Quick thoughts on Nepal’s FY2021 budget

Here are my quick thoughts on FY2021 budget

On 28 May 2020, Finance Minister Dr. Yuba Raj Khatiwada presented FY2021 budget (mid-July 2020 to mid-July 2021) to a joint session of the federal parliament. This is the third budget of the government that commands two-thirds majority in the parliament. The budget is designed to focus on scaling up health sector spending to respond to coronavirus disease, COVID-19, and its impact on the economy and livelihoods. 

The economic disruptions caused by COVID-19 pandemic have severely affected economic activities, lives and livelihoods. This disruption is widespread. The budget for next fiscal is an opportune moment to craft an economic policy to not only respond to COVID-19’s effect, but also to rectify the long pending economic issues such as agricultural transformation, consolidation of social protection schemes (including PM employment program), rationalization of recurrent spending (especially the wasteful ones), nixing some of the politically oriented distributive spending schemes, prioritization of projects, and changes to legal, regulatory, policy and institutional frameworks to increase private sector participation. Most of these are transformative in nature and are growth-enhancing structural changes that are relatively easy to rollout during critical junctures like the one created by COVID-19.

At the outset, FY2021 budget looks like it is trying to strike a balance between responding to the economic, lives, and livelihoods disruptions caused by the COVID-19 pandemic, and continuing with the traditional party-backed signature programs and projects. Given the uncertainty and circumstances under which FY2021 budget had to be unveiled, the finance minister has done a decent job. The prioritization on healthcare spending and some support to businesses is the right one for the coming fiscal, but estimates of revenue or receipts are a bit unrealistic. That said, we should not be too fussy about a surge in fiscal deficit at this stage, but the government should at least have a credible medium-term fiscal consolidation plan. 

However, the budget has also missed one thing that is really needed at this critical juncture: a bold fiscal move and an economic package to reorient the economy towards high value-added production and higher sectoral productivity. This is the time for taking bold steps to structurally transform labor and capital markets, and institutions. This opportunities during such critical juncture do not come often. One such opportunity is to create a unified digital registry of all social protection beneficiaries so that social transfers reach the targeted beneficiaries and leakages are minimized. 

The budget is notable in five ways:

First, there is COVID-19 economic recovery package, but it is not really an extra fiscal package. Most of the already announced incentives and initiatives were subsumed in the budget. It includes NRs 100 billion refinancing facility from the central bank (initially, it was NRs 60 billion refinancing facility, which the government announced to increase to NRs 100 billion), and a separate fund of NRs50 billion to provide subsidized loans to sectors affected by COVID-19. The refinancing facility will be for one year but it can be extended by another year. The separate fund will provide loans at 5% interest to businesses that are facing difficulties in retaining workers and to secure working capital to continue business. In addition to its own contribution, the government is hoping contributions from public enterprises and development partners to the NRs 50 billion fund. The effectiveness of this facility is uncertain at this moment and a detailed standard operating procedure for its roll out is awaited. Besides these refinancing facility and new relief funds, the government argues that there is about NRs 60 billion worth of interest subsidy, utility subsidy, and tax concession. There is a plan to provide employment to 700,000 people too.

Second, the government has committed to pay mandatory contributions to SSF by both workers and employees (total 21%) in organized sector for the duration of lockdown. It has also extended contract and bank guarantees for the period of the lockdown, provided tax concessions on renewal of firms, earmarked funds for concessional working capital loans, and provided insurance cover to healthcare workers. It has also increase incentives for frontline security and healthcare workers. These were continuation of the previous measures. Similarly, social security related cash allowances have been continued. 

Third, there is an increase in allocation for healthcare sector and employment generation. But there is also a decrease in allocation for infrastructure, probably because the government had to save money for healthcare sector and employment generation. 

Fourth, the government has given continuity to constituency development fund despite the call from the opposition to cancel it altogether and use the funds for the COVID-19 response. Now, each parliamentarian is earmarked NRs 40 million, down from NRs 60 million previously. Last year, the finance minister increased allocation for parliamentarians to NRs 60 million from NRs 40 million. Due the lack of accountability and sound oversight, there are reports (even in OAG’s reports) of misappropriation of funds.  

Fifth, the finance minister has tried to maintain fiscal discipline despite the increased expenditure needs and decreased revenue mobilization. The size of the budget has been reduced compare to FY2020 budget estimate, but increased by 37.4% compared to FY2020 revised estimate. Continued lockdown and lack of pick up in economic activities will hit revenue mobilization and further jeopardize fiscal discipline. A large increase in domestic borrowing will create liquidity shortages (already squeezed by deceleration of remittances, lower capital spending, higher credit growth, and now a potentially large number of MSMEs unable to service interest and principal payments on time due to cash flow problems). This might drive interest rates up and crowd out private investment. Since a spike in fiscal deficit was expected in FY2021 given the healthcare and social security related expenditure needs and declining revenue, the government should have also outlined a fiscal consolidation plan for the medium term. A pick up in economic activities will narrow down fiscal deficit if expenditure (especially recurrent) does not rise commensurately in the coming years. 

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

Budget outlay

The total expenditure outlay for FY2021 is NRs 1474.6 billion, which is lower than NRs 1532.9 billion budget estimate for FY2020 but 37.4% higher than the revised estimate for FY2020. The government expects to spend 91.8% of NRs 1215.1 billion allocated in FY2019 (NRs 1073.4 billion). However, given the expenditure trend so far, it is highly unlikely. Due to the lockdown and disruption to economic activities in the last two quarters of FY2020, the government expects to spend 70% of the earmarked budget for FY2020. 

FY2021 budget outlay comprises of NRs 948.9 billion as recurrent expenditures (64.4% of the total outlay), NRs352.9 billion as capital expenditures (23.9%), and NRs 172.8 billion as financial provision. 

As a share of GDP, total budget amounts to 35.9%, including just 8.6% for capital spending. As per FY2020 revised estimates, the government now expects to spend just 73.3% of planned recurrent budget and 58.6% of planned capital budget. Compared to the revised estimates, recurrent budget is up by 35.2% and capital spending by a whopping 47.6%. Without a viable implementation plan and the effect of lockdowns on labor mobility and availability of supplies, it is most likely to be underspent as before. 

FY2021 budget overview
GDP growth target (%)	7
Inflation target (%)
Budget allocation for FY2021	Rs billion	%
Projected total expenditure	1474.6
Recurrent	948.9	64.4
Capital	352.9	23.9
Financial provision	172.8	11.7
Projected total receipts	950.1
Revenue	889.6	93.6
Foreign grants	60.5	6.4
Projected budget surplus (+)/deficit (-)	-524.5
Projected deficit financing	524.5
Foreign loans	299.5	57.1
Domestic borrowing	225.0	42.9

Revenue

A total revenue target of NRs 889.6 billion (21.7% of GDP) has been set for FY2021 (or NRs 1011.8 billion if revenue sharing with subnational governments is included—24.7% of GDP). Foreign grants are expected to be NRs 60.5 billion (1.5% of GDP). Total central receipts (total revenue plus foreign grants less sharing of revenue with subnational governments) turns out to be NRs 950.1 billion (23.2% of GDP). The central government shares, 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 FY2020 is 27.6% of GDP. 

Compared to the revised estimate, revenue growth target for FY2021 is about 22%, which is ambitious in the first place due to the expected decline in nominal GDP. Tax buoyancy is less than one. The government has been unable to meet revenue target since FY2018.

Given that the GDP growth target itself is 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 plans to 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 22.3% of GDP in FY2021, down from 26.8% of GDP in FY2020. Non-tax revenue is projected to be 2.4% of GDP.

Deficit financing

Considering center’s expenditure and its share of revenue in total revenue mobilization, budget deficit turns out to be NRs 524.5 billion, which is to be financed by foreign loans equivalent to NRs 299.5 billion and domestic borrowing of NRs 225 billion. So, government’s revenue is able to fund only 60% of its projected expenditure in FY2021. The government expects foreign aid (grants and loans) to cover about a quarter of its expenditure needs. Domestic borrowing will cover 15% of its financing needs. 

This is going to exacerbate liquidity crunch in the financial market and raise interest rates. The government had a plan to raise NRs 195 billion in FY2020 and is hoping to raise almost 99% of it by mid-July 2020. 

Compared to the revised estimate for FY2020, the government is planning to increase net foreign borrowing by 88.7% to NRs 179.7 billion (4.4% of GDP) and net domestic borrowing by 77.4% to NRs 276.4 billion (6.7% 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 8% of GDP. Fiscal deficit is the difference between revenue including grants and expenditure including net lending. Primary deficit is projected to about 4.8% of GDP.

Where is recurrent budget going?

Almost 52.7% of planned recurrent budget of NRs 948.9 billion is going to subnational governments in the form of fiscal transfer (fiscal equalization, conditional, complementary and special grants) and unconditional grants. 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 14.6% of total recurrent budget. The government has earmarked NRs188.7 billion (4.6% of GDP) for social security spending and NRs74.4 billion for use of goods and services, which also includes some of the pet projects of politicians and government. 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. 

Compared to the revised estimate for FY2020, allocation for compensation of employees has decreased. It shows that the government is expecting tighter revenue conditions, forcing it to cut back on some recurrent spending. The government has already announced cutbacks on allowances for all but front line security and healthcare sector staff.  

The biggest increase within recurrent budget is for miscellaneous expenditure, followed by subsidies and social security. Interest payments are also increasing. Given the high fiscal deficit and accumulation of outstanding public debt due to the 2015 earthquake and fiscal profligacy during elections time, interest payments have been rising fast. Interest payments have more than tripled since FY2015.

Where is capital budget going?

Almost 64% of the planned capital budget of NRs 352.9 billion is going for civil works, 18.7% for constructing or purchasing buildings, and 5.2% for land acquisition. Compared to the FY2020 revised estimate, capital spending has been increased by 47.6%. Allocation for vehicle purchase within capital spending has decreased by 34.6%. In fact, spending on vehicle purchase by central government has been decreasing since FY2018 (this does not mean subnational governments have also decreased vehicles purchase under their capital budget). 

Major takeaways from FY2021 budget

First, COVID-19 has severely affected government’s finances in FY2020. The government is expected to utilize just 70% of total budget allocated for FY2020. For recurrent, capital and financial provision, it is 73.3%, 58.6% and 78.9%, respectively. Revenue mobilization too has suffered. Total central government receipts are expected to be 73% of budget estimate for FY2020. The lowest is for foreign grants, which is expected to be just 55.2% of the one expected in FY2020 budget. Similarly, foreign loans are expected to be just 35% of the estimate in FY2020 budget. 

Second, the focus is on immediate-term only with surge in healthcare sector budget and temporary employment schemes. The short-term challenge is also to prop up demand (through cash transfers, subsidy and tax concessions) and to maintain supplies of essential goods and services (graded easing of lockdown). The medium-term challenge is a sustained recovery. The latter requires preventing layoffs from both organized and unorganized sectors (wage subsidies and incentives to retain workers), and saving struggling MSMEs from collapsing (by offering subsidized credit at a very low rate, longer term refinancing schemes, infusing working capital or equity, and creating credit guarantee schemes. The budget is unclear on the recovery part, largely leaving private sector to fend the crisis for themselves. Refinancing facility and subsidized loan schemes do not take off as expected because some businesses do not have operational bank accounts and some are already not creditworthy in the eyes of the BFIs. A direct fiscal support is needed, but it is missing. 

The COVID-19 specific refinancing facility and recovery funds are not really going to be effective if businesses do not demand for it. Banks will be willing to extend further credit to creditworthy borrowers only, leaving behind the cash-strapped micro, small and medium enterprises (MSMEs). So, the utilization of refinancing facility from NRB will have few takers unless the refinancing tenure and interest rates are lower than the usual refinancing schemes. Similarly, at a time when many MSMEs are struggling with mounting debt payments and uncertainty over business operations, not many of them will be willing to take new loans to pay salary of employees. What if business never takes off as expected in the future? This will saddle them with more debt. The government should have extended even more generous loans on working capital or additional capital to sustain businesses. There are income tax exemptions for micro and small industries ranging from 25% to 75%, but most of these are operating in the informal sector and hence may not be eligible for these exemptions. Furthermore, these exemptions were already existing and now they are extended by few years. It may not be that helpful given that intake previously was already low. Unorganized sector firms and employees need an unconventional policy measure for the time being and an incentive for them to formalize eventually. Furthermore, the exemptions should be continued up to medium-term (because they cannot recover business and fix balance sheet so quickly) and if possible lower them permanently. 

Third, there is fiscal austerity of sort but not to the full extent expected. We should ideally be comparing FY2021 budget allocation with FY2020 revised estimate, not FY2020 budget estimate. The new allocations are made based on the realized or expected spending in the previous year. Compared to FY2020 revised estimate, total expenditure outlay for FY2021 is 37.4% higher. Higher allocation was warranted given the healthcare sector and social protection related spending needs. But the government could have also cut down other recurrent spending. It could also have re-prioritized spending by not including projects that are not expected to be completed over medium-term and are highly uncertain if they will ever be implemented. The larger slump in expenditure compared to center’s receipts is expected to sharply lower fiscal deficit in FY2020. However, due to higher spending and lower receipts (which itself is ambitious), fiscal deficit is expected to increase to around 8% of GDP in FY2021. Bringing this down in the coming years requires a medium-term fiscal consolidation plan. 

Fourth, revenue mobilization growth target is around 22% compared to FY2020 revised estimate. This is a bit ambitious because of two reasons: (i) there is uncertainty over the period of lockdown and what form it will take going forward, meaning that economic activities will be severely affected, and (ii) imports as well as domestic businesses are not expected to recover soon. Both of these will hit revenue mobilization. In fact, the private sector is bracing for collapse of many MSMEs, especially in the travel and tourism sector. Furthermore, an increase in foreign grants by about 90% compared to FY2020 revised estimate is also not a realistic scenario given that it was not this high (INR 60.5 billion) even during and after the 2015 earthquake. The government has been received less than 50% of the estimated grant receipts in budget since FY2015. This further increases fiscal deficit. 

Fifth, expectation of foreign aid receipts is also a bit ambitious. Foreign loans and grants are expected to be about NRs 360 billion. Apart from emergency budget support, most of the other loans are hinged on progress made in projects. With a low capital budget absorption capacity, it will be challenging to receive all the loans as expected. So far, the government has been able to receive around 40% of the expected foreign loans stipulated in budget speech. These will lead to a severe resource crunch for the government. 

Sixth, a large increase in domestic borrowing (about 77% compared to the revised or budget estimate for FY2002) will create liquidity shortages (already squeezed by deceleration of remittances, lower capital spending, higher credit growth, and now a potentially large number of MSMEs unable to service interest and principal payments on time due to cash flow problems). This might drive interest rates up and crowd out private investment. Net domestic borrowing is expected to increase to about 6% of GDP from a surplus of about 0.2% of GDP before FY2016.

Seventh, the government argues that capital spending is higher than the indicates. Generally, the grants that goes to the subnational governments are included as recurrent spending in the central government’s budget. To avoid confusion, the central government should practice an accounting system where it reports central, provincial and local government’s capital spending separately. Perhaps, FCGO can be the agency to do that. 

Eighth, there has to be more explanation for the 7% GDP growth target. Given the extended period of lockdown, uncertainty over the peak spread of COVID-19, and demand as well as supplies slump, a quick V-shaped recovery is not normal. GDP growth in FY2020 may in fact contract now because the 2.3% growth projection by CBS was done with the expectation that economic activities will pick up pace from mid-May. The disruption to labor, capital and supply chains will continue to affect output. Agricultural output will be affected because of shortage of two key inputs, labor and chemical fertilizers, despite the forecast of a normal monsoon. Industrial activities will also remain subdued despite the expected growth in electricity, gas and water sub-sector (more addition of hydropower including Upper Tamakoshi and completion of Melamchi). Construction activities will remain below average and so will mining and quarrying activities. Some manufacturing establishments may not recover at all and those able to resume production will see drastic drop in capacity utilization. On services sector, wholesale and retail trade activities will remain affected because imports will continue to be disrupted (it accounts for about 50% weight) and agricultural output will affect its transactions (accounts for about 25% weight). There is uncertainty over how quickly travel and tourism sector can recover, if at all. Similarly, air transport remains affected as well as education. So, outlook on all sectors is not encouraging. Even with a favorable base effect (FY2020 real GDP growth will likely contract), FY2021 GDP growth target of 7% is too ambitious. 

Ninth, COVID-19 has created a critical juncture for the economy. This is the time to overhaul laws, regulations and institutions so that pace and pattern of structural transformation is growth-enhancing. The government should give generous tax concessions (much more than neighboring countries) and make it easier for private sector to do business. It would help to generate non-agricultural jobs for the unemployed and returning migrant workers. It should also strengthen government mechanism and establish a technology-driven systems reforms so that public service delivery is efficient and leakages are minimized. A unified digital platform and registry for social protection would be transformation at this stage in terms to plugging fund leakages and to target beneficiaries without much bureaucratic or political hassle. These unfortunately are missing. 

Tenth, government-backed employment should only be a temporary social protection measure to fend off financial difficulties faced by the poor people. The plan to provide jobs to 700,000 people is too ambitious because there is not unified registry of unemployed workers and returning migrant workers. These are at the discretion of local governments and the work they are given are not of durable nature. Fudging of rolls is common and so is siphoning off of funds. The PM employment programme should be clubbed with the larger social protection schemes under a unified digital registry. The government expects 200,000 jobs from PMEP; 50,000 from skill training at subnational level; 75,000 from TVETs; 50,000 in private sector (subsidy for private firms employing state-trained workers); 50,000 from Youth and Small Entrepreneur Self Employment Fund, among others. The effectiveness of these programs are not that good at present.

Finallly, I have assumed FY2021 nominal GDP growth to be the same as in FY2020, although the nominal growth in FY2020 will actually be lower than the one estimated by CBS as the estimates pertain to an unrealistic assumption about the duration of the lockdown and resumption of economic activities. In that case, as a share of GDP, expenditure and revenue will be higher than indicated in this piece (as denominator NGDP value decreases).