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 (%)

Inflation target (%)

Budget allocation for FY2017

Rs billion
Budget allocation
Financial provision

Projected total revenue
Foreign grants
Principal repayment

Projected budget surplus (+)/deficit (-)

Projected deficit financing
Foreign loans
Domestic borrowing
FY2016 cash balance

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. 
  • The inflation target is 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). However, sustained low fuel prices and decline in prices in India remain another scenario, which would mean lower inflation or within the target.
  • 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 (given the existing assumptions about budget); 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.