Monday, February 22, 2010

BoP Deficit & Remedies

One of the better columns on Nepal's Balance of Payment (BoP) problem. Couple of comments (a) in every year going back to 1975 (that's when NRB data become available), Nepal has suffered trade deficit (b) 85% Nepal's trade deficit is in the big 4-items machinery, fuel, mfg good and chemicals&drugs. Those items ex-fuel already have very high import tariffs; so Nepal may not be able to do much to curtail them. The solution is therefore to increase exports competitiveness (c) talking about exports competitiveness, NRs depreciation must be on the agenda. NRs160/IRs100 exchange has been intact since 1992 and that absolutely does not make sense given the relative growth of India and Nepal, and more importantly, ballooning trade deficit with India - between 2002-08 Nepal's trade deficit increased by Rs. 102 billion, and of that Rs. 75 billion increase was with India.

BoP deficit & remedies
Bhim Prasad Bhurtel

Presently, Nepal is witnessing a negative Balance of Payment (BoP) after more than seven years. A BoP is an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country’s exports and imports of merchandise trade and service, financial capital and transfer payments for a specific period, usually a year, and is prepared in a single domestic currency for the country concerned. BoP deficit means the payment exceeding the receipts of any country to the external sector particularly in one year. A BoP deficit is a particularly serious issue for a supply-deficient economy like Nepal.

In the current fiscal year 2009/10, Nepal’s foreign trade deficit reached nearly 100 billion and the export-import ratio soared to 84:16. Previously, despite a huge trade deficit, the BoP situation was in favor of Nepal because of huge remittance inflow. According to Nepal Rastra Bank, in the last fiscal year, the total size of merchandise goods and service was 220 billion which was balanced by 210 billion of remittance inflow, 27 billion foreign loans and grants, 18 billion of transfer payments such as pensions and gratuity earned abroad. The BoP surplus was 41 billion during the last fiscal year.

However, in the first quarter of the current fiscal year, BoP deficit stood at 20 billion. Alternatively, it can be said that Nepal had to pay 20 billion more than its earnings from abroad. In other words, Nepal’s net foreign asset declined by 20 billion and the foreign currency reserve declined by 31 billion during the same quarter. This includes the increase in IMF quota by 6.28 billion and the 4 billion that declined due to exchange rate fluctuation. The merchandise trade deficit reached 96.21 billion, an increase of 48.9 percent, and the service sector deficit reached 5 billion.

There are two primary reasons: Implicit and explicit. The implicit causes of BoP deficit are the decline in remittance inflow after the global financial meltdown and the recent Dubai crash, decline in export capacity and escalating import of goods, especially gold. Import records of the first quarter of the current fiscal records 12billion worth of petroleum imports, 8 billion worth of vehicles and spare parts and, surprisingly, 19.26 billion worth of gold.

The explicit causes are policy-related. The first inherent cause of BoP deficit is the perennial low economic growth despite an increase in aggregate demand and national income due to remittance inflow, as a result of which people have more disposable income to consume luxury and necessary goods. However, our economy suffers from supply deficiency as domestic products could not meet the larger section of aggregate domestic demand and supply depended heavily upon imported goods.

The second cause is the fixed exchange rate of the Indian and Nepali currencies and corresponding adjustment with the US Dollar. The trade deficit with India in the last fiscal year was 103 billion. Nepali currency was overvalued with dollar while it remained fixed with Indian currency for more than ninth months that resulted in imports becoming cheaper, which soared. On the other hand, exports became uncompetitive and fell.

Third, Nepal has a high marginal propensity to imports because we do not have comparative advantage in the production of manufactured goods due to lack of adequate infrastructure, the small economy of scale in production, lack of investment incentives, colossal energy crisis, low industrial productivity, political instability and perennial labor disputes. Therefore, increase in national income due to remittance inflow and the “cosmetic” growth in domestic product due to foreign aid and remittance are marinating the gross domestic consumption— it will eventually result in a big increase in imports.

Fourth, after joining World Trade Organization (WTO), Nepal now has to struggle to compete with developed countries due to mandatory provisions. This has caused a considerable decline in Nepal’s export, manufacturing and agriculture sector. For example, the garment and the carpet industry were seriously impacted after the enforcement of the Multi-Fiber Agreement and agro-export suffered because of Sanitary and Phyto-Sanitary Measures—this has led to a persistent deficit in the balance of trade. On top of it, we are flooded by the massive surge of foreign goods due to liberalization of international trade.

The fifth reason – recession in developed countries – also escalated Nepal’s trade deficit. Exports could not increase because Nepal’s main trading partners in North America, Europe and Japan experienced negative economic growth in 2008-9 and they imported less from abroad and obviously our exports too declined worsening the current account.
The sixth key reason for the BoP deficit in Nepal is the growing trend of studying abroad in the UK, USA, Canada, Australia and other countries. Similarly, capital flight also contributed to BoP deficit.

Last but not least, the foreign currency earning tourism sector has not fully revived due to political uncertainty and ultimately it contributed to the BoP deficit.

The short-term measure should aim at immediate response measures such as controlling wayward gold import, currency devaluation and imposing extra duties on imported luxury goods to minimize total import.

Long-term remedies are more policy-based. The first is to develop the economy’s competitiveness by enhancing national production capacity to meet the aggregate domestic demand and thus overcome the problem of supply deficiency. The energy crisis should be tackled as soon as possible. Import of petroleum should be reduced through alternative energy, including promotion of bio-fuel. Second, as tourism is a key to increasing foreign reserve, its development will help to amortize the BoP deficit. Third, to tackle the ongoing gold hoarding caused by speculation, the portfolio investment opportunities should be created and the stock market should be made reliable.

Fourth, the import substitution industry such as pharmaceuticals should be promoted. Export industries should be provided heavy subsidizes to make them competitive domestically as well as dump goods abroad. Fifth, to improve and sustain remittance inflow, the quality of foreign-bound workers should be developed by implementing skill-development programs. If a skilled human resource can be sent abroad, even a small number of them can earn significant remittance. Sixth, some tariff and non-tariff protectionist measures should also be used to prevent the BoP deficits within the WTO framework for least developed countries.

Seventh, Nepali currency should be devaluated with Indian currency to correct the virtual strength of Nepali currency. Eighth, the exchange rate policy, export-import policy, industrial policy, fiscal policy and monetary policy should be used simultaneously. Ninth, the Nepal-India trade deficit being another key factor should be resolved. Nepal should take political as well as diplomatic initiatives to do so.

Lastly, to create a conducive environment for investment, the new constitution should address the overall grievances of the people within the stipulated time and end the chaotic transition phase as transition results in more panic than an economic recession. BoP will always favor Nepal only if we are able to execute these tasks effectively. Myopic policy measures won’t serve in the long term.

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