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Economic Update 2000 - An Executive Summary
- With a per-capita income of only $210 p.a., Nepal is one of the poorest countries in the world. Nearly half of its population is living below the poverty line; and its social indicators are unsatisfactory. A series of economic reforms in the late eighties and early nineties enabled Nepal to make good progress in accelerating economic growth and modestly improving its social and economic indicators; and on the political front, Nepal also made a major transition from an absolute monarchy to a democratic government in 1991. However, this momentum slowed down markedly in the last five to six years, largely due to political instability. Between 1994 and early 2000, there have been nine different governments (including six coalitions), and notwithstanding strong declarations of intent, there has been no coherent overall drive to promote economic development. Moreover, this period has witnessed increasing politicization; weakening of administrative and institutional capacity; increasing corruption and governance problems; and poor economic policies including, among others, ineffective public expenditure management, weak pricing policies, inefficient public enterprises, a dysfunctional financial system and a weak tax administration/low tax compliance. Consequently, economic performance has been in many respects less than satisfactory. On the positive side, macroeconomic stability has been maintained, the balance of payments position has strengthened, and domestic inflationary pressures remain moderate. But, from a development perspective, there is little doubt that the aforementioned policy and implementation shortcomings have put the Nepalese economy on a low growth path. Over the last few years economic growth has decelerated; overall investment and savings levels in the economy have declined; and although exports have recently again increased strongly, private sector economic activities geared to the domestic market remain sluggish. Fiscal management has been poor; and the budget has been balanced largely at the expense of development activities. And, there has been little tangible progress in reducing widespread poverty -- Nepal's principal development challenge -- as well as in addressing structural problems which are hampering Nepal's longer term development. At best, Nepal appears to have stood still, while most of her South Asian neighbors have been making strides in reducing poverty.
- Given its acute poverty situation; Nepal needs to take forceful action to accelerate economic development.. The development strategy which is needed for this purpose is well known. Its key elements include: (i) Accelerating economic growth, together with a more equitable pattern of growth so as to improve incomes and living standards in rural areas where the bulk of Nepal's population and its poor live, while reducing its high population growth rate of 2.5% p.a., (ii) provision of rural infrastructure and social services (such as basic education and health care); and (iii) limited and well-targeted interventions for reducing poverty among the most vulnerable groups. It is also recognized that, in order to accelerate economic growth on a sustainable basis, in the short to medium term Nepal needs to adopt a balanced development strategy aimed at exploiting its potential for growth particularly in agriculture and rural development, tourism, the service sectors, and developing manufacturing activities for export to niche markets in India as well as third countries. And, given its long gestation periods, human resource development (including the provision of basic social infrastructure) also needs to be given high immediate priority. Over the longer term, Nepal will need to develop its two major potential sources of economic growth -- its water resources and its as yet largely uneducated and unskilled human resources -- both of which will take considerable time and effort as well as huge investments.
- To accelerate economic growth and bring about the changes that are needed in the economy's structure and performance, Nepal needs to significantly improve its economic policies and their implementation. These can be grouped into three broad and closely interrelated areas: (i) Improving public resource management through a re-definition of the role of the state and reforms to strengthen expenditure management and enhance revenue mobilization; (ii) Promoting private sector development, particularly by improving the enabling environment for both domestic and foreign investment, undertaking much-needed reforms in the financial sector, and further improving trade policies; and (iii) Addressing a range of over-arching systemic issues which affect the performance of the economy at virtually every level, including both the public and private sectors -- such as governance, institutional capacity, ownership and participation, and devolution/decentralization.
- Efforts to improve public resource management in Nepal must begin with a re-examination of the role of the public sector in the economy. The government's resource position is expected to improve only modestly over the next few years. Accordingly, limited public resources will need to be used efficiently and wisely. For this purpose, the Government needs to decide where to put its limited resources in terms of key priority areas: (i) Wherever the private sector can undertake economic activities and/or deliver goods and services competitively, there is little justification for public involvement. (ii) Public involvement should be limited to those areas and activities which the private sector will not find attractive, i.e., where social benefits exceed private costs, but are not adequately factored in by private providers. (iii) In terms of resource allocation, on a broad sectoral basis, public resources should be channeled to such areas as agriculture and irrigation, human resource development (education, health, drinking water), rural infrastructure, poverty alleviation programs, and backward area development, among others, as well as for O & M activities. But areas such telecommunications, power generation and tourism should be left to the private sector. (iv) Even within the priority areas identified above, there is considerable scope for private involvement within specific sub-sectors -- such as fertilizer and seed supply and distribution, higher education, urban hospitals and air transport. (v) There is also little justification for continued government involvement in many public enterprises, particularly where these involve commercial activities. Thus, the protection currently afforded to public enterprises in several areas (for example, in power generation, telecommunications, the government-owned airline, etc.) will need to be eliminated.
- To improve the efficiency of public spending, the government will need to formulate a manageable and prioritized development program and implement it effectively to produce measurable results. As a part of such reform, a number of actions are needed: (i) To improve budget allocations, it is necessary to integrate the regular and development budgets. This would help to assess resource needs for O & M, other recurrent activities and for development projects/programs in an integrated manner, and to provide the necessary resources for them in terms of priorities for growth, poverty reduction and service delivery objectives. (ii) To avoid over-programming of the development budget, it is essential to ensure greater realism in forecasting revenue and aid inflows, i.e. in line with recent performance and reasonable expectations. (iii) Such estimates, prepared for three years at a time, should provide a medium term framework for the development budget. This would help to bring out the key trade offs that would have to be made, including the need for prioritization, limiting new project starts, downsizing projects/programs which are not working well etc. in order to bring the development program to a manageable level. (iv) Strengthening project screening and appraisal capacity in the National Planning Commission and the line ministries so that there is greater discipline initiating new projects. (v) Once formulated, the expenditure program would need to be better managed, without resorting to ad-hoc expenditure cuts which disrupt project implementation. To this end, the mid year budget review could be used to reassess resource outlook and to make expenditure adjustments in a more systematic manner. (vi) To protect priority projects from any resource shortfalls, a core program of priority projects could be formulated and fund releases to projects/programs based on the core program. (vii) Expenditure reporting by spending units needs to be improved, both in terms of timeliness and quality of reporting; while the capacity for monitoring expenditures as well as physical progress of projects/programs should also be strengthened at various levels of the government. (viii) To expedite project implementation, political interference needs to be eliminated. Clearly defining the approval limits for procurement decisions that can be taken at various administrative levels, together with clarification of procedures to be followed and sanctions for transgressions (through an anti-corruption program); and strict implementation of the recently amended civil service rules regarding staff transfers would help in this regard.
- If such actions are taken to improve the effectiveness of public spending, then additional revenue mobilization by the government would be warranted. The agenda for revenue enhancement is well known, since considerable analytical work has been done already, with technical assistance from donors. Possible measures include, among others: (i) the effective implementation of the VAT; (ii) Improving customs valuation procedures and reducing the scope for administrative discretion; (iii) Simplifying income tax legislation in order to make tax assessment more transparent and predictable; (iv) Reducing pervasive leakages and improving supervision; and (v) Strengthening tax administration.
- Improved public resource management could help to get relatively quick results and to build development momentum in the short term. But over the medium term, the private sector will need to play a greater role in undertaking necessary investments and the provision of goods and services. To nurture and encourage Nepal's small but growing private sector, a number of actions can be taken: (i) It is important to send clear signals to the private sector and the public at large about the private sector's role in the economy. For this to happen, a clearer redefinition of the role of the state as a facilitator and regulator is needed. (ii) It is also necessary to provide a level playing field for the private sector vis-à-vis public enterprises, for example by further opening up virtual public monopolies to private competition, in such areas as power generation, telecommunications and RNAC's international routes. (iii) The provision of a clear and transparent legal and institutional framework for supporting private sector activities - "the rule of law" - is of paramount importance. (iv) Strengthening of governance aspects affecting the private sector by reducing the discretionary powers of officials, and developing appropriate accounting, auditing and disclosure standards which are effectively applied is also important. These improvements should also help attract foreign investors. For this purpose, ensuring an attractive enabling environment where the costs of doing business are transparent and predictable, and where business-related decisions can be transacted with efficiency and speed, is paramount. To be successful, as one of the late entrants into the competition, Nepal needs to demonstrate that it can compete with, or even do better than, other countries in this regard.
- Financial sector reform is a critical issue which needs to be addressed, not only for private sector development, but also for ensuring macro-economic stability. It is generally agreed that the strengthening of the financial system should be anchored on three broad themes: (i) Making the system stable and resilient to crises by effectively regulating and supervising banks, improving management and encouraging good corporate governance; (ii) Improving efficiency and cost-effectiveness by supporting improvements in the legal framework for financial markets, increasing competition and the promotion of institutional investors; and (iii) facilitating broad access to key financial services by creating diverse market instruments and developing domestic debt markets. The priorities for the short term, given the current state of preparations, include the following: (iv) Restructuring of Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL), with improved management, branch rationalization, and improved control mechanisms; (v) Improved prudential regulation, accounting, and auditing practices; (vi) Strengthened regulatory and oversight functions of the central bank; and (vii) Strengthened legislative and institutional framework for loan recovery.
- Nepal's trade and foreign exchange regime is already quite liberal. Nevertheless further improvements in trade and investment policies can help stimulate exports, private sector activity and economic growth: (i) To take advantage of emerging opportunities through membership in World Trade Organization (WTO) and SAPTA and economic liberalization in India, Nepal will need to improve its competitiveness through technological upgrading, skill development, export and tourism promotion, as well as investments aimed at supplying the neighboring Indian market. (ii) Nepal also needs to work out appropriate administrative arrangements with India and undertake the necessary investments in transport improvements, in order to take advantage of bilateral trade and transit agreements.
- Technical improvements such as those outlined above would help to improve the effectiveness of resource use and send strong signals to the private sector. However, they alone are unlikely to be sufficient to pull the Nepalese economy out of its present predicament without addressing the key over-arching problems afflicting the economy. Indeed, the central constraint on Nepal's development over the last few decades has not been the paucity of financial resources, but the lack of effective governance and well functioning institutions which can adequately perform the vital state functions which are essential for a coherent economic and social development process. As outlined in a recent working paper on Governance, there are many manifestations of this problem, including weak institutions and procedures, lack of ownership of development projects and programs, lack of accountability and mismanagement of resources, failure to provide effective delivery of public services, including law and order, and the absence of a well-functioning judicial system, all of which are reflected in increased corruption. While progress in all these areas is important, concerted action in two particular areas can help achieve better development results quickly: (i) Building a consensus within the Nepalese society and among major political parties and leaders on an economic development agenda which is suited to Nepal's current needs, together with strong actions to implement such an agenda; and (ii) Implementing an effective anti-corruption agenda. In addressing these issues, the government undoubtedly needs to take the lead; but it is ultimately the responsibility of Nepalese civil society, including major political parties, authorities at different levels, the private sector and NGOs. It is also important to recognize that whether the governance situation in Nepal is better or worse than in other developing countries is a moot point. As one of the poorest countries in the world, Nepal can least afford the misuse and waste of its limited development resources through continued governance problems; and it needs to address these issues quickly without further semantic debate.
- Persistent institutional weaknesses at virtually all levels are a major impediment to development effectiveness in Nepal. At the heart of the problem is a weak, underpaid and unmotivated civil service. Increased political interference at key points in the project cycle, particularly in procurement matters and in appointments and transfers of key staff, has further undermined the efficiency and effectiveness of the civil service. Against this background, recent efforts to transfer more resources and responsibility for local level programs to district and village committees have met with limited success, both because of the pervasive weaknesses cited above, and because technical and institutional capacity is even more limited at local levels. To enhance development effectiveness, improvements in two areas are critical (i) Civil service reform and (ii) Strengthening the decentralization process.
- Civil service reform needs to be geared to the type of development administration that is needed to deliver public services more effectively in the future and to the severe local resource limitations hampering Nepal. First, with increased emphasis on decentralization, the role of the center, line ministries and supervisory agencies will need to change over time. This will have important implications for skill needs, staffing levels and personnel management. Second, to provide adequate incentives, the overall compensation levels may need to increase significantly, together with a widening of salary differentials between lower and higher grades (i.e. decompressing the salary structure) and the introduction of a merit- based, performance-oriented reward/promotion system. How to pay for civil service reforms thus will be a major issue. Third, different alternatives therefore will have to be considered. Enhancing government revenue through tax reforms is one such option. This will however present its own challenges. Moreover, additional revenues are also needed for increased O & M and other development activities. Other alternatives therefore will also have to be looked at, including downsizing, as well as donor funding for civil service reforms on a relatively short term basis. External assistance however is likely to be forthcoming only if a credible reform program is developed and initiated.
- Decentralization is an important means for delivering the benefits of development to rural communities; but it has its own pitfalls. To make the decentralization process work better, a number of actions are needed: (i) First, it is necessary to remove the political and bureaucratic impediments which currently hamper the decentralization initiative. (ii) Second, it is necessary to improve the technical capacity of local bodies (DDCs and VDCs) both for managing their expenditure programs efficiently and for mobilizing resources at the local level. (iii) Third, to promote better management and accountability, the participation of beneficiary groups in the decision-making and implementation process needs to be increased; together with greater transparency (for example, through an "open-book system") in regard to the availability of budget funds, the nature of projects being financed and public access to financial records. (iv) This would call for greater efforts to promote community mobilization and empowerment, particularly of the poorer and under-privileged groups. (v) Finally, the role of line ministries and departments may need to change from implementers to facilitators, providing essential technical support for and monitoring and supervising the activities of local bodies.
- To foster greater ownership, the government will need to take the lead in designing, financing, and implementing the development program and, even more importantly, in aid coordination itself. It will need to decide what its own development priorities and programs are, and ask the donors to support such programs. And external donors should support this process. Similar efforts are required in the case of fully government-financed programs, for example through: greater devolution of responsibilities by NPC to line ministries for program formulation, monitoring and supervision; (ii) increased involvement of local bodies and beneficiary groups in determining priorities and designing projects to better reflect local needs and implementing such projects; and (iii) developing alternative approaches for project implementation and service delivery, for example, involving the private sector in implementation, contracting out to NGOs specific tasks such as supervision, technical services or program implementation on behalf of community groups etc.
- Finally, the growing law and order problem is an important issue which needs to be addressed as a high priority. This has important political and economic implications. While the reasons and motivations for the current unrest are indeed complex, there is little doubt that widespread poverty; significant disparities in incomes, employment opportunities, and access to resources and basic social and economic services and infrastructure between urban and rural areas and between regions; frustrated public expectations from successive governments for better development results; and perceptions of increasing corruption/weak governance have contributed to these developments. And solutions to the problem cannot focus only on security measures but will need to address the acute development needs of affected areas. This will require substantial additional fiscal resources, which should provide a compelling argument for the government (and the donor community) to take stock of the fiscal position and prioritize the expenditure program.
- The agenda outlined above is long, and would be a major undertaking for any government. Given the capacity and other constraints discussed above, it will not be possible to implement all of it in the short term, and indeed it may not be useful to initiate all of it at once; but given the pervasive poverty and lack of progress in addressing the issue in recent years, a major effort is needed now. The immediate challenge facing the government is two-fold: (i) In the coming months, develop an implementable, prioritized action program consistent with institutional capacity and resource constraints; and (ii) Build up support among the key stakeholders including major political parties, Nepali public and external donors for implementing such an agenda.
- In parallel, important changes will also be required from external donors. While the government takes the lead in introducing critical reforms, the donors need to actively support this process. Towards this end: (i) Donors will need to help the government to prepare the reform program in the short term, as well as help strengthen institutional capacity at various levels over the longer term. (ii) Donors will need to accept the consequences of reform programs (for example, downsizing/canceling poor projects, limiting new project starts for some time etc.); and adjust their own aid programs to support only those projects and activities which fit the country's needs. (iii) It will require stronger efforts among the donors themselves to coordinate their support without competing with each other. (iv) It may call for changes in the way donors prepare and manage projects and technical assistance programs in order to promote greater local ownership. For example, instead of extensive reliance on external consultants, they need to look at alternative, more cost-effective ways of providing technical support. (v) Similarly, donors need to provide the kind of support that is warranted under present circumstances. For example, when the government is ready to move forward with a well-defined reform agenda, donors should be prepared to support such a process with increased assistance, including program aid. But if such a reform effort is not forthcoming, providing more assistance, particularly program aid, is likely to be counter-productive.
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