Wednesday, June 7, 2017

Bloated budget, challenging implementation

It was published in The Kathmandu Post, 5 June 2017. Here is an earlier blog post on FY2018 budget (same in NEF blog). The latest issue of Himal magazine includes an analysis on the same in Nepali language. 

Bloated budget

Fiscal transfer to local bodies warranted a bigger budget, but its implementation will be challenging

On May 29, Finance Minister Krishna Bahadur Mahara presented the budget for fiscal year (FY) 2017-18 to Parliament. The projects and programmes are pretty much a continuation of last year’s budget, since the election code of conduct barred the government from rolling out new initiatives that could influence the outcome of the second phase of the local elections.

Some of the notable features of the budget are its focus on the devolution of spending authority to local bodies, the progress of, and adequate funds for, large-scale infrastructure projects, and post-earthquake reconstruction.

Macro overview

The total expenditure outlay is capped at Rs1.3 trillion, which is equivalent to an estimated 45.5 percent of gross national product (GDP) in FY2018. This is an increase of 36.7 percent over the revised expenditure estimate for FY2017. The government argued that the increase in the size of the budget is justified owing to the fiscal transfers to local bodies in the federal setup. These transfers are clubbed under recurrent spending, which constitutes 62.8 percent of the total budget.

Meanwhile, 26.2 percent of the budget is earmarked for capital spending, which includes public expenditure on new buildings, bridges, roads and civil works, among others. The government is planning to meet 64 percent of expenditure from tax and non-tax revenue, foreign grants and principal repayment.

This leaves a budget deficit of NRs461.3 billion, which the government expects to cover by a combination of foreign loans, domestic borrowing and cash balance from FY2017.

Unrealistic targets

At the aggregate level, three important issues in the budget require scrutiny. First, GDP and revenue targets of 7.2 percent and 25.7 percent respectively are ambitious. The economy grew by an estimated 6.9 percent in FY2017 due to a low base effect, favourable monsoon, improved power supply and normalisation of supplies after two years of disruption. Achieving 7.2 percent growth from such a high base would be challenging, because the usual drivers of growth have to be much stronger than last year. 

Even with good monsoon rains, continued improvement in power supply, acceleration of reconstruction works and capital spending and election-related expenses, GDP growth may be restricted between 5 and 6 percent. Furthermore, expecting revenue growth higher than in FY2017 with pretty much the same revenue policy is a bit of a stretch. FY2017 revenue was higher because of the normalisation of imports, which faced an unexpected dip following the trade embargo in FY2016. The expectation that tax revenue from trade will be the same as in FY2017 (47.5 percent of total tax revenue) is a bit misplaced. 

Second, since the likelihood of meeting revenue growth is pretty slim, the government will aggressively engage in domestic borrowing, which is expected to be about 4.3 percent of GDP. This will undoubtedly put upward pressure on retail interest rates, which will increase the borrowing cost of households and businesses, as deposit growth is still sluggish (amidst higher credit growth) due to the deceleration of remittance inflows and the government’s inability to spend the mobilised revenue on time. A large deficit financing also tends to exert inflationary pressures.

Third, recurrent expenditure is ballooning too fast and needs to be contained. It is expected to be a whopping 110 percent of revenue in FY2018. The previous government sharply increased recurrent budget by inserting all sorts of pet projects and distributive programmes in the ‘red book’, which is a catalogue of all approved projects and programmes. It would be difficult to discontinue such projects once they make their way into the red book and hence this government had no option to exclude them. This, combined with the need for large unconditional fiscal transfer to local bodies, led to an almost 43 percent increase in recurrent spending. It is now time to curb recurrent spending in real terms and cull unproductive, repetitive and “zombie” projects to maintain fiscal prudence.

Execution challenges

In the absence of a Natural Resource and Fiscal Commission to oversee fiscal transfer to local bodies, this budget allocated transfers based on a number of factors such as population, development status and cost of operation. Fiscal transfer and conditional grants to local bodies now constitute about 50 percent of total recurrent spending. This is unprecedented in the sense that the transfers will now be directly credited to the bank accounts of local bodies—bypassing the maze of bureaucratic approvals needed at Singh Durbar—and the local bodies will have the authority to prioritise, design and implement their own projects. These include programmes and projects on agriculture, livestock, irrigation, roads, drinking water and sanitation, schools (including payment for teachers), tourism and sports, among others. 

Despite such large transfers and early spending authority to line ministries, execution of the budget will be challenging. The budget mandates project offices to award contract by mid-October to accelerate capital spending, which averaged 75 percent of planned budget in the last five years. This particular reform addresses expenditure delays attributable to lengthy and repetitive approvals needed at various layers of ministries and the National Planning Commission.

However, other issues contributing to chronically low spending pattern such as lack of project readiness, high staff turnover and poor contract management will need to be addressed swiftly to accelerate capital spending. Furthermore, most of the local bodies do not have the capacity to design, assess, appraise and execute projects at the local level. Hence, an unconditional fiscal transfer to local bodies could be an asset or a liability. If spent in the right way and with proper accountability, it could be an asset and a significant contributor to economic development.

However, with weak oversight, lack of capacity to plan and execute projects and misappropriation of funds, it could become a liability and eventually contribute to fiscal stress. The centre needs to be careful in providing handholding support to local bodies to address execution issues, but it should not try to micromanage projects as in the past.

Overall, the budget gives a mixed picture: bloated in size justified by the compulsion to continue previous projects and direct fiscal transfer to local bodies; ambitious GDP and revenue growth targets; large deficit financing, which would potentially increase interest rates; faster spending authorisation by cutting down lengthy and repetitive approvals; and unsustainable pattern as well as size of recurrent budget. The nature of this budget would also mean that there is no room and justification for a supplementary budget after the local elections.