It was published in The Kathmandu Post, 11 May 2022. Background details are in this blog and Twitter thread.
Economic outlook and fiscal budget
On the backdrop of disappointing national accounts estimates recently released by National Statistics Office (NSO), and an unsatisfactory fiscal performance but improving external sector situation so far this year, the government is busy in budget preparation for next fiscal year 2023/24. While tight monetary and fiscal policy measures mitigated external sector risks, particularly fast depleting foreign exchange reserves, they also squeezed aggregate demand as banking sector lending slowed down, industrial capacity utilization decreased and revenue mobilization shortfall widened as obligatory spending on salaries and social spending increased. It indicates a weak economy with unresolved structural issues and macroeconomic imbalances, which the upcoming budget will have to focus on.
Economic slowdown
The NSO projected gross domestic product (GDP) to grow by 1.9% in 2022/23, down from 5.6% revised estimate for 2021/22 and 4.8% for 2020/21. The growth estimate for this fiscal is also lower than the 8% target in budget and the recent estimates by multilateral institutions. The NSO estimate is based on data and information up to the first nine months of this fiscal (mid-July 2022 to mid-April 2023) and assumption of normal economic activities during the rest of the fiscal, which is not likely given the lower private sector confidence and lack of pick up in capital spending in the last quarter. Consequently, the statistics office may revise down estimates when it releases data next year. Note that seasonally unadjusted data show that the economy grew at just 1.7% in the first quarter and contracted by 1.1% in the second quarter of this fiscal. Seasonally adjusted quarterly GDP estimates show two consecutive quarters of economic contraction.
The lower growth projection is attributed to contraction in manufacturing, construction, and retail and wholesale trade activities, which together account for about 28% of GDP. Specifically, manufacturing activities contracted by 2% owing to lack of adequate electricity supply during dry season— this despite electricity subsector registering the largest growth, 19.4%, in 2022/23 due to addition of new run-of-the-river type hydroelectricity to national grid, high interest rate, import restrictions and generally low government and consumer demand. Nepal Electricity Authority cut supply by almost 12 hours to industries due to a slump in power generation during dry season. It increased the cost of production— including those of cement, rods, and steel industries—, leading to lower output and demand.
Similarly, construction activities contracted by 2.6%, because capital spending slowed down and residential housing and real estate was hit by policy restrictions on real estate plotting and tight as well as high interest rates. This subsector previously benefitted from a highly accommodative monetary policy and lax supervision. Meanwhile, wholesale and retail trade activities contracted by 3% owing to restrictions on imports of goods, a slowdown in domestic industrial output, and lower income growth as lack of adequate electricity supply, inflation, and high input costs hit businesses and households.
Overall, the tight monetary policy to maintain external sector balance, especially to narrow current account deficit and increase foreign exchange reserves, and lower public spending dampened aggregate demand, leading to lower-than-expected real GDP growth. While public and private investments contracted by 20.2% and 7.6% respectively, consumption expenditure grew by just 3.7%. The external sector situation and to some extent the financial sector indicators have improved but this has come at the cost of a slowdown in imports and overall economic activities.
Budget focus
Against this background, the next federal budget should focus on propping up aggregate demand while rectifying short-term macroeconomic imbalances. These include reducing fiscal deficit in view of large revenue expenditure gap, boosting private sector investment, reducing inflationary pressures, lowering interest rate volatility, maintaining financial stability, and maintaining external sector balance even after the withdrawal of policy restrictions on imports.
Expenditure-based fiscal consolidation through rationalization of subsidies and general government expenses, and better targeting of social protection programs including pensions system are urgently needed. Else, it will be difficult to manage recurrent spending with revenue mobilization. On revenue measures, the focus at the federal level could be on avoiding an inverted tax regime where tax rate on inputs is higher than that for final goods. Rationalizing distortionary tax expenditures such as exemptions, concessions, preferential rates, amnesties, and deferrals could also be prioritized. At the subnational level, strengthening revenue system and administration to bring more activities, including property levies, under the tax net could be helpful to reduce the overreliance of subnational governments on the federal government to meet their expenditure needs.
The budget should also focus on capital budget execution, which has receded to less than 60% in recent years. A public investment management regime that focuses on systematic identification, appraisal, approval and monitoring of investment projects, and a procurement regime that also priorities strict contract management could be helpful in this regard.
Meanwhile, a single fiscal budget cannot resolve all structural issues, but it can take corrective steps as a part of a medium-term reform agenda to sustain high, inclusive, and sustainable growth. These include long running structural issues such as boosting overall productivity, inducing an industry-oriented structural change from low value-added services activities, promoting high-value and climate-smart agricultural sector, enhancing governance of and lowering fiscal risk from public enterprises, ensuring effective contract management and good governance, rationalizing as well as targeting of social protection programs, enhancing quality and climate-resilient infrastructure, and boosting human capital development.
The budget could take preparatory steps to facilitate industry-oriented structure change by overhauling our energy generation and use strategy. The share of the industry sector will naturally increase as more hydroelectricity projects get connected to the national grid. Hydroelectricity output now accounts for about 2.1% of GDP, sharply up from less than one percent a decade ago. It should be thought of both as a final product as well as an input to enhance economy-wide output and productivity. The budget could facilitate strategic use of excess electricity generation during non-dry season to boost output and productivity in manufacturing and services sectors. This will not only reduce imports and lower the current account deficit, but also boost growth and employment. Export of electricity should be a second priority for now. Furthermore, given the risk from climatic hazards, it is a good idea to start working on diversifying energy sources to wind and solar, and to increase the peaking or reservoir type hydroelectricity projects. Year-round adequate supply of electricity needs to be managed well so that the industries do not face shortage during certain months, and that consumers have incentive to shift to electric goods and appliances.
