Promise of Prosperity
Unless Nepal makes radical policy changes, investment will remain low and FDI will continue to be a dream.
A country’s prosperity requires two things: creating employment for all and increasing labour productivity (output per employed). Higher investment is a prerequisite for both. But in Nepal, the investment rate (investment as a share GDP) is quite low. Even then, most investment is made in wealth transfer (not wealth creation) and service duplication (not services extension). The irony is that such investments provide high economic rent to investors (payment in excess of productivity) but do not add value to society (GDP). As a result, the social return to investment is low. Several policies have contributed to this malaise.
Cloudy investment climate
The demand for investment occurs if its expected return is at least as high as its cost. Generally, interest rate represents the cost of capital but in Nepal, it is a very poor proxy. This is a country where entrepreneurs with small capital face insurmountable risks. Only 11 percent of loans originate from financial institutions and loans in the non-financial market charge twice as high. And corruption kicks in. A back-of-the-envelope calculation using data on four indices — ease of doing business, cost of start-up business, corruption perceptions and global competitiveness — shows that doing business in Nepal is 42 percent more expensive than the most efficient country in the world. Thus, investment is suppressed due to high interest rate plus corruption plus bureaucratic hassles plus unmanageable uncertainty plus disregard for entrepreneurships.
As a result, Nepal’s average investment rate in the last decade has been very low — 27 percent (for India and China, it was 36 and 45 percent respectively). National savings (at 28 percent) were in excess of investment, dictating that Nepal should have either been lending to foreigners or increasing foreign reserve.
Indeed, throughout the decade, reserves in Nepal Rastra Bank increased (by 11 percent of the GDP in the last two years alone), earning almost zero return. This would have been understandable had it happened because of trade surplus, but alas, it has happened in the face of massive trade deficits financed by remittances. The money from foreign lands, hard-earned by Nepalis, is idle because of a lack of investment opportunities. For a country where there are slacks in every sector and requires investment, and where the unemployment rate is close to 22 percent, investment should be more than national savings, not the other way round.
With the low investment rate, one would expect the social return to investment (benefits to society) to be high, as the country is still picking profitable projects. But it is quite low, as proxied by the inverse of incremental capital output ratio (ICOR), the units of capital required to increase output by one additional unit. In the last decade, with 27 percent of investment rates and 4.3 percent GDP growth, the ICOR (division of two) was 6.3. By comparison, China and India had 4.3 and 4.5, respectively, implying Nepal’s capital efficiency at about two-thirds of its neighbours.
Taking a bit of a detour at this ICOR, to achieve the double-digit growth that the parties in Nepal have aimed for the next one/two decades, the investment rate should be 60 percent (from the present 27 percent). How are they going to do this? No one has a clue.
Besides corruption, the other main reason for low social return is that investment flows towards wealth transfer and service duplication. Most investments, made in the purchase of land, homesteads and houses in urban areas, in private schools and health, are not necessarily adding value to the society. In case of land, when sold — as it is the same piece of land and no employment and output is added — it is only ownership change; wealth transfer not wealth creation. Similarly, in education, private investment has not created provisions for those who would not have education otherwise; rather, it has initiated a switch from public to private schools. Students are getting better education but if there were good public schools, the duplication (there are reports of vacant classrooms in public schools) of resources would not have occurred.
Data on what fraction of national savings is invested in real estate does not exist but households that have a bit of savings think of nothing else but investing in real estate. In the credit market too, real estate is a major pick. Feeling the credit upsurge, Nepal Rastra Bank has put a cap that banks cannot have real estate exposure in excess of 25 percent of the total loan. In July 2013, out of total outstanding banks’ loan at Rs 956 billion, the share of real estate was 14 percent (8 percent of the GDP), a fall from 22 percent in 2010.
Investment is flowing into these sectors because the private return is very high. For example, land prices in Kathmandu increased annually by 330 percent within the last 30 years. In the last 30 years, the annual real return to real estate (after adjusting annual inflation of 9 percent) is phenomenally higher than GDP growth of 4.3 percent; as a rule of thumb the latter may proxy economy-wide returns. Who would invest in low-return sectors that have social value rather than capturing land rent? The process of land hoarding abounds; money never comes out of land. The seller captures enormous rent but as the land is the same and its productivity is almost the same as 30 years ago, GDP does not change.
The following policy-induced reasons are responsible for high returns in real estate, education and health. First, as investors in these sectors do not have to deal with government officials, labour groups and street gangs on a regular basis, the incidence of bribery, strikes and other rent-seeking activities are lower compared to restaurants, retail shops and industries. Second, compared to others, effective tax rates in these sectors are lower. Typically, the property valuation in urban areas is not even half of the actual market value and the property tax rate is only 0.04 percent. Third, these sectors are devoid of any regulation, leaving investors to their own terms. Fourth, for being internationally non-traded, they do not face foreign competition — as opposed to traded sectors (such as agriculture, manufacturing). Fifth, the remittances have raised their demand (to be met domestically) and hence, the prices of these sectors (at the cost of traded-sector).
Unless Nepal makes radical policy changes, investment will remain low; receiving FDI will be a pipe dream and investment will be directed to land and other non-traded sectors only, hollowing-out the traded sector completely. The following set of policies would yield desired outcomes.
First, in the next five years, make Nepal one of the most efficient countries in doing business by reducing corruption, red tape, and rentier activities. Second, increase the effective property tax rate from present 0.02 percent to 1 percent, eventually raising its contribution to the GDP from a negligible 0.001 percent to 2 percent (the UK has 4 percent). This should be done using more up-to-date valuation of property (both houses and empty land) as property tax base, making rental income and capital gain (valuation different at the time of buying and selling) as taxable income and treating more than one unit of property in a family as investment.
Third, unless for a short-term crisis, the authority to deal with the housing and real estate sector should be the government (solid fiscal policy) and not the central bank (creative monetary policy), as is the case now. Fourth, establish a financial institute that finances loans to very small family businesses at market interest rates. Finally, make public schools (till grade 12) as good as private schools so that there are no incentives to send children to private schools.
This article was originally published in The Kathmandu Post on Monday, 14 April 2014 and can be accessed at