Saturday, September 5, 2015

Nepal Macroeconomic Update, August 2015

Here is the executive summary of Macroeconomic Update, August 2015, Vol.3, No.2. It includes FY2015 update on real, fiscal, monetary and external sector, and growth and inflation outlook for FY2016. It provides a comprehensive macroeconomic assessment, including fiscal sustainability, after the April 25 earthquake.

1. The catastrophic 7.8 magnitude earthquake on 25 April 2015 and subsequent multiple aftershocks, and the subnormal monsoon in the first half of the year slowed down economic activities in FY2015, resulting in GDP growth of 3.0%, down from the pre-earthquake growth estimate of 4.6%. The earthquake affected industrial and services sectors the most even though it hit in the tenth month of FY2015. Agricultural output growth dropped to an estimated 1.9% from the pre-earthquake estimate of 2.3%. The industry sector, which comprises a mere 15% of GDP, grew by an estimated 2.6% compared to the estimated pre-earthquake growth of 4.6%. Meanwhile, the earthquake-induced disruptions to main services activities lowered its growth rate by 2.1 percentage points from the estimated pre-earthquake growth of 6.0%. Looking forward, the outlook for FY2016 is cautiously optimistic and is largely contingent upon the scope and pace of post-earthquake reconstruction works. Considering the weak and subnormal monsoon so far, modest to fast pick up in actual implementation of reconstruction projects, political uncertainties, and modest recovery of key services activities, GDP growth is projected to be between 4.5% and 5.5%.

2. The sluggish expenditure in the first three quarters and damages caused by the earthquake in the last quarter of FY2015 significantly affected public expenditure performance. The budget execution delays, and long-running procedural as well as procurement hassles constrained absorptive capacities, resulting in slower capital spending than in the previous years. The estimated actual capital spending was 69.9% of planned capital expenditure in FY2015, lower than the 78.4% achieved in FY2014. Meanwhile, actual recurrent spending was 84.4% of planned recurrent expenditure, marginally lower than the 85.9% in FY2014. Overall expenditure grew by 13.0%, with recurrent and capital spending growth at 11.0% and 22.3%, respectively— lower than the growth rates in FY2014.

3. Total revenue grew by 13.8%, much lower than 20.5% growth in FY2014, reaching NRs405.8 billion (19.1% of GDP). It is lower than the budget target of NRs422.9 billion as the slowdown in economic activities and imports following the earthquake in April hit revenue mobilization. As a share of GDP, tax revenue mobilization has improved significantly, reaching 16.8% in FY2015, up from 9.8% of GDP in FY2007. The continuous reforms in revenue administration, broadening of the tax base, and the higher import bill (mostly financed by remittance income) resulted in robust revenue performance over the last decade.

4. The lower than expected revenue mobilization along with the disappointing expenditure performance resulted in a fiscal deficit equivalent to about 0.2% of GDP in FY2015. Though this is better than the fiscal surplus equivalent to 0.7% of GDP in FY2013 and 0.6% of GDP FY2014, it is still lower than the medium-term average fiscal deficit of about 2.2% of GDP. For a low-income country with a large financing need to bridge the infrastructure deficit, particularly in hydropower and transport, running a modest fiscal deficit without jeopardizing fiscal sustainability is desirable. Nepal has been running a primary surplus since FY2012, meaning that fiscal balance before interest payment on public debt is positive. Nepal’s overall outstanding public debt (external and domestic) has been steadily declining, reaching an estimated 25.6% of GDP in FY2015. The fiscal sustainability analysis shows the government has ample fiscal space for now to expand productivity-enhancing public capital investment, including for reconstruction projects, without jeopardizing fiscal soundness.

5. Inflation (year-on-year [y-o-y] average CPI) sharply declined to 7.2% in FY2015, the lowest since FY2008 as both food and non-food prices cooled down. Food and non-food prices increased by 9.6% and 5.2%, respectively, in FY2015. They increased by 11.6% and 6.8%, respectively, in FY2014. Overall, while food prices contributed 5.3 percentage points to overall inflation, non-food prices contributed 2.7 percentage points in FY2015. Looking forward, the expected low agriculture harvest due to subnormal monsoon, slightly higher price pressures in India, higher demand for reconstruction materials and workers, blockage of major trading routes with the PRC, and supply disruptions, including in distribution networks, as a result of the political strikes in various parts of the country will likely push up general prices of goods and services to between 8.5% and 9.5% in FY2016. Even after accounting for the high probability of subdued fuel prices throughout FY2016, if supply disruptions persist for long, then there is a high likelihood of even higher inflation, probably around 10%.

6. Money supply (M2) grew by 19.9%, reaching NRs311.8 billion, on the back of a robust growth of net foreign assets and net domestic assets. Deposit mobilization of BFIs increased by 20.1%, higher than 18.4% growth in FY2014. The cumulative deposit mobilization reached 79.5% of GDP in FY2015, up from 72.5% of GDP in FY2014. Total credit (loans and advances) of BFIs increased by 17.5% (NRs229.3 billion) in FY2015, up from 14.4% growth in FY2014 (NRs165.5 billion). Cumulatively, 21.8% of the total lending went to wholesale and retail traders, followed 18.8% to industry, 11.2% to construction and 7.9% to services activities. The total credit of BFIs reached 72.6% of GDP in FY2015, up from 67.6% of GDP in FY2014. The central bank mopped up excess liquidity throughout the year deploying a variety of instruments such as reverse repo and deposit auction. However, the frequent use of recurring short-term liquidity management tools amidst fluctuating interest rates throughout the year indicates that the existing liquidity management strategy is a temporary measure and for long term solution the investment climate has to be improved. The persistence of excess liquidity throughout the year pushed short-term interest rates mostly below 1.0%, although the rates were higher after starting February 2015 compared to the corresponding period in FY2014. The commercial banks’ have comfortably satisfied the capital adequacy ratio (CAR) and net liquidity requirements. CAR of commercial banks stood at 11.69%, which is 0.69 percentage points higher than the minimum 10% CAR and 1% buffer requirement.

7. The country’s external situation strengthened in FY2014 with the balance of payment surplus reaching $1.5 billion (6.8% of GDP). The large merchandise trade deficit, which reached 31.2% of GDP, was partially[1] offset by workers’ remittances, which reached a record 29.1% of GDP, and export (4.6% of GDP), resulting in a current account surplus of $1.1 billion (5.1% of GDP), up from 4.6% of GDP in FY2014. . Gross foreign exchange reserves increased from $6.8 billion in FY2014 to $8.3 billion FY2014, sufficient to cover 11.2 months of imports of goods and non-factor services. Overall, the Nepalese rupee depreciated by 19.9% between 15 July 2011 and 15 July 2012 and a further 6.7% between 15 July 2012 and 15 July 2013. It depreciated by 0.9% between 15 July 2013 and 15 July 2014, and a further 5.4% depreciation between 15 July 2014 and 15 July 2015.

8. This edition of Macroeconomic Update’s issue focus discusses the importance and ways to accelerate post-earthquake reconstruction for faster recovery. The earthquake caused tremendous loss of lives and properties. It lowered economic growth rate, pushed about a million people below the poverty line, slowed progress on achieving some of the MDGs, and sapped investors and consumer confidence. The cumulative pledges during the international reconstruction conference exceeded the expected public sector needs for reconstruction. Now, the National Reconstruction Authority and line ministries’ ability to swiftly prepare and implement viable projects will underpin the scope and pace of reconstruction and ultimately a better, faster and smarter recovery. The authority needs to be operationalized without delay and it has to chart out a coherent five-year reconstruction strategy by aligning it with the long-term economic development vision.

9. Accelerated reconstruction would require hiring of competent human resources, preparing a time-bound investment action plan, a strong pipeline of viable projects, outsourcing of design, monitoring and evaluation, political buy-in of proposed actions, and engaging youth, specialized institutions, and civil society at various stages of the project cycle. This would then ‘crowd in’ private investment as well, leading to a higher, sustainable, and inclusive economic growth. Overall, rehabilitation and reconstruction should primarily aim at increasing productivity-enhancing public capital investment, which is a key to ensuring structural transformation whereby high value-added and high-productivity sectors are more dominant than low value-added and low-productivity sectors in the medium term.

[1] Overall, the net goods, services and income balance was a negative 28.3% of GDP, which was offset by net transfers equivalent to 33.4% of GDP, resulting in current account surplus equivalent to 5.1% of GDP.