Thursday, September 10, 2015

Nepal’s fiscal sustainability and post-earthquake reconstruction

This is adapted from Box 3 of Macroeconomic Update, August 2015, Vol.3, No.2 (executive summary here, and FY2016 growth and inflation outlook here). 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.

The cumulative damages and losses as result of the earthquake and the subsequent aftershocks were estimated at about $7.1 billion. However, the cumulative need for recovery is estimated at $6.7 billion. Excluding housing, total public sector damages and losses (excluding housing) amount to $1.7 billion. The NPC’s estimate of total public sector burden, including housing and human settlement, is about $3.8 billion (or about 18% of FY2015 GDP) over the medium term. The total donor pledge during the reconstruction conference exceeds the total public sector needs for recovery. About 50% of the total pledge is on grant basis.

Given that Nepal needs to borrow a higher amount both internally and externally (cumulatively about 9% of GDP over the next five years) to finance reconstruction projects, and tax revenues being barely sufficient to finance recurrent spending, Nepal’s fiscal policy will need to be more prudent in the coming years.

Outstanding public debt (% of GDP)

Source: FCGO; NRM staff estimates

Nepal has a very low fiscal deficit to start with when compared to regional economies and low and lower middle income economies. In FY2013 and FY2014, robust revenue growth (including grants) along with under-spending of the capital budget resulted in a fiscal surplus. This is not ideal for a low income country with huge infrastructure deficit that is constricting overall economic potential. Nepal needs about 8% to 12% of GDP in annual investment in infrastructural till 2020 to close its infrastructure deficit, accelerate inclusive economic growth, and create increased jobs. Hence, increasing borrowing to a fiscally prudent level to fund productivity-enhancing capital investment will be of paramount importance.

The IMF’s latest debt sustainability analysis[1] shows that Nepal’s risk of debt distress continues to be low, mainly attributed to prudent fiscal policy and low capital budget execution. Public external debt stock and servicing ratios are within the policy-dependent indicative thresholds as government borrowing has mostly been on concessional terms. The analysis shows that debt dynamics remain resilient to standard shocks (shocks to GDP growth, exports, non-debt creating flows [captures a remittance shock], a combination of these shocks, and onetime 30% nominal depreciation shock).

Primary and fiscal balances (% of GDP)


Source: Ministry of Finance; FCGO; NRM staff estimates

Fiscal sustainability over the medium to long term can be assessed by looking at the real interest rate, exchange rate, inflation, GDP growth, and the debt stock.

At present, Nepal’s debt stabilizing primary balance is about -1.2% (Table 3.1), which means that it is the primary deficit required to keep debt to GDP ratio constant at FY2015 level (25.6% of GDP). It assumes a 10% depreciation of the currency against the US dollar (which then increases outstanding debt payment), average real interest rate on total government debt stabilizing at FY2015 level (weighted average of real interest rate on domestic and foreign currency debts), and GDP deflator (proxy for inflation) and GDP growth averaging 7.5% and 5.0%[2], respectively, over the medium term. Alternatively, it indicates that if Nepal judiciously utilizes borrowed money on productivity-enhancing investment projects, it has ample fiscal space (mostly borrowing on concessional terms). In FY2015, primary balance amounted to 1.6% of GDP.


Debt stabilizing primary balance

Initial debt to GDP level


Weighted real interest rate


GDP growth rate


Required primary balance


Source: NRM staff estimates

Furthermore, even after taking into account the need for higher borrowing to finance public sector investment needs (an additional 10% of GDP cumulatively over the next ten years), the country can still maintain overall fiscal sustainability. It translates into a targeted debt stock of about 35.6% of GDP by 2025 (Figure 3.1), which can be maintained by a combination of the following scenarios:

Scenario 1: (i) primary deficit of 1.2% of GDP till 2019 (assuming that actual disbursement is higher than the previous years) and then 3.1% of GDP till 2025 (disbursement accelerates even higher); (ii) real interest rate of -0.1; and (iii) GDP growth of 4.8% in FY2016; 5.5% in FY2017 and 5.0% till 2025. It assumes GDP deflator of 7.5% and currency depreciation by 10%.

Scenario 2: If the public debt target is increased by five percentage points of GDP only (increasing public debt stock to 30.6% of GDP by 2025 assuming a slower disbursement) then primary balance requirement after 2020 will decrease (maintaining other assumptions as they are in scenario 1).

In addition, if the government’s spending capacity is drastically enhanced, an additional 5% of GDP could be spent in capital projects throughout the country (i.e. not restricted to earthquake-hit areas) to close the infrastructure gap. Incorporating this scenario, the along with the following assumptions would still result in a manageable fiscal situation (a larger primary deficit and cumulative public debt stock of 40.6% of GDP by 2025)

Scenario 3: (i) primary deficit of 1.2% of GDP till FY2017 and then disbursement accelerates much faster than in scenario 1 (reconstruction expenditure amounting to an additional 10.0% of GDP and a further 5.0% of GDP equivalent of expenditure to close infrastructure gap in remaining areas of the country) leading to increase in primary deficit to 4.1% of GDP from FY2018 to FY2025; (ii) real interest rate of -0.1; and (iii) GDP growth of 4.8% in FY2016; 6.0% in FY2017 and 7.0% till 2025 (higher spending accelerates economic growth as well). It assumes GDP deflator of 7.5% and currency depreciation by 10%. Traditionally, countries having public debt of 40% of GDP are considered fiscally sustainable.

Public debt and primary balance estimate (% of GDP)

Source: NRM staff estimates

Overall, Nepal’s average weighted real borrowing rate is much lower than the GDP growth rate, indicating that a small primary deficit would not jeopardize fiscal sustainability. It opens up more fiscal space, which needs to be exploited by the government by enhancing absorptive capacity with respect to productivity-enhancing capital investment, i.e. avoiding inefficient capital accumulation or using such borrowed money to finance recurrent expenditure. The availability of funds for reconstruction should not be an issue. Drastically enhancing absorptive capacity, however, remains an unresolved issue.

[1] IMF. July 2015. Request for Disbursement Under The Rapid Credit Facility— Debt Sustainability Analysis. International Monetary Fund. Washington, DC

[2] Lower GDP growth necessitates higher levels of primary balance to stabilize debt to GDP ratio.