April 2005
COVER STORY

way ahead

The business community had a mixed reaction towards the Royal Proclamation of February 1, 2005 and the subsequent imposition of emergency. Formally, there was a flood of statements and newspaper advertisements welcoming the development in the hope of a better law and order situation and a complete solution within a few months to the eight-year long crisis. However, during private conversations, some of them were sceptical.

In the fiscal year that ended mid-July 2004, all the sectors except hotels, were doing better compared to the previous year, as reported by this magazine in the March 2005 issue on the basis of published reports of corporate houses. The tempo was also maintained during the first six months (till mid-January 2005) of the current fiscal year, as indicated by the second quarter unaudited financial reports of the commercial banks. It was the case also in most of the other sectors, according to the businesspeople.

The authorities also say that there has been an increase in government expenditure and revenue collection during that period. On March 18, the Ministry of Finance issued a press release claiming that the total government expenditure in the first eight months (till mid-March) of the current fiscal year increased by 10.5 percent as compared to the same period last year. Similarly, it said that the revenue collection during that period this year was 10.1 percent higher than in the same period last year.

But how has the confidence level of corporate Nepal changed after two months of the February 1 development?

When Nubiz contacted some 50 prominent business personalities late March, almost everyone agreed that the situation was quite good for continuing business within the Kathmandu valley, but many parts of the country were suffering different types of disturbances. The Far-western and Mid-western regions are the most badly affected regions. The latest news about the split within the Maoist organisation has created fears in the minds of the people in these regions about possible skirmishes between the two Maoist factions and the further tightening of security by the government forces.

Though all of these businesspeople contacted think that if the current situation is continued, it will be overall good for business to continue, no one was ready to go ahead with new investment projects. The mood was really that of 'let's wait and see.'

At present, the common strategy being followed by the business houses is to control costs and keep the finances as liquid as possible. They are tightening the credit and discouraging dealers from keeping high stocks. Some businesspeople said that they are revising their targets in view of the changed situation.

However, they also say that they are positive about the future because, as they put it, the businesspeople are a hopeful lot. 'When the country was going through a prolonged period of uncertainty, the February 1 move signalled a drastic change. Let's wait for the next steps in this series,' is the gist of what the businesspeople think.

Informal sector more affected

Though almost all the big companies (formal sector organisations), with the exception of tourism related ones, say that they are able to record positive growth in their sales despite the ongoing situation, they also point out that the informal sector economic activities have reduced significantly. The major reason for this is, of course, the decline in the tourism business as most of the informal sector activities were dependent on tourism.

Sector-wise Situation

Consumer Durables: Was up during the first six months of the year, but down in February till early March. Now picking up again. People postponed purchases as their liquidity preference went up during political uncertainity.

FMCG: Doing better. Earlier, the goods could be sold only in the Kathmandu valley. But after February 1, sales have also increased elsewhere.

IT: Down. Purchase of IT hardware for domestic use (e.g. assembled computers) has gone down because of the higher liquidity preference of the people. As some donors have announced suspension of aid, the market for branded IT products has also gone down. Also the duty reduction announced in India from April for import of IT components has affected the business of Nepali traders who deal in IT components. Now it is cheaper to import those items through India . Most importantly, the IT education sector too has started facing a decline. The enrolment has gone down, both in private institutions and university-affiliated colleges, because many graduates from these institutions are now found unemployed.

Beer/Liquor: Growth, though the rate of growth has decelerated. A major chunk of the liquor sales is correlated with the development constructions. With the suspension of work in major construction projects, all the businesses dependent on such activities are facing decline. And most of these activities are in the informal sector, such as restaurants, which are dependent on tourism and development construction business.

Construction material: Doing all right. Reason, the construction business has not gone down much. The construction of new houses in the urban areas has increased significantly, compensating to some extent the decline in the development construction activities. Thus the cement factories (other than the government-owned ones), the paint factories and steel mills are doing all right though the increased transport cost (due to frequent blockades and other disturbances) have reduced the margin of these factories as they are not able to transfer such temporary cost increases on to the customers. Steel mills are suffering more as they completely depend on imported steel and the steel prices in the international market have been rising.

Healthcare/Medicines: Down. People from outside the Kathmandu valley are not coming to Kathmandu for healthcare purposes. Moreover, the tendency for self-medication is increasing. Therefore, the private sector healthcare centres are now directly competing with the government hospitals whereas in the past they were catering to totally different segments of the population and there was no direct competition between the two.

Exports

Ready-made Garments: Down, not only due to the lack of quota facility to export to US, the largest traditional market, but also because of the transport problems that makes it difficult to meet the delivery deadlines. However, exports to the EU and Canada have increased.

Carpets : Up. The contribution is from non-traditional markets, such as the US .

Handicrafts: Up. This indicates that the handicraft sector is not so much correlated with tourist arrival. Perhaps, the handicraft exporters have by now developed good relations with the importers so that the buyers do not have to personally inspect the goods before shipment.

Tourism: Down in all the sub-sectors, except airlines. Though the peace and security situation has improved, the negative connotation of the term "emergency" and the negative travel advisories by the governments of major tourism markets of Nepal have scared the tourists away.

Airlines are doing well. In the international sector, though the tourist component has gone down, the movement of Nepalis has increased very much. In the domestic sector, the airlines are getting more passengers because of the problems in travelling by road. However, they are experiencing a reduction in the number of passengers belonging to the segments of government officers, businesspeople, NGO workers and Indian tourists who otherwise fly via such places as Bhadrapur, Biratnagar, Bhairahawa, Birgunj, Nepalgunj etc. Similarly, airlines have reported a decline in business on tourist routes such as the mountain flights.

This sector (particularly the hotel and airline sub-sectors) is expecting some revival this summer, the season for the arrival of Indian tourists, as the Nepal Tourism Board (NTB) carried out some marketing efforts recently in this market. Moreover, the fare war between the airlines on the Kathmandu-Delhi sector has led to reduced fares; some are lower than domestic route fares, which will definitely help to increase the arrival of Indian tourists this season, it is expected.

Banking: Growth decelerated. Deposits have increased by about 12 percent during the first eight months this fiscal year as compared to about 18 percent in the same period last year. Loan realisation from hotels and other tourism sector is becoming difficult. Foreign banks have started asking for a 100 percent margin to accept letters of credit issued by Nepali banks.

Communication: Down. The FM stations have reported decline in revenue. Similar is the situation in the press (as can be seen from the reduced advertisement space and number of pages in the newspapers) and telecommunication (Nepal Telecom could not earn a single paisa from its mobile phone customers for two months beginning February 1). However, TV Channels contacted reported that their business has not declined significantly.

Retail: Down in the department stores.

Hope

Though abstaining from going ahead with their new projects because of the current situation, the business community has not lost all hope. Almost everyone contacted said that he/she is hopeful of improvement in the situation in the near future, probably in six months. If this positive outlook is encouraged by improving the regulatory regime (e.g. by reducing hassles that the businesses have to face in the government bureaucracy) and a couple of high profile new investment projects are started quickly, it may be able to start the upward spiral once again in investment, employment and business confidence.

One major suggestion in this regard, forwarded by the businesspeople, is the amendment in the Labour Law to make it investor-friendly. Second, the pressure by the banks to recover the loan from the businesses in trouble should be eased (particularly on tourism businesses) and the manufacturing businesses should be helped to tide over the current crisis which is causing inventory build up. Third, the tourism businesspeople reiterate that the national flag carrier RNAC should be strengthened and it should start direct flights to major tourist originating markets, such as Europe and the USA in addition to other Indian cities. As an entrepreneur with investment in a number of sectors put it, "February 1 promised some important results. Now the delivery on these promises should start at earnest and the earliest."

Expert Views

It seems that the business confidence is at a very low level. Sales have been going down, the remittances inflow has decelerated; business borrowers are failing to meet the repayment schedule, and the foreign banks have started asking for a 100 percent margin before accepting L/C from Nepali banks. In your opinion what is the state of the economy at present?

Dr. Bhola Chalise

From the background of your question, it appears that the economic scenario of the country is bleak. But it depends on how one looks at it: a half glass of water can be considered either half empty or half full. One of the major indicators of the health of the economy, government revenue, has not decreased but maintained a reasonable growth. The security situation of the country is not conducive for private sector investment but in spite of that, some smart entrepreneurs have found new ways of doing business. The rent seeking private sector people are complaining that the economic environment is not favourable for their unscrupulous activities. Yet the security situation has forced genuine entrepreneurs to be more innovative.

Dr. Dilli Raj Khanal

Officials claim that the GDP will grow by around 4 percent this year. This is completely misleading if the recent sharp deteriorating trends of the economy are any guide. The imports, which reflect the overall demand pattern of the economy in general and the consumers and investment demand in particular, is again decelerating after some pick-up last year which was a result of a big inflow of remittances. The decline in remittances is partly reflected by the level of imports. The prospects of exports are also very bleak. The garment industry has additionally been the cause for concern. The investment or business confidence is very weak because there is no hope of either improving security situation or of special incentives. The recent political developments adding political instability have increased uncertainty and risk, leading to further adverse environment to the investors. More worrying is that the security and other recurring expenses are now exceeding the internal revenue in the midst of added risk of foreign aid disruption. This means that the dependency on internal borrowing may go up with the likelihood of increased crowding out of private investment. Thus, the economy is bound to decelerate further with added danger of intensification of economic crisis with possibilities of further fuelling of social contradictions and conflict. The kind of situation that is observed in the agriculture sector also adds to such a possibility. The agriculture sector, which is the main source of people’s livelihood, is continuously suffering due to the almost stagnating trend in its productivity in the absence or declining of support services. The agriculture policy asymmetry between Nepal and India (which share an open border and practice free trading of primary products) is dampening the output prices of the agriculture products adversely affecting the farm income and causing additional disincentive to the Nepali producers. The fixed exchange rate policy has additionally worked adversely in this respect. Assuming that there is close link between the agriculture and the non-agriculture sector, the productivity stagnation causes adverse effect also on the non-agriculture sector. In the mean time, pressure on the prices is picking up after the two-time petroleum price hike as well as the three percentage increase in VAT.

Dr. Bhola Chalise, Former Secretary in HMG

This year’s growth rate is bound to remain in the range of three to 3.5 percent if the present trends persist. A macro model based policy simulation exercise carried out in our Institute of Policy Research and Development (examining the effect of exogenous as well as the policy based shocks vis-à-vis the role of countervailing means to nullify or reverse the effect of shocks) indicates that only the remittances income and foreign aid added by good monsoon are contributing to prevent the economic collapse or bring some recovery in the aftermath of the big economic slowdown of 2002. The analysis indicates that the macro-economic policy reforms carried out so far are far from adequate to nullify the shocks emanating from higher petroleum prices, bad weather conditions and political crisis. This means that the shocks originating from or aggravating due to the decline in remittances and reduction in foreign aid will be extremely costly and painful in the ongoing conflict situation. The other message derived is that policies or programmes recently pursued have not been reoriented or designed to nullify the negative effect of the shocks on various fronts of the economy. The income or employment policy also have not been evolved or reoriented in a way to mitigate mounting economic crisis.

Dr. Bijay KC

The state of economy at present is, definitely, not good. The export of major products has declined, remittances inflow has decreased, and production has declined. Donors’ commitment has been shaky. It is good that the ForEx reserve has not yet reached the alarming point but the question is how long this can be sustained given the present trend.

Dr. Yubaraj Khatiwada

Well, private sector business confidence was already been down in the last few years and this has now been aggravated with the recent escalation of strikes, blockades, and violence in the country. The manufacturing sector grew by less than three per cent last year and is expected to go even lower this year—prompted mainly by the slide in ready-made garments following the phase-out of quota facility to the US market.

Political instability, poor governance, conflict and deteriorating business confidence weaken the credit rating of a country. Although Nepal does not have a formal credit rating by any international credit rating institution, investors, lenders and dealers who intend to have investment, lending and business transactions with Nepal would definitely go for their internal ratings. And, when the key rating parameters show a deterioration, the risk of doing business rises; and then it is usual for them to ask for more premium in the business transactions they do with Nepal . A rise in risk premium eventually raises letter of credit, guarantee, and underwriting fees; reinsurance premium, and interest rates. This is what I see happening here in the recent times.

The decline in remittance, as also observed in official statistics, is difficult to conceive, particularly when workers going abroad for work is ever increasing. There must be two reasons; either workers are deferring to send money for security reason or the official statistics is not covering the inflow properly. However, this should not be a major problem so far as people are getting more jobs abroad.

As usual, the announcement of emergency sends a negative message to tourists visiting Nepal , and tourism related industries suffer from low capacity utilisation, low income and hence erode capacity to repay bank loan even if they are willing to. For manufacturing industries, the constraints to domestic movement of goods are posing inventory build up; and production cuts are eminent. This has eventually eroded their loan repayment capacity.

There are, however, silver linings. Households are doing well, as agricultural income is growing by three per cent on average. This, along with high remittance (although not increasing recently), has been instrumental in maintaining household demand on track and thus backstopping the economy. The economy has become resilient to irritants coming from conflict and is moving along a positive growth path.

The stock exchange is showing a rapid increase in the market index, which gives an impression that the investors’ confidence is in fact improving. Do you think the recent developments in the stock exchange truly represent the investor confidence?

Dr. Chalise

The government operates Nepali stock exchange hence it doesn’t reflect the market. The surge in the stock market has been created by the surplus liquidity in the private sector and the falling interest rate.

Dr. Khanal

Not at all. At first, it has to be recognised that Nepal ’s stock exchange is very tiny and underdeveloped. The number of listed companies is small and also the structure is such that it is predominated by the banking and finance sector companies. At present, people are diverting their money mostly toward buying the share of banking and financial institutions in the absence of other options or risk in other areas. That is the reason why the index has increased. But once the banks face problems in extending loan even in non-productive areas (real estate and consumer loans), this will lead to reduced profitability in banks and thereby adverse effect on the share prices. Therefore, unless there is better investment environment in the productive areas with an improved security situation, the present growth in the stock market cannot be expected to sustain.

Dr. KC

Not quite. With the hope that peace will be resorted and stock market will boom, investors were attracted to stocks to reap the benefits of the rising price rather than a long-term investment.

Dr. Khatiwada

The stock market behaviour in Nepal has been less governed by economic and corporate fundamentals and more by the market sentiments and behaviours of a few actors. I do not think that the recent rise in the share price is based on investor confidence. Rather, declining interest rates on bank deposits, disincentive to make new investment, and risk associated with real estate business should have propelled the stock prices.

There is a growing fear of capital flight in the recent months. How is your reading? What are the methods available for taking out capital from Nepal at present?

Dr. Chalise

It is natural that capital flows towards the area of better security. With the development of e-business, no government in the world will be able to stop capital flight. The government measures to control capital flight will only fuel corruption in the banking transactions and thus will cost people more to transfer the capital elsewhere.

Dr. Khanal

In my assessment, capital flight has not taken place in a big scale so far. But if the situation further worsens, as revealed by the trend, there is a big danger ahead. Particularly, given the free convertibility of Nepali and Indian rupees accompanied by increased investment attraction in India in recent years, such a possibility has increased. There is a closer nexus between industrial and business houses of these two countries. The income tax differences between the two countries have now become very wide and there is more a liberalised and friendly investment environment in India while there is conflict situation going on in Nepal and political instability is more pronounced. This signals to possible capital flight in the near future. The informal channel can easily be used for capital flight from Nepal .

Dr. KC

This is quite understandable. Investors need to invest. They cannot follow the ‘Wait and See’ policy in the long-term. Things must improve, otherwise we will have to face even more grave consequences.

Dr. Khatiwada

Dr. Yuvraj Khatiwada, Member, National Planning Commission

The Nepali rupee enjoys free and unlimited convertibility with respect to the Indian rupee. But in respect to convertible currencies, there is capital control. Besides, it is an open secret that there exists parallel market for convertible currencies, and often times even for Indian currency so far as the exchange of high denomination currency notes is concerned. So, had there been capital flight, the premium in the Hundi market must have gone up. Similarly, there should have been a drain of Indian currency in the formal banking channel. Looking at the premium at the parallel market for foreign exchange, which at times of heavy foreign exchange demand used to be even more than 10 per cent, the Hundi rate at present is reported to be at par with the official rate, or even lower. Also not much buying pressure is reported in this market. This denies the flight of capital in convertible foreign exchange. The other channels of capital flight are under-invoicing of exports and over-invoicing of imports, which do not seem to be the case in the recent years. Rather there have been cases of under-invoicing of imports.

Yes, there has been a drain in the Indian currency reserves in the recent years, more so when Nepal started paying Indian currency for the payment of oil imports through India . Besides, the informal sources of Indian currency earning have been vanishing with drastic reduction in the border trade (exports) of third-country imported goods. When imports are re-concentrating towards India at a time of no significant increase in exports earnings following sluggish merchandise exports and decreasing tourist arrival, it is understandable that Indian currency reserves are under heavy pressure. Thus, this does not necessarily signal capital flight to India . Had there been more capital flight through the exchange facility in the informal market for Indian currency, which is perhaps much significant than the formal market, there should have been heavy withdrawal of bank deposits. Again as this does not appear at present, no visible evidence can be cited for capital flight.

What should be the right policy mixture at this juncture for Nepal to revive the business confidence and turn the economy around ?

Dr. Chalise

The restoration of peace and reestablishment of multiparty democratic polity is the only step to create confidence in the private sector. First of all, the government should do away with its discretionary power over the economic and sectoral policies, which affect the private sector’s investment decisions. The government should stop distributing taxpayers’ money under the name of helping the sick industries and ordering the banks to reschedule loans on the pretext of the security situation in the country. It should privatise the stock exchange, amend the Company Act and introduce Insolvency Act, Secured Transaction Act and Competition Act.

Dr. Khanal

Without the restoration of political stability through consensus building processes among main political forces and actors followed by an initiation of peace through dialogue, there is no hope of restoring business confidence and reviving the economy. At the same time, it is essential to reorient policies and improve economic governance focusing on alternatives that could work as countervailing means to minimise the shocks adversely affecting trade and industry. This means that in a given abnormal situation some specific abnormal safeguarding measures will be necessary. In Nepal , the increased vulnerability of losers or cost bearers of reforms is never considered. Steps are taken abruptly without consultations with the stakeholders. This encourages confrontations or distributional conflict. Thus the half-hearted economic revival initiatives, if any, made in isolation are jeopardised. Therefore, a new mechanism of policy co-ordination involving concerned stakeholders has to be evolved and implemented with boldness. This means, instead of isolationist or partial approach followed so far, a comprehensive policy package linking with economic governance is required. This should be done by following, unlike in the past, a broad-based approach that brings agriculture, trade, industry and some important services in the orbit of reform especially designed for conflict prone situation.

Dr. KC

Quick decision making, simple and less cumbersome business procedures, fair dealings, transparency and clear-cut policies of the government can revive business confidence. The foremost is to have a peaceful environment in which one can do business with confidence.

Dr. Khatiwada

Peace building and political stability are preconditions for building business confidence. Safeguarding basic civil rights, in particular property rights, ensuring independent judiciary, and creating a sound macro-economic policy environment are important to promote private capital. There should be predictability of economic policies and guarantee of non-reversal of credible policies. When conflict prolongs with intensified violence, no economic policies—however credible they may be—would not be able to turn the economy around. There are some monetary and fiscal issues which might need correction for the same. But after all, it is the political environment and the state of emergency which prevail over others.