Avoiding the

Slump

Nepali economy is already in a declining trend for over six months now. Still the economists hesitate to call it a recession for technical reasons, because of the lack of information about the quarterly change in the GDP. But the business community seems unanimous that it is already going through a period of recession. Some economists rather like to give it a milder adage of a "slowdown". But the private sector has started behaving as if being in a recession..

Significant job cuts have been effected recently in various sectors, with hotels being on the forefront. The Everest Hotel laid off 47 persons. Another five-star property Soaltee Crowne Plaza did not renew the contract for the employees who were working under labour contracts. Four-star category Hotel Sherpa has made its staff sign an agreement for 50% cut in the salary. These recent adjustments have been in addition to the job cuts effected in the carpets sector (where they had laid off the employees two years ago) and garment sector (where the troubles started only last year).

With all three of the highest foreign exchange earning sectors in doldrums, the chain effect in other sectors are clearly visible: The farmers increased their production last year but the produce could not be sold off. And it was contrary to the conventional wisdom that growth in agriculture induces 1.5 times growth in rest of the sectors. The cause and effect relationship this time is reversed. The slowdown in the industrial growth has led to a slowdown in agriculture sector. The labourer who lost the job in the city went back to the village causing a decline in the urban demand for the foodgrain and other agricultural goods.

Visible as the most affected sectors of the ongoing slowdown (or recession, if one wishes to call it so) are those that have international links, i.e. hotels, handicrafts, airlines, garments, and carpets. Hardest hit among them are those with inflexible labour relations. While the firms using casual labour have easily adjusted the size of their workforce to the requirements of the cutback on production, those using only the permanent labour are facing a large wage bill every month that cannot be serviced. The effect is now spreading to the banks that are finding more and more of their accounts in arrears making it more difficult for them to honour the recent directives of the central bank that require the banks to observe some strong prudential banking norms. Though the growth in deposits in the commercial banks has decelerated, it is still recording a positive figure. But fears are expressed that they will start declining very soon.

Survival Strategies

If one adds liquor industry also to the above list of sectors currently in problems, the list will be quite exhaustive of all the meaningful sectors. And that would be enough to say that the economy is actually in recession, heading towards a slump. Under such a situation, the private sector strategies are being followed also in the public sector. The government closed down four public sector units and the staff there is being sent on forced retirement. The government is also taking some other steps to address the entire economy, though most of them do not seem designed specifically to address the present situation. For example, it has formed the Board of Investment (BOI) with the Prime Minister as the Chairman and the Minister of Industry, Commerce and Supplies as the Vice-Chairman. Though this is in line with the long outstanding demand of the business community, it is not a strategy meant specifically for the current situation. This was to be done even under the normal conditions.

As a specific step meant to address the present situation, the central bank has slashed down the bank rate, refinancing rate and CRR. But doubts are also expressed as to the limit to which such a measure is going to be effective (see Biznews column and the article by Bikash Chandra Bose in this issue).

What is expected from the government is an austerity national budget and that is exactly what some economists are suggesting at present. Some other economists also suggest to increase expenditure in some sectors in line with the argument of Keynesian pump-priming. But the government has not been able to make up its mind about it so far. It is awaiting some promise for help from the donors.

Turning Home

Whether the government is coming with something effective or not, the private sector has to devise its own strategy for survival. Observers expect some innovative strategies to see from some innovative players. One such likely strategy is "turning home", say experts giving the example of what the carpet industry has been pursuing for some time.

Facing a declining trend since last year itself, the carpet industry set up a carpet show room some six months ago in the Kathmandu valley (at Pulchowk) targeting the domestic market. It was in line with the expert opinion that any industry irrespective of its present performance abroad must have a strong base at home so as to be able to withstand the cyclical changes in the international market conditions.

The same is going to be the forthcoming strategy of Nepal Lever Ltd. (a Nepali subsidiary India's Hindustan Lever and thus a member Anglo-Dutch MNC Unilever), according to what the company's senior level officials said recently (NBA, December 2001).

The same realization had dawned also upon the tourism industry some years ago. And the Visit Nepal Year 1998 had promotion of domestic tourism as one of its important components. Though the campaign had achieved a lot in this count, it still had fallen short of the necessary minimum achievements, which is shown by the present level of business in this sector. One example of what still needs to be done is shown by the fact that the Nepali nationals are not granted the status of tourists and therefore are not allowed to travel officially on the tourist buses.

Similar disappointments are there in the case of carpet as well. Though the industry has a speciality showroom, it is not being backed by a well-planned promotional drive to attract the Nepali buyers who are rather buying imported carpets. If one showroom could have solved the problem, there already existed a number of exclusive carpet showrooms in the capital even before the Pulchowk showroom was opened. Still carpet sector seems to be doing something concrete in the comparison to pashmina and garments, which have been doing almost nothing to develop a domestic market.

Regarding garments, the September 11 incident in USA had in fact come as a boon. According to the industry sources, US orders for garments placed earlier on Islamic countries were being diverted to Nepal. But the security situation in Nepal due to suddenly flared up Maoist insurgency put an end to the possibility. The security situation has also thwarted efforts to expand domestic market. The Mahotsavs (festivals) being organized as efforts to promote new destinations for tourism have been suspended now because of the state of emergency. Similarly, the security situation has put hurdles also in expanding the supply chain for the FMCG products. Cigarettes, liquor and beer are particularly hit by this situation. More so about liquor and beer which were specially targeted by some pro-Maoist organizations only a couple of months back.

But the more serious problem is the lack of purchasing power in the hands of the people. Job losses have naturally led to less income and less spending which leads to further job losses - a typical recessionary phenomenon already visible in Nepal now. This is exactly the reason why some economists suggest the Keynesian measures so as to increase the purchasing power of the people.

Turning to the Labor

One commonality in the lists of demands presented to the government by different business associations and chambers is the demand that seeks changes in the existing labour law. To put it simply, the employers want the authority to "hire and fire" employees. And one recent development is that the authorities these days have started publicly acknowledging such a need. First it was Prime Minister Sher Bahadur Deuba went on record publicly endorsing the idea and the same was echoed soon by Finance Minister Dr. Ram Sharan Mahat.

Though the labour ministry is reported to have already drafted such a law, experts still doubt whether such a step will really be taken because of the political costs involved. They rather suggest keeping the labour law mostly unchanged, but providing for relaxation in several clauses of the law for units set up in Export Processing Zones (EPZs). The government may not find it politically convenient to grant the "hire & fire" right to all the employers throughout the country, but it can do so for some of them located at some limited geographical regions such as EPZs. The fascination for EPZ is expected to grow in Nepal looking at the success of EPZs in Bangladesh, which is forecast to record the second highest growth rate during 2002 (see World Trends column) in the entire Asian region.

There is one more suggestion for the government to consider regarding the labour relations and the right to hire and fire. Under the free market economic policies that the government is following, it is necessary all the time for the employers to keep on changing the production volume to adjust to the change in the market demand. Thus the producers may be facing the need to reduce and increase the number of employees very frequently. And the process for such adjustments should be as easy as it is in the USA, it is pointed out. Many firms in USA announced job cuts after the September 11 terrorist attacks and it is being done without any problem on the part of the employer. That sort of flexibility should be there also in Nepal, at least in the sectors which are linked internationally, it is argued.

The flexibility in USA is attributed to the strong social security system there, and therefore, the Nepali trade unions demand that before the government grants such rights to the employers similar social security system as in USA should be put in place also in Nepal. The compromise solution, as suggested by the experts, is to set up a fund with major contribution from the employers to pay the retrenched employee a specified amount as "severance allowance" or unemployment benefit for a specified period (say, six months or till the next employment is found, whichever is earlier). This puts an additional management challenge to the employer, but allows him a flexibility which the can utilize if a job cut is really needed.

Other Demands

The business community seems unanimous about other demands as well. One such demand is for easy and speedy refund of the duty drawbacks that the government has promised to do under all the existing policies. With over a billion rupees blocked as duty drawback arrears, the industrial sector is complaining of escalating working capital costs making the Nepali products incompetitive in the international markets. Nepal Lever alone claims over Rs. 200 million as arrears on this account. The government's commitment made in the budget speech in July this year to refund the outstanding duty drawbacks by issuing government bonds, has not been implemented as yet. The only development so far in this count is the government's recent decision to return VAT "within 15 days".

Another frequent complaint of the businessmen against the government has been about the unscrupulous elements in the tax administration. In response, the government has recently formulated a code of conduct for the taxmen, but its actual implementation is still to be seen.

When did the slowdown start?

Two pronged strategies are needed at this juncture, say the experts. One set of such strategies should be for coping with the situation and to survive till the revival starts. The other set should be targeted to reverse the declining trend as soon as possible.

But the selection of the exact therapy depends on the diagnosis. Different opinions are expressed as to the genesis of the present malady. Some trace it back as early as to the days of South East Asian crisis, others to the 1999 December hijack of Indian Airlines plane and still others to the June 1 incident in the Royal Palace. You can also find some, and with strong logic, that the crisis had started emerging more particularly after India started raising objection to Nepal's so-called 'export surge' about 13 months ago.

And everybody is right. The carpets sector had started feeling the pinch even before South East Asia had started to experience the financial crisis of 1997-98. The Azo-dyes and child labour issue had already damaged the business by 1997. But in tourism, it was only after the 1999 hijack that the real trouble had started brewing and the sector has not been able to recuperate ever since. The main tourism season of year 2000 was lost over the 10% service charge dispute. Year 2001 started with the disturbances over some comments attributed to an Indian film actor. That was followed by the Royal palace incident of June 1. When its effects were gradually subsiding, the September 11 incidence took place in USA. Added to that was Maoist insurgency.

What to Expect

Going by the forecasts so far, revival in the major world economies, particularly in those that are the major markets for Nepal, is expected only around the second half of the year 2002. Even if that is hastened a bit, it may take another couple of months for the benefits to start actually reaching Nepal. Tourists are not likely to start coming until they actually start earning some income and holidays. Order for garments will come only when the countries that can supply them cheaper than Nepal have exhausted their capacities. Carpets are luxuries for the buyers belonging to the lower end of the market who will have to wait till their incomes really start exceeding a certain level. The upper end of the market is already lost by the Nepali carpet sector. Had the upper market image remained intact there would not have been such a sharp decline in the demand even during a global recession. The purchase manager of British Royal Household will not postpone replacing the old rugs from the floors of Buckingham Palace drawing rooms simply because the British economy is not growing for a year.

Carpets and Pashmina could have easily sustained the present recession had they been marketed as something exclusive and premium and had such an image been maintained by meticulous monitoring of the product exported. But the brochures from all the national marketing agencies speak loudly and clearly that both of these products are not Nepali either in the origin or the craft. Carpets are presented as "Nepali Tibetan" carpets made by Tibetan refugees in Nepal, thus indirectly accepting that these are like any carpet made by Tibetan refugees anywhere in the world (e.g. in Dharmashala of India). By the same logic, it can also be expected that Tibet itself may start weaving Tibetan carpets and export them where Nepal is selling them right now. As for Pashmina, the official brochures present it as "Cashmere". And the use of adulterated material has in fact degraded it to the level of Cashmere. The original Pashmina is far more delicate and lighter than Cashmere. Technically, Cashmere cannot be less than 19 microns. Practically a Cashmere less than 16 microns does not exist. Whereas Pashmina is between 14 and 16 microns.

That means the Nepali economy will have to trudge along with a recession for the coming one year or so at the least. And the result will be closing down of more of the units that were set up without any long-term vision. Clever and resourceful companies or business houses will acquire some of these units. A wave of mergers and acquisitions are expected particularly among the airlines, insurance companies and finance companies - the sectors where the plethora of companies is felt to be the highest. Growth Rates (1st three months of each fiscal year)

The revival will also depend on the duration of emergency, view some observers. Longer the emergency, more delayed will be the investment in the new projects for which company registration and seeking licenses etc. are going unabated. According to the Company Registrar's Office and the Department of Industry, the number of new companies formed and the amount of new investment sanctioned is higher during the first four months of the current fiscal year (mid-July to mid- November).

At the same time, it is also likely that some smart business houses will enter some new business.

Turning North

Perhaps a more viable proposition would be to link the economy more with China than with the rest of the world looking at the spectacular growth that China is recording in the face of the world recession. One step in this regard has already been started in tourism. The agreement to bring Chinese tourists to Nepal signed late November is expected to start revival in tourism earlier, but that too is not expected sooner than April when the next Chinese national holidays are planned during which the Chinese are encouraged to go on a spending spree.

Another way to benefit from China is by exporting goods. But the experiences so far do not show any Nepali product except vegetables that can possibly be exported to China in a significant quantity.

Boosting Infrastructure Projects

Though increasing government expenditure as Keynesian pump priming is not popular during these days of neoclassicism, the government still can achieve the same results by fast clearing the private sector proposals for infrastructure projects. This is the period to offer easy terms to the investors who intend to construct roads, power projects, irrigation canals and drinking water supply schemes that have a gestation period of at least one year. While this will create the alternate employment to make up for the losses in other sectors, thus arresting the decline in the people's purchasing power, the completed infrastructure will make Nepali products more competitive when the market starts to expand one year later.

By KG & ML

Analyzing a Crisis

D.R. Khanal

Recent national account estimates indicate that for the first time after the restoration of democracy the economic growth rate is going to be the lowest this year, and remain within the limit of 2.5%. The agricultural sector will register 2.1% growth, which is less than the population growth rate of 2.3% resulting in negative growth in per capita agricultural income. The trade, hotel and tourism sector will suffer the most (0.4% growth) followed by community and social services (1.2%), industry (2.1%) and construction sectors (3.0%).

These preliminary estimates however do not take into account any of the probable far-reaching implications of the deepening crisis. And they also suffer from some methodological shortcomings. First, once the slowdown manifests in other sectors, the chain effect will be such that it becomes difficult to predict on the basis of a simple trend analysis based on the data for only two or three months.

Second, the way the value added in the agriculture has been estimated for both last year and this year is far from being realistic, grossly overestimating the growth rates. Since last year the farm gate prices of paddy and other food crops have fallen sharply and they cover just half of the production cost. This implies that the value added in these crops is declining in real term. This has not been considered in the recent national account estimates.

This gives a clear indication that the income of the farmers has declined at a faster rate than the general impression given by the official statistics. It seems that even the loss incurred by Nepal Electricity Authority due to the compulsion to pay a hefty electricity charge to the Khimti and other private sector power projects has not been deducted while estimating the value added. This raises questions about the reliability of the projected very high growth rate of 27 percent for this year in the electricity sector.

Third, the way the deceleration is taking place in the exports with more than 28 percent decline in third country exports in first three months indicates that the economic downturn will be faster than it is normally anticipated in the days to come. This is further corroborated by very low import growth (3.8 percent). Moreover, the deadlock in renewing the trade treaty with India indicates that the overall impact on both industrial and trade sector will be much more pervasive and severe. As can be seen from the magnitude and direction of both exports and imports also, the industrial sector has been suffering severely since the second half of the last fiscal year. Almost all of the import competitive industries are on the verge of collapse. The major export industries are also experiencing similar fate.

Because of a close linkage between the performances of the industrial sector and the financial system, the banking sector that is already in a crisis now, is to face further survival problems. The problems will not limit to the commercial and development banks in the public sector. The other banks in the private sector are also steadily facing similar problems because of the inability of sick industrial units to service their loans. The volatility in exports on the one hand and unilateral decision of India to prevent the entry of certain Nepali products on the other have intensified such a problem. The tourism industry, which too is on the verge of collapse, is exerting very serious negative effects on travel, trekking, and hotel and airlines sectors. The combined effect of this has already been observed foreign exchange reserve.

The official data also show that for the first time in Nepal's history the level of regular expenditure has surpassed the level of revenue as a result of enormous rise in regular expenditure (about 30%) and a very slow growth in internal revenue. The figures for the first three months do not take into account the huge additional defences liabilities to be borne after the mobilization of the army to fight the Maoists. Already very slow growth in revenue (less than 10 percent in first three months) and the likely expenditure and revenue trend for the coming months indicate the need to rely more on loan to meet regular expenses. This indicates an imminent debt trap.

Although during the recession deficit financing within a certain range is permissible, the excessive reliance on overdraft since last year is posing an additional challenge. On the other hand, even in a situation of deepening economic downturn, the government, rather than making all round efforts toward mobilizing resources and controlling regular expenditure is now massively cutting down the budget allocated to projects and programs to arrange funds to meet military expenses. This will have further adverse effect on, among others, construction works and local level development programs resulting in further slowdown in economic activities, off farm wage employment and people's purchasing capacity.

Expected Immediate Actions

Given the severity of the crisis, a piecemeal approach trying to appease some pressure groups will not help. Fertilizer, interest and irrigation subsidies must be restored immediately along with firm commitment in the implementation of Agriculture Perspective Plan (APP) in its entirety. Rural construction works in the form of Food-for-Work and other similar programs have to be launched in a massive scale.

In the industrial sector, it is necessary to waive income tax on exports and dividends with certain readjustment in import tariff to protect those sick industries that are suffering from lower import duty on final products than on raw materials. Even if this causes some revenue losses in the from of reduced income tax and customs collections, the encouragement it causes to the economic activities will more than compensate the loss. Likewise, the policy announcements to revive sick industries have not been implemented seriously except forming a committee.

Also the measures proposed in the budget are far from adequate to revive sick industries. Hence a comprehensive program has to be developed and implemented in a time bound manner. It is also necessary to implement the commitment made in this year's budget to procure local products for government consumption. Some policy initiatives are also needed to encourage people in consuming the local products. At the same time, a policy of providing bank guarantee buttressed by refinancing facility from the central bank should be introduced for the export industries. Parallel initiatives have to be taken toward international marketing drive by involving our diplomatic missions for our products. In addition to it, efforts should be made to curb misuse of our trademarks. The one window system must be made efficient and effective. From the slightly medium term perspective, and at the same time eyeing WTO, identification and promotion of products and services having competitive advantages will be essential.

Despite big potentials for their development, the agro-based and labor intensive industries have not received adequate priority in terms of facilities and protection. Enhancement of corporate culture is to be central in this proposed reform process by discouraging the distortions caused by unethical policies and practices that provided undue benefits to some people at the cost of industrial development. In this context, strengthening of institutional and regulatory system will be required besides policy reforms.

In view of a close link between industrial and financial sectors, a very strong step is urgently needed in revamping the banking sector as a whole. The reduction in the non-performing assets of the banking system must start along with introduction of new management skills and efficiency by stopping political interventions in the banking system in one way or the other. In this process augmenting the capital base of the banks followed by strong regulatory system will also be essential. To some extent, the central bank has already started some strong supervisory systems. This has to be seriously pursued.

Only recently, the central bank also announced some policy measures to fill up the liquidity crisis in the market following broadly the monetarist's principles. The measures are not sufficient as indicated by the market signals. The various problems including structural ones have to be addressed in a more broader and coordinated way in conjunction with fiscal policies. The experience of even highly developed countries like Japan and USA indicate that merely introducing some changes in the interest rate structure will be far from adequate in the midst of grave structural problems.

In the tourism sector, reassurance of security followed by revamping of air transport is badly needed along with enhancing the credibility of the RNAC. The other area needing an overhaul is government budget. For this, the streamlining of revenue administration along with restructuring of expenditure within the projects and programs is essential. The measures suggested by Public Expenditure Review Commission have to be implemented. If strong measures are taken in those lines, the needed additional fund for military expenses can be mobilized without much effect on development programs. Big cuts in development budget will be self-defeating to a great extent from the point of view of maintaining liquidity and encouraging activities in the economy. It is urgent that a system of policy monitoring be developed and institutionalized so that before the problem aggravates, some precautionary measures could be taken.

Little Hope

The recent behaviors of the government show that the government is not serious about the crisis that the economy has got into. The recent declaration by the finance minister that the overall fundamentals of the economy are all right and in the right direction is a manifestation of the culture promoted by us over the last several years to project a rosy picture about the state of the economy despite the realities indicating just the opposite. Understandably, part of such an irrational behavior is due to the failures of our democratic governance in consolidating a transparent and accountable system. If the recent government appointments and leakage of secrets related to corruption and commissioning are any guide, they indicate that despite the situation becoming very grave, we are still not prepared for the drastic reforms needed to resolve the severity of the present crisis.

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