A recent macroeconomic update by the Asian Development Bank (ADB) forecasts Nepal’s GDP to grow between 5.2 and 6.2 percent in FY2017 compared to a dismal 0.8 percent in FY2016.

This has been a welcome relief for an economy devastated in recent years by natural and economic calamities. However, much of the positive outcome seems to be the result of good fortune—substantial monsoon rains and easy availability of agricultural input—and notably improved electricity supply.

The legal, bureaucratic, and policy constraints that plague the Nepali economy remain firm, so the rosy projection has to be viewed with reservations.

Acknowledging that a structural transformation is crucial to catalyse Nepali economy, a forthcoming paper “Applying the Growth Identification and Facilitation Framework to Nepal” by Jiajun Xu and Sarah Hager-Loss—both from Peking University—offers practical pathways for Nepal to undergo such structural transformation.

They expound that industrial transfer from China can be a crucial solution for a much needed industrial upgrade and a rapid economic advance. 

A study of economic history makes it clear that a vital manufacturing sector is critical for speedy economic transformation of poor countries.

This phenomenon was profoundly demonstrated by Four Asian Tigers—Hong Kong, Singapore, South Korea and Taiwan—between the 1960s and 1990s and more recently by China.

These countries went through rapid industrialisation and were able to post impressive growth figures for a sustained time period. Industrialisation is crucial for sustained economic growth because the manufacturing sector can absorb a large number of unskilled and semi-skilled labour, as operating machines is relatively straightforward and only requires minimal training.

This is not the case in the service sector as productivity gains can occur only through substantial improvement in skill level, which requires a much higher level of human capital.

For countries like Nepal, where productive labour is in short supply, the transition from agriculture to manufacturing is thus critical.

This phase of transition away from agriculture to manufacturing has been skipped by Nepal, which has several adverse implications for the Nepali economy. 

Industrial transfer

One potential way to reintroduce this missing link is through industrial transfer. The examples I offered above—the Asian Tigers and China—all benefited from industrial transfers, primarily from Japan.

According to the report, China may need to transfer as many as 85 million manufacturing jobs to new production locations in the near future.

Attracting only a small percentage of this industrial transfer will provide enormous opportunities for catalysing economic growth for Nepal and rejuvenating its comatose manufacturing sector.

However, Nepal faces severe binding constraints for attracting industrial transfers, mainly poor infrastructure (particularly transport infrastructure) and strenuous labour relations (high minimum wage, frequent strikes, business-unfriendly provisions in labour law and labour outmigration).

Despite this gloomy scenario, the report argues that, with proper implementation and management of Special Economic Zones (SEZs), the binding constraints could be mitigated and Nepal could be a potential location for China’s industrial transfer.

The report derives its assessment from what is known as the Growth Identification and Facilitation Framework (GIFF)—an important tool of the New Structural Economics (NSE).

GIFF formulates pathways for countries based on ‘what the country has’ rather than on ‘what the country lacks’, thus utilising the country’s latent comparative advantage for a speedy transformation.

Using this framework, the report recommends that Nepal should focus on increasing competitiveness in light manufactured goods as they are often labour intensive and require low or easily acquired skills.

Furthermore, rising wages in China has necessitated the transfer of production to new low-cost production locations.

The recently promulgated SEZ Act and subsequent inception of SEZs could be used as instruments to boost competitiveness and make Nepal an attractive destination for industrial transfer from China, according to the report.

Furthermore, the report recommends exploiting the proximity to China and burgeoning good relations with it to land the coveted Chinese investment.

Securing Chinese investment

Nepal entered the arena of SEZs recently by adopting the SEZ Act in September, 2016.

SEZs are special zones established with an objective to stimulate exports and attract investments by offering tax-and-tariff incentives, streamlined customs procedures and minimal regulations.

To get a glimpse of the enormous potential of SEZs, one need not go further than Shenzen, China.

The first SEZ set up in China in 1980, Shenzen has grown from a small fishing village of 30,000 people to a metropolis of over 18 million people with a more than 100-fold increase in per capita GDP in just 35 years.

However, SEZs are not guaranteed to be successful as demonstrated, for instance, by their failure in India.

Being a newcomer, Nepal has the opportunity to learn from other countries’ successes and failures to effectively implement the SEZ programme and manage the SEZs.

The paper explains how Nepal can use SEZs to overcome binding constraints and secure investment; it also provides pragmatic recommendations to increase their efficacy.

The first recommendation provided by the report is regarding the use of SEZs to remove the obstacles created by unreliable electricity supply.

Although not as severe as it was last year, we still rely heavily on electricity imports to power our machines, and our current power capacities will surely prove lacking for a significant industrial upgrade.

In that regard, the report recommends taking advantage of public-private partnership arrangements provisioned in the SEZ Act to recruit zone developers with private electricity generation and transmission capabilities and using partnership with China and India to develop border SEZs with shared commitment and investment to ensure electricity stability. 

Another important recommendation is regarding the use of SEZs to mitigate constraints created by the transportation pressures.

The recommendations include pooling goods bound for international markets among SEZ firms by taking advantage of lower cost container, negotiating price and time guarantees from freight forwarding companies by SEZ management, and locating upstream material production near downstream assembly of final goods.

Similarly, the recommendations for improving the challenging labour conditions through the use of SEZs include, inter alia, reducing the effective wage level within the SEZ by regulating existing piece work payment schemes so that the wages are more closely linked to worker productivity, thus stabilising the unit labour cost.

To effectively handle the issue of reduced effective wage level, the report recommends working with developers to provide non-wage benefits to workers such as accommodation, meals, education, and health services that can benefit from economies of scale within the SEZ.

Similarly, the report proposes allowing the use of skilled foreign labour in SEZs to increase the competency of the labour market, at least until the current trend of outbound migration slows or reverses. 

The report also recommends attracting a few pioneer firms to signal that Nepal is a legitimate production location as this will have the greatest effect in jump-starting the industrialisation process.

Lastly, the report acknowledges that the success of SEZs is entirely dependent on the proper implementation of the SEZ programme and hence offers recommendations like putting structures in place to guard against coordination failures in the large and diverse SEZ steering committee, involving SEZ experts and experienced zone managers, etc.

Recent history has shown us that Special Economic Zones are not always rewarding, and a far better option could be a holistic reform to directly address the constraints presented by insufficient electricity, poor infrastructure, and strenuous labour conditions.

However, judging from Nepal’s history of tardiness in policy reforms, a speedy structural reform seems unlikely.

Hence, the recommendation provided by the GIFF paper regarding the use of the SEZs, if properly implemented, could provide a rapid industrial upgrade.

The Special Economic Zones, thus, could be a precursor to a nationwide reform that will end up making the whole country special.

Dahal is a research officer at South Asia Watch on Trade, Economics and Environment (SAWTEE)