Thursday, July 21, 2016

How to finance large-scale infrastructure in Nepal?

It was published in The Kathmandu Post, 19 July 2016. An earlier blog post on the same issue is here.

Financing infrastructure

Prime Minister KP Oli led government surprised everyone few weeks ago by proposing to initiate key large-scale infrastructure projects, including the much-touted fast track road and Budigandaki hydroelectricity projects, using domestic resources. The intention was to stoke a renewed sense of nationalism high on rhetoric but low in substance, and to extricate the government from binding hooks that come with bilateral financing of such projects. One unruly leftist party even fervently argued for financing all hydropower projects with domestic resources and floated a premature idea to raise money from local shareholders. 

Some politically aligned experts are throwing their weight behind such half-baked proposal without properly analyzing the available financial and knowledge capacities. As it stand now, the economy simply does not have the required financial capacities, stock of knowledge and management capabilities, and competent institutions to initiate large-scale projects entirely on domestic resources. Acquiring such capability requires close collaboration on financing, research and management between external and domestic sources. 

Unfavorable macro

Politicians and their intellectual cheerleaders quickly point to low public debt (in other words fiscal space) to finance large-scale infrastructure projects such as hydroelectricity, roads and airports domestically. The outstanding public debt has decreased sharply from about 52 percent of gross domestic product (GDP) in 2005 to around 25.7 percent of GDP. It means Nepal could theoretically borrow more without jeopardizing fiscal stability (say up to 40 percent of GDP). However, borrowing an additional $3.5 billion or more from domestic and external sources requires the government to drastically enhance its absorption capacity, which unfortunately is eroding.

The outstanding domestic borrowing by selling government bills and bonds amounts to 9.5 percent of GDP and external borrowing, mostly on concessional terms, 16.2 percent of GDP. The government is predominantly selling treasury bills (with maturity of less than one year) to finance recurrent spending as well as multi-year infrastructure projects, and implicitly to manage excess liquidity. This is not a good fiscal practice as large-scale infrastructure projects are financed typically by issuing specific construction bonds, which have long-term maturity and lower risk of asset-liability mismatch. Higher domestic borrowing to fulfill politicians’ whims will crowd out private investment by pushing up interest rates and put unnecessary debt burden on future generation. The FY2017 budget falls in this category.

The use of excess liquidity and treasury savings are identified as alternative sources that could be tapped in to finance infrastructure projects. The persistent excess liquidity is the result of higher growth of deposit compared to the growth of credit. It arises when there is lack of investment-ready projects and unfavorable investment climate, thus constraining banks and financial institutions’ (BFI) capacity to increase credit. Meanwhile, the large growth of deposit is due to the increasing remittance inflows and the government’s inability to spend allocated capital budget on time. While the former is starting to slowdown as the demand for the migrant workers is decreasing, the latter is expected to improve due to relatively better budget execution from this year onward. Transient and volatile excess liquidity and treasury savings cannot be reliable sources for long-term infrastructure financing.

Another related argument on the adequacy of domestic resources is the potential to pool in savings. This argument has its roots in the remittance-backed large deposit growth and oversubscription of shares in the stock market. First, the remittance-backed savings are of short term in nature and using them to invest in projects with long gestation lags create asset-liability mismatch for the BFIs. This is one of the reasons why the BFIs as well as pension funds are financing medium to long term projects through a consortium, which minimizes risk arising from overexpose to one sector. Second, the oversubscription during share issuance is essentially to reap quick profits by trading the shares in the secondary market. This quest for short-term gain does not indicate that there is excess long term saving that could be used for multi-year large-scale infrastructure projects. Nepal’s financial system is not yet mature enough for that.

Regarding external financing, the government won’t be able to drastically increase borrowing because it directly depends on absorption capacity, which stands at a mere 75 percent of budgeted capital spending. Frustration is already running high among Nepal’s key multilateral and bilateral donors owing to the government’s inability to timely use the committed grants and loans. Furthermore, concessional lending from multilateral donors might be drying up. The Asian Development Bank and the World Bank are gradually phasing out concessional lending, which means Nepal might have to borrow at a rate between concessional and nonconcessional terms. The bilateral donors may not be as generous as the multilateral donors as they usually insert binding hooks on procurement and the utilization of funds.

Rhetoric vs realism

Hence, the prospect for domestic and external borrowing may not be as rosy as has been claimed by some politicians and their cheerleaders. Being ambitious on infrastructure projects and their financing is okay, but it should not depart much from what is realistically possible and most importantly it should be not be used to score political points founded on misplaced nationalism. 

The most realistic option for now is to improve investment climate to facilitate private investment (including lowering of country investment risk premium) and to enhance the absorption capacity to accelerate capital spending. It would require addressing head-on the constraints to private investment and low capital spending (including contract management) with an aim to domestically finance large-scale infrastructure projects in the future. Practically, such projects should be financed by issuing long-term construction bonds instead of relying on short-term treasury bills, and medium-term development, employment and savings bonds. An appropriate environment to boost confidence on such long-term bonds is needed.

Properly doing these would require tough reforms, which may not be politically palatable, as opposed to lofty rhetoric on economic development.