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 concludes 2023 Article IV Consultation and completes first and second reviews under the Extended Credit Facility

According to a press release on 28 February 2023, the IMF staff and the Nepal authorities have reached staff-level agreement on the policies needed to complete the combined first and second reviews of the ECF arrangement. Nepal would have access to about US$52 million in financing once the review is formally approved by the Executive Board. 

The IMF stated that the external audit of the Nepal Rastra Bank with the assistance of international auditors – in line with international best practices, publication of reports on both COVID-related spending and custom exemptions to enhance transparency, drafting of amendments to bank asset classification regulations, and strengthening bank supervision by launching the donor-supported Supervision Information System were notable achievements. It further notes that the monetary tightening and gradual unwinding of COVID-19 support measures helped moderate credit growth and contributed to the moderation of inflation stemming from the global commodity price shock caused by the Ukraine war. This combined with resilient remittances eased external pressures and stabilized international reserves but tax collections dampened. It recommended cautious monetary policy and expenditure rationalization while protecting high-quality infrastructure expenditure and social spending.

The ECF-supported program will help Nepal’s economy to remain on a sustainable path over the medium term with the economy projected to grow at around 5 percent and inflation at around 6 percent, while maintaining adequate levels of international reserves and keeping public debt at a sustainable level. The next priority should be given to achieving a fiscal deficit that ensures debt sustainability, while securing additional concessional financing and enhancing debt management.

The IMF projects real GDP growth to be 4.4% in FY2023, supported by recovery in tourism, agriculture sector and resilient remittances. But, Nepal remains vulnerable to exogenous shocks such as volatile and higher global commodity prices and natural hazards. So, cautious monetary policy is warranted to keep inflation at 7% targeted level and to lower pressures on international reserves. Expenditure rationalization while protecting high-quality infrastructure expenditure and social spending is also important. Structural reforms need to be pursued to establish a sustainable and inclusive long-term growth path. These include private sector development by reducing the cost of doing business and barriers to FDI. Financial instruments tailored to migrants, access to finance and financial literacy can further financial inclusion. Digitization would help in the provision of public goods. Transparency and financial oversight of public enterprises can reduce fiscal risks. 

Fiscal strain in Nepal

It was published in The Kathmandu Post, 18 February 2023. 

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Hard times not over

The government should make an all-out effort to increase domestic and foreign investment.

The macroeconomic situation has improved as of the first half of the fiscal year 2022-23, but the economy is not out of the woods yet as the underlying vulnerabilities remain unaddressed. Due to interventions by the government and the central bank, economic activities have recovered from the pandemic slump, bank interest volatility is stabilising and external sector balance is gradually improving. However, the fiscal situation remains dire with lower than anticipated revenue mobilisation against high expenditure commitments and the rising cost of borrowing. The next two quarters will be crucial in terms of judicious fiscal and macroeconomic management and policy coherence.

The unrealistic budget projections are now gradually unravelling. As of the first half of the fiscal year, the government was able to mobilise just 35 percent of the annual revenue target and 74.2 percent of the half-yearly target. Revenue decreased owing to a slowdown in imports and slower than expected economic recovery. A slowdown in construction and real estate and share transactions also affected revenue mobilisation.

Faced with the reality of a revenue shortfall, the Finance Ministry proposed a cut in expenses, especially recurrent spending, by 20 percent in all tiers of government. It also plans to tighten approval of projects that were included in the budget but whose procurement process has not started.

Note that the cut in spending is not only due to lower revenue mobilisation but also less foreign aid and a dismal capital budget absorption rate, which was just 14 percent as of the first half of this fiscal year.

As per the Appropriation Act 2022, the federal government needs to make fiscal transfers in four instalments—on August 18, 2022; October 19, 2022; January 16, 2023 and April 15, 2023—to sub-national governments. These fiscal equalisation, conditional, complementary and special grants should have amounted to Rs129.46 billion for the seven provincial governments and Rs300.37 billion for the local governments. The provincial and local governments are supposed to get an additional Rs163 billion through a revenue-sharing mechanism. It will be challenging for the federal government to honour these commitments, undermining the agenda of cooperative and competitive fiscal federalism.

Fiscal management

Fiscal management is becoming challenging due to internal and external factors. First, sound fiscal discipline, accountability and transparency will be critical to ensure that fiscal deficit and public debt are at manageable levels. Recurrent expenses must be rationalised, and capital projects must be prioritised and well vetted before including them in the budget. For instance, the Ministry of Finance was forced to increase allocations for social security, subsidies, national priority projects and debt payments. It is high time that these were targeted and rationalised because they together account for about 35 percent of the recurrent budget.

Similarly, debt payment has become costlier in recent years as the government attempts to borrow more domestically despite a tight liquidity situation. The depreciation of the Nepali rupee, which makes foreign loan repayments expensive, is also contributing to high fiscal costs. Note that public debt increased by about 19 percentage points in the last five years, reaching 41.5 percent of the gross domestic product (GDP). Interest payments alone account for about 1 percent of the GDP. Coherent fiscal and debt policies anchored to sound medium-term rules-based frameworks are long overdue.

Second, although Nepal’s revenue as a share of the GDP is higher than the average of middle-income countries, greater efforts are needed to boost revenue collection given the high expenditure commitments and fiscal liabilities. Efforts could focus on broadening the tax base, closing loopholes, reducing tax expenditures such as multiple layers of concessions that are not growth-enhancing, employing a sound compliance risk management framework and reducing compliance costs, maintaining accurate and reliable taxpayer registry, boosting uptake of e-payment options, and reducing high and growing level of arrears, among others. For instance, the Finance Ministry has been providing tax concessions to projects that are initiated by government-owned or non-profit organisations, and projects funded by foreign loans or grants. In the first half of the fiscal year, these concessions amounted to Rs3.1 billion. Similarly, additional tax concessions of Rs24.5 billion were given through the Inland Revenue Department during the same period.

Third, to relieve pressure on internal borrowing, the government could focus on increasing foreign grants and loans in the immediate term. Note that the government is borrowing at around 11 percent for 91-day and 364-day treasury bills compared to less than 1 percent in January 2021. Almost all foreign loans are concessional in nature with an interest rate of less than 2 percent and longer grace and maturity periods. However, to boost foreign borrowing, the government will have to accelerate project implementation as project loans are reimbursed based on physical progress, that is, the capital budget absorption rate.

No coordinated effort

During the first half of fiscal 2022-23, the government was able to realise just 11.6 percent of the targeted foreign loans and grants for the year. It could also opt for more budgetary support to relieve interim fiscal pressures, but this kind of lending is contingent upon fulfilling legal, regulatory, policy and institutional conditions that aim for structural reforms over the medium term. However, budget support loans should be discouraged over time so that the focus is on project loans as necessary.

Finally, the government should make an all-out effort to increase domestic and foreign investment. Nepal occasionally tinkers with investment laws, regulations and policies in response to long-running concerns raised by the private sector. However, there has been no proactive and coordinated effort to review and resolve the entire gamut of issues affecting private sector activities, ranging from crippling laws and policies to infrastructure supply and human resources availability. An approach that involves the whole government is required instead of the marginal and siloed focus by the Ministry of Industry, Commerce and Supplies and Investment Board Nepal. Higher private investment, exports and competitiveness will boost growth, revenue and employment. It will make fiscal management a bit less challenging.

Macroeconomic challenges for the next administration in Nepal

It was published in The Kathmandu Post, 28 November 2022.

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Economic promises and challenges

None of the manifestos explains how to mobilise resources and enhance administration.

The major political parties unveiled a long wish list of distributional and aspirational programmes in their election manifestos. Irrespective of the lofty promises, which were also announced five years ago but remain unfulfilled, and their viability due to resource and administrative constraints, the next government will have to steer an economy that is facing substantial internal and external headwinds. Weak economic growth, limited fiscal space amidst rising public borrowing, escalating inflation and financial sector vulnerabilities, and threats to external sector stability are some of the macroeconomic challenges that the next administration will have to confront head on. Unfortunately, there are no easy fixes.

The political parties have aimed for high and sustained growth rates as in the previous manifestos. The Nepali Congress wants to achieve real gross domestic product (GDP) growth of over 7 percent, and the CPN-UML promises a double-digit growth rate. The Nepali Congress and the CPN-UML each have pledged 2 million and 2.5 million annual tourist arrivals, respectively. Additionally, they have vowed to create 250,000 and 400,000 jobs annually. There are equally grand promises on governance, prosperity, inclusivity and sectoral reforms. There is competition among the parties to increase unfunded and unconditional social security handouts outright or lower eligibility requirements. Note that social security expenses nearly doubled as a share of GDP since 2016-17 and are higher than the money the government invests in civil works.

Dream merchants

None of the political parties’ manifestos explains how to mobilise resources and enhance administrative capabilities to achieve the intended goals. In fact, none has costed their proposed projects and programmes. They read like a stripped-down version of the medium-term plan published by the National Planning Commission but without the details on costed programmes, intended resources mobilisation, fiscal deficit, and governance and accountability mechanisms. They also don’t honestly discuss the achievements against the promises in their previous manifestos. There are hardly any substantial changes in the way public finance is governed, development plans are made, and projects and public services are delivered.

The manufacturing sector is still performing poorly due to an unfavourable environment for private sector development. Its growth rate over the last five years averaged just 3.4 percent. Budget execution, particularly the capital spending absorption capacity, has eroded. It averaged 65.2 percent between 2017-18 and 2021-22, lower than 76.2 percent in the preceding five years. Cooperative and competitive federalism remains an unfinished and neglected agenda. Banking sector liquidity problems have become endemic and financial sector vulnerabilities are building up to a level that threatens to unravel economic stability.

Despite overall tight liquidity for an extended period, there was a generous flow of credit to a few sectors, such as real estate and housing, whose prices have skyrocketed throughout the country. The fact that it is happening despite a sharp rise in interest rates points to unresolved structural weaknesses, including asset liability mismatches and evergreening or whitewashing of portfolios. Inflationary pressures have generally been elevated. External sector imbalances loom large, although much of it is masked by the decline in imports due to increased prices, tight bank financing and quantitative restrictions.

Challenges persist

The economy is in this state owing to external factors beyond the government's control, such as the pandemic’s effect on economic activities and the increase in fuel and commodities prices because of the Russian invasion of Ukraine. However, it also reflects the shortcomings of the last and current administrations in decisively tackling the binding constraints to growth, good governance and effective public service delivery.

Going forward, three main macroeconomic challenges confront the next administration. First, the government will be pressed to accelerate growth while taming elevated price pressures. Supporting industrial sector growth, particularly the manufacturing sector, by overhauling legal and regulatory hurdles to ease the process of doing business so that output is cost competitive globally will be the key to sustained growth and employment generation. A cheaper supply of electricity (but not below cost recovery rate) to domestic firms rather than the export of allegedly surplus electricity will be important. A full recovery of the tourism sector with higher per-tourist spending could also provide some momentum. Promotion of agro-processing activities and value chain, year-round irrigation in agricultural belts, and digitisation to improve service delivery and streamline subsidies and targeting will be helpful. However, this must be synced with the need to rein in inflationary pressures, which are partly imported as high energy and commodity prices pass through, and partly exacerbated by domestic supply-side constraints such as lack of adequate infrastructure, black marketeering and sectoral cartels. A tighter monetary policy aimed at unproductive and speculative sectors to reduce vulnerabilities while facilitating a sustainable level of credit to productive sectors may be helpful. A coordinated fiscal and monetary policy response can support growth-enhancing measures without jeopardising price and external sector stability.

Second, effective fiscal management and discipline will be challenging, given the lofty promises. The large fiscal deficit since 2016-17 means that there is limited fiscal space to launch new initiatives as promised by the political parties. Revenue growth is stagnating, but expenditure growth remains high. Tax revenue may not fully cover recurrent expenses. Hence, efforts to rationalise recurrent expenses, especially unfunded handouts and the public wage bill; boost chronically low capital spending and its quality; broaden the tax net and the tax base through effective monitoring and digitisation; and increase concessional external financing will be important in the medium term. Furthermore, judicious cash flow, debt operations and management to reduce the cost of debt servicing and plugging fiscal leakages through digitisation and accountability are vital.

Third, the government will have limited options to manage external sector imbalances. A high cost of production that is eroding comparative and competitive advantages and an adverse external environment due to economic slowdown in major export destinations are affecting exports. The increasing import bill, partly due to high energy and commodity prices globally and a depreciation of the Nepali rupee against convertible currencies, combined with low exports and moderation in remittances growth have widened the current account deficit, which reached 12.8 percent of GDP in 2021-22. Efforts to discourage imports through outright quantitative restrictions and credit tightening have led to a lower current account deficit lately and a slight improvement in import cover by foreign exchange reserves. However, it is not a sustainable approach because the slowdown in essential imports also hampers overall economic activities. Tariffs should be adjusted without breaching multilateral and bilateral trade agreements. Ideally, the adequacy of foreign exchange reserves should not fall below 5.5 months of prospective imports of goods and services.

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.

Short-term priorities for the economy

It was published in The Kathmandu Post, 09 August 2021.

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Short-term priorities for the economy

The focus now should be on executing the budget and curtailing wasteful spending.

The current coalition government led by Prime Minister Sher Bahadur Deuba has inherited a challenging economic situation that continues to be affected by the Covid-19 pandemic and related lockdowns. Finance Minister Janardan Sharma faces an uphill task to revive economic activities, which remain subdued with little likelihood of a convincing rebound beyond the base effect after a contraction in fiscal 2019-20. Specifically, a short-term economic recovery strategy to reap 'low hanging fruits' has to be rolled out and implemented in such a way that it does not deviate much from the 2021-22 budget ordinance and 15th Five-Year Plan.

The major constraint here is the availability of resources amidst unprecedented expenditure pressure while the country stares at a third wave of the pandemic. The government cannot drastically increase expenditure, both actuals and allocations, due to its implementation capacity and funding constraints. The latest data shows that the government fell short of targets in pretty much all fiscal indicators. In 2020-21, while recurrent spending was about 90 percent of the target, capital spending was just 65 percent. Tax revenue mobilisation was about 95 percent of the target, but foreign grants just 34 percent. A relatively slower pace of spending compared to revenue mobilisation meant that the fiscal deficit decreased to 4.8 percent of the gross domestic product (GDP) from 5.5 percent in 2019-20. In the 2021-22 budget, a large increase in expenditure compared to receipts is set to provisionally widen the fiscal deficit to about 6 percent of GDP.

Low-hanging fruits

Against the backdrop of slow economic activities, tight fiscal space, inflationary pressures and deteriorating external sector, the new finance minister faces a challenging task of stimulating broad-based and inclusive economic activity. He perhaps wants to deliver visible results in a short period of time given financing and implementation constraints. Unfortunately, the options are limited.

First, ensuring availability of funds, as and when needed, to respond effectively to the healthcare crisis should be the utmost priority. The most visible outcome for the government right now is an orderly process of testing, tracing and treatment; availability of vital medicines used for the treatment of the coronavirus; and widespread vaccination in the shortest time possible.

Second, the pandemic-hit industry and services sectors need continuous support—be it in the form of tax concessions or utility discounts or direct wage subsidy or social security contribution—until the situation stabilises. A third wave of infections and related mobility restrictions will further affect cash flows. It may actually permanently cut off the struggling small and medium enterprise from production networks. This will have long-term economic consequences as gaps in supply chains cannot be filled immediately. So, the government could prop up aggregate demand not only by increasing public spending, but also by supporting the private sector wade through the crisis so that they can achieve at least pre-pandemic levels of capacity utilisation.

Third, given fiscal and time constraints, a supplementary budget or major amendment to the budget ordinance is not ideal. The focus now should be on executing the budget and, if possible, curtailing some of the wasteful spending and ad hoc projects and programmes included in the budget. With earnest efforts, Sharma could make a difference by prioritising operation and maintenance of dilapidated roads and bridges, water supply and drainage system, electricity distribution lines, school and hospital buildings and other public infrastructure. These initiatives yield quick, visible results, and help to enhance productive efficiency of public spending. Funding for additional operation and maintenance expenses could be arranged through reprioritising and repurposing of existing budget allocations.

The finance minister could also prioritise public investment management by instituting a mechanism whereby only well vetted and prioritised projects are included in the budget and medium-term plan. This means reworking on the existing National Project Bank, which has guidelines for identification, appraisal, selection and prioritisation of projects but are hardly adhered to during implementation. This will aid in allocative efficiency of public spending.

On domestic resource mobilisation, the bulk of the work needs to be in improving revenue administration so that leakages are plugged. Note that new policy measures related to revenue are expected to contribute only 7 percent of the total estimated revenue for this fiscal. The rest 93 percent is planned to be generated from existing measures, which means increasing the taxpayer base and improving compliance. Harmonisation of IT systems of various tax wings, active risk-based audit for taxpayer compliance, and a monetisation strategy for idle public sector assets will be helpful. Furthermore, assisting sub-national governments in revenue administration as well as public investment management will also be important. On deficit financing, since the cost of external borrowing is lower than that of internal borrowing, the former may be prioritised for the interim period. However, this will require sectoral policy and institutional reform commitments, or improved budget execution capacity.

Fourth, fiscal and monetary policies have to be synced with an objective to ensure demand and supply stabilisation, and an eventual economic recovery. Moderate inflationary pressures are okay during the interim period, but a medium-term plan to tame inflationary expectations, which are trending upward, should not be overlooked. There could also be cooperation in ensuring that the existing support measures related to refinancing schemes, subsidised credit and regulatory forbearance are not prematurely withdrawn. That said, the authorities will have to carefully rein in excessive credit growth that is not consistent with indicators such as GDP growth and deposit growth. An unjustifiably bullish stock market and rising real estate and housing prices are not good signs at the moment for the sound health of the financial system.

Minimal physical interface

Fifth, external sector needs to be monitored carefully, especially the direction of remittance inflows amidst a decline in the number of outgoing migrant workers as well as weak demand for them in the destination countries. This, along with widening trade and current account deficits, could put external sector stability at risk. Adjusting import tariffs and tightening bank financing to dissuade demand for expensive foreign vehicles and gold could be considered.

Finally, the finance minister can push for new measures that could have an immediate impact on struggling households and businesses, and aid the recovery process. For instance, a partial credit guarantee scheme with an umbrella framework to cover all guarantees, including credit subsidy to various sectors is helpful. Similarly, digitisation of public services so that there is minimal physical interface between the public and businesses and bureaucrats is another promising area for quick results. Addressing youth unemployment through reskilling, vocational training and temporary employment guarantee schemes is also going to be fruitful.

Monetary framework matter in low income countries

Abstract from a new NBER working paper on if monetary policy framework in maintaining price and macroeconomic stability matter in low income countries, which exhibit high frequency of price adjustment (rather than monetary neutrality):

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Microeconomic evidence indicates a very high frequency of price adjustment in low income countries (LICs), raising the question of whether LICs may be reasonably characterized as exhibiting monetary neutrality. To address this question, we analyze a cross-country panel dataset of 79 LICs over the period 1990 to 2015 to assess the impact of external shocks on real GDP growth, and we find highly significant differences between LICs where the central bank targets monetary aggregates or inflation compared to LICs that maintain rigid nominal exchange rates. We also conduct an event study of the surprise devaluation of the Central African Franc (CFA) in January 1994 and find that it had highly significant effects on the output growth of 10 CFA countries relative to 18 similar countries outside the CFA zone. Consequently, the hypothesis of monetary neutrality is decisively rejected, and these findings provide strong support for the role of monetary policy frameworks in fostering price stability and macroeconomic stability in LICs.

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Key highlights of Nepal's 15th five-year plan (FY2020-FY2024)

National Planning Commission recently published the 15th five-year plan (FY2020-FY2024) taking also into account the effect of COVID-19 pandemic on the government’s priorities and the economy. This plan is considered as a first phase of a 25-year long-term economic vision that aims to position Nepal as a high-income country with per capita income of USD 12,100 by FY2044.  Its theme is 'generating prosperity and happiness' and aims to create the foundation of prosperity and happiness through economic, social and physical infrastructures to accelerate economic growth. 

The government is expecting Nepal to graduate from LDC category to a developing country status within this plan (by 2022 with per capita income of USD 1,400). This plan is expected to contribute to efforts to ensure that Nepal reaches a middle-income country status by FY2030 (with per capita income of USD 2,900) and achieve the SDGs as well. By the end of FY2024, per capita income is estimated to reach USD 1,595.

The plan emphasizes boosting investment in the sectors or thematic issues that are considered as drivers of economic transformation. These include transport, ICT, energy, education and healthcare, tourism, commercialization of agriculture and forest products, urbanization, social protection, subnational economy, and good governance, among others.

 By FY2024, the government wants to achieve a double-digit growth rate, increase per capita income of USD 1,595, reduce population under absolute poverty line to 9.5%, and increase share of formal sector employment to 50%. 

Some of the major national targets for 15th five-year plan (FY2020-FY2024) are as follows:

• Average GDP growth (at basic prices): 9.6%
• Average GDP growth (at producers' prices): 10.1%
• Per capita income: USD 1,595
• Export of goods and services: 15.7%
• Share of essential goods (agri, livestock, food items) in total imports: 5%
• Population under the absolute poverty line: 9.5%
• Population with multidimensional poverty: 11.5%
• Share of formal sector employment: 50%
• Unregistered (formal) establishment: 10% of total establishment
• Literacy rate (15+ years): 95%
• Road density: 0.74 km of road per sq km of land
• Households with access to electricity: 95%
• Population with access to internet: 80%
• Electricity generation (installed capacity): 5,820 MW
• Renewable energy: 12% of total energy consumption
• Per capita electricity consumption: 700 kwh
• Agricultural productivity (major crops): 4 MT per hectare
• Irrigable land with year-round access to irrigation: 50%
• Per capita tourist spending: USD 100 per day
• Human development index: 0.624
• Gender development index: 0.963
• Population covered by basic social security: 60%
• Social security expenditure: 13.7% of budget
• Global competitiveness index: 60
• Ease of doing business index: 68
• Travel and tourism competitiveness index: 3.8
• Corruption perception index: 98
• Nepali citizens with national ID card: 100%
• Population affected by disaster incidents: 9.8%

The NPC estimated average growth in agriculture, industry, and services sectors to be 5.4%, 14.6%, and 9.9%, respectively. By the end of the 15th plan, the government is targeting to increase the share of industry and services sectors to 18.8% and 58.9%, respectively, while the share of agriculture sector is to decrease to 22.3%. To achieve the stated average growth rate, the NPC estimated that NRs 9.229 trillion (at FY2019 constant prices and based on ICOR of 4.9:1; FYI, a lower ICOR indicates efficient production process) investment will be required over the plan period. Public, private and cooperative sectors are expected to contribute 39%, 55.6%, and 5.4%, respectively of this required investment.  

[The government is considering FY2019 as a base year for the long-term economic vision. So, the data is presented in FY2019 constant prices. However, this is not much helpful in doing comparative analysis including that of long-term plans and targets. National account estimates, public finance, and periodic surveys - based on which the numbers are estimated eventually- are either presented with different year as base year (FY2011 for NEA for now) or are in current prices (fiscal, monetary, external sectors, and household surveys.]

As a share of GDP by FY2024, the expected impact on macroeconomic indicators are as follows:

National accounts (focused on increasing investment through savings mobilization)

• Average GDP growth (at producers' prices): 10.1%
• Per capita income: USD 1,595
• Export of goods and services: 15%
• Gross domestic savings: 22%
• Gross national savings: 47.5%
• Gross fixed capital formation: 41.6%

Fiscal sector (focused on allocation and implementation efficiency, and fiscal discipline for expenditure management; maximize revenue mobilization and taxpayer-friendly tax administration)

• Total budget: 43.3%
• Recurrent expenditure: 17.9%
• Capital expenditure: 18.6%
• Financial management: 6.8%
• Revenue: 30%
• Income tax: 10%
• Foreign debt: 5.7%
• Domestic borrowing: 4.3%

Monetary and external sector (focused on controlling inflation, balance of payments stability, and financial stability)

• Average annual Inflation: 6%
• Export of goods and services: 15%
• Import of goods and services: 49%
• Remittances: 22.1%
• Foreign investment: 3%

Meanwhile, the average financing gap to achieve the SDGs is estimated to be NRs 585 billion per year for the entire period of 2016 to 2030 (SDG period). It is on average 8.8% of GDP for 2016-19, 12.3% of GDP for 2020-22, 13% of GDP for 2023-25, and 16.4% of GDP for 2026-30. The overall annual financing gap is estimated at 12.8% of GDP throughout the period of 2016 to 2030.

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.

Restructuring stressed loans and higher government borrowing to stimulate economy

Restructuring stressed loans in India

Ramal Bandyopadhaya writes in Business Standard that the RBI's decision to allow restructuring of stressed bank loans will help to lower gross NPAs in the banking system. Some 80% of the loans in the banking system qualify for restructuring. 

None could miss the collective sigh of relief from the bankers’ community on the Reserve Bank of India’s (RBI) decision to open a restructuring window for stressed loans. Those accounts, which had been in default for not more than 30 days as on March 1, 2020, can be restructured if the borrowers are unable to service them because of their businesses being affected by the Covid-19 pandemic. The loans can be restructured, among others, by funding interest, converting part of debt into equity and giving the borrowers more time to pay up.

The banks must disclose such recast and set aside 10 per cent of the exposure to make provision for the restructured loans. In June 2019, the RBI had framed norms for loan restructuring, making it mandatory for banks to treat restructured, stressed loans as sub-standard unless there was a change in ownership of the borrowing company. Now, the banks can treat the restructured loans for Covid-19-affected companies as a standard asset even if there is no change in ownership.

[...]Going by one estimate, at least 80 per cent of the loans in the banking system will be eligible for such restructuring. One way of looking at this is that it will delay the inevitable by two years. Also, the 10 per cent provision requirement seems to be low as the banks’ unrealised but booked interest income from stressed borrowers is far higher. By RBI’s estimate, the gross bad loans of the banking system, which dropped to 8.5 per cent in March 2020, could rise to 14.7 per cent by March 2021. The restructuring window may not allow such a spike. The one-time forbearance was the need of the hour, particularly when all banks are not adequately capitalised. The good news is the presence of enough caveats to prevent misuse by the banking industry. In absence of this, many banks would have resorted to the tried and tested method of ever-greening — giving fresh loans to the stressed borrowers to keep the accounts good.

Current economic contraction is different from previous ones

Harish Damodaran argues in The Indian Express that arresting the current demand slowdown requires government investment and that debt concerns should not be overead. Despite fiscal slippages, yields on 10-year government bonds have dropped to 5.9% for the center and about 6.4% for states. This may fall further if banks are not able to lend the money they have collected as deposits.

That makes the current contraction totally different from the previous ones which were “supply-side” induced. There’s no shortage today of food, forex or even savings: Aggregate deposits with commercial banks as of July 31 were Rs 14.17 lakh crore or 11.1 per cent higher than a year ago. The closest parallel one could draw is with the 2000-01 to 2002-03 period of the Atal Bihari Vajpayee-led government. The Food Corporation of India’s (FCI) grain stocks in July 2002 were 2.6 times the buffer norm and the country ran current account surpluses in 2001-02 and 2002-03. But the economy didn’t contract then; growth merely fell from 8 per cent in 1999-2000 to an average of 4.5 cent during the next three years.

What we now have is a classic “western-style” demand slowdown that post COVID-19 has turned into a full-fledged recession bereft of consumption and investment demand. Households have cut spending as they have suffered income, if not job, losses. Even those with jobs are saving more than spending because they aren’t sure when their luck would run out. The same goes with businesses. Many have shut or are operating at a fraction of their capacity and pre-lockdown staff strength. The ones still making profits are conserving cash. If at all they are investing, it is to buy out struggling competitors and not to create new capacities. Just as households are uncertain about jobs and incomes, firms don’t know when demand for their products will really return.

This demand-side uncertainty and the resulting economic contraction is something new to India. And it stands out in a situation where food stocks and forex reserves are at record highs. Meanwhile, banks are also facing a problem of plenty. While their deposits are up 11.1 per cent, the corresponding credit growth has been just Rs 5.37 lakh crore or 5.5 per cent. With very little credit demand, the bulk of their incremental deposits are being invested in government securities, which have increased year-on-year by Rs 7.21 lakh crore or 20.3 per cent.

Accommodative monetary policy and implementation challenges

**This is a longer draft version of the previous article on monetary policy for FY2021. A Nepali version of this one is published in Nayapatrika.**

In his first monetary policy, unveiled on August 17, as governor of Nepal Rastra Bank, Maha Prasad Adhikari, rolled out an expansionary policy that aims to provide regulatory as well as immediate relief to struggling businesses and households from pending loan obligations. The healthcare and economic shocks owing to COVID-19 pandemic and subsequent lockdowns to contain its spread have been unprecedently disruptive. Given the extended period of lockdowns, supplies disruption and subdued aggregate demand, economic growth in fiscal 2019/20 is projected to be much lower than 2.3% estimated by Central Bureau of Statistics before the pandemic. The shortage of goods and services has increased inflationary pressures, and lending interest rates have remained in double-digits. The acute cash flow problems faced by businesses, and either layoffs or reduced working hours faced by individuals have increased the risk of a liquidity crisis morphing into a solvency crisis.

Against this backdrop, the monetary policy for 2020/21 aims to achieve the ambitious 7 percent economic growth target set by the government, maintain adequate liquidity, limit inflation to 7 percent, encourage merger of banks and financial institutions, enhance access to finance, and promote reliable digital transactions. The conventional monetary policy tools as well as macroprudential policies have been much more accommodative than what we have seen after the catastrophic earthquakes in 2015. The private sector and banking associations have welcomed the measures outlined in the policy.

Monetary instruments

Among the targets for 2020/21, the central bank wants to limit average inflation to 7%, ensure foreign exchange reserves adequate to cover 7 months of goods and services import, ensure adequate liquidity to facilitate economic recovery and to achieve 7% growth target, 18% growth in money supply, and credit growth to private sector of 20%. 

Since we have fixed our exchange rate with the Indian rupee, Nepal Rastra Bank cannot independently control inflation. Furthermore, supplies side constraints such as a lack of adequate and reliable infrastructure (electricity, road network, and irrigation among others), fuel prices, and market imperfections in the form of cartels or syndicates also affect inflation. That said, NRB can influence credit flows to sectors that are seeing sharp rises in prices. By setting inflation target of 7% NRB has adopted an accommodative monetary policy stance as it seeks to facilitate adequate liquidity and credit flows to sectors affected by COVID-19 pandemic.

To achieve these targets, the central bank is planning to use a number of monetary instruments at its disposal. Although controlling inflation is not fully within the domain of Nepal Rastra Bank, thanks to the fixed exchange rate regime, it nevertheless has accommodated a higher inflation target than last fiscal by rolling an expansionary monetary policy. For instance, it has reduced policy repo rate, which is the rate of interest charged by NRB on the repurchase of government securities, by 50 basis points to 3 percent. This essentially increases liquidity as BFIs can now borrow money at a lower rate from NRB by selling government securities they hold. NRB also uses repo rate to maintain interest rates within the interest rate corridor, which is aimed at reducing interest rate volatility. Similarly, it has reduced term deposit rate, which is the lower bound of interest rate corridor, by 100 basis points to 1 percent. This will discourage BFIs to deposit extra money at the central bank because the rate of return will be even lower. It has also committed to allow long-term repo facility if required as current repo operations are limited to two weeks. In March 2020, NRB had already reduced cash reserve ratio and bank rate by 100 basis points to 3 percent and 5 percent respectively, and lowered policy repo rate by 100 basis points. These measures are aimed at increasing liquidity and to lower interest rates.

In addition to these traditional monetary policy instruments, the central bank has also provided regulatory relief by tweaking macroprudential policies, which are designed to mitigate system-wise risk and to reduce asset-liability mismatches. For instance, it suspended two percent countercyclical buffer requirement, which commercial banks have been maintaining in addition to minimum 10% capital adequacy ratio. The additional buffer is imposed during normal times to lower systemic risk in case of a sudden deterioration in balance sheets. It has tweaked loan classification by allowing credit extended to healthcare sector to be counted as priority sector lending and waived off fees on online transactions.  It has increased credit-to-core capital cum deposit (CCD) ratio to 85 percent from 80 percent till 2020/21.

NRB has also extended moratorium on loan payments and allowed for restructuring as well as rescheduling of loans provided to COVID-19 affected sectors. Furthermore, the central bank has limited dividend payments and extended deadline for issuing debentures or corporate bonds equivalent to at least 25 percent of paid-up capital. Soon it will introduce a loan classification provision whereby good loans affected by COVID-19 may not be required to be classified as bad loans. For some loans that are not repaid by 2020/21, loan loss provision could be just 5 percent. 

Similarly, it has capped loan-to-value ratio for residential home loan at 60%. For real estate, it has maintained the earlier 40% cap in Kathmandu valley and 50% outside of Kathmandu valley. For margin lending, it has increased the cap to 70% from 65%, and the valuation is to be based on the average value in the last 120 days, down from earlier 180 days. BFIs can also extend an additional working capital loan equivalent to 20% of the value as of April 2020.  

Directed lending

Another important aspect of the monetary policy is its emphasis on directed lending, especially to agriculture, energy, tourism, and micro, small and medium enterprises (MSMEs). The central bank has mandated commercial banks to lend at least 15%, up from 10%, to agriculture sector by 2022/23. It has also proposed to transform Agriculture Development Bank Limited as a lead bank for credit to agriculture sector. ADBL is allowed to issue agricultural bond, which commercial banks can purchase to fulfill their own credit requirement to the sector. It has also proposed issuing ‘kisan credit card’ through ADBL, and to simplify existing credit swap facility among BFIs pertaining to agricultural loans. 

Meanwhile, commercial banks will have to lend at least 10%, up from 5%, to energy sector by 2023/24. Commercial banks with experience in energy sector lending are allowed to issue energy bond, which will help to raise long-term capital to finance hydroelectricity projects. For export-oriented hydroelectricity projects and reservoir type projects, BFIs will have to extend loans at rate that is just one percentage point higher than the base rate. Similarly, the NRB has given priority to travel and tourism sector in working capital and subsidized loans (at 5% interest), and in refinancing facility. Commercial banks are required to lend (each loan less than NRs 10 million) at least 15% of total loans to MSMEs by 2023/24.  

Total directed lending has shot up to 40%, up from 25%, for commercial banks. Development banks and finance companies are mandated to lend at least 20% and 15%, respectively, to agriculture, MSMEs, energy and tourism sectors by 2023/24. 

Refinancing facility

The NRB has committed to increase refinancing facility by 5-fold to support economic recovery. Of the total refinancing pool offered by NRB, 20% will be offered as per the individual evaluation of clients, 70% through BFIs, and 10% through microcredit institutions. Depending on the nature of business and the effect of COVID-19 pandemic, refinancing loans attract interest between 2% and 5%. For those refinancing loans offered by BFIs, micro and small enterprises can avail a maximum Rs 1.5 million, and the rest can avail between Rs 50 million and Rs 200 million. 

Merger and acquisition 

The NRB has continued its merger and acquisition policy by providing additional incentives. For instance, BFIs merger by FY2021 will see 0.5 percentage point lower CRR requirement and one percentage point lower capital adequacy ratio, increase in institutional deposits thresholds by 10 percentage points, and lower cooling off period for executive board members and high-level staff, among others.

Implementation challenges

These policies are appropriate given the scale of the crisis we are facing. However, as in the past, the main challenge lies in fully and timely implementing the regulatory relief and concessions. The central bank will also have to be ready to deal with some of the unintended consequences as a result of the policies it has adopted. 

First, monetary policy has addressed the supply of credit part by facilitating availability of liquidity and taking policy measures to keep interest rates down. However, this does not mean all of it will be taken up. The demand for loans for business recovery is contingent on the overall investment climate and growth prospects. Not many businesses will take additional loans just to keep employees in payroll and to pay cost rent and operations costs when there are already substantial losses piled up since the lockdown started. Soon liquidity crisis faced by firms and households may turn into solvency crisis, which will increase the share of bad assets of BFIs and eventually squeeze credit flow. The uncertainty over the likely path of economic recovery further complicates the matter. At this stage, the government should have guaranteed additional working capital loans offered through the banking sector to COVID-19 affected businesses. This would have increased demand for credit and also prevented business closures and layoffs. 

Second, BFIs are generally risk averse amidst lack of improvement in investment climate, growth prospects and governance. They may not be willing to extend credit to new or existing borrowers without being confident about timely repayment. Consequently, the additional liquidity facilitated by NRB may end up back in its own vault because BFIs will see it safer to park funds there even if the rate of return is much lower. BFIs could also purchase government securities and bonds if they are unwilling to increase lending to borrowers in fear of default risk. It will drive down the interest on government security and bonds. 

Third, extending moratorium on payments simply postpones the inevitable, if economic activities do not pick up: a rise in non-performing assets. Subdued business activities and tepid cash flows, and lower income of households due to job losses might lead to unserviceable loans, which eventually are classified as non-performing assets. Despite the commitment by NRB to reschedule and restructure troubled loans, the risk is still there. Note that concerns have been raised repeatedly by International Monetary Fund about the low level of non-performing assets due to the ever-greening and at times imprecise classification of risky assets. Higher levels of non-performing assets in the banking sector pose systemic risk, substantially lower credit growth, and affect economic growth. Perhaps, it is also a good time to deliberate with Ministry of Finance on a potential bad assets management strategy in case things do not turn as expected.

Fourth, the large refinancing facility may not be fully utilized if the banks and financial institutions do not see viable investment projects or creditworthy borrowers. Refinancing facility is offered by central bank but its eventual execution is through the banks and financial institutions. The past refinancing pool offered to households for reconstruction of residential houses destroyed by the earthquake have not been utilized fully. The central bank had offered Rs 2.5 million for households in Kathmandu valley and Rs 1.5 million for households outside the valley. The BFIs could avail the refinancing facility at zero percent interest rate and offer it to clients by levying a maximum two percent interest (excluding third party costs such as insurance, collateral evaluation, loan security fund, etc) for period between 5 to 10 years. Refinancing facility details will be clear after the central bank releases standard operating procedures to execute the policy. 

Fifth, the aggressive push on directed lending— constituting over 40 percent of total loans, up from 25 percent last fiscal— could increase banking sector inefficiencies if proper due diligence is not followed through when extending credit to such sectors. Forcing BFIs to extend credit to particular sectors if they do not have expertise in evaluating soundness of projects is not a good strategy. It invites political interference and fosters moral hazard behavior. For instance, what happens if BFIs are forced to meet the mandatory share of lending to energy sector if hydro projects fail to finalize a viable power purchase agreement with the off-taker? Similarly, what happens if farmers fail to pay debt on time (in the past, the government waived them off with taxpayer funded fiscal rescue). Half-baked and poorly governed directed lending might further exacerbate asset-liability mismatches. Note that NRB started priority sector lending for commercial banks in 1974. It was phased out in 2005 as a part of financial sector reform program as banking sector inefficiencies and political interference bloated non-performing assets as well as misuse of priority sector lending. However, it was again reintroduced in 2012 with 10% minimum lending to agriculture and energy sectors. It was increased to 12% in 2014 and then again to 25% in 2018. Priority sector lending includes credit to agriculture, tourism, MSMEs, pharmaceutical, cement, garment and tourism.  

Sixth, the current incentives for merger may be insufficient as it is primarily held back by differences in ownership and appointments after merger. Nepal has too may BFIs for the size of its economy and there is cut-throat competition without much innovation to attract deposits and to extend loans. In the past, this has led to deterioration in quality of loan approvals, asset-liability mismatches, and sectoral bubbles, which eventually led to a financial crisis in 2011 as real estate and housing bubbles burst. Subsequently, the NRB imposed a cap on lending to the sector. 

Seventh, the plan to transform ADBL, a commercial bank, into a lead bank for agricultural sector may need to thought out well before execution. Initially, it was founded as a separate development bank catering to the agricultural sector, especially in rural areas. After the endorsement of Bank and Financial Institutions Act (BAFIA) in 2005, it operated as a public limited company licensed as a ‘class A’ financial institution by NRB. As a part of rural finance sector development cluster program, they government reduced its share in ADBL to 51% through divestment, and restructured its capital and management (including voluntary retirement of excess staff). The main problem in ADBL before its restructuring was political interference, management inefficiencies, and politically-backed loan or subsidy schemes that government pushed through it. Without clear guidelines on absorbing any risk of default and identification as well as targeting of actual beneficiaries, the new ‘kisan credit card’ may actually increase ADBL’s burden. This kind of credit scheme is used to help farmers meet immediate operational or capital needs such as purchase of fertilizers and seeds before sowing, and tractor or motorcycle after the harvest. After disbursing credit to farmers, it is difficult to monitor if they used it as they said they will during the application process.