With the economy in tatters, Nepal’s yawning trade deficit has once again become a topic of discussion. The trade gap, which shrank by 17 percent year-on-year to Rs1,061 billion in fiscal 2019-20 has increased by 28 percent to Rs1,356 billion in 2020-21. As of the first six months of fiscal 2021-22, the deficit had already crossed the Rs800 billion mark. If this trend continues, the trade deficit will likely reach Rs1,600 billion by the end of the current fiscal year. Although the sharp change in the figures in recent years is mainly due to the pandemic, the trade imbalance problem is not new to the country’s economy. Like other least developed countries which depend on large-scale imports and face a persistent trade deficit as their economies grow, Nepal is also stuck with the same problem, but it has become more severe since the mid-2000s. This state of affairs called for policy to correct the imbalance.

Nepal’s trade policy has made overcoming the enduring trade deficit problem its core objective. It has thus set import substitution and export of services, mainly export of manpower, at the centre of its strategy. Following the same course of action, the government’s piecemeal programmes also relied on these two tactics to fix the persistent problem. But both these approaches look superficial given the country’s existing macro-economic condition and the government’s commitment to these interventions.

Import substitution

Let’s examine the policy of import substitution first. It contains more rhetoric than any concrete plan to substitute imports. Although import substitution is not absolutely desirable given the economic cost of protecting the domestic sector, the move may be justifiable for Nepal to replace imports of labour-intensive and low value-added consumer products. Protecting the products may be less costly because they enjoy a comparative advantage. But imposing the policy without a specific plan may encourage not only wrong industries, but also result in bias against exports as protection through high tariffs raises the cost of imported inputs required for both domestic and export-based industries. That means the overall impact of an arbitrarily applied import substitution policy will lead to misallocation of resources, reduction of consumer welfare, and decline in export competitiveness.

Based on these observations, agriculture can be a potential sector for protection and import substitution against a backdrop of the country's weakened industrial sector. Promoting farm output can help slash the country’s rising food and agriculture import bill, which amounted to Rs100 billion annually in recent years and is growing. Agro and food imports from India alone soared by a staggering 39 percent year-on-year in 2020-21. Considering this situation, it makes sense to substitute imports of food and agriculture products, but this could be unproductive without radical support measures.

The energy sector is another prospective area for import substitution that has attracted much talk but less action. When I raised the possibility of linking Nepal’s hydropower with import substitution as a possible means to ease the country’s trade deficit in an article in this paper eight years ago, few took notice. But the idea of exporting electricity was already in the limelight even though it is economically “monopsony” and technically impractical for cross-border trade without having access to a third country’s transmission lines. The campaign to replace petroleum-powered vehicles with battery-powered vehicles has also attracted massive attention as an environmental cause.

But the government didn’t roll out incentive packages to induce households to use electricity instead of imported liquefied petroleum gas (LPG) for cooking. And industries were not encouraged to use hydropower in place of diesel plants either. These measures could have reduced the import of energy valued at an annual average of Rs130 billion between 2012-13 and 2020-21, and could have ultimately helped to narrow the trade imbalance. But the possibility of substituting energy imports was utterly ignored despite being technically and environmentally feasible and economically rational.

Now let’s turn to the next policy strategy based on an export perspective. Nepal has been giving importance to the export of manpower and remittances as a good source of net transfer to the country. Since 2000, the inflow of remittances has been a comfortable source for financing the trade deficit and has played a crucial role in stabilising the country’s current account balance. Although its role in correcting the trade imbalance is worth admiring, it is not free of economic costs. While the increased inflow of remittances has encouraged imports and perpetuated the trade imbalance, it has also threatened the country's export competitiveness.

The World Bank referred to this phenomenon as the “vicious circle of migration and remittances” a few years ago, but it is still relevant. According to this cycle, increased worker migration and remittances has increased imports and import-based taxation, resulting in decreased export competitiveness through anti-export bias, and ultimately, recurring increased worker migration. As worker migration and remittances increased, the wages and prices of other production factors also soared. And that put pressure on the real exchange rate to appreciate, which resulted in the loss of export competitiveness. Hence, the inflow of remittances is both a vice and a virtue to the economy.

Export strategy

For an import-oriented small economy like Nepal, the scope for import substitution is limited or gets exhausted quickly. Therefore, import substitution policy should coordinate with agriculture policy and promote new products with a comparative advantage. As said earlier, incentives to use hydropower in place of imported energy cannot be refuted outright. Policy combination is essential for this as well.

Suppose industrial policy boosts capital formation and investment in the manufacturing sector through remittances, it supports import substitution policy and offsets the negative impact of remittances, at least in the long run. From the perspective of export strategy, it is necessary to explore markets for already established labour-intensive products. But this is not an easy task for products that are exhausted and need innovations to sustain in the international market. So, it is necessary to act in balance with other sectors to correct the trade imbalance, which is widening to the detriment of Nepal’s macro-economic situation in general and the trade sector in particular.