Nepal. I. Asian Development Bank. II. Department for International Development. III. International Labour Organization.

The views expressed in this publication do not necessarily reﬂect the views of ADB or its

Board of Governors or the governments they represent, DFID, or ILO. ADB, DFID, and ILO do not guarantee the accuracy of data included in this publication and accept no responsibility for any consequence of their use.

In this report, “$” refers to US dollars unless otherwise speciﬁed.

Asian Development Bank 6 ADB Avenue, Mandaluyong City 1550 Metro Manila, Philippines Tel: +63 2 632 4444 Fax: +63 2 636 2444 www.adb.org/economics

Department for International Development 1 Palace Street London SW1E 5HE, United Kingdom Tel: 44 845 300 4100

www.dﬁd.gov.uk/

International Labour Organization 4 route des Morillons CH-1211 Genève 22 Geneva, Switzerland Tel: +41 22 799 6111 Fax: +41 22 798 8685 www.ilo.org

Foreword

lmost three years into the home-grown peace process, the crucial agenda before

Nepal is to ensure sustainable peace. This is just not possible by only ﬁnding

political solutions to many problems that Nepal is facing. It is necessary for us to accelerate development, achieve higher and inclusive economic growth. Nepal’s

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development lost momentum during decade-long conﬂict. Since Fiscal Year 2007/08,

the economy is showing signs of improvement, but there are many impediments to faster

growth and equitable distribution. The conﬂict is not over yet, as many groups spread

in different parts of the country are staking claims for their rightful place in politics and economy.

Without faster development and perceptible change in the lives of ordinary people,

we cannot possibly overcome this post-conﬂict turbulence. We need to move tactfully,

clearly identifying the obstacles, implementing reforms that minimize the obstacles, and at the same time using a development strategy that can work even amidst turbulence and obstacles.

The present report does part of what is outlined in the above paragraph. It identiﬁes

critical development constraints and recommends a series of measures that can minimize them. Therefore, the government welcomes this report. The diagnostic framework used in the study is an attempt to establish priorities among many candidate policies and institutionalreformsaimedatsustainedandinclusivegrowth.Theanalysesandtheinformed recommendations geared to fostering growth and overcome poverty, inequality, and other unwanted economic and social outcomes are of immense value to the government.

Nepal, as the report notes, has implemented a number of important policy reforms

during the past three decades. Today, Nepal has a thriving ﬁnancial sector with a vibrant

stock market, and a growing tourism sector. It is actively pursuing a policy of converting

itself from an electricity deﬁcient nation to a key source of electricity to its fast growing

neighbors in the north and the south. In the area of social development, Nepal adopted the Millennium Development Goals and has made some impressive progress in reducing the poverty levels despite low levels of economic growth.

The government, however, is aware that poverty, exclusion, under-employment, and

income disparities are persistent reminders of the difﬁculties that some of our countrymen

are still experiencing. The report is, thus, very timely and will be a source of valuable inputs in formulating the country’s next development strategy.
The report provides insights that can enrich cooperation between the government of Nepal and development partners, especially the Asian Development Bank (ADB), Department for International Development (DFID), and International Labor Organization (ILO). In particular, we are highly appreciative of the consultative process that the study adopted to ensure that views of all the key stakeholders were taken into account

in the diagnosis and formulation of the policy recommendations. The ﬁndings and

recommendations of the report can form part of the basis for joint work with the development partners toward a common objective of enhancing inclusive and sustainable

growth in Nepal. The high priority given, for example, to ﬁscal management is bound to improve the conduct of ofﬁcial development assistance. The government gratefully

acknowledges ADB, DFID, and ILO for the timely conduct of the study.

Rameshore P. Khanal

Secretary Ministry of Finance

Preface

epal’s performance on the economic development front since the turn of the century has lagged behind that of the other South Asian economies. In terms of per capita gross domestic product (GDP), Nepal is now where Sri Lanka was in 1960, Pakistan was in 1970, and India and Bhutan were in 1980. This lackluster

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economic performance has occurred despite some very important reforms during the 1990s and 2000s. Although the poverty incidence declined from 42% in 1995/96 to about 31% in 2003/2004, it remains high and may climb further if the global recession reduces

remittance ﬂows. Another emerging concern is the sharp rise in inequality from 1995/96

to 2003/04. Although GDP registered an impressive 5.6% growth in 2007/08 compared with 3.0% in 2006/07, the surge was largely due to timely rains leading to a good harvest of the main agricultural crops and to a rise in tourism arrivals—not due to major improvements in economic fundamentals. This raises the question of how Nepal can improve its pace of growth and poverty reduction. Thus the report attempts to identify the most critical constraints that the country faces—constraints that, when removed, can yield the highest welfare gains. The report also attempts to answer how the constraints can be converted

into opportunities for long-term growth and how the beneﬁts of economic growth can be

translated into faster poverty reduction.

Nepal: Critical Development Constraints presents a diagnosis of Nepal’s economy. The

diagnosis was led by the Asian Development Bank (ADB) and jointly undertaken with the UnitedKingdom’sDepartmentforInternationalDevelopment(DFID)andtheInternational Labour Organization (ILO). The work at ADB was led by Muhammad Ehsan Khan; Juzhong Zhuang, assistant chief economist, Economic Analysis and Operations Support Division, Economics and Research Department, provided the oversight and overall direction. DFID’s work on the study was coordinated by Matthew Greenslade, and ILO’s was coordinated by Shengjie Li and Duncan Campbell. The report was prepared by Muhammad Ehsan Khan,

Yoko Niimi, and Ma. Rowena M. Cham with contributions from Peter Owen and Duncan Campbell. The report beneﬁted from background papers prepared by a team of experts

comprising Mahesh Acharya, Dadhi Adhikari, Devendra Chapgain, Madan Kumar Dahal, Rana Hasan, Niny Khor, Simon Lucas, Mick Moore, Posh Raj Pandey, Rabi Jung Pandey, Sabina Panth, Bishwamber Pyakuryal, Jasmin Rajbhandary, Surendra Rajbhandary, Michel Samson, Shiva Sharma, Bandita Sijapati, Para Suriyaarachchi, and Liz Alden Wiley. Navin Dahal, Lucia Hanmer, Stefan Kossoff, Nick Leader, Andrew Masters, Bishnu Pant, Paolo Spantigati, Raju Tuladhar and Tony Venables provided constructive comments and

support in ﬁnalizing the report. The report was edited by Jill Gale de Villa; design, layout,

and typesetting was by Mike Cortes.

The study followed a consultative process where ﬁrst the framework and approach and then the study ﬁndings were discussed with key stakeholders, including the government

of Nepal, academic and research institutions, civil society, development partners, and the private sector. Feedback received during these consultations greatly assisted the report’s preparation, and we believe that the report will provide valuable inputs to the formulation of development policies and reform programs aimed at inclusive growth and sustainable development in Nepal.

We are grateful for the support provided by the government of Nepal. In particular, we would like to thank Secretary Rameshore P. Khanal, Ministry of Finance, the government focal point, for his keen interest in the study and guidance in completing this work. We are also grateful for the support and feedback from Dr. Pitambar Sharma and Dr. Guna Nidhi Sharma, former Vice Chairmen, National Planning Commission (NPC); Secretary Janak Raj Joshi, NPC; Secretary Purna P. Kadariya, Ministry of Physical Planning and Works; and Joint Secretary Bimal Wagley, Ministry of Finance. Finally, we also thank the Federation of Nepalese Chambers of Commerce and Industry, Confederation of Nepalese Industries, Nepal Chamber of Commerce, and other representatives of the private sector for their continued support and interest in the study. We look forward to continued and productive dialogue with the government in pursuing an agenda of inclusive growth and sustained development in Nepal.

Barry J. Hitchcock

Country Director Nepal Resident Mission Asian Development Bank (ADB)

Sarah Sanyahumbi

Head

Nepal Ofﬁce

UK Government’s Department for International Development (DFID)

Shengjie Li

Country Director

Nepal Ofﬁce

International Labour Organization (ILO)

Contents

1. 2.

Introduction

1

113
1.1 1.2 1.3
Objectives Methodology Organization of the Study

Development Performance and Policy

5

568
12 14
2.1 2.2 2.3 2.4 2.5
Political Context of Economic Growth Synopsis of Economic Growth Accounting for Sources of Growth Recent Trends in Poverty and Inequality Evolution of Nepal’s Development Policy

3. 4. 5.

Critical Constraints to Growth

18

20 28 43
3.1 3.2 3.3
Cost of Finance Social Returns to Investments Appropriability of Returns to Investments

Critical Constraints to Inclusiveness

62

62 68 93
4.1 4.2 4.3
The Inclusiveness of Economic Growth Constraints to Inclusive Growth Root Causes of the Constraints

Governance, Political Economy, and the Institutional Context

98

5.1

5.2
Key Features of the Current Governance Context Governance, Political Economy, and Institutional Underpinnings

of the Constraints

101

105

5.3

Implications for Development Partners

6.

Conclusions and Policy Recommendations

107

107 108 117 117
6.1 6.2 6.3 6.4
Key Constraints to Accelerating Economic Growth Policy Recommendations The Way Forward Conclusion

Abbreviations

ANFTU CAR CPIA FSI

FYP

GDP IMF LSGA MTIP NDHS NEA NGO NLSS NPL O&M PAF PETS PPA
————

—

———————————————
All Nepal Federation of Trade Unions capital adequacy ratio country policy and institutional assessment failed states index

ﬁve year plan

gross domestic product International Monetary Fund Local Self-Government Act medium-term investment plan Nepal Demographic and Health Survey National Electricity Authority nongovernment organization Nepal Living Standards Survey nonperforming loan operation and maintenance Poverty Alleviation Fund Public Expenditure Tracking System power purchase agreement poverty reduction growth facility social protection index
PRGF SPI

Measures

GWh ha km MW t
—————gigawatt-hour hectare kilometer megawatt ton (metric)

Chapter 1
Introduction

1.1. Objectives

This report has two interrelated objectives. The

ﬁrst is to identify critical constraints to long-run

economic growth and equitable development in Nepal. The second is to spell out policy options that stand a good chance of overcoming the constraints

identiﬁed to broad-based growth and to achie-

ving the government’s development targets. epal’s performance in terms of economic development has lagged behind that of the other South Asian economies despite the important reforms made during the 1990s. In

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per capita terms, the growth was even less favorable: Nepal’s per capita gross domestic product (GDP) has been the lowest in the region since 1990. Despite the lackluster growth performance, poverty incidence declined from about 42% in 1995/96 to 31% in 2003/04. While this is a welcome development, the level of poverty remains high. In addition,anemergingconcernistheriseininequality over the same period—from 0.34 to 0.41 in terms of

the Gini coefficient. Given that inequality is thought to be one of the most significant drivers of the recent conflict, it is important that a new growth stra-

tegy opens up economic opportunities for hitherto excluded groups.

1.2. Methodology

The study uses

a

diagnostic approach, and

broadly follows growth diagnostics developed by Hausmann, Rodrik, and Velasco (2005). The growth diagnostics approach provides a consistent framework for identifying the most critical or binding constraints to growth and for discerning the priorities and sequence of policies required to ignite and sustain growth. The growth diagnostics approach differs from the laundry list approach, as implied by the Washington Consensus, and recognizes that the economic and political environment differs a great deal among developing

countries: there is no “one-size-ﬁts-all” solution to

development problems and, therefore, the ordering

of policy priorities contingent on country-speciﬁc

circumstances is critically important. Further, countries at an early stage of development may not have adequate capacity to implement a wide array of policy reforms at the same time. With the diagnostic approach, reforms can start with easing a few critical areas that most constrain growth. Therefore, the approach offers a practical tool for

The latest national plan, the Three Year

Interim Plan (2007/08–2009/10), spells out the government’s commitments for addressing the many challenges it still faces, particularly against the backdrop of its fragile law-and-order situation,

following the end of the 11-year armed conﬂict in

April 2006. The plan focuses on enhancing reconstruction and rehabilitation, improving governance, and pursuing a more inclusive development process, and aims to achieve 5.5% GDP growth per annum and to reduce poverty incidence by 7 percentage points to 24% by 2010 (NPC various years).

Nepal: Critical Development Constraints

policy makers and development planners to use in broad determinants of growth is in turn a function

formulating country-speciﬁc growth strategies. The of many other factors, which can be presented in a

application of growth diagnostics is one of the efforts problem tree (Figure 1.1). in the search for new approaches to growth strategy after the Washington Consensus was questioned in recent years.
The problem tree provides a framework for diagnosing critical constraints to growth. The diagnosis starts by asking what keeps the level of
The growth diagnostics approach starts private investment and entrepreneurship low. Is it with a set of proximate determinants of growth, low social return to investment, inadequate private investigates which of these post the greatest appropriability of the social return, or high cost impediments or are the most critical constraints to of ﬁnancing? If it is low social return, is that due

higher growth, and figures out specific distortions to insufficient levels of complementary factors of

behind the impediments. The inquiry’s point of production—in particular, human capital, technical departure is a standard endogenous growth model know-how,and/orinfrastructure?Iftheimpediment in which growth depends on the social return to is poor private appropriability, is it due to macro accumulation, private appropriability of this social vulnerability, high taxation, poor property rights

return, and the cost of ﬁnancing. Each of these three and contract enforcement, labor–capital conﬂicts,

Figure 1.1. Growth Diagnostics Framework

Low Levels of Private Investment and Entrepreneurship

Low Return to Economic Activity
High Cost of Finance

Low
Social Returns
Low
Appropriability
Bad
International
Finance
Poor Local Finance

Government Failures
Market Failures

Low
Domestic Savings

Poor
Geography
Poor
Infrastructure
Information

Externalities:

Poor
Intermediation

“Self-Discovery”

Coordination Externalities

Low Human Capital
Micro Risks: Property Rights, Corruption,
Taxes
Macro Risks: Financial, Monetary, Fiscal Instability

Source: Hausmann, Rodrik, and Velasco (2005).

2

Chapter 1. Introduction

information and learning externalities, and/or to poor growth, by unequal access to opportunities,

coordination failures? If high cost of ﬁnance is the and/or by the absence of effective and adequate

problem, is it due to low domestic savings, poor social safety nets. While the absence of productive

intermediation in the domestic ﬁnancial markets, or employment opportunities is one of the key factors poor integration with external ﬁnancial markets?

that hinder households from improving their livelihoods, unequal access to opportunities can
At each node of the problem tree, the diagnosis also constrain the inclusiveness of growth. looks for signals that may help determine which

constraints are most binding. The two types of

Inequitable access to economic opportunities

diagnostic signals that one can look for are price can be attributable to weak human capabilities and/ signals and nonprice signals. Examples of price or an uneven playing ﬁeld, both of which can prevent signals are returns to education, interest rates, individuals from participating in and contributing and cost of transport. For example, if education to the growth process on an equal basis regardless is undersupplied, returns to skills/education will of their individual circumstances. Each of these be high and unemployment of skilled people will can, in turn, be due to a number of factors, such be low; if investment is constrained by savings, as exclusion, market failures, and/or government interest rates will be high and growth will respond failures to deliver adequate public services. In

to changes in available savings (for example, inﬂows Nepal, exclusion has multiple dimensions—social,

of foreign resources); and if poor transport link is geographic, and economic—and is a cross-cutting a serious constraint, bottlenecks will occur and the issue that needs to be addressed in order to attain

cost of private transport will be high.

the development objectives.

The use of nonprice signals is based on the

Diagnostic frameworks can identify key factors

idea that when a constraint binds, activities may that are constraining economic growth and its be designed to get around it. For example, high inclusiveness, which can then help policy makers taxation may lead to “high informality” (e.g., formulate effective measures to overcome the under-reporting of income, resulting in lower tax constraints. revenues); poor legal institutions may result in

high demand for informal mechanisms of conﬂict

resolution and contract enforcement; and poor 1.3. Organization of the Study

ﬁnancial intermediation may lead to internalization of ﬁnance through business groups. Cross-country The rest of the report is organized as follows.

and cross-period benchmarking and results of Chapter

2

provides an overview of Nepal’s

business surveys are useful means to gauge whether development performance and the evolution of particular diagnostic evidence signals a binding its development policies during the last several

constraint for the country concerned.

decades. The chapter describes the episodes of

growth, discusses key growth drivers, and examines
Although the growth diagnostics approach progress in poverty reduction. Chapter 3 elaborates was developed to identify the binding constraints on growth diagnostics, focusing on the three broad to growth and associated policy priorities, the determinants of growth that could act as constraints: approach can also be applied to other areas of policy social return to investment, private appropriability, analysis, such as identifying critical constraints and cost of ﬁnance. Chapter 4 looks at critical to inclusiveness of growth (Figure 1.2). Despite constraints to broadening the inclusiveness of Nepal’s poverty reduction between 1995–1996 and growth. Chapter 5 examines the governance and

2003–2004, the evidence suggests that the beneﬁts political underpinnings of the constraints to growth

of economic growth were not shared equally across and its inclusiveness. Chapter 6 summarizes the the segments of society. Limited inclusiveness can ﬁndings and discusses policy implications. be caused by the lack of economic opportunities due