Nepal’s trade deficit crossed the Rs700-billion mark in the last fiscal year 2015-16. The figure is equivalent to approximately one-third of the country’s Gross Domestic Product (GDP). Before the deficit reached this historic milestone, it had been doubling every three to four years. This unprecedented rise in Nepal’s trade deficit has drawn strong attention of policymakers and trade experts. The conventional view about Nepal’s trade deficit, put forward by experts and accepted by the general public, is that swelling consumption-oriented imports encouraged by rapidly growing remittance inflow has led to the ballooning trade imbalance. Nepal witnessed an unexpected fivefold growth in remittance accompanied by a matching growth in imports during the period.

This argument is valid to a large extent because most remittance-dependent, low-income people have a higher propensity to consume with increased incomes from remittance. In the initial phase of rising income levels, people in the low-income bracket tend to spend disproportionately more to pay for their requirement of better food, clothes, schooling and health care after they have fulfilled their basic needs. In effect, the domestic economy spends more than it produces, and this excess demand is met by net inflow of imported goods ultimately leading to a massive trade deficit. The problem of trade imbalance intensifies if underlying macroeconomic conditions are left unattended.

The conventional view reveals more than this link between growing remittance and swelling imports. Its impact on the country’s waning export trade is worth recalling. Due to increased worker migration, the export sector faced an acute labour shortage impacting the cost of production and productivity. This impaired the competitiveness of the export trade which was already in dire straits. A glaring example is the dwindling export values of carpets, garments and farm products, which are labour-intensive products and crucial to the country’s external trade. In this connection, it is relevant to mention here a recent World Bank study on Nepal’s trade integration, which explains the role of remittance in financing the trade deficit and in perpetuating it.

Vicious cycle

This interesting report delves into Nepal’s current remittance-driven growth model and an anti-export bias with relevance to the growing trade deficit that the country has been facing. Its findings are loud and clear: Nepal has been trapped in a vicious cycle of increased worker migration and rising remittance leading to low competitiveness and swelling imports which, in turn, has led to increased taxes on imports and decreased export competitiveness due to an anti-export bias.

Looking closely at this thought-provoking report will show that remittance, despite being a key source of foreign exchange and means of poverty alleviation in the country, has been expanding the trade deficit and contributing to an appreciation of the real exchange rate from a macroeconomic perspective. According to the study, a 10 percent increase in remittance results in a 0.5 percent appreciation of the real exchange rate in the long run. As remittance puts upward pressure on prices of non-tradable goods (in a situation where the nominal exchange rate regime is pegged to the Indian rupee), the result is an appreciation of the real exchange rate.

As remittance has grown rapidly over the last 20 years pushing up the real exchange rate, it favoured imports and discouraged exports by making domestic production uncompetitive. Therefore, the impact was extremely high on low-value, low-margin manufactured goods which occupy a big space in Nepal’s small export basket. Furthermore, rising imports are an attractive taxation base for the government which has begun to rely more on import tariffs for revenue generation. This has compounded the anti-export bias, as exporters depend heavily on imported goods which are major inputs for their production. Hence, a high tariff regime has resulted in high export prices, particularly when the duty drawback and incentive schemes for exporters have proved to be ineffective. Therefore, the whole scenario suggests a bias against domestic production and export trade that is likely to perpetuate the current vicious cycle.

Policy prescription

This poses a big challenge for the country to get out of the vicious circle. Considering both the benefits and disadvantages of remittances, the option commonly put forward is increasing the competitiveness of domestic production, particularly in the export sector, to create more jobs. In order to achieve this, the World Bank study has prescribed measures to gradually move away from import-based taxation, streamline tariff lines and reduce tariff rates, especially on intermediates that are vital to major export products. Also, it is important to rationalise the duty-drawback system for exporters under which the import duty paid on a product is refunded when it is subsequently exported.

But these recommendations could be a bitter pill to swallow for the government and policymakers who have become overly dependent on import tariffs for revenue generation and have promoted import substitution without deep thought. The government, without prejudice, should be willing to change the ‘controversial’ cash incentive scheme which has not reached the targeted exporters or made any clear impact on export growth and diversification. Thus, the authorities responsible for trade promotion should not tinker with policies any more if they want to see the trade deficit shrinking in favour of macroeconomic stability.

Shakya is an associate professor of economics at Tribhuvan University