Tuesday, February 7, 2017

Nepal's self-inflicted liquidity/credit crunch

It was published in The Kathmandu Post, 07 February 2017.

The current liquidity crunch is the result of faulty operation and management of BFIs

The financial sector is in a temporary yet recurring state of disarray right now as a self-inflicted ‘liquidity crunch’ has handicapped most banks and financial institutions (BFIs). While the business community is unnerved by the rapid shrinkage of loanable funds and prospects of an interest rate hike, BFIs are struggling to stay within the mandated credit-to-deposit threshold. 

Nepal Rastra Bank (NRB) has rightly refused to increase the 80 percent threshold as it is one of the widely used tools to ensure the viability of the financial system and security of deposits. The liquidity/credit crunch is the consequence of flawed operation and management practices of BFIs.

BFIs are required to maintain at least 20 percent of their deposits in the form of very liquid assets, which means cash or assets that can be readily turned into cash. The credit to core capital plus deposit ratio should not exceed 80 percent. If they are close to the ceiling and are unable to attract more deposits, they need to hold back on aggressive lending. Any drop in deposits means that BFIs will have to lower credit growth too so that they do not overshoot the threshold.

To better secure deposits, reduce the number of BFIs and improve the financial sector, NRB instructed BFIs to increase their paid-up capital by mid-July 2017 (Rs8 billion for commercial banks). In response, several weak BFIs merged or were acquired by stronger ones. Others floated shares or are in the process of doing so. BFIs also had to increase credit growth to maintain a high profit target. Without many alternatives, they engaged in aggressive, unproductive and irresponsible lending to three particular sectors: real estate, hire purchase and share investment. Demand for loanable funds in these sectors is always high, and with little hassle and transaction cost, BFIs earn disproportionally large profits compared to lending to other sectors such as energy, agriculture, infrastructure and tourism. Underneath this lending practice lies ever-greening and at times imprecise classification of risky assets.

Socialise losses, privatise profits

Real estate prices began heating up after the earthquakes in 2015 following a few years of stability. Most BFIs had some room left for real estate lending, and due to lack of other bankable investment opportunities, they started issuing loans generously. Simultaneously, they increased margin lending, which contributed to a bullish stock market despite no noticeable change in economic fundamentals.

The other profitable market segment that could absorb credit quickly was vehicle purchase whose import demand spiked after a lull triggered by a crippling supplies disruption last year. Lending to these sectors swelled so fast, and without proper scrutiny of sustainability of the balance sheet, that the total credit growth outstripped deposit growth. At the same time, deposit growth slowed because of a deceleration in remittance inflows and the inability of BFIs to offer innovative savings instruments. The situation exacerbated to such a level that BFIs are now imploring the central bank to temporarily increase the credit-to-deposit threshold to 85 percent.

Pleading for an increase in the upper limit is akin to begging for a subsidy so that BFIs can continue enjoying the profits from imprudent and unsustainable lending practices and meet their high profit targets year after year. This is utterly reckless and reeks of an intention to socialise losses but privatise profits. The central bank should remain steadfast in its policy on the credit-to-deposit rate and defend the measures required to ensure a prudent financial system.

We went through this kind of situation in 2011 when there was a slowdown in deposit growth and unhealthy and cutthroat competition to increase lending and the real estate bubble burst disrupting financial flows. It resulted in a severe liquidity crisis and a loss of confidence in the banking system after the then Vibor Bikas Bank knocked the doors of the central bank in June 2011 to either inject money or take over its management. Subsequently, NRB imposed a 25 percent cap on real estate and housing loans and implemented reforms to improve the health of the financial sector.

Incongruous arguments

BFIs still have not learnt from their mistakes. First, the recommendation by BFIs to increase the credit-to-deposit threshold is nonsensical. It will not solve the structural operational and management flaws on which they try to flourish. They point to a liquidity crunch, but react unenthusiastically when the central bank offers temporary liquidity facilities. It looks like BFIs just want to cover up their reckless and imprudent operations. Second, they argue that slow capital expenditure and a slowdown in deposit growth led to the credit crunch. Yes, that is true. But then these two factors (which tend to drive deposit growth) were expected anyway. Given that there has not been any change in the expenditure absorption capacity, low capital spending was entirely predictable when the fiscal budget was introduced. Similarly, overseas migration started declining immediately after the earthquake and remittances started decelerating from May 2016. This was also anticipated well in advance.

BFIs knew that they were close to the threshold as early as the beginning of 2016, but they still engaged in aggressive lending to quick return and unproductive sectors to attain high profit targets. Whining for an increase in the threshold by floating incongruous arguments is irresponsible. They presented the same arguments in 2011 too. BFIs should have been conservative on credit growth (and its quality), which should be consistent with deposit growth to avoid a sustained asset-liability mismatch. The central bank should not increase the threshold now. The situation will likely normalise in the last trimester when most of the capital spending happens.

Unless BFIs change their operational and management model, the same thing is going to happen again. They should scrutinise loan proposals more intensely, invest more in research and personnel training, introduce innovative deposit and credit schemes, diversify their asset portfolio, lower unsustainable profit targets, improve corporate governance and continue consolidation efforts.

Thursday, January 19, 2017

Melamchi and the mismanaged KUKL

It was published in The Kathmandu Post, 18 January 2017

Mismanaged KUKL

The organisation needs an urgent overhaul to ensure efficient distribution of Melamchi water

Once known for its financial and administrative mismanagement, Nepal Electricity Authority (NEA) is now the most talked about public enterprise that is giving hope of a bright future. Apart from the scheduled electricity generation and additional import from India, drastically reducing load-shedding would not have been possible without the administrative acumen of NEA’s Managing Director Kul Man Ghising, unflinching support by a majority of the board of directors, and strong support by Energy Minister Janardan Sharma.

Meanwhile, gross negligence by management, especially the chairman of the board of directors, and excessive political interference is turning Kathmandu Upatyaka Khanepani Limited (KUKL) into a new basket case of administrative and financial mismanagement. It is an alarming development requiring urgent attention of and intervention by the government. Else, the dream of channelling Melamchi’s water through the dry taps in Kathmandu will continue to remain a daydream despite the fact that the main tunnel work is going to be completed by 2017.

NEA as a model

After the Nepal Oil Corporation, NEA is probably the second-most decried and politically interfered public enterprise in Nepal. The combined financial loss—a direct product of administrative mess, political interference and a mismatch between cost and retail prices—of these two enterprises was about 0.7 percent of gross domestic product (GDP) in FY2014. The intermittent petroleum shortages and prolonged load-shedding was throwing regular life out of gear. Fortunately, the low oil prices in the international market and its ability to still charge high prices in the domestic market was a blessing in disguise for the NOC, which despite being embroiled in an administrative mess and political interference through the labour unions, has turned its negative balance sheet positive in the matter of a year.

The case with NEA is different though. It continues to have a negative balance sheet, generating loss amounting to about 0.6 percent of GDP in FY2016. The administrative, political and union related troubles continue to beset its financial health and public service delivery. It cannot revise upward retail electricity prices like the NOC and continues to sell electricity below the cost of production. Hence, the government’s decision to write off 26.5 billion rupees of accumulated debt in 2011 was not enough to turn around its negative balance sheet.

But NOC is still a lost cause, given its core troubles despite the improved financials thanks to external factors. But NEA is a beacon of hope despite its bad financials thanks to a capable managing director and the backing of the board of directors. The tireless effort, management shrewdness, and commendable drive to achieve allocative efficiency have led to a drastic reduction in power cuts, making the public and the business community happy.

Ending Kathmandu’s water woes

The kind of overhaul seen in NEA and its recent improvement in service need to be replicated in KUKL. KUKL is a semi-public organisation tasked with managing water supply distribution and sewer systems (including treatment plants) in Kathmandu. To avoid the fate of a failing public enterprise, KUKL was established as a public company, which could loosely operate like a public-private-partnership (PPP) entity. Although the private sector collectively has just a 15 percent share, it is nevertheless allowed to head the board and have an important say on key issues. While this was done in good faith, given the mess with public enterprises, it is becoming a bane for the future of KUKL.

A political, inefficient and carefree chairman of the board of directors (from the private sector) is trying to prolong his tenure and blocking human resources and administrative reforms that are required to enable KUKL to distribute and manage water from Melamchi, which is expected to be completed by 2017. Finishing Melamchi’s tunnel work and channelling water to Kathmandu is only half the story. Efficient management and distribution of over 300 million litres of water per day is the other equally important half of the story.

Kathmandu’s water woes will not end unless the government intervenes in order to mend three core issues: address current staffing; remove the obstructionist chair of board of directors; and stop political interference in personnel hiring and in putting water supply lobbyists (water bottlers and tankers suppliers) above KUKL’s interests.

KUKL should hire competent staff for the vacant positions and replace personnel who do not have the required abilities. These include engineers of varying skills, machine operators, mid-to-senior level sectoral management staff, and overseers. The current general manager is not getting timely and appropriate cooperation from the board chair to fill these positions and enhance capacity of the existing ones. It will affect service delivery of KUKL.

Furthermore, the current board chair is staying beyond his term limit by coaxing politicians, delaying annual general meetings (which have not taken place since 2014), and making KULK a dumping ground for employing politically affiliated personnel. An uncooperative board chair—who has been on KUKL’s board since 2008 and chairman since 2014—with no respect for corporate governance, and who interferes in day-to-day administrative issues can virtually immobilise other management staff, including its competent general manager. The current board chair, who has even lost confidence in his fellow board members, needs to be booted out of KUKL.

Taking action

KULK’s annual general meeting is scheduled for the third week of January. The government should use its rightful authority and coerce the board chairman out of KUKL. Furthermore, the two large private sector umbrella organisations that are represented in the board of directors of KUKL need to behave as professional private sector players and not do the bidding of politicians and lobbyists. The private sector representation is failing to deliver the kind of management skills and visionary leadership expected of them at KUKL.

KUKL needs the recent NEA-type management, ie a competent and respected managing director or general manager fully backed by the board of directors, to ensure that Melamchi water is timely and efficiently distributed to the people of Kathmandu.

Wednesday, January 11, 2017

Growth prospects for Nepal and India in FY2017

Here are the major highlights from Global Economic Prospects January 2017:

Global growth is estimated at 2.3% in 2016 and is projected to grow marginally to 2.7% in 2017 due to “receding obstacles to activity in commodity exporters and solid domestic demand in commodity importers”. 
  • Increasing policy uncertainty in major economies (particularly in the US and Europe), financial market disruptions (amidst tighter global financing conditions) and weakening potential growth are some of the downside risks.
  • Fiscal stimulus in the advanced economics could push GDP growth up. 
  • Weak investment and productivity growth are affecting medium-term prospects. Structural reforms to boost potential growth (support domestic demand and reinvigorate investment) should be a medium-term priority. In advanced economies, low or negative real equilibrium interest rates constrain effectiveness of monetary policy and may necessitate supportive fiscal policies.
  • Investment in human and physical capital is essential to meet the skills and infrastructure needs to support long term growth. Other measures include rebuilding policy space, addressing vulnerabilities, and enhancing international integration (trade and FDI).
  • Commodity prices, particularly oil, are expected to increase. Agricultural prices are projected to remain stable as maize, wheat and rice stocks are at high levels.

  • Indian economy is expected to grow at 7.0% in FY2017 (ending on 31 March 2017), 7.6% in FY2018 and 7.8% in FY2019 and FY2020. Higher infrastructure spending, strong demand-led manufacturing activity, and regulatory reforms will support growth till the medium term.  
  • The demonetization shock in India affected growth prospects in the third quarter. Fourth quarter growth is affected by weak private sector investment (excess capacity, corporate deleveraging and credit constraints). 
    • Demonetization may be beneficial over the medium term because of liquidity expansion, which will help to lower lending rates.  
  • High growth up to second quarter of FY2017 was “underpinned by robust private and public consumption, which offset the slowing fixed investment, subdued industrial activity and lethargic exports”. Consumption was supported by low energy costs, increases in public sector wages and pension and favorable monsoon (which boosted rural and urban incomes).
  • Reduction in administered prices and low energy costs eased inflationary pressures. 
  • South Asian regional growth is estimated at 7.1% in 2017 and 7.3% in 2018 supported by robust domestic demand

UPDATE (2017-01-17): In its WEO Update January 2017, the IMF trimmed India's GDP growth for FY2016/17 to 6.6% (one percentage point lower than its October 2016 forecast) and 7.2% for next fiscal year (0.4 percentage point lower than its October 2016 forecast), thanks to the demonetization shock.

  • Nepalese economy is expected grow at 5.0% in FY2017 (ending 15 July) and 4.8% in FY2018. 
    • Favorable monsoon and expected acceleration post-earthquake reconstruction will underpin growth along with the normalization of trade after the four-and-a-half-month long border blockade.
    • Deceleration of remittance inflows may constrain consumption and investment. Medium-term growth will be supported by continued post-earthquake reconstruction, uptick in manufacturing activity, and favorable tourism activities. 
  • Surge in post-earthquake reconstruction related imports and deceleration of remittances will worsen current account balance.
  • Demonetization shock spillovers from India to Nepal, through trade and remittance channels may affect growth.

UPDATE (2017-01-24): In its latest assessment, the IMF has projected Nepal’s GDP to grow at 5.5% in FY2017 and inflation to undershoot the target.

The mission expects growth to reach 5.5 percent in FY 2016/17 (ending July 15). The normalization of economic activity is being supported by a good monsoon, accommodative monetary policy, and rising government spending. India’s sudden withdrawal of high-denomination banknotes is expected to have a limited impact on activity overall; bank holdings of Indian rupee currency are small but some corporates and households who hold such notes have seen their purchasing power affected. The main risk to the outlook pertains to failure of capital budget implementation to improve.
The normalization of prices in the aftermath of last year’s trade disruption is pushing down inflation which is expected to undershoot the authorities’ mid-2017 inflation target of 7.5 percent.

Wednesday, December 21, 2016

Impact of demonetization of Indian notes in Nepal

It was published in The Kathmandu Post, 20 December 2016. 

The surprise decision to withdraw the two highest denomination Indian currency notes by Indian Prime Minister Narendra Modi on 8 November has led to confusion and uncertainty not only in India, but also in neighbouring countries where Indian currency is freely used as a medium of exchange. The administrative unpreparedness and the ensuing management mess in India have put Nepali policymakers, traders and ordinary people, who use the Indian currency for various purposes, in a terrible fix.

The close economic integration between the Nepali and the Indian economy, especially in trade, employment, remittance inflows, tourism and investment, means that the demonetisation drive in India is having ripple effects on the Nepali economy as well. Unfortunately, the Nepali monetary and fiscal authorities cannot do much to mitigate its direct impact as the shock is entirely exogenous and its fallout poorly managed.

Economic ties

Almost all macroeconomic indicators in Nepal are influenced by the fiscal and monetary changes in India. Imports from India accounted for about 62 percent of total imports in 2016. The total value of imported goods—ranging from petroleum products and vehicle parts to chemical fertilisers and agricultural goods—from India is equivalent to about 23 percent of gross domestic product (GDP). Similarly, exports to India accounted for about 56 percent of total exports. The two countries have a trade and transit treaty—although it was knocked sideways during the four-and-half-month-long crippling supplies blockade—that cuts deeper than any other multilateral and regional trade agreements. Investment commitment and tourist inflows (recreational as well as religious) have also been the highest from India. Nepal has pegged its currency to the Indian rupee at a rate of NRs1.6 to IRe1 since 1993, partially contributing to macroeconomic stability even in times of tumultuous politics. Furthermore, the Indian market is a stable employment destination for seasonal Nepali migrant workers.

Against this backdrop, the ripple effects of any changes to fiscal or monetary policies in India are bound to be felt in Nepal too. In the demonetisation case, the transmission mechanism would most likely be more pronounced through depleted savings (although transient in nature) of seasonal workers, setbacks to informal trade flows and investment in small and medium enterprises, and lower spending by Indian tourists. For Nepali citizens using services in India, such as students, pilgrims and medical patients, it would be a nightmare to implement their plans without Indian currency in hand.

Persistent effect

The effect of these factors will most likely be gradual, yet persistent, resulting in downward pressures on economic growth.

First, India is a popular employment destination for seasonal workers, who migrate for short-term unskilled work, especially during lean agricultural period. Survey estimates show that India accounts for over 41 percent of the total stock of Nepali overseas migrants and they send about 20 percent of total remittance inflows. A unique feature about the Indian market is that it provides unhindered seasonal employment to a large number of unskilled Nepali workers compared to other employment destinations such as the Gulf countries and Malaysia. An open labour market, language familiarity and low cost of migration may be the most important factors for such a trend. Furthermore, members of the poorest households across Nepal, especially from the plains and the mid-hills, tend to migrate to India for short-term work. They include members of households affected by last year’s earthquakes.

Note that this group of unskilled migrant workers earn a stipulated daily wage in cash, which they usually save in higher denomination notes that are easier to carry back home. The demonetisation shock has made this group of people, many of whom do not have a bank account, the most vulnerable and hapless. Their cash savings are on the verge of being worthless, and they cannot afford to queue outside banks for hours. Worse, they are probably not paid for the daily work they are doing due to the lack of cash in their employer’s vault. The remittance income of this group of migrant workers normally constitutes one the strongest pillars of the consumption-based local economic activities back in their villages. This is now at risk.

Second, recent estimates show that just 29 percent of total imports from India are transacted through letter of credit, that is through the formal banking system. It means a substantial portion of imports is settled in cash or other means such as bank drafts or travellers’ checks to mainly avoid taxes and bureaucratic hassles. Also, surveys on informal trade show that informal agricultural imports from India account for about 15 percent of total formal imports. The total informal merchandise imports from India may well be over 30 percent of total imports. As these are mostly settled in cash by small- and medium-scale traders, a shock to this process will generate a slow but persistent impact on the Nepali economy.

Third, small-scale investments—in retail and wholesale trade, agro and manufacturing enterprises—along the border areas do not flow through the formal banking process. They are transacted locally in cash. We will continue witnessing a slowdown there as well. Additionally, there is a real possibility of a decline in the number of Indian tourists and their spending capacity in Nepal. Tourism related purchases are settled in cash, especially by Indian tourists who drive into Nepal for a short vacation over a weekend.

Now what?

These are a few potential transmission channels through which the demonetisation shock will have a downward effect on economic activities in Nepal. That said, there still is much uncertainty over the stability of the Indian currency market and the normalisation of administrative mess to match demand for and supply of new notes.

Nepal cannot do much directly, but that does not mean that the central bank and government should stay idle and wait for a response from their Indian counterparts. The amount of higher denomination Indian rupee in circulation in Nepal is far higher than the paltry IRs34 million said to be in the banking system. India will not be paying much attention to our troubles when its own administrative and banking capacities are deficient to deal effectively with the ensuing chaos.

Our government and the central bank cannot turn their back on the poor seasonal migrant workers, general public and traders, and point to the evolving perplexity in India. They need to work proactively to address the troubles faced by the public and small- and medium-scale traders. Furthermore, local economic activities need to be closely monitored, especially in areas with high seasonal migration to India.

Tuesday, October 18, 2016

NPC, MOF and the failure of planning in Nepal

It was published in The Kathmandu Post, 14 October 2016. 

Constraints on effective development planning are pretty much the same now as they were in the 1960s

The Ministry of Finance (MoF) and the National Planning Commission (NPC) are the two most important government agencies responsible for designing fiscal policy, which primarily consists of prioritising public expenditure and mobilising internal (tax and non-tax revenue) and external (grants and loans) resources. They also oversee formulation of laws and policies that have fiscal implications, prepare medium- and long-term development plans and advise the government on the optimal path to achieving political-economic priorities.

However, with their existing administrative structure, leadership style, and roles and responsibilities, these two crucial agencies are increasingly ineffective in fiscal management and economic planning. Ministers, secretaries and joint secretaries from other ministries regularly complain about the implementation hurdles in these bodies such as delays in budget approval, insufficient fund allocation, and a heavy-handed approach to the selection of sector-specific projects. This lack of effective inter- and intra-ministry coordination and haphazard project planning contribute to the low capital spending. Last year, for example, only 56 percent of planned spending was expended. The functional and administrative structure of the MoF and the NPC, which was created about six decades ago and marginally tweaked in successive years, cannot effectively respond to the fiscal management and economic development challenges the country faces now.

Recurring issues

Despite the socio-political changes over the decades, the constraints on effective development planning and its implementation are pretty much the same now as they were in the 1960s. In a 1972 paper titled ‘Why Planning Fails in Nepal?’ published in the journal Administrative Science Quarterly, Aaron Wildavsky (the then dean of the Graduate School of Public Policy, University of California at Berkeley) outlines the probable reasons: “insufficient information, few and poor project proposals, inability to program foreign aid, opposition of the finance ministry, and severely limited capacity to administer development.” The paper highlights the ritualistic meetings at the NPC and its lack of authority; inadequate attention to boost absorption capacity by determining targets and outlays; lack of competent and relevant officials at the helm of planning and budget execution; and the rise in recurrent expenditure due to shoddy capital spending.

Furthermore, other problematic issues outlined in the paper are the under-execution of capital budget; the cumbersome and obstructive processes at the MoF and the NPC to release funds for already approved projects; a tug-of-war between the NPC and the MoF in planning, financing and monitoring of projects; high staff turnover; low incentive to perform better; deficient technical education of divisional heads (joint secretaries) or project directors; and a culture of waiting for orders from above to skip decision-making on management and implementation issues by project directors. In essence, “economic development is only a sometime thing for them”, concludes Wildavsky.

These were some of the administrative and operational issues hindering planning and implementation back in 1972, when the economy was still closed to competition and trade. Fast forward to 2016 and these issues still remain the same despite the economy’s liberalisation, entry into the global and regional trade regimes, a devastating decade-long Maoist insurgency, and a sea of change on social, economic and political fronts. It, unfortunately, points to the fact that these two agencies have failed to evolve to confront the emerging economic and development challenges.

In every monthly or quarterly project portfolio meetings, these issues are discussed without much sense of responsibility. The ministries point fingers at the MoF and the NPC, and vice versa. At best, they end up forming a committee to study the constraints and recommend appropriate remedies. This drama of project planning, budget approval and implementation and formation of countless committees is repeated in every budget cycle.

The MoF officials act as if they are the ultimate authority to decide on project selection, planning and financing and, at times, even impose their will on the line ministries by controlling budget allocation and approval. Meanwhile, the NPC veering off its intended path is lost in the political and bureaucratic quagmire. It has become a toothless organisation with no tangible authority to make line ministries follow the path outlined in the medium- and long-term development plans. Its top leadership has remained unstable and busy in inaugurating insignificant workshops, attending futile overseas seminars and bickering with politicians over petty projects. The core functions of development planning and policy advising to the government are forgotten. Amidst this mess, the line ministries are seeking guidance on project preparation, planning, funding and implementation along with appropriate policies and laws.

Restructuring the two agencies

The corridors of the MoF and the NPC are most abuzz during budget preparation. But except for the fruitless yet ritualistic portfolio meetings, they remain largely silent during the phase of budget execution. Hollow steps are taken to deal with issues on project implementation by forming countless committees and subcommittees while, in reality, real progress is as elusive as it was six decades ago.

This has to change now. As a start, the functional and administrative restructuring of the MoF and the NPC should be initiated. The NPC should focus on designing and monitoring medium- to long-term development agenda with a time-bound action plan to be implemented by the line ministries, on assisting the line ministries in project readiness, including public private partnership projects, and on advising the government on fiscal and development issues. Additionally, given the shortage of investment-ready projects, the NPC should work with line ministries to come up with a project bank, which may include shovel-ready projects that could be taken up for implementation if funds are available.

Meanwhile, the MoF needs to focus on fiscal management—expenditure and debt management and resource mobilisation (revenue and foreign aid). It still lacks a centralised public debt management office, which could effectively shoulder the responsibility of managing domestic and foreign debt. Instead of micromanaging the line ministries’ projects, the MoF should focus on arranging and approving funds to the projects that need it the most. Furthermore, its Chief Economic Advisor’s office, Economic Policy Analysis Division, Revenue Management Division, and Budget and Programme Division need to be more agile and effective. They all should facilitate, not hinder, project implementation across all ministries.

Tuesday, September 27, 2016

Efficiency and integrity in public procurement in Nepal

This piece is adapted from the issue focus section of Macroeconomic Update Nepal, Vol.4, No.2, published by Asian Development Bank, Nepal Resident Mission.

I. Introduction

Many medium to large-scale development projects in Nepal are plagued by implementation delays and cost overruns. At the core of such recurrent hurdles is inefficient public procurement, contributed by a range of factors such as legal and policy complications, lack of required human resources to manage contracts, political intervention at management and operational levels, weak leadership by project directors and their high turnover, and prolonged delays by oversight and judicial agencies to clear contentious procurement. Consequently, project implementation is slow with cost and time overruns, quality of infrastructure construction is not up to the taxpayers’ expectation, and disbursement is slow and below target. These all result in low capital expenditure, insufficient jobs creation, and sluggish economic growth.

Efficiency and integrity in public procurement (of goods, works and services) enhance value for money and accelerate project implementation, which in turn stimulates private sector activities and innovations. Furthermore, if done in the right way and on time to maximize the value for taxpayers’ money, public procurement could be used as a strategic policy tool to address the myriad of economic, social and environmental challenges faced by the country.[1] Hence, efficiency and integrity in public procurement—equivalent to around 12% of GDP[2]— is vital to not only accelerate project implementation, but also to achieve medium-term goal of graduation from LDC category and long-term goal to be a middle income country by 2030, which also is the target date to achieve the Sustainable Development Goals (SGDs).

Public procurement is done when taxpayers’ money and/or grants and loans funded by development partners are used to finance public goods and services, including building of roads, airports, dry ports, hydroelectricity, irrigation canals, drinking water facilities, school and hospital buildings, and consultancy/advisory services. Unscrupulous procurement practices (resulting in wasteful capital spending in the last quarter of fiscal year) tends to increase recurrent spending in the next several years, since the sub-standard fixed assets need to be maintained more frequently. Furthermore, implementation delays unnecessarily prolong the project construction and completion, which ultimately is a drain of public funds. Hence, if done in the right way, efficient public procurement, which makes spending effective and has the potential to yield substantive savings (on whole-of-life cost basis),[3] contributes significantly to create the foundation for economic growth to take off on a high and sustainable path.

II. Key Highlights of the Amended PPA 2016

The recently amended Public Procurement Act (PPA) 2016, which has come about after prolonged revisions and delays, dictates public procurement in Nepal. In line with the amended PPA, procurement policy, operating guidelines and necessary administrative changes (including capacity enhancement) need to be rolled out to effectively implement it. The amended PPA includes procurement methods such as lump sum, catalogue shopping, limited tendering and buy back method (which is a new addition to the methods of procurement).

Preparation and approval of estimates: Cost estimate is not required, except works, for procurement up to NRs100,000. Regarding the approval of estimates, the officials involved in the design or estimation, checking or approval and the consultant involved, shall be responsible and subjected to legal action if the revised estimate is more than 25% of the initial estimate or due to defective design or abnormal estimation. In the previous version of the PPA, cost estimate was not required for procurement of up to NRs25,000.

Qualification of bidder or proposer: No qualification requirements is prescribed for the procurement of a construction work with cost estimate less than NRs 20 million  unless the procuring entity has decided that the work requires qualification criteria. In the previous version of the PPA, no qualification requirements were needed for the procurement of a construction work with cost estimate less than NRs 6 million.

Invitation to bid: A re-invitation with reduced submission period may be given if no bids/ proposals are submitted within the stipulated time or all the submitted bids/ proposals are non-responsive. The period shall be at least 15 days for national competitive  bidding and at least 21 days for international competitive bidding. However, in case no bids/ proposals are submitted during re-invitation period or all of the submitted bids/ proposals are non-responsive and there will be loss to the procuring entity (or some activity of the PE will be affected), then the procuring entity may re-invite the bid by giving at least seven day notice for national bidding. Else, it could procure following the methods specified under Section 8, with approval from one level higher authority. Furthermore, works within the prescribed estimate amount under national competitive bidding may be procured competitively only from domestic bidders. In the previous version of the PPA, in the case of procurement of construction work, preference was given according to the sub-section (1) of section 12 of the Construction Entrepreneur Act, 1958.

Withdrawal or modification of bid: A bidder has to make a sealed application 24 hours prior to the deadline for submission if it intends to modify or withdraw its bid unless the bid is submitted through electronic submission. In the previous version of the PPA, a bidder may, prior to expiry of the deadline for the submission of bids, make a sealed application for modification to or withdrawal of bid that a bidder has once submitted.

Acceptance of bid and procurement contract: A performance security of 5% is levied if the bid price is up to 15% below the estimate. An additional performance security equivalent to half the difference between the bid price and the amount that is 15% below the estimate is needed if the bid price is lower than 15% of the estimate.

Provision of advance: The procuring entity, after the agreement, may provide advance of up to 20% of the contract amount by getting a bank guarantee to the supplier, construction entrepreneur or service provider. Initially half of the advance is provided, and the other half is given based on the utilization of the initial advance. Moreover, except under the provision of Section 10(5), the payment for advance is made to a specially opened account for the contract. The contract may be terminated if the contractor misuses the advance payment.

Variation order: The variation of up to 5% may be done by gazette II class officer, up to 10% by Gazetted I class officer, up to 15% by department chief, between 15% and 25% by Secretary, and 25% and above by the Council of Ministers. However, for the procurement of amount less than NRs6 million, the department chief may approve the variation order in excess of 15%. In the previous version of the PPA, a variation order above  15%  was issued as per the decision by the Council of Ministers.

Price adjustment in procurement contract: Unless otherwise provided in the procurement contract, if price needs to be adjusted in the course of implementation of a procurement contract having duration exceeding 12 months, then the competent authority may adjust the price. In the previous version of the PPA, the duration period was 15 months. 

Mechanism for dispute settlement: Contract agreement will include provision of dispute settlement through prevailing law on arbitration if the dispute cannot be settled amicably.

Termination of contract and remedy: The procuring entity may terminate procurement contract if the supplier, consultant, service provider or construction entrepreneur does not perform as per contract, or its conduct is not as specified in section 62(2) or it misuses the advance payment. If the contract is terminated because the contractor did not start, abandoned or did not attain progress as per the agreement, the procuring entity may terminate the contract anytime. If the contract is terminated as per section 59(7), the full amount of performance security shall be forfeited. Any additional amount to complete the remaining work shall be recovered as amount due to the government. The remaining work after the termination of contract may be completed by inviting financial proposal from the remaining bidders selected under section 25 by giving 15 day notice. Meanwhile, the approval of one level higher authority is required prior to requesting for financial proposal as per section 59(9). In the previous version of the PPA, the procuring entity could terminate procurement contract if the supplier, consultant, service provider or construction entrepreneur did not perform as per the contract.

Blacklisting: If a bidder selected pursuant to section 27 or a consultant selected pursuant to section 38 does not come to sign the contract, then it may be blacklisted.

Hindrance of procurement process: The authority authorized to investigate is required to request any document from the procuring entity with due consideration to not hinder the procurement process as far as possible.

III. Implications for Public Procurement Management

The PPA has been amended after an iteration of discussion with a range of stakeholders. Overall, the added or amended provisions are in the right direction. For instance, the onus of timely and quality procurement is placed on the chief of the procuring entity (department, division or section of a project or program), including the completion of the task within the stipulated time. Additionally, in order to make procurement official more accountable, a provision on non-compliance is added. Specifically, the amended PPA has included a provision that  “Ensuring completion within the set time by conducting regular supervision, monitoring, and quality control measures to implement or to cause to implement the procurement agreement made under this act, will be the responsibility of the chief of the concerned public entity.” This opens up the possibility of prosecution of underperformers.

The other positive aspects of the amended PPA are that e-bidding is now explicitly mentioned and six additional direct procurement methods are added, facilitating the procurement by public enterprises. These include: (i) procurement of goods and services between two public entities; (ii) public entities/enterprises doing business by competing with private sector; (iii) procuring aviation, aircraft and associated equipment; (iv) procuring goods and services on rates fixed by international organizations; (v) procuring goods and services for organizing programs and promotional activities outside the country; and (vi) procuring goods and services by diplomatic mission.

Another important amendment is the provisions to facilitate fast decision-making on matters related to cost variation. For instance, department heads can approve variation of up to 15%, between 15% and 25% by the concerned Secretary, and on and above 25% by the Cabinet. Although an additional layer of committee is added in this process, the overall amendment will likely speed up review and approval of variation, which is one of the most contentious issues in public procurement and has been delaying project implementation. A related positive amendment concerns the shortening of price adjustment applicable for contracts exceeding 12 months instead of 15 months in the previous version of the PPA. This price adjustment is applicable to the contract procured under the multi-year contract that is tendered.

On the institutional side, regulatory function of PPMO has been strengthened to include additional functions to (i) issue necessary manuals; work procedures; and technical notes required for procurement methods such as turnkey, EPC, schedule rate contract, and management contracts, etc.; (ii) review and cause to review after procurement, (iii) develop roaster of contractors, consultants, suppliers, and  service providers regarding their procurement qualification and experience, (iv) issue electronic procurement guidelines, (v)  certify/ accredit procurement experts, and (vi) forward case to competent authority for necessary action if the procurement carried out by the public entity is found to be contradicting with the PPA, its rules, work procedure, or guidelines. PPMO has been entrusted sole responsibility to maintain a national e-GP system and the PPA has provisioned that the method of submitting the bids through e-bidding shall be in accordance with the procedure approved by PPMO. Public entity may adopt only electronic- procurement procedure partially or completely in public procurement. In other words, public entity, based on the capacity, may phase out the paper based submission to obtain full benefit of the e-GP system.

Furthermore, the amended PPA has explicitly mentioned that the procurement process will not apply to the following methods and a separate working procedure to procure goods, services and works may be issued: (i) design and build; (ii) turn key/EPC; (iii) design, build and operate; (iv) public private partnership/build operate and transfer; (v) framework agreement; (vi) cost replacement; (vii) management agreement; (viii) exchange; (ix) installments; (x) buy on lease; (xi) buying land properties; and (xii) operation and maintenance or management procurement based on performance. These are an improvement because the previous version of the PPA was silent on these methods and had created confusion especially on the procurement related issues for public private partnership projects.

Remaining Gaps. While these amendments are expected to make procurement timely and efficient, thus helping to accelerate project implementation, a number of shortcomings also appear in the amended PPA. These need to be gradually addressed over time as it may slowdown the speed of project implementation.

The additional penalty (forfeiture of bid security and other financial penalties to the bidder) imposed in case the contract is not signed is impractical as merely putting a stringent provision may not help to get a good contractor. There is a need for concurrently improving the quality of selection. Specifically, any deficiencies of the bids (such as serious errors in a price bid) that may oblige the bidder to withdraw later, need to be detected and such bid be duly rejected. Similarly, reduced rebidding time, in case the first round of bidding fails, does not necessarily provide fare treatment to new bidders or lead to the most efficient selection of a contractor.

The amended PPA also provided clearer provision of dealing with the low bids, by specifying the level of additional performance guarantees. While this can provide clarity to deal with such circumstances, the issue of low price bidding needs to be dealt with by strengthening the technical evaluation, thereby effectively rejecting the insufficiently experienced and skilled bidders, which is one of the causes of the low price bidding. On this account, within the context of PPR amendment, PPMO is considering the introduction of one-stage two envelope (1S2E) selection process, in which technical and financial evaluation is separately undertaken. Likewise, there is a need for strengthening the disciplines of contract management for higher compliance with cost, time, and quality in executing the works after contract signing.     

The earlier draft PPA had included a provision of additional advance without bank guarantee, which could be used for the additional deployment of construction materials and equipment. The provision was entirely removed from the final PPA. This could have provided a basis for meeting such requirements, with specification of how the paid amount was to be guaranteed (through material valuation or bank guarantee).

Furthermore, the increase in threshold of works contract/tender without requiring bidders’ qualifications up to NRs 20 million (current threshold is NRs 6 million) may foster malpractice in the construction industry. First, entry of insufficiently experienced and skilled contractors can undermine the timeliness, quality, and cost of the works. Second, contractors may prefer to register a new firm every time they bid for a new contract whenever the firm’s past performance record was poor. This has the potential to undermine capacity development of the construction industry. Third, the absence of qualification for such contracts may result in irregular practices with political pressures.  Such system may best be introduced after establishment of sound registration and performance recording system of the contractors.

The threshold applied to international bidders may violate WTO as well as procurement procedures of multilateral development banks (MDBs). Country system needs to be harmonized to MDBs procurement standard. This provision will restrict participation of international bidders in domestic market and may open up avenues for political pressure to frequently change the thresholds, which will lead to unpredictable procurement environment in the country.[4] Similarly, the provision to allow withdrawal of bid only before 24 hours of the deadline is impracticable. Bidders should be allowed to withdraw their bids at any point in time before the bid submission deadline.

IV. Way forward

Almost all of capital spending and some capital formation related components of recurrent spending (such as use of grant to local bodies to build local infrastructure, operation and maintenance, etc.) are subjected to public procurement in Nepal, which together amount to 12% of GDP. Efficiency and integrity in procurement for goods, services and works is vital to accelerate project implementation and enhance the quality of spending, which eventually leads to higher, sustainable and employment-centric inclusive economic growth. This in turn is essential to graduate from LDC category by 2022, and to become a middle income country by 2030 along with the achievement of the SDGs.

Public procurement is governed by the recently amended PPA 2016. While the amendments or addition of new provision are expected to lead to timely and efficient procurement, a number of shortcomings need to be gradually addressed over time. Additionally, timely implementation of the amended PPA by rolling out updated policy, regulations, operational guidelines and manuals, and institutional setup is equally important. For instance, fully rolling out e-bidding system is urgently required, given that the present system still requires that original bid security must be submitted on paper, which undermines the effectiveness of e-submission of bids.  This will help to make public procurement efficient, transparent and rules based. Similarly, the evaluation bids should be completed within the stipulated timeframe and payment of contract processed on time.

The government needs to ensure that transaction costs are not prohibitively high, which is a natural barrier for the participation of small and medium contractors, whose capacity needs to be enhanced. E-procurement, which creates a marketplace characterized by equal access and competition under a transparent framework, needs mainstreaming along with the capacity enhancement of implementing agencies, contractors, and other stakeholders. It lowers the likelihood of rent-seeking opportunities as it minimizes in-person contacts before bid submission and during bid evaluation. A rigged tendering process in the absence of e-procurement stifles competition, leading to lower quality of goods, works or services at higher cost.

The executing and implementing agencies need to boost their capacity on technical and administrative matters related to efficient procurement, including clarity about the scope and nature of work, contract management methodology, and the associated financial aspects of procurement design and processing. A lack of professionalism remains one of the major weaknesses. Public procurement is a specialized profession requiring effective integration of technical, financial, and legal requirements in its process of preparation, contractor selection, and execution. Competent human resources required for its efficient execution are critical. It essentially is a strategic policy lever/function of the government as opposed to mundane administrative service.

A careful procurement planning and effective performance monitoring yield value for taxpayers’ money used for public procurement. This is equally important throughout the procurement life cycle: preparation of bids, submission and evaluation of bids, awarding contracts and executing contracts with sound contract management, which is another critical subject for efficient execution of infrastructure investments in Nepal while duly controlling time, cost, and quality. (See Box 4.) Exception to the rule (bypassing the amended PPA) and breaching threshold procurement should be minimized in order to maximize the utility of taxpayer’s money and to leverage the bulk purchasing power of the government.
[1] OECD. 2016. Public Procurement for Sustainable and Inclusive Growth. Paris.
[2] Average of capital spending, grant/transfer to local bodies and use of goods and services over the last five years.
[3] It refers to (potential) cost savings throughout the lifetime of the projects despite the short-term cost being relatively higher. Exclusive focus on short-term savings, for instance awarding contract to those bidding under a reasonable cost estimate (in other words, below threshold procurement) and those with weak contract management, priority may lead to cost overruns and higher recurrent costs in the subsequent years. A combination of low cost and quality consideration in awarding contracts could result in long-term cost savings.
[4] For example, the proposed PPR amendment has provision that procurement of cost estimate from NRs 20 million ($200,000 equivalent) to NRs1 billion ($10 million equivalent), bidding may be among domestic contractors only.

Thursday, September 22, 2016

Economic and social risks from declining overseas migration & decelerating remittance inflows

It was published in The Kathmandu Post, 20 September 2016. Previous posts on remittances and migration here.

Nepal needs urgent reforms to deal with challenges stemming from a deceleration in remittance inflows

If there is one consistent narrative about Nepal over the last two decades, it must be about migration and remittances. Political and development activities in the country have always remained volatile. While political culture is punctured by intra- and inter-party fighting and external interference, economic development is beset by stalled projects and implementation complexities arising from sub-standard procurement and eroding bureaucratic capacity. However, migration and remittances have been notably resilient to internal and external shocks, providing a crucial support to the economy characterised by high unemployment and slow economic growth but a significant demand for imported goods and services.

Lately, this citadel of stability is starting to crumble following the persistently low fuel prices and sluggish economic growth in most developed and emerging economies. The economic stress, at least in terms of macroeconomic numbers, arising from the gloomy global outlook is gradually being felt in Nepal too. It could soon become a prime trigger factor for economic and social instability. The almost muted response from the politicians and the bureaucracy to this distressing development is mindboggling and irresponsible.

Multiple impacts

Although statistics show unemployment in Nepal to be lower than in most developed countries (for instance, the latest annual household survey puts it at 3.6 percent), it should be noted that this does not include ‘discouraged’ workers, who are not considered as a part of the labour force. Hence, the actual unemployment is substantially higher, with some agencies estimating it to be over 45 percent. Given the low economic growth and deindustrialisation, especially after the start of the Maoist rebellion, such a high level of unemployment is unsurprising. This is one of the reasons why until last year about 1,400 working age men and women legally left the country daily to work overseas, primarily in Saudi Arabia, Qatar and Malaysia, which together account for about 80 percent of total overseas migration.

Unfortunately, the global economic slowdown (which lowers external demand), low oil prices and the subsequent decline in investment, especially in natural resources, construction and security services, are weakening economic activities in these countries. It is having a direct impact on the Nepali economy through the lower demand for migrant workers and the deceleration in remittance inflows.

The overseas migration growth averaged 14.2 percent between fiscal years 2012 and 2014. It started to decline as low fuel and commodity prices affected investment and subsequently the demand for migrant workers from countries such as Nepal. Consequently, the number of migrant workers decreased by 2.8 percent in FY2015 and then by a further 18.4 percent in FY2016. (The April 2015 earthquake also contributed to the slowdown.) The figures translate into a daily average of 1,446 migrant workers in FY2014, 1,405 in FY2015 and 1,147 in FY2016—a clear downward trend. Migration to Malaysia declined by a whopping 70 percent as it put a moratorium on new hiring and opened up foreign employment in private security services—earlier restricted to Nepali and Malaysian nationals only—to other countries as well. Furthermore, its overall economic growth is affected by low fuel and commodity prices.

The declining demand for Nepali migrant workers will have a direct impact on remittance inflows, which will then affect household and macroeconomic activities. The growth of the remittance inflows has remained robust, averaging 25.3 percent over FY2012-FY2015. It remained resilient ($6.2 billion in FY2016) compared to other inflows such as foreign direct investment and official development assistance. However, a deceleration in remittance inflows is a very likely scenario given the drastic decrease in the number of migrant workers in the last three years.

Amounting to about 29 percent of gross domestic product (GDP), remittances have been a major factor supporting economic growth, poverty reduction and household expenditure, irrespective of the household’s domestic income. A decline in remittance inflows would lower the services sector growth, which primarily depends on remittance-financed consumption of imported goods. Since services sector constitutes over 50 percent of GDP, it will bring down overall economic growth as well. Furthermore, lower remittance inflows would likely lower government revenue, which is largely generated from taxes levied on remittance-financed consumption. Another significant impact will be on current account balance, which can easily go into the negative territory like in FY2010 and FY2011. It could then lead to a negative balance of payments and lower foreign exchange reserves. Given the pegged exchange rate with India, high dependence on remittance income and the composition of imports, Nepal needs to maintain reserves to finance at least seven months of import. In FY2011, when remittance growth declined but was not negative, reserves were enough to finance just 7.3 months of import.

The deceleration in remittance income triggered by the slowdown in migration will affect household consumption expenditure (and subsequently poverty), fiscal balance (as high consumption-based revenue growth tapers off), financial stability (as deposit growth slows down), and external sector (as current account and balance of payments fall into the negative territory).

Economic and social blowback

Robust remittance inflows fostered laxity in reducing policy weaknesses and in facilitating sound investment climate as politicians and bureaucracy had to do little work to generate moderate growth of below 5 percent and to reduce poverty. This needs to change now given the deceleration in remittance inflows and the slowdown in the demand for Nepali migrant workers. Medium- and long-term reforms have to be rolled out and implemented to boost investment, lower inflation, and create appropriate investment instruments that can channel the short-term remittance deposits into long-term infrastructure financing. Meanwhile, faster post-earthquake reconstruction works could help create a modest number of unskilled and semi-skilled jobs, which match the employment needs of would-be migrants.

These reform measures could not only address the immediate economic challenges arising from the deceleration in remittance inflows, but also tackle the Dutch disease effects (which broadly refers to the decline in tradable sector, chiefly manufacturing, and an appreciation of real effective exchange rate) seen in the economy since 2000. The primary focus should be on the active facilitation of investment and on transforming from the current low value-added, low productivity activities to high value-added and high productivity activities.

Further delays in addressing these issues would make it difficult for the country to fend off the economic and social blowback arising from the slowdown in overseas migration and the deceleration in remittance inflows.