Tuesday, September 27, 2016

Efficiency and integrity in public procurement in Nepal

This piece is adapted from the issue focus section of Macroeconomic Update Nepal, Vol.4, No.2, published by Asian Development Bank, Nepal Resident Mission.

I. Introduction

Many medium to large-scale development projects in Nepal are plagued by implementation delays and cost overruns. At the core of such recurrent hurdles is inefficient public procurement, contributed by a range of factors such as legal and policy complications, lack of required human resources to manage contracts, political intervention at management and operational levels, weak leadership by project directors and their high turnover, and prolonged delays by oversight and judicial agencies to clear contentious procurement. Consequently, project implementation is slow with cost and time overruns, quality of infrastructure construction is not up to the taxpayers’ expectation, and disbursement is slow and below target. These all result in low capital expenditure, insufficient jobs creation, and sluggish economic growth.

Efficiency and integrity in public procurement (of goods, works and services) enhance value for money and accelerate project implementation, which in turn stimulates private sector activities and innovations. Furthermore, if done in the right way and on time to maximize the value for taxpayers’ money, public procurement could be used as a strategic policy tool to address the myriad of economic, social and environmental challenges faced by the country.[1] Hence, efficiency and integrity in public procurement—equivalent to around 12% of GDP[2]— is vital to not only accelerate project implementation, but also to achieve medium-term goal of graduation from LDC category and long-term goal to be a middle income country by 2030, which also is the target date to achieve the Sustainable Development Goals (SGDs).

Public procurement is done when taxpayers’ money and/or grants and loans funded by development partners are used to finance public goods and services, including building of roads, airports, dry ports, hydroelectricity, irrigation canals, drinking water facilities, school and hospital buildings, and consultancy/advisory services. Unscrupulous procurement practices (resulting in wasteful capital spending in the last quarter of fiscal year) tends to increase recurrent spending in the next several years, since the sub-standard fixed assets need to be maintained more frequently. Furthermore, implementation delays unnecessarily prolong the project construction and completion, which ultimately is a drain of public funds. Hence, if done in the right way, efficient public procurement, which makes spending effective and has the potential to yield substantive savings (on whole-of-life cost basis),[3] contributes significantly to create the foundation for economic growth to take off on a high and sustainable path.

II. Key Highlights of the Amended PPA 2016

The recently amended Public Procurement Act (PPA) 2016, which has come about after prolonged revisions and delays, dictates public procurement in Nepal. In line with the amended PPA, procurement policy, operating guidelines and necessary administrative changes (including capacity enhancement) need to be rolled out to effectively implement it. The amended PPA includes procurement methods such as lump sum, catalogue shopping, limited tendering and buy back method (which is a new addition to the methods of procurement).

Preparation and approval of estimates: Cost estimate is not required, except works, for procurement up to NRs100,000. Regarding the approval of estimates, the officials involved in the design or estimation, checking or approval and the consultant involved, shall be responsible and subjected to legal action if the revised estimate is more than 25% of the initial estimate or due to defective design or abnormal estimation. In the previous version of the PPA, cost estimate was not required for procurement of up to NRs25,000.

Qualification of bidder or proposer: No qualification requirements is prescribed for the procurement of a construction work with cost estimate less than NRs 20 million  unless the procuring entity has decided that the work requires qualification criteria. In the previous version of the PPA, no qualification requirements were needed for the procurement of a construction work with cost estimate less than NRs 6 million.

Invitation to bid: A re-invitation with reduced submission period may be given if no bids/ proposals are submitted within the stipulated time or all the submitted bids/ proposals are non-responsive. The period shall be at least 15 days for national competitive  bidding and at least 21 days for international competitive bidding. However, in case no bids/ proposals are submitted during re-invitation period or all of the submitted bids/ proposals are non-responsive and there will be loss to the procuring entity (or some activity of the PE will be affected), then the procuring entity may re-invite the bid by giving at least seven day notice for national bidding. Else, it could procure following the methods specified under Section 8, with approval from one level higher authority. Furthermore, works within the prescribed estimate amount under national competitive bidding may be procured competitively only from domestic bidders. In the previous version of the PPA, in the case of procurement of construction work, preference was given according to the sub-section (1) of section 12 of the Construction Entrepreneur Act, 1958.

Withdrawal or modification of bid: A bidder has to make a sealed application 24 hours prior to the deadline for submission if it intends to modify or withdraw its bid unless the bid is submitted through electronic submission. In the previous version of the PPA, a bidder may, prior to expiry of the deadline for the submission of bids, make a sealed application for modification to or withdrawal of bid that a bidder has once submitted.

Acceptance of bid and procurement contract: A performance security of 5% is levied if the bid price is up to 15% below the estimate. An additional performance security equivalent to half the difference between the bid price and the amount that is 15% below the estimate is needed if the bid price is lower than 15% of the estimate.

Provision of advance: The procuring entity, after the agreement, may provide advance of up to 20% of the contract amount by getting a bank guarantee to the supplier, construction entrepreneur or service provider. Initially half of the advance is provided, and the other half is given based on the utilization of the initial advance. Moreover, except under the provision of Section 10(5), the payment for advance is made to a specially opened account for the contract. The contract may be terminated if the contractor misuses the advance payment.

Variation order: The variation of up to 5% may be done by gazette II class officer, up to 10% by Gazetted I class officer, up to 15% by department chief, between 15% and 25% by Secretary, and 25% and above by the Council of Ministers. However, for the procurement of amount less than NRs6 million, the department chief may approve the variation order in excess of 15%. In the previous version of the PPA, a variation order above  15%  was issued as per the decision by the Council of Ministers.

Price adjustment in procurement contract: Unless otherwise provided in the procurement contract, if price needs to be adjusted in the course of implementation of a procurement contract having duration exceeding 12 months, then the competent authority may adjust the price. In the previous version of the PPA, the duration period was 15 months. 

Mechanism for dispute settlement: Contract agreement will include provision of dispute settlement through prevailing law on arbitration if the dispute cannot be settled amicably.

Termination of contract and remedy: The procuring entity may terminate procurement contract if the supplier, consultant, service provider or construction entrepreneur does not perform as per contract, or its conduct is not as specified in section 62(2) or it misuses the advance payment. If the contract is terminated because the contractor did not start, abandoned or did not attain progress as per the agreement, the procuring entity may terminate the contract anytime. If the contract is terminated as per section 59(7), the full amount of performance security shall be forfeited. Any additional amount to complete the remaining work shall be recovered as amount due to the government. The remaining work after the termination of contract may be completed by inviting financial proposal from the remaining bidders selected under section 25 by giving 15 day notice. Meanwhile, the approval of one level higher authority is required prior to requesting for financial proposal as per section 59(9). In the previous version of the PPA, the procuring entity could terminate procurement contract if the supplier, consultant, service provider or construction entrepreneur did not perform as per the contract.

Blacklisting: If a bidder selected pursuant to section 27 or a consultant selected pursuant to section 38 does not come to sign the contract, then it may be blacklisted.

Hindrance of procurement process: The authority authorized to investigate is required to request any document from the procuring entity with due consideration to not hinder the procurement process as far as possible.

III. Implications for Public Procurement Management

The PPA has been amended after an iteration of discussion with a range of stakeholders. Overall, the added or amended provisions are in the right direction. For instance, the onus of timely and quality procurement is placed on the chief of the procuring entity (department, division or section of a project or program), including the completion of the task within the stipulated time. Additionally, in order to make procurement official more accountable, a provision on non-compliance is added. Specifically, the amended PPA has included a provision that  “Ensuring completion within the set time by conducting regular supervision, monitoring, and quality control measures to implement or to cause to implement the procurement agreement made under this act, will be the responsibility of the chief of the concerned public entity.” This opens up the possibility of prosecution of underperformers.

The other positive aspects of the amended PPA are that e-bidding is now explicitly mentioned and six additional direct procurement methods are added, facilitating the procurement by public enterprises. These include: (i) procurement of goods and services between two public entities; (ii) public entities/enterprises doing business by competing with private sector; (iii) procuring aviation, aircraft and associated equipment; (iv) procuring goods and services on rates fixed by international organizations; (v) procuring goods and services for organizing programs and promotional activities outside the country; and (vi) procuring goods and services by diplomatic mission.

Another important amendment is the provisions to facilitate fast decision-making on matters related to cost variation. For instance, department heads can approve variation of up to 15%, between 15% and 25% by the concerned Secretary, and on and above 25% by the Cabinet. Although an additional layer of committee is added in this process, the overall amendment will likely speed up review and approval of variation, which is one of the most contentious issues in public procurement and has been delaying project implementation. A related positive amendment concerns the shortening of price adjustment applicable for contracts exceeding 12 months instead of 15 months in the previous version of the PPA. This price adjustment is applicable to the contract procured under the multi-year contract that is tendered.

On the institutional side, regulatory function of PPMO has been strengthened to include additional functions to (i) issue necessary manuals; work procedures; and technical notes required for procurement methods such as turnkey, EPC, schedule rate contract, and management contracts, etc.; (ii) review and cause to review after procurement, (iii) develop roaster of contractors, consultants, suppliers, and  service providers regarding their procurement qualification and experience, (iv) issue electronic procurement guidelines, (v)  certify/ accredit procurement experts, and (vi) forward case to competent authority for necessary action if the procurement carried out by the public entity is found to be contradicting with the PPA, its rules, work procedure, or guidelines. PPMO has been entrusted sole responsibility to maintain a national e-GP system and the PPA has provisioned that the method of submitting the bids through e-bidding shall be in accordance with the procedure approved by PPMO. Public entity may adopt only electronic- procurement procedure partially or completely in public procurement. In other words, public entity, based on the capacity, may phase out the paper based submission to obtain full benefit of the e-GP system.

Furthermore, the amended PPA has explicitly mentioned that the procurement process will not apply to the following methods and a separate working procedure to procure goods, services and works may be issued: (i) design and build; (ii) turn key/EPC; (iii) design, build and operate; (iv) public private partnership/build operate and transfer; (v) framework agreement; (vi) cost replacement; (vii) management agreement; (viii) exchange; (ix) installments; (x) buy on lease; (xi) buying land properties; and (xii) operation and maintenance or management procurement based on performance. These are an improvement because the previous version of the PPA was silent on these methods and had created confusion especially on the procurement related issues for public private partnership projects.

Remaining Gaps. While these amendments are expected to make procurement timely and efficient, thus helping to accelerate project implementation, a number of shortcomings also appear in the amended PPA. These need to be gradually addressed over time as it may slowdown the speed of project implementation.

The additional penalty (forfeiture of bid security and other financial penalties to the bidder) imposed in case the contract is not signed is impractical as merely putting a stringent provision may not help to get a good contractor. There is a need for concurrently improving the quality of selection. Specifically, any deficiencies of the bids (such as serious errors in a price bid) that may oblige the bidder to withdraw later, need to be detected and such bid be duly rejected. Similarly, reduced rebidding time, in case the first round of bidding fails, does not necessarily provide fare treatment to new bidders or lead to the most efficient selection of a contractor.

The amended PPA also provided clearer provision of dealing with the low bids, by specifying the level of additional performance guarantees. While this can provide clarity to deal with such circumstances, the issue of low price bidding needs to be dealt with by strengthening the technical evaluation, thereby effectively rejecting the insufficiently experienced and skilled bidders, which is one of the causes of the low price bidding. On this account, within the context of PPR amendment, PPMO is considering the introduction of one-stage two envelope (1S2E) selection process, in which technical and financial evaluation is separately undertaken. Likewise, there is a need for strengthening the disciplines of contract management for higher compliance with cost, time, and quality in executing the works after contract signing.     

The earlier draft PPA had included a provision of additional advance without bank guarantee, which could be used for the additional deployment of construction materials and equipment. The provision was entirely removed from the final PPA. This could have provided a basis for meeting such requirements, with specification of how the paid amount was to be guaranteed (through material valuation or bank guarantee).

Furthermore, the increase in threshold of works contract/tender without requiring bidders’ qualifications up to NRs 20 million (current threshold is NRs 6 million) may foster malpractice in the construction industry. First, entry of insufficiently experienced and skilled contractors can undermine the timeliness, quality, and cost of the works. Second, contractors may prefer to register a new firm every time they bid for a new contract whenever the firm’s past performance record was poor. This has the potential to undermine capacity development of the construction industry. Third, the absence of qualification for such contracts may result in irregular practices with political pressures.  Such system may best be introduced after establishment of sound registration and performance recording system of the contractors.

The threshold applied to international bidders may violate WTO as well as procurement procedures of multilateral development banks (MDBs). Country system needs to be harmonized to MDBs procurement standard. This provision will restrict participation of international bidders in domestic market and may open up avenues for political pressure to frequently change the thresholds, which will lead to unpredictable procurement environment in the country.[4] Similarly, the provision to allow withdrawal of bid only before 24 hours of the deadline is impracticable. Bidders should be allowed to withdraw their bids at any point in time before the bid submission deadline.

IV. Way forward

Almost all of capital spending and some capital formation related components of recurrent spending (such as use of grant to local bodies to build local infrastructure, operation and maintenance, etc.) are subjected to public procurement in Nepal, which together amount to 12% of GDP. Efficiency and integrity in procurement for goods, services and works is vital to accelerate project implementation and enhance the quality of spending, which eventually leads to higher, sustainable and employment-centric inclusive economic growth. This in turn is essential to graduate from LDC category by 2022, and to become a middle income country by 2030 along with the achievement of the SDGs.

Public procurement is governed by the recently amended PPA 2016. While the amendments or addition of new provision are expected to lead to timely and efficient procurement, a number of shortcomings need to be gradually addressed over time. Additionally, timely implementation of the amended PPA by rolling out updated policy, regulations, operational guidelines and manuals, and institutional setup is equally important. For instance, fully rolling out e-bidding system is urgently required, given that the present system still requires that original bid security must be submitted on paper, which undermines the effectiveness of e-submission of bids.  This will help to make public procurement efficient, transparent and rules based. Similarly, the evaluation bids should be completed within the stipulated timeframe and payment of contract processed on time.

The government needs to ensure that transaction costs are not prohibitively high, which is a natural barrier for the participation of small and medium contractors, whose capacity needs to be enhanced. E-procurement, which creates a marketplace characterized by equal access and competition under a transparent framework, needs mainstreaming along with the capacity enhancement of implementing agencies, contractors, and other stakeholders. It lowers the likelihood of rent-seeking opportunities as it minimizes in-person contacts before bid submission and during bid evaluation. A rigged tendering process in the absence of e-procurement stifles competition, leading to lower quality of goods, works or services at higher cost.

The executing and implementing agencies need to boost their capacity on technical and administrative matters related to efficient procurement, including clarity about the scope and nature of work, contract management methodology, and the associated financial aspects of procurement design and processing. A lack of professionalism remains one of the major weaknesses. Public procurement is a specialized profession requiring effective integration of technical, financial, and legal requirements in its process of preparation, contractor selection, and execution. Competent human resources required for its efficient execution are critical. It essentially is a strategic policy lever/function of the government as opposed to mundane administrative service.

A careful procurement planning and effective performance monitoring yield value for taxpayers’ money used for public procurement. This is equally important throughout the procurement life cycle: preparation of bids, submission and evaluation of bids, awarding contracts and executing contracts with sound contract management, which is another critical subject for efficient execution of infrastructure investments in Nepal while duly controlling time, cost, and quality. (See Box 4.) Exception to the rule (bypassing the amended PPA) and breaching threshold procurement should be minimized in order to maximize the utility of taxpayer’s money and to leverage the bulk purchasing power of the government.
[1] OECD. 2016. Public Procurement for Sustainable and Inclusive Growth. Paris.
[2] Average of capital spending, grant/transfer to local bodies and use of goods and services over the last five years.
[3] It refers to (potential) cost savings throughout the lifetime of the projects despite the short-term cost being relatively higher. Exclusive focus on short-term savings, for instance awarding contract to those bidding under a reasonable cost estimate (in other words, below threshold procurement) and those with weak contract management, priority may lead to cost overruns and higher recurrent costs in the subsequent years. A combination of low cost and quality consideration in awarding contracts could result in long-term cost savings.
[4] For example, the proposed PPR amendment has provision that procurement of cost estimate from NRs 20 million ($200,000 equivalent) to NRs1 billion ($10 million equivalent), bidding may be among domestic contractors only.

Thursday, September 22, 2016

Economic and social risks from declining overseas migration & decelerating remittance inflows

It was published in The Kathmandu Post, 20 September 2016. Previous posts on remittances and migration here.

Nepal needs urgent reforms to deal with challenges stemming from a deceleration in remittance inflows

If there is one consistent narrative about Nepal over the last two decades, it must be about migration and remittances. Political and development activities in the country have always remained volatile. While political culture is punctured by intra- and inter-party fighting and external interference, economic development is beset by stalled projects and implementation complexities arising from sub-standard procurement and eroding bureaucratic capacity. However, migration and remittances have been notably resilient to internal and external shocks, providing a crucial support to the economy characterised by high unemployment and slow economic growth but a significant demand for imported goods and services.

Lately, this citadel of stability is starting to crumble following the persistently low fuel prices and sluggish economic growth in most developed and emerging economies. The economic stress, at least in terms of macroeconomic numbers, arising from the gloomy global outlook is gradually being felt in Nepal too. It could soon become a prime trigger factor for economic and social instability. The almost muted response from the politicians and the bureaucracy to this distressing development is mindboggling and irresponsible.

Multiple impacts

Although statistics show unemployment in Nepal to be lower than in most developed countries (for instance, the latest annual household survey puts it at 3.6 percent), it should be noted that this does not include ‘discouraged’ workers, who are not considered as a part of the labour force. Hence, the actual unemployment is substantially higher, with some agencies estimating it to be over 45 percent. Given the low economic growth and deindustrialisation, especially after the start of the Maoist rebellion, such a high level of unemployment is unsurprising. This is one of the reasons why until last year about 1,400 working age men and women legally left the country daily to work overseas, primarily in Saudi Arabia, Qatar and Malaysia, which together account for about 80 percent of total overseas migration.

Unfortunately, the global economic slowdown (which lowers external demand), low oil prices and the subsequent decline in investment, especially in natural resources, construction and security services, are weakening economic activities in these countries. It is having a direct impact on the Nepali economy through the lower demand for migrant workers and the deceleration in remittance inflows.

The overseas migration growth averaged 14.2 percent between fiscal years 2012 and 2014. It started to decline as low fuel and commodity prices affected investment and subsequently the demand for migrant workers from countries such as Nepal. Consequently, the number of migrant workers decreased by 2.8 percent in FY2015 and then by a further 18.4 percent in FY2016. (The April 2015 earthquake also contributed to the slowdown.) The figures translate into a daily average of 1,446 migrant workers in FY2014, 1,405 in FY2015 and 1,147 in FY2016—a clear downward trend. Migration to Malaysia declined by a whopping 70 percent as it put a moratorium on new hiring and opened up foreign employment in private security services—earlier restricted to Nepali and Malaysian nationals only—to other countries as well. Furthermore, its overall economic growth is affected by low fuel and commodity prices.

The declining demand for Nepali migrant workers will have a direct impact on remittance inflows, which will then affect household and macroeconomic activities. The growth of the remittance inflows has remained robust, averaging 25.3 percent over FY2012-FY2015. It remained resilient ($6.2 billion in FY2016) compared to other inflows such as foreign direct investment and official development assistance. However, a deceleration in remittance inflows is a very likely scenario given the drastic decrease in the number of migrant workers in the last three years.

Amounting to about 29 percent of gross domestic product (GDP), remittances have been a major factor supporting economic growth, poverty reduction and household expenditure, irrespective of the household’s domestic income. A decline in remittance inflows would lower the services sector growth, which primarily depends on remittance-financed consumption of imported goods. Since services sector constitutes over 50 percent of GDP, it will bring down overall economic growth as well. Furthermore, lower remittance inflows would likely lower government revenue, which is largely generated from taxes levied on remittance-financed consumption. Another significant impact will be on current account balance, which can easily go into the negative territory like in FY2010 and FY2011. It could then lead to a negative balance of payments and lower foreign exchange reserves. Given the pegged exchange rate with India, high dependence on remittance income and the composition of imports, Nepal needs to maintain reserves to finance at least seven months of import. In FY2011, when remittance growth declined but was not negative, reserves were enough to finance just 7.3 months of import.

The deceleration in remittance income triggered by the slowdown in migration will affect household consumption expenditure (and subsequently poverty), fiscal balance (as high consumption-based revenue growth tapers off), financial stability (as deposit growth slows down), and external sector (as current account and balance of payments fall into the negative territory).

Economic and social blowback

Robust remittance inflows fostered laxity in reducing policy weaknesses and in facilitating sound investment climate as politicians and bureaucracy had to do little work to generate moderate growth of below 5 percent and to reduce poverty. This needs to change now given the deceleration in remittance inflows and the slowdown in the demand for Nepali migrant workers. Medium- and long-term reforms have to be rolled out and implemented to boost investment, lower inflation, and create appropriate investment instruments that can channel the short-term remittance deposits into long-term infrastructure financing. Meanwhile, faster post-earthquake reconstruction works could help create a modest number of unskilled and semi-skilled jobs, which match the employment needs of would-be migrants.

These reform measures could not only address the immediate economic challenges arising from the deceleration in remittance inflows, but also tackle the Dutch disease effects (which broadly refers to the decline in tradable sector, chiefly manufacturing, and an appreciation of real effective exchange rate) seen in the economy since 2000. The primary focus should be on the active facilitation of investment and on transforming from the current low value-added, low productivity activities to high value-added and high productivity activities.

Further delays in addressing these issues would make it difficult for the country to fend off the economic and social blowback arising from the slowdown in overseas migration and the deceleration in remittance inflows.

Tuesday, September 20, 2016

Electricity demand in Nepal in 2030

This piece is adapted from Macroeconomic Update Nepal, Vol.4, No.2, published by Asian Development Bank, Nepal Resident Mission. Executive summary is here and FY2017 economic outlook here.

In a report published by the Investment Board of Nepal (IBN) the total energy demand is projected to reach 33,433 gigawatt hour (GWh), which is equivalent to 6,358 mega watt (MW) at 60% system capacity factor in 2030. Additionally, accounting for transmission loss (1,211 MW), outages (2,523 MW), and the constant daily demand load curve, the required installed capacity to meet energy demand in 2030 is 10,092 MW in 2030. A lower system factor (arising from supplementary sources such as storage plants and capacity increases in renewables) would mean higher installed capacities to meet demand. At 50% system capacity factor, the required installed capacity to meet energy demand would be about 12,000 MW.

It uses the model for analysis of energy demand (MAED) to forecast energy demand in the next 15 years. This differs significantly from the linear energy demand projection. The model considers latent demand (for instance, switching from traditional cooling methods to air conditioning, from liquefied petroleum gas to electrical appliances to cook food, and from fuel to electricity to power up vehicles) in such forecast and takes into account the evolution of socio-economic, technological and demographic patterns.

While these projections may be on the higher side given the optimistic assumptions for sectoral growth and its pattern, the direction and magnitude of energy demand in the next 15 years points to a plausible scenario of large demand-supply deficit if the planned projects are not completed on time. This has to be accompanied by reform of the entire sector, including enacting and implementing the legal, regulatory, institutional and administrative reforms. NEA system losses are already one of the highest in the world. In FY2016 its system losses were 25.9%, up from 24.4% in FY2015. It largely reflecting a dated distribution system (including sub par transformers). The country faces a challenge to meet the energy demand given the slow pace of project implementation (generation, transmission and distribution).


Update: Lately, it has been reported that the new Minister for Energy Janardan Sharma has ordered new estimation of electricity demand. He has refused to take ownership of the study commissioned by the IBN in collaboration with the NPC. His main argument is that IBN is not the authorized body to estimate electricity demand. It should be Water and Energy Commission Secretariat (WECS). This is a useless argument and is an indication of the maze of bureaucratic hurdles (created by self-interested bureaucrats chasing and chased by lobbyists and politicians) and lack of ownership of a report published by a agency which is chaired by the Prime Minister. There is no need for another study by WECS, which will probably lead a committee to finalize a TOR for new consultant and then lobby for funds to finance the one-year-plus long study. If it goes through, then the contract would most likely go to one of the pseudo-consulting firms close to the bureaucrats or the politicians. Just another study report to employ currently unemployed pseudo-intellects.

The need is not for a similar study report for the sake of 'ownership'. The urgent need is to accelerate project implementation, especially the stalled hydro energy projects and administrative reform of the various agencies, including NEA and the energy ministry. The country doesn't have the luxury of time and resources to commission yet another study of long-term energy projection by the energy ministry. The priority should be to do the needful to ensure that the ongoing projects are completed on time.

Some bureaucrats, politicians and energy lobbyists have been objecting to the IBN's proactive role in promoting large-scale hydro energy projects since its establishment. They are not happy with the IBN as it is taking away their business interest and is really taking forward contentious projects in a short time. The energy sector needs to be protected from this group of bureaucrats, lobbyists and politicians.

Sunday, September 18, 2016

NEPAL: Growth and inflation outlook for FY2017

This piece is adapted from Macroeconomic Update Nepal, Vol.4, No.2, published by Asian Development Bank, Nepal Resident Mission. Executive summary is here.

FY2017 growth outlook

The outlook for FY2017 growth is moderately optimistic and hinges on the scale of recovery of agricultural output given the normal monsoon, the scope and pace of post-earthquake reconstruction and rehabilitation, budget execution, and remittance inflows. The monsoon rains were above normal and on time unlike in the past few years. Approximately, 80% of total rainfall occurs between June and September. The Ministry of Agricultural Development estimated that paddy transplantation has been higher than in previous years. Paddy transplantation averaged about 95% of 1.4 million hectares of rice field by the first week of August, much higher than 75% in FY2015. However, widespread flooding in the Terai region and mid-Hills, and landslides caused some damage to crops during the last week of July and the first week of August. The outlook for industrial and services output is contingent upon the evolving political situation, reconstruction work, pace of budget execution, recovery of tourism sector and remittance inflows. The scope and pace of reconstruction projects will affect demand for quarrying, manufacturing and construction activities, which largely dictates the trajectory of industrial output. Timely, effective and judicious budget execution, which includes both accelerated spending and reform measures, will be at the core of industrial and services sector recovery. Similarly, a slowdown in the growth of overseas migrants is bound to affect remittance inflows, which subsequently would affect the major components in the services sector.

Considering these developments and a cautiously optimistic outlook on reconstruction and political situation, GDP growth (at basic prices) is forecast at 4.8%, lower than the government’s target of 6.5% announced in the FY2017 budget speech. Agriculture, industry and services outputs are expected to contribute 0.7, 1.0 and 3.0 percentage points. A downside risk to the forecast is the more than expected damage caused by natural disasters, especially flooding and landslides, to agricultural output; slow rehabilitation and reconstruction works; the slow pace of budget execution; and depressed demand in services sector arising from the deceleration of remittance inflows.

FY2017 inflation outlook

Better agricultural harvest due to the normal monsoon, subdued inflation in India, low international fuel and commodity prices and normalization of production and supplies since February 2016 will likely lower general prices of goods and services in FY2017 despite the demand-side pressures emanating from the earthquake related fiscal stimulus. The prices of cereal grains, paddy, pulses and legume are expected to moderate on account of the favorable monsoon. However, the prices of alcoholic drinks and tobacco products will likely escalate due to the hike in its tariff rate in the FY2017 budget. Similarly, restaurant and hotel prices are also likely to increase as the rebound in tourism sector will stimulate demand. Meanwhile, normalization of supplies and cooling off of demand pressures in housing and utilities will drive the de-escalation of non-food and services inflation. Although furnishing and housing equipment may see a rise in prices on account of the increased demand arising from gradual revival of real estate and housing markets, its impact will not be large enough to offset the decline in prices of other items in the non-food and services basket. Consequently, food and non-food inflation are projected to contribute 4.3 and 4.2 percentage points, respectively to overall inflation of 8.5% in FY2017.

Saturday, September 17, 2016

The state of macroeconomics in Nepal

This piece is adapted from Macroeconomic Update Nepal, Vol.4, No.2, published by Asian Development Bank, Nepal Resident Mission.

The lingering impact of the catastrophic earthquakes in FY2015, slow post-earthquake reconstruction, and crippling trade and supplies disruption resulted in gross domestic product (GDP) growth of just 0.8% in FY2016. The earthquake-led disruption of economic activities, especially in agricultural and industrial production, struggled to recover as reconstruction and rehabilitation efforts could not pick up speed. This was exacerbated by the trade and supply disruption between September 2015 and February 2016. The combined effect was quite disruptive for the economy as GDP growth dipped to its lowest level since FY2002. Agricultural output grew by an estimated 1.3%, marginally higher than 0.8% in FY2015. Meanwhile, industrial output registered a negative growth of 6.3% in FY2016, sharply down from 1.5% growth in FY2015. The services sector, which accounts for about 53% of GDP and is the key driver of GDP growth, grew by 2.7%, lower than 3.6% after the earthquake in FY2015 and 6.2% in FY2014. The outlook for FY2017 is moderately optimistic and hinges depending on the scale of recovery of agricultural output given the normal monsoon, the scope and pace of post-earthquake reconstruction and rehabilitation, budget execution, and remittance inflows. Considering these factors, GDP growth is forecast at 4.8% in FY2017.

The trade and supply disruption affected public spending although the pattern of spending, with heavy bunching up in the last quarter, was no different from previous years. Capital spending stalled for almost five months as the severe shortage of fuel and construction materials paralyzed project implementation as well as post-earthquake reconstruction. Budget under-execution has been a major fiscal issue in Nepal. The estimated actual capital spending was just 56.3% of planned capital spending in FY2016, sharply down from about 76% in the last five years. Meanwhile, actual recurrent spending was 75.6% of planned recurrent spending in FY2016, a significant drop compared to an average 90% in the last five years. Overall, expenditure grew by 13%, with recurrent and capital spending growth at 7.9% and 32.6%, respectively— lower than the growth rates in FY2015.

The continuous reforms in revenue administration, gradual broadening of the tax base, and the higher import bill (mostly financed by remittance income) resulted in robust revenue performance over the last decade. Total revenue grew by 18.9%, higher than the 13.7% growth in FY2015 but lower than the 20.5% growth in FY2014. Despite the five months long trade and supply disruption, revenue growth accelerated in the last five months of FY2016 as imports gradually normalized along with the clearance of the backlog of goods stuck at various customs points along the Nepal-India border. As a share of GDP, tax revenue mobilization increased significantly, reaching 18.8% of GDP in FY2016, up from 9.8% of GDP in FY2007. Non-tax revenue amounted 2.7% of GDP in FY2016. Total revenue growth averaged 20% in the last five years.

The robust revenue mobilization but disappointing expenditure performance resulted in a fiscal surplus equivalent to 1.4% of GDP in FY2016. The country ran a fiscal surplus in FY2013 and FY2014, but a fiscal deficit (of about 0.7% of GDP) in FY2015. For a country with one of the lowest per capita incomes in Asia, running a fiscal surplus indicates chronic problems associated with budget execution. A fiscal policy anchored on a modest deficit to finance productivity-enhancing infrastructure would not jeopardize fiscal sustainability. Nepal faces an estimated infrastructure financing gap of between 8% and 12% of GDP annually until 2020. Ramping up public spending on physical and social infrastructures, including those related to post-earthquake reconstruction, is essential for accelerated, employment-centric and inclusive economic growth. Primary surplus— fiscal balance before interest payment on public debt— increased to 3.8% of GDP. Nepal has been running a primary surplus since FY2012. Combined with the low and declining outstanding public debt (about 27.6% of GDP), it indicates that the government has ample fiscal space to ramp up productivity enhancing public capital investment without jeopardizing fiscal sustainability. However, a major constraint for doing that is the eroding expenditure absorption capacity.

Inflation (year-on-year average consumer price index [CPI]) increased by 9.9%, higher than 7.2% increase in FY2015, as the unfavorable monsoon affected agricultural output and the trade disruption created a severe shortage of essential goods, including cooking gas and petroleum products. Overall, food prices and non-food prices contributed 4.8 and 5.1 percentage points to overall inflation. Looking forward, the expected bumper agricultural harvest due to the normal monsoon, expected subdued inflation in India, low fuel and commodity prices and normalization of trade and supplies will likely lower general prices of goods and services in FY2017 despite the demand-side pressures emanating from the earthquake related fiscal stimulus, especially the committed $2000 grant to over half a million affected households. Consequently, food and non-food inflation are projected to contribute 4.3 and 4.2 percentage points, respectively to overall inflation forecast of 8.5% in FY2017. The possibility of supplies disruption arising from natural disasters and political instability is a major downside risk to the inflation forecast.

Money supply (M2) grew by 19.5%, reaching NRs366.8 billion, supported by a robust increase in net foreign assets. However, it is marginally lower than the 19.9% growth in FY2015 owing to the decrease in net domestic assets. The BFIs mobilized NRs328 billion (reaching a total NRs2016.8 billion) in deposits in FY2016, higher than NRs282 billion mobilized in FY2015, as higher remittance inflows (despite the decrease in the number of migrant workers) and slower government expenditure boosted deposits. Total credit (loans and advances) of BFIs increased by 23.3% (NRs360 billion) in FY2016, up from 17.5% growth in FY2015 (NRs229.3 billion). Credits by commercial banks grew by 25.9% (NRs327.9 billion), up from a rate of 18.8% in FY2015. Responding to the persistent excess liquidity in the banking sector in FY2016, the Nepal Rastra Bank (NRB) mopped up liquidity equivalent to NRs235.9 billion through reverse repo auctions— one of the short-term tools used by the central bank to manage liquidity— at weighted interest rates between 0.0001% and 1.3%; NRs9 billion through outright sale auctions at weighted interest rate between 1.06% and 2.88%; NRs297.5 billion through deposit auction at a weighted interest rate of 0.85%; and NRs49.1 billion by selling NRB bonds. The short-term interest ratesfluctuated throughout the year and were slightly higher than in the corresponding months in FY2015.

The balance of payments surplus reached $1.8 billion (8.5% of GDP) in FY2016, up from $1.4 billion in the previous year. The large merchandise trade deficit, which declined to 30.3% of GDP from 31.3% of GDP in FY2015, was partially offset by workers’ remittances, which hit a record 29.6% of GDP, resulting in a current account surplus of $1.3 billion (6.2% of GDP), up from 5.1% of GDP in FY2015. Meanwhile, FDI inflows increased to $55.8 million from $44.2 million in FY2015. Gross foreign exchange reserves increased from $8.1 billion in FY2015 to $9.7 billion in FY2016, sufficient to cover 14.1 months of import of goods and non-factor services. The Nepalese rupee continued to remain weak against the US dollar, closely following movement of the Indian rupee, to which the currency is pegged since 1993. Overall, the Nepalese rupee depreciated by 5.2% between mid-July 2015 and mid-July 2016.

This edition of Macroeconomic Update’s issue focus delves into the efficiency and integrity of public procurement and its effects on accelerating inclusive economic growth. Many medium to large-scale development projects in Nepal are plagued by implementation delays and cost overruns. At the core of such recurrent hurdles is inefficient public procurement, contributed by a slew of factors such as legal and policy complications, poor performance of contractor, lack of required human resources to manage contract and high staff turnover, political meddling at management and operational levels, weak leadership by project directors, and prolonged delays by oversight and judicial agencies to clear contentious procurement. Consequently, project implementation is slow with cost and time overruns, quality and scale of infrastructure construction is not up to the taxpayers’ expectation, and disbursement is slow and below target. All these result in sluggish economic growth and
insufficient jobs creation.

Efficiency and integrity in public procurement (of goods, works and services) accelerate project implementation, which in turn enhances capital spending and positively affects economic growth, research and development (innovation), stimulation of private sector activities and jobs creation. Furthermore, if done in the right way and on time to maximize the value for taxpayers’ money, public procurement could be used as a strategic policy tool to address the myriad of economic, social and environmental challenges faced by the country. Hence, efficiency and integrity in public procurement— equivalent to around 12% of GDP— is vital to not only accelerate project implementation, but also to achieve medium-term goal of graduation from LDC category and long-term goal to be a middle income country by 2030, which also is the target date to achieve the Sustainable Development Goals (SGDs).

Friday, September 2, 2016

Remittances and fiscal and monetary policies

High inflow of remittances limits the central bank's ability to influence through the traditional monetary policy. Here are excerpts from a recent article by Barajas et al in the latest edition Finance & Development magazine.

On fiscal policy

Remittances directly expand the tax base, which makes it easier for countries to maintain fiscal sustainability, in the sense of avoiding a situation of ever-expanding public debt. However, remittances can also skew the behavior of governments, in undesirable ways. First, and somewhat paradoxically, the very expansion in the revenue base could distort government incentives, lowering the costs of engaging in wasteful spending. Second, the supplemental income that remittances provide to households increases their ability to purchase goods that substitute for government services and reduces their incentive to hold the government accountable.

On monetary policy

For low-income countries, there is growing evidence that monetary policy transmission is substantially weaker than in advanced economies. While a variety of transmission channels may operate, Mishra, Montiel, and Spilimbergo (2012) argue that weak securities market development, imperfect integration with international financial markets, and highly managed exchange rates are likely to leave poorer countries with only one operable channel—bank lending. A change in the policy rate ripples through markets for short-term securities, ultimately affecting banks’ cost of funds at the margin and thus their ability to lend to private entities, whether people or firms.
However, even the bank-lending channel may be seriously weakened if there is little banking competition, the quality of institutions is poor, interbank markets in which banks deal with each other are underdeveloped, and information is lacking about the quality of borrowers. These factors conspire to short-circuit the transmission of moves in the short-term policy rate to banks’ cost of funds.
[...]remittances expand bank balance sheets by providing a stable and essentially costless source of deposits—because they are largely insensitive to interest rates. [...]because the remittance deposits increase the amount of financial intermediation (the process of banks matching up savers and borrowers), remittances might be expected to contribute to stronger monetary policy transmission.
[...]although banks might receive ample and virtually costless additional funding year after year from deposited remittances, that does not mean they will increase lending to the private sector one for one. Remittance-recipient economies—such as economies in most of the developing world—are often plagued by a number of problems, including a weak institutional and regulatory environment and a dearth of creditworthy borrowers.
[...]remittance flows may have a hand in weakening governance. This fragile lending environment reduces banks’ willingness to lend beyond a very limited pool of “qualified” borrowers, a reluctance that the additional lendable funds do nothing to counteract. Banks in recipient countries, then, tend to hold larger shares of liquid assets, excess reserves, and government securities than banks in nonrecipient countries. As a result, because banks are flush with liquidity, an interbank market—in which institutions in need of short-term funds borrow from those with excess balances—fails to develop. Because the policy rate is designed to affect the marginal cost of funds for banks, when there is virtually no interbank market, the effect of policy rate movements is weakened or nonexistent. The bank lending channel becomes impaired.

On transmission mechanism

Our empirical analysis confirms that, as remittances increase, monetary transmission through the bank lending channel weakens notably. Based on a sample of 58 countries worldwide between 1990 and 2013, we find that the strength of transmission, measured as the direct effect of a change in the policy rate on changes in bank lending rates, declines continuously as the size of remittances increases. In countries that do not receive remittances and have competitive banking systems, nearly 90 percent of a change in the policy rate is transmitted to the bank lending rate. In contrast, in an economy that receives 5 percent of GDP annually in remittances, only about 4 percent of the same change to the lending rate is transmitted, even when banking systems are competitive. In fact, when remittances reach 7.6 percent of GDP, the policy rate has no effect on bank lending rates. If the banking system is not competitive, the turning point occurs at a much lower level of remittances—1.2 percent of GDP.
[...]remittance-recipient countries may opt to scale back plans for full monetary policy independence. In fact, research suggests that greater remittance inflows are indeed associated with greater intervention in foreign currency markets, whether to fully fix the exchange rate or manage its fluctuations.