This paper has sought to examine the factors that have contributed to the economic growth of Nepal and Bhutan. After a brief discussion of the economy and growth strategy of each country, standard growth models for Nepal and Bhutan are developed and estimated. The results indicate that domestic capital has been a significant source of economic growth in Nepal whereas foreign aid has not had any appreciable effect on growth. The reverse is true for Bhutan

Dhakal, Dharmendra

Pradhan, Gyan

Upadhyaya, Kamal P.

English

University of New Mexico

Himalayan Journal of Development and Democracy, Special Issue, 2006 
 
Nepal and Bhutan: Development Strategies and Growth 
 
Kamal P. Upadhyaya 
University of New Haven 
 
Gyan Pradhan 
Westminster College  
 
Dharmendra Dhakal 
Tennessee State University   
 
I. Introduction 
Nepal and Bhutan are both landlocked mountainous countries 
surrounded by China in the north and by India on the other three sides. 
Until recently, both countries have been ruled by active monarchies. India 
is the major trading partner for both countries, accounting for 50 percent 
of Nepal’s and over 80 percent of Bhutan’s trade. There are also important 
differences between the two countries. For instance, Nepal is relatively 
more independent of India in terms of its defense as well as foreign policy. 
In addition, Nepal is larger than Bhutan in terms of population, population 
density, size of economy, arable land, agricultural production and 
hydropower potential. Nepal’s population is also much more diverse in 
terms of ethnicity. Another difference is that Nepal’s economic growth 
rate has been quite dismal compared to that of Bhutan, particularly in 
recent decades. In this paper we examine the economic development 
strategies of the two countries and estimate a growth model in order to 
provide some insight into the complex development problems facing these 
nations. 
II. The Economies 
Nepal’s economy grew at a reasonably fast pace during the 1990s 
as the economy responded to macroeconomic stability, liberalization, 
declining population growth rates and a rapid growth in trade (World 
Bank, 2005). The human development index improved as a result of better 
health and education indicators along with income growth. The proportion 
of the population living in absolute poverty declined as a result of the 
relatively broad-based growth performance of the economy and the 
growing significance of remittances. However, in the 2000s, political 
instability, effects of the global recession, and intensification of the Maoist 
conflict led to a sharp reduction in exports, manufacturing and tourism 
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Himalayan Journal of Development and Democracy, Special Issue, 2006 
 
services. In recent years, growth has continued to suffer, poverty has 
remained endemic and income distribution has become more unequal.  
Bhutan has established a record of high and sustained growth in 
recent years based mainly on its vast hydropower resources for export to 
India and strong international assistance. Bhutan’s economy grew at 
nearly 9 percent in 2005 with the high growth of construction associated 
with a major hydropower project accounting for half of the growth in 
GDP. Despite steady progress, however, a third of the population lives 
below the poverty line and income distribution is highly unequal—the 
income of the top 20 percent is eight times higher than that of the bottom 
20 percent. The economic base is narrow and largely depends on 
hydropower which accounts for 12 percent of GDP and 45 percent of 
government revenues. 
III. Development Strategies 
Nepal emerged from self-imposed isolation and started its 
development process with its First Five Year Development Plan in 1956 
which emphasized the development of infrastructures, agriculture and 
import substituting industries. Subsequent development plans continued to 
emphasize the development of infrastructures and agriculture as the 
country lacked basic infrastructures. In addition, these plans also 
emphasized trade diversification, private involvement and fulfillment of 
basic needs of the population with the objective of achieving high growth 
with employment (Khatiwada and Sharma, 2002). Nepal created several 
public enterprises which were essentially government monopolies. Huge 
government investments in inefficient public enterprises, continuously 
growing government budgets and low revenue efforts created budgetary 
deficits, inflationary pressures and balance of payments problems which 
were accentuated due to an overvalued exchange rate. As a result, the 
country suffered from serious macroeconomic instability by the mid-1980s 
which forced it to adopt a structural adjustment and economic 
liberalization program. 
Bhutan also started its development process late. The country 
lacked indigenous capital, manpower and infrastructure necessary for 
economic growth. Until the end of its First Five Year Development Plan 
(1961-66) the country was virtually inaccessible by road and air. 
Therefore, the main goal of the first plan was to build roads. In subsequent 
five-year plans, roads, transport and public works continued to receive 
high priorities. The Second Five Year Plan (1966-71) placed emphasis on 
power generation from its vast hydropower potential and helped it end its 
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Himalayan Journal of Development and Democracy, Special Issue, 2006 
 
physical isolation. In the third and fourth development plans, emphasis 
was placed on industrialization. In the 1980s, the development 
decentralization process was started under which development plans were 
drawn up for each district (Labh, 1984). As in Nepal, by the end of the 
1980s, privatization processes were initiated under which public 
enterprises were privatized.  
IV. Sources of Growth 
Standard growth models suggest that the rate of output growth 
depends primarily on the incremental change in the capital stock (Dhakal 
et al. 1996). Given the shortage of capital in developing countries, foreign 
assistance supplements the amount of capital and thereby contributes to 
economic growth (Chenery and Strout, 1966). Assuming the amount of 
labor is constant, the following model is developed: 
y = AKbe        (1) 
Where y denotes the level of output, A represents the efficiency 
parameter, K is the amount of capital, b represents the contribution of 
capital, and e is the random error term. After log transformation, equation 
(1) can be written as: 
log y = A + b log K + e     (2) 
The first difference of equation (2) changes it into growth form: 
Δ log y = c0 +c1 Δ log K + v     (3) 
Replacing K in equation (3) by AID (foreign aid defined as grants 
and foreign borrowing), 
Δ log y = c0 + c1 Δ log AID + v    (4) 
where v in equations (3) and (4) is the random error term. 
Equations (3) and (4) are estimated for Nepal and Bhutan using annual 
time series data. An error correction model is estimated for Nepal in order 
to capture the long-run relationship between the variables. For Bhutan an 
error correction model is not developed because the length of data 
required was not available. In order to capture the lagged effect, a one-
year lag of K is also added. The estimated results are reported below. 
Nepal 
Δ log y = 0.038 + 0.18 Δ log K – 0.09 Δ log K-1  - 0.04 ER-1 – 0.67 AR (1)        (5) 
   (8.08)***  (2.66)**         (1.36)                  (2.89)**     (4.04)*** 
Adj. R2= 0.171      DW = 2.41     F = 2.34    RESET F = 1.18       
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Himalayan Journal of Development and Democracy, Special Issue, 2006 
 
 
 
Δ log y = 0.04 + 0.02 Δ log AID + 0.00007 Δ log AID -1 - 0.05 ER-1          (6) 
           (7.72)*** (0.91)                 (0.002)                           (1.79)*    
 
Adj. R2= 0.013      DW = 2.49     F = 1.12    RESET F = 0.311       
             
Bhutan 
 
Δ log y = 0.05 + 0.03 Δ log K + 0.06 Δ log K-1               (7) 
             (2.54)** (0.26)              (0.58) 
 
Adj. R2= 0.171      DW = 2.41     F = 2.34    RESET F = 1.93    
 
Δ log y = 0.037 + 0.06 Δ log AID + 0.12 Δ log AID -1                    (8) 
            (2.57)*** (1.31)                   (2.33)**    
 
Adj. R2= 0.186      DW = 1.93     F = 3.06    RESET F = 1.72       
  
Figures in parentheses are t-values.  ***significant at 1% critical level, 
** significant at 5% critical level, and *significant at 10% critical level. 
 
Because of serial correlation, equation (5) is estimated using AR 
(1) term. The overall estimation of this equation appears fine in terms of 
the R-squared statistic and F value. The Durbin-Watson value falls within 
the inconclusive range but the ARCH-LM test suggests the absence of 
autocorrelation. The results thus indicate that in Nepal domestic capital 
has had a significant effect on growth while foreign aid and borrowing 
have had very little effect. The opposite holds true for Bhutan—domestic 
capital does not seem to have had any significant effect on growth; 
instead, foreign aid has been the source of growth. Given that the private 
sector is still relatively underdeveloped and that Indian assistance has been 
well-utilized for mega electricity and other infrastructure development 
projects, this finding is not surprising. 
V. Conclusion 
This paper has sought to examine the factors that have contributed 
to the economic growth of Nepal and Bhutan. After a brief discussion of 
the economy and growth strategy of each country, standard growth models 
for Nepal and Bhutan are developed and estimated. The results indicate 
that domestic capital has been a significant source of economic growth in 
 57
Himalayan Journal of Development and Democracy, Special Issue, 2006 
 
Nepal whereas foreign aid has not had any appreciable effect on growth. 
The reverse is true for Bhutan. 
 
References 
Chenery, H.B., and A.M Strout. (1966) “Foreign Assistance and 
Economic Growth,” American Economic Review, vol. 56, pp. 679-
733. 
Dhakal, Dharmendra, Kamal Upadhyaya, and Mukti Upadhyay. (1996) 
“Foreign Aid, Economic Growth and Causality,” Rivista 
Internazional di Scienze Economiche e Commerciaili, vol XLIII, 
no. 3, pp. 597-606. 
International Monetary Fund, International Financial Statistics, various 
issues. 
Khatiwada, Yubaraj and Suman Sharma. (2002) Nepal: Country Study 
Report, IIDS, Kathmandu, Nepal. 
Labh, Kapileshwar. (1994) “Economic Development in Bhutan: Recent 
Trends and Prospects,” International Studies, vol. 31, no. 2., pp. 
189-206. 
World Bank, World Development Indicators 2005. 
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