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Background Papers
THE ROLE OF THE PRIVATE SECTOR IN NEPAL'S DEVELOPMENT:
AN IMPROVED FRAMEWORK FOR PRIVATE SECTOR DEVELOPMENT
A Paper Prepared by the Donor Community in Nepal for Purposes of the Nepal Development Forum (NDF)
April 17 - 19, 2000 (Paris)
Executive Summary
- Introduction
- The Structure of the Private Sector in Nepal
- The Importance of PSD
- An Improved Framework for Private Sector Development
- Private Sector Environment
- Strengthening of the Legal Framework
- Politics and Bureaucracy
- Strengthening of Private Sector Governance
- Privatization of State-Owned Enterprises
- The Role on the International Community
- Conclusion
EXECUTIVE SUMMARY
Recent policy initiatives have had some positive impact on private sector development in Nepal. Despite progress in a number of areas, there is a widespread feeling within the private sector and amongst the donors, that much more could have been achieved. This paper presents some of the principal constraints with respect to Private Sector Development (PSD) in Nepal, and suggests issues for HMGN to consider.
The Private Sector includes in principle all activities which are outside the direct influence of the public sector. It includes not only the medium and large scale enterprises with which the term Private Sector has traditionally been associated with, but also smaller scale private initiatives which may cover NGOs and cooperatives in addition to small and medium scale business initiatives.
The Private Sector at large has a key role to play in poverty reduction in Nepal. The rural poor will benefit most from genuine private sector development and a strengthening of the role of the state as regulator, as supervisor, and as facilitator. In addition to the commercial private sector, the non-commercial private sector, including NGOs, cooperatives and community-based organizations has an important role to play to ensure broad-based pro-poor economic growth.
The Rule of Law and a strong role of the Government as regulator and supervisor are the two core requirements for private sector development. An urgent public debate is required to get a better understanding of the role of the State in the modern world, and to substantially reduce the reach and direct influence of the Government, and strengthen the role of the Government to ensure the rule of law, and as regulator. For the Rule of Law to work and create a favorable environment, the legislation governing the private sector needs to be balanced and transparent. Specialized courts are needed to deal with specialized issues specific to the private sector. The Government has to ensure that the legislative framework is "enabling", as opposed to "directive" or "interventionist". A review of existing legislation for clarity, comprehensiveness and transparency is urgently needed.
Political stability and a public sector that works in a more transparent manner are an imperative for rapid private sector-led economic growth. Financial reporting and accounting practices which conform to internationally acceptable standards are a pre-requisite for successful private sector investment. Government and the donor community have to work together in an effective manner to ensure that adequate strengthening of the Government in the areas of regulation and supervision takes place.
I. Introduction
1. Since the reintroduction of a democratic system in 1990, a number of measures have been undertaken to liberalize trade, investment and the financial system with the objective to stimulate industrial growth and private sector development. These measures ranged from convertibility of the current account, reduction in import duties, enabling legislation for private investment in hydropower projects, privatization of a number of State-Owned Enterprises, opening up of the commercial banking sector to foreign investors, and the introduction of numerous concessions for domestic and international investors.
2. These measures have had a positive impact on private sector development in Nepal. During the decade, the private sector grew at a faster pace than the economy as a whole. Exports, led by carpets and garments, have greatly expanded, while tourism, which is mainly private sector-led, has grown at a healthy pace. Over $300 million has been has been invested by the private sector in hydropower development. Despite progress in a number of areas, there is a widespread feeling within the private sector and amongst the donors, that much more could have been achieved.
3. This paper presents some of the principal constraints with respect to Private Sector Development (PSD) in Nepal, and suggests issues for HMGN to consider. The focus is on those issues on which HMGN could make progress with discernable impact, if policy decisions are taken in a firm and transparent manner, with great attention to implementation issues. The paper will only discuss generic PSD issues, as there are many sector specific issues which are considered to be outside its scope. The role and functioning of the private sector is closely linked to the role of the State (and therefore to civil service reform), and to the issues involved in financial sector reform. The paper should therefore be considered in conjunction with the paper on Governance and Civil Service Reform, and the one on Financial Sector Reform.
II. The Structure of the Private Sector in Nepal
4. The Private Sector includes in principle all activities which are outside the direct influence of the public sector. It includes not only the medium and large scale enterprises with which the term Private Sector has traditionally been associated with, but also smaller scale private initiatives which may cover NGOs and cooperatives in addition to small and medium scale business initiatives. The Private Sector also includes the majority of the agriculture sector, although that particular sector has not been readily viewed in that light in the past.
5. It is difficult to develop a fully comprehensive understanding of the size, coverage, and overall composition of the private sector in Nepal. Several industrial surveys, undertaken by the Central Bureau of Statistics and the Ministry of Industry do exist and these provide some indication of the what the private sector looks like. According to available data, around 360 industrial enterprises operate in Nepal. Distribution of industrial activity by geographic area indicates a very clear concentration of industrial activity around the central district, where Kathmandu is located, and the Eastern district. By stark contrast, the location of industrial activity declines west of Kathmandu with the Western Region, the Mid-Western Region, and the Far Western Region having successively less and less industrial enterprises operating in their locations. These three western districts represent around 15 percent of total industrial activity. By contrast, 52 percent of all industries are located in the Central Region and 30 percent are located in the Eastern District.
6. Since 1991, there has been a decline in new investments in the private sector, despite the policy shift to deregulation and liberalization. After an initial growth spurt in the early 1990s as a result of both political democratization and economic liberalization, the amount of new industrial activity slowed considerably thereafter. A brief revival in the registration of new industrial activities in the mid-1990's was subsequently followed by an overall decline in the number of new company registrations, total capital invested, and new employment opportunities generated from about 1995 onward.
7. In terms of origin of foreign investment, India is by far the most important, representing around one third of all new companies registered, 37 percent of all total fixed capital investment, and 40 percent of all employment generated. The next closest competitor to India, in terms of foreign direct investment into Nepal, is the United States of America with 9 percent of companies registered, 16 percent of total investment and 7.7 percent of total employment generated. Other important foreign investors in terms of these variables include Japan, South Korea, Germany, China, Hong Kong, France, the United Kingdom and Pakistan.
8. An important part of Foreign Direct Investment (FDI) has been in the garment industry, which has flourished under the existing international Multi-fiber Agreement, allowing the garment industry to become the third largest foreign exchange earner after carpets and tourism. Under the new WTO rules, this agreement will cease in 2004. This could lead to a serious disruption in the textile and garments industries in Nepal as preferential quotas are revoked, and Nepal is forced to compete on equal footing with India and the Peoples Republic of China. This may not only adversely impact an important part of the private sector, but it will also have adverse ramifications for exports, employment, foreign exchange, investment, and growth..
III. The Importance of PSD
The Private Sector at large has a key role to play in poverty reduction in Nepal. The rural poor will benefit most from genuine private sector development and a strengthening of the role of the state as regulator, as supervisor, and as facilitator.
9. The Government's stated primary policy concern is poverty alleviation, which is the core objective of the 9th Plan document. To achieve the objective of poverty alleviation, and the target of reducing the incidence of poverty by over 50 percent in the next 15 years, strong pro-poor economic growth, led by a substantial increase in private sector investments (both domestic and foreign) is required. International experience shows that private sector-led growth is a fundamental requirement for successful employment creation and real poverty alleviation. By contrast, attempts at targeted poverty interventions in an environment without substantial economic growth are doomed to failure.
10. The development of the private sector is important to substantially increase the efficiency of resource utilization in Nepal, and to reduce transaction costs. This goes hand in hand with a reduction of the direct involvement of the public sector in productive activities, a decrease in direct interventions by the government, and a strengthening of the role of the Government as a regulator and in providing an enabling environment, with, most importantly, the rule of law as the core ingredient. Given the fact that the majority of the poor and near-poor live in rural areas in Nepal, rural economic growth is important. Therefore, in addition to the commercial private sector, the non-commercial private sector, including NGOs, cooperatives and community-based organizations has an important role to play to ensure broad-based pro-poor economic growth.
IV. An Improved Framework for Private Sector Development
11. Issues to be considered for PSD in the Nepal context are discussed below under the following headings: A) Private Sector Environment; B) Strengthening of the Legal Framework, C) Politics and Bureaucracy, D) Strengthening of Private Sector Governance; E) Privatization of State-owned Enterprises; and F) the Role of the International Community. Closely related issues are discussed in the papers on Financial Sector Reform and on Governance (civil service reform).
- Private Sector Environment
Principal Constraints
12. The 1997 World Development Report stated: "Interest has revived in finding ways for the government to work with the private sector in support of economic development, and to provide regulatory frameworks supportive of competitive markets. Yet in all too many countries, state and market remain fundamentally at odds. Private initiative is still held hostage to a legacy of antagonistic relations with the state." This also applies to Nepal. The private sector environment can be characterized by two sets of failures. The first one is that while at the policy level the right noises have been and are being made regarding PSD, the resultant legal framework is weak and internally inconsistent. It does not provide a transparent and level playing field. The second failure is the poor implementation of the Government's policies. There are a number of reasons for this. First is the weak management style and lack of accountability which is common in the Nepal civil service. Second is the absence of a transparent legislation and a fair and predictable judiciary. Third is a general lack of knowledge and understanding of HMGN's policies for PSD.
13. There is a tendency in Nepal to view the private sector as "bad" because its prime motivator is making profits. It is not readily recognized that the incentive structures provided by an open and transparent "market" create optimal decisions (from a macroeconomic point of view) with respect to resource allocations, and that the same market forces produce efficiencies which result in lower production and transaction costs. This will benefit all, especially the poor, as they generally suffer most from high transaction costs, hidden costs and inefficiencies. The regulatory powers of the Government should be utilized to ensure competitive markets and avoid situations of monopoly and deliberate market manipulation.
14. What applies to domestic businesses, also applies to foreign investors. Foreign Direct Investment (FDI) is extremely low in Nepal in comparison with most other countries. And most of the FDI in the past has been from India, to make use of the open border situation, or to service the tourism industry which is dominated by tourists from India. Evidence from other countries shows that FDI can contribute in a substantial way to stimulating private investment and economic growth, if due attention is paid to sustainability and regulatory issues. Principal issues constraining the development of FDI include the lack of rule of law (contract enforcement, dispute arbitration), of transparency (of the legal framework, of rules and regulations, of tax administration), predictability (of application of laws and regulations), lack of reliable professional services (legal, audit and accountancy profession), absence of dispute arbitration mechanisms, absence of foreclosure and bankruptcy laws, etc.
Issues for the Government to consider
The Rule of Law and a Strong Role of the Government as regulator and supervisor are the two core requirements for private sector development.
15. The private sector environment in Nepal is directly linked with the Government's and the general public's understanding of the role of the State and its relationship with the private sector. An urgent public debate is required to get a better understanding of the role of the State in the modern world, and to substantially reduce the reach and direct influence of the Government, and strengthen the role of the Government to ensure the rule of law, and as regulator.
16. There is a need for the Government to recognize that the rule of law is key to Nepal's development. By providing legal security to all participants in the economic life of the country, economic decisions will become easier to make, transaction costs will be lower and the economy more dynamic. There is an urgent need for the Government to develop specific policies to ensure the rule of law for the private sector.
17. It is generally recognized that special incentive schemes do not work if the general environment is not right, and that subsidies generally do not benefit those for whom they are intended. The Government should review the many special incentive schemes, tax holidays and subsidies which are in force throughout the economy with a view to rationalize the incentive structures and to reduce the existing distortions in the economy.
B. Strengthening of the Legal Framework
Principal Constraints
18. The private sector can not develop far without effective property rights (in the widest economic sense) and contract enforcement. For this, there are three conditions that need to be fulfilled: i) protection from theft, and violence; ii) protection from arbitrary government acts; and iii) a reasonably fair and predictable judiciary .
19. A primary element for competitive and efficient markets must therefore be the establishment of an effective rule of law. For markets to operate well, participants need to know the "rules of the game", and to know that the rules can be relied upon to protect their rights. Laws should be comprehensive, understandable and written to support competitive and efficient markets. At a minimum there need to be effective laws covering contracts, and those contracts must be enforceable in a way that passes the tests of simplicity, fairness and lowered transaction costs.
20. For contracts to be enforceable in practice, there must be an effective judicial system, where professional judges and prosecutors can base decisions on well-designed laws, where they are trained in relevant corporate and financial issues and where the court has the capability promptly to execute judgements.
21. Notwithstanding a number of incentive schemes and facilities offered by HMGNN, costs related to doing business in Nepal are regarded as being high by the private sector. This is largely due to non-transparent legislation that allows for discretionary interpretation and unexpected delays and costs, weak implementation of rules and regulation, and lack of reliable financial information and legal recourse that ensure accountability of business entities.
22. Despite a number of new acts that were introduced in the recent years, the country's legal system has not been fully equipped to cater to the emerging business needs. There is no commercial court in Nepal and settlement through the existing court system is usually a lengthy process.
Issues for the Government to consider
For the Rule of Law to work and create a favorable environment, the legislation governing the private sector needs to be balanced and transparent. Specialized courts are needed to deal with specialized issues specific to the private sector.
23. The Government has to ensure that the legislative framework is "enabling", as opposed to "directive" or "interventionist". A review of existing legislation for clarity, comprehensiveness and transparency is urgently needed. To ensure accountability for business activities and thereby to improve efficiency, it is critical to strengthen bankruptcy and foreclosure mechanisms in Nepal. Improvement in quality of legal professionals is another crucial factor for private sector development.
24. There is a need for specialized arbitration mechanisms and maybe even commercial courts, with the aim to promptly reach settlements or execute judgements in a professional and well-considered way. There would be a need for a training institute to train judges to this effect, while continuous training would also be needed for both public sector and private sector lawyers. Such an institute could be set up as a public-private partnership.
25. HMGNN should develop, in collaboration with the private sector, suitable legal training institutions with sufficient commercial orientation. The controlled opening of the services sector to allow qualified foreign legal professionals to practice in Nepal will be particularly important to attract additional foreign investment. Equally important will be an official translation of key corporate legislation in English to improve transparency for both domestic and foreign investors. HMGN should push ahead with the existing proposal to establish a commercial office which would sell official translations of legislation, acts and cabinet decisions to interested parties.
26. HMGN should review existing laws regarding intellectual property to insure that they conform to international norms. The improvement and standardization of such laws and their enforcement may serve to increase domestic and foreign investment and strengthen the nascent industrial base of Nepal.
C. Politics and Bureaucracy
Principal Constraints
27. Political stability, that is a certain degree of predictability as to which Government will rule in the foreseeable future and what is the policy agenda, is an imperative for private sector investment decisions. Arguably, the political instability over the last 6 years or so in Nepal has been damaging to private sector investment decisions, both foreign and domestic. Accompanying this political instability has been an increase in political interference in the bureaucracy, which has led to short-term inconsistent policy decisions.
28. Private sector development, as has been discussed above, needs an enabling environment. This also includes an environment free of large scale and petty bureaucratic corruption, hassles and other obstacles which drastically increase transaction costs and make private sector transaction and decisions more difficult. Examples abound of entrepreneurs and exporters who have to obtain numerous signatures on official documents to get permission for import or export of certain goods. This presents opportunity for rent-seeking behavior in the civil service and public sector agencies. It is not uncommon for an exporter of perishable food items to have to obtain 15 signatures in 6 different offices, at considerable expense in time and money, under sever pressure of time.
Issues for the Government to consider
Political stability and a public sector that works in a more transparent manner are an imperative for rapid private sector-led economic growth.
29. While the causes of political instability are many, there would be merit in HMGN actively engaging politicians at large in a public debate on the merits of private sector development and the important role of a stable political environment. Such a dialogue and education process could be actively supported by civil society and the donor community.
30. Corruption is difficult to combat directly, but substantial progress can be made by greatly reducing the opportunities for corruption. It is strongly suggested that HMGN reviews the existing rules and regulations requiring bureaucratic decisions on small issues, or just another signature, with the aim of streamlining official approval processes so that the necessary paperwork is reduced to the absolute minimum.
D. Strengthening of Private Sector Governance
Principal Constraints
31. Private Sector Governance (PSG) relates to the relationships between private sector entities, the government and the general public on the one hand, and a set of relationships between an organization's management, its board, its shareholders and other stakeholders (corporate governance) on the other hand. Corporate governance provides the structure through which the objectives of a company or organization are set. It provides the means of attaining those objectives and also for monitoring performance. Good governance should provide proper incentives for board and management to pursue objectives that are in the interests of the organization and its shareholders. The macro economic consequences of regulation on this micro level are obvious. The importance for an emerging economy and in particular its financial sector are also clear.
32. PSG therefore applies to all formal private sector entities, including companies (large and small), small businesses, NGOs, cooperatives and any other formal private sector organization. PSG is important at a macro and sectoral level, and at the level of the direct stakeholders, whether they be shareholders, or consumer of services. Crucially, PSG includes the urgent need for improved financial reporting at all levels, without which it would be hard to imagine an improvement of the situation.
33. For corporations, there are inadequate incentives for boards and management to conduct business in the interests of companies and their shareholders. One of the most serious impediments for sustained growth of the private sector in Nepal is the existence of weak accounting and financial reporting systems. Lack of reliable financial information not only makes investment and lending decisions difficult, but also undermines accountability of the management, and hence, weakens corporate governance. Ineffective tax assessment and collection have a role to play here.
34. State-owned Enterprises (SOEs) in particular suffer from bad reporting practices and direct political interference and patronage. In addition they lack clear commercial objectives. Directors and managers have little personal or collective stakes in the success of SOEs under their nominal control. NGOs, cooperatives and other such private sector organizations suffer from poor internal management, poor financial reporting, lack of accountability, and too much government and sometimes political interference.
Issues for the Government to consider
Financial reporting and accounting practices which conform to internationally acceptable standards are a pre-requisite for successful private sector investment
35. The Company Act (1997) should be revised to establish clear legal standards, obligations, and duties for company managers, consistent with international practices. An action plan should be developed to strengthen accountability for management performance through wider and less concentrated share ownership.
36. Generate and maintain better quality financial information by implementing existing proposals relating to accounting, auditing and disclosure standards, which would also enable the entrance of foreign professional firms. There is an urgent need to upgrade the accounting profession through an appropriate qualification system, covering fully Chartered and technician level accountants, and the effective implementation of the 1997 Chartered Accountant Act.
37. Reduce the scope for discretion in tax administration (including customs valuation) by improving appeal procedures, and broadening awareness of the responsibilities of the private sector.
38. For SOEs, reform the rules so that boards and chief executives are appointed by an independent commission following strict rules concerning competition, transparency and selection. Changes in the shape of legislation have a role to play in ensuring that SOEs have greater freedom to pursue commercial objectives, render transparent non-commercial objectives and define management duties more clearly.
39. For NGOs, cooperatives and such organizations, direct government involvement should be eliminated. Instead, legislation should allow professional umbrella organizations to register and regulate their members within the framework set by the law. Stricter adherence to financial reporting and more transparency and accountability could be achieved through this.
E. Privatization of State-Owned Enterprises
Principal Constraints
40. As is the case in other countries, state enterprises in Nepal dominate economic terrain that could more effectively be occupied by the private sector. In some sectors, inefficient state enterprises block private dynamism entirely, even as its imposes an unmanageable fiscal and administrative burden on the rest of the public sector. Privatization can (i) free up public resources for high-priority activities such as direct support for poverty alleviation and social services, (ii) pave the way for better, cheaper services, and (iii) unlock opportunities for private sector development. Thus privatization is a means to reduce the ineffective reach of an over-extended state and to stimulate private sector development.
Box: Privatization of Industrial State-Owned Enterprises in Nepal
Strategic focus. Nepal's privatization program, as articulated in HMGN`s 9th Plan, forms a key part of efforts to promote private sector participation in the economy with Government playing a role as facilitator and supporter of private sector activities. Since the program began in 1992 a number of enterprises (mainly agricultural and industrial) have been privatized but within the last 4 years momentum has slowed down.
To date the focus has been mainly on small loss-making enterprises, reflecting concerns over increasing losses and bad debts of the State Owned Enterprise (SOE) sector. Privatization has not yet contributed significantly to the broader aim of improved efficiency and economic performance.
Current program. The privatization program has come to a virtual standstill. Obstacles have been cited by a range of commentators as follows:
- there is little evidence of broad based political commitment needed to implement privatization. As of May 31st 1999 preparatory work on a pipeline of several (eleven) enterprises had been completed. Since then there has been little impetus from the Government to move the program forward.
- despite the fact that some good progress has been made, public perception is far from positive. While the policy aim is widely accepted by stakeholders (business community, general public, trade unions, and political parties) there is criticism relating to its implementation, in particular: transparency of the process; influence of vested interests; utilization of proceeds; modalities of privatization; and interests of workers.
- protracted decision making and lack of clear authority contribute to delay, in turn undermining confidence in the process. Potential investors have become less inclined to participate. Enterprises suffer from uncertainty about their future status, which can translate into poorer performance and asset-stripping.
Way Forward. The following is suggested in the light of experience of past privatizations and difficulties in implementing the current pipeline:
- a clearer demonstration by Government of its stated political commitment to the program is needed. This might take the form of a policy statement setting out strategic objectives, clear timetable and forward schedule for future privatizations.
- the program should be re-focused on strategic objectives relating to economic efficiency and role of Government in the economy. The State Enterprise Sector could usefully be reviewed in order to select key enterprises for reform, through privatization or commercialization.
- consensus and confidence in the program needs to be built up. The Government has an important role to play in disseminating information, addressing stakeholder concerns and ensuring that implementation is transparent. A more consultative and open approach could make a positive difference.
The time needed to handle individual transactions needs to be reduced by streamlining the decision making process. Greater clarity and some redefinition of the responsibilities of parties involved (Cabinet, Ministry of Finance including Privatization Committee and Privatization Cell, and line Ministries) could help reduce overlap and simplify decision events.
F. The Role of the International Community
Principal Constraints
41. The donor community in Nepal has been increasingly calling attention to the importance of PSD, and has been advocating more involvement of the private sector in Nepal's development efforts. This is part of a global trend that recognizes the efficiency gains that can come from such private sector involvement, while the private sector is also sometimes seen as an alternative source of funding of projects or services. It should however be recognized that different donors have different views on the ultimate scope of PSD, that is to what extent the private sector can be involved in areas which are traditionally seen as exclusively in the public domain. There is therefore a certain degree of ideology attached to the PSD agenda of donors. This should be readily recognized and discussed in an open and transparent manner.
42. Whatever the views of donors on PSD, it is clear that the role of the State as enforcer of the rule of law, and as economic regulator needs considerable strengthening. The international community has an important role to play in this respect. It is suggested that the tendency of some to ignore or bypass the central government may weaken the role of the government in this respect, rather than strengthen it. Ultimately, the extent to which sustainable PSD will contribute to the country's economic development depends on the quality of the enabling and regulatory environment provided by the Government.
Issues to Consider
Government and the donor community have to work together in an effective manner to ensure that adequate strengthening of the Government in the areas of regulation and supervision takes place.
43. The donor community, in promoting PSD, should take into account the capacity of the Government to regulate and maintain the rule of law. Both have to go hand in hand. The donor community may also consider a joint strategy (with HMGN) to strengthen the government's regulatory capacity. Better donor coordination is needed, with a better focus on assisting the Government in these areas.
V. Conclusion
44. PSD faces a complex set of issues which touches upon almost all aspects of society. A long term strategy will need to be developed to deal with the issues in a considered and properly sequenced manner. As a first step there is a need for a consensus on the role of the Private Sector and the role of the State in Nepal's economy. There is a need to strongly reduce the direct involvement of the government in economic life, and at the same time, a need to substantially strengthen the role of the Government as a regulator of economic life. There is also a need to substantially strengthen the rule of law, without which PSD is hard to imagine.
45. While these are issues which need a long term effort to bring about change, there are many smaller steps that can be taken, often at nominal financial cost, to make substantial progress in PSD, some of which have been touched upon in this paper. It is up to the Government to recognize this, and mobilize civil society to build consensus and make it happen, where possible with active support from outside sources.
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