Is Modi’s magic fading (economically)?

The MOSPI released preliminary estimates of growth for Q1 (April-June) 2017/18 (FY2018) today and looks like demonetization effects have not faded away. The gross value added (at basic prices) grew at 5.6% year-on-year in Q1 FY2018, down from 7.6% in Q1 FY2017. In fact, agricultural, industrial and services output growth were lower in Q1 FY2018 than in Q1 FY2017. GDP at basic prices (GVA plus net taxes) grew by 5.7%, down from 7.9% in Q1 FY2017.

The effects of demonetization have not tapered off completely as second round effect are still persistent (dent in economic activities in informal sector where cash transaction is more prevalent is finally showing up in formal sector activities, which is picked up by official statistics). Additionally, the expected rollout of GST might have affected small and medium scale economic activities (remember that most of the economic activities in India happen at SME level). GST is seen as a burden for SMEs in the short-term as it increases accounting and transactional costs. They may have destocked their inventories and slowed down orders.

Specifically, agricultural output grew by 2.3% compared to 2.5% in Q1 FY2017. Rabi season output (agricultural crops such as rice, wheat, coarse cereals, pulses and oil seeds sown in winter but harvested in the spring) growth mostly likely was not as robust as in Q1 FY2017. Similarly, livestock products, forestry and fisheries (which account for about 43.1% of GVA of agricultural sector) grew at just 3.4% in Q1 FY2018.

Industrial sector is the one whose output decelerated the most, growing at just 1.6% in Q1 FY2018 compared to 7.4% in Q1 FY2017, probably because effects of demonetization haven’t fully tapered off and concerns over implementation of GST dented economic activities of SMEs. Mining and quarrying activities continued to grow at a negative rate; manufacturing output grew at a mere 1.2% compared to 10.7% in the corresponding period last year; and electricity, gas, water supply and other utility services too grew at a slower pace (7% vs 10.3% in Q1 FY2017). Specifically, production of coal grew at a negative rate (probably signaling lower power demand and excess inventory) and mining activities grew at 1.2% (much lower than 7.5% in Q1 FY2017). Private sector manufacturing activities slumped drastically (had a negative growth), and quasi-corporate and unorganized segment’s activities too slowed down. Furthermore, construction activities such as production of cement and non-metallic minerals slumped. 

Services output growth moderated a little bit to 8.7% from 9.0% in Q1 FY2017. Activities in retail & wholesale trade, hotels & restaurants, and transport & communication activities grew at a robust 11.1%, up from 8.9% in Q1 FY2017. Similarly, public administration, defense & other services grew at 9.5% (up from 8.6% in Q1 FY2017). However, financial intermediation, and real estate & business activities slowed down to 6.4% from 9.4% in Q1 FY2017. Trading activities are recovering after the demand denting demonetization (but industrial production is still clouded by this as well as GST’s effect on SMEs) and railways and aviation traffic is growing modestly. Meanwhile, real estate and business activities have slowed down for the same reasons mentioned above. The central government’s increase in revenue expenditure (i.e., recurrent spending) has boosted growth of public administration and allied activities.  

Overall, it’s the slump in industrial sector output that has pulled down overall GVA growth. In fact, while agricultural and services sector contributed 0.3 and 4.9 percentage points to overall GVA growth in the first quarter of FY2017 and FY2018, industrial sector’s contribution dropped sharply to 0.5 percentage points from 2.4 percentage points in Q1 FY2017. Hence, GVA output growth was just 5.6% in Q1 FY2018.

Now, if you look at the QGDP figures from expenditure side, then you will see a continuing slump in fixed capital formation. Gross fixed capital formation growth was just 1.6%, down from 7.4% in Q1 FY2017. Similarly, inventories are not being cleared and restocked as fast as one would like the economy to do it (here is where the uncertainty over GST's effect is affecting SMEs). Change in stock grew at 1.2% compared to 8.9% in Q1 FY2017. Exports growth slowed down but imports growth grew at a robust rate, resulting in a negative net exports growth. A substantial increase in private consumption growth was insufficient to make up for the slowdown in other sectors, resulting in GDP growth (at basic prices) of 5.7%, down from 7.9% in Q1 FY2017.

The government’s GVA growth target for FY2018 is 7.3%. Economic activities are usually robust in the first two quarters as the government tends to front-load spending and households tend to purchase goods ahead of the festival season in the third quarter. However, in FY2017, economic activities, especially industrial and services, slowed down in all the four quarters. This trend is continuing in FY2018 as well, signaling a cooling off trend further accelerated by first by demonetization and then by concerns over the implementation of GST and its impact on SMEs. 

Five quarters of consecutive GVA deceleration is not consistent with the promise of a rising and shining Indian economy under the present leadership (even though it has undertaken landmark reforms such as demonetization, GST, easing of doing business, etc). May be there aren’t low hanging fruits! Favorable monsoon will boost agricultural output and gradual recovery of services activities will continue as demonetization fades away fully. But, the real concern here is acceleration both public and private capital formation. Private sector investment is still slowing down as stressed corporates are not able to expand business by borrowing more. Non-stressed corporates (usually SMEs) are concerned by the exact impact of the implementation of GST on their businesses, particularly administrative and transaction costs. Increasing private sector investment is tricky in India and would require drastic measures on both fiscal and monetary policy fronts. Meanwhile, public capital spending needs to be accelerated by effectively tackling a myriad of bureaucratic as well as legislative factors— land, environment, tax incentives clearance, etc.

Links of interest (2017-08-31) : Effectiveness of demonetization in India; Electoral constituencies in Nepal

How effective was demonetization in India?

The main objectives of the demonetization shock on 8 November 2016 were: “(i) flushing out black money, (ii) eliminate Fake Indian Currency Notes (FICN), (iii) to strike at the root of financing of terrorism and left wing extremism, (iv) to convert non-formal economy into a formal economy to expand tax base and employment and (v) to give a big boost to digitalization of payments to make India a less cash economy”

The latest RBI annual report 2017 says that the value of IRs500 and IRs1000 notes that were returned was IRs15.3 trillion versus IRS15.4 trillion in circulation before demonetization. This means almost 98.9% of the invalidated notes were returned back to the RBI by 30 June 2017. So, if pretty much all of the invalidated notes were returned back, then does this mean ‘black money’ was not flushed out as touted? In a way, yes! However, the government is also investigating IRs1.75 trillion deposited in banks after demonetization. The hefty penalty, if sources are not substantiated, would mean higher one-off revenue for the government later on. Digitization and formalization of the economy got a boost. RBI detected 762,072 fake notes (valued at IRs430 million) in 2016/17 compared to 632,926 fake notes in 2015/16.  

The RBI sees rosy prospects for FY2018, thanks to favorable monsoon (boosts rural demand and lowers food inflation); strong urban demand coming from income boost due to upward revision in house rent allowance to central government employees and the possibility of implementation of wage revisions at state level; reforms to lower the cost of doing business that will increase investment; faster project implementation; higher credit demand following low interest rates post-demonetization in the case of stress-free corporates; etc. It points to slow industrial output growth and low fixed capital formation as concerns for the economy along with challenges to resolving highly indebted corporates and public sector banks. 

It expects GVA growth of 7.3% in 2017/18. Headline inflation is expected to be between 2.0% and 3.5% in H1FY2018, and 3.5% and 4.5% in H2FY2018 (prospect of wages and compensation increase, and farm loan waivers driving some part of the upward trend). Here is a good review of the economy in FY2017 (an earlier related blog here).

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Constituency Delimitation Commission (CDC) finalizes 165 electoral constituencies

CDC in Nepal carved out 165 first-past-the-post electoral constituencies for House of Representatives and 330 constituencies for provincial assembly. Of the total 165 electoral constituencies, 78 are in 20 Tarai districts which make up 47.27 percent of the country’s total geography. CDC gave 90% weight to population and 10% to geography (after ensuring that each district has at least one constituency). Province 3 will have the highest number of constituencies with 33, followed by Province 2 (32 constituencies), Province 1 (28) constituencies), Province 5 (26 constituencies), Province 4 (18 constituencies), Province 7 (16 constituencies) and Province 6 (12 constituencies).

The CDC was formed on July 20 to complete its task within 21 days. Its term was extended by 15 days on August 16. The new constituencies carved out by the CDC cannot be altered for another 20 years and the CDC recommendations cannot be challenged in any court of law, as per the constitution.

Meanwhile, federal and provincial polls will be held simultaneously in two phases in November 26 and December 7. 

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Rasuwagadhi-Kerung becomes int’l crossing point

The Rasuwagadi-Kerung border point, the only trade route currently in operation between Nepal and China, has been upgraded to an international crossing point. Citizens from other countries besides Nepalese and Chinese can travel across the border.

NEPAL: Macroeconomic outlook for FY2018

The previous blog post covered the major macroeconomic highlights in FY2017. This blog post will provide an outlook for FY2018 (mid-July 2017 to mid-July 2018). 

GDP growth

The government’s GDP growth target is 7.2%, up from a 6.9% growth (at market prices) in FY2017 thanks to a favorable base effect, good monsoon, improved energy supply, reconstruction activities and normalization of supplies after two years of disruption (earthquakes in FY2015 and trade blockade in FY2016). Achieving a higher growth rate in FY2018 would require stronger factors than in FY2017. However, this is an unlikely scenario. 

First, the base effect will dissipate fast and there won’t be any fluke in FY2018 (at least as of now). Second, the usual factors that underpin robust economic activities are not as strong as in FY2017. 

Monsoon arrived not only late, but there was also uneven rainfall across the country. There was at least a week of dry spell during the peak paddy planting time. Then incessant rain, caused by a cloud burst, in the second and third weeks of August led to widespread flooding and landslides, wreaking havoc in the Terai plains (which is also considered a breadbasket of the country). In fact, according to Ministry of Agricultural Development, paddy plantation rate was 92.8% (1.4 million hectares out of 1.6 million hectares of cultivable land) in FY2018 (as of August 2017). In FY2017, it was 97% and paddy production was a record 5.23 million tons. Therefore, agricultural output growth will most likely be lower than in FY2017. Additionally, flooding has affected livestock and fishery. 

Although reconstruction activities are expected to accelerate (distribution of second and third tranche of housing grants), stimulating construction and mining and quarrying activities, manufacturing output may still be affected by the uncertainty over uninterrupted energy supply and the damage caused by flooding and landslides. The prospect of load-shedding is high in FY2018 as there has been setback to temporary plans to plug energy demand and supply gap. Higher energy import from India is likely as additional electricity generated by new small and medium scale hydroelectricity projects won’t be sufficient. Furthermore, floods have damaged and disrupted manufacturing activities in the main industrial belt. Against this backdrop, even industrial output growth will likely be lower than in FY2017. Accelerated reconstruction work and completion of large infrastructure projects, if realized within FY2018, might help to keep industrial output growth high.

The deceleration of remittances and temporary supplies disruption due to flooding and landslides will dent services activities. Tourism activities are beginning to pick up (tourist arrivals are up and bed occupancy is high ahead of the tourism season), but its momentum is slowed by the flooding in Terai (affected overland tourist arrival to hotspots in Terai such as Lumbini and Chitwan). Similarly, transportation activities are occasionally being disrupted along the main trading route due to landslides and weak management. Real estate and business activities may not pick up given the tight credit situation and regulatory squeeze. Wholesale and retail trading may not be as robust as in FY2017 as base effect related to supplies normalization fade away quickly and deceleration of remittance income weakens consumer demand (although post-earthquake housing grants, post-flooding reconstruction efforts, and elections related expenses may provide some backup). 

Against this backdrop, GDP growth (at basic prices) may hover around 5.2% (kind of optimistic one as of August 2017). Of this, contributions of agricultural, industrial and services sectors come to be around 1.2, 1.1 and 2.9 percentage points, respectively. However, given the uncertainty over the direction of some of the key factors (industrial activities and extent of damage caused by flooding) it is appropriate to consider a range for GDP growth forecast, which I think could be between 4.5% and 5.5%.

Inflation

CPI inflation (FY2015=100) in FY2017 was 4.5%, sharply down from 9.9% in FY2016, thanks to bumper agricultural harvest, low fuel prices, low inflation India, improved energy supply (one of the main supply-side constraints) and normalization of supplies. However, in FY2018 inflationary pressures are likely to be high, especially coming from higher food and beverage prices. 

Food prices are expected to heat up as floods and landslides put strain on agricultural output and its distribution. Prices of cereals, vegetables and meat products will most likely grow higher than last year. Similarly, non-food inflation will also be higher than in FY2017, mostly coming from higher prices of clothing, housing and utilities, and transportation. Overall, elections (third phase of local election in province two on September 18, and provincial and federal elections in two phases on November 26 and December 7) related spending and disruptions caused by flooding in Terai will exert inflationary pressures on daily consumable and non-durable goods, and reconstruction works, if it accelerates, may increase demand for construction materials and unskilled and semi-skilled wages. Furthermore, CPI inflation in India (2012=100; fiscal year starts in April and ends in March) is also expected to be higher than in FY2017 (RBI’s target is an average 4%, but can tolerate a range of 2% to 6%). 

Accordingly, inflation may hover around 7.7% (in the neighborhood of NRB’s target of 7.5%), out of which contributions of food and non-food inflation would be 3.3 and 4.4 percentage points, respectively. As before, there remains substantial uncertainty over the intensity of the factors that drive inflation. Therefore, it is better to put up a range for inflation forecast, which I believe would be between 7.5% and 8.0%. 

External sector

A large increase in trade deficit coupled with deceleration/slow growth of workers’ remittances led to a current account deficit of about 0.4% of GDP in FY2017 (the first CAD since FY2011). In FY2018, this pattern will also probably remain the same. 

Nepal’s export is crippled by structural bottlenecks as well as supply-side constraints, and import demand of fuel and durables/construction materials is somewhat inelastic due to the wide gap between production and demand in the economy. Hence, trade deficit will further widen. Meanwhile, remittance inflows will decelerate or remain low as there has been a notable decline in the number of overseas migrant workers. Consequently, current account will likely remain in negative territory (around 2.2% of GDP or even higher). 

Brief snapshot of Nepalese economy in FY2017

Since the full year FY2017 (mid-July 2016 to mid-July 2017) provisional data is available, except for some public finance variables, this post will try to give an overall picture of the performance of the economy. I will have a brief outlook for FY2018 in the next blog post. 

Real sector

Central Bureau of Statistics (CBS) estimated that Nepal’s economy (gross value added at basic prices) would likely grow by 6.9% in FY2017, sharply up from 0.01% in FY2016 and 3% in FY2015. It projected agricultural, industrial and services will grow by 5.3%, 10.9% and 6.9%, respectively. Base effect, favorable monsoon, improved electricity supply, normalization of supplies and tourism activities contributed to the rosy economic activities. For detailed analysis, see this.

Fiscal sector

Both recurrent and capital spending grew at a rate higher than in FY2016. Overall, expenditure grew by 46%, up from 15.3% in FY2016, led by acceleration of reconstruction works (including distribution of first and second tranche of grants) and some progress in capital spending. But, the overall pattern of spending did not change even though budget was announced one-and-a-half months prior to the start of the fiscal year. It was argued that this will give ministries adequate time to get approval for spending and initiate preparatory project planning (especially procurement documents), all of which were expected to accelerate capital spending. Specifically, the idea was to finish all preparatory work and start issuing tender notices and in some cases finalize contractors before the start of festival season (September-November). However, this was not the case. 

First, the spending pattern (i.e. quality of spending) hardly changed despite the early approval of budget. Almost 60% of the actual capital spending happened in the last quarter and 41.2% in the last month. It raises doubt over the quality of spending. Second, capital spending absorption capacity has receded. Just 65.5% of planned capital budget was spent in FY2017 (NRs204.3 billion spent vs NRs311.9 billion planned). Although it is slight higher than 58.6% in FY2016 (when the economy was crippled by trade and supplies disruptions), it is still lower than 76% in FY2015 (when earthquakes struck around the last quarter of fiscal year). As a share of GDP, capital spending increased to 7.9% of GDP, up from 5.4% of GDP. The planned capital spending in FY2017 was 12% of GDP. For more on capital spending, see this.  

In FY2017, total spending reached an estimated 27.8% of GDP (recurrent 19.9% of GDP and capital 7.9% of GDP). Total expenditure including net lending was 29.9% of GDP. Revenue mobilization was higher than targeted, thanks to the normalization of imports/supplies and pickup in economic activities. Revenue mobilization reached 23.4% of GDP (including tax revenue of 21.1% of GDP). VAT and customs tariffs contributed 26.3% and 24.3%, respectively to the overall revenue mobilized in FY2017. Foreign grants increased to 2.9% of GDP as reconstruction aid started to materialize gradually.

These together resulted in a fiscal deficit of about 3.6% of GDP. Primary deficit was 0.6% of GDP. Overall, expenditure growth was faster than revenue growth, leading to a larger fiscal and primary deficit. This is okay for now given the reconstruction and investment needs of an economy with low per capita income. However, the priority should be to enhance quantity as well as quantity of capital spending (and to rein in rising recurrent spending). Outstanding public debt stood at around 25% of GDP (figures up to Q3FY2017). For a quick review of FY2018 budget, see this.

Monetary sector

Inflation moderated substantially to 4.5% in FY2017, down from an average 9.1% over FY2010-FY2016, thanks to normalization of supplies & base effect, low inflation in India, low and stable administered fuel prices, bumper agricultural harvest due to favorable monsoon, and improved energy supply. Specifically, food inflation dropped to 1.9% from 10.9% in the previous year, and non-food inflation slumped to 6.5% from 9.2% in the same period. Prices grew at a negative rate in the case of vegetable, fish and meat, ghee and oil, transportation and communication. In fact, prices of all items in the CPI basket decreased except for sugar and sugar products. If you look at monthly inflation figures, there is a deflationary trend in the case of food and beverage prices since January 2017.

The effect of deceleration of remittance is quite visible in monetary aggregates and external sector. Money supply (M2) growth moderated to 15.5% (from 19.5% in FY2016) due to the slump in net foreign assets, which grew by just 8.6% (compared to 25.3% in FY2016). Credit to private sector decelerated but government borrowing increased. Overall, deposit growth was 14%, but credit growth was 17.8% (both are lower than in FY2016). Credit and deposit growths of development and finance companies were even negative. About 29.8% of the total increase in lending in FY2017 (NRs.304.4 billion) went to wholesalers and retailers, followed by industry, finance & insurance, services, and construction. As a share of GDP, M2, total deposit and total credit stood at 99.7%, 88.5% and 86.2% respectively in FY2017. 

The slow deposit growth (caused by deceleration of remittances and slow government spending) and little room for credit expansion by BFIs (some were hitting the capital to deposit ratio of 80) resulted in volatile interest rates. The weighted average deposit and lending rates were 4.5% and 9.9%, respectively in FY2017 (both higher than in FY2016). Similarly, interbank lending and 91-day treasury bills rate increased to 2.6% and 1.45% (again both higher than in FY2016). Rates for 14 days deposit auction and 14 days repo auction (liquidity management policy tools used by the NRB) averaged 0.25% and 4.87%, respectively. Reverse repo rate was 1.58%. 

Non-performing loans continue to decline, reaching 1.63% of total loan by mid-April 2017. Capital adequacy ratio is above the regulatory threshold (10% plus 1% buffer).

Overall, inflation is moderating, but retail interest rates are rising indicating the deficiency of liquidity management tools (liquidity was ample towards the last month of FY2017 and first quarter of FY2018).

The stock market too remained volatile with NEPSE index closing at 1582.7 at the end of FY2017, down from a high of 1818.2 in FY2016. The number of listed companies decreased to 208 from 230 in the previous year. Stock market capitalization decreased to 71.4% of GDP from 84.1% of GDP in FY2016. Stock market turnover was NRs205 billion (0.011% of market capitalization). Commercial banks had the largest share (about 46.5%) of total turnover, followed by insurance and development banks.

External sector

External sector deteriorated in FY2017. The normalization of supplies (after crippling trade embargo in FY2016) resulted in modest export growth but a large import growth. In US dollar terms, merchandise export (fob) increased by 9.8% but merchandise import (cif) increased by 29.4%, leading to increase of merchandise trade deficit by 31.6%. Meanwhile, workers’ remittances continued to decelerate (in NRs terms). While it grew by 4.6% in Nepalese rupee terms (slower than in the last three years), it grew by 4.7% in US dollar terms (slightly higher than 2.1% in FY2016). The deceleration/slow growth of remittances is due to the decrease in the number of overseas migrant workers. On an average, 1,093 migrant workers left the country daily in FY2017, down from 1,147 in FY2016, 1,405 in FY2015 and 1,446 in FY2014. Workers’ remittances was US$6.6 billion (about 26.8% of GDP).

Nepal’s export is crippled by structural bottlenecks as well as supply-side constraints, and import demand of fuel and durables/construction materials is somewhat inelastic due to the wide gap between production and demand in the economy. Meanwhile, given that remittance inflows are likely to continue to slowdown, current account may be in negative territory for the next couple of years. For more on the impact of slowdown in remittance inflows, see this.

Overall, merchandise trade deficit reached 34.5% of GDP, but net transfers (includes remittances) was just 32.8% of GDP and net services and income balance were just 1.3% of GDP, resulting in current account deficit of 0.4% of GDP. The last time Nepal had CAD was in FY2011. FDI inflows increased to US$127.5 million from US$55.8 million. Balance of payments surplus decreased to 3.2% of GDP from 8.4% of GDP in FY2016. Gross foreign exchange reserves stood at US$10.1 billion, which is enough to cover 11.4 months of import of goods and services. 

Nepalese currency appreciated by 3.8% vis-à-vis US dollar at the end of FY2017 after five years of continuous depreciation. 

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In a nutshell, the Nepalese economy in FY2017 recovered fast from the slump triggered by crippling supplies disruption, political instability, lingering effects of 2015 earthquakes and slow reconstruction in FY2016. Growth was one of the highest in recent decades, but this is largely a base effect blessing. Revenue mobilization surged past the target as supplies normalized and economic activities started to pick up. Expenditure was higher, but not of expected level especially capital spending. Inflation was lower but retail interest rates are rising as deficient liquidity management took a toll on credit flows. The banking sector also contributed to this by engaging in reckless lending to a select (unproductive) sectors. External sector deteriorated with current account in the negative territory (but it was expected).

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India after demonetization (growth, public finance and inflation)

A lot has been written about the impact of the demonetization shock on 8 November 2016 in India. PM Narendra Modi's government took a surprise decision to withdraw IRs1000 and IRs500 denomination currency notes (about 86% of value of total notes in circulation) to rein in corruption, counterfeiting, terrorist financing, and accumulation of black money (income that’s hidden from tax authorities). While the move is generally good for the economy over the medium and long terms (higher GDP growth, tax compliance, tax revenues, digitization, lower interest rates as liquidity in banking sector increases, etc), it had significant impact on economic activity in the short term, especially due to the botched implementation (shortages of cash, confusion, temporary withdrawal limits, sporadic bank closure due to the inability to withstand demand, etc).

Here are some charts that depict the partial impact of demonetization on economic activities. Note that others factors are also at play here and it is hard to isolate just the impact of demonetization. However, one thing is clear: this shock increased the slope of deceleration for at least two to three quarters.

Provisional estimates show that economic activities (at basic prices) decelerated to 7.1% in FY2017 (April 2016 – March 2017) from 8% in FY2016. GVA growth (at basic prices) was 6.6% in FY2017. While the favorable monsoon boosted agricultural output by 4.9%, industrial and services outputs grew by 5.6% and 7.7%, respectively. These are lower than 8.8% and 9.7%, respectively, in the previous year. Within industrial sector, mining and quarrying and construction outputs decreased the most as demonetization (mainly through shortage of cash to conduct daily transactions) dented transactions and payments (both formal and informal ones). Mining and quarrying grew by just 1.8% compared to 10.5% in FY2016. Similarly, construction activities grew by 1.7%, sharply down from 9.7% in FY2016. Manufacturing activities also slowed down compared to the previous year. Meanwhile, within services sector, wholesale and retail as well as hotel and restaurant activities slowed down. Same with financial and real estate activities. Note that, agriculture, industry and services sectors constitute 15%, 31% and 54%, respectively, of gross value added. 

If we look at the quarterly estimates of GDP, the deceleration is faster after Q2 of FY2017 (November falls in Q3). Economic activities are usually robust in the first two quarters as the government tends to front-load spending and households tend to purchase goods ahead of the festival season in the third quarter. However, in FY2017, economic activities, especially industrial and services, slowed down in all the four quarters. In a way, the economy was starting to cool off even before the shock in the third quarter and then demonetization accelerated the downward slide. Also, note that in FY2016 India updated the way GDP is computed, especially moving from GDP at factor cost to reporting GVA at basic prices plus base year was changed to 2011-12 for GDP, IIP, CPI, and WPI as well. As such, nominal GDP growth (market prices) in FY2017 is provisionally estimated at 11%, which is marginally lower than the no-demonetization scenario of about 11.9% (CSO’s estimate before demonetization).

Now, the expenditure side data reveal kind of similar narrative. Consumption grew by 10.5% (compared to 5.7% in FY2016) led by a notable growth of government consumption (20.8% vs. 3.3% in the previous year). Private consumption, which constitutes about 84% of total consumption and 56% of total GDP at market prices, grew slightly higher than in FY2016. Demonetization seems to have dented investment the most, pulling down overall GDP growth. Gross capital formation grew by just 1.7%. Within it gross fixed capital formation grew by 2.4% (compared to 6.5% in the previous year), led by a dip in private fixed capital formation across all sub-sectors (particularly investment in dwellings and building structures, and machinery and equipment— these together account for about 91% of private GFCF). 

There was some improvement in net exports (as export growth outstripped import growth), but it was not sufficient to compensate for the dip in investment. The big gap between the GDP growth (market prices) line and the stacked up bars in FY2016 is due to the large discrepancies, which shot up drastically in that particular year (remember the data revision mentioned above and the statistical discrepancies associated with it).

If you look at the quarterly GDP data on expenditure side, the narrative is similar to the one mentioned above for quarterly GDP data on supply side. After the demonetization, government consumption increased drastically but gross investment and net exports slowed down. In fact, gross capital formation and net exports registered negative growth in Q4. 

Now, let us look at the impact on public finance. The rush to declare hidden income and deposit it in banks after November 2016 seems to have favored the government (increase in revenue) and banking sector (increase in liquidity). Revenue (tax and non-tax) increased by 19.1%, the highest in the last six years (surprisingly, share of monthly revenue between Nov-Mar remained pretty much unchanged: 49.5% in FY2017 vs. 50.8% in FY2016— folks definitely paid more taxes in the last five months of FY2017 compared to FY2016, but the distribution was same).

As a share of GDP, center’s revenue increased to an estimated 9.4% of GDP (quite low considering the revenue mobilized by other comparable emerging economics, but then we need to also look at combined revenue of center and state, which is around 20% of GDP), up from 8.7% of GDP in the previous year. Recurrent spending grew by 12.8%, up from 4.8% (this complemented to some extent the slowdown in private consumption) but capital spending growth slowed down to 10.6% from 28.6% in the previous year. Overall, fiscal deficit is estimated to be within 3.5% of GDP and primary deficit 0.3% of GDP (both an improvement compared to previous year). 

Demonetization seems to have had a favorable effect (together with bountiful harvest due to good monsoon, and low fuel prices among others) on inflation by dampening consumer demand. Inflation has been decelerating in recent months and is far below 6.1% recorded in July 2016. Food prices, which has 45.9% weight in CPI basket, have cooled off substantially, but consumer prices of tobacco have grown pretty consistently, and housing and fuel prices are heating up. Demand for durables and everyday items (under miscellaneous heading) is cooling off. Overall, annual average (monthly) inflation of 4.5% for FY2017 is between RBI’s lower and upper bounds of 2% and 6%, respectively (average of 4%). The largest contribution to CPI inflation in FY2017 came from food & beverage prices, followed by miscellaneous items; housing; clothing and footwear; fuel and lighting; and pan and tobacco products. 

The wholesale price index shows a bit different picture. It was on a downward spiral since July 2104 until August 2015, and then started to pick up till February 2017 before declining. The WPI inflation for three months following the demonetization shock shows no sign of modereation. However, after that it seems to have had an impact. 

If we look at IIP, then there seems to be an impact after November as demand for manufacturing goods (which has 77.6% weight in IIP basket) moderated substantially. Specifically, demand for primary, and capital goods, and consumer durables slumped (in other words, contraction of urban demand). In May, IIP growth was negative. This might have come from both demand and supply sides. The depressed consumer demand may be caused first by the immediate drop in formal sector demand and then by a (second round) drop in informal sector demand (official statistics pick up the first one faster and then the slowdown in formal sector is reflected as further dip in formal sector demand after few months). In other words, the demand shock in informal sector takes some time to reflect as demand depression in formal sector. This might have slowed down supply of investment. Meanwhile, demand for investment may also be slowing down (and consequently bank credit has contracted) due to waning confidence about returns and consumer demand. 

Anyway, both CPI and WPI inflation are expected to rise (but still stay between the RBI’s lower and upper bounds) as demand depressing effect of demonetization dissipate and consumer demand for both perishable as well as durable goods gain some momentum (especially coming from the hike in public salary and allowance, and heating up of vegetable prices). Also, GST may lubricate the rusty industrial engines and boost both production and investment. Government, meanwhile, needs to enhance capital spending by accelerating project implementation (stuck by a myriad of bureaucratic as well as legislative factors— land, environment, tax incentives clearance, etc). Both private and public capital formation needs to increase. It needs to be seen how overly leveraged companies will increase investment and how government speeds up capital spending (especially in rural housing, roads & bridges, and other infrastructure projects; but potential farm loan waivers by states mean that they will have less fiscal space to increase capex).

GVA growth (at basic prices) is targeted at 7.3% for FY2018.

Nepal's central bank needs younger talents

It was published in The Kathmandu Post, 07 August 2017

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Errant NRB

Nepal Rastra Bank needs to be objective and pragmatic to maintain institutional credibility

The Nepal Rastra Bank (NRB) should ideally operate without courting much controversy over its internal management, operational modality, assessment of the economy, and the regulatory and supervisory mandate. Staying above reproach would ensure financial stability as well as the achievement of its two main macroeconomic targets—curbing inflation and boosting the growth rate. NRB needs to be as objective and pragmatic as possible to maintain institutional credibility and integrity on the execution of monetary policy.

Unfortunately, this supposedly impartial autonomous institution is in the news these days for all the bad reasons; including the leadership’s ill-intentioned plan to do away with the 30-year employment limit, ad hoc changes to monetary rules and regulations, and weak monitoring and evaluation of banks and financial institutions (BFIs).

One of the most controversial issues faced by the central bank currently is internal lobbying to do away with the 30-year employment limit for its employees. This has been a recurring issue since 2001, when such a provision was introduced under the financial sector reform project. Currently, employees are mandated to retire if they have served for 30 years or are above 58 years of age. NRB recently formed a new committee to suggest amendments to its employment regulations. Many suspect this to be a pretext to end the threshold on the years of service. This has generated mixed reaction within and outside of NRB. While some have expressed strong reservation over the intention to form the committee, others either have remained silent or are actively lobbying to end the limit on years of employment. 

There is no justifiable logic in changing current terms and conditions for employment. Some argue that ending the age limit on years of employment will ensure that a large proportion of senior employees will be able to retain their jobs for the time being, avoiding disruption to service delivery caused by retirement of old employees and loss of institutional capacities.

This is hogwash, as the NRB needs young talent in all its departments to effectively execute its policies, undertake research activities, and fulfil its regulatory and supervisory mandate. The marginal benefit of retaining old employees is far less than the marginal cost of hiring young people and training them to take on the required job responsibilities.  The central bank needs to attract top talent from domestic as well as foreign universities by offering attractive entry-level research or management positions. Importantly, a fresh breath of air is needed at NRB so that its actions are proactive rather than reactive. The latter has been the case for the past few years as NRB has repeatedly missed clear signals of disruptive credit flows and accumulation of unbalanced portfolio by BFIs.

NRB’s gain as well as the gain for the entire financial sector will be higher if the old guns follow the current employment regulation and make way for younger talent. The constant tussle among its old and new employees, politically-affiliated unions, and rolling out ad hoc management regulations undermines NRB’s credibility and distracts it from focusing on its main tasks: helping the government achieve growth and inflation targets without jeopardising financial stability, enhancing access to finance, and effectively supervising and regulating the financial sector.

Drifting away

The other important issues that are bogging down NRB are changes to set monetary rules and regulations, and weak monitoring and evaluation of BFIs. First, responding to the sudden credit squeeze—a result of the BFIs repetitive practice to accelerate credit growth more than deposit growth—NRB became overly accommodative by tweaking accounting rules in computing the credit to core capital-cum-deposit (CCD) ratio in its mid-year review of the fiscal year (FY) 2017 monetary policy. This ad hoc policy change was in effect a reward for the BFIs struggling to mend their ways after recklessly increasing credit to few unproductive sectors.

NRB allowed BFIs to discount 50 percent of productive lending, plus lending to deprived sectors and the agro sector at subsidised interest rates, while computing the CCD ratio. It gave some breathing space to BFIs to rework on their lending practices and meet the mandatory threshold of 80. However, NRB rolled back this provision in its FY2018 monetary policy. This kind of overly accommodative ad hoc measure has fostered a moral hazard, whereby BFIs continue to act recklessly , anticipating a reprieve from NRB in case of negative consequences. In doing so, they privatise profits and socialise losses. NRB has acted on behalf of the BFIs rather than acting as their supervisor and regulator, and committing to protect people’s deposits and return on savings. 

Second, the central bank failed to stabilise interest rates, which have remained volatile in recent years. Retail interest rates have gone up sharply, a result of the reactive working culture at NRB. Its monetary instruments to smooth liquidity flows have so far been ineffective. Recently, it changed its approach to maintaining retail interest rates between 3 and 7 percent. As long as NRB uses selling and buying of treasury bills and bonds as its main instrument to manage liquidity and monetary policy, retail interest rates will continue remain volatile. It’s a management problem as well as being a demand-supply problem. NRB needs to be more creative in liquidity management, and monitoring and evaluation of BFIs.

Lastly, in its monetary policy for FY2018 the central bank is aimlessly throwing arrows in all directions to achieve economic growth and inflation targets of 7.2 percent and 7 percent, respectively. NRB is yet to explain how it is going to achieve a higher growth rate than in FY2017, which itself was largely a ‘base effect’ blessing, by virtually keeping unchanged money supply growth and policy rates. Liquidity will likely be tight soon owing to the continuing deceleration of remittance income and the slow as well as uneven pattern of government spending. 

Meanwhile, a bloated budget dependent on large deficit financing is going to put upward pressure on interest rates. This is going to increase borrowing costs for businesses and individuals and eventually slow down economic activities, especially if the government is unable to spend the money it collects from taxes and borrowing. Given past experience, the FY2018 budget will likely be under spent. 

Orderly house

NRB needs to keep its house in order so as to be an effective regulator of the financial sector, a catalyst for enhanced financial inclusion, and a vibrant knowledge hub. Specifically, it needs to set an example by not tinkering its employment regulations to benefit old employees. Instead, it should allow young talent to take up challenging roles, thus fostering creativity, policy innovation and better service delivery.

It should also desist from rolling out ad hoc policy measures to reward moral hazard behaviour in the financial sector. A stop-gap, ad hoc policy as well as management style undermines its credibility and trust.

Why does the government under-execute capital budget?

Towards the last quarter of fiscal year, pretty much everyone talks about slow capital spending. Parliamentary committees issue notices/instructions to government agencies to accelerate spending. Ministry of Finance summons line ministries’ representatives to review progress on stated milestones every quarter. The media also gives ample space to spending level and pattern, raising questions over hasty spending on shoddy works before the end of fiscal year. The same reasons are debated and recycled during each quarterly review meeting. The cycle of issuing notices, review of quarterly portfolios and pondering over the same reasons for slow capital spending keeps on rotating each year. Unfortunately, nothing substantial comes out of it (with respect to achieved outputs).

The government and MOF said FY2017 (mid-July 2016 to mid-July 2017) would be different because budget was announced one-and-a-half months prior to the start of the fiscal year. They said it will give ministries adequate time to get approval for spending and initiate preparatory project planning (especially procurement documents), all of which were expected to accelerate capital spending. Specifically, the idea was to finish all preparatory work and start issuing tender notices and in some cases finalize contractors before the start of festival season (September-November). 

So, was the result? Pretty much the same or even worse: 

• First, the spending pattern (i.e. quality of spending) hardly changed despite the early approval of budget. Almost 60% of the actual capital spending happened in the last quarter and 41.2% in the last month. It raises doubt over the quality of spending. Often, spending (and approval of payments for completed as well as some pending works) is accelerated in the last month by doing shoddy work. The haste in spending without any quality control by the ministries (what is the monitoring and evaluation unit doing?) leads to cheapjack construction. This in turn increases operation and maintenance budget (which is a part of recurrent spending) for the next few years. 
• Second, capital spending absorption capacity has receded. Just 65.5% of planned capital budget was spent in FY2017 (NRs204.3 billion spent vs NRs311.9 billion planned). Although it is slight higher than 58.6% in FY2016 (when the economy was crippled by trade and supplies disruptions), it is still lower than 76% in FY2015 (when earthquakes struck around the last quarter of fiscal year). As a share of GDP, capital spending increased to 7.9% of GDP, up from 5.4% of GDP. The planned capital spending in FY2017 was 12% of GDP.

Now, the MOF sometimes points to the National Reconstruction Authority (NRA) for slow capital spending as reconstruction work did not pick up steam as expected. However, NRA itself was burdened with approval from Cabinet, lack of cooperation from line ministries, and the hooks kept by the MOF on NRA’s discretion in spending the allocated budget (including to cover procedural administrative costs). These exerted an inertia on NRA’s speed and efficiency. Nevertheless, preliminary data from the MOF’s ‘Red Book’ itself show that NRA did quite well in FY2017. It was asked to spend around NRs140 billion in housing grants, reconstruction, and administrative expenses. It seems to have kept the promise for now as per preliminary data. We will have to look at the full year data to see how close NRA was to the spending target. The pick up in reconstruction activities boosted growth of construction, real estate and housing, and mining & quarrying activities in FY2017. In FY2018, NRA is asked to spend NRs146.2 billion on reconstruction of infrastructure and housing grants. 

So, it seems the same factors have been constraining capital spending and approving budget early is not going to change that unwanted steady equilibrium drastically. Budget execution is affected by: (i) structural weaknesses in project preparation and implementation (i.e. lack of initial planning); (ii) low project readiness (no feasibility studies, land acquisition, environment clearance, detail design and procurement milestones); (iii) bureaucratic hassle in project approvals and sanctioning of spending; (iv) weak project and contract management (high staff turnover and inability to rein in errant contractors); and (v) political interference at planning, management and operational stages. FY2017 budget spending was also affected by local elections as government staff were deputed to conducting and monitoring elections instead of managing projects. 

These key issues that slow down spending have more to do with the capacity of government staff and the strength of their offices (institutional memory, motivation, etc) than early release of budget. Of course, early approval of budget provides certainty of spending but it does not directly address the above mentioned issues. 

For project readiness, the NPC should be assisting line ministries and local bodies to conduct pre-feasibility studies. Importantly, it should be appraising the project proposals prepared by line ministries and local bodies keeping in mind factors such as land acquisition, rate of return, cost-benefit analysis, implementation modality, etc. These then should be aligned with medium term expenditure/revenue framework. The NPC should be playing a pro-active role in assisting line ministries and local bodies in project planning and appraising (a sort of localized ‘project bank’). 

Meanwhile, the MOF should be keeping tab on expenditure allocation, especially restraining the temptation to allocate budget for projects that are not ready or are not sanctioned by the NPC. This usually happens because of political pressure. Furthermore, MOF should closely collaborate with NPC and OPMCM (especially their M&E units) to monitor progress and unwind constraints faced during the implementation phase (including speedy resolution of constraints by taking the issues up the political chain and if necessary the cabinet). The obsession with meeting revenue targets has meant that these crucial tasks are delegated as ceremonial undertakings. The MOF and NPC need to be more agile, responsive and cooperative.

Then comes the line ministries. These are primarily responsible for project conception, design and execution. The onus of faster and quality spending lies in project directors (mostly those at joint secretary level). If the government staff at project offices are lethargic, then no project will see accelerated spending. 

The role of multilateral and bilateral donors, who implement projects through the government mechanism, is also crucial as sometimes approvals or endorsements or disbursements are stuck at their offices. Again, being proactive in smart project and contract management is the key to accelerating capital spending. The hassle created by Acts and policies are not going to be solved overnight. Low hanging fruits should be harvested first.

Same applies to the various parliamentary committees that are increasingly infringing on project management (by ordering halt to procurement process, summoning multiple times for hearing but without any tangible outcome, etc) and issuing orders after orders for faster capital spending. How about these committees also give some attention to the need for project readiness, the resources needed for it, and monitoring and evaluation (in collaboration with NPC, MOF, OPMCM and local experts)? Negligence by politically-affiliated local contractors (who bid for projects that are beyond their financial and management capacity) is costing the taxpayers dearly. A strong M&E system is needed in addition to enhancing capacity of project offices to design, appraise and implement projects. 

Overall, the government met the revenue target (more on this in later blog posts), but failed to accelerate capital spending as expected. What will be the fate of FY2018 budget? Note that accelerated capital spending is one of the pillars for rapid structural transformation given Nepal's stage of development right now.