Tuesday, August 11, 2015

India’s (and Nepal’s) problem with manufacturing sector

The problem with India’s (can relate to Nepal’s as well) manufacturing sector explained by The Economist:

  1. India opened up product market to competition (including imports), but left its factor market (land, labor and capital) unreformed.
  2. Companies needed to ensure economies of scale in production to effectively compete in the global market. But, high cost of capital, inflation and inefficient court clearance (of recovery of bad loans) led to high production costs.
  3. Complex laws make it difficult to acquire farmland for industry or infrastructure.
  4. Dated labor laws burden businesses with cumbersome (disincentivizing) regulations and processes. Hiring is easy, but firing is very difficult (even when the company’s revenue/profit dips south). Unruly trade unionism is a major concern.
  5. Hence, most firms and economic activities are capital-light (IT services, services sector, etc).

With the ‘Make in India’ initiative, one of the signature campaigns of PM Modi, some positive signs are emerging: Mahindra Aerospace, Foxconn, Micromax, Ford, BMW, Mercedes, etc are opening new factories.

For Nepal, it has been disappointing ride all along as investment and share of manufacturing in GDP are both shrinking (the above reasons apply, plus lack of adequate supply of electricity, lack of skilled workforce, and political instability).

Tuesday, July 28, 2015

Major highlights of Nepal’s FY2016 monetary policy

Dr. Chiranjivi Nepal, Governor of Nepal Rastra Bank (the central bank), presented monetary policy for FY2016, the first under his governorship, last week. It was also the first one after the catastrophic 7.8 magnitude earthquake on 25 April. It followed the FY2016 budget introduced by Dr. Ram Sharan Mahat.

The monetary policy aims to help achieve the GDP growth and inflation targets, and to maintain balance of payments stability. It also aims to maintain overall financial sector stability, manage excess liquidity, channel credit to productive sectors, and make access to finance more inclusive, including subsidized housing credit to households who lost houses due to the earthquake.

The table below summarizes the major indicators and targets of monetary policy for FY2016.

Monetary Policy
Indicators FY2012 FY2013 FY2014 FY2015R FY2016E
GDP growth (%) 4.5 3.6 5.1 3.0 6.0
Inflation (%) 8.3 9.9 9.0 7.5 8.5
Imports of goods and nonfactor services (months) 9.4 9.3 10.5 11.3 8.0
M2 growth (%) 22.7 16.4 19.0 16.0 18.0
Total credit growth (%) 13.2 17.2 12.7 18.7 23.4
Growth of credit to government  -0.3 3 -16.4 -22 68.5
Growth of credit to private sector 11.6 20.2 7.3 18.0 20
Cash Reserve Ratio (%)
Commercial banks 5.0 5.9 5.0 6.0 6.0
Development banks 5.0 5.5 4.5 5.0 5.0
Finance companies 5.0 5.0 4.0 4.0 4.0
Bank rate (%) 7.0 8.0 8.0 8.0 7.0
Productive sector mandatory lending (% of total loans)
Commercial banks 20.0 20.0 20.0
Agriculture and energy 10.0 12.0 12.0 12.0
Development banks 15.0 15.0
Finance companies 10.0 10.0
Refinancing rates (%)
Agriculture, hydro, poultry, livestock, fishery 6.0 5.0 4.0 4.0
re-lending max 9.0 9.0 9.0 9.0
Sick industries 1.5 1.5 1.0 1.0 1.0
re-lending max 4.5 4.5 4.5 4.5 4.5

Earthquake-related provisions:

  • Zero percent refinancing facility for BFIs willing to provide loans at 2% interest to those households affected by the earthquake, provided that such households meet the requirements set by the government. Accordingly, households within and outside Kathmandu Valley can access the subsidized loans of up to NRs2.5 million and NRs1.5 million, respectively.
  • The NRB will help assist in the establishment of an Economic Rehabilitation Fund, which will provide refinancing facility and interest subsidy to the business community affected by the earthquake.

One of the main features of this monetary policy is the mandatory provision to increase paid-capital by FY2017. Specifically, the policy mandates commercial banks to increase their paid-up capital four-fold to $80 million by end-FY2017. Similarly, national level development banks will have to increase their paid-up capital by nearly three-fold to $25 million. For other development banks and finance companies, the mandatory increase in paid-up capital is as per their operational coverage in the country, but is still substantial.

Interestingly, it also mentions the review of the moratorium on the establishment of new banks and financial institutions. The first provision would in a way compel the BFIs to merge to meet the paid-up capital requirement. The second provision opens up the possibility to increase the number of BFIs.

The economy is still not ready to add new BFIs as too many of them vied for the small base of customers earlier, resulting in unhealthy competition and the banking crisis in FY2011. Consolidation of BFIs should still be one of the main agendas. If the intention of the review of the moratorium is to increase access to finance, then there are other ways to achieve the same objective (e.g, making it easy for existing BFIs to operate in the unbanked areas, credit through microfinance/microcredit institutions, etc). Also, monetary policy cannot alone correct the anomalies arising from persistent supply-side constraints and seemingly unfavorable investment climate.

Friday, July 17, 2015

Nepal’s budget after the earthquake and its effective implementation

Finance Minister Dr. Ram Sharan Mahat presented budget for FY2016 (ends 15 July 2016) to the Constituent Assembly on 14 July. This is the first budget after the catastrophic 7.8 magnitude earthquake on 25 April and the subsequent aftershocks, and the reconstruction conference on 25 June.

The budget was highly anticipated by the public because it was supposed supposed to focus squarely on rehabilitation and reconstruction. And it did meet that expectation in terms of numbers and direction of spending allocation. However, it fell short of outlining an implementation arrangement to accelerate capital spending, of which almost half would be set aside for reconstruction over the next five years.

First, the budget outlay:  

The total expenditure outlay for FY2016 is NRs819 billion (an estimated 33.8% of GDP), which is 56.7% higher than the revised total expenditure in FY2015. The FY2016 outlay comprises NRs484 billion for recurrent expenditures (59.1% of the total outlay), NRs208.9 billion for capital expenditures (25.5%), and NRs126.3 billion for financial provision (15.4%).

The substantially larger size of the budget is due the 141% increase in planned capital spending (compared to the FY2015 revised estimate), which will primarily be used for post-earthquake reconstruction of physical and social infrastructure.

The outlay for recurrent expenditure (equivalent to 20.0% of GDP) is 42.8% higher than the revised estimated expenditure in FY2015. The planned capital spending has been increased by a whopping 141.2% over the FY2015 revised estimate (equivalent to 8.6% of GDP compared with 4.1% of GDP in FY2015). About NRs91 billion is set aside for reconstruction activities.

FY2016 budget overview
GDP growth target (%) 6  
Inflation target (%) ---  
Budget allocation for FY2016 FY2016BE  
Rs billion %
Budget allocation 819.0 100
Recurrent  484.3 59.1
Capital 208.9 25.5
Financial provision 126.3 15.4
Projected total revenue 587.9 100
Revenue 475.0 80.8
Foreign grants 110.9 18.9
Principal repayment 2.0 0.3
Projected budget surplus (+)/deficit (-) -231.1
Projected deficit financing 231.5 100
Foreign loans 95.0 41.0
Domestic borrowing 88.0 38.0
FY2014 cash balance 48.6 21.0

Second, revenue mobilization:

A total revenue target of NRs587.9 billion (24.3% of GDP) has been set for FY2016, including projected foreign grants of NRs110.9 billion (4.6% of GDP) and principal repayment of NRs2.0 billion. The revised estimate for revenue mobilization (including grants) in FY2015 was 20.3% of GDP.

This government has increased the business transaction threshold for value added tax (VAT) to NRs5 million from NRs2 million and has also given tax concessions on import of construction materials (zinc sheet and pre-fabricated home), and agricultural machinery. The rates of excise duty on cigarette, beer and alcohol, and vehicle tax have been revised upward. Besides these, there isn’t significant change in revenue policy.

Third, deficit financing:

The budget deficit is to be financed by foreign loans amounting to NRs95.0 billion, domestic borrowing of NRs88.0 billion, and FY2015 cash balance of NRs48.6 billion.

Net foreign loans and net domestic borrowings are projected to be 3.0% and 1.9% of GDP, respectively

Overall, fiscal deficit (expenditure including net lending – revenue including grants and carry over) is projected to be about 5.0% of GDP. Large internal borrowing could exert upward pressure on interest rate.

Fourth, the focus on reconstruction:

The budget aims to complete all reconstruction work within the next five years. A total of NRs91 billion ($910 million) has been earmarked for reconstruction work, including $740 million for National Reconstruction Fund, which will initially prioritize reconstruction of housing, public buildings, archeological structures, physical infrastructure and enhancement of productive capacity. About $170 million is earmarked for sector ministries and agencies to carry out reconstruction works till the reconstruction authority is operational.

Fifth, where is the recurrent budget going?

Almost 43% of planned recurrent expenditure of NRs484.3 billion is going to local bodies as grants (or transfers) to enable them to launch local level development works on their own. The other big ticket item is compensation of employees, which takes up about 22% of total recurrent budget. These amount to an estimated 8.5% and 4.3% of GDP respectively.

Sixth, where is the capital budget going?

Almost 65% of the planned capital budget of NRs208.9 billion) is going for civil works— a 113.5% increase over FY2015’s revised estimate. About 18% is allocated for building work— a 286.8% increase over FY2015’s revised estimate. These amount to an estimated 5.6% and 1.5% of GDP, respectively.

Seventh, the two main takeaways from FY2016 budget are:

  1. The drastic increase in capital budget for reconstruction is in the right direction.
  2. Unfortunately, the expectation of a robust, credible and a time-bound implementation plan to spend the allocated money is missing. This is disappointing because the next three priorities should have been implementation, implementation and implementation. This issue should have been kept above mundane political tussle.

Related to #2 is #1 as the inability of the government to spend the money on time and higher revenues will eventually likely lower the projected fiscal deficit to about 2-3% of GDP (as has been happening in the past). So, the perceived large increase in fiscal deficit in FY2016 (it was just 1.3% of GDP in FY2015 and fiscal surplus in FY2013 and FY2014) may not be realized and would likely end up with a lower deficit. This should be manageable for now.

Before going into more detail on that, lets give credit where its due. FY2016 is touted as ‘Budget Implementation Year’. Accordingly, line ministries administering large projects now have the authority to spend the allocated budget without getting prior approval from National Planning Commission and Ministry of Finance. Furthermore, project directors, account chiefs and key staff won’t be transferred until the project period if they achieve more than 80% of the targeted spending. Also, progress against the target will see their budget surrendered to MOF for reallocation to performing projects. Now, these partly address four issues related to weak budget execution: delays in approval after introducing the budget, high staff turnover, delays in awarding contract, and inadequate allocation for performing projects.

Now, the main point: the above four measures address only a part of the problem related to persistently weak budget execution. The capital budget absorption rate averaged just 72% in the last ten years. It was 74.2% in FY2015. The gap between actual and planned capital budget is persistent. Capital budget was just 4.1% of GDP in FY2015 against a target of 5.5% of GDP. Higher quantum and quality of capital spending (productivity-enhancing) is needed for an high and inclusive growth. Furthermore, when private sector investment is suppressed, public investment plays a crucial role in stimulating aggregate demand quickly, accelerating recovery and establishing more sustainable growth patterns, encouraging technological innovation, and spurring private sector investment by increasing returns.

However, this is not the case as there are many pending issues that need to be resolved before capital budget is fully spent. Some of these include following:

  1. Bureaucratic hassles
    • Project approval hassles
      • The budget addresses delays caused at NPC and MOF. Now, the secretaries at sector ministries need to give faster spending authority to local level bodies within their jurisdiction.
    • Weak inter and intra ministry coordination
  2. Structural issues
    • Limited capacity of sector ministries (planning & implementation)
    • Lack of strong pipeline of projects ready for implementation
    • Legislation hurdles (procurement & maze of processes dictated by various Acts and policies)
  3. Low project readiness/allocative inefficiency
    • Lack of ready detailed design
      • Important for building a strong pipeline of key national infrastructure projects (sort of a Project Bank)
    • Hassles in land acquisition
    • Frequent staff turnover
      • The budget addresses part of this problem by anchoring performance to time-bound spending target
    • Lack of feasible procurement plans
    • Weak capacity of contractors
    • Weak contract management
    • Efficiency of budget approval and execution processes

Now, despite these long-running issues, why were most folks expecting accelerated capital sending going forward? Well, the reason was the decision to establish National Reconstruction Authority by giving it sweeping powers to do away with the above hassles in one go. On this regard, the lack of a clear institutional set up, competent human resources and a time-bound action plan missing in the budget is a disappointment.

About $740 million is deposited in the National Reconstruction Fund, which will be used when the authority comes up in shape. About $170 million is allocated to sector ministries to initiate reconstruction work as an interim arrangement. Here lies the challenge. The sector ministries won’t be able to get past the maze of issues raised above in a short period of time as they themselves are not able to spend even the regular capital budget allocated to them. The same process, mindset and governing laws and policies won’t cut it in terms of accelerated capital spending.

The delayed implementation will also mean lower foreign aid as disbursement will be lower. The total foreign aid (grant and loan) expected in FY2016 is $2.059 billion (8.5% of GDP). It was just $632 million (3% of GDP) in FY2015. Most of the foreign aid committed for reconstruction are included in the National Reconstruction Fund heading in the Red Book. It means that unless the authority is up and running, the money from the fund may not be utilized as expected.

Had the authority been given full shape right now, then it would have been able to take fast-track decision on most of the issues raised above and handover shovel-ready projects to sector ministries for implementation. Unfortunately, this is missing and hence reconstruction will be delayed, hitting the expected growth target of 6% and dampening the affected people’s hope of an early recovery of livelihood and restoration of basic infrastructure and public services.

  NRs billion Share of GDP
FY2015 budget details FY2015RE FY2016BE FY2015RE FY2016BE
GDP growth target (%) 3 6    
Inflation target (%) below 8% --    
Details of Income and Expenditure
Projected total expenditure 425.8 693.1 20.0 28.6
Recurrent  339.2 484.3 16.0 20.0
Capital 86.6 208.9 4.1 8.6
Projected total revenue 431.2 585.9 20.3 24.2
Revenue 393.5 475.0 18.5 19.6
Tax revenue 353.5 427.0 16.6 17.6
Foreign grants 37.7 110.9 1.8 4.6
Projected surplus (-)/deficit (+) -5.5 107.2 -0.26 4.4
Projected financing 27.5 -58.4 1.3 -2.4
Net loan investment 20.2 48.9 1.0 2.0
Net share investment 10.2 11.9 0.5 0.5
Net foreign loans -8.0 -72.6 -0.4 -3.0
Net domestic borrowing 5.0 -46.7 0.2 -1.9
Projected overall surplus (-)/deficit(+) 22.0 48.8 1.0 2.0

Saturday, July 4, 2015

Nepal earthquake: Economic and poverty impact, PDNA, reconstruction conference, and way forward

Two months has passed since the catastrophic 7.8 magnitude earthquake struck Nepal on 25 April 2015. More than 338 aftershocks of over 4 magnitude (including 6.7 magnitude on 26 April and 7.3 magnitude on 12 May) were recorded by the National Seismological Center (as of 1 July).

The earthquake and subsequent aftershocks severely hit the upper and middle belt of central and western administrative regions. 31 of the 75 districts were affected and 14 of these were declared ‘crisis-hit’ to prioritize rescue and relief operations. About 8,500 people are dead, 22,307 injured and over a half a million houses fully damaged. In addition, public infrastructure and services are either destroyed or disrupted.

Impact on GDP growth

According to the preliminary estimates published on 8 June by Central Bureau of Statistics, the earthquake lowered GDP growth by over 1.5 percentage points from an estimate of 4.6% in a no-earthquake scenario in FY2015 (ends 15 July 2015). This new estimate is in line with the lower growth forecast mentioned on 22 May blog post.

Figure 1: GDP growth (basic prices), %

Source: Central Bureau of Statistics

Although the earthquake struck Nepal in the tenth month of FY2015, the impact on GDP growth seems to be sizable especially on the services sector, which is expected to grow by 3.9% compared to 6% in a no-earthquake scenario. Wholesale and retail trade; tourism activities (affects air transport, and hotel and restaurant businesses); real estate, renting and business activities; and education sub-sectors are the most affected.

Agriculture sector is expected to grow by 1.9% and industry by 2.7%, down from earlier no-earthquake scenario forecast of 3% and 3.5%, respectively. The sharp drop in agricultural output is primarily due to the negative impact of delayed and weak monsoon in the first half of FY2015, and later the loss of livestock due to the earthquake.

The slowdown in industry sector is due to the drastic drop in quarrying (stones, aggregates, sand and soil extraction slowing down in affected districts, and the moratorium on construction activities till mid-July 2015); manufacturing (physical damage, labor shortage and weak demand); and construction (policy to temporarily halt construction activities, and low production of construction materials, among others).

Figure 2: Gross value added loss in FY2015 ($ million)

Source: Central Bureau of Statistics

Nepal’s GDP is estimated to be $21.6 billion in FY2015 ($371 million less than what would have been in a no-earthquake scenario). The loss amounts to 1.5% of GDP. About 62% of the total gross value added (GVA) loss is accounted for by the services sector.

Impact on per capita income

Per capita GDP is estimated to decrease by $23 compared to the no-earthquake scenario (in which case per capita income would have been $785). Real per capita GDP increased by just 0.6% against 3.6% in a no-earthquake scenario.

Figure 3: Nominal per capita GDP (US$)

Source: Central Bureau of Statistics

Impact on poverty

Preliminary estimates show that the income shock as a result of the earthquake will likely push 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%. About 50%-70% will come from rural Central hills and mountains, where the vulnerability prior to the earthquake was already high. The income shock is largely felt though the loss of income-generating opportunities/livelihoods (including death and injuries to primary wage earners) and the loss of housing, productive assets (seeds, livestock, and farm equipment), and durable assets (assorted household items).

Beyond this monetary-based poverty estimate, a larger impact can be expected when factoring in multidimensional poverty, which includes additional factors such as water and sanitation services, disruption of schools and health services and the possibility of an uptick in food insecurity. The poor and vulnerable are particularly dependent on local infrastructure (roads, bridges, health posts, and schools) for access to labor and commodity markets, and for accumulation of human capital (especially those of children). Reviving local economic activities and resumption of basic public services along with an accelerated implementation of reconstruction projects will be critical to make up for the set back on poverty reduction caused by the earthquake.

Post-disaster needs assessment (PDNA)

The total economic cost of losses and for recovery will be much higher than the loss of flow of economic activities in FY2015. According to PDNA estimates, the cumulative damage and loss amounts to 33.3% of GDP ($7.1 billion) and the cumulative need for recovery is estimated at $6.7 billion (31.5% of GDP).

Table 1: Damages, losses and needs ($ billion)

PDNA (US$ billion)
Sector Themes Included sectors Damage Loss  Total needs
Social Cultural Heritage, Education, Health and Population, Housing and Human Settlements 3.5 0.5 4.0
Productive Agriculture, Financial Sector, Industry and Commerce, Irrigation, Tourism 0.6 1.2 1.2
Infrastructure Communications, Community Infrastructure, Electricity, Transport, Water and Sanitation 0.5 0.1 0.7
Cross-Cutting Gender, Social Protection, Nutrition, Employment & Livelihoods, Disaster Risk Reduction, Environment and Forestry, Governance 0.5 0.3 0.8
Total   5.1 2.1 6.7

Source: PDNA Secretariat, National Planning Commission

Of the total estimated need for recovery, about 50% is accounted for by private housing and settlement. Productive and infrastructure clusters account for 17.3% and 11.1%, respectively, of the total estimated need for recovery. It amounts to about 5.5% and 3.5% of GDP, respectively. The recovery need requirement for agriculture, education, electricity, and transport is estimated at $156 million, $397 million, $186 million, and $282 million, respectively. Furthermore, recovery of tourism sector and restoration of cultural heritage are estimated to require $387 million and $206 million, respectively.

Reconstruction conference

On 25 June, the government organized an international conference on Nepal’s reconstruction (ICNR). High level representatives from over 50 countries and multilateral agencies participated in the conference.

ADB, represented by its president, Takehiko Nakao, pledged $600 million—including $200 million emergency assistance approved by its Board of Directors on 24 June—to cover a part of the need to rebuild school buildings, roads and public buildings.

The government estimated that the total pledging was to the tune of $4.4 billion (equally spilt in grants and concessional loans). India and Peoples’ Republic of China committed $1 billion and $483 million, respectively. World Bank, Japan, the US and the EU pledged $500 million, $260 million, $130 million, and $112 million, respectively.

According PDNA, total public sector losses and damages amount to $1.7 billion, which excludes housing. The National Planning Commission estimated that about 57% of the recovery needs ($3.8 billion), including housing, will have to be shoulder by the government. In this respect, the total pledged amount is higher than the public sector recovery needs till the medium-term. However, a much higher amount of investment may be needed in the long-term to build better and earthquake-resilient public infrastructure throughout the country.

Figure 4: Aid pledged at ICNR ($ million)

Source: Authors’ compilation

Way forward

The way forward will not be easy given the huge challenges. ADB has indicated five principles of effective reconstruction: (i) building back better; (ii) inclusiveness; (iii) robust institutional set up for reconstruction; (iv) sound governance and fiduciary risk management; and (v) effective donor coordination and government ownership.

As part of that, some of the important tasks are:

  • Operationalize the National Reconstruction Authority and fill key posts with competent professionals.
  • Ensure the pledged aid is fully spent. For this, the government needs to come up with viable project proposals and address concerns related to the budget execution capacity and governance structure of the proposed authority.
  • Ensure swift and effective decision making on the reconstruction program, especially on planning, budget allocation and execution, supervision, monitoring and evaluation. Outsourcing design, supervision and management of reconstruction projects may be needed if government capacity is limited.
  • Prepare a time-bound project implementation plan with broad political ownership.
  • Continue reforms to increase private sector investment, especially with an aim to initiate some of the reconstruction projects on a public private partnership (PPP) basis. This will require the government to pass the nearly finalized PPP Policy and speedily enact Nepal’s PPP Act. Other policies and acts prepared or updated with the aim to develop the private sector and increase their investment also need to be passed or enacted in an expeditious manner.
  • Link the reconstruction activities with the development of a long-term economic development vision, which includes increasing per capita income to the level of a middle-income country by 2030. It is especially important because the PDNA did not include earthquake-resilient reconstruction throughout the country. The cost of rebuilding houses beyond the set size, retrofitting standing buildings in Kathmandu Valley and affected districts, and nationwide resilience (such as ensuring housing and school safety across the country) need to be kept in mind while planning and initiating rehabilitation and reconstruction projects.
  • Rehabilitation and reconstruction should primarily aim at increasing productivity-enhancing public capital investment. This is key to ensuring a structural transformation with high value-added and high-productivity sectors more dominant than low value-added and low-productivity sectors in the medium term. Promoting agribusiness, industrial capacity, innovation and high-productivity services need to be at the center of such a structural transformation strategy.

This blog post is in line with this and this blog posts on Asian Development Blog.

Friday, June 26, 2015

Initial views on reconstruction conference and governance of aid

Speaking live on Channel News Asia, 25 June 2015. Here is an earlier news on the same topic. A detailed blog on this topic over the weekend.


For those interested here are related news stories, where I have been quoted: