By Dr. Roop Jyoti

Value Added Tax (VAT) was introduced in Nepal in response to a realization that a fundamental change was necessary in the country’s revenue policy. The business community was strongly against VAT in the beginning, but they gradually withdrew the opposition as they went on being clearer about the positive aspects of VAT and also about the simplicity of the VAT system and the reforms in other spheres of revenue policies that VAT could usher in.

Successive finance ministers belonging to different political parties expressed their realization that VAT was a very good revenue policy. This sent a message across the business community that VAT was definitely going to be introduced and that the necessary reforms in the other revenue policies would also follow.

What is also worth noting is that the taxpayers were opposed to VAT not because of any defect in VAT as a system. Rather they were afraid of frequent contacts with revenue officials who were historically notorious for a behaviour that exploited the taxpayers. Particularly in customs and income tax, the revenue officials are still vested with wide ranging discretionary power to collect taxes in arbitrary manner. On the other hand, the business people were adopting various tax-saving measures. For example, they would under-declare the volume of their transaction and thereby show lower taxable income. But VAT would bring more transparency in their transactions and they would be required to pay higher taxes. The tax officials could also cause further trouble to the taxpayers on the basis of such information.

The success of VAT is dependent on some fundamental prerequisites, such as:

a. Acceptance of the correct invoice prices.

b. Self-assessment of taxes

c. Refund of the tax amount in a speedy and simple manner when the conditions for a tax refund are met.

The business people accepted VAT when HMG assured them that these conditions would be fulfilled. Moreover, as VAT became the main source of revenue, the government would simplify the customs and income tax systems and the rates too would be reduced speedily to the minimum levels as recommended by various domestic and foreign tax experts. This is the context against which we should evaluate the VAT today after good four years of it being under implementation.

VAT has a number of special features. Major among them are:

A. Limited scope for revenue officials to use discretion.

B. Honest taxpayers have practically no need to have contacts with the tax officials.

C. Due to the self-enforcing mechanism of VAT, the taxpayers are forced to become honest.

For these reasons the possibilities and opportunities for corruption are automatically minimized. If the system of recognizing the actual invoice value and self-assessment were followed under customs and income tax as well, the possibilities and opportunities for corruption would also reduce there.

But, unfortunately, the revenue officials either cannot subsist on their normal salary and emoluments or they have already developed a habit of making extra money in a corrupt manner. Therefore, the tendency ingrained in their mind to exact extra income from the taxpayers is difficult to remove without a change in the tax system and policy.

Looking at the current situation of VAT, we can find that it is operating smoothly in many ways. Honest taxpayers, who are in a significant number, are able to conduct their business smoothly under the existing VAT system. Under this category are domestic manufacturing industries and hoteliers. This is a very important and positive aspect of VAT. But it is felt that VAT compliance is very weak and improper in trading sector.

This is not because of any defect in the VAT system or VAT law but because of the failure to enforce VAT in a proper way. The two major reasons in this regard are:

a. Inadequate and incorrect step taken to ensure billing and/or billing at the correct prices.

b. Failure to enforce VAT threshold in an effective way.

It is easy for the taxpayer to avoid VAT because there is insufficient arrangement to check whether all the transaction are being invoiced and whether all the invoices record the correct and actual transaction value. Moreover, as there have been no effective steps taken to enforce the threshold, those who wish to evade the VAT can do so easily.

To resolve this problem the best measure would be to mobilize the private sector itself. I have been suggesting some measures in this regard for quite some time. Let me present these suggestions once again.

The idea is based on the fact that if a taxpayer evades VAT or customs, its effect will be more than reduced government revenue. It adversely affects the business of the other businessmen who honestly pay VAT and customs. Secondly, the competing businessmen are in a better position than the government officials to know the actual price of a product.

To Ensure Proper Invoicing

a) On imports: The importers should be made to declare their sales and distribution arrangement and to declare the estimated sales price at each of these stages of sales. If this information is not made available or if there persists some doubt about the correctness of the supplied information and prices, the invoice value of the import should then be disclosed to the other traders. The importers shall be made to provide such information to the customs office one month in advance of the estimated arrival of the goods there. If any other trader is ready to buy the goods at the import invoice price so disclosed by the importer, they should be allowed to do so by paying the price plus freight, customs, VAT and a reasonable profit to the importer. Just the possibility that one trader’s import value is going to be checked by another trader will be enough to begin an era of correct invoicing. I strongly believe that this step alone can reduce the problem of under invoicing by 65-75%.

b) On domestic sales: Once the system of correct invoicing begins for imports, this will automatically lead to correct invoicing in the retail sales also. An additional measure to discourage under-invoicing at the retail sales is to publicize the doubtful and under-declared prices to the buyers. Other measures can also be developed to mobilize customers’ support to ensure that correct invoices are issued for each transaction.

To Enforce the Threshold

One easy method to evade VAT is to show one’s transaction as falling below the threshold level. Again, the competitors are more capable than the government officials to make a correct estimate of the trading volume of each other. Therefore, it would be a better idea to mobilize the Chambers of Commerce to assess whether a particular trader’s transaction volume is in fact below the VAT threshold. If it is sufficiently proved that the transaction of a particular establishment is below the threshold, a certificate of the same should be issued and such a certificate should be displayed outside the premises of the establishment in such a manner that everyone can see it. If the Chamber of Commerce is not prepared to undertake this task, the establishments themselves can be allowed to declare themselves to be under the VAT threshold but such declaration must also be displayed outside the premises in a prominent manner for all to see. This would put greater responsibility on the person who certifies the transaction volume. In case an establishment is entitled for the VAT exemption for reasons other than the threshold, such a certificate should be issued by the Inland Revenue Department itself and also this certificate should be displayed in a manner that everyone can see it. All enterprises other than those so certified should be made to compulsorily register under VAT and comply with the VAT rules.

These measures will help to implement VAT effectively. But the government also needs to fulfil its assurances in the other areas as stated below. Otherwise, the resistance to VAT as in the past could reemerge and thwart the efforts for it proper implementation.

a. VAT Refund: The present practice of refunding the VAT amount to the taxpayers who are eligible for such refund should be made speedier and simpler. Particularly the exporters are complaining, at present, of the process being cumbersome and slow.

b. Income Tax System needs to be simplified and the rates should not be higher than 15%. If we exclude the income tax paid by the MNCs and financial institutions, the total income tax collection of HMG is a negligible 5 or 6% of her total revenue. Still, income tax has emerged as a tax under which almost every taxpayer is harassed and terrorized by the tax officials. The soon-to-be-implemented new Income Tax Act has further worsened the situation. It has to be corrected. For Nepal, VAT should be made the main source of revenue, income tax rules must be as simple as possible and the rates should be kept at the minimum and this tax should be used only as a means to make the tax system complete. Otherwise, VAT will again be resisted due to the problems with the income tax.

c. Customs: Once the conditions for actual and correct invoicing are in place, the rates of import duty should be minimized and kept at 5% or 10% only. Only in some cases where the domestic industry must be protected or the imports of the goods are to be discouraged should the rates be higher. In case of the raw materials for export-oriented or basic industries, the import duty should be as nearly zero as possible.

VAT if implemented correctly helps in the implementation of other taxes as well. It also helps in the proper development of a market economy. What is required for this is patience and proper attitude. But we have observed in the past that wrong notions, inadequate homework and wrong methods of implementation have guided VAT in Nepal. One such example was the effort to raise VAT from the carried over but undervalued stock. It was against the fundamental principles of VAT. One special feature of VAT is its simplicity. There is no need to keep the account of stocks or inventories. A purchase register and a sales register are enough. Correct invoices are to be issued and the VAT statements and payments are to be submitted in time. These are the only requirements under VAT. So, an honest taxpayer has no need to worry. But instead of encouraging the practice of actual and correct invoicing, the taxpayers’ premises were raided and verification of the stock accounts and cash balances were carried out. These practices have developed wrong and negative impressions about VAT.

Two rules incorporated in the budget speech (Finance Bill) for the current fiscal year (2001-2002) are also against the basic principles of VAT. The compulsory requirement for the seller to mention the name and the tax registration number of the buyer on the invoice is impractical and unnecessary. It is not difficult for the buyer to get someone else’s number mentioned on the invoice - I have had it tried several times and it was easy. With rules that cannot be implemented, we create only harassment and confusion. Also unnecessary is the requirement that a VAT registered buyer should buy only from a VAT registered seller. As the buyer gets the facility of tax credit, it is for his benefit to buy from a VAT registered seller. But making it a legal and compulsory requirement causes practical problems. If one buys from a seller who is not registered under VAT, he has still to collect VAT on his sale. VAT is a multistage tax system. So, such rule causes suffering only to the VAT registered business establishments.

I would like to conclude with following summary:

1. The VAT administration should concentrate zon promoting a habit of actual and correct invoicing at all stages of sales including at the retail sales level.

2. The private sector should be mobilized to correctly enforce the VAT threshold.

3. The attention of the revenue administration and taxpayers should not be allowed to be diverted from VAT to income tax. Therefore, the Income Tax Act needs to be simplified and income tax rates minimized.

4. As the practice of actual and correct invoicing becomes effective, the customs duties should be reduced rapidly.

5. The existing problems related to VAT should be resolved as soon as possible. Specifically, the system of VAT refund should be made simple and fast.

6. The practice of introducing rules that are against the fundamental VAT principles should be avoided.

(Dr. Jyoti holds MBA, MPA and PhD from Harvard University and is a sitting member of the Rastriya Sabha, the upper house of the Nepali Parliament and the Vice-Chairman of Jyoti Group of Companies. This article was prepared by Dr. Jyoti in Nepali and later translated by NBA desk.)

Asymmetry of Information

By D. R. Khanal

The findings of the recently released report on Human Development in South Asia show that liberalization and globalization policies may be of little help in reducing the poverty and enhancing human development objectives unless they are evolved carefully by taking into account the socio-economic and market conditions. The report support, the findings of a vast number of earlier empirical studies that the basic assumptions upholding the neo-classical thinking may not be valid because of externalities and market imperfections. This has added the relevance of a theory advanced quite recently by Prof. Joseph Stiglitz, George Aakerlof and Michel Spence that because of asymmetry of information, market failures are normal and, by implication, there a need to correct markets for ensuring economic progress with social justice. Their work, which was rewarded with Nobel Prize for the year 2001, together with events revealing continuous market failures, may be of great help in deriving various policy inferences useful from the perspective of human development.

Information Asymmetry

The major argument advanced in the work of Prof. Stiglitz and others is that different people in the market know or perceive things differently, based on the extent of knowledge and information. The seller of a car may know better about his car than the buyer. Similarly, the buyers of insurance may know more about the possibilities of an incident than the sellers. The non-existences of markets, widening unemployment, concentration of economic and wealth power in a few hands and failures of corporate governance are some of the additional examples to support their arguments. Thus their conclusion is that the policy prescriptions based of neo-classical assumptions are bound to fail due to market imperfections. This means that perfect competition, essential for the working of neo-classical model, does not exist in either of the product or factor market. Their findings also contradict the theoretical assumption of perfect mobility of resources. In short, their study refutes the claim of market fundamentalists that markets are self-adjusting.

Market Failures and Corporate Sector Crisis

The corollary to this conclusion is that the capital markets are not that efficient to channel savings to the most profitable investment. The global financial markets especially from the 1990s have been behaving quite erratically with serious repercussions on the functioning of the economy in general and corporate sector in particular. The crisis first originates from the corporate sector and gradually impinges the economy as a whole. No conclusive judgement has been made yet about what exactly caused the crisis in East Asia in 1997. But it is quite often linked to the banking system – the failure in supervising the behavior of the short-term capital. The principle reason, however, may lie in the cosmetic policies meant to impress the investors that the economies are sound and competitive.

Prior to crisis, there was a policy of fixing the exchange rate within a certain range while maintaining a regime of full convertibility in the capital account. At the same time, policies of targeting inflation and fixing high interest rates were pursued side by side presumably with the aim of attracting external capital and maintaining export competitiveness.

The World Bank and the IMF praised these policies very loudly. But in the aftermath of the crisis, there was massive policy reversal in such a way that contrary to market based principles very soft fiscal and monetary policies were followed with a stated objective to inject the capital and liquidity in the economy in general and in the corporate sector in particular. After a short interval, of that complete restructuring of the corporate sector was initiated beginning in Korea focusing on managerial transparency, good corporate governance and better accountability in addition to steps for revamping highly indebted big companies through measures such as debt-equity swaps and merger and acquisitions.

Although host of policy initiatives helped Korea and other East Asian countries to overcome the crisis to some extent, the social cost of strong austerity measures has been extremely high and very painful. Because of the ongoing recession in USA, Japan and other countries, these countries are again in the threshold of economic crisis originating and enlarging from the corporate sector itself.

The recent crisis of Argentina is not only a vivid example of market failures but also a warning to those who blindly argue in favor of all out second generation reform. The currency board system was all right for many years especially in combating the hyperinflation. Now it is argued that it was because of pegging Peso with dollar that the Argentinian economy almost collapsed because it was done while Argentina’s export competitiveness was weakening due to devaluation by other major trading partners. The extremely high interest rate was the other major culprit for the enormous rise in the external debt.

But it should not be forgotten that there still are many questions, which are difficult to answer only on the basis of theoretical reasoning. The stability in the exchange rate accompanied by non-inflationary conditions should have helped enhance the efficiency in the economy particularly when so much external capital inflow was also present. This would also have helped MNCs to source their supplies from Argentina. Therefore, the logic that the devaluation in the neighbouring countries led to erode the competitiveness of Argentina is not fully convincing. Similarly, no reasonable explanation can be found about the escalation of interest rate in such a liberalized system. The recent devaluation of Peso by about 29 percent has created a situation in which most of the companies that were borrowing in dollar will collapse due to their incapacity to pay the loan. More importantly, the devaluation during such a crisis will further perpetuate both unemployment and poverty which will probably lead to more social unrest.

Another type of severe economic crisis impinging the entire world today originated in the economic bubbles first in Japan in 1990 and subsequently in America in 2000. As we know a bubble had begun in Japan in 1980s giving an impression that Japan’s manufacturing sector is the most competitive in the world. Likewise, America’s Internet industry flourished for some time attracting the investors to the IT sectors. As a result, asset prices soared up. Early investors were lucky but the late comers had to suffer a lot with a kind of chain effect in almost all sectors leading to recession in the entire economy. Japan, despite her pump priming fiscal measures accompanied by easy monetary policy, has been unable to overcome the crisis because of inability to restructure the corporate sector which is badly affected by bad debt and non-performing assets in the banking system.

The unethical corporate practices that challenge the efficacy of policies along with asymmetry of information, have compelled Japan to remain in the recessionary trap for the last one decade. In USA, despite several reductions in the interest rates and taxes, no symptom of economic recovery is visible so far. In both countries, recession has affected labor market very adversely with all time high level of unemployment since the second world war. Interestingly, the dollar is still getting strength every day despite the fact that USA is running a trade deficit of more than 450 billion dollars per annum. No economic logic can be forwarded to justify this phenomenon.

Policy Reforms for Human Development

The above examples are more than sufficient to rebut the logic advanced in the line of neo-classical thinking for justifying the appropriateness of uniformly devised liberalization and globalization policies in all conditions. Moreover, the experience of East Asia, Argentina and even Japan and USA reveal that the full fledged market based system cannot operate in any country, be it developed or developing, due to the underlying reasons pointed above.

The case of developing countries like Nepal is more typical and many policies are bound to be either ineffective or troublesome because of chronic structural and institutional problems in both private and public sectors. Therefore, any reform measure has to take into account the fact that reform in the corporate sector is a fundamental prerequisite because in the market-based system economic crisis essentially starts from the private sector itself. Therefore, to begin with, an introduction of standard auditing and accounting system in the corporate sector will be necessary followed by strong disclosure rules in the financial markets. At the same time formulation and implementation of competition and bankruptcy laws will be essential in addition to strong regulatory and policy monitoring system. The bankruptcy of Enron has exposed more problem areas in this count. Transparency, better management and business ethics are critically important for consolidating a corporate culture, which in turn is the prerequisite for avoiding frequent market failures.

This is not all. In a country like ours even for the sustainability of a market based system, a broad based development strategy has to be pursued with topmost priority on reforming the rural based feudal type of agrarian structure. This again has to be followed by the enhancement of agro-based and other local resource based cottage and small scale industries through some sort of time bound protective and other incentive measures. This is however still not adequate especially from the standpoint of human development. Therefore, implementation of programs for universal and good quality basic education and skill based training programs in conformity with labor market signals will be equally necessary.

Likewise, gradual restructuring of the production system adopting labor and knowledge intensive techniques will be required to make the reform as a means of enhancing people’s well being. Additionally, targeted programs for the poorest of the poor will have to be launched by mobilizing the participation of the beneficiary groups from the very beginning. This is one of the messages given, by the report on Human Development in South Asia 2001 for Nepal as Nepal remains far below in terms of various indices of Human Development.

(Dr. Khanal is an economist, a former member of National Commission and sitting MP in the Lower House of Parliament with CPN-UML ticket.)

Traditional Vs. Modern Business

By John Adams

It is time for us all to think very carefully about the scale and functions of components of the parallel traditional economy even as we struggle to build modern corporate and financial institutions in Nepal. My claim is forceful: we cannot succeed with our efforts in Corporate and Financial Governance (CFG) until we understand deeply the workings of the traditional institutions that historically and to the present have performed the business and financial tasks that we seek to accomplish with modern corporate practices, capital markets, and banking methods: guiding commercial transactions, managing firms, raising investment funds, and providing customers and enterprises with deposit and loan facilities suited to their needs.

There are at least four key areas in which traditional and modern institutions play competing and overlapping roles, and I will discuss each one very briefly. These are:

1. the dualism of the rural credit market, divided between moneylenders and formal agencies such as the ADBN or microfinance institutions;

2. the organization of the informal and formal patterns of international trade and financial flows with Nepal’s neighbors;

3. traditional and modern forms of corporate governance, ownership, and management; and,

4. the informal and formal channels that transmit earnings from Nepal’s numerous expatriate workers back to families and communities.

Rural Credit

In the field of rural credit, the traditional-modern division is between moneylenders and the Agriculture Development Bank (ADBN), commercial banks, and micro-finance institutions. To date, no organized-sector rural credit delivery system has been able to compete effectively with the established traditional lenders. It has been understood for several decades, as a result of careful field research, that moneylenders work in local, segmented markets, but are generally numerous enough so that there is some degree of competition. Their apparently high interest rates include not just the opportunity cost of their loan funds, but incorporate other components. These include risk, supervision costs, information costs, and transactions costs. Where the moneylender is a merchant-lender, there may be charges as well for storage or shipment. Moneylenders are generally flexible about terms of payment and do not attempt to bar borrowers from using funds for weddings or other family purposes. They do not normally require collateral, although sometimes parts or all of a harvest may be pledged. At times, without doubt, peasants have sometimes lost their lands, but on the whole moneylenders do not want to operate farms and much prefer to leave a farmer in place, making some payments towards his debt.

On the other side we have ADBN branches, a few commercial bank offices, and microfinance institutions. What we observe in the field, when we look carefully, is that a farmer will pay more or less the same in interest and other costs as he would have done with a moneylender. It is true that the apparent interest rate is low, in part because it is often subsidized. What we find, though, is that the true cost of the loan is much higher. Compared to the moneylender, the ADBN office requires lots of paperwork and certifications of such things as land ownership. It is costly for an illiterate farmer to gather all this information, bribes may have to be paid to land record offices, and there is a need for several visits, which in Nepal means many days lost and paying out of pocket expenses. The loan officer may expect to get a side payment of at least 10 percent of the loan. When the loan is granted the farmer still must take the chit to a commercial bank to receive cash; sometimes the loan officer will offer the option of a discount of, say, 10 percent on the chit and provide cash out of his own pocket to save the costs of the trip to the bank in the nearest town.

What we see then is a convergence of formal interest rates, including other costs, upwards to the range of those of the moneylenders. Since at least 90 percent of rural credit in Nepal is still provided by the informal sector, it is not too hard to guess which set of lenders is doing its job most efficiently, best meeting customer needs, and showing staying power because of the viability of their operations.

Regional Trade and Payments

The general pattern of Nepal’s reported international trade and payments relationships has been stable for some time. According to official counting, Nepal exports about $800 million in products per year, while importing goods valued at $1.6 billion. This trade deficit of some $800 million is financed by tourism, grants, other invisibles, and a miscellaneous balancing item. About 40 percent of Nepal’s exports, valued at $320 million, go to India and there is an official overall deficit with India of around $250 million per year. There is certainly much anecdotal evidence, such as newspaper accounts of smugglers being chased or of corruption in the customs service, that these official data substantially underestimate the magnitudes of commercial and financial flows between Nepal and India.

On the surface, informal trade between Nepal and India would appear to be challenging and risky. There is the need to dodge or bribe customs officials. Goods delivered to importers in the other country may not be up to expected quality standards, and payments could be slow or uncertain. In the language of the new institutional economics, contract enforcement could be prohibitively costly. Taneja and Pohit undertook a survey of formal and informal traders on both sides of the border. They discovered that, in reality, informal trade possesses numerous advantages over formal trade in terms of reducing transactions costs. Generally, traders know each other after repeated dealing, mitigating risks of default or cheating. Rare disputes are settled by appeal to mutually acceptable arbitrators. Evasion of authorities at the border is easy and there is pervasive complicity. There is no paperwork or procedural delay. Trucks are not held up. Payments are speedy, rendered in cash or via the hundi network, and are often tendered in advance. Demand and price information circulates freely and is usually obtained personally during visits. In other words, transactions costs are in total lower in the informal segment. What is crucial to recognize is that the evasion of customs duties is only a fraction of the savings realized on total transactions costs so that SAFTA or WTO inspired reductions may not staunch informal trade.

The informal trade between Nepal and India is two-way. Nepal serves as a transit point for high-end electronic goods and consumer items, flowing nowadays from China and Southeast Asia, entering from Tibet or deflected with the connivance of Indian officials after arrival in Kolkata. Trade from India to Nepal centers on rice and foodstuffs, textiles, and garments. Most traders are small dealers and many in Nepal are of Indian origin.

What does all of this mean for corporate governance and the financial sector? Clearly, the two-way informal trade is large and efficient. Most payments occur outside the modern banking sector and the total amounts are very big. There is little incentive for informal traders to conform to tax, tariff, or disclosure requirements. The main point is that Nepal’s informal trade and payments systems are well-organized and, by and large, smoothly operating. There is a facilitative nexus between officials and traders on both sides of the border. The goal should not be to use brute force or coercion to dampen these patterns of exchange. Rather, we can only bring larger segments of the parallel sector into the modern sector by reducing customs, transport, paperwork, and other transactions costs. CFG legislation passed in Kathmandu will have little impact in and of itself. We have to rely upon positive rather than negative incentives.

Traditional and Modern Forms of Business Organization & Management

The prevalence of family business combines in Nepal and India is widely known in commerce, industry, and banking. Of course, farms and shops are overwhelmingly family owned and run. When we consider moving towards a corporate structure with diffuse public ownership, listings on the stock exchange, timely public disclosure of standardized accounts, elected boards, and professional management, we seek to create an alternative model of business organization and management. The secrecy of the family houses is legendary. One observer reported that a house could keep up to five sets of books: one for itself, one for the tax authority, one for its bankers, one for customs officials, and one for its foreign partners. The set for its own use might draw upon traditional and opaque forms of ledger entry rather than the Western double entry system. Family sons and sons-in-law, and occasionally a daughter, succeed to ownership and senior management positions. If there are minority shareholders, they rarely receive adequate information or, for that matter, the dividends they expected when they purchased shares. From the government’s perspective, it is virtually impossible to levy and collect required taxes, but reliance on crude rules of thumb, combined with chaipani for the agent, alienates the business firms further.

Family-based business combines have been a highly visible type of firm organization in European, American, and Asian economic histories, and remain so today. If family managers are reasonably competent, they benefit from the advantages of confidence in one another; there is no division between the interests of owners and managers. Communication is easy and continuous, overspilling into family meals or social events. Trust is assured because no family member would risk the ostracism that lying or theft would bring. When there are geographically dispersed offices, a family member may be placed at the head of each. In a joint family system the assets and income of the business may be inseparable from those of the family, particularly for such major items as houses, cars, or land. The family takes care of the business, the business takes care of the family.

Nepal has something like two dozen major trading houses, with interests in manufacturing and banking. They often raise capital internally and do not need to approach the stock exchange and submit to disclosure standards. A number have started banks or finance companies to mop up public savings as a low-cost means of obtaining liquid funds. They have little or no interest in redesigning themselves to accommodate corporate governance benchmarks or to conform to international accounting standards. Frankly, we should not expect them to do so, and as far as coercion or judicial remedy is concerned, they are likely to be as successful as they have been in the past at dodging such strictures. Except for the possibility of gaining access to outside capital, there is little or no reason for them to adopt a more modern corporate structure. That said, in India, we are beginning to see some shift from the family-based type of firm towards professional management, conformity to international standards, and the issuance of standard financial statements. Family firms do become vulnerable when there is a lack of talent, conflict among members, or strong competition from more innovative and progressive domestic or international rivals.

In Nepal, we cannot expect the family business style of organization to collapse overnight, and indeed we would not want it to, since its demise would bring down large segments of trade, industry, and banking. There will continue to be tensions between government and business over taxes and over the provision of adequate public goods such as infrastructure, law and order, and education to provide increasingly skilled workers. Fortunately, there is much evidence that when government does its job, the willingness to pay taxes rises. For many decades, though, we should expect to see a duality in Nepal between family dominated firms on the one hand and, on the other, modern businesses, including foreign investors, conforming to international accounting and corporate governance practices. Shifting the boundary will take time, patience, and well-designed incentives.

Remittances

A recent report sponsored by the U.K.’s Department for International Development (DFID) has estimated the number of Nepalis who work in other countries, mostly in India, and the amounts of money they remit to their families. (David Seddon,, with Jagannath Adhikari and Ganesh Gurung, Foreign Labor Migration and the Remittance Economy of Nepal, Overseas Development Group, University of East Anglia, July 2000). The authors correctly assert that studies of agriculture, poverty, and employment in Nepal have neglected this important aspect of family work choices. At least one-quarter of Nepal’s families receive remittances from workers in India, other countries, or urban and rural areas of Nepal itself. Using careful methods, the authors estimated, for 1997, that actual transfers were 10 times the officially reported Rs. 2.9 billion, amounting to $820 million, or about one-fifth of the nation’s gross domestic product, and more than export and tourist earnings combined.

Most of the remittances sent to Nepal from abroad do not come through the formal banking channels. Some may be conveyed in the form of gold or goods movements but the vast majority come through the hundi system. Workers give cash to an agent who commits to effecting a transfer in Nepali rupees to a named person, usually a family member, in Nepal. This system, which has counterparts in such countries as the Philippines, is simple and very reliable. Studies generally show it is a quicker and cheaper means of transferring money compared to using a formal bank whose charges may be higher and, on the receiving end, where a percentage may be demanded before payment is handed over to the family member. Traditional remittance mechanisms succeed because of their cost and service advantages over what are supposedly modern methods.

Implications for CFG Reforms

The traditional and modern institutions of business and finance exist side-by-side in Nepal. In fact, the distinction is not that simple however convenient it is as a starting point. The hundi system sometimes relies on telephones, and for all I know may use the Internet to communicate transfer instructions. A visit to a so-called modern bank provides evidence to the eyes that efficiency and service are not everywhere to be found. Some of the most progressive and customer-oriented banks in Nepal are owned by family combines.

A summary judgement is that in each of the four aspects of traditional-modern alternatives in Nepal’s financial and business sector, the established practices remain largely in control of the field. It is impossible to work towards the adoption of conventional international practices without considering the functions and utility of the traditional formulae. There is a tendency in donor and official reform endeavors to espouse imported templates and to argue for the use of coercive means of securing compliance. This approach ignores and is usually frustrated by traditional practices that resist the informational and cooperative demands of such initiatives. More importantly, the traditional methodologies involved in rural moneylending, underground foreign trade, family management, and remittance transfers are highly apposite in terms of costs, functionality, and survivorship. For advocates of reform, this recognition of the strengths of the existing institutions is not a defeatist stance, but shows awareness of the double need to understand fully why current practices operate as they do and to devise instrumental and cost-effective ripostes, in which incentives for reflexive compliance and adoption of newly adaptive behaviors are irresistible. Policy design should incorporate competitive and complementarity tactics in relations between the traditional and modern spheres.

Whether we are scholars, advisors, or policy makers, working on CFG issues and tasks, what is essential is that we develop full awareness of the incentives, and cost and service advantages, that bind managers, workers, borrowers, and savers to traditional institutions. The only feasible means to encourage and extend CFG reform programs is to create better opportunities, higher returns, lower costs, and superior products and services on a competitive basis in the modern sector.

(Adams is associated with Centre for South Asian Studies, University of Virginia. This article is an excerpt from a paper he presented to a seminar held in Kathmandu on Corporate & Financial Governance on October 16, 2001.)

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