Structural Changes and Economic Growth in

Nepal
∗
Prakash Kumar Shrestha

October 19, 2010

New School for Social Research, New York

Abstract
This paper analyzes the structural change and performance of the
Nepalese economy over the period of 1965 to 2009, specially focus-
ing on the impact of IMF and World Bank's structural adjustment
program implemented since the mid-1980s based on the Washington
consensus. The performance of Nepalese economy has not improved
much after the implementation of a series of structural adjustment
programs in conjunction with economic liberalization policy. Instead,
poverty is widespread and per capital income is still low with widen-
ing income inequality. Rather, the Washington consensus helped ex-
pand social tension with rising unemployment and inequality drag-
ging Nepal into a decade long internal conict with poor and weak-
ening governance system.

1 Introduction

Nepal is a developing country situated between China and India geographically.

It remained almost in isolation from outside world both economically and po-

litically until the fall of more than one century long autocratic regime in 1951.

∗ PhD Student at the New School for Social Research, email: shrep518@newschool.edu

1
Only after that, Nepal embarked on democratization and developmental process

with the beginning of planned development eort in 1956. With the passage of

time, many dierent types of political systems have been observed . Political
1

system is still fragile and has now been undergoing a major political transition

with yet to settle peace process since 2006.

Nepalese economy has been witnessing a gradual change along with the

change in political system, from fully agrarian economy to a semi-modern sys-

tem. However, Nepal is still one of the poor countries in the world. It shows that

something has gone wrong. Actually, economic development requires economic

transformation to constantly generate new dynamic activities(Ocampo et al.,

2009) which Nepal, totally, lacks so far. Dynamic interaction among markets,

forces of innovation, nance, productive sectors and stable political system can

produce a virtuous circle of growth and development in any country. This re-

quires active market, strong government and capable social institutions. More

importantly,  an economy can be considered to be performing well if it has

sustained productivity growth and a stable or rising employment/population

ratio (Ocampo et al., 2009, p41). Nepal lacks many of these requirements and

has been slow in the development process even toady in the 21st century.

As in other many developing countries, Nepal began to implement structural

adjustment program of IMF and World Bank since the mid-1980s, with a hope

of accelerating economic development and growth after facing a continuous bal-

ance of payments (BOP) decit in the rst half of the 1980s. After a series

of structural adjustment programs, Nepal also concluded the PRGF program

with IMF recently, in 2007. Even after more than the two decades of structural

adjustment program and economic liberalization process, Nepal is still in the

low end of development ladder. These programs have actually weakened the

government capacity and neither was it able to create institutional mechanism

necessary for strong economy. Instead, the country became fragile and volatile

to unstable politics, with widespread poverty and rising inequality. As a con-

sequence of a number of factors like unemployment, poverty, isolation and lack

of good governance, internal armed conict erupted in 1996 and lasted for a

decade. Only in 2006, the peace process began but it has not settled yet to

a logical end. Hence, Nepal is still on the way of nalizing political agenda,

leaving far behind economic development process.

With the World Bank and IMF's suggestion, Nepal embraced neo-liberal

1 See Appendix 1 for brief account of evolution of Nepalese political system.

2
policy of privatization of state owned enterprises, market determined price sys-

tem, trade liberalization, nancial sector liberalization, scal consolidation and

indirect monetary policy instruments as early as mid-1980s. Although Nepal

is now relatively one of the most liberalized countries in the South Asian re-

gion, the economic growth has been low and stagnant, unable to increase per

capita income for uplifting living standard, with sluggish exports and stagnating

investment (Khanal and Shrestha, 2008).

In this context, using macroeconomic data available since 1965, obtained

from the dierent sources such as IMF, Central Bureau of Statistics of Nepal

(CBS), Ministry of Finance, and Nepal Rastra Bank (Central Bank of Nepal),

hereafter NRB, this paper has explored the structural changes observed and

macroeconomic performance of the Nepalese economy in order to identify the

performance of neo-liberal period. This paper has followed the structuralist

approach adopted in Ocampo et al. (2009) and argues that structural reform

failed to make economic and social structure conducive for political stability

and economic development.

The remainder of the paper is organized into four sections. Section 2 outlines

the policy changes in the past, followed by the analysis of changes in economic

structure and macroeconomic performance of Nepalese economy in section 3.

Section 4 discusses Nepalese socio-economic situation and nally, section 5 pro-

vides some concluding remarks.

2 Structural Adjustment Program and Policy Re-

form

After the demise of xed exchange rate based Bretton Wood System and de-

clining corporate prot after oil shock, in the beginning 1970s, and particularly

from the 1980s, there has been signicant change in the overall framework of

development policies based on the Washington Consensus all over the world.

The Washington Consensus

2 strongly emphasizes the private sector initiatives

and lowers the role of government or narrows the policy space, considering the

fact that market provides a key to successful economic development (Ocampo

et al., 2009)

Under the support of World Bank and IMF, Nepal also embarked on eco-

nomic liberalization process through the implementation of structural adjust-

2 Detail in Taylor (1993)

3
ment program. Nepal rst time introduced the Structural Adjustment Program

(SAP) in 1985 against the background of deteriorating macroeconomic situation;

particularly BOP decit during 1982/83 to 1984/85 period. Before that, Nepal

had been following an import substitution policy with a focus on industrializa-

tion through setting up public enterprises. The main objectives of the SAP were

to attain macroeconomic balances and raise GDP growth rate on a sustainable

basis. SAP was implemented for the period of 1986/87 to 1988/89 intending to

make the transition from economic stabilization to more rapid development on

a sustainable basis through market oriented reform. A GDP growth rate of four

to ve percent per annum was targeted through scal consolidation and mobi-

lization of private sector investment. For the latter, the SAP was designed to

liberalize industry, trade and exchange rate, interest rate and monetary policies

for promoting exports and attracting private investment, and privatization of

public enterprises.

After a set back from the trade and transit stalemate from India in 1989 and

change in political regime in 1990, from absolute monarchy to constitutional

monarchy system with multi-party democracy (see Appendix 1), the elected

government after the political change, however, expedited the economic liberal-

ization process with a full faith on market economy. In order to increase the pace

of the reforms, the second Structural Adjustment Program SAP-II was imple-

mented in 1989/90 for three years, despite no BOP crisis at this time
3 . In late

1992, the government further negotiated a new Enhanced Structural Adjust-

ment Facility (ESAF) arrangement with the Fund. This provides a framework

for continued economic reform and structural adjustment as per the advice of

IMF and World Bank, with a hope that it would automatically reduce poverty

and create employment in the economy. Ironically, on the process of liberal-

ization, immediately after the introduction of many market oriented policies

and programs, a serious internal armed conict broke out in 1996, reecting

dissatisfaction of people from widespread poverty and unemployment. Utilizing

the people's discontent, Nepal Communist Party (Maoist) began armed strug-

gle from villages to overthrow the monarchy and existing governance system to

establish a republican government.

Amidst growing political fragility, with a view of reducing poverty to calm

3 With the objectives of revamping the tax system, rationalizing the management of de-
velopment spending, restructuring two large state-owned banks and opening up the nancial
sector, improving the distribution of fertilizer, and making irrigation more eective.
(http://lnweb90.worldbank.org/oed/oeddoclib.nsf/DocUNIDViewForJavaSearch/
5992D15BFBBCB41E852567F5005D8D57).

4
people's unrest and agitation, realizing that structural adjustment program

failed to enhance the living standard of people, Nepal began to implement

Poverty Reduction and Growth Facility Program with IMF

4 and Poverty Re-

duction Support Credit with the World Bank in 2003, and which was extended

later a year due to political change in 2006 and nally concluded in 2007.  Like

all support from the IMF, it was intended to alleviate BOP pressures (Pitt,

2008). But, during that time, Nepal had BOP surplus on the one hand and on

the other hand, it is dicult to understand how and which mechanism the giving

of US$79.1 million soft loans to the coer of Central Bank of Nepal could reduce

the level of poverty

5 . For the rational of PRGF, an IMF resident representative

to Nepal, Alexander Pitt (2008) argues that the PRGF arrangement consisted

not only in providing nancial resources but also in supplying a framework

for tackling emerging economic imbalances, and focusing and reinforcing the

structural reform eort. An additional role was to provide the signal that IMF

support sends to third parties, in particular multilateral and bilateral donors

(Pitt, 2008, p5). In practice, the PRGF was, however, a way of dictating the

government in policy formulation and a dimension of poverty level is still high

even after the PRGF(described later).

Over the course of structural adjustment process, Nepal has liberalized exter-

nal account, nancial sector and privatized some public enterprises, dismantled

industrial policy intervention and allowed a greater private sector role in eco-

nomic activities by squeezing the role of the government (detail to be followed

shortly). However, all of these IMF supported structural adjustment programs

failed to focus on generating employment creation to reduce unemployment

problem.

Nepal opened up its current account in 1993 and lowered tari rate sub-

stantially with new liberal Trade Policy in 1992

6 . For export promotion, the

4 IMF established the Poverty Reduction and Growth Facility (PRGF) arrangement in
September 1999. On 14 November 2003, the IMF Executive Board approved a three-year
PRGF arrangement to Nepal for an amount equivalent to SDR 49.9 million (about US$79.1
million) to support the country's economic reform programs, which was 70 percent of Nepal's
quota.
5 Areas typically covered by the IMF include advising on prudent macroeconomic and
nancial policies and related structural reforms such as exchange rate and tax policy, scal
management, budget execution, scal transparency, and tax and customs administration (Pitt,
2008)
6 Pre-liberalization trade policy was guided by the inward-looking import substitution strat-
egy. Protection of domestic industries and state-led industrialization were the main policy
measures. However, a license was required from the Government for involvement in export-
import businesses. High tari and quota restrictions were practiced in order to protect do-
mestic industries, guided by the policy of self-suciency. Even imports of intermediate inputs

5
trade policy waived the license requirement for exports, introduced duty draw

back scheme, and exempted exports from taxes and charges. Imports have also

been liberalized fully without any sort of restriction. After the accession to

World Trade Organization (WTO) in 2004, under the WTO agreement, Nepal

has further committed to eliminating other duties and charges. Because of this,

according to mainstream economists, there should be a higher rate of growth

as a result of higher investment and sustained gains in factor productivity as a

bonanza of liberalization (Franklin and Romer, 1999).

To promote investment, the government introduced market-oriented new

policies and acts such as Industrial Policy 1992, Industrial Enterprises Act 1992,

Foreign Investment and One-window Policy 1992, and the Foreign Investment

and Technology Transfer Act 1992. These policies have given a priority to

investment promotion for accelerating industrialization in Nepal by providing

incentives, for example no permission required for the establishment of indus-

try, except those related to security, public health and the environment, and

substantial tax exemption. In the large and medium-sized industries, full for-

eign equity participation is permissible, with no restrictions on repatriation of

invested funds. The Foreign Investment and Technology Transfer Act 1992 have

simplied both the process of obtaining visas to foreign investors and dispute

settlement mechanism (Khanal and Shrestha, 2008).

However, FDI inow has remained at the lowest in Nepal even when com-

pared with other landlocked countries (World Bank, 2003). No strong dynamic

eect of trade on investment can be found in the Nepalese context and no one

was fully satised with the existing policies and the investment environment

(Khanal and Shrestha, 2008). Trade liberalization has been just one more ad-

verse shock for nascent manufacturing sector in Nepal. An inux of cheap goods

from China and India with the opening up the trade account has driven out

many domestic industries and employment, forcing people to seek for foreign

employment.

In nancial sector, private sector was allowed to open nancial institutions.

The NRB deregulated the interest rate regime and adopted indirect monetary

policy instrument in 1989. Financial sector reform program was initiated to

make the central bank eective on core functions: conducting monetary policy,

and eective regulation and supervision, stripping o other functions like micro

nance, and restructuring the two old state-owned commercial banks in order

were subject to import licensing. Strict and rigorous control was imposed on the foreign
exchange facility, which required ocial permission (Shrestha and Khanal, 2008).

6
to privatize them. Downsizing of the central bank through voluntarily and com-

pulsory retirement schemes and not hiring adequately in the reform process has

resulted in the shortage of sta with specialized skills, seriously hampering the

execution of central banking functions especially when the nancial institutions

are mushrooming in the market.

Under the public sector reform, there was a retrenchment of civil sta, pri-

vatization and closure of some public enterprises, making the existing public

enterprises defunct, which generated further unemployment and dissatisfaction

among people, playing a catalytic role for destabilizing political environment.

Downsizing of the government made vacancy opening very rare on public sector

and the government isolated from the basic needs of public, while people had

high aspiration for economic prosperity from the newly elected government af-

ter the restoration of multiparty democracy in 1990. In addition, private sector

investment remained low and was not enough to generate sucient employment

for increasing labor force. Cheap imports with opening up external account

wiped out many nascent and old manufacturing industries, which further ag-

gravated the unemployment situation.

In a nutshell, IMF-supported structure reform remained more focused on

scal austerity, ination control, trade decit, but less on economic growth and

remained completely silent on unemployment and poverty. The tightening of

scal and monetary policies has constrained the employment growth by lowering

the eective demand. With market reform, on the other hand, the gap between

the haves and the have-nots has widened, thereby aggravating the social con-

tradictions and unrest. On external front, the worsening trade decit because

of easy imports, but lack of competitiveness in exports further worsened the

domestic eective demand to increase employment in the economy.

3 Change in Economic Structure and Macroeco-

nomic Situation

Economic structure is dened as  the composition of production activities, the

associated patterns of specialization in international trade, the technological

capability of the economy,. . . .. the structure of ownership of factors of pro-

duction, and the nature and development of basic state institutions, and the

degree of development and constraints under which certain market operates

(Ocampo et al., 2009, p7). The sustained growth in successful regions was as-

7
sociated with the change in economic structure in several dimensions, making

economic transformation to higher productivity and increasing return to scale.

The rapidly growing Asian countries showed a substantial shift in shares from

primary to secondary and tertiary sector with high technological content (ibid,

p38). Nepal has observed a change in structure of the economy in many fronts

as follow.

3.1 Output Structure and Per Capita Income

As in many countries, Nepal has also experienced change in structure of econ-

omy. The share of agriculture output in total GDP started to decline since

the mid-1970s  from 71.6 percent in 1975 to 33.7 percent in 2008/09  38

percentage point decline

7 (Figure 1). During the same time, the share of ser-

vice output increased from about 20 percent to 50 percent. The contribution

of industrial sector, which incorporates mining and quarrying, manufacturing;

electricity, gas and water; and construction subsectors, has not increased much,

just from 10 percent to 16.3 percent. Within this sector, the contribution of

manufacturing sector, which can contribute to increase in productivity of the

overall economy, remained just at 7.0 percent in 2009. Historically, manufac-

turing has almost always served as the engine for productivity growth (Ocampo

et al., 2009, p9). But in Nepal, the manufacturing sector could not expand,

rather its establishments are being closed, and because of unfavorable internal

and external environment, capacity utilization rates for most of the major types

of manufacturing units are 3075% (ADB, 2009).

Although there is a structural shift in output production away from agricul-

ture toward service sector, per capita income has not increased much in Nepal,

as observed in many other countries as shown in Ocampo et al. (2009). During

the period 1961 to 2007, the per capita real GDP grew by 1.3 percent; for the

period 1965-1985, it had grown by 0.6 percent and the period after that i.e. in

the neoliberal period, it increased by a slightly higher rate of 1.8 percent, but it

is still lower than 2 percent that is required, as Ocampo et al. (2009)argue, to

stop the widening gap with the advanced countries. Average per capita GDP

growth remained not only low, but also highly volatile as seen in Figure 2.

According to the Penn World Table data (Heston et al., 2009), real GDP

per capita of Nepal reached 2049 International dollar (I$) in current Prices in

2007, increased from 230 in 1965. However, the real GDP per capita relative

7 In Nepal, scal year begins from mid-July.

8
 Figure 1: Changing Composition of GDP

60 Agriculture

40
Service

20
Industry

0
1965 1970 1975 1980 1985 1990 1995 2000 2005
Source: Central Bureau of Statistics, Nepal (www.cbs.gov.np)

Figure 2: Growth rate of Real GDP Chain Per capita

-2

-4

-6

-8
1965 1970 1975 1980 1985 1990 1995 2000 2005
Source: Penn World Table

9
Figure 3: Real Gross Domestic Product per capita relative to the US , G-K
method, current price

3
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Source: Penn World Table

to the US has constantly declining (see Figure 3). Not only in terms of US

per capita income, Asian Development Bank's report (2009) shows that Nepal's

per capita gross domestic product (GDP) also remains the lowest in the South

Asian region. In 2007, the per capita GDP in 2000 prices was estimated at $243

compared with $439 for Bangladesh, $660 for Pakistan, $686 for India, $1,144

for Sri Lanka, $1,277 for Bhutan, and $3,668 for Maldives. ADB (2009) realizes

that this lackluster economic performance has occurred despite market reforms

during the 1990s and 2000s.

Between 1966 and 2009, real GDP increased on an average by 3.6 percent,

while agriculture GDP by 2.0 percent, industry by 6.4 percent and service sector

by 5.5 percent. If we decompose the period, real GDP had grown by 2.9 percent,

agriculture GDP by 1.6 percent, industry sector by 8.3 percent and service

sector by 4.9 percent during the pre-liberalization period (1965-1985). During

the liberalization period, real GDP increased by 4.2 percent, and agriculture

GDP by 2.3 percent which were higher than the previous period. However,

industrial GDP increased by lower rate of 4.8 percent in the neo-liberal period.

Service sector increased by 6.0 percent in the liberalization period which is higher

than that of pre-liberalization period. In the liberalization period, agriculture

10
 Figure 4: Labor and Capital Productivity

3600 2.8

Labor productivity (2000 PPP chain index)

3200 2.4

Capital productivity
2800 2.0

2400 1.6

2000 1.2

1600 0.8

1200 0.4
1975 1980 1985 1990 1995 2000

Source: Extended Penn World Table http://homepage.newschool.edu/~foleyd/epwt/

output remained almost stagnant and industrial output witnessed a deceleration.

Most importantly, manufacturing sector suered mostly with the opening up the

external account because of increasing competition from cheap imported goods,

with deteriorating internal investment climate.

Albeit declining, agriculture is still a dominant sector supporting almost

one-third of output and two-third of employment. Its productivity growth is

crucial for overall poverty reduction and for providing impetus to other sectors,

but productivity increases in this sector are low, constrained by lack of access

to modern technology, and low fertility of land. Removable of subsidies given to

farmers in the process of liberalization has made this sector further weak and

vulnerable to compete with Indian farmers. Irrigation infrastructure is very

poor so that agriculture output is still highly rain fed. Nepal's irrigated area

as a percentage of total arable land is one of the lowest in South Asia (ADB,

2009).

There is a dearth of data to make concrete analysis of change in produc-

tivity of dierent sector of the Nepalese economy over the course of reform.

However, using Extended Penn World Table, for the period of 1973-2003, as in

other East Asian Countries, capital productivity has been declining, while the

labor productivity has been increasing (Figure 4). However, it has not been

successful in generating a sustained per capita income growth because of ever

rising population, but slower output growth.

On the other hand, ADB (2009) reports show that in 2006, Nepal's GDP

11
per worker was estimated at $614 in 2000 terms, which was about two thirds

of labor productivity in Bangladesh, one third that in India and Pakistan, and

one fourth that in Bhutan and Sri Lanka.

3.2 Trade structure

Changes in the pattern of specialization in international trade are an essential

part of the transformation of production structure in any economy. To be de-

veloped, a country should move its exports from raw materials to manufactured

products of more technically sophisticated (Ocampo et al., 2009). Economic

liberalization and globalization put more emphasis on the opening up external

account to reap the benet of comparative advantage and expedite the economic

growth of any country. As I explained elsewhere, however, the economic growth

in Nepal has not been satisfactory and is inadequate for reducing poverty and

rising per capita income level. After the two decades of economic liberalization,

trade sector has also not performed as expected; export sector has been weaken-

ing, with growing trade decit, for example trade decit as percentage of GDP

has increased from 3.8 percent in 1965-1975 to 18.0 percent in 1996-2005 and

26.9 percent in 2009/10.

Worsening competitive capacity is also reected in declining export/import

ratio, which shows that import sustained capacity of exports has declined from

almost two-third to one-sixth recently. With the opening up of the economy, it

is imports, which has increased rapidly than the exports, which is also reected

in exports/GDP ratio and imports/GDP ratio. Exports/GDP ratio increased

from 5.63 in 1976-1985 to 7.11 in 1986-1995, to 10.73 in 1996-2005 period, then

declined to 8.44 for 2006-2009 and 5.2 percent in 2009/10 (Table 1). But,

imports/GDP has constantly been increasing from 9.67 percent in 1965-1975

period to 29.35 percent in 2006-2009 period to 32.0 percent in 2009/10. Nepal

has South Asia's lowest level of exports as a percentage of GDP: exports in

2007 for other countries in the region ranged from 12.1 percent of GDP for

Pakistan to 23.9 percent for Sri Lanka (ADB, 2009). However, current account

has turned into surplus since 2003, despite widening trade decit, because of

growing remittance inows

8 before becoming negative again in 2009/10 with the

slowdown of remittance after the global nancial crisis. Further, in the external

account, out of 45 years between 1965 and 2010, BOP witnessed surplus except

8 Because of lack of employment within the country amidst the rising labor force, people
started seeking foreign employment with the opening up the economy. Hence, more than
two-third labor force enter annually in the labor market go to foreign employment.

12
 Table 1: Some External Sector Indicators ( As % of GDP)

Time Period Trade Def Ex/Im ratio CAC BOP Exports Imports

1965-1975 -3.8 62.8 0.91 5.90 9.67

1976-1985 -9.8 38.4 -1.7 0.47 5.63 15.46
1986-1995 -14.4 32.8 -6.2 2.16 7.11 21.47
1996-2005 -18.0 37.9 -2.2 1.71 10.73 28.71
2006-2009 -20.9 28.9 2.4 3.27 8.44 29.35
2009/10 -26.9 16.1 -2.7 -0.2 5.2 32.0

Source: Various Publications of Nepal Rastra Bank and Ministry of Finance.

for nine years, initially it was due to foreign aid inows and recently due to

surplus in current account, supported by remittance inows.

In this way, with the openness, it is leakage i.e. imports getting bigger, lower-

ing eective demand. This has seriously been squeezing domestic employment.

With the cheap imports, many nascent industries have already been wiped out

and the remaining in the process of getting eroded.

Nepal's external sector has remained a quite vulnerable, which neo-liberal

policies have not contributed much to change this situation. Nepal does not

have any minerals to export, nor does she has goods of comparative advantage.

Whatever she can export or has been exporting so far are primary products

and some manufacturing products like woolen carpet and readymade garment,

for which she has to compete with the big economies like India and China

with other South Asian countries. Another bottleneck for trade is that Nepal

is geographically landlocked country, and has to depend on India, to get the

access to sea port for international trade.

India is the largest trading partner for both imports and exports for Nepal
9 .

However, even in so-called neo-liberal era, being regional super-power in South

Asia, India has imposed quota on the exports of some commodities from Nepal

while renewing Trade and Transit Treaty in 2002. Formally and informally, India

imposes tari and non-tari barrier on exports of goods from Nepal, handicap-

ping the exports capacity of Nepal. These international institutions like IMF

and World Bank have not done anything in this context; they only advocate the

slogan of economic liberalization ignoring the ground reality.

Appendix 2 shows that there has been some shift in structure of trade in favor

of low technology manufactured items. However, these items do not command

competitions in the international market. As a result, Nepal's export perfor-

9 For example, 58.7 percent of total trade was with India alone in 2009/10.

13
Table 2: Expansion of Deposit Taking Institutions in Nepal following the Fi-
nancial Liberalization
a b
Financial Institutions 1985 1990 1995 2000 2005 2010

Commercial Banks 3 5 10 13 17 27
Development Banks 2 2 3 7 26 78
Finance Companies 0 0 30 47 60 79
Micro Finance Development Banks 0 0 4 8 11 18

a/ as of mid-July; b/as of mid-April 2010

Source: NRB (2010b)

mance has been quite low, unable to contribute enough to generate eective

demand for the economy.

3.3 Financial Structure

The most important structural change occurred in the liberalization period is in

nancial sector. Before the liberalization process, only the government owned

nancial institutions were in operation, but with the liberalization process, pri-

vate sector has shown great interest in this sector. Under the economic liberal-

ization process, nancial sector has expanded substantially from 2 commercial

banks and 2 development banks in 1980 to 5 commercial banks and 2 develop-

ment banks in 1990 to 10 commercial banks, 3 development banks, 30 nance

companies and 4 micronance development banks in 1995, which further in-

creased to 27 commercial banks, 78 development banks, 79 nance companies,

and 18 micronance development banks as of mid-April 2010 (Table 2). It has

made nancial system more prone to instability

10 , with increasing diculty to

regulate and supervise the system because of growing inter-linkage among them.

Broad money, which includes currency in circulation, demand deposits and

time deposits of commercial banks has increased from 7.1 percent of GDP in

1965 to 63.5 percent in 2009

11 , and total assets of nancial institutions has ex-

ceeded the GDP recently. Despite the nancial expansion, rural areas are still

out of reach of the modern nancial service, only about one-third are receiv-

ing nancial service from formal nancial institutions. It shows that nancial

expansion has been heavily urban centric. The Nepalese nancial system looks

10 Already one development bank collapsed in 2010 and other couple of nancial institutions
are in the verge of collapsing.
11 The central bank has not produced the detailed nancial survey incorporating other de-
posit taking institutions so far. Broad money includes only deposits of commercial banks so
far.

14
 Table 3: Some Other Macroeconomic Indicators
Time Period Ination As % of GDP

External debt International Reserves Fiscal decit

1965-1975 1.1 8.38 -0.63

1976-1985 7.5 9.9 7.77 -5.10
1986-1995 11.4 40.4 10.85 -7.45
1996-2005 5.8 49.6 17.42 -4.87
2006-2009 9.2 33.5 21.9 -4.31

Source: Economic Survey, Government of Nepal and Quarterly Economic

Bulletin, Nepal Rastra Bank

like a stage II nance described in Ocampo et al. (2009), borrowing abroad is

still restricted. However, inter-linkage among dierent nancial institutions has

been increasing and real sector has not been performing well so that the overall

nancial system seems to be more vulnerable and fragile

12 .

3.4 Other Macroeconomic Situation

3.4.1 Ination
Ination in Nepal has remained high most of the time, but no hyperination so

far as observed in Germany in 1923 and Latin America in the 1980s and 1990s.

During the rst decade of liberalization (1986-1995) average ination stood at

11.4 percent; during that time, ination reached as high as 21.1 percent in

1992/93. Then after, ination slowed down to 5.8 percent for the period of

1996-2005, especially low ination was recorded in the rst half of 2000s, below

5 percent, without any ination targeting framework

13 . However, with rise in

prices of oil and food items globally in 2007 and 2008, ination soared again to

13.2 percent in 2008/09 before sliding down to 10.5 percent in 2009/10 (NRB,

2010a). Since Nepal has been adopting more or less xed exchange rate with

India during the observation period

14 , ination in Nepal is highly co-related

with Indian ination.

12 Financial expansion has not been able to lead economic growth on account of incessant
political uncertainties.
13 Nepal has a pegged exchange rate system with Indian currency which is anchoring the
monetary management. Since capital account is restricted, the NRB has been following money
growth targeting monetary policy framework consistent with the pegged exchange rate.
14 With the opening up the current account in 1993, Nepal ocially pegged the exchange
rate of Nepalese rupee with Indian currency, letting the exchange rate with other convertible
currencies determined in the market. Before that, Nepal had adopted basket system since
mid-1980s.

15
3.4.2 External Debt and International Reserves
Since capital account is still close, private sector has not been allowed to borrow

abroad. Hence, external debt so far is solely of the government, mainly from

the multilateral institutions like World Bank and Asian Development Bank,

and some bilateral sources

15 . External debt was increasing immediately after

the initiation of structural adjustment programs, to 49.6 percent of GDP on an

average over the period 1996-2005

16 . Because of decreasing absorption capacity

with the escalation of internal conict and squeezing government expenditure

even on needy areas like physical infrastructure in a line with a scal austerity

measure, foreign borrowing slowed down, and nally declined to 40 percent of

GDP in 2005, which further declined and as such on an average it is about one-

third of GDP in recent years. It shows that Nepal is not in debt trap like Latin

American and African countries, but this is heavily at the cost of low economic

growth and high unemployment. Finally IMF (2010) has realized that Nepal

has scal space to expand at the time when there is no eective government.

With the declining external debt burden, and rising remittance inows, inter-

national reserve accumulation has been rising steadily, to one-quarter of GDP,

being able to sustain ever rising imports. In 2008/09, it was sucient to im-

port ten months of merchandise, which has declined to 7.3 months in 2009/10

because of slow down in remittance inows as results of adverse impact of the

global nancial crisis. Actually, remittance has increased to 21.8 percent of GDP

as of scal year 2008/09, reecting the growing dependency of the economy on

remittance.

3.4.3 Fiscal decit

During 1983-1985, there was twin decit as advocated by mainstream, both s-

cal and BOP decits for a brief period of time; scal decit reached as high as

9.6 percent of GDP in 1983; although it declined, it was still high at 8 percent in

1985, but BOP turned into surplus in 1986, which continued thereafter except

in 1995, 1996, 2002 and recently in 2009/10. Fiscal decit declined continuously

to 5.3 percent in 1997, before rising to 6.1 percent following year, but then it

began to decline again and recorded the lowest of 3.2 percent in 2004; then

it rose slightly to above 4 percent for the period 2006-2009. IMF's scal aus-

15 External debt of Nepal is mainly of concessional type with longer gestation period and
lower interest rate, because Nepal has not borrowed from market so far.
16 It was increasing until 1998.

16
terity measure contributed to maintain scal decit under control, keeping the

government expenditure on about 21 percent of GDP, which is comparatively

lower than in other countries. But, current account is in surplus, not due to

low scal decit but remittance inows, with growing workers' demand in East

Asian countries and Middle East.

3.4.4 Physical Infrastructure

Such a scal balance occurred at the cost of low public investment on infras-

tructure (Shrestha, 2009) and a little contribution to employment creation in

the economy. As a result of low priority in infrastructure investment, the avail-

ability of infrastructure has remained very dismal in Nepal. Its road density

is the lowest in the region, with 0.6 kilometers (km) of road per 1,000 people

compared with 6.5 km in Bhutan, 4.7 km in Sri Lanka, 3.0 km in India, 1.9 km

in Bangladesh, and 1.7 km in Pakistan (ADB, 2009). In Nepal, only 37 percent

of households are availed with paved road within 30 minutes, while 27 percent

have to travel for 3 hours or more(CBS, 2004). In 2007, nearly 57 percent

of the rural population did not have year-round access to roads(ADB, 2009).

Because of the poor condition of road infrastructure, the cost of exporting a

container from Nepal was estimated at $1,764 in 2008, compared to $970 from

Bangladesh, $945 from India, and $611 from Pakistan (ADB, 2009). Obviously,

this situation discourages any private investment.

As regards the electricity development, Nepal has also remained extremely

weak, despite having a tremendous potentiality. According to Nepal Living

Standard Survey 2003/04, only 37 percent of the households have access to elec-

tricity in their dwellings(CBS, 2004). Nepal has been in unprecedented energy

crisis for the last ve years, with continuous load shedding (power-outage) of as

high as 16 hours a day recently, which has been adversely impacting the eco-

nomic activities in recent years. Of the feasible potentiality of 43,000 megawatts

(MW), Nepal has so far utilized a mere 661 MW, i.e. just a 1.5 percent of total

feasibility. The electrication rate in 2005 was 33 percent in Nepal compared

to 60 percent in India's and Pakistan and 66 percent in Sri Lanka (ADB, 2009).

A high economic growth is only possible with higher energy consumption.

ADB (2009)mentions that  during 19902007, public sector development ex-

penditures as a percentage of GDP shrank by as much as two thirds. During

that period, government spending on electricity, gas, and water as a percentage

of total government expenditures declined by 58 percent; for agriculture, by 49

17
 Figure 5: Real Lending Rate
Real Lending Rate

10

-5
1975 1980 1985 1990 1995 2000 2005

Source: Quarterly Economic Bulletin and Current Macroeconomic Situation,

Nepal Rastra Bank

percent and for transport, by 32 percent. At the same time, investment require-

ments have been rising rapidly due to increasing demand and deterioration in

existing infrastructure resulting from delayed and inadequate maintenance and

damaged from civil war/conict (ADB, 2009, p6).

3.4.5 Real Interest rate and Investment

For production and employment, the real exchange rate should not be too low

and the real interest rate should not be too high (Ocampo et al., 2009, p12).

There is no ocial data about real exchange rate so that we cannot make anal-

ysis and constructing these data for the time being is beyond the scope of this

paper. However, real interest rate has been computed by average (of minimum

and maximum) industrial lending interest rate less ination. This remained

very volatile as shown in Figure 5 with some upward trend over all. Although

in recent years, it has been declining with inow of remittances and low invest-

ment demand because of political instability and lack of proper law and order

situation.

There is no reliable data on investment. Ocial investment data show a

higher investment rate e.g. 31.9 percent of GDP in 2008/09 which is not vali-

dated by the economic growth. This may be misleading because investment is

estimated as the residual value to balance the income and expenditure account

and is prone to estimation errors and statistical discrepancies as pointed out by

ADB (2009). Hence, analysis on investment could not be made. However, ADB

18
(2009) states that Nepal's investment levels is the lowest in South Asia, which

is very likely.

4 Socio-economic Situation

The persistent of unsatised needs, and considerable income and wealth dis-

parity are important feature of Nepalese economy, providing a fertile ground

for internal conict and social unrest. Poverty has still persisted in Nepal be-

cause of low economic growth, inadequate social and economic infrastructure,

weak social safety net and relatively high population growth. One-third of the

populations are still living under the absolute poverty line as per the ocial

data.

Despite the slower economic growth, the poverty situation showed some im-

provement during 1996-2004, however. The Nepal Living Standards Survey

showed the ratio of population below the poverty line fell from 41.76 percent

in 1995/96 to 30.85 percent in 2003/04, due mainly to the growth in the farm

income, non-farm income and remittances. Out of the 11 percent decline in

poverty level, remittance contributed to more than 7 percent. However, regional

and ethnic disparity in poverty level is wide. Poverty incidence remains may

climb further if the global recession reduces remittance ows (ADB, 2009). But,

very recent ocial report has claimed that poverty level declined to 25.4 percent

by 2008/09(NPC, 2010). However, there are some contradictions. Multidimen-

sional poverty index (MPI) constructed by Oxford University and published in

July 2010
17 , showed that an intensity of poverty in Nepal is as high as 64.7

percent(Alkire and Santos, 2010). Moreover, ADB (2010) also indicates that

more than half the population still survives on less than $1.25 a day in Nepal.

On the other side, income inequality has been increasing in the market based

reform process. In terms of the Gini coecient, inequality increased from 0.34

in 1995/96 to 0.41 in 2003/04 (CBS, 2004) and to 0.46 in 2008/09(NPC, 2010).

This might be one of the economic reason for escalating conict in Nepal. More-

over, there is a distributional conict among industrialist and workers resulting

in poor industrial relations during the political transition.

There is no frequent measurement of unemployment gure like ination in

Nepal. Census survey and Living Standard Survey and Labor Force Survey

provide some information of unemployment. Because of heavy involvement in

17 http://www.ophi.org.uk/policy/multidimensional-poverty-index/

19
agriculture including other informal sector, the full unemployment rate reported

in survey is quite low. However, underemployment is quite signicant as high as

half of the work force. Recent ocial report indicates the unemployment rate

of 30 percent recently (NPC, 2010). Although there is no regular publication

of unemployment data as in advanced countries, facts like labor force growth of

3 percent, a large number of applications for a few advertised vacancies , and

about 300 thousands workers going abroad for foreign employment annually

show that unemployment is a serious issue in Nepal and it may be a root cause

of political disturbance and social unrest. But, there is no serious attention paid

on this matter. Because of a large number of idle youth, any political party or

a small group can collect easily enough number of unemployed youths to make

demonstration on their political demand.

Downsizing the government by retiring the civil sta and no new hiring

under the public reform program have aggravated the unemployment issue from

the very beginning of the reform process. Downsizing of government and almost

defunct public enterprises have created a situation in which getting job inside

the country is highly elusive. Annually, 400 thousand people enter into the

labor market, two-third of them have been going for foreign employment, and

remaining are either unemployed or underemployed, large enough for creating

social chaos and disturbance in the name of politics. Then, the continuous act

of disturbances, strikes, closures and blockade by frustrated unemployed people

has made the implementation of whatever policies and programs dicult in

reality.

As a result of political instability and conict due to failed promise of eco-

nomic liberalization and structural adjustment programs, Nepal witnessed a

decade long armed internal conict over the period 1996-2006, when more than

fourteen thousands people were killed. Even after the Comprehensive peace

deal in 2006, political issues have not been settled logically yet.  Crime and

insecurity; political and criminal extortion from private business; strikes and

road blocks; and trade union militancy (ADB, 2009, p4) are part of daily aair

in recent time, which has severely been aecting investment climate. The gov-

ernment has been so weak so that it has been unable to maintain law and order.

Governance indicator has been very poor in all aspects(ADB, 2009). Actually,

there is both market and government failure in Nepal. As a result, economic

development and prosperity in Nepal is seemed to be a dream of far distant in

future.

20
5 Conclusion

In the preliminary stage of development, the government should be instrumen-

tal in bringing the economy into the development path. Although the state

can fail in many dimensions, but as Polanyi (1944) emphasized, the state is the

central economic actor

18 . Historically, the state has played a crucial role 19 .

However, structural adjustment programs by the IMF and World Bank based

on the Washington Consensus minimized the role of the government in favor

of market. Rather than strengthening the government and social institutions,

these policies weakened the capacity of government, thereby creating a fertile

ground for conict in Nepal. Hence, Nepal is still on the way of nding the

appropriate government system in the 21st century. The governance system has

deteriorated in the neo-liberal period, with a systematic attempt to narrow the

policy space by the structural reform programs, bypassing the role of strong and

eective government needed to facilitate the market mechanism. The liberaliza-

tion process has tied the hand of the government and a frequent interference by

IMF and World Bank, in conjunction to other donors has made the government

ocials passive to craft and implement policy of their own needs.

Under the Washington consensus, macro policies were made center on re-

ducing ination and external decit at the cost of employment and growth; or

achievement of stabilized stagnation as mentioned by Taylor (1993). In Nepal,

hence, despite external and internal balance, economic growth has remained

dismal to increase per capita income to raise the living standard of people, in

spite of the structural change that the economy has witnessed with declining

contribution of agriculture sector. Trade liberalization has not been eective

for industrialization and export promotion for driving economic development,

so has been the nancial liberalization for private investment. Rather, Nepal

has been suering from widespread poverty, unemployment and inequality, re-

sulting in social and political unrest. Actually, the government should be strong

and eective and devise industrial policy strategy to promote entrepreneurship

to induce Schumpeterian innovation for economic growth and should also be

involved actively in the construction of physical infrastructure, necessary for

economic development. Without the expansion of manufacturing sector and

18 Actually  the road to the free market in Western Europe was opened and kept open by an
enormous increase in continuous, centrally organized and controlled interventionism (Polanyi,
1944, p140).
19 For example, in the nineteenth century, there were enormous public subsidies to support
investment in canals and railroad and the highest taris in the world to protect industry
(Ocampo et al. 2009, p11)

21
increasing productivity, a sustained per capita income growth is not possible;

and employment creation requires eective demand in the economy from higher

investment, productive government expenditure and exports growth.

22
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Alkire, S. and Santos, M. E. (2010). Nepal country brieng. Oxford Poverty

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CBS (2004). Nepal Living Standard Survey 2003/04, Vol I and II. Central
Bureau of Statistics, Kathmandu.

Franklin, J. and Romer, D. (1999). Does trade cause growth? American Eco-
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Heston, A., Summers, R., and Aten, B. (2009). Penn world table version 6.3.

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Khanal, D. R. and Shrestha, P. K. (2008). Trade and investment linkages and

coordination in Nepal: Impact on productivity and exports and business per-
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NPC (2010). Three Years Plan Approach Paper 2010/11 to 2013/14 (in Nepali).
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NRB (2010a). Current Macroeconomic Situation (Based on annual data of

2009/10). Nepal Rastra Bank.

NRB (2010b). Quarterly Economic Bulletin, volume 46. Nepal Rastra Bank.

Ocampo, J. A., Rada, C., and Taylor, L. (2009). Growth and Policy in the
Developing Countries. Columbia University Press, New York.

Pitt, A. (2008). PRGF: Importance and need in Nepal. In Poverty Reduction

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mandu.

Shrestha, P. K. (2009). The composition of public expenditure, physical infras-

tructure and economic growth in Nepal. Economic Review, 21:7995.
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World Bank (2003). Nepal: Trade and Competitiveness Study. The World Bank.

23
 Appendix 1

A Brief Account of Nepalese Political System

After the fall of family based autocratic regime in 1951, some sort of demo-

cratic system was observed between 1951 and 1961. But the late King Mahendra

rst banned the political parties in 1961 and introduced party less `Panchyat'

system'. His son King Birendra continued the system after the death of his

father in January 1972 until 1990, when he accepted the people's pressure and

agreed to the system of constitutional monarchy with party system. Under this

system, the rst election was held in 1991. The elected majority government

followed the economic liberalization policy blindly, believing that market would

solve all economic problems and began to face criticism outside and within the

party. However within three years, political instability began, because of in-

ternal conict within the party, the then Prime Minister announced mid-term

election. But, no party got a majority to form government in this election. At-

tempts to make coalition government in combinations of dierent parties began

, but did not last long, so frequent change in government has become a political

norm in Nepal.

On the background of a frequent government changes ignoring people's as-

piration for development, radical leftist party, the Nepal Communist Party

(Maoist), got a chance to encash dissatisfaction of people and started guer-

rilla war in rural areas aiming at ousting monarch and replacing existing system

by People's Republic, which ignited a decade long armed conict that lasted

until 2006, killing more than 13000 people and damaged existing physical in-

frastructure. In the meantime, royal massacre occurred in 2001, killing the

king Briendra and his whole family, which helped further to make the political

system volatile and people lost their faith on monarchy. His brother, King Gya-

nendra, a successor king, took direct power in February 2005 by dissolving the

then parliament and declared emergency to defeat Maoists, which turned into

counterproductive. Maoist rebels and main opposition political parties made an

alliance to restore democracy. After a few weeks of violent strikes and protests

against direct royal rule in 2006 (April), King Gyanendra agreed to reinstate

the already dissolved parliament, after which a series of historically signicant

events happened rapidly.

In May 2006, the restated Parliament voted unanimously to curtail the king's

political powers, and the government and Maoist rebels began peace talks. In

24
November 2006, the government and Maoists signed a comprehensive peace

accord, declaring a formal end to a 10-year rebel insurgency. Then, the rebels

joined in a transitional government in January 2007 and placed their weapons

under UN supervision. In the meantime, violent ethnic protests erupted in the

south-east Nepal demanding the autonomy for the region. In December 2007,

the Parliament approved the abolition of monarchy as a part of peace deal with

Maoists.

In April 2008, the election for Constituent Assembly was held as part of

agreement, in which former Maoist rebels won the largest number of seats,

but fail to get an outright majority. Then in May 2008, the newly elected

Constituent Assembly declared Nepal as a republic country by abolishing the

250-year old monarchical system formally. In July 2008, after two months after

the departure of King Gyanendra, the Constituent Assembly elected the rst

president of Nepal. Now, the Constituent Assembly is mandated to draft the

new constitutions to make Nepal, a country of federal states. However, there

are dierent views among political parties on designing federal states. After the

election for Constituent Assembly, political parties are now basically bickering

on forming the government, keeping aside the main agenda of making constitu-

tion. The rst government after the election headed by the then rebel party just

lasted for nine months. Then, the third largest party has been heading the gov-

ernment since May 2009, while the Maoist party is now in opposition. Although

the new constitution should be ready within two years of the election by May

2010, it did not happen. Now, the expiration time of constitutional assembly

has been extended to additional one year until May 2011. As a precondition set

by Maoist party for extending life of constitutional assembly, incumbent Prime

Minister resigned in June 2010. However, because of lack of political under-

standing among parties, the constitutional assembly, which is also acting as an

interim parliament has been failing to elect another Prime Minister even after

12th round of election (4 months) so far. Hence, the politics is still in limbo in

Nepal, dragging behind the economic development process.

25
Appendix 2

Structure of Exports

Mineral,
Food Fuels Machinery Mis.
and Tobacco and Oil Chemical Manu- and manu- Not
Live and Crude Lubrica and and factured Transport factured classifie
Animal Beverage Materials nt Fat Drugs goods equipment items d
1975-1985 42.4 0.7 29.8 0.1 1.8 0.3 18.0 0.5 6.3 0.3
1986-1995 14.9 0.1 6.8 0.0 2.0 0.5 48.4 0.2 27.2 0.0
1996-2005 10.7 0.1 1.8 0.0 7.4 6.6 41.2 0.5 31.6 0.0
2006-2009 18.6 0.2 2.3 0.0 4.8 5.6 47.7 1.6 19.2 0.0

Source: Quarterly Economic Bulletin, NRB (2010)

26