Thursday, May 30, 2019

Quick thoughts on Nepal’s FY2020 budget

Here are my quick thoughts on FY2020 budget:

On 29 may 2019, Finance Minister Dr. Yuba Raj Khatiwada presented FY2020 budget (mid-July 2019 to mid-July 2020) to a joint assembly of the federal parliament. This is the second budget of the government that commands two-thirds majority in the parliament. It is designed to placate the dissatisfied NCP politicians that were batting for more discretionary funds and to adhere to party’s election manifesto, particularly increasing cash-based social security allowances. The finance minister argues that FY2020 budget focuses on institutionalizing the achievements of FY2019, fair distribution of resources, and strong social security regime. 

This was an opportune time to consolidate social security schemes, streamline scattered and incoherent projects and enhance allocative efficiency of capital spending, institute sound governance regime while awarding and implementing projects, take transformative measures to bring about growth-enhancing structural changes in agriculture, labor and industrial markets, and institute some fiscal discipline. However, these were overshadowed by the urge to bring out a distributive and populist budget. Given the deteriorating state of fiscal, financial and external sectors, the focus of FY2020 budget should have been on allocative efficiency, targeted social security assistance under one framework, and fiscal discipline. 

The budget is notable in four ways:

First, in FY2019, the finance minister tried his best to maintain fiscal discipline by resisting pressure from NCP leaders to increase social security allowances and by not overblowing the already high government expenditure. However, this year the finance minister yielded to intense pressure to increase cash allowances and funds for parliamentarians that are used to finance incoherent pet projects without much governance and oversight. The finance minister increased discretionary funds to be used by parliamentarians to Rs60 million, up from Rs40 million. Even senior party leaders from NCP itself were against allocating funds to the parliamentarians, terming it a waste of taxpayers’ money and a breeding ground for misappropriation.

Meanwhile, the government increased cash allowance for 70 years and above by Rs1000, making it a total of Rs3000 per month (plus Rs1000 medical benefit). There are about 1.3 million people registered to get that benefit. The government has to allocate at least Rs15 billion additional money for this purpose. Similarly, single woman (60 years and older, either divorced or unmarried), fully and partially disabled, and indigenous people will also get an additional Rs1000 per month, making it a total of Rs2000 per month. 

Second, compared to revised estimate of FY2019 budget, the FY2020 budget outlay increased by about 27%. Total federal budget is about 38.3% of GDP, marginally higher than 38% of GDP in FY2019. Here I assume nominal GDP to increase by 15.4% in FY2020 (if you increase this growth rate of nominal GDP like the government did in its latest version of MTEF to show 8.5% real GDP growth, then the size of budget will appear smaller). Fiscal deficit is expected to be about 10.7% of GDP. This is too high and a deficit binge expenditure model will exacerbate inflation as well as liquidity situation in the financial market, which then affects interest rates and crowds out the private sector. 

Fiscal discipline is at stake here. The revised estimates for FY2019 shows that tax and non-tax revenue is projected to barely cover recurrent spending (24.8% of GDP vs 24.4% of GDP, respectively). In FY2020, revenue is projected to be 26% of GDP and recurrent spending is projected to be 23.9% of GDP. Net domestic borrowing is about 4% of GDP and fiscal deficit is about 10% of GDP.

Third, the revision of public employees’ wages and compensation (which happens every two years) contributed to the large size of the budget. Salary went up by 18% (for gazetted officers) to 20% (for non-gazetted officers). However, this increase is far higher than the average inflation rate during the same period. Raising public sector wages drastically affects private sector wages too and exerts inflationary pressures.

Fourth, there are no new programs as such but existing ones are too scattered too. There are some efforts to bring scholarship assistance under one framework and to introduce conditionality on the use of assistance to ensure accountability and greater impact (such as giving payment to mothers of child that need day meal in schools). Similarly, the government has committed to bring all social security assistance under one framework. Melamchi project has been allocated additional money to continue the stalled work. Crucial airport construction and infrastructure works are prioritized. The commitment to consolidate the number of BFIs and to design a revenue regime that favors domestic production is commendable. The private sector seem happy with the budget but are suspicious of its implementation. 

More on these later, but first let us look at the macroeconomic specifics:

Budget outlay

The total expenditure outlay for FY2020 is NRs1532.9 billion (an estimated 38.8% of GDP), which is 27% higher than the revised expenditure estimate for FY2019. The government expects to spend 91.8% of NRs1215.1 billion allocated in FY2019. However, given the expenditure trend so far, it is highly unlikely. 

FY2020 budget outlay comprises of NRs957.1 billion as recurrent expenditures (62.4% of the total outlay), NRs408.1 billion as capital expenditures (26.6%), and NRs167.5 billion as financial provision. 

As a share of GDP, total budget amounts to 38.3%, including just 10.2% for capital spending. As per FY2019 revised estimates, the government now expects to spend just 92.6% of planned recurrent budget and 86.9% of planned capital budget. Compared to the revised estimates, recurrent spending is up by 22.3% and capital spending by a whopping 49.6%. Capital budget has been increased at a time when its absorption rate is lower than in FY2018. Without a viable implementation plan, it is not going to fully spent. 

FY2020 budget overview
GDP growth target (%)
8.5

Inflation target (%)
6

Budget allocation for FY2020
Rs billion
%
Projected total expenditure
1532.7
Recurrent
957.1
62.4
Capital
408.1
26.6
Financial provision
167.5
10.9

Projected total revenue
1039.1
Revenue
981.1
94.4
Foreign grants
58.0
5.6

Projected budget surplus (+)/deficit (-)
-493.5

Projected deficit financing
493.3
Foreign loans
298.3
60.5
Domestic borrowing
195.0
39.5

Revenue

A total revenue target of NRs1,112 billion (27.8% of GDP) has been set for FY2019 (or NRs981.1 billion if revenue sharing with subnational governments is excluded). Foreign grants are expected to be NRs58 billion (1.5% of GDP). Total revenue plus foreign grants less sharing of revenue with subnational governments leaves the government with NRs1039.1 billion. The government will share, based on monthly collections, 30% of VAT and internal excise duty, and 50% of royalties from natural resources with subnational governments. The revised estimate for federal revenue mobilization (including grants) in FY2019 is 25.7% of GDP. Compared to the revised estimate, revenue growth target for FY2020 is 29.5%, which is ambitious and was achieved just once in the last decade. The government had a similar target in FY2019 but failed to achieve it.  

Given that the GDP growth target itself is overly ambitious, and revenue administration reforms along with tinkering of import tariff on some non-essential items have its limit in increasing import-based revenue, it needs to be seen how this government will achieve the revenue target.

Nepal’s revenue mobilization is already one of the highest among low-income countries and about 45% of it comes from taxes on imports. Tax revenue is projected to be around 25.2% of GDP in FY2020, up from 22.4% of GDP in FY2019. Non-tax revenue is projected to be 2.6% of GDP.

Deficit financing

Considering federal expenditure and its share of revenue in total revenue mobilization, the budget deficit turns out to be NRs493.5 billion, which is financed by foreign loans equivalent to NRs298.3 billion and domestic borrowing of NRs195 billion. This is going to exacerbate liquidity crunch in the financial market and raise interest rates. The government had an ambitious plan to raise NRs136.9 billion in FY2019, but its bill and bonds are undersubscribed at the moment. 

The government is planning to increase net foreign borrowing by 45.7% to NRs272 billion (6.8% of GDP) and net domestic borrowing by 13.3% to NRs136.9 billion (3.9% of GDP). Again, without substantial improvement in budget execution capacity, it is unlikely that the government will be able to borrow the targeted amount. 

Overall, fiscal deficit is projected to be about 10.7% of GDP. Fiscal deficit is the difference between revenue including grants and expenditure including net lending.

Where is recurrent budget going?

Almost 53.5% of planned recurrent budget of NRs957.1 billion is going to provincial and local governments in the form of fiscal transfer (fiscal equalization, conditional, complementary and special grants) and unconditional grants. This is where pet projects of politicians are usually embedded in as these grants are to cover both recurrent and capital spending at subnational level. The other big ticket item is the compensation of employees, which takes up about 15.2% of total recurrent budget. The government has earmarked NRs157.3.1 billion (3.9% of GDP) for social security spending and NRs73.6 billion for use of goods and services. Use of goods and services consists of (i) rent & services; (ii) operation and maintenance of capital assets; (iii) office materials and services; (iv) consultancy and other services fee;(v) program expenses; (vi) monitoring, evaluation and travel expenses; (vii) recurrent contingencies; and (viii) miscellaneous.

Where is capital budget going?

Almost 57.5% of the planned capital budget of NRs408.1 billion is going for civil works, 22.1% for constructing or purchasing building, and 6.9% for land acquisition. Compared to the FY2019 revised estimate, capital spending has been increased by 49.6%. Some of this expenditure also include post-disaster related reconstruction activities.

Subnational governments

Grants to provincial and local governments (under federal government’s recurrent expenditure) consist of revenue sharing as mandated by the constitution, NNRFC Act, and Intergovernmental Fiscal Management Act. The central government needs to share 30% of VAT and internal excise duty (15% each to local and provincial governments) mobilized in a given year. Similarly, it has to share 50% of royalties generated from natural resources (mountaineering, electricity, forests, mines and minerals). In addition, on expenditure side, it categorically allocates fiscal equalization and conditional as well as unconditional grants. 
Total grants or transfers to subnational governments is projected to be NRs463 billion and revenue sharing of NRs130.9 billion. Some local governments are using these grants to purchase vehicles and other goods instead of using them in local level capital projects. There are high fiduciary risk when local governments use such grants without much oversight and institutional capacity to execute projects. 

Grants to sub-national governments
Rs billion
Total grants
463.0
Unconditional
149.3
Fiscal transfer
313.7
Province government
99.9
Fiscal equalization
55.3
Conditional
44.55
Local government
213.8
Fiscal equalization
90.0
Conditional
123.9

Major takeaways from FY2020 budget

First, the finance minister has tried to give continuity to the programs and projects he launched in FY2019 budget. However, some of the projects were never initiated, indicating allocative inefficiency. Rationalization of recurrent expenditures— especially to streamline subsidies and allowances, and to avoid duplicate, incoherent and wasteful projects—  is missing too. This could have been transformative in setting the course of budget formulation. He could have also facilitated closure of defunct public enterprises that are not in operation or not making any profit for a long period of time. There is no point in keeping employees of such public enterprises in the payroll. Similarly, steps could have been taken to root out redundant temporary/contractual staff, often in lower tier jobs in government offices, who were hired by politicians without a work plan. 

Second, the finance minister succumbed to political pressure and increased allowances as well as funds for parliamentarians. Each directly elected representative will now be able to spend Rs60 million in projects of over Rs1 million. This kind of piecemeal funding to construct substandard youth clubs, temples, covered halls, playground, local roads, bridges, etc without coordination with other agencies and projects is an utter waste of taxpayers’ money. Indirectly, this is an avenue to distribute money to party supporters and party-affiliated contractors. Similarly, increasing elderly allowance is another bait to attract voters at the cost of fiscal prudence. 

Third, like in the previous budget, a robust, credible and a time-bound implementation plan to spend the earmarked money is missing. So, improvements in allocative efficiency in budget preparation, and its impact on budget execution, remain a far cry. Granted that the budget speech would not ideally elaborate on implementation plan. However, since this lies at the heart of the chronically low capital spending in the first place, it should have been briefly elaborated. In the past, the MOF released an implementation plan few day after the budget speech. But, that also didn’t work. The core issues for chronically low capital spending (structural weaknesses in project preparation and implementation, low project readiness, bureaucratic hassle in approving and reapproving projects, poor project management and contractor capacity, high fiduciary risk in project implementation at subnational level, and political interference both at planning and operational levels) and bunching of spending in the last quarter (note that over 40% of actual capital spending happens in the last month of fiscal year) are hardly addressed in the budget, as always. This raises doubt over timely budget execution in FY2020 as well. As an example, hiring project head from outside of government service does not add much value if person has to go through the same bureaucracy to get routine approvals and authorizations. 



Fourth, revenue target also seems to be a bit ambitious given that the government failed to achieve the target in FY2019. Compared to revised estimate of FY2019, revenue growth target is set at around 29% (compared to FY2019 budget estimate, growth target is just 18% but this is not the right comparison here). This target is going to go up if the government is unable to mobilize Rs757.5 billion revised estimate for FY2019 (which is 91% of the FY2019 budget target). The government really has to up its game in plugging leakages and also hope that economic activities accelerate as expected to meet the revenue target. Tax rates are unchanged except for some adjustment in custom duties and additional tax on petrol and diesel to fund road maintenance (by the way, government has been already levying similar tax for road maintenance and for construction of Budhi Gandaki). Custom duty on imported chicken is up from 10% to 30%, and custom and excise duty on sugary products have increased. Same with alcoholic drinks and cigarettes. Some of the agricultural goods on which tariffs have been raised (such as sugar) raises the possibility of higher domestic prices. The manipulation of sugar prices by domestic produces by forcing the government to impose quantitative restrictions in import is already a hotly debated issue. 

There are three ways to increase revenue: (i) a higher GDP growth rate means accelerated economic activities, which means higher tax and nontax revenue; (ii) plug revenue leakages like under-invoicing of imported goods, selective tax waivers either due to corruption or political pressure, automated revenue administration, enhance capacity of local bodies to raise local revenues (they know the locality better, for instance, house or land or services tax), etc.; and (iii) a tax regime that promotes formal economy (exorbitantly high income and corporate tax rates encourage informality and narrows tax base). 

Fifth, the fiscal deficit (and primary deficit) is at alarming level. Higher deficit exerts inflationary pressure, raises interest rates, crowds out private sector and fuels imports. Expansionary fiscal and monetary policies need to be managed well. 

Sixth, the government seems overly optimistic in its ability to raise money from the domestic market. In FY2019, it was unable to sell its bills and bonds as the financial market committed to buy just half of what it proposed to sell in May. On the one hand, the government wants to borrow more from domestic market to meet its ballooning expenditure needs. On the other hand, tight liquidity situation in the financial sector continues unabated as BFIs are close to the credit to core capital-cum-deposit (CCD) ratio of 80. In this situation, trying to raise more money from the domestic market will further push up interest rates and crowd-out the private sector. [That said, with high interest rates amidst tight liquidity, BFIs are maintaining profit margin.]

Seventh, GDP growth target of 8.5% is too ambitious. GDP growth (at basic prices) will likely be between 6.0% and 6.5% (at producers’ prices between 6.4% and 6.8%). Unfavorable monsoon (expected to be below average for much of the country) will lower agricultural growth, but industrial sector will likely grow at a robust pace. Specifically, post-earthquake reconstruction work will continue to act as a stimulus (government is bankrolling most of the reconstruction work even for private houses) and hydroelectricity generation will nearly double as 456 MW Upper Tamakoshi, 40 MW Khanikhola-1, 42.5 MW Sanjen, 111 MW Rasuwagadhi, and 82MW Lower Solu, among others are expected to be completed by mid-July 2020. Similarly, provided that public capital spending accelerates as expected (which means completion of the hydropower projects as well as notable progress in Melamchi, GBIA, PIA, national highways, etc), construction activities will pick-up pace lost in FY2019. Meanwhile, adequate and stable supply of electricity, and implementation of the investment-friendly laws and regulations will likely support manufacturing activities. Services sector growth will continue to be high, underpinned by wholesale and retail trading activities and tourism activities (Visit Nepal 2020 will draw in more number of tourists). The downside risks to the forecast are slow public capital spending as in the past, continued tight liquidity in the financial sector and an adverse investment climate due to security risks. 

Eighth, the government really needs to work on two fronts to boost GDP growth rate: (i) enhance public budget execution capacity, and increase private investment by implementing the recently enacted laws, which need to be supplemented by policies, regulations, guidelines, and institutional framework; and (ii) ensure sound governance and security. Better budget execution means faster project completion, which stimulates economic activities. This in turn will increase revenue and create jobs. On promotion of private investment, so far industrial policy and export promotion incentives are like tokens given to the private sector because they complain a lot. They need relatively and reasonably good business-friendly policies (it would have been better if the government set a target to climb few notches up the annual Doing Business ranking), and an ecosystem where there is a steady flow of investment in enhancing human capital and institutions. 

Unfortunately, except for the usual high-sounding commitments, there is no structured viable vision or policy to promote backward and forward linkages in industrial and agribusiness sectors. Private sector needs an enabling environment to flourish: infrastructure (like good roads network), adequate and reliable electricity supply, sensible tax regimes so that raw materials are not taxed higher than final goods produced out of it, strong financial sector, adequate labor pool and human capital, clear and stable policies, etc. Furthermore, we also need to think of how we can lower electricity tariff for industries as we move from deficit to surplus production by FY2020. It could also encourage use of electric vehicles and promote innovation, especially in SME sector. Additionally, it could promote import-competing production and help to lower trade deficit. A meaningful structural transformation that forms the basis for sustained and inclusive growth as well as adequate jobs creation requires transformative thinking, incentives and policies. 

Overall, FY2020 budget is not too bad given the demand for NRs100 million for discretionary spending by parliamentarians and higher social security allowances. It has also given continuity to previous programs and projects, including commitment to improve investment climate and government operations. However, it doesn’t rein in on scattered projects, enhance allocative efficiency and promote fiscal prudence given the alarmingly high fiscal deficit. This could be a big ask from the finance minister given that he is under intense political pressure to bring out a distributive and populist budget that is consistent with NCP’s election manifesto. 

3 comments:

  1. Nice article Chandan ji.. Very well articulated and beautifully presented. I totally agree on most of the large projects of Nepal just being a source of feeding politically affiliated so called beneficiaries. I do a lot of program evaluation nowadays and am a first hand observer of how tax payers money is being wasted in so called attractive projects. This budget (like always) looks like the government is just working on securing its vote bank for next election without a real vision.

    ReplyDelete
  2. Nice article Chandan ji.. Very well articulated and beautifully presented. I totally agree on most of the large projects of Nepal just being a source of feeding politically affiliated so called beneficiaries. I do a lot of program evaluation nowadays and am a first hand observer of how tax payers money is being wasted in so called attractive projects. This budget (like always) looks like the government is just working on securing its vote bank for next election without a real vision.

    Milan Joshi

    ReplyDelete
  3. Really convincing and intellectual review Dr Chandan

    ReplyDelete