Handbook on the South Asian Economies

HANDBOOK ON THE SOUTH ASIAN ECONOMIES

Handbook on the South Asian Economies

Edited by

Anis Chowdhury University of Western Sydney, Australia

Wahiduddin Mahmud University of Dhaka, Bangladesh

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Anis Chowdhury and Wahiduddin Mahmud 2008 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2008924974

ISBN 978 1 84376 988 0 Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall

Contents vi ix

List of contributors Preface

1. 2. 3. 4. 5. 6. 7.

Introduction: South Asian economic development: impressive achievements but continuing challenges Wahiduddin Mahmud and Anis Chowdhury India S. Mahendra Dev Pakistan Parvez Hasan Bangladesh Wahiduddin Mahmud Sri Lanka Saman Kelegama Nepal S.R. Osmani and B.B. Bajracharya Bhutan S.R. Osmani, S. Tenzing and T. Wangyal The Maldives Mamta Chowdhury

1 25 63 93 125 157 190 221

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Contributors Bhuban Bajracharya was a Professor at the Center for Economic Development and Administration, Kathmandu, Nepal. He has worked in the fields of planning, poverty analysis, economic and sectoral policy analysis, fiscal policy analysis, monitoring and evaluation and socioeconomic analysis. He has recently worked as the Team Leader for the Technical Review of School Education, an exercise in the monitoring of financial and sector-wise progress in the school education sub-sector in Nepal. He has served the National Planning Commission and Ministry of Finance of the Government of Nepal as Senior Adviser and was involved in developing the Poverty Reduction Strategy Paper of the country. Anis Chowdhury is Professor of Economics at the University of Western Sydney (Australia) and Founder Co-editor of the Journal of the Asia Pacific Economy. He obtained his PhD from the University of Manitoba, Canada. He has taught at the University of Manitoba, National University of Singapore and the University of New England (Australia). He has published extensively on East and Southeast Asian economies and has been a consultant to UNDP and ILO. He was a visiting Fellow at UNU-WIDER, Reserve Bank of San Francisco and the Institute of Southeast Asian Studies (Singapore). Mamta Chowdhury obtained her PhD from the Australian National University. Currently, she is a Senior Lecturer in the School of Economics and Finance, University of Western Sydney. Her research interests are development economics, macroeconomic policy management and environmental economics. Her research monograph, Resources Booms and Macroeconomic Adjustments in Developing Countries was published in 2004 by Ashgate. She is currently working on growth in Indian economy and its impacts on smaller South Asian Association for Regional Cooperation (SAARC) countries and economic reforms in SAARC countries. S. Mahendra Dev is currently Director of the Centre for Economic and Social Studies, Hyderabad, India. He has written extensively on agricultural development, poverty and public policy, food security, employment guarantee schemes, social security, farm and nonfarm employment. He has more than 80 research publications in national and international journals. His recent books include, Inclusive Growth: Agriculture, Poverty, Human Development and Regional Disparities (Oxford University Press). His co-edited books include Social and Economic Security in India (Institute for Human Development), Towards A Food Secure India: Issues and Policies (Institute for Human Development and Centre for Economic and Social Studies), Andhra Pradesh Development: Economic Reforms and Challenges Ahead (Centre for Economic and Social Studies) and Rural Poverty in India: Incidence, Issues and Policies (Indira Gandhi Institute of Development Research). He has been a consultant to many international organizations like the UNDP, World Bank, International Food Policy Research Institute and ESCAP. He has been a member of several government committees including the Prime Minister’s Task Force on Employment. vi

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Parvez Hasan obtained a PhD from Yale University and is a freelance economist with very broad national and international experience. He served as an economic adviser in central banks of Pakistan and Saudi Arabia (1960–65), as a planner and development administrator with the Government of Pakistan (1965–70) and as an international civil servant with the World Bank (1970–96). His publications include: Korea: Problems and Issues in a Rapidly Growing Economy (Johns Hopkins University Press), Korea: Policy Issues for Long-term Development (Johns Hopkins University Press, co-author), Malaysia: Growth and Equity in a Multiracial Society (Johns Hopkins University Press, co-author), Pakistan’s Economy at the Crossroads: Past Policies and Present Imperatives (Oxford University Press). Saman Kelegama is the Executive Director of the Institute of Policy Studies of Sri Lanka. He received his Doctorate (DPhil) in Economics from the University of Oxford, UK and Masters in Mathematics from the Indian Institute of Technology in Kanpur, India. He serves (and has served) as a Governing Board Director in an advisory capacity in a number of government institutions. He is a Fellow of the National Academy of Sciences of Sri Lanka and was the President of the Sri Lanka Economic Association during 1999–2003. He has published extensively on Sri Lankan economic issues in both local and international journals. His latest books are: Economic Policy in Sri Lanka: Issues and Debates (Sage Publications, co-author), Ready-made Garment Industry in Sri Lanka: Facing the Global Challenge (IPS Publications, editor), and South Asia After the Quota System: The Impact of the MFA Phase-Out (IPS & FES Publications, editor). He is the co-editor of the South Asia Economic Journal (Sage Publications). Wahiduddin Mahmud obtained his PhD from the University of Cambridge and is currently Professor of Economics at the University of Dhaka. He has held teaching and research appointments at Cambridge, IDS at Sussex, IFPRI and the World Bank. He is a founder and Chairman of PKSF, an apex institution in Bangladesh for funding microcredit programmes of non-government organizations. His recent books include Popular Economics: Unpopular Essays, Growth and Poverty: The Development Experience of Bangladesh and an edited volume for the International Economic Association titled Adjustment and Beyond: the Reform Experience in South Asia. Siddiqur Rahman Osmani is Professor of Development Economics at the University of Ulster, United Kingdom. He obtained a PhD in Economics from the London School of Economics and then worked at the Bangladesh Institute of Development Studies, Dhaka and at the World Institute for Development Economics Research, Helsinki before joining the University of Ulster. He has published widely on issues related to poverty, inequality, hunger, famine, nutrition, rights-based approach to development, and development problems in general, and his books include Economic Inequality and Group Welfare, and Nutrition and Poverty. Sonam Tenzing is a socioeconomist with Excel Consulting, a Thimphu-based firm, Bhutan. He studied in Mount Hermon School, Darjeeling (India), Sherubtse College, Bhutan and Otaru University in Japan. Currently, he is working with the Planning Commission Secretariat on the Tenth Five-Year Plan for Bhutan.

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Tashi Wangyal is a freelance consultant specializing in economic development and trade policy issues. He received his education in Punakha High School in Bhutan, Trent University in Canada and Cambridge University in the United Kingdom. From 2000–05, he worked as an economist in the Ministry of Finance and as research analyst at the Ministry of Foreign Affairs. At present he is also a member of the Advisory Committee to the Planning Commission and the Negotiation Team for Bhutan’s Accession to the WTO.

Preface South Asia is home to nearly one-quarter of the world population. The region’s cultural diversity, rich history, social and economic developments have always fascinated thinkers, from Adam Smith to Karl Marx, to Nobel Laureate Gunnar Myrdal, who titled his famous magnum opus on the region, Asian Drama (1968). South Asia provided a rich testing ground for development practitioners, and leading paradigms in development economics can be traced back to the region. For a while, though, there was a loss of interest in South Asia with the ascendency of East and Southeast Asia. Since the 1990s, the focus of development economists has begun to shift back to the region, with the region poised to take off, following economic reforms. However, as always, the region’s experience is diverse; the challenges of and responses by different countries of the region are varied. Even when they faced the same challenge, their responses were not the same. Thus, the efforts to understand the complex development experience of the region have spawned a large amount of literature. This volume is a collection of chapters on economic and social development in South Asia. The analytical narratives on the economic transformation of South Asian economies are based on the wide-ranging extant literature, and highlight the interactions of sociopolitical factors as they impact on development outcomes. In particular, they examine the role of economic policies that were influenced by historical and political circumstances of the time. Each chapter, written by country experts, begins with a brief discussion of the political history of the country and ends with a discussion of future prospects and challenges. The introductory chapter by the editors attempts to provide a comprehensive survey of South Asian economic development, highlighting the economic policy reforms, their outcomes and their political economy contexts. It seeks to understand the drivers of accelerated economic growth in South Asia – such as India’s high-tech software exports – and the various pathways to social development, such as those followed by Sri Lanka and the Indian state of Kerala and, more recently, by Bangladesh. It wonders whether, in spite of the diversity of experiences of South Asian countries, there is a unique South Asian development model. And if so, what are its salient features? Do the varying experiences of economic reforms across South Asian countries, with their distinctive socioeconomic settings, governance environment, and public cultures, provide fresh perspectives on the emerging development paradigms? Four decades ago, after completing the three-volume Asian Drama, Gunnar Myrdal ‘frankly’ confessed ‘that I have found my task much more difficult than I expected’.1 We must admit, we have the same feeling. Since then, the literature has grown much more and there are more contesting hypotheses. However, like Myrdal, we were not without friends and colleagues who provided generous feedback and materials. Among them are T.N. Srinivasan (Yale University), Shantaganan Devarajan (World Bank), Sadiq Ahmed (World Bank) and Iyanatul Islam (Griffith University), to name a few. We are extremely grateful to them. We also acknowledge the support of our families. Finally, though, we ix

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drew inspiration from the resilience of the quarter of the humanity who toil everyday to better their lives under the trying conditions of South Asia. We dedicate this volume to them. Note 1. Asian Drama (1968), New York: Pantheon (Random House), p. x.

Introduction: South Asian economic development: impressive achievements but continuing challenges Wahiduddin Mahmud and Anis Chowdhury

Setting the context South Asia comprises Bangladesh, Bhutan, India, the Maldives, Nepal, Pakistan, and Sri Lanka and is home to almost 1.5 billion people, nearly a third of them very poor, having less than US$1 (in purchasing power parity terms) a day to consume.1 Only Sri Lanka and the Maldives belong to the category of ‘low-middle’-income countries as defined by the World Bank; the rest are all low-income countries. Not least because of its large population size, South Asia has more poor people than any other region in the world. South Asia also holds the key to a significant reduction of global poverty. The region has been next only to East Asia in its economic growth performance since the beginning of the 1980s. Its average annual growth rate of real GDP at 5.6 per cent in the 1980s and 5.5 per cent during 1990–2001 exceeded that of low-income countries, at 4.5 per cent and 3.4 per cent respectively, during the same periods.2 More recent growth performance in some of the economies of the region, especially India, is even more promising. The success of the Four Little Dragons (Hong Kong, Singapore, South Korea and Taiwan) in East Asia is now said to be followed by that of the Two Giants – China and India – which together are now leading the ascendancy of Asia in the global stage (Radelet and Sachs, 1997). However, whether the economic fundamentals in the South Asian countries have changed enough to put them on a higher growth trajectory matching that of their East Asian counterparts still remains doubtful. South Asia’s economic performance is all the more impressive and may have come as a surprise, since the countries in the subcontinent are alleged to suffer in varying degrees from many growth-retarding factors, such as corruption, conflict, high fiscal deficits, poor infrastructure and an overall adverse investment environment (Devarajan, 2005). Under similar adverse conditions, economies in other regions, especially in Sub-Saharan Africa, have done far worse. Moreover, unlike in other regions, economic development has been widely shared among the countries in South Asia.3 This raises the question regarding whether the South Asian economic model has some unique inherent strength and resilience, or whether such a distinct model can be identified in the first place. In spite of diverse sociopolitical cultures, there are important commonalities in development experience among the countries of the region. While a shared colonial legacy influenced the attitudes towards development thinking in the early years after independence, many institutional structures inherited from the colonial period still continue to exist. Despite apparently contrasting patterns of political development – such as democracy in India and authoritarianism in Pakistan – the social structures and political processes in South Asia can hardly be distinguished by the existing state boundaries; across the subcontinent, these are shaped in varying degrees by such factors as language, religion, ethnicity, class and caste (Jalal, 1995). Looking at the development experience of 1

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not only the individual countries, but also regions within the countries, can thus throw light on how responses to economic policies can vary under a variety of sociocultural settings. At the same time, examining the South Asian development experience as a whole can also be useful, particularly in revisiting some of the prevailing development paradigms, encompassing the role of history, culture, geography, politics and economic policies in determining development outcomes. The development strategies and the subsequent policy shifts have been more or less similar in the major economies of the region. Compared with their East Asian counterparts, these countries pursued inward-looking policies with tight controls on foreign trade and an emphasis on import-substituting industrialization for a longer period. The state ownership was extensive, covering many manufacturing and service enterprises. Banks and other financial institutions were either publicly owned or tightly controlled and the government also intervened in the commodity markets, particularly those for agricultural inputs and outputs. Interestingly, the South Asian policy-makers tended either to dismiss the East Asian economic success as irrelevant for drawing any policy lessons applicable to their countries or attribute it to idiosyncratic features of East Asia. However, once the rapid growth of China became evident by the late 1980s following the opening up of its economy, it clearly indicated to South Asian policy-makers that there was something amiss in their development strategy and that economic reforms had to be undertaken. Systematic reforms towards economic liberalization gathered momentum in the region only in the 1990s, except in Sri Lanka, where such reforms were started in 1977. The basic thrusts of the reform process in all the countries of the region were similar, in line with the so-called ‘Washington Consensus’ as advocated by the IMF and the World Bank, though the relative emphasis on components of the reform agenda naturally differed. These reforms, which have generally followed a gradualist approach, are regarded as still incomplete, but there are ongoing debates about how to proceed further with the reforms. It may be true that South Asia’s overall record of economic performance has been impressive following the reforms, but without a closer look at the drivers of economic growth, it would be unwise to attribute the improvements entirely to reforms.4 South Asia’s experience with market-oriented liberalizing reforms may indeed be useful in informing the ongoing debates surrounding the ‘Washington Consensus’. The Consensus, which grew out of the experience of the so-called structural adjustment policies of the late 1980s, emphasized fiscal discipline, deregulation and privatization, openness to trade, market-determined exchange and interest rates, protection of property rights and redirection of public spending towards social sectors.5 The Consensus has subsequently undergone many modifications as its initial formulation was found deficient in several important respects as a development framework (Stiglitz, 2004). The problem is less what the Consensus contains than what it leaves out – the issues of governance and institutions, the role of empowerment and social mobilization, the need for giving more attention to poverty reduction, the costs and pace of transformation and an appropriate state–market mix based on the context–specific evidence on what works and what does not. Much of the debates regarding the effectiveness of economic reforms have to do with the above dimensions of economic development that vary from one region to another. That is why looking at the outcomes of economic reforms in South Asia’s specific circumstances may be particularly rewarding.

Introduction

3

Growth performance: robust and promising? The overall growth of GDP per capita of South Asia was 1.9 per cent annually during the 1960s and declined to 0.6 per cent in the 1970s (coinciding with the first oil shock); then it accelerated to 3.3 per cent in the 1980s and 3.4 per cent during 1990–2003.6 These accelerated growth rates of the later periods still lagged far behind those of East Asia, but represented a superior growth performance compared with other developing regions. The contrast is most striking with Sub-Saharan Africa, which experienced decline or stagnation in per capita GNP during the 1980s and 1990s. India has led South Asia’s growth acceleration since the beginning of the 1980s, not only because of its size (80 per cent of the region’s GDP and of the total population) but also because of its superior growth performance. Its GDP growth in the most recent years (three years up to the fiscal year 2005/06) has averaged about 8 per cent annually, and even conservative analysts put the country’s current ‘trend’ annual GDP growth to be at least 6 per cent – the rate it has achieved since 1991. The growth acceleration in India had started even earlier, with the growth rate of GDP averaging 5.5 per cent per year in the 1980s, compared with the infamous ‘Hindu rate of growth’ of about 3.5 per cent per year during the three previous decades. In spite of India’s leading role, economic growth has been broadly based among the South Asian economies. In terms of long-term growth, Sri Lanka has performed best, and Nepal worst, but even Nepal’s per capita GDP growth at an average of 1.8 per cent per annum over the decades of the 1970s, 1980s and 1990s represents significant progress.7 In the recent years, the growth performance of the economies has withstood many adverse factors – natural disasters, internal conflict and external economic shocks – and this speaks to the resilience and robustness of the growth that has been taking place (Devarajan, 2005).8 This overall assessment of the region’s growth performance should not, however, detract attention from important variations across the countries and over time within countries. For example, Pakistan’s annual GDP growth rate declined significantly from 6.3 per cent in the 1980s to 3.6 per cent during 1990–2001, but there has been a recent turnaround with an average growth rate near 6 per cent. India’s impressive growth performance in the 1990s hides the fact that the economy grew at an impressive 6.7 per cent in the first five years after the reforms and then it slowed down to 5.4 per cent in the next five years. Sri Lanka’s average annual growth rate accelerated from 4 per cent in the 1980s to 6 per cent in the 1990s, but then declined to less than 5 per cent in the following fiveyear period. Nepal’s GDP growth rate in the 1990s was the same as in the 1980s; there was a significant acceleration in manufacturing growth, which was offset by a decline in agricultural growth. Among the major South Asian countries, only Bangladesh has had a steady increase in the average growth rate over the successive five-year periods, from 3.7 per cent in the first half of the 1980s to 5.5 per cent during 2001–05. Because of these uneven trends, it is not easy to relate economic performance to the reforms. There are the usual controversies regarding the effect of extraneous factors (the problem of the counterfactual) and also regarding the short-run and long-run effects of reforms, given the uncertain time-lags between reforms and their outcomes (Nayyar, 2001). The changes in the political regimes, with the associated changes in the governance environment, are also likely to have affected both the implementation of reforms and their effectiveness. It is also possible that some aspects of the reforms have propelled growth by

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removing the binding constraints at certain times, and not at other times. Critics of reforms have often blamed the slowdowns or lack of acceleration in growth on the ineffectiveness of such reforms, while the opposite view is that it is the failure to implement the reforms fast enough that resulted in less-than-expected outcomes. The latter view, in turn, is derived from South Asia’s gradualist approach to reforms, which has meant a slow pace of implementation.9 Pakistan’s growth failure in the 1990s is often attributed to the dysfunctional and corruption-ridden democratic system of that time that resulted in weak governance and financial indiscipline. In contrast, Bangladesh’s improved growth performance during the same period took place in spite of weak democratic governance. India’s growth accelerated in the 1980s when there was only a hesitant and piecemeal attempt towards economic liberalization. It may, however, be argued that this growth acceleration was in part due to the soaring public sector deficits financed by both domestic and external borrowings that were unsustainable (Srinivasan, 2000).10 Another plausible hypothesis is that, in a highly controlled economy such as was India, even a piecemeal approach of doing away with the more irksome controls can unleash considerable growth momentum. India’s growth in manufacturing actually declined in the post-reform period after having peaked during the 1980s.11 However, this decline was compensated by acceleration in the growth of the tertiary sector. Another contentious issue regarding the effectiveness of reforms in India is the growth slowdown during the late 1990s. One explanation is that the country’s investment climate turned poor after perking up during the initial years of the reform. If so, uneven outcomes from reforms may be explained in part by the variability of investor mood – or the so-called ‘desire-to-invest’ factors – that have assumed greater importance in the post-reform period because of the redefining of the role of public investment. External economic factors like the East Asian financial crisis in the late 1990s and the global economic recession around 2000 and 2001 are also alleged to have had an adverse impact on the region’s growth performance. The smaller and more export-dependent economies such as Sri Lanka and Bangladesh are likely to have been affected by the global recession to a greater extent than the less open and larger economies such as India and Pakistan. In any case, the decline in growth in India in the late 1990s preceded the onset of the global recession and Pakistan’s poor performance was of even longer duration. South Asia’s economic growth has passed through different phases, with growth impulses coming from varying sources. Both in India and Pakistan, the Green Revolution farm technology provided the early growth impetus. The rapid growth in agricultural production, combined with import-substituting industrialization, made the 1960s the period of most rapid growth in GDP in Pakistan’s entire history.12 India’s Green Revolution led to a period of rural-led development in the 1970s and 1980s, with the Green Revolution state of Punjab becoming the country’s fastest-growing and richest state. However, since the 1980s, and especially since the 1990s, urban-based manufacturing and services have led the way. An important part of this shift in the drivers of growth is the phenomenal rise of the IT-based industries. India’s ability to take advantage of the new possibilities in high-tech information services largely resulted from its long-standing investments in higher education, especially in the Indian Institutes of Technology.13 Bangladesh has over the years made the transition from being primarily a juteexporting country to a garment-exporting one. This transition has been dictated by the

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country’s resource endowment, characterized by extreme land scarcity and abundant labour, which makes economic growth dependent on the export of labour-intensive manufactures. In both Bangladesh and Nepal, rapid growth in remittances of migrant workers since the 1990s has had a significant impact on economic growth and poverty reduction. In spite of the structural transformation that has been taking place in the South Asian economies, their manufacturing base still remains narrow and undiversified, especially relative to their counterparts in the Pacific Rim. Only India’s recent manufacturing trends seem to be powerful enough to spread into relatively high-tech industries such as electronics, pharmaceuticals and automotive components. Agricultural growth declined across most of South Asia in the 1990s, which is blamed by some authors on the fact that agricultural markets have been kept out of reforms, as in India and Sri Lanka.14 In other countries, where reforms towards privatization and deregulation have included the agricultural sector, as in Bangladesh and Nepal, there are concerns about how to redefine the government’s role in providing support for agriculture in a liberalized market-oriented environment.15 Another common feature among these economies, including India, is that the share of manufacturing in GDP has not increased much over the years; instead, the decline in the share of agriculture has been largely offset by the increased share of the tertiary sector. This, again, is in contrast to the experience of the East Asian economies. Poverty reduction despite increasing inequality South Asia has achieved significant poverty reduction since the 1980s, but not as fast as in East Asia. During this time, Sub-Saharan Africa has in fact seen a rise in its poverty incidence, which is now higher than that of South Asia – a reversal of its initial position.16 The pattern of changes in poverty across the regions thus broadly reflects the pattern of growth in per capita income. More progress against poverty would have been made in South Asia had income distribution not worsened in both rural and urban areas. There is also increasing regional and rural–urban disparities. The national level estimates show that income inequality, as measured by Gini coefficient of the distribution of household consumption, has worsened in all the major South Asian countries, particularly since the 1990s.17 Although this inequality is not still high by the standards of developing countries, its worsening trends have compromised in varying degrees the impact of economic growth on poverty reduction across the countries of the region. Poverty is not just endemic, but increasingly concentrated in particular lagging regions (Devarajan and Nabi, 2006). Not only are these regions poorer, but their growth rates are substantially slower than the better-off regions. The difference in regional development outcomes is exemplified by the discussion about the ‘two Indias’, one inexorably falling behind the other. Estimates for 2002–03 show that per capita GDP in the poorest seven states (accounting for 55 per cent of the population) was nearly half of that in the richest seven states (with 33 per cent of the population). In the two largest and poorest northern states of India, Bihar and Uttar Pradesh (accounting for 25 per cent of the country’s population), per capita GDP was less than half the national average and only a third of the richest states. Furthermore, in terms of GDP growth, the richer southern states like Andhra Pradesh, Karnataka and Tamil Nadu are galloping ahead of the poorest but populous northern states, thus threatening to increase the already existing poverty gap between the two regions. There is also evidence that interstate inequality has been increasing more

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rapidly since the 1990s, as many low-income states saw a fall in their GDP growth compared with the 1980s.18 Regional disparity in income and poverty is not peculiar to a large country like India. For example, most of Sri Lanka’s economic growth has been concentrated in the Western Province led by Colombo. As a result, this province, accounting for 30 per cent of the country’s population, has increased its share of national GDP from 40 to 47 per cent over the past decade. Even within sub-regions, there is significant inequality. In Pakistan’s Punjab province, central and northern districts are much better off than the southern districts. With higher educational standards and better infrastructure, the better-off districts can attract more investment and can thus grow more rapidly. Despite increasing inequality, the trends in the national headcount estimates of poverty incidence in the South Asian countries show the positive impact of economic growth on poverty reduction. There are, of course, considerable controversies surrounding these poverty estimates, arising from data problems and the sensitivity of the estimates to the particular ‘poverty line’ used.19 The national poverty estimates are also not comparable across countries, or in some cases even within countries over time. In India, the data on poverty based on household expenditure surveys show that until 1977–78, the proportion of the poor in the population had fluctuated around 50 per cent with no downward trend, but with the acceleration in the growth of per capita GDP during the 1980s and 1990s, poverty declined to nearly 25 per cent in 2000. There is, however, a great deal of controversy regarding the extent of decline in rural poverty in the post-reform period of 1993–2000, the estimates ranging between ten and three percentage points (Deaton and Dreze, 2002; Sen and Himanshu, 2004). In Pakistan, the poverty ratio fell from around 45 per cent in 1985–86 to 30 per cent in 1995–96, only to rise to around 32 per cent in 1999–2000. Clearly, the steep decline in GDP growth in the late 1990s contributed to the reversal of the earlier favourable poverty trends. In Bangladesh, the poverty ratio declined by about one percentage point a year during the 1990s – a period when GDP growth accelerated with increasing inequality – but more recent data suggest that there has been no further deterioration of income distribution and that the poverty proportion has declined by two percentage points annually between 2000 and 2005.20 Nepal has also experienced a rapid fall in poverty during 1995–96 and 2003–04 (the period for which reliable poverty data are available), especially in the urban areas.21 Moreover, Nepal’s experience provides an exception to the unequalizing pattern of poverty reduction: the fastest reduction in poverty was observed in the region with the highest incidence of poverty to start with (the Far Western Region), and the slowest reduction was observed in the region with least poverty in 1995–96 (the Central Region).22 Sri Lanka provides an example of the growth–poverty link being seriously affected by increasing inequality. The country not only has the most unequal income distribution in South Asia as measured by the Gini coefficient, but also has experienced the sharpest rise in inequality in the 1990s. This explains why the country has seen such anaemic and uneven poverty reduction despite a relatively high growth in per capita income. While urban poverty fell by half in the 1990s, rural poverty fell by only five percentage points, and poverty in the estates rose by 50 per cent.23 To understand the dynamics of poverty and inequality, one needs to look at the quality and pattern of economic growth. South Asia is renowned for its Green Revolution of the 1970s and 1980s that led to improved food security and a decline in rural poverty. Famines

Introduction

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in South Asia are a phenomenon of the past. India has achieved not only self-sufficiency in food grains, but has also become a grain-exporting nation. Despite these achievements, poverty in South Asia is still largely a rural phenomenon with about 70 per cent of the population and 75 per cent of the poor living in rural areas. While there is untapped potential for strengthening and diversifying the agricultural and rural economy, agricultural growth has slowed in recent years.24 The multitude of small farmers remain specially disadvantaged, particularly in terms of access to credit needed to pay for more expensive hybrid and genetically modified seeds and to meet the costs of producing high-value crops. Extreme inequality in land distribution, such as in Pakistan and Nepal, also aggravates rural poverty. Attempts at land reforms in terms of land ceilings and redistribution have been largely ineffective. Moreover, the poverty situation is accentuated by the social systems of castes and ethnicity that affect household economic opportunities in many parts of the subcontinent. The vast informal and rural non-farm sectors, where the poor predominate, have also not had much attention in the policy reforms. Studies have shown that the development of small-scale enterprises provides potential paths out of poverty through the creation of productive employment opportunities.25 For example, while Indian large-scale manufacturing seems to be booming at the moment, it alone is unlikely to create enough jobs to lift India out of poverty. Moreover, even within the organized manufacturing sector in India, the pattern of growth in the post-liberalization period seems to have contributed to increased inequality. Studies based on enterprise-level data suggest that liberalization has benefited those parts of the manufacturing sector that were already more technologically advanced and were located in the states with more business-friendly environments (Aghion et al., 2004). The growth–inequality link in South Asia raises the spectre of the Kuznets hypothesis, according to which inequality increases to a point at the initial stage of economic development before it starts to improve. The logic of the hypothesis is simple: because of urban–rural disparity, urbanization initially leads to higher income inequality, which is eventually gradually lowered as the size of the urban population becomes predominant. Although the general validity of the Kuznets process has not been borne out by crosscountry experience (Anand and Kanbur, 1993; Ravallion and Chen, 1997), this does not negate its relevance in particular country situations. For example, the increase in inequality in Nepal during 1995–96 to 2003–04 can be explained almost entirely by the growth of urbanization, with no deterioration of inequality within rural and urban areas.26 Bangladesh’s recent levelling off of the inequality trends may also seem like a Kuznetzian ‘turning point’, although the underlying factors are perhaps of a different kind. The pattern of growth in Bangladesh would appear to have been fairly pro-poor – with the main stimulus to economic growth coming from labour-intensive garment exports, micro- and small-scale enterprises in manufacturing and services, and remittances from migrant workers. All these sectors typically provide scope for upward economic mobility for the poor. Even then, inequality tended to increase because the parts of the economy experiencing higher growth happened to be the ones with relatively unequal income – such as the dynamic part of the rural non-farm sector vis-à-vis agriculture – and also because growth, though employment-intensive, was not strong enough to pull wages in the vast agricultural and informal labour markets. These wages have shown strong upward trends only since the end of the 1990s, thus heralding a turning point in the income–inequality link.27

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Social development: varying outcomes and alternative pathways South Asia has made considerable progress in key areas of human development. However, as in the case of economic growth and poverty reduction, the overall improvement in human development indicators hides large differences among countries and among regions within countries. While these indicators are expected to improve with growth in income levels, more remarkable are the observed deviations between performance in economic growth and human development, the examples of which are in plenty in South Asia. These deviations can be found both by comparing levels of incomes and other measures of social well-being at a given time and by comparing the extent of improvements over time. Sri Lanka is the well-known example of excelling in human development. For example, its success in reducing maternal mortality from 486 to 24 deaths per 100 000 births over the last four decades (from the mid-60s) is one of the globally recognized health triumphs. Its other health and social indicators including literacy and longevity are equally remarkable for a country with its level of per capita income. The government has always actively promoted social development, which is reflected in the country’s historically high levels of public social spending. Sri Lanka currently spends about 5 per cent of its GDP on health and education (and used to spend even more in the 1960s and 1970s), which is comparable to that in East Asian countries and is higher than in other South Asian countries. Pakistan, which is clearly a laggard in key human development indicators, provides the opposite example of spending less than 3 per cent of GDP on social sectors, with other South Asian countries falling in between. Given Sri Lanka’s relatively high per capita income among the countries of the region, the disparity in absolute amount of per capita social spending is even much higher.28 In India, achievements in human development are impressive only in a few southern states, particularly Kerala, that are neighbours of Sri Lanka. For the country as a whole, progress in human development indicators seems to have slowed in the 1990s. Moreover, the progress has been highly uneven among the states, largely depending on the extent of political commitment of the state governments. In states like Kerala, Tamil Nadu, Maharashtra, Haryana and Himachal Pradesh, a combination of state support and community awareness has resulted in improved human development outcomes, especially in primary education including gender parity. In contrast, in the laggard states like Bihar, Orissa and Uttar Pradesh, not only government commitment was lacking, but also weak social cohesion and low community involvement have persisted in reducing the effectiveness of public social spending. In both Bangladesh and Nepal, the progress in basic human development indicators in the 1990s has clearly outpaced the progress made by the bigger and richer countries of the region, Pakistan and India. Nepal’s achievements are remarkable, given its low economic growth and its geography that makes delivery of basic services in remote areas a major challenge. But unlike Bangladesh, Nepal’s human development indicators reflect an acute form of gender discrimination and severe ethnic and regional disparities. Bangladesh’s progress in human development has been so remarkable that it has been termed as one of South Asia’s ‘development surprises’.29 From being a laggard until the 1990s, Bangladesh now outperforms most Indian states and South Asia as a whole in indicators such as female school enrolment, child mortality and contraceptive adoption rates.

Introduction

9

Much of these achievements have been made possible by the adoption of low-cost solutions (such as oral dehydration technology for diarrhoea treatment leading to decrease in child mortality) and by creating more awareness about, for example, immunization or contraceptives or female child enrolment. The scaling up of programmes has been relatively easy in Bangladesh, helped by the density of settlements (and their lack of ‘remoteness’) and effective social mobilization campaigns. Strong presence of non-government organizations (NGOs) and favourable budgetary allocations towards public social spending have also helped. The variety of experiences in South Asian countries points to the possibilities and limitations of various pathways to human development. Amartya Sen, for example, distinguishes between ‘income-mediated’ and ‘support-led’ human development.30 The former works through rapid and broad-based economic growth, which facilitates better standards of living and better provision of social services. The latter works primarily through effective welfare programmes that support health, education and social security. Sri Lanka and the Indian state of Kerala are cited as the examples of achieving support-led human development. The achievements in the other progressive Indian states, as mentioned above, possibly represent a combination of both income-mediated and support-led human development, since most of these states have benefited not only from the effort and commitment of their political leadership but also from relatively high income growth compared with the lagging states. South Asian experience also shows that the success in support-led human development depends not only on the level of public social spending (representing the supply-side of public services), but also on the degree of public awareness (leading to demand for services). The regions that have performed well in human development have all benefited from favourable social attitudes and cultural factors that reinforce the impact of the government’s effort in terms of public social spending and welfare programmes. Bangladesh’s experience shows that social attitudes can be changed in a relatively short time and that much progress in human development can be made, at least at an initial stage, by creating more public awareness. Bangladesh does not in fact seem to have followed either of the typical pathways to human development discussed above. Its human development indicators compare favourably with the progressive states of India, although it lags far behind those states both in per capita income levels and per capita public social spending in absolute terms. However, as the gains from low-cost easy solutions are reaped, further progress will increasingly depend on the amount of public social spending, quality of service delivery and synergies with poverty reduction.31 Like most parts of South Asia, Bangladesh suffers from poor quality of public health care, primary education and other public services. Sri Lanka’s exemplary achievements in support-led human development are also not without some limitations. The country is currently maintaining its stance as a welfare state only at the cost of large fiscal deficits that have increasingly become unsustainable. It even experienced a balance of payments crisis in 2001–02, which is attributed in part to the fact that the government had resorted to external borrowings on commercial terms to maintain and fund its public welfare system.32 The challenge for Sri Lanka is to make its social welfare programmes more cost-effective and better targeted, so that the costs to the public exchequer can be reduced while maintaining its high human development standards.

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Handbook on the South Asian economies

Macroeconomic trends: basis for sustained growth? The countries of the region have been generally successful in achieving economic stabilization, particularly in keeping inflation low and reducing the external current account deficits to sustainable levels. India has generally maintained low current account deficits, reflecting its cautious approach to external borrowings and a somewhat conservative stance towards foreign private capital inflows. Since the external payment crisis of 1991, India’s balance of payments situation has remarkably improved, and in recent years, the country has run current account surpluses along with a rapid accumulation of foreign exchange reserves (Acharya, 2002). Sri Lanka has had relatively large external deficits, reflecting in part the inflow of foreign aid on concessional terms and in part the country’s more liberal policies (compared with India) towards private foreign investment. Bangladesh’s previously large current account deficits have declined rapidly over the last two decades, reflecting an equally rapid decline in net foreign aid inflows as a proportion of GDP. Interestingly, unlike in India and Pakistan, trade liberalization along with reduction in external deficits in Bangladesh did not result in any large real devaluation of the domestic currency, which is largely explained by strong export growth and rapidly growing workers’ remittances.33 Nepal has maintained relatively large current account deficits by heavily depending on foreign aid inflows, but it has been able to reduce its deficits sharply in recent years by benefiting from rapidly increasing inflows of remittances. Each of these countries has managed their external debt in a way so that their debt servicing capacity (measured by annual debt repayment as a proportion of earnings from exports of goods and services) has substantially increased since the early 1990s. In each case, this was a reversal of the experience of the 1980s.34 Only Pakistan’s experience of managing the balance of payments in the post-reform period of the 1990s is different and telling. A combination of non-concessional foreign aid and a liberal attitude toward foreign capital inflow resulted in a large debt overhang that was out of proportion to the increase in the country’s debt servicing capacity. The result was an external payments crisis and disruption in economic growth during 1998–2000. The lessons of this crisis seem to have been learnt as reform efforts subsequently succeeded in reversing the crisis and restoring the growth momentum. This reversal was, however, largely also due to the US backing of the Pakistani government in the so-called war on global terrorism, resulting in large inflows of concessional foreign assistance.35 In regard to the reform agenda for fiscal consolidation, the results are less encouraging. In India, in the first five years of reforms, there was indeed a significant improvement in the fiscal situation with the combined deficits of central and state governments falling from above 9.4 per cent in the crisis year of 1990–91 to 6.4 per cent of GDP in 1996–97. Since then, however, the deficits have climbed back to the previous high levels, making India one of the world’s few countries with the highest fiscal deficits (as a proportion of GDP).36 Sri Lanka is also in similar straits, and its fiscal problem is explained largely by the costs of ongoing armed conflict with the Tamil insurgents over and above the costs of maintaining its extensive social welfare system. The budget deficits of the other countries are lower and at a more sustainable level. One common feature of fiscal adjustment in most South Asian countries is that the fiscal deficits were reduced by curtailing capital expenditure and development spending and not by reducing current expenditure or by mobilizing more revenue (the only notable

Introduction

11

exception was a once-and-for-all increase in the tax–GDP ratio in Bangladesh following the introduction of value-added tax in the early 1990s). As a consequence, public saving as a proportion of GDP has increased very little, or has in fact declined, and remains much too low by East Asian standards.37 Another consequence is that the efforts at fiscal stabilization have come mostly at the expense of resources devoted to such key areas as human capital accumulation and infrastructure development. In India, not only was there a deterioration in fiscal deficits after 1996–97, public investment as a percentage of GDP declined significantly throughout the 1990s: from 9.3 per cent in 1990–91 to 7 per cent in 1996–97, and further to 5.8 per cent by 2001–02. This sharp fall in public investment has taken its toll on infrastructure development. The resulting fiscal situation had the worst of both worlds: the potential effect of high deficits in crowding out private investment from the credit market, and lack of public investments in infrastructure that were needed to ‘crowd in’ private investment. Expenditures on social sectors and rural development also suffered from inadequate allocations of resources from the centre and the states, while, as noted earlier, the differences in efficiencies and spending priorities among states made the regional disparities in poverty reduction and human development outcomes even worse (Ahluwalia, 2001). India’s experience in being able to sustain economic growth and macroeconomic stability with such high fiscal deficits remains somewhat of a puzzle. It defies one of the fundamental tenets of the ‘Washington Consensus’ regarding the need for maintaining low fiscal deficits. Although India faced a surge in inflationary pressure in the early 1990s, it was soon brought under control. Moreover, the large fiscal deficits financed by the domestic banking system did not apparently spill over as external current account deficits or put pressure on interest rates, which actually fell. This is all the more striking since there has been a build up of foreign reserves. Thus, it seems the Reserve Bank of India (RBI) was following a too cautious monetary policy in light of the balance of payments crisis and acceleration of inflation in the early 1990s. The build up of assets in its balance sheet due to increased foreign reserves and credit to the government was at least partially offset by reduced credit to the private sector. While the cautious monetary policy enabled the government to finance its fiscal deficits without overheating the economy, it squeezed the room for expansion of credit to the private sector.38 That is, the macroeconomic policy mix of the time had some opportunity cost in terms of not enough credit available for the private sector, particularly those activities that have limited access to credit – small-scale enterprises and agriculture. However, the fact that the interest rate fell indicates that there was an overall decline in demand for credit. The stymied credit demand in the private sector is likely to have arisen from adverse ‘desireto-invest’ variables due to an unfavourable investment environment. Some evidence does suggest that private corporate investment as a proportion of GDP declined after 1996–97. The saving and investment rates generally exhibited a rising trend in South Asia and had exceeded 20 per cent of the region’s GDP by the end of the 1990s, with further growth in the more recent years. Periods of growth acceleration were generally associated with higher investment rates. For example, an increase in investment rate in Pakistan in the 1980s led to higher GDP growth, while the decline in the growth rates in the 1990s was associated with lower investment rates.39 Moreover, Pakistan’s saving and investment rates have been the lowest in South Asia in recent times.

12

Handbook on the South Asian economies

In all the countries, the increase in the investment rate was largely driven by the private sector, while the scope of public investment was redefined and curtailed as part of reforms under structural adjustment. As mentioned earlier, the ‘desire-to-invest’ factors as affected by the overall investment environment have thus assumed much greater importance in the post-reform era. For example, had there been a stronger response to reforms from private entrepreneurs, India arguably could have had more investment in recent years instead of building up foreign reserves and running external current account surpluses. To a smaller extent, this applies to the recent developments in Pakistan as well. Further, there may be a positive relationship between public and private investment. Hence, there is a doubt whether if and when fiscal deficits are reduced in India, the private sector will be able to fill in the gap in aggregate demand through higher investment. In Bangladesh in the early 1990s, the significant increase in domestic savings (resulting largely from higher public saving) was not matched by a similar increase in investment demand, thus resulting in recessionary symptoms (Mahmud, 2004). It may be tempting to even suggest, on the basis of the South Asian experience so far, that if investment demand were to rise, matching savings would be forthcoming.40 Improving the institutional, infrastructural and policy environment for private investment thus appears to be the common challenge facing the South Asian economies. This said, the importance of mobilizing more domestic savings cannot be ignored either. The region has not yet been very successful in attracting foreign private capital and has to depend therefore on domestic resources for increasing investment. The decline in foreign aid in Bangladesh and Nepal has resulted in increasing reliance on domestic savings for financing investment. Sri Lanka’s relatively high inflation, along with persistently high fiscal deficits, points to the need for mobilizing more domestic savings, particularly public savings, to maintain the economy’s aggregate supply–demand balance.41 The importance of a domestic resource constraint is also amply demonstrated by Pakistan’s recent turnaround in growth performance; increased foreign assistance along with fiscal consolidation has made it possible to expand credit flows and investment in the private sector leading to a recovery in GDP growth. External liberalization: integrating with global markets On the external front, all the countries have moved towards integration with the global economy through a process of lowering tariff and non-tariff barriers to imports and easing the restrictions on the inflow of foreign capital. They have also chosen to adopt a managed float arrangement (except Nepal pegging its currency with that of India), while trying to avoid excessive volatility in their exchange rates. The pace and extent of import liberalization have varied among the countries. Sri Lanka and Nepal moved the fastest, followed by Pakistan in the 1990s. Bangladesh and India have adopted a relatively staggered approach in dismantling their trade barriers and are still more heavily protected than most other developing countries. Even after the most recent reductions in tariffs in India, its tariffs are likely to remain significantly higher than China’s. But, surprisingly, compared with other regions, the extent of reduction in import tariffs since the 1980s has been highest in South Asia, largely because of the initial high tariffs (World Bank, 2004). In terms of integrating with the world markets, there is yet some way to go. South Asia’s share in global trade continues to be low. By 2003, this share had risen to only 2.4 per cent after remaining nearly stagnant at about 2 per cent during the three decades from the

Introduction

13

1960s to the 1980s. The contrast between India and China is particularly striking. Even after a decade of opening up, India’s share in world exports rose only to 0.8 per cent in 2002 compared with 0.5 per cent in 1990; China’s share, in contrast, was 5.2 per cent in 2002 as compared with 1.3 per cent when it opened up in 1978. At the other end is the relative poor performance of Sub-Saharan Africa, whose share in global trade in 2003 was almost the same as that of South Asia, but was only one-third of what it was in the 1980s. Did liberalization help export growth? Import liberalization with exchange rate flexibility is expected to boost exports by removing the existing anti-export biases – through reduced protection provided to domestic import substituting industries, greater access to imported inputs and increased prices of exportables vis-à-vis non-tradables resulting from the devaluation of the domestic currency accompanying import liberalization. Exports expanded in Bangladesh and India with their opening up in the 1990s. India’s export growth in the 1980s picked up to an average annual rate of 6.5 per cent (slightly ahead of GDP growth), up from a meagre 3 per cent over 1965–80; since the early 1990s, merchandise exports alone have grown at more than 15 per cent per annum, leaving aside the boom in IT-related export of services. Sri Lanka has the lowest trade barriers with the highest trade–GDP proportion, followed by Nepal and Pakistan. However, trade liberalization is only one of many factors behind export growth. Pakistan’s export volume either stagnated or declined slightly after 1993, after having grown at nearly 8 per cent per annum during 1960–93. It is argued that the country could not fully benefit from its trade liberalization until 2000 because of the offsetting effect of adverse macroeconomic developments (Hasan, 1998). While Bangladesh’s export–GDP ratio has nearly doubled since the early 1990s, the improved export performance is entirely due to the rapid growth of ready-made garment export. The garment industry has flourished in Bangladesh because of the confluence of a number of favourable factors, especially the preferential access provided to Bangladesh’s garment export in the major markets of the West and the creation of a set of enclavetype arrangements (e.g., bonded warehouses and back-to-back Letters of Credits (L/Cs) to facilitate duty-free import of fabrics).42 However, the country’s export base remains narrow as the impressive success in garment export has yet to be replicated in other industries. Indeed, Bangladesh’s experience with the garment industry demonstrates the limitation of relying on enclave-type arrangements to facilitate export growth in a specific activity, while postponing institutional reforms for improving the investment climate generally. Institutional bottlenecks are not, however, unique to Bangladesh. Throughout most of South Asia, export expansion has suffered from such factors as bureaucratic hurdles, inefficient customs administration, rigid labour laws and inadequate export infrastructure. For example, with the exception of Colombo, the seaports in South Asia are far too inefficient by international standards.43 To offset these disadvantages (as well as the antiexport bias arising from the tariff structure), various measures of implicit and explicit subsidization of exports were put in place. But access to some of them, such as duty drawbacks on imported inputs, has proved cumbersome, time-consuming and corruption-prone.44 Clearly, many complementary factors other than import liberalization are needed for success in achieving export growth, and the absence of these factors may explain why South Asia could not fully take advantage of the opportunities offered by the explosive growth in world trade in manufactured exports.

14

Handbook on the South Asian economies

The phenomenal success of India’s IT industry, which grew in a decade’s time from nothing to US$15 billion worth of export, is explained largely by factors other than trade reforms: the new Internet-based technological possibilities and the availability of trained personnel. The IT industry has thrived also in part because it has escaped the red tape that continues to make life difficult for Indian businesses. Across South Asia, tariff escalation has been used as a means of protecting domestic import-substituting industries while pursuing import liberalization. India’s early import liberalization, for example, was mainly confined to industrial inputs, which helped to retain relatively high rates of effective protection on finished products. Thus, Indian industries were not exposed to foreign competition (Joshi and Little, 1996). In Bangladesh, capital goods and primary commodities are subject to much lower rates of tariffs compared with intermediate goods, while the highest rates apply to finished consumer goods. This has helped to retain relatively high rates of protection for the later goods even within the much lower average import tariffs; at the same time, the anti-export bias of the tax system has been reduced to some extent because of lower taxes on imported inputs. Such a system of tariff escalation has suited the interest of the protectionist lobbies, since the domestic import-substituting industries mainly produce finished consumer goods. In Sri Lanka, where tariffs have always been lower than in the larger South Asian countries, the difference in mean tariff between primary and manufactured product groups has also been small; even then the structure of tariffs and the cascading effects of turnover taxes and mark-ups are such that the effective protection rates on several products continue to be high. The structure of industrial incentives created by import tariffs and the various export incentives raises an important policy dilemma. The effect of these tariffs and incentives are bound to vary across industries, even if for no other reason than for the limitations of administrative feasibility in applying these various incentive mechanisms. In other words, if there is no industrial policy by design, there will be one by default, at least as long as the import liberalization process remains incomplete. At the same time, it is argued that the governance environment in South Asia is not suitable for a ‘picking the winners’ policy to produce good results, as it has done in East Asia.45 In this respect, South Asia’s approach may be closer to that of post-reform China, namely, improvization through learning-by-doing. In India, well-intentioned policies to promote small-scale enterprises may have hurt the country’s opportunity to penetrate the global markets. A large number of sectors have been reserved for small-scale units defined in terms of certain prescribed upper limits for the value of plant and equipment.46 The reservation of low-tech items with large export potential such as garments, toys and shoes is believed to have cost India dearly in terms of lost exports. India and China exported comparable amounts of toys, shoes, garments and some similar items in 1975. If India had shared the global market with China, India should have been exporting today US$55 billion worth of these items instead of US$15 billion. In spite of acceleration in export growth, South Asia’s exports remain undiversified and of low technology content. Exports are either resource-based or consist of simple manufactured products. Ready-made garments alone account for nearly 80 per cent of Bangladesh’s and half of Sri Lanka’s exports, while the cotton value-addition chain (raw cotton, yarn and textiles) accounts for about two-thirds of Pakistan’s exports. Only India is now venturing into some high-tech exports, besides its software exports.

Introduction

15

Besides trade openness, the extent of foreign private capital flows is another measure of integration with the global economy. South Asia is not a preferred destination for external investors for several reasons. One reason is the still continuing bureaucratic hurdles. But a major reason is the inadequate physical and social (that is, human capital) infrastructure in comparison to China and other East Asian countries. In China, foreign direct investment (FDI) has been attracted to infrastructural sectors and also to export activities. India’s initial attempt to have foreign investors in power generation failed due to the fiasco surrounding the currently idle large power plant that Enron built in Dabhol in the state of Maharashtra. All others who had proposed investments subsequently withdrew. This reflects not only the complex governance problems surrounding such investments but also the near bankruptcy of state-owned electricity boards to which the independent power producers had to sell their output. The near bankruptcy is itself due to subsidization of agricultural users as well as large losses from electricity theft. Recent reforms are aimed at opening up power generation, transmission and distribution to greater competition. In both Pakistan and Bangladesh, the entry of private independent power producers in a largely state-owned electricity sector has created problems for the same reasons. Of all the South Asian countries, Sri Lanka has been most successful in attracting private foreign investors in the energy and telecommunications sector and in the expansion of ports. It needs to be recognized that, in the infrastructural sectors, privatization (involving both foreign and domestic investors) is a complex process, which is often ignored in making simplistic prescriptions. It is true that public ownership in these sectors has led to gross inefficiencies. At the same time, privatization and market competition may not always be the answer because of several reasons: many of the infrastructural services are natural monopolies and they are often of the nature of ‘public goods’ with several kinds of externalities.47 There is thus a need for effective regulatory agencies for privatization to be beneficial; but such agencies are only in their infancy in South Asia. There is also scope for institutional innovations in these sectors involving varying degrees of state–market mix. The problem of involving foreign private investors is compounded when such investors take into account their perception of ‘country risk’ in negotiating the terms of investments, such as regarding the ‘administered’ prices at which the government will buy electricity from independent power producers. This puts countries like Bangladesh at a disadvantage.48 One reason why India has been slow to open its economy to FDI is the high degree of protection still afforded to the industries serving the domestic market. As was argued long ago by Brecher and Alejandro (1977), in a situation of continuing protection of importcompeting sectors, investment of foreign capital in these sectors may not be beneficial, particularly if the investments are of a capital-intensive type. India’s domestic market can be attractive to FDI because of its large size. In the smaller countries of the region, however, whatever FDI has come in sectors other than infrastructure or mining, it has come mostly in export industries, such as the export-oriented garment industry in Bangladesh. Governance and institutions Weak governance is a key constraint for South Asia to realize its economic promise and potential. Governance problems can be interpreted to cover a broad spectrum of issues,

16

Handbook on the South Asian economies

ranging from political and economic corruption to capability of the state machinery for economic management and to the functioning of the political systems. The governance environment in South Asia, which cuts across all these issues, is alleged to be characterized by regional tensions, internal conflict, corruption and patronage politics, weak law and order, inadequate regulatory systems and public sector with a poor record of managing public enterprises and delivering services. The scale and nature of the governance problems, however, can be seen to differ widely across the region, depending on which aspects of governance one has in mind. On conflict, Sri Lanka has had a civil war for the last 20 years and Nepal has had a Maoist insurgency since the mid-1990s. These internal conflicts must have adversely affected the economies of both the countries, but in neither case has the impact been nearly as severe as in the case of many conflict-ridden countries in Sub-Saharan Africa. Sri Lanka’s experience shows that if conflict is localized in an economy having otherwise favourable conditions (e.g., high literacy, good policies), there can be economic growth in non-conflict areas. Nepal’s impressive performance in reducing poverty over the last decade or so is owed to a great extent to a sharp increase in remittances from migrant workers.49 A lesson from Nepal’s experience is the danger of political instability arising from regional economic disparities. The Mid-western Development Region and the Far Western Development Region are the most economically backward parts of the country. These regions inherited the worst legacy of the caste system and suffered from prolonged neglect from successive governments of all political hues. The resulting widespread poverty in these regions provided the fertile grounds for breeding and sustaining the insurgency. Fortunately for the country, recent political developments with the inclusion of the Maoists in the central government have opened up possibilities for the resolution of the conflict. As regards political systems, India and Sri Lanka are the most mature democracies in the region, but their governments are often characterized by weak coalitions. Bangladesh’s parliamentary democracy remains fragile, in spite of three credible national elections held since 1991. Pakistan has been mostly under some form of military rule; during 1988 to 1999, it had an interlude of democratic politics, which failed to provide a stable political framework. In Nepal, which has hereditary monarchy, democratic politics introduced in 1991 turned out to be extremely factionalized with frequent changes of government. Irrespective of the nature of the political regime, the countries of the region share many common governance problems. All the countries, for example, have serious corruption problems; only the nature and scale vary. Again, strong public awareness about governance problems and corruption in particular, which has found expression through civic actions and a lively media, has been a mitigating factor throughout South Asia. Democratic politics in India and elsewhere in the region will ensure that these issues have remained in the forefront of public consciousness and therefore on the political agenda, and there will be continuous pressure for improvement.50 Both in Pakistan and Bangladesh, regimes fell because of the public’s perception of deterioration in the quality of governance and increase in the incidence of corruption. In Bangladesh since 1991, popular discontent with corruption was expressed through credibly held elections since 199l, leading to the fall of the successive governments led by Begum Khaleda Zia and Sheikh Hasina respectively. Even when elected regimes, such as those led by Nawaz Sahrif

Introduction

17

and Benazir Bhutto in Pakistan, were removed through authoritarian interventions, the legitimacy of those actions derived from the popular discontent about corruption committed by those governments. People seemed to have demonstrated a willingness to move against regimes once they crossed some vaguely defined threshold with respect to poor governance and corruption. The problem is that, without reasonably strong democratic institutions, the lessons learned by the leaders about the terrible consequences of bad governance are not translated into durable mitigating measures. In this respect, India and Sri Lanka have an advantage over Pakistan and Bangladesh – the two countries that rank near the top in the ‘corruption index’ prepared by Transparency International. One redeeming feature of the South Asian experience is that, even in the absence of strong institutions, public awareness and civic actions can sometime lead to impressive development outcomes by providing some informal mechanisms of accountability of the government. Even corrupt leaders have had to seek a compromise between private gains and public good (Mahmud, 2002). How have the varying political settings across South Asia affected economic performance and the quality of economic management? On the whole, democracy seems to have served South Asia well, although it is not easy to make generalizations or establish causal connections. India and Sri Lanka, the only two established democracies in the region, have had the highest long-term growth among the major regional economies. Their institutions of political and economic governance are superior to those of the other countries – Pakistan and Bangladesh in particular – where economic reforms have generally lagged behind institutional reforms (Mahmud, 2001). In Bangladesh, acceleration in both economic growth and social development took place following a transition to democracy in 1991. In Nepal, a shift towards a liberal economic regime in 1991 coincided with the restoration of multi-party democracy under a constitutional monarchy. Earlier, the initiation of outward-oriented policies and dismantling of the public sector enterprises had taken place in the 1980s when a liberal Panchayat system (a form of local governance) replaced a more autocratic system with absolute monarchy. The political economy of reforms under democracy is, however, liable to be affected by the electoral cycle and the resulting emphasis on short-run political cost–benefit calculations. The reforms that are seen to have immediate adverse affect on large sections of the population – like the withdrawal of food and agricultural subsidies – are vote-losing and likely to be politically blocked, as has happened in India. Similarly, in Sri Lanka, efforts to make the welfare system better targeted and cost-effective have met with political resistance. There are the other kinds of reforms that affect small but powerful interest groups, such as labour unions resisting reforms of state-owned enterprises or protectionist lobbies resisting import liberalization. With respect to such reforms, Sri Lanka is far ahead of the other countries, but Pakistan is also considerably ahead of India – which only shows that the relationship between the nature of the political regime and its ability to further economic reform is a complex one. To take another example, Bangladesh’s success in withdrawing excessive agricultural and food subsidies in the 1980s had perhaps little to do with the fact that there was an authoritarian regime in place; the deciding factors were skilful timing, public awareness about the exclusion of the poor from the beneficiaries and donor conditionality that looked sensible (Mahmud, Ahmed and Mahajan, 2007). In spite of ideological differences among political parties, there have not been major policy reversals in South Asia since the introduction of reforms towards economic

18

Handbook on the South Asian economies

liberalization. Sri Lanka’s two major political parties with ideological differences have not hindered reforms over the long term, although the pace of reforms and the emphasis on spending on social sectors and welfare programmes have differed. This is also true of the two dominant political parties in Bangladesh – one left of centre and the other right of centre – which have been alternatively elected to power since 1991. In India, the first set of reforms in the early 1990s (after the elections in 1991) was in fact initiated by a weak minority coalition government faced with a balance of payments crisis. The governments formed by Congress-led coalitions may have in fact helped to make reforms possible by bringing in non-economic considerations; in trying to keep the Hindutva-based Bharatiya Janata Party (BJP) out of power, the secular parties compromised on their respective economic agenda, both in 1991 and in the current government (Varshney, 1999). On the other hand, it is also argued that governments formed by unstable coalitions are likely to have at best weak commitment to economic reforms.51 In fact, each coalition government in India since 1991 (and there have been five governments at the union level, some quite fragile) has endorsed and furthered the reform process.52 The reforms have been slow but durable. There have, however, been some changes of direction in the policy agenda, depending on the mood of the electorate. For example, in the elections of mid-2004, the BJP-led government was voted out because of their alleged neglect of agricultural development and rural poverty. The current Congress-led government has acknowledged that the country cannot achieve prosperity without widespread improvement for the agricultural sector. In a recent budget speech, Mr Chidambaram, the Indian Minister for Finance, quoted Nehru: ‘Everything else can wait, but not agriculture’. There are, however, opposing views regarding such a change of course in response to popular verdict. One view is that the expression of popular will in democracy may lead to corrective actions towards making growth more inclusive and pro-poor.53 The other view is that increasing economic inequality could elicit a backlash against market-oriented pro-growth policies, sometimes leading to populist policies that slow growth.54 Pakistan’s experience seems to provide a counter-example of the relative economic performance under democratic versus authoritarian rule (Easterly, 2003). Economic growth declined sharply in the 1990s following the introduction of democratic politics, after having peaked during the previous decade under the military rule of General Ziaul-Haq. Again, a steady turnaround in the economy has taken place since the military takeover by General Pervez Musharraf. One is tempted to conclude that the greater stability under military dictatorships and the accompanying strong technical management have led to periods of higher growth. On the other hand, the elected governments under the premiership of Benazir Bhutto and Nawab Sharif were extremely weak and failed to provide even a minimum governance framework. It is noteworthy that the balance of payments crises in both 1993 and 1996 coincided with episodes of major political instability arising from conflict between the President and the Prime Minister. There were, of course, other external factors affecting the variations in economic performance, such as the economic sanctions imposed on Pakistan following its nuclear tests in the late 1990s and the reversal of the situation since Pakistan has become an ally of the West in the socalled fight against global terrorism. Another noteworthy aspect of Pakistan’s experience is that high economic growth under autocratic regimes (in the 1960s under General Ayub Khan and in the 1980s under General Zia-ul-Haq) did not lead to a transition to a viable

Introduction

19

democratic order without disrupting growth, as happened in, for example, South Korea and Taiwan. Regarding the quality of economic administration, South Asian countries suffer from many common problems. In fact, many of the development challenges faced by these countries – be they relating to inadequate infrastructure, inefficient financial markets, adverse investment climate, lack of foreign direct investment, poor delivery of public services – are related directly or indirectly to governance problems and their foundation in political economy. The effectiveness of public development spending is often compromised by large-scale leakages of funds. The allegedly high absenteeism of teachers in schools and doctors in health care facilities is one aspect of the poor governance of public service delivery. The financial viability of commercial ventures in the power sector is jeopardized by widespread electricity theft. The inefficiency of seaports arises in part from the stranglehold on them by politicized labour unions. The state-owned banks, which dominate the banking sector, are saddled with non-performing assets arising from their politically influenced loan operations. The list goes on. South Asia’s good development outcomes have occurred despite weak institutions of governance, which may appear as a puzzle (Devarajan, 2005). Bangladesh and Pakistan, in particular, suffer from serious shortcomings in most aspects of governance and appear to be outliers in cross-country comparisons relating governance to economic growth (ignoring Pakistan’s low growth in the 1990s).55 This calls for a better understanding of the relationship between governance and economic growth – a topic that has attracted considerable attention in recent years (Acemoglu, Johnson and Robinson, 2005; Rodrik, Subramanian and Trebbi, 2004). One view is that the effects of a large number of good policies have prevailed despite overall weak institutions.56 Another view is that, despite the overall negative perception, the quality of governance in many crucial aspects is not as bad as to have proved binding constraints thus far. Overall, the governance environment across South Asia may have been barely adequate for the economies to break out of stagnation and extreme poverty, but it may increasingly prove a barrier to putting these economies firmly on a path of modernization, global integration and poverty reduction. Concluding remarks The recent improvements in growth outcomes in South Asia are encouraging and constitute a platform for further consolidation of economic performance in the coming years. These achievements have taken place despite numerous obstacles, such as conflict in Sri Lanka and Nepal, high fiscal deficits in India and Sri Lanka, and widespread corruption in most parts of South Asia – particularly in Bangladesh and Pakistan. This calls for a better understanding of the factors contributing to the resilience of the growth process. While these constraints may not have been binding in the past, they may become so in the future, as South Asia attempts to accelerate growth to eliminate poverty. The moot question is whether South Asia has the ingredients of rapid growth that East Asia had. There are still numerous gaps between the two Asias in respect of these growth ingredients – such as in savings and investment rates, export orientation, technology intensity of manufacturing and the quality of labour. This does not mean that South Asia can or should entirely follow the East Asian growth model. The democratic institutions as prevalent in most parts of South Asia and its governance environment dictate that it has to find solutions to its specific problems, while still learning from the success stories

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Handbook on the South Asian economies

of East Asia. As noted among others by Rodrik and Mukand (2005), sound economic principles – such as incentives, competition, fiscal prudence, sound money and property rights – do not translate into unique institutional and governance solutions, but need to be adapted to particular economic and social contexts.57 Many of the policy challenges facing South Asian countries are specific to the individual country’s circumstances. Nevertheless, just as South Asian countries are jointly experiencing economic growth, they share some common themes for accelerating and sustaining this growth. They need to upgrade their infrastructure, attract more foreign investment, diversify their industrial and export base, and deepen their human capital through improved training and education. The income inequalities and regional economic disparities accompanying accelerated growth have created a sense that ‘growth is not enough’. The recent experience of growth acceleration in Bangladesh shows that deterioration in income inequality is not inevitable, provided efforts are made towards a more inclusive growth strategy. The diversity of South Asian experience also shows the various possible pathways to human and social development – through increasing incomes, greater government support and creation of public awareness through effective social campaigns. In spite of shared growth among the countries of the region, South Asia remains the least economically integrated region in the world. This is shown by the very low share of cross-border trade within South Asia – about 6 per cent – out of the region’s worldwide trade.58 This means that cross-border economic synergies due to proximity are not being exploited. In part, this is the result of conflicts between India and Pakistan, but also reflects poor intra-regional trade logistics. Both India and Pakistan incur large military expenditures at the expense of much-needed social development. It is essential to manage conflicts in a way that social investments are protected and intra-regional trade, investment and people’s mobility are restored to levels enjoyed by other regional groupings. The governance reform agenda in South Asia is large and cuts across a wide range of institutions and threatens powerful vested interests. Developing a strategic, sequenced approach that relies on success in a few key areas to generate momentum and demand for reform in other areas will be crucial. Compared with the first-generation reforms, there is a need for deeper and more complex policy innovations to deal with the emerging challenges. Will the governance environment improve through strengthened democratic institutions, increased civic activism and a lower tolerance shown by the public for weak governance? Or will there be a ‘path-dependent’ institutional deterioration as postulated, among others, by Douglass North?59 Much will depend on which of these opposing forces will prevail on the other. Notes 1.

2. 3. 4. 5.

Latest poverty estimates according to the World Bank’s World Development Indicators show that the proportion of population below US$1 (PPP) a day was 36 per cent in Bangladesh in 2000, 35 per cent in India in 1999–2000, 39 per cent in Nepal in 1995–96, 17 per cent in Pakistan in 2000 and 6 per cent in Sri Lanka in 2002; see World Bank (2006). World Bank (2003: Table 4.1). See, for example, Ahmed (2006) and Devarajan and Nabi (2006). For some of the early doubts about the effects of economic reforms in India, see Nayyar (2001). In retrospect, the Washington Consensus was not created exclusively by institutions based in Washington, DC, and did not really represent a consensus; see Stern, Dethier and Rogers (2005: 156–63).

Introduction 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16.

17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36.

21

These growth estimates are based on the World Bank’s database; see Ahmed (2006: Table 2.2). During the period from 1960 to 2003, average annual growth in per capita GDP ranged from 2.8 in Sri Lanka to 2.5 per cent in both India and Pakistan and to 1.3 per cent in Nepal (while the growth rate in Bangladesh was 2 per cent during 1973 to 2003). For example, among all the seven countries of the region including Maldives and Bhutan, average GDP growth in the five-year period up to 2006 was below 5 per cent only in Nepal. However, even a gradualist approach to reform should be able to achieve significant policy changes over a 10–15-year period; on this, see Ahluwalia (2002). The reforms in India were triggered by a severe balance of payments crisis that hit the country in 1990–91 after the Gulf War broke out and the domestic political uncertainty induced non-resident Indians to withdraw their deposits in India; see Srinivasan (2000). The growth of manufacturing is estimated to be 7.1 per cent during 1980–81 to 1989–90 and 5.8 per cent during 1993–94 to 2002–03. The estimates are derived from the national income statistics by using semilog functions; see the chapter on India in this volume. Pakistan’s GDP growth rate peaked at 6.7 per cent during 1960–70, with even much higher growth rate during the first half of the decade; the other growth peak was attained in the 1980s with annual GDP growth at 6.4 per cent. India’s IT industries, consisting mainly of software programming, offshore back-office services and longdistance data transcription, grew from a negligible base in the early 1990s to US$17 billion in gross revenue terms in 2000–01. However, it still contributed less than 3 per cent of GDP. Srinivasan (2000: 141) argues that one of the shortcomings of Indian reforms is that two important sectors, agriculture and social sectors, have largely been kept out of the reform process. For similar argument on Sri Lanka, see Devarajan (2005: 4014). In Nepal, for example, although small agricultural schemes managed by farmers have done well, more government involvement in irrigation may be needed to revive agricultural growth; see the chapter on Nepal in this volume. According to the World Bank’s estimates, the percentage of people living on less than a dollar a day (in purchasing power parity) fell from 58 per cent to 15 per cent in East Asia over 1981–2001, from 52 per cent to 31 per cent in South Asia and increased from 42 per cent to 47 per cent in Sub-Saharan Africa; see Chen and Ravallion (2000). See Ahmed (2006: Table 6.1). The states include Bihar, Orissa, Madhya Pradesh and Assam. Punjab is an exception among high-income states to have experienced a fall in the growth rate. In Bangladesh, for example, two poverty lines are used, an upper and a lower one. Even then, poverty incidence remained as high as nearly 40 per cent in 2005. Of the two poverty lines used, this estimate is according to the higher one. During this period, the poverty rate declined from 22 per cent to 10 per cent in urban areas and from 43 per cent to 35 per cent in rural areas. See the chapter on Nepal in this volume. The estimate of poverty incidence in 2002 is 25 per cent for rural areas, 8 per cent for urban areas and 23 per cent at the national level; see Ahmed (2006: Table 2.3). In 2006, for the first time since the Green Revolution, India had to import wheat, and it had to do so in 2007 as well. See, for example, Stern et al. (2005: 233–9). See the chapter on Nepal in this volume. See the chapter on Bangladesh in this volume. According to the World Bank’s World Development Indicators, the level of per capita public social spending in 2000 was equivalent of US$35 in Sri Lanka, US$19 in India, and US$12 both in Pakistan and Bangladesh; World Bank (2003). See Ahluwalia and Mahmud (2004); Devarajan (2005) and Sachs (2005: 10–14). Sen (1999: Chapter 2). In spite of favourable budgetary allocations to the social sectors, Bangladesh’s public social spending (say, in dollar terms) remains much lower than that of India as a whole, let alone the progressive high-income states; see the chapter on Bangladesh in this volume. See the chapter on Sri Lanka in this volume. See Mahmud (2004). Ahmed (2006: Table 3.3). Pakistan was the world’s largest recipient of foreign aid in 2002, some US$2.1 billion, mostly concessional loans from the World Bank and the IMF and US foreign assistance. See Srinivasan (2002). The fiscal deficits will be even higher if the contingent liability of the government arising from the losses of state-owned enterprises is taken into account.

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37.

In India, for example, the deterioration of the fiscal situation after mid-1990s was reflected in a major decline in public saving, from 1.7 per cent of GDP in 1996–97 to
2.7 per cent in 2001–02. 38. The lending practices of publicly owned banks may also have been responsible for keeping potential investors from accessing bank credit. These banks have shown a reluctance to lend to anyone other than long-established large farms and have invested much more in government securities than they are obliged to do under various reserve requirements. 39. An exception is the growth acceleration in Sri Lanka in the 1990s with a lower average investment rate compared with the 1980s. 40. A plausible explanation for this is that with more investment opportunities, potential savings are likely to be diverted away from unproductive uses. 41. In 2007, Sri Lanka’s inflation rate peaked at 20 per cent, which is much higher than the one-digit rates of inflation experienced by other South Asian countries since the 1990s. 42. The other favourable factors were the early relocation of garment producers and marketing intermediaries from East Asian countries (especially South Korea) to Bangladesh to evade import quotas in the US and European markets, easy transfer and spread of garment-industry-specific managerial and production skills and the abundance of low-cost female labour; see, for example, Easterly (2003: Chapter 8). 43. Most cargo traffic to and out of India takes place through transshipment at more efficient ports like Colombo and Singapore, thus adding to the trading costs. 44. There has been a recent move in India to do away with these schemes. 45. See, for example, Stern et al. (2005: 162). 46. The policy of reservation was left untouched in the early reforms; only in the late 1990s farm equipment was excluded and the limit of investment was raised to allow bigger plants. 47. Public goods are characterized by their being non-excludable in their use. The externalities may be of different kinds, such as network externalities in telecommunications and transport systems, environmental and health externalities in the case of investment in water supply systems, sewage and waste disposal. 48. In India, only the period since 2001–02 saw some major policy initiatives in infrastructure development involving private sector participation. Reforms in telecommunications, which have moved faster than in the power sector, have led to better service at lower prices for significantly larger number of consumers. 49. The increased migration is partly due to the fact that families with young males sent their sons across the border to avoid them being recruited by the Maoists; see Devarajan (2005). 50. On this, see Ahluwalia (1997). 51. Srinivasan (2000), p. 151; see also Kohli (1991). 52. See Ahluwalia (2001). 53. See, for example, Sachs (2005: 183). 54. Devarajan and Nabi (2006: 3575–6). 55. According to the governance data set for 2005 prepared by the World Bank Institute, Bangladesh and Pakistan lag far behind India in most governance aspects – such as rule of law, government effectiveness and control of corruption. Only in respect of voice and accountability, Bangladesh does relatively well, although still behind India. 56. See Devarajan (2005) and Ahmed (2006: 8). 57. Some of the favourable policy ingredients behind East Asia’s success are now well-recognized: openness to competition, the use of international markets, a high level of literacy and school education, successful land reform and public provision of incentives for investment, export and industrialization. 58. The corresponding figures for other regional blocks are 23 per cent in ASEAN, 56 per cent in NAFTA and 61 per cent in EU and 12 per cent in MERCOSUR. 59. See, for example, North (1997).

References Acemoglu, D., S. Johnson and J.A. Robinson (2005), ‘Institutions as the fundamental cause of long-run growth’, in P. Aghion and S. Durlauf, Handbook of Economic Growth, New York: Elsevier. Acharya, Sankar (2002), ‘Managing India’s external economic challenges in the 1990s’, in M.S. Ahluwalia, Y.V. Reddy and S.S. Tarapore (eds), Macroeconomics and Monetary Policy: Issues for a Reforming Economy, New Delhi: Oxford Economic Press. Aghion, P., R. Burgess, S. Redding and F. Zilibotti (2004), ‘The unequalizing effect of liberalization: theory and evidence from India’, mimeo, Harvard University and University College, London. Ahluwalia, M.S. (1997), ‘Governance Issues in India’s Economic Reforms’, Paper presented at the Workshop on Governance Issues in South Asia, Yale University, 19 November.

Introduction

23

Ahluwalia, M.S. (2001), ‘State-level Performance and Economic Reforms in India’, Working Paper No. 96, Center for Research on Economic Development and Policy Reform, Stanford University, March 2001. Ahluwalia, Montek S. (2002), ‘Economic reforms in India since 1991: has gradualism worked?’, Journal of Economic Perspectives, 16 (3), Summer, 67–88. Ahluwalia, I.J. and W. Mahmud (2004), ‘Economic transformation and social development in Bangladesh’, Economic and Political Weekly, 39 (36), 4009–11. Ahmed, Sadiq (2006), Explaining South Asia’s Development Success: the Role of Good Policies, Washington, DC: The World Bank. Anand, S. and R. Kanbur (1993), ‘The Kuznets process and the inequality–development relationship’, Journal of Development Economics, 40 (1993), 25–52. Brecher, R. and C. Alejandro (1977), ‘Tariffs, foreign capital and immiserising growth’, Journal of International Economics, 7 (1977), 317–22. Chen, Shaohua and M. Ravallion (2000), ‘How Did the World’s Poorest Fare in the 1990s?’, Policy Research Working Paper 2409, Washington, DC: The World Bank. Deaton, A. and Jean Dreze (2002), ‘Poverty and inequality in India: a re-examination’, Economic and Political Weekly, 37 (36). Devarajan, S. (2005), ‘South Asian surprises’, Economic and Political Weekly, 40 (37), 4013–15. Devarajan, S. and Ijaz Nabi (2006), ‘Economic growth in South Asia: promising, unequalising, sustainable?’, Economic and Political Weekly, 41 (33), 3573–80. Easterly, W. (2003), ‘The political economy of growth without development; the case study of Pakistan’, in D. Rodrik (ed.), In Search of Prosperity: Analytical Narratives on Economic Growth, New Jersey: Princeton University Press. Hasan, Parvez (1998), Pakistan Economy at the Crossroads, Karachi: Oxford University Press. Jalal, Ayesha (1995), Democracy and Authoritarianism in South Asia: A Comparative and Historical Perspective, Cambridge, UK: Cambridge University Press. Joshi, Vijay and I.M.D. Little (1996), India’s Economic Reforms, Oxford, UK: Oxford University Press. Kohli, Atul (1991), Democracy and Discontent: India’s Growing Crisis of Governability, Cambridge, UK: Cambridge University Press. Mahmud, W. (2001), ‘Introduction’, in W. Mahmud (ed.), Adjustment and Beyond: the Reform Experience in South Asia, Basingstoke, UK: Palgrave-Macmillan in association with International Economic Association. Mahmud, W. (2002), ‘National Budgets, Social Spending and Public Choice: the Case of Bangladesh’, IDS Working Paper 162, Brighton, UK: Institute of Development Studies, University of Sussex. Mahmud, W. (2004), ‘Macroeconomic management: from stabilization to growth?’, Economic and Political Weekly, 39 (36), 4023–32. Mahmud, W., Sadiq Ahmed and Sandeep Mahajan (2007), ‘Policy Reforms, Growth and Governance: the Political Economy of Bangladesh’s Development Surprise’, Paper prepared for the Growth Commission, Washington, DC: World Bank (South Asia Region), mimeo. Nayyar, Deepak (2001), ‘Macroeconomic reforms in India: short-term effects and long-run implications, in W. Mahmud (ed.), Adjustment and Beyond: the Reform Experience in South Asia, Basingstoke, UK: PalgraveMacmillan in association with International Economic Association. North, Douglass (1997), ‘The Contribution of the New Institutional Economics to an Understanding of the Transitional Problem’, Annual Lecture 1, Helsinki: United Nations World Institute of Development Economics Research (UN-WIDER). Radelet, S. and J. Sachs (1997), ‘Asia’s Re-emergence’, Foreign Affairs, 76 (6). Ravallion, M. and Shaohua Chen (1997), ‘What can new survey data tell us about recent changes in distribution and poverty?’, World Bank Economic Review, 11 (2), 357–82. Rodrik, D. and S. Mukand (2005), ‘In search of the Holy Grail: policy convergence, experimentation, and economic perfromance’, American Economic Review, 95 (1), 374–83. Rodrik, D., A. Subramanian and F. Trebbi ((2004), ‘Institutions rule: the primacy of institutions over geography and integration in economic development’, Journal of Economic Growth, 9 (2), January. Sachs, J.D. (2005), The End of Poverty: Economic Possibilities of Our Time, New York: Penguin Books. Sen, A.K. (1999), Development as Freedom, Oxford: Oxford University Press. Sen, Abhijit and Himanshu (2004), ‘Poverty and inequality in India – I and II’, Economic and Political Weekly, 39 (38), 4247–63. Srinivasan, T.N. (2000), ‘Economic reforms in South Asia’, in Anne O. Krueger (ed.), Economic Policy Reforms; The Second Stage, Chicago: The Chicago University Press, pp. 99–154. Srinivasan, T.N. (2002), ‘India’s fiscal situation: is a crisis ahead?’, in Anne O. Krueger (ed.), Economic Policy Reforms and the Indian Economy, New Delhi: Oxford University Press. Stern, J., J.-J. Dethier and F.H. Rogers (2005), Growth and Empowerment: Making Development Happen, Cambridge, MA: The MIT Press.

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Stiglitz, Joseph E. (2004), ‘The Post-Washington Consensus Consensus’, Initiative for Policy Dialogue, Working Paper No. 7, Columbia University. Varshney, Ashutosh (1999), ‘Mass politics or elite politics? India’s economic reforms in comparative perspective’, in J.D. Sachs, A. Varshney and N. Bajpai (eds), India in the Era of Economic Reforms, New Delhi: Oxford University Press. World Bank (2003), World Development Indicators, Washington, DC: The World Bank. World Bank (2004), Trade Policies in South Asia: An Overview, Report 29949, Washington, DC: The World Bank. World Bank (2006), World Development Report 2006: Equity and Development, Washington, DC: The World Bank.

1

India S. Mahendra Dev

Political and economic history – the legacy of colonial rule India inherited a stagnant economy at the time of independence in August 1947. The economy was predominantly agrarian with little industrial development. Before independence, the aggregate real output increased at the rate of less than 2 per cent per annum; in per capita terms, it was less than 0.5 per cent. Agriculture was almost stagnant, with a growth rate of around 0.3 per cent per annum in the first half of the 20th century. The condition of the social sector was equally poor. Poverty was very high and concentrated in rural areas. Illiteracy was as high as 88 per cent and public health facilities, water supply and sanitation were very poor. On the eve of independence, Jawaharlal Nehru declared: ‘Long years ago we made a tryst with destiny, and now the time comes when we shall redeem our pledge.’ The pledge included ‘the ending of poverty and ignorance and disease and inequality of opportunity’.1 An important historical characteristic that deeply influenced the development path of India was its British colonial legacy. The intellectual and political leaders of the independence movement developed a deep distrust of market forces and international trade, the cornerstones of colonial economic policies. These policies were thought to serve mainly imperial economic interests.2 Two other factors – the success of the newly established Soviet Union in achieving state-led rapid industrialization, and the powerful Latin American argument for import-substituting industrialization – also influenced the development thoughts of the Indian political and economic thinkers. Almost a decade before independence, Indian nationalists started thinking about the objectives and strategy of economic development for an independent India. We have four documents representing four different perspectives.3 First is the Plan prepared by the National Planning Committee (NPC), set up by the Indian National Congress in 1938. The NPC was headed by Jawaharlal Nehru, the future prime minister of the country. The committee included ‘well-known industrialists, financiers, economists, professors, and scientists, as well as representatives from the Trade Union Congress and the Village Industries Association’ (Nehru, 1946: 399). The NPC recognized that the first task was to have an objective in the form of a goal. The Committee declared that: Obviously we could not consider any problem, much less plan, without some definite aim and social objective. That aim was declared to be to ensure an adequate standard of living for the masses. In other words, to get rid of the appalling poverty of the people.. . . There was a lack of food, clothing, of housing and of every other essential requirement of human existence. To remove this lack and ensure an irreducible minimum standard for everybody, the national income had to be greatly increased, and, in addition to this increased production, there had to be a more equitable distribution of wealth. (Ibid.: 402)4

The second is the Bombay Plan, prepared by leading industrialists in the country and published in 1945.5 This plan saw massive investments in infrastructure and basic 25

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Handbook on the South Asian economies

industries as being necessary to facilitate the growth of the private sector and set the country on the road to rapid development. It also identified the elimination of poverty as the central objective of development. The third is the report by a leading Indian engineer, M. Vishveshwaraiya, and the fourth is the People’s Plan, published in 1944 by the Indian Federation of Labour.6,7 All four plan documents agreed on the central objective of poverty removal and on the important role of the government in economic development. The NPC Plan and the report prepared by Vishveshwaraiya strongly stressed industrialization, with an emphasis on heavy and capital goods industries, whereas the People’s Plan called for an emphasis on agriculture. Both the NPC document and the Bombay Plan argued for the protection of medium, small-scale and cottage industries. The experience of the East India Company made the Indian nationalists argue against the entry of foreign capital. The dominant roles of the state and the public sector, import substitution and self-reliance, were clearly articulated in most of these plans. The pre-independence debate on India’s development problems was also dominated by the Gandhian approach on the one hand, and the ‘modernizing’ approach of Jawaharlal Nehru on the other.8 Gandhiji was sceptical of too much state control, although he recognized the potential ill-effects of private monopolies. His solution was a ‘trusteeship’, under which private individuals would operate large enterprises as trustees of society’s capital. Gandhiji’s emphasis on khadi (hand-spun cotton) and swadeshi (self-sufficiency) during the independence movement had its own logic. This was reflected in India’s approach to industrialization. Along with heavy industries, emphasis was also given to the small-scale sector. On the other hand, Nehru was influenced by Fabian socialism. In his famous pamphlet Whither India?, written in the 1930s, Nehru wrote in favourable terms about Soviet socialism.9 The modernizing school under Nehru won the day over Gandhiji’s village approach. The first three Five Year Plans of independent India bore the personal imprint of Nehru, with an emphasis on heavy industries and infrastructure. Nehru described his approach to planning under a democratic pattern of socialism as a new model for Asian and African development. According to him, this philosophy is an area of agreement between the opposing ideologies of capitalism on the one hand and communism on the other. He spoke of it as ‘a third way which takes the best from all existing systems – the Russians, the Americans and the others – and seeks to create something suited to one’s own history and philosophy’.10 Thus, the objective of India’s development strategy has been to establish a socialistic pattern of society through economic growth with self-reliance, social justice and the alleviation of poverty. These objectives were to be achieved in a democratic political framework. The institutional framework of a mixed economy has been used, where both public and private sectors co-exist. The preamble of the constitution declared the resolve of the people to constitute India into a sovereign, socialist, secular, democratic republic. The preamble also pronounced a resolve to secure justice for the people – social, economic and political; liberty of thought, expression, belief, faith and worship; equality of status and opportunity; and to promote fraternity among them all, assuring the dignity of the individual and the unity and integrity of the nation. India was also among the first countries to include legislation aimed at affirmative actions in the form of reservations for socially oppressed sections, such as Scheduled Castes (SCs) and Scheduled Tribes (STs). However, in spite of these reservations, SCs and

India

27

STs are still socially disadvantaged classes. The caste system in India remains one of the main reasons for the social and economic problems of the country. The contradictions in political, social and economic equalities were well articulated by Dr B.R. Ambedkar, the Chairman of the Constituent Assembly Drafting Committee. He concluded his work with a warning: ‘on the 26th January 1950, we are going to enter into a life of contradictions. In politics we will have equality and in social and economic life we will have inequality’.11 Unlike in the Soviet Union and other socialist economies, India’s multi-class and multicaste social structure remained intact. It was thought that economic development would remove the social problems. However, ‘the content of planning and especially the manner of its implementation in India were powerfully influenced by the prevailing social structure and the vested interests’.12 Economic progress and structural changes India’s average economic growth rate of 3–3.5 per cent in the first three decades of its independence was termed as ‘the Hindu rate of growth’.13 The growth rate accelerated only since the early 1980s, following the introduction of reforms by Rajiv Ghandhi. Economic growth and its sources The First Five Year Plan aimed at doubling the national income by 1971–72 (in 21 years) and per capita income by 1977–78 (in 27 years). While the first goal was achieved in 19 years, the achievement of the second goal took 39 years. The per capita GDP of India (in 1993–94 constant prices) in 1950–51 was Rs.3913 and it doubled in the year 1989–90. In 2004–05, the per capita income in 1993–94 constant prices was Rs.12 416. It has increased 3.2 times over the last 54 years. In current prices, the per capita income of India in 2005–06 was around Rs.25 726. The performance of India in terms of economic growth is creditable compared with that of the pre-independence period. GDP growth in the 1950s and 1970s was between 3 and 3.3 per cent per annum (Table 1.1).14 However, it was not enough to make any significant dent in poverty. The turnaround for economic growth that began in the early 1980s continued in the 1990s and beyond. In the post-reform period 1993–2003, the country achieved its highest growth rate of nearly 6 per cent per annum. During the Tenth Plan period (2002–07), India recorded the highest growth rate of 7.6 per cent per annum. In fact, India’s GDP growth was nearly 9 per cent per annum in the last four years (8.5 per cent in Table 1.1

Decadal growth rates of GDP and per capita GDP (%)

Sectors GDP Per capita GDP

1950–51 to 1959–60

1960–61 to 1969–70

1970–71 to 1979–80

1980–81 to 1989–90

1993–94 to 2002–03

3.21 1.22

3.02 0.82

3.33 1.07

5.24 3.10

5.82 3.96

Notes: a. The growth rates are computed by using semi-log functions. b. The GDP data are at 1993–94 prices. Source: Various issues of National Accounts Statistics.

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2003–04, 7.5 per cent in 2004–05, 9.0 per cent in 2005–06 and 9.8 per cent in 2006–07). The Eleventh Five Year Plan aims to achieve 9 to 10 per cent growth per annum. This growth can double per capita income in one decade. The growth rate in per capita GDP was quite low, at around 0.8 to 1.2 per cent in the first three decades after independence. This was partly due to high population growth. The growth rate of per capita GDP since the early 1980s has been more than 3 per cent per annum. In the post-reform period, the per capita GDP growth rose to nearly 4 per cent per annum, partly due to the deceleration in population growth. During the Tenth Plan period and in the last four years, the per capita GDP growth was nearly 6 per cent and 7 per cent per annum respectively. This is a remarkable achievement by any standards. Sivasubramonian (2004) examined sources of GDP growth through growth accounting during 1950–2000. The main determinants of output are labour, capital and land. Hence, the output can be increased either by increasing the inputs or by increasing the output from the same quantity of inputs (total factor productivity, or TFP). The components of output growth per unit of input can be identified as: (1) those due to structural changes, that is, gains from reallocation of resources; (2) irregular fluctuations due to changes in weather; (3) economies of scale; (4) the foreign trade effect; (5) the energy effect. The results are given in Table 1.2. As can be seen, TFP was the major contributor in the 1950s, with 45.4 per cent, followed by labour and capital. In the decelerating phase of two decades, the contribution of TFP declined to 32.5 per cent in the 1960s and a mere Table 1.2 Sources of GDP growth in the non-residential sector (contributions to GDP growth in percentage points)

Sources Non-residential GDP Labour input Employment Age-sex composition Education Capital input Non-residential structures Equipment Inventories Land Total factor input Output per unit of input Structural change Influence of weather Economies of scale Foreign trade effect Energy effect Residual (advances in knowledge and others) Source: Sivasubramonian (2004).

1950–51 to 1960–61

1960–61 to 1970–71

1970–71 to 1980–81

1980–81 to 1990–91

1990–91 to 1999–2000

3.99 1.12 0.92 0.03 0.17 0.85 0.42 0.35 0.08 0.21 2.18 1.81 0.31 0.21 0.12 0.02 – 1.15

3.74 1.10 1.05
0.02 0.07 1.35 0.92 0.33 0.1 0.09 2.54 1.2 0.11 0.12 0.11 0.02
0.03 0.87

3.08 1.50 1.37
0.01 0.14 1.35 0.93 0.33 0.09 0.07 2.92 0.16 0.33
0.27 0.09 0.04
0.05 0.06

5.50 1.38 1.13 0.07 0.18 2.06 0.85 1.03 0.18 0.04 3.48 2.02 0.37 0.05 0.16 0.04 0.15 1.25

5.87 0.98 0.74 0.05 0.14 2.88 1.27 1.51 0.1 0.01 3.86 2.01 0.3
0.07 0.18 0.10
0.14 1.64

India

29

5.2 per cent in the 1970s. The labour input share increased during these two decades. In the acceleration phase of the 1980s and 1990s, capital input played an important role. TFP’s share was also high at 36.7 per cent in the 1980s and 34.1 per cent in the 1990s. However, as noted by Sivasubramonian (2004) ‘the contributions of education, which reflects the possible improvement in the quality of labour input, and that of machinery and equipment, which reflects adoption of modern technology, have not yet become as important as they should be in a rapidly growing economy’ (p. 297). Sectoral growth and structural changes The agriculture sector grew by nearly 3 per cent in the 1950s, followed by around 1 per cent in the 1960s (Table 1.3). Agricultural growth recovered to around 2 per cent per annum in the 1970s, and it grew by more than 3 per cent in the 1980s. In the post-reform period, the growth rate declined to 2.20 per cent per annum. Growth in agriculture GDP, which was 4.7 per cent per annum during the Eighth Plan (1992–97) declined to 2.1 per cent during the Ninth Plan (1997–2002) and to 1.8 per cent per annum during the Tenth Plan (2002–07). Thus, there has been significant deterioration in the growth rate of agriculture since the mid-1990s. In the case of industrial sector, the highest growth rate of 7 per cent was recorded in the 1980s, followed by 6 per cent per annum in the post-reform period. However, industry recorded nearly 9.5 per cent growth per annum in the last four years (2003–04 to 2006–07). The tertiary sector recorded the highest growth of nearly 8 per cent per annum during the post-reform period. Services registered growth of 9.7 per cent per annum during the period 2003–04 to 2006–07. Thus, in contrast to low growth of the agriculture sector, the non-agriculture sector showed a high growth of GDP in the last four years. In the early 1950s, the share of agriculture was nearly 50 per cent in GDP, while the shares of the secondary sector and the tertiary sectors were 15 per cent and 28 per cent respectively (Table 1.4). By the 2000–03 triennium, agriculture accounted for 21.3 per cent of GDP, while the share of the secondary sector increased to 27 per cent. The tertiary sector made the biggest gain, and its share rose to nearly 50 per cent. The share of agriculture and allied activities in GDP declined from 57.7 per cent in 1950–51 to 25 per cent in 1999–2000 and to 20 per cent in 2004–05. The share of Table 1.3

Decadal growth rates of GDP by sectors (%)

Sectors Primary Secondary Tertiary Agriculture Manufacturing

1950–51 to 1959–60

1960–61 to 1969–70

1970–71 to 1979–80

1980–81 to 1989–90

1993–94 to 2002–03

2.25 5.61 3.59 2.89 5.39

1.36 5.01 4.50 1.12 4.06

1.72 4.45 4.55 1.92 4.78

2.91 6.46 6.63 3.08 7.08

2.25 5.79 7.89 2.20 5.92

Notes: a. The growth rates are computed by using semi-log functions. b. The GDP data are at 1993–94 prices. Source: Various issues of National Accounts Statistics.

30

Handbook on the South Asian economies

Table 1.4

Shares of GDP by sectors by decades

Sector Primary Secondary Tertiary Agriculture Manufacturing

1950–53

1960–63

1970–73

1980–83

1990–93

2000–03

57.16 14.86 27.98 49.89 8.91

53.25 18.52 28.23 47.30 10.84

44.73 22.21 33.06 39.24 12.98

39.04 24.06 36.90 35.24 14.17

31.66 26.78 41.56 28.99 16.04

23.29 27.03 49.68 21.27 17.09

agriculture in total labour force, however, declined slowly from 75.9 per cent in 1961 to 59.9 per cent in 1999–2000 and to 56.7 per cent in 2004–05. Between 1961 and 2004–05, there was a 34 percentage point decline in the share of agriculture in GDP while the decline in the share of agriculture in employment was 19 percentage points only. As a result, labour productivity in agriculture has increased only marginally while that of nonagricultural workers increased rapidly. Agriculture Indian agriculture has been characterized by extensive cultivation during the pre-1965 ‘Green Revolution’ era, and by intensive cultivation in the post-Green Revolution period. There has been a significant increase in the use of modern inputs in Indian agriculture. Output of all crops increased at a compound growth rate of 3.15 per cent per annum during 1949–65, significantly led by area expansion (Table 1.5). However, the sources of growth have changed from area expansion in the pre-Green Revolution period to yield growth in the later periods. Yield growth at 2.56 per cent per annum was the highest in the 1980s. Yield growth declined significantly to 1.31 per cent in the 1990s. In fact, yield growth has been stagnant for the crop sector in the decade 1996–97 to 2005–06. The aggregate output growth at the national level hides a great deal of variation in the performance of different regions. Certain regions such as Punjab, Haryana, Western Uttar Pradesh, parts of Andhra Pradesh and Tamil Nadu benefited more during the initial phase of the Green Revolution. This accentuated regional disparities in the immediate postGreen Revolution period. An important feature of the 1980s and in the early 1990s, however, is that there has been a much more equitable spread of agricultural growth. According to Bhalla and Singh (1997) the period 1980–83 to 1990–93 marks a turning point (in terms of growth) in India’s agricultural development. After performing poorly during the early years of the Green Revolution, many of the states – Assam, Bihar, Orissa, Madhya Pradesh and West Bengal – where poverty is widespread, have shown significant growth in the 1980s. In the post-reform period, regional disparities increased. Growth rates in agriculture GDP during the period 1995–96 to 2004–05 declined in all the states except in Bihar. However, the deceleration is the highest in the states with a greater proportion of rain-fed areas (Gujarat, Rajasthan, Madhya Pradesh, Karnataka and Maharashtra). Agriculture growth in these states was less than 1 per cent per annum in the last decade. During the post-reform period, in response to the growing domestic and export demand for non-cereal items of food, there has been a discernible shift in the allocation of resources in the Indian agriculture away from cereals, particularly coarse cereals, to the enterprises like dairy, poultry, edible oils, meat, fish, vegetables and fruits. These

31

India Table 1.5

Compound growth rates of area, output and yield: all India (%) All Crops

Food Grains

Non-food Grains

Period

Area

Output

Yield

Area

Output

Yield

Area

Output

Yield

1949–50 1964–65 1967–68 1980–81 1980–81 1989–90 1990–91 1999–2000

1.58

3.15

1.21


1.35

2.82

1.36

2.44

3.74

0.89

0.51

2.19

1.28


0.38

2.15

1.33

0.94

2.26

1.19

0.10

3.19

2.56


0.23

2.85

2.74

1.12

3.77

2.31

0.25

2.28

1.31


0.17

1.94

1.52

1.37

2.78

1.04

Source: Ministry of Agriculture, Government of India.

enterprises, being labour-intensive, are suited to smallholders, and hence have caused a rise in wage employment. They are also high-value products, hence helping farmers raise their incomes. Additionally, since these cash crops are generally less land- and waterintensive, they are environmentally friendly. Industry Since independence, the share of industry in GDP increased substantially. In the first 15year period after independence (1950–65), the growth rate of manufacturing was around 6.5 per cent. During the period 1964–73, however, industrial growth decelerated to 3.4 per cent, as opposed to the target of 8–10 per cent in the Fourth Five Year Plan. There has been a lively academic debate on the possible explanations for the slowdown in industrial growth after the mid-1960s. Ahluwalia (1985) attributed this to three principal factors: underinvestment and poor efficiency in infrastructure sectors such as power and railways; slow growth in per capita incomes in the agriculture sector; and controls on industry and trade sectors.15 According to Dandekar (1992: 55–6), the reason for slower industrial growth ‘is not that industry in India received insufficient attention. With hindsight, one must admit that the failure of Indian industry to achieve higher rates of growth has been a misdirected industrial policy’. The Indian industrial sector has undergone a significant transformation. In the broad categories, the shares of mining and quarrying and electricity increased, while that of manufacturing declined. But a very diversified industrial base has been created. At the time of independence, the consumer goods industry accounted for almost half of all industrial production. In 1980–81, consumer goods accounted for only about 24 per cent (Table 1.6). On the other hand, capital goods, which constituted less than 5 per cent in the 1950s, accounted for 16 per cent in the early 1980s. Similarly, the share of basic goods increased from about 22 per cent in 1956 to 39 per cent in 1980. Between 1980 and 1994, the share of consumer goods increased, while those of basic and capital goods declined. There was a boom for consumer durables in the last two and a half decades as shown by 14.8 per cent and 10.4 per cent growth in the pre- and post-reform periods respectively. In the last few years, basic goods, intermediate goods and consumer goods recorded high growth rates due to increased investment activities.

32

Handbook on the South Asian economies

Table 1.6

Structural changes in Indian industry and decadal growth (%) Sectoral Shares

Sector Group Basic goods Capital goods Intermediate goods Consumer goods Consumer durables Consumer nondurables

Growth Rates (% per annum)

1970–71 1980–81 1990–91 1993–94 to to to to 1956 1960 1970 1980–81 1993–94 1979–80 1990–91 1993–94 2002–03 22.35 25.11 32.28 4.71 11.76 15.25 24.59 25.88 20.95

39.42 16.43 20.51

35.51 9.69 26.44

6.0 5.6 3.5

7.9 11.3 6.3

5.8
3.9 4.9

5.0 6.6 7.4

48.37 37.25 31.52

23.65

28.36

3.4

6.5

2.2

6.6

3.41

2.55

5.12

4.6

14.8

0.7

10.4

46.16 31.57 28.11

21.10

23.25

3.3

5.1

2.6

5.5

2.21

5.68

Source: EPWRF (2002).

IT Revolution The 1990s witnessed a revolution in the information technology (IT) sector, and in ITenabled services (ITES), India has emerged as the most preferred destination for business process outsourcing (BPO), a key driver of growth for the software industry and the services sector. India controls 44 per cent of the global offshore outsourcing market for software and back-office services, with revenues of US$17.2 billion in the year ended March 2005. At the end of March 2005, India’s outsourcing industry employed 1.05 million programmers and other skilled workers, while giving indirect employment to 2.5 million people in support services such as transport and catering. The industry’s comparative advantage lies in the technical base of India’s higher education in the form of Indian Institutes of Technology (IITs) and regional engineering colleges.16 English-medium education and a strong stream of science and mathematics at school and college levels have been the major advantages for the southern states of Andhra Pradesh, Karnataka and Tamil Nadu (with Hyderabad, Bangalore and Chennai as capital cities respectively) in accelerating the growth of this industry.17 It has also spread to North Indian cities in recent years. The revenue, including exports, grew at a phenomenal rate in the 1990s. The revenue increased from US$0.2 billion in 1989–90 to US$8.3 billion in 2000–01 (Table 1.7). Exports increased from around US$1 billion in 1996–97 to US$12.2 billion in 2003–04. The growth rates of software revenue and exports have been higher than 50 per cent in most of the years since the mid-1990s. In spite of the spectacular growth, India’s IT sector in 2000–01 was less than 3 per cent of GDP, indicating that there is considerable room for further growth. As per the projections of the National Association of Software and Services Companies (NASSCOM), the share of the software industry is expected to rise to 8 per cent of GDP by 2008. The vision of IT policy is to use IT as a tool for raising the living standards of the common people and enriching their lives. Towards this end, the Department of Information Technology

India Table 1.7

33

Revenue and exports of Indian software industry (US$ billion)

Year

Total

Domestic

Exports

1989–90 1994–95 1995–96 1996–97 1997–98 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04

0.197 0.835 1.224 1.755 2.700 3.900 5.70 8.260 – – –

0.097 0.350 0.490 0.670 0.950 1.250 1.700 1.960 – – –

0.100 0.485 0.734 1.085 1.750 2.650 4.000 6.300 7.650 9.530 12.200

Source: Kumar (2001) up to 2000–01; Economic Survey, 2004–05 for the period 2001–02 to 2003–04.

has taken up an ambitious programme of PC and Internet penetration to the rural and underserved urban areas.18 Stock market boom Another development in India in the 1990s has been the significant expansion of the stock market. India figures prominently in the list of the biggest exchanges in the world, measured by the number of transactions. The National Stock Exchange (NSE) displaced Shanghai to take third place, and the Bombay Stock Exchange (BSE) moved up from eighth rank in 2001 to fifth rank in 2003. The NSE and BSE were stable at third and fifth rank respectively in 2003 and 2004. Macroeconomic indicators India’s macroeconomy remained more or less stable, except for a few years. It experienced neither rapid growth nor accelerating inflation. Only in a few years did it record very high budget deficits and balance of payments difficulties. Inflation The inflation rate in the 1950s was very low, and in the 1960s it was close to 7 per cent. The decade of the 1970s recorded the highest rate of inflation at 10 per cent per annum. In the 1980s, the inflation rate declined to 6.5 per cent and further to 5.9 per cent in the post-reform period (Table 1.8). The food price inflation, which is more relevant for the poor, has been mostly in line with the overall inflation rate. There is a lack of consensus about the tolerable rate of inflation. The Chakravarty Committee indicated 4 per cent as the acceptable rise in prices, and this can be regarded as the first influential fix on the threshold rate of inflation in India. Testing for the threshold within the framework of a macroeconometric model suggested a range of 5 per cent to 7 per cent (Rangarajan, 1997).19 Other studies using different methodologies obtain a range from 4 per cent to 7 per cent for the threshold inflation rate. The lower bound of 4 per cent may be regarded as an output-neutral inflation rate with the positive effects of

34

Handbook on the South Asian economies

Table 1.8 Period 1952–62 1962–71 1971–82 1982–94 1994–2003

Rate of inflation: wholesale price index All Commodities

Food Index

1.65 6.90 10.26 6.53 5.90

0.56 8.56 9.32 7.23 6.02

Sources: Various issues of Economic Survey, Government of India; Reserve Bank of India Bulletins.

inflation petering off after 7 per cent (RBI, 2002). Inflation rates over 10 per cent are found to have an adverse impact on growth. Empirical evidence also shows that there is no significant trade-off between anticipated inflation and output growth. Studies also show that for inflation of up to 6.5 per cent, the growth objective of monetary policy can take precedence over the price stability objective. Once it reaches the level of 6.5 per cent, the price stability objective may have to be given greater relative importance. The average annual growth of inflation was 4.7 per cent during 2001–06. In recent years, rising world crude oil prices and problems in supply of food items have put pressures on inflation. Point to point inflation was nearly 6 per cent by the end of March 2007. Savings and investment By developing country standards, India’s saving rate continues to be fairly impressive. However, compared with some East Asian economies, the saving rate has been low in India. In recent years, both savings and investments have been more than 30 per cent of GDP. The decadal averages show that the saving rate improved steadily from 10 per cent in the 1950s to 23.7 per cent in the post-reform period (Table 1.9). The increase was mainly due to the household sector savings. On the other hand, the public sector saving rate declined drastically since the 1990s. In fact, there were dis-savings for the public sector since 1998–99. In recent years, all the sources of savings improved but the rate of increase was the highest for the private corporate sector. Gross domestic capital formation gradually increased over time from 11.1 per cent in the 1950s to 24.5 per cent in the post-reform period. However, the composition of investment changed in the last few decades. The share of private investment has increased significantly, while the rate of public investment declined in the post-reform period. The deceleration of public investment and private corporate investment in the second half of the 1990s was a concern. Gross domestic capital formation rates used to be higher than gross domestic savings, with the investment savings gap accounting for foreign savings. The situation reversed in 2001–02 with the emergence of a surplus current account of balance of payments. In 2001–02, gross domestic capital formation was lower by three percentage points compared with the 1995–96 level.20 However, the investment rate increased to more than 30 per cent of GDP in recent years. The investment rate is expected to be more than 35 per cent in 2006–07. The overall investment rate increased because of the improvement in the corporate investment rate from around 5 per cent in the initial yeas of this decade to around 13 per cent in 2005–06.

35

India Table 1.9

Savings and investments (%) Gross Domestic Savings Rate

Decade Averages 1950–60 1960–70 1970–80 1980–90 1990–2004 2004–05 2005–06#

Gross Domestic Investment Rate

Household sector

Private Corporate

Public sector

Total

Household sector

Private Corporate

Public sector

Total

7.1 8.4 12.2 14.6 19.7 21.6 22.3

1.0 1.5 1.6 1.8 3.8 7.1 8.1

1.8 2.8 3.7 3.0 0.3 2.4 2.0

10.0 12.7 17.5 19.4 23.7 31.1 32.4

5.2* 5.7 7.7 7.8 9.4 11.4 10.7

1.7* 2.8 2.4 4.2 6.2 9.9 12.9

4.4* 7.0 9.0 11.1 7.3 7.1 7.4

11.1* 14.7 17.6 21.2 24.5 29.7** 32.2**

Notes: Savings and investments are as % GDP in current market prices. * Adjusted for errors and omissions; # quick estimates; ** includes valuables of 1.3 per cent of GDP. Source:

National Accounts Statistics, Central Statistical Organisation, Government of India.

Table 1.10 Direct and indirect tax revenues of central and state governments (% of GDP)

Decade Averages 1970–80 1980–90 1990–2000 1990–2004 2005–06 2006–07

Centre’s Gross Tax Revenue

States’ Own Tax Revenue

Combined (CentreStates)

Direct

Indirect

Total

Direct

Indirect

Total

Direct

Indirect

Total

2.3 2.0 2.7 3.0 4.8 5.7

6.5 8.1 6.4 6.0 5.7 5.8

8.8 10.1 9.2 9.0 10.5 11.5

0.3 0.5 0.6 0.7 0.8 0.7

3.9 4.6 4.7 4.9 5.4 5.3

4.2 5.2 5.3 5.5 6.2 6.0

2.6 2.5 3.3 3.6 4.9 5.2

10.4 12.8 11.1 10.8 11.8 11.8

13.0 15.3 14.4 14.5 16.7 17.0

Note: Combined tax revenue figures for 1970s are mentioned as ‘All India’ in Indian Public Finance Statistics. In the Handbook of Statistics on the Indian Economy 2003–04, 2005–06, RBI (2005), it is centre and the states together. Sources: For 1970s: Indian Public Finance Statistics 2003–04, Ministry of Finance, Government of India. From 1980–81 onwards: Handbook of Statistics on the Indian Economy 2003–04, 2005–06, RBI (2005).

Fiscal situation: trends in revenue and expenditures We look at the fiscal situation at three levels: centre, states and combined centre and states. The combined data on revenue and expenditure of centre and states is adjusted for the transfer of funds to states. Trends in revenues Tax revenue for the central government increased from 8.8 per cent in the 1970s to 10.1 per cent of GDP in the 1980s (Table 1.10). However, in the postreform period, it declined to 9 per cent of GDP. The decline was mainly due to a fall in

36

Handbook on the South Asian economies

Table 1.11

Non-tax revenue of the centre, states and combined (% of GDP)

Decade Averages 1970–80 1980–90 1990–2000 1990–2004 2005–06 2006–07

Centre

States

Combined

2.1 2.5 2.5 2.7 2.2 1.9

1.8 1.9 1.7 1.6 1.3 1.3

2.7 2.8 2.6 2.6 2.6 2.4

Note: Combined includes centre, states and Union Territories (UTs) for the period 1970–71 to 1989–90. From 1990–91 onwards it is centre and the states together. Sources: Data for the central government and state governments: Handbook of Statistics on the Indian Economy 2003–04, RBI (2005); data for combined centre and states: for the period 1970–71 to 1985–86: India Database: The Economy (Annual Time Series Data), H.L. Chandhok and The Policy Group (1990); from 1986–87 onwards: Indian Public Finance Statistics 2003–04, Ministry of Finance, Government of India.

indirect tax revenues from 8 per cent of GDP in the 1980s to 6 per cent in the post-reform period. This was caused by tax reforms in the form of reductions in customs and excise duties. Contrary to this, the total tax revenue as a percentage of GDP for the states slightly increased from 5.3 per cent in 1990 to around 5.6–5.8 per cent in the last few years. The combined central and states tax revenue declined from 15.3 per cent in the 1980s to 14.5 per cent in the post-reform period. Between 1993–94 and 2001–04, the tax revenue hovered around 13.4 per cent to 15 per cent of GDP. On the whole, India lost 1 per cent of GDP due to tax reforms in the post-reform period. However, in recent years the tax revenues of both central and state governments increased. The gross tax revenue of the central government rose from 8 per cent in 2000–01 to 11.5 per cent in 2006–07. The combined (centre + states) tax revenue increased from about 15 per cent in the initial years of this decade to nearly 17 per cent of GDP in 2005–06 and 2006–07. In the case of non-tax revenue, there was only a marginal increase for the central government in the last three decades from 2.1 per cent in the 1970s to 2.7 per cent in the postreform period, while there was a marginal decline for the states (Table 1.11). On the whole, the combined centre and states non-tax revenue remained more or less unchanged. The recent data for the years 2005–06 and 2006–07 also confirms this point. Trends in expenditure The revenue expenditure used for current expenses increased for the central government from 8.6 per cent in the 1970s to 12.8 per cent in the post-reform period (Table 1.12). In the case of the states, current expenditure increased significantly in the post-reform period, compared with the 1970s and 1980s. As a result, the combined current expenditure also increased in the 1990s. Capital expenditure declined for both central and state governments in the post-reform period. For the combined centre and states, the ratio of current expenditures increased while that of capital declined. If the decline in public capital expenditure is not matched by an increase in private investment then this would have serious implications for future growth potential. In recent years, capital expenditure as percentage of GDP increased but still lower than that of the 1980s.

India Table 1.12 Decade Averages 1970–80 1980–90 1990–2000 1990–2004 2005–06 2006–07

37

Expenditure trends of the centre and the states (% of GDP) Central Government

State Governments

Total Expenditure

Current Capital Combined Current Capital Combined Current Capital Combined 8.6 12.0 12.3 12.8 12.5 12.4

6.1 6.3 3.5 3.3 1.94 1.92

14.8 18.2 15.8 16.1 14.4 14.3

8.8 11.8 12.7 13.3 13.0 12.5

4.3 4.2 2.8 3.2 2.7 2.6

13.1 16.0 15.5 16.5 15.72 15.04

14.7 21.4 22.5 23.6 23.0 21.9

5.9 6.7 3.7 3.6 4.3 4.2

20.7 28.1 26.2 27.2 27.3 26.1

Sources: Data for the central government and state governments: Handbook of Statistics on the Indian Economy 2003–04, RBI (2005); data for combined centre and states: revenue expenditure 1970–71 to 80–81: H.L. Chandhok and The Policy Group (1990); revenue expenditure 1980–81 onwards: Handbook of Statistics on the Indian Economy 2003–04, RBI (2005) (centre states); for capital expenditure 1970–71 to 1985–86: H.L. Chandhok (centre, states and UTs); 1986–87 to 1989–90: Indian Economic Statistics (1991) (centre, states and UTs); 1990–91 onwards: Indian Public Finance Statistics (various issues) (centre and the states).

Trends in fiscal deficit Since the 1950s, there has been a debate on the role of deficit financing in raising economic growth. There was an intense advocacy for deficit financing in the 1960s and 1970s. The 1970s was a period of moderate growth in public expenditure in line with revenue flows. The gross fiscal deficit in the 1970s was low at 4 per cent for the centre and 2 per cent for the states. There was no deficit in the recurrent expenditure budget for both the centre and states. However, in the 1980s there was an explosive growth in both development and current expenditures, leading to heavy borrowing requirements. In the 1980s, the gross fiscal deficit was 8.3 per cent of GDP. Government expenditure increased from 26 per cent in the early 1980s to 30 per cent of GDP in the late 1980s. Rising interest payments were largely responsible for the increase. This widening resource gap and heavy borrowings led to the accumulation of public debt. The combined fiscal deficit was 9.4 per cent in 1990–91 (Table 1.13). One of the aims of the fiscal reforms since 1991 was to reduce fiscal deficit. Although there was some decline in central government deficit, the deficits of state governments increased in the post-reform period. For the state governments, current budget deficits increased significantly and it was between 2 to 3 per cent of GDP since the mid-1990s. The Report on Currency and Finance 2000–01 of RBI (2002) has cautioned about the deteriorating fiscal performance of the states. It says: the low and declining buoyancies in both tax and non-tax receipts, constraints on internal resource mobilisation due to losses incurred by state PSUs, electricity boards and decelerating resource transfers from the Centre have resulted in the rising fiscal deficits of State Governments, with an accompanying surge in the outstanding stock of debt. (p. 34)

Fifth Pay Commission recommendations also added to the problem of rising expenditures for the governments. Under the Fiscal Responsibility and Budget Management Act (FRBM), the revenue deficit has to be zero by 2007–08. The recent data show the targets set by FRBM Act can be achieved. The combined (centre + states) gross fiscal deficit has already come down to 6.3 per cent in 2006–07.

38

Handbook on the South Asian economies

Table 1.13

Key deficit indicators of the centre, states and combined

Central Government Decade Averages 1970–80 1980–90 1990–2000 1990–2004 2005–06 2006–07

State Governments

Combined (Centre and the States)

Gross Gross Gross fiscal Primary Revenue fiscal Primary Revenue fiscal Primary Revenue deficit deficit deficit deficit deficit deficit deficit deficit deficit 4.0 7.1 5.8 5.7 3.7 3.3

2.4 4.2 1.5 1.2 0.5 0.2

–0.3 2.0 3.1 3.6 2.0 1.6

2.0 2.9 3.3 3.8 2.6 2.1

1.2 1.7 1.4 1.5 0.7 0.2

–0.7 0.1 1.4 1.9 0.5 0.1

– 8.3 7.9 8.6 7.5 6.3

– 5.0 2.7 3.0 1.6 0.8

– 2.1 4.5 5.5 3.0 2.2

Note: ‘–’ indicates revenue surplus. Sources: Data for the central government and state governments: Handbook of Statistics on the Indian Economy 2003–04, RBI (2005); data for combined centre and states: 1970–71 to 1979–80: calculated from the data in H.L. Chandhok (1990) (centre, states and UTs); 1980–81 to 2003–04: Handbook of Statistics on the Indian Economy 2003–04 (centre, states).

External sector During the 1950s, import substitution constituted a major strategy of India’s trade and industrial policies. India was largely insulated from the world market for more than four decades since independence. During 1950–73 when world exports were growing at 8 per cent per annum, India’s export growth was 2.7 per cent per annum (Srinivasan, 2004). The ratio of exports to GDP declined from 7.3 per cent in 1951 to its lowest level of 3 per cent in 1965. The depreciation of the rupee and a deliberate emphasis on export promotion led to a faster growth of exports, on average, than world exports since 1973. However, in value terms, India’s share in world merchandise exports declined from 2.2 per cent in 1948 to 0.5 per cent in 1983. A severe balance of payments crisis in 1991 prompted the liberalization of trade and the second phase of economic reforms. Following reforms, exports as a percentage of GDP increased from 4.8 per cent during 1985–90 to 8–10 per cent in the 1990s and beyond. Similarly, imports as a percentage of GDP rose from 7.7 per cent in 1985–90 to 13 per cent in 2000–01. In the latter years, the trade balance was –3.1 per cent of GDP. However, net invisibles were positive at 2 to 3 per cent of GDP. As a result, the deficit in the current account balance was low in the 1990s. The growth of exports was nearly 20 per cent during 1993–96. Although there was a decline in the late 1990s due to the East Asian crisis, exports have picked up since 2000–01. Recent data for the period 2001–04 show that current account balance had surplus and it increased from 0.7 per cent in 2001–02 to 2.3 per cent of GDP in 2003–04 (Table 1.14). This surplus was mainly due to an increase in the invisibles balance. A rise in the software exports and remittances from abroad has contributed to the invisibles balance. However, due to increase in world crude oil prices, the current account balance has shown deficit in the years 2004–05 and 2005–06. The services sector accounts for 51 per cent of GDP and 31 per cent of total exports. There was an upward shift in the trend growth of services exports (in US dollar terms)

India

39

Table 1.14

Selected indicators of external sector (% of GDP), 2001–06

Year

Exports

Imports

Trade Balance

Invisibles Balance

Current Account Balance

External Debt

9.4 10.6 11.0 12.2 13.1

11.8 12.7 13.3 17.1 19.5


2.4
2.1
2.3
4.9
6.4

3.1 3.3 4.6 4.5 5.3

0.7 1.2 2.3
0.4
1.1

21.2 20.3 17.8 17.3 15.8

2001–02 2002–03 2003–04 2004–05 2005–06 Source:

Economic Survey 2006–07, Government of India.

from 7.9 per cent in the beginning of the 1990s to 15.3 per cent during 2001–04. Software and other miscellaneous services (including professional, technical and business services) have emerged as the main categories in India’s export of services. The relative shares of travel and transportation in India’s service exports have declined over the years, while the share of software exports has risen to 49 per cent in 2003–04. Trade deficit, which was only 2.1 per cent of GDP in 2002–03, widened to 4.9 per cent of GDP in 2004–05 and to 6.4 per cent of GDP in 2005–06. Imports grew rapidly and trade deficit widened sharply due to increases in expenditure on oil imports. On the other hand, invisibles balance increased to more than 5 per cent of GDP in 2005–06 due to increased software and business services, travel, transportation and remittances. Composition of merchandise exports and imports The diversification of exports constitutes an important element of India’s export promotion strategy. India has gradually transformed from a predominantly primary products exporting country into an exporter of manufactured goods. The share of manufactured goods in India’s total exports increased from 70.7 per cent during 1987–90 to 77 per cent in 2002–03. Exports of petroleum products have also increased in recent years. The commodity composition within the major groups has also undergone considerable transformation. Within the primary products group, the shares of ‘ores and minerals’ in total exports had declined while the share of agricultural and allied activities remained almost unchanged at around 18 per cent between 1990–91 and 1998–99, but declined thereafter to 13.4 per cent in 2000–01. In agriculture, the share of traditional export items such as tea, coffee, cereals, handicrafts and carpets declined. Within the manufacturing exports, the shares of engineering and chemical products increased, whereas that of labour-intensive leather products declined. The declines in labourintensive exports may explain the less than expected impact of growth on employment, resulting in a decline in employment elasticity – a point taken up later. There have also been changes in the composition of imports. The share of oil imports in total imports increased from 17.1 per cent during 1987–90 to 34 per cent in 2006–07. Apart from sharp fluctuations in international crude oil prices, an increase in domestic consumption and stagnation of domestic crude oil production were responsible for the increase in oil import bills. Gold imports also increased during 1992–98. Imports of capital goods registered a sharp increase in the initial years of the reform period but later dropped, indicating a slackening in investment demand. Among other imports, the

40

Handbook on the South Asian economies

Table 1.15

Foreign investment and foreign exchange reserves (US$ billion)

Foreign direct investment Foreign institutional investors Non-resident deposits Foreign reserves

1990–91

1999–2000

2002–03

2003–04

2004–05

2005–06

0.10 0 1.54 5.83

2.09 2.14 1.54 38.04

3.21 3.0 2.98 76.10

3.42 11.38 3.64 112.96

2.2 9.3
1.0 141.5*

4.7 12.49 2.79 207.6**

Note: * In March 2005; ** on 6 July 2006. Source:

Economic Survey 2004–05, RBI Bulletin, May 2005.

relative shares of fertilizers, non-ferrous metals, iron and steel etc, generally showed a declining trend. Foreign investment and foreign exchange reserves In the first three decades since independence, foreign investment in India was highly regulated. In the 1980s, there was some easing of foreign investment policy, and a number of measures were taken to promote foreign direct investment (FDI) during the second phase of reforms. As can be seen from Table 1.15, FDI increased significantly since the mid1990s. It varied between US$2.2 billion and US$4.7 billion during 1997–2005. Portfolio investment also increased significantly and stood at US$10.92 billion in 2003–04 and US$12.5 billion in 2005–06. Various deposit schemes for non-resident Indians (NRIs) played a significant role in bolstering overall banking capital inflows and the capital account surplus since 2001–02. In 1990–91, foreign exchange reserves of US$5 billion were enough for only two months of imports. The reserves increased significantly to US$29.37 billion in 1997–98 and reached US$207 billion in July 2007. External debt India’s outstanding debt at the end of December 2004 was US$120.9 billion. According to the Global Development Finance 2004 report (World Bank), India ranks eighth among the top 15 debtor countries of the world. However, the key external indicators show considerable improvement in the recent past. External debt was 27 per cent of GDP in 1991 and increased to 31 per cent in 1995, and thereafter it declined continuously to stand at 17.3 per cent in 2005 (Table 1.16). Short-term debt declined from 10 per cent of total debt in 1991 to 4 per cent in 2004 but rose to 7 per cent in 2006. In terms of composition, India’s external debt has shifted in favour of private debt over the last decade. The ratio of government and non-government debt, which was roughly 60:40 during 1990–95, declined to 40:60 by end-September 2004 (Economic Survey, 2004–05). The large accumulation of private debt was essentially under NRI deposits and export credit and commercial borrowings. With the increasing importance of external debt of the non-government variety, the share of concessional debt fell from 46.7 per cent of total debt in 1991 to about 32 per cent in 2006. Labour force and employment Population Censuses, conducted once every ten years and the five-yearly sample surveys of the National Sample Survey Organisation (NSSO) on Employment and Unemployment

India Table 1.16

External debt indicators

As at End March 1991 1995 2000 2004 2005 2006 Source:

41

Debt Stock–GDP Ratio

Short-term Debt as % of Total Debt

Concessional Debt as % of Total Debt

26.8 30.8 22.1 17.8 17.3 15.8

9.9 4.3 4.0 4.0 6.1 7.0

46.7 45.3 38.9 36.1 33.3 31.5

Handbook of Statistics on the Indian Economy, RBI (2005–06).

are the two main sources of data on overall employment and unemployment in the country. While there are some other agencies that also collect information on employment aspects, their scope and coverage are limited to a particular sector of the economy or a particular segment of the labour force. In this study we basically rely on NSSO data on employment and unemployment. Between 1977 and 1994, the worker–population ratios (WPR) for rural males fluctuated between 54 and 55 per cent, while for rural females it was between 32 and 34 per cent. For urban males, it increased from 50.8 to 52.1 per cent, while it was around 15 to 15.5 per cent for urban females. During the period 1993–2000, work participation rates declined for all categories – the decline being the highest for rural females. However, these ratios increased significantly during the period 1999–2000 to 2004–05. For example, the overall WPR for all (principal status + subsidiary status) workers, which was around 41 to 42 per cent during 1977–78 to 1993–94, declined to 39.7 per cent in 1999–2000. Recent estimates, however, show that WPR again increased to 42 per cent in 2004–05 (to the level of 1993–94). Changes in the structure of the workforce There have been significant structural changes in the workforce during the last four decades. The share of agricultural workforce declined from 76 per cent to 60 per cent between 1961 and 2000 (Table 1.17). But the share of manufacturing workforce increased only by 2.7 percentage points in four decades. This is the difference between the Indian experience and that of East Asia. In India, the share of the service sector workforce increased from 12.5 per cent in 1961 to 22.7 per cent in 2000. The fastest increase occurred in trade, hotels and restaurants. The recent NSSO estimates (61st Round) shows that the share of agriculture declined from 59.9 per cent in 1999–2000 to 56.7 per cent in 2004–05. In other words, non-agriculture share in total employment was 43.3 per cent in 2004–05. Growth of employment NSSO has recently released 61st Round data on employment and unemployment for the year 2004–05. According to the Approach Paper of the Eleventh Plan, employment growth during 1999–2000 to 2004–05 was 2.6 per cent per annum. According to our estimates, the growth rate was 2.86 per cent per annum (Table 1.18). Differences in growth rates were due to differences in population estimates based on the Census. If we look at two long periods, namely 1983 to 1993–94 and 1993–94 to 2004–05, the growth rate of employment was lower

42

Handbook on the South Asian economies

Table 1.17

Changes in structure of workforce (sectoral % share in total), 1961–2000

Sector Agriculture and allied activities Mining and quarrying Manufacturing sector and repair services Electricity, gas and water Construction Trade, hotels and restaurants Transport, storage and communication Finance, insurance, real estate and business services Community, social and personnel services Total

1961

1999–2000

75.9 0.5 9.5 0.1 1.5 4.3 1.7 0.3 6.1

59.9 0.6 12.2 0.4 4.4 9.4 3.7 1.2 8.4

100.0

100.0

Source: Sundaram (2001).

Table 1.18 Number of workers by usual status (p s) and annual growth during 1983 to 2005 Annual Growth Rate (%)

Total Rural Urban

1983 to 1993–94

1993–94 to 2004–05

1993–94 to 1999–2000

1999–2000 to 2004–05

2.01 1.72 3.10

1.89 1.50 3.16

1.09 0.71 2.36

2.86 2.45 4.14

Notes: a. The NSSO ratios are applied to Interpolated and Projected Census Population. b. p s  principal and subsidiary. Sources: Growth rates for 1983 to 1993–94 are taken from Unni and Ravindran (2007). The rest of the growth rates are estimated by us.

in the post-reform period compared with the pre-reform period. It declined particularly in rural areas while in urban areas it marginally increased. The post-reform period (1999–2000 to 2004–05) witnessed high growth rates of employment in both rural and urban areas. Unemployment and underemployment The NSSO provides three types of unemployment rates. They are: long-term unemployment rates (US), weekly unemployment rates (CWS), and daily unemployment rates (CDS). All unemployment rates are generally found to be higher in the urban areas than in rural areas. Female unemployment rates are also found to be higher than male rates. The unemployment rate peaked during 1987–88 and then declined steadily until 1993–94 (Table 1.19). Since then, there have been increases in all unemployment rates. Particularly, the CDS unemployment rate increased for rural males, rural females and urban females in the year 2004–05. The measured unemployment rate in most developing countries does not reflect the true nature of labour under-utilization. Some of the people categorized as usually employed do not have work throughout the year due to seasonality in work or otherwise, and their

India Table 1.19

43

Unemployment rates, 1977–2005 Male

Period

US

1977–78 1983 1987–88 1993–94 1999–2000 2004–05 1977–78 1983 1987–88 1993–94 1999–2000 2004–05

Female

CWS

CDS

US

CWS

CDS

Rural 2.2 2.1 2.8 2.0 2.1 2.1

3.6 3.7 4.2 3.1 3.9 3.8

7.1 7.5 4.6 5.6 7.2 8.0

5.5 1.4 3.5 1.3 1.5 3.1

4.1 4.3 4.4 2.9 3.7 4.2

9.2 9.0 6.7 5.6 7.0 8.7

Urban 6.5 5.9 6.1 5.4 4.8 4.4

7.1 6.7 6.6 5.2 5.6 5.2

9.4 9.2 8.8 6.7 7.3 7.5

17.8 6.9 8.5 8.3 7.1 9.1

10.9 7.5 9.2 7.9 7.3 9.0

14.5 11.0 12.0 10.4 9.4 11.6

Source: NSSO Employment and Unemployment Surveys.

Table 1.20 Per 1000 distribution of person days of usually employed by their broad current daily status for various rounds: rural India (underemployment) Male Status Employed Unemployed Not in lab. force Total

Female

1987–88 1993–94 1999–2000 2004–05 1987–88 1993–94 1999–2000 2004–05 926 27 47

909 40 51

897 53 51

893 61 46

638 26 336

663 30 306

676 41 283

657 47 296

1000

1000

1000

1000

1000

1000

1000

1000

Source: Same as Table 1.18.

labour time is not fully utilized – they are, therefore, underemployed. A measure of the visible underemployment is obtained by cross-classifying persons by their usual and current daily statuses (Table 1.20). It is observed that the proportion of person days of the usually employed utilized for work was quite low for females compared with males in all the surveys, although it has been increasing. It is also observed that when work is not available, a large proportion of females withdraw from the labour force rather than report themselves as unemployed. The unemployed days also have been increasing for both males and females. In other words, underemployment has been increasing. The NSSO also provides the percentages of usually working persons who sought or were available for additional work. This proportion for rural males has increased from 6.9 per cent in 1993–94 to 10.5 per cent in 1999–2000. During the same period, the proportion for rural females increased from 6.0 per cent to 8.3 per cent.

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Handbook on the South Asian economies

Elasticity of employment The rise in both unemployment and underemployment implies that employment growth lagged behind GDP growth. Employment elasticity with respect to GDP declined sharply from 0.53 in the period 1977–83 to 0.41 in the period 1983–94. Employment elasticity as a whole declined further to 0.15 during 1993–2000, when employment elasticities in agriculture and community, social and personal services were almost zero. In the case of manufacturing, the employment elasticity declined from 0.67 in the late 1970s to 0.26 in the 1990s. The wholesale and retail trade sector’s employment elasticity dropped from 0.78 to 0.55 during the same period. With the increase in growth rate of employment, the elasticity would have increased in 2004–05 compared with that of 1999–2000. Labour productivity Bhalla’s study provides estimates of labour productivity for different sectors up to 1993–94 (Bhalla, 2000). The study shows that labour productivity declined in many sectors during 1987–94. The recent estimates provided by Sundaram (2001), however, show that labour productivity increased significantly in most of the sectors except construction during 1993–2000. Table 1.21 shows that the growth of labour productivity at the aggregate level was around 6 per cent per annum. Manufacturing and services recorded higher labour productivity growth rates. The rise in labour productivity is consistent with the decline in employment elasticities in the 1990s. Regional disparities We examine here regional disparities in economic growth in the post-reform period vis-àvis the pre-reform period.21 We try to explain the causal mechanisms that explain regional disparities. Table 1.22 provides growth rates in gross state domestic product (GSDP) and per capita GSDP for two periods. It shows that in the 1980s, four states – Andhra Pradesh, Table 1.21

Sectoral labour productivity (output per worker) Output Per Worker (in Rs.) at 1993–94 Prices

Labour Productivity Growth

Sector

1993–94

1999–2000

% per year

Agricultural and allied activities Mining and quarrying Manufacturing (less repair services) Electricity, gas and water Construction Trade, hotels restaurants Transport, storage and communication Financing, insurance etc (less: GDP in dwellings) Community, social services including repair services All activities

10 120 74 942 30 767 135 989 33 418 34 864 47 462 127 329

12 323 118 010 43 970 271 655 33 647 41 116 57 770 190 921

3.34 7.86 6.13 12.22 0.11 2.79 3.33 6.98

26 549

47 263

10.01

19708

28120

6.10

Source: Sundaram (2001).

India Table 1.22

45

Growth rates of gross state domestic product (GSDP) and per capita GSDP Growth of GSDP (%)

State

Growth of Per Capita GSDP (%)

1980–81 to 1990–91

1993–94 to 2000–01

1980–81 to 1990–91

1993–94 to 2000–01

5.50 3.51 4.55 4.96 6.23 5.16 3.51 4.46 5.85 4.20 5.18 6.39 5.24 4.83 4.60 5.37

5.31 2.59 4.50 5.98 5.57 7.92 5.17 4.33 5.75 3.22 4.96 6.26 6.04 5.26 6.88 6.13

3.33 1.37 2.42 3.00 3.81 3.20 2.13 2.10 3.56 2.39 3.30 3.84 3.80 2.54 2.41 3.24

4.04 0.98 2.81 4.39 3.68 6.41 4.05 2.36 4.30 2.00 3.01 4.22 4.99 3.10 5.32 4.38

Andhra Pradesh Assam Bihar Gujarat Haryana Karnataka Kerala Madhya Pradesh Maharashtra Orissa Punjab Rajasthan Tamil Nadu Uttar Pradesh West Bengal All India

Note: For Bihar, Madhya Pradesh and Uttar Pradesh the data are for the years before the reorganization of these states – 1993–94 and 1998–99. Growth rates are estimated by using semi-log function. Source: Dev and Ravi (2003).

Haryana, Maharashtra and Rajasthan – experienced higher growth than all India (figures in Column 1). The growth rates seem to be more balanced in the 1980s as some of the poor states, for example, Bihar and Orissa, also recorded more than 4 per cent growth per annum. Column 2 shows that four states – Karnataka, Rajasthan, Tamil Nadu and West Bengal – recorded more than 6 per cent growth in the 1990s. Gujarat and Maharashtra also recorded nearly 6 per cent growth in the 1990s. On the other hand, poorer states like Bihar, Orissa, Uttar Pradesh and Assam had low growth rates compared with all India. It may be noted that high-income states like Punjab also recorded low growth in the 1990s. Shetty’s study (2003b) shows that regional variations across 16 states measured by a coefficient of variation increased from 18 per cent in the 1980s to 27 per cent in the 1990s. The coefficient of variation in per capita GSDP increased from 25 per cent in the 1980s to 43 per cent in the 1990s. Eight states – Andhra Pradesh, Gujarat, Karnataka, Kerala, Maharashtra, Rajasthan, Tamil Nadu and West Bengal – recorded more than 4 per cent growth per annum in per capita GSDP in the 1990s (Column 4, Table 1.22). On the other hand, states like Assam, Bihar, Orissa and Madhya Pradesh recorded less than 3 per cent growth in per capita GSDP in the post-reform period (Column 4). Rajasthan seems to have come out of the list of poorer states. There is an inverse relationship between population growth and GSDP growth. Poorer states suffer from high population growth rates and low economic growth. As a result, disparities in per capita GSDP are much higher than those for GSDP.

46

Handbook on the South Asian economies

Another notable change in the 1990s is the increase in the share of services in GDP to more than 50 per cent. In the 1990s, ten states recorded more than 7 per cent growth in services compared with five states in the 1980s. On the other hand, agricultural growth is low in poorer states. Assam and Orissa registered less than 3.5 per cent industrial growth in the 1990s (Dev and Ravi, 2003). Ahluwalia (2000: 1639) observes that ‘while inter-state inequality as measured by the Gini coefficient has clearly increased, the common perception that the rich states got richer and the poor states got poorer is not entirely accurate’. It is true that rich states like Punjab and Haryana recorded lower growth in the 1990s than in the 1980s. But in general, the growth rates of poorer states (Uttar Pradesh, Bihar, and Orissa) declined in the 1990s. In the case of Rajasthan and Madhya Pradesh, there was no increase in the growth rate in the 1990s. Therefore, in five major states, there was no acceleration in the growth rate in the post-reform period. In contrast, acceleration occurred in western and southern states and West Bengal. How does one explain the failure of some states to benefit from economic reforms? The answer lies partly in the initial or pre-reform level of social and economic infrastructure and partly in the rate of capital formation, physical as well as human, in the post-reform period. Infrastructure Physical and social infrastructures are important for economic growth and higher human development. The reports of the Tenth and Eleventh Finance Commissions provide an index of social and economic infrastructure for major Indian states. The Index of Social and Economic Infrastructure was much higher than all India in seven states, namely West Bengal, Maharashtra, Gujarat, Haryana, Tamil Nadu, Kerala and Punjab in both 1995 and 2000 (Table 1.23). In general, there is a positive relationship between infrastructure and growth. However, there are some outliers. For example, Punjab did not record high growth in spite of a high level of infrastructure, while Rajasthan registered high growth in spite of low infrastructure. Similarly, Karnataka and Andhra Pradesh have similar levels of infrastructure, but the former recorded much higher growth than the latter. Detailed data also show that the key infrastructure sectors of power, roads, telecommunications, post and banking are better developed in richer and middle-income states (see GOI, 2003). Investment generally flows to the states where infrastructure facilities are high. Investment and capital flows We do not have appropriate time series data on private investments in different states. Therefore, we look at some important indicators of capital flows towards the end of the 1990s. Ahluwalia (2000) examines the relationship between state plan expenditure as a percentage of GDP and growth rates in GSDP. The study finds that plan expenditure–GSDP ratios declined in both the better performing states as well as poor performing states. Orissa had the highest state plan expenditure at 7.1 per cent of GSDP in the 1990s, but experienced low growth in GSDP. In contrast, West Bengal had the lowest plan ratio of 2.7 per cent but recorded very high growth in the 1990s. The lack of correlation between the state plan expenditure–GSDP ratio and growth rate of GSDP indicates that the total investment, which includes private investment, is more important than state plan expenditure. In the post-liberalization period, private, institutional and external investments have tended to become more and more market-determined.

India Table 1.23

47

Index of social and economic infrastructure Index

States Andhra Pradesh Assam Bihar Gujarat Haryana Karnataka Kerala Madhya Pradesh Maharashtra Orissa Punjab Rajasthan Tamil Nadu Uttar Pradesh West Bengal All India

Rank

1995

2000

1995

2000

99.19 81.94 92.04 123.01 158.89 101.2 205.41 65.92 121.7 74.46 219.19 70.46 149.86 111.8 131.67 100

103.3 77.72 81.33 124.31 137.54 104.88 178.68 76.79 112.8 81 187.57 75.86 149.1 101.23 111.25 100

10 12 11 6 3 9 2 14 7 13 1 15 4 8 5 –

9 13 11 5 4 8 2 14 6 12 1 15 3 10 7 –

Source: Dev and Ravi (2003).

Table 1.24 provides information on per capita capital flows to different states. One can see significant inter-state disparities in the five indicators. The per capita public and private investment in Gujarat (Rs.33 875) was more than ten times that of Bihar (Rs.2852) and Uttar Pradesh (Rs.3304).22 If we take only per capita plan outlays, the disparities are lower than those for total investment. In the case of institutional investment, too, the disparities are lower than for total investment. Per capita total credit utilization in Maharashtra was more than 20 times that of Bihar and nine times that of Uttar Pradesh. Shetty’s study (2003a) shows that there has been a narrowing of regional disparities in the credit-deposit (C-D) ratios in the 1970s and 1980s. However, in the 1990s, the C-D ratios have fallen in all regions – the decline being much steeper in backward states and regions. For example, in the eastern region, the C-D ratios declined from 54 per cent in 1981 to 37 per cent in 2001. Similarly, in the central region (Madhya Pradesh and Uttar Pradesh), the C-D ratios declined from 50 per cent in 1991 to 33 per cent in 2001 (Shetty, 2003a). Table 1.25 provides a list of the top five leading states in terms of selected indicators. It shows that Karnataka and Goa figure in four, Orissa and Punjab in three and Gujarat, Tamil Nadu and Maharashtra in two out of five categories (GOI, 2003). Generally, there is a positive relationship between higher levels of infrastructure/income and capital flows, particularly in per capita total investment. There are some exceptions, like Orissa. In the case of Orissa, relatively high levels of external aid and higher levels of private investment in the power sector could be responsible for figuring in three categories. Rajasthan appears with lower infrastructure figures in one category. On the other hand, Andhra Pradesh appears in one category due to a very high per capita level of externally aided projects (EAPs). The correlation between per capita EAPs and infrastructure/income levels is

48

Source:

GOI (2003).

14 715 6 328 n.a. n.a. 18 685 21 551 n.a. 16 343 18 262 10 907 23 398 9 162 23 040 12 533 19 141 9 765 15 569

Per Capita NSDP (Rs.) 1999–2000 21 447 2 852 12 209 56 057 33 875 9 201 9 105 24 775 12 235 7 287 17 556 25 525 12 688 6 763 26 292 3 304 7 113

Per Capita Public and Private Investment (Rs.) 1032 319 631 3 423 1285 861 836 1 499 710 652 1 120 627 1 244 822 837 293 710

Per Capita Plan Outlay (Rs.)

Per capita capital flows to states: 1999–2001

Andhra Pradesh Bihar Chhattisgarh Goa Gujarat Haryana Jharkhand Karnataka Kerala Madhya Pradesh Maharashtra Orissa Punjab Rajasthan Tamil Nadu Uttar Pradesh West Bengal

Major States

Table 1.24

910 546 32 1 821 720 827 37 688 1 173 725 660 1 049 1 078 914 709 619 662

Per Capita Institutional Investment (Rs.) 4668 669 1803 14 489 5827 5098 1 759 6 420 5 872 2 528 14 890 1 706 7 707 2 419 9 194 1638 3 674

Per Capita Total Credit Utilization (Rs.)

221 11 n.a. 25 138 106 n.a. 125 19 62 52 118 68 35 83 47 89

Per Capita Per Annum Externally Aided Projects (average 1997–2002) (Rs.)

India Table 1.25

49

Leading states in per capita flows

Per Capita Flows Of

Top Five Among Major States

Plan outlays Public & private investments Institutional investment Credit utilization Additional central assistance for externally aided projects

Goa, Karnataka, Gujarat, Punjab, Maharashtra Goa, Gujarat, Tamil Nadu, Orissa, Karnataka Goa, Kerala, Punjab, Orissa, Rajasthan Maharashtra, Goa, Tamil Nadu, Punjab, Karnataka Andhra Pradesh, Gujarat, Karnataka, Orissa, Haryana

Source: GOI (2003).

weak. It shows that there is a large scope for getting funds through additional central assistance in the form of EAPs. The states ranking higher in social and economic infrastructure could attract greater foreign direct investment (FDI). Between 1991 and 2001, the top five states in terms of attracting FDI, namely Maharashtra, Delhi, Tamil Nadu, Karnataka and Gujarat, accounted for 52 per cent of total FDI approvals in the country. Despite its reforms, Andhra Pradesh could manage to attract only about 4.6 per cent of total FDI in the country. Social progress Since the declaration by Nehru on the eve of independence to redeem the pledge of ‘ending of poverty and ignorance and disease and inequality of opportunity’, a lot has been achieved. A lot has been achieved in the past half-century. The incidence of poverty has declined from over 60 per cent in the 1950s to around 28 per cent in 2004–05. The literacy rate has increased from less than 20 per cent in 1951 to 65 per cent in 2001. It is expected to reach 75 per cent by 2007 (the target set for Tenth Five Year Plan). According to the recent Human Development Reports of the UNDP, India moved from the category of ‘low’ human development to that of ‘medium’ human development and its present rank is 126. India’s rank in the Human Development Index (HDI) improved from 132 in 1997 to 126 in 2004. The rank of Gender Development Index (GDI) improved from 112 to 96 during the same period. Nevertheless, the performance of India in the social sector is far from satisfactory. It is still far behind other Southeast and East Asian countries. There are also widespread rural–urban disparities in health and education. The rate of poverty among the lower castes (Scheduled and Tribal) also remains quite high, exceeding the overall rate by 12–14 percentage points in the urban areas and by 10–20 per cent in the rural areas. As Dreze and Sen (1995) observe, India’s achievements in social development could have been much better. Trends in poverty The official poverty rates for all India and major states are given in Table 1.26.23 It shows that poverty declined from about 55 per cent in the early 1970s to 28 per cent in 2004–05. In almost all states, poverty declined in the post-reform period. However, in urban areas of Bihar, Orissa and Rajasthan, poverty increased between 1993–94 and 2004–05. The star performer is Rajasthan, a resource-poor state, where the poverty rate fell from over 46 per cent in the early 1970s to 22.1 per cent in 2004–05. Haryana, too, did very well, where the

50

Handbook on the South Asian economies

Table 1.26

Incidence of poverty across states (%) Rural

States

Urban

Total

1973–74 1993–94 2004–05 1973–74 1993–94 2004–05 1973–74 1993–94 2004–05

A.P. Assam Bihar Guj. Har. Karn. Ker. M.P. Mah. Orissa Punj. Raj. T.N. U.P. W.B.

48.41 52.67 62.99 46.35 34.23 55.14 59.19 62.66 57.71 67.28 28.21 44.76 57.43 56.53 73.16

15.92 45.01 58.21 22.18 28.02 29.88 25.76 40.64 37.93 49.72 11.95 26.46 32.48 42.28 40.80

11.2 22.3 42.1 19.1 13.6 20.8 13.2 36.9 29.6 46.8 9.1 18.7 22.8 33.4 28.6

50.61 36.92 52.96 52.57 40.18 52.53 62.74 57.65 43.87 55.62 27.96 52.13 49.40 60.09 34.67

38.33 7.73 34.50 27.89 16.38 40.14 24.55 48.38 35.15 41.64 11.35 30.49 39.77 35.39 22.41

28.0 3.3 34.6 13.0 15.1 32.6 20.2 42.1 32.2 44.3 7.1 32.9 22.2 30.6 14.8

48.86 51.21 61.91 48.15 35.36 54.47 59.79 61.78 53.24 66.18 28.15 46.14 54.94 57.07 63.43

22.19 40.86 54.96 24.21 25.05 33.16 25.43 42.52 36.86 48.56 11.77 27.41 35.03 40.85 35.66

15.8 19.7 41.4 16.8 14.0 25.0 15.0 38.3 30.7 46.4 8.4 22.1 22.5 32.8 24.7

India

56.44

37.27

28.3

49.01

32.36

25.7

54.88

35.97

27.5

Source:

Economic Survey 2001–02, Government of India Planning Commission, press release, March 2007.

poverty rate fell from over 35 per cent to around 14 per cent. Punjab has the lowest poverty rate (8.4 per cent) and Orissa has the highest poverty rate (46.4 per cent), followed by Bihar (41.4 per cent). Thus, regional disparities in poverty are quite high in the country. Uniform and mixed period poverty estimates Till the 50th Round (1993–94), NSSO had uniform recall period (URP) of 30-day questions for food and non-food. It is known that in the 55th Round (1999–2000) NSSO used mixed recall period (MRP). The reference periods for 1999–2000 were changed from the uniform 30-day recall to both seven-day and 30-day questions for food and intoxicants and only 365-day questions for items of clothing, footwear, education, institutional medical expenses and durable goods. The 61st Round provides both estimates (uniform recall and mixed recall periods). With this uniform recall estimates of 2004–05 can be compared with those of 1993–94 and mixed recall estimates with 1999–2000. The comparable estimates at all India level based are given in Table 1.27. It shows that the poverty levels are lower with mixed recall period in 2004–05. Moreover, there has been faster decline of poverty in the period 1999–2000 to 2004–05 as compared with that of 1993–94 to 2004–05. A recent study by Dev and Ravi (2007) on trends in poverty and inequality for the period 1983 to 2004–05 shows that the extent of decline in the post-reform period in poverty is not higher compared with the pre-reform period in spite of higher overall growth. Apart from other factors, increased inequality seems to have slowed down the rate of reduction of poverty in the post-reform period. However, changes in two sub-periods of the post-reform period are interesting. The extent of decline in the second period (1999–2005) seems to be higher than the first period (1993–2000) of the post-reform period. This result is surprising

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Table 1.27 Comparison of poverty estimates based on uniform and mixed recall periods (%) Uniform Recall Period Population Rural Urban Total

Mixed Recall Period

1993–94

2004–05

1999–2000

2004–05

37.3 32.4 36.0

28.3 25.7 27.5

27.1 23.6 26.1

21.8 21.7 21.8

Source: Planning Commission, Government of India, press release, March 2007.

given that the second period witnessed the lowest growth in agriculture. Factors such as low relative food prices, higher growth in employment, particularly in the non-farm sector, might have been responsible for higher reduction in poverty during the 1999–2005 period. Although this needs to be further investigated, there are two unambiguous conclusions. One is that there is no evidence of higher rate of decline in poverty in the post-reform period as a whole compared with the pre-reform period. Second, inequality increased significantly in the post-reform period compared with the earlier decade. Higher inclusive growth that increases agriculture and rural non-farm sector growth, reduction in regional, rural–urban and social disparities is important for faster reduction in poverty. Low relative food prices seem to be an important variable that reduces income poverty. Alternative estimates of poverty It is known that the 1999–2000 NSSO-based estimates on poverty are not comparable with earlier years because of changes in the reference period. The reference periods for 1999–2000 (55th Round) were changed from the uniform 30-day recall to both seven-day and 30-day questions for food and intoxicants and 365-day questions for items of clothing, footwear, education, institutional medical expenses and durable goods. Official estimates have not adjusted for the changes in reference periods. On the other hand, individual researchers have made several adjustments to make the 1999–2000 data comparable with those of earlier rounds. For example, Deaton and Dreze (2002) estimated alternative poverty ratios based on the unit prices generated from NSSO data. They have also adjusted for the non-comparability of 1999–2000 NSSO data. It shows that the rural poverty was lower by around two percentage points, while urban poverty for all India was considerably lower in the alternative estimates compared with official estimates. It also shows that in all the states, urban poverty was lower than rural poverty. The official estimates show a 10.0 percentage point decline in rural poverty during 1993–2000. Deaton and Dreze show a decline of 6.7 percentage points. A study by Sundaram and Tendulkar (2003) show a 5.3 percentage point decline during the same period. On the other hand, Sen and Himanshu (2004) show a decline of only around 3.0 percentage points in the 1990s. Thus, the decline for rural poverty during 1993–2000 varies between 10.0 percentage points (unadjusted official estimates) and 3.0 percentage points by Sen and Himanshu. Changes in the number of rural poor also vary from a decline of 50 million (official estimates) to an increase of 1.5 million during 1993–2000. The Sen and Himanshu study is more reliable than official estimates, because the former makes adjustments for the non-comparability of 55th Round data.

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Trends in inequality The Gini coefficient in consumer expenditure distribution is used to measure inequality. There has not been any significant change in consumption distribution since 1960 in both rural and urban areas. The Gini coefficient fluctuated between 0.28 and 0.32 for rural areas and between 0.31 and 0.36 for urban since 1960. There was a fall in the Gini coefficient from the mid-1950s to early 1960s, particularly in rural areas, and remained more or less unchanged until the early 1990s. Inequality increased in both rural and urban areas during the post-reform period of 1993–2000. Dev and Ravi (2007) showed that inequality increased in the post-reform period as compared to that of the pre-reform period. Education There have been significant achievements in literacy and education, particularly in technical education. India’s overall literacy rate increased from around 17 per cent in 1951 to 65 per cent in 2001. Literacy in rural areas increased from 36 per cent in 1981 to 59 per cent in 2001. During the same time, literacy in urban areas increased from 67 per cent to 80 per cent. The rural–urban gap has declined from 31 to 21 percentage points in the last two decades. Female literacy increased over time but still around 53 per cent of rural females were illiterate in 2001. Also, 30 to 33 per cent of rural girls in the age group 6–14 were not attending school in 1999–2000. India’s literacy is still low compared with many countries, particularly China. Additionally, there are significant inter-state disparities in literacy and education. For example, rural female literacy in Kerala was 87 per cent, while in Bihar it was 30 per cent in 2001. Similarly, the school attendance ratios for Kerala girls (6–13 years) were 97 per cent, but in Bihar it was 35 per cent in 1995–96. There are also significant inter-state variations regarding school facilities, like access to schools, teacher–pupil ratios, classrooms etc. There are also significant disparities across social groups. For example, among Scheduled Castes and Scheduled Tribes, 40 to 45 per cent of girls were not attending school. Health The health indicators show that the life expectancy of males improved from around 37 in 1951 to 64 in 2001–05. For females, it improved faster from 36.2 to 66.9 during the same period. The infant mortality per 1000 live births declined from 146 in 1951 to 58 in 2005. Maternal mortality rate per 100 000 live births declined from 437 in the early 1990s, to 301 by 2001–03, but is still quite high compared with many other developing countries (Table 1.28). As in education, there are significant regional variations, rural–urban disparities, and lower castes remain disadvantaged. For example, the infant mortality rate in Kerala was 14, while in Orissa it was 97 in 1999 (GOI, 2003). The life expectancy in rural areas was 59, while in urban areas it was 66 in 1992–96 (Table 1.29). In rural areas, nearly 70 per cent of the births are not attended by professionals, compared with only 30 per cent in urban areas. The health indicators for various social groups are much lower for Scheduled Tribes and Scheduled Castes (Table 1.30). For example, the under-five mortality rate was 127 for Scheduled Tribes, compared with 83 for others. The percentage of undernourished children was also higher for the Scheduled Castes and Tribes.

India Table 1.28

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Selected health indicators

Parameter

1951

1981

1991

Current Level

Crude birth rate (per 1000 population) Crude death rate (per 1000 population) Total fertility rate (TFR) (per woman) Maternal mortality rate (MMR) (per 100 000 live births) Infant mortality rate (IMR) (per 1000 live births) Child (0–4 years) mortality rate per 1000 children Couple protection rate (%)

40.8

33.9

29.5

23.8 (2005)

25.1

12.5

9.8

7.6 (2005)

6.0

4.5

3.6

2.9 (2005)

Life expectancy at birth male Life expectancy at birth female

NA

NA

146 (1951–61)

110

437 (1992–93) NFHS 80

57.3 (1972)

41.2

26.5

10.4 (1971)

22.8

44.1

37.2 36.2

54.1 54.7

59.7 (1991–95) 60.9 (1991–95)

301 (2001–03) 58 (2005) 17.0 (2004) 48.2 (1998–99) NFHS 63.9 (2001–06) 66.9 (2001–06)

Notes: a. The dates in brackets indicate years for which latest information is available. b. NFHS: National Family Health Survey; NA: not available. Source:

Economic Survey, 2006–07, Government of India.

Table 1.29

Rural and urban health indicators, 1998–99

Indicators

Rural

Urban

Life expectancy* Infant mortality rate Under-five mortality rate Undernourished children (%) Births attended by health professionals

59.4 75 103.7 49.6 33.5

66.3 44 63.1 38.4 73.3

Notes: Sources:

* 1992–96. GOI (2003); NFHS-1; NFHS-2.

Thus, after half a century since independence, the pledge by one of its founding fathers to remove ‘poverty and ignorance and disease and inequality of opportunity’ remains partly unfulfilled, and the fear expressed by Ambedkar that ‘in social and economic life we will have inequality’ remains uncomfortably true. Economic policy regimes While discussing markets and long-term economic growth, Tendulkar and Sen (2003) divide the economic policy regime of India into six phases. These are summarized in Box 1.1. This section highlights the policy reform efforts since the early 1980s.

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Table 1.30

Health indicators of various social groups

Indicators Scheduled Castes Scheduled Tribes Other disadvantaged Others India

Infant Mortality Rate

Under-Five Mortality Rate

Malnutrition Among Children

83.0 84.2 76.0 61.8 70

119.3 126.6 103.1 82.6 94.9

53.5 55.9 47.3 41.1 47.0

Source: GOI (2003).

BOX 1.1

EVOLUTION OF ECONOMIC POLICY REGIMES IN INDIA SINCE INDEPENDENCE

1. Period of autarchic industrialization conditioned by pre-existing economic nationalism and deep-seated export pessimism, with the dominant industrializing role of the public sector under centralized investment planning and strong reliance on basic and heavy industries (1950–60). 2. Period of growing instability leading to ‘first cracks’ in the sustainability of the autarchic model, with considerable growth deceleration in the first five years, but failing to usher in even selective liberalization due to adverse political economy (1960–73).24 3. Period of coping with external shocks arising from oil-price hikes, helped by a favourable confluence of factors such as opening up of oil-rich gulf countries as new markets for Indian exports, increased flow of remittances from overseas immigrant workers, and ‘covert depreciation’ of the rupee against the US dollar (1973–80). 4. Phase of hesitant deregulation, including selective deregulation of controls on private investment and on transactions in international trade, mostly on non-competing imports (1980–91). 5. Crisis-induced policy shift in 1991, following foreign-exchange liquidity crisis, which was, in turn, triggered by a combination of macroeconomic and political instability towards the end of the 1980s and rising current account deficits. 6. Period of economic reform (1991–97), with a focus on stabilization on one hand, and liberalization on the other, leading to the substantive liberalization of controls on private participation in economic activities (including relaxation of restrictions on foreign private investment), removal of quantitative controls on most intermediate and capital-goods imports, considerable reduction in tariff rates and withdrawal of export restrictions. Source: Adapted from Tendulkar and Sen (2003: 203–4).

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Policies during the 1980s: attempts at deregulation and redistribution The attempts at deregulation, particularly during Rajiv Gandhi’s government, more or less coincided with the Seventh Five Year Plan (1985–90). Two official committees – one on trade policies headed by Abid Hussain (GOI-MOC, 1985) and another on controls chaired by M. Narasimham (GOI-MOF) – recommended selected deregulation of controls on international trade and private investment.25 These recommendations were accepted and implemented in the middle of the 1980s. In the second half of the 1980s, there was a depreciation of the real exchange rate, and it helped in improving the growth of exports. On the redistribution front, the direct anti-poverty programmes (self- and wage employment programmes) started in a big way in the Sixth Plan (1980–85). However, the shift in emphasis away from the earlier concept of a ‘traverse’, with its so-called heavyindustry bias, to a strategy centring around food and fuels occurred in the Fifth Plan (Chakravarty, 1987: 38). The Seventh Plan (1985–90) continued the policies of the Sixth Plan and attempted to integrate poverty alleviation programmes with other developmental activities in rural areas. The decade of the 1980s witnessed the highest GDP growth rates. GDP growth and per capita GDP growth rates were 5.2 per cent and 3.1 per cent respectively. Agriculture also recorded the highest growth rate of 3 per cent in this decade. Similarly, the manufacturing growth rate was also high at 7 per cent. However, there were problems in the balance of payments and fiscal situation by the end of the 1980s. The current account deficit was nearly 3 per cent of GDP. The expansionary policies of central and state governments led to high fiscal deficits, and inflationary pressures were building up. Foreign exchange reserves were limited to cover only one or two months of imports. In other words, macroeconomically, the situation was unsustainable and a correction was needed. Economic reforms since 1991 Economic reforms were initiated in mid-1991 as (1) an insurmountable external debt surfaced in early 1991, bringing India close to default in repayment; (2) the balance of payments situation became almost unmanageable; (3) the possibility of an acceleration in the rate of inflation became high; and (4) the underlying fiscal crisis was acute. External factors, such as the Gulf War and the collapse of the Soviet economy, also contributed to this crisis. With a view to tiding over the unprecedented economic crisis and ensuring the sustainability of the growth process, it was considered necessary to introduce certain major policy reforms on industrial, trade and public sector fronts, almost simultaneously with measures of stabilization for reduction in fiscal and current account deficits. These reforms were consciously fashioned as close to the package developed by the two Bretton Woods Institutions (the IMF and the World Bank) as permitted by domestic conditions.26 These reforms aimed at a fundamental shift towards a greater reliance on the market mechanism to allocate resources and influence decision-making. Thus, they amount to a shift from a model of accumulation based on the domestic market and import substitution to one oriented towards the international market. A summary of the economic reforms undertaken so far from 1991 to 2003 is given in Table 1.31. It documents the main reform policies and comments on the reforms to be undertaken.27

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Table 1.31

Reforms in India since 1991

Economic Reforms

Main Reform Policies

Further Comments

Fiscal, monetary and financial policy

1991: 18% devaluation of the rupee; after 1991: gradual introduction of full convertibility for current account transactions; liberalization of foreign exchange dealings; attempt to reduce fiscal deficit; limited tax reforms; 1991: liberalization of banking; gradual freeing interest rates; 1999: reform of insurance sector; 2004: relaxation of capital controls; reform of regulatory institutions, such as the Securities and Exchange Board of India and the Insurance Regulatory Authority

Fiscal deficit was initially reduced but again began to increase from 1993–94 onwards; recommendations of the Kelkar committees (2002) on tax reforms not implemented; VAT not (yet) implemented; changes introduced in tax rates and a shift towards direct tax collection

Trade policy

1991: virtual abolition of import licensing controls; from 1991: gradual reduction of custom duties and tariffs; 1991: elimination of quantitative import restrictions on intermediate and capital goods; 1998–2001: elimination of quantitative import restrictions on consumer goods

Industrial policy and foreign capital

1991: virtual abolition of industrial licensing; further abolition in 1998–99; sharp reduction in number of industries reserved for the public sector (opening up of electricity and telecommunications); 1991 and 1997: substantive relaxation of foreign investment up to 51% equity; gradual liberalization of foreign direct and portfolio investment

Reservation of products for smallscale industry still largely in place; power: unbundling took place, 10% of generation is in private hands, distribution still by and large done by Public Sector Units (PSUs), tariff increases met with resistance; telecommunications: reforms widely regarded as successful

Agricultural policy

Abolition of restrictions on movement of commodities and liberalization of agricultural trade; liberalization of exports

Continuation of subsidy on fertilizer, food and power; basic staple prices controlled by minimum support prices

Social sector

1997: introduction of targeting in the public food distribution system; 2001: enactment of the 93rd Constitutional Amendment, making education a fundamental right; educational and health reforms implemented at the state level

India Table 1.31

57

(continued)

Economic Reforms

Main Reform Policies

Further Comments

Labour policies

2001: proposals made to reduce ‘Labour market rigidities’

Proposals still not formally accepted, but on the ground, gradual changes have taken place

Privatization and disinvestments

1991: disinvestment policy officially introduced; greater autonomy/ accountability of public enterprises

Large-scale disinvestment and privatization still to take place; from 2001 onwards, the policy started to gain some momentum (VSNL, Maruti); some initiatives have also been taken by various state governments

Governance and administration

1992: enactment of the 73rd and 74th Constitutional Amendments; 1997: implementation of salary revisions as recommended by the Fifth Pay Commission

No significant reduction in the size of government despite various recommendations

Source: Mooij (2005).

Performance in the post-reform period In the post-reform period, there have been improvements in some indicators, such as balance of payments, growth in services, foreign exchange reserves, the IT revolution, telecommunications, the stock market boom, and so on. Indian economy is on a high growth path of 8 to 10 per cent GDP growth per annum. In spite of the relatively satisfactory performance in some of the macroeconomic variables, the post-reform period witnessed a slow rate of reduction in poverty, low quality of employment growth, increase in rural–urban disparities, inequalities across social groups and regional disparities. Agriculture growth was low in the last ten years. Farmers’ suicides are more evident now than before. Although there has been some progress in education, the rate of growth in health indicators (e.g., infant mortality) was lower in the post-reform period as compared with the pre-reform period. In the first few years of this decade, there was a feeling that ‘India was shining’. It was, however, realized that the ‘feel good factor’ was only in some indicators such as growth in services, IT and communication revolutions, balance of payments, foreign exchange reserves, booming stock market and so on. On the other hand, rural India and the social sector have not been shining. Social exclusion is taking place in terms of regions, social and marginal groups, women, minorities and children. There was an increasing feeling that only a few sections of the population such as the rich and middle class, particularly in urban areas, corporate sector, foreign institutional investors, IT sector have benefited from the economic reforms. Fortunately, these issues of social exclusion are being discussed by politicians, bureaucracy, policy-makers and civil society. The Common Minimum Programme of the United Progressive Alliance (UPA) government also stressed on, among other things, the need for focus on agriculture, rural development, employment and the social sector. There is some sort of consensus now that growth should be shared by all sections of society rather than limited to a few categories

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of population. This is important to reduce poverty and various types of inequalities in the economy and society. In order to correct the imbalances, the Approach Paper of the Eleventh Five Year Plan suggests moving ‘towards faster and more inclusive growth’. It says that ‘the Eleventh Plan provides an opportunity to restructure policies to achieve a new vision based on faster, more broad-based and inclusive growth. It is designed to reduce poverty and focus on bridging the various divides that continue to fragment our society’ (p. 1). Prospects and challenges ahead Economic growth In the last two decades, India was among the 10–12 highest growing economies in the world. Three recent papers: the BRICs (Brazil, Russia, India and China) report by Goldman Sachs (Wilson and Purushothaman, 2003); Kelkar (2004) and Rodrik and Subramanian (2004), portray very optimistic scenarios on India’s medium- and long-term growth prospects. According to the Goldman Sachs report, Brazil, Russia, India, and China could become a large force in the world economy by 2050. The other two studies also feel that India would maintain a growth rate of 7 per cent or so in the medium to long term. However, Acharya (2004) questions the conclusions of these studies, and says that in the medium term India can expect to have a growth rate of 5.5 to 6 per cent per annum. According to Acharya, the optimism of these studies is based on four factors: India’s relatively young population due to demographic changes, productivity increases, the country’s institutional strengths and optimism about economic reforms. One can easily doubt the prospect for continued productivity growth and sustained economic reforms. India also faces growing competition from other low-cost emerging countries, in particular China. India also faces shortages of critical infrastructure and resources to sustain rapid growth with macroeconomic stability. The problem becomes starker in an environment of high international oil prices. India’s search for higher growth necessitated the building of dams for alternative energy (hydroelectricity) and the diversion of major rivers for irrigation. These are likely to have serious environmental consequences. However, the recent growth performance shows that India can sustain 8 to 9 per cent of GDP growth over time. Finally, India needs to make sure that future growth does not accentuate inequality and regional disparities. Growing inequality and regional disparities can be politically destabilizing. Social progress: can India achieve Millennium Development Goals? According to the international poverty line of US$1 a day, India’s poverty was 42 per cent in 1990. The Millennium Development Goal (MDG) is to reduce it to half by 2015. In other words, poverty should be 21 per cent in 2015 if India wants to achieve the MDG on poverty. In 2001, the poverty ratio based on the US$1 a day method was 34.7 per cent. If we consider the rate of reduction in recent years, India can achieve the MDG 21 per cent poverty ratio. In the case of child malnutrition, India may not be able to achieve the MDG at the current rates of progress. The MDG is to reduce the percentage of underweight children by one-half between 1990 and 2015, which would imply for India a reduction in the child

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underweight rate from 54.8 per cent in 1990 to 27.4 per cent in 2015. Currently 47 per cent of Indian children are underweight. In the case of education, the MDG is to ensure that, by 2015, all children are in school, the net primary enrolment ratio is 100 per cent and all the students entering grade 1 are retained until grade 5. India has made rapid strides in education during the last four to five decades. The gross enrolment ratio for primary schools is around 95 per cent. However, as in other countries, gross enrolment rates obtained from school administrative records differ significantly from household survey-based estimates on enrolment. Data from the National Sample Survey (NSS) show that net enrolment is around 75 per cent. It may be difficult for India to achieve the MDG of 100 per cent primary net enrolment by 2015. The MDG for gender equality is to eliminate gender disparities in schooling, such that the ratio of girls to boys enrolled at all schooling levels is 100 per cent. Data show that this ratio is between 80 and 85 per cent and the prospect for achieving the MDG of 100 per cent looks possible. Another MDG on gender equality is that the proportion of women in Parliament should be 50 per cent. The present proportion is much lower than this, and it is difficult to achieve this goal given the prevailing gender bias in the society. For health indicators, the MDG is to reduce infant and child mortality by two-thirds between 1990 and 2015. For India, this would imply a reduction of the infant mortality rate (IMR) to 28 per 1000 and of the under-five mortality rate (U5MR) to 41 by 2015. In 2002, the IMR was 63 and the U5MR was 87 per 1000 live births. At this rate, achieving MDGs for the IMR and child mortality will be difficult. Similarly, the MDG for the maternal mortality rate (MMR) is to reduce it by two-thirds between 1990 and 2015. For India, the MMR should be 142 per 100 000 live births by 2015. However, the present MMR is 301. At the current rate, it would be difficult to achieve the MDG for maternal mortality. India may also not achieve the MDG concerning HIV/AIDS given the current increasing trend of infection. Other important MDG indicators are water and sanitation. The MDG for water is to halve by 2015 the proportion of people without sustainable access to safe drinking water. At current levels, the MDG may be achieved, but the quality of drinking water seems to be a problem in both rural and urban areas. In the case of sanitation, only 18 per cent of the rural population in India has sanitation facilities. Therefore, achieving the goal of 50 per cent in rural areas may not be possible at the current rate. So far we have discussed national averages for India. It may be noted, however, that there are significant disparities across regions and social groups for MDG indicators in India. For example, 81 per cent of the regions in India cannot achieve the MDG goal of infant mortality. Rural poverty varies between 46 per cent in Orissa and 8 per cent in Punjab, giving a national rate of 28 per cent. Child malnutrition in Madhya Pradesh (55 per cent) is twice that of Kerala (26 per cent). There is five times the difference in infant mortality between Kerala (16) and Uttar Pradesh (87), and the child mortality rate is 20 times higher in Kerala than in Uttar Pradesh. In general, states like Bihar, Orissa, Uttar Pradesh and Madhya Pradesh are far behind other states in poverty and human development. There are also significant disparities in MDG indicators among various social groups. The lower castes (Scheduled Castes and Scheduled Tribes) are likely to lag behind in social development for a long time to come.

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Notes 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27.

Quoted by Dreze and Sen (2002). See Ahluwalia and Williamson (2003). Parikh (1999). Quoted in Parikh (1999). This plan was prepared by Purushottamdas Thakurdas, J.R.D. Tata, G.D. Birla, Shri Ram, Kasturbhai Lalbhai, A.D. Shroff, Ardeshir Dalal and John Mathai. Vishveshwaraiya (1934). Banerjee et al. (1944). Chakravarty (1987). Ibid.: 9. R.K. Karanjia, The Mind of Mr. Nehru: An Interview, pp. 100–101, quoted in Frankel (2005). This was quoted by Dreze and Sen (2002). Rao (2005: 1). Late Prof. Raj Krishna termed India’s GDP growth rate of 3.5 per cent per annum as the ‘Hindu rate of growth’. There are fluctuations if we take different periods during the three decades. The growth rate of GDP for the period 1950–51 to 1964–65 was 3.87 per cent per annum while it was 2.91 per cent and 4.47 per cent for the periods 1964–65 to 1973–74 and 1973–74 to 1980–81 respectively. The country had severe droughts during 1965–66 and 1966–67. If we ignore these drought years, the growth of GDP during 1967–68 to 1980–81 was 3.38 per cent per annum. For different explanations on slowdown of industrial growth, see Raj (1976); Shetty (1978) and Patnaik (1981). See Ramachandraiah (2003). Ibid. For a discussion on IT sector and development see Murthy (2004). Also see Rangarajan (1998). According to Shetty (2005), both the savings and investment rates in 2002–03 and 2003–04 are exaggerated due to the use of an outdated estimation technique. There are a number of studies on regional disparities in India in recent years. Among others see Ahluwalia (2000); Nagaraj, Varoudakis and Veganzones (2000); Kalirajan, Rao and Shand (1999); Shetty (2003b); Dholakia (2003); Deaton and Dreze (2002); Dev and Ravi (2003); Bhattacharya and Sakthivel (2003). Domestic private investment is influenced by the availability of social and economic infrastructure. For example, of the financial assistance disbursed by the All India financial institutions, the cumulative share was 13.5 per cent for Gujarat and 21.0 per cent for Maharashtra. The poverty line is computed based on a fixed basket of 1973–74, which satisfied the minimum calorie requirement of 2400 kcal in rural areas and 2100 in urban areas. The poverty line for rural areas in 1973–74 was Rs.49 per person per month. Consumer price indices are used to obtain poverty lines for subsequent years. Note that the autarchic policies of both the first and second periods took place in the backdrop of unprecedented expansion in world trade since 1950. See Tendulkar and Sen (2003). This reform package is also termed the ‘Washington Consensus’. On limitations and critical analysis of this package, see Chandrasekhar and Ghosh (2002). There are many studies that have documented the progress of economic reforms in India. Among others see Rao and Linneman (1996); Bhaduri and Nayyar (1996); Joshi and Little (1996); Parikh (1997); Ahluwalia and Little (1998).

References Acharya, Shankar (2004), ‘India’s growth prospects revisited’, Economic and Political Weekly, 39 (41), 4537–4542. Ahluwalia, I.J. (1985), Industrial Growth in India, Stagnation since the mid-1960s, New Delhi: Oxford University Press. Ahluwalia, Montek Singh (2000), ‘Economic performance of states in post-reform period’, Economic and Political Weekly, 35 (19), 1637–1648. Ahluwalia, I.J. and I.M.D. Little (1998) (eds), India’s Economic Reforms and Development: Essays for Manmohan Singh, New Delhi: Oxford University Press. Ahluwalia, I.J. and John Williamson (eds) (2003), The South Asian Experience with Growth, New Delhi: Oxford University Press. Banerjee, B.N. et al. (1944), People’s Plan for Economic Development of India, Bombay: The Indian Federation of Labour.

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Bhaduri, Amit and Deepak Nayyar (1996), The Intelligent Person’s Guide to Liberalization, New Delhi: Penguin Books. Bhalla, G.S. and Gurmail Singh (1997), ‘Recent developments in Indian agriculture: a state-level analysis’, Economic and Political Weekly, 32 (13), A-2-A-18. Bhalla, S. (2000), ‘Behind Poverty: the Qualitative Deterioration of Employment Prospects for Rural Indians’, Working Paper No. 7, New Delhi: Institute for Human Development. Bhattacharya, B.B. and Shakthivel (2003), ‘Economic reforms and jobless growth in India in the 1990s’, Indian Journal of Labour Economics, 46 (4), 845–865. Chakravarty, Sukhamoy (1987), Development Planning, The Indian Experience, Oxford: Clarendon Press Chandrasekhar, C.P. and Jayati Ghosh (2002), A Decade of Neoliberal Economic Reforms in India, New Delhi: Leftword Books. Dandekar, V.M. (1992), ‘Forty years after Independence’ in Bimal Jalan (ed.), The Indian Economy, Problems and Prospects, New Delhi: Penguin Books India. Deaton, A. and Jean Dreze (2002), ‘Poverty and inequality in India: a Re-examination’, Economic and Political Weekly, 37 (36), 3729–48. Dev, S. Mahendra and C. Ravi (2003), ‘Macroeconomic scene: performance and policies’, in C.H. Hanumantha Rao and S. Mahendra Dev (eds), Andhra Pradesh Development: Economic Reforms and Challenges Ahead, Centre for Economic and Social Studies, Hyderabad. Dev, S. Mahendra and C. Ravi (2007), ‘Poverty and inequality: all India and states, 1983–2005’, Economic and Political Weekly, 42 (6), 509–521. Dholakia (2003), ‘Regional disparity in economic and human development in India’, Economic and Political Weekly, 38 (39), 4166–4172. Dreze, Jean and Amartya Sen (1995), Economic Development and Social Opportunity, New Delhi: Oxford University Press. Dreze, Jean and Amartya Sen (2002), India: Development and Participation, New Delhi: Oxford University Press. EPWRF (2002), Annual Survey of Industries 1973–74 to 1997–98, a database on industrial sector in India, Mumbai: EPW Research Foundation. Frankel, Francine R. (2005), India’s Political Economy: 1947–2004, New Delhi: Oxford University Press. GOI (2003), Tenth Five Year Plan, Vols 1, II and III, Planning Commission, Government of India. Joshi, Vijay and I.M.D. Little (1996), India’s Economic Reforms, 1991–2001, New Delhi: Oxford University Press. Kalirajan, K.P., M. Govinda Rao and R. Shand (1999), ‘Convergence of income across Indian states: a divergent view’, Economic and Political Weekly, 34 (13), 769–778. Kelkar, Vijay (2004), India: On The Growth Turnpike, mimeo, Narayan Oration, Australian National University, April. Kumar, Nagesh (2001), ‘Indian software industry development: international and national perspective’, Economic and Political Weekly, 36 (45), 4278–4290. Mooij, Jos (2005) (ed.), The Politics of Economic Reforms in India, New Delhi: Sage Publications. Murthy, Narayana (2004), ‘The impact of economic reforms on industry in India: a case study of the software Industry’, in Kaushik Basu (ed.), India’s Emerging Economy: Performance and Prospects in the 1990s and Beyond, New Delhi: Oxford University Press. Nagaraj, R., A. Varoudakis and M.A. Veganzones (2000), ‘Long-term growth trends and convergence across Indian states’, Journal of International Development, 12 (1), 45–70. Nehru, Jawaharlal (1946), The Discovery of India, New York: The John Day Company. Parikh, K.S. (ed.) (1997), India Development Report, New Delhi: Oxford University Press. Parikh, K.S. (1999), ‘Economy’, in M. Bouton and P. Oldenburg (eds), India Briefing: A Transformative Fifty Years, London: M.E. Sharpe. Patnaik, P. (1981), ‘An exploratory hypothesis on the Indian industrial stagnation’, in A.K. Bagchi and N. Banerji (eds), Change and Choice in Indian Industry, Calcutta: Bagchi & Co. Raj, K.N. (1976), ‘Growth and stagnation in industrial development’, Economic and Political Weekly, 11 (5 & 7), 186–198. Ramachandraiah, C. (2003), ‘Information technology and social development’, in C.H. Rao and S. Mahendra Dev (eds) (2003), Andhra Pradesh Development: Economic Reforms and Challenges Ahead, Hyderabad: Centre for Economic and Social Studies. Rangarajan, C. (1997), ‘The Changing Context of Monetary Policy’, Address at the 31st Convocation of the Indian Statistical Institute, Calcutta, 31 March. Rangarajan, C. (1998), ‘Development, inflation and monetary policy’, in I.J. Ahluwalia and I.M.D. Little, India’s Economic Reforms and Development: Essays for Manmohan Singh, New Delhi: Oxford University Press. Rao, C.H. Hanumantha (2005), Agriculture, Food Security, Poverty, and Environment: Essays on Post-Reform India, New Delhi: Oxford University Press. Rao, C.H. Hanumantha and Hans Linneman (1996), Economic Reforms and Poverty Alleviation in India, IndoDutch Studies on Development Alternatives – 17, IDPAD, New Delhi: Sage Publications India.

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Rodrik, Dani and Arvind Subramanian (2004), ‘Why India can grow at 7 per cent a year or more’, Economic and Political weekly, 39 (16), 1591–1596. RBI (2002), Report on Currency and Finance 2000–01, Mumbai: Reserve Bank of India. RBI (2005), Handbook of Statistics on the Indian Economy, Mumbai: Reserve Bank of India. Sen, Abhijit and Himanshu (2004), ‘Poverty and inequality in India – I and II’, Economic and Political Weekly, 39 (38), 4247–63. Shetty, S.L. (1978), ‘Structural retrogression in the Indian economy since the mid-sixties’, Economic and Political Weekly, 13 (6–7), 185–244. Shetty, S.L. (2003a), Credit Flows to Rural Poor, mimeo, Mumbai: EPW Research Foundation. Shetty, S.L. (2003b), ‘Growth of SDP and structural changes in state economies: interstate comparisons’, Economic and Political Weekly, 38 (49), 5189–5200. Shetty, S.L. (2005), ‘Saving and investment estimates: time to take a fresh look’, Economic and Political Weekly, 40 (7), 606–610. Sivasubramonian, S. (2004), The Sources of Economic Growth in India: 1950–1 to 1999–2000, New Delhi: Oxford University Press. Srinivasan, T.N. (2004), ‘Integrating India with the world economy: progress, problems and prospects’, in A.O. Krueger and S.Z. Chinoy (eds), Reforming India’s External, Financial and Fiscal Policies, New Delhi: Oxford University Press. Sundaram, K. (2001), ‘Employment and poverty in the 1990s: further results from NSS 55th Round, Employment and Unemployment Survey, 1999–2000’, Economic and Political Weekly, 36 (32), 3039–3049. Sundaram, K. and S.D. Tendulkar (2003), ‘Poverty in India in the 1990s: revised results for all India and 15 major states for 1993–94’, Economic and Political Weekly, 38 (46), 4865–4872. Tendulkar, S.D. and A. Sen (2003), ‘Markets and long-term economic growth in South Asia 1950–97’, in I.J. Ahluwalia and John Williamson (eds), The South Asian Experience with Growth, New Delhi: Oxford University Press. Unni, J. and G. Ravindran (2007), ‘Growth of Employment (1993–94 to 2004–05): Illusion of Inclusiveness?’, Economic and Political Weekly, 42 (3), 196–199. Vishveshwaraiya, M. (1934) Planned Economy for India, Bangalore: Bangalore Press. Wilson, Dominic and Roopa Purushothaman (2003), ‘Dreaming with BRICs: The Path to 2050’, Goldman Sachs Global Economic Paper, No. 99 at www.gs.com, October.

2

Pakistan Parvez Hasan

Political setting of economic development Pakistan came into existence as a national entity with the partition of British India on 14 August 1947. It consisted of two wings, East Pakistan and West Pakistan, separated geographically by nearly 1000 miles of Indian territory. The lack of geographical contiguity, though it seemed strange to the outside world, did not particularly concern either the leadership or the people. The desire for an independent homeland for Muslims free from the likely Hindu-dominated majority rule in an undivided India had become very strong. Indeed, the widespread communal riots in the year preceding partition led to a decision by the British government to hasten the announcement of independence and partition on 3 June 1947, though the boundaries of the new states were not to be known till 17 August 1947. The partition had many unintended and unforeseen consequences that have continued to shape the economic and political history of Pakistan, including the role of the military, and relations with India. No one was prepared for the deepening of communal violence and the mass movement of population across the new borders immediately following independence, largely fed by religious fears. According to most conservative estimates, casualties included 250 000 dead and 12 to 24 million refugees.1 While there was movement of population across the border in both wings of Pakistan, West Pakistan was most affected by the transfer of population. Almost all Hindus and Sikhs left the west wing while all of the Muslim population in the Eastern Punjab migrated to the Pakistani side of Punjab. At the same time, a significant part of the educated Indian Muslim elite moved to Pakistan. The refugees, known as Mohajirs, settled in major cities, especially Karachi, the capital at the time. Educated and elite Mohajirs partly filled the vacuum created by the out-migration of the dominant commercial and professional class of non-Muslims. The relations with India deteriorated quickly, reflecting the numerous problems arising out of the partition, such as communal violence, the refugee crisis, disputes on the transfer of assets, distribution of common canal waters and, above all, the Kashmir settlement. Kashmir, a princely state with a largely Muslim population but ruled by a Hindu Maharaja, decided to accede to India in October 1947. Pakistan refused to recognize the accession, which was clearly against the will of the majority of the Kashmiri people. The military conflict that ensued between the two countries ended only in January 1949, when the UN Security Council brought about a ceasefire. The UN-directed plebiscite agreed upon by both countries to determine the wishes of Kashmiri population was never held. The ceasefire line, called the line of control (LOC), is the de facto border, though not officially recognized by either country. But the Kashmir dispute remains a major stumbling block in better relations between India and Pakistan, and has been the source of several military conflicts. The need to assert economic sovereignty and independence from the big neighbour was a key factor that shaped economic policy-making in the early years of Pakistan. The 63

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deterioration in political relations with India almost at the outset, and the widely held perception that India was not reconciled to the creation of Pakistan, had a great influence on the political and economic agenda of Pakistan. It set the stage for a priority on defence, a greater self-reliance in the processing of domestic raw materials, the diversion of trade away from India and the forging of economic ties with the outside world.2 In the early years, there was unanimity on these goals and no significant difference in public opinion between East and West Pakistan. In addition to relations with India, the diverging views on the nature of the state in Pakistan have been a major factor influencing political and economic history and societal evolution. The Pakistan movement was led and dominated by Mohammad Ali Jinnah, not a particularly religious person; rather, he was a thoroughly modern and secular man. All Islamic political parties vehemently opposed the Pakistan movement and the partition of India. Jinnah never thought of Pakistan as a theocratic state. In his speech to the Constituent Assembly on 11 August 1947 he said: You are free; you are free to go to your temples, and you are free to go to your mosques or to any other place of worship that has nothing to do with the business of the state . . . We are starting with this fundamental principle that we are all citizens and equal citizens of the one state. I think we should keep in front of us this ideal and you will find that in the course of time Hindus will cease to be Hindus and Muslims will cease to be Muslims, not in the religious sense, because it is the personal faith of each individual, but in the political sense as citizens of the State.

The economic and social uplift of seriously backward Muslims in the Muslim majority provinces of India was the major concern of Jinnah. Jinnah, who had been the pivotal force for the creation of Pakistan, died in 1948. With the assassination of Prime Minister Liaquat Ali Khan in 1951, strong political leadership disappeared from the scene. Those who became prime ministers between 1951 and 1958 had weak public mandates. The first constitution of the country was not approved till March 1956. It was preceded by the creation of One Unit in October 1955 and the abolition of the provinces in West Pakistan. East and West Pakistan were to have equal representation in the National Assembly, even though East Pakistan had a larger population. The creation of One Unit was an administrative attempt to ensure that the majority province of East Pakistan could not dominate political life.3 The military takeover by General Muhammad Ayub Khan, Commander-in-Chief of the army, in October 1958 was widely greeted by Pakistanis. The deterioration in the economic situation and political instability in the preceding years had made them wary of politicians. Economic and social reforms were high on Ayub’s agenda. A number of commissions, including land reform and education, were set up to review policies and make recommendations. Though in the end only limited progress was achieved on issues like education and land reform, economic policy-making was at the centre stage in Ayub’s period. His commitment to economic development was strong and clear and his approach to economic issues was essentially pragmatic. In the heyday of Ayub’s era in the mid-1960s, Pakistan’s economic development efforts were hailed as a rare success story.4 However, notwithstanding rapid economic growth, economic and political tensions in society and between the two wings grew, especially after the war with India in September 1965. The tension was aggravated by the squeeze on resources due to the levelling-off of foreign assistance, increased allocations to defence

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and relatively more allocation of foreign assistance to East Pakistan.5 Indeed, the 1965 war was a watershed in Pakistan’s history. It seriously interrupted the development momentum of the first half of the 1960s. The additional taxation and money creation required to finance increased defence spending caused hardship, especially in the urban areas. Social and political unrest finally exploded in the winter of 1968, forcing Ayub Khan to hand over power to General Yahya Khan in March 1969. The early 1970s were the most traumatic and turbulent years of Pakistan’s political and economic history. Yahya Khan’s attempts to resolve the political and economic problems with East Pakistan first on the basis of one person–one vote and free elections, and subsequently through the use of military force, were to have disastrous consequences.6 The National Assembly elections held in December 1970 under President General Muhammad Yahya Khan gave Sheikh Mujibur Rahman not only a complete political mandate in East Pakistan but also provided him with a majority in the Parliament. This led to the fear that Mujibur Rahman would demand virtual independence for Bangladesh. Both the military and Zulfikar Ali Bhutto, whose Pakistan People’s Party (PPP) had won a strong majority in West Pakistan, pre-empted this by refusing to accept Mujibur Rahman as the leader of the newly elected Parliament. The political impasse that followed resulted in the ill-considered military action in East Pakistan in March 1971, and the start of the armed conflict with the separatists who were given full support by India. Thus began a chain of events that eventually led to war with India, Pakistan’s military defeat and the creation of the independent state of Bangladesh in December 1971. The separation of East Pakistan was the culmination of political, economic, administrative and social currents that first erupted in the 1952 language movement. These forces were provided with a push by the 1965 war, which exposed the vulnerability of East Pakistan’s defence and had the effect of isolating East Pakistan. No doubt Yahya Khan’s ineptitude, Bhutto’s ambition to be the dominant leader in Pakistan, and Sheikh Mujibur Rahman’s inflexibility, all contributed to the break-up of Pakistan. But in the ultimate analysis, longer-term political and economic factors were dominant in Bangladesh’s drive for independence. It was driven by the desire for genuine political participation and the broad perception in East Pakistan that the government’s development policies were favouring West Pakistan.7 West Pakistan became Pakistan after its military defeat. Bhutto was brought into power by Pakistan’s armed forces and became president on December 20. Bhutto’s rule lasted till the middle of 1977, when he was removed from office by General Zia-ul-Haq against the backdrop of growing political discontent focused on the rigging of the March 1977 elections. The Bhutto period saw major changes in the direction of the economy. The PPP manifesto of 1970 had promised a more equitable economic order and much greater social control of the nation’s economic assets. Socialism and meeting of the basic needs of food, clothing and shelter were central planks of the PPP. Bhutto himself had strong socialist leanings and might have brought about fundamental changes in public ownership of means of production had his rule lasted. Bhutto undertook a large-scale nationalization of industry, insurance and banking, extending the state control of the modern sector significantly. Bhutto’s government also took full control of the country’s educational system by nationalizing private educational establishments. This experiment with socialism had far-reaching and long-term consequences. Though successive governments in the next two

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decades attempted privatization, large segments of banking, insurance and industry remained with the state till the end of the 1990s. While extending the state control over the economy, Bhutto had to deal with the economic consequences of the separation of East Pakistan and with the large and unexpected oil shock of 1973 and the related international recession. To add to the complications, the agricultural output during some years suffered from exceptionally adverse weather conditions, both drought and floods. It is hardly surprising that economic growth slowed, inflation accelerated and macroeconomic imbalances widened, undermining Bhutto’s support, especially among the middle class and professionals. The disruption in economic activity would have been greater except for the large-scale inflows of foreign capital and remittances after 1973, which cushioned the impact of the steep rise in the oil import bills. General Zia-ul-Haq, Chief of the Army Staff, seized power on 5 July 1977, arrested Prime Minister Zulfikar Ali Bhutto and imposed martial law. The military intervention came when strong public protests against Bhutto, in the wake of alleged irregularities in the elections held in March 1977, showed no signs of abating. Zia-ul-Haq’s takeover with the full support of senior army commanders was with the declared purpose of resolving the impasse between Bhutto’s People’s Party and the combined opposition, and holding free and fair elections within 90 days. But Bhutto’s continuing public popularity in a large segment of the population and the fear that his return to power through free elections could unleash a vendetta against the top military leadership prompted Zia and his colleagues to postpone elections. Attention turned, instead, to investigating abuses of power during the Bhutto years. The government published a number of white papers, outlining the Bhutto administration’s misdeeds. More importantly, the military government pursued a pending complaint, accusing Bhutto of complicity in the murder of a political opponent. The Lahore High Court found Bhutto guilty in March 1978 and ordered his execution. By a narrow margin, the Supreme Court of Pakistan upheld the judgment in March 1979. Zia-ul-Haq, in spite of enormous diplomatic pressure from foreign leaders, refused to grant Bhutto clemency and to reduce his sentence. Bhutto was hanged on 4 April 1979. Bhutto’s execution was, in the final analysis, a political act. It set the stage for a long period of military rule that ended only with Zia’s sudden death in a mysterious air crash in August 1988. After Bhutto had been eliminated from the scene, Zia’s political legitimacy was at a low ebb. However, the Soviet invasion of Afghanistan in December 1979 gave a new lease on life to the regime, as it softened both domestic and external pressures for broader political participation. The elections were finally held in March 1985 on a non-party basis, and the constitution was amended before the elections to increase substantially the powers of the president. Following the elections, Zia handpicked Muhammad Khan Junejo, a veteran politician from Sindh, as prime minister. Junejo showed considerable independence, and persuaded Zia at the end of 1985 to lift martial law and allow political parties to function. But Junejo’s assertion of authority eventually led to a conflict with Zia, and his government was dismissed on grounds of incompetence in May 1988. One observer noted, ‘had Zia lived, he would have attempted to change the political system to a presidential form of government’.8 Zia was politically more astute than Ayub and Yahya. However, there were four other factors that helped Zia to prolong his rule. First, Zia used his efforts to Islamize society

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to broaden his political support. Second, the Soviet occupation of Afghanistan and Zia’s highly successful efforts to mobilize and coordinate considerable external assistance for the Mujahideens from diverse sources such as the United States and Saudi Arabia, increased his political standing and control after 1980. Third, Zia extended the role of the army in governance through extensive use of military intelligence, the appointment of senior officers to key positions and a general dispensation of patronage to the armed forces. He thus created a strong vested interest for the army in the continuation of his regime. Fourth, the economy under Zia enjoyed a high and sustained rate of growth. The economy expanded by nearly 6.6 per cent per annum, and inflation tended to decline during 1977–88. There was also a broad sharing of the benefits of growth, real wages increased and poverty tended to decline, largely under the impact of record remittances from migrant workers in the Middle East. The apparently remarkable economic performance over a period of more than a decade, however, masked a deepening of the long-term structural problems: an inadequate level of national savings, growing fiscal deficits, insufficient attention to social development, a high rate of population growth, an anti-export bias of trade policy, a lack of agricultural diversification, excessive dependence on cotton textiles for export and industrial development and an overarching role of the state in key economic areas. None of the difficult policy issues that had emerged during the 1960s and the l970s were resolutely tackled under Zia, and were left to simmer under the surface. At the same time, serious shortages of physical infrastructure developed, especially power, roads and water supply, which affected both the quality of life and the quality of growth. The economy that the democratic government of Benazir Bhutto inherited in December 1988 was not in good shape: macroeconomic imbalances were large; the fiscal deficit had touched a new peak of 8.5 per cent of GDP in 1987–88 and the burden of public debt had grown sharply. The period between Zia’s death in August 1988 and October 1999 was marked by a great deal of political instability, slowing economic growth and recurring foreign exchange crises. The restoration of the democratic government, though with somewhat circumscribed powers of the prime minister, failed to provide a stable political framework for the country. The successive elections in 1988, 1990 and 1993 following the frequent dismissal of the governments did not result in a strong and clear mandate for either of the two major political parties, Benazir Bhutto’s Pakistan People’s Party and Nawaz Sharif’s Pakistan Muslim League. The elected governments were not only politically weak, but were also dominated by strong vested interests, notably the landed aristocracy. At the same time, there were widespread allegations of growing corruption, abuse of power, financial indiscipline and ineffective use of public resources against a number of major politicians. Under these circumstances, the serious economic and social problems inherited from the Zia period deepened, notwithstanding major efforts by successive governments to liberalize the economy and to provide a greater role for the private sector. The period after 1988 not only saw macroeconomic instability, but also a worsening of income distribution and an increase in the incidence of poverty. Among the most serious manifestations of the worsening economic situation in Pakistan were the crises of 1993 and 1996 in the external payments position. These crises coincided with major problems between the president and the prime minister on the effectiveness of the government. Frustration with the economic management of elected governments, no doubt, contributed to the exercise of extraordinary constitutional powers by President Ghulam

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Ishaq in 1990 and 1993 and President Farooq Ahmed Leghari in 1996 to dismiss the elected governments and order fresh elections. Unfortunately, both Benazir Bhutto and Nawaz Sharif as prime ministers were either unwilling or unable to take decisive steps to halt the economic decline and political drift. Meanwhile, the confidence of the public in the government sank to a new low, creating governance problems in areas such as tax collection. In the 1997 elections, Nawaz Sharif again came to power and this time with a large majority in the Parliament. He tried to consolidate his power by reversing some of the constitutional changes that had been introduced by Zia to increase presidential powers. But he came into conflict with the President Leghari, the judiciary, and ultimately, the army, with his personalized style of government. Meanwhile, the economic and foreign exchange position of Pakistan was weakened by foreign sanctions that followed the decision to follow India to test a nuclear device. The relations with India deteriorated after Pakistan’s army action in Kashmir at Kargil. But ultimately, it was Nawaz Sharif’s attempt to dismiss General Pervez Musharraf, the Chief of Army Staff, within a short while of forcing the resignation of the previous head of the army, that triggered the seizure of power by the army again in October 1999, the fourth time in Pakistan’s short history. Unfortunately, democracy could not take a firm root in Pakistan’s polity. The majority of Pakistanis view Pakistan as a moderate liberal Islamic state and resist the notion of a theocratic state based on strict interpretations of Sharia (Islamic religious law) derived from the Qur’an and Sunnah (practices and sayings of the Prophet). However, as economic development failed to ensure fair distribution of the benefits of growth, human development has lagged, and population pressures intensified, the public sympathy for a pure form of Islam has grown. These forces especially gathered momentum during President Zia-ul-Haq’s regime and the enthusiastic support provided to the Mujahideens fighting the Soviet invasion in Afghanistan, with full-scale assistance from the United States and other Muslim countries, especially Saudi Arabia. The transition to a fullfledged democracy, away from essential control by the military as at present, improvement in the law and order situation, especially the curbing of sectarian violence, and the control of extremist Islamic elements, remain challenges for Pakistan. Overall economic performance9 In some ways, Pakistan’s economic growth since 1947 has been remarkable. The country’s economic viability was seriously doubted in some quarters at its emergence, but it has managed, despite a quadrupling of the population, to bring about a significant improvement in the average living standards.10 Per capita GNP growth, on average around 2 per cent per annum over a long stretch of more than 50 years, has been as high as growth in India, and about the average for South Asia. This growth has meant roughly a doubling of average living standards over 1950–2005 (Table 2.1). Initial conditions At partition, both India and Pakistan were underdeveloped, but of the two, Pakistan was more underdeveloped and poor.11 Agriculture provided employment for the large majority of the population, and accounted for nearly 60 per cent of GDP, as industry was in its infancy. Pakistan’s per capita income in 1948–49 was around US$55 compared with a per capita income in India of US$70–80. Large-scale manufacturing accounted for less than

Pakistan Table 2.1 Years 1950–60 1960–70 1970–77 1977–88 1988–96 1996–2000 2000–05 Source:

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Annual growth rates of GNP, population and per capita GNP (% per annum) GNP

Population

Per Capita GNP

3.1 6.7 4.4 6.4 4.3 3.3 5.0

2.4 2.9 3.2 3.1 3.0 2.4 2.0

0.6 3.8 1.3 3.3 1.2 0.9 3.0

Economic Surveys, Government of Pakistan.

2 per cent of the domestic product. The west wing that came to constitute part of Pakistan in 1947 had been, before the partition of the subcontinent, producing food and raw material for the rest of India and had relied almost entirely on the supply of manufactured goods from other parts of India. In 1949–50, investment accounted for only 4 per cent of GDP. The domestic savings rate was a little over 2 per cent of GDP compared with the savings rate in India of 4–5 per cent. The current account deficit in the balance of payments, financed mainly by the running down of sterling balances accumulated in the United Kingdom during the Second World War, provided about half of the investment resources. At the time of independence, Pakistan had very rudimentary infrastructure. For example, the effective electric generation capacity in West Pakistan in 1948–49 was 50 MW (compared with 19 478 MW in 2003–04), and even low levels of electric power consumption required imports from India. The total number of telephones in the country was 16 500 in 1948–49 (over 10 million in 2005, including mobile telephones). The level of social development was similarly low. Adult literacy was probably no higher than 10–15 per cent. Primary enrolment numbers for years immediately after the partition suggest that only 15–20 per cent of the relevant age group was in school. Girls constituted less than 15 per cent of the primary enrolment in 1948. That only 5–6 per cent of primary-school-aged girls were in school in West Pakistan is indicative of the daunting challenge the country faced at independence. Overview By 2003, per capita GNP rose to US$520 compared with US$540 for India and US$400 for Bangladesh, according to World Bank estimates.12 For 2004–05, Pakistan official sources place per capita GNP at US$736, reflecting mainly strong gains during the last two years.13 In purchasing power terms, however, India still has a substantial edge over Pakistan in per capita income (see Table 2.4). The economy has diversified from its heavy dependence on agriculture. Agriculture now accounts for less than a quarter of GDP compared with nearly 60 per cent at partition. The share of large-scale manufacturing, though still rather low, had grown from about 2 per cent in 1949–50 to 12 per cent by 2003–04 (Table 2.2). Pakistan has also been generally able to avoid high rates of inflation and prolonged periods of monetary instability. As a result, the annual variability in GDP growth has

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Table 2.2

Structure of output (%)

Sector

1972–73

1980–81

1990–91

2003–04

Agriculture Industry (of which, Manufacturing) Services

35.6 23.6 (16.9) 40.8

30.8 22.5 (15.0) 46.7

25.7 25.8 (17.7) 48.5

23.3 24.5 (17.5) 52.2

Total

100.0

100.0

100.0

100.0

Note: 1972–73 figures are based on data in 1959–60 prices, 1980–81 and 1990–91 figures are based on data in 1980–81 prices, and 2003–04 figures relate to the new series in 1999–2000 prices.

Table 2.3 Average annual growth rates of GDP (% per annum) of countries in South and East Asia Countries

1960–70

1970–80

1980–90

1990–2001

South Asia Bangladesh India Pakistan Sri Lanka

4.0 3.7 6.7 4.6

3.4 3.0 4.7 4.6

4.3 5.8 6.3 4.2

4.9 5.9 3.7 4.8

East Asia China Indonesia Korea Malaysia Philippines Thailand

5.2 3.9 8.6 6.5 5.1 8.4

6.0 7.6 7.2 7.9 5.8 7.1

10.2 6.1 9.4 5.2 1.0 7.6

10.0 3.8 5.7 6.5 3.3 3.8

Source: World Bank, World Development Reports.

been small compared with most developing countries: indeed the years of negative growth have been rare. The improvement in per capita income over time has been impressive, given a very high rate of population growth, which averaged nearly 3 per cent per annum during 1950–2000.14 Pakistan’s GDP growth of close to 6 per cent per annum during 1960–90 was the best on the Indian subcontinent and substantially higher than the growth in India (Table 2.3). However, the growth slowed down to 3.7 per cent per annum in the 1990s. Allowing for population growth and the divergence between GDP and GNP,15 the per capita GNP growth in Pakistan was only about 1 per cent per annum, in sharp contrast to a rise in Indian GNP per capita of over 4 per cent during the 1990s. Thus, as it approached the new century, Pakistan faced not only the worst financial crisis of its history, but also a serious, though less clearly perceived, ‘growth crisis’. The country needed major structural changes and further policy reforms to re-ignite significant positive growth in per capita income (Hasan, 1998: 23).

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Table 2.4 Purchasing power estimates of GNP per capita, 2003, of countries in South and East Asia Countries Bangladesh China India Indonesia Korea Malaysia Pakistan Thailand Sri Lanka Source:

Current US$ 1 870 9 810 2 880 3 210 18 000 8 970 2 040 7 450 3 740

World Development Indicators 2005, World Bank.

Pakistan, like many other developing countries, has not been able to narrow the gap between itself and rich industrial nations. Equally important, Pakistan also lost substantial economic ground to the rapidly growing economies of East Asia, notably China, South Korea, Thailand, Malaysia and Indonesia. In 1960, South Korea’s per capita income was only marginally ahead of Pakistan’s per capita income. In a short period of one generation, Korea has achieved an income level that, on purchasing power parity basis, is nearly nine times that of Pakistan (Table 2.4). On the same basis, China and Malaysia now enjoy a per capita income advantage of 400 and 300 per cent over Pakistan. Much of the large gap in per capita GNP between China has developed since 1980. Pakistan’s development suffered from a great deal of political instability, tensions and military conflicts with India, and, until recently, a persistently high level of defence spending. Additionally, the relatively satisfactory average growth rate since independence masks not only the sharp slowing down of the growth rate in per capita incomes to barely 1 per cent per annum in the 1990s, but also the rather inequitable distribution of growth benefits, the serious neglect of social sectors and poverty alleviation and an excessive reliance on external resources for financing domestic capital. By the end of the 1990s, the sustainability of Pakistan’s level and pattern of growth was under serious pressure. The build-up of external debt threatened a serious external crisis. The neglect of human resources and infrastructure investment was hampering investment, growth and structural change, and Pakistan was losing its market share in the international markets. Recent turnaround There has, however, been a steady turnaround in Pakistan’s economy since 2000, following the military takeover by General Pervez Musharraf in October 1999. The strong stabilization policies followed with the assistance of the IMF and the World Bank have resulted in the stabilization of currency, the strengthening of the balance of payments and the reduction of the burden of both public and external debt. The stabilization policies combined with structural reforms aimed at accelerating privatization, improving governance and further liberalizing the economy, have been responsible for a sharp recovery in the GDP growth rate from the low point of 1.8 per cent in 2000–01 to an estimated 8.4 per cent in

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2004–05. Additionally, the turnaround in the economy has been made possible by a fundamental transformation in relations with the West, especially the United States following the 11 September 2001 event. Pakistan is now a major ally of the United States in the war on global terrorism. The lifting of US sanctions, increased concessionary assistance and an improved climate for exports and foreign investment, have reinforced the impact of stabilization policies and wide-ranging structural reforms. These have greatly improved the confidence in the currency and reversed the capital flight of the previous decade. Some central questions about Pakistan’s development experience Pakistan’s development experience raises several interesting questions. What factors contributed to the steady, if not spectacular, growth in Pakistan notwithstanding high political volatility and the failure of development to dominate the national agenda over long stretches of time? Why has growth been so lopsided that the sustainability of the process has been jeopardized? Why did not Pakistan fulfil its earlier promising start and become an Asian Tiger? Is the economic turnaround now underway sustainable, and will it deliver a more equitable distribution of growth benefits and help reduce the rather high incidence of poverty? The remaining part of this chapter explores these questions in the context of economic aggregates, macroeconomic developments, saving-investment trends, major developments in productive sectors and social developments, including poverty incidence. In examining economic and social trends, special attention is given to the roles of political leaders (including military leaders who have governed the country for more than half of Pakistan’s existence), economic policy regimes and institutional changes in determining the speed and direction of development. Growth and political regimes As Table 2.1 shows, there were substantial variations in the growth rate of the economy during various periods. Growth was relatively slow during the civilian rules in the 1950s, under Zulfikar Ali Bhutto’s rule (1972–77) and in the period 1988–2000 under successive democratic governments. The two long periods of military rule under Ayub Khan and Zia-ul-Haq were periods of exceptional growth. The economy under General Musharraf has also experienced a remarkable recovery. Thus, one is tempted to conclude that the relatively greater political stability under military rules and the accompanying strong technocratic management have contributed to high growth. However, differences in the growth rates by political periods can be exaggerated and cannot be used uncritically as performance yardsticks. For instance, the exceptional growth during the Ayub years was in no small part due to the sharp stepping up of the rate of investment, especially public investment, in the 1950s. The slowdown of growth during 1970–77 was due, in part, to the separation of East Pakistan, oil price shocks, poor weather conditions and technical problems that delayed the availability of water from the Tarbela Dam. Growth during the Zia period benefited not only from the completion of a sizable investment in water, fertilizer, cement and steel undertaken by the previous civilian government, but also from the substantially positive impact of large-scale remittances, external assistance for Afghan Mujahideens and growth in the narcotics trade. Growth in the period after 1988 suffered, in part, because long-term investment was neglected under Zia, the large overhang of domestic public debt made the reduction of the fiscal deficit difficult and the stimulus provided to the economy by large worker remittances continued

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to wane. Similarly, as mentioned above, the economy since 2000 has benefited from more favourable external relations and circumstances. The high growth during the military regimes should also be placed in the perspective of major economic and social weaknesses they left behind. In sum, military rulers whose legitimacy lay essentially in rapid economic development were unable to create a foundation for sustainable and equitable growth. But the democratic governments that followed the military rules in Pakistan also did not cope well with the fundamental structural problems. Bhutto’s experiment with socialism in the 1970s seriously set back private sector development, and left the state burdened with inefficient public enterprises and a large unwieldy public education system. The democratic regimes in the 1990s did liberalize the economy and provided strong incentives for the private sector but these efforts were undercut by macroeconomic instability caused by the large overhang of public and external debt that they inherited and inability to enforce financial discipline. The effectiveness of these regimes was also undercut both by increased corruption and poor governance. It can be argued, however, that the limited tenures of successive elected governments also adversely affected their performance and in any case the military retained considerable influence on decision-making even under democratic regimes. It is also true that there are only a few cases, notably Korea and Taiwan, where transition to democratic institutions from autocratic regimes was made relatively effectively without disrupting growth. For instance in Indonesia, the downfall of the Soeharto’s regime led to a major economic breakdown.16 Positive factors in growth Why Pakistan has not been able to match the record of the above-mentioned East Asian economies is a question to which we will later turn. But first we must examine the factors that enabled Pakistan to achieve a respectable, if not exciting, GDP growth rate of 5 per cent per annum for five decades. Among the key factors that have had a positive impact on Pakistan’s economy, the following deserve special attention: ●

●

●

●

Very rapid growth in domestic capital formation till the mid-1960s, financed to a substantial extent by external inflows. Notwithstanding a relative neglect of human capital and some lapses in resource use during the 1990s, generally effective use of public sector development funds. A strong and relatively steady growth rate of agriculture of nearly 4 per cent per annum after 1960, reflecting major investments in water development, speedy and successful exploitation of opportunities offered by the Green Revolution for raising wheat and rice yields and, more recently, advances in cotton productivity spurred by a strengthening of incentives and removal of agriculture price distortions. The abnormally low level of manufacturing activity in Pakistan in 1947 compared with what one would expect from a country of Pakistan’s size and income level opened up major opportunities for industrial growth. Manufacture of cotton textiles for the home market presented especially attractive opportunities. After the serious setback dealt to private sector development during the Zulfiqar Ali Bhutto period (1970–77), a gradual liberalization of economic and trade policies, including loosening of investment and foreign exchange controls and privatization of public sector banks, industrial units and utilities. The liberal policies have been

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●

Handbook on the South Asian economies largely in place since the early 1990s, but their impact on investment activity was undercut by political instability and macroeconomic imbalances. Renewed efforts to invigorate the private sector are now underway. A great deal of direction to and continuity in economic management provided by the powerful bureaucracy almost throughout all of Pakistan’s history. The political conditions and regimes have had, of course, a profound impact on economic performance and economic policies. The role of bureaucrats was, no doubt, especially important in the periods of military rule. But even under the three periods of civilian rule, the early years (1947–58), Zulfikar Ali Bhutto’s government (1971–77) and four democratic governments after Zia (1988–99), the effective control of the crucial finance ministry and the Planning Commission remained mostly in the hands of experienced civil servants or technocrats.

Investment expansion The growth in domestic capital formation in West Pakistan (now Pakistan) was truly remarkable in the early decades. The investment boom accelerated during the first half of the 1960s with large flows of external assistance and an improved climate for the private sector. The ratio of gross fixed investment to GDP rose sharply from 4 per cent in 1949–50, to a peak of nearly 21 per cent in 1964–65, just before the war with India (Table 2.5). In absolute terms, real investment grew nearly tenfold over a 15-year period. In the 1950s, though there was substantial private investment, especially in cotton textiles, large public sector outlays on infrastructure dominated the investment picture.17 Public sector investment further expanded sharply in the 1960s, under the impetus of increased external assistance. The signing of the Indus Basin Treaty with India led to the initiation of major expenditures on water development, including the construction of the Mangla and Tarbela Dams, completed in 1968 and 1977 respectively. Though a large part of the expenditures under the Indus Basin were for replacement, they did lead to a substantial augmentation of water availability and better control of irrigation supplies (see Table 2.5 Year 1949–50 1954–55 1959–60 1964–65 1969–70 1976–77 1987–88 1995–96 1999–2000 2003–04 2004–05

Gross fixed public and private investment (as % of GDP) Private

Public

Total

2.5 3.2 4.3 11.6 7.3 5.2 7.7 8.9 10.4 10.8 10.9

1.6 3.8 7.2 9.2 7.0 12.5 8.8 8.1 5.6 4.8 4.4

4.1 7.0 11.5 20.8 14.3 17.7 16.5 17.0 16.0 15.6 15.3

Note: The figures for 1999–2000 and later years are not strictly comparable with the past data because of substantial upward revision in both national income and investment figures. Sources: Hasan (1998) and Pakistan Economic Surveys, Ministry of Finance.

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discussion on agriculture below), as well as a large supply of hydroelectric power. In general, the long gestation period of investments made in water and power during the 1960s and 1970s sustained economic growth well into the 1980s. While public sector investments in infrastructure in the earlier decades underpinned long-term growth, it was the dramatic growth in private sector investment that drove economic growth during 1960–65. As Table 2.5 indicates, the level of private investment as a percentage of GDP rose from 4.3 to 11.6 over a short period. However, private investment dropped sharply during the 1970s and the investment–GDP ratio recovered only slowly during the 1980s and 1990s. The overall rate of investment is still below the level attained in the mid-1960s. Several factors have been responsible for the relatively poor performance of investment after the boom of the 1960s. First, nearly half of the investment in West Pakistan, now Pakistan, was financed from foreign savings in the mid-1960s. Availability of external assistance was adversely affected by the changed relationship with the United States after the 1965 war and a larger allocation of aid to East Pakistan. Aid availability was further disrupted by tensions following the separation of East Pakistan as Bangladesh. In the 1980s and early 1990s, excessive external borrowing led to a sharp rise in the debt burden, limiting further reliance on foreign inflows. Second, within more limited public sector resources, a progressively greater emphasis on defence spending after the war with India, the separation of East Pakistan and the assumption of power by Zia-ul-Haq, led to a major and almost progressive squeeze on public development outlays.18 In the 1990s, with the rising burden of debt payments and lagging tax revenues, real public sector spending, both development and non-development, stagnated.19 Third, private sector activity was hurt by the anti-private sector bias of the Bhutto years. Bhutto undertook a large-scale nationalization of industry, insurance and banking, extending the state control of the modern sector significantly. Though successive governments in the last two decades have attempted privatization, large segments of banking, insurance and industry remained with the state until relatively recently. Finally, macro-instability in the late 1990s and a worsening of the relationship with the West, especially after the detonation of nuclear devices by India and then Pakistan, also hurt investment. Strong and sustained agricultural growth Pakistan’s economy has been sustained to a remarkable extent by a steady and relatively high agriculture growth rate. After the relative neglect of agriculture in the 1950s, which led to the emergence of large-scale food grain imports, the 1960s saw a surge in the agricultural growth rate to 5 per cent per annum, exceeded internationally only by Malaysia and Thailand. Since then, the agricultural growth rate has averaged nearly 4 per cent per annum, though the drought and water shortages during the last few years make the present trend unclear. As Table 2.6 indicates, Pakistan’s record in aggregate agricultural growth compares favourably with most large Asian countries. However, on a per capita basis, agricultural output growth of little over 1 per cent per annum in Pakistan since 1960 appears less impressive. Still, good agricultural growth enabled the country to cope with the needs of a sharply growing population, maintain near self-sufficiency in food grains and provide underpinning for the expansion of domestic textile industry and exports. The good agricultural performance has been the result of a significant investment in water resources both in the public and the private sectors, improved incentives for farmers,

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Table 2.6 Countries

Agricultural growth rates, 1960–99 (% per annum) 1960–70

1970–80

1980–90

1990–99

South Asia Bangladesh India Pakistan Sri Lanka

2.7 1.9 5.1 3.0

0.6 1.8 2.4 2.8

2.7 3.1 4.3 2.2

2.3 3.8 4.3 1.5

East Asia China Indonesia Korea Malaysia Philippines Thailand

0.8 2.9 4.4 5.5 4.3 5.6

2.6 4.1 2.7 5.0 4.0 4.4

5.9 3.4 2.8 3.8 1.0 3.9

4.3 2.6 2.1 1.1 1.5 2.7

Source:

World Development Reports, World Bank and Pakistan Economic Surveys, Ministry of Finance.

especially for fertilizer, a remarkably coordinated and effective government response to the opportunities offered by the availability of improved varieties of wheat and rice after 1967, and the gradual liberalization of agricultural prices and policies in the late 1980s and 1990s. Public policies, such as price supports, fertilizer subsidies, groundwater development and the introduction of the private sector in fertilizer distribution were especially important in the quick spread of the Green Revolution in the late 1960s. To a considerable extent, the increase in agricultural output in Pakistan has come from the expansion of cropped areas due to enormous increases in the availability of inputs, especially water, fertilizer and pesticides. The improvements in efficiency have been relatively limited, and yields per hectare have shown rather modest increases over long periods.20 The important exceptions were the dramatic increase in cotton yields during the 1980s, and wheat and rice yield improvements in the second half of the 1960s. After nearstagnation for a decade, cotton production showed a sharp jump of nearly 30 per cent in 2004–05, reflecting a combination of factors: new varieties of cotton, more effective pest control and favourable weather conditions. That Pakistan has not fully exploited its advantage in agriculture is clear from the comparison between crop yields between the Pakistani and Indian Punjab (Table 2.7). A greater role of peasant-owned farms in the Indian Punjab compared with the Pakistani Punjab, where absentee landlords still remain important, and greater levels of educational attainment in India, are probably the key factors in explaining the differences in yields, though it must be mentioned that the agricultural subsidies are also higher in the Indian Punjab. Large-scale manufacturing growth Large-scale manufacturing has had a more chequered history than agriculture. The extraordinary high rate of manufacturing growth in the 1950s was principally due to two factors: 1) the abnormally low level of manufacturing activity that Pakistan had at the time of partition relative to what one would expect from a country of Pakistan’s size and income level and 2) government policies that ensured a very high rate of profit in manufacturing through high domestic protection. A good deal,

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Pakistan Table 2.7

Average yield (t/ha) in Pakistani Punjab, Indian Punjab and Egypt in 2002

Crop Wheat Coarse rice (paddy) Cotton (phutti) Sugarcane

Pakistani Punjab

Indian Punjab

Egypt

2.5 3.3 1.8 45.1

4.5 5.3 1.3 65.2

6.2 9.4 2.8 90.9

Source: World Bank (2004), ‘Accelerating agricultural growth in the Punjab’, draft chapter for Punjab Economic Report (June).

Table 2.8 Years 1960s 1970s 1980s 1990s 2000–05

Manufacturing growth (average % per annum) Growth 9.9 5.5 8.2 4.4 9.4

though not all, of the protection afforded to industry could be justified on grounds that industry was in its infancy.21 Through a combination of a complicated multiple exchange scheme and a continued reliance on an extensive system of import controls, Pakistan managed to provide its industrial sector with the double advantage of substantial protection against imports, and substantial incentives for exports. Under this protected regime, large-scale manufacturing growth (Table 2.8) was at 16 per cent per annum during the first half of the 1960s, and remained at 10 per cent in the second half of the 1960s, notwithstanding the emergence of foreign exchange shortages. Bhutto’s experiment with socialism dealt a major blow to large-scale manufacturing development in the private sector. Even though the nationalization of industry itself affected less than 20 per cent of the value-added in the manufacturing sector, the lack of discipline and labour militancy, the nationalization of commercial banks and the hostile attitude of the government in general toward the private sector resulted in a precipitous drop in private investment in medium and large-scale industries. By 1976–77, real private investment in this sector was only about 40 per cent of the level in 1969–70. However, under Bhutto, the public sector undertook large industrial investments, including steel mills, fertilizer and cement plants and several sugar and textile mills. Public sector investment in industry rose nearly tenfold in real terms between 1969–70 and 1976–77. But this sizable investment was concentrated in long gestation projects. The immediate effect of Bhutto’s policies was that large-scale manufacturing grew only by 2.8 per cent per annum during 1972–77, following an actual fall (6 per cent) during 1970–72, reflecting the disruption caused by political disturbances and the eventual separation of East Pakistan. The overall manufacturing sector growth during 1977–88 (the Zia years) recovered to 9 per cent per annum compared with 3.7 per cent recorded during 1972–77. Several factors

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were behind this rapid recovery. First, large public sector investments in industry, which were started under Bhutto and continued in the early Zia period, resulted in major increases in steel, cement, fertilizer and vehicle production. Second, the investment climate for the private sector improved due to guarantees against future nationalization, clearer demarcation of activities between the private and the public sectors, relaxation of investment controls and additional tax concessions. While there was no wholesale denationalization, nationalized enterprises were transferred to former owners on a case-by-case basis. Third, incentives for the export of manufactured goods were strengthened by the introduction of flexible exchange rate policies and the strengthening of export rebates and subsidies. As a result, private sector investment grew rapidly, and by the late 1980s rose to over 90 per cent of total industrial investment, in contrast to a little over 25 per cent in 1976–77. The revival of private industrial investment was particularly important for addition to capacity in traditional industries such as cotton textiles, which have a quick pay-off. The rapid growth of raw cotton production also stimulated the cotton textile industry. Unfortunately, the structure of incentives continued to favour relatively simple and limited value-added processing, notably cotton yarn production. Just as in the 1960s, the manufactured exports boom of the 1980s was narrowly linked to the expansion of raw cotton and excessive incentives for cotton textiles. As a result, the share of cotton and cotton-based exports increased sharply from around 40 per cent in 1979–80 to nearly 60 per cent in 1989–90. The export difficulties experienced in the mid-1990s were directly related to a weakness in the structure of exports that developed in the 1980s. As raw cotton production stumbled after 1992, and as unsustainable incentives for cotton textiles were withdrawn, the non-competitiveness of a large segment of this important industry became more obvious. This resulted in the decline of the textile industry, and with it, the growth of the manufacturing sector. The large-scale manufacturing growth, which averaged less than 4 per cent per annum during the 1990s, further slowed down in the second half. The slowdown reflected not only the structural problems in cotton textiles, but also the poor performance in manufactured exports in general, and the greater inroads made by imports. The latter two were due to the failure to adjust the value of the exchange rate in a timely fashion to offset the effect of higher domestic inflation on the competitiveness of exports, and to cushion the impact of import liberalization measures on industry after 1990. However, there has been a strong recovery in large-scale manufacturing growth rate during the last five years, 2000–05. Output has grown over 60 per cent during this period, the bulk of the increase occurring in 2003–05. A much better performance reflects both the sharp growth in domestic demand due to successful stabilization measures completed by 2002, and a strong expansion in exports, mainly textiles and related products, as the exchange rate adjustments improved competitiveness, and the prospects of the phase-out of the MFA (Multi-Fibre Arrangement) spurred new investments in modernization and the expansion of the textile industry. Weaknesses in the economy Pakistan’s inability to sustain the rapid growth of its early years can be attributed to a number of structural weaknesses and policy failures. One crucial structural weakness has been low domestic savings, caused in part by large fiscal deficits. This forced Pakistan to rely excessively on foreign assistance for development financing. The main trade policy

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failure has been Pakistan’s inability to switch its emphasis from the import substitution industrialization strategy of early periods to export promotion. The neglect of investments in human capital has been another major policy weakness. Though it must be emphasized that high population growth, which on the one hand has constrained resource mobilization, and on the other hand increased the need for social spending, compounded the problems caused by neglect of human development. Related to the lag in social development has been insufficient progress in poverty alleviation. These policy issues and problems are discussed in some detail below and the reform efforts that have been underway in recent years are also highlighted. Low level of domestic savings and excessive external dependence As mentioned earlier, Pakistan’s domestic savings rate at the time of independence was little over 2 per cent of GDP. Thus, from the very beginning, Pakistan has had to rely on external assistance for financing, not only its development efforts, but also to its import bills. Pakistan did not have much problem in attracting aid from Western countries, in particular the United States, as it was regarded as a reliable and crucial ally in the Cold War. External assistance reached its peak at over 10 per cent of GDP in 1964–65 (Table 2.9). However, this made Pakistan extremely vulnerable to the attitudes of the donors. This became clear after the 1965 war with India. External assistance dropped to less than 5 per cent of GDP during 1969–70. Aid flow was further disrupted after the separation of East Pakistan. This forced Pakistan to borrow from commercial sources, and the debt burden became unsustainable in the 1980s and early 1990s. The domestic savings ratio barely averaged 11–12 per cent of GDP during this period, as opposed to over 30 per cent in fastgrowing Southeast Asian countries such as Indonesia and Malaysia. Table 2.9 Year 1964–65 1969–70 1976–77 1987–88 1990–91 1995–96 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05

Investment and savings rates as % of GDP (selected years) Investment

Foreign Savings

National Savings

21.1 14.6 19.3 18.0 19.0 18.8 15.6 17.4 17.2 16.8 16.7 17.3 16.9

10.5 4.5 7.0 4.4 4.8 7.2 3.9 1.6 0.7
1.9
3.8
1.7 1.8

10.6 10.1 12.3 13.6 14.2 11.6 11.7 15.8 16.5 18.1 20.6 9.0 15.1

Notes: The foreign savings are defined as current account balance of payments deficit. The figures after 1999–2000 are not strictly comparable with revisions in National Accounts data, which increased both level of GDP and investment, thus affecting the ratios. Sources:

Hasan (1998); Pakistan Economic Surveys, Ministry of Finance.

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In 1998, the suspension of external assistance and the imposition of sanctions following a nuclear Pakistan, forced a foreign exchange crisis resulting in a government freeze on foreign currency deposits. In the next few years, Pakistan teetered on the verge of default of external debt, requiring several Paris Club debt reschedulings. In the past, Pakistan’s inability to raise domestic saving levels over long periods was related to a complex interplay of forces that have operated ever since the partition. There have been political, policy and institutional failures on the broad front of domestic mobilization of resources. There are at least six factors that have adversely affected domestic savings performance: political conditions and social attitudes; a high rate of population growth and a high number of dependents as a percentage of the working age population; relative ease of external resource options; the failure of fiscal policies to generate public savings, given the pressures of large defence spending; the absence of a clear framework for private sector development and the poor development of the financial sector. One factor that had direct impact on national savings is large fiscal deficits. Fiscal deficits in the 1970s averaged 8 per cent of GDP (Table 2.10). The emergence of large fiscal deficits reflected both a failure to develop an effective and elastic tax system, and a large and growing defence spending up to the late 1980s. The fact that the large deficits in the 1980s could be financed in part from non-bank borrowing by mobilizing a large part of incoming worker remittances, helped to moderate the inflationary pressures, and thus led to complacency. In the 1990s, however, the drying up of the non-inflationary sources of financing led to a sharp rise in inflation to over 10 per cent per annum, compared with 6–7 per cent during the 1980s. More importantly, the rising burden of interest payments pre-empted a growing proportion of slow-growing government revenue. By 1999–2000, interest payments accounted for 33 per cent of total government expenditure and nearly 60 per cent of government revenue.22 The fiscal squeeze in the 1990s also had grave consequences for growth and social spending. Because of the heavy burden of debt payments, non-interest public spending, both defence and non-defence, stagnated, and actually declined by 15 per cent in real terms over 1992–99.23 Fiscal adjustment and macroeconomic stability The painful process of fiscal adjustment was attempted with the help of several IMF programmes during the successive democratic governments that succeeded Zia-ul-Haq. However, success was limited. Fiscal stabilization was pursued very strongly after 1999, and stringent policies followed with the Table 2.10 Years 1973–77 1978–83 1983–88 1989–91 1992–94 1994–96 1997–2000 2001–05

Fiscal deficits (as % of GDP) Annual Averages 8.1 6.6 7.8 7.5 7.5 6.1 6.5 3.5

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financial and technical help of the IMF. With the additional help of very favourable debt rescheduling, and an increase in grant assistance following 9/11, Pakistan has been able to reduce fiscal deficits to a sustainable level of 3 per cent or so. Pakistan has also restrained defence spending; it fell from over 6 per cent of GDP in the 1980s to 3 per cent in 2004–05. The consequences have been both a substantial opening up of fiscal space for social and development spending, and a very significant reduction in the public debt burden. The introduction of strong financial discipline after the rather lax fiscal policies of previous decades bodes generally well for future macroeconomic stability. Government dissaving, defined as the excess of consolidated government revenue over current expenditures, averaged over 3 per cent of GDP in the late 1990s.24 This dissaving has been largely eliminated as a result of successful fiscal adjustment. The fiscal adjustment has not only resulted in sharp reductions in the levels of public and external debt but has also contributed to an almost spectacular increase in foreign exchange reserves. As a result, the confidence in currency is now strong, and the exchange rate both in nominal and real terms has been quite stable during the three years, 2002–04. The rate of inflation during this period had dropped to an average of around 4 per cent per annum. Even though inflation jumped up to nearly double-digit level during 2004–05, the pressure on the exchange rate and foreign exchange reserves was quite moderate. It is hoped that the lessons learnt from past experience about the cost of financial indiscipline, an excessive reliance on easy external options, and the repercussions for growth of an imbalance between defence and development spending, will not be easily forgotten. Some other factors should also help to increase the long-term saving rate. First, the high rate of population growth has slowed down to less than 2 per cent per annum, and the declining trend is likely to continue, though it needs to be more strongly supported by social policies. The trend of the increasing number of children per household and a high dependency ratio (the proportion of dependent children to working age population) should begin to change. The dependency ratio was 0.9 in 1995, compared with 0.7 in India, 0.5 in China and 0.6 in Indonesia. It has been noted that high dependency ratios are often associated with lower household savings, and Pakistan is no exception.25 Second, the climate for private investment is better now than it has been in decades, and the trade and investment regimes are quite liberal. The pace of privatization has picked up, and the banking system is now largely in private hands. Third, the financial system has been put on a sounder footing, the proportion of non-performing loans has declined, and financial assets are growing rapidly. Finally, improvement in relations with India and the easing of the tensions in Kashmir should help improve trade and investment relations between the two countries, and in South Asia, more generally. Missed export opportunities and policy failures There are three interrelated reasons why Pakistan lagged behind the successful economies of East and Southeast Asia by failing to use the opportunities offered by the explosive growth in the world trade in manufactured goods. First, the development strategy did not emphasize exports sufficiently. The availability of the large captive market in East Pakistan was certainly a factor in the neglect of exports until at least the early 1970s. Second, the trade policy distortions with relatively high duties on intermediate products discouraged processing for exports. The heavy reliance on foreign trade taxation, and the inability to develop a broad-based system of income and sales taxation, hampered efforts to reduce tariffs. Thus, there was a general

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anti-export bias resulting from the high cost of inputs required for exports, and the relative attraction of the domestic market. Third, the industrial strategy had an excessive emphasis on the processing of domestic raw materials, notably cotton. In the period immediately after partition, import substitution was rightly emphasized. However, with the approaching self-sufficiency of the cotton textiles in the second half of the 1950s, export development had become vital. However, continued availability of the protected market in East Pakistan (now Bangladesh) and the availability of large-scale foreign assistance diluted this urgency. The target for export growth during both the First Plan (1955–60) and the Second Plan (1960–65) was only 3 per cent per annum in nominal terms. The pessimism about exports was probably linked to low expectations about agriculture, and the widespread view at the time that there were serious international demand limitations on manufactured goods exports. Pakistan was, however, not unique among developing countries in attaching low priority to export development in the early period. The strategic failure was not to learn from the experience of manufactured goods exports by Korea, Taiwan, Hong Kong and Singapore in the 1960s, Thailand, Philippines, Malaysia and Indonesia in the early 1970s and China and Turkey in the 1980s. Even though manufactured exports from Pakistan did rise sharply in the 1960s, this growth was artificial to a large extent, because it was achieved through high rates of effective subsidy on cotton textile exports, which largely substituted for raw cotton exports. The Export Bonus Scheme, introduced in January 1959 as a temporary expedient to boost exports, perpetuated a system of multiple exchange rates, which lasted till 1972. This system caused major economic distortions and acted against the normal process of industrial deepening and structural change, that is, the rise in the share of intermediate and capital goods in industrial output. The effective rate of subsidy on the export of manufactured goods in 1967–68 was well over 100 per cent, and even higher for cotton textiles. Given the large profit margins in standard cotton textiles, there were few pressures for moving into areas of greater value-added, such as garments or mixed textiles, and even less for moving into intermediate products or capital goods. At the same time, imports could come in at the overvalued exchange rate.26 It is interesting to note that the massive formal devaluation of May 1972 failed to remove the basic anomalies that had crept in Pakistan’s trade and exchange system in the 1950s and 1960s, partly because they were deep-rooted and had lasted so long. Because the wedge between the effective export and import exchange rate remained large, policies continued generally to favour import substitution and discriminate against exports.27 Even though exports of manufactured goods received a higher effective exchange rate than primary products because of the heavy taxation on the latter, it was not enough to offset the relative attractiveness of the domestic market, resulting from a high degree of effective protection to industry. The system of export rebates was never greatly effective in Pakistan. The high rates of import duty persisted until the mid-1990s; the average rate of duty on dutiable imports remained around 35 per cent in 1996. Selective export subsidies and substantial real devaluation of the rupee during the Zia years did help to expand manufactured exports after their extremely disappointing performance in the 1970s. But the fundamental reliance on cotton textiles and related exports persisted, and they remained heavily dependent on the subsidy on domestic sales of raw cotton. With the gradual phasing out of the subsidy on cotton, the competitiveness of textile exports came under pressure in the 1990s. The high rate of domestic inflation in the 1990s

Pakistan Table 2.11

83

Export performance of major developing countries, 1980–99 Merchandise exports (billions US$)

Export* growth (% per annum)

Exports* as share of GDP (%)

Countries

2001

1980–90

1990–99

1990

1999

Bangladesh China India Indonesia Korea Malaysia Pakistan Philippines Sri Lanka Thailand

6.3 266.2 43.9 56.7 150.7 88.5 9.2 33.6 4.9 64.2

7.7 19.3 5.9 2.9 12.0 10.9 8.4 3.5 4.9 14.1

23.2 12.4 11.3 9.2 15.6 11.0 2.7 9.8 8.4 9.4

6 18 7 28 29 76 16 28 30 34

14 22 11 54 42 124 15 56 36 57

Note: * Exports include goods and services. Source:

World Development Reports, World Bank.

and lags in the adjustment of the nominal exchange rate also eroded competitiveness. Pakistan certainly lost market share in world manufactured goods exports in the period 1990–2000. Pakistan’s merchandise exports compare very unfavourably with most Asian countries, not only in absolute terms but also as a percentage of GDP (see Table 2.11). What is more, in the 1990s, Pakistan became less open, as the export of goods and services as a percentage of GDP declined somewhat. This was in sharp contrast to all major Asian countries, whose export orientation increased very significantly. Despite export recovery in recent years, Pakistan is still well behind its comparators, and remains well below its considerable potential. China, which began its drive for manufactured exports only after 1980, had manufactured exports of nearly US$300 billion in 2004. Malaysia and Thailand had manufactured exports of around US$80 and US$60 billion, compared with Pakistan’s manufactured exports of barely US$10 billion. Mixed record of poverty alleviation Pakistan does not fare well on the distribution of growth benefits. Clearly, the pattern of development has favoured the rich and feudal military and civil elite at the cost of poverty alleviation.28 Some worsening of the pattern of income distribution is to be expected during the course of capitalist development. Indeed, even in the rapidly growing economies of East Asia, including China and Korea, there is evidence of a rise in income inequalities over time. However, in most of these countries, there was a steady reduction in the incidence of absolute poverty. Though estimates vary, there is a reasonable consensus that poverty incidence in Pakistan was also reduced over 1960–90, from around 50 per cent in the early 1960s to around 34 per cent in 1990–91.29 But after some further progress during 1991–94, the poverty incidence apparently rose in the late 1990s. The Planning Commission estimates, based on the Integrated Household Survey Data, show poverty incidence at 30.6 per cent in 1998–99 and 32.1 per cent in 2001–02, a drought

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year. These estimates for the first time used an official poverty line, set at 2350 calories per adult per day (2150 calories in urban areas and 2450 in rural areas). This poverty line is higher than that of India (2250 calories) and Bangladesh (2150 calories). The latest official estimates imply a poverty incidence of 29.1 per cent in 1986–87 and 26.1 per cent in 1990–91.30 There is now a broad agreement that progress towards a decline in poverty was halted, if not actually reversed, in the 1990s. However, there is some evidence of a reduction in poverty incidence over 2001–05 as growth revived. The recent release of provisional poverty estimates (March 2006) show a reduction in the incidence of nationwide poverty from 32.1 per cent in 2001 to 25.4 per cent in 2005. While a definitive analysis of poverty trends would have to await the release of household income and expenditure data and the methodologies applied, the reported decline in poverty incidence appears quite plausible because of the sharp recovery in overall growth rate, exceptional good agricultural production during 2005–06 and recent expansion in poverty-related spending. At the same time, there is no reason for joy or complacency because the reported numbers do not provide much comfort that the widespread problem of poverty, which is a part of the more general problem of growing economic inequities in the society, is on the way of being resolved quickly and effectively.31 The persistence of a high level of rural poverty, 31.8 per cent in 2004–05, according to provisional figures, is a major concern. In addition, the sheer rise in the total number of poor in Pakistan, a large majority of whom are illiterate, has probably been a root cause of social discontent. At the time of partition, out of a population of around 30 million, about 55 per cent or 16.5 million people were poor. This number now is nearly 40 million (out of a population of 154 million). It is this large number of poor that remains at the core of Pakistan’s social and political problems. It is hardly surprising that tensions within society have grown over time and have erupted with increasing frequency in ethnic and sectarian violence, and the law and order situation has deteriorated. In a real sense, the governance problems facing Pakistan have had their roots in the pattern of economic development. There are five key factors that have held back more rapid progress on poverty alleviation, and have also contributed to undermining rapid and sustained per capita income growth. They are: a large concentration of ownership in land holdings; high population growth; inadequate job creation through the promotion of labour-intensive manufactured exports; a great neglect of social sector investments and, finally, fiscal policies and a tax system that have taxed the rich lightly and have not provided adequate funding for pro-poor programmes. The land reforms undertaken during the Ayub and Bhutto periods were not very effective in transferring land to the landless. More than one-half of the rural population is landless and constitutes nearly 70 per cent of the rural poor. While there is scope for increasing allocation for the landless from state lands and new developments, large-scale land reform is not politically feasible given the power of vested interests. More rapid progress in poverty alleviation must come largely from a quicker pace of job creation, greater investments in social sectors, more pro-poor fiscal interventions and further reductions in the rate of population growth. These elements are closely interrelated. As discussed below, progress in one area will often reinforce the prospects for better outcomes in other areas. A continued good overall growth rate and macroeconomic stability would remain, however, important pre-conditions for sustained poverty reduction.

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The demographic transition There is not enough appreciation of the extent to which the very high population growth in the past has impeded both poverty alleviation and social development. Fortunately, the demographic transition has already begun in Pakistan, but both the fertility rate and natural rate of growth of the population remain substantially higher than both India and Bangladesh.32 The current population growth rate is a little less than 2 per cent per annum in Pakistan, compared with 1.5 and 1.3 per cent respectively for India and Bangladesh. The total fertility rate for the latter is around 3, compared with 4.8 in Pakistan. Since the total fertility rate in Pakistan is still quite high, the future demographic trends can be strongly influenced by policy measures in education, health and family planning. A paramount need is to strengthen policies, especially for female education and literacy, so as to reduce the desired family size. Reflecting the high rates of illiteracy among women (66 per cent) and the low rate of participation of women in the labour force (less than 15 per cent), the desired number of children in Pakistan is still four compared with only two in Bangladesh. A dramatic improvement in women’s education and status in society will help to lower the desired family size and thus increase the demand for family planning services. But even at present, there is substantial unmet demand for family planning services. Thus, there remains substantial scope for the expansion of family planning services, even with the present attitude towards family size. Learning from the experience of Bangladesh, public policy should set the ambitious goal of achieving replacement-level fertility over the next 25 years. If the total fertility rate can be reduced to 2 by 2025, there are good prospects for limiting the annual average growth rate of the population to below 1.5 per cent during the next 25 years. Human development33 As is well known, the human development indicators for Pakistan are low, and in some cases, compare unfavourably even with the average low-income countries. The lag, however, is most serious in education. The literacy rate in Pakistan was 53 per cent in 2003–04, compared with 63 per cent for low-income countries and 60 per cent in South Asia. Female literacy in Pakistan was only 42 per cent, reflecting a large gender gap, especially in rural areas. The official gross primary enrolment ratio of 74 per cent in 2002 also compared quite unfavourably with that of 97 per cent in South Asia, and 96 per cent for low-income countries. What is more, the age-adjusted net primary enrolment rate, as reported by the World Bank, was only 42 per cent. But it does need to be emphasized that at the time of partition in 1947, Pakistan faced poor initial conditions. The total primary school enrolment in West Pakistan in 1948–49 was only 0.6 million, indicating a gross primary enrolment ratio of only about 15–20 per cent, compared with 40 per cent in East Pakistan. Only 5–6 per cent of school-age girls were in primary school. Starting from this low level, primary school enrolment in West Pakistan grew by over 10 per cent per annum, to 1.89 million in 1959–60. It expanded almost as fast during the period of the Second Plan, to 3 million in 1964–65 and the primary school enrolment ratio improved to 36 per cent. However, after the 1965 war with India, due to increased defence spending, the education sector faced a sharp cut in expenditure and primary education was cut disproportionately. Primary school enrolment growth slowed down to 5 per cent per annum during the Third Plan, and, surprisingly enough, the rate did not recover much during the Bhutto years. During the Zia years (1977–88), primary school enrolment slowed down to 4 per cent per annum, only moderately faster than the rate of population growth. The pace of primary enrolment did pick up sharply in the 1990s to over 6 per cent

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per annum. A substantial narrowing of the gender gap in basic education during the last decade has been achieved, and policy actions and investment allocations have become more focused. But the efforts undertaken by the Social Action Programme (1994–98) to improve the quality and effectiveness of primary education were not successful because of mismanagement and corruption. As the stories about ghost schools and phantom teachers suggest, there were substantial leakages from the expenditures. In the historical context, a great deal of responsibility for the failures in basic education can be traced back to the decision of Zulfikar Ali Bhutto to nationalize private educational institutions in 1972, even though primary schools were not affected by the decision. As a direct consequence of the nationalization decision, the management capacity of the government was overextended. The competition for resources within the education sector deepened the urban and higher education bias, and thus, the quick development of basic education and literacy was hampered. Total government expenditures on education have remained low over long periods of time, and, despite increases during the last few years, were still only 2.1 per cent of GDP during 2004–05. While further increases in the level of education spending are needed, a more rational allocation of resources and a greater attention to the access of the poor to basic education are also required. Inefficient use of resources has adversely affected the education system, especially at the primary level. Spending on buildings often took priority over increasing the number of teachers and other aids to education. The increasing politicization of educational allocations, especially in the 1990s, meant that the site selection for schools and the hiring of teachers have not always been based on merit. In the ultimate analysis, the failure to make primary education universal even after 50 years of independence is a societal failure, resulting from feudal dominance in rural areas, the pre-emption of resources by the urban middle class, a high level of defence spending and a lack of sufficient demand for basic education, especially girls’ education. Had the demand for primary education been very strong, it would not have been possible for politicians and technocrats to ignore this sector for so long. In the case of boys, the opportunity cost of time spent in school, and in the case of girls, cultural attitudes, especially in rural areas, have hampered the growth of primary enrolment. In 2000, the female primary and secondary enrolment ratio to males was 61 per cent in Pakistan, compared with 78 per cent in India and 101 per cent in Bangladesh.34 But this is now changing, Partly as a result of incentives provided for girls’ education in rural areas, there has been a pronounced increase in girl enrolments especially at the primary level during 2002–05. Prospects and challenges35 Economic growth has clearly revived, the rate of GDP growth increasing from the average of 3.3 per cent during 1997–2002, to an average of nearly 6 per cent during 2002–04. GDP growth touched a new high of 8.4 per cent during 2004–05, helped in part by a very impressive growth rate of 7.5 per cent in agriculture. While it is not easy to determine the underlying trend growth rate, the prospects of a sustained annual growth rate of 6–7 per cent per annum over the next five to ten years appear quite good. Optimism can be grounded in several factors. For the first time since the first half of the 1960s, Pakistan does not have a serious resource constraint and, more importantly, sharply rising levels of investment can be financed without resorting to too heavy reliance on net foreign borrowing. Foreign private investment flows have accelerated and are likely to stay high. The

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burden of defence spending on the economy has come down sharply compared with the 1980s, and can be contained if relations with India show steady improvement. While political processes are not yet firmly rooted in a democratic system that fully works, and would sustain itself in all circumstances, the prospects for political stability in the near term seem good, due to strong leadership of President Musharraf, who enjoys a fairly broad, if tacit, support from a sizable majority of politicians and the public. Musharraf has unflinching support for technocratic management and a clean government, under the charge of able Prime Minister Shaukat Aziz. There can be little doubt that tremendous strides have been made in improving economic management and further liberalizing economic policies during the last five years. The most notable successes have been achieved in improving public finances, accelerating privatization, strengthening the regulation of the financial sector increasing export orientation through reducing the anti-export bias in trade policies and decentralizing governance, especially in the delivery of social services. Pakistan has attained a great measure of macroeconomic stability and the chances of sustaining this stability appear good. External and public debt burdens have declined much more rapidly than could have been imagined just a few years ago. The foreign exchange reserves are at a high level, and the confidence in the currency remains strong, notwithstanding a small depreciation of the currency, reflecting higher oil prices and rising imports in response to the strong revival of economic activity, especially investment. Capital flight, which was rampant towards the end of the 1990s, and was a significant element in the worsening financial position, was reversed during the last three years and does not appear to have re-emerged as a major factor in the balance of payments. Inflationary pressures, though somewhat high, appear under control. The danger of a widening of fiscal deficits remains small, as government domestic debt in real terms is rising very little, and the high level of foreign exchange reserves has enabled an accommodative monetary policy and lower real interest rates that, in turn, have helped to lower the cost of government debt. The opening of the fiscal space, defined as non-interest non-defence spending as a percentage of GDP, has made possible increased attention to social sectors and pro-poor public spending. Education spending increased from a low of 1.8 per cent of GDP in 2000–01 to an estimated 2.1 per cent in 2004–05. Overall expenditure under the Poverty Reduction Strategy Paper (2003) rose nearly 50 per cent in 2002–05, rising from 3.8 per cent to 4.8 per cent of GDP over the period. A further increase to 6.0 per cent of GDP by 2007–08 is planned. The improved access of the poor to social and economic development programmes, and adequate funding of the local governments, created in 2002, remain important issues. There is also great scope for improving the effectiveness and impact of public expenditure. There is increasing confidence that the broad changes in policies would be sustained, even with political changes.36 ‘There is wide recognition in Pakistan now that prudent macroeconomic policies are pre-requisites for achieving high growth rates and maintaining stability in the markets.’37 Fiscal responsibility and the Debt Limitation Law put limits on fiscal deficits and thus ensure fiscal discipline. The authority of the central bank and other regulatory agencies has been greatly strengthened. A strong and independent media is increasingly acting as a watchdog on the wrongdoings of the government and encouraging the private sector. The emergence of stronger civil society organizations help to

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reinforce the role played by the media. Finally, and perhaps most importantly, all major political parties are agreed on structural reforms such as privatization, deregulation and liberalization, and indeed, as noted above, these reforms were initiated under the democratic governments of the 1990s. Despite considerable progress, however, Pakistan has major policy challenges to overcome to sustain a high growth rate of say 7–8 per cent, and to ensure that the benefits of growth are shared more equitably. There are seven major policy weaknesses, which unless addressed, would constrain rapid growth and speedy poverty alleviation: ● ●

●

●

● ●

●

A narrow base of taxation and slow progress on improving the effectiveness of tax machinery and the elasticity of the tax system. Export orientation is still limited, and there is too heavy a reliance on textile and related exports. The considerable scope for job creation through a broad and diversified export base is far from being exploited. Since the past pattern of agricultural growth, which relied heavily on area expansion and input intensification, cannot be replicated, future agricultural growth will have to come mainly from more efficient use of major inputs such as water and fertilizer as well as greater agricultural diversification. A policy framework that will ensure such a transition is not yet in place. More effective use of water resources will be particularly vital and would require a substantial increase in water charges coupled with much larger investments in improvements of delivery systems. The delivery system for public services, especially education, remains very inadequate, and the initiatives for decentralizing services to the district level and below, with elected Nazims (local government officials), has not been adequately funded. Linked to the above, pro-poor programmes do not yet have the scale and the effectiveness to make a major dent in poverty. While in general there has been improvement in public sector management, public power entities are running large financial losses due to inefficiency, corruption and theft. Key governance institutions, the civil service, the judiciary and the police need to be reformed, restructured and adequately paid to play the essential role required of them.

Critical importance of expanding revenues In a sense, the enlargement of the base of government revenues would be critical for achieving several other objectives, increasing investment in infrastructure, expanding pro-poor spending and strengthening the public services. Despite progress made during the last few years in expanding the Central Board of Revenue collections through broad administrative reforms, the consolidated public sector tax revenues as a ratio of GDP were barely 10 per cent in 2004–05. What is more, the growth in taxes during the last few years has not kept pace with the growth in the economy, suggesting a continuing low elasticity of the tax system. The slow growth in overall revenues is partly the result of the desirable reduction in reliance on foreign trade taxes from nearly 40 per cent in the mid-1970s and 25 to 30 per cent in the mid-1990s, to 10–12 per cent of the total at present. The structure of Pakistan’s taxation has certainly improved, and the distortionary effects of high import tariffs on exports have been greatly reduced. But there has

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been very limited success in expanding revenue from direct taxes, especially individual income tax. Apart from further strengthening the tax administration, two issues, the tax powers of provincial and local governments, and equity of the taxation system, need much attention from the policy-makers. Though detailed studies of the incidence of taxation in Pakistan are not available, it is generally agreed that the present tax system taxes the rich very lightly and is probably regressive. In most countries personal income tax with progressive rates is the main instrument to transfer income from the rich to the poor. In Pakistan, however, the revenue from personal income tax has been too small (a little over 1 per cent of GDP) to make any real difference. Three measures that can yield additional revenue and improve redistribution while not negatively affecting economic incentives and the level of domestic economic activity are capital gains taxation, estate taxes (death duties) and the extension of income tax to global incomes. First, Pakistan is one of the few countries that do not have a tax on capital gains. Now that Pakistan has a low income tax rate, there is no justification for exempting capital gains from the normal income tax, although there can be some allowance (say 25–50 per cent) for the impact of inflation on assets held longer than five or ten years. The taxation of capital gains (which, in real estate, have been phenomenal in recent years) will not only be socially just, but will also tend to curb purely speculative investments and help direct investments to longer-term productive uses. Second, large inherited wealth should also be subject to taxation in the interest of equity. The introduction of progressive estate duties ranging from 10 to 20 per cent on estates in excess of Rs.10 million could help to moderate the growing income disparities in the long run. Third, Pakistan should extend the coverage of income tax to income derived from foreign sources. Most countries tax the foreign income of their residents. The broader issue is that greater freedom for the private sector and a relatively low tax regime must be accompanied by fiscal responsibility and a reasonable degree of equity if increasing the capitalist orientation of the economy is to be made acceptable to the general public. Additionally, in order to make decentralization effective and improve the incentives for resource mobilization below the central government, the direct tax powers of provincial and local authorities also need to be enlarged. It should be stressed again that the need for expanding government revenues is being argued in the context of a rather low level of present public spending in Pakistan. Excluding interest and defence, Pakistan’s public spending is less than 10 per cent of GDP, a ratio that compares very unfavourably not only with other South Asian countries, but also is much lower than the average in low-income countries. With this degree of constraint on public spending, the objectives of accelerating growth and reducing poverty will continue to be compromised. Need for export expansion and diversification Rapid export growth and diversification will be critical for accelerated growth. The competitiveness and other issues influencing textile and garments exports, miscellaneous manufactured goods exports and agricultural exports, would all be important. While Pakistan faces challenges in its garments and textile exports in the post-MFA world, the biggest problem is the heavy concentration on textiles in manufactured exports. How can Pakistan get a foothold in the still-expanding markets for labour-intensive miscellaneous

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manufactured goods exports? How can it best guard itself from intense pressure in these goods from China (and, potentially, India)? How can it overcome the obstacles keeping Pakistan from exploiting the considerable potential in import substitution in edible oils and exports of fruits and vegetables? Policy responses to these questions will significantly determine the future outcome of growth. Need for raising savings and investment rates A sustained high growth of 7 per cent per annum would require a gradual increase in the investment rate from the present 18 per cent, to around 25 per cent of GDP over the next decade. The implied expansion in real investment of nearly threefold by 2015 need not pose major financing challenges if the present policies favouring domestic and foreign investment are maintained, the export push is both deepened and broadened, and the public sector plays its appropriate role in the mobilization of funds for investments in human and physical infrastructure, and ensuring their effective use. In a scenario of steadily expanding exports, Pakistan could safely run a current account balance of payments of 4 per cent of GDP, financed equally from foreign investment and net foreign borrowing, without increasing the burden of foreign obligations. Foreign investment interest in Pakistan is currently very strong, especially from the Middle Eastern investors. The recent privatization of the controlling 26 per cent in the national Telecommunications Corporation netted the government US$2.5 billion – nearly double the reserve price. But even with a moderately high level of external foreign investment, Pakistan will need to boost its domestic marginal savings rate to 25 per cent, compared with only 15 per cent in the past. This is a formidable but feasible target. Conservative fiscal policies aimed at increasing public savings, continued strength in the value of currency, a strong private investment climate, a much better functioning financial system and, finally, a declining rate of population growth, are all factors that could help improve the rather dismal record of domestic savings in the past. Challenge of poverty alleviation Pakistan’s recent economic history does not provide comfort that growth alone would translate into broad-based prosperity, reducing poverty levels, increasing real wages and generally improving the quality of life of the average citizen. Thus, the poverty alleviation dimensions of growth, especially through a tightening of the labour market, have to be a central pillar of the development strategy. In this context, the goals of better governance and devolution, and expanding service delivery, need to focus not only on overall progress, but also service delivery and access to justice for the poor and the bottom half of income receivers, deprived groups, children, women and backward and lagging districts. In summary, the prospect that Pakistan can more than double the average per capita growth recorded in its first half-century to a rate of 4–5 per cent per annum in the next quarter-century, and combine this with greater equity and faster poverty reduction, appear quite good. The risks are mainly political. A lack of political stability, confrontation with India and higher defence spending are some of the elements that can derail steady progress. The challenges for the government are also to build a wider constituency for reform by a demonstrated improvement in the lot of the poor, to contain extremism and sectarian violence and to steadily improve the democratic process.

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Notes 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16.

17. 18.

19. 20. 21.

22. 23. 24. 25. 26. 27. 28. 29. 30. 31.

Blood (1995: Chapter 1). For a broad survey of Pakistan’s foreign policy, see Tahir-Kheli (1992). West Pakistan was again broken up in mid-1970 (about a year and a half before the separation of East Pakistan) into provinces that existed at the time of partition – Punjab, Sind, North-West Frontier Province (NWFP) and Baluchistan. Papanek (1967: 1–2). See Hasan (1998: Chapter 3). For an insider’s account, see Choudhury (1974); Jahan (1972) and Zaheer (1994). Report of the East Pakistan Economists on the Fourth Plan Economic Advisory Panel, Planning Commission of Pakistan (1970) sheds light on the economic tensions between the two regions. Jahan (1972); Zaheer (1994) and Planning Commission of Pakistan (1970). Burki (1991: 85). References to Pakistan relate only to West Pakistan for the period before the separation of East Pakistan as Bangladesh. See Ali (1967); also Papanek (1967). According to Bhagwati (1966), the per capita income of India was US$72 and that of Pakistan was US$56 in the mid-1950s. World Bank (2005). Ministry of Finance (2005), Economic Survey, 2005. But for the high population growth, the pressure on Pakistan’s resources would not have been so severe, higher levels of savings and investments would have been possible and lags in social and human development would not have been so severe. This reflected, on the one hand, the relative decline in worker remittances and on the other, a rise in external interest payments. Rodrik (1998; 2000), sifting international evidence, noted that autocratic regimes may produce high growth, but are characterized by high volatility. On the other hand, average growth in democracies may be moderate, but are more stable. Przeworski et al. (2000) found no evidence to support the widespread belief that the rate of investment is low in democracies. They observed (pp. 271–2): ‘Although democracies are far from perfect, lives under dictatorships are grim and short . . . They [dictatorships] are successful economically only if they are “stable” . . . Because in dictatorships the policies depend on the will, and sometimes whim, of a dictator, they exhibit high variance of economic performance’. The low level of historical investments in areas comprising Pakistan was reflected in grave deficiencies in infrastructure. The only exception to the downward trend in public investment was the Bhutto period (1971–77) when there was a massive growth in real public development outlays of nearly threefold, nearly 40 per cent of it for public sector industry especially steel, cement, sugar, fertilizers and heavy engineering. The large, but not always economic, investment in public industry to a considerable extent merely replaced private medium and large-scale manufacturing investment. World Bank (2004). The best measure of productivity is total factor productivity (TFP), which isolates the effect of input growth on output expansion. Two recent studies find that TFP has stagnated or even declined in the post-Green Revolution period in Pakistan, that is, the period since the mid-1970s. The studies are cited in Byerly (1994). The excessive protection afforded to industry and extensive quantitative restriction on imports resulted not so much in the wrong industries being established but rather excessive profits being generated for the industrialists mainly at the cost of urban consumers and the rural population. Lower agricultural growth and a widening income gap between the rich and the poor were the real consequences of excessive protection to industry. Debt Committee report (2001: 14–21). World Bank (2004: 7). Debt Committee report (2001: 15). Khan (1992). Khan quotes among others, Professors A.K. Sen and J. Sachs of Harvard University and Susan Cochrane in favour of the argument that high population growth depresses savings especially in the rural areas. In social terms, the high burden of industrialization on consumers and high unearned industrial profits may have contributed to the unrest in the late 1960s. Hasan (1998: Tables 4.6 and 4.7). For an interesting book on the pattern of development, see Husain (1999). Also see Easterly (2003) who summarizes several recent political economy models that shed light on Pakistan’s growth without development. Naseem (1986); Hasan (1998); World Bank (2002). Amjad (2004). Hasan (2006).

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32.

The three subcontinental countries share similar cultural backgrounds and have similarly low literacy rates. Both Bangladesh and Pakistan are predominantly Muslim countries, while India has a large Muslim population. The distinct difference between Pakistan and India has been their political regimes. India has been a democracy since its independence, while for most periods, Pakistan has been under military dictatorships. Interestingly Przeworski et al. (2000) found higher population growth and fertility rates in dictatorships. They, however, were not certain why fertility is higher in dictatorships, but hypothesized that policy instability inherent in dictatorships induces families to procreate. ‘Because their policies and their performances are so unpredictable, they do not allow people to plan their lives over a longer horizon, and thus they induce households to hoard the least risky asset, namely, children’ (p. 272). This section draws heavily on the analysis in the author’s Pakistan’s Economy at the Crossroads, (see Hasan, 1998: 63–7). World Bank, World Development Report (2004: 254–5). This section was written before the political crises following the dismissal of the Chief Justice of the Supreme Court and later the murder of Benazir Bhutto. See Husain (2005). Ibid.

33. 34. 35. 36. 37.

References Ali, M. (1967), Emergence of Pakistan, New York: Columbia University Press. Amjad, R. (2004) ‘Solving Pakistan’s Poverty Puzzle’, The Omar Asghar Khan Memorial Lecture, 19th Annual General Conference of PSDE, Pakistan Institute of Development Economics, January. Bhagwati, J. (1966), The Economics of Underdeveloped Countries, London: World University Library. Blood, P.R. (ed.) (1995), Pakistan: A Country Study, Washington, DC: Federal Research Division of Library of Congress 1995. Burki, S.J. (1991), Pakistan: Continuing Search for Nationhood, Boulder, CO: Westview Press. Byerly, D. (1994), Agricultural Productivity in Pakistan: Problems and Potential, prepared for World Bank Agricultural Sector Review. Choudhury, G.W. (1974), The Last Days of United Pakistan, Bloomington: Indiana University Press. Government of Pakistan, Finance Division (2001), A Debt Burden Reduction and Management Strategy, Report of Debt Reduction and Management Committee, March 2001. Easterly, W. (2003), ‘The political economy of growth without development: a case study of Pakistan’, in D. Rodrik (ed.), In Search of Prosperity: Analytical Narratives on Economic Growth, New Jersey: Princeton University Press. Hasan, P. (1998), Pakistan’s Economy at the Crossroads, Karachi: Oxford University Press. Hasan, P. (2006), ‘Mixed messages in poverty numbers’, Dawn Newspaper, Karachi, 3 April. Husain, I. (1999), Pakistan, Economy of an Elitist Society, Karachi: Oxford University Press. Husain, I. (2005) ‘State Bank of Pakistan’, Address on 15 April in Washington, DC. Jahan, R. (1972), Pakistan’s Failure in National Integration, New York: Columbia University Press. Khan, A.H. (1992), ‘Socio-economic characteristics and household saving behaviour in Pakistan’, The Pakistan Development Review, 31 (1). Naseem, S.M. (1986), ‘Rural poverty and landlessness in Pakistan’, in Mahbub ul Haq and Moin Baqai (eds), Employment Distribution and Basic Needs in Pakistan, Lahore: Progressive Publishers. Papanek, G. (1967), Pakistan’s Development, Cambridge, MA: Harvard University Press. Planning Commission of Pakistan (1970), Report of the East Pakistan Economists on the Fourth Plan Economic Advisory Panel, Planning Commission. Przeworski, A., M.E. Alvarez, J.A. Cheibub and F. Limongi (2000), Democracy and Development: Political Institutions and Well-being in the World, 1950–1990, Cambridge: Cambridge University Press. Rodrik, D. (1998), ‘Democracy and Economic Performance’, Paper presented at the Conference on Democratization and Economic Reform in South Africa, Cape Town, 16–19 January. Rodrik, D. (2000), ‘Participatory Politics and Social Cooperation and Economic Stability’, Paper presented at the Conference of American Economic Association, Boston, January 7–9. Tahir-Kheli, S. (1992) ‘External affairs’, in William E. James and Suboroto Roy (eds), Foundations of Pakistan’s Political Economy, New Delhi: Sage Publications. World Bank (2002), Pakistan Poverty Assessment, 2002. World Bank (2004), Pakistan Public Expenditure Management, January. World Bank (2005), World Development Indicators. Zaheer, H. (1994), The Separation of East Pakistan, Karachi: Oxford University Press.

3

Bangladesh Wahiduddin Mahmud

Political and economic history The present political boundary of Bangladesh was drawn for the first time in 1947 when it emerged as the eastern wing of Pakistan as a consequence of the independence and partitioning of British India. It consisted of the Muslim majority districts of the former province of Bengal and a part of the adjoining province of Assam. During the quartercentury of association with Pakistan, there was growing disparity in economic development and living standards between East and West Pakistan (now Bangladesh and Pakistan, respectively). The people of East Pakistan felt economically deprived and politically dominated, and this led to the demand for greater regional autonomy of East Pakistan – a demand that gradually developed into a powerful movement and ultimately resulted in the war of independence of 1971. The independence war was preceded by the elections held in 1970, in which Sheikh Mujibur Rahman’s Awami League achieved an overwhelming mandate to negotiate full regional autonomy within a new constitution for Pakistan. Subsequently, the negotiations broke down and the military rulers of Pakistan resorted to a massive use of force against the civilian population to put down the uprising of the Bengalis. A guerrilla war was waged by the Bengali defectors from the Pakistan army along with new recruits, using bases in India. Towards the end of 1971, war broke out between India and Pakistan. The Indian armed forces, supported by the Bengali guerrillas, marched into Bangladesh, forcing the Pakistan army there to surrender. On 16 December, the independent government of Bangladesh was installed in Dhaka. Although the nation started with a Westminster-type parliamentary democracy, this democratic experiment ended when the Awami League drastically changed the constitution to institute a one-party presidential rule in 1975. In that same year, Sheikh Mujibur Rahman was assassinated by a group of junior army officers and this was followed by a series of coups d’état, at the end of which General Ziaur Rahman emerged as the de facto ruler. He subsequently got himself elected as a civilian president by forming the Bangladesh Nationalist Party (BNP) and a period of comparative stability followed until he too was assassinated by some rebellious army personnel in 1981. The following year, General Ershad assumed power by unseating a weakened BNP government through a bloodless coup d’état. Although he too subsequently formed his own political party and transformed himself from a military ruler to an elected president, his regime remained characterized by its autocratic style and lack of legitimacy. General Ershad was overthrown by a mass upsurge in 1990 and this led to a transition to parliamentary democracy. Since then, three governments have been formed through national elections, two by the BNP, led by Begum Khaleda Zia (General Ziaur Rahman’s widow) and one by the Awami League, led by Sheikh Hasina (Sheikh Mujibur’s daughter). The political scene, however, remains volatile and is characterized by extreme rivalry and animosity between the two major political parties, a culture of street agitation and 93

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violence and an almost dysfunctional parliament. The politics of confrontation, along with widespread rent-seeking and a winners-take-all system, has increasingly raised the stakes in winning elections. As a result, after three reasonably fair elections held since 1991, the elections scheduled for late 2006 had to be postponed under the threat of extreme political unrest. This has prolonged the tenure of the present non-party caretaker government and has broadened its mandate beyond holding the elections. The popular expectations are that this government will bring about the necessary institutional changes to put the governance framework on a proper footing again. Bangladesh was once designated as a ‘test case’ for development while Henry Kissinger called it ‘an international basket case’.1 The country had then just emerged from its war of independence, desperately poor and over-populated and reeling from overwhelming war damage to its institutional and physical capital. Its economy was further ravaged by acute food shortages and famines during the early years, triggered by floods and compounded by Cold War rivalry.2 It was not until 1978/79 that per capita income had recovered to its pre-independence level (Khan and Hossain, 1989, Table 2.3). At the time of independence, income per head in Bangladesh was unquestionably among the lowest of the very low – low in the lowest decile of world incomes per head. In 1972, Bangladesh was supporting some 1400 persons per square mile – 25 times as many as the average of the United States, nearly twice as many as Belgium or the Netherlands, two and half times the average of India – and importing one-eighth of its food needs every year (Robinson and Griffin, 1974: xv). Bangladesh had no known natural resources except natural gas and the possibility of a limited quantity of coal and limestone. The poor state of the Bangladesh economy at the time of independence can be gleaned from Table 3.1. The war of liberation dealt a severe blow to the economic structure of the country. The economy contracted by about 12 per cent between 1969/70 and 1972/73. There were huge losses of physical assets including roads and railway bridges. Half the trucks and buses were estimated to have been destroyed. The two seaports at Chittagong and Chalna both were heavily damaged and blocked with sunken vessels. About 10 million people fled to Table 3.1

Socioeconomic conditions, 1972–73

Indicators

Rates

GDP per Capita Population growth rate Savings rate Investment rate Share of industry in GDP Share of agriculture in GDP Poverty rate Serious inadequacy in calorie intake Adult literacy rate Life expectancy at birth Infant mortality rate

US$50–60 2.8–3.0% 5–6% 10–11% 5% 56% 71% 50% 20% 49 years for men & 47 years for women 140 per thousand

Sources:

Khan (1972), Robinson and Griffin (1974) and Islam (1977).

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India and about 20 million were dislocated internally during the war. The dislocation caused a serious shortage of food, amounting to 3 million tons. The public expenditure on relief, reconstruction and rehabilitation between January 1972 and June 1973 amounted to Tk.290 crores (US$400 million).3 The economic strategies and policies in Bangladesh since the early 1970s have undergone major shifts, often linked with the change in the ruling political regime. In the early years following the war of liberation in 1971, macroeconomic management was primarily aimed at reviving a war-ravaged economy in an overall framework of extensive state control and with an avowed ideology of socialism. The state became the de facto owner of a large number of enterprises that had been abandoned by their Pakistani owners. After the killing of Sheikh Mujibur Rahman and the change of government, there was a policy shift towards privatization and the promotion of the public sector. The denationalization of abandoned enterprises continued in varying speed into the 1980s when a second wave of divestment was initiated under the military government of General Ershad. From the late 1970s to the beginning of the 1980s, there was a short-lived episode of investment boom, with investment in both public and private sectors growing at nearly 15 per cent annually in real terms (Mahmud, 1995). This was made possible by relying on an increasing flow of foreign aid and adopting a privatization strategy based on lavish dispensation of cheap credit and provision of other incentives such as highly protected markets for domestic industries. To a large extent, the latter-day problems regarding the so-called ‘sick’ industries and the large-scale default of bank loans originated from this experiment with aid-dependent state-sponsored private capitalism.4 There was no mobilization of domestic savings, so that the investment boom ended abruptly when the external aid climate severely deteriorated in the early 1980s. A major change of direction occurred during the 1980s with the adoption of marketoriented liberalizing policy reforms undertaken along the guidelines of the World Bank and the IMF and implemented under fairly rigid aid conditionality. These reforms were initiated against the backdrop of serious macroeconomic imbalances, which had been caused in part by a decline in foreign aid and in part by a preceding episode of severe deterioration in the country’s terms of trade. The beginning of the 1990s saw the launching of a more comprehensive programme of macroeconomic reforms, which coincided with a transition to parliamentary democracy from a semi-autocratic rule. Some 30 years later, Bangladesh still ranks among the poorest countries of the world, but it has also made considerable progress. With sustained growth in food production and a good record of disaster management, famines have become a phenomenon of the past. Bangladesh’s per capita GDP has more than doubled since 1975. Life expectancy has risen from 50 to 63 years, population growth rates of 3 per cent a year have been halved, child mortality rates of 240 per 1000 births have been cut by 70 per cent, literacy has more than doubled and the country has achieved gender parity in primary and secondary schools. Much of these gains have taken place since the early 1990s, when the introduction of wide-ranging economic reforms coincided with transition to democracy. The growth of per capita GDP had been slow in the 1980s, at an annual average of 1.6 per cent a year, but it accelerated to 3 per cent in the 1990s, and to about 4 per cent in the more recent period. The acceleration resulted partly from a slowdown in population growth but also from a sustained increase in GDP growth, which averaged 3.7 per cent annually during the 1980s, 4.8 per cent during the 1990s and 5.6 per cent since then. Progress in the human development indicators

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was even more impressive, and Bangladesh ranked among the top-performing countries in the 1990s in the extent of improvement in the UNDP Human Development Index.5 Bangladesh’s above achievements may appear as a ‘development surprise’, given the country’s desperate initial conditions and allegedly poor record in governance adversely affecting the investment climate and the quality of public service delivery (Ahluwalia and Mahmud, 2004; Devarajan, 2005; Mahmud, Ahmed and Mahajan, 2007). Over the years, the country has recovered from its image of being prone to famines and disasters, only to be perceived as one of the most corrupt and ill-governed countries.6 On the positive side, the country is known for its successful microcredit programmes intiated by Grameen Bank, which, along with its founder Muhammad Yunus, received the 2006 Nobel Peace Prize. Questions have been raised as to how the progress achieved thus far has been possible under the prevailing political economy environment and the governance challenges. Or, can further progress be sustained without strengthening the country’s institutions of political and economic governance? These are questions that touch upon some of the major themes of contemporary development thinking relating to how the outcomes of economic policies are shaped by the quality of governance and institutions, and initial conditions. Macroeconomic performance: from stabilization to growth Trends in macroeconomic indicators The reforms initiated in the 1980s were aimed at reducing the fiscal and external deficits to a sustainable level, consistent with the reduced level of aid availability.7 This effort was accompanied by a range of market-oriented reforms, which in the 1980s included mainly the withdrawal of food and agricultural subsidies, privatization of state-owned enterprises, financial liberalization and withdrawal of quantitative import restrictions. The reforms of the early 1990s were particularly aimed at moving towards an open economy – such as making the currency convertible on the current account, reducing import duties generally to much lower levels, involving foreign investors in key sectors like telecommunications and power production and removing virtually all controls on the movements of foreign private capital. Besides, fiscal reforms were undertaken including the introduction of the value-added tax. The trends in various macroeconomic indicators over the last two decades are shown in Table 3.2. Although both the fiscal deficit and the external current account deficit can be seen to have been continually reduced over each successive five-year period, there are important contrasts in macroeconomic performance between the 1980s and the period thereafter. In the 1980s, the macroeconomic balances were improved not so much by raising revenue or exports, but by squeezing public development spending and private investment on the domestic front and imports on the external front. Thus, between the two halves of the decade, the tax–GDP ratio barely increased, while development expenditure as a percentage of GDP declined from 6.6 per cent to 5.4 per cent. Similarly, export revenue as a percentage of GDP barely increased, while the import–GDP ratio declined from 14.3 per cent to 12.8 per cent. Thus, as in the case of most other early experiments in structural adjustment, the attempt to achieve macroeconomic stabilization in Bangladesh in the 1980s was made along the contractionary route.8 In contrast, the launching of the wide-ranging policy reforms in the beginning of the 1990s was followed by some very positive developments in the macroeconomic scene. There

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Table 3.2 Macroeconomic balances, 1980/81–20004/05; five-year averages (all figures are in percentages of GDP at current market prices) 1980/81– 1984/85

1985/86– 1989/90

1990/91– 1994/95

1995/96– 1999/2000

2000/01– 2004/05

External sector Exports of goods and services Imports of goods and services Trade deficit Workers’ remittancesa Current accounts deficitb

5.4 14.3 8.9 2.7 6.7

5.6 12.8 7.2 2.9 4.7

8.6 12.6 5.4 2.9 2.1

12.7 17.3 6.2 3.6 1.9

15.2 20.9 5.7 5.8 –0.6

Investment and savings Gross investment Public Private Gross domestic savingsc Gross national savingsd

16.9 4.8 12.1 8.0 10.7

16.6 6.1 10.4 9.4 12.3

17.9 6.7 11.3 12.5 15.5

21.5 6.8 14.7 15.3 18.9

23.6 6.4 17.2 16.9 23.0

Government budget Total revenue Tax revenue Current expenditure Development expendituree Total expendituref Budget deficit Domestic borrowingg Foreign financingh

6.3 5.2 4.6 6.6 12.9 6.6 1.0 5.6

6.7 5.4 6.0 5.4 12.2 5.6 0.5 5.0

8.6 6.9 6.5 5.6 13.4 4.8 0.8 4.0

9.0 7.2 7.2 5.7 13.4 4.4 1.9 2.5

10.0 8.4 8.2 5.4 14.0 4.0 2.2 1.8

Indicators

Notes: a. Remittances from Bangladeshi workers abroad. b. Equals trade deficit minus net factor income from abroad; the latter includes private transfers (mainly remittances), interest payments on external public debt and other investment incomes; differs from the official estimates because of not including official transfers (foreign aid as grants); a negative value implies surplus. c. Equals gross investment minus trade deficit; also equals gross national savings minus net factor income from abroad. d. Equals gross investment minus current account deficit. e. Expenditure under Annual Development Plan (ADP). f. Includes food account balance and certain capital expenditures and net lending not included in the development budget. g. Includes net borrowing from the banking system and net sale proceeds of savings certificates. h. Includes grants and concessional loans net of amortization. Budgetary figures are the realised actual and may differ from the official ones because of the data reconciliation done by the World Bank and IMF. Sources: Various publications of the World Bank, IMF, Bangladesh Bank and the Bangladesh Bureau of Statistics.

was a marked improvement in the government’s budgetary position, particularly in terms of increased revenue mobilization in the early 1990s. While the net inflow of foreign capital continued to decline, both investment and saving rates steadily improved, thus paving the way for superior growth performance. The ratio of investment to GDP, which had stagnated at less than 17 per cent in the 1980s, increased to about 24 per cent in the most recent period.

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This increase was almost entirely due to the dynamism in private investment, which has risen from less than 10 per cent of GDP to 17 per cent since the late 1980s, with the investment rate in the public sector remaining almost unchanged at around 6 to 7 per cent of GDP. The growth of GDP, which averaged 3.7 per cent annually during the 1980s, had increased to 5.2 per cent by the second half of the 1990s and is currently averaging about 6 per cent annually. Meanwhile, due to robust and sustained growth in export earnings, the export–GDP ratio increased from less than 6 per cent in the later half of the 1980s to the current level of above 15 per cent. With the accompanying increase in imports, the trade openness of the economy (that is, the combined ratio of imports and exports to GDP) nearly doubled during the same period. All this was achieved along with remarkable success in keeping inflation under control. In the first half of the 1980s, the average annual rate of inflation as measured by the consumer price index was ominously high at 13 per cent. It is only the contractionary effect of structural adjustment of that period that brought inflation down – to around 8 per cent in the second half of the decade. During the 1990s, the average inflation rate further declined to 5.6 per cent, and this time the reduction was achieved despite relative buoyancy of the economy compared with the preceding decade. The 1990s thus saw positive developments on several fronts: transition to parliamentary democracy, strengthening of economic growth performance and consolidation of economic stabilization in the face of declining foreign capital inflow. This said, there were some periodic lapses in the macroeconomic discipline – particularly related to the timing of approaching national elections – thus producing the symptoms of the so-called ‘political business cycle’.9 Despite the overall soundness of these macroeconomic trends, there were some disconcerting features. While the increase in the investment rate was entirely led by private investment, there were some symptoms of a feeble investment response to policy reforms. In the early 1990s, for example, the marked increase in the domestic savings rate found no commensurate response from private investment, producing a situation of aggregate demand deficiency. This was evident from a sharp fall in the inflation rate to near zero, along with a fall in private sector credit expansion and an unprecedented build-up of international reserves.10 It is difficult to ascertain whether the rapid reduction in industrial protection achieved through import liberalization at that time played a role in this. The uncertainty created by these reforms, which had no pre-announced targets or timetable, could have been a contributing factor as well. There were other episodes of stagnation or decline in investment in manufacturing.11 Thus, apart from the resource constraint on investment growth, the ‘desire to invest’ factors may have become important in the post-reform era, particularly because of the withdrawal of public investment from the directly productive sectors. This problem may have much less to do with the structure of industrial incentives than with the overall investment climate. The factors that discourage investment in Bangladesh are well documented, including poor infrastructure, a weak financial system, corrupt and inefficient bureaucracy, collection of illegal protection money and an inadequate legal system. These factors also inhibit the inflow of foreign private investment, which remains insignificant despite Bangladesh’s liberal policies. The experience of macroeconomic management in the 1990s also shows the fragility of the country’s balance of payments, notwithstanding the very impressive export growth. Periods of marked dynamism in investment and industrial activity turned out to

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be short-lived, limited by the balance of payments constraint and resulting in the depletion of foreign exchange reserves. This was true of the two episodes of mini-boom that took place around 1994/95 and 2000/01. In both cases, there was an upturn in large-scale manufacturing production associated with a rapid expansion of private sector credit and high growth in the import of capital goods and industrial inputs.12 In both cases, external deficits increased and foreign reserves sharply diminished, until stabilization measures stifled the growth of investment and manufacturing activities. The above phenomenon is reminiscent of a dominant ‘trade gap’ in the erstwhile popular two-gap model of foreign aid.13 It reflects the highly import-intensive nature of investment and manufacturing activities in Bangladesh, where most capital goods are imported, domestic manufacturing depends heavily on imported raw materials and intermediate goods and finished consumer goods account for less than 10 per cent of all imports. Thus, there seems to be little room for adjusting to lower import growth without subduing investment demand or creating capacity under-utilization in the economy. There were also other adverse factors limiting the prospects of an economic upturn. Political unrest and natural disasters like floods severely disrupted the economy from time to time. The effectiveness of public development spending was compromised by widespread corruption and inefficiency in project implementation. Again, because of the inefficient banking system, there was apprehension that a large part of any increased credit flow might turn into bad loans. The surge in credit disbursements had therefore to be restrained, not only to keep monetary expansion within safe limits, but also to prevent a further deterioration in the banking discipline. While domestic savings show very healthy trends since the early 1990s, it is not easy to explain these trends. The determinants of domestic saving mobilization are poorly understood in Bangladesh. One visible source of the increase in the saving rate in the early 1990s was the significant improvement in the government’s budgetary position resulting in a likely increase in public savings. The surplus of revenue earnings over current expenditures clearly increased in that period (Table 3.2).14 But this cannot explain the continued increase in domestic savings since then. In fact, one may be tempted to conclude from the experience of the recent years that if investment demand were to rise, matching savings would be forthcoming. However, there are uncertainties about these saving estimates. These are derived indirectly from the investment estimates, which themselves suffer from many methodological and data deficiencies. Also, in the recent years, the official estimate of export earnings is suspected to have had an increasingly upward bias, thus resulting in a possible underestimation of the external current account deficit. This would upwardly bias the savings estimates as well, increasingly so for the later years.15 Sources of growth stimulus All broad sectors of the economy – agriculture, industry and services – have contributed to the growth acceleration since the early 1990s. The average annual growth of agricultural GDP accelerated from 2.5 per cent in the 1980s to 3.2 per cent in the 1990s, industrial GDP from 5.8 to 7.0 per cent, and the service sector GDP from 3.7 to 4.5 per cent.16 In spite of some fluctuations in crop production, the volatility in long-term GDP growth in Bangladesh is found to be remarkably low among developing countries.17 The growth in crop agriculture, averaging about 2 per cent annually over the last two decades, has thus far been almost entirely due to increased rice and wheat production.

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Table 3.3 Growth of Bangladesh economy 1980/81–2004/05 (% annual average growth rates) Five-yearly Average Area of Growth

1980/81– 1984/85

1985/86– 1988/89

1990/91– 1994/95

1995/96– 1999/2000

2000/01– 2004/05

Real GDP* Population Per capita GDP

3.72 2.19 1.53

3.74 2.13 1.61

4.40 1.98 2.42

5.21 1.60 3.61

5.38 1.55 3.83

Note: * At market prices. Source: Official national income statistics.

Table 3.4 Bangladesh: Composition of exports, 1990/91 and 2004/05 (Annual export earnings in million US dollars) Export Item Ready-made garments and knitwear Frozen foods (mainly frozen shrimp) Raw jute and jute goods Leather and leather goods All other exports Total exports Of which, manufactured exports

1990/91

2004/05

890 142 395 137 154 1718 1411

6418 421 404 221 1190 8654 8006

Sources: Official export data of the Export Promotion Bureau as reported in Bangladesh Bank’s Annual Report (various years).

Profitability analyses show that, beyond the attainment of self-sufficiency in rice, there is potential to accelerate agricultural growth through crop diversification, especially by shifting to high-value crops like fruits and vegetables that can be profitably produced both for domestic consumption and for export (Mahmud, Rahman and Zohir, 2000). This potential, however, has remained mostly unexploited. Within manufacturing, the growth has come largely from the ready-made garment industry; during the 1990s, medium- and large-scale manufacturing as a whole grew at about 7 per cent annually, but at only about 4 per cent excluding the garment industry.18 This implies that growth in the organized manufacturing sector has been mainly exportled. But it also means that the manufacturing and export base of the economy has become more concentrated rather than more diverse. Fisheries have been another high-performing activity, with an annual growth rate rising from about 2.5 per cent in the 1980s to more than 8 per cent in the 1990s. It is noteworthy that, aside from garments, frozen shrimp was the only fast-growing major export item in the 1990s (Table 3.4). Until hit by the global recession in 2001, Bangladesh had achieved robust and sustained growth of export earnings, averaging about 15 per cent a year in nominal US dollar terms

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in the 1990s. In 2001–02, export earnings declined in dollar terms for the first time since 1985–86, but there was a recovery in the following year and export growth has remained strong since then. In fact, Bangladesh seems to have successfully withstood the initial impact of the post-MFA (Multi-Fibre Arrangement) competition in the global markets for garment export, although the real test may be yet to come. Another very positive factor has been the rapid growth in the inflow of migrant workers’ remittances – from about 2.5 per cent of GDP in the beginning of the 1990s to nearly 10 per cent in 2006–07, amounting to about US$6 billion annually. Exports are, however, only a part of the growth dynamics in Bangladesh. Though the structure of the economy is changing, the organized sectors of the economy still remain relatively small with no more than 12 per cent of GDP currently originating from largeand medium-scale manufacturing. Agriculture still contributes about 20 per cent of GDP, and a much larger share of GDP originates from the so-called informal sectors outside agriculture: small-scale processing and manufacturing and various informal services.19 The growth rates of these informal activities accelerated in the 1990s, contributing substantially to the acceleration of overall GDP growth. Many of these activities – being extremely labour-intensive and requiring very little capital investment – are largely demand-driven, responding to at least three major sources of increased income: crop production, readymade garment exports and workers’ remittances, in that order of importance.20 Though these informal activities have expanded largely as a result of demand linkages with the leading productive sectors of the economy, they have their internal growth dynamics as well. There is evidence that their growth acceleration in the 1990s was accompanied by a tilt towards relatively scaled-up activities that use labour more productively and can cater to more income-elastic demand (Mahmud, 2006). Thus, small-scale manufacturing activities fared better than both cottage industries and large-scale manufacturing, growing at an average rate of more than 9 per cent annually in the 1990s.21 Small industries seem to have benefited from the liberalization of imports of capital machinery and raw materials, while their products – being mostly remote substitutes for imported items – had an advantage over those of their large-scale counterparts, which faced stiffer competition from imports. The rapid growth of the urban centres and rural towns has also helped the informal sector activities to become more diversified, productive and dynamic, especially by creating the complementarities that accompany urban growth. Dhaka, with 12 million inhabitants, has seen an eightfold increase in its population since 1970 and is reckoned to be among the two fastest-growing mega-cities in the world.22 Not the least because of the rapid growth of the export-oriented garment industry and the related housing construction boom, urbanization has been accompanied by rapid job creation. In the countryside, there has been a rapid growth of rural towns, helped by an extensive network of rural roads. The clusters of habitation around these rural towns have helped to promote those non-farm activities that can cater to urban-like and income-elastic consumer demand; and these are the kinds of activities that are found to have shown more dynamism within the rural non-farm sector in terms of improved technology and higher labour productivity (Mahmud, 1996). Very rapid expansion of microcredit since the early 1990s is also likely to have played an important part in this process.23 In spite of the extremely high population density in Bangladesh, the country is in fact enjoying a demographic advantage in making gains in per capita income. Population

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growth in Bangladesh has passed through three distinct phases: very low growth until the 1930s with high fertility and high mortality levels, rising growth between the 1930s and the 1980s with falling mortality but unchanging fertility levels and declining growth thereafter with fertility levels falling faster than the mortality levels. Because of this demographic transition there is a low dependency ratio, with the labour force growing faster than the population. This demographic advantage has been further strengthened by the rapid increase in female labour force participation that has been taking place in the recent decades. Poverty reduction, social development and economic mobility Poverty trends With the acceleration in the growth of per capita income, Bangladesh has made considerable progress in poverty reduction. In the 1980s, there was very little progress in poverty reduction, particularly in the rural areas (Osmani et al., 2003). During the 1990s, however, the national incidence of poverty declined considerably, from nearly 60 per cent to about 50 per cent; and a much more rapid reduction in poverty seems to have taken place in the following five-year period with the national poverty rate reduced to about 40 per cent.24 More progress against poverty would have been made in the 1990s had income distribution not worsened in both rural and urban areas. In the recent periods, growth acceleration in other South Asian countries has been accompanied by increased income inequality (Devarajan and Nabi, 2006). The growth–inequality links in the case of Bangladesh seems to be, however, of a different nature. The pattern of growth in Bangladesh would appear to be fairly pro-poor – with the main stimulus to economic growth coming from labourintensive garment exports, small-scale and micro-enterprises in manufacturing and services and remittances from migrant workers. All these sectors typically provide scope for upward economic mobility for the poor. Even then, inequality tended to increase because the more dynamic parts of the economy happened to be the ones with relatively unequal income – such as the urban/organized sector vis-à-vis the rural/informal sector or the dynamic part of the rural non-farm sector vis-à-vis agriculture – and also because growth, though employment-intensive, was not strong enough to pull wages in the vast agricultural and informal labour markets.25 However, the estimates for the most recent period from 2000 to 2005 suggest that the process of increasing income inequality has slowed down or even reversed; as a result, the impact of income growth on poverty reduction has been much more pronounced during this period than in the 1990s (Table 3.5). The real wages in agriculture and construction – the sectors dominated by informal labour markets – have shown strong upward trends since the end-1990s, after having been stagnant for a long time.26 It would thus appear that Bangladesh is perhaps past the turning point of the ‘Kuznets curve’ in the income–inequality link.27 Occupational shifts and economic mobility Much of the poverty impact of economic growth is mediated through the changing patterns of employment and the associated occupational shifts of the labour force. Nearly half of the labour force is in agriculture, although this share has been declining. Over the years, there has been a shift of labour from agriculture to the rural non-farm sector, whose

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Table 3.5 Trends in poverty and income distribution in rural and urban areas, 1991–92 to 2005 Percentage of Population Under Poverty Line Year 1991/92 2000 2005

Rural

Urban

61.2 53.0 44.5

44.9 36.6 28.8

Gini Coefficient of Urban–Rural Ratio Consumption Expenditure of Per Capita National Rural Urban Expenditure 58.8 49.8 40.6

0.24 0.27 0.28

0.31 0.37 0.35

1.65 1.87 1.67

Note: The poverty estimates are those of the Bangladesh Bureau of Statistics relating to the ‘upper poverty line’ and derived from a cost-of-basic-needs methodology. The Gini coefficients are estimated by adjusting per capita consumption for spatial price variations; but urban–rural ratios relate to nominal per capita consumption expenditure. Sources: Reports of various rounds of the Household Expenditure Survey published by the Bangladesh Bureau of Statistics (2003; 2006).

share in the rural labour force increased from 34 per cent in 1983–84 to 39 per cent in 1990–2000. Given that most of the poor live in rural areas, the process of this employment shift, along with rural-to-urban migration, has been crucially important in determining the nature of poverty dynamics. Research findings have thrown light on certain important characteristics of these shifts in the occupational structure of the labour force, particularly for the period since the 1980s. Although urban poverty is to a large extent a spillover of rural poverty, the rural–urban migration has more often than not resulted in income gains for the migrants and their families. In other words, the ‘pull’ of higher income rather the ‘push’ of rural poverty has dominated the migration process (Khundker et al., 1994). Even in the shift of employment from agriculture to rural non-farm occupations, the pull factors have been found to dominate over the push factors, implying that such a shift largely represents upward economic mobility (Mahmud, 1996). Evidence on the earning levels and poverty incidence suggests that shifting from agricultural wage employment to even low-productivity self-employment in the non-farm sector usually entails income gains, although increasing earnings from self-employment through scaling up of microenterprises is also found to be a way out of poverty.28 Another important route out of poverty is to shift from casual employment as day labourers to permanent employee status in small enterprises. Of course, there are important entry barriers to such occupational shifts, which can be mostly explained by the differences in various types of endowments – such as human capital and physical assets.29 An important change in the structure of the labour force has been a rapid increase in the share of female labour out of total labour force, from 9 per cent in 1983–84 to 22 per cent in 1999–2000 (according to the Labour Force Surveys of the respective years).30 This trend towards ‘feminization’ of the labour force has been accompanied by a gradual breaking down of gender barriers to employment in various occupations and it has generally contributed to upward economic mobility – particularly through its positive impact on the gender dimensions of poverty – in spite of the large gender gaps in wages that still remain. A notable example of this is the growth of employment in the ready-made

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garment industry, which currently employs about 1.5 million workers, mostly women and many of them migrants from rural areas (Kabeer and Mahmud, 2004). A broad picture of the changing structure of the rural economy emerges when a number of different kinds of evidence are pieced together (Osmani et al., 2003; Mahmud, 2006). There are important contrasts between the experience of the 1980s and of the later periods. In the 1980s, the growth of employment in the rural non-farm sector was characterized by a proliferation of low-productivity self-employment with declining overall labour productivity. The employment shift out of agriculture to the rural non-farm sector took place entirely among the landless households, instead of land-owning households diversifying their sources of income towards non-farm activities. Such a shift still entailed an income gain in most cases, but it also led to some overcrowding in the face of market constraints for the products of low-productivity activities that cannot cater to incomeelastic demand. Overall, the growth of rural non-farm income was egalitarian but low, and possibly unsustainable. In the 1990s, there was a tilt within the rural non-farm sector towards relatively largerscale and more productive enterprises involving more wage employment vis-à-vis selfemployment, including higher-paid salaried employment. The sector grew more rapidly in terms of value-added compared with the 1980s, labour productivity increased and there was a large increase in the share of non-farm income out of total rural household income (from 25 per cent in 1990–91 to 41 per cent in 1999–2000, according to the results of the Household Expenditure Surveys). But rural non-farm income, along with rural income as a whole, became noticeably more unequally distributed and the shift of labour to the sector from agriculture also slowed down. Income growth was thus stronger but inequitable. These somewhat divergent growth patterns in the 1980s and in the 1990s and the subsequent developments have important implications for the evolving nature of poverty dynamics in rural Bangladesh. The expansion of low-productivity self-employment can help poverty reduction to the extent permitted by the market demand constraint facing the products of such activities. But the other and historically more tried path to poverty alleviation is through increasing wage employment in relatively more productive jobs through the gradual scaling up of enterprises. An appropriate combination of these two approaches to employment creation can thus result in broad-based growth of the rural economy.31 If at the same time, there is strong growth in agricultural income, this will have an equalizing effect and the impact on poverty will be much stronger. All these factors may have worked behind the positive trends in poverty and income equality in rural Bangladesh observed in the most recent period (Table 3.5), but a confirmation of this will need to await more detailed analysis. Human development Bangladesh has made significant progress in improving human development indicators, particularly since the early 1990s, and is among the few developing countries that are on target for achieving most of the Millennium Development Goals (World Bank, 2003b; Government of Bangladesh, 2005). The decline achieved in infant and child mortality rates, for example, is among the fastest in the developing world. Bangladesh has already eliminated gender disparity in primary and secondary school enrolment and has made remarkable progress in providing universal basic education (Table 3.6).

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Table 3.6 Improvements in some Human Development Indicators since 1990, Bangladesh and South Asia Indicators Gross primary enrolment rate (%) Ratio of girls to boys in primary and secondary education (%) Under-five mortality rate (per 1000 live births) Population with access to improved sanitation (%)

Bangladesh South Asia Bangladesh South Asia Bangladesh South Asia Bangladesh South Asia

1990

2002–04

80 95 77 71 144 130 23 20

109 103 107 89 69 86 48 37

Sources: Estimates of access to sanitation are from UNDP’s Human Development Report 2005; all other estimates are compiled from the World Bank’s World Development Indicators as reported in World Bank (2006a) and World Bank (2006b).

Its success in reducing the population growth rate through the adoption of birth control methods is also unique among countries at similar per capita income levels. Bangladesh belongs to a regional belt, stretching across Northern Africa, the Middle East, Pakistan and Northern India, that is characterized by patriarchal family structures along with female seclusion and deprivation. This makes its achievements all the more noteworthy. There is no easy explanation of how such social transformation has been possible under conditions of still widespread poverty and the poor governance of public service delivery systems as exist in Bangladesh. Much of the progress has been due to the adoption of lowcost solutions like oral rehydration technology for diarrhoea treatment, leading to a decrease in child mortality, and due to increased awareness created by effective social mobilization campaigns such as for immunization or contraceptive use or female child enrolment. The scaling up of programmes through spread of new ideas is helped in Bangladesh by a strong presence of non-governmental organizations (NGOs), and also by the density of settlements and their lack of remoteness. Increased budgetary allocations and support from external donors also helped. There are, however, some doubts about whether these trends in human development indicators can be sustained. Two decades or so ago, Bangladesh was in fact a laggard among countries with similar per capita income levels, so that the progress represents in part a ‘catching up’ (World Bank, 2003b). As the situation has now clearly reversed, and as the gains from low-cost solutions are reaped, maintaining recent rates of progress will become increasingly difficult and will require commitment of more resources.32 For example, lowering the maternal mortality rate or preventing infant mortality related to birth complications requires the provision of relatively costly health services. Hence, the level of public health expenditure and the quality of health services will become important determinants of progress. Similarly, remarkable progress has been made in school enrolment, especially for girls, but there are serious concerns now about the quality of education. Clearly, the challenge in these areas increasingly lies in mobilizing more resources and improving the quality of service delivery.

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External sector policies Impact of import liberalization By international standards, Bangladesh has had one of the most rapid episodes of import liberalization, from the withdrawal of quota restrictions in the late 1980s to the reductions in tariffs in the first half of the 1990s. But since then, the pace of further import liberalization has slowed down. Table 3.7 shows the trends in the average rate of protective import duties since the early 1990s (as well as the average rate of all import duties based on actual collection). Taking into account all import duties having a protective effect, the average nominal protection rate has fallen from 74 per cent in 1991/92 to 32 per cent in 1995/96 and 29 per cent in 2003/04. The slower decline since the mid-1990s is partly because cuts in customs duties were offset by other protective duties and para-tariffs. As a result of these reforms, Bangladesh still has a relatively closed economy. A feature of the above tariff reforms is the end-use-based discrimination in protective duty rates. Capital goods and primary commodities are subject to much lower rates of tariffs compared with intermediate goods, while the highest rates apply to finished consumer goods.33 This has helped to retain relatively high rates of protection for the later goods even within the much lower average import tariffs; at the same time, the antiexport bias of the tax system is reduced because of lower taxes on imported inputs. Such a system of tariff escalation has suited the interest of the protectionist lobbies, since the domestic import-substituting industries mainly produce finished consumer goods. The system of incentives thus created makes the domestic industries even more importdependent. Another fallout of the above system of tariffs is to create very low, even negative protection for the domestic engineering and capital goods industry, thus stifling its growth.34 This adverse effect has been discounted because of the rather small size of this industry and because the removal of duties on machinery imports has been a means of providing incentives for other industries. This ignores the potential role of a domestic capital goods Table 3.7

Average rates of customs duties and all protective import dutiesa

Rates Average customs duty, unweighted (%) Average protection rate, unweighted (%)b Average collection rate (%)c

1991/92

1995/96

2003/04

70.6 73.6 28.7 (37.4)

28.7 32.0 23.7 (31.8)

18.8 29.1 18.0 (25.5)

Notes: a. The average rates reported here are based on eight-digit 6877 tariff lines; they do not include tariff exemptions or concessions, nor do they reflect ‘preferential’ tariffs. b. Incorporates the protection provided by all other import duties, surcharge and fees in addition to customs duty, and also the protection that arises when the Supplementary Duty and VAT are levied on only imports but not on domestic production or when higher rates are applied on imports. c. The collection rate reflects tax exemptions as well as tax evasion; includes duties on all lines of import items, but not the advance income tax on imports. Figures within brackets are average collection rates excluding import of duty-free export-related items. Source: Estimated from World Bank (2004a) and World Bank (2004b).

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industry in technological adaptation, which is especially important for upgrading the traditional technology in the informal sector. Large-scale industries in Bangladesh, on the other hand, rely almost entirely on imported machinery. In spite of the reduction in import tariffs, considerable anti-export bias still remains (World Bank, 2004b). This problem is addressed to some extent by the existing schemes of duty-drawback, bonded warehouses and selective cash incentives for exports, which are essentially means for providing exporters duty-free access to imported inputs or for compensating for the payment of such duties. There may also be a pure ‘subsidy’ element in the cash incentives, which are currently provided to a number of export items including fresh fruits and vegetables, light engineering products, jute products and fabrics used for exported garments. However, the scope and effectiveness of such schemes are limited both by concerns of revenue and administrative feasibility. While external liberalization in Bangladesh has been accompanied by acceleration in overall industrial growth, this is mostly attributable to the success in garment exports. Many import-substituting industries seem to have been adversely affected; indeed, the official index of large- and medium-scale manufacturing production shows that almost half of the country’s four-digit industries contracted during the first half of the 1990s – the period of rapid tariff reductions. And though some gains were made in the overall production efficiency of import-substituting industries, they occurred more because of the exit of the relatively inefficient (mostly state-owned) industrial units than because of technological improvements made at the firm level (World Bank, 1999; 2004b). Clearly, domestic industries need to improve production efficiency in order to be able to withstand further reduction in protection. One exception is the pharmaceutical industry, which grew rapidly as an import-substituting industry, trebling its output in the 1990s, and is now well positioned to enter the export market.35 The extent and speed of further import liberalization remain a contentious issue in the country’s economic reform agenda. In the absence of any pre-announced target and timetable, tariff reform in Bangladesh would seem to be a ‘learning-by-doing’ process (even if not consciously recognized to be so). The credibility of such an approach depends on the government’s willingness and capability to conduct trade policy reforms in an analytical way. The effectiveness of tariff reforms also needs to be assessed in relation to policy reforms in other areas, such as tax administration, provision of infrastructure and the functioning of financial and labour markets. The impact of protection afforded through tariff escalation and of the selective interventions for export promotion is bound to be discriminatory in nature. While the room for such discrimination may be gradually reduced with further import liberalization, there is clearly a role for an active industrial policy, at least in the transitional reform period. If there is no well-devised industrial policy, there will be one by default. Export growth Bangladesh increased its garment exports rapidly by taking advantage of export quotas and preferential access in the major markets (the United States and the European Union) along with its abundance of low-cost female labour. Thus far, Bangladesh’s garment industry has performed well in coping with the phase-out of the MFA quotas in the US market. In fact, led by a surge in garment exports, the country’s export earnings in US dollars grew by more than 20 per cent in the most recent year of 2005–06.

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There are, however, several risks involved. Within Bangladesh’s total garment exports, there has been a marked slowdown in the export of woven garments, reflecting a loss of competitiveness in this sub-sector, but this has been more than compensated for the time being by a strong performance in the export of knitted garments. Moreover, in maintaining competitiveness, the country’s garment industry has absorbed a sharp decline in export prices, while letting the wages of garment workers, mostly women, fall in real terms. The garment industry is now facing domestic labour unrest as well as increased pressure from foreign buyers demanding better labour standards. It is difficult to gauge how Bangladesh’s garment industry will fare in the longer run. Among the major garment exporters, Bangladesh has the advantage of the lowest wage rate, but it loses out in the marketing value chain because of its dependence on marketing intermediaries. The dependence on imported fabrics and yarns puts Bangladeshi garment exporters at a disadvantage, by increasing the lead time needed to meet orders from foreign buyers. In recent years, there has been some growth in backward-linkage domestic production of fabrics, but only under high cash incentives (subsidies) that are now being phased out. In the quota-free export market, there is likely to be a restructuring of the garment industry in Bangladesh; the relatively larger firms with better marketing ability will have a better chance of surviving the competition and even gaining. Bangladesh’s export base remains very narrow, with garment exports currently accounting for about 75 per cent of total export earnings. Sustaining a strong export growth, which is crucial to the country’s overall growth prospects, will require continued growth of garment export as well as export diversification. Bangladesh has a potential comparative advantage in a number of export items such as horticultural products, leather goods, light engineering products and certain chemical products. It should also be able to take benefit from the provisions of duty-free access of exports from least developed countries to the EU, Canada, Australia and other industrialized countries that may allow such concessions. To take advantage of these opportunities, it will need to give attention to a number of export-facilitating factors: better infrastructure, including efficient port facilities; standardization of product quality; technological improvements, leading to higher productivity; and an improvement in the overall domestic investment climate. It may be noted that the heavy dependence of domestic industries on imported raw materials and intermediate goods makes it difficult for Bangladesh to satisfy the so-called ‘rules of origin’ in getting preferential access for its exports in the markets of the developed countries. Thus, most of Bangladesh’s export of woven garments is not eligible for the Generalized System of Preferences (GSP) in the EU market, since they are made largely from imported fabrics. This is also true of the EU’s offer of allowing duty-free import of ‘everything but arms’ from the least developed countries, since the same rules of origin as under the GSP also apply here as well. Within the textile category, a relaxation in the rules of origin for knitted garments since 1999 has led to a surge of exports of knitwear from Bangladesh to the EU market.36 Trends in the real exchange rate A remarkable aspect of Bangladesh’s reform experience has been the relative stability of its real exchange rate (Figure 3.1). Though substantial trade liberalization took place at a time of marked and steady decline in external deficits, there was hardly any real devaluation of the taka (with only modest devaluation up to about 1997, followed by mild

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200 Bangladesh

180 India

India

Index of Real Exchange Rate

160 140 Bangladesh 120 100 80 60 40 20 0

Month (January 1980 to April 2002)

Note: A negative change indicates depreciation of the domestic currency. Source: IMF financial statistics.

Figure 3.1 Movements of indices of real effective exchange rates of India and Bangladesh (monthly data, January 1980 to April 2002; base: 1990 = 100) appreciation since then). The strength of the taka was due to the rapid growth in export earnings, along with increasing flows of workers’ remittances, which together more than offset the decline that took place in aid inflows relative to GDP. During this time, the currencies of many developing countries including India and Pakistan underwent massive real devaluation.37 This put Bangladesh at a disadvantage in export competition and in marketing its exports within these countries, especially neighbouring India. The real value of the Bangladesh taka appreciated by an estimated 25 per cent or more against the Indian rupee between the late 1980s and the mid-1990s. This, combined with the fact that Bangladesh opted for much faster import liberalization than did India at that time, resulted in a dramatic increase in Bangladesh’s trade deficit with India. By the late 1990s, Bangladesh’s exports to India could pay only for a meagre 4 per cent of its imports from that country, compared with more than 15 per cent a decade or so earlier. From the poverty perspective, however, these movements in the bilateral real exchange rate produced a benefit; with the liberalization of rice imports, commercial rice imports from India can now help to smooth consumer prices when rice harvests in Bangladesh are poor (Dorosh and Shahabuddin, 1999).

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While the success in garment export may have at times raised the spectre of the ‘Dutch disease’ (that is, too much success in a single export item creating disincentive for other exports through its impact on the exchange rate), the prospect of a large real devaluation caused by an export debacle is a more serious concern for Bangladesh. Most parts of the Bangladeshi economy in effect represent semi- or non-tradeables; these include not only services, which account for nearly half of GDP, but also small-scale manufacturing producing poor substitutes for imports, and many agricultural products in which Bangladesh has no commercial foreign trade in most years.38 Devaluation would depress production incentives in these activities by increasing the price of imported inputs and turning the domestic terms of trade against these activities vis-à-vis the tradeable sectors – not an encouraging prospect for achieving accelerated GDP growth, let alone pro-poor growth. The dangers of a large devaluation underline the importance of international support to tide over the adverse balance of payments effect of an export slowdown. They also highlight the importance of promoting export growth and diversification through various non-price incentives and measures as mentioned above, rather than relying on an aggressive exchange rate policy, as is often advocated. An added implication is that – in an economy that has yet to complete a transition from non-tradeable-based to tradeablebased growth – the use of the exchange rate as a tool for export promotion needs to be approached with caution.39 Fiscal management Budgetary trends The budgetary trends, as shown earlier in Table 3.2, have some notable features. First, fiscal operations of the government had to be defined in the context of a steadily declining availability of foreign aid. The decline has been particularly rapid in the 1990s. Net foreign financing came down from 5 per cent of GDP in the second half of the 1980s to 2.6 per cent in the second half of the 1990s and 1.8 per cent in the following five-year period. The overall budget deficit also shows a declining trend all along, although there was some recourse to increased domestic borrowing, especially since the late 1990s. Second, the revenue–GDP ratio increased significantly in the first half of the 1990s, by about two percentage points of GDP, and more modestly thereafter. Thus, since the early 1990s, the challenge of reduced aid availability was met by improved revenue effort, and to a lesser extent by increased domestic borrowing, and not by reducing expenditure. In fact, there was a slight increase in total government expenditure as a proportion of GDP – a reversal of the trend of the 1980s. Third, of the two broad components of government expenditure – current and development – it is the current expenditure that has risen over the last two and a half decades – from 4.6 per cent to 8.2 per cent of GDP. The increase was particularly sharp in the second half of the 1980s; since then the rise has been somewhat restrained. With regard to the development budget, its size as a proportion of GDP slightly increased in the 1990s, but it never fully recovered to the level of the early 1980s. Overall, the fiscal policy since the early 1990s has played a useful role of averting a potential contraction in demand in the face of declining foreign aid availability. Along with higher revenue mobilization and some increase in domestic borrowing, the budget

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deficit was brought down a little and inflation was reduced to a low level. The result was a reasonably stable macroeconomic environment, which allowed the real side of the economy to attain modest growth acceleration. This said, fiscal management seems to have often played only a passive role as a tool of aggregate demand management. The government’s development spending, being the flexible part of the budgetary expenditures, can potentially play a counter-cyclical role. In practice, this is hardly the case because of weak implementation and monitoring of the Annual Development Plan (ADP). Actual development spending usually falls short of the budgeted amount, in some years by very large margins, and about half of all development spending is usually incurred in the last quarter of the financial year. In the early 1990s, for example, when the economy seemed to be suffering from an aggregate demand deficiency, the government was unable to increase the size of the ADP (Mahmud, 1995). Public spending patterns Public spending patterns have undergone some significant changes in the last two decades, reflecting the changing developmental role of the government under the economic reforms. These changes are mostly captured by the trends in sectoral allocations of development spending, which is the flexible part of budgetary expenditure.40 As can be seen from Table 3.8, allocations have fallen appreciably for a number of sectors – most notably, the manufacturing industry, water resources, energy and agriculture. The reverse of this structural change in development spending is the increased proportional allocations to transport and communication, rural development and to social sectors, especially education. Allocations to manufacturing industries have been reduced to an almost insignificant proportion, showing that the government has virtually withdrawn from investment in setting up new industries. The sharp fall in allocations to agriculture in the later half of the 1980s reflects the reduction or elimination of agricultural subsidies in that period. Table 3.8

Sectoral shares in development expenditure (percentages; five-year averages)

Sector Agriculture Rural development Water resources Industry Energy Transport & communication Physical planning & housing Education Health and family planning Others Total

1980/81– 1984/85

1985/86– 1989/90

1990/91– 1994/95

1995/96– 1999/2000

13.09 3.51 13.99 9.57 21.87 15.34 5.32 3.97 5.18 8.16

5.48 2.59 12.63 11.60 23.33 10.71 3.77 4.40 4.71 20.78

5.93 5.40 8.76 1.59 17.74 18.82 5.48 8.14 7.73 20.41

4.72 9.14 7.16 1.24 17.08 21.96 5.50 13.08 8.04 12.08

100.00

100.00

100.00

100.00

Sources: Based on the Revised Budget figures as reported in various World Bank publications and Bangladesh Economic Survey, Ministry of Finance (various issues).

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With the rapid expansion of tube-well irrigation in the private sector, the proportion of allocations to water resource development has also declined. Also, the decline in investment in energy reflects increased reliance on private companies for the generation of electricity and for the exploration activities. Broadly speaking, one finds a close concordance between the accepted development strategy and the patterns and trends in public development expenditures. The government has gradually withdrawn from the directly productive sectors, while concentrating more on providing public goods in the form of education and health, physical infrastructure and rural development. Two points, however, may be made at this stage regarding the above restructuring of development spending. First, the a priori rationale and the actual effectiveness of increased allocations to social sectors are two separate aspects, so that much will depend on the quality of implementation of projects and programmes. Second, the structural shift in the budget towards larger social spending has come about from a redefining of the role of the government and is, therefore, of a once-and-for-all nature. In future, higher allocations to social sectors will require more difficult reforms, for example, in respect to preventing tax evasion or downsizing the government. It is worth taking a closer look at public expenditure on health and education by combining both current and development expenditure.41 Table 3.9 shows the trends in public expenditure on education and health (including family planning) as shares of total budget expenditure and as percentages of GDP. It can be seen that the proportional allocation of education and health has continuously increased all throughout the reform period beginning from the early 1980s. Their combined share of total budgetary expenditure has gone up from 14 per cent to 23 per cent during this period. The increase has been particularly rapid for education, whose share has nearly doubled. This restructuring of public expenditure also resulted in a rising proportion of GDP being allocated to these two sectors. It is remarkable that these proportions were not allowed to fall even when total budgetary expenditure declined as a proportion of GDP, as in the second half of the 1980s. The analysis of benefit incidence shows that the distribution of benefit from public spending on both health and education among households is weakly pro-poor, that is, the distribution is more equal than the overall income distribution in the economy, although it favours the relatively rich. Only expenditure on mother and child health and on primary education is strongly pro-poor, so that the poor get more absolute benefit than the rich Table 3.9 Government expenditure on health and education (as shares of the budget and as % of GDP; five-year averages)

Areas of Expenditure Percentage of total budget expenditure Education Health & population planning Percentage of GDP at market prices Education Health & population planning Sources: Same as for Table 3.8.

1980/81– 1984/85

1985/86– 1989/90

1990/91– 1994/95

1995/96– 1999/2000

8.16 5.40

11.24 5.88

13.62 6.77

15.51 7.13

1.00 0.66

1.33 0.70

1.81 0.90

2.11 0.97

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Table 3.10 Per capita public spending on education and health in South Asian countries (US dollars) Country India Pakistan Sri Lanka Bangladesh

1997

1998

1999

2000

15 15 32 11

16 14 34 11

15 13 33 11

19 12 35 12

Source: Estimated from data reported in the World Bank’s World Development Indicators; see World Bank (2003a).

(World Bank, 2003a). As mentioned earlier, the delivery of public services in these social sectors suffer from poor governance. Clearly, ensuring adequate access of the poor to education and health services of sufficient quantity and quality requires much more than allocating more budgetary resources to these sectors. Nevertheless, it must be acknowledged that public expenditure policy of Bangladesh deserves credit for raising the share of these sectors in the total budget, and also for implementing at least a weakly pro-poor stance in the distribution of benefits. In spite of favourable budgetary allocations, per capita public expenditure on health and education in Bangladesh in absolute terms is quite low even by South Asian standards (Table 3.10). This is a reminder of the fact that the scarcity of resources, arising from the low levels of per capita income and of public spending generally, is a major limiting factor in improving the education and health of the poor in Bangladesh. Revenue mobilization In spite of an appreciable improvement in revenue collection in the 1990s, the revenue-toGDP ratio in Bangladesh remains very low by international standards. Even within the subcontinent, the revenue-to-GDP ratios of Pakistan (15 per cent), India (17 per cent) and Sri Lanka (19 per cent) exceed that of Bangladesh (10 per cent) by a wide margin. Particularly appalling is the state of direct taxation, which accounts for only about 15 per cent of total revenue and 1 per cent of GDP (Table 3.11). The low tax–GDP ratio results from huge tax evasion and from the fact that agriculture and other informal sectors are virtually excluded from the tax net due to weak tax administration. In the past, the tax ratio could be increased, or prevented from falling, mostly by enhancing the rate structure and expanding the tax base, suggesting that the tax system is income-inelastic (Mahmud, 2001). In fact, most of the revenue gains during the early 1990s were due to the introduction of the value-added tax (VAT) with its higher coverage and rates compared with the taxes it replaced, that is, excise duties on domestic production and sales tax on imports. However, those gains turned out to be mostly of a once-and-for-all nature. One important concern regarding trade liberalization through reduction of import duties is its likely adverse impact on the government’s revenue. As discussed earlier, trade policy reforms in Bangladesh involved a very substantial reduction in customs duties, especially in the early 1990s. Although the share of these taxes in total tax revenue has declined to some extent, their revenue contribution as a proportion of GDP has not

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Table 3.11 Structure of taxes in Bangladesh 1986/87–1999/2000 (as % share of total tax revenue; figures in parentheses are percentages of GDP at market prices) Taxes Direct taxes Income tax Land tax Indirect taxes Sales tax/VAT Customs duties Excise duties Others Total tax revenue

1986/87–1989/90

1990/91–1994/95

1995/96–1999/2000

16.78 (0.92) 14.98 1.80 83.22 (4.58) 11.63 (0.64) 37.98 (2.09) 27.05 6.73

17.99 (1.22) 16.84 1.14 82.01 (5.58) 31.27 (2.20) 33.68 (2.28) 10.27 6.79

15.54 (1.15) 14.17 1.39 84.46 (6.26) 46.38 (3.44) 29.67 (2.20) 1.41 6.99

100.00 (5.50)

100.00 (6.81)

100.00 (7.41)

Source: Based on estimated actual revenue collection as reported in Bangladesh Economic Survey, Ministry of Finance (various years).

(Table 3.11). This has been made possible by the rapid increase in the import–GDP ratio, which has more than compensated for the reductions in the duty rates. The adverse revenue effect of import liberalization was thus avoided by increased trade openness. The introduction of VAT in 1992 also helped in raising revenue from import while rates of protective duties (customs duties) were being reduced. When applied uniformly on imported and domestically produced goods, VAT on import has no protective effect and is not therefore in conflict with the policy of reducing protective tariffs. Although essentially a tax on consumption, it is imposed on most types of imports including raw materials and intermediate goods because of the ease of collection at the import stage. While the VAT paid on imported inputs is adjusted for in assessing the VAT on domestic production, such import taxes are also a means of taxing production in the informal sector lying outside the tax net. Another potential tax instrument for sustaining revenue effort while reducing protective tariffs is provided by the so-called Supplementary Duty, which was introduced alongside the VAT. Like the VAT, it is meant to be a tax on consumption to be imposed equally on import and domestic production, and it can also be selectively imposed on relatively inessential items of consumption. In practice, however, the potential role of this tax does not seem to have been fully appreciated. It has been often used as a protective import duty, and at times it has also been imposed on domestically produced intermediate products like natural gas, thus implying a departure from the principle of incentive neutrality. As a result of these tax reforms, the share of import taxes in total tax revenue thus remains high following trade liberalization. In 2000/01, for example, this share was more than half, with 26 per cent of tax revenue coming from customs duties, 20 per cent from VAT on imports and another 7 per cent from Supplementary Duties on imports. The

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continuing import dependence of tax revenue involves some risks. A slowdown in import growth may adversely affect tax revenue, particularly in the event of further reduction of protective import duties. Further tax reforms in Bangladesh will therefore have to find ways of mobilizing more revenue from domestic sources. Political economy and governance The governance–growth nexus Bangladesh’s impressive record of economic growth and social development has been achieved despite apparently poor governance. Bangladesh is thus an outlier in crosscountry comparisons relating governance to economic growth (Mahmud et al., 2007). Recent studies show increasingly compelling evidence that good governance matters to growth, although there are many controversies surrounding these studies regarding the definition of ‘good governance’, the biases in perception of governance, the direction of causality, and the problem of isolating the effects of country-specific institutional and other factors in explaining cross-national variations. While it is quite evident that Bangladesh’s economic performance has been negatively affected by some of the adverse governance factors, the more interesting question relates to why the country’s economy has performed in the way it has despite wide-ranging governance failure. Most international comparisons show relatively very poor perceptions of governance in Bangladesh. For example, in the most recent governance data set released by the World Bank Institute for 2005, Bangladesh’s ranking among 210 countries varies from the bottom 7th to 32nd percentile in the six indicators: 6.6 for political stability, 14.9 for regulatory quality, 19.8 for rule of law, 7.9 for control of corruption, 21.1 for government effectiveness and 31.4 for voice and accountability. Bangladesh’s position is significantly worse compared with its South Asian neighbours in most indicators; only in respect to voice and accountability is it ahead of Nepal and Pakistan. The information from the Investment Climate and Doing Business Surveys carried out by the World Bank Group is also not encouraging for Bangladesh in most respects. Even more discouraging is Bangladesh’s very poor ranking in the World Economic Forum’s Global Competitiveness Index, in which Bangladesh recently ranked 98th out of 102 countries. In some aspects of governance, however, Bangladesh does well. For example, Bangladesh ranks among the top 50 per cent of the countries in terms of the ease of doing business according to the World Bank’s Doing Business Survey of 2006. It actually ranks above most developing countries in terms of investor protection.42 The perception indices may also neglect many ground-level realities. Although Bangladesh scores very poorly in terms of enforcements of contracts, casual observation suggests that local business people do not regard it as any great hindrance in an environment where such enforcement can be biased to favour them and where informal methods based on business mores and customs and reputation play an important role. The corporate tax regime is relatively liberal in Bangladesh and profits are fairly high in formal sector enterprises. It is worth mentioning that the World Bank’s Doing Business index does not take account of business profitability. Bangladesh has in fact enjoyed governance successes in some key areas. The state has actively supported the emergence of what is a vibrant domestic private sector. It has done this by various policy reforms aimed at maintaining macroeconomic stability, keeping fiscal deficits low so as not to crowd out bank lending to the private sector, providing

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access to imported inputs through import liberalization, and improving the central bank’s oversight functions in respect to commercial banking. The successive democratically elected governments have been able to make prudent public expenditure choices. The disaster management capacity of the government has also improved significantly over the years. The state has created space and forged partnerships with non-governmental organizations (NGOs) and the private sector to help deliver social services. And there has also been a certain degree of continuity in policy in spite of changes in government. The two major political parties, the Awami League and the Bangladesh Nationalist Party (BNP) are both centrist parties with almost similar economic agenda, in spite of their left-ofcentre and right-of-centre postures, respectively. The governance–growth nexus needs to be understood in the individual country contexts, in which institutions, the historical and cultural settings and the stage of development all matter. To understand Bangladesh’s development conundrum, one needs to deconstruct the economic growth process and focus on the main drivers behind accelerated growth. As discussed earlier in this chapter, the acceleration of growth of Bangladesh’s economy since the early 1990s has been underpinned by strong export growth, led almost entirely by the growth in ready-made garment exports. The garment industry has flourished in Bangladesh because of the confluence of a number of favourable factors: the early relocation of garment producers and marketing intermediaries from East Asian countries (especially South Korea) to Bangladesh to evade import quotas in the US and European markets; easy transfer and spread of garment-industryspecific managerial and production skills; preferential access of Bangladesh’s garment export in the major markets of the West; favourable policies adopted by the government in supporting the industry, specially by creating a set of enclave-type arrangements (e.g., bonded warehouses and back-to-back Letters of Credits (L/Cs) to facilitate duty-free import of fabrics) and the abundance of low-cost female labour.43 Once the growth of the industry gathered momentum and became the main foreign exchange earner, it gained in efficiency and could exercise more clout in shaping government policies in its favour. Besides garment exports, growth impulses have come from workers’ remittances and from growth in agriculture and in small-scale industries and services, mostly belonging to the informal sector. The government has pursued policies since the early 1980s to encourage labour export and attract remittances by negotiating with host countries, offering favourable exchange rates for workers’ remittances during the previous exchange control regime and facilitating remittances through banking channels by various means. Growth in agriculture has been helped by market-oriented reforms in agricultural input markets despite the withdrawal or reduction of agricultural subsidies.44 Moreover, because both agriculture and informal sector activities mostly remain outside the purview of the government’s regulatory functions, these are likely to be less adversely affected by poor governance compared with the activities in the modern organized sectors of the economy.45 There are, however, signs that the institutional weaknesses may have already reached the tipping point beyond which these may prove to be the binding growth constraints. Future growth will have to come increasingly more from the urban organized sectors of the economy, which will need a better-functioning regulatory framework and improved provision of infrastructure facilities. Strengthening agricultural growth through a shift from rice to high-value crops will also need a modernization of the marketing infrastructure. While the rapid growth of the urban centres has greatly contributed to economic

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growth, its unplanned nature is already creating a huge problem of urban governance in respect to environmental sustainability and provision of basic services. Bangladesh has made the transition from being primarily a jute-exporting country to a garment-exporting one. The transition has been dictated by the country’s resource endowment, characterized by extreme land scarcity and a very high population density, which makes economic growth dependent on the export of labour-intensive manufactures. It is not, however, easy for a least-developed country like Bangladesh to specialize in manufactured exports. Having low wage costs can hardly compensate for its relative disadvantage in marketing skills and infrastructure (including transport, ports, product standards and certification facilities). Indeed, Bangladesh’s experience with the garment industry has demonstrated the limitation of relying on enclave-type arrangements to facilitate export growth in a specific activity, while postponing institutional reforms for improving the investment climate generally. There is also a need for foreign direct investment (FDI) for facilitating technology transfer and for meeting the resource needs. Local entrepreneurs may have become used to dealing with many aspects of the governance problems, but this is not true for prospective foreign investors. Besides the export-oriented garment industry, FDIs have mainly come in sectors like electricity generation and exploration and production of natural gas, which involve purchase or sale contracts with the government at ‘administered’ prices. Since the perceived high country risk for investment in Bangladesh is likely to be taken into account by prospective foreign investors in their profitability calculations, the negotiated terms tend to be less favourable to Bangladesh than they otherwise could be. While an increasingly large proportion of the population in the labour force represents a potential strength of the economy, enough jobs need to be created to reap the economic gains from it. A slackening of the labour market will keep wages from rising and may lead to political discontent. The garment industry is already facing labour agitation demanding higher wages. Bangladesh also needs more skilled and well-trained workers to boost productivity, and with it, global competitiveness. Improved governance of the education system will be needed to raise the quality of education and consolidate the earlier gains from the increase in primary school enrolment. Political incentives and policy-making It is generally agreed that economic reforms in Bangladesh have not been matched by progress in building the institutions of political and economic governance. The degree of resistance to reforms of different kinds depends on the nature of prevailing political cultures. Bangladesh has successfully implemented many reforms that are usually considered as unpopular and vote-losing, such as the withdrawal of agricultural and food subsidies affecting large sections of the population. Considerable progress has also been made in implementing reforms that are liable to antagonize organized militant groups who can create short-term disruption through agitation, such as the trade unions resisting the privatization of state-owned enterprises. As part of the above reforms, the early emphasis on privatization of marketing of agricultural inputs and withdrawal of agricultural subsidies made sense on grounds of pragmatism. By the late 1970s, about one-third of the entire development budget used to have been eaten up by agricultural input subsidies. To promote modern rice technology, government policies had emphasized the public distribution of fertilizers and renting of

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publicly owned irrigation equipment at a heavy subsidy. These policies did have a major role in the initial adoption of the modern high-yielding variety (HYV) rice technology, but their rationale became weakened as farmers became familiar with the use of modern inputs, government controls became burdensome and budgetary costs proved unsustainable. Even though debates on agricultural subsidies still reappear from time to time, the case for subsidies has been weakened by the fact that increased budgetary allocations have gone to rural infrastructure and social sectors as part of fiscal adjustment. At about the same time as agricultural subsidies were being reduced, public food distribution in the form of food rations in urban and rural areas was also gradually phased out. This was not an easy decision, given that the politically vocal urban middle class was its main beneficiary. In many other countries, attempts to abolish such food rations met with violent political protests. The budgetary burden was again a consideration, but public opinion was also shaped by the evidence that the poorest families had little access to the food rations. The success of the reform programme regarding the public food distribution system in Bangladesh is partly explained by its gradualism and its clever design. In the years of high food grain prices, the ration prices were raised without creating much resentment (because of still higher market prices), but the ration prices were not reduced in years of low market prices (which again was acceptable, since only an increase in ration prices was a sensitive issue). The gap between the market and ration prices was thus gradually reduced, so that ultimately there was little incentive for the beneficiaries to access such rations (Mahmud et al., 2007). On the other hand, there was a strong case on equity grounds in support of the policy to continue with, and even strengthen, the food distribution programmes targeted at the poor, such as those relating to food-for-work and feeding vulnerable women and children. With regard to external sector reforms, the pattern of reductions in import duties suggests that the government’s revenue concerns rather than protectionist appeals have been a stronger deterrent to faster import liberalization.46 As mentioned earlier, the reason why tariff reforms have not been strongly resisted by domestic industrial lobbies is the end-usebased discrimination in protective duty rates, which has helped to retain relatively high rates of protection for finished consumer goods even within the much lower average import tariffs. But even within such a policy of tariff escalation, revenue concerns seem to have dominated over protectionist ones, so that duties on major imported intermediate goods remained higher than those on relatively minor ones.47 Moreover, the prospect for export growth and diversification may provide further leverage for import liberalization. Most industrialists in Bangladesh now have a stake in the export-oriented garment industry. The other fast-growing industries like pharmaceuticals and ceramics have gone into the export market after graduating from being entirely import-substituting industries. This may weaken the resistance to further reducing the anti-export bias in the duty structure that now exists. In contrast to the economic reforms, the most politically challenging reforms have been the ones aimed at dealing with a whole range of governance-related problems: wilful default of bank loans, large-scale tax evasion, electricity pilferage, corruption in public procurement, deteriorating quality of public administration, poor law and order, inadequate justice system and erosion of integrity of most other state institutions. These problems are largely related to the country’s core governance systems as shaped by the nature of its politics. Political power has been concentrated in two major parties (e.g., the BNP

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and the Awami League), which has helped to form governments with large stable majorities, but this has also resulted in a system in which winners in elections take all and the losers have difficulty in reconciling themselves to their loss. The result is a dysfunctional parliament and a highly confrontational nature of politics. There is little democratic practice within the major parties, which are run by authoritarian control from the top; this is a reflection of the personalized and patron–client relationships pervading the Bangladeshi society at large. The above structure of governance provides an ideal breeding ground for corruption through the exercise of large discretionary powers with little accountability. Spoils and privileges are parcelled out to different clientele groups as an essential tool of political management. On top of this, a large part of the bureaucracy is seen to be corrupt and incompetent, which further feeds this vicious cycle of poor governance. Economic reforms have no doubt contributed to decreasing the scope of rent-seeking, such as from the import licensing system. New laws of public procurement have been introduced to make the public procurement system more transparent and accountable, but the system has hardly worked. Moreover, financial extortion (including illegal collections of tolls and protection money) under political patronage has been an increasing phenomenon contributing to the cost of doing business. Overall, one could thus conclude that if there is a demand in the political system for illegal incomes and rent-seeking, economic reforms alone will not be the remedy (Mahmud, 2001). Public economic functions are, however, affected by both adverse and beneficial political incentives. It is true that, given the weaknesses of the democratic institutions, there is hardly any effective oversight mechanism to ensure the accountability of the government’s fiscal operations and other economic functions. However, the national elections since 1991, held under a unique system of non-party caretaker government, have been seen as fair and credible. This has created an incentive structure in which public representatives try to respond to the genuine popular sentiments in order to win re-election while still engaging themselves in rent-seeking activities. There also seem to be at work some noninstitutional mechanisms for ensuring public accountability, such as through civic activism, a free press and widespread political awareness among the people at large. This probably explains why, in spite of many perverse political incentives embedded in the system, governments have played, overall, an effective developmental role. The developments in the banking sector provide an example of how policies have been shaped by the opposing compulsions of patronage politics and maintaining a sound economic order. The banking sector has long been suffering from the widespread culture of wilful default in loan repayment. The reasons for loan default on such a large scale have been many, such as politically influenced loans given by state-owned banks, ‘insider’ loans given by private banks to their sponsor-directors and the weakness of legal provisions for loan recovery. The adverse economic effects of such fiduciary indiscipline gradually grew to unsustainable proportions and created widespread public resentment. Public opinion against loan defaulters was reflected in the introduction of a law in 1996 debarring such defaulters from participating in national elections. Bold reforms have subsequently been adopted towards preventing banks from giving more loans to defaulters, removing unscrupulous sponsor-directors from the boards of the private banks and making the stateowned banks more disciplined and autonomous for their eventual privatization. In spite of the improvements, however, the banking sector continues to suffer from much inefficiency.

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In some other key sectors, however, such incentives for economic reforms have not worked. In power generation, potential private investors have been put off by the interference of vested interests in the tendering and negotiation process. The result is an acute power shortage that has not only proved to be a brake on economic growth but also a source of great embarrassment for the erstwhile BNP government. Successive governments have also neglected to improve the management of the Chittagong port, which suffers from the corruption in the customs procedures, deficient logistical capacity and the interference of highly politicized labour unions. As a result, the only major seaport of the country ranks among the world’s least efficient container ports. Conclusion Bangladesh has made some beginnings in converting the gains of macroeconomic stabilization into sustained and accelerated growth. To consolidate this process and to meet the risks of slippage, it has to address the emerging challenges on many fronts. While the governance environment may have been barely adequate so far to cope with an economy breaking out of stagnation and extreme poverty, it is increasingly proving a barrier to putting the economy firmly on a path of modernization, global integration and poverty reduction. Fortunately, Bangladesh’s problem is not to jumpstart growth, but to maintain, and to the extent possible, accelerate it. The governance agenda is large and cuts across a wide range of institutions and threatens powerful vested interests. Developing a strategic, sequenced approach that relies on success in a few key areas to generate momentum and demand for reform in other areas will be crucial. Compared with the first-generation reforms, there is a need for deeper and more complex policy innovations to deal with the emerging binding constraints to growth, such as the inefficient and overburdened seaport, inadequate power and infrastructure, urban congestion and mismanagement, acute skill shortages and limited successes in attracting foreign investments. Bangladesh’s economic growth prospects will ultimately depend on the viability of its core systems of political governance. Will political governance improve through increased civic activism and a lower tolerance shown by the public for weak governance? Or, will there be a ‘path-dependent’ institutional deterioration as postulated by Douglass North?48 Bangladesh’s recent political developments show both these tendencies. On the one hand, the state has played an active developmental role and there is no evidence of as much elite capture of the system as one would expect from the country’s image of being one of the most corrupt and ill-governed countries. On the other hand, patronage politics as exists in Bangladesh seems to have resulted in more and more rent-seeking as a means of political management, thus raising the stakes in winning elections and rendering the system increasingly unsustainable. The shape of Bangladesh’s political and economic future will largely depend on which of these opposing forces will prevail on the other. Notes 1. 2.

3.

Cf. Faaland and Parkinson (1976). Bangladesh’s war of independence received support from the Soviet bloc, and was opposed by China and the United States. Hence, during the initial years of independence, Bangladesh’s foreign policy was aligned towards the Soviet bloc. Bangladesh’s trade agreement with Cuba angered the United States, which blocked the shipment of food. See Islam (1974) in Robinson and Griffin (eds) for details.

Bangladesh 4. 5. 6. 7. 8.

9. 10. 11. 12. 13.

14. 15. 16. 17. 18. 19. 20. 21.

22. 23. 24. 25. 26. 27.

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The subsequent decline of the development financing institutions (DFIs) was also closely linked to the shortcomings of that round of privatization in Bangladesh. The absolute increase in the value of Human Development Index for Bangladesh between 1990 and 2001 is surpassed only by that for China and Cape Verde among all the countries for which such estimates are available; UNDP (2003: 241–4). Most international comparisons show relatively very poor perception about Bangladesh regarding the key elements of governance. For a discussion on these reforms and the macroeconomic developments in the 1980s, see Task Forces (1991). One redeeming feature of the macroeconomic developments in the 1980s as shown in Table 3.2 is the increase in public investment. This increase, however, barely compensated for the decline in private investment, resulting in a slight decline in the overall investment rate. However, the actual investment scenario of the decade was probably much worse. The investment figures are based on the revised national income series, which was initially estimated from 1990–91 onward, but was subsequently extended backward to cover the period of the 1980s. In spite of the improved estimation methodology used in the revised series, the investment estimates suffer from many weaknesses, which are likely to have been made worse through backward extrapolation. In fact, the old series show a substantial decline in the investment–GDP ratio during the 1980s, which is also borne out by a decline in the import of capital goods; see Task Forces (1991). It is also highly improbable that public investment was increasing at a time when public development expenditure was being curtailed, although the two are not exactly the same. In 1995–96 and 2000–01, both pre-election years, the government’s domestic borrowing and the rate of credit expansion in the private sector were unusually high, while trade deficits increased substantially and foreign exchange reserves fell; see Mahmud (2004). Ibid.: Table 2. This can be seen from the growth of machinery imports, which is a good proxy for industrial investment; see Mahmud (1997). Mahmud (2004: Table 2). In other words, the persistent problem seems to be one of the external balance rather than of the aggregate resource balance, that is, the savings–investment balance. This is more evident from the later episode of upturn in 2000–01; the domestic inflation rate in fact declined to less than 2 per cent in that year, but the foreign exchange reserves came down to a critically low level, equivalent to less than two months’ import payments; see Mahmud (2004: Table 2). Public savings are not however identical with the government budget’s revenue surplus, since the budget’s current expenditure does not fully reflect public consumption. The official estimate of export earnings is from the data of the Export Promotion Bureau; as a result, Bangladesh Bank’s balance of payments estimates are reconciled by including an ‘errors and omissions’ figure. The estimates are derived from the official national income statistics. The industrial sector includes construction, mining and utilities, besides manufacturing. World Bank (2003b: 7–8). These are estimated annual compound growth rates between the years 1991/92 and 1999/2000 and are based on the official national income statistics as reported in the annual Statistical Yearbook of Bangladesh of the Bangladesh Bureau of Statistics. According to the official 1999/2000 Labour Force Survey, these informal activities employ about threefourths of the country’s non-agricultural labour force. For an estimation of the relative importance of these growth stimuli, see Osmani et al. (2003). During the same period, cottage industries grew in terms of value-added at only 2.8 per cent annually. The growth rates are the estimated annual compound growth rates between the years 1991/92 and 1999/2000, based on the official national income statistics. These estimates do not include handlooms, which are treated as a separate category in the official manufacturing statistics. Lagos in Nigeria is the other. Acharya (2006) explains the contrasts between Dhaka’s commercial and construction boom and the lack of it in Kolkata and Mumbai. The official poverty estimates are made with reference to an ‘upper’ and a ‘lower’ poverty line. According to the lower poverty line, national poverty incidence is estimated to have declined from 43 per cent in 1991/92 to 34 per cent in 2000 and 26 per cent in 2005. See Mahmud (2006) and Osmani et al. (2003). See Mahmud (2006). The wage data for the more recent years are available from the unpublished reports of the Bangladesh Bureau of Statistics. Although the general validity of the Kuznets process has not been borne out by recent cross-country experience (see, for example, Anand and Kanbur, 1993), this does not imply that it cannot be valid for specific country situations.

122 28. 29. 30. 31.

32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48.

Handbook on the South Asian economies While non-farm activities of residual nature with extremely low returns to labour are still found to proliferate, these activities usually provide supplementary family incomes and do not represent the main earning source of the families. For evidence on this, see Osmani et al. (2003) and Mahmud (2006). Between 1983–84 and 1999–2000, the female labour force participation rate increased from 7 per cent to 22 per cent in rural areas and from 12 per cent to 26 per cent in urban areas. Experience of high-performing economies, such as the East Asian ones, shows that a rise in rural per capita income is likely to be accompanied by a gradual shift to relatively larger-scale non-farm activities accompanied by higher labour productivity, higher wage rates and an increasing proportion of wage labour visà-vis self-employment. For most social development indicators, the actual values of the indicators achieved by the country are found to be far superior to the predicted values at the given level of per capita income; see Government of Bangladesh (2005: Table 1). Between 1992 and 1996, the import-weighted average customs duty rate on capital goods declined from 19 per cent to 10 per cent, and for final consumer goods, from 47 per cent to 21 per cent; see World Bank (1999: 39). A striking example is provided by the decline of domestic textile machinery industry (power looms); this industry has been virtually eliminated during the past seven to eight years. Incidentally, Bangladesh stands to gain from the WTO agreement regarding the waiver of patent rights for the domestic production of drugs in the LDCs until 2016 and for the production and trade in certain lifesaving drugs among developing countries generally. More recently, a similar relaxation in the Canadian market has led to another surge in garment export from Bangladesh to that market, although on a much smaller scale. According to the IMF estimates, Pakistan, India and China have all maintained a lower real effective exchange rate (REER) of their respective currencies compared with Bangladesh with 1990 as the base year; only Sri Lanka and Vietnam had higher real effective exchange rates. The non-tradeable nature of these agricultural products arises from the large spread between export and import parity prices caused by poor marketing infrastructure and limited access to export markets; see Mahmud et al. (2000). See, for example, Harberger (2001: 559). In comparison, the sectoral allocation pattern of current expenditures has remained relatively stable; see Mahmud (2002). Among the few notable changes in the current expenditure pattern was increased allocations to education, especially towards the late 1980s; see Osmani et al. (2003). In terms of investor protection index, Bangladesh scores 6.7 compared with the OECD average of 6.0 and the South Asian average of 5.0. Easterly (2001: Chapter 8) elaborately describes how, by some historical accident, the Korean firm, Daewoo, and an influential Bangladeshi bureaucrat-turned-industrialist, Noorul Quader, got together to start the process of transfer of knowledge and skills for setting up an export-oriented garment industry. See Ahmed (2001: Chapter 5). There is, however, evidence that with a deterioration of law and order, small-scale and informal sector activities can be more vulnerable to illegal extortion and toll collection than larger-scale enterprise in terms of the proportionate increase in the cost of doing business. This is evident from the fact that the government sought to protect revenue by reducing tariffs on minor items rather than those with a large recorded import value; see Mahmud (2001). This is reflected in the higher estimated import-value-weighted average duty rate compared with the unweighted rate in respect of these categories of imports; see Mahmud et al. (2007). See, for example, North (1997).

References Acharya, Shankar (2006), A Tale of Three Cities, New Delhi: Indian Council for Research on International Economic Relations (ICRIER), mimeo. Ahluwalia, I.J. and W. Mahmud (2004), ‘Economic transformation and social development in Bangladesh’, Economic and Political Weekly, 4 September, 39 (36), 4009–11. Ahmed, Raisuddin (2001), Retrospects and Prospects of the Rice Economy of Bangladesh, Dhaka: University Press Ltd. Anand, S. and R. Kanbur (1993), ‘The Kuznets process and the inequality–development relationship’, Journal of Development Economics, 40 (1), 25–52. Bangladesh Bureau of Statistics (2003), Report of the Household Income and Expenditure Survey 2000, Dhaka: Ministry of Planning, Government of Bangladesh.

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Bangladesh Bureau of Statistics (2006), Preliminary Report of Household Income and Expenditure Survey 2005, Dhaka: Ministry of Planning, Government of Bangladesh. Devarajan, Shantayanan (2005), ‘South Asian surprises’, Economic and Political Weekly, 10 September, 40 (37), 4013–5. Devarajan, S. and I. Nabi (2006), ‘Economic growth in South Asia: promising, unequalising, sustainable?’, Economic and Political Weekly, 19 August, 41, 3573–80. Dorosh, P. and Q. Shahabuddin (1999), ‘Price Stabilization and Public Food Grain Distribution: Policy Options to Enhance National Food Security’, Working Paper No. 12, Food Management and Research Support Project, Dhaka: Ministry of Food and International Food Policy Research Institute. Easterly, W. (2001), The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics, Cambridge, MA: MIT Press. Faaland, J. and J. Parkinson (1976), Bangladesh: The Test Case of Development, London: C. Hurst. Government of Bangladesh (2005), Unlocking the Potential: National Strategy for Accelerated Poverty Reduction, Dhaka: Planning Commission (General Economics Division). Harberger, A.C. (2001), ‘The view from the trenches: development processes and policies as seen by a working professional’, in G.M. Meier and J.E. Stiglitz, Frontiers of Development Economics: The Future in Perspective, Washington, DC: World Bank and New York: Oxford University Press. Islam, N. (1974), ‘The state and prospects of the Bangladesh economy’, in E.A.G. Robinson and K. Griffin (eds), The Economic Development of Bangladesh Within a Socialist Framework: Proceedings of a Conference by International Economic Association, London: Macmillan. Islam, N. (1977), Development Planning in Bangladesh, Dhaka: University Press Ltd. Kabeer, N. and S. Mahmud (2004), ‘Globalization, gender and poverty: Bangladesh women workers in export and local markets’, Journal of International Development, 16 (1), 93–109. Khan, A.R. (1972), The Economy of Bangladesh, Delhi: Macmillan. Khan, A.R. and M. Hossain (1989), The Strategy of Development in Bangladesh, Basingstoke, UK: Macmillan in association with OECD Development Centre. Khundker, N., W. Mahmud, B. Sen and M.U. Ahmad (1994), ‘Urban poverty in Bangladesh: trends, determinants and policy issues’, Asian Development Review, 12 (1), 1–31. Mahmud, W. (1995), ‘Recent macroeconomic developments’, in Centre for Policy Dialogue, Experiences with Economic Reform: A Review of Bangladesh’s Development 1995, Dhaka: University Press Limited. Mahmud, W. (1996), ‘Employment patterns and income formation in rural Bangladesh: the role of rural nonfarm sector, The Bangladesh Development Studies, 24 (3 and 4), Sept.–Dec. Mahmud, W. (1997), ‘Macroeconomic update’, in Centre for Policy Dialogue, Growth or Stagnation: A Review of Bangladesh’s Development 1996, Dhaka: University Press Limited. Mahmud, W. (2001), ‘Bangladesh: structural adjustment and beyond’, in W. Mahmud (ed.), Adjustment and Beyond: the Reform Experience in South Asia, Basingstoke, UK: Palgrave-Macmillan in association with International Economic Association. Mahmud, W. (2002), ‘National Budgets, Social Spending and Public Choice: The Case of Bangladesh’, IDS Working Paper 162, Brighton, UK: Institute of Development Studies, University of Sussex. Mahmud, W. (2004), ‘Macroeconomic management: from stabilization to growth?’, Economic and Political Weekly, 4 September, 39 (36), 4023–32. Mahmud, W. (2006), ‘Employment, incomes and poverty: prospects of pro-poor growth in Bangladesh’, in Sadiq Ahmed and W. Mahmud (eds), Growth and Poverty: The Development Experience in Bangladesh, Dhaka: University Press Ltd for the World Bank. Mahmud, W., Sadiq Ahmed and Sandeep Mahajan (2007), ‘Policy Reforms, Growth and Governance: the Political Economy of Bangladesh’s Development Surprise’, Paper prepared for the Growth Commission, Washington, DC: World Bank (South Asia Region), mimeo. Mahmud, W., S.H. Rahman and S. Zohir (2000), ‘Agricultural diversification: a strategic factor for growth’, in R. Ahmed, S. Haggblade and T. Chowdhury (eds), Out of the Shadow of Famine: Evolving Food Markets and Food Policy in Bangladesh, Baltimore: The Johns Hopkins University Press. North, Douglass (1997), ‘The Contribution of the New Institutional Economics to an Understanding of the Transitional Problem’, Annual Lecture 1, Helsinki: United Nations World Institute of Development Economics Research (UN-WIDER). Osmani, S.R., W. Mahmud, B. Sen, H. Dagdeviren and A. Seth (2003), The Macroeconomics of Poverty Reduction: The Case of Bangladesh, Dhaka and Kathmandu: UNDP Asia-Pacific Regional Programme of Macroeconomics of Poverty Reduction. Robinson, E.A.G. and K. Griffin (eds) (1974), The Economic Development of Bangladesh Within a Socialist Framework: Proceedings of a Conference by International Economic Association, London: Macmillan. Task Forces (1991), ‘Macroeconomic policies’, in Report of the Task Forces on the Bangladesh Development Strategies for the 1990s, Dhaka: University Press Ltd.

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UNDP (2003), Human Development Report 2003, New York and Oxford: Oxford University Press for the United Nations Development Programme. World Bank (1999), Bangladesh Trade Liberalization: Its Pace and Impacts, Report No. 19591 BD, Washington, DC: World Bank (South Asia Region). World Bank (2003a), Bangladesh: Public Expenditure Review, Washington, DC: World Bank and Manila: Asian Development Bank. World Bank (2003b), Bangladesh Development Policy Review, Report No. 26154-BD, Washington, DC: World Bank. World Bank (2004a), Trade Policies in South Asia: An Overview, Report No. 29949, Washington, DC: World Bank. World Bank (2004b), Bangladesh: Growth and Export Competitiveness, Draft, Washington, DC: World Bank (South Asia Region). World Bank (2006a), World Development Report 2006: Equity and Development, Washington, DC: World Bank. World Bank (2006b), 2004 World Development Indicators, Washington, DC: World Bank.

4

Sri Lanka1 Saman Kelegama

Background: economic history Sri Lanka is a small island economy situated in a strategic geographical location in the Indian Ocean. Many years ago it became a port of call for Arab, Chinese and Greek traders. In the 16th century the Sri Lankan coastal belt came under the influence of European traders starting with the Portuguese (1505–1657), Dutch (1658–1795) and British (1796–1948). The British rule extended to the entire country in 1815, and ended in 1948. Thus, Sri Lanka was under the influence of European powers for nearly four centuries. Although Sri Lanka progressed under the Portuguese and the Dutch for nearly three centuries, the dramatic transformation in the economy took place mainly under British rule. Coffee was first planted as an export crop in 1836. After the destruction of coffee plantations in a plague, the British introduced tea in 1856. A modern infrastructure constituting roads, railways, ports, banking and insurance services was introduced to support the tea industry. Gradually, rubber and coconuts were cultivated on a commercial basis. At the time of independence in 1948, Sri Lanka was basically an agro-based economy with tea, rubber and coconuts accounting for 90 per cent of exports. During the last stages of colonial rule, Sri Lanka also benefited from an extensive social welfare programme, and achieved Universal Adult Franchise in 1931. Sri Lanka inherited from the British a Westminster-type democratic parliamentary system, education and judicial systems akin to that of the British system, and among others an administrative and civil service network. At independence in 1948 Sri Lanka was deemed to be one of Asia’s most promising new nations. The country emerged unscathed from World War II and, unlike India and Pakistan, the country did not have to shed blood for its independence. In referring to the favourable initial conditions and peaceful transfer of power, Snodgrass (1999: 89) posed: ‘what more could a newly independent nation want?’ Strategically located in the Indian Ocean, Sri Lanka had the best chance, compared with its neighbours, for a rapid economic take-off. The first Governor General of Sri Lanka made the observation that these initial conditions had provided the setting for the expectation that, of all post-colonial nations, Sri Lanka would prove ‘the best bet in Asia’ (Lal and Rajapatirana, 1989: 1).2 This rosy picture of the socioeconomic environment was, however, somewhat deceptive. Politically, the nation was polarized between the conservative right and the communistoriented left. The trade union movement was very strong, and industrial strikes ended up as general strikes in the late 1940s. Above all, historical ethnic tensions between the two main communities – Sinhalese and Tamils – remained unresolved. Thus, some commentators had reservations about Sri Lanka’s future progress. For instance, Oliver (1957: i) noted: ‘Its civilization is old and hence probably more resistant to change than would be a younger and less integrated culture’. 125

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Sri Lanka made quite impressive progress since independence in certain areas. The country became an exception among developing countries in regard to human development. Its long-term growth in per capita terms (2.5 per cent) compared favourably with most of the developing world. However, there were major disconcerting features in its development pattern. It remained a low-income country with substantial poverty. In 2005, for instance, 25 per cent of the country’s 20 million people lived below the national poverty line. Its long-term growth also fell well short of the growth rates achieved in the last three-and-a-half decades by high-performing East Asian countries, such as Korea, Malaysia, Thailand and Indonesia. In 1960 for instance, Sri Lanka’s per capita GNP (US$141) was substantially higher than that of Thailand (US$96) and Indonesia (US$51), about the same as South Korea (US$156) and only about half of Malaysia’s per capita GNP (US$273).3 By 1995, however, a totally different picture emerged where Sri Lanka’s per capita income had risen to only US$700 compared with Korea’s US$9700, Malaysia’s US$3890, Thailand’s US$2740 and Indonesia’s US$980. The period from 1948–2005 could be divided into various sub-periods according to the political regime in power (Table 4.1). Sri Lanka has been ruled by two main political parties, viz the United National Party (UNP) and the Sri Lanka Freedom Party (SLFP). Until 1994, the economic policies pursued by the UNP-led governments have been generally more market- and private-sector-oriented, whereas SLFP-led governments have generally followed welfare state policies and favoured controls and restrictions. After 1994, the SLFPled governments also embraced the more market-oriented model with an additional component called ‘the human face’. Based on the economic policy ideology of various regimes, the post-independent period can be divided into three major phases: 1948–56 as a period of continuing with the colonial market economy, 1956–77 as a period of pursuing a state-dominated closed economy model and post-1977 as a period of adapting to a marketTable 4.1

Political regime and average growth rates, 1948–2005(%)

Period

Political Party

Head of State/Government

1948–52 1953–56 1956–59 1960–65 1965–70 1970–77 1977–88 1989–93 1994–2001 2002–03 2004–05

UNPa UNP SLFPb& others SLFP UNP SLFP & others UNP UNP PAc UNP PA & others

D.S. Senanayake John Kotelawala S.W.R.D. Bandaranaike Sirimavo Bandaranaike Dudley Senanayake Sirimavo Bandaranaike J.R. Jayawardene Ranasinghe Premadasa Chandrika Kumaratunga Ranil Wickremasinghe Chandrika Kumaratunga

Notes: a. UNP – United National Party. b. SLFP – Sri Lanka Freedom Party. c. PA – People’s Alliance (grand alliance with the SLFP). Sources: Central Bank of Sri Lanka (various issues) and CBSL (1998).

Average Growth Rate 5.4 2.8 1.6 4.2 4.8 3.1 4.9 4.8 4.3 5.0 5.4

Sri Lanka 127 oriented open economy model. Economic performance during various political regimes is summarized in Table 4.1. The controls and restrictions that were imposed on the Sri Lankan economy since the late 1950s were intensified in the early 1970s, and Herring (1987) referred to Sri Lanka in the early 1970s as the most controlled economy outside the Soviet bloc. These controls were imposed to support import substitution industrialization. The first phase of it took place during 1960–65 and the second phase took place during 1970–77. However, there was a partial (import) liberalization of the economy during 1965–70 to support some ailing industries, and to promote agro-based industries (Cuthbertson and Athukorala, 1991). With the UNP government coming into power in 1977, and ruling the country until mid-1994, there was a radical change in policy where most of the import licensing was removed, and foreign direct investment (FDI) inflows were further liberalized. However, the focus was more on trade and commodity markets and less on financial and labour markets. A second wave of liberalization was unleashed in 1989–90 with privatization and further liberalization of the investment regime.4 Measures were taken to liberalize the labour market during the third wave of liberalization in 2002–03. There has been a slowing down in implementing reforms since 2004 with the search for an economic middle ground to balance growth with equity (Kelegama, 2006b). Sri Lanka was the first country in South Asia to experiment with economic liberalization. Yet its experience with such policies has been a bumpy ride. The civil war in the North and East of the country diverted the government’s attention away from economic liberalization programmes and extracted significant resources that could have otherwise been used for development activities. The war that commenced as the Eelam War I in 1983 had two subsequent phases: Eelam War II (1990–94) and Eelam War III (1995–2001). The disturbances caused by the war added to other internal and external shocks, and made managing the economy a difficult task. Managing the economy and implementing the delayed reforms in various sectors became the priority in the post-2001 period, in particular, during 2002–03 with the cessation of hostility. However, this has been marked by weak political coalitions in power, and political coalition management received priority in many instances. The situation was aggravated by the devastation caused by the tsunami waves in December 2004. Relief and rehabilitation of nearly half a million displaced people and reconstruction of damaged infrastructure became new dimensions in economic management (IPS, 2005). Political economy of policy progress Sri Lanka’s economic progress during the first five years of independence was quite good due mainly to the favourable impact of the boom caused by the Korean War. The foreign exchange surplus gave a sense of complacency. For example, reforms in the agriculture sector for crop diversification were postponed, and there was no concerted effort to embark on industrialization either. Social welfare programmes were maintained at the same pre-independence level during the 1950s, sustained by the plantation sector income. An attempt to reduce welfare measures triggered a mass protest in 1953, and until 1977 the political establishment did very little to reform the various programmes (Table 4.2). Nonetheless, the welfare measures did contribute to enhancing the basic needs indicators of Sri Lanka. Even the World Bank, long critical of Sri Lanka’s social welfare programmes, commended Sri Lanka’s

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Table 4.2 Period 1951–55 1956–60 1961–65 1966–70 1971–75 1976–80

Social expenditure (as a % of GNP): 1951–80 Education

Health

Food Subsidy

Other

Total Social Expenditure

2.9 3.8 4.7 4.4 3.6 2.9

1.9 2.2 2.2 2.1 1.8 1.5

2.3 2.3 4.2 3.0 4.2 3.7

0.4 0.8 0.4 0.5 0.5 0.7

7.5 9.1 11.5 10.0 10.1 8.8

Source: Central Bank of Sri Lanka (various issues).

achievements in human development and argued that the trade-off between human development and growth ‘has not been so sharp as it is sometimes suggested’, but also noted that ‘Sri Lanka could have done even better had better economic policies been pursued’ (World Bank, 1980: 90). As in other newly independent countries, Sri Lanka adopted the strategy of planning. However, there was an immediate tendency to abandon most of the work of the previous political regime with the change of government. Such acts have caused a major waste of resources and constrained long-term vision and growth. The failure to develop a national identity immediately after independence laid the foundation for ethnic tension. In the mid-1950s, the Sinhala language policy was adopted and this aggravated the ethnic divisions, which eventually led to the North-East civil war in the 1980s and 1990s. Additionally, the language policy of the mid-1950s retarded the quality of civil servants. 1977 marked significant changes in both economic and political spheres. As noted before, Sri Lanka abandoned the dirigistic economic policies of controls and embraced the principles of a market economy. On the political front, the Westminster-type parliamentary system was changed to a hybrid of Gaullist–Westminster-type model where an executive presidency was created with full powers over cabinet and parliament. The objective of this change was to produce more representative and stable governments. However, the change did not result in a stable government. A number of coalition governments became fragile and unstable during the post-2000 period. In 1988, the 13th Amendment to the Constitution was enacted consequent to the IndoSri Lanka Political Accord, and the Provincial Council system came into operation as a device to address the North-East conflict. However, the system failed to live up to expectation, and the political power decentralization was far from satisfactory (IPS, 2005). Opening the economy with two waves of liberalization The liberalization policies initiated in 1977 slowed down after 1983 due to the North-East civil war. During 1983–89 hardly any reforms were implemented, but by late 1989 a second wave of liberalization was unleashed with a privatization programme, stock market reform and further liberalization of FDI. However, the growth record of 1990–94 was mixed due to the escalation of the North-East civil war in the early 1990s (Eelam War II). The first wave of liberalization (1977–88) was accompanied by a major public investment programme (PIP) centred on the Mahaweli River Scheme during 1979–84 to develop the

Sri Lanka 129 Table 4.3

Budget deficit and inflation rates (1980–2004)

Year

Budget Deficit (as a % of GDP)

Inflation Rate*

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004


23.1
17.4
9.0
12.2
15.7
9.9
7.3
10.0
8.9
9.2
9.9
8.9
8.2

26.1 10.8 16.6 8.0 14.0 21.5 11.4 8.4 15.9 9.4 6.2 9.6 7.6

Note:

* Inflation rate calculated by using Colombo Consumer Price Index (1952  100).

Source: Central Bank of Sri Lanka (various issues).

country’s infrastructure and the supply base, such as hydroelectric power and irrigation. The massive foreign aid inflows for this programme created a ‘Dutch disease’ type of impact and exerted an upward pressure on the exchange rate (Athukorala and Jayasuriya, 1994). Thus, although a concerted effort was made for export-oriented industrialization, export growth and diversification was slow. The PIP created large budget deficits and high inflation during the early 1980s, which continued until the mid-1980s (Tables 4.3 and 4.13). The escalation of the war after the mid-1980s increased defence expenditure and, consequently, significant reductions in the budget deficit were difficult. Thus, liberalization during 1977–88 was taken forward in an environment of macroeconomic instability. Growth during this period did not generate adequate employment and most unemployed youth joined the leftist political party, JVP (Janatha Vimukthi Peramuna) in the hope of a better future. The economy faced a set-back during 1988–89 due to a rebellion by the JVP in Southern Sri Lanka. The rebellion adversely affected economic growth and external reserves depleted during the late 1980s. This, together with high budget deficits, forced the government to go for a stand-by package (SBP) with the IMF in 1989–90. The programme brought some degree of macroeconomic stability. For the first time, the private sector was declared as the engine of growth in 1991 and many impediments for private sector growth were gradually removed. This was the beginning of the second wave of liberalization. Doubling the per capita income by the year 2000 was set as a target, and with strong political leadership, reforms were implemented to achieve this goal (Dunham and Kelegama, 1997). Moreover, a poverty alleviation policy (Janasaviya Programme) was explicitly built in to the open economy framework, dubbed as a ‘two legged strategy’ (Lakshman, 2002). Open economy with a human face: broadening reforms, 1994–2001 In 1994, there was a change of government, but no reversal of market-oriented policies.5 For the first time in history, the two major political parties were in agreement on

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economic reforms, but there were differences in the degree of emphasis on policy areas. For instance, the new government of 1994 emphasized the need for a ‘human face’. The earlier reforms were consolidated with broadening reforms; for instance, privatization was extended to public utilities and infrastructure. Major public utilities such as shipping ports, airlines, telecom and gas were privatized. At the same time, there was a renewed emphasis on poverty alleviation and social sector reforms. A new poverty alleviation programme, named the Samurdhi Development Programme, having the same format as the Janasaviya Programme, was put into effect. Samurdhi was implemented across the island, covering a larger segment of the poor than the earlier Janasaviya Programme (Dissanayake, 1995). However, the ‘human face’ was restricted to peripheral activities and the introduction of this new face to the open economy remained a ‘failed promise’ (Lakshman, 2002). By 1998, after two decades of implementing economic reforms, Sri Lanka still had not engaged in implementing much reform in the labour market, foreign exchange market, public administration and some other key areas. Implementation of reforms was very slow during 1999 and 2000 as the country faced two major shocks – war escalation in the North and an international oil price hike. By the late 1990s, public utilities such as the Ceylon Electricity Board, Ceylon Railway, Sri Lanka Postal Services, Sri Lanka Transport Board, People’s Bank and Bank of Ceylon had become heavy burdens on the state budget.6 Reforms in these areas were postponed due to trade union pressure, and the preoccupation with escalating war and elections in 1999–2000. Although Sri Lanka recorded a growth rate of 6 per cent in 2000, underlying this growth was a serious macroeconomic crisis due to escalating war and the international oil price hike. The purchase of military equipment and heavy dependence on imported oil both caused a sharp decline in the country’s foreign exchange reserves. By early 2001 the government had to implement a free float exchange rate regime, and impose a 40 per cent surcharge on all non-essential imports to arrest the situation (IPS, 2001). In March 2001, for the first time, the People’s Alliance (PA) regime had to sign a standby package (SBP) with the IMF to address the foreign exchange crisis and bring some discipline into macroeconomic management. The re-election of the PA in late 2000 was an opportunity to implement second-generation reforms and thereby initiate a third wave of liberalization. However, with the break up of the political coalition in the first year of the government, political coalition management received higher priority. Consequently, the IMF package started falling apart and macroeconomic management became lax by the end of 2001. The economy receiving directives according to political imperatives aggravated the situation. The overall result of these developments was that in 2001, Sri Lanka experienced a growth rate of –1.5 per cent – the lowest in the post-independence period. Third wave of liberalization: 2002–03 In late 2001, the elections resulted for the first time in a ruling party different from that of the executive president.7 Thus, policy implementation would take place in an environment of uneasy political cohabitation. The new government had to rescue the IMF package, instil some order in macroeconomic management and implement reforms. It was the view of the government that all this could not be done without the war coming to an end and a peaceful atmosphere coming into operation. Thus, a ceasefire agreement (CFA) and a peace package were worked out with the Liberation Tigers of Tamil Eelam (LTTE).

Sri Lanka 131 A more reform-oriented UNP-led government attempted reforms in most of the areas where there was an unfinished agenda of reforms. Creating new institutions and regulatory structures, factor market liberalization, deregulation measures – were all implemented with aid support from donors during 2002–2003. The IMF SBP of 2001 was rescued with a stringent stabilization programme put in place. Cuts in state expenditure were achieved by reducing fertilizer subsidy, removing petroleum subsidy, freezing public sector recruitment and reducing capital expenditure. Thus, the foundation was laid for a PRGF-EFF (Poverty Reduction Growth Facility-Extended Fund Facility) with the IMF in April 2003. These measures were facilitated by the CFA in early 2002. The CFA, donor support and stabilization measures restored growth levels to 4 per cent and 5.9 per cent respectively in 2002 and 2003. A more forceful attempt at implementing reforms was prevented by the thin majority in parliament and the uneasy cohabitation with the executive president (IPS, 2003). Although optimistic at the start of the peace process, no significant economic dividend was visible in Southern Sri Lanka (no-conflict area), as the peace process coincided with the costly stabilization programme of the IMF. Economic dividend in the conflict area was also less than expected due to the prevalent complex institutional and military structure in the North-East, and the multiplicity of factors relating to the progress of the peace package. Furthermore, the government’s institutional structure delayed aid disbursement and reconstruction in the conflict area. Aid donors’ ‘tool kit’ approach and bias towards large infrastructure projects also confounded the problem. Among other factors, the lack of peace dividend halted the peace talks in April 2003 in the North-East, and led to the rejection of the government in Southern Sri Lanka at the April 2004 polls. An international safety net that was devised to rescue the peace process did work in the sense of preventing the rebels from going back to war, however, it did not revive the peace talks or expedite the economic dividend. In search of economic middle ground: post-2003 period In early 2004, there was once again a change of government with a newly formed SLFP-led coalition assuming power (UPFA – United People’s Freedom Alliance). A key feature was the presence of the radical JVP in the government. The new government was formed on a political platform of the UNP’s rapid turn towards orthodox neo-liberal policies, such as offering tax amnesties and 100 per cent land ownership to foreigners, and internationalization of the North-East crisis. There was a mass movement against these policies sometimes referred to as ‘re-colonization of Sri Lanka’ by the JVP. As a result, the traditional ‘Washington Consensus’ package was modified to recognize the role of the state in generating economic growth and alleviating poverty (GOSL, 2005; Kelegama, 2006b). In place of privatization, a Strategic Enterprise Management Agency (SEMA) was created for public utilities and the Voluntary Retrenchment Scheme (VRS) compensation formula was revised to reflect the concerns of trade unions. The modified package also included a new poverty programme to reflect the micro-level poverty concerns and the role of the state in the delivery of services that are relevant to poverty issues (GOSL, 2005). The UPFA government also embarked on restoring the fertilizer subsidy, recruitment of unemployed graduates in the already bloated state sector, continued with the electricity, petroleum and transport subsidies and increased public investment. However, in general, the existing status quo vis-à-vis market economy was maintained.

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These policies did not find favour with multilateral financial institutions; for example, the PRGF signed in 2003 with the IMF fell apart. The World Bank’s budgetary assistance and project lending became conditional on a revised PRSP (Poverty Reduction Strategy Paper).8 Disbursement of funds from other multilateral agencies, such as the Asian Development Bank (ADB), was also slow due to the lack of reforms in huge loss-making state-owned enterprises, such as the Ceylon Electricity Board, Ceylon Petroleum Corporation and Sri Lanka Railways. State-owned enterprises (including public institutions and corporations) that were involved in delivering subsidized services were costing the government 3 per cent of GDP annually. These enterprises had to be substantially restructured and allowed to operate on a commercial basis with no political interference and be subject to hard budget constraints. But the SEMA was slow in managing this change and restructuring these enterprises (IPS, 2005). The escalating oil prices were making a huge dent on external reserves so much so that the rupee was rapidly sliding down from mid- to end-2004. The deteriorating reserves received a boost from the tsunami funds that flowed in massive scale in 2005, and this in turn halted the rapid fall of the rupee. All these developments were taking place when the public debt to GDP was close to 106 per cent of GDP and the government revenue as a percentage of GDP had declined to about 15 per cent of GDP.9 The entire government revenue was absorbed in interest payments, meeting the public sector wage bill and allocations for subsidies and transfers. Thus, additional funds for the government’s welfare-oriented programmes, let alone new development projects related to infrastructure, were increasingly becoming scarce with concessional foreign funding no longer being available for Sri Lanka.10 The government saw commercial borrowing from the international financial markets as the only way out of the problem and to have some ‘policy space’ (as such funds are nonconditional) for the government to engage in its desired activities.11 Thus, a sovereign rating was obtained in late 2005 where Fitch gave a BB
rating and Standard and Poor gave a B+ rating – both three to four points below the standard investment grading. With budget deficits running in the range of 8–9 per cent of GDP and a huge public debt, commercial borrowing appeared risky, but the government felt that it was the only way to stimulate growth and thereby engage in fiscal consolidation. The UPFA government maintained the CFA, however, peace talks remained at a standstill during 2004–05 due to the lack of progress of a possible Interim Administration for the LTTE – which was one of the major demands of the rebel group. The December 2004 Indian Ocean tsunami wave devastation changed the scenario in regard to providing an Interim Administration structure for the LTTE. Instead, a Post-Tsunami Operation Management Scheme (P-TOMS) for fund sharing between the government and the LTTE became the centrepoint of debate. The P-TOMS was proposed in June 2005 and it was welcomed by all donor agencies who pledged US$3.3 billion for the tsunami rehabilitation work. The donors saw P-TOMS as a confidence-building measure to revive peace talks and bring about a reasonable solution to the North-East problem. However, the main coalition partner of the government – JVP – saw P-TOMS as laying the foundation for division of the country, and hence pulled out of the political coalition in June 2005.12 Thus, P-TOMS fell apart and once again political coalition management took priority over economic management issues. The presidential elections held in November 2005 was won by the ruling party candidate who campaigned for the continuation of the policies initiated in 2004 and further

Sri Lanka 133 increasing the government subsidies for the less well-off people. The newly formed government made further adjustments to the hitherto followed development strategy. While the liberalized policy framework has been basically maintained, the new policy stance has placed greater emphasis on pro-poor growth strategies and regional development (Ministry of Finance and Planning, 2005). The new government has also adopted a fresh approach (based on the unitary status of Sri Lanka compared with the united status of Sri Lanka earlier) to seek a negotiated settlement to the North-East conflict with a view to earning an early peace dividend. The challenge for the new government is to find a solution for the North-East crisis while preserving the unitary state of Sri Lanka. This will be the overriding objective on which the economic take-off will depend. Economic growth Being an island economy without many natural resources, Sri Lanka remains a country highly vulnerable to external shocks. The terms of trade deterioration for the plantation exports had a major impact on overall growth during the first two decades after independence. Sri Lanka was also vulnerable to escalation of international oil prices. In 1973, the adjustments to the shock were postponed while in 1979 problems were less felt due to aid inflows and a mini-tea boom in 1983–84 (Athukorala and Jayasuriya, 1994; Athukorala, 2004; Weerakoon, 2004). Sri Lanka was also vulnerable to internal shocks. Two youth uprisings in Southern Sri Lanka in 1971 and 1988/89 severely affected economic growth. Needless to say, the NorthEast war has contributed significantly to growth slowdowns during the 1983–2001 period. The Central Bank of Sri Lanka estimated that the war reduced the country’s growth by 2–3 per cent per year over the period of conflict (CBSL, 1998). A simple extrapolative exercise shows that in the absence of a war, Sri Lanka’s per capita GDP in 2002 would have been around US$1500 instead of around US$900. A comprehensive present value (1996) estimate of the economic cost of the war for the 1984–96 period (discounted at 5 per cent) places it as 1.7 times Sri Lanka’s 1996 GDP (Arunatilake, Jayasuriya and Kelegama, 2001). Sri Lanka averaged a growth rate of 5 per cent during the 1984–2001 period. This was mainly due to the fact that the key growth-generating areas, such as banking, shipping ports and telecom services, ready-made garments and tea exports and remittances from Sri Lankan workers overseas, were minimally affected by the war. Moreover, the bulk of these activities were concentrated in the Western Province that accounted for 50 per cent of the country’s GDP. Some have challenged this viewpoint, arguing that since 1990 there has been a non-inclusion of the North-East Provinces in the national income accounting, thus overestimating the growth rates. These provinces would have most probably incurred negative growth rates during the post-1990 period, and had they been included, the overall average growth rate would have been lower than the recorded 5 per cent (Sarvanathan, 2005: 26). The largest contributor to growth is the service sector, followed by the industrial sector. The agriculture sector no longer plays a vital role in the economic growth, but is a vital sector still in addressing rural poverty. Table 4.4 shows the changes in composition in manufacturing, agriculture and services in GDP. While the services sector has gradually increased its share to 56 per cent, the agricultural share has declined from about 36 per cent in the mid-1950s to 18 per cent in 2004. The share of the manufacturing sector has increased and stabilized at a level of 14–16 per cent of GDP. The manufacturing sector

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Table 4.4

Changes in sectoral composition of GDP: 1950–2004 (%)

Year

Agriculture

Manufacturing

Services

Other*

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2004

35.6 35.8 32.5 31.4 30.3 27.6 26.6 25.9 23.2 20.1 19.9 17.8

16.7 14.3 14.8 16.0 17.6 15.9 14.5 14.8 17.3 20.4 16.8 16.3

41.0 41.2 43.6 45.5 43.5 46.7 47.3 49.7 49.6 50.2 52.8 55.7

6.7 8.7 9.1 7.1 8.6 9.8 11.6 9.6 9.9 9.3 10.5 10.2

Note: * Other: mining, quarrying and construction. Source: Central Bank of Sri Lanka (various issues).

grew by an average growth rate of about 9 per cent since 1977, and the main growth derives from export-oriented industries. The key service sector growth areas are telecom, banking, tourism, remittances and ports. Annual remittances amount to about 7 per cent of GDP, and are an important contributor to the foreign exchange earnings of Sri Lanka. Tourism, which accounts for 2 per cent of GDP, is the fourth largest foreign exchange earner. After opening up the telecom sector in the late 1980s and the subsequent privatization of Sri Lanka Telecom in 1997, the sector has grown rapidly, touching the rural heartland of Sri Lanka. Banking is also a fastgrowing sector and is gradually spreading to rural areas where the informal lending is quite large and still accounts for 30 per cent of overall lending in the country (CFS, 2003/04). Key growth areas of the industrial sector are the export-oriented industries such as ready-made garments, gems and jewellery, rubber-based products and ceramics. Import substitution industries in the food and beverages sector have been performing reasonably well. Industrial growth has been affected from time to time by power shortages, high interest rates and labour-related disputes (World Bank, 2005). FDI has played a major role in stimulating some export-oriented industries and thereby industrial growth (Athukorala, 1986; Kelegama, 1992). There are few studies on total factor productivity (TFP) in Sri Lanka. Athukorala (1996) found that the TFP in the manufacturing sector has significantly increased after the 1977 reforms. Another study by Kelegama, Samararatne and Knight-John (1999) showed that in some manufacturing sub-sectors TFP growth was not very significant. Chandrasiri (2004) found industrial concentration rather than technology intensity to be the important determinant of industrial productivity. The agriculture sector consists of an 85 per cent non-plantation sector and a 15 per cent plantation sector. The latter has shown some vibrancy in recent years after the privatization of the plantation companies in the mid-1990s and favourable international prices for the key plantation export, tea. However, the non-plantation sector has experienced slow growth throughout the 1980s and 1990s due to stagnation in the large paddy sector and

Sri Lanka 135 Table 4.5

Savings and investment: 1960–2004

Year

Domestic Savings (as a % of GDP)

National Savings (as a % of GDP)

Total

Private

Public

1960 1965 1970 1975 1980 1985 1990 1995 2000 2004

11.7 12.9 16.7 8.1 11.2 11.9 14.3 15.3 17.4 15.9

10.6 12.5 15.0 7.4 13.9 14.2 16.8 21.5 21.5 21.6

14.6 12.5 18.9 15.5 33.7 23.8 22.1 25.7 28.1 25.0

10.1 7.5 14.5 9.9 25.2 19.0 18.2 22.2 24.8 19.8

4.5 5.0 4.4 5.6 8.5 4.8 3.9 3.5 3.3 5.2

Investment (as a % of GDP)

Source: Central Bank of Sri Lanka (various issues).

unorganized production of most other non-plantation crops (World Bank, 1996). Needless to say, weather fluctuations and other internal shocks (such as the North-East civil war) have contributed to the decline in some non-plantation areas such as paddy and fish. Key impediments to sectoral growth are the lack of modern infrastructure, macroeconomic imbalance centred around large budget deficits and rigid factor markets. For example, while access to electricity has increased from 16 per cent in the early 1980s to about 74 per cent in 2000, generation capacity has not kept up with demand.13 Increased defence expenditure and continuous focus on consumption spending diverted resources away from public investment in economic infrastructure (power, water, transport, communications), which fell from 14 per cent of GDP in 1985 to 6 per cent of GDP by 2000. Due to a lack of a proper regulatory framework Sri Lanka has not been very successful in upgrading the infrastructure via private–public partnerships. The government has to work hard to push the economy to a higher growth trajectory. The current investment levels are at 25 per cent. A simple Harrod-Domar framework estimation shows that in order to achieve growth rates of 8 per cent, Sri Lanka needs to reduce capital output ratio to 4.0 and enhance overall investment to 32 per cent.14 In 2004, the private investment/GDP ratio amounted to 20 per cent and overall investment was 25 per cent (Table 4.5). Sri Lanka’s domestic savings have not been at a high level and averaged around 14–16 per cent of GDP (Table 4.5) compared with 30 per cent in Malaysia and 25 per cent in South Korea. Public sector dissavings have been a major problem in Sri Lanka. A 32 per cent of GDP investment target needs further policy reforms as the additional investment will come from domestic private investment, increase in government investment and FDI. Macroeconomic scenario External sector Imports The overall dependence on imports is about 34 per cent of GDP. Sri Lanka’s key imports are oil and petroleum products, wheat and textiles. Import tariffs are restricted to

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four bands (as of mid-2005), 2.5, 6, 15 and 28 per cent, while most non-tariff barriers have been removed. Normally the lowest band is applicable to investment goods, and the highest band to consumer goods while the intermediate goods are governed by the middle band. Since the beginning of 2001, a 40 per cent surcharge was imposed on most imports other than essential items to address a severe foreign exchange shortage in 2001. Import duty as a percentage of GDP amounts to about 2 per cent. According to a study by the Economic and Social Commission for Asia and the Pacific (ESCAP, 2003), 70 per cent of imports (value terms) come in as duty-free, mainly due to Board of Investment (BOI) incentives that have been granted from time to time. Agriculture receives the highest tariff protection. Sri Lanka is a net food importing country. The country imports 100 per cent of its wheat flour requirements, 85 per cent of its sugar requirements, 55 per cent of milk and 84 per cent of potatoes. However, the share of food items in total imports has dropped from 21 per cent in 1979 to 16.4 per cent in 1989 and to 7.7 per cent in 1999 due to the rapid increase in imports of capital and intermediate goods especially to meet the requirements of the growing manufacturing and service sectors (Table 4.6). The main import sources are Asia and Europe, with the former accounting for between 55 and 60 per cent of overall imports while the latter accounts for 15–20 per cent (Table 4.7). The United States accounts for 3–6 per cent of overall imports. India, Japan, China (plus Hong Kong) and Iran are the major Asian sources of imports while the United Kingdom and Germany are the main European sources of imports. India overtook Japan as the main import source in 1995. With the Indo-Sri Lanka Bilateral Free Trade Agreement (ILBFTA) coming into operation in 2000, India’s share rose to 18 per cent in 2005 and it has stabilized at an average level of 16 per cent during the last three years. Exports Sri Lankan exports amounted to Rs.584 000 million (US$5757 million) in 2004 and accounted for 28 per cent of GDP. As Table 4.8 shows, there was a radical change in the composition of exports from agriculture exports in the mid-1970s to manufacturing Table 4.6

Changes in import composition: 1950–2004

Year

Consumer Goods

Intermediate Goods

Investment Goods

Other Goods*

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2004

51.0 51.7 61.0 52.8 55.4 50.5 29.9 19.4 26.4 18.5 17.3 20.2

10.1 16.4 20.3 28.1 20.0 36.0 45.7 54.3 51.8 54.6 53.5 58.0

38.9 31.9 18.1 17.7 23.6 12.4 24.0 19.2 21.7 22.4 23.6 20.8

0.0 0.0 0.6 1.4 1.0 1.1 0.4 7.1 0.0 4.5 5.6 1.0

Note:

* Other goods: unclassified imports.

Source: Central Bank of Sri Lanka (various issues).

Sri Lanka 137 Table 4.7

Trade direction in exports and imports (as a % of total): 1950–2004 Exports

Imports

Year

USA

Europe

Asia

Other

USA

Europe

Asia

Other

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2004

21.3 9.1 9.0 7.5 7.1 5.6 10.9 21.2 24.8 35.6 39.5 32.4

34.4 36.1 37.0 30.9 45.8 23.2 27.6 25.0 30.3 36.4 31.0 32.4

5.6 11.6 13.1 13.0 19.9 28.5 20.1 15.7 14.5 14.4 12.7 13.3

38.7 43.2 41.0 48.6 27.2 42.7 41.4 38.1 30.4 13.6 16.8 21.9

3.0 3.2 3.6 3.8 5.7 6.4 4.4 6.5 7.7 3.3 3.5 3.0

23.0 30.6 30.6 24.7 36.2 24.7 26.6 18.6 19.4 20.1 13.5 15.7

45.4 41.4 38.9 24.3 41.6 40.2 33.9 38.6 51.6 54.2 54.4 56.8

28.6 24.8 26.9 47.2 16.4 28.6 35.1 36.3 21.4 22.5 28.6 24.5

Source: Central Bank of Sri Lanka (various issues).

Table 4.8

Changes in export composition: 1950–2004 (%)

Year

Agricultural Exports

Industrial Exports

Other Exports*

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2004

89.9 91.2 90.5 93.8 91.7 78.7 61.8 52.5 36.3 21.8 18.1 18.4

– – – – – 13.2 33.0 39.5 52.2 75.4 77.6 78.3

10.1 8.8 9.5 6.2 8.3 8.1 5.2 8.0 11.4 2.8 4.3 3.3

Note:

* Other exports: mineral exports and unclassified exports.

Source: Central Bank of Sri Lanka (various issues).

exports in the mid-2000s. The ready-made garment sector has given the lead to industrial exports and accounted for 50 per cent of overall exports by 2000. Diamonds, gems and jewellery and rubber products are the other manufacturing exports that have grown rapidly in recent years (Table 4.9). Although ready-made garment exports are heavily import-dependent, the turnover is such that it became a larger foreign exchange earner to the nation than tea since 1992. Sri Lanka’s main export destinations are the United States and the EU, with the former accounting for 35–40 per cent of overall exports and the latter accounting for 30–35 per cent.

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Table 4.9

Percentage share of exports by product: 1997–2004

Product Description

1997

1998

1999

Agricultural products 24.2 24.5 21.8 Tea 15.5 16.2 13.4 Natural rubber 1.7 0.9 0.7 Coconut 2.4 1.9 2.7 Spices & other export crops 3.0 3.4 3.4 Fisheries products 1.6 2.1 1.6 Industrial products 74.8 74.5 77.2 Diamonds, gems & jewellery 4.9 3.9 4.9 Textiles & garments 48.9 51.1 52.4 Other manufacturers 18.1 17.3 17.4 Food, beverages & tobacco 0.4 0.4 0.4 Leather finished products 2.4 3.1 2.9 Wooden products 0.3 0.2 0.2 Paper products 0.5 0.5 0.4 Rubber products 3.8 3.7 3.5 Chemicals & plastic products 1.3 1.2 1.2 Electrical & mechanical products 0.8 1.4 1.5 Electronic products 3.0 2.0 2.2 Ceramics & porcelain products 1.2 1.1 1.1 Footwear 1.5 1.3 1.5 Toys, games & sports requirements 1.2 1.0 1.0 Others 1.6 1.4 1.6 Petroleum products 2.1 1.3 1.7 Others 0.8 0.9 0.8 Total exports 98.9 98.9 99.0 Re-exports 1.1 0.9 1.0 Grand total 100.0 100.0 100.0

2000

2001

2002

2003

2004

18.0 21.2 21.6 20.5 19.9 12.7 14.3 14.0 13.3 12.8 0.5 0.5 0.6 0.7 0.9 1.3 1.6 1.7 1.7 1.9 2.5 2.7 3.5 2.8 2.7 1.0 2.1 1.8 2.0 1.6 77.5 77.0 77.0 77.4 79.0 5.2 5.5 6.2 6.1 6.5 54.0 52.7 51.5 50.0 48.6 15.8 16.8 17.8 19.2 21.4 0.4 0.6 0.8 1.0 1.3 2.2 2.4 1.4 0.7 0.5 0.2 0.2 0.3 0.4 0.5 0.5 0.4 0.5 0.6 0.5 3.6 3.7 4.0 4.5 4.9 1.2 1.3 1.4 1.5 1.8 1.2 1.2 1.0 1.5 1.9 2.7 2.0 1.3 1.5 1.3 0.9 0.9 0.9 0.8 0.8 1.0 0.7 0.4 0.4 0.2 0.6 0.6 0.6 0.5 0.5 1.4 2.9 5.2 5.7 7.1 1.9 1.4 1.6 1.3 1.7 0.6 0.6 0.6 0.8 0.8 97.9 98.2 99.2 97.9 98.9 2.5 1.8 0.8 2.1 1.1 100.0 100.0 100.0 100.0 100.0

Source: Sri Lanka Export Development Board.

Asia – although the main source of imports – accounts only for 10–15 per cent of overall exports (Table 4.7). In the Asian market, India has become the third largest destination of Sri Lankan exports in 2005, after the implementation of ILBFTA. Before that only 1 per cent of Sri Lankan exports went to India and by 2005 Sri Lankan exports to India amounted to 8 per cent of exports. Sri Lankan exports do not benefit from any preferential schemes in the US market. However, in the EU market, Sri Lankan exports have been a beneficiary of the EU’s Generalized System of Tariff Preference (GSP) scheme; but its utilization rate has not been satisfactory due to rules of origin governing the scheme (IPS, 2005). In February 2004, Sri Lanka was granted an additional 20 per cent preference for GSP due to complying with the labour standards as stipulated by the EU. On 1 July 2005, Sri Lanka was granted dutyfree entry to the EU as tsunami concessions. However, as before, the fulfilment of rules of origin – based on SAARC (South Asian Association for Regional Cooperation) cumulation – still remains a problem. Sri Lankan exports also benefit from a number of

Sri Lanka 139 Table 4.10

Key current account indicators (US$ million): 2001–04

Description Value of total exports Total value of imports Trade balance Current account balance US dollar/rupees equivalent rate

2001

2002

2003

2004

4817 5974
1157
215 89.36

4699 6106
1406
236 95.66

5130 6672
1539
71 96.52

5757 8000
2243
648 101.19

Source: Central Bank Report and Sri Lanka Customs.

Table 4.11

Labour migration and remittance: 1980–2004 Remittance Inflow

Year

Total Gross Out Migration (number of workers in ’000s)

Rs. Million

% of GDP

% of current account receipts

% of net capital inflow

1980 1984 1988 1992 1996 2000 2004

7.6 15.7 18.4 44.7 162.6 182.2 213.0

2 467.4 7 253.3 11 362.3 24 036.7 46 003.0 87 697.0 158 291.0

2.89 5.18 5.58 6.21 6.61 7.79 8.90

9.2 13.3 15.9 14.7 14.6 15.4 17.4

34.3 80.3 137.0 101.3 225.0 318.7 207.2

Source: Central Bank of Sri Lanka (various issues).

preferential arrangements like the South Asian Preferential Trade Arrangement (SAPTA) and the Bangkok Agreement (BA). Balance of payments Sri Lanka’s imports are more than her exports. The deficit in the merchandise goods trade sector is somewhat reduced by a surplus in services trade, especially tourism, remittances and earnings from the Port of Colombo (Table 4.10). Sri Lanka achieved full convertibility in the current account of the balance of payments in 1994. Tourist arrivals exceeded 500 000 for the first time in 2002. Privatization of Sri Lankan airlines, partial liberalization of air space, issuance of visas on arrival for SAARC citizens in 2002, and later extending it to nearly 80 countries, and the ceasefire agreement (CFA) with the LTTE in early 2002, all contributed to raise tourist arrivals. Liberalization in 1977 also contributed to the rapid rise in overseas employment. Overseas employment rose from 76 000 in 1980 to 213 000 in 2004, and, consequently, remittances rose from 2.9 per cent of GDP in 1980 to 8.9 per cent in 2004 (Table 4.11). As noted earlier, overseas remittances remain the largest foreign exchange earner. Sri Lanka has on average about 171 000 people working annually in the Middle East (80 per cent of the total overseas employees) and the largest contribution to remittances comes from the workers based in the Middle East.

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The Port of Colombo’s trans-shipment rose from 666 000 TCUs (Twenty-foot Equivalent Container Units) in 1994 to 1 531 000 TCUs in 2004. The geographical location, expansion and modernization of the terminals via foreign assistance in the 1980s, and introducing private sector management in the late 1990s, went a long way in making it a hub port in the region. Capital account of the balance of payments has been always positive. However, Sri Lanka has not been able to attract a significant amount of FDI due to the uncertainty created by the North-East war during 1983–2001 and the lack of stability in the post-2001 political regimes. FDI has ranged between a meagre 0.3 per cent and 1.5 per cent of GDP during the post-liberalization period. When liberalization was unleashed in 1977, and the Greater Colombo Economic Commission (GCEC) was created, a number of foreign investors from Japan and the United States showed an interest in investing in the country. In 1982, the Far Eastern Economic Review referred to Sri Lanka as the ‘new investment centre in Asia’. But the 1983 ethnic riots dealt a severe blow to all attempts made to attract more FDI.15 The institutional framework governing FDI management was changed in the early 1990s by forming the Board of Investment (BOI) with ‘one stop’ facility. In order to compensate for the instability in domestic political environment (and in some years, the macroeconomic environment), the government (through the BOI) offered exclusive status for some foreign investors (Booker, Nestlé, Prima, Shell and Caltex) thinking that by attracting some well-known transnational corporations, the measures would trigger the arrival of others. However, this was not the case due to the escalation of the war – which received wide publicity in the international media. Foreign portfolio investment has been very unstable. The market capitalization of the Colombo Stock Exchange (CSE) is about Rs.382 billion (US$3.82 billion). It is 0.75 per cent the size of India’s stock exchange and amounts to nearly 20 per cent of GDP. Thus, the depth of the capital market is insignificant. Only 240 out of the 11 000 registered companies are quoted on the CSE. Although the CSE has grown during the last 15 years, only about 10 per cent of corporate financing is done through the CSE. The Sri Lankan stock market benefited from the first wave of foreign portfolio inflows in the early 1990s. Thereafter, throughout 1995–2001 the stock market showed a declining trend to pick up once again in 2002. This was mainly due to the confidence that was generated by the ceasefire agreement. Since 1997, Sri Lanka did not receive much concessional lending because it was categorized as a middle-income country with per capita income exceeding US$750. Thus, Sri Lanka has been increasingly resorting to foreign borrowing from commercial sources, although this was muted somewhat by the generous donor assistance for the peace process in 2003 and the tsunami relief in 2005. Sri Lanka has still not fully opened up its capital account of the balance of payments, although the debate started in the late 1990s (IPS, 2002). The fiscal situation and the imbalance in the macroeconomy do not permit capital account liberalization. Sri Lanka faced balance of payment difficulties twice during the post-liberalization period, namely, 1988–89 and 2000–01. The former was due to the Southern insurgency that brought the economy to a halt, and the latter was due to escalating war coinciding with the international oil price hike. As noted earlier, on both occasions the government signed a standby package with the IMF and committed to implement certain reform measures.

Sri Lanka 141 Domestic sector Fiscal situation Sri Lanka’s fiscal situation came to a point where it could no longer fund the social welfare programmes, which amounted to nearly 10 per cent of GDP in the mid1970s, without substantial new funding. Export taxes from the traditional tree crops were gradually declining and so were the revenues generated from income and corporate taxation. In 1979, the universal food subsidy programme was replaced by a targeted food stamp scheme. Moreover, funding physical infrastructure received priority over funding social infrastructure. The government succeeded in mobilizing large amounts of foreign resources for pursuing an ambitious public investment programme (PIP). There was an escalation of defence and rehabilitation budget to finance the North-East war. Government current expenditure needed substantial cutting to bring about some degree of macroeconomic stability. In the mid-1980s an Administration Reform Commission suggested certain reforms in the administration to cut down expenditure, however, very little reform was undertaken due to political resistance (Dunham, 2004). The initiation of the privatization programme in the early 1990s reduced the burden on the government of subsidizing loss-making state-owned enterprises. However, the expenditure reduction received low priority in fiscal management. The privatization programme was seen more as a revenue-earning strategy for the government rather than achieving other objectives of efficiency and competition. Revenue enhancement received priority after the Taxation Commission Report came up with a number of recommendations in the early 1990s. A goods and services tax (GST) with a single rate was introduced in 1998 to replace the then operational business turnover tax (BTT) – which was a cascading tax. But the single rate GST (at 12.5 per cent) failed to bring in additional revenue due to the rate being lower than what it should have been.16 In 2002, a two-band (later single band) value-added tax (VAT) replaced the GST but was not extended to the retail sector fearing cost of living implications. There has been a shift from direct taxation to indirect taxation over the years. Indirect taxation amounted to 80 per cent of tax revenue or 11 per cent of GDP in the mid-2000s. The national security levy, first introduced in 1992 as the defence levy, was one of the most effective indirect taxation instruments that financed nearly 44 per cent of the defence budget in 2001. This tax was abolished in 2002 after the CFA came into operation. Revenue as a percentage of GDP has been on the decline since the early 1990s (from about 20 per cent of GDP in 1990 to about 15 per cent of GDP in 2002) (Table 4.12). BOI duty concessions, transition from BTT to GST, then to VAT, and various tax exemptions and amnesties, have contributed to this situation. Moreover, the Inland Revenue Department has been slow to broaden the tax base in the country, and there has been a stagnation of revenue from income taxes (Waidyasekera, 2004). Interest payments on previous borrowings to finance the budget deficit occupied a key position in government expenditure (31 per cent), followed by wages and salaries (22 per cent). Sri Lanka has a large public sector with employment close to 1 094 415 (armed forces and school teachers account for a bulk of them). Thus, the wages and salaries component also ranks high on expenditure (5.2 per cent of GDP). The Provincial Council system absorbs 9 per cent of government expenditure and duplicates a number of functions of the central government.

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Table 4.12

Fiscal operation as a percentage of GDP: 1980–2003

Government expenditure 1. Current 2. Capital 3. Lending/Repayment Government revenue 1. Revenue – Tax – Non-tax 2. Grants Current account (surplus /deficit) Budget deficit

1980

1984

1988

1992

1996

2000

2003

42.7 18.5 182 5.9 23.5 19.6 16.2 2.6 3.9 1.1
19.2

31.1 20.8 10.3 3.4 24.3 18.8 18.0 2.2 3.0 6.1
6.8

34.5 21.1 5.9 0.6 21.8 20.2 16.2 2.6 1.9
2.0
12.7

27.5 22.2 5.2 0.5 22.1 20.7 14.5 2.3 1.9
0.9
7.3

27.9 20.2 4.3 2.2 20.1 16.8 16.9 2.1 0.4
3.2
8.9

26.7 20.2 4.3 2.2 17.2 16.8 14.5 2.3 0.4
3.4
9.9

23.7 19.0 4.3 0.4 16.1 15.7 13.1 2.5 0.4
3.3
8.0

Source: Central Bank of Sri Lanka (various issues) and Economic Progress of Independent Sri Lanka (CBSL, 1998).

The pension budget amounted to 2.2 per cent of GDP and underwent some reforms in 2002 when pensions of new recruits to the public sector were brought under a funded scheme (MOFP, 2002). The Poverty Alleviation Programme centred around Samurdhi also amounts to nearly 0.5 per cent GDP. The Sri Lanka Integrated Survey shows that 40 per cent of the recipients are not the deserving poor. A restructuring of the Samurdhi Programme initiated by the UNF (United National Front) government in 2002 was halted by the new government, which assumed office in 2004. Public debt now hovers around 95–105 per cent of GDP, constituting mainly domestic debt (65 per cent). There has been a structural change in public debt during the last decade – domestic debt increased from 41 per cent of GDP in 1991 to 60 per cent of GDP in 2002, while external debt reduced from 58 per cent to 46 per cent of GDP during the same period (Table 4.13). The reduction of public debt, and restructuring of state-owned enterprises for reducing budget deficits have been key requirements of the IMF PRGF. In 2002, the Fiscal Management Responsibility Act was put into operation to impose some self-discipline in regard to fiscal slippage. There was some improvement in budget deficits in 2002 and 2003, but such improvement could not be sustained when new economic promises had to be fulfilled in 2004. Moreover, the unexpected tsunami impact pushed up state expenditures, and hence the fiscal deficit rose to above 8 per cent of GDP by 2005 (Table 4.12). New instruments to finance the deficit, such as Treasury Bonds were introduced in the late 1990s; they did assist in reducing bank borrowing but did not become a panacea for fiscal deficit-related problems. Non-bank financing of the fiscal deficit via captive sources such as the National Savings Bank (NSB), Employees’ Provident Fund (EPF) and Employees’ Trust Fund (ETF) is commonly resorted to by the government. Despite high budget deficits and inflation running at double-digit levels, interest rates are kept at single digit at around 7.5–8 per cent, resulting in negative interest rates. This is done purely from the public debt perspective and is unlikely to be sustainable in the medium term. Fiscal management has been a difficult task over the years due to the slow reforms in the large public sector.

Sri Lanka 143 Table 4.13

Government debt as a percentage of GDP: 1980–2004

Year

Domestic

Foreign

Total

1980 1984 1988 1992 1996 2000 2004

43.7 33.6 44.4 40.0 45.4 53.8 56.4

33.5 34.9 56.6 55.4 46.8 43.1 49.1

77.2 68.5 101.0 95.4 92.2 96.9 105.5

Source: Central Bank of Sri Lanka (various issues). 30

Percentage

25 20 15 10 5

20 04

20 02

20 00

19 98

19 96

19 94

19 92

19 90

19 88

19 86

19 84

19 82

19 80

0

Years Source: Central Bank of Sri Lanka (various issues).

Figure 4.1

Annual average inflation rate (based on the CCPI): 1980–2004

Inflation The measurement of inflation has been subjected to debate in Sri Lanka (Nicholas, 1991; Hewavitharana, 1992; Korale, 2001 and others). The usage of an outdated basket of goods of 1952 in the Colombo Consumer Price Index (CCPI) has been the main point of contention in the debate. The CCPI is the commonly used indicator despite the availability of other indices such as the Greater Colombo Consumer Price Index. Since 2002, a new index called Sri Lanka Consumer Price Index (SCPI) has been derived by the Department of Census and Statistics, which has addressed some of the shortcomings of the CCPI. During the last few decades, inflation in Sri Lanka has been relatively high and volatile. The second oil price shock pushed the inflation rate to its peak (over 26 per cent) in 1980. However, the inflation rate fell sharply to less than 3 per cent by the mid-1980s. During the later half of the 1980s, Sri Lanka experienced rapid inflation due to excessive domestic bank borrowing to finance the public investment programme-driven deficit (Table 4.3 and Figure 4.1). As food comprises a large share of the consumer basket, the fluctuations

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in the domestic food supply situation also has an impact on inflation. Since the early 1990s inflation has been declining albeit with high volatility. According to the available studies, supply-side factors appear to be important in influencing the general price level in Sri Lanka. In other words, inflation in Sri Lanka has been mainly ‘cost push’ in nature although ‘demand pull’ factors played a major role in the early 1980s. High import dependence (about 34 per cent of GDP), high interest rates during the 1990s and a rapid deceleration of currency are some important ‘cost push’ factors for inflation (Nicholas, 1991). Sectoral policy Industrialization Sri Lanka was basically an agro-based economy at the time of independence. A World Bank mission report in the immediate aftermath of independence argued that Sri Lanka’s comparative advantage was in the agriculture sector and should not go into industrialization (World Bank, 1953). However, with the terms of trade shocks and lack of diversification in export-based agriculture, Sri Lanka decided to embark on industrialization in the mid-1950s, in accordance with the then prevalent ideological thinking of importsubstitution industrialization (ISI). Industrialization in Sri Lanka continued with ISI till the mid-1960s. However, 1965–70 witnessed the partial liberalization of the economy and experimenting with exportoriented industrialization (EOI). 1970–77 saw once again reverting back to ISI and finally back again to EOI with a more aggressive liberalization of the economy. FDI to support EOI was substantially discouraged by the uncertainty created by the North-East war after 1983. Sri Lanka’s industrial transformation was based on labour-intensive products, namely, ready-made garments (RMG), gems and jewellery, rubber products and ceramics. The industrial transformation from ISI to EOI was impressive, however, industrial diversification and the geographical spread of industries were limited. There was no industrial policy during the first decade of liberalization. However, since 1989, industrial policies were put into operation with the initiation of the Industrial Promotion Act of 1990. Contrary to views expressed by some commentators, industries were promoted by selective incentives, such as tariffs and BOI incentives. There was some geographical spread of RMG industries as a result of selective incentives offered under the BOI during the early 1990s. Thus, Sri Lankan industrialization cannot be regarded as a neo-liberal success story. While the open liberal regime played a significant role in the growth of the RMG industry, it must be noted that the MFA (Multi-Fibre Arrangement) played an equally significant role in attracting quota-hopping East Asian industrialists, and thereby encouraging local entrepreneurs to embark on RMG production and export. Using cheap labour and incentives generated by the liberal economy, RMG exports grew to occupy 52 per cent of Sri Lanka’s exports and 6.5 per cent of GDP by 2000, accounting for 330 000 jobs (6 per cent of the labour force) and 1.3 million livelihoods. Sri Lanka has established a reputation as a quality RMG producer; in particular, intimate apparel. RMG exports, despite their low value-added, account for a large foreign exchange earning in Sri Lanka. The country is currently facing a challenge in the global market in an MFA-free trading environment, especially from China, India, Bangladesh and other labour-abundant countries.

Sri Lanka 145 Agriculture Soon after independence, Sri Lanka’s development strategy was directed at the agriculture sector with the aim of reviving the nation’s ancient self-sufficient agricultural economy. The agriculture development strategy consisted of rehabilitation of irrigation systems, colonization of abandoned agriculture land and resettlement of farmers from densely populated areas of Southern Sri Lanka. This strategy basically continued until the mid-1970s with a ‘Green Revolution’ plugged in during the late 1960s to boost the import substitution agriculture sector. Agriculture suffered a severe setback in the 1970s with the nationalization of the plantation sector, which accounted for 27.6 per cent of agriculture GDP in 1975. Plantation exports accounted for 90 per cent of export earnings in 1948, but gradually declined over the years. Today, plantation exports amount to 15 per cent of exports, and overall agriculture accounts for 20 per cent of exports. The tea industry continues to play a vital role in the plantation sector, while rubber and coconuts have diminished in importance. Smallholders’ contribution towards tea production has been increasing, and at present accounts for nearly 62 per cent of the total tea production. There are more than 200 000 smallholders, and more than 80 per cent of the smallholders are in the low-grown tea areas. The massive public investment in irrigation in the late 1970s and early 1980s paid dividends by making Sri Lanka near self-sufficient in rice in the mid-1980s. However, the desired non-plantation agriculture diversification has been slow. A number of institutional and market impediments contributed to this situation. In the mid-1990s, Sri Lanka bounded its agricultural tariffs at 50 per cent (with the WTO) with the intention of developing the agriculture sector according to the country’s comparative advantage. By 2005 it was clear that this strategy did not achieve the desired objective. In fact, low binding was done when many outdated regulations (quarantine restrictions on seeds importation, restrictions on land ownership, etc) were in operation and institutions (marketing systems, post-harvest storage, etc) were far from developed. In the external world, the EU and US subsidies on agriculture were hardly reduced, thus, international prices of agricultural imports were distorted. Market access for some Sri Lankan agricultural exports was hindered by various non-tariff barriers in the industrialized countries. In such an environment, the agriculture sector could not develop according to its comparative advantage. On the contrary, the low tariffs binding led to gradual erosion of some non-plantation agriculture production and triggered ad hoc tariff changes and imposition of specific duties (para-tariffs) to satisfy various agriculture producer lobbies. Moreover, in order to satisfy consumers, some tariffs were made seasonal. This led to most farmers receiving conflicting signals in rice, potato and chilli production, which, in turn, had an adverse impact on production. In the ILBFTA, the entire agriculture sector was put on the negative list due to farmer lobby pressure. Additionally, the 50 per cent binding was in contrast to other South Asian countries, which bounded tariffs at a higher level for bargaining in multilateral negotiations and safeguarding their production base from the prevailing international price distortions in agricultural trade (Athukorala, 2000). In the context of agriculture, food security is an important issue. Food security has been a misunderstood concept in Sri Lanka. There are many who equate food security with food self-sufficiency (Sanderatne, 2006). Perhaps this may be due to the legacy of

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equating agriculture development to patriotism by the first post-independent prime minister of Sri Lanka (Senanayake [1935] 1985). There have been shifts in policy vis-à-vis food imports. Although at the macro-level food security is maintained, at the micro-level food security is not properly addressed (Kelegama, 2006a; Sanderatne, 2006). Labour market and employment Sri Lanka’s annual addition to the labour force is close to 150 000 workers. The unemployment rate in 2004 was close to 9 per cent. Table 4.14 shows the unemployment patterns in the country over the years. Out of the 7.5 million labour force, 31.1 per cent are females. If the unemployment figures are disaggregated, one can see that a large concentration of unemployment is in the 20–35-year age groups. Moreover, the unemployment levels are higher in areas other than the Western Province. Self-employment accounts for 32 per cent of employment. Around 215 0000 people per annum go outside Sri Lanka for overseas jobs (Korale, 2004). Close to 1 million people work in the public sector.17 The Sri Lankan labour market is segmented into three: namely, regulated, informal and the estate markets. The regulated market is governed by strict labour legislations, especially for hiring and firing of labour. However, these restrictions do not explain the unemployment among the poor and relatively uneducated people who do not qualify for employment in the protected segment. The main explanation for this kind of unemployment is probably the web of constraints faced by the poor in terms of education, health, physical isolation and isolation from information (Prywes, 1995). There are three hypotheses that have been put forward to explain unemployment in Sri Lanka. They are the skill mismatch hypothesis, the queuing hypothesis and the rigidities in the labour market hypothesis. The skill mismatch hypothesis originated from an ILO study (1971), which basically argued that the skills in demand in the market are not produced by the human resource development system in Sri Lanka. Alailima (1992) argued that this is not the case, while Gunatilleke (1986) argued that there is some element of it in the job market. The queuing hypothesis has now been substantiated with empirical evidence (Rama, 2003). The pay level at the lower level of the public sector is more attractive than in the private sector. Moreover, there are various add-on benefits that provide more job security in these public sector jobs. Since the government engages in time-totime hiring, most unemployed people at the lower job level queue for jobs in the state sector. The Sri Lankan labour market is governed by outdated legislations, which are less meaningful for contemporary requirements. Some of these legislations were enacted Table 4.14 Year 1963 1973 1981/82 1992 2004

Unemployment rate in selected years during 1963–2004 Unemployment Rate (%)

Male (%)

Female (%)

16.6 18.3 11.7 14.6 8.5

15.3 13.7 7.8 9.4 6.3

20.0 26.8 21.3 23.1 13.2

Source: Central Bank of Sri Lanka (various issues).

Sri Lanka 147 during the colonial era and some others during the closed economy periods of the 1960s and the 1970s. These legislations do not permit the labour market to be flexible enough to respond to the needs of an open economy. Reforms in the labour market have been painfully slow due to resistance from strong trade unions, some of which are affiliated with political parties (Kelegama and Gunatilaka, 1996). Due to these rigidities, private sector companies resort to subcontracting where possible and some companies to capital-intensive techniques. Such strategies have had an adverse impact on employment generation. Wages are determined in Sri Lanka via a tripartite board comprising equal numbers of employer representatives, government representatives and trade union representatives (see Athukorale and Jayasuriya, 1994 and Rodrigo, 1996). Sometimes ad hoc wage increases by the government for public servants trigger a wage increase in the private sector. In the estate sector, the Ceylon Workers Congress (CWC) exerts pressure on the management for wage increases. Such government- and trade union-led wage increases are opposed by the Employers’ Federation of Ceylon, which has a policy of wage increases indexed to inflation. A National Council of Administration was established in 2004 to advise the government on public sector salary adjustments, however, it was abolished in 2006 due to trade union pressure.18 There is an impending problem of a rapidly ageing population. The above-65-years population is going to double by 2015. As a result, the labour force is going to decline in the coming years and Sri Lanka may have to import labour by about 2012. Social welfare, demographic change and poverty Social welfare During the time of British Colonial rule, welfare programmes were introduced soon after the achievement of Universal Adult Franchise. These programmes were intensified during World War II. Thus, at the time of independence, Sri Lanka inherited a strong welfare state, characterized by free supply of education and health and a food subsidy centred on rice. People increasingly started treating the welfare state as an inalienable right and resisted any attempt by the state to reduce welfare measures (Sanderatne, 2000). In Sri Lanka, 7–10 per cent of GDP has been allocated for social welfare. Allocations are for free education, health services, food subsidies, subsidized credit to improve living standards and ensuring minimum consumption levels of households perceived to be in need (Table 4.2). These measures have no doubt contributed to Sri Lanka’s relatively high basic needs indicators at a low per capita level (Sen, 1981; Isenman, 1980). In the late 1970s when liberalization was initiated the government got rid of the food subsidy programme and expenditure cuts were introduced from time to time in the health and education sectors. Table 4.15 and Figure 4.2 show the general expenditure reductions during the post-reform period. In the contemporary global growth–equity debate, Sri Lanka always features in the literature. It is an exception among developing countries in achieving high basic needs indicators when the per capita income level is low (Table 4.16). Bhalla and Glewwe (1986) argued that given the high basic needs indicators (BNI) achieved by the early 1960s, a growth-based strategy would have been more effective in achieving both high BNIs and enhancing per capita income. Sen (1988), Isenman (1987) and others disputed this and a

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Table 4.15

Social expenditure in selected years (as a % of GDP): 1980–2004

Year

Education

Health

Food Subsidya

Other Social Expenditureb

Total

1980 1985 1990 1995 2000 2004

2.8 2.7 3.0 2.8 2.5 2.1

1.2 1.3 1.5 1.6 1.6 1.7

3.6 3.0 3.7 2.5 2.0 2.4

1.2 0.5 0.3 2.9 1.3 0.5

8.8 7.5 8.5 9.8 7.4 6.7

Notes: a. Food subsidy: food stamp, Janasaviya (1991–94), Samurdhi (1995–2000). b. Other: housing and community services. Source: Central Bank of Sri Lanka (various issues).

5

As a % of GDP

4 3 2 1 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2004 Years Education

Health

Source: Central Bank of Sri Lanka (various issues).

Figure 4.2

Trends in expenditure on education and health: 1950–2004

review of the literature on the subject by Osmani (1994) showed that there is no trade-off between growth and equity, and that both could be achieved by well harmonized policies. However, there was inadequate support from the growth process to maintain the welfare state in Sri Lanka. The social welfare expenditures were sustained more by the intensively competitive political process in the country than by the economic growth process. Education and health expenditures ranged between 4 per cent and 6 per cent of GDP during 1970–2000. Education expenditure averaged around 3 per cent of GDP and health expenditure at about 1.5 per cent of GDP. Both these sectors require reforms to

Sri Lanka 149 Table 4.16

Basic indicators relating to human development: 1970–2004

Year

Literacy Rate

Infant Mortality Rate (per 1000 live births)

Life Expectancy at Birth

Human Development

1970 1975 1980 1985 1990 1995 2000 2004

71.6 78.5 78.5 87.2 87.2 90.1 90.1 92.5

50 45 34 24 19 17 12.2 11.1

61.7 65.5 65.5 69.9 69.9 72.5 73.1 74.1

0.602 0.613 0.648 0.674 0.698 0.719 0.741 0.740

Source: Central Bank of Sri Lanka (various issues).

suit the needs of the changing socioeconomic conditions, especially demography and lifestyles. Demographic transition Sri Lanka’s demographic transition is unique among developing countries. Sri Lanka went through all three stages of the usual demographic transition in a comparatively short period of 70–100 years. The second phase of demographic transition in Sri Lanka, where there was high population growth (sharp decline in mortality without an accompanying decrease in fertility), began soon after independence, continuing in the 1950s through the 1970s. The third phase, characterized by slow population growth, close to 1 per cent (where the decline in mortality was accompanied by low fertility), picked up momentum in the 1980s and manifested in the 1990s. These developments are expected to stabilize Sri Lanka’s population in the third decade of the 21st century at a level around 23 million. The twofold increase in population during the first three decades since independence lay at the root of many economic, social and political problems in the country. The social welfare expenditures had to be revised to meet the increase in population, thereby becoming a burden on the budget. The surge in population resulted in the swelling of youths (below 20 years of age), accounting for 50 per cent of the country’s population in the early 1970s. However, Sri Lanka could not take advantage of this ‘demographic dividend’ by creating jobs and the reservoir of unemployed youth ballooned. It led to the 1971 insurrection, creating many further problems. In short, Sri Lanka did not possess the policy environment to create jobs for the working population that was available and thereby create economic growth and prosperity. The rapid rise in population contributed to entrenched poverty, the decline in per capita arable land availability to 0.2 hectares in the 1980s and the decline in natural forest cover from 44 per cent in the late 1950s to 24 per cent in 1991 (Sanderatne, 2000). The average 4 per cent growth rate in the first four decades after independence was simply inadequate to accommodate the growing needs of the increasing population. The main feature of a low fertility rate and a low mortality rate resulting from the past social welfare expenditures is the rapid ageing of the population. Sri Lanka will be the only country among developing countries to have a population of above 65 years constituting

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more than 20 per cent in the years 2020–25 (De Silva, 1999). While countries in Europe took 45–145 years for the above-65-aged population to double, in Sri Lanka this will happen in 20 years. The failure to take advantage of earlier demographic dividends means Sri Lanka could not accumulate enough to look after its older population and demography remains a burden. Pension payments can absorb about 20 per cent of expenditure in the future and distort public expenditure patterns with serious implications for public investment and economic growth (IPS, 1998). Sanderatne (2000) argues that there is little justification for the retiring age to be 55 years for men and 50 years for women in the public service (with possible extension of another five years) as this was set when life expectancy was 55 years in Sri Lanka. Today, life expectancy is 72 years and Sanderatne (ibid.) argues for an increase in the retirement age and also a phased retirement programme. Poverty Sri Lanka has been successful in addressing social poverty but not income poverty. Before economic reforms started in 1977, Sri Lanka had 35 per cent of the population below the poverty line and the Gini coefficient was 0.45. With economic reforms, the scenario changed as income distribution became more skewed, which slowed poverty reduction (Table 4.17). Poverty still remains at an unacceptable high level in the plantation estates (Table 4.18). A study by UNICEF (1985) on poverty and inequality resulted in a High-level Commission on Poverty Alleviation in 1988. The final outcome was an income support scheme for the poor called the Janasaviya Programme, which was implemented in 1989 (it had four components – social mobilization for infrastructure development, human resource development, nutrition and an investment component). The post-1988 government also initiated a number of community-based projects to address the issue of poverty directly. The Janasaviya Programme, implemented in phases, did not cover the entire island when it came into effect. Hence, when the government changed in 1994, an islandwide programme called Samurdhi was put into operation in 1995 (Dissanayake, 1995). The government has several social assistance programmes and subsidy schemes. Samurdhi is the largest government social assistance programme, amounting to 1 per cent Table 4.17

Income inequality: 1953–2004

Year

Income Received (%) (lowest 40 % of households)

Income Received (%) (highest 20 % of households)

Gini Coefficient

1953 1963 1973 1979 1982 1987 1997 2004

14.5 14.7 19.3 16.1 15.3 14.1 15.7 13.9

53.8 52.3 43.0 49.9 52.0 52.4 49.4 55.1

0.46 0.45 0.35 0.43 0.45 0.46 0.43 0.47

Source: Central Bank of Sri Lanka (various issues).

Sri Lanka 151 Table 4.18

Poverty headcounts: 1990–2002

Population National Urban Rural Estate

1990–91

1995–96

2002

26.1 16.3 29.4 20.5

28.8 14.0 30.9 38.4*

22.7 7.9 24.7 30.0

Note: * Compatibility of estate headcount for 1995–96 with that for other years may be affected by the fact that the Household Integrated Economic Survey (HIES) in 1995–96 was sampled differently for the estate sector. Source: World Bank (2004).

of GDP per annum. By 1999, 2 million families and by 2004, 1.9 million families – about 41 per cent of all the population in Sri Lanka – were receiving benefits from Samurdhi. The second largest item in the social transfer budget (0.3 per cent of GDP in 1999 and 0.5 per cent of GDP in 2002) is the assistance to the Internally Displaced People (IDPs) and war-affected people. There are several other programmes with a safety net function directly or indirectly, such as free text books and school uniforms, school transport subsidy and a nutrition intervention programme intended to increase household incomes. Besides, housing development, Integrated Rural Development Programmes, and microfinance based on income transfers operate in tandem with these programmes. The politicization of the poverty programme has been an issue of contention between multilateral financial institutions and the government. Many non-deserving people have been receiving the Samurdhi allowance either through improper targeting or under political considerations. It is reported that the Samurdhi programme misses 36 per cent of households ranked in the lowest expenditure quintile, while 30 and 14 per cent of households from two highest expenditure quintiles receive Samurdhi consumption grants (World Bank, 2000). Agriculture is a key sector where there is a high concentration of poverty. Increased agricultural income and productivity requires improved access, use and transactions of land. Land market reform is one of the ingredients for higher agricultural growth rates, as the experience of Thailand and Indonesia has shown (World Bank, 2004). Past land policies in Sri Lanka, which aimed at equitably distributing land among small farmers, may have fostered smallholder subsistence agriculture. The land market in Sri Lanka is characterized by the state’s role as the dominant landlord, by restrictions on land sale and use in some areas, and by inadequate land registry. The World Bank (ibid.) argues that state control over land, along with ill-defined property rights and tight restrictions on transferability and use of land, restrict farmers’ ability to obtain credit and move, or shift into higher value crops. However, this position has been questioned by Samaratunghe and Marawila (2006) who argue that there are socio-political and cultural issues that are more important than land ownership per se in agriculture diversification. In the poverty alleviation debate, the role of small and medium enterprises (SMEs) is also recognized. The SMEs account for 14 per cent of industrial output and 23 per cent of industrial employment (WP, 2002). As a result of liberalization measures, SMEs have

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been finding it increasingly difficult to survive in the economy due to intense competition from larger firms and imports, especially from China. In 2001, a decision was made to revive SMEs with a suitable facilitating framework – providing business support services and coordination via an SME authority. Steps have been taken in these directions and it is expected that with the revival of SMEs more rural jobs will be created, thereby contributing to enhancing income in rural households to come out of poverty. Governance and redefinition of the role of the state Sri Lanka has failed with its experiment with decentralization. The design and implementation of decentralized government structures have inhibited high-quality, demanddriven service delivery to all segments of the population. Inadequate attention has been paid to economic incentives associated with the fiscal aspect of decentralization, and the central government has not withdrawn from some devolved functions.19 Consequently, Sri Lanka has developed a highly complex framework of decentralization, which has created confusion and ambiguity regarding roles and responsibilities at both central and decentralized levels. The result has been reduced accountability and transparency, which constrain the growth and maturation of decentralized government institutions. Traditionally, public sector management in Sri Lanka was considered superior to that in many other developing countries. There is a perception that the quality of governance has declined since the 1970s after direct political interference became common in public sector appointments. Thus, Sri Lanka’s movement towards a liberalized open economy has not been accompanied by a similar transformation in the public administration. The public sector is large and costly, and suffers from low effectiveness and efficiency. With 12 per cent of the labour force employed in government in 1999, Sri Lanka has the largest bureaucracy per capita in Asia (World Bank, 2004). This bureaucracy is also expensive to maintain, as public sector workers with the lowest level of education earn almost twice as much as their counterparts in the non-public sector. The state owns large shares of the banking system (nearly 55 per cent of the Banking assets via the Bank of Ceylon and People’s Bank), power utilities, all water utilities, railway, postal services and all higher education institutions. This has diverted investment away from much-needed infrastructure. The UNF regime of 2002–03 attempted to privatize some of these loss-making ventures by creating a suitable regulatory framework via establishing a multi-sector regulatory authority (IPS, 2003), but had to abandon them due to trade union pressure and a lack of a strategy to manage change. The PA element of the UPFA is in favour of continuing the UNP policies for these sectors, however, they were halted due to fierce resistance from the JVP. The UPFA government plans to manage these state utilities via a newly established institution called the SEMA (Strategic Enterprise Management Agency). Infrastructure needs urgent modernization. Indicators of per capita consumption of energy and number of phone lines, for instance, are significantly lower in Sri Lanka than those countries with comparable per capita income levels, such as Bolivia and China. Poorer regions of Sri Lanka and poorer households face the most severe shortfalls. The poor have less access to basic services, such as clean drinking water, sanitation, electricity, safe cooking fuel and communication than wealthier households. Provision of basic infrastructure, such as power, water and sanitation, is deficient especially outside Colombo and in plantations, where most of the poor live. In other words, decentralization of service delivery via the Provincial Councils has been far from satisfactory.

Sri Lanka 153 The challenge ahead Sri Lanka inherited from the British a well developed administration system. It had a relatively educated labour force and a well entrenched welfare system and even by the mid1950s Sri Lanka was more developed than Singapore or Thailand. Sri Lanka could have become a much more developed country with per capita close to that of Malaysia today, if not for the policy errors, missed opportunities and over-politicization of the system (Bruton et al., 1992 and others). Missed opportunities were many – either they were a result of the five-year electoral cycle, North-East civil war or policy errors. The World Bank produced a report in 2000 titled Sri Lanka: Missed Opportunities, which highlighted a number of these areas and Snodgrass (1999) described the Sri Lankan post-independence economic development experience as ‘a tale of missed opportunities’. Policy postponement, living beyond means, improper sequencing of reform, all characterized the policy errors over the years and partly these were a result of over-politicization of the system. Sri Lanka is not a nation that can become an industrial power. It does not have the natural resources or the size to engage in heavy engineering industries. Its main advantage lies as a service provider given its geographical location. Being strategically located between the Middle East and East Asia in the Indian Ocean, Sri Lanka is looking to becoming a hub in port services: sea and air; tourism; health and education services. Given its low labour cost it can provide services for various business process outsourcing (BPO) from more developed countries. These areas alone could provide the much-needed impetus when the limitation of the industrial and agriculture sector in stimulating growth is becoming apparent in recent times. There are three major problems that Sri Lanka needs to address immediately if the country is to be put on an accelerated growth track. First, solve the North-East separatist conflict, second, change the current constitution in order to produce more stable and representative governments that could take hard decisions pertaining to the economy and third, put the economy back on a sustainable growth path. For this purpose, fundamental problems engulfing the economy such as a large public debt, huge budget deficit, inefficient public sector and low productivity in the agriculture sector, need to be addressed. How to go about doing this has been discussed for a long time, however, the political will to implement such policies and reforms has been lacking (IPS, 2003). The challenge for the government is to carve out the mixed economy with selected deregulation for unleashing more sectors for private sector participation while strengthening the regulatory system for public delivery and strengthening the role of the state where the private sector involvement is weak. Meeting this challenge will be easier with the peace process moving forward and with political realignments that strengthen the ruling political coalition in parliament. To what extent the government will work in all these areas and move to meet the economic challenge remains to be seen. Notes 1. 2.

I am most grateful to Dilani Hirimutugoda of the Institute of Policy Studies of Sri Lanka for excellent research assistance. Colin Clark, who visited Sri Lanka in 1947 declared that bar Japan, Sri Lanka had the highest per capita income in Asia (Ministry of Finance, 1948). Tunku Abdul Rahman of Malaysia had expressed in 1956 that his aim was to equal the economic performance of Sri Lanka, while Lee Kuan Yew of Singapore had

154

3. 4. 5.

6.

7.

8. 9. 10. 11.

12. 13. 14.

15. 16. 17. 18. 19.

Handbook on the South Asian economies stated, on his return from Cambridge after pursuing higher studies, he thought that Singapore would be doing extremely well if it could imitate Sri Lanka (see Chapter 1 of Kelegama, 2006a). If estimates of purchasing power parity are used to adjust per capita income (à la Kravis), then in 1960, per capita income in Sri Lanka was higher than in either Brazil or Mexico (Lal and Rajapatirana, 1989: 4). The 1977 reform package has been extensively discussed in Cuthbertson and Athukorala (1991); Athukorala and Jayasuriya (1994); Kelegama (2006a). For detailed analysis of the second wave of reforms, see Dunham and Kelegama (1997). Although there was progress on the economic front, 17 years of UNP rule was also characterized by increasing bribery and corruption, lack of transparency in policy-making, violation of human rights in the process of consolidating the government’s authority, and so on. Thus, people needed a change of government and a new approach to address some of the above-mentioned issues. The People’s Bank and the Bank of Ceylon were on the verge of bankruptcy in 1992. The government infused a sum of Rs.24 000 million in 1993 to recapitalize them and bring their capital adequacy to the international level. However, the state continued to inject Rs.19 300 million once again in 1996 to improve their conditions. The accumulated annual loss of the Ceylon Electricity Board was close to US$800 million. By mid-2001 the PA coalition became fragile with a leading coalition partner (Sri Lanka Muslim Congress) leaving the government. In late 2001 with the exodus of some leading ministers of the government to the opposition ranks, the PA lost an overall majority in the parliament and this compelled the president to dissolve parliament for a new general election in December 2001, when the ruling PA was defeated by a UNPled coalition. Budgetary assistance was made available in 2005 in the absence of a PRSP taking into account the adverse impact of the tsunami of 26 December 2004. The developing country average was close to 20 per cent. Such funding gradually came to an end when Sri Lanka’s per capita income exceeded US$750 in 1997. The government felt that when the debt service ratio was averaging at 12 per cent that Sri Lanka could afford to engage in commercial borrowing from the international market. The following factors were taken into account: 1) although funds from multilateral financial institutions were available for various projects from past commitments the government required matching counterpart funds to complete those projects, 2) the government required funds to start new infrastructure projects and fulfil election pledges, 3) the government wanted to reduce borrowing from the domestic market to reduce the pressure on the interest rate and cost of living – the level of inflation was running at 11.6 per cent in 2005 and 4) the government wanted to settle some expensive commercial debt from past borrowings before it became a greater burden on debt. Moreover, P-TOMS was challenged in the Supreme Court and it was never implemented. Increased reliance on expensive emergency supply of electric power as well as large technical and financial losses by the Ceylon Electricity Board resulted in relatively high cost of electricity in Sri Lanka compared with other Asian countries. Studies done on economic growth by Ahmed and Ranjan (1995) show that Sri Lanka’s capital output ratio was around 5.0 in the early 1990s. This ratio is also high compared with relatively fast-growing developing countries. According to the same authors, the ratio was close to 3.0 in Korea and Thailand and close to 4.0 in Malaysia and Indonesia. See Athukorala (1995) and Kelegama, et al. (1999). The BTT had three bands: 8, 12 and 20. Studies have shown that the GST rate that would bring the same revenue as the BTT to be close to 16.5 per cent. This rate was not considered on cost-of-living grounds. Out of this 1 million, about 436 000 are in the central government, 310 000 in both provincial and local governments, and 175 000 in state-owned enterprises. Daily Mirror, 22 March 2006. The concurrent list under the 13th Amendment to the Constitution should be gradually given to the Provincial Councils but the state keeps a firm grip over these functions even at present.

References Ahmed, S. and P. Ranjan (1995), ‘Promoting Growth in Sri Lanka: Lessons from East Asia’, Policy Research Working Paper, No. 1478, South Asia Country Department, Washington, DC: The World Bank. Alailima, P. (1992), Education–employment linkages: the macro profile, Sri Lanka Journal of Social Sciences, 15 (1 & 2). Arunatilake, N., S. Jayasuriya and S. Kelegama (2001), ‘The economic cost of the war in Sri Lanka’, World Development, 29 (9). Athukorala, P. (1986), ‘The impact of 1977 policy reforms on domestic industry’, Upanathi, 1 (1), 69–105. Athukorala, P. (1995), ‘Foreign direct investment and manufacturing for export in a new exporting country: the case of Sri Lanka’, The World Economy, 18 (4).

Sri Lanka 155 Athukorala, P. (1996), Labour Productivity in the Manufacturing Sector in Sri Lanka, Colombo: Department of National Planning, Ministry of Finance and Planning. Athukorala, P. (2000), ‘Agriculture trade policy reform in South Asia: the role of the Uruguay Round and policy options for the future WTO agenda’, Journal of Asian Economics, 11 (2), 169–93. Athukorala, P. (2004), ‘Growth of manufactured exports and terms of trade: pessimism confounded’, in S. Kelegama (ed.), Economic Policy in Sri Lanka: Issues and Debates, India: Sage Publications. Athukorala, P. and S. Jayasuriya (1994), Macroeconomic Policies, Crises, and Growth in Sri Lanka, 1969–90, Washington, DC: The World Bank. Bhalla, S. and P. Glewwe (1986), ‘Growth and equity in developing countries: a reinterpretation of the Sri Lankan experience’, World Bank Economic Review, 1 (1). Bruton, H. et al. (1992), Sri Lanka and Malaysia: The Political Economy of Poverty, Equity, and Growth, Oxford: Oxford University Press for the World Bank. Central Bank of Sri Lanka (CBSL) (various years), Annual Reports, Colombo. Central Bank of Sri Lanka (CBSL) (1998), Economic Progress of Independent Sri Lanka: 1948–1998, Colombo. CFS (2003/04), Consumer Finance and Socio-Economic Survey 2003/2004, Central Bank of Sri Lanka. Chandrasiri, S. (2004), ‘Productivity and technology in Sri Lankan manufacturing industries’, in A.D.V. de S. Indraratna (ed.), Human Development in a Knowledge-based Society: Sri Lankan Scene, Colombo: Sri Lanka Economic Association. Cuthbertson, A.G. and P. Athukorala (1991), ‘Sri Lanka’, in D. Papageougiou, M. Michaely and A.M. Choksi (eds), Liberalizing Foreign Trade, Volume 5, Oxford: Blackwell. De Silva, W.J. (1999), Population Projections for Sri Lanka: 1991–2041, Human Resource Development Series, No. 2, Colombo: Institute of Policy Studies. Dissanayake, S.B. (1995). ‘Samurdhi Program: concepts and challenges’, Economic Review, 21 (5), Colombo: People’s Bank. Dunham, D. (2004), ‘Economic liberalization and institutional reform’ in S. Kelegama (ed.), Economic Policy in Sri Lanka: Issues and Debates, India: Sage Publications. Dunham, D. and S. Kelegama (1997), ‘Does leadership matter in the economic reform process? Liberalization and governance in Sri Lanka, 1989–93’, World Development, 25 (2). Economic and Social Commission for Asia and the Pacific (ESCAP) (2003), Tariff and Trade Policy Framework for Sri Lanka, Report prepared for UN-ESCAP by Sandy Cuthbertson, Sri Lanka: Tariff Advisory Council. GOSL (2005), Sri Lanka: Creating Our Future, Building Our Nation, New Development Strategy – Framework for Economic Growth and Poverty Reduction, Colombo: Ministry of Finance and Planning. Gunatilleke, G. (1986), The Extent and Nature of the Structural Mismatch in the Domestic Labour Market, Research Studies, Employment Series No. 10, Colombo: Institute of Policy Studies. Herring, R.J. (1987), ‘Economic liberalization policies in Sri Lanka: international pressures, constraints and support’, Economic and Political Weekly, 22 (8). Hewavitharana, B. (1992), The Search for an Accurate Consumer Price Index for Sri Lanka, Colombo: Friedrich Ebert Stiftung. ILO (1971), Matching Employment Opportunities and Expectations – A Programme of Action for Ceylon, Geneva: Technical Papers. IPS (various issues), Sri Lanka: State of the Economy, Institute of Policy Studies of Sri Lanka (IPS), Colombo. Isenman, P. (1980), ‘Basic Needs: The Case of Sri Lanka’, World Development, 8 (3). Isenman, P. (1987), ‘A comment on growth and equity in developing countries: a reinterpretation of the Sri Lankan experience by Bhalla and Glewwe’, World Bank Economic Review, 1 (3), 521–31. Kelegama, S. (1992), Liberalization and Industrialization: The Sri Lankan Experience of the 1980s, Industrialization Series No. 2, Colombo: Institute of Policy Studies. Kelegama, S. (2006a), Development under Stress: Sri Lankan Economy in Transition, India: Sage Publications. Kelegama, S. (2006b), Contemporary Economic Issues: Sri Lanka in the Global Context, Colombo: Sri Lanka Economic Association. Kelegama, S. and R. Gunatilaka (1996), Study on the Impact of Labour Legislation on Labour Demand in Sri Lanka, Colombo: Department of National Planning. Kelegama, S., P. Samararatne and M. Knight-John (1999), Productivity and Labour Cost in Manufacturing Industries: Sri Lanka, SAAT, New Delhi: ILO. Korale, R.B.M. (2001), The Problems of Measuring Cost of Living in Sri Lanka, Macroeconomic Policy and Planning Series No. 14, Colombo: Institute of Policy Studies. Korale, R.B.M. (2004), ‘Migration and brain drain’, in S. Kelegama (ed.), Economic Policy in Sri Lanka: Issues and Debates, India: Sage Publications. Lakshman, W.D. (2002), ‘Challenge of development beyond “open economy” ’ , The Island, 3 November 2002 (Felicitation Lecture for Gamani Corea at the N.M. Perera Centre, Colombo, 17 October 2002). Lal, D. and S. Rajapatirana (1989), Impediments to Trade Liberalization in Sri Lanka, Thames Essays, London: Trade Policy Research Centre, Gower.

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Ministry of Finance (1948), Budget Speech, Government of Ceylon Press. Ministry of Finance and Planning (MOFP) (2002), Budget Speech 2003 (March 2002), Government of Sri Lanka. Ministry of Finance and Planning (MOFP) (2005), Budget Speech 2006 (8 December 2005), Government of Sri Lanka. Nicholas, H. (1991), Inflation in Sri Lanka 1971–1987: A Preliminary Study, Macroeconomic Series, No. 3, Colombo: Institute of Policy Studies. Oliver, H.M. (1957), Economic Opinion and Policy in Ceylon, Duke University Commonwealth Studies Centre, London: Cambridge University Press. Osmani, S. (1994), ‘Is there a conflict between growth and welfarism: the tale of Sri Lanka’, Development and Change, 25 (2), 387–421. Prywes, M. (1995), Unemployment in Sri Lanka: Sources and Solutions, Washington, DC: The World Bank. Rama, M. (2003), ‘The Sri Lankan unemployment problem revisited’, Review of Development Economics, 7 (3), 510–25. Rodrigo, C. (1996), ‘Wage behaviour in the liberalized economy, 1978–1993: a review of evidence, Upanthi, 7 (1 & 2). Samaratunghe, P. and D. Marawila (2006), Major Characteristics and their Determinants of the Rural Land Sector in Sri Lanka: Implications for Land Policy, Agriculture Policy Series, No. 7, Colombo: Institute of Policy Studies. Sanderatne, N. (2000), Economic Growth and Social Transformations: Five Lectures on Sri Lanka, Colombo: Tamarind Publications. Sanderatne, N. (2006), Food Security Issues in Sri Lanka, Manuscript for publication. Sarvananthan, M. (2005), ‘Macroeconomic overview’, in M. Sarvananthan (ed.), Economic Reforms in Sri Lanka: Post-1977 Period, Colombo: International Centre for Ethnic Studies. Sen, A.K. (1981), ‘Public action and quality of life in developing countries’, Oxford Bulletin of Economics and Statistics, 43 (4), 287–319. Sen, A.K. (1988), ‘Sri Lanka’s achievements: how and when?’, in T.N. Srinivasan and P. Bardhan (eds), Rural Poverty in South Asia, New York: Columbia University Press. Senanayake, D.S. [1935] (1985), Agriculture and Patriotism, reprinted, Colombo: Lake House. Snodgrass, D.R. (1999), ‘Sri Lanka: a tale of missed opportunities’, in R. Rotberg (ed.), Creating Peace in Sri Lanka: Civil War and Reconciliation, Washington, DC: Brookings Institution Press. UNICEF (1985), Sri Lanka: The Social Impact of Economic Policies During the Last Decade, Colombo: United Nations. Waidyasekera, D.D.M. (2004), ‘Current fiscal policy’, in S. Kelegama (ed.), Economic Policy in Sri Lanka: Issues and Debates, India: Sage Publications. Weerakoon, D. (2004), ‘The influence of development ideology in macroeconomic policy reform process’, in S. Kelegama (ed.), Economic Policy in Sri Lanka: Issues and Debates, India: Sage Publications. World Bank (various years), World Development Report, Washington, DC: The World Bank. World Bank (1953), The Economic Development of Ceylon, Baltimore: Johns Hopkins University Press. World Bank (1996), Sri Lanka: Non-plantation Crop Sector Policy Alternatives, Report No. 14564-CE, Washington, DC: Country Department: South Asia Region. World Bank (2000), Sri Lanka: Recapturing Missed Opportunities, World Bank Country Report, Washington, DC. World Bank (2004), Sri Lanka: Development Policy Review, Washington, DC: The World Bank. World Bank (2005), Sri Lanka: Improving the Rural and Urban Investment Climate, Washington, DC: The World Bank. WP (2002), National Strategy for Small and Medium Enterprise Sector Development in Sri Lanka – White Paper, Task Force for Small & Medium Enterprise Sector Development Programme, Colombo. Available at: www. ips.lk/publications/series/gov_reports/sme_white_paper/sme_white_paper.pdf.

5

Nepal S.R. Osmani and B.B. Bajracharya

A short political history of Nepal The Kingdom of Nepal was formed in the 18th century when King Prithvi Narayan Shah brought together of a number of fiefdoms and small states at the foot of the Himalayas under his rule. The Shah dynasty was, however, soon embroiled in a protracted power struggle that culminated in the emergence of Jung Bahadur Rana in 1846, who introduced the system of hereditary prime minister, giving rise to the powerful Rana oligarchy. During the Rana regime, some isolated efforts were made to bring about progressive political and social changes, but these were thwarted by conservative elements among the oligarchy who perceived such changes as threats to their hold on power. Eventually, however, the Rana regime sank under the weight of its own unpopularity and was overthrown by the joint efforts of the Shah kings and the people in 1951, heralding the emergence of modern Nepal. The restoration of the Shah kings to power brought about fundamental changes in the polity and economy of Nepal. On the political front, the people of Nepal tasted multiparty democracy for the first time in their history, and in the economic sphere, they witnessed the first attempts to achieve planned socioeconomic development. The first ever annual budget of the country was announced in 1953, and the first development plan was launched in 1957. Unfortunately, the experiment in multi-party democracy soon degenerated into inter-party as well as intra-party squabbles for power that led to political instability and precluded long-lasting economic reforms. As the political instability intensified, King Mahendra dismissed the democratic government of Nepali Congress Party in 1960 and suspended the parliament. He assumed all executive power and established the panchayat system in 1960, which was to remain the dominant form of political dispensation in Nepal for three decades. It was a partyless system of pseudo-democracy in which people elected their representatives from different constituencies on an individual basis, not on the basis of any political ideology or party. Under the king’s direction, the government instituted a number of social reforms, including the modernization of the legal code in 1962 and land reforms in 1964. The practice of pursuing socioeconomic development through five-year development plans was consolidated, with emphasis on physical and social infrastructure. The economic regime assumed a distinctly interventionist character as the government came to control many crucial prices and the monopoly of production activities was vested in public corporations, thereby precluding the growth of the private sector. After King Mahendra passed away, his son King Birendra adhered to the politicaleconomic system established by his father until the anti-monarchist movement seriously challenged his authority in 1980. Riots broke out, and in a 1980 referendum on the form of government, the voters decided to retain the non-party panchayat system with certain modifications. From that time onward, the king gradually relaxed his control over the polity and sowed the seeds of economic liberalization in Nepal, starting with the liberalization of the 157

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financial and social sectors, especially education. This marked the beginning of a gradual decline in government intervention in economic activity. In the political arena, the autocratic panchayat system led to the consolidation of power in the periphery of the palace. The resulting abuse of power and the alienation felt by the ordinary people brewed yet another political movement wherein once again the Shah dynasty joined with the people and successfully established a constitutional monarchy with a multi-party governmental set-up in 1991. This transformation in the political landscape was helped in a small measure by India, which had imposed an economic blockade on Nepal with a view to destabilizing the autocratic regime. The restoration of democracy in 1991 coincided with a decisive shift towards a liberal economic regime and an ever-closer economic relationship with India. However, nascent economic reforms were soon blunted by the re-emergence of inter-party and intra-party feuds, reminiscent of the 1950s. Moreover, the failure of big political parties to accommodate the aspirations of smaller parties undermined the very existence of a democratic polity. Political alienation took an extreme form in the case of the Communist Party of Nepal (Maoists), which took to an armed struggle in 1996 that continued to strike mortal wounds in the fabric of the society for almost a decade. The Maoist movement began in a modest way in the six districts of the Mid-western Development Region, but spread eventually to most parts of the country. The Midwestern Development Region and Far Western Development Region are the most economically backward parts of the country. They have inherited the worst legacy of the caste system and suffered from prolonged neglect on the part of governments of all political hues. The widespread poverty in these regions has made them fertile grounds for breeding and sustaining the Maoist movement. Maoist attacks on government institutions and personnel intensified after 2000. In return, the government also resorted to draconian measures to curb the insurgency. By 2004, more than 10 000 people had been killed as a result of this conflict. Against the backdrop of escalating Maoist insurgency and unabated political bickering among the mainstream political parties, democracy was dealt a mortal blow in 2002 when the prime minister dissolved the parliament and continued to exercise power with the blessing of the king. An even bigger blow came in February 2005, when King Gyanendra dismissed the coalition government, suspended democracy and civil liberties and assumed absolute political power in much the same way that King Mahendra did in 1960. The major difference this time was that there were now three political forces instead of two, trying to assert their supremacy and wrest political control of the country: the king, the mainstream political parties and the Maoists. This tripartite struggle for power continued to ravage Nepalese society until a popular uprising against the king changed the political landscape yet again in 2006, bringing fresh hopes of political stability. Democracy emerged victorious as the powers of the king were seriously curtailed and the Maoists showed an inclination to merge into the mainstream political process by shunning the path of violence. In light of the political evolution briefly outlined above, the history of the economic transformation of modern Nepal can be divided into four phases.1 The first phase covers the period from the mid-1960s to 1980, when the economy was public-sector-dominated and supported by vigorous development planning. Politically, the period was characterized by an autocratic panchayat system with an absolute monarchy. The second phase,

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spanning the decade 1981–90, witnessed the introduction of a liberal panchayat system, followed by the initiation of outward-oriented economic policies and the gradual dismantling of the public sector. The third phase, covering the decade 1991–2000, saw the restoration of multi-party democracy under a constitutional monarchy and the adoption of a vigorous programme of economic liberalization, privatization and globalization of the economy. The fourth and final phase started from around 2000. During this phase, a liberal economic stance was maintained, but its impact was stymied by an all-engulfing political turmoil caused by a bitter tripartite struggle for power that continued until 2006. Economic growth and the macroeconomic scenario Growth and structure of the economy During the final three decades of the last century, the Nepalese economy grew at the average rate of 4 per cent per annum. With the population growing at 2.2 per cent during the same period, per capita income increased at the rate of 1.8 per cent per annum. Cumulated over three decades, this rate of growth translates into a 70 per cent increase in the living standards of an average Nepali within one generation. This is not insignificant progress, but it does represent the slowest growth of per capita income in the whole of South Asia. The contrast is even sharper with the countries of East and Southeast Asia, most of which took only 10 to 15 years to double their per capita income, something that Nepal was not able to do even in 30 years. The situation was especially bad in the 1970s, when GDP and population both grew at around 2.1 per cent per annum, causing stagnation in per capita income. There was, however, some improvement in the next two decades, when GDP grew at a faster rate of about 5 per cent, and per capita income grew at 2.3 per cent. The momentum of this acceleration was maintained with the advent of the present century, as the growth of GDP rose further to 5.5 per cent in 2001 and the growth of per capita income rose to 3.1 per cent. However, the intensification of internal conflict, combined with a downturn in the external economic environment, took a heavy toll on the economy in subsequent years, from which the country has yet to recover. The growth rate turned negative in 2002, and although it recovered slightly afterwards, it remained well below the rates achieved in the 1990s (Table 5.1). Although the economy of Nepal grew at similar rates in both the 1980s and 1990s, which was close to 5 per cent, the proximate sources of growth were different in the two decades. The improvement in growth that occurred in the 1980s compared with the 1970s was driven mainly by agriculture. In the 1970s, agriculture had performed dismally, growing at less Table 5.1 Growth of real GDP: 1971–2004 (periodic average growth rate per annum, in percentage) Areas of Growth Real GDP growth Population growth Per capita GDP growth Sources:

1971–80

1981–90

1991–2000

2001–04

2.8 2.1 0.8

4.5 2.3 2.2

4.7 2.4 2.4

2.9 2.3 0.6

World Bank (2005a: Table 1.1); Asian Development Bank, Key Indicators 2005.

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Table 5.2 Sectoral GDP growth at constant prices 1976–2004 (periodic average growth rate per annum, in percentage) Sectors Agriculture Non-agriculture Mining and quarrying Manufacturing Electricity, gas and water Construction Trade, restaurants and hotels Transport and communication Finance and real estate All others GDP at factor cost

1976–80 1981–85 1986–90 1991–95 1996–2000 2001–04
1.3 7.5 9.1 2.1 6.7 17.4 5.6 12.0 5.9 6.3 2.4

5.2 4.9 15.2 5.3 14.8 7.3 4.9 1.7 2.4 8.3 5.0

4.1 5.5 5.5 5.2 13.9 6.5 4.4 5.3 5.2 6.7 4.8

1.5 8.1 5.8 14.0 10.1 6.5 7.5 9.8 6.4 6.8 5.0

3.6 6.0 5.9 7.6 7.8 5.4 4.7 7.0 5.7 6.2 5.0

3.5 2.2 2.1
0.6 11.6 1.0 0.3 4.4 2.8 5.0 2.7

Sources: Deraniyagala et al. (2003: Table 3.2); Asian Development Bank, Key Indicators 2005.

than 2 per cent in the first half of the decade and experiencing negative growth in the second half. But there was a significant turnaround in the 1980s, when agricultural growth rose to about 4.5 per cent, well above the population growth rate of 2.3 per cent (Table 5.2). The condition of agriculture turned for the worse again in the early 1990s, and although the situation improved slightly in the second half of the decade, the average growth rate for the decade as a whole fell to almost half of the rate achieved in the 1980s. The fact that overall GDP growth was nonetheless maintained in the 1990s was due primarily to the improved performance of non-agricultural sectors, especially manufacturing. All this has led to significant structural changes in the Nepalese economy. Around 1975, agriculture used to account for more than 70 per cent of GDP. By 2000, its share had come down to just about 40 per cent. By contrast, the share of manufacturing, which was a paltry 4 per cent in 1975, increased to over 9 per cent by 2000. Other non-agricultural activities such as construction, trade, transportation, finance and real estate have also increased their share of GDP considerably during the last two and half decades (Table 5.3). A recent attempt at growth accounting sheds further light on the proximate sources of growth in Nepal (Khatiwada and Sharma, 2002). The study has found that during the two decades between 1980 and 2000, growth of output occurred mainly through capital accumulation. By contrast, total factor productivity did not contribute much to the growth process. Indeed, taking the two decades as a whole, total factor productivity actually declined, thereby subtracting from growth of output rather than contributing to it. The decline in total factor productivity was, however, confined to the 1980s. There was a distinct improvement in the 1990s, when total factor productivity made a positive, albeit modest, contribution, accounting for 10 per cent of the growth of output. Despite negative contributions from total factor productivity, growth accelerated in the 1980s compared with the 1970s, due to rapid growth in capital formation. The rate of investment increased from an average of 16 per cent of GDP in the 1970s to 20 per cent in the 1980s, and further to 23 per cent in the 1990s (Table 5.4). This increase in investment was not, however, financed primarily by domestic savings, as the savings rate

Nepal Table 5.3

Structure of GDP at current prices (percentage share in GDP): 1975–2004

Sectors Agriculture Non-agriculture Mining and quarrying Manufacturing Electricity, gas and water Construction Trade, restaurants and hotels Transport and communication Finance and real estate All others Total GDP Sources:

161

1975

1980

1990

2000

2004

71.6 28.4 0.1 4.2 0.2 3.7 3.4 4.3 6.9 5.7

61.8 38.2 0.2 4.3 0.3 7.2 4.1 7.0 8.4 6.8

50.6 49.4 0.5 6.0 0.5 9.0 10.5 5.7 9.3 7.9

39.5 60.5 0.5 9.2 1.6 10.2 11.7 8.0 10.1 9.2

38.7 61.3 0.5 7.7 2.3 10.3 10.4 9.2 10.9 9.8

100

100

100

100

100

Khatiwada and Sharma (2002: Table 2.1); Asian Development Bank, Key Indicators 2005.

Table 5.4 Savings and investment rates: 1971–2004 (periodic average; as percentage of GDP) Investments/Savings Investment (including stocks) Public fixed investment Private fixed investment Gross domestic savings Sources:

1971–80

1981–90

1991–2000

2001–04

16.3 3.9 9.2 9.0

19.9 7.7 10.8 10.5

23.3 7.0 13.7 12.8

26.0 7.3 12.1 12.4

World Bank (2005a: Table 1.1); Asian Development Bank, Key Indicators 2005.

increased only marginally from an average of 9 per cent of GDP in the 1970s to 13 per cent in the 1990s. In the 1980s, the increasing gap between investment and savings was financed by foreign aid. As a percentage of GDP, the flow of foreign aid increased from an average of 4 per cent in the 1970s to an average of about 7 per cent in the 1980s. The relative importance of foreign aid declined, however, in the next decade as the flow went down to less than 6 per cent of GDP. Fortunately for Nepal, the effects of declining foreign aid were offset by a vastly increased flow of remittances from Nepalese workers working abroad, which became the major source of financing the gap between investment and domestic savings in the 1990s. Indeed, the growth of remittances has perhaps been the most significant development in the Nepalese economy in recent years. The size of remittances has grown at a remarkably high rate of 30 per cent per annum since the early 1990s, with important ramifications for economic growth, poverty and inequality. Around 2004, some 800 000 workers were employed abroad, mostly in India, and their remittances accounted for some 12 per cent of GDP. For a comparative perspective on the importance of remittance for the Nepalese economy, it may be noted that its contribution to the earnings of foreign

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exchange (US$800 million) exceeded that of merchandise exports (US$633 million) and tourism (US$155 million) in 2004. The surge in investment in the 1980s was led primarily by public investment, financed by an increased inflow of foreign aid, and supplemented by increasing recourse to deficit financing. The share of public investment in GDP rose from about 4 per cent in the 1970s to over 7 per cent in the 1980s (Table 5.4). Private investment, however, increased only marginally during this period. But the opposite happened in the 1990s, when, for the first time in Nepal’s history, there were signs of private investment gathering momentum even though public investment stagnated. The share of private investment in GDP rose to 14 per cent from the average of 11 per cent in the preceding decade. In fact, it was only the growth of private investment that kept the overall investment rate rising in the 1990s, as the rate of public investment remained stagnant. However, as the general investment climate deteriorated at the turn of the century with the intensification of the Maoist insurgency and the downturn in the world economy, private investment predictably declined, recovering only very slowly in recent years. Fiscal trends The fiscal operations of the government of Nepal have been severely constrained by its inability to generate adequate domestic revenue. In the 1970s, only 7 per cent of the GDP was collected as government revenue. Two decades later, in the 1990s, this ratio had risen slowly to 10 per cent. Government expenditure in the meantime rose much faster – from 11 per cent to 17 per cent of GDP (Table 5.5). Initially, the rise in expenditure was driven mainly by the need to spend more on building infrastructures for economic and social development. In the process, development expenditure as a ratio of GDP increased from 8.7 per cent in the second half of the 1970s to 12.6 per cent in the 1980s. However, the share of development expenditure subsequently declined, partly in order to accommodate the growing demands on resources made by the need to deal with the insurgency problem. By the turn of the present century, the share of development expenditure in GDP had fallen back even below the levels prevailing in the 1970s. Table 5.5

Budgetary trends, money supply and inflation: 1971–2004 (periodic averages)

Indicators Total revenue as % of GDP Total expenditure as % of GDP Development expenditure Budget deficit as % of GDP O/w domestic financing Broad money as % of GDP Rate of inflation (per annum)

1971–80

1981–90

1991–2000

2001–04

6.5 11.0 8.7 2.2 1.1 16.2 7.5

8.5 17.6 12.6 6.5 2.8 27.2 10.6

9.8 16.5 10.1 5.3 1.5 37.5 9.3

11.3 17.2 6.9 5.8 2.3 53.9 3.7

Note: For development expenditure, the figures in the first column refer to 1976–80 and the figures in the final column refer to 2001–03. Sources: World Bank (2005a: Table 1.1); Deraniyagala et al. (2003: Table 3.9) and MOF (2004).

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163

Throughout this period, the bulk of Nepal’s development expenditure was financed by foreign aid. Indeed, it was the increasing flow of aid that made a rising share of development expenditure possible despite sluggish growth in domestic revenue. From 4.1 per cent of GDP in the late 1970s, the amount of foreign aid increased to 7.6 per cent in the late 1980s. However, the ratio declined in the 1990s, and by the end of the decade it was only marginally higher than what it was in the late 1970s. This pattern in the flow of foreign aid – rising in the 1980s and falling in the 1990s – was mirrored fully in the trends in development expenditure, which also followed exactly the same time path – rising in the 1980s and falling in the next decade. Development expenditure has thus been doubly squeezed in recent years, by the decline in the relative size of foreign aid on the one hand, and by the diversion of resources caused by the escalation in the Maoist insurgency on the other. The urge to push up development expenditure in the face of slow revenue growth caused fiscal imbalances in the 1980s, which had serious repercussions on the overall macroeconomic scenario of the country. Budget deficits mounted, climbing to 6.5 per cent of GDP as compared with the average deficit of 2.2 per cent prevailing in the 1970s (Table 5.5). More importantly, the part of the deficit financed domestically also went up sharply, from 1.1 per cent of GDP in the 1970s to 2.8 per cent in the 1980s. The resulting surge in deficit financing caused inflation and balance of payments difficulties, calling for a set of economic reforms aimed at restoring macroeconomic stability and spurring economic growth. These reforms were largely successful in reducing macroeconomic imbalances, in the sense that budget deficits came down and so did inflation and balance of payments deficits, but their success in spurring economic growth remains a matter of debate.2 Nepal’s reliance on foreign aid as the primary source of financing its rising development expenditure has resulted in sharply rising indebtedness. In the late 1970s, the outstanding amount of foreign debt amounted to just 5 per cent of GDP. One decade later, in the late 1980s, this ratio had jumped to 29 per cent, and another decade later, in the late 1990s, it had jumped further to 52 per cent. Fortunately, most of this debt represents soft loans, which has kept the debt repayment burden within manageable limits. Nonetheless, the debt-servicing ratio (loan repayments as a percentage of export earnings) has risen significantly from 3.5 per cent in 1984/85 to 9.3 per cent in 2003/04. The really disconcerting aspect of the debt burden relates, however, to the pressure on government budget. Combining internal and external debt, the repayment burden currently absorbs over a quarter of total government revenue, up from less than one-fifth in the mid-1980s. Another revealing way of looking at the debt burden is to note that total repayments for internal and external debt amount to more than half of development expenditure. For instance, debt repayments were equivalent to about 56 per cent of development expenditure in 2003/04. The debt problem for Nepal is thus more of a fiscal problem than a balance of payments one, but a very serious problem nonetheless. The main reason why Nepal has had to incur huge debts in order to finance its development expenditure lies in its chronic inability to raise government revenue. There was an upsurge in the growth of revenue in the first half of the 1990s, following the government’s adoption of a number of fiscal reforms, but it did not last long – the growth rate was almost halved in the second half of the decade. By the year 2003/04, barely 11 per cent of GDP was collected as government revenue, against a government expenditure of 17 per cent of GDP.

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Table 5.6 The structure of government revenue: 1980–2004 (percentage share in total revenue) Revenues Tax revenue Direct taxes Indirect taxes Non-tax revenue Total revenue

1980

1985

1990

1995

2000

2004

81.3 13.5 67.8 18.7

80.5 14.3 66.2 19.5

78.2 15.4 62.8 21.8

79.9 15.6 64.3 20.1

77.3 20.9 56.4 22.7

77.3 19.1 58.2 22.7

100.0

100.0

100.0

100.0

100.0

100.0

Sources: Khatiwada and Sharma (2002: Table 2.9) and MOF (2005).

Indirect taxes contribute the bulk of the revenue, as in most other developing countries. Their share of total revenue remained fairly constant at around 65 per cent until the mid1990s, after which it declined to less than 60 per cent (Table 5.6). The composition of indirect taxes has also undergone some changes. During the 1990s, when tariffs were slashed and trade liberalization was pursued with some vigour, the share of customs duties in total revenue declined slightly from 29 per cent to 25 per cent, but at the same time, the share of sales taxes increased from 18 per cent to 24 per cent. Direct taxes currently account for nearly one-fifth of all revenue. This represents an improvement over the preceding two decades, when the share of direct taxes remained virtually stagnant at around 14 per cent. It was only in the second half of the 1990s that there was a decisive upturn in the collection of direct taxes. The structure of public expenditure has also shifted somewhat over the decades. The major changes consist of increasing shares of social services and debt servicing on the one hand and declining share of economic services on the other. The shift of public spending from economic to social sectors is in conformity with the avowed objective of successive budgetary reforms that aimed at allocating more resources towards the social sectors. The rationale for this strategy was that the economic sectors would be taken care of by the private sector following economic liberalization and privatization. Since 1990, when the reform programmes started in earnest, allocation to economic sectors has increased 50 per cent faster than the allocation for economic services. Taking a longer-term perspective, in the 20 years from the second half of the 1970s, the share of social services has gone up from 23 per cent to 30 per cent of all public expenditure. During the same period, the share of economic services has fallen from 51 per cent to 35 per cent (Table 5.7). The decline in the share of economic sectors has arguably been too drastic, resulting in the stagnation in public investment even before the accentuation of the economic and social crisis that occurred at the turn of the present century. Stagnation in public investment in essential economic infrastructure must undermine Nepal’s ability to generate sustained growth. It should be noted, however, that only a part – roughly half – of the decline in the share of economic sectors can be attributed to a deliberate trade-off with social services. The other part is attributable to the rising burden of repayment of past debts. The share of debt servicing in total public expenditure has increased very rapidly from under 5 per cent in the late 1970s to almost 15 per cent in the late 1990s. It is thus arguable that it is primarily the legacy of excessive borrowing in the past that has constrained Nepal’s

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Table 5.7 The structure of government expenditure: 1976–2000 (periodic average share in total expenditure; in percentages) Expenditures Social services Education Health Local government Others Economic services Debt servicing Others Total expenditure

1976–80

1981–85

1986–90

1991–95

1996–2000

22.5 10.6 5.2 3.1 3.6 51.1 4.7 21.7

23.6 10.0 4.4 4.8 4.4 49.9 5.8 20.7

22.3 10.3 4.2 3.0 4.8 47.3 10.4 20.0

24.2 11.9 3.3 2.9 6.1 43.3 13.9 18.6

29.9 13.7 4.8 6.8 4.6 35.3 14.5 20.3

100.0

100.0

100.0

100.0

100.0

Source: Khatiwada and Sharma (2002: Table 2.11).

ability to sustain acceptable levels of expenditure on economic sectors, while raising the share of social sectors, which underlies the point made earlier that debt burden has emerged as a matter of serious fiscal concern in Nepal. A positive aspect of the budgetary allocation of Nepal has been the importance the government has attached to priority areas in social spending. Judged against the benchmark of the ‘20/20 compact’, which envisages 20 per cent of government expenditure to be allocated in social priority sectors, to be topped up with an equal share from the donors’ funds, it would appear that the trend of budgetary allocation is in the right direction. Out of the government’s own resources, allocation to social priority sectors increased from 8.3 per cent of the total budgetary expenditure in 1976 to 17 per cent in 2001. The donors’ share also went up from 7.5 per cent in 1993 to 15 per cent in 2001. However, other aspects of budgetary allocation have fallen well short of the prescribed international norms. For example, in the early years of the current decade, the share of total budgetary expenditure in GNP remained at around 20 per cent, against the prescribed norm of 25 per cent. Similarly, the social sector allocation ratio stood at 31 per cent, against the required ratio of 40 per cent. Even the priority sector allocation ratio, which remained at satisfactory levels till the late 1990s, went down in subsequent years. This has resulted in a reduction in the level of human development expenditure, amounting to just 15 per cent of public expenditure and 3 per cent of GNP in 2000, compared with the prescribed norms of 20 per cent and 5 per cent, respectively. During the past decade and a half, the government of Nepal has made conscious attempts to impart a pro-poor stance to public expenditure, with mixed success. It has been estimated that about one-third of total public spending goes into pro-poor programmes. Further, one-third of spending goes into social services and more than half of it has been allocated to the social priority sectors. At the same time, fiscal decentralization has been pursued as an active instrument of promoting pro-poor spending. It has been observed that about 50 per cent of the expenditure undertaken by Village Development Councils (VDCs) was spent on social priority areas in the late 1990s. However, the poor quality of services rendered by much of these local-level expenditures has remained a matter of abiding concern.3

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Money and inflation The conduct of monetary policy is severely restricted in Nepal because of its exchange rate regime. In order to facilitate free and expanding trade with India, Nepal has maintained a policy of fixed peg and free convertibility between its own rupee and the Indian rupee. But this has had the consequence of severely circumscribing the monetary autonomy of Nepal. In particular, Nepal is obliged to align its interest rates closely to those of India, so as to avoid any destabilizing capital flight between the two countries. Since the mid-1970s, Nepal had been pursuing a policy of maintaining its deposit rates slightly above those of India in order to ensure that savings do not flow out of the country. However, following financial liberalization, a mismatch between the interest rate structures of Nepal and India began to emerge in the early 1990s, when interest rates tended to rise in India and yet tended to fall in Nepal due to excess liquidity in the banking system caused mainly by higher volumes of capital inflow. As a result, the Nepalese interest rates remained lower than in India. As this differential in interest rates posed a threat of capital flight towards India, the Nepalese banks began to revise the deposit rates upwards since the mid-1990s, so as to converge them with the Indian ones. As a consequence of these adjustments, the deposit rate structure in Nepal is now on the whole back in line with that of India. Nepal’s inflationary experience has been similar to that of the rest of South Asia – a moderate rate of inflation marked by periodic fluctuations. The average rate of inflation during the last three decades and a half was about 9 per cent. In the 1960s, the inflation rate was actually quite low – averaging about 5 per cent. The oil crisis of the early 1970s gave a temporary push to inflationary pressures in Nepal, as the rate of inflation entered double-digit figures for the first time, but by the end of the decade it had fallen back to the 5 per cent mark. After 1980, Nepal entered what might be described as a phase of relatively high inflation, when for nearly a decade and a half, the rate of inflation remained above 10 per cent (Table 5.5). This phase of high inflation was ushered in by high fiscal deficits incurred in the first half of the 1980s. Deficit financing had both direct and indirect effects on inflation. The direct effect was felt through the emergence of excess demand that was caused by budget deficits. The indirect effect operated through the balance of payments. The excess-demand-induced inflationary pressures led to balance of payments deficits, prompting a 15 per cent devaluation in the mid-1980s, which in turn stoked up further inflationary pressure in the second half of the decade. Inflation continued to remain high in the first half of the 1990s, thanks partly to a 21 per cent devaluation that was made necessary by a similar devaluation by India, with which Nepal has close economic ties. It was only after the mid-1990s that the inflation rate began to climb down. Especially since 1999, there has been significant progress in the price situation. The average inflation in the four years since 2000 stood at 3.7 per cent, compared with the average of 9.3 per cent in the second half of the 1990s. The recent slowdown in inflation is attributed partly to low import prices and partly to the economic slowdown in the country. Nepal has a long and open border with India, allowing free flow of goods and services across the border based on free convertibility of the two currencies. Cross-border flows of daily consumption goods help to equalize cross-border prices. As a result, low food prices that have recently prevailed in India have resulted in depressed food prices in Nepal as well. This, together with depressed domestic demand for non-food items owing to economic slowdown, has resulted in low inflation since 2000.

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167

Trend and structure of the external sector When Nepal first embarked on the path of modern economic development in the 1950s, India was almost its sole trading partner, accounting for more than 95 per cent of all its trade. Over time, the trade regime of Nepal has experienced considerable diversification, although India still remains its most important trading partner. The regime of fixed exchange rate and free convertibility with the Indian rupee, coupled with a large and porous border between India and Nepal, have helped maintain India’s large share in Nepal’s foreign trade. Yet in the 20 years between the mid-1970s and mid-1990s, there was a gradual decline in India’s importance as a trading partner, as its share had fallen to just 15 per cent of Nepal’s exports and 33 per cent of its imports. However, this trend was reversed after the mid-1990s, when the new Trade Treaty signed between the two countries in 1996 gave fresh impetus to Indo-Nepalese trade by further liberalizing trade with each other. The most recent Indo-Nepal Treaty, renewed in 2002, has, however, introduced several new restrictions in the form of tighter rules of origin requirement and documentation, and also in the form of trade-related quotas to be triggered by export volume. Nevertheless, India currently accounts for about half of Nepal’s export and imports. Moreover, it is not just on account of merchandise trade that India looms large in Nepal’s international transactions. More than one-third of its foreign direct investment (FDI) comes in the form of joint ventures with India, and more than 70 per cent of Nepal’s labour force abroad works in India, which means that remittance income, which has come to play such a prominent role in the Nepalese economy, also originates mostly from India. Along with diversification in trading partners, Nepal has also experienced significant increases in the volume of its foreign trade. Trade ratio, measured as the sum of exports and imports as a percentage of GDP, has increased from 19 per cent in the second half of the 1970s to almost 40 per cent during 2001–04, making Nepal one of the most open economies of South Asia (Table 5.8). Both exports and imports have grown rapidly, although the latter has grown much faster. The export-to-GDP ratio has almost doubled, rising from 6 per cent in the second half of the 1970s to about 12 per cent in 2001–04, while the imports-to-GDP ratio has increased from 13 per cent to 27 per cent during the same period. Trade deficit, meanwhile, increased sharply from 7 per cent in the second half of the 1970s to 21 per cent in the second half of the 1990s, before falling off slightly to 15 per cent in the next four years. Fortunately, however, despite the widening trade deficit, the Table 5.8 Trends of exports and imports: 1976–2004 (periodic average; in percentage of GDP)

Total trade Export Import Trade balance Current account balance Sources:

1976–80

1981–85

1986–90

1991–95

1996–2000

2001–04

18.9 6.0 12.9
6.9
0.2

21.9 4.9 17.0
12.1
3.0

23.7 5.3 18.4
13.1
6.2

33.6 9.0 24.6
15.7
6.2

40.7 10.1 30.6
20.5
4.5

38.7 11.7 27.0
15.2
2.6

Khatiwada and Sharma (2002: Table 2.5); Asian Development Bank, Key Indicators 2005.

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current account has improved since 1990, because of growing contributions from service and transfer income, especially from workers’ remittances. The overall balance of payments has also remained in surplus most of the time, resulting in a comfortable cushion of foreign exchange reserves. The structure of Nepal’s exports has undergone significant transformation over the decades. The most remarkable feature is the growing importance of manufactured exports. Between 1980 and 2001, the share of primary goods exports declined from nearly 70 per cent to 17 per cent, whereas the share of manufactured exports increased from 30 per cent to 75 per cent during the same period. Yet, it has to be recognized that Nepal’s export sector is marked by serious structural weaknesses. The main problem is that the export sector is very narrowly concentrated on a few products – garments, carpets and pashmina wool – which accounted for around 50 per cent of all export earnings in 2001. Nepalese exports are also characterized by a very high level of market concentration, making the country especially vulnerable to external shocks. Poverty and human development Poverty and inequality Nepal is one of the poorest countries in the world, but there is evidence that poverty has been declining since the 1990s. The trend prevailing over the longer term is difficult to judge because of the absence of comparable data. Poverty estimates have actually been made by using data from household income and expenditure surveys carried out in 1976/77, 1984/85, 1991 (rural areas only), 1995/96 and 2003/04. However, it is difficult to discern any long-term trends from these estimates, as the only comparable estimates are the ones derived from the last two surveys. Given the non-comparability of data, it is best to study the evolution of poverty in Nepal in parts, first for the pre-1995 period and then for the post-1995 period. For the pre-1995 period, the World Bank (1999) made an attempt to derive comparable estimates of poverty over time by applying the same definitions of poverty line, income and consumption across the surveys. Since the definitions employed in the Nepal Living Standards Survey of 1995/96 are in many ways superior to the ones used earlier, it would have been ideal to apply these definitions to the earlier data sets, but this was not possible due to the non-availability of raw data of the earlier surveys. The researchers therefore had to adopt the less satisfactory approach of applying the definitions employed in earlier surveys to the data for 1995/96. At least this procedure had the merit of yielding estimates for different points in time that were comparable to each other. Table 5.9 presents two sets of such estimates. The first set takes the existing poverty estimates for 1976/77, and uses the definitions employed in the 1976/77 survey to derive comparable poverty estimates for 1995/96. The second set takes the existing poverty estimates for 1984/85 and uses the definitions employed in 1984/85 survey to derive comparable poverty estimates for 1995/96. The first set thus enables us to compare 1976/77 with 1995/96, and the second set to compare 1984/85 with 1995/96. The most striking result to emerge from these estimates is that the incidence of poverty clearly increased in Nepal between 1976/77 and 1995/96, from 33 per cent to 42 per cent. Although the exact figures are not entirely reliable because of the questionable definitions used, one can have a greater degree of confidence in the direction of change as revealed

Nepal Table 5.9

169

Evolution of poverty in Nepal: 1976/77–1995/96 (in percentages) Comparison of Headcount Ratios

Area of Poverty Rural Urban Nepal

Comparison of Headcount Ratios

1976/77

1995/96

1984/85

1995/96

33.0 22.0 33.0

44.0 20.0 42.0

43.1 19.2 41.4

46.6 17.8 44.6

Source: World Bank (1999).

by them. The extent to which poverty worsened also appears to be substantial, far beyond any plausible margin of error arising from sampling and non-sampling sources. The second noteworthy feature is that the worsening of poverty was entirely a rural phenomenon. Urban poverty appears to have declined, albeit marginally. The third point of note is that the worsening of rural poverty appears to have occurred mainly in the decade preceding 1984/85. This is indicated by the fact that between 1984/85 and 1995/96 there was only a small increase in rural poverty. Furthermore, whatever small improvement in urban poverty is observed since 1977 appears to have occurred mostly after 1984/85. Thus, on the whole, the Nepalese economy appears to have performed better on the poverty front in the decade following 1984/85 compared with the preceding decade. Comparison between 1991 and 1995/96 lends further support to the thesis that performance on the poverty front was better in the second half of the period. By applying consistent definitions to the data obtained from the 1991 Rural Credit Survey and the 1995/96 Living Standard Survey, the World Bank (1999) has found that rural poverty at best fell slightly, and at worst did not rise at all in the first half of the 1990s. Further analysis of data showed that it was mainly the rural areas surrounding the Kathmandu Valley and the rural Terai (southern plains) region that experienced improvement in the 1990s; the rest of rural Nepal actually became worse off. The overall pattern that emerges from the evidence presented above can be summed up as follows. Until the mid-1990s, the growth process of the Nepalese economy mostly bypassed the rural poor. Some improvement did occur in the urban sector however, and the pull of the growing urban economy may also have had a positive spillover effect on some of the neighbouring rural areas, but the rest of rural Nepal experienced increasing poverty in the decade between mid-1970s and mid-1980s, and at best unchanged poverty in the following decade. These findings are broadly consistent with the overall growth pattern of the Nepalese economy. In the decades following the mid-1970s, agricultural growth barely exceeded the population growth rate of 2.6 per cent. It is therefore hardly surprising that rural poverty intensified during this period. By contrast, the urban-based non-agricultural sector grew fairly respectably, at least after the mid-1980s; as a result, urban poverty came down to some extent. It is plausible to argue that urban poverty would have declined much more substantially but for rural-to-urban migration. However, the same migration phenomenon, coupled with other trickle-down mechanisms, has also meant that rural areas in the vicinity of the growing urban centres (mainly in the Kathmandu Valley) were able to gain

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from the growth process. But the trickle-down effect of urban-biased growth was obviously much too feeble to make any appreciable dent in rural poverty further afield. The picture for the post-1995 period is based on much firmer ground, as data from the comparable Living Standard Surveys of 1995/96 and 2003/04 can be used to derive consistent estimates of poverty. Estimates derived by applying the same methodology on data from these two surveys show that poverty has declined appreciably between 1995/96 and 2003/04, with the headcount ratio going down from 42 per cent to 31 per cent (Table 5.10). The decline was especially sharp in urban areas, where poverty was more than halved within the space of just eight years, as the headcount ratio went down from 22 per cent to 10 per cent. In rural areas, poverty declined less dramatically – from 43 per cent to 35 per cent, but the extent of decline was still appreciable, especially when viewed against the evidence on rising rural poverty in the two decades between mid-1970s and mid-1990s. One apparent problem with these estimates is that the magnitude of poverty reduction appears to be far too dramatic in the light of what one would expect from the national accounts statistics. The reason is that household surveys, on the basis of which poverty estimates are made, indicate a much bigger improvement in private consumption than what is indicated by national accounts statistics. Thus, the estimates yielded by the national accounts statistics show a 12 per cent increase in real per capita private consumption over the period from 1995/96 to 2003/04, whereas the household survey data show a 42 per cent increase over the same period. Judged by the national accounts data, therefore, the extent of poverty reduction would appear to be grossly overstated. There are, however, good reasons to believe that the actual rate of improvement in private consumption would be higher than what the national accounts reveal, although whether it would be as high as survey-based estimates is a moot point. In the first place, the GDP growth rate in Nepal is believed to be underestimated, especially in such industries as trade, construction, livestock and dairy products. More importantly, national income estimates do not fully capture the growth in remittances sent by Nepalese workers working abroad. Remittances have assumed an important position in the Nepalese economy, amounting to as much as 12 per cent of GDP in 2002/03, and have undoubtedly played a major role in reducing poverty in Nepal. The growth in remittances picked up in the late 1990s, and household surveys are likely to capture this growth far better than national income data. The rapidity at which poverty has declined is therefore not as implausible as it may otherwise appear. Besides, estimates of subjective poverty, derived from perception data gathered by the same household surveys, reveal an almost identical Table 5.10

Poverty and inequality in Nepal: 1995/96–2003/04 Headcount Ratio (%)

Area of Poverty Nepal Urban Rural

Poverty Gap (%)

Inequality (Gini)

1995/96

2003/04

1995/96

2003/04

1995/96

2003/04

41.8 21.6 43.3

30.9 9.6 34.6

11.8 6.5 12.1

7.6 2.2 8.5

0.34 0.43 0.31

0.41 0.44 0.35

Source: MOF (2005: Table 7a); World Bank (2005b).

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magnitude of reduction. Objective estimates of rural wages also confirm all-round improvement in the conditions of the poor.4 Thus, all in all, while the precision of poverty estimates may well be questioned, there is little reason to doubt that Nepal has experienced a substantial decline in poverty over the last decade. The decline in poverty has been remarkably broad-based, although far from uniform, across occupational, regional and ethnic divides. People across the whole spectrum of occupations experienced reduced poverty after 1995/96 – the self-employed as well as wage earners, and agriculturists as well as those engaged in manufacturing and service. The only exception were the landless agricultural labourers, constituting about 10 per cent of the labour force in Nepal, whose poverty remained essentially unchanged (World Bank, 2005b: Table 4.1). Poverty has declined in each of the five so-called ‘development regions’ of the country (Table 5.11). At the same time, regional disparity in the incidence of poverty has also narrowed, as the fastest reduction in poverty was observed in the region with the highest incidence of poverty in 1995/96 (Far Western Region), and the slowest reduction was observed in the region with the lowest incidence in 1995/96 (Central Region). The same pattern holds for the three ecological belts of the country – namely, Terai (southern plains), Hills and Mountains. It used to be said that regional poverty in Nepal varied directly with height – lowest in the plains, slightly higher in the Hills and the highest in the Mountains. Apparently, while this conventional wisdom was valid at least until 1995/96, it was no longer so by 2003/04. At 57 per cent, the incidence of poverty was by far the highest in the Mountains in 1995/96, compared with just over 40 per cent in Terai and the Hills. However, the next eight years saw the fastest reduction of poverty in the Mountains, so much so that by 2003/04, the extent of poverty was slightly lower in this belt (33 per cent) than in the Hills (35 per cent) and not much higher than in Terai (28 per cent). Table 5.11

Regional pattern of poverty: 1995/96–2003/04 (in percentages) Headcount Ratio

Region Development region Eastern Central Western Mid-western Far Western Total Ecological belt Mountain Hill Terai Total

Distribution of Poor

Distribution of People

1995/96

2003/04

1995/96

2003/04

1995/96

2003/04

38.9 32.5 38.6 59.9 63.9 41.8

29.3 27.1 27.1 44.8 41.0 30.8

21.0 26.9 18.7 18.5 14.8 100.0

23.4 32.2 16.7 17.7 9.9 100.0

22.5 34.6 20.3 12.9 9.7 100.0

24.7 36.6 18.9 12.2 7.5 100.0

57.0 40.7 40.3 41.8

32.6 34.5 27.6 31.8

10.7 41.9 47.4 100.0

7.5 47.1 45.4 100.0

7.9 43.0 49.2 100.0

7.1 42.1 50.8 100.0

Note: Components may not add up to 100 because of rounding. Source: MOF (2005: Table 7b).

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It should be noted, however, that a somewhat different classification of regions shows that there are parts of the country that did not share in the overall reduction of poverty. People in the rural Eastern Hills actually had the opposite experience, as poverty increased in this part of the country from 36 per cent in 1995/96 to 43 per cent in 2003/04. This exception from the general pattern may owe itself at least in part to the regional distribution of remittances. It is significant that this is the only region in Nepal that experienced a decline in the flow of remittances, while all other regions experienced an increase in varying degrees.5 Among the ethnic groups, Dalits (the untouchables) had all along been the poorest, followed by the indigenous people (Janajati). Both these groups experienced declining poverty between 1995/96 and 2003/04 (Table 5.12), but the rate of decline was far slower for them compared with the upper caste people (Brahmins, Chhetri and Yadavs), who already had the lowest incidence of poverty. As a result, the relative disparity among ethnic groups widened even further, even though all groups enjoyed improvement in absolute terms. The ever-widening ethnic divide remains an abiding problem for Nepalese society. The overall trend of poverty in Nepal may thus be summarized as follows. After rising for two decades between the mid-1970s and mid-1990s, poverty declined in Nepal after 1995/96. This reversal of trend occurred primarily on account of the changing fortune of rural Nepal. Urban poverty has consistently declined in Nepal, at least since the mid1980s, but rural poverty increased sharply between the mid-1970s and mid-1990s, especially in the first half of the period. After 1995, however, rural poverty also declined, along with urban poverty, making poverty reduction a countrywide phenomenon for the first time in Nepal’s history. The reduction of poverty that occurred between 1995/96 and 2003/04 was reasonably broad-based, benefiting all regions as well as most occupation and ethnic groups. In fact, the most poverty-stricken regions saw their poverty go down the fastest, resulting in a process of convergence among the regions in terms of the incidence of poverty. There were some disconcerting features, though. Among the regions, the rural Eastern Hills Table 5.12

Ethnic and caste distribution of poverty: 1995/96–2003/04 (in percentages) Headcount Ratio

Distribution of Poor

Distribution of People 1995/96

Ethnic Group

1995/96

2003/04

1995/96

Upper castes Yadavs Newar Dalits Hill Janajati Terai Janajati Muslims Others

34.1 28.7 57.8 19.3 48.7 53.4 43.7 46.1

18.4 21.3 45.5 14.0 44.0 35.4 41.3 31.3

26.7 2.9 10.6 2.5 19.7 10.4 5.7 21.4

15.7 1.9 10.9 3.4 27.8 9.2 8.7 22.3

32.7 4.2 7.7 5.5 16.9 8.2 5.4 19.4

26.3 2.8 7.4 7.5 19.5 8.1 6.5 21.9

Total

41.8

30.8

100.0

100.0

100.0

100.0

Source: World Bank (2005b: Table 4.5).

2003/04

2003/04

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experienced an increase in poverty in contrast with the general pattern; among the occupational groups, landless agricultural workers barely gained from the process of poverty reduction, and among the ethnic groups, those from the lower castes gained much less compared with those among the upper castes. In exploring the reasons behind the decline of poverty in Nepal after 1995, it is instructive to consider rural poverty in particular, as it was rural Nepal that saw quite a remarkable reversal of trend after 1995. Useful insights can be gained by looking at the sources of the growth of rural income, especially the income of the rural poor. Table 5.13 presents the relevant evidence, breaking up the income of the bottom 40 per cent of the rural population into its various sources. The most striking finding is that almost the entire increase in income that the rural poor enjoyed between 1995/96 and 2003/04 came from two sources, both of which reside outside agriculture, from which the majority of the rural poor draw their sustenance. Non-agricultural wage income contributed 51 per cent of the incremental income of the rural poor and remittances contributed 47 per cent. By contrast, agriculture actually made a negative contribution. It would thus appear that the decline in rural poverty after 1995 had little to do with what was happening in rural Nepal itself. What helped the rural poor most was the spillover effect of rapid growth of the non-agricultural sector in the 1990s. As noted earlier, a similar spillover effect also operated in the first half of the 1990s, but it was confined mostly in the vicinity of the Kathmandu Valley. The difference after 1995 was that growth of non-agricultural activities became much more widespread, thereby enabling the rural poor in most parts of the country to engage in wage labour outside agriculture. An almost equally important factor was the remittance bonanza. The Living Standard Surveys show that in the country as a whole, the proportion of households receiving remittances increased from 23 per cent in 1995/96 to 32 per cent in 2003/04, and, more significantly, per capita remittance increased by more than 150 per cent in real terms during this period. Moreover, semi-urban and rural areas shared in this bonanza no less than urban Nepal. In fact, for the Kathmandu region, the direct benefit of remittances was less than the national average – the rest of Nepal gained relatively more. It was thus the combined effect of remittances and increased employment opportunities opened up by the Table 5.13 Sources of real income growth of the bottom 40% of the population: 1995/96–2003/04

Farm income Agricultural wage income Non-agricultural wage income Income from non-agr. enterprises Remittance income Other income Total income Sources:

1995/96 (1)

2003/04 (2)

Absolute Change (3)  (2)
(1)

Contribution to Growth (%) (4)

1976 808 588 294 237 333 4236

1923 774 895 361 521 369 4843


53
34 307 67 284 36 607


8.7
5.6 50.6 11.0 46.8 5.9 100.0

Computed from World Bank (2005b: Table 7.3).

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non-agricultural economy that explains the success in reducing poverty across rural regions in Nepal after 1995. While poverty has declined, the distribution of income and expenditure has become significantly more unequal in Nepal since 1995. The Gini coefficient of consumption expenditure has increased sharply from 0.34 in 1995/96 to 0.41 in 2003/04 (Table 5.10). Looking separately at urban and rural areas, it is interesting to note that the urban Gini coefficient has remained practically constant at around 0.43, while the rural Gini has increased from 0.31 to 0.35. The fact that the overall Gini coefficient has increased so much more than the urban and rural coefficients taken separately, suggests that the growing disparity between urban and rural areas has acted as the major unequalizing force in Nepal. Two related forces have been working here. First, urban income, which was already much higher than rural income, has grown much faster than rural income. Thus, during the period between 1995/96 and 2003/04, urban per capita expenditure has grown at an annual rate of 4.5 per cent, against 3 per cent in rural areas, thereby exacerbating the urban–rural disparity. Second, the urban population has also been growing much faster than the rural population. In the eight years after 1995, the share of urban areas in total population more than doubled, from 7 per cent to 15 per cent. Since the urban areas have a much higher degree of inequality than rural areas, this process of urbanization has accentuated overall inequality in the classical Kuznetzian fashion. Growing inequality within rural Nepal has also contributed to rising overall inequality in Nepal. There are several reasons behind this phenomenon. First, growing inequality within rural Nepal is closely linked to deep-rooted ethnic disparities. It was noted earlier that while poverty has declined for all ethnic groups between 1995/96 and 2003/04, it has declined much more slowly for the lower castes compared with the rest of the society. Since the lower castes already comprise the poorest segment of society, such an unequal pace of poverty reduction has made the existing inequalities even sharper. Second, growing inequality of land ownership has made matters worse. The Living Standards Surveys show that the proportion of households with less than one hectare of land has gone up during the period from 1995/96 and 2003/04 (World Bank 2005b: Table 4.1). Since these households have a much higher level of poverty compared with larger landowners, this shift of population towards the lower end of land distribution must have exerted an unequalizing force on the distribution of income. Finally, unequal distribution of remittance income has also played a part. Survey data reveal that while households from all income groups have enjoyed growing remittance income during 1995/96 and 2003/04, the richer households have enjoyed a faster growth of remittance income than the poorer ones. For example, per capita remittance income increased by 150 per cent for the richest quintile of households, against 120 per cent for the poorest quintile. Health, education and human development Nepal has made significant strides over the past decades in improving the health status of its people. Between 1970 and 2001, average life expectancy has increased from 45 years to 60 years, infant mortality has declined from 160 per 1000 to 64, and the proportion of underweight children has gone down from 69 per cent to 48 per cent (Table 5.14). The progress has been steady rather than spectacular, and all the indicators have improved in

Nepal Table 5.14

Trends in health indicators: 1970–2001

Indicators Life expectancy at birth (years) Infant mortality rate (per ’000) Under-five mortality rate (per ’000) Underweight children (%) Note:

175

1970–75

1980–85

1990

2001

45 160 234 69

51 115 180 n.a.

54 99 143 n.a.

60 64 91 48

The underweight figure for 1970–75 refers to 1975.

Sources: NPC (2002: Table 1.6); UN (2002); UNDP (2001); National Nutrition Survey 1975; National Family and Health Survey of Nepal 1996; Nepal Demographic and Health Survey 2001.

Table 5.15

Trends in education indicators: 1980–2003 (%)

Indicators Net primary enrolment rate Completion of primary cycle Gross secondary enrolment rate Youth literacy rate Adult literacy rate Note:

1980–85

1990

2003

60 n.a. 27 n.a. 22

n.a. 52 n.a. 47 30

84 62 32 62 48

Completion of primary cycle and gross secondary enrolment rate for 2003 refer to 2001.

Sources:

NPC (2002: Table 1.6); NPC (2005).

each decade, signifying the robustness of the underlying processes that has led to the improvement. Despite continuous improvements, the absolute levels of most of these indicators remain lower than the South Asian average, mainly because Nepal started from a very low base of health status. What is remarkable, however, is the fact that the rate of progress achieved in the 1990s outpaced the average improvement in South Asia. Nepal, along with Bangladesh, has been a star performer in the region, outpacing the progress made by bigger and richer countries such as India and Pakistan by a comfortable margin. Progress has also been made on the education front, even though the rate of improvement has not been quite as impressive as in the case of health. Net enrolment at the primary level has increased from 60 per cent in the early 1980s to 84 per cent in 2003, and the adult literacy rate has gone up from 22 per cent to 48 per cent during the same period (Table 5.15). Progress, however, has been much slower at the secondary level, where the gross enrolment ratio has crawled from 27 per cent in the early 1980s to just 32 per cent in 2001. The overall improvements made on the fronts of health and education mask, however, sharp disparities within Nepal. Such disparities run along ethnic, regional and gender divides. For all available indicators of health and education, the lower castes, comprising of the Janajatis and Dalits, score much poorer than the upper castes such as Brahmin and Chhetri (Table 5.16). For instance, in the mid-1990s, people from the lower castes had an

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Table 5.16

Health and educational outcomes by caste and ethnicity: mid-1990s

Ethnic Group Brahmin Chhetri Newar Janajati Dalit All Nepal

Life Expectancy

Adult Literacy

Mean Schooling

HDI

60.8 56.3 62.2 53.0 50.3 55.0

58.0 42.0 54.8 36.2 23.6 36.7

4.7 2.8 4.4 2.0 1.2 2.3

0.44 0.35 0.46 0.30 0.24 0.33

Source: World Bank (2005a: Table 1.8).

Table 5.17

Gender disparity in health and educational outcomes: 1996–2000 1996

Infant mortality rate Under-five mortality Life expectancy (yrs) Adult literacy (%) Mean schooling (yrs)

2000

Male

Female

M/F ratio

Male

Female

M/F ratio

102 143 55 54 2.6

84 136 52 21 1.1

1.2 1.1 1.1 2.6 2.3

79 105 60 66 4.5

75 112 60 35 2.3

1.1 0.9 1.0 1.9 2.0

Source: NPC (2002).

average life expectancy of 50 to 53 years, against an average of over 60 years enjoyed by the Brahmins. Similarly, mean years of schooling attained by the lower castes were less than two years, compared with close to five years attained by the upper castes. These disparities along ethnic divides are also reflected in disparities across ecological regions. Thus, in the Mountains, where most of the Janajatis and Dalits live, average life expectancy was only 50 years in 2000, compared with an average of 60 years for Nepal as a whole. Similarly, during the 1990s, the average rate of infant mortality was 112 in the Mountains, compared with 77 in the whole of Nepal (UNDP, 2001: Table 4.7 and Annex 1). Among the development regions, the Far Western and Mid-western Regions clearly lag behind a long way from the rest of the country in terms of health and educational outcomes, as well as per capita income and overall human development. It is no coincidence that these are also the regions where the Maoist insurgency has struck the deepest roots. As in most other countries of South Asia, Nepal suffers acutely from gender discrimination. There is some evidence that gender disparities may have been closing over time in several dimensions, but large disparities still persist, especially in education (Table 5.17). The policy regime This section reviews the policy regime that has guided the development process in Nepal. Considering the relative importance of different types of policies in the context of Nepal, the discussion here focuses on three aspects of the policy regime: namely, macroeconomic policy reforms, agricultural policy and poverty alleviation programmes and decentralization.

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Macroeconomic reforms and structural adjustments It was noted in the second section that the economy of Nepal experienced a marked acceleration in growth in the first half of the 1980s, but it was based on an unsustainable expansion of aggregate demand generated through expansionary fiscal and monetary policies. Public expenditure accelerated sharply in the 1980s, unmatched by a similar acceleration in public revenue, leading to rising budget deficits. Development expenditure, in particular, went up spectacularly – from 8.7 per cent of GDP in the second half of the 1970s to 12.4 per cent in the first half of the 1980s, but government revenue struggled to rise from 7.7 per cent of GDP to just 8.7 per cent during the same period. As a result, budget deficit more than doubled – from 3.1 per cent to 6.7 per cent of GDP. At the same time, money supply also increased rapidly, with the supply of broad money rising from 16.2 per cent of GDP to 27.2 per cent. The adoption of expansionary fiscal and monetary policies did help bring about an acceleration in economic growth, led by the non-tradeable sectors, especially construction. However, it also made the growth unsustainable by fuelling inflation and adversely affecting the balance of payments. For the first time since planned development started in the 1950s, inflation remained persistently at the double-digit level. From an average of 7.5 per cent in the 1970s, the rate of inflation went up to an average of 10.6 per cent in the 1980s. As the real exchange rate appreciated with rising inflation, the balance of payments situation also deteriorated. Exports plummeted from 6.0 per cent of GDP in the second half of the 1970s to 4.9 per cent in the first half of the 1980s, while imports shot up from 12.9 per cent of GDP to 17 per cent. Consequently, the balance of trade worsened from 6.9 per cent to 12.1 per cent of GDP, while the current account balance deteriorated from a near balance to
3 per cent. The emergence of these macroeconomic imbalances led first to the adoption of a stabilization programme in 1985, followed by a structural adjustment programme in 1987. All the reforms did not, however, take place at the same time in a big bang fashion. Instead, they were spread out over more than a decade, evolving in light of events. Four distinct phases of policy reforms can be identified. The first reform episode (1985–86) focused mainly on standard stabilization measures, but without much success. On the contrary, devaluation made things worse by triggering further inflation. Real exchange rates did depreciate despite rising inflation, which helped raise exports, but imports went up even faster, resulting in a further worsening of the current account in the second half of the 1980s. There wasn’t much joy on the fiscal front either, as budget deficit edged up slightly from 6.7 per cent of GDP in the first half of the 1980s to 7.8 per cent in the second half of the decade. Overall, the macroeconomic situation continued to remain grave. A much more serious attempt at macroeconomic reform came in the second phase, starting in the early 1990s, when a popularly elected democratic government assumed power. During this phase, the tax base was broadened, revenue administration improved, and trade and industrial policies were further liberalized. A programme of steady reduction in tariffs was launched and quantitative restrictions virtually dismantled. The foreign exchange system was unified and current account made convertible. Interest rates were liberalized and banking sector entry was facilitated. The third reform episode started around 1997. Its major components were liberalization of the agricultural sector, introduction of a neutral VAT and strengthening of local

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governments. The fourth episode, which started around 2000, was more in the nature of governance reform than macroeconomic reform. During this phase, the government tried to improve tax policy and administration, introduced a medium-term expenditure framework, restructured the management of Nepal’s two main commercial banks and strengthened financial sector regulations and anti-corruption efforts. The most important component of the second phase of reforms initiated by the new democratic government involved trade policy, aiming simultaneously to accelerate the process of trade liberalization and provide encouragement to exporters through a range of incentives. The average tariff rates were cut from 32 per cent in the early 1990s to 14 per cent in 2000, while the peak basic tariff was reduced from 200 per cent to 110 per cent, and the number of tariff slabs was reduced from more than 100 rates to just 5 by 2001/02. Moreover, quantitative restrictions were almost completely eliminated. As a result of these measures, the effective rate of protection in manufacturing fell from 114 per cent in 1989 to 8.5 per cent in 1996. The level of agricultural tariffs in Nepal is also relatively low, ranging between 5 and 25 per cent. The exchange rate system was completely overhauled in the process of reform. Partial convertibility in the current account was introduced in 1992, followed by full convertibility in 1993. The prevalent dual exchange rate system was abolished and the exchange rate against convertible currencies was allowed to be market-determined. However, the exchange rate against the Indian rupee continued to be officially determined. Exporters were offered incentives of various kinds in order to neutralize the export bias of the previous trade regime. Steps were also taken to attract foreign direct investment, permitting 100 per cent foreign ownership in most sectors. In addition, foreign investors were allowed to own up to 25 per cent of listed companies. A new trade treaty was signed with India in 1996, which eliminated most non-tariff barriers, including the value-added requirement, which required Nepalese or Indian raw material content to be at least 50 per cent as a condition for getting duty-free access in the Indian market. Along with this, Indian investment in Nepal was almost fully liberalized. Taken together, these measures signified a fundamental departure from the earlier regime of trade restrictions. Nepal could now claim to have a higher degree of openness compared with most other developing countries. This was evidenced by the IMF index of trade restrictiveness, in which Nepal scored 2 out of 10, where a lower value signifies a greater degree of openness. Another major component of the second phase of reforms initiated in the early 1990s consisted of privatization and allowing private sector entry into activities hitherto reserved for the public sector. The latter initially included the banking sector, which experienced a surge of private sector participation, especially under joint ventures, and the energy sector where private capital has been encouraged to develop small-scale hydropower projects to meet local needs. In phase three of reform, the private sector was also encouraged to participate more vigorously in agriculture, by taking part in the distribution of inputs, which had hitherto been a preserve of government agencies and by engaging in commercial agriculture. The reform process initiated in the early 1990s did seem to yield some tangible results. For instance, the reforms in trade and exchange rate regime succeeded in generating rapid export growth, with the result that the share of exports in GDP almost doubled from 5 per cent in the 1980s to close to 10 per cent in the 1990s. Imports also went up strongly

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at the same time, and the overall trade–GDP ratio increased from 23 per cent in the 1980s to an impressive 38 per cent in the 1990s. Although trade deficit increased sharply from 13 per cent of GDP in the second half of the 1980s to 21 per cent in the second half of the 1990s, the current account deficit came down from 6.2 per cent of GDP to 4.5 per cent during the same period. Higher export earnings, combined with remittances and tourism earnings, helped improve current account and reserves and allowed steady increase in the import of capital goods at the rate of 10 per cent per annum during the 1990s. Yet another indictor of the positive effects of reforms is the upsurge in private sector investment. After stagnating at around 10 per cent of GDP in the pre-reform decades, the share of private investment surged to about 14 per cent in the 1990s, even as the share of public sector investment stagnated around 7 per cent. Privatization, coupled with many incentives given to the private sector, apparently did spur a healthy growth in private investment, at least until the escalation of insurgency vitiated the business environment at the turn of the present century. The question, however, remains as to how far all these improvements added up to a decisive shift in the trend of long-term growth of Nepal. The Breton Woods institutions have argued that the reform package taken as a whole did mark a break in the long-term trend, putting the economy on a higher growth path. In a recent review of the Nepalese economy, the World Bank, for example, has made this case by comparing the growth rates between what it has called the pre-reform period 1965–85 and the post-reform period 1985–2000. This comparison shows that the post-reform growth rate was clearly higher than the pre-reform one (World Bank, 2005a). The idea behind taking 1985 as the cut-off point was that it was around the mid-1980s that the first phase of reforms began. Nevertheless, this comparison is misleading. In the first place, by lumping the early years of Nepal’s development – that is, the 1960s and the 1970s – into the pre-reform period, this comparison artificially tilts the balance in favour of reforms. Those early years were not just dirigistic, they were also marked by low levels of physical infrastructure and human capital that were a consequence of low level of development itself. As time progressed, higher investment in physical and human capital would have made for higher growth in any case, even without reforms. This was already evident in the first half of the 1980s, part of the pre-reform period, when the growth rate made a quantum leap from the earlier trend.6 Therefore, the inclusion of the pre-1980 primitive economy of Nepal in the pre-reform period is bound to give distorted results by failing to isolate the effects of policies from the effects of initial conditions. Second, taking 1985 as the cut-off point is questionable because the first phase of reforms was patchy, with negligible impact on the economy. The really substantive reforms came with the inception of the second phase in the early 1990s. Their effects, if any, would have been felt in the 1990s, and also beyond, if the escalation of insurgency and other extraneous factors had not spoiled the scene from 2001 onward. Accordingly, it is more logical to identify pre-reform and post-reform periods as the 1980s and the 1990s respectively. At an aggregative level, comparison of these two decades shows no discernible improvement in growth performance, as the average growth rate hovered around the 5 per cent mark in both decades (Table 5.1). The case for or against reform cannot, however, rest on such crude comparisons of

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pre- and post-reform growth rates. A much more nuanced analysis, involving plausible counterfactuals, would be required to resolve the issue. Such an exercise is beyond the scope of this chapter, but some insights can be gained by taking a more disaggregated view of economic performance. It is instructive to note that manufacturing growth improved sharply in the first half of the 1990s, averaging about 14 per cent compared with the 5 per cent rate experienced in the 1980s (Table 5.2). Manufactures also led the impressive upsurge that Nepal experienced in the 1990s. However, the improved performance of manufacturing was neutralized by agriculture’s abysmally poor performance, thus preventing the overall growth rate from rising in the first half of the 1990s. Reforms cannot be blamed for the poor performance of agriculture, though, because deep agricultural reforms did not start until the mid-1990s, and when they did, agricultural performance actually improved in the late 1990s. It is thus arguable that if the economic reforms did have a positive effect in the early stage, it was felt mainly in manufacturing, offset only by a struggling agriculture beset with deep-seated structural problems. Even this mild claim, however, has to be tempered by two other considerations. The first relates to the impact of rapidly rising remittances and the second to the new Trade Treaty signed with India in 1996, both of which must have played a big role in stimulating manufacturing growth, independently of macroeconomic reforms. After isolating these two effects, what remains of the impact of economic reforms on manufacturing is a moot question. What can be said more confidently, though, is that these reforms helped render economic growth more sustainable by basing it on sounder macroeconomic footing. The macroeconomic fundamentals clearly improved in the post-reform period. Budget deficits came down, inflation fell back to single digits from the double-digit levels of the 1980s, and the balance of payments improved. So, even if the rate of economic growth did not improve a great deal following reforms, at least it became more sustainable, unlike the growth of the 1980s generated artificially by unsustainable expansion of demand. An indication of greater sustainability of growth in the post-reform period is provided by the sources of growth before and after reforms. Even though the growth rate of the post-reform period (the 1990s) was not substantially different from that of the pre-reform period (the 1980s), the two decades differed significantly in terms of sources of growth. In particular, the growth of the 1990s was based on a significant improvement in productivity growth. Total factor productivity, which had experienced a negative growth of
0.76 per cent in the 1980s, turned around in the 1990s to experience a positive growth of 0.51 per cent per annum (Khatiwada and Sharma, 2002: Table 4.2). This was no mean achievement, but it’s a tragedy for Nepal that a cluster of internal and extraneous shocks destroyed the basis of sustainable growth at the turn of the present century. Agricultural reforms Agricultural backwardness has been the Achilles’ heel of Nepal’s economy. While most of South Asia was able to raise agricultural production faster than population growth, belying dire predictions to the contrary, in Nepal, agricultural growth barely kept pace with population growth. Over the period from 1965 to 2000, agricultural GDP grew at the rate of just 2.5 per cent, just above the population growth of 2.2 per cent, while overall GDP was growing at the rate of 3.8 per cent per annum.

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The result was a virtual stagnation in per capita agricultural production on the one hand, and a rapid decline in the relative contribution of agriculture to overall GDP on the other. From 1975 to 2000, agriculture’s share in GDP came down from 72 per cent to 40 per cent. The proportion of workforce engaged in agriculture did not decline in the same proportion, however. From over 90 per cent it declined to about 66 per cent or so, indicating a secular decline in labour productivity in agriculture, which has remained a serious impediment to Nepal’s ability to speed up economic growth and reduce poverty over the longer term. The proximate cause of slow productivity growth lies in the low level of input use and continued reliance on primitive technology. For instance, only 40 per cent of farm land was irrigated by 2002, even though two-thirds of the total cultivable area of Nepal is potentially irrigable, and only 17 per cent received year-round irrigation. Part of the problem lies in the rugged and mountainous terrain of Nepal, which makes it difficult to extend irrigation at affordable costs. That is why more than two-thirds of irrigated land lies in the plain terrain of Terai, and only 16 per cent in the Hills. But even in Terai yearround irrigation is limited to only 20 per cent of land, well below the potential. Moreover, the facilities that exist are not maintained well. It has been estimated that governmentmanaged irrigation schemes, which account for the major part of the irrigation system in Nepal, have a cost recovery rate just over 1 per cent (World Bank, 2005a). Schemes managed by participatory water users’ associations have a much better record of cost recovery and maintenance, but that does not fully solve the problem, as government needs to get involved in large-scale schemes. Household-level survey data collected by the Nepal Living Standards Surveys of 2003/04 revealed that only about 5 per cent of farm households used improved varieties of seeds. The same survey also shows that nearly a third of farmers do not use any organic fertilizers, and even those who do, use them well below the optimal levels. The majority of farmers have very little access to credit from the formal financial sector. Only 14 per cent of households had access to credit, and in the bottom quintile only 8 per cent of the households did so. One of the structural problems underlying the agrarian economy of Nepal lies in grossly unequal access to land. More than two-thirds of households have less than one hectare of land and account for only around 30 per cent of all farm area. In contrast, only 1.5 per cent of holdings own plots of more than 5 hectares and account for 14 per cent of cultivated land. Some 16 per cent of rural households are completely landless. The Land Reform Act of 1962 imposed ownership ceilings and tenancy rights. However, the redistributive aim of the Act remained largely unfulfilled as only 1.5 per cent of land was redistributed. As a result, the vast majority of farmers continue to have too little control over land, which adversely affects both their incentive and ability to undertake productivityenhancing measures. Nepal has had a tradition of a dual tenure system that allowed both landlord and tenant to lay claim on the land. This system of divided property rights acted as a serious disincentive to invest in land on the part of both claimants. A 1995 amendment of the Land Act tried to rectify the problem by abolishing dual ownership and physically splitting the land between the landlord and the tenant. But implementation of the law has been almost a total failure. Yet another structural problem consists of the physical remoteness of many farming communities in the Hills and Mountains, unconnected by modern infrastructure, which

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exacerbates the problem of access to inputs and markets. The Nepal Living Standards Survey of 1995/96 found, for example, that chemical and fertilizer inputs tend not be used beyond a distance of five hours from the nearest market. Moreover, more lucrative vegetable production tends to occur within three hours’ distance from an urban market; while subsistence production of cereals and pulses dominates in areas within eight hours’ distance from markets. Generally, beyond eight hours’ travel time, the local economy is selfcontained, with little interaction with markets. All these constraints have contributed to the stifling of agricultural growth in Nepal. The consequence can be seen from the fact that between early 1960s and late 1990s, paddy yields grew only at 0.6 per cent per year, while neighbouring countries achieved growth rates between 1.4 and 2 per cent. In order to overcome the deep-rooted structural problems of Nepal’s agriculture, the government adopted a comprehensive programme of agricultural reforms in the mid1990s as part of the overall economic reforms that were undertaken in that decade. The reform programme was implemented in two stages. The first-stage reforms were packaged under the Agricultural Perspective Plan (APP) launched in 1995 as part of the Ninth Plan. The Plan sought to promote agricultural growth in a regionally balanced manner with the twin objectives of promoting efficiency through specialization according to regional comparative advantage and ensuring that the poor people of all the regions could benefit from the growth process. The essence of this strategy was to pursue two different sets of policies for the two main ecological regions of Nepal – the plains of Terai and the Hills/Mountains. Terai was to be targeted for the production of basic food staples, while the Hills and Mountains were to be targeted for the promotion of livestock and highervalued commercial crops, and the two regions were to grow in a complementary manner by providing demand for each other. In practice, the Perspective Plan was only partially implemented, and it was soon overtaken by the second phase of reforms that were linked to the Second Agricultural Program Loan of the Asian Development Bank signed in 1998. While the new set of reforms continued to support the differentiated growth strategy based on regional comparative advantage, it marked a decisive shift towards market liberalization as opposed to government intervention as the primary instrument of growth. Government monopoly in the import and distribution of essential inputs such as fertilizer and irrigation equipment was abolished, making room for increased participation of the private sector in the distribution chain. At the same time, prices of fertilizer and irrigation equipment were decontrolled at the retail level and subsidies were eliminated, although a small amount of transport subsidy was retained in order to encourage the flow of inputs into remote areas. The impact of these reforms on agricultural performance has remained a matter of some debate, however. In some respects, the performance of the agricultural sector certainly improved in the second half of the 1990s, as agricultural growth accelerated from 1.5 per cent in 1991–95 to 3.6 per cent in 1996–2001 (Table 5.2). This improvement was brought about by increased use of modern inputs,7 higher cropping intensity and diversification to higher-value crops.8 Despite these positive changes, questions have been raised about how far the reforms can claim credit. In the first place, any attempt to evaluate the effects of reforms by comparing performance between the two halves of the 1990s is slightly problematic, as agriculture was unusually depressed in the first half and it could be argued that all that

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happened in the second half was that growth rate returned to the level experienced in the 1980s. Second, any causal analysis of improved performance must take note of the fact that apart from agricultural reforms, there were also other forces operating in the economy that could explain at least part of the improvement. Two of the most important among them were sharply increased flow of remittances and a highly liberal Trade Treaty signed with India in 1996. How important these demand-side forces were, relative to any effect of reforms operating on the supply side, is a moot question. There are indeed question marks over whether even the supply-side incentives improved at all following reforms. For one thing, the inter-sectoral terms of trade actually declined for agriculture in the second half of the decade. There are also indications that privatization of input distribution, combined with removal of subsidies, may have made it harder for small farmers in remote areas to access essential inputs. The effect of all this was clearly felt in lower productivity as well as lower profitability of cultivation. Survey data show that per hectare output of field crops declined by 7 per cent between 1995/96 and 2003/04, while costs per hectare increased by 46 per cent. As a result, net profit per hectare declined by 10 per cent and real profit per worker declined by 16 per cent (World Bank, 2005c). In all these matters, it is of course difficult to disentangle the effects of reforms from that of the conflict that escalated since 2001. But the weight of all the evidence put together warrants at least the mild conclusion that despite the attempted reforms, the structural problems besetting Nepalese agriculture remain stubbornly resistant to change. Poverty alleviation programmes and decentralization9 As in other countries in the region, Nepal has pursued a whole range of targeted interventions for the benefit of specific groups of poor and marginalized people. These programmes can be classified into three categories – those targeted at specific areas, those targeted at specific population groups and those that chose a specific entry point (e.g., credit) in order to reach the intended beneficiaries. Despite some overlap among these categories, this classification provides a convenient framework for discussing the multitude of targeted interventions pursued in Nepal. Area-based programmes have been implemented over those districts that have been identified as being relatively more backward, remote, isolated and endowed with a lower level of socioeconomic infrastructure. One of the major programmes of this kind is the Remote Area Development Programme (RADP) initiated in 1992. By the late 1990s, this programme covered 22 districts, with major emphasis on the development of infrastructure. There were also provisions for skill development, training of women and training in horticulture and vegetable farming. This programme was supposed to complement the process of decentralization that the government of Nepal attempted to reinvigorate at the same time. As such, resources set aside for this programme were allocated and disbursed to respective Village Development Committees (VDCs) from the centre. There was, however, little or no participation of people at the grassroots level. The Special Area Development Programme (SADP) was introduced in 1998 as a political response to people’s display of disenchantment and frustration with unabated economic hardship, which in some districts took the form of violent eruptions. A total of 25 districts were selected, of which 22 were already included in the RADP, by applying the criteria of backwardness, remoteness, low levels of socioeconomic infrastructure and/or

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ongoing Maoist activities. The focus of the programme was broader than that of RADP, as it sought to promote agriculture and livestock in addition to infrastructure. The target-group-oriented programmes have been launched primarily for indigenous people (Janajati), the untouchables (Dalits), the so-called Socially and Economically Disadvantaged Groups (SEDGs) and women and children. For the first two groups, specific actions have included reserving a fraction of the government’s grants to VDCs, combined with social mobilization with the help of NGOs. The SEDGs include bonded labour (Kamaiyas), migrant households (Sukumbasis), marginal farmers and landless peasants, disabled people, senior citizens and certain backward ethnic groups who do not fall under the Janajati list. The programmes for this group include the Kamaiya Debt Relief Programme and Kamaiya Skill Training Programme for bonded labourers, land resettlement schemes for Sukumbasis and landless/marginal peasants and various safety net programmes for the senior citizens, widows and disabled people. Most of these programmes are, however, very small in size and very little is known about their impact. Specific policies and programmes for women were introduced for the first time in Nepal during the Sixth Plan (1980–85) in the form of a National Plan of Action for Women in 1981. From a long-term perspective, the most important action undertaken so far is the granting of scholarships to girl students. Other programmes have aimed at economic upliftment of women. These include credit provided by five regional banks, GrameenBank-type replications as well as Community Development Programmes run by NGOs, and several programmes run by the Ministry of Local Development – Women Farmers Programme, Production Credit for Rural Women (PCRW) and Micro Credit Project for Women (MCPW). The most important of these programmes overlap with entry-pointbased interventions and are discussed more fully below. The entry-point-based programmes have used three major entry points – credit, institution and infrastructure. Credit-based programmes have a long history in Nepal dating back to the introduction of the Small Farmers Development Programme (SFDP) in 1975. Credit was given to small farmers (defined as those who owned less than 1 hectare of land in the hills and 2.67 hectares in the Terai) through group organizations and in the form of collateral-free loans for productive activities. The SFDP is discussed in more detail below in connection with institution-based programmes, as the overall thrust of a subsequently revitalized SFDP was to build local institutional capacity for the purpose of creating selfsustaining credit-providing entities at the local level. Programmes that were modelled after the SFDP, but were specifically targeted to women, include Production Credit for Rural Women (PCRW) and Micro Credit Project for Women (MCPW). PCRW was initiated in 1982 with the objective of increasing the income of poor rural women through provision of credit and other services. By the late 1990s, it was being implemented in 67 districts. The impact of PCRW on rural women has been fairly positive in terms of their empowerment and enhancement of their self-reliance and awareness. MCPW was started in 1994 with a similar objective as the PCRW with two major differences. First, its target group included urban as well as rural women from households below the poverty line, and second, it aimed to provide credit as well as other services by using NGOs as intermediaries. A total of 88 NGOs were mobilized and trained as of October 1998 for this purpose. The programme is characterized by a very high loan

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recovery rate – as high as 98 per cent, according to an internal progress report prepared by the Ministry of Local Government. Other credit-based initiatives include replications of the Grameen Bank model of Bangladesh initiated by Nepal Rastra Bank through the establishment of five Regional Rural Development Banks (RRDBs), the Banking with the Poor Programme introduced in 1992 by the Rastriya Banijya Bank and the Rural Micro Credit Development Centre (RMDC) set up with the responsibility of providing wholesale credit to poor people through a variety of intermediary organizations such as NGOs, savings and credit cooperatives and Grameen Bank prototypes. These targeted credit programmes have helped a substantial number of women and men in rural areas through income generation and employment expansion. However, many of these programmes have also suffered from mistargeting, lack of understanding of poor people’s absorptive capacity, declining repayment ratio, high service delivery cost, insufficient local institutional capacity and inability to retain competent staff. Others have suffered due to the lack of support services such as technology, extension services, access to market and so on. This is especially true of programmes targeted at the hardcore poor such as the Kamaiyas, for whom support services in the form of a complete package was absolutely essential. Institution-based poverty alleviation programmes have focused on building institutional capacity, and fostering decentralization and local governance in an attempt to address poverty alleviation at the local level. The Small Farmers Development Programme, introduced in 1975, is the first programme of this kind in Nepal. Its focus was on group formation at the local level for the purpose of credit delivery and other services. In the early stage of its implementation, a major problem appeared to be inadequate quality of group formation, as most of the groups lacked sufficient training and expertise, leading to poor management of loans, low recovery of loans and so on. To address this shortcoming, SFDP increasingly embodied the concept of Institutional Development Programme (IDP) with the objective of strengthening the institutional management capabilities of small farmers’ organizations. Using this new concept, SFDP began an experimental project called the Small Farmers’ Cooperative Limited (SFCL) in 1987/88, which expanded rapidly in other parts of the country. Compared with the performance of the SFDP the repayment rate was found to be higher in SFCL, overhead costs to be lower and the density of coverage and mobilization of local resources greater. The period since 2000 has seen two major initiatives in the sphere of targeted interventions. The first initiative was based on the recognition that past programmes and policies had failed to address the fundamental problems of social exclusion faced by a number of population groups. These groups included women, constituting half of the population, people living in the Western to Far Western Hills accounting for 22 per cent of the population (and providing the hotbed of Maoist insurgency), and the untouchables (Dalits) and indigenous peoples (Janajatis), who accounted for 46 per cent of the population. Recognizing that the roots of inequities that give rise to social exclusion lie deep in Nepalese society, the government has recently made a bold attempt to go beyond traditional poverty alleviation programmes, and to undertake affirmative actions of various kinds. Recent initiatives have focused mainly on two areas: (1) a flurry of landmark legislation aimed at mitigating or removing existing restrictive laws, for example, revisions to the Civil

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Code (Inheritance Law and Property Bill) in 2003, which allowed women the right to inherit and hold property for the first time in the history of Nepal, and (2) affirmative action programmes and policies aimed at ensuring greater representation of women and caste/ethnic groups in civil service and local government structures. The National Foundation for Development of Indigenous Nationalities (NFDIN) was set up by law in 2002 for improving the welfare of Janajatis. It has undertaken a number of special programmes, such as the Chepang Development Programme, and special scholarship programmes for disadvantaged Janajati groups. Similarly, the National Dalit Commission was established under an executive order in 2002 for the benefit of the untouchables. Since about the mid-1990s, national scholarships have been provided exclusively to Dalit students for study from primary to higher levels. In addition, a total of 65 income- and skill-oriented projects were in place as of 2005 for the welfare of Dalit households. The second major initiative consists of the inauguration of a Poverty Alleviation Fund (PAF) in 2003. Set up with assistance from external partners and the government’s own resources, PAF is meant to operate as an umbrella for all kinds of targeted programmes, including the affirmative action programmes aimed at combating social exclusion. The main objective is to improve the livelihoods of the rural poor and the socially excluded by creating infrastructure, employment and income-generating opportunities in the most depressed villages and communities. The activities to be undertaken with this fund are expected to follow a demand-based approach, utilizing NGOs and CBOs as support groups. Community sub-projects are to be implemented mainly through partner organizations (POs). These POs could be District Development Committees (DDCs), VDCs, local NGOs or the private sector, but all would have to demonstrate a proven record of working with the target populations locally and enjoying their trust. POs will also be responsible for assisting communities in preparing sub-project proposals and submitting them to PAF, monitoring the quality of participation and interacting with government agencies and other programmes. Beneficiaries would need to form groups to benefit from PAF. For example, existing community organizations, self-help groups, forest users groups, water users groups and other groups formed around economic activities can be supported by the sub-projects. Unfortunately, like most other activities in Nepal, the operation of PAF has also been badly hampered by the Maoist insurgency and continuing political uncertainty. It is clear from the preceding discussion that Nepal has had the opportunity to experiment with a large variety of targeted interventions for the poor. Independent evaluations show, however, that most of them failed to achieve their stated goals in a sustained manner. The rare success stories include the Small Farmers’ Development Programme (SFDP), Production Credit for Rural Women (PCRW) and Micro Credit Project for Women (MCPW). The key to their success appears to lie in the institution-building effort that underpinned all of them. In particular, institutions that enabled the beneficiaries to participate at all levels of programme implementation contributed to their success. The attempts at decentralization made from time to time assume a special relevance in this context. Decentralization in various forms has been practised in Nepal for a long time, but until the 1990s it was used mainly to serve the interests of the elites ruling at the centre. Attempts at genuine decentralization came following the constitutional changes in 1990, first with the Local Body (LB) Acts of 1992 and then with the landmark Local

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Self-Governance Act (LSGA) 1999, whose principles were subsequently embedded in the Ninth and Tenth Plans. It was recognized that for decentralization to work for the benefit of the poor, the people must be empowered at the grassroots level and that such empowerment could only come if they were mobilized into autonomous community organizations. In this regard, a strong impetus came from the UNDP, which conceptualized and implemented programmes like the Participatory District Development Programme (PDDP) and Local Governance Programme (LGP). At the same time, the government began to implement fiscal decentralization by providing development grants to local bodies to carry out local level development activities and by building their institutional capacity. Several government services such as primary education, basic health care and agricultural extension and livestock services were transferred to local bodies. The local bodies were also entrusted with the responsibilities of providing for small-scale drinking water and irrigation facilities, construction of agricultural roads and maintenance of district and urban roads. Notwithstanding these initiatives, progress has been stymied by domestic uncertainties as well as difficulties inherent in the decentralization process. The Maoist insurgency seriously impaired the ability of local bodies to function effectively by causing damage or destruction of physical infrastructure. At the same time, the political tug of war between the king on the one hand and the opposition parties and the Maoists on the other left the local bodies without elected representatives for several years. In the absence of elected representatives, local-level government officials carried out the responsibilities entrusted to local bodies, which amounted to a serious retrogression of the participatory decentralization that Nepal had so boldly initiated in the 1990s. Concluding observations Nepal embarked on the path of modern economic development in the 1960s under a particularly trying set of initial conditions. The challenges it faced ranged widely, involving geography, history and culture. Geographically, Nepal had to contend with the disadvantages of being a landlocked country and having a difficult terrain that rises steeply from the plains of Terai in the South to the middle hills and the Himalayan range in the North. Historically, it had to bear the legacy of more than a century of rule by a rapacious dynasty that thrived on the extraction of resources from the land and the people and repressed any political or economic threat to its power. Culturally, it had to deal with a fragmented society vitiated by caste and ethnic divisions. These problems were compounded in the first few decades of planned development by an excessively interventionist policy regime that undermined the prospects of development by encouraging rent-seeking by the elite on the one hand and discouraging private enterprise on the other. After 1990, there were signs that the economy was finally waking up from a long slumber. In the market place there were stirrings of a new enterprise that had the potential of taking the economy to a higher growth trajectory, and in the sphere of governance there was a decisive move towards a participatory and decentralized decision-making process that had the potential of reorienting development towards the disadvantaged segments of the society. But the potential benefits of these initiatives were largely dissipated as a consequence of a protracted political vacuum caused by a tripartite power struggle between the king, the main political parties and Maoist insurgents.

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The Maoist insurgency that began in 1996 and escalated viciously after 2001, inviting an equally vicious response from the government, put a stranglehold on the economy and the society at large. Quite apart from the human tragedy it has caused in terms of loss of human lives,10 it has also seriously hampered the process of economic and social development in Nepal. The areas worst affected by the insurgency have obviously suffered the most. For example, it has been revealed by the Nepal Living Standard Surveys that even though the small farmers in the Western Hills (which fall within the worst-affected areas) had the highest levels of land and labour productivity in 1995/96 compared with farmers of similar size in the rest of the country, by 2003/04 they had the lowest productivity of all. The proximate reason for this decline lies in the relative lack of access to essential inputs and market, owing to the disruptions caused by insurgency. While average irrigated area increased between 1995/96 and 2003/04 for all other groups of farmers, it remained stagnant on small farms in the Western Hills; only 46 per cent of them reported usage of fertilizer compared with 70 per cent in the Eastern Hills; the proportion of small farmers using improved seeds for paddy was also the least in the Western Hills; and the region was also the least commercialized. Clearly, the insurgency-related disruption in market transactions is blighting the livelihood prospects of many a poor farmer in the affected regions. It has also been observed that the level of human development across regions is inversely correlated with the intensity of conflict. It has been estimated, for example, that the worst-affected districts had a human development index of 0.27 as compared with an index of 0.38 for the most lightly affected ones (World Bank, 2005a: Table 1.4). There is, of course, a problem here of disentangling the direction of causality, since lack of human development can be both a cause and a consequence of insurgency. There is, however, no reason to doubt that insurgency has played a causal role in depressing human development, even though the quantitative magnitude of the effect cannot be easily estimated. The clearest evidence of this comes from the information on disruptions in service delivery caused by dismantling of elected local governments as well as disruption of specific services. A recent survey has found, for instance, that compared with the national average of 75 per cent of children being vaccinated, less than 37 per cent of children were vaccinated in two conflict-ridden districts (World Bank, 2005a: 6). The education sector has suffered particularly badly because of persistent attacks on educational institutions. Nevertheless, it is not just the affected districts that have suffered as a consequence of the ongoing conflict. The economy as a whole has suffered due to loss of infrastructure, worsening of the investment climate, diversion of scarce resources for internal security, reduction in tourism and a general disruption in development activities as the conflict has spread to most parts of the country. Although other factors were partly to blame, the escalation of insurgency was directly responsible for turning the growth rate negative in 2002 and keeping the average growth rate since 2000 well below the rates achieved in the 1990s. In all this, the political impasse created by the power struggle between the king and the main political parties also played a role by accentuating uncertainties and disrupting the political processes underlying economic policy-making. The possibilities of a new lease of life for democracy and a rapprochement with the Maoists that have emerged with the demise of royal power since 2006 at last offer an opportunity for ensuring the shoots of development that seemed to be sprouting in the 1990s are not destroyed completely.

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Notes 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

The characterization of the first three phases closely follows the description given in Khatiwada and Sharma (2002). These reforms, their antecedents and their consequences are discussed more fully in Section 4 below on the policy regime. For a more detailed discussion of the degree of pro-poor property of public expenditure in Nepal, see Deraniyagala et al. (2003). For a fuller discussion of all these pieces of evidence, see World Bank (2005b). The evidence on the regional distribution of remittances, as obtained from Nepal Living Standard Surveys, is discussed in World Bank (2005b). It is instructive that the average growth in the post-1985 period was not significantly higher than what was already achieved in the first half of the 1980s. The use of fertilizer increased despite reduction of subsidy. Even among the poorest quintile, the proportion using fertilizer increased from 41 per cent to 55 per cent between the two halves of the 1990s. For more detailed discussion of the evidence, see World Bank (2005a; 2005c). The Nepal Living Standards Surveys show that between 1995/96 and 2003/04, cropping intensity increased from 1.6 to 1.8, and the share of commercial crops in gross crop output increased from 24 per cent to 31 per cent. The discussion in this sub-section draws heavily on Osmani, Bajracharya and Sharma (1999). The ten-year-long insurgency has cost more than 10 000 lives, most of them since 2002.

References Deraniyagala, S., Y. Khatiwada, S. Sharma, R. Roy and A. Deshpande (2003), Pro-poor Macro Policies in Nepal, New York: UNDP. Khatiwada, Y.R. and S. Sharma (2002), ‘Nepal: Country Study Report’ (mimeo), Paper prepared for the Global Development Network’s project on Sources of Long-term Growth: Washington DC. MOF (2004), Economic Survey 2003/04, Kathmandu: Ministry of Finance, Government of Nepal. MOF (2005), Economic Survey 2004/05, Kathmandu: Ministry of Finance, Government of Nepal. NPC (2002), Tenth Plan (PRSP), Kathmandu: National Planning Commission, Government of Nepal. NPC (2005), An Assessment of the Implementation of the Tenth Plan (PRSP), Kathmandu: National Planning Commission, Government of Nepal. Osmani, S.R., B. Bajracharya and S. Sharma (1999), Assessment of National Anti-poverty Programmes: The Case of Nepal (mimeo), New York: UNDP. UN (2002), Progress Report 2002: Millennium Development Goals, Kathmandu: United Nations Country Team in Nepal. UNDP (2001), National Human Development Report 2001: Poverty Reduction and Governance, Kathmandu: UNDP. World Bank (1999), Nepal: Poverty at the Turn of Twenty First Century, Washington DC: World Bank. World Bank (2005a), Nepal: Development Policy Review, Washington DC: World Bank. World Bank (2005b), ‘Poverty Trends in Nepal between 1995–96 and 2003–04’ (mimeo), Background paper for Nepal: Poverty Assessment. Washington DC: World Bank. World Bank (2005c), ‘Agriculture, Non-farm Employment and Rural Poverty in Nepal’ (mimeo), Background paper for Nepal: Poverty Assessment, Washington DC: World Bank.

6

Bhutan S.R. Osmani, S. Tenzing and T. Wangyal

The background Bhutan is a small landlocked country at the foothills of the Himalayas. An especially rugged mountainous terrain, lack of easy access to seaports and a small population living in scattered low-density settlements all conspire to make life difficult in Bhutan. Yet, unnoticed by most of the outside world, the country has quietly made significant strides in both economic and social spheres. The economy has grown at an average rate of close to 7 per cent per annum for more than two decades, lifting the material standard of living more than two-and-a-half-fold within a single generation. At the same time, a benevolent welfare-oriented state has tried to ensure that every one of its citizens is assured of minimum basic needs such as access to land, housing, health and education. As a result of these efforts, mortality has gone down sharply, life expectancy has soared and the goal of universal access to basic education is well within sight, even though it still remains poor enough to be designated as a least developed country by UN definition. Significantly, Bhutan has achieved all this without the kind of environmental degradation and cultural atrophy that has bedevilled the development efforts of many other countries in the world. The nation of Bhutan was born in the early 17th century, when a number of small but independent principalities were brought together under a unified administration by a charismatic leader called Shabdrung Ngawang Namgyal. He established a theocracy and gave Bhutan an administrative system and a code of law, which worked reasonably well for over two centuries. However, by the second half of the 19th century, frequent disputes over the issue of succession to the office of the Shabdrung brought internal strife and instability in the country. In a bid to restore stability, the clergy, the ruling elite and representatives of the people unanimously decided in 1907 to establish a monarchy, marking the beginning of a new era in the history of Bhutan. Ugyen Wangchuck was chosen as the first hereditary king of Bhutan. By uniting the country and establishing a central authority, he brought peace and stability to the country and laid the foundation for the emergence of modern Bhutan. Throughout its history, Bhutan has remained independent, being one of the few countries in Asia never to become a colony. Bhutan was fairly isolated from the outside world until the 1960s when the third king, Jigme Dorji Wangchuck (1928–72), opened links with other countries and initiated the development of a modern economy. He also introduced many social, legal and constitutional reforms, which had far-reaching effects. There has been until now no room for formal democracy in the polity of Bhutan. However, the present king, Jigme Singye Wangchuck, who acceded the throne in 1972, has tried to open the way for increasing people’s participation in decision-making processes in a gradual step-by-step manner. The majority members of the National Assembly, the supreme legislative body of the country, consist of popularly elected representatives, albeit on non-party basis. The scope for people’s participation was expanded 190

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further when decentralization of administration was implemented in 1981 through the establishment of Development Committees at the dzongkhag (district) level followed by further decentralization to the gewog (block) level in 1991. In 1998, the king gave up the position of the head of the government, retaining only the position of head of state. Most significantly, he has inspired and personally guided the drafting of a new constitution, which will transform Bhutan into a constitutional monarchy in 2007, ushering in for the first time the era of multi-party democracy. Apart from guiding the process of political transition towards democracy, the present king has also shaped the broad strategy of economic and social development of Bhutan through a series of personal initiatives. Indeed, much of what is good about Bhutan today is generally attributed to the wisdom and benevolence of the present king. His most important contribution in this regard has been the enunciation of a new paradigm of development, called the Gross National Happiness (GNH) approach to development. Fusing the traditional values of Buddhism with modern concerns with environment and equity, the GNH approach explicitly shuns the purely materialistic approach to development. It calls for a holistic approach to development, embracing material, environmental, cultural and spiritual goals. Although there remains some ambiguity in the interpretation and implementation of the GNH approach, its underlying philosophy has guided policy-making at all levels over the last two-and-a-half decades. The other factor that has shaped the destiny of Bhutan is its close relationship with India. Until about 1960, Bhutan’s main external links were with Tibet in the north. But in the early 1960s, the links with Tibet were closed and economic transactions with India in the south gained prominence, mainly as a consequence of geo-political rivalries between India and China. Since then, the Bhutanese economy has become inextricably linked with that of India. Before Bhutan introduced its own currency, the Bhutanese ngultrum (BTN or Nu) in 1974, the Indian rupee circulated freely as the medium of exchange. Even after the ngultrum was introduced, the Indian rupee continued to remain side by side, exchanged with the ngultrum on a one-to-one basis, leading to a virtual dual currency system. A free trade agreement with India ensures free exchange of goods and services between the two countries, with payments being made in Indian rupees, which spares Bhutan the onerous task of earning hard currency for most of its imports. India remains by far the largest trading partner of Bhutan, accounting for over 90 per cent of its exports and over 80 per cent of imports. India provides generous budgetary support in the form of grants; during the 1990s, these grants financed almost 45 per cent of total budgetary expenditure. Since the internal revenue earned by the government of Bhutan is spent almost entirely on current expenditure, it is the Indian grants, supplemented by funds from other donors, that has been the main resource with which Bhutan has built up its physical infrastructure over the years. India also provides substantial extra-budgetary support, especially in the form of investment funds for the massive hydropower projects that have been the main driving force of the economy over the last two decades. India also supplies the workers, machinery and technical expertise for building the hydropower projects, and eventually purchases most of the electricity at a negotiated price. Because of these multi-faceted relationships, both the economy and politics of India have a profound impact on the opportunities and constraints faced by Bhutan.

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Economic growth and the macroeconomic scenario Growth and structural change The economy of Bhutan has grown strongly in recent decades. Going back to 1980, the year from which systematic and consistent national accounts data are available, GDP has grown at an average rate of 7 per cent per annum in the quarter-century to 2004. No other country in the South Asia region, and not many in the developing world, has achieved such a high rate of growth over such an extended period of time. Indeed, in terms of at least the rate of growth, Bhutan would appear to belong to almost the same league as the high-performing Southeast Asian economies. A more detailed analysis shows, however, that unlike the Southeast Asian countries Bhutan has not been able to translate its high rate of growth into fundamental structural change of the economy, in particular to usher in an era of modern industrialization. Its growth has been underpinned mainly by export of hydropower to India and activities related to hydropower, but the resulting growth has yet to lay the foundations of a modern industrial economy. Nonetheless, sustained high growth has led to substantial improvement in the living standards of the Bhutanese people. In the absence of reliable data on population growth,1 it is hard to be sure about the magnitude of improvement in terms of per capita income. However, using a rough estimate of population growth of around 3 per cent based on fragmentary evidence, per capita income would have increased at the highly respectable rate of around 4 per cent per annum for the past quarter-century. This implies that the current generation of the Bhutanese people is on average more than two-and-a-half times richer than the immediately preceding generation. To achieve so much in just one generation is highly commendable by any standards. Sectoral breakdown of growth rates and sources of growth clearly demonstrate that the driving force of the Bhutanese economy has been industry, broadly defined to include both energy and construction sectors in addition to manufacturing. In the quartercentury to 2004, industry was the fastest-growing sector with an annual average growth rate of over 12 per cent. Services came a distant second, with a growth rate of about 6 per cent – half that of industry, while agriculture was a long way behind with a growth rate of just 3.6 per cent (Table 6.1). Agriculture did particularly poorly in the early 1990s, and while it has since recovered somewhat, it still remains the weakest sector of the Bhutanese economy. Table 6.1 Average annual growth rates: 1980–2004 (periodic annual average: figures in percentages) Period 1980–85 1985–90 1990–95 1995–2000 2000–04 1980–2004

Agriculture

Industry

Services

All

5.5 5.6 0.4 2.9 3.2 3.6

18.0 23.1 7.2 7.6 12.3 13.5

4.6 8.5 4.6 9.6 5.9 6.5

6.8 10.2 3.9 6.6 7.8 7.0

Source: Estimated from NSB (2004a) and RMA (2005).

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Bhutan Table 6.2

Sectoral share of output: 1980–2004 (percentages)

Year

Agriculture

Industry

Services

All

1980 1985 1990 1995 2000 2004

52.3 49.4 40.3 34.1 28.5 24.0

14.3 20.6 31.6 36.9 38.3 45.1

33.4 30.0 28.1 29.0 33.2 30.9

100.0 100.0 100.0 100.0 100.0 100.0

Source: Estimated from NSB (2004a) and RMA (2005).

Table 6.3 Growth rates of major sub-sectors: 1980–2004 (periodic annual average: figures in percentages) Period 1980–85 1985–90 1990–95 1995–2000 2000–04 1995–2004 1980–2004

Crop

Livestock

Forestry

Manufacture

Energy

Construction

6.7 4.6 1.9 3.0 2.7 2.8 3.8

6.0 5.6
0.5 3.6 4.1 3.8 3.7

3.1 7.4
0.8 2.0 3.3 2.6 3.0

28.4 22.5 7.6 4.8 5.9 5.3 14.2

19.8 356.3 4.0 0.8 7.0 3.6 80.5

15.4
7.5 13.3 20.8 19.2 20.1 11.9

Source: Estimated from NSB (2004a) and RMA (2005).

The economy has undergone significant structural shifts as a result of these trends. In 1980, agriculture accounted for over half of total GDP, but by 2004 its share came down to barely a quarter, while the share of industry went up from just 14 per cent in 1980 to as high as 45 per cent in 2004. In the meantime, the service sector held its own with a share of about 30 per cent (Table 6.2). These structural changes have not, however, transformed the Bhutanese economy into a modern industrial society in the sense of creating a strong manufacturing base. Decomposing the broad sectors into their constituent parts, it can be seen that manufacturing has in fact been the weakest link of the industrial sector, especially in recent years. Over the longer period from 1980 to 2004, energy has been the dominant sub-sector, far outstripping the growth of manufacturing, while in recent years construction has taken over the leading role (Table 6.3). In fact, over the last decade, construction has been the most dynamic sector of the Bhutanese economy, growing at nearly 20 per cent per annum, compared with just 5 per cent for manufacturing. During this decade, as much as a quarter of GDP growth has come from the construction sector, much of it being energy-related. Another 16 per cent has come directly from the energy sector, while only 10 per cent of GDP growth has come from manufacturing. During the last decade, the direct output of the energy sector has also grown relatively slowly (at less than 4 per cent per annum), but it should be noted that a large part of the

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construction activity that has occurred in recent years is related to the upcoming Tala hydropower project, another part being accounted for by an unprecedented housing boom. Moreover, a large part of the manufacturing activities is also dependent on hydropower as they specialize in power-intensive products such as cement, calcium carbide and ferro alloys. Thus, one way or the other it is the energy sector that has provided the major stimulus to growth in the Bhutanese economy. This stimulus, however, has largely bypassed the agricultural sector and only marginally benefited manufacturing. The situation with agriculture is particularly precarious as it currently contributes only one-fourth of the GDP while absorbing as much as 63 per cent of the labour force. At the same time, the rural people are stuck in agriculture despite its lack of dynamism because manufacturing does not provide an alternative source of employment for most of them. The classical pattern of development whereby productivity growth in agriculture allows labour to be released from land so that they can be absorbed into an expanding manufacturing sector has so far eluded Bhutan. Infusing dynamism into agriculture and manufacturing remains a major challenge for Bhutan in the years ahead. Savings and investment Rapid growth of the Bhutanese economy has been underpinned by exceptionally high rates of savings and investment. Over a period of nearly two-and-a-half decades (1981–2003), gross investment (gross domestic capital formation) has grown at the average rate of 10 per cent per annum, while GDP has grown at an average rate of about 7 per cent. Moreover, the gap between capital growth and output growth has widened over time, indicating that the incremental capital–output ratio (ICOR) is rising fast in Bhutan. Normally, rising ICOR would be a matter of concern, as it would indicate falling productivity of capital. In the case of Bhutan, however, changes in ICOR as normally measured should be interpreted with caution. Much of the recent rise in ICOR is explained by the fact that a great deal of physical infrastructure is being created in connection with the massive Tala hydropower project, while the output of the project has yet to arrive. It remains true, however, that the rate of capital formation and the ICOR are exceptionally high in Bhutan compared with other countries at similar levels of income. Already in the early 1980s, gross domestic capital formation accounted for over 40 per cent of GDP. In recent years this proportion has gone up to nearly 66 per cent (Table 6.4). Such a high rate of capital formation is partly explained by the hydropower projects, as noted above. But partly this is also a consequence of low density of population living in a rugged mountainous terrain. The cost of physical infrastructure necessary to connect people in different parts of the country and to provide essential services to them is bound to be high under these conditions. Despite the inevitable high cost, the Bhutanese government makes a serious effort to develop the necessary infrastructure in keeping with its commitment to regionally balanced and equitable development as one of the pillars of the GNH approach to development. High rates of capital formation and a high ICOR are thus expected to remain persistent features of the Bhutanese economy in the years ahead. So far, a combination of a high domestic savings rate and generous inflow of foreign assistance, mostly from India, has sustained a high rate of capital formation, although the relative contributions of these two sources have changed dramatically over the last two-

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Table 6.4 Rates of savings and investment: 1981–2003 (periodic annual average; as per cent of GDP) Savings and Investments Gross domestic investment Net capital inflow Gross domestic saving Public saving Private saving Note:

1981–85

1986–90

1991–95

1996–2000

2001–03

41.7 46.8
5.2
12.6 7.4

33.3 18.8 14.5 2.3 12.3

44.8 17.1 29.0 5.5 23.5

43.7 23.3 22.2 2.5 19.7

63.7 24.9 40.8 3.6 37.2

Figures before and after 1990 are not strictly comparable.

Sources:

Estimated from NSB (2000) and NSB (2004a).

and-a-half decades. In the early 1980s, gross domestic saving was actually negative, to the tune of over 5 per cent of GDP (Table 6.4). However, as the Chhukha hydropower project brought in unprecedented revenue for the government after 1986, domestic savings gradually became large enough to eclipse foreign capital as the major source of investment finance. After 2000, domestic savings have become exceptionally high at 41 per cent of GDP (Table 6.4). The fiscal regime Given the low level of development of the private sector, the government has traditionally played an important role in the Bhutanese economy – not only in providing infrastructure and social services but also in producing economic goods and services. As a result, the size of fiscal operations is exceptionally large in Bhutan by South Asian standards. Of the various production activities undertaken by the government, the expenditure on large hydropower projects is kept outside the budget (although the dividends and taxes earned from the projects are included in the revenue side of the budget). In spite of this exclusion, government expenditure has accounted for over 40 per cent of GDP in recent years (Table 6.5), making the relative size of the government in Bhutan by far the largest in South Asia. The large size of government budget is sustained to a considerable degree by foreign assistance, of which the lion’s share comes from India. During the last five years, for example, foreign grants and loans (excluding loans for the major hydropower projects) contributed nearly 45 per cent of total budgetary expenditure. Of the remaining 55 per cent that was contributed by domestic revenue the major part was also derived indirectly from foreign assistance. This is because the bulk of the revenue came from taxes and dividends of hydropower projects, for which the investment fund came almost entirely from outside (as loans, mostly from India). Thus, directly and indirectly, it is the foreign grants and loans – essentially, Indian grants and loans – that underpins almost the whole of the government budget. Despite high level of dependence on foreign resources, the overall public debt has remained within manageable bounds. The debt–GDP ratio stood at 75 per cent in 2003/04, which may seem very high by South Asian standards, but the redeeming feature is that much of it is rupee loan, which can be serviced reasonably comfortably by the earnings

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Table 6.5 Budgetary trends: 1990/91–2003/04 (periodic average annual figures as per cent of GDP) Income and Expenditure Revenue and grants Revenue Tax Non-tax Grants Expenditure Current Capital Overall deficit Foreign loan Domestic deficit Borrowing Monetization

1990/91–1994/95

1995/96–1999/2000

2000/01–2003/04

40.05 22.24 6.60 15.64 17.81 40.23 21.03 19.20
0.18 0.66
0.48
0.07
0.39

41.64 22.68 8.78 13.90 18.96 42.70 19.91 22.79
1.06 2.02
0.96
0.10
0.87

35.24 20.15 10.17 9.97 15.09 41.76 18.73 23.03
6.52 4.98 1.53
0.40 1.62

Note: Components may not add up to total because of rounding. Sources: Budgetary figures are from Asian Development Bank, Key Indicators (various years) and RMA, Annual Report (various years) and GDP figures are from NSB (2004a) and RMA (2005).

from the export of hydropower to India. It is the convertible currency loan that is a matter of some concern. While generous inflow of Indian grants has undoubtedly helped Bhutan to maintain a large budget, domestic resource mobilization has also played a role. The domestic revenue ratio of around 22 per cent of GDP is in fact quite high for a low-income country like Bhutan. This has been made possible by the government’s ability to draw upon an unusually large source of non-tax revenue. In the 1990s, the greater part of domestic revenue came from non-tax sources, in the form of dividends from various corporations in which the government held the majority share. By contrast, the tax effort was very weak. Tax revenue as a percentage of GDP, which averaged about 8 per cent in the 1990s, was actually one of the lowest in South Asia. The overall fiscal position of Bhutan has been remarkably sound. Current expenditure, which was maintained at around 20 per cent of GDP in the 1990s, closely tracked domestic revenue, and generally remained slightly below it, yielding a small revenue surplus. In recent years, however, the government has found it increasingly difficult to maintain the overall level of public expenditure. This is mainly because the relative size of foreign grants has fallen sharply – from an average of around 19 per cent of GDP in the second half of the 1990s to only around 15 per cent during FY01–FY04. As a result, the overall budget deficit has increased from just over 1 per cent of GDP in the second half of the 1990s to over 6 per cent of GDP in the next four years. The structure of public expenditure in Bhutan exhibits a number of distinctive propoor features. First, a serious attempt has been made at fiscal decentralization. The Ninth Plan made provision for nearly a quarter of total budgetary resources to be spent at the local level – mostly on education and health – in accordance with locally determined

Bhutan Table 6.6

197

Inflation trends (periodic annual average: in percentages)

Price Index CPI index GDP deflator

1982–1984

1985–89

1990–94

1995–99

2000–04

11.7 9.4

7.4 6.0

11.3 10.8

7.7 9.7

4.1 4.4

Sources: Estimated from Asian Development Bank, Key Indicators (various years) and RMA, Annual Report (various years) and GDP figures are from NSB (2004a) and RMA (2005).

priorities. Second, the government has set up separate trust funds dedicated for health, education and environment in order to protect these sectors from the vagaries of fluctuations in government revenue and foreign grants. Third, a large part of the budget has traditionally been devoted to social sectors, especially health and education. Combining expenditure at central and local levels, it has been estimated that during FY04–FY05, education and health sectors together received 28 per cent of total expenditure. This is not only a very high ratio by South Asian standards, it also represents a big jump from the average of 18 per cent in the 1990s. The monetary regime The government of Bhutan first issued its own paper currency ngultrum (BTN or Nu) in 1974, and pegged it at par with the Indian rupee. Both currencies existed side by side and were used interchangeably for domestic transactions, while only the Indian rupee was used for trade with India. This system of dual currency with a one-to-one exchange rate has survived to this day. In view of the rather late entry of Bhutan in the world of money, a large part of the economy still works on barter. However, the extent of monetization is difficult to estimate, especially because an unknown quantity of Indian rupees also circulate within Bhutan as legal tender. Nonetheless, the data on the growth of money supply in relation to GDP does indicate an impressive speed of monetization, as the supply of broad money increased from 5 per cent of GDP in the early 1980s to over 60 per cent of GDP by the period 2000–04. Rapid increase in money supply has not, however, led to rapid inflation, as a large proportion of the additional money supply has served to integrate an increasing proportion of the barter economy into the cash nexus. As in other South Asian countries, inflation has remained largely under control in Bhutan. Indeed, the overall inflationary situation has become better in the last five years compared with the earlier decades (Table 6.6). This stability has, however, been achieved not primarily through active monetary or fiscal policy, but through the exchange rate policy of keeping the local currency, the ngultrum, pegged with the Indian rupee. Adoption of a fixed exchange rate with by far the largest trading partner ensures that inflation in Bhutan is essentially one of the imported inflation variety, tracking closely the inflation in India. As Indian inflation has remained relatively low by international standards, so has the imported inflation in Bhutan. In particular, the sharp decline in inflation observed in Bhutan after 2000 reflects an equally sharp decline in Indian inflation at the same time rather than any fundamental changes in either the economic structure or policy framework in Bhutan.

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The trade regime From being a virtually closed economy around 1960, Bhutan has completely transformed itself in the subsequent decades into a classical case of a small open economy characterized by a high degree of dependence on trade (Table 6.7). Already by the early 1980s, when systematic statistics first began to be collected, the combined export and import trade of Bhutan amounted to 55 per cent of its GDP – a far greater trade ratio than anything observed in the rest of South Asia. Over time, the dependence on trade has become even greater until the trade ratio reached nearly 74 per cent in the second half of the 1990s. The ratio has declined somewhat since then, but with the imminent prospect of exporting electricity to India from the Tala project, it is likely to shoot up again in the next couple of years. A rising trade ratio has been accompanied by a falling trade deficit. Underlying both the upward trend in the volume of trade and the downward trend in the trade gap relative to GDP is the exceptionally fast increase in the volume of export. Thus, in the period from 1981 to 2003, the dollar value of exports has grown at the compound rate of 8.5 per cent per annum, as against import growth of 5.5 per cent and real GDP growth of 6.5 per cent. Although declining, trade deficits have remained large as a result of a very high level of imports, which stems from the continued inability of Bhutan’s economy to expand the productive base (outside the power sector). Even after including the earnings from ‘invisibles’, which essentially means earnings from tourism, the current account deficit remains large and growing in absolute terms. These deficits have been sustained by generous grants received from abroad, an increasing proportion of which comes from India. In the mid1990s, India’s share of grants was already high at around 50 per cent; by 2003/04, it had risen to 75 per cent. India is also by far the most important trading partner of Bhutan. In the early 1990s, about 88 per cent of all exports were destined for India; a decade later, that proportion has increased to 95 per cent. During the same period, India’s share in imports has increased from 74 per cent to 81 per cent. Bangladesh is the second largest export market for Bhutan, with a share of about 4 per cent, and Japan is the second largest source of imports, also with a share of 4 per cent. A number of factors have contributed to the predominance of India in Bhutan’s external trade. The most important of these are geographical proximity and the support India had provided to Bhutan both for producing exportables (such as electricity) destined for the Indian market and for sustaining imports through generous grants made in non-convertible rupees. All this has been facilitated by an institutional framework that Table 6.7 Period 1981–84 1985–89 1990–94 1995–99 2000–03

Trade penetration ratios: 1981–2003 (periodic annual averages; percentages) Export/GDP Ratio Import/GDP Ratio Trade/GDP Ratio 11.2 21.3 27.7 32.6 21.9

44.3 41.7 40.6 41.0 37.6

55.6 62.9 68.3 73.7 59.4

Trade Gap/ GDP Ratio (
)33.1 (
)20.4 (
)12.9 (
)8.4 (
)15.7

Sources: Estimated from Asian Development Bank, Key Indicators (various years) and RMA, Annual Report (various years).

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includes a bilateral free trade agreement between the two countries, use of the Indian rupee as a medium of exchange both internally in Bhutan and for trade with India and a fixed exchange rate between the rupee and the ngultrum. The dominance of bilateral trade with India signifies Bhutan’s limited ability to diversify its export markets. This creates a mismatch between the import from and export to third countries as nearly 16 per cent of imports are denominated in convertible currency, while less than 5 per cent of exports earn convertible currency. This mismatch between the earning and spending of hard currency leads to a severe foreign exchange constraint, which continues to plague the Bhutanese economy even as trade with India flourishes. It should be pointed out that despite persistent deficit in the hard currency component of the current account, the overall balance has usually been comfortably positive. It means that the availability of hard currency loans has been adequate not only to finance any shortfall in the current account that grants were unable to meet but also to add to the reserves of hard currency. At the same time, the rupee reserve has also increased over the years as a result of a persistently healthy surplus in the rupee component of the current account (with grants), supplemented by the rupee loans received from India. As a result, the reserve position of the Royal Monetary Authority (RMA) has improved at a great speed over the last decade. Total reserves have shot up with more than threefold increase within a span of just one decade. The hydropower economy Bhutan can be correctly described as a hydropower economy. Since the commissioning of the Chhukha project, the first major hydropower project in Bhutan, in the mid-1980s, hydropower has emerged as the driving force of the economy. It looms large in almost every aspect of the economy – as a major contributor to GDP, as the single biggest source of government revenue and as by far the most important item of export. Understanding the Bhutanese economy cannot be complete without a proper appreciation of the role hydropower plays in shaping it. Bhutan’s mountainous topography and its fast-flowing four major rivers have endowed the country with a great potential to develop hydropower. The first major hydropower project, the 336 MW Chhukha plant, was fully commissioned in 1988 followed by a number of smaller ones. The construction of the largest hydropower project to date, Tala, with an installed capacity of 1020 MW, was started in 1993 and was scheduled for completion in 2006. Most of the major projects have been developed with Indian assistance based on a 60 per cent grant and 40 per cent loan financing model. Ever since the mid-1980s, economic growth of Bhutan has been inextricably linked with the development of hydropower. The share of hydropower output in GDP shot up 0.2 per cent to 11.6 per cent in 1987, the year Chhukha came on line, and has remained between 8–11 per cent thereafter. The rising contribution has come partly from increased volume of electricity generation and partly from periodic revision of the export tariff, which has more than doubled in real terms since 1988. Hydropower development has also contributed to GDP growth indirectly by boosting the construction sector through both backward and forward linkages and by facilitating the growth of power-intensive industries. Bhutan’s manufacturing sector is indeed dominated by power-intensive industries such as cement, ferro alloys and calcium carbide, supported by large subsidy in the form of cheap energy. It is the combined contribution of

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the energy sector itself, and of energy-related activities such as construction and powerintensive industries that has enabled Bhutan to sustain a remarkably high growth rate of around 7 per cent over a period of two decades, despite slow growth of agriculture. Hydropower also makes an overwhelming contribution to the public exchequer, through both tax and non-tax revenue. The average share of hydropower revenues to total domestic revenues for the period 1992/93 to 2001/02 was around 30 per cent. It is expected to rise even further to about 50 per cent after the commissioning of the Tala project. Considering the fact that the revenues earned from construction and power-intensive manufacturing industries are also owed indirectly to hydropower, it is no exaggeration to say that it is the rents extracted through the exploitation of hydropower that have financed the major chunk of Bhutan’s budget over the years (the other chunk being financed by grants from India). Most of the government revenue earned from the sale of hydropower has been used to maintain high levels of social expenditure and for infrastructure. At the same time, most of the earnings from electricity exports have been used to import consumer goods, including essential foodstuff, from India. Without this import, the social expenditure as well as construction and other activities spurred by hydropower development would have faced serious problems due to the wage goods constraint. The softening of the wage goods constraint has been one of the principal pathways through which hydropower contributed to sustaining the growth process in Bhutan. Hydropower also dominates on the export front. Since the commissioning of the Chhukha project in 1986, the share of hydropower in total exports has remained close to 50 per cent. The share is expected to rise substantially after the massive Tala project begins to export electricity to India. Bhutan clearly has a comparative advantage in hydropower, as its costs of production are substantially lower than the current market price in India. Bhutan also has the advantage of possessing an institutional framework that enables export-oriented hydropower projects to be implemented more easily than in India, where hydropower development is hampered by inter-state water disputes and rehabilitation controversies. This is true to a lesser extent for Nepal as well, where NGO opposition to large hydropower projects has been a serious problem. For all its potential, though, hydropower has not been able to solve Bhutan’s foreign exchange constraint – in particular the hard currency component of it. For both geographical and political reasons, Bhutan has not so far been able to sell its hydropower to countries other than India – even though a potential market exists in Bangladesh, and at a stretch even in China. It has thus made no direct contribution to the earning of hard currency, and it is unlikely to do so in the short-to-medium term. Bhutan’s economy will have to rely on hydropower for the foreseeable future and fortunately for the country a huge potential for expansion still exists. On the supply side, it has been estimated that only 2 per cent of the potential has been developed so far. On the demand side, although at present India is the only market for Bhutanese hydropower, the risk of reduced demand from India is very small. Northern India faces chronic power shortages, which are expected to rise even further. At present, Bhutan supplies less than 0.5 per cent of India’s demand, which can absorb all the hydropower that Bhutan can develop over the next 20 years. There are, however, constraints too, not the least of which is the potential environmental hazard of a glacial lake outburst flood, lurking in the Himalayas as a consequence

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of global warming. The other concerns that have been much discussed of late in Bhutan are possibilities of ‘Dutch disease’ on the one hand and rent-seeking on the other, problems that are often associated with large-scale exploitation of natural resources. Bhutan has largely been able to avoid both these problems so far, but potential dangers remain. Poverty. human development and employment Unlike most other countries in the developing world, Bhutan’s economic and social policies have been underpinned by a broad view of poverty that goes beyond the concerns with personal income. Although no systematic attempt was made to measure the prevalence of the multi-dimensional concept of poverty implicitly adopted by Bhutan, casual empiricism suggested to most Bhutanese observers that poverty was not a serious problem in the country. This presumption was based partly on the existence of a kind of welfare state instituted by the King of Bhutan that was unique among the developing countries. The evidence to support the benevolent nature of the welfare state in Bhutan is indeed found in the measures of human development recently estimated by the Royal Government of Bhutan (RGOB, 2005). From a low value of 0.325 in 1984, HDI has gone up to 0.597 in 2002, that is, almost doubled within a space of just two decades. The gains appear to be gradually slowing down, however, principally because the earlier gains were made from a smaller base. Nonetheless, Bhutan’s human development index reflects a relatively higher level of human development in comparison with the least developed countries to which it belongs. In South Asia in particular, it has a higher HDI than Bangladesh, Pakistan and Nepal. Only Maldives, Sri Lanka and India are better placed than Bhutan in terms of HDI. The perception of a moderately high level of human development in Bhutan has gone hand in hand with a common perception that acute and endemic hunger was not as serious a phenomenon here as in most other countries in South Asia. Since the problem was not perceived as serious, there was felt no need to measure it either. A large-scale household income and expenditure survey was conducted for the first time on a pilot basis in the year 2000. Based on the experiences gained from the pilot phase, a more sophisticated household survey, called the Bhutan Living Standard Survey, was conducted in the year 2003. Using the data generated by this survey and by applying the standard procedures for estimating poverty developed by the World Bank and others, the government of Bhutan has for the first time come up with official estimates of poverty. According to these estimates, 32 per cent of the people living in Bhutan were to be counted as poor in the year 2003. This estimate has surprised many, including the government itself. For a nation confident in its belief that its welfare state had almost conquered poverty, the message that one in three people lived in poverty was shocking, to say the least. All kinds of questions have been raised about the reliability of data, appropriateness of the methodology of estimation, and so on. A proper scrutiny of the data and the methodology has yet to be undertaken, however. While one must await such a scrutiny before making a final judgement about the quality of the estimate, for the moment one can do no better than going by what estimates are actually available. These estimates show that poverty is essentially a rural phenomenon in Bhutan (Table 6.8). As many as 38 per cent of the rural people are poor, compared with only about 4 per cent of the urban population. There is also a great deal of regional variation in

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Table 6.8

Prevalence and incidence of poverty: 2003 Headcount Ratio (%)

Share of the Poor (%)

Poverty Gap Index

Poverty Severity Index

31.7 38.3 4.2

100.0 97.4 2.6

0.085 0.105 0.007

0.031 0.038 0.002

18.7 29.5 48.8

23.6 24.2 52.3

0.047 0.066 0.147

0.016 0.021 0.056

Bhutan Rural Urban Region Western Central Eastern Source: NSB (2004b).

poverty. The Eastern region has the largest incidence of poverty, with almost half the population living below the poverty line. In contrast, the Western region has the lowest incidence with a headcount ratio of just 19 per cent. The Central region, with a ratio of 30 per cent, is somewhere in the middle. Analysis of the poverty profile shows that, apart from the region in which a person lives, there are several other variables that are closely correlated with poverty. One of them is physical infrastructure – greater proximity to roads is associated with lower incidence of poverty. Educational level of the household head is also an important factor – lack of education is more pervasive among the poor, and the education difference between the poor and the non-poor is especially sharp in urban areas. A couple of demographic characteristics of the households are also relevant. First, households with a higher dependency ratio tend to be poorer. Second, gender of the household head has an effect, although not a very pronounced one. Female-headed households have been found to have a slightly higher level of poverty than the male-headed ones. Besides poverty, inequality is also surprisingly high in Bhutan. The Gini index of expenditure distribution has been estimated to be 0.42 for the country as a whole, 0.37 in urban areas and 0.38 in rural areas in 2003 (NSB, 2004b). The richest 20 per cent of the population of Bhutan enjoys nearly half (48.7 per cent) of total consumption expenditure while the poorest 20 per cent receive a share of only 6.5 per cent. These figures indicate a high degree of inequality by the standards of South Asia, especially for rural areas.2 High levels of both poverty and inequality stem from the failure to improve the productivity of the majority of its population, in stark contrast to the achievements in social spheres. While basic needs such as health, shelter, primary education and freedom from acute hunger have been met for most people through the welfare-state policies pursued by the government, precious little has been done to enhance their income-earning capacity. Agriculture, which is the mainstay of the rural population, has received the lowest priority in terms of policies and resource allocation. The share of agriculture in total plan outlay has come down from 15.6 per cent in the Sixth Five Year Plan (1987–92) to 10.1 per cent in the Ninth Plan (2002–07). The relative decline in public expenditure on agriculture has been brought about by privatization of many activities that used be undertaken by government corporations and the ensuing reduction of subsidies on different agricultural inputs. The evidence so far does not, however, indicate that greater play of

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market forces in the agricultural sector has benefited the poor people. If anything, there is some evidence to suggest that access to some of the essential support services has declined in some remote areas to the detriment of the interest of the poor. Subsistence agriculture in particular has received little support in terms of productivity-enhancing technology and inputs. On the contrary, the subsistence of many poor Bhutanese has been jeopardized by a policy of strict environmental conservation that has limited their access to forest resources and their freedom to practise shifting cultivation. Whatever growth has occurred in agriculture, through crop diversification and commercialization, has benefited mainly the large landowners, and the problem has been aggravated by the high degree of inequality in the distribution of land. Although the problem of landlessness is not as acute in Bhutan as in other South Asian countries,3 the distribution of land is highly skewed. Less than 10 per cent of the households owning 10 acres or more account for over 30 per cent of total agricultural land. On the other hand, nearly 14 per cent of the total agrarian households owning less than an acre account for only 1.4 per cent of the available land. The combined effect of sluggish productivity growth in subsistence agriculture, unequal distribution of land and large landownerdriven growth in commercial agriculture has manifested itself in high levels of poverty and inequality in rural areas. In the face of slow agricultural growth, the overall growth of the economy has been driven by hydropower and related activities in construction and power-intensive manufacturing. But the direct benefit for the poor from this growth process has been minimal, as none of these activities generate much employment. Moreover, whatever employment that has been generated by them has gone mostly to Indian workers, who have been employed in the hydropower projects and construction sites by Indian contractors entrusted with the responsibility of executing these projects. In the manufacturing activities too, Indian labourers have taken the lion’s share. Most of the industries are located near the Indian border for convenience of proximity to the Indian market, which is the main destination of their products, and daily labourers from across the border have proved to be a lot cheaper than the Bhutanese workers, whose reservation wages seem to have been buoyed up by the comforts of the welfare state. If direct benefit for the poor in terms of employment has been negligible, there is reason to suspect that any indirect benefit in terms of resource transfer has not been very significant either. In the last couple of decades, most of the incremental revenue for the government exchequer has accrued from periodic revisions in the tariff of hydropower exported to India. Taking the latest three revisions together (spanning the period from 1997 to 2005), it has been estimated that as much as 56 per cent of the additional revenue generated by higher tariffs has gone to the civil servants and elected representatives in the form of higher salary (Osmani et al., 2005: 99). Whichever way the remainder of the additional revenue was utilized, the per capita benefit accruing to the poor population must have been a tiny proportion of the per capita benefit accruing to the governing elite. This, along with the concentration of high-growth activities in capital-intensive sectors, has played a big role in sustaining a high degree of inequality. The preceding discussion has focused on the magnitude of poverty and inequality at a point in time, because comparable data for other points in time are not available to permit a comparison over time. However, other indicators, such as those related to health and education, reveal considerable improvement in the standard of living. Both infant

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Table 6.9

Health status indicators

Indicators

1984

1994

2000

Crude death rate (per 1000 population) Infant mortality rate (per 1000 live births) Under-five mortality rate (per 1000 live births) Maternal mortality rate (per 100 000 live births) Life expectancy (in years) Male Female

13.4 102.8 162.4 7.7 47.5 45.8 49.1

9.0 70.7 96.9 3.8 66.1 66.0 66.2

8.6 60.5 84.0 2.6

Sources: MOHE (1994; 2000); NSB (2005).

Table 6.10

School enrolment and completion rates

Gross primary enrolment rate Proportion of pupils starting grade 1 who reach grade 5 Proportion of pupils starting grade 1 who reach grade 7

1990

2000

55 73 35

72 86 69

Source: RGOB (2002).

mortality and maternal mortality have declined significantly, leading to a spectacular increase in life expectancy from 48 years in 1984 to 66 years in 1994 (Table 6.9). There has also been significant improvement in educational attainment in terms of both enrolment and completion rates (Table 6.10). Despite rapid progress made in the past, Bhutan is still some way behind the goal of universal primary education. One of the problems surely lies in reaching educational services to a scattered population living in remote mountainous regions. However, great strides have been made in building schools in remote areas and providing free boarding facilities to students who do not have easy access to school from their homes. As a result, when the recent Living Standard Survey enquired about the reasons for children not attending school, the distance of the school did not figure as a major problem. In fact, none of the urban respondents cited it as a cause and only 8 per cent of rural respondents did so. A much more important reason was economic compulsion. As much as 44 per cent of all absences were explained by either ‘cannot afford to go to the school’ or ‘the child needed to work’. It would appear that persistent poverty of the household rather than access to schooling facilities now remains the major stumbling block towards achieving the goal of universal primary education. In the absence of a population census, the employment pattern of the Bhutanese people can only be gauged from a series of Labour Force Surveys carried out between 1998 and 2004.4 These surveys reveal that the sectoral distribution of employment fluctuates quite wildly from year to year, which calls into question the reliability of these figures (Table 6.11). Yet, some broad conclusions can perhaps be drawn. First, the Bhutanese economy remains largely agricultural. Second, the service sector is the second largest

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Sectoral distribution of employment: 1998–2004 (percentage share)

Sector

1998

1999

2001

2003

2004

Agriculture Industry Services All

76.0 5.9 18.1 100

74.9 4.8 20.3 100

46.5 5.6 47.9 100

75.5 4.0 20.5 100

63.2 9.8 27.0 100

Source:

Labour Force Survey, various years.

employer after agriculture, employing somewhere between 20 and 30 per cent of the labour force. Third, industrial employment is very small; no more than 6 per cent of the labour force was employed in this sector in most of the survey years. As in most other developing countries, open unemployment is very low in Bhutan, although it has gone up slightly from 1.4 per cent in 1998 to 2.6 per cent in 2004. The age distribution of the unemployed people shows that open unemployment is essentially a problem of youth unemployment in Bhutan, which has more than doubled from 2.6 per cent in 1998 to 5.5 per cent in 2004. This increase has been concentrated mainly in rural areas. The combination of slow growth of agricultural production and shift towards labour-saving devices has resulted in sluggish growth in the demand for labour within agriculture. Given this scenario, the educated rural youth has tended to migrate in increasing numbers to urban areas in search of non-agricultural employment. This trend has been causing serious concern among policy-makers in Bhutan, who are struggling to provide the necessary amenities and jobs to a growing urban population. The policy regime The macroeconomic policy regime External sector policy The Government of Bhutan is keenly aware that for a small country like Bhutan, international trade is essential in order to compensate for the limited availability of domestic resources as well as to overcome the limitations of a small local market. The most important trade policy instrument employed by Bhutan is the bilateral free trade agreement with India. Since India accounts for about 95 per cent of Bhutan’s export trade and over 80 per cent of its import trade, this agreement ensures that Bhutan follows by and large an open economy policy. Bhutan also has a preferential trade agreement (PTA) with Bangladesh, which is its second largest export market. The agreement allows for various concessions on duties on a range of products under which Bangladeshi products are granted duty-free access in the country while Bhutanese exports are exempted 50 per cent of the normal duty in Bangladesh. Bhutan has expressed its intention to further liberalize trade with Bangladesh through negotiations for deeper reduction in tariff and elimination of non-tariff barriers and expansion of product coverage under the existing agreement. Trade with countries other than India used to be controlled rigidly by a quota system until the early 1990s. Protection was not, however, the principal motive. As Bhutan is an import-dependent economy (with imports amounting to 60 or 70 per cent of GDP in recent years), there has been minimal compulsion to protect the domestic economy with

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import tariffs or quantitative restrictions. Due to a limited domestic market, the industrial sector has been largely export-oriented. The domestic agriculture sector has also not lobbied for protection, owing perhaps to a scattered population and the dominance of small subsistence farmers. Against this backdrop, the chief motivation for imposing quota restrictions came from the desire to conserve scarce hard currency rather than to protect domestic industry. These restrictions applied only to the 20–30 per cent of imports that were made in hard currency from countries other than India. The remainder, that is, the bulk of import trade, was covered under the free trade agreement with India. As a result, Bhutan has long been the most open economy in South Asia, with the most liberal trade regime. Further liberalization took place in the early 1990s, when the country began to move away from quantitative restrictions towards imposition of taxes and tariff, as part of a broader move towards allowing market mechanism a greater role in the allocation of resources. The replacement of quotas by tariffs was also justified on the grounds that tariffs would raise additional revenue for the government, by transferring the rents that had previously accrued to importers in the form of scarcity premium. Beyond this conversion of quotas into tariffs, however, not much has been done by way of trade liberalization; in particular, there has been no move to reduce the tariff rates. On the contrary, the rates of sales taxes and customs duty on imported goods were actually revised upward in September 2004 by an average of 30 per cent. The stated rationale for the revision was mainly to ‘conserve hard currency’ by discouraging imports from third countries. Customs duty and sales tax were also increased on items like plastic to discourage its use due to environmental concerns. The protective effect of customs duty, however, remains minimal for a number of reasons. First and foremost is the fact that it does not apply to trade with India, which accounts for 70–80 per cent of all imports. Second, even where it does apply, that is, on hard currency imports from countries other than India, there are many exemptions and leakages that dilute its effect. A much more important protective role is played by direct control on the use of convertible currency. As noted in Section 2 on economic growth, Bhutan has persistently run large current account deficits in its hard currency trade, which could not be offset even by the inflow of foreign grants. This suggests that the ngultrum is overvalued relative to the convertible currencies. Had there existed full current account convertibility between the ngultrum and hard currencies, this overvaluation would have been eliminated, leading to a depreciation of the ngultrum to the extent required to eliminate the current account deficit. In that case, it would not have been necessary to resort to administrative rationing of hard currency. So, the question must be asked: why isn’t convertibility allowed? The standard answer to this sort of question is that in a ‘thin’ currency market convertibility will generate excessive volatility of the exchange rate. This argument applies to Bhutan as much as in other developing countries, if not more because in Bhutan’s case the hard currency market is certainly thinner than usual. But there is an additional reason in the case of Bhutan that is even more compelling. Free convertibility of the ngultrum into hard currency is precluded by the policy of pegging the ngultrum to the Indian rupee. Given the peg, the ngultrum’s exchange rates with all other currencies are determined entirely by the rupee’s rates of exchange with them. But the exchange rates that are appropriate for India are not necessarily appropriate for Bhutan. Thus, it is

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entirely possible for the ngultrum to be overvalued vis-à-vis hard currencies even if the rupee is not. And since the overvalued ngultrum necessarily implies that demand for hard currencies exceeds their supply, there is no option but to resort to administrative rationing. The preceding analysis brings out a unique feature of Bhutan’s foreign exchange regime. In most other developing countries, administrative rationing of foreign exchange is resorted to for a variety of reasons (including an implicit belief that government can allocate scarce foreign exchange more wisely than the market), and overvaluation of the currency is a consequence of such rationing. In Bhutan, however, the direction of causality is reversed. Here overvaluation exists because of the policy of maintaining peg with the Indian rupee, and administrative rationing is a consequence of this overvaluation. This raises an important issue about exchange rate policy in Bhutan. Any inefficiency caused by the overvaluation of the ngultrum vis-à-vis hard currencies, and by the administrative rationing that goes with it, is a price Bhutan has to pay if it continues to maintain a fixed peg with the rupee. It is widely acknowledged that the peg with the rupee confers many benefits to Bhutan in respect of trade with India. It is equally clear, however, that the same policy also causes inefficiency in respect to trade with the rest of the world. In particular, by causing overvaluation of the ngultrum vis-à-vis hard currencies, it inhibits the growth of hard currency exports. It is not being suggested that overvaluation is the only or even the most important reason for Bhutan’s inability to earn more hard currency; only that it also contributes to the problem. An important policy instrument in the context of hard currency earnings is the foreign direct investment (FDI) policy. In December 2002, the government approved the foreign direct investment policy with a view to fostering private sector development, generate employment, enable transfer of capital, technology and skills and enhance convertible currency earnings. In the case of Bhutan, FDI is understood as investments made in convertible currency only (i.e., non-rupee investments). The foreign investor can hold up to 70 per cent of the equity. Previously, only limited foreign investment was allowed into the banking, tourism and industrial sector on a ‘case by case basis’. Under the new policy a wide range of manufacturing industries were opened up for foreign investment (with a minimum investment of US$1 million), as were services such as hotels, transport services, roads and bridges, education, business infrastructure, information technology, financial services and housing (with a minimum investment of US$0.5 million). Many observers feel that despite these new initiatives, the FDI policy is still unduly conservative, reflecting the cautious approach of the government aimed at ensuring that local entrepreneurs are not disadvantaged. Considering the small Bhutanese market and few comparative advantages that Bhutan offers it is unlikely that foreign investors will rush into Bhutan except in a few specific sectors such as tourism and power-intensive industries. Not a single foreign investor has come into Bhutan since the adoption of the FDI policy in 2002. Although FDI could potentially be important for export-oriented industries, the structural and locational constraints place severe limitations on its success. While access to the vast Indian market, via Bhutan, would have been an attraction even a few years ago, the economic liberalization process in India makes such a move less attractive to foreign investors today. Given the geographic realities, India will remain the most important market for Bhutanese products; therefore, the non-convertibility of the Indian rupee on the capital account will constrain potential foreign investors from investing in Bhutan.

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Monetary and financial policy The monetary policy framework of Bhutan can be characterized as something close to a currency board system. The domestic currency, the ngultrum is pegged to the Indian rupee with a one-to-one exchange rate, guaranteed by at least 100 per cent reserve backing of all the ngultrum issued. The existence of the peg has given rise to a monetary policy by default, whose rationale is to maintain price stability through exchange rate targeting. However, unlike other countries that deliberately adopt exchange rate targeting in order to confer credibility to their anti-inflation policy, Bhutan does not have a tradition of high inflation that needed to be countered by such a device. Therefore, the initial logic of a guaranteed peg with the Indian rupee was not based on the monetary consideration of price stability. It was based on the commercial consideration of facilitating trade with India. But given the existence of the peg, and the government’s desire to maintain it on trade grounds, monetary authorities have no option but to support it. That is why exchange rate targeting as practised in Bhutan is best described as monetary policy by default. As a consequence of this policy, Bhutan has entered into a de facto monetary (currency) union with India, with the inflation and interest rates of the two countries staying close together. Of course, since India happens to be by far the larger partner of this de facto union, it is the inflation and interest rate of Bhutan that track those of India rather than the other way round. Until 1997, the interest rates were administered by the RMA, providing little flexibility to the financial institutions to set their own deposit and lending rates on the basis of their cost of funds, risk of default, operating expenses and yield on assets. In order to create an environment more conducive to the growth of the financial system, the RMA partially liberalized the interest rates in October, 1997, allowing each institution to determine the rates on the basis of the prevailing market conditions. This was only a partial liberalization because the spread between lending and deposit rates continued to be determined by the RMA. However, in April 1999, to encourage competition among the financial institutions, the RMA abolished the system of spreads, liberalizing the interest rates fully on both loans and advances. Yet another dimension of financial liberalization relates to exchange control. Administrative control over foreign exchange transactions used to be pervasive in Bhutan and to some extent it still is. But in line with the government’s programme of liberalizing trade and industrial policies, the RMA Board approved the new Foreign Exchange Regulations 1997, removing a number of restrictions on foreign exchange transactions. The aim is to move eventually towards current account convertibility. After the regime of administered interest rates gave way to that of market-determined rates in 1997, there was no immediate movement in interest rates. It took a while for the market to respond to the changed environment. The first initiative came in 2000, when the Bank of Bhutan decided to lower its interest rates on selected loan schemes. Since then, a wider effect of interest rate liberalization can be observed (Table 6.12). The downward movement is most clearly visible in the case of deposit rates, and less so in the case of lending rates. As a result of these disparate movements between deposit and lending rates, the average interest spread, which was already high at 5.4 per cent in 2000, climbed even higher to 7.5 per cent. Although the nominal interest rates have declined in the past five years, this cannot necessarily be taken as an indication that financial liberalization has engendered a

Bhutan Table 6.12

209

Trends in interest rates (nominal interest rates; percentages)

Year

Deposit Rate

Lending Rate

Average Spread

1997 1998 1999 2000 2001 2002 2003 2004 2005

8.8 8.8 8.8 8.8 8.4 8.1 6.7 5.8 5.7

14.2 14.2 14.2 14.2 13.9 13.7 13.6 13.5 13.2

5.4 5.4 5.4 5.4 5.5 5.6 6.9 7.7 7.5

Source: RMA, Annual Report, various years.

genuinely competitive environment in the financial sector. Some decline in nominal interest rates was inevitable in view of the decline in inflation observed in the last five years. The average inflation rate came down from 7.7 per cent in the second half of the 1990s to 4.1 per cent in the next five years – a 3.6 percentage point decline. It is interesting to note that the average deposit rate has come down by an almost identical amount – 3.2 percentage points – during the same period. As a result, the real interest rate on deposits has remained virtually unchanged. By contrast, since the average lending rate has declined by only 1.0 percentage point, the real lending rate has actually increased by 2.0 percentage points. Therefore, the financial institutions have taken advantage of liberalization to keep the interest they have to pay to depositors unchanged in real terms by lowering the nominal rates in line with declining inflation, but have raised the real interest rate they charge the borrowers by reducing the nominal rate far less than what was warranted by the fall in inflation. The interest rate spread, or the margin of intermediation, has as a consequence increased in both nominal and real terms. There is, however, nothing in the real economy to suggest that the cost of financial intermediation has increased in Bhutan in the last five years to justify a rising spread. Given the shallowness of the financial market in Bhutan, the spread is understandably high, but the issue here is not why the spread is high but why it has become higher. For that, there is no apparent justification from the cost side. The only inference one can draw is that given the non-competitive nature of the financial market in Bhutan, the financial institutions have exercised their market power to raise the profit margin to the maximum level the market would bear. The market was noncompetitive before, as it is now, and it is not being suggested that the market has become less competitive than before. What has rather happened is that with the onset of liberalization, the non-competitive lenders have for the first time been able to exercise their market power, which they always had but found it artificially suppressed before by the regime of administered interest rates. In other words, while previously their market power was potential rather than actual, liberalization has enabled them to transform that potential into actual market power. The non-competitive nature of the financial sector stems fundamentally from the tension between the scale economies of financial intermediation and the exceedingly small

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size of the market in Bhutan. As the fixed costs are too high relative to the size of the market, the financial sector operates virtually in a situation of natural monopoly, or rather duopoly in the case of Bhutan. In principle, even a duopolistic market can be fiercely competitive. However, given the long tradition and vastly larger size of one of the two commercial banks (Bank of Bhutan) relative to the other (Bhutan National Bank), the market structure that has emerged is more of the leader-follower type. The Bank of Bhutan sets the trend and the Bhutan National Bank (as well as two non-bank financial institutions) follows suit, which makes the market non-competitive. The leader-follower behaviour enables both banks to enjoy the rent associated with natural monopoly instead of competing it away. The consequence, as we have seen, is the enlargement of the profit margin in the wake of financial liberalization. Domestic credit expanded rapidly in the wake of financial liberalization. Total credit took a sharp upward turn in 1997, exactly the year in which financial liberalization was initiated (Table 6.13). Moreover, this upward turn can be attributed almost entirely to a correspondingly sharp upward turn in private sector credit. At first sight, the timing of this acceleration suggests that the financial liberalization that was initiated in 1997 might have spurred the expansion of credit. But this impression is misleading. As noted above, liberalization did not lead to any substantial decline in nominal lending rates; in fact, the lending rates have actually increased in real terms. If the private sector borrowed more despite higher real interest rates, the primary reason must lie in some extraneous factors.5 These factors include mainly the construction boom stemming from the ancillary activities associated with the Tala hydropower project and a housing boom fuelled partly by rising urban affluence and partly by rapid rural-to-urban migration, especially into the capital city Thimphu.6 If liberalization had an effect it would be felt more in the allocation of credit among various sectors, and there were indeed some significant changes in this regard. During Table 6.13

Expansion of domestic credit: 1992–2004

Year

Total (Nu million)

Private Sector (Nu million)

Private Sector Share (%)

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

1195.9 1284.4 1339.6 1290.3 1241.8 1930.1 1889.9 1849.8 2086.7 2745.1 3404.9 3924.8 5038.3

425.8 488.8 485.0 521.5 564.4 1252.3 1301.4 1352.5 1624.3 2308.7 3031.5 3536.6 4599.5

35.6 38.1 36.2 40.4 45.5 64.9 68.9 73.1 77.8 84.1 89.0 90.1 91.3

Note: The figures exclude claims on the government. Source: RMA, Annual Report, various years.

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Table 6.14 Allocation of advances by economic sectors (periodic annual average; percentage share) Sectors Agriculture Manufacturing Construction Trade and commerce Transport Others Total Note:

1993–2000

2001–04

4.3 28.5 19.7 13.5 22.0 12.0

3.7 18.6 23.2 21.6 12.3 20.7

100.0

100.0

Components may not add up to 100 because of rounding.

Source: RMA, Annual Report, various years.

1993–2000, taken here as the pre-liberalization period,7 the manufacturing sector used to claim the largest share of loans, accounting for some 29 per cent of the total, followed by transport and construction. By contrast, during the post-liberalization period (2001–04), construction and trade sectors have emerged as the major destinations of loans, while the share of manufacturing has declined (Table 6.14). It is a matter of some concern that the surge in private sector credit that has occurred after liberalization has not been of any great benefit to the manufacturing sector, on which the country pins much hope for spurring productivity growth in the coming years. Another major concern is the share of agriculture. Even before liberalization, agriculture had a very low share of loans from the formal sector – just over 4 per cent. After liberalization, this small share has got even smaller, dipping below 4 per cent. In view of the low level of monetization of the agrarian economy, one would, of course, expect the share of loans going to agriculture to be lower than its share of GDP. But the fact that the share is exceedingly small and getting even smaller indicates continued failure on the part of the Bhutanese institutions and policies to modernize agriculture. Apart from farmers, entrepreneurs in the small and medium enterprises (SMEs) have also been starved of credit. Credit flows to agriculture and small businesses are not just dismally low but have been declining in the post-liberalization period. It’s not just that their shares have declined; even the absolute amount of credit going to them has either declined or stagnated, in both nominal and real terms. The GNH strategy of development For the past two-and-a-half decades, the development strategy of Bhutan has been underpinned by an overarching philosophy of human well-being. The present King of Bhutan enunciated this philosophy under the rubric of the Gross National Happiness (GNH) approach to development. By deliberately juxtaposing itself against the traditional preoccupation with the Gross National Product (GNP), this philosophy explicitly rejects the purely materialistic approach to development and calls for a holistic approach to development, embracing material, environmental, cultural and spiritual goals.

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For operational purposes, the GNH approach has been defined in terms of four pillars: 1) equitable development, ensuring equity between individuals as well as regions, 2) environmental sustainability, 3) cultural and spiritual upliftment and 4) good governance. Although there exists some uncertainty as well as ambiguity as to how exactly to translate these principles into actual policy-making, the government of Bhutan continues to make conscious attempts to ensure that its development strategy conforms to these principles as closely as possible.8 In support of the first pillar, namely equitable development, Bhutan has consistently emphasized the need for sustainable and geographically balanced development so as to ensure equitable improvement in the well-being of all Bhutanese people. The regional dimension of development thus assumes special importance in the development strategy of Bhutan. This goal is especially relevant in Bhutan because of its demographic and geographic characteristics. A small population is scattered over a relatively large area, giving rise to low-density settlements in far-flung areas separated by rugged mountains and poorly connected with each other by roads or other means. In such a condition, the benefits of growth will not automatically percolate to all parts of the country unless special measures are taken to make sure that they do. The Royal Government of Bhutan has tried to implement the strategy of regionally balanced human development through various policy instruments, including political and fiscal decentralization, widespread network of primary health care, aiming for universal access to primary education, and creating a well spread out network of physical infrastructure. As a result of the concerted effort to take health facilities to the doorstep of rural people, as much as 90 per cent of the country has by now come to have access to these facilities. Health care is delivered through an integrated system with national, regional and district hospitals serving as referral centres, followed by the Basic Health Units (BHU) at the community level. The Units serve remote areas and are staffed by welltrained paramedics who are equipped to treat minor ailments and advise on preventive measures against communicable diseases. In the field of education, the government not only provides free education at all levels (including higher studies abroad), but also operates a system of free board and lodging for needy students. Many schools provide boarding facilities for students living in areas far from the nearest school. Children from communities that do not have their own schools enrol in the distant schools either as a day scholar or as a boarder. This has been made possible largely through the provision of meals by the World Food Programme (WFP). At higher levels of education, a deliberate decision was made to locate the only college of the country in the Eastern region, which has traditionally been the most disadvantaged part of the country for both geographical and historical reasons. The nascent university system is also designed to consist of a network of institutions of specialized education spread out in different parts of the country instead of being located in a single campus. Apart from providing access to health care and education as widely as possible, the government of Bhutan has also tried to meet the basic needs of food and shelter for each and every citizen. Every citizen of Bhutan is entitled to a minimum amount of land for cultivation, so that he or she can grow the basic food needed for survival. Every household is also entitled to receive timber at heavily subsidized prices for the purpose of constructing a modest dwelling. The actual size of the subsidy is difficult to estimate, but a recent study shows that the subsidy provided during the Seventh Five Year Plan period (1992–97)

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represented about 2.2 per cent of the average current expenditure during the plan period. If the commercial value of the timber were taken into account, the revenue foregone would amount to about 40 per cent of the average annual revenue for the plan period (Osmani et al., 2005). In keeping with its focus on balanced regional development, based on people’s participation in decision-making processes, the Royal Government of Bhutan has systematically pursued the policy of administrative and fiscal decentralization. This strategy was meant to promote simultaneously two pillars of the GNH approach – equitable development and good governance. The attempt to introduce administrative decentralization dates back to 1981 when the Royal Government of Bhutan established Dzongkhag Yargay Tshogchung (DYTs) or District Development Committees giving dzongkhag (district) administrations the responsibility of preparing and implementing their own development plans in consultation with the DYTs. In 1991, this process was extended further down to the level of gewog (block, the lowest level administrative unit), by creating Gewog Yargay Tshogchungs (GYTs). Cementing this process, the government has recently introduced laws that require gups, the chiefs of gewogs, to be elected on the basis of adult franchise. The chathrims (laws) of 2002 formally devolved the authorities – regulatory, administrative and financial – to the local bodies. Accordingly, the gups are equipped with the responsibilities and authorities to assess local needs, determine priorities, decide upon programmes and monitor progress. They are also responsible for collecting taxes, mobilizing resources for community services, settling local disputes, maintaining water supplies and supervising social services. The system of administrative and fiscal decentralization allows each dzongkhag and gewog to draw up its own local plan, depending on its own priorities and coordinated by popularly elected representatives. These local-level plans constitute an integral part of the overall national Five Year Plans and are financed partly by locally mobilized resources, mainly in the form of labour contributions from the local population, and partly from subventions from the central government. In recent years, central subventions have amounted to nearly a quarter of the national budget. To what extent these and other efforts have succeeded in promoting a regionally balanced pattern of human development cannot be assessed fully because of the absence of sufficiently disaggregated data at the local level. However, some general patterns can be gauged from a countrywide rapid survey carried out by the Planning Commission in 2000 to assess regional indicators of well-being (RGOB, 2000). The study, called the Poverty Assessment and Analysis Report (PAAR) covered all 22 townships and 201 gewogs. Indicators were developed for ten different aspects of well-being – income, education, health, access to economic activities, physical facilities, environment, transport links, communication links, position of women and non-material needs. A composite index was also constructed to rank different dzongkhags and gewogs in terms of relative vulnerability. A major finding of this study is that despite serious efforts made in the past to achieve regional balance, six dzongkhags located in the Eastern region of the country continue to remain relatively disadvantaged compared with the rest of the country. Judging by most of the separate indicators as well as a composite index of well-being, all six Eastern districts were found to fall in the bottom half of the ranking. It should be emphasized that since these findings relate to a particular point in time (year 2000) and no comparable information is available for earlier periods, nothing can be inferred from these figures

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about the success or failure of the policy of balanced regional development. All that can be inferred is that considerable regional disparity persists even after four-and-a-half decades of planned development. One of the reasons for persistent disparity in well-being lies in the fact that parts of the country still suffer from lack of connectivity to the rest of the country, especially to the centres of administration and commerce. Thus, the same report from which the preceding evidence was drawn also shows that the Eastern districts are particularly disadvantaged in respect of connectivity. Nearly half of the gewogs that were not connected even by feeder roads belonged to the Eastern districts. Similarly, some 40 per cent of gewogs that were more than eight hours of walking distance away from the nearest highway belonged to these districts. A significant contributor to regional development is government expenditure at the regional level. A rough comparison of regional distribution of government expenditure with the distribution of households shows that broadly speaking the two distributions conform quite well to each other, indicating a fair degree of regional equity in the distribution of government expenditure (Osmani et al., 2005). There are, however, some conspicuous exceptions. For example, four dzongkhags in the West-Central region of the country received a far greater proportion of central government expenditures compared with the proportion of households they have. By contrast, there are certain other dzongkhags (three of them are in the east) for which central government expenditures are much lower than what would be warranted by their share of households. Interestingly, these two sets of dzongkhags stand at the opposite ends of the development spectrum – the former being the most developed and the latter the least. To what extent unbalanced government expenditure contributes to this unequal status of development and to what extent unequal development itself warrants unequal government expenditure is difficult to judge without a deeper analysis. But the fact that unequal government expenditure contributes to some extent to unequal regional development cannot be denied. Notwithstanding the exceptions mentioned above, it must be acknowledged that government expenditure has on the whole been reasonably balanced across regions. The fact that balanced government expenditure on social services has so far enabled Bhutan to achieve a fairly balanced regional development in several social dimensions is confirmed by the Poverty Assessment and Analysis Report (PAAR) (RGOB, 2000). The study finds that while the ranking of dzongkhags in terms of the composite index of development is highly correlated with the index of physical infrastructure, indicating that lack of connectivity has held back overall progress in the backward districts, there is very little correlation between the overall ranking and ranking in terms of the health index. This suggests that government efforts have helped to redress to some extent the disadvantages of the backward districts at least in the sphere of social sectors. The task that remains is to ensure a more balanced access to productive activities for all people across the country so that the goal of an all-round balanced development can be achieved. There is, however, a possibility that it might be more difficult to achieve regional balance in the days to come. The present balance has been achieved mainly because of the welfare programmes the government has implemented in education and health sectors, which by their very nature tend to be distributed largely in proportion to the population in the regions under consideration. But as government expenditures are likely to be dominated in future by investment on physical infrastructures promoting competitive

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advantages of the regions, the possibility of increasing imbalance in regional development could easily arise. Environmental sustainability, the second pillar of the GNH approach, has also received high priority in the formulation of government policies. One manifestation of this priority is found in the decision to set up a Trust Fund for the environment in order to insulate environment-promoting expenditures from unforeseen budgetary fluctuations. But the main strategy the government has followed for this purpose is to adopt deliberately cautious policies with respect to the use of forest resources and the expansion of the tourism industry. The choices made by the government in these respects invariably entail trade-offs between environmental sustainability and other policy goals. Understanding these tradeoffs is an essential part of both understanding and improving the policy regime in Bhutan. Bhutan lies in the Eastern Himalayas, which is recognized as one of the ten global ‘hot spots’ for biodiversity. The microclimatic conditions prevalent in Bhutan allow for rich ecosystem diversity and it is home to numerous species of birds, animals and plants. Bhutan is lauded internationally for its environmental credentials, and the actions it has undertaken to earn these credentials include a constitutional mandate to keep at least 60 per cent of land under perennial forest cover. The present coverage is estimated to be about 72 per cent, and rising. The forest cover is also a great asset for the people of Bhutan. Free access to forest products, especially for the rural people, has effectively helped to avert situations of extreme poverty, destitution and homelessness. Besides, timber and wood-based products derived from the forests are an important source of export earnings. Forests are also vital for maintaining water catchment areas to support agriculture, the main source of livelihood for the people, and the hydropower sector, which is the largest source of revenue and growth. Maintenance of an adequate forest cover is thus seen as desirable from both environmental and economic points of view. However, some tensions are emerging between environmental and economic concerns. These tensions are arising in the context of both subsistence and commercial use of forest resources. In the context of subsistence use, an example of such tension arises from the setting aside of a large chunk of forestland as protected areas in the form of national parks. At present almost 28 per cent of the country is declared as protected area. Unlike other countries with wide expanses of pure wilderness, national parks in Bhutan also include areas with significant human settlement. Due to the extensive interface between agriculture and forestry in Bhutan the people have traditionally depended on the forests as a source of timber, food, fodder and so on. Therefore, the declaration of these areas as national parks creates tensions between conservation and forest utilization. State interventions to govern access to resources are justified on the basis that increasing population pressure and growing commercialization could lead to over-exploitation of the forest resources. For the vast majority of people dependent on subsistence agriculture and forest resources, however, biodiversity conservation is often a secondary concern compared with the compulsions of making a living. For example, the establishment of the Jigme Singye Wangchuck National Park (formerly the Black Mountain National Park) in 1995 was received with mixed responses from the public. Small communities called the Monpas depend on resin tapping from chirpine forests for over 25 per cent of their income. However, the Park management in 2002 banned resin tapping, stating conservation reasons without compensation or

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alternative income opportunities. Such actions not only threaten livelihoods of the poor but may also be counterproductive from an environmental point of view as well, because it is likely that the absence of ownership and user rights to these resources will reduce the incentive for local people to conserve and manage forest resources sustainably. Similar tensions exist also in the commercial use of forest resources. The wood-based industries form the single largest group of production and manufacturing industries in Bhutan comprising 46 per cent of the total number of industries. The comparative advantage of these industries lies in the availability of cheap timber at prices ranging from US$65–102/m3 compared with international prices of US$126–238/m3. Despite the obvious comparative advantage, the contribution of the forestry sector to exports is far below its potential. In recent years, wood products have contributed less than 5 per cent of total exports. The main reason for such low levels of export performance lies in strict conservation policies, as manifested in the existing ban on the exports of logs, sawn timber and semi-finished timber products. The only timber-related products that can be exported are finished wood products. The explicit reason given for this restrictive policy is promotion of greater value-added by concentrating on finished products. But such a policy is not necessarily efficient. What matters for economic efficiency is that encouragement be given to products with comparative advantage; and products with higher value-added do not necessarily have comparative advantage over those with lower value-added. It is quite plausible that Bhutan has a comparative advantage in the whole range of products starting from timber to finished woodbased products. In that case, the existing policy involves a loss of efficiency. It might be argued that this loss of efficiency is a trade-off that Bhutan has deliberately accepted for the sake of environmental sustainability. But this argument does not stand up to scrutiny. Current assessment shows that Bhutan’s timber resources are largely underutilized from both stock and flow perspectives. Taking first the perspective of stock, it has been officially estimated that about 34 per cent of the total forest area can be used for timber production. However, at present only 6 per cent is under management plans of the public corporation that has the monopoly right to extract timber for commercial purposes, and 9 per cent is around local settlements for supply of timber for the rural people. This leaves another 15 per cent of total forest area that is potentially suitable for timber extraction but not currently utilized. From the perspective of sustainable flow, one may consider the magnitude of the annual allowable cut (AAC) as it provides a dynamic measure of resource sustainability. The AAC is defined as the volume of timber that can be harvested from a particular area in any one year without harming future sustainability. According to official estimates, the AAC from the areas presently under official management plans is around 17 million ft3 per annum. However, the present annual cut is only about 8–9 million ft3 per annum. Thus, the annual cut is only 50 per cent of the AAC, which indicates a vast potential to increase the amount of timber extraction in a sustainable manner and without violating the constitutional mandate of keeping at least 60 per cent of the land under forest cover.9 This assessment indicates that Bhutan may be pursuing an excessively restrictive policy with respect to the use of forest resources. A somewhat similar argument may be made with respect to Bhutan’s policy towards tourism. While the country’s location, terrain and relative isolation have posed significant barriers to economic or industrial diversification, these very conditions also provide a strong

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comparative advantage for Bhutan as a special tourist destination for nature and cultural tours. However, the government of Bhutan has followed a deliberately restrictive policy of discouraging an influx of ‘low value’ tourists (such as backpackers) for fear that they might compromise the relatively pristine nature of Bhutan’s environment as well as culture. As a result, a ‘high value, low volume’ policy has been in place since the inception of tourism in the early 1970s. Under this policy, tourists must visit Bhutan in organized groups through a travel agent who offers an integrated package that includes food, lodge, transport and guide services. The minimum tariff has been fixed by the government at US$200 and US$165 per person per day for the peak season and lean season respectively, from which the government deducts US$65 and US$55 as tourism royalty. Such a cautious policy has successfully ensured that the local culture and the environment are not overwhelmed by mass tourism. This has, however, come at the expense of foregone economic gains. Tourism receipts amounted to only about 2 per cent of GDP in 2000. In the wake of the subsequent global slump in tourism, the contribution has come down to just over 1 per cent. Even in this restrictive form, however, tourism plays an important role in Bhutan’s economic development. It has significant potential for backward linkages in the domestic economy and for employment generation for the rising numbers of educated youth. But most importantly, it has been the largest commercial source of convertible currency earnings for Bhutan. Around 2000, the amount of convertible currencies earned through tourism was almost double the amount earned through merchandise exports (to countries other than India). Even with the subsequent decline, tourism still remains the largest earner of convertible currency. This particular role of the tourism industry is especially important in view of the argument made earlier that lack of convertible currency currently poses the binding constraint to economic growth in Bhutan. Since the landlocked nature of Bhutan makes it difficult to earn convertible currency by exporting merchandise to destinations beyond India, the arrival of tourists offers a golden opportunity to earn convertible currency by exporting services in a manner that circumvents the problem of landlockedness. From this perspective, the restrictions imposed on tourism clearly entail a trade-off between environmental concerns and the concern for growth. Considering that sustained growth is essential, though not sufficient, for rapid poverty reduction, this also entails a trade-off between concern for environment and concern for improving the living standards of the poor. Concluding observations The long-term development prospects of Bhutan are constrained by two objective conditions that limit the options open to the policy-makers. These constraints arise from some special features of the demography and geography of Bhutan. The demographic constraint emerges from the small size of its population. With a population of just over half a million, Bhutan is one of the smallest economies in the world. While most other countries of South Asia suffer from an excess of population relative to resources, Bhutan faces the opposite problem of having too few people. There are two economic implications of a small population that are relevant in this context. First, a small population means a small domestic market for producers of goods and services. A small market limits the scope for specialization and makes it hard to reap the benefits of economies of scale, without which sustained productivity growth cannot be achieved. Second, a small population also means a small labour force. There are worrying

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signs that scarcity of labour is already beginning to limit the scope of production in different sectors of the Bhutanese economy, especially in agriculture. In other sectors such as hydropower, construction and, to a limited extent, manufacturing, the problem of labour shortage has been circumvented by the use of cheap Indian labour. But there are political and cultural limits on how far an economy can be propped up by foreign labour. There are indications that Bhutan is not too far off those limits. It is, therefore, quite likely that at least in quantitative terms a shortage of labour will remain a persistent feature of the Bhutanese economy. One implication of this constraint is that instead of adopting a labour-intensive strategy of development that suits most other countries of South Asia, Bhutan must pursue an approach that is intensive in the use of skill and technology. The geographical constraint also has two dimensions – one internal and one external. The internal constraint arises from the fact that the few people that Bhutan has are scattered over a large mountainous terrain. The result is low density of population combined with lack of accessibility. This is a pernicious combination because it implies first that transportation adds enormously to the cost of production, second that provision of any kind of services to the people become hugely expensive, and third that setting up any local-level enterprise becomes uneconomic as it becomes difficult to reach a reasonable scale of production. The external constraint emerges from the fact that Bhutan is a landlocked country, surrounded by two giant neighbours, India and China. Friendly relations with India has enabled Bhutan to circumvent the problem to some extent by using India both as a market and a source of technology, capital as well as various types of consumer and intermediate goods. However, reaching out to the wider world remains a major problem. Moreover, political realities inhibit the prospect of taking advantage of China’s presence as a big and resourceful neighbour in the same way that India’s presence has been. In view of these constraints, the long-term development prospects of Bhutan must rest on the adoption of a distinctive strategy with the following characteristics: an outwardoriented economy that relies on exporting low-volume high-value goods and services based on skilled labour and modern technology, in return for imports of most consumer goods, except for some basic foodstuff. Such a strategy would also be consistent with the GNH approach to which Bhutan is wedded, as it would minimize the country’s dependence on the use of natural resources, which has potentially adverse implications for environment and culture. The government of Bhutan is evidently conscious of the need to adopt the kind of strategy described above. What is not so evident, however, is whether it is understood that the adoption of such a strategy would involve some hard choices in the short-tomedium term, that is, in the transition period when the economy will need to equip itself with the capabilities required for the adoption of the long-term strategy. For instance, the economy will need to acquire the skills and technology required for specialization in ‘low-volume high-value’ products. This process would call for investments that would involve the use of hard currency, whose shortage is currently proving to be the binding constraint to growth in Bhutan. In order to solve this constraint, Bhutan will have to invest heavily during the transition period into hard-currency-earning activities such as niche agricultural products, forest products and tourism, all of which involve the use of natural resources other than hydropower. Bhutan has so far been reluctant to expand some of these activities – especially forest products and tourism – for fear of potentially

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adverse consequences on the environment. This fear is understandable in the light of Bhutan’s commitment to the GNH philosophy. But unless some compromise is made in the transition period, the persistence of a hard currency constraint will inhibit the acquisition of the skill and technology necessary for the adoption of the long-term strategy. As a result, the transition period will be lengthened, thereby delaying the day when Bhutan would be able to implement the GNH-consistent long-term strategy fully. In other words, what Bhutan faces is an inter-temporal trade-off – between strict adherence to the GNH approach today and hastening the adoption of a GNH-consistent long-term strategy in the future. One way or the other, the people of Bhutan will have to confront this trade-off and resolve it in the light of their value judgements. The muchanticipated transformation of the Bhutanese polity into multi-party democracy gives an opportunity to the people of Bhutan to resolve the trade-off in a democratic and participatory manner. Notes 1. The first comprehensive population census of Bhutan was carried out only as recently as May 2005. According to the preliminary results unofficially available, the population of Bhutan would be somewhere around 650 million. 2. By way of comparison, the Gini index based on consumption expenditure in Bangladesh was only 0.30 in rural areas in 2000, while in the urban areas the index was similar to that in Bhutan. 3. Survey estimates show that only 2.6 per cent of households are landless in Bhutan. 4. In addition, the Bhutan Living Standard Survey of 2003 also contains data on employment, but the sample size is much smaller and not directly comparable with the Labour Force Surveys. 5. This is also evident from the fact that private sector credit had already increased sharply during the period 1996–2000 when lending rates had remained static in nominal terms despite liberalization. 6. Expansion of credit for the housing sector may have been helped by the fact that the lending rate for this sector was lowered more substantially than for any other sector. To that extent, interest rate liberalization did have a role to play in the expansion of credit, but the quantitative significance of this role relative to that of migration cannot be judged in the absence of a more detailed study. 7. Year 2000 has been taken as the cut-off line between the two periods, because although the process of liberalization started in 1997 the full effect began to be felt only after 2000 with the removal of administered spread in 1999 and the first initiative taken by the banks to alter the interest rates in 2000. 8. For an attempt to operationalize the concept of GNH in terms of practical policy-making, see, among others, RGOB, 1999. 9. Note that the concept of annual allowable cut (AAC) is not directly related to the constitutional mandate of keeping at least 60 per cent of land under forest cover. However, since extraction of timber up to the limit of AAC would by definition sustain the present forest cover, and since the present cover is higher than the minimum cover mandated by the constitution, it follows that raising the flow of extraction up to the AAC level would not violate the constitutional mandate.

References MOHE (1994), Report on National Health Survey 1994, Thimphu: Ministry of Health and Education, Royal Government of Bhutan. MOHE (2000), A Report: National Health Survey 2000, Thimphu: Ministry of Health and Education, Royal Government of Bhutan. NSB (2000), National Accounts Statistics Report, 1980–1999, Thimphu: National Statistical Bureau, Royal Government of Bhutan. NSB (2004a), National Accounts Statistics Report, 2003, Thimphu: National Statistical Bureau, Royal Government of Bhutan. NSB (2004b), Poverty Analysis Report, Bhutan, Thimphu: National Statistical Bureau, Royal Government of Bhutan. NSB (2004c), Bhutan Living Standard Survey 2003, Thimphu: National Statistical Bureau, Royal Government of Bhutan. NSB (2005), Statistical Yearbook of Bhutan 2004, Thimphu: National Statistical Bureau, Royal Government of Bhutan.

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Osmani, S.R., B.B. Bajracharya, S. Tenzing and T. Wangyal (2005), Macroeconomics of Poverty Reduction: The Case Study of Bhutan, A report prepared for the UNDP regional project on the Macroeconomics of Poverty Reduction. RGOB (1999), Vision 2020: A Vision for Peace, Prosperity and Happinesss, Thimphu: Planning Commission, Royal Government of Bhutan. RGOB (2000), Poverty Assessment and Analysis Report 2000, Thimphu: Planning Commission, Royal Government of Bhutan. RGOB (2002), Millennium Development Goals: Progress Report 2002 Bhutan, Thimphu: Royal Government of Bhutan. RGOB (2005), Bhutan Human Development Report 2005, Thimphu: Planning Commission, Royal Government of Bhutan. RMA (2005), Selected Economic Indicators, June 2005, Thimphu: Royal Monetary Authority.

7

The Maldives Mamta Chowdhury

Introduction The Maldives, whose islands are popularly known as the ‘pearls of the Indian Ocean’, is located south of Lakshadweep Islands, about 480 km southwest of Cape Comorin, India and 650 km southwest of Sri Lanka. The country comprises of 1190 low-lying small coral reef islands, grouped in 26 natural atolls, stretching 820 km north to south and 120 km east to west. These 26 atolls are organized into 19 administrative units with the capital island Malé. Only 200 islands are inhabited, with 88 islands used as exclusive resorts. The climate of the country is humid and warm and mainly governed by southwest and northeast monsoons. The temperature stays around 29 to 32º C. Precipitation is on average 160–230 cm a year. The Maldives enjoys very clear water around it due to the nonexistence of rivers and run-off carrying sediments from inland, which facilitate the ideal conditions for coral growth. The capital city Malé stretches over an area of 4 km. According to the census of 2005 the population of the country is around 349 106. The population is relatively young, with 43 per cent of population under 15 years and only 3 per cent over 65 years of age. The citizens of the country are known as Maldivians, and two-thirds of the population live in Malé. The annual average growth rate of the population was 2.8 per cent over 2001 to 2005 and is falling quite rapidly over the recent years. Since the country has more territorial sea than dry land, sea resources and coral reefs play a very important role in the economic and social life of the country. The expansion of the agricultural sector is constrained by potable water, limited arable land and mineral resources. The economy of the Maldives has been growing at an average of over 10 per cent since the late 1970s, assisted by rich marine resources and tourism. Tourism and commercial fisheries contributed about 40 per cent to the GDP of the country in 2002. The economy is regarded as exemplary in the region as the private sector as well as the public sector is becoming more dynamic and competent. In terms of foreign trade and investment, the country is increasingly becoming more open and offers a favourable environment for direct foreign investment. Social indicators have shown parallel improvement with economic performance, and substantial public resources have been channelled into education, health, safe water access and rural electrification over the last two decades. The open unemployment rate is low despite rapid population growth of more than 2 per cent. The country ranks high among the Indian Ocean countries in terms of several social indicators. History The history of the Maldives goes as far back as 1000 BC. As the recent archaeological findings suggest, the land was on the Silk Route and inhabited at that time. The early settlers probably came from the Indus Valley Civilization of Southern India and Sri Lanka during about the 4th and the 5th centuries BC. 221

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The legend narrates that a Sinhalese prince was stranded with his bride in a Maldivian lagoon and stayed on to rule the country as the first sultan. In around AD 947, recorded contact with the outside world began with the first Arab travellers who came to know the Maldives for its potential for trade in pearls, spices, coconuts, dried fish and cowry shells (which were used as accepted currencies from Africa to China). Sailors from Arab and East African countries started coming to the Maldives in the 12th century AD. Three major ethnic groups, South Indians, Sinhalese and Arabs, are prominent in the country. Islam is the official religion of the country. The majority of Maldivians originally converted to Sunni Islam from Buddhism in the mid-12th century. During most of its history from 1153 to 1968, the Maldives was governed as an independent Islamic sultanate. In the 16th century, the Portuguese ruled the island for 15 years between 1558 and 1573. They were driven out by the Maldives’ warrior patriot Muhammad Thakurufar Al-Azam. The country was a British protectorate from 1887 until 25 July 1965. The sultanate continued until 11 November 1968 and was replaced by a republic – the Republic of Maldives, the present name of the country. The first written constitution was proclaimed in 1932. The national language of the country is Dhivehi, an Indo-European language close to Sinhalese, but writes from right to left like Arabic. However, English is the medium of instruction in the government schools and widely used in trade and commerce. Government and political conditions A new constitution, adopted after full independence from the British in 1968, gives supreme power to the president, including the appointment and dismissal of the prime minister and the cabinet ministers. The president heads the executive branch and appoints the cabinet, nominated for a five-year term by the secret ballot of the Majlis (Parliament). The Majlis is composed of 48 members serving a five-year term. The Maldives’ legal system is derived from traditional Islamic laws and administered by secular officials, appointed by the president and the Ministry of Justice. The Maldives does not have any organized political parties. The current president Maumoon Abdul Gayoom was chosen by the Majlis in July 1978. A political party named the Maldivian Democratic Party (MDP) was registered by 42 prominent Maldivians in 2001, but was blocked by the Majlis on the grounds that the existence of political parties may create divisions among the public and would be counterproductive. However, MDP was formed in exile in Sri Lanka in that year. In the Majlis election held in January 2005, the MDP won 18 of 42 available legislative seats. Although President Gayoom announced after the election that he intended to establish a multiparty democracy in the Maldives within one year, this has not happened yet. Social development indicators Encouraging social developments have accompanied the economic growth of the country. The Maldives’ progress in terms of its social development indicators over the last two decades is well above those of other least developed countries (LDCs) in the region (Table 7.1). Between 1991 and 1998, urban population growth was 27 per cent on average, which increased to 28 per cent in 2001. Life expectancy increased from 65 years on average during 1991–98 to 73 years in 2003 with 73 years for males and 74 years for females.

The Maldives Table 7.1 Indicators

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Selected social development indicators of the Maldives 1985–2005 1985

1990

1995

2000

2005

Total population 180 088 213 215 244 814 280 000 349 106 Average annual growth rate of 3.2 3.4 2.7 1.9 2.8 population (%) (1985–90) (1991–95) (1996–2000) (2001–05) Life expectancy at birth (years) 61 65 70 71 74 Infant mortality per 1000 58 34 32 14 (2003) 15 (2004) live births Population with access to 58 94 100 100 safe water (1980–85) Public expenditure on 4 4.7 7.7 18 education (% of GDP) Adult literacy rate (%) 93 99 100 Total school enrolment 50 055 63 370 87 870 10 5356 104 214 (2004) GNP per capita (US$) 2130 2300 (2003) Human development index 0.5 0.75 0.745 HDI rank of the country 112/173 89/175 96/177 Sources: Government of the Maldives, Statistical Year Book of Maldives (1997, 2005); World Bank (2002); UNDP (2003), Human Development Report 2003; CIA (2006), The World Fact Book: Maldives.

Infant mortality per 1000 live births declined to 14 in 2003 from 58 in 1986. Child malnutrition for children under five years was on average 39 per cent between 1991 and 1998, which increased to 45 per cent in 2001. By 2001, everyone in the country had access to safe water compared to 58 per cent on average between 1980 and 1985. The adult literacy rate stood at 100 per cent in 2005. The net primary school enrolment rate was 98.6 per cent of the relevant age group, and the net secondary enrolment rate was about 40 per cent in 2000. Most communicable diseases, such as measles, leprosy, childhood TB and so on became largely under control by 2002, and childhood immunization for children under 12 months reached 96 per cent by the end of 2000. The Maldives has been declared a malaria-free zone since 1984. HIV/AIDS and other sexually transmitted infections appear low in recent years. Only ten cases have been reported in the population since 1991. It is observed that Maldivian women are among the most liberated in South Asia. Institutionalized gender discrimination is virtually absent in terms of access to education, health and labour force participation in the public sector. Education Over the past two decades, the Maldives achieved a great improvement in education, driven by high values on education placed by society. The government put a high priority on education and training programmes and undertook policies to enhance the productivity and living standards for citizens. By 1998, the adult literacy rate reached 98 per cent. The functional literacy rate reached 100 per cent in the Maldives by 2005. Primary education is virtually universal. Almost 100 per cent of children complete their five years’ primary education with a large number of them also completing seven years of basic

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education. Government expenditure on education as a percentage of GDP increased from 4.7 per cent in 1995 to 7.7 per cent in 2000. Modern and traditional schools exist side by side. English is the medium of instruction for most of the schools that follow the British education system. However, some schools use Arabic or Dhivehi as the medium of instruction provided by community-paid teachers. These schools provide basic numeracy and literacy skills in addition to religious instruction. All inhabited islands of the Maldives are equipped to provide education up to year 5 from early 2003. A few islands have secondary school facilities from years 6 to 10 and the only high school providing years 11 and 12 standard education is located at Malé, the capital city. Only 5 per cent of students go to high school. Health The Maldives’ health care facilities are quite adequate. The government also placed a high priority on the improved heath of its population by ensuring equitable access to health services with a focus on prevention of diseases and promotion of a healthy lifestyle. Government expenditure shows a strong commitment to health care, which accounted for more than 10 per cent of public expenditure and about 4.5 per cent of total GDP. Per capita spending on health also steadily increased both in nominal and real terms during the second half of 1990. Per capita spending on health increased from about Rf700 (rufiyaa) (US$60) in 1995 to about Rf1153 (US$94) in 2001, showing an average increase of 7.5 per cent per annum. There is a good public–private mix for the tertiary health care. Two large hospitals, the publicly owned Indira Gandhi Memorial Hospital (IGM) and the privately owned Abduarahman Don Kaleyfan Hospital (ADK), provide high-standard medical care. ADK accepts some insurance plans, but IGM does not. Infrastructure The Maldives’ government expenditure on infrastructure development is not as highly endorsed as in the health and education sectors. Major involvement by the government has been directed towards land reclamation and development of government housing, transport, rural electrification and regional development activities in recent years. The private sector is the key provider of sea transport, which is the major mode of transportation in the Maldives. However, the public sector has the responsibility of airport and harbour development as well as development of intra- and inter-city road constructions. A sophisticated communication system with up-to-date technology and international satellite links have been in place since the last decade. International Direct Dialling and card phone facilities are available on all islands of the Maldives. Labour force The labour force (Table 7.2) of the country comprises about 50 per cent of the total population. A large number of expatriate workers is a distinctive feature of the country’s labour force as it has a shortage of skilled labour. Thus, expatriate labourers, including teachers, medical personnel and other professionals, as well as construction workers and other low-skilled labourers play an important role in the ongoing development of the country.

The Maldives Table 7.2

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Labour force and sectoral participation rates 1985–2000

Sectors Total labour force Female Expatriate labour Labour force participation rate (% of working age population) Male Female Sectoral participation (% of labour force) Manufacturing Fishing Agriculture Others*

1985

1990

1995

2000

51 478 11 160 14 701

56 018 11 117 14 782

67 233 18 214 18 510

88 000 29 000 27 716

54.6

52.5

51.2

55.0

82.2 24.7

96.4 21.2

72.9 27.1

71.9 36.3

22.5 24.2 5.9 47.4

15.1 20.6 4.7 59.6

18.1 18.8 3.4 59.8

13.0 10.0 14.0 61.2

Note: * Others include quarrying, electricity, gas and water, construction, wholesale and retail trade, hotels and restaurants, transportation, storage, communication, financing, insurance and business and community, social and personal services. Sources:

World Bank (1999); Government of the Maldives, Statistical Yearbook of Maldives, 2005.

In 1985, the total labour force was 51 478 persons with an 82 per cent participation rate among men and 25 per cent participation rate among women, which gave a combined participation rate of 54.6 per cent. The labour force of the country increased to 67 223 persons in 1995 with an increase of about 3.0 percentage points for women and about a 10.0 percentage point decline in the participation rate for men. Domestic labour force increased by about 71 per cent from 1985 to 2000. According to the 2000 census, total employment of the country is 97 987 of which 88 000 were the domestic labour force and two-thirds of them were male. The domestic labour force growth was quite slow compared with the expatriate employment due to skill shortages caused by low educational attainment. Easy access by unskilled expatriate labourers in the Maldives and the relative decline of female workers because of geographic and social reasons are also contributing to this fall in domestic labour force participation rate. Due to the rapid growth of the economy over the last two decades and limited availability of local skilled labour for some occupations, the Maldives has been encouraging expatriate workers. In 1985 a total of 14 701 expatriate workers were employed in the Maldives, of which 24.8 per cent were employed in the public sector and 75.2 per cent in the private sector (World Bank, 1999: Table A1.5). During the first quarter of 2004, the expatriate labour force averaged at around 34 265 persons compared with 31 160 during the first quarter of 2003, reflecting an annual growth of 10 per cent (Maldives Monetary Authority, 2004). The tourism industry employed 40 per cent of the expatriate labourers and the rest are employed by fisheries and community, social work and education, construction and personal services sectors. The economy of the Maldives: progress and performance The Maldives has achieved impressive economic and social development since independence in 1965. The economic performance of the country has been quite strong since the

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late 1970s. In its dualistic economic structure, tourism has emerged as one of the most dynamic and leading sectors of the country in terms of its contribution to economic growth followed by fisheries. These two sectors together account for about 40 per cent of GDP and employ more than a third of the labour force. Government has taken a pragmatic approach in terms of using public sector resources as well as foreign aid and grants in economic activities and the provision of social services. About 70 per cent of total development expenditure was funded by external sources, of which concessional loan and grants occupy a major share. This section discusses the progress and performance of the Maldives’ economy. Favourable conditions in the external sectors and proper utilization of foreign aid and grants helped the economy to have an average GDP growth of about 7 per cent per annum between 1997 and 2003 (Table 7.3). This rapid GDP growth elevated the per capita income of the country in purchasing power parity measure from less than US$100 in the 1970s to $3900 in 2002. Real economic growth was more than 8.5 per cent in 2003, caused by rapid recovery in the tourism sector, which contributed about 33 per cent to GDP and accounted for more than 90 per cent of foreign exchange receipts and 31 per cent of all domestic revenue. The economy is based on tourism, commercial fisheries and shipping. GDP of the country was US$2.36 million in 1974 with a population size of 134 000, which increased to $1.25 billion in 2002. However, according to estimates by the World Bank, the gross national income (GNI) of the country, measured at average 2001–03 prices, was US$656 million, which is equivalent to a per capita income of US$2300 in 2003. The country has been experiencing rapid growth over the past 15 years due to social and political stability. The real GDP growth was about 10 per cent over the 1980s. Between 1989 and 1994, the economy was growing at an average rate of 9 per cent per annum, which fell to an average of 7.4 per cent between 1995 and 2003. The population of the country was growing at an average annual rate of 2.5 per cent between 1990 and 2003, leading to a real GDP per capita growth of 4.9 per cent per annum between 1995 and 2003. The Asian Development Bank’s (ADB, 2004) estimates indicate that the growth rate of GDP was 8.4 per cent in 2003 and 8.8 per cent in 2004 (Maldives, in Europaworld, 2006). However, the economy shrunk by 5.5 per cent in 2005 as a result of the tsunami in December 2004. Table 7.3

Gross domestic product and sectoral contribution (Rf millions) 1989–2004

Year

Real GDP (1995 100)

Real GDP Growth (%)

CPI (2000  100)

Primary Sector (% GDP)

Secondary Sector (% GDP)

Tertiary Sector (% GDP)

1989 1993 1994 1998 2002 2004

2637 3700 3978 5648 6993 8158

9 5 8 10 7 7

47.9 80.0 82.7 98.3 101.6 105.0

27.3 22.4 21.5 10.3 10.4 9.6

14.1 15.4 15.4 14.2 15.6 15.7

58.7 62.3 63.1 79.6 77.9 78.7

Sources: IMF, International Financial Statistics 2005; various World Bank documents; Government of the Maldives, Statistical Yearbook of the Maldives, 2005 and author’s own calculation for sectoral contribution and splicing the indices of price changes.

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The primary sector (Table 7.3) comprising agriculture, fisheries, coral and sand mining accounted for 27 per cent of GDP in 1989, which declined to 9.4 per cent of GDP in 2000. The secondary sector consists of electricity, water supply, and the construction and manufacturing sectors, occupying 14 per cent of GDP in 1989 (Table 7.3). The share of the secondary sector increased to 18 per cent of GDP in 2000. The tertiary sector (Table 7.3), encompassing wholesale and retail trade, tourism, transport, communication, financial, real estate and other business services, government administration, education, health and social services, accounted for 59 per cent of the country’s GDP in 1989, where tourism occupied the largest share followed by distribution and government administration. The tertiary sector’s share increased to 64 per cent of GDP in 1995 with a spectacular growth in the tourism sector. The contribution of this sector stood at 75 per cent of GDP in 2003, and expanded by about 9.5 per cent in 2004 (Europaworld, 2006). Historically, poor soil, scarce arable land and a domestic labour shortage are the major constraints on the Maldives’ agricultural sector. Thus, most food, including some staples are imported. Agriculture provides only 10 per cent of the food requirement of the country and is limited to the production of a few subsistence crops, such as banana, breadfruit, papayas, mangoes, taro, betel, chillies, sweet potatoes and onions. Coconut production is one of the dominant agricultural products of the country. This sector generated 14 per cent of employment in 2000. Fishing is the largest industry, contributing 68 per cent of the export earnings and employing more than 10 per cent of the total working population. This sector is an important source of government revenue too. Agriculture and fishing accounted for an estimated 9.2 per cent of GDP in real terms in 2003. The annual average real growth rate of the sector was 3.3 per cent between 1990 and 2003. The industrial sector, comprising mining, manufacturing, utilities and construction, contributed 16 per cent to GDP and employed 19 per cent of the working population in 2003. The sector grew by 7.5 per cent in 2003 and 9.9 per cent in 2004. Mining and quarrying accounted for 0.6 per cent of GDP in 2003, and accounted for 0.5 per cent of employment in 2000. Mining GDP increased by 8.0 per cent in 2003 from its previous year. The manufacturing sector is characterized by a small number of manufacturing enterprises, and lacks diversification. The country imports most of its capital and consumer goods from abroad. The industry comprises fish canning, soft drink bottling, boat building, handicrafts and ready-made garments. Expansion of the industry is constrained by the limited size of the market. The sector contributed 8.3 per cent to GDP in 2003, and employed about 13 per cent of the labour force in 2000. The sector grew at an average annual rate of 6.3 per cent between 1990 and 2003. The Maldives’ shipping industry is mainly operated by the private sector, with only a small number of tonnage vessels operated by the national carrier, Maldives Shipping Management Ltd. However, the industry’s share in GDP has declined since the 1980s. The Maldives has successfully marketed its natural beauty and tourist services. Tourism is the largest industry in the Maldives, and accounted for 33 per cent of GDP in 2004, bringing in about US$198 million a year. The first tourist resort was established in 1972 and currently 88 islands have been developed, with a total capacity of 19 000 beds. The number of tourists increased from 1100 in 1972 to 500 000 in 2003. Tourist arrivals increased by 16.3 per cent in 2003 from the previous year. The government of the Maldives planned to convert 11 more islands into tourist resorts and open nine more atolls for tourism. However, the tourism sector’s performance fell to zero growth after 11 September 2001 due to tourists’

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concern about safety and loss of confidence in holiday travelling. Again the tourism sector was hard hit, and the economy was adversely affected by the devastating tsunami in December 2004. External sector The country has an open economy with a very narrow export base but is highly dependent on imports for its economic activities. As a result, the merchandise trade balance of the country records a high deficit (Table 7.4). The major exported items are fish products and garments, exporting to the United States, Sri Lanka, the EU, Thailand and Japan. This sector accounted for 10 to 15 per cent of GDP in recent years. The major imported items are oil, textiles and yarn, rice, cigarettes, cement, engines for boats, electronic and electrical equipments, mineral products, aircraft parts, prefabricated buildings and vegetables. The main sources of imports are India, Sri Lanka, the EU, Singapore, Malaysia and the United Arab Emirates. The high import dependence of the economy is reflected in the high import–GDP ratio, which stood at 61 per cent during 2000–2005. Services and transfers accounted for about 34 per cent of GDP in recent years and have shown net surplus. Services receipts are dominated by tourism-related activities. The capital account is influenced by a large direct foreign investment, however, the country is missing the inflow of portfolio investment due to the absence of a developed capital market. External debt was 38 per cent of GDP during 1997–2000. The Maldives does not have any exchange control legislation, and hence the residents of the country are free to maintain foreign currency accounts both at home and in foreign countries. However, direct foreign investment requires prior approval of the government. The country’s external sector’s position improved in 2002 as there was an 18 per cent increase in total exports and 2.4 per cent decrease in total imports from its previous year. As a result, the trade deficit decreased to US$212 million in 2002 from US$236 million in 2001. However, the receipts from tourism fell by 2.6 per cent during the year as a repercussion of 11 September of the previous year. The current account deficit reduced to about US$36 million, equivalent to 7.4 per cent of GDP. The capital account recorded a surplus of US$75.5 million, which represents an overall balance of payments surplus of about US$40 million, a significant improvement from the deficit of US$21.4 million in 2001. The growth of exports and imports was increasingly Table 7.4

Balance of payments 1989–2004 (US$ million at current price)

Current Capital Current Trade Total Total Services Unrequited Account Account Overall Account Year Balance Exports Imports (net) Transfers Balance Balance Balance (% GDP) 1989 1993 1997 2001 2004


47.6
125.1
214.5
236
386.4

63.7 52.7 92.5 110.2 181.1


111.3
177.8
307
346.3
567.3

45 84.5 189.1 207 349.5

13.2
13.2
10.7
29.7
54.2

10.6
53.8
36.1
58.7
133.9


14.7 37.9 63.5 37.3 192.7


4.1
15.9 27.4
21.4 58.8

8.3 24.8 10.6 9.4 17.4

Sources: Various World Bank documents; IMF, International Financial Statistics 2005; Maldives Monetary Authority (2005), Quarterly Economic Bulletin.

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229

positive in 2003 and 2004. The current account recorded a trade deficit of US$262 million and US$386 million in 2003 and 2004 respectively. The Maldives received a total of US$17.7 million foreign aid and grants in 2002. Japan has been the largest donor to the Maldives. China was expected to give about US$2 million dollars worth of grants in 2004. Government finance: revenue, expenditure and budget The public sector plays an important role in the Maldives economy as state-owned enterprises cover a wide range of economic activities including the banking sector, fisheries, tourism, air and sea transport, shipping, communication, electricity supply and distribution of imports. Fiscal revenue comprises about 48 per cent of taxes. Since there is no income and goods and services tax (GST), the majority of government tax revenue collection comes from import duties (60 per cent of total tax revenue) and tourism taxes (about 40 per cent). The major sources of non-tax revenues are resort lease rents and stateowned enterprises. A significant portion of public expenditure is supported by bilateral grants and concessional loans. However, over the years the dependence on grants has fallen significantly from 4.2 per cent of GDP in 1995 to 2.5 per cent of GDP in 2001 (Figure 7.1 and Table 7.5). On the expenditure side, 16 per cent of total government expenditure goes to services of economic activities, and 41 per cent to social services. From 1987 to 2004, the Maldives 45

40

Government revenue, expenditure and overall deficit as % of GDP (millions of rufiyaa)

35

30

25 Revenue and grant Expenditure Overall Deficit

20

15

10

5

0 1995

1996

1997

1998

1999

2000

2001

2002

Year

Source: Author’s own construction based on data provided in Table 7.5.

Figure 7.1

Central government revenue and expenditure 1995–2004

2003

2004

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Handbook on the South Asian economies

Table 7.5

Central government revenue and expenditure 1989–2004 (millions of rufiyaa)

Year

Total Revenue and Grants

Total Expenditure and Net Lending

Overall Deficit

1989 1993 1997 2001 2002 2003 2004

596.0 918.0 1824.7 2522.6 2714.9 3061.8 3424.7

634.0 1331.0 1934.4 2885.9 3117.3 3428.4 3582.6

38.0 413.0 64.6 363.3 402.4 366.6 157.9

Sources: Various World Bank documents; Asian Development Bank (2004); Maldives Monetary Authority (2005), Quarterly Economic Bulletin.

incurred budget deficits in every single year except for 1987 and 1988. Total revenue and grants accounted for 52 per cent of GDP, whereas expenditure and net lending was 55.2 per cent of GDP, leaving the budget deficit at about 3.3 per cent of GDP in 1989 (Figure 7.1 and Table 7.5). The government’s current and capital expenditure has been rising since 1999 as the fiscal expansion initiated in 1999 continued in 2000 and 2001 (Figure 7.1 and Table 7.5). Over these three years current expenditure increased by about 19 per cent from 23.5 per cent of GDP in 1999 to 28.9 per cent of GDP in 2001 due to sharp increases in general administration and social services expenditures. A major contributor to this increase was a 35 per cent increase in government salaries and wages from September 1999 compared with 1997. Capital expenditure increased by 8.8 per cent in 2001, 9.1 per cent in 2002 and 12.5 per cent in 2003. This large capital expenditure was mainly contributed by the government’s Hulhumale project to develop a new town near the capital city Malé. The annual average growth rate of revenue was 9.1 per cent over 2001 and 2003. Total revenue and grants increased from about 30 per cent of GDP in 1995 to 36 per cent of GDP in 2001. Expenditure and net lending increased from about 36 per cent of GDP in 1995 to 41 per cent in 2001. Moderate increases in both the current and capital expenditure led to reduced budget deficits from 4.1 per cent of GDP in 2003 to 1.5 per cent of GDP in 2004. Financial sector The Maldives’ financial sector is still underdeveloped except for the banking sector. The banking sector consists of one locally owned commercial bank and branches of three South Asian partly state-owned commercial banks and a branch of an international bank, HSBC. The country does not have any developed security market and the lack of a capital market is a serious constraint on the mobilization of domestic resources. Total deposits of the commercial banks stood at 48 per cent of GDP and the stock of credit expanded by 31 per cent in 2001. Domestic credit grew rapidly between 1989 and 1994. It increased by 18.5 per cent in 1990 to Rf680 million from its previous year. A spectacular credit growth of 51.5 per cent was experienced by the sector over the 12 months of 1993. However, the credit growth slowed down during the second half of the 1990s. Domestic credit fell by – 2.5 per cent (Table 7.6) in 1996 as total domestic credit fell to

231

The Maldives Table 7.6 Monetary development 1995–2003 (% change from the previous year) (rufiyaa million at current prices) Development indicators

1995

1996

1997

1998

1999

2000

2001

2002

2003

Net foreign assets Net domestic assets Domestic credit Total liquidity (M2)

137.4 1.9 6.3 15.6

165.6
11.0
2.5 25.9

39.1 10.4 8.8 23.1

29.8 15.9 18.6 22.8


5.7 13.9 8.0 3.6

6.6 14.0 14.5 4.1

12.1 25.0 19.4 9.0

44.2 6.1 11.5 19.3

57.2 16.2 5.8 14.6

Sources: Maldives Monetary Authority; Government of the Maldives, Statistical Yearbook of Maldives, various issues and author’s own computation.

Table 7.7

Prices and nominal exchange rate 1989–2004

Year

CPI (2000 100)

GDP Deflator (2000100)

1989 1993 1997 2001 2002 2003 2004

47.9 80.0 99.7 100.7 101.6 98.7 105.0

55.4 81.4 98.9 102.0 101.4 101.6 107.5

Exchange Rate (rufiyaa per US$)

Inflation (CPI) (2000100)

Inflation (GDP Deflator) (2000 100)

% Change in Nominal Exchange Rate

9.2 11.1 11.8 12.8 12.8 12.8 12.8

20.1 7.6 0.7 0.9
2.9 6.4

11.4 2.4 2.0
0.6 0.2 5.8

5.4 0.0 8.8 0.0 0.0 0.0

Sources: IMF, International Financial Statistics 2005; various World Bank documents; Government of the Maldives, Statistical Yearbook of Maldives 2005 and author’s own calculation for sectoral contribution and splicing the indices of price changes.

Rf1621 million from Rf1662 million in 1995. Domestic credit increased by 32 per cent from Rf2091 million in 1998 to Rf3089.9 million in 2001. There was another 7 per cent increase in domestic credit from Rf3246.6 million in December 2003 to Rf3473.9 million in March 2004 mainly due to strong growth in credit to the private sector. The monetary condition in the Maldives was characterized by a large increase in foreign assets since 2001. A strong foreign credit growth was reflected by an increase of 57 per cent from its previous year from Rf1662.9 million in 2002 to Rf2613.4 million in 2003. The credit growth fuelled the total liquidity growth in the country. The net foreign asset in the Maldives’ banking system increased by 18 per cent in the three months to March 2004. Prices and inflation The Maldives’ general price level is greatly influenced by the change in fish prices and the world price level as the country’s Consumer Price Index (CPI) (Table 7.7) basket is composed of mainly fish products and foreign imports. In the early 1980s, the annual price level increased by more than 20 per cent according to the World Bank report (World Bank, 2002). The inflation rate in 1981 was 23.7 per cent, which declined to 14.7 per cent in 1991. Between 1995 and 2003, the average annual rate of inflation was 1.6 per cent.

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The inflation rate ranged from 5.5 per cent in 1995 to 7.6 per cent in 1997. However, inflation rates indicated a negative growth of
1.4 per cent in 1998 and
1.2 per cent in 2000. The CPI increased by 0.7 per cent in 2001 from its previous year, and recorded a moderate increase of 0.9 per cent in 2002. The inflation rate fell to
2.9 per cent in 2003, caused by a large fish catch and a subsequent drop in fish prices and a decline in food, beverage and tobacco indices. Food items, as well as other indices, such as transport, fuel, water, power and medical expenses declined on average by 2 per cent during this period. However, the inflation rate estimated by the IMF indicates that the Maldives experienced 6.4 per cent inflation in 2004. The price increase was observed mainly in clothing and footwear and education during 2004. Comparative study The Maldives is constrained by all the major characteristics of small island developing states (SIDS) including smallness, remoteness, fragmented and small markets, less developed infrastructure, isolation from the major economies, vulnerability to external shocks and a lack of resource endowment. Globalization and liberalization of trade brought opportunities as well as challenges for the Maldives in terms of taking advantage of the provision of special concessions for foreign market access and finance and its comparative advantage for niche markets. Although the Maldives’ economic performance was quite vibrant over the recent years, it experienced a negative GDP growth rate in 2005 with an increasing inflation rate. The country’s economic potential has to be placed in the context of SIDS or a small open economy. This section compares the Maldives’ socioeconomic performance with that of two underdeveloped SIDS, namely, Samoa and Trinidad and Tobago and one developed SID, Singapore. They all gained independence during the early to mid-1960s. Although Singapore is now in the league of newly industrialized countries, at the time of independence it was a developing country with a large unemployment rate and poor infrastructure. During the last four decades, their development diverged and per capita income in the purchasing power parity (PPP) measure of these countries ranges from US$28 100 in Singapore to US$3900 in the Maldives. The Maldives and Samoa are both among the least developed SIDS with annual GDP around US$1 billion (in 2005), constrained by geographical isolation and highly concentrated products and markets for their exports. Like many other SIDS, both the countries are highly dependent on external sources for goods and services as they possess limited natural resources as well as limited skilled labour force. They also suffer from diseconomies of scale caused by geographical isolation, and a fragmented and minuscule domestic market, which are exacerbated by high transportation and unit labour costs. Singapore, an East Asian country, and Trinidad and Tobago, a Caribbean Island country, are two SIDS success stories. Both the countries, from a modest beginning in the early 1960s, have currently developed themselves as excellent destinations of international business and investment. The Singapore economy experienced an average growth of 8.6 per cent per annum between 1965 and 1999, more than twice the annual average growth rate of the OECD countries of 3.3 per cent over the same period. Singapore was challenged by chronic unemployment, a poorly skilled and uneducated population, inadequate housing and a low level of saving rate immediately after independence in 1965. Prudent economic strategies helped Singapore to adopt

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233

outward-looking trade policies and encouraged foreign direct investment (FDI) to overcome the limitations of lack of natural resources and small size of population in the 1960s. Beginning from a very low average gross national savings (GNS) of 2.3 per cent in the early 1960s, Singapore was able to transform its demand-side economic structure from consumption to investment and net exports of goods and services accompanied by high savings. GNS increased to 50 per cent of GNP in 1995 (Wong and Lin, 1996). GNS was 44 per cent of GDP in 2005. Singapore pursued labour-intensive manufacturing in the early 1970s to create employment, and then it restructured its economy towards more high-skilled capital-intensive production to maintain its international competitiveness. From the mid-1980s, the country was able to diversify its economy in the financial services sector. Both merchandise exports and imports accounted for about 150 and 130 per cent of GDP respectively from the mid-1980s. The composition of exports moved from lower value-added food and beverage products to high value-added electronic products and chemicals. Electronics accounted for 67 per cent of exports in 1999 compared with 33 per cent in 1976 (MAS, 2005). Within the electronic exports, the composition of products moved from lower-value manufacturing products to knowledge-based high-tech products. Table 7.8 compares the external trade performances of the Maldives, Samoa, Singapore and Trinidad and Tobago for 1985–2004. Trinidad and Tobago also experienced continuous economic growth of an average of around 8.5 per cent over the three decades of 1970s, 1980s and 1990s, based on the petrochemical and hydrocarbon sector. Currently Trinidad is the supplier of about 70 per cent of the world’s liquidified natural gas (LNG) and the largest exporter of methanol and ammonia. The government of Trinidad and Tobago has made concerted efforts in further exploration and diversification of its economy in other heavy industrial production of machinery and steel, as well as the light manufacturing sector, such as food and furniture. Tobago is the major contributor to the country’s agricultural and tourism sector and employs 71 per cent (7 per cent in agriculture and 64 per cent in tourism) of the labour force of the country. A recent study (FAO, 2003) indicates that Trinidad and Tobago is experiencing improvement in overall competitiveness, whereas the Maldives and Samoa have been experiencing a worsening of their overall competitiveness in agricultural, forestry and fisheries sectors. The Maldives ranks 98th compared with 25th place for Singapore among 177 countries in terms of human development index (HDI). The HDI measures overall progress in three basic human developments, namely, educational attainment, life expectancy and per capita income. However, in all these three criteria, Samoa scored relatively better than the Maldives. In terms of human poverty index (HPI), the Maldives’ rank was 36th in 2004 compared with 17th for Trinidad and Tobago (Table 7.9). Policy prescription The above discussion thus indicates that the key weakness of the Maldives’ economy is its heavy dependency on the two major exports industries, namely, tourism and fisheries for its employment, domestic production, as well as its fiscal revenue, foreign exchange earnings and economic growth. It also faces very steep competition in the world market for its goods and services. There is no set road map for success. However, much can be learnt from analysing the evolution and success stories of prominent SIDS like Singapore and Trinidad and Tobago where appropriate policies created a conducive investment environment for

234

Import Growth Rate (annual average)

Imports/GDP

20.9 –5.5 12.0 16.8

4.3 16.3 8.8 9.9

10.4 – 11.4 20.7

23.0 31.0 18.0 3.0 6.0 3.2 142.0 134.0 185.0 38.7 37.0 49.0

20.3 9.5 10.5 9.7

12.5 4.0 7.1 20.1

6.05 54.0 9.9 9.0

92.0 102.0 92.0 50.0 48.8 – 164.0 127.0 161.0 21.9 49.2 40.5

50.0 64.0 n/a n/a

1997

75.0 79.0 n/a n/a

1997

Sources: Based on data contained in Asian Development Bank, Asian Development Outlook (Oxford University Press), various issues and Key Indicators of Developing Asian and Pacific Countries (Oxford University Press), various issues and author’s own computation.

Maldives Samoa Singapore Trinidad and Tobago

Exports/GDP

1985–89 1990–98 1999–2004 1990 1998 2004 1985–89 1990–98 1999–2004 1990 1998 2004

Export Growth Rate (annual average)

Share of Share of Two Major Two Major Exports in Markets in Total Total Exports Exports

Table 7.8 External trade performance in the Maldives, Samoa, Singapore and Trinidad and Tobago 1985–2004

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The Maldives Table 7.9 Selected social development indicators for the Maldives, Samoa, Singapore and Trinidad and Tobago

Countries

GDP per Gross GDP per Capita HDI Rank HPI Life Enrolment Capita, Rank Independence 2004 (177 Rank (177 Expectancy Ratio (%) PPP US$ 2004 (177 (year) countries) countries) at Birth (2002–03) (2004) countries)

Maldives

1965

98

36

73

75

Samoa Singapore Trinidad and Tobago

1962 1965 1962

75 25 57

– 7 17

70 79 70

71 87 66

3 900 (2002) 5 613 28 100 16 700 (2005)

103 97 21 52

Sources: UNDP (2006) Human Development Reports, 2005 and 2006; and CIA (2006) World Fact Book: Maldives.

the private sector. They also encouraged FDI by setting appropriate legal and other regulatory framework. Like many least developed SIDS, it is difficult for the Maldives to attract FDI due to a less developed capital market, smallness of the local market, remoteness of the country, the lack of a skilled labour force and climatic risks, which outweigh the investment gains. However, the Maldives has to make a concerted effort to enhance human development and investment in infrastructure, which is ‘likely to crowd in private investment’ (Chowdhury and Vidyattama, 2006: 18). Institutional capacity-building is of crucial importance in this regard. The Maldives has to identify both its short-term adjustment and long-run strategies to deal with the expected changes. Diversifying the economic base, developing the financial market and building up human resources should get priority as they are complementary to each other. Developing human capital will not only help diversification of the economy based on the natural endowment of the country, it will also facilitate the development of a knowledge-based economy to sustain a dynamic economic growth and development. Training and education to develop a skilled labour force and improving the productivity is essential for reducing cost of production and making exports more competitive. The Maldives needs to focus its efforts on raising its competitive position in its traditional production and exports, and diversify into other fastgrowing globally dynamic commodities together with niche products and services based on its natural and cultural endowments. These must be based on a realistic assessment of actual and potential comparative advantage of the country. The Maldives needs to make an effort to employ fiscal and monetary policies to smooth out the domestic business cycles as well as external economic changes. This will not be effective in the absence of a proper income tax system. Sound macroeconomic policies accompanied by a liberalized trade regime will not only encourage the imports of hightech products and investment, but also help the diffusion of knowledge. This will increase the supply capacity and competitiveness of its exports to ensure a stable growth and increase the standard of living of the country.

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Future challenges Despite the strong economic growth in recent years, the Maldives’ dependency on tourism and traditional fishing pose particular policy challenges due to its vulnerability to changes in the international economic conditions and environmental factors. The Maldives is vulnerable to sea-level rise and average temperature increase, as 80 per cent of the land is less than 1 m above the mean sea level. The major developmental challenges facing the Maldives include effective protection of its marine and coastal environment, and ensuring better management, diversification and growth of its two key earning sources – tourism and fisheries. Climatic change has been affecting its coral reefs, adversely associated with El Niño events. Negative consequences of these climatic changes might be quite heavy on infrastructure and human settlements, the quality and quantity of freshwater resources, beach erosion and island displacements, mortality of coral reefs and biodiversity of the environment. Unfavourable climate change outcomes may seriously impinge on the major activities of the country, mainly the tourism and fisheries industries. On 26 December 2004, a series of tsunamis devastated many of the low-lying islands of the country. Several islands were rendered uninhabitable, and an estimated 13 000 people became homeless. It has adversely impacted on the economic growth of the country; the tourism industry especially is profoundly affected by this natural disaster. It is, therefore, very important for the country to find appropriate solutions to these challenges with international assistance. The Maldives needs to have integrated mediumand long-run effective policies and institutional frameworks to protect its environment and economy. The government of the country showed concerted efforts in addressing and implementing some of the actions to combat the climatic problems faced by the country. It has participated in international debates within the framework of the UN Environment Programme and the UN Economic and Social Commission for Asia and the Pacific (ESCAP). Building public awareness about the long-term harmful effects of coral and sand mining, over-fishing and the dumping of solid waste have been campaigned strongly over the years in the Maldives. Strengthening the institutional capacity for environmental protection and policies to protect corals and coastal zones, increasing the atoll-based administration of the management of natural resources and diversifying income-generating opportunity should be taken as priority policy prescriptions at all levels of the country. To enhance a sustainable socioeconomic growth and performance by expanding and diversifying these sectors, the government needs to work with the private sector in partnership. The private sector’s involvement in this process and establishing well defined property rights would rapidly facilitate the sustainable economic growth and protection of the environment of the country. References Asian Development Bank (ADB) (2004), Country Economic Review, Maldives, CER: MLD 2004–13. Chowdhury, A. and Y. Vidyattama (2006), ‘Macroeconomic Policies for Prosperity in Small Pacific Island Economies’, Paper prepared for the UNU-WIDER Project on Fragility and Development. CIA (2006), The World Fact Book: Maldives (online), Available from: http://www.cia.gov/library/publications/ the-world-factbook/geos/mv.html (accessed 23 September 2007). Europaworld (2006), Maldives (online), available from: http://www.europaworld.com/entry/mv. Food and Agriculture Organization (FAO) (2003), Special Ministerial Conference on Agriculture in Small Island Developing States, Rome, 12 March 1999, Report and Background, Rome, 2003.

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Government of the Maldives, Statistical Year Book of Maldives, Various years, Malé: Ministry of Planning and Development. International Monetary Fund, International Financial Statistics, Various years. Maldives Monetary Authority (2004), Quarterly Economic Bulletin, Economic Research and Statistics Division, 10 (1). Maldives Monetary Authority (2005), Annual Report 2005. Maldives Monetary Authority (2005), Quarterly Economic Bulletin, Economic Research and Statistics Division, 11 (4). Monetary Authority of Singapore (MAS) (2005), Overview of the Singapore Economy, Economic Growth in Singapore (online), available from: http://www.mas.gov.sg/masmcm/html (accessed 13 October 2006). United Nation’s Development Programme (UNDP) (2003), Human Development Report 2003, New York: Oxford University Press. United Nations Development Programme (UNDP) (2006), Human Development Report (online), Available from: http://www.undp.org (retreived 25 March 2006). Wong, S.T. and T.S. Lin (1996), ‘Structural changes in the Singapore economy’, Statistical Singapore Newsletter, 18 (4). World Bank (1999), Policies for Sustaining Economic Growth, Maldives Country Economic Memorandum, Report No. 18340-MAL. World Bank (2002), Maldives Public Expenditure Review, Report No. 24238-MV.

Index agriculture Bangladesh 99–100, 102, 117–18 Bhutan 192–3, 202–3, 211 growth performance 4, 5 in India 29–31 Maldives 227 Nepal 180–83 Pakistan 68, 69, 75–6 and rural poverty 7 Sri Lanka 133, 134–5, 145–6, 151 Ahluwalia, I.J. 31 Ahluwalia, M.S. 46 Alailima, P. 146 Athukorala, P. 134 Ayub Khan, Muhammad 64–5 balance of payments Bangladesh 98–9 Maldives 228 Sri Lanka 139–40 Bangladesh adverse factors limiting growth 98–9 agriculture 99–100, 101, 102, 117–18 balance of payments 98–9 banking sector 119 budgetary trends 110–11 corruption 119 current account deficits 10 demographic transition 101–2 domestic savings 12, 99 economic growth and poverty 6 economic history 94–6 education 112–13 exports 100–101, 107–8, 118 external sector policies 106–10, 118 feminization of the workforce 103–4 fiscal management 110–15 food distribution reforms 118 foreign direct investment (FDI) 117 garment industry 107–8, 116 governance-growth nexus 115–17 governance systems 118–19 growth performance 3, 4–5 health 112–13 human development 104–5 import liberalization 106–7, 118 inequality in income 102, 103 inflation 98 investment 12, 98, 121

macroeconomic indicators 96–9 manufacturing 100, 101, 102 occupational structure of labour force 102–4 political history 93–4 political incentives and policy-making 117–20 population 101–2 poverty 102, 103, 104 power generation sector 120 public spending 111–13 real exchange rate 108–9 reforms in 1980s 96 revenue mobilization 113–15 social and human development 8–9 sources of growth stimulus 99–102 South Asia 5–7 Supplementary Duty 114 taxation 113–15 trade liberalization 113–14 urbanization 101 Value Added Tax (VAT) 114–15 banking sector Bangladesh 119 Maldives 230–31 Bhalla, G.S. 30 Bhalla, S. 44 Bhutan agriculture 192–3, 194, 202–3, 211 close relationship with India 191 constraints on development 217–18 construction sector 193–4 decentralization 213 development prospects 218–19 domestic savings 194–5 economic growth 190, 192–4 education 204, 212 employment 203, 204–5 energy sector 193–4 environmental sustainability 215–16 exports 198–9, 200, 205–7 external sector 198–9, 205–7 fiscal regime 195–7 foreign aid 195 foreign direct investment (FDI) 207 Gross National Happiness (GNH) 191, 211–17 health 203–4, 212

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human development 212–15 hydropower 192, 199–201 imports 198–9, 205–7 industry 192, 193 inequalities in income 202 inflation 197 investment 195 macroeconomic policy regime 205–11 monetary and financial policies 208–11 monetization of 197 policy regime 205–17 political history 190–91 poverty 201–2 public debt 195–6 public expenditure 196–7 regional disparities 213–15 revenue 196, 200, 203 savings and investment 194–5 service sector 193 structural change 192–4 taxation 196 tourism 216–17 trade regime 198–9 wood-based industries 216 Bhutto, Benazir 67, 68 Bhutto, Zulfikar Ali 65–6 Bombay Plan, India 25–6 budgetary trends, Bangladesh 110–11 capital flows, regional disparities in India 46–9 caste system in India 27 Nepal 172, 175–6 Chandarasiri, S. 134 child malnutrition, India 58–9 construction sector, Bhutan 193–4 corruption, Bangladesh 119 current account deficits 10 Dandekar, V.M. 31 Deaton, A. 51 debt external, India 40, 41 and foreign aid, Nepal 163 public, Bhutan 195–6 decentralization Bhutan 213 Nepal 186–7 demographic transition Bangladesh 101–2 Pakistan 85 Sri Lanka 149–50 Dev, S.M. 50 disparities in Nepal 175–6 see also regional disparities

domestic savings 12 Bangladesh 99 Bhutan 194–5 Pakistan 79–80 domestic sector, Sri Lanka 141–4 Dreze, J. 51 East Asia, economic success of 2 economic growth Bhutan 190, 192–4 and its sources in India 27–9 Maldives 221, 225–8 Nepal 159–62 and poverty 6–7 and poverty, Bangladesh 6 and poverty, India 6 prospects for in India 58–9 and regimes 72–3, 91, 126 regional disparities in India 44–9 Sri Lanka 133–5 economic policy reforms, India 53–8 education Bhutan 204, 212 India 52, 59 Maldives 223–4 Nepal 175 Pakistan 85–6 elasticity of employment 44 employment Bhutan 203, 204–5 elasticity of 44 India 40–44 Maldives 224–5 Sri Lanka 146–7 energy sector Bangladesh 120 Bhutan 193–4 environmental sustainability, Bhutan 215–16 Ershad, Hussein M. 93 expenditure Bangladesh 111–13 India 36, 37 Maldives 229–30 Nepal 162–3, 164–5 public, Bhutan 196–7 exports Bangladesh 100–101, 107–8, 118 Bhutan 198–9, 200, 205–7 India 39–40 major developing countries 83 Maldives 228–9 Nepal 167–8 Pakistan 81–3, 89–90 South Asia 12–15 Sri Lanka 136–9

Index external sector Bangladesh 106–10, 118 Bhutan 198–9, 205–7 India 38–40 Maldives 228–9 Nepal 167–8 South Asia 12–15 Sri Lanka 135–40, 136–9 feminization of the workforce, Bangladesh 103–4 fertility rates 92 financial sector Bangladesh 119 Maldives 230–31 fiscal regime and management 10–11 Bhutan 195–7 India 37, 38 Nepal 162–5 Pakistan 80 Sri Lanka 141–2 fishing in The Maldives 227 food distribution, Bangladesh 118 foreign aid Bhutan 195 Nepal 163 foreign direct investment (FDI) Bangladesh 117 Bhutan 207 India 40 Sri Lanka 140 foreign exchange reserves, India 40 Gandhi, Mahatma 26 garment industry, Bangladesh 107–8, 116 gender equality/disparity India 59 Nepal 176 governance Bangladesh 118–19 Maldives 222 South Asia 15–19 Sri Lanka 128, 152 governance–growth nexus, Bangladesh 115–17 Green Revolution in India 4 growth performance Pakistan 69–71 and political regimes in Pakistan 72–3, 91 South Asia 3–5 see also economic growth Gunatilleke, G. 146 health Bhutan 203–4, 212 India 52, 53, 54, 59

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Maldives 222–3, 224 Nepal 174–5 Herring, R.J. 127 Himanshu 51 human development Bangladesh 104–5 Bhutan 212–15 Nepal 188 Pakistan 85–6 South Asia 8–9 Sri Lanka 127–8 hydropower, Bhutan 192, 199–201 imports Bangladesh 106, 106–7, 118 Bhutan 198, 198–9, 205–7 Maldives 228–9 Nepal 167, 167–8 South Asia 12–15 Sri Lanka 135–6 income inequality Bangladesh 102, 103 India 52 Nepal 170, 174 South Asia 5–7 Sri Lanka 150–2 India agriculture sector 29–31, 76 caste system 27 child malnutrition 58–9 composition of exports and imports 39–40 current account deficits 10 debt, external 40, 41 development strategy following independence 25–7 economic growth and its sources 27–9 economic growth and poverty 6 economic policy reforms 53–8 education 52, 59 elasticity of employment 44 employment and unemployment 40–44 expenditure trends 36, 37 external sector 38–40 fiscal deficits 10, 11, 37 foreign direct investment 40 foreign exchange reserves 40 gender equality 59 Green Revolution in 4 growth performance 3, 4, 5 health 52, 53, 54, 59 industrial growth 31, 32 inequality trends 52 inflation 33–4 information technology sector 4, 32–3 investment 12

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labour force 40–44 labour productivity 44 literacy 52 macroeconomic indicators 33–8 outsourcing industry 32 poverty 5–6, 49–51, 58 prospects for economic growth 58–9 Punjab 76 real exchange rate 109 regional disparities in capital flows 46–9 regional disparities in economic growth 44–9 regional disparities in infrastructure 46, 47 regional disparities in poverty 5–6 relations with Bhutan 191 relations with Nepal 166 revenue trends 35–6 savings and investment 34, 35 sectoral growth 29–33 services exports 38–40 social and human development 8 social progress 49–53 stock market 33 water and sanitation 59 industry Bhutan 192, 193 India 31, 32 Maldives 227 Sri Lanka 144 inequality in income Bangladesh 102, 103 Bhutan 202 India 52 Nepal 170, 174 South Asia 5–7 Sri Lanka 150–52 inflation Bangladesh 98 Bhutan 197 India 34 Maldives 231–2 Nepal 166 Sri Lanka 143–4 information technology sector, India 4, 32–3 infrastructure Maldives 224 regional disparities in India 47 investment Bangladesh 98, 121n8 Bhutan 195 Nepal 161, 162, 164 Pakistan 74–5, 90, 91 South Asia 11–12 Isenman, P. 147

Jinnah, Mohammed Ali 64 Kashmir 63 Kelegama, S. 134 Knight-John, M. 134 Kuznets hypothesis 7 labour market India 40–44 Maldives 224–5 Sri Lanka 146–7 labour migration and remittance, Sri Lanka 139 labour productivity, India 44 liberalization in South Asia 2 Sri Lanka 128–9, 130–31 see also external sector literacy, India 52 macroeconomics Bangladesh 96–9 India 33–8 Nepal 177–80 South Asia 10–12 Sri Lanka 135–44 Maldives agriculture 227 balance of payments 228 compared to similar states 232–3, 234, 235 economic growth 221, 225–8 education 223–4 employment 224–5 expenditure 229–30 exports 228–9 external sector 228–9 financial sector 230–31 fishing 227 future challenges 236 governance 222 health 222–3, 224 history 221–2 imports 228–9 industry 227 inflation 231–2 infrastructure 224 labour force 224–5 legal system 222 manufacturing 227 policy prescriptions 233–4 prices 231 revenue 229, 230 sectoral contribution to growth in 226, 227–8 shipping industry 227

Index social development 222–5 taxation 229 tourism 227–8 malnutrition, child 58–9 manufacturing Bangladesh 100, 101, 102 growth performance 5 Maldives 227 Nepal 193 Pakistan 77 Sri Lanka 133–4 Maoist insurgency in Nepal 158, 188 Millennium Development Goals Bangladesh 104 India 58–9 monetary and financial policies, Bhutan 208–11 monetization of Bhutan 197 Mujibur Rahman 93 National identity, Sri Lanka 128 National Planning Committee, India 25 Nawaz Sharif, Mian Muhammad 67–8 Nehru, Jawaharlal 25, 26 Nepal agriculture 180–83 caste disparities 172, 175–6 current account deficits 10 decentralization 186–7 disparities within 175–6 domestic savings 12 economic growth and poverty 6 education 175, 176 expenditure 162–3, 164 exports 167–8 external sector 167–8 fiscal trends 162–5 foreign aid and debt 163 gender disparity 176 growth and structure of the economy 159–62 growth performance 3, 5 health 174–5, 176 human development 188 imports 167–8 inequality in income 170, 174 inflation 166 investment 162, 164 macroeconomic reforms 177–80 manufacturing 193 Maoist insurgency 158, 188 money and relations with India 166 policy regime 176–87 political history 157–9 poverty 168–74, 183–6

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public expenditure 164–5 regional disparities 171–2, 176 remittances 161–2, 170, 174 revenue 162, 163–4 savings and investment rates 161 sectoral growth 159–60, 161 social and human development 8 taxation 162, 163–4 Oliver, H.M. 125 Osmani, S. 148 outsourcing industry, India 32 Pakistan agriculture 68, 69, 75–6 current account deficits 10 demographic transition 85 domestic savings 79–80 economic growth and poverty 6 education 85–6 exports 81–3, 89–90 external dependence 79–80 fertility rates 92 fiscal adjustments 80–81 fiscal deficits 80 following partition 68–9 growth and political regimes 72–3, 91 growth performance 3, 4, 69–71 human development 85–6 investment 11–12, 74–5, 90, 91n18 Kashmir 63 macroeconomic stability 81 manufacturing growth 76–8 origin of 63 policy weaknesses 88 political setting for economic development 63–8 population 85, 92 positive factors in growth 73–8 poverty in 83–4, 85 prospects and challenges 86–90 recent turnaround 71–2 regional differences in income and poverty 6 relations with India 63, 65 revenue expansion 88–9 savings and investment rates 90 social and human development 8 taxation 88–9 weaknesses in the economy 78–86 People’s Plan, India 26 policy regimes Bhutan 205–17 external sector, Bangladesh 106–10, 118 Nepal 176–87 sectoral, Sri Lanka 144–6

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political regimes and growth Pakistan 72–3, 91 Sri Lanka 126 population Bangladesh 101–2 Pakistan 85, 92 Sri Lanka 147, 149–50 poverty Bangladesh 103, 104 Bhutan 201–2 and economic growth 6–7 India 49–51, 58 Nepal 168–74, 183–6 Pakistan 83–4, 85 and regional differences 5–6 South Asia 5–7 Sri Lanka 150–51 power generation sector Bangladesh 120 hydropower, Bhutan 192, 199–201 prices, Maldives 231 productivity, labour, India 44 Przeworski, A. 91, 92 public expenditure Bangladesh 111–13 Bhutan 196–7 Nepal 164–5 queuing hypothesis 146 Ravi, C. 50 real exchange rate, Bangladesh and India 108–9 reforms in South Asia 2 regimes and growth Pakistan 72–3, 91 Sri Lanka 126 regional disparities Bhutan 213–15 capital flows in India 46–9 economic growth in India 44–9 health in India 52 human development in India 8 India and MDG indicators 59 infrastructure in India 46 literacy and education in India 52 poverty in Bhutan 201–2 poverty in Nepal 171–2 poverty levels 5–6 remittances Nepal 161–2, 170, 174 Sri Lanka 139 revenue Bangladesh 113–15 Bhutan 196, 200, 203

India 35–6 Maldives 229, 230 Nepal 162, 163–4 Pakistan 88–9 Sri Lanka 141 Rodrik, D. 91 Samararatne, P. 134 Samoa 232, 233, 234, 235 sanitation, India 59 savings and investment Bhutan 194–5 India 34, 35 Pakistan 90 South Asia 11–12 Sri Lanka 135 sectors allocation of credit in Bhutan 211 changes in Bhutan 192–4 contribution to growth in The Maldives 226, 227–8 employment in Bhutan 204–5 growth in India 29–33 growth in Nepal 159–60 labour productivity in India 44 policy in Sri Lanka 144–6 Sen, A. K. 9, 147 Sen, Abhijit 51 Sen, B. 53, 54 service sector Bhutan 192, 193 India 38–40 Sri Lanka 133, 134 Shetty, S.L. 45 shipping industry in The Maldives 227 SIDS see small and medium enterprises (SMEs) Singapore 232–3, 234, 235 Singh, G. 30 Sivasubramonian, S. 28–9 skill mismatch hypothesis 146 small and medium enterprises (SMEs), Sri Lanka 151–2 small island developing states (SIDS) 232 Snodgrass, D.R. 125 social development Bhutan, Gross National Happiness (GNH) 191, 211–17 India 49–53 Maldives 222–5 South Asia 8–9 social welfare Sri Lanka 147–9 South Asia background 1–2

Index domestic savings 12 external sector 12–15 growth performance 3–5 macroeconomic trends 10–12 poverty reduction 5–7 saving and investment rates 11–12 social and human development 8–9 Sri Lanka agriculture 134–5, 145–6, 151 balance of payments 139–40 challenges ahead 153 current account deficits 10 demographic transition 149–50 domestic savings 12 domestic sector 141–4 economic growth 133–5 economic growth and poverty 6 economic history 125–7 economic middle ground 131–3 employment 146–7 exports 136–9 external sector 135–40 fiscal deficits 10 fiscal management 141–2 foreign direct investment (FDI) 140 governance 128, 152 growth performance 3, 4 human development 127–8 imports 135–6 income inequality 150–52 industrialization 144 inflation 143–4 labour market 146–7 labour migration and remittance 139 liberalization 128–9, 130–31 macroeconomic indicators 135–44 manufacturing 133–4 national identity 128 political regimes and growth 126 population 147, 149–50 poverty 150–52 reforms 1994–2001 129–30 regional differences in income and poverty 6 revenue 141, 142 savings and investment 135 sectoral policy 144–6 service sector 133, 134

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small and medium enterprises (SMEs) 151–2 social and human development 8, 9 social welfare 147–9 taxation 141, 142 unemployment 146, 146 vulnerability to shocks 133 wages 147 stock market, India 33 Sundaram, K. 44, 51 Supplementary Duty, Bangladesh 114 support-led human development 9 sustainability, environmental, Bhutan 215–16 taxation Bangladesh 113–15 Bhutan 196 Maldives 229 Nepal 162, 163–4, 164 Pakistan 88–9 Sri Lanka 141, 142 Tendulkar, S.D. 51, 53, 54 tourism Bhutan 216–17 Maldives 227–8 trade liberalization see external sector trade regime. see external sector Trinidad and Tobago 232, 233, 234, 235 unemployment India 40–44 Sri Lanka 146 see also employment urbanization, Bangladesh 101 Value Added Tax (VAT), Bangladesh 114–15 Vishveshwaraiya, M. 26 wages, Sri Lanka 147 Washington Consensus 2 water and sanitation, India 59 wood-based industries in Bhutan 216 Yahya Khan, Muhammad 65 Zia-ul-haq, Muhammad 66–7 Ziaur Rahman 93