Macroeconomic stability and structural transformation in Nepal

It was published in The Kathmandu Post, 19 September 2023.

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Macro struggle and transformation

Latest data from fiscal year 2022-23 indicate a challenging economic landscape. While the external situation has improved and the banking sector is gradually emerging from a recurring liquidity crunch, fiscal and real sectors are under stress. Specifically, the large current account deficit and depleting foreign exchange reserves reversed course, and the availability of loanable funds in the banking sector improved along with the declining interest rates and sizable liquidity. However, gross domestic product (GDP) growth decreased while fiscal deficit, public debt and inflation increased.

It gives the impression of an economy struggling to maintain macroeconomic stability, especially after the onset of the pandemic. The effect is compounded by the unresolved structural issues affecting economic and social transformation for a long time.

Macroeconomic stability has been challenging due to external and internal reasons. Exogenous shocks, such as the Russian invasion of Ukraine and the ensuing effect on fuel and commodity prices have increased trade costs and inflation. Monetary tightening in the developed countries has depreciated the Indian rupee, to which the Nepali rupee is pegged. These are negatively affecting Nepal’s external sector performance. In response, the Nepal Rastra Bank tightened monetary policy, and the government banned the import of certain goods that were draining foreign exchange reserves. These were internal policy choices in response to the exogenous shocks—the interaction of both has affected macroeconomic performances.

Mixed performance

The cumulative effect is seen in the 2022-23 macroeconomic data. GDP growth is estimated to have dropped to 1.9 percent from above 4.5 percent in the last two fiscal years. This is primarily due to the contraction in both public and private investment and a slowdown in consumption and exports. In fact, public and private fixed capital investments are expected to contract by 20.2 percent and 55.9 percent, respectively, reflecting not only lower public capital spending but also dismal private sector investment. Manufacturing, construction, retail and wholesale trade activities—which account for about 28 percent of GDP—have also contracted.

The fiscal performance of the federal government was worse than expected. The contraction in revenue mobilisation and grants amidst high expenditure levels widened the fiscal deficit to over 7 percent of GDP, up from about 5.4 percent in the last fiscal year. According to the latest data from the Financial Comptroller General Office, tax revenue decreased by 12.1 percent and grants by 22.5 percent in 2022-23. It primarily reflects the sharp decrease in imports, in particular, as trade-based tax collections account for nearly half of the total tax revenue and economic slowdown in general. The government increased domestic and external borrowings to bridge the revenue and expenditure gap, pushing total outstanding debt to 41.3 percent of GDP in 2022-23. It was just 22.5 percent in 2014-15. Domestic debt servicing nearly doubled in 2022-23 due to high interest rates on government bills and bonds. The interest rate on 91-day treasury bills averaged 9.5 percent, the highest since 1997-98.

Monetary sector performance was broadly in line with expectations as tight monetary policies dampened credit growth. Deposit grew faster than credit (12.3 percent versus 5.5 percent) owing to a surge in remittance inflows and high interest rates. However, the high-interest rates and slowdown in aggregate demand discouraged private sector investment, resulting in private sector credit growth of just 4.6 percent compared to 13.3 percent in the previous fiscal. The weighted average deposit and lending rates reached 8.2 percent and 12.6 percent, respectively—the highest in the last decade. Inflation increased by 7.7 percent, the highest since 2015-16, owing to high fuel and commodity prices.

External sector performance, the main target of policy choices in the last two years, fared better. The current account deficit sharply decreased to 1.3 percent of GDP from 12.6 percent in 2021-22. It was mainly due to a drastic drop in imports (nearly 10 percentage points of GDP) and a pickup in remittance inflows, amounting to 22.7 percent of GDP. Foreign exchange reserves also increased to cover 10 months of import of goods and services, up from 6.9 months in 2021-22.

Structural issues

Beyond the short-term effects, this volatility or sharp readjustment of macroeconomic indicators points to unresolved structural issues that must be addressed through legal, regulatory, policy and institutional reforms. These structural issues should not be masked by the rosier economic outlook for 2023-24 compared to the last fiscal.

The vulnerability to exogenous shocks will continue to compound until a meaningful structural economic transformation. For instance, shifting from low- to high-value-added sectors with increasing productivity and employment opportunities will require less reliance on remittances for growth, poverty reduction, revenue mobilisation, banking sector liquidity and external sector stability. A high inflow of remittances supports high consumption (over 90 percent of GDP), which is fulfilled by imported goods and services without adequate domestic output. Foreign exchange earned from remittances is used to finance imports. Large-scale outmigration and remittances have been critical in reducing poverty, propping up real estate and housing businesses, and facilitating internal migration from rural to urban areas.

The government must ramp up capital budget execution to fund critical physical and social infrastructure and services and promote private sector investment to lay the foundation for a meaningful structural transformation. Capital budget execution, which averaged 61 percent in the last three fiscal years, is affected by prolonged government procedures leading to approval delays and coordination failures, structural weaknesses in project preparation, including inadequate consideration for climate change and natural hazards, and allocative inefficiency. The government needs to increase capital budget execution by addressing these constraints and also secure additional resources to improve overall capital expenditure. Amidst stagnating revenue growth and high fiscal deficit, they must rationalise recurrent expenses and reform loss-making public enterprises to create extra fiscal space to boost capital expenditure. The quality of capital spending is also crucial as it was hastily spent in the last quarter of the fiscal year when about 54 percent of actual spending or disbursement happens. In 2021/22, capital spending, a share of GDP, of federal, provincial and local governments was 4.4 percent, 2.2 percent and 3.4 percent, respectively.

Structural issues related to the financial sector—particularly, perennial asset-liability mismatch and the impact of high credit growth on the productive sector and aspired structural transformation—need rethinking. This might require reorientation of the monetary policy, addressing long-term structural issues in addition to short-term credit flows and interest rate volatility. To boost output and exports, overall productivity needs to be enhanced by lowering the cost of doing business, which will incentivise private sector investment and increase industrial capacity utilisation. 

IMF's latest view on capital flows: CFM and MPMs can be applied pre-emptively without surge in capital inflows

The IMF has updated its view on capital flows. Specifically, it now recommends that countries should have the option to pre-emptively curb debt flows to safeguard macroeconomic and financial stability. Excerpts from a blog post:

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Economies with large external debts can be vulnerable to financial crises and deep recessions when capital flows out. External liabilities are riskiest when they generate currency mismatches—when external debt is in foreign currency and is not offset by foreign currency assets or hedges. [...]Since the beginning of the pandemic many countries have spent to support the recovery, which has led to a build-up of their external debt. In some cases, the increase in debt in foreign currency was not offset by foreign currency assets or hedges. This creates new vulnerabilities in the event of a sudden loss of appetite for emerging market debt that could lead to severe financial distress in some markets.

In a review of its Institutional View on capital flows released today, the IMF said that countries should have more flexibility to introduce measures that fall within the intersection of two categories of tools: capital flow management measures (CFMs) and macroprudential measures (MPMs). [...]these measures, known as CFM/MPMs, can help countries to reduce capital inflows and thus mitigate risks to financial stability—not only when capital inflows surge, but at other times too. 

The main update is the addition of CFM/MPMs that can be applied pre-emptively, even when there is no surge in capital inflows, to the policy toolkit. [...]Pre-emptive CFM/MPMs to restrict inflows can mitigate risks from external debt. Yet they should not be used in a manner that leads to excessive distortions. Nor should they substitute for necessary macroeconomic and structural policies or be used to keep currencies excessively weak.

CFMs to restrict inflows might be appropriate for a limited period, the Institutional View said, when a surge in capital inflows constrains the policy space to address currency overvaluation and economic overheating. It said CFMs to restrict outflows might be useful when disruptive outflows risk causing a crisis. In turn, CFM/MPMs on inflows were considered useful only during surges of capital inflows, assuming that financial stability risks from inflows would arise mainly in that context.

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Preemptive CFM/MPMs on debt inflows (primarily in FX) may be useful in the presence of private sector debt stock vulnerabilities (primarily FX mismatches), which MPMs cannot sufficiently address. Those stock vulnerabilities may have accumulated during prior inflow surges or gradually over time without an inflow surge. Preemptive inflow CFM/MPMs should be targeted, transparent and, while potentially longer-lasting, temporary, being recalibrated or removed as the vulnerabilities that led to their adoption subside, or if an effective MPM (that is not designed to limit capital flows) becomes available.

In the context of capital inflow surges, inflow CFM/MPMs may be useful to address financial stability risks arising from the surge, and CFMs on inflows may be useful in the circumstances outlined in the Venn Diagram in Figure 2 (upper panel).

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Post pandemic economic recovery in Nepal

It was published in The Kathmandu Post, 14 March 2022.

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Medium-term economic recovery

A course correction beyond the band-aid nature of policy reaction is warranted.

The weaknesses of the economy, masked by pandemic-related fiscal and monetary relief measures and regulatory forbearances, are starting to unravel. Economic growth is persistently below target, the budget deficit is large and widening, public debt is increasing sharply, current account and balance of payments deficit are growing, and foreign exchange reserves are falling. The overall macroeconomic situation and growth outlook are not encouraging. A course correction beyond the band-aid nature of policy reaction is warranted to ensure the country has the available resources to finance the investment needed for medium-term economic recovery.

Deteriorating situation

The economy contracted by an estimated 2.1 percent in fiscal 2019-20, the first contraction in over four decades, as demand, supply and health shocks disrupted economic activities. A sharp and considerable economic rebound is unlikely due to a setback in agricultural output, especially a shortage of chemical fertilisers, and the continued deceleration of remittances that affect households’ purchasing power. Gross domestic product (GDP) growth may hover around 5 percent as base effect (which refers to the tendency of achieving an arithmetically high rate of growth when starting from a very low base) dissipates, and remittances decelerate (which constrains aggregate demand).

The state of public finance is also not encouraging given the large and growing fiscal deficit, which refers to expenditure net lending minus total receipts. Federal receipt, which includes foreign grants, is estimated to reach 23.7 percent of GDP this fiscal, but federal expenditure is estimated to top 34.8 percent of GDP, of which recurrent expenses account for 65 percent. Despite expenditure and revenue shortfalls relative to budget targets, the deficit will likely be over 6 percent of GDP. Note that the spending pattern has not changed much with capital spending absorption capacity still low, and over 50 percent of actual capital spending bunched in the last quarter, raising concerns over the quality of assets and fiduciary risks. It was just 16 percent of the budget estimate in the first seven months of this fiscal.

Capital spending is beset with structural weaknesses (low project readiness, weak contract management, and high staff turnover), allocative inefficiency (ad hoc allocation, lack of adherence to medium-term framework, and weak project pipeline), and bureaucratic delays (political interference at operational and management levels, weak intra- and inter-ministry coordination, and maze of approvals). Meanwhile, outstanding public debt has nearly doubled in a matter of just five years, reaching 40.7 percent of GDP in 2020-21.

The financial sector is also not in good standing. An aggressive increase in credit relative to deposits, which has fallen in tandem with the deceleration of remittances, has contributed to a chronic liquidity crisis. The liquidity situation used to be periodic in the past, that is it fluctuated in line with capital spending. However, it has been persistent in recent years, implying structural weaknesses and increased vulnerabilities in the financial sector. The outsized real estate and housing bubbles and the bullish stock market are not in sync with the macroeconomic fundamentals. It could pose a significant challenge after pandemic-related regulatory forbearances and relief measures are withdrawn. The elevated inflationary pressure, primarily due to supply disruption, rise in fuel and commodity prices, and Nepali rupee depreciation, will worsen the matter.

The external sector is in bad shape. The current account deficit in the first six months of this fiscal year is already higher than the whole of the last fiscal year. This is mainly due to the widening trade deficit and deceleration of remittances, which is not expected to recover soon. Consequently, the balance of payments is negative and foreign exchange reserves are falling steadily. Now, foreign exchange reserves are sufficient to cover 6.6 months of merchandise and services imports. It was about 14 months of import cover in mid-July 2016. Given the currency peg with the Indian rupee, vulnerability to natural disasters and the need for an additional buffer for remittances and tourism-related vulnerabilities, the optimal level of reserves is estimated to be 5.5 months of prospective import of goods and services.

Medium-term priority

Economic recovery will only be strong and sustained if medium-term priority is reoriented to reduce reliance on exogenous factors to support growth, poverty and inequality reduction, revenue mobilisation, and financial and external sector stability. For instance, the pattern and intensity of monsoon rainfall largely dictate agricultural output in the absence of reliable supply of farm inputs such as year-round irrigation, timely availability of chemical fertilisers, cheaper access to finance, and connectivity to link farmgate and retail markets, and farmers and consumers. Similarly, remittance income largely dictates consumption, especially private consumption, accounting for 90 percent of total consumption and demand in services and industrial sectors. This is neither resilient nor sustainable. Policy effort should be directed towards reorienting the sources of growth to more reliable factors through investment in physical infrastructure and human capital development, private sector development, and public sector reforms. These are essential to boost aggregate output and productivity.

Creating fiscal space required to boost spending on physical infrastructure and human capital development in the public sector is essential. This can be done through expenditure management and/or higher revenue mobilisation. Reduction of recurrent spending through expenditure consolidation or by plugging in leakages (for instance, in the distribution of allowances, unnecessary recruitment, and mundane charges), enhancing budget transparency and policy direction, accounting for fiscal risks and liabilities, and decreasing fiscal burden due to loan and share investment in non-performing public enterprises are some of the areas that require urgent attention for expenditure management. Since raising taxes is not ideal given the already high rates, efforts should be redirected at enhancing revenue administration, including reducing tax expenditures (subsidies, rebates, concessions), broadening the tax base, and divesting the government’s share in public enterprises and the monetisation of their assets. These will be helpful to create the fiscal space needed to finance medium-term recovery and promote competitive and cooperative federalism.

Similarly, financial sector volatility and vulnerabilities need to be curbed by using macroprudential tools. Credit growth needs to be consistent with deposit growth, asset-liability mismatch minimised, sectoral bubbles contained, and evergreening of troubled assets discouraged. These contribute to high volatility of liquidity and hence unpredictable interest rates. The current monetary policy and financial sector architecture do not adequately stop the misallocation of resources to sectors that do not contribute much to boosting domestic economic activities and job creation.

Another priority area should be private sector development to boost competitiveness and unshackle the economy from the grip of sectoral cartels and crony capitalists that distort factor and product markets. A holistic review of policies, rules and regulations is needed to get a clear picture of why investment is not increasing as expected despite the slew of legal changes enacted in the last five years. This review should also answer why special economic zones remain vacant and what needs to be done, the possibility of providing relatively cheaper electricity to businesses to boost cost competitiveness of industrial and services sectors, and the effectiveness of Investment Board Nepal in promoting investment and public-private partnership.

Divergent recovery and policy options

In the latest edition of World Economic Outlook (WEO, April 2021), the IMF states that without the extraordinary fiscal and monetary policies, the pandemic would have resulted in an economic contraction three times larger than the current estimates. 

GDP growth

The IMF is projecting the global economy to grow at 6% in 2021, up from an estimated contraction of 3.3% in 2020, and moderate to 4.4% in 2022. These revised projections are higher than earlier estimates owing to the favorable effect of easing of lockdowns, adapting to new ways of working, substantial fiscal support in advanced economies, and an anticipated vaccine-led recovery in the second half of 2021. The IMF projects global growth to moderate to 3.3% over the medium term as the damage to supply chains scars output capacity and aging in advanced economies slows down labor force growth.

Inflation

Inflation in advanced economies is projected to rise to 1.4% in 2021, up from 0.4% in 2020, and 1.9% in 2023. In EMDEs, inflation is projected to remain stable at around 3% from 2021-2023, up from 2.8% in 2020.

The IMF expects price volatility to be short lived and that inflation will return to its long-term average as remaining slack subsides gradually and commodity-driven base effects fade away. Commodity prices, particularly oil, are expected to firm up in the months ahead. But, overall subdued inflation outlook reflects labor market conditions as well, especially subdued wage growth and weak worker bargaining power that are compounded by high unemployment, underemployment, and lower labor force participation rates. 

The IMF notes that unless output gaps become positive and very large for an extended period of time, and monetary policy does not react to rising inflation expectations, inflation is unlikely to increase much. It also does not expect monetary policy to be used primarily to keep government borrowing costs low at the expense of price stability as most economies have independent central banks. 

External sector

On external sector, the IMF projected global trade to accelerate to 8.4% due to the rebound in merchandise goods. But, cross-border services trade (travel and tourism) is expected to remain subdued. 

Divergent effects

The output losses have been divergent. The most affected are the economies that rely on tourism and commodity exports and those with limited fiscal space to respond to the crisis. Many countries entered the crisis without much fiscal space and the ability to mount an effective healthcare policy response. The WEO states that economic situation now (and eventual recovery) is influenced by factors such as the proportion of ‘teleworkable’ jobs, share of employment in small and medium enterprises, capital market deepening, size of informal sector, and quality of and access to digital infrastructure. 

The economic recovery since the second half of 2020 has been led by strong demand for products suitable for working from home and pent-up demand for durable goods such as automobiles. Industrial output is now at pre-pandemic level, but contact-intensive services activities have remained depressed. Likewise, although merchandise trade is back to the pre-pandemic levels, cross-border trade in services remains subdued.  

Unemployment and underemployment remain at elevated level. Labor force participation rate has dropped despite wage and jobs retention programs in many countries. The report notes that youth, women, less educated workers, and informally employed are hardest hit by the pandemic. Poverty (additional 95 million people) and income inequality are likely to increase. The unequal setback to schooling could further exacerbate inequality. 

Asset markets have been surging, thanks to policy stimulus and expectations of a vaccine-driven normalization. However, the IMF notes that the divergence between valuations and broader economic prospects raise financial stability risks. 

GDP loss

The IMF projects the average annual loss in per capita GDP over 2020–24, relative to pre-pandemic forecasts, to be 5.7% in low-income countries and 4.7% in emerging markets. In advanced economies the losses are expected to be 2.3%. Unlike the global financial crisis in 2008, the substantial policy support in response to the pandemic has averted a financial crisis, and medium-term losses are expected to be lower than in 2008 (about 3% lower). However, the emerging markets and low-income countries are expected to face greater scarring owing to their limited policy space. 

Fiscal authorities provided relief to households and firms in the form of transfers, wage subsidies, liquidity support, expansion of safety net such as unemployment insurance and nutrition assistance. Financial regulators facilitated credit provision by easing classification guidelines for nonperforming loans, relaxing provisioning requirements for banks, reducing risk weights on bankruptcy proceedings, and flexibility regarding bank capital requirements. 

The IMF estimates that policy actions such as automatic stabilizers, discretionary measures, and financial sector measures contributed about six percentage points to global growth in 2020. 

Economic outlook

There is considerable uncertainty over the economic outlook though. The WEO notes that it is contingent on the path of the health crisis including vaccine effectiveness against new variants, the effectiveness of policy actions to limit persistent economic damage (scarring), the evolution of financial conditions and commodity prices, and the adjustment capacity of the economy. 

Vaccine procurement and distribution are uneven with broad vaccine availability in advanced economies and some emerging market economies. Since vaccine deployment will be staggered across regions, spread of new variants forcing occasional and localized lockdowns is possible. However, the IMF notes that these may not constrain economic activities like in the initial lockdowns because they will be more targeted and that people and firms have adapted to remote work. 

The size of fiscal package will also drive the nature of recovery. The fiscal package unveiled by the US government will boost growth in the US in 2021 and provide sizable positive spillovers to its trading partners, the WEO states. The IMF expects debt service costs to remain manageable across advanced economies because their debt profile is largely dominated by long-term and sometimes negative-yielding bonds. However, it notes that EMDEs will have limited fiscal support now, but as revenue mobilization improves with pickup in economic activities and crisis-related expenditures unwind, they will have lower fiscal deficits than now. But high debt service costs are expected in EMDEs. 

The crisis could still result in substantial and persistent damage to supply potential and extend scarring due to diminishing labor force participation, bankruptcies, and disruption of production networks. It argues that the longer the recession, the more likely that the effects will be permanent, especially in EMDEs where the prevalence of relatively small firms and shallow capital markets could dampen investment and employment for an extended period of time. These may cripple productivity growth too. 

The IMF expects monetary policy to remain accommodative and tighten only gradually as recovery takes hold. It also expects oil prices to increase as OPEC+ producers curb supply. The strong rebound in PRC will put upward pressure on metal prices. Food prices are also expected to increase in 2021. 

Policy response

Against this backdrop, the IMF recommends policymakers to prioritize policies prudently including strengthening social protection with wider eligibility for unemployment to cover the self-employed and informally employed; adequate resource for healthcare, early childhood development programs, education, and vocation training; and investment in green infrastructure to accelerate the transition to lower carbon dependence. Policy support should be flexible such as shifting lifelines, reallocations, and linked to improvements in activity, but they should safeguard social spending and avoid inefficient spending outlays. Anchoring short-term support in credible medium-term frameworks is key. Economies facing high debt burden should consider creating fiscal space through increased revenue mobilization and reduced wasteful subsidies.

It recommends policy responses to be tailored to the stage of the pandemic, strength of the recovery, and structural characteristics of the economy. As the pandemic continues, policies should focus on prioritizing the healthcare spending, providing well-targeted fiscal support, and maintaining accommodative monetary policy. As recovery progresses, policymakers should limit long-term economic scarring by broadening productive capacity and increasing incentives for an efficient allocation of productive resources. 

Vietnam as a rising star in global supply chains

Cheap labor costs, big investment incentives, political and policy stability, and strong trade relations appeal Vietnam as an alternative investment destination to China, according to a special report published by The Economist Intelligence Unit. The country is now rated more highly than competitors such as China, Indonesia, India, Bangladesh and Pakistan. [Interestingly, Sri Lanka is rated the most favorable in South Asia in terms of business environment.]

The report focuses on labor, investment incentives, and trade relations, which are central to Vietnam’s competitiveness as a manufacturing hub.

First, the report argues that the ample supply of low-skilled labor will remain a core strength of Vietnam. Working age population is estimated at 68 million, which is about 70% of total population. It appears to be enjoying a “demographic dividend”, which refers to a share of working-age population being larger than those under 15 and over 64 years of age. Agricultural sector accounts for over one-third of the employed workforce, and workers from rural areas have been a key source of labor in manufacturing sector. There is still a stock of surplus labor in the agricultural sector, which means wages growth among low-skilled and unskilled workers in manufacturing sector will remain restrained. However, the availability of skilled labor force will still be an issue.

Second, the report states that Vietnam is offering generous concessions for high-tech manufacturers thinking to relocate labor-intensive processes. Incentives for lower-value added industries will be continue to be rolled back. Vietnam offers various incentives for FDI in industrial zones (industrial parks and export-processing zones), special economic zones, and technology parks. Most are export-oriented industries. It offers corporate and personal income tax exemption and rate reduction. High-tech sectors such as automotive, machinery, and production of advanced capital goods are offered below-market land rents, which is a major incentive amidst rising rent costs. Eligibility criteria are made flexible, especially for large firms. EPZs are not that popular these days because of reduction of import tariffs, which have made duty-free intermediate imports under EPZs largely redundant. The report notes that going forward the eligibility criteria for investment incentives will focus on higher value-added industries. 

Industrial clusters in Vietnam are concentrated in four geographical areas that were designated as priority regions for industrial development: Northern, Central, Southern and Mekong Delta Key Economic Zones. Footwear, textile and garment industries are well developed with advanced labor specialization and scaled-up manufacturing operations. Electronics exports have limited domestic value added, which the government is trying to change through vertical integration in the production of smartphones (Samsung is opening a R&D facility and a phone screen manufacturing plant).

Third, the report notes that Vietnam participates in more trade agreements and has better trading relations with major trading partners than its regional neighbors. This helps in promoting competitive export. It is a member of ASEAN Economic Community, Regional Comprehensive Partnership Framework, Comprehensive and Progressive Agreement for Trans-Pacific Partnership, and the EU-Vietnam Free Trade Agreement. For instance, CPTTP opens up more access to Canada and Mexico (with whom it did not have agreements before) for Vietnamese sports footwear, telephone sets, electrical machinery, and clothing and apparel.

Remittances and external sector stability in Nepal

It was published in The Kathmandu Post, 02 September 2020. Related Twitter thread with charts here. 

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The cash cow is drying up

Don’t be fooled by the better-than-expected results from the external sector, the effects are only temporary.

The latest provisional data for the fiscal year 2019-20 released by the Nepal Rastra Bank provide interesting insights on the impact of Covid-19 and the subsequent lockdowns on the economy. Almost all areas, except for the external sector, have been hit hard since the first lockdown began in late March. Specifically, unlike projections of a sharp drop, the data shows just a small deceleration in remittances.

This has led some to argue that Nepal’s external sector is sound as well as resilient and that vulnerabilities are on the downside. However, the reality is that it only appears sound owing to a larger import contraction than export contraction, and slower than expected deceleration of remittances. Remittances are an important household coping strategy when faced with an adverse income or consumption shock. Migrant workers tend to use precautionary savings to remit more after such shocks. This should not be construed as a sign of resilience.

Still unstable

A sudden supplies disruption was expected to hit imports and remittances, resulting in an improvement in the current account balance, which is a record of Nepal’s transactions with the rest of the world. Exports pretty much stalled after the pandemic spread globally. Imports, except for medical equipment and supplies, were also severely curtailed due to disruptions and logistical hurdles. Further, oil imports, which normally account for 15 percent of the total import bill, decreased on account of a drop in internal demand, particularly for transportation and development projects.

Declining global oil prices also contributed to a lower oil import bill. Consequently, imports decreased much faster than exports. For instance, in US dollar terms, merchandise exports and imports contracted by 7.9 percent and 18.9 percent, respectively. In a reversal of the previous trend, merchandise trade deficit actually dropped to 28.2 percent of the gross domestic product in 2019-20 from 37.1 percent of GDP in 2018/19.

Similarly, the trade imbalance in services also improved as services import (which includes outbound travel and foreign educational expenses) decreased much more than services export (which includes inbound travel and tourism). A sharp contraction of imports but a small contraction of remittances (by just 3.4 percent) improved the current account balance. This is what the analysts meant when they argued that the external sector remained stable despite the adverse external environment.

Meanwhile, the balance of payments reached a record $2.4 billion as a large contraction of imports but a lower than expected deceleration of remittances and an increase in foreign direct investment and foreign emergency loans all played crucial roles. Similarly, gross foreign exchange reserves have also hit record levels. The Nepali rupee depreciated by 9.2 percent against the US dollar at the end of 2019-20.

The improvement in the current account balance, a large balance of payments surplus and record foreign exchange reserves might have given a misplaced assurance that all is sound and stable. But regardless of the pandemic being contained or the country choosing to simply live with the virus, as the economy opens up after the lockdowns and supply chains are restored, the situation might quickly change.

Most prominently, the import of commodities (oil, food and raw materials) as well as intermediate capital goods will increase. Meanwhile, given the lack of price competitiveness, an unfavourable policy environment, distortionary incentives and generally subdued external demand, exports will likely not recover soon. Travel and tourism activities may not also recover quickly. These will deteriorate the tenuous external sector stability and put a strain on foreign exchange reserves.

A short respite

The problem will be compounded by the expected deceleration of remittance inflows. Apart from its positive effect on reducing poverty and boosting consumer demand, government revenue and financial sector liquidity, large remittance inflows have been a saving grace for external sector stability in the face of a large and growing trade deficit. The number of Nepali migrant workers has been continuously declining since 2014-15. The persistent deceleration of remittances will be coupled with a smaller expatriate workforce, with fewer outbound migrant workers and a reduction in the work hours of those already working abroad.

There are three main reasons why remittances did not decelerate as expected in 2019-20. First, remittances tend to increase immediately after a shock in receiving countries. For instance, remittances increased by 12.2 percent in 2014-15 as migrant workers, drawing from their precautionary savings, remitted more income to their earthquake-affected families. However, the following fiscal it only grew by 0.8 percent. Second, the depreciation of the Nepali rupee against the US dollar also provides an incentive for migrant workers to remit more money. The rupee depreciated by 9.2 percent in mid-July 2020, much higher than 0.02 percent depreciation in mid-July 2019. Third, the use of formal banking channels to remit income has increased along with the rise in the number of money transfer agencies and the crackdown on informal inflows.

The Nepali economy entered the Covid-19 era with pre-existing weaknesses: a weak foundation for meaningful structural transformation, volatile GDP growth and inflation, mounting fiscal stress due to a large fiscal deficit and increasing public debt, persistent asset-liability mismatches and high credit growth by financial institutions, and decelerating remittances. It was exacerbated by weak governance and contract management in public projects, political infighting within the ruling party, over-politicisation of the Millennium Challenge Corporation’s compact programme and geopolitical discord. The potential deceleration of remittances will exacerbate these trends, and heighten external sector stress.

The impact of COVID-19 on Africa

Paul Collier explains how four shocks (drop in commodity prices, remittances, tourism, and international capital) due to the overarching COVID-19 shock are threatening Africa's progress.

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Two in three jobs in sub-Saharan Africa are in the informal sector. There are no economies of scale or specialisation. Small is not beautiful, it is unproductive. Africa needs more companies capable of organising a workforce into specialised, collaborative teams, disciplined by competition. Yet even the firms that Africa has are bleeding from the economic impact of coronavirus.

This shock is not predominantly a result of Africa’s health crisis. The causes are the sharp downturns in advanced economies. Commodity prices have dropped and Africa is a major net exporter.

Senegal and Ethiopia are major recipients of remittances from citizens working abroad. Normally, these rise during a domestic crisis, but in this global emergency Africa’s diaspora are losing their jobs. This also hits the most desperate places such as Yemen.

Finally, the retreat of international capital to safety is hitting hardest the countries that were most promising for investors. Ghana was attracting US pension fund money and major companies such as Volkswagen and Bosch. All four shocks are eroding Africa’s scarce organisational capital and are likely to persist for the medium term.

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Impact of COVID-19 on the external sector

The IMF’s latest external sector report highlights the state current account balance amidst the global trade and supplies disruptions caused by the COVID-19 pandemic. The pandemic has sharply curtailed global trade, lowered commodity prices, and tightened external financing conditions. 

According to the report, the world had a current account surplus of about 2.9% of world GDP in 2019. About 40% of current account surpluses and deficits were excessive in 2019. Euro area had larger-than-warranted current account balances, but the US, the UK and Canada had lower-than-warranted current account balances. China’s external position remained unchanged and they were broadly in line with fundamentals and desirable policies. Currency movements were generally modest, but with preexisting vulnerabilities/fundamentals in EMDEs (large current account deficits, a high share of foreign currency debt, and limited international reserves or reserves adequacy). 

The IMF forecasts current account surplus narrowing by 0.3% of world GDP in 2020, thanks to large fiscal expansion but offsetting increases in private savings and lower investment (precautionary move by household and business sectors). Economies dependent on severely affected sectors such as oil and tourism, and remittances have been hit hard.  There was a sudden capital flow reversal and currency depreciations in EMDEs as financial market sentiment deteriorated during the initial days of the crisis. Unsurprisingly, global reserve currencies appreciated as investors looked for safe haven amidst the financial stress. There is some unwinding now though, reflecting exceptional monetary and fiscal policy support. 

Current account balances in 2020 will be affected by 

• Contraction in economic activity (lower output/export and import demand)
• Tightening in global financial conditions
• Lower commodity prices (oil, metals, food, raw materials)
• Contraction in tourism
• Decline in remittances 

The number of export restrictions in 2020 is higher than during the global financial crisis, but the number of import restrictions is lower. Sectors such as pharmaceutical and medical supplies, made-up textile articles, wearing apparel, rubber products, and ethyl alcohol and spirituous beverages faced the most export restrictions.  

Some EMDEs with preexisting vulnerabilities (large current account deficits, a high share of foreign currency debt, and limited international reserves) might face high risk of an external crisis (with capital flow reversals and currency pressures) if risk sentiment deteriorates. 

A second wave of the pandemic could lead to tightening of global financial conditions, narrow the scope of EMDEs to run current account deficit, further reduce current account balances of commodity exporters, and deepen the decline in global trade. Up to now, swift response of central banks (policy rate cuts, liquidity support, asset purchase programs, and swap lines offered by the US Federal Reserve) and expansionary fiscal policy have contributed to an easing in global financial conditions. EMDEs experienced sudden capital flow reversals in late February and march but then stabilized in most cases with even modest inflows in selected economies. 

Near-term priority

The near-term priority should be to provide relief and promote economic recovery. 

• Flexible exchange rates should be allowed to adjust as needed to absorb external shocks (especially a fall in commodity prices or tourism). 
• Official financing to ensure continued healthcare spending is required for those economies experiencing disruptive balance of payments pressures and without access to private external financing. 
• Tariff and non-tariff barriers to trade, especially on medical equipment and supplies, should be avoided. 
• Countries with adequate forex reserves could engage in exchange rate intervention to avoid disorderly market conditions and limit financial stress. 
• Countries with limited reserves and facing reversals of external financing, capital outflows management measures could be useful (but these should be used to substitute the warranted macroeconomic and structural policy actions).

Medium-term priorities

Preexisting economic and policy distortions may persist or worsen over the medium-term.

• Fiscal consolidation over the medium term would promote debt sustainability, reduce current account gap, and facilitate raising international reserves. Note that excess current account deficits in 2019 partly reflected larger-than-desirable fiscal deficits. 
• Productivity-enhancing reforms would benefit economies with low export competitiveness. 
• For countries with large current account surpluses after the COVID-19 pandemic, prioritizing reforms to encourage investment and discourage excessive private savings are warranted. In some instances, economies with large current account surpluses could discourage excessive precautionary savings by expanding the social safety nets. 
• For economies with some fiscal space, emphasis on greater public sector investment would be helpful to narrow excess surpluses and to stimulate economic activities. 

Outlook for 2021

The outlook for 2021 is highly uncertain. Under a scenario where a second major global outbreak occurs in early 2021 (disruptions to economic activity is assumed to be half the size of the baseline in 2020, financing tightening of about one-half of the increase in sovereign and corporate spreads since the outbreak began in EMDEs, and relatively limited tightening of sovereign premiums for advanced economies),

• Global trade is projected to decline by an addition 6%, global GDP decline by 5%, and oil prices to be higher by 12% compared to the baseline. 
• Recovery in global trade will be underpinned by the need to rebuild the capital stock (investment goes up), and higher import intensity of exports. 
• Emerging market economies will face higher borrowing costs, lower oil prices and subdued domestic demand – it will raise current account balances toward surplus. 
• Net oil exporters will face lower oil prices, which will reduce their current account balances.
• Advanced economies will face relatively limited tightening in external financing conditions and greater fiscal policy space will mean lesser import compression than among EMs, leading to lower current account balances. 
• So, capital will flow from EMs to AEs, highlighting the unequal impact of the crisis and the need for a global policy response. 
• Under a faster recovery scenario, global trade rises by 4% in 2021 compared to the baseline. 

The report notes that the historical relationship between trade and the components of GDP/aggregate demand (or import-intensity-adjusted measure of aggregate demand, which basically is a weighted average of aggregate demand components in which the weights are the import content of each component computed from national accounts input-output tables) fully explains the expected global decline in trade of goods. A part of the impact of lower economic activity on trade is felt through global value chains. After the global finance crisis circa 2009, residual factors such as rising protectionism explained part of the fall in trade in goods and services as they could not be fully explained by the fall in economic activity alone. Services trade contraction in 2020 is more severe than what could be expected based on the historical relationship between services trade and aggregate demand, suggesting the role of special factors such as travel restrictions. 

The IMF determines excessive current account balances by comparing the actual current account (stripped of cyclical and temporary factors) and the current account balance that is consistent with fundamentals and desirable policies. The resultant gap reflects policy distortions (e.g., higher current account balance than implied by fundamentals and desirable policies correspond to a positive current account gap, whose elimination is desirable over the medium-term). The IMF also considers REER that is normally consistent with the assessed current account gap. A positive REER implies an overvalued exchange rate. Other indicators that are considered are financial account balances, international investment position, reserve adequacy, and other competitiveness measures such as the unit-labor-cost-based REER and staff views on the current account gap using country-specific trade elasticities. 

On economic and financial fundamentals, and desired policies, advanced economies with higher incomes, older population, and lower growth prospects have positive current account norms. EMDEs tend to have negative current account norms because they are expected to import capital to invest and exploit their higher growth potential.

COVID-19 induced recession worst since the Great Depression

In the latest World Economic Outlook (April 2020), the IMF projected global growth to contract sharply to -3% in 2020. The cumulative loss to global GDP over 2020 and 2021 from the pandemic crisis could be around 9 trillion dollars, greater than the economies of Japan and Germany, combined. For the first time since the Great Depression both advanced economies and emerging market and developing economies are in recession. It argues that many countries face a multi-layered crisis comprising a health shock, domestic economic disruptions, plummeting external demand, capital flow reversals, and a collapse in commodity prices.

Under the assumption that the pandemic and required containment peaks in the second quarter for most countries in the world, and recedes in the second half of this year, in the April World Economic Outlook the IMF projects global growth in 2020 to fall to -3 percent. This is a downgrade of 6.3 percentage points from January 2020. This makes the Great Lockdown the worst recession since the Great Depression, and far worse than the Global Financial Crisis.

Assuming the pandemic fades in the second half of 2020 and that policy actions taken around the world are effective in preventing widespread firm bankruptcies, extended job losses, and system-wide financial strains, the IMF projects global growth in 2021 to rebound to 5.8 percent.

In an adverse scenario, the pandemic may not recede in the second half of this year, leading to longer durations of containment, worsening financial conditions, and further breakdowns of global supply chains. This could mean even greater fall in global GDP: an additional 3 percent in 2020 (below the baseline in 2002) if the pandemic is more protracted this year, while, if the pandemic continues into 2021, it may fall next year by an additional 8 percent compared to our baseline scenario.

The IMF recommends that countries continue to spend generously on their health systems, perform widespread testing, and refrain from trade restrictions on medical supplies. It also recommends continued support to households and businesses throughout the containment period: credit guarantees, liquidity facilities, loan forbearance, expanded unemployment insurance, enhanced benefits, and tax relief. During the recovery phase, policies should shift to supporting demand, incentivizing firm hiring, and repairing balance sheets in private and public sector. It recommends moratoria on debt repayments and debt restructuring to be continued during the recovery phase too. 

Substantial targeted fiscal, monetary, and financial measures to maintain the economic ties between workers and firms and lenders and borrowers is required to keep intact the economic and financial infrastructure of society. Meanwhile, broad-based stimulus and liquidity facilities to reduce systemic stress in the financial system can lift confidence and prevent an even deeper contraction in demand by limiting the amplification of the shock through the financial system and bolstering expectations for the eventual economic recovery.

INDIA: 

• The IMF has projected India’s economy to grow at 4.2% in 2019/20, 1.9% in 2020/21 and then quickly recover to 7.4% in 2021/22. 
• Inflation is projected to remain low at 3.3% in 2020/21 and 3.6% in 2021/22. 
• Current account balance is projected to narrow to -0.6% of GDP in 2020/21 and then increase to -1.4% of GDP in 2021/22.

NEPAL:

• The IMF has projected Nepal's economy to grow at 2.5% in 2019/20 and 5% in 2020/21. 
• Inflation is projected to remain at 6.7% in FY2020 and FY2021. 
• Current account balance is projected to be -6.5% in FY2020 and -6.2% in FY2021.

Policy measures for the immediate-term:

• Sizable, specific, temporary, and targeted fiscal measures to cushion the impact on the most affected households and businesses, and to preserve economic relationships (by reducing firm closures). Digital payments may improve the delivery of targeted transfers to the informally employed.
• Central banks can provide ample liquidity to banks and nonbank finance companies, and credit guarantee on loans to SMEs. It could also encourage banks to renegotiate loan terms for distressed borrowers without lowering loan classification and provisioning standards. Beyond conventional interest rate cuts, expanded asset purchase programs may be helpful. 
• Broad-based fiscal stimulus such as public infrastructure investment or across-the-board tax cuts can help to boost confidence, stimulate aggregate demand, reduce bankruptcies and avert an even-deeper downturn. 
• Flexible exchange rates should be allowed to adjust as needed. Temporary capital flow measures on outflows could be useful.

Policy measures for the recovery phase:

• Secure swift recovery as even after the containment phase, uncertainty about contagion could subdue consumer demand. Firms will hire staff and utilize capacity gradually. Hiring subsidies may be required and worker retraining programs may alleviate labor market friction. Scaling back targeted, temporary measures may be warranted. 
• Balance sheet repair and debt restructuring may be required. Banks and regulators should encourage early and proactive recognition of nonperforming loans. Steps to strengthen the insolvency and debt enforcement framework, and measures to facilitate the development of a distressed debt market could be helpful.
• Strong multilateral cooperation is a must, especially on international trade and multilateral assistance.

Rethinking advise to emerging markets

In an opinion piece for the Financial Times, IMF's managing director Kristalina Georgieva highlights the Fund's new approach to advising emerging markets given their unique context and diversity of policies pursued by them. Initially, the integrated policy framework will focus on monetary policy, macroprudential policy, exchange rate interventions and capital flow measures. It will be expanded to include fiscal policy. Excerpts from the FT piece.

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Our goal is to provide country-specific advice on the appropriate mix of policies needed to preserve growth and financial stability.

Our new “integrated policy framework” will reassess the costs and benefits of four tools — monetary policy, macroprudential policy, exchange rate interventions and capital flow measures — to help stabilise economies exposed to domestic and external shocks. Importantly, the “integrated” aspect of the new framework will capture how these tools interact with each other and with country circumstances.

The IMF’s current framework, grounded in more conventional economic thinking, broadly steers members towards using the exchange rate as a shock absorber. This approach provides a good approximation of how advanced economies adjust to external shocks and exchange rate movements. But it can miss important characteristics of emerging markets that alter their economies’ response to external shocks and may call for a different policy prescription.

New research indicates that while emerging markets are deeply integrated in global trade, their trade is disproportionately invoiced in dollars and consequently flexible exchange rates provide limited insulation. Similarly, while emerging markets are substantially integrated in global capital markets, their foreign debt is denominated extensively in dollars. That can cause exchange rates to become shock amplifiers as they can suddenly increase debt service costs and liabilities.

In fact, the striking diversity of policies pursued among economies could reflect their differing exposure to external shocks. Emerging markets also differ widely in the liquidity of their foreign exchange markets, which could affect the range of tools available to them for stabilisation.

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