Monday, November 16, 2015

Earthquake and Blockade: A wrecked Nepalese economy

Earthquake and economy

The catastrophic 7.8 magnitude earthquake on 25 April and subsequent aftershocks (two of them very strong) crippled the economy on all fronts: agricultural output as well as agricultural land was lost, and industrial and services sectors struggled to keep operation open amidst widespread disruption of production and distribution networks, especially on the main demand centers (urban areas including Kathmandu) and trade routes with China. Consequently, GDP growth came tumbling down to 3.0% from an expected 4.6% in FY2015 (unfavorable monsoon had already lowered GDP growth from 5.1% in FY2014). Meanwhile, the subdued market prices during the first three quarters more than offset the increase in prices of goods and services post-earthquake (which struck in the tenth month of FY2015), leading to inflation of about 7.2%.

External sector strengthened as lower import growth and higher remittance inflows immediately after the earthquake increased current account balance and balance of payments surpluses (5.1% of GDP and 6.8% of GDP, respectively). Fiscal performance remained dismal as estimated actual capital spending was just about 70% of planned capital spending, and revenue mobilization grew at 13.8% against 20.5% in FY2014.  Capital spending remains woefully low at around 3.5 to 4.0% of GDP. The low expenditure performance and relatively high revenue mobilization led to a fiscal deficit of around 0.2% of GDP (with primary surplus of about 1.6% of GDP in FY2015). Migration slowed down immediately after the earthquake, unprecedented scale of international assistance (primarily led by India together with PRC and the US) was mobilized, and the affected folks struggled to normalize household activity. About a million people fell below the poverty line.

The government estimated that the recovery cost would amount to about $6.7 billion (half of it needed for housing and human settlement), almost a quarter of FY2015 GDP. The international community pledged about $4 billion to finance post-earthquake rehabilitation and reconstruction (which is more than the share to be shouldered by the public sector). So, money was not an issue. The capacity to spend it effectively was. To give momentum to this, the government focused FY2016 budget (and monetary policy) on “building back better” and faster. To this end, an ordinance was promulgated to establish National Reconstruction Authority. The ordinance never made it to the parliament within 30 days and hence its life ended drastically. A bill on NRA is pending in the parliament. It has become a victim of political infighting, delaying post-earthquake reconstruction (urgently needed for short-term recovery and for long-term preparedness in this seismically active country). Initial euphoria about post-earthquake reconstruction has dampened. Pledged funds have remained idle (some may get cancelled if there is no progress), affected folks are still struggling to get by normal life, economy is weaker than before, and the lack of direction on reconstruction has raised frustration levels and the attrition of labor force. Meanwhile, political leadership has lost the sense urgency, hastened promulgation of constitution disgruntling some section of the population, and is still engaged in political infighting. Bureaucracy remains confused and increasingly looking for guidance from political leadership even in minor matters.

Now, that’s the story about post-earthquake economic tragedy triggered by the natural disaster that affected the upper and middle belts of western and mid-western administrative regions.

Blockade and economy

Enter the crisis in the Terai region and the debilitating impact on the economy. The crisis was brewing prior to the promulgation of the constitution as some Madhesh-based political parties objected to some provisions included in the draft constitution, which was passed by an overwhelming majority in the Constitution Assembly. The main point was the demarcation of federal states in the Terai region. With no flexibility (both sides) shown to settle the issue politically, the discomfort, disdain (not all but among some) and alienation increased. Consequently, protests and the state’s reaction to protesters (at times excessive on both sides) intensified. India came into the picture to influence changes to the constitution and many analysts allege that it is imposing an ‘unofficial blockade’ on the borders. Supporters of protesting parties picketed the border areas, virtually halting the movement of goods and services. What, how, who, when, etc narrative differ based on the ideological leaning (passion is overpowering reason and cool-headedness) of analysts, consultants, journalists, lawyers, politicians, etc (however ‘independent’ they are).

Anyway, the focus here is economy. Since Nepal is a landlocked country and trade with India accounts for about 60% of imports and exports (plus it provides access to its ports), the activities on the border have severely crippled the economy, which was already hamstrung by the impact of the earthquake and the government’s and the bureaucracy’s inability to initiate rehabilitation and reconstruction swiftly.

The supply disruptions (some allege it as official/unofficial blockade by India) have affected pretty much every economic activity. The Terai belt is considered an important agricultural and industrial hub, and it has all the major custom points along the major border crossings with India. The Terai region accounts for about 51% of agricultural output, 52% of industrial output and 40% of services output. The population of Terai (quite diverse in terms of ethnicity, class, language, income, vocation, etc) is about 50% of total population.

The subnormal monsoon was already affecting plantation and hence potential agricultural output. The disruption to household agricultural activities and shortage of chemical fertilizers along with uncertainty over timely harvesting have dented the outlook for agricultural output. Industrial activity has come to a grinding halt. Mining and quarrying, and construction works have not progressed much due to the delay in post-earthquake reconstruction. The shortage of supply of raw materials or intermediate goods (including petroleum fuel and LPG cooking gas) along with the closure of manufacturing plants have affected manufacturing and construction activities. Industrial sector will most probably grow at a negative rate.

Meanwhile, services sector, which is largely based on remittance-financed imported goods, has been severely crippled. Wholesale and retail trade (which is by far one of the most important and stable drivers of growth in addition to agricultural output) has been severely disrupted. Hotels and restaurants are struggling to cope with the acute shortage of cooking gas and diesel (fires up generator during load-shedding hours). Tourist arrival has plummeted. Real estate and associated businesses are in doldrums. Education institutions are shut down or are partially operational. Hospitals are running out of emergency as well as normal items. Services sector will also most likely grow at a negative rate.

So, the economic outlook looks very grim. As of now (with uncertainty over the resolution of the crisis), the growth rate in FY2016 will most likely be negative (it hasn’t happened so far and the lowest growth [0.2%] was registered in FY2002 immediately after the intensification of Maoist insurgency; services growth was negative 1.8%). My estimate is that GDP growth will plunge to around negative 0.8% in FY2016. Importantly, subject to the longevity of ongoing supply and production disruptions, the effect of the disruption to and dislocation of economic activities as a result of the earthquake and subsequently the crisis in Terai (including blockade) are going to linger on for the next few years if the response from the government is not swift (after the resolution of Terai crisis, which lets hope will happen sooner). The rate of exit from the labor force will be high and potentially migration for overseas work will increase. The existing growth rate is already too low. With the weak state of infrastructure supply and institutional fundamentals, the economic and employment potentials are further constricted. Not a good sign to bring back production and economic activities back to normal!

The food as well as non-food inflationary pressures will likely shoot up overall inflation above 10% and it might linger at higher levels in the following year(s). On the external front, trade deficit will come down along with the plunge in both exports and imports. Remittance inflows may remain strong and hence current account surplus may be remain at high levels. Lower lending compared to deposit will likely lead to liquidity surplus. Lower expenditure and lower revenue growths may result in not much deterioration of fiscal position. However, lower expenditure as well as lower revenue growth will mean some of the fiscal targets will be beyond the reach for this year and the next. Lets hope FY2017 will be better!

In a nutshell, tough times for the economy, the poor and the middle class throughout the country!

Finally, the issue about what needs to be done?
  • Economic outlook will continue to be bleak if the supply disruptions continue. Speeches about self-sufficiency right now are useless. The country cannot simply become self-sufficient [self-reliant(?)] in food and energy in one or three years. Hydroelectricity production is not going to be sufficient over the medium term (within 5 years). While some are awaiting repairs following the earthquake, others are struggling to accelerate construction. However, the issue here is of raw materials/intermediate goods, which need to be imported (ranging from fuel to nuts and bolts and cement to heavy equipment). With the blockade in place, all construction work is already delayed by many months because it will take more time to restore pre-crisis (plus pre-earthquake) pace of work, which will partially depend on the clearance at the border and transportation of inputs to construction sites. So, resolve the Terai issue pronto to rescue the economy. No other way out!
  • Rather than giving pompous statement about self-sufficiency and ending load-shedding, the government should bring out a time-bound strategy on how to achieve them. This would require taking tough decisions: taming unruly labor unions and interest groups hindering reform, enhancing productivity of workers, better community relations (think of obstruction caused due to the demand for shares by locals, etc), expedited construction of transmission and distribution lines (these have been trailing behind hydroelectricity construction affecting expected return on some of the investment), reforming NEA and NOC (and a slew of other moribund public enterprises), promoting the use of alternative sources of energy, updating the relevant Acts and implementing them in earnest, creating stable institutions and manning them with competent human resources, etc. The list is long and very challenging to do over the medium term given the will of political leaders and interest groups rallying behind them. See this piece on why Nepal is poor?
  • Enough has been said already about National Reconstruction Authority. Just pass the Act, appoint a competent CEO, bring all implementing ministries on board and do the reconstruction within a stipulated timeframe.
  • Boost public sector’s capacity to spend money. The availability of funds in the short-term is not an issue. The country is running a primary surplus already. Just use the funds wisely and in an accelerated way in productivity-enhancing investments (physical and social infrastructure).
  • Revitalize the private sector and provide it with adequate incentives to focus on domestic production as opposed to trading of imported goods. Here also comes in the strategy to diversify the production base to reduce dependence on a single country for export and import. Upgrade customs points located in the northern and southern borders. Promote value chain development (intra and inter sector) and facilitate supply chains.
  • Good governance is very important in all of these. Enough has already been said about it. Time to introspect and do the right thing.

Friday, October 30, 2015

Poverty in Nepal and South Asia based on $1.90 a day poverty line

The World Bank recently updated its global poverty line, which is now re-estimated at $1.90 a day, up from $1.25 a day earlier. Accordingly, poverty estimates for all countries have been revised, mostly downward.

Nepal’s absolute poverty at $1.90 a day stood at 14.9% in 2010, a sharp decrease from 47.1% in 2003 and 61.7% in 1995. Compare this with the estimate based on $1.25 a day (2005 PPP): in 2010 absolute poverty stood at 23.7%, also sharply down from 53.1% in 2003 and 68.0% in 1995. The new poverty benchmark shows a marginal acceleration in absolute poverty reduction, but overall not much difference in rate of decrease over the last two decades.

The estimates based on national poverty line, which is fixed at NRs 19,261 (NRs 11,929 for food items and NRs 7,332 for non-food items in 2011 prices) are the same. The estimates based on NLSS III data show that about 25.2% of the people lived below the national poverty line in 2010/11. Consumption basket was changed in this round of estimate, so it cannot be strictly compared to the previous estimates. See this for more and this for poverty by district. The major contributing factors for poverty reduction are remittance income (see here and here), higher agricultural wages, urbanization (mostly propelled by rural-urban migration) and investment in public services (education and healthcare, financed mostly by donors) (see here). It has hardly anything to do with economic growth.

Poverty in South Asia

Now, lets look at how the other South Asian economies fare with the re-estimated global poverty estimate. India has the highest poverty rate (21.3%) in South Asia, followed by Nepal and Pakistan. Overall, all countries have managed to lower poverty save the Maldives.

Inequality in South Asia

Nepal lowered inequality (as measured by Gini index based on consumption) from 43.3 in 2003 to 32.8 in 2010. Similarly, Bangladesh, the Maldives and Pakistan have marginally also lowered inequality. The most progress is achieved by Nepal. Inequality seems to have increased in Bhutan, India and Sri Lanka.

Consumption share

The share in consumption of the lowest 40% of the population stood at 20.5% and the highest 40%’s share was 63.3% in Nepal in 2010. The share of consumption attributed to the lowest 40% has increased and the share of the highest 40% decreased during the last two living standard survey periods. India and Sri Lanka saw a marginal decline in the consumption share of the lowest 40% population.

Briefly about the re-estimated international poverty line

While the new poverty line is based on 2011 purchasing-power-parity (PPP), the earlier poverty line was based on 2005 PPP prices. The other methods of computing the poverty line remains the same (basically, the earlier global extreme poverty line was expressed in 2011 PPP values computed under the International Comparison Program in 2014).

The new global poverty line is computed by taking the average of national poverty lines of the 15 poorest countries (Chad, Ethiopia, The Gambia, Ghana, Guinea-Bissau, Malawi, Mali, Mozambique, Nepal, Niger, Rwanda, Sierra Leone, Tajikistan, Tanzania and Uganda) in 2011 and then converted into US dollars using 2011 PPP. So, starting October 2015 the new global extreme poverty line is $1.90 a day. About 987 million people globally (14.2% of global population) lived under this line in 2012 and it is projected to drop to around 700 million in 2015. More here and here.

A bit of timeline of the global poverty estimates:
  • $1 a day created in 1991 used 1985 PPP
  • Re-estimated to $1.08 a day using 1993 PPP
  • Re-estimated to $1.25 a day using 2005 PPP
  • Re-estimated to $1.90 a day (precisely $1.88 a day) using 2011 PPP

Saturday, October 17, 2015

Deaton vs Friedman: Is income more volatile than consumption?

Angus Deaton was awarded the 2015 Nobel Prize in economics for his "analysis of consumption, poverty and welfare."  Here you can read about his work summarized and analyzed by the Nobel committee.

One of the micro-macro issues that Deaton tackled was if income was more volatile than consumption. Milton Friedman argued that people smooth consumption over time even if they experience temporary income shock (permanent income hypothesis). In other words, consumption is not as volatile as income. However, Deaton argued that it may not be the case if people expect several bouts of income increase. In this case, consumption would not be smooth. This is the Deaton Paradox, which comes from his analysis of household's income pattern and consumption behavior. 

The Economist summarizes this:

But Mr Deaton’s work exposed this as sloppy thinking. First, he noted that the relationship between consumption and income in Friedman’s model depended on the kinds of income shocks hitting an economy. If one pay rise acts as a signal that there are more to come, then the “rational” agent in Mr Friedman’s model should anticipate future increases, and spend even more than their initial income boost. In this case, consumption should be more volatile than income, not the other way round.
So indeed it proved. Mr Deaton examined the aggregate income data more carefully, and found that it did not seem to support the idea of consumption smoothing. His microeconomic theory, allied with his empirical observations about aggregate income, together implied that income should be smoother than consumption, in contrast to what the macroeconomists had been trying to explain in the first place. This inconsistency was the Deaton paradox.

And some word of advise to economists:

As well as his specific contributions to our understanding of the world, Mr Deaton offers three lessons to aspiring economists. First, the theory should tally with the data—but if not, then do not despair. Puzzles and inconsistencies help to prompt innovation. Second, the average is rarely good enough. It is only by understanding differences between people that we can understand the whole. Finally, measurement matters. In the words of Mr Deaton, “progress cannot be coherently discussed without definitions and supporting evidence”. In the words of Mr Muellbauer, Mr Deaton’s win is “a triumph for evidence-based economics”.

Saturday, September 26, 2015

The 17 Sustainable Development Goals (SDGs)

Here is the list of the 17 SDGs agreed this week at the UN. There are many targets within each group. SDGs are the set of long term global development goals. They succeeded the MDGs.

  1. End poverty in all its forms everywhere
  2. End hunger, achieve food security and improved nutrition and promote sustainable agriculture
  3. Ensure healthy lives and promote well-being for all at all ages
  4. Ensure inclusive and equitable quality education and promote lifelong learning opportunities for all
  5. Achieve gender equality and empower all women and girls
  6. Ensure availability and sustainable management of water and sanitation for all
  7. Ensure access to affordable, reliable, sustainable and modern energy for all
  8. Promote sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all
  9. Build resilient infrastructure, promote inclusive and sustainable industrialization and foster innovation
  10. Reduce inequality within and among countries
  11. Make cities and human settlements inclusive, safe, resilient and sustainable
  12. Ensure sustainable consumption and production patterns
  13. Take urgent action to combat climate change and its impacts
  14. Conserve and sustainably use the oceans, seas and marine resources for sustainable development
  15. Protect, restore and promote sustainable use of terrestrial ecosystems, sustainably manage forests, combat desertification, and halt and reverse land degradation and halt biodiversity loss
  16. Promote peaceful and inclusive societies for sustainable development, provide access to justice for all and build effective, accountable and inclusive institutions at all levels
  17. Strengthen the means of implementation and revitalize the global partnership for sustainable development

The targets within Goal #8 (Promote sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all) are as follows:

8.1. Sustain per capita economic growth in accordance with national circumstances and, in particular, at least 7 per cent gross domestic product growth per annum in the least developed countries

8.2. Achieve higher levels of economic productivity through diversification, technological upgrading and innovation, including through a focus on high-value added and labour-intensive sectors

8.3. Promote development-oriented policies that support productive activities, decent job creation, entrepreneurship, creativity and innovation, and encourage the formalization and growth of micro-, small- and medium-sized enterprises, including through access to financial services

8.4. Improve progressively, through 2030, global resource efficiency in consumption and production and endeavour to decouple economic growth from environmental degradation, in accordance with the 10-year framework of programmes on sustainable consumption and production, with developed countries taking the lead

8.5. By 2030, achieve full and productive employment and decent work for all women and men, including for young people and persons with disabilities, and equal pay for work of equal value

8.6. By 2020, substantially reduce the proportion of youth not in employment, education or training

8.7. Take immediate and effective measures to eradicate forced labour, end modern slavery and human trafficking and secure the prohibition and elimination of the worst forms of child labour, including recruitment and use of child soldiers, and by 2025 end child labour in all its forms

8.8. Protect labour rights and promote safe and secure working environments for all workers, including migrant workers, in particular women migrants, and those in precarious employment

8.9. By 2030, devise and implement policies to promote sustainable tourism that creates jobs and promotes local culture and products

8.10. Strengthen the capacity of domestic financial institutions to encourage and expand access to banking, insurance and financial services for all

8.a. Increase Aid for Trade support for developing countries, in particular least developed countries, including through the Enhanced Integrated Framework for Trade-Related Technical Assistance to Least Developed Countries

8.b. By 2020, develop and operationalize a global strategy for youth employment and implement the Global Jobs Pact of the International Labour Organization

Migration, remittances and balance of payments post April 25 earthquake in Nepal

This is adapted from Macroeconomic Update, August 2015, Vol.3, No.2 (executive summary here, and FY2016 growth and inflation outlook here). It presents is the composition of Nepal’s outstanding internal and external debt. The Macroeconomic Update includes FY2015 update on real, fiscal, monetary and external sector, and growth and inflation outlook for FY2016. It provides a comprehensive macroeconomic assessment, including fiscal sustainability, after the April 25 earthquake.

I. Remittances

Despite the deceleration of remittance inflows till the third quarter of FY2015, the earthquake in the last quarter prompted migrant workers to drastically increase the amount of income remitted to Nepal. Consequently, workers’ remittance inflows reached a record 29.1% of GDP in FY2015, equivalent to $6.2 billion (Figure 1). In US$ terms, remittance inflows grew by 12.2%, marginally up from 11.9% growth in FY2014.[1] This follows a 16.4% growth of migrant workers (those who obtained permits form the Department of Foreign Employment).

Figure 1: Number of migrants and remittance inflows

II. Migration

According to the Department of Foreign Employment, growth of migrant workers decreased by 2.8% (Table 1) against a growth of 16.4% in FY2014 as recruitment process got derailed for over a month and potential migrant workers deferred travel plans in view of the immediate relief and temporary reconstruction works needed in the earthquake affected areas. A total of 512, 887 migrants legally left to work overseas in FY2015 (daily average of 1,405), down from 527,814 in FY2014 (daily average of 1,466). Malaysia, Qatar, Saudi Arabia, and UAE have remained the top employment destinations for low and semi-skilled Nepalese migrant workers (Figure 2). They together accounted for 92% of total migrant workers in FY2015. As a share of total migrants, Malaysia’s share increased from 34.6% in FY2013 to 40.6% in FY2014, but declined to 39.5% in FY2015. Meanwhile, Qatar’s share also decreased from 24.4% in FY2014 to 24.2% in FY2015. Saudi Arabia, Japan and South Korea absorbed higher share of migrant workers when compared to the shares in FY2014.

Figure 2: Destination-wise distribution of labor migrants

Table 1: Monthly out-migration

Number of migrants Y-o-Y growth
mid-month FY2014 FY2015 FY2014 FY2015
August     45,519     42,309 39.3 -7.1
September     24,214     51,551 -13.8 112.9
October     31,959     35,550 -15.9 11.2
November     31,949     43,213 24.7 35.3
December     41,634     53,354 19.1 28.2
January     50,032     45,362 22.4 -9.3
February     37,285     48,941 -0.5 31.3
March     48,552     44,460 24.2 -8.4
April     45,854     52,210 10.1 13.9
May     54,173     31,375 37.9 -42.1
June     54,926     37,962 21.0 -30.9
July     61,717     26,600 22.3 -56.9
Total   527,814  512,887 16.4 -2.8

III. Balance of payments

Despite the weak currency, which improved relative price competitiveness, exports failed to pick up in the first three quarters and then plunged drastically as production got severely affected by the April earthquake and its aftershocks. Merchandise exports (free on board [fob]), in US dollar terms, decreased by 3.9%-- a sharp fall from 5.1% growth in FY2014. The country exported merchandise goods worth $990.8 million, down from $1.03 billion in FY2014. Overall, merchandise exports decreased to 4.6% of GDP in FY2015 from 5.2% of GDP in FY2014. Exports to India, the People’s Republic of China (PRC), and other countries accounted for 65.5%, 2.6% and 31.9%, respectively, of total exports in FY2015.

Merchandise imports growth (cost, insurance freight [cif]) in dollar terms slowed down to 8.0% from 13.9% growth in FY2014 as it got hit due to the severe disruption in economic activities and a slump in import demand following the earthquake. Of the total imports of $7.6 billion, 14.7% was oil imports. In US dollar terms, this is equivalent to $1.1 billion, higher than the value of the country’s total merchandise exports but lower than the oil import bill in FY2014. This is primarily due to the low international oil prices and the weakening of aggregate demand in the last quarter of FY2015. Overall, merchandise imports stayed unchanged at 35.9% of GDP in FY2015 and FY2014. Imports from India, PRC, and other countries accounted for 63.5%, 12.9% and 23.6%, respectively, of total imports in FY2015.

Figure 3: Balance of payments (% of GDP)

The country’s external situation strengthened in FY2015 with the balance of payment surplus reaching $1.5 billion (6.8% of GDP). Though this is an impressive increase from the $1.3 billion (6.5% of GDP) surplus in FY2014, it is still lower than the $1.6 billion (8.2% of GDP) surplus in FY2012 (Figure 3). The large merchandise trade deficit, which reached 31.2% of GDP, was partially[2] offset by workers’ remittances, which reached a record 29.1% of GDP, and export (4.6% of GDP), resulting in a current account surplus of $1.1 billion (5.1% of GDP), up from 4.6% of GDP in FY2014. While capital transfers decreased by 14.3%, financial transfers increased by 57.0% as a result of the 35.5% jump in foreign direct investment, amounted to $44.2 million. Gross foreign exchange reserves increased from $6.8 billion in FY2014 to $8.3 billion FY2014, sufficient to cover 11.2 months of imports of goods and non-factor services.

[1] In local currency, the growth rate was 13.6% in FY2015, down 25.0% growth in FY2014.

[1] Overall, the net goods, services and income balance was a negative 28.3% of GDP, which was offset by net transfers equivalent to 33.4% of GDP, resulting in current account surplus equivalent to 5.1% of GDP.

Friday, September 25, 2015

Recent interest rate trend in Nepal

This is adapted from Macroeconomic Update, August 2015, Vol.3, No.2 (executive summary here, and FY2016 growth and inflation outlook here). It presents is the composition of Nepal’s outstanding internal and external debt. The Macroeconomic Update includes FY2015 update on real, fiscal, monetary and external sector, and growth and inflation outlook for FY2016. It provides a comprehensive macroeconomic assessment, including fiscal sustainability, after the April 25 earthquake.

The persistence of excess liquidity throughout the year pushed short-term interest rates mostly below 1.0%, although the rates were higher after starting February 2015 compared to the corresponding period in FY2014 (Figure 1). The 91-day treasury bills weighted average rate was 0.0004% in mid-August 2014, which jumped to 0.17% in mid-July 2015 and averaged 0.43% in FY2015, higher than 0.13% in FY2014. Similarly, inter-bank rate increased from 0.15% in mid-August 2014 to 1.01% in mid-July 2015, and averaged 1.06% in FY2015, much higher than 0,22% in FY2014. It indicates that the short-term liquidity management measures deployed by the NRB worked in lowering down excess liquidity. However, the persistent and recurring excess liquidity has to be sustainably resolved by address overall investment climate and structural issues in the banking sector.

Figure 1: Weighted average interbank and 91-day treasury bills rate (%)

The weighted average deposit and lending rates fell as the BFIs struggled to boost lending amidst persistence of excess liquidity (Figure 2). The weighted average deposit rate of commercial banks dropped to 3.94% in mid-July 2015 from 3.99% in mid-August 2014. It has fallen consistently from a high of 6.17% in mid-July 2012. Similarly, the weighted average lending rate fell to 9.62% in mid-July 2015 from 10.3% in mid-August 2014. The weighted average interest rate spread stood at 5.7% by mid-July 2015. Base rate continued to decline as well, reaching 7.88% in mid-July 2015.

Figure 2: Weighted average interest rates of commercial banks (%)

The cash reserve ratio (CRR), which is the minimum mandatory deposits that BFIs needs to hold as reserves either in cash or as deposits with the central bank and is usually used as one of the tools to achieve monetary policy goals, has remained unchanged since mid-August 2014. The present CRR for commercial banks, development banks and finance companies is 6.0%, 5.0% and 4.0%, respectively (Figure 3). The bank rate and standing liquidity facility have been kept unchanged at 8%.

Figure 3: Policy rates (%)

Meanwhile, the commercial banks’ have comfortably satisfied the capital adequacy ratio (CAR) and net liquidity requirements. CAR of commercial banks stood at 11.69%, which is 0.69 percentage points higher than the minimum 10% CAR and 1% buffer requirement. Similarly, credit to deposit ratio stood at 77.8% against a maximum limit of 80% and net liquidity stood at 31.8% against the minimum 20% requirement, indicating that there is still room for commercial banks to expand credit and reduce their excess liquidity (Figure 4). Non-performing loans declined to 2.68% of total loan by mid-June 2015 from 3.01% in mid-October 2014. Average productivity sector lending (agriculture, energy, tourism, and cottage & small industries), was 21.88% of total credit by mid-June 2015. Credit to agriculture and energy sectors alone stood at 13.24% of total credit by mid-June 2015.

Figure 4: CAR, net liquidity and NPL (%)

Thursday, September 24, 2015

Nepal’s fiscal performance needs drastic improvement

This is adapted from Macroeconomic Update, August 2015, Vol.3, No.2 (executive summary here, and FY2016 growth and inflation outlook here). It presents is the composition of Nepal’s outstanding internal and external debt. The Macroeconomic Update includes FY2015 update on real, fiscal, monetary and external sector, and growth and inflation outlook for FY2016. It provides a comprehensive macroeconomic assessment, including fiscal sustainability, after the April 25 earthquake.

I. Expenditure Performance

1. The sluggish expenditure in the first three quarters and damages caused by the earthquake in the last quarter of FY2015 significantly affected public expenditure. The budget execution delays, and long-running procedural as well as procurement hassles constrained absorptive capacities[1], resulting in slower capital spending than previous years. After the April earthquake, the institutional and bureaucratic mechanism derailed for about two weeks and then it resumed with a singular focus on rescue and relief operations. This virtually stalled the capital spending related procedural approval, procurement execution, and implementation not only in the earthquake-affected areas, but throughout the country. The estimated actual capital spending was 69.9% of planned capital expenditure in FY2015, lower than the 78.4% achieved in FY2014. Meanwhile, actual recurrent spending was 84.4% of planned recurrent expenditure, marginally lower than the 85.9% in FY2014 (Figure 1). Overall expenditure grew by 13.0%, with recurrent and capital spending growth at 11.0% and 22.3%, respectively— lower than the growth rates in FY2014 (Figure 2).

Figure 1: Absorption capacity (% of planned expenditure)

Figure 2: Growth rate of total, recurrent and capital expenditures (% change)

2. Within recurrent expenditures, compensation of employees increased by 4.1%, grants to local bodies and subsidies[2] by 10.4%, use of goods and services[3] by 8.2% and social security by 48.6%. Overall, recurrent expenditures are estimated to be 15.9% of GDP, marginally higher than 15.6% of GDP in FY2014 (Figure 3).

Figure 3: Recurrent expenditures (% of GDP)

3. Capital spending continued to be sluggish, reaching just 3.8% of GDP against 5.5% of GDP planned for FY2015 (Figure 4). Apart from the slowdown caused by the earthquake in the last quarter, the time when most of the capital spending happens, of FY2015, other persistent factors impeding capital spending are: (i) lack of project readiness, in terms of timely preparatory activities such as detailed project design, land acquisition, establishment of project management offices and required personnel, and procurement plans; (ii) delays in project approval and budget release; (iii) delays in procurement related processes; and (iv) overall weak project planning and implementation capacity[4]. The damage caused by the earthquake in addition to the large investment needed to close the infrastructure deficit has meant that Nepal needs to drastically enhance its capital budget execution performance. Else, the foundations for graduation from LDC category to a developing country status by 2022[5] and the overarching goal to become a middle income country by 2030 will continue to remain weak.

Figure 4: Total, recurrent and capital expenditures (% of GDP)

4. Within capital expenditure although vehicle purchase declined by 31.8%, all other components registered robust growth. But still actual capital spending fell far short of the planned capital spending. Spending on building construction, plant and machinery, and research and consultancy grew by over 90%. Building related capital spending grew by a whopping 286.8%, which could partly be attributed to the low base effect. The expenditure for civil works increased by 113.5%, reflecting slightly better performance than previous years but still requiring further enhancement. Except for civil works— which was 2.3% of GDP, the same as in FY2012 and FY2013— none of the eight sub-categories within capital expenditures was above 1.0% of GDP (Figure 5).

Figure 5: Capital expenditures (% of GDP)

5. As in the previous years, FY2015 saw bunching of spending, especially capital spending, towards the last quarter. Almost one-fourth of actual total public expenditure was done in the last month and 43.9% in the last three months. Of the actual capital spending, 37.8% was spent in the last month and 61.2% in the last three months (Figure 6). This pattern of spending is not much different from previous years, irrespective of the timeliness of issuance of budget. It raises concerns about not only the absorptive capacity, but also the structural issues concerning budget execution.

Figure 6: Monthly spending in FY2015, NRs billion

6. The ballooning recurrent expenditure needs to be rationalized by cutting down subsidies; improving the quality of spending, including operations and maintenance of assets created; weeding out unproductive projects; and reducing the number of priority projects so that more focus is accorded to the strategically important ones. Planning, allocation, delivery, monitoring and evaluation of public sector expenditure must be efficient and productivity-oriented. The urgency also comes from the fact that tax revenue mobilization and its growth rate are marginally higher than recurrent expenditure and its growth rate. Rationalization of recurrent spending will create more fiscal space to boost allocations for capital spending, which needs to be drastically ramped up to create the physical and social infrastructure foundations to accelerate short-term growth and to sustain long-term growth, resulting in an accelerated, high and inclusive growth process.

II. Revenue Performance

7. Total revenue grew by 13.8%, much lower than 20.5% growth in FY2014, reaching NRs405.8 billion (19.1% of GDP). It is lower than the budget target of NRs422.9 billion as the slowdown in economic activities and imports following the earthquake in April hit revenue mobilization. While non-tax revenue grew by 13.0% as opposed to an increase by 20.1% in FY2015, tax revenue growth slowed down to 13.9% from 20.5% in FY2014. Tax revenue and total revenue growth rates have been continuously decreasing since FY2013. As a share of GDP, tax revenue mobilization has improved significantly, reaching 16.8% in FY2015, up from 9.8% of GDP in FY2007 (Figure 7).

Figure 7: Tax and non-tax revenue (% of GDP)

8. The continuous reforms in revenue administration, broadening of the tax base, and the higher import bill (mostly financed by remittance income) resulted in robust revenue performance over the last decade. Some of the notable reforms undertaken in recent years include: (i) information and communication technology based tax returns filing and payments systems; (ii) establishment of a data link with the Company Registrar’s Office to enhance tax compliance[6]; (iii) measures to reduce tax compliance costs; (iv) strengthening of tax monitoring and audit systems; (v) measures to widen the tax net for various tax categories; and (vi) implementation of the Any Branch Banking System (ABBS) for large tax payers.

9. Revenue mobilization from major sources decelerated in FY2015. The growth rates of value added tax (VAT), income tax, customs and excise duty were lower than in FY2015. They grew by 11.3%, 14.1%, 10.1% and 17.9%, respectively. Meanwhile, land registration fee, vehicle tax and health service tax grew by 41.3%, 26.9% and 31.7%, respectively— higher than the growth rates in the previous year (Figure 8). The deceleration in the major sources of revenue is attributed to the economic and imports slowdown following the earthquake. The acceleration in vehicle tax and land registration fee mobilization is due to the higher import of vehicles and land transactions, respectively, in the first three quarters of FY2015. The slower non-tax revenue growth is attributed to the decrease in interest and dividend paid by some public enterprises. Overall, VAT contributed the largest (27.7%) to total revenue mobilization, followed by income tax (22.0%), customs (18.4%), and excise duty (13.2%) (Figure 9). Taxes on consumption and imported goods, which are largely financed by remittance income, constitute a lion’s share of total tax revenue mobilization—around 70%. Furthermore, import-based revenues (custom duties, VAT, and excise on imports only) account for about 45% of total revenue.

Figure 8: Revenue growth (% change)

Figure 9: Composition of total revenue in FY2015

III. Fiscal Balance

10. The lower than expected revenue mobilization along with the disappointing expenditure performance resulted in a fiscal deficit[7] equivalent to about 0.2% of GDP in FY2015 (Figure 10). Though this is better than the fiscal surplus equivalent to 0.7% of GDP in FY2013 and 0.6% of GDP FY2014, it is still lower than the medium-term average fiscal deficit of about 2.2% of GDP. For a low-income country with a large financing need to bridge the infrastructure deficit, particularly in hydropower and transport, running a modest fiscal deficit without jeopardizing fiscal sustainability is desirable. Nepal faces an estimated infrastructure financing gap of between 8-12% of GDP until 2020. The damage wrought by the earthquake and subsequent aftershocks has necessitated the need to ramp up even more productivity-enhancing public spending in physical and social infrastructures.

Figure 10: Fiscal indicators (% of GDP)

11. The total net borrowing amounted to just NRs2.9 billion in FY2015 (0.1% of GDP). Net external borrowing was NRs8 billion, but net internal borrowing was a negative NRs5 billion. The amount of foreign grants is continuously declining since FY2011, when it was 3.4% of GDP against 1.8% of GDP in FY2015, indicating the slow disbursement in projects funded with foreign assistance. This is not ideal given the large investment required not only in infrastructure, education and health sectors, but also in capacity building of public institutions. Furthermore, Nepal has been running a primary surplus since FY2012, meaning that fiscal balance before interest payment on public debt is positive (Figure 11). Combined with the low and declining outstanding public debt, it indicates that the government has ample fiscal space for now to expand productivity-enhancing public capital investment without jeopardizing fiscal sustainability. Box 3 includes further analysis on fiscal sustainability.

Figure 11: Primary and fiscal balance (% of GDP)


IV. Public Debt

12. Nepal’s overall outstanding public debt (external and domestic) has been steadily declining, reaching an estimated 25.6% of GDP in FY2015 (Figure 12). Total external debt decreased to 16.1% of GDP in FY2015 from 17.9% of GDP in FY2014. Similarly, total domestic debt declined to 9.5% of GDP from 10.6% of GDP in FY2014, reflecting the lower than targeted domestic borrowing as a result of the wide gap between actual and planned expenditure. External debt service payments stands at around 8.1% of exports of goods and non-factor services. The declining stock of public debt and debt service payments generally indicate prudent fiscal and public debt management. Nepal’s external debt is mostly on concessional terms and faces low debt distress as per the latest debt sustainability analysis. Box 1 provides further insight on the composition of Nepal’s outstanding public debt.

Figure: 12: Public debt (% of GDP)

V. Public Enterprises

13. The overall performance of public enterprises (PEs) worsened in FY2014 as a result of large losses incurred by Nepal Oil Corporation (NOC) and Nepal Electricity Authority (NEA). The continued mismatch between international price of oil and domestic retail price led to the huge losses of NOC. Similarly, the mismatch between per unit production cost of electricity and per unit selling price resulted in large loss of NEA. However, in FY2015 the net profit of public enterprises is expected to increase drastically, largely due to the huge profit earned by NOC and stable profit of Nepal Telecom (Figure 13). Of the 37 PEs, 15 are expected to make losses in FY2015. As a result of the automatic price adjustment mechanism followed by NOC and continued low international oil prices, including that of LPG cooking gas, NOC is expected to post net profit of NRs18.0 billon (0.85% of GDP) after five years of continued losses. NEA’s losses are expected to increase by twofold to NRs8.5 billion (0.4% of GDP) as the wedge between production and retail price widens. [8] Nepal Telecom is expected to post a marginal increase in profit, reaching NRs11.9 billion (0.6% of GDP).

Figure 13: Net earnings of select public enterprises (% of GDP)

14.. The cumulative liabilities of PEs decreased from 2.5% of GDP in FY2013 to 1.8% of GDP in FY2014 as a result of the decline in both unfunded and contingent liabilities. The unfunded liabilities (salary, pension, social security contribution, health care, and recurrent costs, among others, that the PEs cannot finance themselves) had increased steadily from 1.0% of GDP in FY2009 to 1.6% of GDP in FY2013 and marginally declined to 1.4% of GDP in FY2014. A major contributor to the rise in unfunded liabilities is the hike in salary and allowances in the public sector. Meanwhile, contingent liabilities (state guarantees of loans, defaults of PEs, and clean-up liabilities of privatized PEs, among others) increased in FY2013 after a steady decline in the past four years, but again declined in FY2014. It declined from 0.9% of GDP in FY2013 to 0.5% of GDP in FY2014 (Figure 14).

Figure 14: Unfunded and contingent liabilities (% of GDP)

15.. Either privatization or liquidation of loss making PEs needs to be accelerated to reduce the budget drain. The weak financial position of PEs has led to large unfunded liabilities, especially for pension and other related retirement benefits, which could ultimately become the government’s liabilities. It may be noted that due to the lack of accurate and updated data, the contingent liability of PEs presented here are at best conservative estimates. It is likely that the government is exposed to much higher level of liabilities. In this regard, fiscal and macroeconomic stability could potentially be subject to significant risks. Continuing the adjustment of electricity tariffs and automatic adjustment of fuel prices to reflect the true cost of production will help to lower the losses and liabilities.

[1] Absorptive capacity generally refers to the skills mastered by bureaucracy, state of infrastructure, and quality of institutions.

[2] Subsidies include direct subsidies to non-financial public corporations and private enterprises only. Actual direct and indirect subsidies are much higher. This does not include subsidies for chemical and organic fertilizer, micro-hydropower projects, transportation subsidy for seed and fertilizer supply, and interest subsidies to farmers groups and cooperatives, among others.

[3] Use of goods and services consists of (i) rent & services; (ii) operation and maintenance of capital assets; (iii) office materials and services; (iv) consultancy and other services fee; (v) program expenses; (vi) monitoring, evaluation and travel expenses; (vii) recurrent contingencies; and (viii) miscellaneous.

[4] The Commission for Investigation of Abuse of Authority’s (CIAA) pro-active monitoring of corruption in bureaucracy has also delayed decision making, especially those related to procurement.

[5] For a detailed analysis on prospects for Nepal’s graduation to a developing country status by 2022, see: ADB. August 2013. Macroeconomic Update. Vol.1, No.2, Manila: Asian Development Bank.

[6] The cost of collection per NRs1,000 decreased from NRs16.4 in FY2007 to NRs12.7 in FY2011.

[7] Fiscal balance is computed as expenditures (including net lending) minus revenue (including grants). However, normal fiscal balance (revenue minus expenditure and net financing) was a surplus equivalent to 1.3% of GDP.

[8] The high losses of NEA are also attributed to the rising electricity import, which is sold at suppressed rates, from India, and the still large provisioning for pension and gratuity of employees. The average electricity import price is NRs8.4 per unit, but the retail price is NRs8.04 per unit. Nepal imports around 250 MW of electricity during the dry season.