Wednesday, June 7, 2017

Bloated budget, challenging implementation

It was published in The Kathmandu Post, 5 June 2017. Here is an earlier blog post on FY2018 budget (same in NEF blog). The latest issue of Himal magazine includes an analysis on the same in Nepali language. 

Bloated budget

Fiscal transfer to local bodies warranted a bigger budget, but its implementation will be challenging

On May 29, Finance Minister Krishna Bahadur Mahara presented the budget for fiscal year (FY) 2017-18 to Parliament. The projects and programmes are pretty much a continuation of last year’s budget, since the election code of conduct barred the government from rolling out new initiatives that could influence the outcome of the second phase of the local elections.

Some of the notable features of the budget are its focus on the devolution of spending authority to local bodies, the progress of, and adequate funds for, large-scale infrastructure projects, and post-earthquake reconstruction.

Macro overview

The total expenditure outlay is capped at Rs1.3 trillion, which is equivalent to an estimated 45.5 percent of gross national product (GDP) in FY2018. This is an increase of 36.7 percent over the revised expenditure estimate for FY2017. The government argued that the increase in the size of the budget is justified owing to the fiscal transfers to local bodies in the federal setup. These transfers are clubbed under recurrent spending, which constitutes 62.8 percent of the total budget.

Meanwhile, 26.2 percent of the budget is earmarked for capital spending, which includes public expenditure on new buildings, bridges, roads and civil works, among others. The government is planning to meet 64 percent of expenditure from tax and non-tax revenue, foreign grants and principal repayment.

This leaves a budget deficit of NRs461.3 billion, which the government expects to cover by a combination of foreign loans, domestic borrowing and cash balance from FY2017.

Unrealistic targets

At the aggregate level, three important issues in the budget require scrutiny. First, GDP and revenue targets of 7.2 percent and 25.7 percent respectively are ambitious. The economy grew by an estimated 6.9 percent in FY2017 due to a low base effect, favourable monsoon, improved power supply and normalisation of supplies after two years of disruption. Achieving 7.2 percent growth from such a high base would be challenging, because the usual drivers of growth have to be much stronger than last year. 

Even with good monsoon rains, continued improvement in power supply, acceleration of reconstruction works and capital spending and election-related expenses, GDP growth may be restricted between 5 and 6 percent. Furthermore, expecting revenue growth higher than in FY2017 with pretty much the same revenue policy is a bit of a stretch. FY2017 revenue was higher because of the normalisation of imports, which faced an unexpected dip following the trade embargo in FY2016. The expectation that tax revenue from trade will be the same as in FY2017 (47.5 percent of total tax revenue) is a bit misplaced. 

Second, since the likelihood of meeting revenue growth is pretty slim, the government will aggressively engage in domestic borrowing, which is expected to be about 4.3 percent of GDP. This will undoubtedly put upward pressure on retail interest rates, which will increase the borrowing cost of households and businesses, as deposit growth is still sluggish (amidst higher credit growth) due to the deceleration of remittance inflows and the government’s inability to spend the mobilised revenue on time. A large deficit financing also tends to exert inflationary pressures.

Third, recurrent expenditure is ballooning too fast and needs to be contained. It is expected to be a whopping 110 percent of revenue in FY2018. The previous government sharply increased recurrent budget by inserting all sorts of pet projects and distributive programmes in the ‘red book’, which is a catalogue of all approved projects and programmes. It would be difficult to discontinue such projects once they make their way into the red book and hence this government had no option to exclude them. This, combined with the need for large unconditional fiscal transfer to local bodies, led to an almost 43 percent increase in recurrent spending. It is now time to curb recurrent spending in real terms and cull unproductive, repetitive and “zombie” projects to maintain fiscal prudence.

Execution challenges

In the absence of a Natural Resource and Fiscal Commission to oversee fiscal transfer to local bodies, this budget allocated transfers based on a number of factors such as population, development status and cost of operation. Fiscal transfer and conditional grants to local bodies now constitute about 50 percent of total recurrent spending. This is unprecedented in the sense that the transfers will now be directly credited to the bank accounts of local bodies—bypassing the maze of bureaucratic approvals needed at Singh Durbar—and the local bodies will have the authority to prioritise, design and implement their own projects. These include programmes and projects on agriculture, livestock, irrigation, roads, drinking water and sanitation, schools (including payment for teachers), tourism and sports, among others. 

Despite such large transfers and early spending authority to line ministries, execution of the budget will be challenging. The budget mandates project offices to award contract by mid-October to accelerate capital spending, which averaged 75 percent of planned budget in the last five years. This particular reform addresses expenditure delays attributable to lengthy and repetitive approvals needed at various layers of ministries and the National Planning Commission.

However, other issues contributing to chronically low spending pattern such as lack of project readiness, high staff turnover and poor contract management will need to be addressed swiftly to accelerate capital spending. Furthermore, most of the local bodies do not have the capacity to design, assess, appraise and execute projects at the local level. Hence, an unconditional fiscal transfer to local bodies could be an asset or a liability. If spent in the right way and with proper accountability, it could be an asset and a significant contributor to economic development.

However, with weak oversight, lack of capacity to plan and execute projects and misappropriation of funds, it could become a liability and eventually contribute to fiscal stress. The centre needs to be careful in providing handholding support to local bodies to address execution issues, but it should not try to micromanage projects as in the past.

Overall, the budget gives a mixed picture: bloated in size justified by the compulsion to continue previous projects and direct fiscal transfer to local bodies; ambitious GDP and revenue growth targets; large deficit financing, which would potentially increase interest rates; faster spending authorisation by cutting down lengthy and repetitive approvals; and unsustainable pattern as well as size of recurrent budget. The nature of this budget would also mean that there is no room and justification for a supplementary budget after the local elections.

Thursday, June 1, 2017

Quick thoughts on Nepal’s FY2018 budget

Here are my quick thoughts on the FY2018 budget.

Deputy Prime Minister and Minister of Finance Krishna Bahadur Mahara presented FY2018 budget (mid-July 2017 to mid-July 2018) to the parliament on 29 May. The budget focuses on implementation of federalism (particularly at this stage, providing initial financing to local bodies), post-earthquake reconstruction, continuation of previous programs and policies (because the government cannot roll out distributive programs and pet projects during the election time), and ensuring adequate funds for large infrastructure projects.

The budget is unique in three ways: 
  • First, it tries to bypass the usual Singha Durbar related procedural hassles by directly transferring funds to local bodies so that they can initiate institutional setup and some local level projects. Local bodies are supposed to get NRs225.1 billion and provinces are supposed to get NRs7.1 billion. On top of this, there is the usual transfer to local bodies (as grants under recurrent expenditure), which is about NRs174.7 billion.  
  • Second, the budget is pretty much a continuation of the FY2017 programs and policies as the ongoing local election bars the government from introducing new projects that are of distributive nature or that can influence the outcome of elections.
  • Third, the expenditure level is growing very fast and needs to be stabilized until the ministries figure out what is working and what is not (zombie and unnecessary/duplicate projects need to be culled line by line). Time has come now to seriously rationalize recurrent spending. The FY2017 budget was prepared in an irresponsible way by substantially jacking up expenditure. It will be hard to remove such expenditures from the 'Red Book' once included. The FY2018 budget has become a victim of that fiscally irresponsible/populist move. Recurrent expenditure in FY2016 was 16.5% of GDP, which was jacked up to 23.7% of GDP in FY2017 (revised estimate) and in FY2018 budget it is around 27.4% of GDP (see the figure below). 
FY2018 budget overview
GDP growth target (%)

Inflation target (%)

Budget allocation 

Rs billion
Budget allocation
Financial provision

Projected total revenue
Foreign grants
Principal repayment

Projected budget surplus (+)/deficit (-)

Projected deficit financing
Foreign loans
Domestic borrowing
FY2017 cash balance

1. Budget outlay:

The total expenditure outlay for FY2018 is NRs1,279 billion (an estimated 43.5% of GDP), which is 21.9% higher than the budget estimate for FY2017. The FY2018 outlay comprises NRs803.5 billion for recurrent expenditures (62.8% of the total outlay), NRs335.2 billion for capital expenditures (26,2%), and NRs140.3 billion for financial provision (11%).

The substantially larger size of the budget is due the sharp increase in recurrent and capital spending, particularly the increase in recurrent spending (which as stated earlier includes large transfer to local bodies). The outlay for recurrent expenditure (equivalent to 27.8% of GDP) is 43.1% higher than the revised estimated expenditure in FY2017. The planned capital spending has been increased by 27.9% over the FY2017 revised estimate (an estimated 11.4% of GDP). About NRs146 billion is set aside for post-earthquake rehabilitation and reconstruction.

2. Revenue target:

A total revenue target of NRs817.7 billion (27.8% of GDP) has been set for FY2018, including projected foreign grants of NRs72.2 billion (2.5% of GDP) and principal repayment of NRs15 billion. The revised estimate for revenue mobilization (including grants) in FY2017 is 25.2% of GDP. Revenue (tax and non-tax) growth target is 25.7%.

3, Deficit financing:

The budget deficit is to be financed by foreign loans equivalent to NRs214.4 billion, domestic borrowing of NRs145 billion, and FY2017 cash balance of NRs102.7 billion. Net foreign loans and net domestic borrowings are projected to be 6.3% and 4.3% of GDP, respectively. Overall, fiscal deficit is projected to be about 3.5% of GDP.

4. Where is the recurrent budget going?

Almost 29% of planned recurrent expenditure of NRs803.5 billion is going to local bodies (plus provincial bodies)  as fiscal transfer and another 23% is going as grants (including some social service grant) to local bodies (some of this money is used for local level capital projects as well, but then it also includes scattered pet projects of politicians).  The other big ticket item is the compensation of employees, which takes up about 16% of total recurrent budget. These amount to an estimated 14.2% and 4.4% of GDP respectively.

6. Where is the capital budget going?

Almost 60% of the planned capital budget of NRs335.2 billion is going for civil works. About 23% is allocated for building work. These amount to an estimated 6.8% and 2.6% of GDP, respectively.

7. How much are the local bodies getting?

The government has not formed Natural Resource and Fiscal Commission to oversee fiscal transfer, revenue distribution and grants to local bodies. So, a number of factors (population, development status, cost of operation, etc) has been considered to allocate transfer to local bodies. The distribution is as follows (see the details here):
  • Rural municipalities: NRs100 - NRs390 million (plus conditional grant NRs12 - NRs172.2 million)
  • Municipalities: NRs150 - NRs430 million (plus conditional grant NRs39.5 - NRs312.7 million)
  • Sub-metropolitan cities: NRs400 - NRs630 million (plus conditional grant NRs148 - NRs310 million)
  • Metropolitan cities: NRs560 - NRs1,240 million (plus conditional grant NRs281.2 - NRs783.9 million)
The local bodies will directly get the budget in their bank account by mid-August. A local council will approve the programs to be initiated by local bodies in their locality. These include program and projects on agricultural, livestock, irrigation, roads, drinking water and sanitation, schools (payment for teachers as well), tourism and sports, among others.

These are substantial fiscal transfers and grants that were approved and monitored by at Singha Durbar in the past, leading to substantial delays in project completion. Now, these can be directly used by the local bodies, which means the local residents will need to keep an eye on project selection, contract award and project progress. The local residents now have to point their fingers first at their local representatives instead of the bureaucrats and politicians at Singh Durbar.

These transfers are clubbed under recurrent spending. Fiscal transfer and grants to local bodies together constitute about 50% of planned recurrent spending in FY2018. In FY2017 grants to local bodies alone accounted for about 44% of estimated recurrent expenditure. So, in a way there isn't much increase in transfer to local bodies. It just that a little bit more has been added and some of the conditional grants to local bodies has been diverted as unconditional fiscal transfer so that the local bodies are not at the mercy of the lethargic bureaucracy at Singha Durbar. Some of it is used in capital accumulation or capital maintenance projects. But, a large portion of this for now will go to meeting recurrent expenses of local bodies. 

8. What about implementation?

Budget under-execution is a chronic issue. This budget tries to facilitate budget execution by cutting away several approvals needed even after the projects are included in the Red Book
  • Expenditure authorization will now be approved based on trimester work plan outlined in LMBIS of the MOF. Spending authority will be given to line ministries prior to the start of FY2018.
  • The government commits to establish project offices by mid-August. There will be a detailed work plan for project chiefs and relevant staff (this is nothing new, but it hardly get followed). 
  • Project preparation and tender calls should be completed by mid-August and contract should be signed by mid-October (after completing bid evaluation). Contracts will be canceled if the contractor does not adhere to the timeline agreed beforehand. Contractors will be barred from sub-contracting works (beyond their capacity but they nevertheless bid for the project) unless approved by project chief. 
Capital spending is affected by six major factors. First, structural weaknesses in project preparation and implementation remains unresolved. Barely any substantial homework is done before the inclusion of projects and programs in budget, leading to allocative inefficiencies to begin with. 

Second, low project readiness is another recurring problem as pork barrel and populist projects are inserted without feasibility studies and detail design, and time bound procurement plans and land acquisition plans. 

Third, bureaucratic hassle in approving and reapproving projects at various layers (sector ministries, Ministry of Finance and National Planning Commission) and weak intra and inter ministry coordination delay the full and effective realization of planned capital spending. This is the issue FY2018 budget is trying to resolve by directly transferring funds to local bodies and by doing away with approvals needed even after projects are listed in Red Book

Fourth, infrastructure projects of any scale and nature are riddled with poor project management, especially due to high staff turnover (which erodes institutional memory), lack of staff capacity to administer project implementation, lengthy procurement process, subpar capacity of contractor and weak contract management.

Fifth, high fiduciary risks in project implementation in suburban and rural areas when projects are implemented through local government having limited human resources and administration capacity not only delays spending, but also makes it inefficient. The funds allocated to parliamentarians to spend in their constituencies fall in this category.

Finally, political instability and interference both at planning and operational levels hinder timely completion of projects.

9. Here are the main takeaways from FY2018 budget:

The budget is introduced one and a half months prior to the start of FY2018, as per the constitutional provision. It is expected to boost capital spending. However, looking at last year's expenditure absorption rate, the progress is not as expected. Although the government is estimating 84% of the planned capital budget in FY2017 will be spent, the progress so far points to a much slower absorption rate. As of 29 May, only 34.1% of the planned capital budget is spent. 

This raises doubt over the commitment by the government to accelerate capital spending even though the government has committed adequate funds for infrastructure projects. The FY2018 budget commits to approve spending for projects from the beginning of the fiscal year and also directly transfer funds to the local bodies, bypassing the lengthy approvals needed at various layers of line ministries, NPC and MOF. However, the funds cannot be spent just like that. The local bodies need to follow procurement guidelines and develop project proposals. It is going to take time as the local bodies lack human resources and expertise to design, appraise, approve and execute project. Completing procurement by mid-October will be a huge challenge. The pace of capital spending, hence, depends on how well the center facilitates the local bodies in tackling these issues. Furthermore, the two more rounds of elections by January 2018 (on top of second phase of local elections on June 28) will require government employees to focus on conducting elections, which will deprive them of properly assessing and execute projects outlined in the budget. 

A robust, credible and a time-bound implementation plan to spend the earmarked money is partially addressed (the MOF says it is somehow included in the LMBIS, the inter-ministry budgetary information system). We will have to wait and see until the first trimester to evaluate its efficacy. 

The GDP growth target of 7.2% is a bit ambitious because it is easy to grow from a low base than from a higher base. FY2017 growth rate was high because of the low base effect, good monsoon, improved supply of electricity, some pickup in reconstruction and capital expenditure, and normalization of supplies. However, maintaining a high growth rate will be much more challenging. The rationale for 7.2% growth rate is not convincing even with a good monsoon, prospect of continuation of improved power supply, expected acceleration of reconstruction works and capital spending, and election-related expenses (provincial and federal elections after the local elections by January 2018). These drivers need to be much stronger than in FY2017 to attain a higher growth rate. This is unlikely to be the case as of now. A growth target between 5% and 6% looks reasonable if budget execution (including those at the local level), monsoon rains and elections-related expenditures happen as expected. 

The target to limit inflation within 7% is seems reasonable. Inflation are expected to be subdued in India and global oil prices are not projected to rise dramatically. General prices may heat up due to the increased recurrent budget (but then if the past is any guide not all of the planned budget will be spent). The downside risk to inflation target could be supplies disruption due to political tension in Terai region (as election day approaches and constitution amendment bill does not materialize). We need to see what kind of monetary policy the central bank will roll out in the coming months. 

Furthermore, net borrowing of about 4.3% of GDP (higher than 3.6% in FY2017) may put upward pressure on interest rates (especially when bank liquidity is drying up due to the deceleration of remittance inflows and the large government savings in NRB) and inflation (if actual spending is close to the planned one, which in all likelihood won’t be the case). Overall, fiscal deficit is projected to be about 3.5% of GDP. Net foreign loans are projected to be about 6.3% of GDP. 

The problem with such a large spending plan (met through increasing deficit financing) is that revenue is increased by all means, but then actual spending falls far short of planned one. This leads to substantial government savings, which are used to bloat the budget in the next  period (by committing to finance a part of it using cash balance). This is a bad budgetary practice. The government savings from previous years should ideally be used as a basket fund to finance large-scale infrastructure projects instead of financing a part of recurrent expenses. Budgetary practices should be clear to avoid ambiguity and misappropriation. FY2017 cash balance used in FY2018 budget is almost 22.2% of total planned deficit financing. 

There is no substantial change to existing tax policy. So, achieving revenue growth of 25.7% looks ambitious. If the revenue target is not met, then the government will for sure try to borrow a large amount of money from the market (usually it doesn’t exhaust its borrowing target unless there is a necessity to tweak the budget figures: for instance, to ensure that the fiscal budget is not in surplus like in the past).

Macroeconomy-wise, its a mixed picture: (i) a bloated budget justified to ensure reasonable initial financing and grants to local bodies in the federal setup; (ii) ambitious GDP and revenue growth targets; (iii) widening of net domestic and foreign borrowing; and (iv) a potential surge in interest rate due to the sharp increase in net domestic borrowing. 

With this kind of a bloated budget, which is practically beyond the absorption capacity of the bureaucracy and institutions, the government should not try to bring a supplementary budget after the local elections are over. The priority should be to fully execute the budget. Furthermore, time has come to stabilize the recurrent budget at this level and then start culling unproductive, repetitive and zombie projects. Revenue (tax and non-tax) is not even able to finance recurrent expenditure: in FY2017 recurrent expenditure was 97% of revenue and in FY2018 it is expected to be 110% of revenue. 

Tuesday, May 23, 2017

Can Nepal become a middle-income country by 2030?

May be, but it depends on the pace of reforms and how fast it is able to break the low growth, high migration equilibrium, according to a latest report by the World Bank. Nepal’s performance so far can be summed up as: impressive decline in absolute poverty rate (proportion of population below $1.90 a day, 2011 PPP), low growth grate (below 5%), large-scale out-migration for work, and huge inflow of remittances that is popping up revenue growth, consumption demand and more. Also, see this paper on remittance in Nepal: boon or bane.

A business-as-usual scenario (BAU) and the resulting GDP growth would lead to per capita income (GNI) of $958 in 2030 (short of $1025 benchmark for lower middle income country as per the WB definition). However, under a reform scenario (investment and productivity improve until 2021 and then level off), per capita income level will breach the lower-middle income threshold in 2027. The exercise comes out of a classic neoclassical growth model (growth accounting/long-term trend [steady state] analysis). 

The WB recommends a “systematic assault” to break the inferior equilibrium through:
  • Breaking policy barriers (ramp up public investment, promote competition, trade integration)
  • Building new sources of growth (mainly hydropower)
  • Revitalizing existing sources of growth (reform agriculture)
  • Investing in people (take advantage of the demographic dividend and invest in skills of youths)
Here is an earlier analysis (Macroeconomic Update August 2013, ADB) on prospects for graduation from LDC category by 2022. Also, here is a piece on rapid economic transformation to be a middle-income country by 2030. Here is a econ-political analysis on why is Nepal poor. And, here is a short piece on low growth trap and the unusual structural transformation

Wednesday, May 17, 2017

Nepal joins Belt and Road Initiative (BRI). Now what?

On 14 March, Foreign Secretary Shanker Das Bairagi and Chinese Ambassador Yu Hong signed a memorandum of understanding, in Kathmandu, on the framework agreement on China’s Belt and Road Initiative (BRI), or commonly referred to as One Belt One Road (OBOR). The primary interest in joining the new initiative is to increase Chinese investment and assistance in Nepal, primarily in infrastructure, technology transfer, and connectivity. The signing of MOU comes ahead of the Belt and Road Forum for International Cooperation summit in Beijing on May 14-15. 

Now, Nepal has to come up with project proposals that suit the objectives of BRI. These projects will then likely be funded, mostly concessional or non-concessional loans, through Chinese public and private investment companies (plus AIIB, which invests in projects; Silk Road Fund, which is primarily designed for equity investment in projects;  EXIM Bank; China Development Bank; New Development Bank, etc).

Unveiled in September 2013, the initiative covers 65 countries (home to 62% of world's population and constitutes one-third of global GDP). It consists of two major parts: Silk Road Economic Belt (road stretching from China to other countries/continents that will facilitate trade and investment in infrastructure projects) and 21st Century Maritime Silk Road (sea-based network of shipping lanes and port development).

Here is a list of latest pledge ($124 billion) by China for the BRI initiative:
  • an extra 100 billion yuan ($14.50 billion) into the existing Silk Road Fund
  • 250 billion yuan in loans from China Development Bank
  • 130 billion yuan in loans from Export-Import Bank of China
  • 60 billion yuan in aid to developing countries and international institutions in new Silk Road countries
  • encouraging financial institutions to expand their overseas yuan fund businesses to the tune of 300 billion yuan
  • 2 billion yuan in emergency food aid
  • $1 billion to a South–South Cooperation fund
  • $1 billion for cooperation projects in countries on the new Silk Road

Now what? Nepal joined AIIB with great fanfare, but nothing substantial has come out of it. Similar with the transit treaty with China that theoretically ended the sole dependence on India for utilizing the transit right of a landlocked country. It would be great if Nepal secures funding for projects that caters to domestic demand and subsequently facilitates cross-country trade and investments. Let me outline some of the issues that need to be kept in mind going forward.

First, some people are taking Nepal joining BRI as a response to India's heavy-handedness in Nepali politics and economy after the promulgation of constitution in 2015. The trade embargo crippled the Nepali economy. The anger arising from the trade embargo-inflicted pain is understandable. But, joining BRI should not be a retribution strategy from which Nepal gets nothing in substance. The biggest task for Nepal is to present projects that are appealing to Chinese investors, both public and private sectors that are part of BRI. But then we also know that this is where Nepal is chronically lacking. Nepal’s fiscal operation is squeezed by a lack of project readiness and its neglect/inability to prepare a stock of investment-ready projects (referred to as Project Bank). Precisely because of this, capital spending is below 80% of budged amount. Nepal is not even able to fully utilize the highly concessional loans offered by multilateral institutions (ADB and WB). 

Second, Nepal needs to first present its own version for rapid economic transformation, with broad-based political support, and then seek funding for its implementation. It should align with domestic needs and development aspirations. We should collaborate (not wholly let them do it) with Chinese or whoever is competent to draw an economic corridor blueprint and then seek funding on the most cost-effective way. We should draw lessons (on what not to do) from $45 billion China Pakistan Economic Corridor master plan. The deal comes with a lot of economic, political and geographical influence.

Third, on what terms and conditions are the Chinese investments going to flow in? It is not going to be in the form of traditional aid for sure. The emphasis is on equity investment, i.e. partial ownership of projects and assets. What would be the fiscal implication and debt liability? We need to be clear on this before its too late. Nepal may be asked for sovereign guarantee of project investments even in the case of private players. Also, Nepal may be asked to revise/modify laws to accommodate investments (for concessions) and make regulations to suit Chinese procurement (of course, it will be single sourcing without competition). The devil is always in the detail. If Japan, India or any other multilateral institutions offer loan in more concessional terms (interest plus principal payment schedule) and easier procurement rules, then Nepal should not stick for project financing with BRI just for its sake (domestic politics plus response to Indian influence). 

Fourth, there are talks about developing Nepal as a vibrant transit nation between China and India (or transform it from landlocked into land-linked). That’s appealing in principle and is a great topic for never-ending workshops. However, as the reality is now, this is a distant dream. India is opposed to Chinese investment in disputed regions in Pakistan. India will want to expand its own interest along Nepalese border and increase connectivity, which is happening at snail’s pace. The geography is also on the Indian side: plains versus the rugged mountains. We may be chasing a chicken that may not lay much eggs, but creates a lot of noise. Nevertheless, Nepal's primary interest should be to attract investment and increase exports to both India and China (and not only a 'land-linked' transit nation, which to me sounds a bit unrealistic given the political and economic realities).

Fifth, it would be prudent to first prioritize what Nepal needs now and what is needed in the future to sustain high growth? There is unanimous consensus on increasing investment in hydropower projects, domestic transport networks (including airports), urban development, tourism, agriculture and education sectors. This is where foreign investment should be flowing in, be it Chinese through BRI or Indian and Japanese bilateral aid or any kind of aid from other countries and multilateral financial institutions. Then only we need to think of large-scale inter-country infrastructure linkages with China (like railways). The returns on such investments for now is too low and markets too small. A metro rail within Kathmandu is much desired for now than cross-country rail link with China. Similarly, upgradation of poor facilities and preservation of Lumbini is much desired than just a rail link to Lumbini. 

There is much to discuss on this issue. For now here are two good readings: 
  • The EIU's report on OBOR here
  • Akhilesh Upadhyay's take on why Nepali's don't share Indian ambivalence towards China here

Thursday, April 27, 2017

NEPAL: CBS projects GDP to grow by 6.9% in FY2017

On 25 April, Central Bureau of Statistics (CBS) estimated that Nepal’s economy would likely grow by 6.9% in FY2017, sharply up from 0.01% in FY2016 and 3% in FY2015. This is the highest GDP growth rate (at basic prices, FY2001=100) since FY1994 (when GDP grew by 7.9%) and is higher than the government’s target of 6.5%. It projected agricultural, industrial and services will grow by 5.3%, 10.9% and 6.9%, respectively. Agricultural sector contributed 1.7 percentage points, industrial sector 1.6 percentage points and services sector 3.6 percentage points to the overall projected GDP growth of 6.9%. These projections are based on eight to nine months data. 

Specifically, electricity, gas and water sub-sector will likely grow at fastest rate (a whopping 13%) compared to a negative 7.4% growth in FY2016. Similarly, construction activities will likely grow at 11.7%, up from a negative 4.4% in FY2016. Wholesale, and retail trade, and manufacturing are projected to grow by 9.8% and 9.7%, respectively (up from negative growth rates in FY2016).

An obvious query is: how is this possible? Well, it’s a combination of base effect, good monsoon, improved supply of electricity and normalization of supplies following the catastrophic earthquakes in FY2015 (April and May 2015) and the crippling supplies disruption in FY2016 (September 2015-February 2016). A growth rate of around 6% was expected.

First, it’s the base effect, which refers to the tendency of achieving an arithmetically high rate of growth when starting from a very low base. Hence, only the normalization of economic activities disrupted by the crippling embargo and the lingering impact of the earthquakes would have generated a high growth rate. Note that FY2017 is compared to the performance in FY2016, when growth was almost negligible (0.01%). Even a slight improvement in the normal drivers of growth would have produced a large growth rate in FY2017. Indeed, the seven highest growing sub-sectors in FY2017 had negative growth rates in FY2016 caused by the crippling supplies disruption, which dented economic activities much more than the earthquakes in FY2015. Similarly, agriculture and forestry subsector grew at a negative 0.2% in FY2016 due to the subnormal monsoon, and continued land and harvest disruption caused by natural disasters.

Second, an above average monsoon rains led to record paddy harvest and consequently an impressive agricultural growth. This is an exogenous positive shock. The government also adequately supplied agricultural inputs (including chemical fertilizers and seeds) and restored irrigation facilities (depreciation, and disruption by earthquakes and landslides). It also helped. Paddy output is projected to grow by 21.7% (paddy alone contributes 20.7% to agricultural gross value added). Wheat and maize outputs are projected to grow by 2% and 1.3%, respectively. 

Third, the industrial sector pretty much got a facelift, thanks to the sound management and supply of electricity, improved investor confidence, and pick up in post-earthquake reconstruction works (both private and public). This is where the government’s efforts are most visible. The demand for concrete, sand, soil and other construction materials boosted mining and quarrying activities. Similarly, manufacturing activities got a boost from improved political situation (no strikes and labor disruptions) and energy supply, thanks to the NEA’s excellent efforts in managing existing stock of energy and adding additional units to the grid (domestic as well as imported). Manufacturing, and electricity, gas and water subsectors are expected to contribute 0.6 and 0.3 percentage points, respectively, to the overall GDP growth.  Furthermore, construction activities accelerated due to the pick up in post-earthquake reconstruction works and substantial improvement in works related to large infrastructure projects (Melamchi, Upper Tamakoshi, etc).

Fourth, the demand dampening from deceleration of remittances and marginal effects of demonetization were dominated by the surge in demand following the normalization of supplies and increasing tourist arrivals, thus ensuring a robust services growth. Wholesale and retail activities, which were severely crippled by supplies disruption and grew at a negative 2.5% in FY2016, are projected to grow by 9.8% (thus contribution 1.3 percentage points to the overall GDP growth). Similarly, there were improvements in tourism activities (contributed by domestic tourism as well as international tourists arrivals), transportation and communication (no notable strikes and blockade), and real estate business. Election related expenses will also give boost to services activities. 

Hence, a large base effect together with favorable exogenous factors (good monsoon rains and remittances-backed demand of imported as well as domestically produced goods, whose supplies gradually normalized) and to some extent the government’s efforts led to this impressive growth rate. An important challenge would be to sustain this rate. It is easy to move from almost nil growth to over 6% growth. But, it is difficult to sustain it at this level. It requires a rapid and meaningful structural transformation. The CBS will likely revise down this projection in April 2018, when it releases the revised estimate. The reason is that the services output growth looks a bit more optimistic.

On the expenditure side, private fixed investment seems to have increased to 26.5% of GDP from 21.7% of GDP in FY2016. Overall, fixed investment is expected to reach 33.8% of GDP. Consumption accounted for about 89.7% of GDP. Trade deficit is projected to widen to 32.3% of GDP from 29.9% of GDP in FY2016.

The economy can sustain growth of over 7% with an appropriate mix of macroeconomic strategies, financial arrangements, smart project execution, and supportive institutions and policies. Government has an important role to play in providing critical infrastructure, addressing market failures, designing a growth-enhancing tax regime, and implementing business-friendly policies to usher in a meaningful structural transformation. It also needs to enhance both the quantum and quality of public capital spending to over 8 percent of GDP annually. Given the sound fiscal space, though Nepal doesn’t have a shortage of funds until medium-term, a dearth of capacity to fully execute the budget and finish projects on time may prove problematic. 

Achieving and sustaining a high growth rate is critical to achieve the long-term goal of becoming a prosperous middle-income country by 2030. Hence, implementing the vision of a rapid economic transformation would require consistent and committed political leadership, and a competent bureaucracy. This would form the institutional fabric that helps translate good economics into good politics with economic development as the core theme. It ensures shared prosperity, makes reversibility of policies costly, enhances individual’s and firm’s confidence in the economy, and encourages the bureaucracy to provide faster and better service delivery.

Tuesday, April 25, 2017

Two years since the earthquake reconstruction work is dismal

Today marks the second anniversary of 25 April Gorkha earthquake. A catastrophic 7.8 magnitude earthquake struck Barpak of Gorkha district at 11:56 AM. In between numerous aftershocks of below 5 magnitude, two powerful 6.7 magnitude (26 April) and 7.3 magnitude (12 May) aftershocks shook a large part of the country, particularly central and western administrative regions. It caused further damage to the already weakened houses and physical infrastructure, and also triggered numerous landslides in the rural areas. The calamity added a new challenge to Nepal’s short-to-medium term economic growth and development prospects.

Over 8,800 were confirmed dead and 22,309 injured. Furthermore, 602,257 and 285,099 private houses were fully and partially damaged, respectively, forcing thousands of people to seek temporary shelter under tents and tarpaulin sheets. Furthermore, 2,673 and 3,757 public buildings were fully and partially damaged, respectively. To prioritize rescue and relief operations, the government declared 14 districts as severely affected (mostly in the central and western regions) although the earthquake has affected 31 of Nepal’s 75 districts.

According to PDNA estimates, the cumulative damage and loss amount to 33.3% of GDP ($7.1 billion) and the cumulative need for recovery is estimated at $6.7 billion (31.5% of GDP). Of the total estimated recovery needs, about 50% is for rebuilding private housing and settlement. Productive and infrastructure clusters need 17.3% and 11.1%, respectively. These amount to about 5.5% and 3.5% of GDP, respectively. The recovery needs requirement for agriculture, education, electricity, and transport is estimated at $156 million, $397 million, $186 million, and $282 million, respectively. Furthermore, recovery of the tourism sector and restoration of cultural heritage are estimated to require $387 million and $206 million, respectively.

Preliminary estimates showed that the income shock as a result of the earthquake likely pushed an additional 700,000-982,000 people below the poverty line. This translates into an additional 2.5%-3.5% of the estimated population in 2015 pushed into poverty compared to the no-earthquake baseline scenario of about 21%.

The government organized an international conference to raise funds for reconstruction, which all political parties said would be swift and free of procedural bottlenecks. Accordingly, multilateral and bilateral donors pledged around $4.1 billion (see figure below).

So, what has been the progress after two years?
  • 22,310 houses reconstructed (mostly private) 
  • Of 717,251 families eligible for housing grants, only 564,029 have received the first tranche of NRs50,000. 
  • Of 564,029 that received the first tranche, only 49,681 have started rebuilding their houses
  • Of 34,294 households that have applied for second tranche, 14,557 have be certified to receive it. 
  • Of 750 heritage structures (fully damaged 133 and the rest partially damaged), only 90 are in reconstruction process. Only 1 (Bauddhanath Stupa) was completed (that too by local initiative).
  • Schools that need reconstruction: 7,923. 1,141 construction completed. 1,059 construction ongoing.
  • Of 929 health facilities (fully and partially damaged), 200 have been reconstructed
  • 2,688 government buildings need reconstruction
  • Of 7,741 drinking water projects that need reconstruction, 363 completed
Obviously, the progress so far is disappointing. The National Reconstruction Authority (NRA) points to three factors for the slackness: 
  • lack of mobilization of competent human resources
  • weak coordination and cooperation
  • funding gap
What is surprising is that these were exactly the things folks feared during the run up to establishment of the NRA. There was strong recommendation to make the NRA as powerful as it can be (definitely not a parallel government as come interpreted it back then!) so that it doesn’t have to knock on the doors of various ministries and the Cabinet to take crucial decision as and when necessary to expedite reconstruction works. No one wanted the NRA to suffer the same fate as other ministries in spending capital budget (bureaucratic hassles, structural weakness in planning, low project readiness, weak project management, and political influence).

Unfortunately, this is exactly whats happening right now. NRA looks like another bloated ministry without much tooth. It has to depend on the Ministry of Finance to get funds. It is not given adequate discretionary expenditure to carry out tasks that may crop up as work progresses. MOF is too slow and lethargic to not only release but also to think beyond the usual bureaucratic procedures on this matter. 

Political infighting during the appointment of CEO and awarding contracts to cronies have been the most controversial moves. Initially, the NRA ordinance was deliberately allowed to lapse, which led to questions about the very existence of NRA. Then NRA Act was passed by diluting all the procedures that would have ensured faster decision-making and disbursement of funds. A robust institutional setup for reconstruction was not the priority for political parties. The coalition governments were/are more interested in having their yes-man in the leadership position and helping cronies associate with reconstruction efforts (either for project assignment or local influence). The major chunk of the blame for the disappointing pace of reconstruction so far must go to the big three political parties. 

Then comes the development partners. I still cannot understand why some donors keep on pressing for stringent verification procedures for disbursement of housing grant. Importantly, I cannot get the logic of breaking housing grant in three tranches as if it’s a robotic way to building houses. Who starts building a house with NRs50,000 and then waits for additional tranche to plan for another phase of construction? How are these folks supposed to do contract with laborers and purchase raw materials needed to build a house when the money is given in tranches subject to stringent verification procedures? The cost of construction materials and labor goes up by the time these processes are cleared. The housing grant should have been given in a big NRs200,000 chunk. Then only an orderly planning would work. I keep on thinking: how about asking the specialist/officer who proposed such an impractical tranche condition to build a house following the rules he/she set? This reflects an inadequate understanding of building houses through financing (grant or bank loan) and poor project planning & preparation. 

Anyway, the slow reconstruction so far is a shameful tragedy. Reconstruction work needs to be fast now. NRA needs to be given discretionary expenditure so that it won’t have to knock on the doors of MOF all the time. Cabinet needs to delegate procedural approval processes to NRA board itself. Donors need to be a bit flexible. Remember, some inefficiency is always inevitable if we carry out work of this scale. After all, a good cause is worth some inefficiency (so said Paul Samuelson)! Political parties need to keep out of the NRA, especially its leadership and the housing grant at local level. And the NRA needs to mobilize private sector if there is shortage of (or unwilling) civil servants to work on reconstruction tasks. Planning phase is too long already. The people need results immediately. 

At this pace I doubt if reconstruction will be completed in the next three to four years. It’s a sad story on top of the pain inflicted by the devastating natural disaster.