Nepal Private Sector Engagement Assessment, 2020

EXECUTIVE SUMMARYFor over seven decades, the U.S. Government has committed itself to improve the lives and livelihoodsof all Nepalis. As the main provider of US foreign assistance, the Agency for International Development(USAID) works in almost all areas that, in one way or another, touch the life of a Nepali and are essentialin improving their well-being – from social environment and economic development (agriculture, energy,natural resource management), health, education, governance, and disaster risk reduction,reconstruction, and resilience.Over the years of USAID engagement in Nepal, many things have changed both in the country, as well asin the way the Agency conducts foreign assistance, which holds promise for the country’s prosperity andstability. For the first time in decades, Nepal is experiencing growing political stability and improvinggovernance, as it ratified a new constitution, elected a supermajority in government, and transitioned intoa federal structure of government. Building on these successes, the Government of Nepal (GON) laid outan ambitious objective to reach middle-income status by 2030 and attain the goal for a Prosperous Nepal,Happy Nepalis. To make this happen, the GON must foster an environment where growth occurs at arapid and sustained rate to make up for years of stagnation, strong enough to meet the needs of therapidly growing population, and inclusive enough to reverse the high levels of inequality and poverty thatcharacterize Nepali communities.Nepal’s economic landscape also has changed from decades ago in ways that indicate important roles forthe private sector. In terms of capital inflows, in the 1990s, Nepal received substantial support in theform of official development assistance and concessional loans, which represented a total of 94 percent offoreign capital inflows into the country. More recently, this share shrank to 16 percent and wasovertaken by capital inflows in the form of remittances from Nepali laborers working abroad, which nowrepresents 83 percent of annual total capital flow into the country. Also, Nepal has the potential to growforeign direct investment that currently stands at only 0.5 percent of GDP, which is among the lowest inSouth Asia. These changes in international capital flows point to the increasing capacity of the privatesector to play a critical role in the transformation of Nepal’s economy.The changes in Nepal’s economic landscape coincided with USAID's adoption of a new policy frameworkthat articulates a renewed focus on supporting Nepal advance in its journey to self-reliance – to plan,finance, and implement Nepal’s own solutions to development problems. Ultimately, the vision is forNepal to transition from being a beneficiary of foreign assistance to a self-reliant and reliable partnerpromoting peace and prosperity in the Asian region. USAID recognizes in the new framework that officialdevelopment assistance is not enough to address Nepal’s seemingly insurmountable developmentchallenges and advance the country toward self-reliance. At the same time, convinced by theoverwhelming evidence on the power of enterprises to promote the well-being of Nepalis, USAID’swork in Nepal will be informed by an awareness that increasing private-sector investment will be theprimary catalyst for the type of transformative economic growth that leads to long-term improvements inthe wealth and well-being of Nepalis. To guide future strategy in support of the Nepali people, the USAIDMission to Nepal requested USAID’s Monitoring, Evaluation, and Learning (MEL) Activity to undertakethis assessment on private-sector engagement in October 2019, which it did through a subcontract toBeed Management Private Limited.USAID/Nepal’s Monitoring, Evaluation and Learning Activity1

As envisioned in the Private Sector Engagement (PSE) Policy, this assessment aims to inform the Mission’sshift to more market-based approaches as a means to accelerate Nepal’s progress on the Journey to SelfReliance, by answering the questions posed in the policy for the Mission to consider every time itapproaches development issues. What factors are constraining the private sector from involvement and investment to addressNepal’s development challenges in the selected sectors?What role can USAID play to help alleviate or eliminate these constraints?This study is designed as a series of eight sub-studies with separate research questions presented in eachsub-section in the main text of the report that defines and limits their scopes. It aims to identifyopportunities to engage with the private sector to provide market-based approaches to achieve inclusiveand sustainable economic growth to reduce extreme poverty, inclusive and effective governance, disastersafety and resilience, and increase human capital in the form of a better-skilled and healthier population.Market-based approaches depend on the presence of an effective demand to achieve scale andsustainability on products and services that advance development objectives. The overall study conducteda rapid assessment on the factors that impeded the demand for investments that fuel economic growth,demand for pro-growth policies, demand for disaster-safe infrastructure and the derived demand forstandard quality construction material, demand for standard quality pharmaceutical products thatcontribute to a healthier population, and demand for learning that results in productivity gains for theeconomy.The assessment’s sub-studies center on understanding the binding constraints that impede growthenhancing investment. To this end, the study undertook two cross-cutting sub-studies, the first of whichused the Haussmann-Rodrik-Velasco growth diagnostic methodology (HRV). HRV lays out the universeof factors that could potentially impede investment and provides a logical framework to determine if suchfactors are binding constraints, such as the high cost of capital, low social returns, and elevated risk onthe ability of private investors to retain gains to investment. As public policy (or lack of) is suspected bymany to be one of the primitive and proximate underlying factors that created the constraints toinvestment, caused the poor performance of various supply chains, including construction materials andpharmaceutical product supply chains, and contributed to the low human capital in Nepal, the secondcross-cutting sub-study analyzed the GON’s policy formulation process.The assessment also undertook sector-specific sub-studies. As export market opportunities serve as amain driver that attract investment, the next sub-study assessed the strategic position of Nepal’smerchandise exports using a two-factor export opportunity map that determines the proportion ofproducts in the export basket that the country holds a comparative advantage in, as measured by therevealed comparative advantage (RCA) and the demand strength of those products’ export markets; aswell as using a product space analysis to determine the country’s capability to accelerate growth throughdiversification into higher value-added export products. Another sub-study uses a price competitivenessindex, assessing the competitiveness of four agricultural products, paddy, maize, potato, and tomato,whose imports have surged over the last decade. As the country’s natural resources largely determinethe sustainability of Nepal’s growth trajectory, another sub-study explored market-based approaches foreffective and efficient management of natural resources.USAID/Nepal’s Monitoring, Evaluation and Learning Activity2

Two other sub-studies applied the Structure, Conduct, and Performance (SCP) framework to assess theperformance of the construction material supply chain and, separately, the pharmaceutical supply chain tocontribute to the reconstruction of disaster safe infrastructure and the promotion of better health inNepal, and the supply chains’ ability to correct poor performance in an organic manner. The sub-studiesuse the SCP framework to identify the factors impeding investments that created gaps in the supplychains to provide standard quality construction materials and pharmaceutical products at standardizedprices in the market. A final sub-study used a Mincer Equation methodology to estimate returns toeducation in Nepal and assess whether investment to expand access to education likely will produce theexpected productivity gains in the economy. This executive summary provides an overview of keyconclusions and recommendations, with the substantiating findings and greater depth provided in themain text of the report.BINDING CONSTRAINTS TO ECONOMIC GROWTH IN NEPALInvestments1 drive long-term economic growth as it increases aggregate demand, expands productivecapacity, and grows productivity, which creates more market opportunities as countries become morecompetitive in the global market. Countries that experienced transformational growth, such as SouthKorea, Thailand, and more recently, Vietnam, demonstrated a sustained acceleration of investment,expansion of exports, and a growing share of high value-added products in the export basket, resulting inan exponential growth in per capita income.This section of the report identifies the binding constraints using the HRV growth diagnosticmethodology that have impeded investment and economic growth in Nepal. An earlier growth diagnosticstudy by the Asian Development Bank (ADB) and the Millennium Challenge Corporation (MCC) analyzedthe binding constraints on Nepal’s economy in the pre-earthquake period. This sub-study assesses ifthose constraints remain binding and if new ones have emerged in the period after the earthquake. TheADB and MCC study attributed the low level of private fixed capital formation (i.e., private investment)and slow economic growth to limited investment opportunities with a remunerative return to privateinvestment and not to the high cost of finance. In particular, the studies attributed the low private returnsto low social returns due to inadequate infrastructure (electricity and transport) and the low likelihoodof retaining returns on investment due to uncertainty in policy implementation and challenges in industriallabor relations.The current study began with an analysis of the economic performance of Nepal over the last fivedecades, examining the growth patterns experienced by the country and aiming to discover symptoms ofmaladies in the economy. The analysis reveals the following three insights on the economy:1. Nepali enterprises have demonstrated the ability to increase investment when presented withprofitable market opportunities. First, as Nepal gained preferential market access in developedwestern markets under the 1974-2004 Multi Fiber Agreement (MFA), its investment rate almostquadrupled to 17.6 percent at the end of the Agreement. Second, driven by a boost in aggregatedemand from reconstruction activities, Nepal’s investment rate increased by 6.5 percentage1This study defines investment as private capital fixed capital formation, as measured in the national accounts.USAID/Nepal’s Monitoring, Evaluation and Learning Activity3

points in the post-earthquake period, with gross capital formation ranking among the highest inthe world in 2018/19.2. At the end of the MFA, Nepal’s economy entered a high migration and low growth (driven byremittance-led consumption) state, as the textile sector shrunk, and the economy failed to createenough job opportunities for new Nepali workers entering the labor market, who instead soughtemployment abroad. During this period, gross capital formation (GCF) accelerated, but mostly inthe form of merchandise inventory that Nepali enterprises accumulated to meet growingconsumer demand. However, with an overvalued Nepali currency and low productivity,enterprises met such an increase in merchandise inventory from imports. As a result, suchgrowth in the GCF did not create a net increase in aggregate demand, and hence, had a limitedimpact on economic growth.3. In the post-earthquake period, Nepal achieved a rapid growth of 7.3 percent, which, for the firsttime in decades, exceeds its South Asian neighbors by 1.4 percentage points. However, Nepalmay not be able to sustain such rapid growth, for the following three reasons: a) waning pent-updemand for reconstruction; b) growth-focused primarily in two sectors – agriculture, andwholesale and retail trade (contributing 46 percent); and c) potential reversion to a remittanceled, consumption-driven economy, which produced a growth rate of 4 percent to 5 percent only.The analysis made the following determinations on the binding constraints that have impeded investmentand economic growth in the country in the post-earthquake period:1. The study found abundant evidence that investment in Nepal is constrained because of lowprivate returns to capital, not by low availability of savings (finance). That is, investors do not findproductive investments, as the high cost and risk of doing business have eroded Nepalienterprises’ competitiveness. As a result, they have priced themselves out in many markets in theworld.2. Economic activities in Nepal are not sufficiently rewarded (i.e., low social returns), primarily dueto bad infrastructure. This study found electricity supply is no longer a binding constraint, asNepal has successfully added new power generation capacity, increased use efficiency, andallowed trade with India to meet supply deficits during peak load periods. However, the high costof transport remains a binding constraint. Road access remains a challenge not only in terms ofreach but in terms of the quality of roads. Nepal’s landlocked location, difficult terrain, and poorquality road systems continue to raise the cost of moving products within the country and acrossthe border, and the domination of transport syndicates adds to the complexities. Unlikeelectricity where supply deficits can be substituted by imports from India, transportation is a nontradable service, and any supply deficits directly translate into higher fees.3. The problem of low social return to investment is compounded by the considerable downsiderisk in realizing the return expected by investors. The MCC study identified policyimplementation uncertainty as a binding constraint, which it attributed to political instability.USAID/Nepal’s Monitoring, Evaluation and Learning Activity4

Despite the growing political stability in the country, policy uncertainty remains a bindingconstraint due to institutional and bureaucratic weaknesses, such as the confusion in thetransition to a federal structure, which, according to the IMF, faces monumental challenges. Inaddition, the high cost and risk of doing business burdens Nepal

that articulates a renewed focus on supporting Nepal advance in its journey to selfreliance - - to plan, finance, and implement Nepal's own solutions to development problems. Ultimately, the vision is for Nepal to transition from being a beneficiary of foreign assistance to a self-reliant and reliable partner