Systemic crisis?

Systemic crisis?
Republica, 4-Mar-2010
Dr. Prakash Chandra Lohani

Dr. Lohani is the co-chairman of Rastriya Janashakti Party.

Nepal’s neighbors, both India and China, are the fastest-growing economies in the world today. Even Bihar considered as sick and feudal in the Indian Union is now growing at a breakneck speed of over 10 percent. In fact, Nepal’s neighborhood is emerging in economic terms as one of the most dynamic and vibrant in Asia. Nepal, on the other hand, remains in a state of hope as well as despair. There is the hope that this new dynamism in the region can be a powerful stimulus to Nepal’s own economic ambitions. The private sector in Nepal has sensed this opportunity. In spite of increasing lethargy and corruption in the government, new initiatives from the private sector in tourism, hydropower generation and even information technology come into focus.

On the other hand, there is also despair in view of the uncertain political situation and the inability of the political leaders to arrive at a consensus on providing a new constitutional framework for the nation. While political wrangling for power continues in a naked fashion, the ability of the government to provide even basis services continues to deteriorate. In the name of political transition, even gross violation of legal norms and values are accepted in a routine manner as if it is the best that can be expected under the circumstances. As of now, there is very little discussion on economic issues. There seems to be an unstated assumption that the permutation and combination for political power can continue indefinitely since the economy will take care of itself. In the months to come, this might prove to be a costly mistake.

The Binding Constraint

The main challenge facing the Nepali economy is political. It is reflected in the deteriorating law and order situation in the country and a pervasive feeling among the people that the government is not able to protect the life and property of the people. A recent report by a credible human rights organization mentions that in the year 2009, 41 people have been killed by the state and another 432 by non-state actors many of whom claim to be at war with the state (Annapurna Post, Feb 20). Similarly, forced extortion from the business community in the name of donation continues even though it is strictly prohibited by the peace agreement. For the business community, partisan rather than legal protection is becoming the best policy of survival. Similarly, a weak legal system and a governmental decision mechanism that thrives on rent-seeking reduce private profitability in investments and becomes the reason for the export of capital.

In this sense, the most important binding constraint to economic growth in Nepal at present is the lack of consensus among the political parties about the future institutional arrangements in the nation. This is reflected in the inability of the coalition headed by the relatively moderate United Marxist Leninist party and the opposition, the hardliner Unified Maoist party, to reach a consensus on the future shape of the constitution that is to be promulgated by May 2010.

Political uncertainty as the most important binding constraint has created fertile ground for impunity to corruption. Rent-seeking in the bureaucracy has become a rule rather than an exception discouraging private as well as foreign investments. The attitude that anything is possible if one has the “right connection and protection” makes a mockery of the concept of the rule of law.

The primacy to politics even if it means ignoring economic issues has encouraged the politicization of the bureaucracy and state enterprises. Formally, there is the Public Service Commission to assure merit and order in the bureaucracy. In practice, however, top-level bureaucrats are being pigeonholed in terms of their allegiance to different political parties. This has literally created a situation where government employees in decision-making positions are being goaded to maximize the interest of the ruling party/parties in the government irrespective of its effects on the delivery capacity of the government. When a new government is formed, which is rather frequent since the average tenure of a government is only about a year before it has to resign, the first interest of the new minister is to appoint his “own” people in top managerial positions including the board of directors of state enterprises under his ministry so as to insure that his commands and interests that often try to maximize private gain at public cost are obeyed.

Similarly, there is a virtual scramble to have the secretary in the ministry a person who is considered sympathetic to the minister or the party that he represents. In this setting, the bureaucracy faces an incentive structure that is partisan and not focused on the interest of the people. This is a problem that plagued Nepal’s politics and bureaucracy in the past even during the parliamentary era. However, after the people’s movement leading to the declaration of the republic, the problem has been assuming serious proportion. Now, there is not even a pretense to merit and impartiality. In the mad rush to have one’s “own” people appointed in top positions, including constitutional organs, there is often disagreement within the government and between the government and the opposition leading to agonizing delays and a sense of paralysis in the system.

The post of the governor of the Central Bank has been remaining vacant and yet the government is unable to make a decision because of disagreement within the ruling coalition. The same sense of indecision and paralysis plagues the appointment in different constitutional organs because the opposition and the government cannot agree on the candidates.

Politics as a binding constraint to economic development also manifests in the total insensitivity of the political parties to consider the economic implications of their decisions to the common people and the business community. Labor strikes are frequent and shutdowns of national highways and production facilities as political pressure tactics have become routine. There is hardly a day when some or all parts of the country are not under forced strikes or similar political agitation directly affecting transport and production of goods and services. Labor unions now increasingly under the influence of the Maoist party have been pressing for a “once-hired, never-fired” policy which discourages both national and foreign investments in labor-intensive manufacturing. This is reflected in the fact that contribution of the industrial sector to GDP has actually declined: It was 23.8 percent in 1999/2000 and 16 percent in 2008/2009. In this setting, for people looking for investment opportunities inside the country, real estate becomes an attractive sector.

The Crisis Ahead

While political uncertainty and lawlessness is the most important binding constraint in the growth of Nepali economy, it remains ignored by the political parties. Rising remittances to the tune of 40 percent during the last two years has helped to cover the distortions, inequities and lost opportunities. However, there are clear indications that the next few months are going to be difficult. What we may witness in the next few months is a sudden rise in systemic risk leading to an economic crisis that could be devastating.

During the last two years, the GDP of Nepal has increased by an average of 3.8 percent. However, the gross disposable income of the people (GDIP) has been increasing at 8 percent because of abnormal growth in remittances to the tune of 40 percent annually. It is this new inflow of remittance income that is responsible for rising government revenue based on imports and abnormal increase in land prices and land speculation. Banks flush with new cash, and hankering for an ever-increasing level of profit, have been eager to join the gravy train. Some of them have been reckless in their credit policies ignoring the normally prudent relationship between credit and deposit. The profit of the financial sector has remained attractive and bank managers have been the highest paid officials in the private sector with a certain measure of glamor.

However, all this may now be threatened because of three reasons. First, the growth rate of remittances has decreased from 40 percent in the fiscal year 2008/2009 to just 10 percent during the last five months of the current fiscal year. This is bound to affect the liquidity of the banking system. Second, the central bank, afraid that land speculation that has already reached a “bubble” proportion will precipitate a new financial crisis, has tightened credit to the real estate sector along with other across the board lending restrictions. This will affect the balance sheet position of real estate speculators after a certain time lag. Third, the continuing political uncertainty seems to have increased people’s preference for cash, gold and/or export of capital. Thus, during the last five months (July-Dec 2009) total bank deposits have gone up by only 4.6 percent, much lower than 8.2 percent for the same period last year.

All these three reasons combined have created an extraordinary liquidity crunch in the banking system with interest rates shooting for the sky. Naturally, the real estate sector is now going to feel the pinch. Once this happens, the balance sheet position of some banks may come under serious strain leading to a financial crisis that our power-centered politicians have blissfully ignored. If such a scenario materializes, the political cost in terms of a new social turmoil will be extremely serious. It will emerge as a systemic crisis that will be hard to contain.