Sunday, November 5, 2017

Doing Business 2018: Nepal ranked 105 and India 100

Doing Business 2018 report ranks Nepal 105 out of 190 economies in terms of ease of doing business. In South Asia, Nepal ranked third, after Bhutan (75) and India (100). Nepal’s distance to frontier, which is the relative distance between Nepal’s score and the best preforming economy in a given indicator, score (59.95) is higher than the average for South Asia (53.64).

Due to change in methodology the rankings are not comparable by year, but the distance to frontier (DTF) score can be compared. DTF ranges from 0 to 100 and a score close to 100 is better. Bhutan improved its DTF score in 2014 and has continued to maintain it at the highest level in South Asia. Similarly, the recent push to ease business regulations in India (GST and construction reforms are not reflected in DB2018) paid off as well.

In South Asia, Bhutan has the best overall environment for doing business. India got a big boost in rankings as its distance to frontier score increased from 56.05 to 60.76. All the countries’, except for Afghanistan, had an improvement of DTF score in DB2018.

The DTF score for India in starting a business is the lowest in South Asia. Starting a business requires 11.5 documents, 29.8 men days and 14.8% of income per capita. In Nepal’s case, it is 7 documents, 16.5 men days and 24.9% of income per capita.

In dealing with construction permits, India ranked 181 out of 190 economies (with a DTF score of 38.8). This indicator tracks the procedures, time and cost to build a warehouse, including obtaining necessary licenses and permits. In Nepal, to open a standardized warehouse, it requires 12 procedures, 117 days and 16.6% of warehouse value. Nepal’s DTF score is 55.74 and rank 157. In India, to open a standardized warehouse, it requires 30.1 procedures, 143.9 days and 23.2% of warehouse value.

In getting electricity, India has made a remarkable progress. This indicator measures the procedures, time and cost required to obtain a permanent electricity connection for a newly constructed warehouse. In India, it requires 5 procedures, 45.9 days and 96.7% of income per capita. Reliability of electricity supply and transparency of tariff are also considered, in which Nepal’s performance is miserable. In Nepal it requires 5 procedures, 70 days and 993.7% of income per capita to obtain an electricity connection. This places Nepal in 133 rank among 190 economies.  

To register property, an entrepreneur in Nepal is required to fulfill 4 procedures, takes 6 days and costs 4.8% of value of the property. It places Nepal 84th among 190 economies (with DTF score of 64.82). In India, it takes 8 procedures, 53 days and 8.4% of value of the property. With a DTF score of 47.08, India is ranked 154. 

In the ease of getting credit (measures the strength of credit reporting system and the effectiveness of collateral and bankruptcy laws in facilitating lending), Nepal scored a DTF score of 50 (rank 90) and India 75 with rank 29. India has improved a lot since 2014 and currently it has the most favorable conditions for getting credit.

In protecting minority investors (measures the strength of minority shareholder protections against misuse of corporate assets by directors, governance standards and corporate transparency), Npeal ranked 62nd with a DTF score of 58.33. Meanwhile, India ranked 4th with a DTF score of  80. Again, India has the best system for protecting minority investors in the region.

In South Asia, paying taxes is easiest in Bhutan. Paying taxes indicator measures taxes and mandatory contributions that a company must pay or withhold in a given year and the administrative burden complying with the regulations. In Nepal, there are 34 payments per year, takes 339 hours per year and companies pay about 29.6% of profit for tax and contributions. It places Nepal at 146th position out of 190 economies (with a DTF score of 58.01). India is ranked 119th with a DTF score of 66.06. In India there are 13 payments per year, takes 214 hours per year, and tax and contribution rate stands at 55.3% of profit. India’s rank is improving in this category as well.

In trading across borders, which records time and cost associated with the logistical process of exporting and importing goods, Nepal ranks 76th with a DTF score of 77.17. India is ranked 146th with a STF score of 58.56. In Nepal, it takes 56 hours to comply with export regulations at the border, costs $288 and takes 43 hours to comply with documentary requirements (at a cost of $110). For import, these numbers are 61, $190, and 48 ($80), respectively. In India, it takes 106.1 hours to comply with export regulations, costs $382.4 and takes 38.4 hours to comply with documentary requirements (at a cost of $91.9). For import, these numbers are 264.5, $543.2, and 61.3 ($134.8), respectively.

The other two indicators are enforcing contracts and resolving insolvency. Nepal has fairly better standing than India on these but India is catching up. 

The data for DB2018 are as of 01 June 2017. The ranking includes ten indicators: starting a business, dealing with construction permits, getting electricity, registering property, getting credit, protecting minority investors, paying taxes, trading across borders, enforcing contracts and resolving insolvency. The data also includes labor market regulations but it is not included in the ranking. 

This a transit post (waiting in Delhi airport transit after 9 hours long flight). So, please ignore the typos! :-)

Friday, November 3, 2017

Communists and fiscal imprudence in Nepal

It was published in The Kathmandu Post, 01 November 2017.



There is a danger of fiscal mismanagement by the Left alliance in case they secure a majority to form govt

The decision to forge a Left alliance for the upcoming provincial and federal elections by two major communist parties on October 3 baffled all the other political parties. The commitment to merge the Communist Party of Nepal (Unified Marxist-Leninist) (UML) and Communist Party of Nepal (Maoist Centre) immediately after the elections has rattled ‘democratic’ parties and international powers that hobnob with Nepali politicians and try to influence their decisions.

While some hailed the leftist alliance as a harbinger of political stability given the fickle coalition politics, others have raised concern over the intention of the alliance, seeing it as a means to hold on to power and tilt politics and the economy towards socialism characterised by flamboyant jingoism and redistributive experiments. Beyond these partisan arguments lies a real danger of fiscal mismanagement by the communist alliance in case they secure a majority to form a government in the upcoming elections.

Extractive politics

At the core of it, the alliance smacks of a desire to hold on to power and protect political and commercial interests—the antithesis of economic prosperity and political stability in the current political ecosystem. UML and Maoist Centre will try to reconstruct political and economic institutions such as private property, labour regulations, competitive practices, the judiciary, the bureaucracy, security of returns to investment and sound macroeconomic management to serve party interests and politicians. As seen in the past, communist governments have proactively supported unruly labour unions and strikes; debt-ridden public enterprises; cartels in sectors ranging from agriculture and construction to education, energy and healthcare; uneconomical redistributive pet programs; and land capture. These have resulted in the inefficient use of taxpayers’ money, substandard delivery of public services, and low growth potential.

For instance, UML and Maoist Centre jointly opposed licensing restrictions for new medical colleges and progressive reforms in the healthcare industry that are supported by a large section of the population and healthcare professionals. These two political parties are set against meeting any demands of Dr Govinda KC, a noted orthopaedic surgeon and philanthropic activist who just recently completed his 13th hunger strike protesting against the political parties’ attempt to pass a regressive medical education bill which prioritises politicians’ commercial interests but does little to ensure quality healthcare and access for common Nepali citizens. Similarly, bankers-cum-politicians from these parties lobbied to amend the Bank and Financial Institution Act to protect their commercial interests at the cost of sound corporate governance and banking practices.

Another example is the frequent transfer of professional staff that have been appointed for fixed terms in specialised offices. When UML came to power in the past, it did not waste time in placing yes-men in key positions. Three of these important specialised agencies are the Investment Board of Nepal, the National Reconstruction Authority and the Millennium Challenge Corporation Nepal. Appointing henchmen to key posts and awarding public contracts to quasi-political organisations faithful to these political parties have been hallmarks of their tenure in government.

These practices will not lead to political stability and economic prosperity. Instead, they will further erode effectiveness of progressive political and economic institutions. Note that this does not mean that the other political parties are clean of these malpractices. The difference is that some parties are less tainted than others.

Budgetary concerns

Leftist parties have traditionally favoured big increases to the fiscal budget, primarily due to their penchant for redistributive programs and pet projects irrespective of fiscal and macroeconomic soundness. Finance ministers from communist parties have lobbied for inconsequential hand-outs in the form of social allowance and the inclusion of multiple, small and incoherent pet projects to benefit their voter base and local contractors. Furthermore, they have discontinued or neglected previous reform initiatives, fostered moral hazards through blanket debt relief and self-employment programs, and have tried to bring in a supplementary budget despite recommendations from senior bureaucrats advising them against such a budget. Their budgets were bloated, wastefully redistributed and fiscally irresponsible. Recurrent spending growth outstripped revenue growth in five of the last 10 fiscal years—four times of which occurred when communists were leading the finance ministry.

As the then finance minister, Baburam Bhattarai increased the budget by almost 47 percent in 2008/09 and waived off farmers’ loans with a hope of lowering their debt burden and eventually encouraging more farmers to produce more goods. Instead of increasing agricultural productivity, the blanket loan waiver (a good move if well targeted and implemented efficiently) fostered a moral hazard, as these farmers are now just as indebted as before. The emphasis on cooperatives and attempts to tame the private sector also backfired. The mushrooming of cooperatives—of which over 50 percent were saving and credit cooperatives that directly competed with commercial banks in the absence of a strong cooperatives regulator—and their reckless conduct aggravated the financial sector crisis in 2011. Recently, lawmakers from these communist parties also actively lobbied to ensure that the amended cooperatives bill had less governance standards and regulatory oversight than suggested by experts.

The first fiscal budget by the Maoist government set the stage for an ever-increasing budget envelope as it was hard to discontinue populist recurrent programs in subsequent budgets. Additionally, championing unionism in public service was another detrimental policy that resulted in factionalism within the government service, encouraged frequent staff transfers, and eroded the effectiveness of public service delivery.

When UML’s Bharat Mohan Adhikari was finance minister in 2011, he tried to bring a supplementary budget barely three months before the end of fiscal year, completely ignoring the full year budget presented by former finance minister Surendra Pandey from his own party. Adhikari’s conduct was so irrational that the then finance secretary Rameshore Prasad Khanal resigned citing differences over the supplementary budget, handling of the fake value added tax bills scam, and the transfer of officials in the ministry. Furthermore, the budget for 2011/12 was leaked before Adhikari presented it to Parliament.

UML’s Bishnu Prasad Poudel introduced another fiscally irresponsible, bloated budget when he was finance minister in 2016. He increased the budget outlay by 74.5 percent by modestly increasing spending allocation for post-earthquake reconstruction and by aggressively diverting resources to multiple small pet programs and projects that had budgetary and macroeconomic consequences in the following year as well. Furthermore, during his tenure, key leadership in specialised agencies were unceremoniously replaced. 

Overall, communist governments have a history of being fiscally imprudent and protective of their political and commercial interests at the cost of sound economic and social reforms. In terms of progressive economic policies and inclusive institutions, we should not expect too much from the latest communist alliance.

Wednesday, October 25, 2017

Indian economy gets an implicit stimulus

After much criticism of the government over the deceleration of economic activities following demonetization and the rollout of GST (FY2018 Q1 growth slumped to 5.7%), the government has announced two major plans:

1. Recapitalization of state-owned banks: IRs2.11 trillion (IRs2 lakh 11 thousand crores) recapitalization package consisting of IRs1.35 trillion from sale of ‘recapitalization bonds’ and IRs76,000 crore from budgetary support and ‘market-raising’. Initially, the government had planned IRs20,000 crore bank recapitalization strategy for FY2018 and FY2019. This is a major step to ‘unfreeze’ the credit market where by banks are saddled with high non-performing assets (around IRs7.7 trillion) and major corporates high on debt already are not able to borrow with restructuring their loans. One question that looms large is that how is this not going to add to the fiscal deficit target of 3.2% of GDP for FY2018 (except for IRs18,000 already committed under Indradanush Recapitalization Scheme over the next two years)? Isn't recapitalization a form of net lending by the government (okay, you don't pay interest on it immediately after issuance but in subsequent years both interest and principal payments will need to be factored in)? CEA Arvind Subramanian says that recapitalization bonds do not impact fiscal deficit as per IMF accounting rules but will increase government liability/debt.


2. Approval of IRs6.92 trillion worth of highway projects: The plan is to construct 80,677 km of highways over the next five years. It aims to crate 14.2 crore man-days of jobs and would ensure substantial delegation of authority to enable accelerated implementation. This includes BharatMala projects (34,500 km of roads with an investment of IRs5.35 trillion) consisting of economic corridors, inter-corridor and feeder route, border roads and international connectivity, and coastal roads and port connectivity, among others.

One unanswered question is that will these implicit stimulus measures turn around the slumping economic activities, especially in FY2018? Both the reforms outlined above are medium-term measures and their effectiveness would depend on how fast and effectively they are implemented (coupled with administrative and operational reforms at PSBs and execution of capital projects).

Tuesday, October 10, 2017

Growth from above: Impact of trade disruptions was larger than impact of earthquakes

It is adapted from South Asia Economic Focus, Fall 2017. An earlier blog post on the same issue here (update figures here). 


With two major earthquakes in April and May, and a severe disruption of trade with India from August onwards, the year 2015 was no doubt Nepal’s most turbulent since the end of its armed conflict. The two earthquakes killed about 9,000 people, injured at least twice as many, and destroyed uncountable houses and buildings. Later in the year, dissatisfaction among the Madhesi minority about their representation under the new federal arrangements triggered protests that culminated in the complete shutdown of international trade with India. Official statistics put GDP growth for FY2015 (which starts in October 2014) at 1.6 percent, and for FY2016 at 0.8 percent. This represents a drop of roughly 4 percentage points relative to previous years.

Based on monthly nightlight data, the economic impact of the 2015 shocks was smaller than official statistics suggest. The earthquakes affected most severely rural areas that were characterized by low nightlight intensity even in good times. The fact that these areas were mostly in the dark suggests that even if local impacts were large in relative terms, they may not have made a major difference at the aggregate level. The impact of the trade disruption, on the other hand, was massive. Based on the elasticity approach, from June to October 2015 the GDP growth rate of Nepal declined by 4 percentage points. But economic activity bounced back strongly in November, and over the full year the GDP growth rate might have declined by less than 2 percentage points.


The shocks had a more substantial impact at the local level. This can be seen by using the spatial approach to estimate GDP by district, and then comparing the performance of districts directly affected by the shocks to that of unaffected districts. However, instead of spatially distributing the official annual GDP, the methodology is applied to the monthly GDP estimated using the elasticity approach. This way of proceeding allows to assess local economic activity on a monthly basis.

In comparing growth rates at the district level, it is important to keep in mind that the locations most affected by the earthquakes, or most affected by the trade disruptions, could be systematically different from other locations. As a result, they could grow at a different pace even in normal times. To address this possible bias, a “differences-in-differences” approach can be used.


The first difference is between the annual growth rate of local GDP in the two months following the shock and the annual growth rate in the same two months of the previous year. The two months considered are April and May in the case of the earthquakes, and September and October for the trade disruptions. Growth rates are computed relative to the same two months one year earlier. This first difference can be called a growth shock, for brevity. The second difference is between the growth shocks experienced by affected and unaffected districts. The median growth shock across districts in each group is used for the comparison.

Based on this exercise, in April and May 2015 districts affected by the earthquakes experienced a decline in their local GDP by 1.8 percentage points, while unaffected districts grew slightly faster than before. And in September and October 2015, districts in the Terai region closer to India contracted by 9.0 percentage points, whereas the rest of the country saw GDP growth decline by a more modest 1.4 percentage points. These results confirm, once again, that the impact of the trade disruption was much more severe than that of the earthquakes.

Wednesday, October 4, 2017

Communist alliance in Nepal; RBI lowers growth forecast in India

Communist parties form alliance for upcoming polls


Two major leftist forces-CPN-UML and CPN (Maoist Centre), along with the Babu Ram Bhattarai-led Naya Shakti Party-Nepalformed a broad electoral alliance ahead of the upcoming provincial and federal elections. They also agreed to form an eight-member panel that would work for a formal merger of the three parties at the earliest.

Meanwhile, Nepali Congress, which was taken by surprise by the latest political development, is considering a democratic alliance including Terai-based parties.


RBI keeps policy rate unchanged but lowers growth forecast


Anticipating upside risks to retail inflation, Reserve Bank of India (RBI)  kept interest rates unchanged at 6% on October 4. It sees upside risks to inflation coming from farm loan waivers, tates’ implementation of pay commission allowances, and price revisions following GST and rising international crude prices. The RBI expects inflation to rise from its current level and range between 4.2-4.6 per cent in the second half of FY2018 (ends March 2018). In August, the RBI slashed the repo rate by 25 basis points (bps). The central bank's medium-term target for CPI inflation is 4% (+/- 2%).

Gross value added (GVA) growth forecast is lowered to 6.7% from 7.3% owing to the adverse impact of GST implementation particularly on manufacturing activity; investment squeeze due to stressed balance sheets of banks and corporates; lower than expected kharif foodgrains output (deficient and uneven pattern of south-west monsoon);  

Wednesday, September 27, 2017

Schooling is not enough, learning is important too

Just attending school itself is not enough. Learning is equally important in primary and secondary schools to boost wages and opportunities later in life, according to World Development Report 2018. It dubs the current state of educaiton a “learning crisis”.
Examples:
  • In rural India, nearly three-quarters of students in grade 3 could not solve a two-digit subtraction such as 46–17, and by grade 5 half could still not do it. 
  • In urban Pakistan in 2015, only three-fifths of grade 3 students could correctly perform a subtraction such as 54–25, and in rural areas only just over two-fifths could.
  • In Kenya, Tanzania, and Uganda, when grade 3 students were asked to read a simple sentence like “The name of the dog is Puppy,” three-quarters did not understand what it said.
  • In Uruguay, poor children in grade 6 are assessed as “not competent” in math at five times the rate of wealthy children.
  • By the end of primary school, only 5 percent of girls in Cameroon from the poorest quintile of households have learned enough to continue school, compared with 76 percent of girls from the richest quintile.
Teaching-learning relationships breakdown due to: 

(i) Malnutrition, illness, low parental investments, and harsh environment associated with poverty would mean that children come to school unprepared to learn

(ii) Teachers lacking the skills or motivation to teach effectively 

  • Across 14 Sub-Saharan countries, the average grade 6 teacher performs no better on reading tests than the highest-performing grade 6 students;  
  • In seven Sub-Saharan countries, one in five teachers was absent from school during recent unannounced visits by survey teams, with another fifth of teachers at school but absent from the classroom
(iii) Educational inputs fail to reach classrooms or to affect learning (textbooks don’t reach schools or even when they reach the students don’t get it on time)

(iv) Poor management and governance undermine schooling quality (ineffective school leadership; no set goals that prioritize learning; lack of autonomy for schools; ineffective community engagement)

It recommends countries to:
  • Design student assessments to gauge their learning
  • Create conducive environment for learning, including addressing stunting and promoting brain development through early nutrition and stimulation, using technologies, strengthening school management
  • Increase accountability by mobilizing all stakeholders and create political will for education reform

Thursday, September 21, 2017

Nepal's medium-term macroeconomic challenges

It was published in Nefport#30 (pp.58-62), Nepal Economic Forum 

Except for a few episodes of growth spurts, economic growth has largely been low yet volatile in Nepal, mostly stagnating below 5 percent. Similarly, inflation has been stubbornly high, mostly settling in between 6 percent and 12 percent. Public expenditure absorption capacity is receding but revenue mobilization is robust on the back of taxes on remittance-financed imports and domestic consumption. Outstanding public debt is only about a quarter of gross domestic product (GDP). External sector is largely stable, but is vulnerable to fluctuation of remittance inflows. Financial sector is relatively stable, but remains exposed to asset-liability mismatches arising from recurring sources, including reckless lending growth amid slowdown in deposit growth, ever-greening of troubled assets and mismanagement. Meanwhile, unemployment remains high. 

This scenario does not portray an economy that is macroeconomically sound with robust fundamentals to support high and sustainable inclusive economic growth. Instead, it resembles an economy that is susceptible to macroeconomic imbalance triggered by a few exogenous factors, including fluctuation of remittance income, monsoon rains, trade and supplies disruptions, and political instability. These challenges need to be properly diagnosed and addressed (to exploit low hanging fruits) as the country marches towards its overarching goal to become a middle-income country by 2030. Specifically, medium-term macroeconomic challenges emerge from low capital formation, fiscal mismanagement, stubbornly high inflation, and financial and external sectors vulnerabilities.

Base effect blessing

Some analysts quickly point to the impressive growth and inflation numbers in FY2017 and argue that the economy may have reached an inflection point from where the trajectory will be upward and stable. GDP growth (at basic prices) increased to an estimated 6.9 percent and inflation moderated to 4.5 percent in FY2017. These largely reflect a ‘base effect’ blessing and to some extent the government’s efforts to improve electricity supply and accelerate reconstruction works. In FY2018, the base effect will quickly dissipate. Hence, it will be difficult to attain FY2018 growth and inflation targets of 7.2 percent and 7.5 percent, respectively, unless the factors supporting growth and inflation are much stronger than in FY2017. This is unlikely to be the case.

Figure 1: Contributions to GDP growth (percentage points)
Source: Central Bureau of Statistics

Overall, the economy has not reached an inflection point and the performance of key macroeconomic variables will continue to be underpinned by the same exogenous factors such as monsoon and remittances. The gradual deindustrialization beginning FY1997 (i.e., coinciding with the Maoist insurgency) hasn’t stopped as this sector barely constitutes 14 percent of GDP now, down from a high of 22.3 percent of GDP in FY1996 (the outcome of liberalization and structural reforms initiated in the early 1990s). 

Macroeconomic challenges

The current state of macroeconomics will not support a rapid structural transformation, whereby the pace and pattern of economic growth and development are supported by a vibrant industrial sector, higher absorption of unemployed workforce in productive sectors, and production of high-valued, high-productivity goods and services across all sectors. Five key macroeconomic challenges will dictate the nature of structural transformation Nepalese economy will be undergoing during the medium term. 

First, sources of growth have to be reliable, i.e. less reliance on monsoon rains for agricultural output growth and on remittances-backed demand for services output growth. A substantial proportion of the variability of GDP growth is caused by volatility of agricultural output growth, which is dictated largely by monsoon rains as irrigation network is too limited to substitute for water shortfall during weak monsoon. For a more dependable source of growth, capital formation must increase so that the most binding constraint to economic growth— inadequate supply of infrastructure, mainly energy, transport, and irrigation— is addressed head-on. Hence, a major macroeconomic challenge in the medium-term would be to enhance quantity as well as quality of public and private investment. 

Public gross fixed capital formation averaged just 5.8 percent of GDP in the last five years. This needs to increase to about 8-12 percent of GDP annually. The public sector has to lead the way by accelerating capital spending, which has been affected by structural weaknesses in project preparation and implementation; low project readiness; bureaucratic hassle in project approval and sanctioning of spending authority; weak project and contract management; and political interference at planning, management and operational stages. Public capital spending averaged just 4.8 percent of GDP in the last five years. Furthermore, almost 60 percent of the actual capital spending happened in the last quarter and 41.2 percent in the last month, raising doubts over the quality of spending. Low quality of capital investment tends to increase operation and maintenance budget, which is a part of recurrent spending, for the next few years. 

Figure 2: Monthly share of actual annual spending (percent)
Source: Financial Comptroller General Office (FCGO)

Furthermore, private gross fixed investment, which averaged 21.6 percent of GDP in the last five years, also needs to increase so that total gross fixed investment is at least above 30 percent of GDP. Currently, total gross fixed investment is below the average for low-income countries. In addition to enhancing capital spending absorption capacity, private sector investment needs to be facilitated by implementing laws, policies and regulations that are already in place and by amending those that are deemed deficient. The current state of policy implementation paralysis is deterring both domestic as well as foreign investment. Net FDI inflows are barely one percent of GDP.

Second, while there a need to enhance quality and quantity of capital spending, there is also a need to contain growth of recurrent spending, which is almost equivalent to tax revenue. This calls for a bit of fiscal discipline although public debt is only a quarter of GDP. Just because there is ample fiscal space does not mean that recurrent spending can be indefinitely increased to satisfy politician’s voter base and supporters (including local contractors) by doling out incoherent pet projects and cash handouts. Better fiscal management is especially important in the federal setup. Additionally, revenue leakages (through under-invoicing of imported goods and tax waivers) need to be plugged in and tax sources diversified in order to mobilize enough revenue to cover rising recurrent spending and to maintain sound fiscal balance.

Figure 3: Expenditure and revenue overview (share of GDP)
Source: Budget speech, Ministry of Finance

Third, stubbornly high inflation has to be lowered by primarily addressing supply-side constraints as monetary policy does not have much traction to contain it due to pegged exchange rate between Nepalese and Indian currency and the fact that almost 60 percent of imports, including fuel and cooking gas, are sourced from India. Average annual inflation of around 8.7 percent in the last ten years is too high, and discourages investment and saving. Supply-side issues such as shortage of electricity and fuel, high transport and wage costs, low productivity, and excessive labor unionizing for political reasons are threats to lowering inflation and accelerating industrialization. Ideally, inflation in Nepal should not deviate much from that prevalent in India. The central bank and the government need to pay special attention to transitory and structural factors driving inflation.

Figure 4: Contributions to inflation (percentage points)
Note: For Nepal, FY2015 (mid-July to mid-July) = 100; for India, FY2012=100 (April-March) 
Source: Nepal Rastra Bank; Reserve Bank of India

Fourth, financial sector stability is another macroeconomic challenge over the medium-term. Financial sector troubles are recurring, typically caused by accumulation of unbalanced portfolio, lax monitoring and supervision, and asset-liability mismatch. As experienced in the past, a sudden credit squeeze arising from such factors leads to erosion of confidence on and efficacy of the regulator. The central bank needs to enhance its capacity to enforce monetary rules and regulations, and intensify monitoring and evaluation of banks and financial institutions. Consolidation of financial sector; better quality and diversification of portfolio; and expansion of traditional as well as new financial services throughout the country are some of the unfinished tasks for the central bank. Furthermore, the central bank needs to think beyond buying and selling of government bills and bonds as a core monetary policy instrument. As such, back-loading of budgetary spending in the last month of fiscal year drastically increases liquidity in the first quarter of next fiscal year and then it begins to get tighter in the next two quarters, heightening interest rate volatility. 

Fifth, the gap between demand for and supply of materials needed for post-earthquake reconstruction and the inelastic nature of import demand would mean that import growth will likely remain high in the next few years. Meanwhile, without much improvement in supply-side constraints and implementation of investment-friendly laws and policies, export growth may be at most moderate. Given forecast of low fuel prices globally due to supplies glut as well as subdued demand, investment will likely continue to slowdown in the major fuel and commodity exporting countries, some of which employ a large number of Nepalese migrant workers. This would mean either continued deceleration or tepid growth of remittance inflows, potentially resulting in current account deficit. The widening trade deficit coupled with decelerating remittances resulted in a current account deficit of 0.4 percent of GDP in FY2017, the first deficit since FY2011. Note that Nepal’s low per capita income, limited production base, and the need to import materials for reconstruction necessitate tolerance to moderate level of current account deficit in the medium term. However, the government and the central bank need to keep an eye on the level of balance of payments and foreign exchange reserves so that it is enough to sustain at least 7 months of import of goods and services. 

Figure 5: External sector (share of GDP)
Source: Nepal Rastra Bank

Tuesday, September 19, 2017

MCC grant to Nepal: Can it be completed without time and cost overruns?

It was published in The Kathmandu Post, 18 September 2017.

A matter of time

Government transitions and failure to maintain consistent policies over time may hamper investment grant pledges

On September 14, Finance Minister Gyanendra Bahadur Karki and Millennium Challenge Corporation (MCC) acting CEO Jonathan Nash signed a $500 million grant agreement for investment in the energy and transportation sectors. This assistance is especially significant for two reasons: it is the single largest one-time grant assistance by a development partner, and no cost and time overruns are entertained once the grant becomes effective.

A large one-time grant amount equivalent to about two percent of Nepal’s gross domestic product by a specialised foreign aid agency, which uses a fairly transparent yet rigorous selection methodology to assess eligible countries, is in itself a significant positive development for Nepal. However, the challenge would be to complete the projects considered under the assistance without cost and time overruns, which unfortunately are also the two most common yet unresolved issues concerning public capital spending in Nepal.

Binding constraints

The MCC selected Nepal to develop a five-year compact program in December 2014 after Nepal met the eligibility requirement, which includes sound performance in about one and a half dozen independent policy indicators related to democratic governance, economic freedom and investment in citizens. Earlier, a threshold program, which has a smaller grant assistance than the compact program, in December 2011 led to a rigorous analysis of Nepal’s growth constraints and identification of potential areas for policy improvement. The diagnostics study—an update of a 2009 study led by Asian Development Bank—identified four key constraints to growth: policy implementation uncertainty, inadequate supply of electricity, high cost of transport and challenging labour relations.

This diagnostic study formed the basis for selection of energy and transport sectors for investment, and sectorial reforms under the compact program. A series of stakeholder consultations—including public and private sectors and donors—were held to identify fairly large investment projects that could be completed within five years and that have the potential to yield substantive outcomes by tackling some of the most binding constraints to economic growth.

Out of $630 million (including $130 million as counterpart investment by the government), about $520 million is planned for the electricity transmission project, under which 300 kilometres of high voltage electricity transmission network will be built and capacity of the country’s energy regulator enhanced. This kind of infrastructure is crucial for supporting transmission of power generated by various hydroelectricity projects across the country and for greater electricity trade between Nepal and India. Around $55 million is earmarked for road maintenance, under which 305 kilometres of road will be built and rehabilitated. The remaining amount is allocated to cover project administration costs, including procurement and monitoring and evaluation expenses.

No overruns

The actual implementation of projects will probably start towards the end of 2018 after they are investment-ready, i.e. procurement packages are finalised, significant proportion of land is acquired, detailed implementation plan is outlined and implementation offices are established. Once implementation starts they have to be completed within five years and without any cost overruns. Else, the unspent grant amount will be returned to the MCC. Against this backdrop, if the same structure of project implementation including staff deputation, policies and laws are going to govern the MCC’s investment projects, then there is little room to be optimistic that it will be completed within five years.

Execution of capital budget is hamstrung by a maze of bureaucratic and structural factors, leading to under spending as well as heavy bunching of spending in the last quarter of every fiscal year. For instance, in 2016/17, the budget was approved one and a half months prior to the start of fiscal year, which in principle gave the ministries time cushion to get approval for spending and initiate preparatory project planning (especially procurement documents). Still, 60 percent of actual spending happened in the last quarter, and 41.2 percent in the last month itself, raising doubts over the quality of spending. Worse, just 65.5 percent of planned capital budget was spent. This pattern of spending, and deficient expenditure absorption capacity, has been persistent irrespective of which political party leads the government.

Capital budget execution is affected by structural weaknesses in project preparation and implementation; low project readiness; bureaucratic hassles in project approvals and sanctioning of spending authority; weak project and contract management; and political interference at planning, management and operation stages. These issues are common across all projects irrespective of investment amount and duration.

Political interference

The exact details about the implementation modality of MCC’s projects in Nepal are not known yet. The MCC usually establishes its own local office to manage and oversee project implementation, which is fairly independent, rigorous and transparent. Meanwhile, the government procures land and secures environment clearances along with preparation of procurement documents before implementation starts. Unfortunately, the government does not have a good track record of completing these preparatory works on time.

Two specific issues are of particular concern regarding implementation. First, the upcoming provincial and federal elections will result in a new political structure along with changes in government leadership, as a coalition government would be a defining feature because no party is likely to secure the necessary majority in Parliament. This in turn would entail transfer of government staff loyal to ruling parties to large project management or implementation offices, leading to snags in implementation and opening up of avenues for funds misappropriation.

For instance, the Communist Party of Nepal-Unified Marxist Leninist (CPN-UML) led coalition government in 2016 abruptly decided to not renew the contract of former secretary Krishna Gyawali, who was serving as a national coordinator of MCC Nepal upon appointment by the previous Nepali Congress (NC) led coalition government. Similarly, the same government terminated the contract of Radhesh Pant, former CEO of Investment Board Nepal, in 2016, even though Pant’s contract was renewed for an additional term by the NC-led coalition government. The case with the CEO of National Reconstruction Authority is also similar. These kinds of unceremonious contract terminations and transfers to put party loyalists in key positions affect project implementation timelines and escalate costs. The MCC’s projects need to be insulated from this kind of party-based selfish political incursion.

Second, Nepal needs to retain its score above median (threshold score) each year for a majority of policy indicators. For instance, worsening of governance may pull down the country score below the yearly median. Failure to have a satisfactory score in a majority of the policy indicators would also lead to either suspension or termination of grant assistance.

Thursday, August 31, 2017

Is Modi’s magic fading (economically)?

The MOSPI released preliminary estimates of growth for Q1 (April-June) 2017/18 (FY2018) today and looks like demonetization effects have not faded away. The gross value added (at basic prices) grew at 5.6% year-on-year in Q1 FY2018, down from 7.6% in Q1 FY2017. In fact, agricultural, industrial and services output growth were lower in Q1 FY2018 than in Q1 FY2017. GDP at basic prices (GVA plus net taxes) grew by 5.7%, down from 7.9% in Q1 FY2017.

The effects of demonetization have not tapered off completely as second round effect are still persistent (dent in economic activities in informal sector where cash transaction is more prevalent is finally showing up in formal sector activities, which is picked up by official statistics). Additionally, the expected rollout of GST might have affected small and medium scale economic activities (remember that most of the economic activities in India happen at SME level). GST is seen as a burden for SMEs in the short-term as it increases accounting and transactional costs. They may have destocked their inventories and slowed down orders.

Specifically, agricultural output grew by 2.3% compared to 2.5% in Q1 FY2017. Rabi season output (agricultural crops such as rice, wheat, coarse cereals, pulses and oil seeds sown in winter but harvested in the spring) growth mostly likely was not as robust as in Q1 FY2017. Similarly, livestock products, forestry and fisheries (which account for about 43.1% of GVA of agricultural sector) grew at just 3.4% in Q1 FY2018.

Industrial sector is the one whose output decelerated the most, growing at just 1.6% in Q1 FY2018 compared to 7.4% in Q1 FY2017, probably because effects of demonetization haven’t fully tapered off and concerns over implementation of GST dented economic activities of SMEs. Mining and quarrying activities continued to grow at a negative rate; manufacturing output grew at a mere 1.2% compared to 10.7% in the corresponding period last year; and electricity, gas, water supply and other utility services too grew at a slower pace (7% vs 10.3% in Q1 FY2017). Specifically, production of coal grew at a negative rate (probably signaling lower power demand and excess inventory) and mining activities grew at 1.2% (much lower than 7.5% in Q1 FY2017). Private sector manufacturing activities slumped drastically (had a negative growth), and quasi-corporate and unorganized segment’s activities too slowed down. Furthermore, construction activities such as production of cement and non-metallic minerals slumped. 

Services output growth moderated a little bit to 8.7% from 9.0% in Q1 FY2017. Activities in retail & wholesale trade, hotels & restaurants, and transport & communication activities grew at a robust 11.1%, up from 8.9% in Q1 FY2017. Similarly, public administration, defense & other services grew at 9.5% (up from 8.6% in Q1 FY2017). However, financial intermediation, and real estate & business activities slowed down to 6.4% from 9.4% in Q1 FY2017. Trading activities are recovering after the demand denting demonetization (but industrial production is still clouded by this as well as GST’s effect on SMEs) and railways and aviation traffic is growing modestly. Meanwhile, real estate and business activities have slowed down for the same reasons mentioned above. The central government’s increase in revenue expenditure (i.e., recurrent spending) has boosted growth of public administration and allied activities.  

Overall, it’s the slump in industrial sector output that has pulled down overall GVA growth. In fact, while agricultural and services sector contributed 0.3 and 4.9 percentage points to overall GVA growth in the first quarter of FY2017 and FY2018, industrial sector’s contribution dropped sharply to 0.5 percentage points from 2.4 percentage points in Q1 FY2017. Hence, GVA output growth was just 5.6% in Q1 FY2018.

Now, if you look at the QGDP figures from expenditure side, then you will see a continuing slump in fixed capital formation. Gross fixed capital formation growth was just 1.6%, down from 7.4% in Q1 FY2017. Similarly, inventories are not being cleared and restocked as fast as one would like the economy to do it (here is where the uncertainty over GST's effect is affecting SMEs). Change in stock grew at 1.2% compared to 8.9% in Q1 FY2017. Exports growth slowed down but imports growth grew at a robust rate, resulting in a negative net exports growth. A substantial increase in private consumption growth was insufficient to make up for the slowdown in other sectors, resulting in GDP growth (at basic prices) of 5.7%, down from 7.9% in Q1 FY2017.

The government’s GVA growth target for FY2018 is 7.3%. Economic activities are usually robust in the first two quarters as the government tends to front-load spending and households tend to purchase goods ahead of the festival season in the third quarter. However, in FY2017, economic activities, especially industrial and services, slowed down in all the four quarters. This trend is continuing in FY2018 as well, signaling a cooling off trend further accelerated by first by demonetization and then by concerns over the implementation of GST and its impact on SMEs. 

Five quarters of consecutive GVA deceleration is not consistent with the promise of a rising and shining Indian economy under the present leadership (even though it has undertaken landmark reforms such as demonetization, GST, easing of doing business, etc). May be there aren’t low hanging fruits! Favorable monsoon will boost agricultural output and gradual recovery of services activities will continue as demonetization fades away fully. But, the real concern here is acceleration both public and private capital formation. Private sector investment is still slowing down as stressed corporates are not able to expand business by borrowing more. Non-stressed corporates (usually SMEs) are concerned by the exact impact of the implementation of GST on their businesses, particularly administrative and transaction costs. Increasing private sector investment is tricky in India and would require drastic measures on both fiscal and monetary policy fronts. Meanwhile, public capital spending needs to be accelerated by effectively tackling a myriad of bureaucratic as well as legislative factors— land, environment, tax incentives clearance, etc.

Links of interest (2017-08-31) : Effectiveness of demonetization in India; Electoral constituencies in Nepal

How effective was demonetization in India?


The main objectives of the demonetization shock on 8 November 2016 were: “(i) flushing out black money, (ii) eliminate Fake Indian Currency Notes (FICN), (iii) to strike at the root of financing of terrorism and left wing extremism, (iv) to convert non-formal economy into a formal economy to expand tax base and employment and (v) to give a big boost to digitalization of payments to make India a less cash economy”

The latest RBI annual report 2017 says that the value of IRs500 and IRs1000 notes that were returned was IRs15.3 trillion versus IRS15.4 trillion in circulation before demonetization. This means almost 98.9% of the invalidated notes were returned back to the RBI by 30 June 2017. So, if pretty much all of the invalidated notes were returned back, then does this mean ‘black money’ was not flushed out as touted? In a way, yes! However, the government is also investigating IRs1.75 trillion deposited in banks after demonetization. The hefty penalty, if sources are not substantiated, would mean higher one-off revenue for the government later on. Digitization and formalization of the economy got a boost. RBI detected 762,072 fake notes (valued at IRs430 million) in 2016/17 compared to 632,926 fake notes in 2015/16.  

The RBI sees rosy prospects for FY2018, thanks to favorable monsoon (boosts rural demand and lowers food inflation); strong urban demand coming from income boost due to upward revision in house rent allowance to central government employees and the possibility of implementation of wage revisions at state level; reforms to lower the cost of doing business that will increase investment; faster project implementation; higher credit demand following low interest rates post-demonetization in the case of stress-free corporates; etc. It points to slow industrial output growth and low fixed capital formation as concerns for the economy along with challenges to resolving highly indebted corporates and public sector banks. 

It expects GVA growth of 7.3% in 2017/18. Headline inflation is expected to be between 2.0% and 3.5% in H1FY2018, and 3.5% and 4.5% in H2FY2018 (prospect of wages and compensation increase, and farm loan waivers driving some part of the upward trend). Here is a good review of the economy in FY2017 (an earlier related blog here).



Constituency Delimitation Commission (CDC) finalizes 165 electoral constituencies


CDC in Nepal carved out 165 first-past-the-post electoral constituencies for House of Representatives and 330 constituencies for provincial assembly. Of the total 165 electoral constituencies, 78 are in 20 Tarai districts which make up 47.27 percent of the country’s total geography. CDC gave 90% weight to population and 10% to geography (after ensuring that each district has at least one constituency). Province 3 will have the highest number of constituencies with 33, followed by Province 2 (32 constituencies), Province 1 (28) constituencies), Province 5 (26 constituencies), Province 4 (18 constituencies), Province 7 (16 constituencies) and Province 6 (12 constituencies).

The CDC was formed on July 20 to complete its task within 21 days. Its term was extended by 15 days on August 16. The new constituencies carved out by the CDC cannot be altered for another 20 years and the CDC recommendations cannot be challenged in any court of law, as per the constitution.

Meanwhile, federal and provincial polls will be held simultaneously in two phases in November 26 and December 7. 


Rasuwagadhi-Kerung becomes int’l crossing point


The Rasuwagadi-Kerung border point, the only trade route currently in operation between Nepal and China, has been upgraded to an international crossing point. Citizens from other countries besides Nepalese and Chinese can travel across the border.

Tuesday, August 29, 2017

NEPAL: Macroeconomic outlook for FY2018

The previous blog post covered the major macroeconomic highlights in FY2017. This blog post will provide an outlook for FY2018 (mid-July 2017 to mid-July 2018). 

GDP growth

The government’s GDP growth target is 7.2%, up from a 6.9% growth (at market prices) in FY2017 thanks to a favorable base effect, good monsoon, improved energy supply, reconstruction activities and normalization of supplies after two years of disruption (earthquakes in FY2015 and trade blockade in FY2016). Achieving a higher growth rate in FY2018 would require stronger factors than in FY2017. However, this is an unlikely scenario. 

First, the base effect will dissipate fast and there won’t be any fluke in FY2018 (at least as of now). Second, the usual factors that underpin robust economic activities are not as strong as in FY2017. 

Monsoon arrived not only late, but there was also uneven rainfall across the country. There was at least a week of dry spell during the peak paddy planting time. Then incessant rain, caused by a cloud burst, in the second and third weeks of August led to widespread flooding and landslides, wreaking havoc in the Terai plains (which is also considered a breadbasket of the country). In fact, according to Ministry of Agricultural Development, paddy plantation rate was 92.8% (1.4 million hectares out of 1.6 million hectares of cultivable land) in FY2018 (as of August 2017). In FY2017, it was 97% and paddy production was a record 5.23 million tons. Therefore, agricultural output growth will most likely be lower than in FY2017. Additionally, flooding has affected livestock and fishery. 

Although reconstruction activities are expected to accelerate (distribution of second and third tranche of housing grants), stimulating construction and mining and quarrying activities, manufacturing output may still be affected by the uncertainty over uninterrupted energy supply and the damage caused by flooding and landslides. The prospect of load-shedding is high in FY2018 as there has been setback to temporary plans to plug energy demand and supply gap. Higher energy import from India is likely as additional electricity generated by new small and medium scale hydroelectricity projects won’t be sufficient. Furthermore, floods have damaged and disrupted manufacturing activities in the main industrial belt. Against this backdrop, even industrial output growth will likely be lower than in FY2017. Accelerated reconstruction work and completion of large infrastructure projects, if realized within FY2018, might help to keep industrial output growth high.

The deceleration of remittances and temporary supplies disruption due to flooding and landslides will dent services activities. Tourism activities are beginning to pick up (tourist arrivals are up and bed occupancy is high ahead of the tourism season), but its momentum is slowed by the flooding in Terai (affected overland tourist arrival to hotspots in Terai such as Lumbini and Chitwan). Similarly, transportation activities are occasionally being disrupted along the main trading route due to landslides and weak management. Real estate and business activities may not pick up given the tight credit situation and regulatory squeeze. Wholesale and retail trading may not be as robust as in FY2017 as base effect related to supplies normalization fade away quickly and deceleration of remittance income weakens consumer demand (although post-earthquake housing grants, post-flooding reconstruction efforts, and elections related expenses may provide some backup). 

Against this backdrop, GDP growth (at basic prices) may hover around 5.2% (kind of optimistic one as of August 2017). Of this, contributions of agricultural, industrial and services sectors come to be around 1.2, 1.1 and 2.9 percentage points, respectively. However, given the uncertainty over the direction of some of the key factors (industrial activities and extent of damage caused by flooding) it is appropriate to consider a range for GDP growth forecast, which I think could be between 4.5% and 5.5%.

Inflation

CPI inflation (FY2015=100) in FY2017 was 4.5%, sharply down from 9.9% in FY2016, thanks to bumper agricultural harvest, low fuel prices, low inflation India, improved energy supply (one of the main supply-side constraints) and normalization of supplies. However, in FY2018 inflationary pressures are likely to be high, especially coming from higher food and beverage prices. 

Food prices are expected to heat up as floods and landslides put strain on agricultural output and its distribution. Prices of cereals, vegetables and meat products will most likely grow higher than last year. Similarly, non-food inflation will also be higher than in FY2017, mostly coming from higher prices of clothing, housing and utilities, and transportation. Overall, elections (third phase of local election in province two on September 18, and provincial and federal elections in two phases on November 26 and December 7) related spending and disruptions caused by flooding in Terai will exert inflationary pressures on daily consumable and non-durable goods, and reconstruction works, if it accelerates, may increase demand for construction materials and unskilled and semi-skilled wages. Furthermore, CPI inflation in India (2012=100; fiscal year starts in April and ends in March) is also expected to be higher than in FY2017 (RBI’s target is an average 4%, but can tolerate a range of 2% to 6%). 

Accordingly, inflation may hover around 7.7% (in the neighborhood of NRB’s target of 7.5%), out of which contributions of food and non-food inflation would be 3.3 and 4.4 percentage points, respectively. As before, there remains substantial uncertainty over the intensity of the factors that drive inflation. Therefore, it is better to put up a range for inflation forecast, which I believe would be between 7.5% and 8.0%. 

External sector


A large increase in trade deficit coupled with deceleration/slow growth of workers’ remittances led to a current account deficit of about 0.4% of GDP in FY2017 (the first CAD since FY2011). In FY2018, this pattern will also probably remain the same. 

Nepal’s export is crippled by structural bottlenecks as well as supply-side constraints, and import demand of fuel and durables/construction materials is somewhat inelastic due to the wide gap between production and demand in the economy. Hence, trade deficit will further widen. Meanwhile, remittance inflows will decelerate or remain low as there has been a notable decline in the number of overseas migrant workers. Consequently, current account will likely remain in negative territory (around 2.2% of GDP or even higher).