Does low public debt signal prudent fiscal management in Nepal?

A latest FCGO report shows that cumulative public debt is consistently decreasing in Nepal, reaching an estimated 28.7% of GDP in FY2014 (down from about 52% of GDP in FY2005). Total external and domestic debt stood at 18.0% and 10.7% of GDP in FY2014, respectively.

Generally, a declining public debt is a good sign of a sound/prudent macroeconomic situation in an economy. Recall how high level of debt in the EU and the US after the financial crisis (post-2007) resulted in harsh fiscal measures, including austerity measures, to bring down spending. Quite contrary to that Nepal’s public debt is declining rapidly.

If Nepal cannot mobilize enough revenue to finance its expenditure (both recurrent and capital), then the gap is bridged by domestic as well as external borrowing. Each year the country borrows money equivalent to about 2.0% of GDP from the domestic market. External borrowing is limited to long-term loans at concessional rates from multilateral and some bilateral donors. Overall, total stock of public debt is influenced by economic growth, which then affects revenue mobilization (positively) and jobs creation (positively).

Consider the following trends in recent years:

• GDP has been growing at below 5.0% (above 5.0% just twice in the last decade).
• Tax revenue averaged 20.9% in the last decade, reaching an estimated 16.2% of GDP in FY2014.
• Actual capital expenditure averaged just 71.3% of planned capital expenditure in the last decade. Actual  expenditure averaged about 92% of planned recurrent expenditure in the same time period.
• Fiscal balance (expenditure and net lending minus revenue and grants) averaged just minus 1.6% of GDP in the last decade. In FY2013, the country ran a fiscal surplus equivalent to 0.7% of GDP.

It is fair to deduce the following from the above four points:

• GDP growth is largely supported by monsoon-fed agricultural growth and remittance-backed services growth (mainly wholesale and retail trade, which is sustained by imported goods). Industrial sector growth has been chronically sluggish. There is hardly any discernible impact on employment generation (about 1,500 workers leave each day to work overseas). So, the prudent/sound macroeconomic situation/fiscal management as indicated by low and declining public debt (also low fiscal deficit) has little to do with economic growth and jobs creation. Structural transformation is unusual and labor productivity growth is dismal (more here and here).
• Revenue growth is largely dependent on taxes on imported goods, which are financed by remittances (reached about 28.2% of GDP in FY2014— also, merchandise trade deficit reached 30.9% of GDP in FY2014). Tax revenue on consumption and imported goods account for about 70% of total tax revenue mobilization.
• Low capital expenditure and high revenue mobilization have resulted in a large treasury surplus and the need to borrow less from domestic and external sources (grants are always welcome!). For a country like Nepal with a tremendous financing needs to plug the severe infrastructure deficit, running such a low fiscal deficit is not an optimum fiscal policy stance. Annual  infrastructure financing requirement over 2011-2020 is estimated between 8% and 12% of GDP. The country could afford to easily borrow more to finance higher capital expenditure in critical infrastructure projects. However, this option is constrained by the low and receding expenditure absorption capacity. (Lets not even touch on the quality of such spending in this blog post).

It is leading to two unreasonable developments on public debt front (based on the level of income per capita of Nepal):

1. The low fiscal deficit means less borrowing, and hence accumulation of low outstanding debt. External borrowing is declining even when generous concessional terms are being offered. Lately domestic borrowing is mainly used for managing liquidity in the economy (this should not be treated as a monetary instrument to manage liquidity!)
2. The high revenue growth and low expenditure have also resulted in substantial government savings, which are being used to service debt payments. Total debt service payments averaged 17.9% of total revenue over FY2007-FY2014. Not only interest payments, the country is rapidly repaying principal amount as well. Over the same period, principal and interest payments averaged 12.4% and 5.5% of total revenue, respectively. External debt service payments averaged 10.3% of total exports of goods and non-factor services in the last decade.

Note that low fiscal deficit means slowdown in the accumulation of public debt, and high principal and interest repayment means fast offloading of debt payment obligations. Consequently, this leads to lower stock of outstanding public debt, which in turn is interpreted as a sign of sound/prudent macroeconomic situation/management (despite sluggish GDP and income growth rate, and high unemployment).

The low public debt also affects the debt sustainability analysis, which showed Nepal faced a low risk of debt distress in 2014. In 2012 DSA, Nepal was categorized as facing moderate risk of debt distress. The DSA is used mainly by multilateral development banks to determine if a low income country needs either concessional/soft loans only or grants only or a combination of both. They conduct country economic, social, policy and institutional reform and capacity assessments independently and the resulting composite score (threshold) is ultimately evaluated against the various debt scenarios/simulations and the corresponding debt distress classification. Now that Nepal has been categorized as facing low risk of debt distress, multilateral development banks are more inclined to providing concessional/soft loans only (and the allocations/commitments may increase depending on the public expenditure performance of the country).

So, there is no point boasting about sound/prudent macroeconomic situation and at the same time whining about losing grants by multilateral development banks. Nepal has to efficiently and optimally manage fiscal and macroeconomic situation.

HAPPY NEW YEAR 2015!

New paper: Inclusive Economic Growth in Nepal

Below is the abstract of a recent paper published in Journal of Poverty Alleviation and International Development, Vol.5, No.2, pp.77-116 (authored by yours truly!) :) 

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Inclusive economic growth is one of the most prominent development agendas. However, a systematic evaluation of progress toward greater inclusivity in the developing countries, and the required strategic foci for the future, remain largely absent from debates in both the academic and policymaking spheres. This paper applies and complements the Asian Development Bank’s inclusive economic growth framework by including an intra-country analysis, and in particular, the convergence and divergence across a range of relevant indicators among consumption quintiles in Nepal. It finds three stark disparities: (i) Nepal’s GDP growth and per capita growth remain the lowest in South Asia; (ii) the slow growth rate has failed to create adequate job opportunities, resulting in large-scale out-migration of workers from all consumption quintiles; and (iii) despite the overall inclusive pattern of growth over the last decade, there remains large disparities in the reach and utilization of social services and economic opportunities among the poorest quintiles. In addition, the pattern of growth could be made more inclusive by creating new opportunities and ensuring that the existing ones are shared more proportionately with the bottom quintiles.

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Illicit financial outflows from Nepal over 2003-2012

A latest report from Global Financial Integrity (GFI) ranks Nepal 68 out of 145 economies in terms of average annual illicit financial flows— the cross-border movement of money that is illegally earned, transferred, or utilized— over 2003-2012. On an average, from Nepal, between 2003 and 2012, US$755 million was illegally earned, transferred, or utilized.

Illicit financial outflows has drastically reduced lately, largely due to lower import over-invoicing. In 2012, Nepal ranked 102 out of 151 economies, with illicit financial outflow equivalent to US$106 million. Here is an earlier blog post on previous reports. Illicit capital flows are detected by analyzing misinvoicing of external trade transactions and leakages from the balance of payments.

Cumulative illicit hot money outflows and trade misinvoicing were equivalent to US$228 million and US$7,254 million, respectively. Total illicit outflows between 2003 and 2012 was US$7,542 million. The largest illicit outflows came from trade misinvoicing (export over-invoicing and import over-invoicing). Import under-invoicing and export under-invoicing were not recorded. Over 2003-2012, cumulative import over-invoicing and export over-invoicing were US$7.254 billion and US$1.451 billion, respectively. This might be one of the reasons for the sudden slowdown in the growth of remittances in recent months of FY2015. Any downward trend in the growth of remittance inflows creates far reaching ripple effects across all sectors (real, fiscal, monetary and external).

Over-invoicing imports is common and is mostly attributed to high taxes (reduces corporate profits) and incentives to benefit from foreign exchange transaction in the black market. Over-invoicing exports is not that common and is mostly done to receive higher government subsidies (like in the case of cash incentives for exports).

In South Asia, India saw the largest illicit financial outflows, followed by Bangladesh, Pakistan, Sri Lanka, the Maldives, Bhutan, and Nepal. Overall, US$991.2 billion flowed illicitly out of developing and emerging economies in 2012.

Illicit financial outflows (HMN+GER), US$ million
Country	2008	2009	2010	2011	2012
Afghanistan	0	0	0	0	0
Bangladesh	1,229	1,063	672	593	1,780
Bhutan	0	0	0	44	168
India	47,179	29,002	70,236	86,002	94,757
Maldives	55	38	62	69	185
Nepal	854	1,551	1,883	645	106
Pakistan	51	0	729	0	405
Sri Lanka	0	0	881	337	349

Illicit/unrecorded money moves across borders under the following three forms:

• Corrupt: Proceeds of bribery and theft by government officials
• Criminal: Proceeds of drug trading, human trafficking, counterfeiting, contraband, and myriad forms of additional activities
• Commercial: Proceeds arising from import and export transactions conducted so as to manipulate customs duties, VAT taxes, income taxes, excise taxes, or other sources of government revenues

Here is how GFI computes the illicit flows:

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In analyzing illicit financial flows (IFFs), GFI utilizes sources of data and analytical methodologies that have been used by international institutions, governments, and economists for decades. Basically, these data sources and methodologies are providing information on gaps—gaps in balance of payments data and gaps in trade data. Where recorded sources and uses of funds in balance of payments data do not match, the difference is net errors and omissions, indicating an inflow or outflow that was not recorded. Where bilateral trade data does not match (after adjusting for freight and insurance in the data of the importing country) this indicates re-invoicing of transactions between export from one country and import into another country.

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GFI recommends countries to:

• Comply with all of the Financial Action Task Force (FATF) Recommendations to combat money laundering and terrorist financing
• Require meaningful confirmation of beneficial ownership in all banking and securities accounts
• Automatic exchange of financial information
• Require multinational corporations to publicly disclose their revenues, profits, losses, sales, taxes paid, subsidiaries, and staff levels on a country-by-country basis, as a means of detecting and deterring abusive tax avoidance practices
• Boost customs enforcement by equipping and training officers to better detect the intentional misinvoicing of trade transactions (it accounts for 77.8% of all illicit flows).

Impact of inequality or equality on growth…it depends

Dani Rodrik on inequality: there is no universal evidence that inequality jeopardizes growth (alternatively, equality supports growth). It all depends on other supporting factors (the root causes may not be known or cannot be factored in econometric analysis), and there is no iron law.

Excerpts from the article:

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The belief that boosting equality requires sacrificing economic efficiency is grounded in one of the most cherished ideas in economics: incentives. Firms and individuals need the prospect of higher incomes to save, invest, work hard, and innovate. If taxation of profitable firms and rich households blunts those prospects, the result is reduced effort and lower economic growth. Communist countries, where egalitarian experiments led to economic disaster, long served as “Exhibit A” in the case against redistributive policies.

In recent years, however, neither economic theory nor empirical evidence has been kind to the presumed tradeoff. Economists have produced new arguments showing why good economic performance is not only compatible with distributive fairness, but may even demand it.

For example, in high-inequality societies, where poor households are deprived of economic and educational opportunities, economic growth is depressed. Then there are the Scandinavian countries, where egalitarian policies evidently have not stood in the way of economic prosperity.

[…]Economics is a science that can claim to have uncovered few, if any, universal truths. Like almost everything else in social life, the relationship between equality and economic performance is likely to be contingent rather than fixed, depending on the deeper causes of inequality and many mediating factors. So the emerging new consensus on the harmful effects of inequality is as likely to mislead as the old one was.

Consider, for example, the relationship between industrialization and inequality. In a poor country where the bulk of the workforce is employed in traditional agriculture, the rise of urban industrial opportunities is likely to produce inequality, at least during the early stages of industrialization. As farmers move to cities and earn higher pay, income gaps open up. And yet this is the same process that produces economic growth; all successful developing countries have gone through it.

In China, for example, rapid economic growth after the late 1970s was associated with a significant rise in inequality. Roughly half of the increase was the result of urban-rural earnings gaps, which also acted as the engine of growth.

Or consider transfer policies that tax the rich and the middle classes in order to increase the income of poor households. Many countries in Latin America, such as Mexico and Bolivia, undertook such policies in a fiscally prudent manner, ensuring that government deficits would not lead to high debt and macroeconomic instability.

[…]It is good that economists no longer regard the equality-efficiency tradeoff as an iron law. We should not invert the error and conclude that greater equality and better economic performance always go together. After all, there really is only one universal truth in economics: It depends.

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Labor productivity and structural transformation in Nepal (plus LDCs)

The latest LDC Report 2014 focuses on the linkages between structural transformation, economic growth and human development. It argues that economic growth “must be accompanied by structural transformation and the creation of decent jobs in higher-productivity activities”. It has came up with a new term: "LDC paradox", which refers to “the failure of the MDGs to recognize the need for a policy framework that generates transformative growth, and in the inability of the LDCs to achieve structural transformation”.

The report underscores that the post-2015 agenda (Sustainable Development Goals) should focus on structural transformation of LDCs towards a modern and diversified economy (higher value-added sectors and more knowledge-intensive activities) in order to reverse the decline in labor productivity and to increase employment. It recommends three specific policy measures:

• Resource mobilization (to generate financing for productive public and private investment)
• Industrial policy (to direct those resources into sectors and activities that promote structural transformation)
• Prudent macroeconomic framework/policies(to support structural transformation rather than impeding it— mainly, public investment, credit, real exchange rate, and domestic demand)

Labor productivity growth is a crucial factor in determining the pace and pattern of economic growth— essentially a structural transformation (changes in composition of output, employment, exports and aggregate demand). Labor productivity is generally higher in countries that export more manufactured and mixed goods— reflective of the structure of the economies they have. Countries with sluggish growth tend to export more food and agriculture products.

Economic performance is based on two interrelated processes: labor productivity and structural change. Labor productivity growth is determined by: (i) innovations within sectors (increases in capital, new technology and knowledge), and (ii) shift of labor across sectors (from lower to higher productivity activities). Labor productivity growth can be decomposed into growth of labor productivity by sector and the growth of employment (demographic and labor market components).

For countries like Nepal economic growth should be characterized by a dynamic transformation of sectors and employment share— as opposed to the growth being propped up by monsoon rains and remittance-induced demand for imported goods. Nepal needs to boost productivity within sectors (shifting from lower value added agriculture and services activities to higher value added activities within the sectors), and productivity across sectors (shifting production/employment structure from agriculture to industry before jumping into services sector— this is the proven path for sustained rise in income per capita).

The report decomposes aggregate labor productivity into three main components:

• Direct productivity growth effect (changes in aggregate output per sector due to increases in productivity within sector)
• Structural/reallocation effect (changes due to movements of labor between sectors with different levels of output per capita)
• Terms-of-trade effect (changes due to relative output prices between sectors)

Manufacturing sector is important for higher productivity gains emanating from intersectoral reallocation of labor. Also, higher aggregate output per worker is strongly associated with higher productivity in the industrial sector, and with the transfer of workers to this sector.

Here is how Nepal stands relative to other LDCs in South Asia (and People’s Republic of China, which is not a LDC but has transformed is economy drastically within a generation’s time): 

• Productivity gains within sectors contributed more to aggregate labor productivity growth than structural effect (this is expected because due to the lack of domestic employment opportunities there is a large-scale out migration of workers each year, contributing workers’ remittances equivalent to about 28% of GDP, which finance either the imported goods traded in services sector or nontradable activities within the sector). Bhutan had more productivity growth coming from structural/reallocation effect because of the large shift of workers to industry sector (electricity falls under this) after the hydropower boom.
• Nepal’s labor productivity growth is low compared to the regional economies (see the dots in the above chart) .
• In direct productivity growth effect and reallocation effect, services sector contributed the most.
• Relocation effects in agriculture is negative, reflecting its reduced share in employment because of the shift of workers to other high productivity sectors. It shows trade-offs between employment generation and labor productivity (inverse).

• The highest level of employment growth is registered in services sector. However, these are mostly informal in nature with severe lack of productive capacities at the firm level (low level of capital and information technology). Employment growth in services sector is broadly at the expense of gains in labor productivity. The reallocation effects (agriculture to services sectors) added to overall productivity growth because average productivity is higher in services sector (even if underemployment is high).
• Industry sector productivity (both within and across) is considerably low (most probably due to the crippling binding supply-side constraints).

More on structural transformation in Nepal here (interested folks can follow the links within the blog post as well). Briefly, Nepal has ended up with an unusual structural transformation. Most of the GDP growth is coming from non-tradable sectors such as construction, retail and wholesale trade and real estate and housing. The demand for the services sector activities are in turn driven by public expenditure and remittances (see the rise in services sector value added while a premature deindustrialization in the chart below). Tradable sectors such as manufacturing and high-value agriculture activities are not prominent. Worse, more and more workers are shifting to informal activities in services sector until they find jobs overseas. Addressing this will be one of the major economic challenges for the Constituent Assembly II, if the country wants to realize its goal of graduating from LDC status by 2022.