Friday, June 5, 2020

Nepal's FY2021 budget at a critical juncture

It was published in The Kathmandu Post, 03 June 2020. An earlier blog post is here (in Nepali language here).



The government has, once again, not been able to enact structural change when afforded an opportunity by the extraordinary circumstances.

The federal government’s budget for the fiscal year 2020-21, presented by Finance Minister Yubaraj Khatiwada, prioritises short-term measures to respond to health, economic and employment crises caused by the novel coronavirus disease, Covid-19. The unique nature of concurrent health, demand and supply shocks due to the pandemic and the consequent lockdowns to contain its spread, meant that the government had no option but to increase spending in healthcare and social protection, even if it increased fiscal deficit sharply.

That said, this critical juncture is also an opportune moment to not only craft a short-term response to deal with the effect of Covid-19 on lives, livelihoods and the economy, but also to overhaul the existing inefficient systems and rectify long-running economic ills that are holding back inclusive economic growth and prosperity. Unfortunately, the budget loses sight of this opportunity at this critical juncture. Similarly, the budget is not clear about the medium-term strategy for economic recovery, growth-enhancing revenue policy and a consolidation plan to narrow the widening fiscal deficit.

The federal government’s total budget for the next fiscal year is Rs1.47 trillion, which is lower than the Rs1.53 trillion budget estimate for 2019-20, but 37.4 percent higher than the revised estimate. It comprises Rs948.9 billion as recurrent expenditures (64.4 percent of the total outlay), Rs352.9 billion as capital expenditures, and Rs172.8 billion as a financial provision. Note that fiscal transfers and conditional grants to subnational governments are also included in recurrent spending of the federal government. So, the capital spending allocation of all tiers of government is a bit higher than the one indicated in the centre’s budget.

Total central receipts (revenue and foreign grants) are expected to cover 65 percent of the budget. The government is planning to cover the budget gap by borrowing internally and externally. The fiscal deficit is expected to increase to about 8 percent of the gross domestic product.

Underwhelming response

The budget also includes a Covid-19 economic recovery package, but it is not really an additional fiscal package that is going to prop up subdued demand and business activities. Nor is it likely to restore the severely disrupted supply networks and output. Most of the already announced incentives and initiatives are subsumed in the budget, including a Rs100 billion refinancing facility by the central bank. The government is planning to set up a separate Rs50 billion fund to provide subsidised loans, at 5 percent interest, to sectors badly affected by the Covid-19. The government has not committed a full amount to the fund as it expects contributions from public enterprises and development partners. The operationalisation and effectiveness of this fund is uncertain, as there is no standard operating procedure that outlines eligibility and bureaucratic prerequisites.

Furthermore, the government argues that there is about NRs 60 billion worth of interest and utility subsidies, and tax concessions. There is also a plan to employ 700,000 people through direct employment, and provide training related to skills upgradation and technical education.

Besides these mundane, halfhearted measures to deal with the immediate effect of the crisis, the government had an opportunity to overhaul long-running economic ills and rigid systems that have fostered extractive economic and political institutions. It is easier to do when an economy reaches a critical juncture, which according to economists Daron Acemoglu and James Robinson are ‘major events that disrupt the existing political and economic balance’. In their book Why Nations Fail, they argue that at critical junctures a country can transform its extractive political and economic institutions into inclusive ones, resulting in meaningful socioeconomic changes and acceleration on the path to prosperity. Nepal reached this kind of critical juncture in the 1950s (end of Rana rule), 1990s (restoration of democracy), 2006 (end of Maoist insurgency and monarchy) and 2015 (catastrophic earthquakes). Unfortunately, we have missed opportunities to reorient economic and political institutions during these times for greater good. Instead, we have let the prevailing political-business nexus to capture land, labour, capital and product markets.

At the critical juncture created by the pandemic, we are once again missing a chance to roll out transformative reforms to create inclusive political and economic institutions. These include agricultural transformation; consolidation of social protection schemes with a unified digital registry of all beneficiaries (including the Prime Minister Employment Programme and cash allowances); rationalisation of ballooning recurrent spending; freeing markets from the clutches of cartels; changing revenue policy to support growth and innovation; nixing politically-oriented distributive spending; harmonising planning and financial reporting standards across all tiers of governments; prioritising projects strictly based on implementation readiness; sound governance framework to curb misappropriation of public funds, and, lastly, changes to legal, policy and institutional frameworks to increase private sector participation.

Most of these are transformative in nature and growth-enhancing structural changes that are relatively easy to roll out during critical junctures. They set in motion a process of creative destruction and creative creation processes, which are vital for enhancing private investment, innovation, and public services delivery. They also boost the entrepreneurial spirit and incentivise saving, investment and innovation.

Budget takeaways

Besides this missed opportunity, there are three particular macroeconomic takeaways. First, there is no medium-term recovery plan for a sustained recovery. The focus is on immediate-term only with increased funding for the healthcare sector and state-led employment creation. Propping up demand (through additional cash transfers, subsidy and income tax concessions) and maintaining supplies of essential goods and services (including through graded easing of the lockdown), even during the immediate-term, are pretty much ignored. A medium-term recovery strategy could at least include assistance for preventing layoffs in both organised and unorganised sectors, and saving struggling micro, small and medium enterprises from collapsing. The private sector has been largely left to fend the crisis for themselves.

Second, with declining revenue and increasing spending needs, the fiscal deficit is expected to be around 8 percent of GDP. Besides some discretionary spending—such as insurance cover for frontline staff and social security fund payments—other increased recurrent spending may not be easy to rollback. It will keep recurrent spending at a high level even after the crisis subsides. With consistently lower than expected revenue mobilisation since 2017-18 and an increase in recurrent spending, narrowing down the widening fiscal deficit will require a credible medium-term fiscal consolidation plan. A drastic increase in domestic borrowing to fund the deficit will likely squeeze liquidity and raise interest rates, thus crowding-out private investment.

Third, revenue and foreign aid budget estimates and growth targets are too ambitious. For instance, given the past trend, tinkering import duties alone will not be helpful to achieve revenue mobilisation target of 22 percent. Likewise, foreign grant and loans targets are 89 percent and 147 percent respectively—higher than the revised estimate for 2019-20. Note that even after the 2015 earthquakes, the government was able to mobilise less than 50 percent of foreign grants and loans estimated during the budget speech. Similarly, even with a favourable base effect, a GDP growth target of 7 percent is unrealistic, particularly given the prospect of a continued slowdown in agriculture (thanks to a shortage of chemical fertilisers and workers), subdued industrial activities (especially manufacturing and construction), and uncertainty over the recovery of services—especially in travel and tourism, wholesale and retail trade, transportation, real estate, and education.

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