Tuesday, July 26, 2016

Macroeconomic essentials for Nepal Vision 2030

This article is adapted from Nepal Economic Forum's 25th issue of Nefport.


Although a bit late, the government is finally gearing up to formulate a long-term vision for economic development. The tentative targets for now are to graduate from the Least Developed Country (LDC) status by 2022 and to attain the slew of Sustainable Development Goals by 2030. However, a bold and time-bound economic development vision for the country should go beyond these goalposts that were contextualized on the basis of global targets. Nepal should aim to become a vibrant lower-middle income economy within the next two decades.

At the core, it essentially means increasing gross national income (GNI) per capita (World Bank’s Atlas method) from existing USD 730 to about USD 4,125 (the threshold between lower-middle income and upper-middle income economy). In order to achieve such a goal, it is essential that the government draw up a list of strategic flagship projects in physical and social infrastructure sectors and execute them with an efficient and workable implementation arrangement that is in sharp departure from the current discouraging project implementation ecosystem.

Given an appropriate mix of macroeconomic strategy, financial arrangement, smart project execution and supportive institutions, a meaningful structural transformation is possible and the stated goals are achievable. This piece focuses on the macroeconomic aspect of marching on that path.

Macroeconomic essentials

A large amount of public and private investment is required to increase income per capita by almost six folds within two decades. The scale and scope of public investment would depend on revenue mobilization, rationalization of ballooning recurrent spending, and foreign aid. Meanwhile, private investment would depend on investor-friendly environment, including protection of investment and returns, supportive laws and policies, mechanisms for sharing of risk, returns and technology (such as public private partnerships), and maturity of the financial market, among others.

Overall, sound macroeconomic environment will be at the heart of financing for such large scale public and private investment. At around 21% of GDP, the gross fixed investment is lower than the average for low income countries. This needs to be over 30% of GDP to accelerate growth rate (beyond the contribution by exogenous factors such as monsoon and remittances), which will then boost income per capita, and employment generation, primarily through investment in productivity-enhancing physical and social infrastructure. Specifically, public fixed capital investment has to increase to about 10% of GDP over the next decade from the existing 4.5% of GDP.

On the financing part, a combination of rationalization of recurrent expenditure, higher domestic revenue, domestic borrowing, and higher grants as well as concessional and non-concessional loans are needed. At the current level and growth of recurrent expenditure, it will be challenging to cover it sustainably by tax revenue, whose growth rate has stagnated at around 15%. Hence, trimming wasteful recurrent spending in uncoordinated programs and projects should be a priority as a part of sound fiscal management to attain the long-term vision. Second, along with efforts to expand the tax base, the revenue administration will have to be made more efficient and responsive. The present revenue system is too dependent on taxes on remittance-financed imported goods and services. Third, domestic borrowing has to be managed judiciously keeping in mind the optimum market liquidity. Finally, foreign assistance needs to be better utilized by enhancing expenditure absorption capacity. These will partly cover the required resources for public sector investment.

Additionally, fiscal and monetary policies need to be synchronized to tame inflation so that it is not persistently and prohibitively high to discourage investment. At present, inflation is mostly a supply-side phenomenon although localized sectoral inflation (such as unnatural escalation of real estate and housing prices few years back) is mostly within the ambit of monetary authorities. More generally, monetary policy can support the vision by creating appropriate incentives to channel savings into infrastructure investment that typically pay-off in the long-term. Finally, external sector stability should not be much of an issue as long as the economy is gradually diversified and production is competitive in addition to a net positive transfers and sizable foreign exchange reserves. 

Supportive environment

An investment-friendly environment is essential to increase domestic as well as foreign investment. While a slew of laws need updating, policies need rewriting to facilitate and simplify investment rules and approvals. In the meantime, drastic enhancement of capital spending absorption capacity is required to increase public spending in infrastructure, a lack of which is the most binding constraint to inclusive economic growth. Supportive institutions that can foster creative creation and creative destruction need to be promoted as opposed to the protection of business interests through syndicates and cartels. This is crucial for entrepreneurial spirit and to incentivize saving, investment and innovation. Inclusive political and economic institutions are vital to sustaining an equitable and rising income per capita. It is also important to change the course of out-migration for jobs and improved opportunities, and to enhance external sector competitiveness.

Structural transformation

A meaningful structural transformation underpins the pace and pattern of economic growth. Along with the decline of the agricultural sector, Nepal is seeing the rise of low value added, low productivity services sector activities. This structural shift is bypassing industrial sector growth (a sort of deindustrialization), which is vital for productive employment, sustained rise in income per capita, and high growth rate initially. Reversing this trend and revitalization of industrial sector along with promotion of high value added agriculture and services sector activities, with an employment centric strategy to absorb the surplus labor, should form the core of the structural transformation process, which will then lead to higher and inclusive economic growth.

With the right mix of reforms and policies, supportive institutions, enhancement of absorption capacity, and a sound macroeconomic environment to support such structural transformation, the likelihood of attaining the long-term vision is high.

Thursday, July 21, 2016

How to finance large-scale infrastructure in Nepal?

It was published in The Kathmandu Post, 19 July 2016. An earlier blog post on the same issue is here.

Financing infrastructure


Prime Minister KP Oli led government surprised everyone few weeks ago by proposing to initiate key large-scale infrastructure projects, including the much-touted fast track road and Budigandaki hydroelectricity projects, using domestic resources. The intention was to stoke a renewed sense of nationalism high on rhetoric but low in substance, and to extricate the government from binding hooks that come with bilateral financing of such projects. One unruly leftist party even fervently argued for financing all hydropower projects with domestic resources and floated a premature idea to raise money from local shareholders. 

Some politically aligned experts are throwing their weight behind such half-baked proposal without properly analyzing the available financial and knowledge capacities. As it stand now, the economy simply does not have the required financial capacities, stock of knowledge and management capabilities, and competent institutions to initiate large-scale projects entirely on domestic resources. Acquiring such capability requires close collaboration on financing, research and management between external and domestic sources. 

Unfavorable macro

Politicians and their intellectual cheerleaders quickly point to low public debt (in other words fiscal space) to finance large-scale infrastructure projects such as hydroelectricity, roads and airports domestically. The outstanding public debt has decreased sharply from about 52 percent of gross domestic product (GDP) in 2005 to around 25.7 percent of GDP. It means Nepal could theoretically borrow more without jeopardizing fiscal stability (say up to 40 percent of GDP). However, borrowing an additional $3.5 billion or more from domestic and external sources requires the government to drastically enhance its absorption capacity, which unfortunately is eroding.

The outstanding domestic borrowing by selling government bills and bonds amounts to 9.5 percent of GDP and external borrowing, mostly on concessional terms, 16.2 percent of GDP. The government is predominantly selling treasury bills (with maturity of less than one year) to finance recurrent spending as well as multi-year infrastructure projects, and implicitly to manage excess liquidity. This is not a good fiscal practice as large-scale infrastructure projects are financed typically by issuing specific construction bonds, which have long-term maturity and lower risk of asset-liability mismatch. Higher domestic borrowing to fulfill politicians’ whims will crowd out private investment by pushing up interest rates and put unnecessary debt burden on future generation. The FY2017 budget falls in this category.

The use of excess liquidity and treasury savings are identified as alternative sources that could be tapped in to finance infrastructure projects. The persistent excess liquidity is the result of higher growth of deposit compared to the growth of credit. It arises when there is lack of investment-ready projects and unfavorable investment climate, thus constraining banks and financial institutions’ (BFI) capacity to increase credit. Meanwhile, the large growth of deposit is due to the increasing remittance inflows and the government’s inability to spend allocated capital budget on time. While the former is starting to slowdown as the demand for the migrant workers is decreasing, the latter is expected to improve due to relatively better budget execution from this year onward. Transient and volatile excess liquidity and treasury savings cannot be reliable sources for long-term infrastructure financing.

Another related argument on the adequacy of domestic resources is the potential to pool in savings. This argument has its roots in the remittance-backed large deposit growth and oversubscription of shares in the stock market. First, the remittance-backed savings are of short term in nature and using them to invest in projects with long gestation lags create asset-liability mismatch for the BFIs. This is one of the reasons why the BFIs as well as pension funds are financing medium to long term projects through a consortium, which minimizes risk arising from overexpose to one sector. Second, the oversubscription during share issuance is essentially to reap quick profits by trading the shares in the secondary market. This quest for short-term gain does not indicate that there is excess long term saving that could be used for multi-year large-scale infrastructure projects. Nepal’s financial system is not yet mature enough for that.

Regarding external financing, the government won’t be able to drastically increase borrowing because it directly depends on absorption capacity, which stands at a mere 75 percent of budgeted capital spending. Frustration is already running high among Nepal’s key multilateral and bilateral donors owing to the government’s inability to timely use the committed grants and loans. Furthermore, concessional lending from multilateral donors might be drying up. The Asian Development Bank and the World Bank are gradually phasing out concessional lending, which means Nepal might have to borrow at a rate between concessional and nonconcessional terms. The bilateral donors may not be as generous as the multilateral donors as they usually insert binding hooks on procurement and the utilization of funds.

Rhetoric vs realism

Hence, the prospect for domestic and external borrowing may not be as rosy as has been claimed by some politicians and their cheerleaders. Being ambitious on infrastructure projects and their financing is okay, but it should not depart much from what is realistically possible and most importantly it should be not be used to score political points founded on misplaced nationalism. 

The most realistic option for now is to improve investment climate to facilitate private investment (including lowering of country investment risk premium) and to enhance the absorption capacity to accelerate capital spending. It would require addressing head-on the constraints to private investment and low capital spending (including contract management) with an aim to domestically finance large-scale infrastructure projects in the future. Practically, such projects should be financed by issuing long-term construction bonds instead of relying on short-term treasury bills, and medium-term development, employment and savings bonds. An appropriate environment to boost confidence on such long-term bonds is needed.

Properly doing these would require tough reforms, which may not be politically palatable, as opposed to lofty rhetoric on economic development.

Tuesday, July 5, 2016

असारे बिकास: The pitfalls of shoddy and bunching up of capital spending

The media is awash with stories (here, here, here and here) about hasty capital spending throughout the country as FY2016 ends on mid-July. Government agencies, especially the local authorities, tend to award contract for repetitive projects to contractors in the last quarter of fiscal year to avoid freezing of the allocated fund. 

The (politically affiliated) local contractors rush to spend money when the monsoon starts (easy to blame the rain and the ensuing floods and landslides for tawdry work). Consequently, a bloated bill is presented at the end of the fiscal year for shoddy development projects, which need to be redone for the next several years. The same pattern of spending is happening amidst the erosion of bureaucratic and institutional capacities along with politicization of the project level decision-making and operational processes. 

The upshot: (i) the delay in awarding contracts after necessary review of investment projects lowers actual capital spending relative to the planned level; and (ii) the shoddy construction by unscrupulous contractors, who usually bid for projects that are beyond their own financial and technical capacities, rip off the treasury and force the government to continue such projects for a number of years. 

For instance, in the last three months of FY2015, 63% of the capital expenditure (which itself is dismally low) was spent. In the last month, it was 44%. This pattern is not new, irrespective of natural or political shocks (in effect, the bureaucracy blames politicization by coalition governments, and the government blames the tardy bureaucracy). See the monthly spending figure below (unit is in NRs billion). Here I have highlighted six major issues behind this kind of slow spending and bunching of such spending in the last quarter. More on capital spending here and here.


Such low quality of capital spending tends to increase recurrent spending in consecutive years. Especially, the use of goods and services and grants to local bodies-- the two major components of recurrent spending-- tend to swell up. The use of goods and services consists of (i) rent & services; (ii) operation and maintenance of capital assets; (iii) office materials and services; (iv) consultancy and other services fee; (v) program expenses; (vi) monitoring, evaluation and travel expenses; (vii) recurrent contingencies; and (viii) miscellaneous. Grants to local bodies (or fiscal transfers) are used to cover a mix of local development projects and recurrent/administrative costs. These together account for about 8.5% of GDP, which is far larger than capital spending of about 4% of GDP. The governance of such spending has been a major public finance management issue in Nepal.



The figure below provides a snapshot of such jerry-built capital projects on recurrent spending in ten successive years. A shock to capital spending sharply increases recurrent spending till the second year, after which it gradually declines and finally dies out after fourth year. It loosely means that shoddy capital spending (“असारे बिकास” in local lingo) is costly to the treasury as its effect is seen in higher recurrent spending in the next four years (in operations and maintenance costs and larger transfer to local bodies without acceptable spending norms). This result comes from the orthogonalized impulse response function of a VAR model (with sample data of about 40 years and endogenous real variables as GDP, capital and recurrent spending, and private investment). If we use SVAR model, where we can allow for contemporaneous effects as well and also put restrictions on some variables (such as capital spending does not contemporaneously affect recurrent spending, but has lagged effect), we also get pretty much the same result. Despite fiscal data quality issues, the result is quite revealing. 


Final points: (i) low capital spending constrains potential economic growth by depriving the economy of necessary physical infrastructure (& meaningful structural transformation) and also affects economic growth contemporaneously; and (ii) shoddy capital spending increases recurrent spending for several years as such projects need to be continuously repaired and maintained. It will have negative fiscal consequences because recurrent spending is surpassing tax revenue. A higher recurrent spending will further squeeze prospects for higher quantum of capital spending (without bunching towards the last quarter).

Monday, June 20, 2016

FY2017 budget: Unprecedented amount, messy macroeconomics and budgetary dishonesty

It was published in The Kathmandu Post, 17 June 2016. An earlier blog post on FY2017 budget is here.

Drastically increasing the budget without improving absorption capacity is reckless and shows a lack of accountability

The Oli government’s first budget, presented by the Finance Minister Bishnu Prasad Poudel, has triggered debate over its focus, impact and intention. While the supporters argue that the budget is balanced and reflects the aspirations enshrined in the constitution, the dissenters charge that the budget is old wine in a new bottle, with enhanced distributive features designed to placate the voters. However, an informed yet dispassionate discussion on its macroeconomic implications has largely been missing.

Overall, the budget is characterised by two main features: Sharp increase in planned spending owing to the inclusion of additional pet programmes and projects that will have macroeconomic consequences in the future; and an absence of noteworthy plans to implement the budget, especially capital spending.

Unprecedented amount

That the budget 2016-2017 was unveiled one and a half month before the start of the fiscal year is a positive development. The additional time will provide the bureaucracy with a cushion to initiate preparatory work for the timely implementation of the projects from mid-July. Hopefully, the Nepali people will not have to wait till the end of the festival season to see development activities initiated in their communities. This should ideally enhance the quantity and quality of spending.

The budget is of an unprecedented amount, topping Rs1,049 billion, out of which 58.8 percent is earmarked for recurrent spending, 29.7 percent for capital spending and 11.4 percent for financial provision. The budget includes pork-barrel projects and programmes that are distributive in nature, post-earthquake reconstruction, and funds to initiate preparatory work for critical, long-term infrastructure projects.

The government intends to cover about 65 percent of the budget from tax and non-tax revenues, foreign grants and principal repayment. To finance the deficit, it is planning to borrow about 29 percent of the budget from domestic and foreign sources, and utilise about Rs60 billion of the money saved from last year’s budget.

Messy macroeconomics

The expansionary budget is a mess in terms of macroeconomics, primarily due to the uncertainty over the resources to finance such a large spike in expenditure.

First, most likely the ambitious revenue target will not be met—a 20 percent increase in revenue is unrealistic given that it averaged only 17 percent in the last five years. This will result in budgetary complication, especially in honouring the large distributive commitments. Some economists are justifying the high revenue target based on the expected growth target of 6.5 percent, which itself is highly optimistic. Note that import-based revenue accounts for about 45 percent of total revenue and except for income tax (22 percent), the rest depends on indirect taxes on the consumption of goods and services that are largely financed by remittance income.

Without widening the tax base significantly, increasing the share of direct tax (which means more individuals paying income tax), higher remittance inflows and revenue administration reforms (enhancing work efficiency and plugging leakages), it would be difficult to meet a high revenue target year after year. The existing mechanism is reaching its limit to increase revenue higher than the prevailing growth rate.

Second, the deficit financing plan is unrealistically optimistic. The planned domestic borrowing is 26 percent higher than last year’s budget estimate. The government is hoping that excess liquidity will persist in the market and there will be enthusiastic support for its bills and bonds. However, as businesses get back to normal after a lull triggered by the earthquake and the trade blockade, excess liquidity will also start to dry up. Demand for loans will pick up and so the interest rate will rise accordingly. High domestic borrowing will further raise interest rates, which will be an extra burden to the public and business enterprises. Similarly, the planned foreign loan is 106 percent higher. It is foolhardy to expect such a drastic increase in foreign loans given that the disbursement rate is hardly 25 percent. Finally, the intention to use the cash balance of last year’s budget for a mix of recurrent and capital spending can set a bad precedent. The unspent budget should ideally be used exclusively for designated infrastructure projects by creating an independent fund.

Third, the budget is so high that even tax revenue will not be able to cover it. There is no dispute that public sector salary needs to be adjusted to inflation. However, it is also true that the number of public employees is too high compared to their productivity (their salary is about 66 percent of capital spending). The government should lay off some public employees and use the resulting ‘potential savings’ to increase the salary of the remaining employees so that they are incentivised to be more productive. Furthermore, grant to local bodies, which contains some capital spending component, is also drastically increased without paying much attention to their absorptive capacities and the governance structure.

Lastly, the growth target of 6.5 percent is ambitious and the inflation target of 7.5 percent is conservative. GDP growth rate of 4.5 percent to 5.5 percent is attainable with a favourable monsoon, revival of the service sector and accelerated reconstruction activities. But inflation is bound to go beyond the target as a result of the inflationary expectations arising from an increase in public sector wages and the large planned spending, which will create demand pressure amidst supply capacity constraint.

Budgetary dishonesty

The nature of spending on certain programmes and projects and the envisaged pattern of financing for them will have long term consequences. The massive increase in net domestic borrowing (3.5 percent of GDP, up from about two percent of GDP in 2015-2016) and net foreign loans (6.4 percent of GDP, up from about 1.5 percent of GDP in 2015-2016) without heeding market conditions and absorption capacity is bound to create budgetary pressures. Importantly, it will be challenging to reconcile such spending with projected revenue in the 2017-2018 budget. Moreover, there is no contingency plan to plug the deficit if the revenue mobilisation and borrowing targets are not met. This is budgetary dishonesty and a burden to the future generation.

An appropriate way would be to freeze the budget in real terms and focus all energy on fully spending the funds intended for infrastructure projects. Additional funds for critical projects could be arranged by rationalising unproductive recurrent spending. Drastically increasing the budget without improving absorption capacity is reckless and shows a lack of accountability.

Saturday, May 28, 2016

Quick thoughts on Nepal's FY2017 budget

Here is my quick thought on the FY2017 budget.

Finance Minister Bishnu Prasad Poudel presented budget for FY2017 (mid-July 2016 to mid-July 2017) to the parliament on May 29. The budget is focused on distributive programs, post-earthquake reconstruction and measures to diversify the economy through the provision of critical infrastructure (preliminary funds earmarked for key priority projects for preparatory work).

The budget is kind of unique in two ways: (i) a massive increase in spending targets with the inclusion of pet programs/projects that will have budgetary and macroeconomic consequences for years to come, and (ii) there is no notable plan to accelerate capital spending (without which the promises will remain a daydream).

FY2017 budget overview
GDP growth target (%)
6.5

Inflation target (%)
7.5

Budget allocation for FY2017
FY2017BE

Rs billion
%
Budget allocation
1048.9
Recurrent
617.2
58.8
Capital
311.9
29.7
Financial provision
119.8
11.4

Projected total revenue
682.8
Revenue
565.9
82.9
Foreign grants
106.9
15.7
Principal repayment
10.0
1.5

Projected budget surplus (+)/deficit (-)
-366.1



Projected deficit financing
366.1
Foreign loans
195.7
53.5
Domestic borrowing
111.0
30.3
FY2016 cash balance
59.4
16.2

First, the budget outlay:  

The total expenditure outlay for FY2017 is NRs1048 billion (an estimated 39.5% of GDP), which is 28.1% higher than the budget estimate for FY2016. The FY2017 outlay comprises NRs617.2 billion for recurrent expenditures (58.8% of the total outlay), NRs311.9 billion for capital expenditures (29.7%), and NRs119.8 billion for financial provision (11.4%).

The substantially larger size of the budget is due the large increase in recurrent and capital spending. The outlay for recurrent expenditure (equivalent to 23.3% of GDP) is 42.2% higher than the revised estimated expenditure in FY2016. The planned capital spending has been increased by 96.1% over the FY2016 revised estimate (equivalent to 11.8% of GDP; normally actual capital spending is about 4.0% of GDP). About Rs140 billion is set aside for post-earthquake rehabilitation and reconstruction.



Second, revenue targets:

A total revenue target of NRs682.8 billion (25.7% of GDP) has been set for FY2017, including projected foreign grants of NRs106.9 billion (4.0% of GDP) and principal repayment of NRs10 billion. The revised estimate for revenue mobilization (including grants) in FY2016 was 23.5% of GDP.

Third, deficit financing:

The budget deficit is to be financed by foreign loans amounting to NRs195.7 billion, domestic borrowing of NRs111.0 billion, and FY2016 cash balance of NRs59.4 billion. Net foreign loans and net domestic borrowings are projected to be 6.4% and 3.5% of GDP, respectively. Overall, budget deficit is projected to be about 7.0% of GDP. 

Fourth, where is the recurrent budget going?

Almost 43% of planned recurrent expenditure of NRs617.2 billion is going to local bodies as grants (or transfers) to enable them to launch local level development works on their own (this is where pet projects and politically hinged programs are hidden). The other big ticket item is the compensation of employees, which takes up about 21% of total recurrent budget. These amount to an estimated 9.9% and 5.0% of GDP respectively.



Fifth, where is the capital budget going?

Almost 58% of the planned capital budget of NRs311.8 billion is going for civil works. About 29% is allocated for building work. These amount to an estimated 6.8% and 3.4% of GDP, respectively.

Sixth, the main takeaways from FY2017 budget are:
  • The early budget adhering to the constitutional provision is a good start.
  • The increase in capital budget for reconstruction and other infrastructure related work was as expected. It is a good strategy because  the capital budget allocation itself was low given the huge infrastructure deficit the country is facing (then there is a chronic issue of low absorption capacity). 
  • Unfortunately, the expectation of a robust, credible and a time-bound implementation plan to spend the allocated money is missing. This issue should have been kept above mundane political pet projects and programs. It is not unique to this government.
  • The GDP growth target may be achievable/ambitious (between 5% and 6% is within range if budget execution is above expectation) given the improving monsoon, normalization of supplies (which reinvigorates the services sector), planned spending on rehabilitation and reconstruction (acts as temporary fiscal stimulus), and most importantly the low base effect. But, the downside risks might weigh heavy if reforms and implementation of projects lag behind. Realistically, GDP growth may be between 4% and 5%.
  • The inflation target is very conservative because: (i) the increase in salary of public sector employees will heighten inflationary expectation, which will eventually result in upward pressure on prices of goods and services; (ii) the massive size of the budget itself (especially the distributive programs) will have similar effect (becomes a self-fulfilling prophesy); (iii) the increased demand for reconstruction related intermediate and final goods and services will put upward pressure on prices (given that domestic firms' capacity utilization is below 50% at present); (iv) the expected strikes are going to temporarily escalate prices; and (v) the new levy on petrol, diesel and aviation fuel (on top of the already high tariff) will put pressure on general prices of goods and services (note that diesel is still used to power up generators to run SMEs- a better option would have been to raise excise duty without increasing the final price like it was done in India and several other countries, especially when international prices are low.). These are both demand-side and supply-side factors that are not within the usual bound of the central bank. Let us wait for the NRB’s inflation target for FY2017 (I hope it will be a bit realistic).
  • The new petroleum levy is intended for the Budhigandaki hydroelectricity project. The initiation of the huge reservoir type project is a good move, but the financing arrangement for it is very myopic. Inflation is already at high levels (thanks to supplies disruptions caused mostly by the trade blockade) and the massive increase in spending and hike in public sector salaries will put even higher pressures. The resources for the project should have been found by rationalizing recurrent spending together with issuance of construction bonds (as is the practice elsewhere). These two measures ensure relatively more accountability and do not disrupt market sentiment when compared to the new levy on petroleum fuel. The financing mechanism for the project economically does not look good to me. By the way, the government is already levying, on an average, the following tax rates (share of retail price): 35.4% in petrol/liter, 22.7% in diesel/liter; 7.9% in kerosene/liter; 26.2%/liter in ATF; and 18.4% in LPG/cylinder (these are tariff, VAT and excise duties as well as infrastructure development levy).
  • Macroeconomy-wise, it looks like a mess: (i) an expenditure target the country cannot attain, especially the capital budget, and a bloated recurrent spending; (ii) an ambitious revenue target of about 20% annual growth; (iii) a massive increase in net domestic borrowing to about 3.5% of GDP (this is hitting its prudential limit now); (iv) a massive increase in net foreign loans (6.4% of GDP, up from 1.6% of GDP in FY2016); (v) an increase in inflation beyond 10%; and (iv) a surge in interest rates due to high borrowing (compounded by the resumption of normal banking activities, which will drastically lower the existing excess liquidity).

  • The large increase in net foreign loans to finance reconstruction and other infrastructure related work is an indication of the dearth of domestic resources to sustain such large scale infrastructure projects and reconstruction work. Here is more.
  • Notice that the budgetary estimate of foreign grants for FY2017 is lower than the FY2016BE. It reflects the drying up of grants (given the poor absorption capacity and preference of large multilateral donors to shift to more loans). 
  • Importantly, it will be challenging for the next government to implement the budget. The government will face two seemingly insurmountable challenges: (i) no uptick in absorption capacity as the means to achieve it are clearly lacking in the budget; and (ii) the possibility of drying up of excess liquidity as businesses get back to normal. The former will make it hard for the government to increase capital spending beyond existing level. The latter will make it difficult for the government to raise money from domestic market (plus what would happen if the revenue target won’t be met?). I don’t see notable contingency planning. 
  • More importantly, the next government will find it hard to reconcile FY2018 numbers during the preparation of budget because that one will be based on FY2017 budget (or its revised estimate), which is bloated with too many incoherent, small program and projects (especially welfare and distributive ones) that can’t be discontinued by successive governments. This year’s budget itself is on the highly optimistic side as the revised expenditure for FY2016 is simply unrealistic given the progress so far. If FY2018 budget is going to be larger than FY2017’s (which in all likelihood will be), then it will be challenging to find extra resources. It cannot increase spending at existing rate (especially unproductive recurrent spending). The tax revenue is not even sufficient to finance recurrent spending. FY2017’s planned recurrent spending is higher than the entire FY2015 budget. 

Friday, May 27, 2016

Why capital spending is chronically low and what can be done about it

It was published in The Kathmandu Post, 23 May 2016.

Unspent budget

Political instability and interference both at the planning and operational levels hinder timely completion of projects

The government is unveiling budget for fiscal year 2016/17 at the end of May, one and a half months prior to the start of FY2017. The expectation is that it will give the government and bureaucracy adequate time to finish approval of programs and projects and subsequently speed up project implementation, resulting in higher spending at the end of the year. This is an important step to create the enabling environment for accelerating spending. However, policymakers should not lose sight of the other problems affecting spending capacity. 

The under-execution of capital budget is a chronic fiscal issue that is intertwined with politics, bureaucratic competence, management capability of contractors, governance and the maze of Acts and policies that are hindering timely, faster and efficient spending. The existing ecosystem for capital budget execution is obstructing, rather than facilitating, timely spending. 

Low spending

For a low income economy like Nepal that is struggling to close the infrastructure deficit, the low capital budget allocation and then dismally low absorption rates give a sense of the enormity of the problem. While the planned capital spending averaged 5.5% of gross domestic product (GDP) in the last five years, actual spending averaged just 4% of GDP. In FY2016, planned capital budget is around 9.3% of GDP (Rs208.9 billion), of which only 23% was spent in the first 10 months. A substantial portion of the Rs91 billion allocated for post-earthquake rehabilitation and reconstruction remains unspent.



It is not hard to notice three patterns here: (i) planned capital spending itself is lower given that Nepal needs to invest an estimated 8-12% of GDP annually in transport, electricity, water supply, solid waste management, telecom and irrigation to close the infrastructure gap; (ii) capital budget absorption capacity has been chronically low (about 75% of planned budget) for a long time; and (iii) persistent bunching of spending in the last few months of fiscal year (about 45% capital spending occurs in the last month and 65% in the last three months), raising red flags over not only low spending, but also the quality of spending.

Additionally, capital spending is far lower than recurrent spending, which stands at around 16% of GDP. Higher capital spending not only creates the fundamental for growth to take off and helps to usher in a meaningful structural transformation, but also boosts immediate demand for construction materials, increases production of intermediate goods, and generates jobs. It includes spending on civil works, building, plant and machinery, land, vehicles, furniture and fittings, etc. The growth jolt from recurrent spending is not as strong as that from capital spending. Recurrent spending consists of grant to local bodies (includes some capital spending as well), wages and salaries to government employees, interest and subsidy payments, social security, and operation and maintenance.

Unhelpful ecosystem

Politicians and senior bureaucrats lament the low capital spending and openly admit the chronically low absorption capacity, but still seek higher share of budget each year. In FY2017, the size of budget will likely be higher than Rs819 billion appropriated for FY2016 despite the fact that the existing mechanism won’t be able to spend it in full without rectifying the distorted ecosystem governing project selection, spending approval at the center and spending pattern at the local level.

Six major issues plague capital spending in Nepal. 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. For instance, projects of all nature (complex, large or piecemeal and of varying timeframe) are included in the budget on the basis of political priorities and not on economic imperatives (which requires a strong pipeline of projects ready for implementation subject to finance, knowledge and technology availability). Furthermore, these are usually not in sync with medium-term expenditure framework and the medium-term plans.

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. 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. For instance, the recurring political meddling in the duties of the board of Nepal Electricity Authority and Kathmandu Upatkaya Khanepani Limited are two classic cases. Furthermore, unfruitful interference and inconclusive governance oversight by various parliament committees and Commission for the Investigation of Abuse of Authority disincentivize honest and committed public officials and contractors.

Scaling up spending

All of these problems cannot be solved overnight. However, few immediate steps could go a long way in mending this chronic problem. Since there will always be political element to program selection and inclusion of some pork barrel projects, this issue pops up in every budget cycle. However, the sector ministries, NPC and MOF could work on a common platform to improve allocative efficiency by sanctioning enough funds (with the flexibility of multi-year contract) for projects that are implementation-ready. Furthermore, monitoring and evaluation at all these government agencies could be made more effective than just clicking check boxes during review sessions. Finally, strong leadership especially by joint secretaries, who are normally project directors, secretaries and ministers is essential to effectively administer and complete a project.

Else, capital budget and the funds allocated for post-earthquake rehabilitation and reconstruction won’t be timely and efficiently spent. 

Thursday, May 19, 2016

About domestic resources and infrastructure financing in Nepal

There has been a lot of debate about the use of domestic funds to finance large-scale infrastructure projects, especially hydroelectricity, roads and airports. Let me provide a brief background and readers can see for themselves which claims made by ‘experts’ hold water and which ones are impractical and outlandish. 

First, issue about fiscal space to finance large scale projects. Nepal has a very low outstanding public debt (about 25.6% of GDP), with internal and external debt stock amounting to 9.5% and 16.1% of GDP, respectively. The outstanding public debt decreased drastically from about 52% of GDP in FY2005. This was a result of faster repayment of principal and interest (due to high revenue growth rate but eroding low expenditure capacity). Now, given the huge infrastructure deficit and low per capita income, Nepal can afford to increase it by few percentage points and use those money in productivity-enhancing infrastructure projects. Here is brief study on increasing public debt by 10 percentage points to finance post-earthquake reconstruction without jeopardizing fiscal sustainability (that is, maintaining the present level of primary balance). 

To increase this limit further needs attention on two fronts: (i) a higher growth rate (ideally above 5%), concessional nature of external borrowing and higher remittance-financed imports, which then boosts revenue; and (ii) drastic enhancement of absorption capacity. 

On the first point, no comment on growth rate as we know well what drives it in Nepal. But, the concessional financing may be drying up. The ADB is phasing out concessional lending in few years and Nepal may have to borrow at a rate between concessional rate (for low income countries) and nonconcessional rates (for lower to middle income countries). The WB is also moving in the same direction. AIIB financing may not be as concessional as those from the ADB and the WB. We will have to wait and see that one. Bilateral financing may or may not be equally generous in terms of interest and maturity, but the downside is that there are hooks on procurement and utilization of funds.

On remittance-financed imports, remittance inflows may not be as stable as before given the continued slump in oil prices and fiscal strain in the countries where Nepali workers go for employment. Remittance inflow is already decelerating, i.e. its growth rate is decreasing although the amount is rising.

On the second point, without drastic enhancement of absorption capacity, even concessional financing won’t come (disbursement happens after government spends money, submits the bills or details of spending to donors and then gets reimbursed). And it is no secret that spending absorption capacity is receding in the last couple of years. So, yes POTENTIAL financing options are available, but REALIZING it is an entirely different ball game. It is not as simple as it sounds. 

What about domestic financing (from treasury savings), domestic borrowing and using some forex reserves? Again, utilizing these is linked to macroeconomic balance and fiscal space. Given the occasional fiscal surplus (even primary balance is in surplus) the government can afford to run fiscal deficit IF the additional money is used in productivity-enhancing infrastructure projects in an accelerated manner. This is more and more unlikely given the receding disbursement rates of major projects and the usual legal, institutional and political hiccups overpowering project implementation. 

A lot of folks are also talking about pooling in the liquidity in the market and household savings apart from those in the banks (as seen when several IPOs being oversubscribed in recent years) to generate funds for large-scale infrastructure projects. But then this liquidity is transitory because of the adverse market conditions. Domestic financing will quickly dry up as soon as real estate and trading activities regain momentum, and BFIs see a favorable credit demand with less socio-political risk. Another aspect associated with this is the domestic borrowing by government through the selling of bills and bonds. This cannot be extended beyond 2-2.5% of GDP to maintain fiscal stability. This is already being practiced (as the government targets to raise around Rs50 billion annually). Higher domestic borrowing by government will push up lending rates (not good for private sector and households as it stifles growth and then subsequently revenue and then finally the funds available for such projects—boomerang!).

Additionally, most of the savings are for short term, but infrastructure financing is for long term. So pooling in money to explicitly finance large-scale infrastructure projects is difficult as folks don’t want to wait for years to get financial benefit. This is different from IPOs, where folks want to purchase shares with an objective to trade it at higher prices after the moratorium on selling is over after few months. Also, banks will be unwilling to invest in large amount in long-term projects out of the short-term deposits. Can you see the asset-liability mismatch there (and the troubles BFIs would be in)?

Next, what about treasury surplus? Again, it is not as easy as it sounds as the government has been using a portion of it as “carry over from last year” to finance the burgeoning (recurrent) expenditure. Not a new thing, but its size will deplete as soon as the government spends more on other projects across the country. If we pin much hope on treasury savings, then we are basically saying lets decrease capital spending in the rest of the country, save the money and then use it in few of the large infrastructure projects. The treasury savings (about Rs50 billion in the first nine months of FY2015) are there because the government is raising revenue (thanks to remittance-finance imports and consumption) that it cannot spend on in infrastructure projects. It is not an additional bonus to domestic financing that you can use for large-scale infrastructure projects! Importantly, at the core of it, it does not solve the problem: the government is not able to spend the money it appropriates for various infrastructure projects across the country. The focus should be in resolving this aspect and ensuring that major projects on an average spend over 90% of allocated money (but not 60% of those in the last quarter; preferably at least 50% by the first seven months of fiscal year).

Finally, what about the forex reserves (about $10 billion as of the ninth month of FY2016). Nepal cannot use this like that because it needs to maintain enough reserves to finance around 7 months of import of goods and services (given the peg to the Indian rupee, to fend off external shocks and the opportunity cost of holding reserves). And the amount of reserves fluctuates depending on remittance inflows and the level of import of goods and services.  

Overall, yes some room for domestic financing is there, but not as high as is being perceived by folks out there.