Unidentified debts increase public debts higher than projected

According to Fiscal Monitor October 2024, global public debt is expected to exceed $100 trillion, which is about 93% of global GDP, and could reach 100% of GDP by 2030. It translates into an additional 10 percentage points of since 2019. Under the “debt-at-risk” framework (the level of future debt in an extreme adverse scenario) is estimated to be nearly 20 percentage points of GDP higher three years ahead in the baseline projections. The framework shows how changes in economic, financial, and political conditions can shift the distribution of future debt-to-GDP ratios

The fiscal outlook of many countries might be worse than expected for three reasons: large spending pressures, optimism bias of debt projections, and sizable unidentified debt. Countries will need to increasingly spend more to cope with aging and healthcare; with the green transition and climate adaptation; and with defense and energy security, due to growing geopolitical tensions.

Debt will increase because of weaker growth, tighter financing conditions, fiscal slippages, and greater economic and policy uncertainty. The spillovers due to policy uncertainty in systematically important countries (such as the US) further complicate the situation. Unidentified debt when realized tends to increase public debt. Based on analysis of over 30 countries, the report states 40 percent of unidentified debt stems from contingent liabilities and fiscal risks governments face, of which most are related to losses in state-owned enterprises. 

Unidentified debts build up emerge from extra-budgetary spending, institutional changes, arrears, and materialization of contingent liabilities and fiscal risks. Unidentified debt is the change in debt not explained by interest-growth differentials, budgetary deficits, or exchange rate movements.  Historically, these tend to 1 to 1.5% of GDP on average but increase sharply during periods of financial stress.

The report recommends fiscal adjustments to contain debt risks, warning that current fiscal adjustments—on average, of 1 percent of GDP over six years by 2029—even if implemented in full, are not enough to significantly reduce or stabilize debt with a high probability. Tightening to the tune to 3.8% of GDP may be required to ensure debt stabilization. 

It recommends countries to tackle debt risks with carefully designed fiscal policies that protect growth and vulnerable households. For advanced economies, advance entitlement reforms, reprioritize expenditures, and increase revenues where taxation is low is recommended. Emerging market and developing economies have greater potential to mobilize tax revenues—by broadening tax bases and enhancing revenue administration capacity—while strengthening social safety nets and safeguarding public investment to support long-term growth.  Some countries with high risk of debt distress will need front-loaded adjustments.

Some of the recommendations include:

• Identifying the size of fiscal adjustment and designing its composition (expenditure rationalization but also protecting vulnerable households)
• Calibrating the pace of adjustment
• Building credibility by having MTFFs and modern PFM systems to anchor adjustment paths and reduce fiscal policy uncertainty. Governments need deliberate fiscal plans, framed within credible medium-term fiscal frameworks and modern public financial management systems to anchor their adjustment paths and reduce fiscal policy uncertainty. Strong independent fiscal oversight can reinforce government credibility.
• Strengthening fiscal governance by addressing contingent liabilities, including those associated with SOEs. 
• Addressing debt distress by undertaking timely and adequate restructuring (for countries facing debt distress or unsustainable debt)

Structural transformation in Nepal: Employment, sectoral shift and labor productivity

Based on the population census and national accounts data (also see blog post on demographic dividend), this blog post highlights key features related to structural transformation (employment, sectoral shift in output). Overall, the share of employment in agriculture is decreasing, but the share of employment in services in increasing. Industry sector's share in employment is recovering, but it is still below the peak in 2001, after which the political instability along with the intensification of the Maoist insurgency, power cuts, and poor industrial relations decreased its share in employment and GDP. It started to recover in the last decade. 

The sectoral shift in GDP follows the pattern in sectoral shift in employment but the pace of change is not commensurate -- services sector value added GDP grew at a faster pace than its share in employment, and industry's share in employment decreased at a faster pace than the decrease in its share in GDP. It means that the largest sector in GDP and its expansion was not jobs centric.

Labor productivity barely increased between 2011 and 2021 and productivity growth was negative in all sectors, with the highest dip in industry sector. At the broad economic activity level, labor productivity was positive in mining and quarrying; manufacturing; and public administration, defense, education, and health, etc. Manufacturing’s share in employment and GDP has decreased, but labor productivity has increased. Construction’s share in employment and GDP has increased but labor productivity has decreased. Labor productivity in wholesale and retail trade has reduced but its share in employment and GDP has increased. 

Structural change: sectoral value added and employment.

The share of employment in the agriculture sector is decreasing but the share of employment in the services sector is increasing. However, the shift in employment does not match the pace of shift in sectoral value added. The population census includes those who were employed as well as those not usually active in the last 12 months before the census date in employment figures, i.e. they had performed any economic activity in the reference period.

1981: The share of agricultural value added in GDP was 60.9%, industry 12.4% and services 26.7%. The share of employment (as a share of those that had performed any economic activity in a reference period of the last eight months or 12 months before census date) in agriculture, industry and services sectors was 91.1%, 0.6% and 6.4%. The remainder did not state sectoral employment.

2001:  The share of agricultural value added in GDP was 36.6%, industry 17.3% and services 46.1%. The share of employment in agriculture, industry and services sectors was 65.7%, 13.4% and 20.7%. The remainder did not state sectoral employment. 

• Note that between 1981 and 2001, while the share of both agricultural employment and gross value added decreased almost by the percentage points, the share of industry sector employment increased faster than the increase in its share in GDP (14.3 vs 4.9 percentage points). Meanwhile, services gross value added in GDP grew at a faster pace than the share of services employment. 
• In essence, between those 20 years, the industrial sector exhibited jobs-centric growth.  

2011: The share of agricultural value added in GDP was 33.4%, industry 14.5% and services 52.0%. The share of employment in agriculture, industry and services sectors was 64.0%, 9.5% and 24.0%. The remainder did not state sectoral employment. 

• Note that between 2001 and 2011, the shift in agriculture (as a share of GDP) was faster than the shift in agriculture employment (decrease by 3.1 percentage points versus 1.7 percentage points). While industry’s share in GDP decreased by 2.7 percentage points, employment in industry sector decreased at a steeper rate of 3.8 percentage points. Meanwhile, services’ share in GDP increased by 5.9 percentage points but employment increased by 3.3 percentage points. 
• In essence, the industrial sector was not jobs centric as the decrease in employment was faster than the decrease in its share of GDP. Likewise, the gain in employment in the services sector was at a lower pace than the increase in its share of GDP.

2021: The share of agricultural value added as a share of GDP was 36.6%, industry 17.3% and services 46.1%. The share of employment in agriculture, industry and services sectors was 65.7%, 13.4% and 20.7%, respectively. The remainder did not state sectoral employment.

• Note that between 2011 and 2021, pretty much the same trend held like in the previous decade, and the share of services sector in GDP grew at a faster pace than its share in employment, indicating that the services sector growth was not jobs centric.

So, what were the structural changes in the last 30 years, the period which endured the Maoist insurgency, the overthrow of the Shah dynasty, the transition to a federal democratic republic, catastrophic earthquakes, and COVID-19 pandemic. 

While the share of agriculture and industry in GDP decreased, the share of services sector increased. The share of employment in these sectors also followed the same pattern, but at a varying pace. The agriculture sector’s share in GDP decreased from 47.7% in 1991 to 25.8% in 2021. The industry sector’s share in GDP decreased from 17.5% in 1991 to 13.8% in 2021. However, the employment in this sector increased from 2.7% to 12.6% in 2021. Employment between 1991 and 2001 increased but as the political instability intensified, it decreased between 2001 and 2011 and then recovered between 2011 and 2021. The services sector’s share in GDP increased from 34.8% of GDP in 1991 to 60.4% of GDP in 2021. Employment in the sector increased from 15.1% to 30.0% of the total employed over the same period. 

The overall trend is that agricultural value added and agricultural employment followed almost the same pattern (decreased by 21.9 percentage points and 23.9 percentage points), but there was employment gain in the industry sector despite a decrease in its share in GDP (9.9 percentage point increase versus 3.7 percentage point decrease). The services sector GVA grew at a faster pace than employment in the sector (increase by 25.6 percentage points versus 14.9 percentage points).

What could be the underlying reasons for these changes? The rural-urban migration has impacted agriculture activities and employment. In the industry sector, the share of employment is the highest in construction sector (8.1% in 2021 compared to 0.5% in 1991), indicating the boom in real estate and construction activities that were driven by the inflow of remittances. The share of employment in the manufacturing sector declined from a high of 8.8% in 2001 to 3.8% in 2021. This sector was one of the most affected by conflict, and policy as well as political instability, leading to fast erosion of cost and price competitiveness to imported goods. In the services sector, most people are employed in the wholesale and retail trade and repair of motor vehicles and motorcycles activity (12.5%), which also is the largest services sector activity as a share of GDP. About 2.2% were employed in transportation and storage, and 2.9% in education. 

FYI, in 2021, about 8.6 million people were employed in the agricultural sector, 2.0 million in the industry sector (of which 0.5 million in manufacturing and 1.2 million in construction), and 4.5 million in the services sector (of which 1.9 million in wholesale and retail trade). It includes those who had done any economic activity in the reference period (employed [10.3 million] and those not usually active [4.7 million]).

The number of hours worked has also decreased. About 65.5% of those who did economic work worked for 6 months and above, 18.2% between 3-5 months, and 16.2% less than 3 months. In 1991, 91.3% of those engaged in economic work worked for 6 months and above, 6.0% between 3-5 months, and 2.2% less than 3 months. It may, again, reflect the increasing trend of outmigration among youths, who tend to engage in a particular economic activity as a stop-gap measures to sustain livelihoods while in Nepal, and then immediately leave for work or study abroad once opportunity arises. 

Most of the workers are in low productivity, low skilled occupations such as agriculture, forestry and fishery (50.1%) and elementary workers (23%). 

Of the 9.0 million people who did not do any economic work, 46.9% said it was because they were student, 21.9% due to household chores, and 11% due to old age.

Census versus Nepal Labor Force Survey (NLFS) III: These may be different from the estimates in NLFS III, which estimated population at 29 million in 2018 itself. The working age population was estimated at 20.7 million (around 71% of the estimated population). Among the 20.7 million people of working age, 12.7 million were not in the labor force (61.3%). About 8 million people were in the labor force (7.1 million employed and 0.9 million unemployed). The labor force consists of individuals who are employed and those that are considered unemployed. The unemployment rate was estimated to be 11.4%. 

On sectoral employment, NLFS III showed agricultural, industrial and services has 21.5%, 30.8% and 47.4% employment share. Compared to the census 2021 data, the share of employment in agriculture is lower, industry and services higher. It may be because the definition of employment is narrower in NLFS III— the new definition of employment includes only work performed for others for pay or profit, i.e., production for own final use is not considered as employment.

Labor productivity

Let us compare labor productivity (real GDP in census year/number of people who performed any economic activity as recorded in the census) at constant FY2011 prices. 

Overall labor productivity barely increased between 2011 and 2021. It was NRs157,028 in 2011 and NRs159,832 in 2021. Between 2011 and 2021, labor productivity growth in all sectors (agriculture, industry, and services) was negative. 

At the disaggregated economic activity level, labor productivity was positive in mining and quarrying; manufacturing; and public administration, defense, education, and health, etc.

Comparing labor productivity and share of employment, we see that labor productivity in wholesale and retail trade has reduced but its share in employment and GDP has increased. Manufacturing’s share in employment and GDP has decreased, but labor productivity has increased. Construction’s share in employment and GDP has increased but labor productivity has decreased. Finance, insurance, and real estate activities share in employment and GDP has decreased, but labor productivity has increased. In fact, within it as well, it is real estate business activities, and professional and technical activities that are driving this activity’s high labor productivity.

Population structure and demographic dividend in Nepal

Based on the population census data, this blog post highlights key features related to population, and its structure and evolution. Overall, the population growth rate is declining, working age population is increasing, dependency ratio is decreasing, and new entrants to the labor market are almost peaking. The demographic dividend may not last long unless the enabling policy and institutional environment are created along with investments in critical physical and social infrastructures. Gradually, new entrants to the labor market will decrease, dependency ratio will increase (as 65 years and above population increase), and working age population will shrink. It will not be an ideal situation for a country with low per capital income and the vast untapped opportunities.

Population structure

Population growth is slowing down. In 2021, the population of Nepal was 29.2 million (of which 49% are male and 51% female), up from 26.5 million in 2011. However, the population growth rate was 0.92% between 2011-2021, down from 1.35% between 2001-2011.

The number of households is increasing but the average household size is decreasing, indicating the increase in nuclear families (or the decrease in joint families). There were 6.7 million households with an average household size of 4.4 in 2021. These were 5.4 million and 4.9 in 2011, respectively.

Urban population constituted 66.2% of total population, up from 63.2% in 2011. Note that the definition of urban area was changed after the country adopted a federal structure of governance. The number of urban municipalities increased from 58 in 2013/14 to 293 in 2017/18.

Madhesh and Bagmati provinces each have 21.0% of the total population, Lumbini 17.6%, Koshi 17.0%, Sudrupaschim 9.2%, Gandaki 8.5%, and Karnali 5.8%.

The highest populated districts are: Kathmandu 6.6%, 4.0% Rupandehi, 3.7% Morang, 3.3% Kailali, 3.1% Jhapa, and 3.1% in Sarlahi.

Literacy rate has increased, but there is wide gender disparity. Among males 10 years and above, 83.6% are literate, but it is just 69.4% among females. These were 75.2% and 57.4%, respectively, in 2011.

Demographic dividend

The working age population (15-64 years) is increasing, reaching 65.2% of total population in 2021 or 19 million people. The population below 15 years of age is decreasing (reaching 27.8% of total population or 8.1 million people) but those 65 years and above are increasing (reaching 6.9% of total population or 2 million people). In 1991, these were 54.1% and 3.5% of the total population, respectively. 

The increase in working age population also means that the dependency ratio is decreasing (from 84.7% in 1991 to 53.3% in 2021). Dependency ratio is defined as the dependent population (0-14 years plus 65 years and above) per 100 productive population.

The declining population growth rate and dependency ratio, rising life expectancy along with declining fertility and child mortality, and gradually peaking working age population indicate that Nepal may be hitting the unique point where it could exploit this demographic change to spur economic growth (or demographic dividend), i.e. more people to work and fewer people to support. 

Seizing this opportunity would require reorienting policies to facilitate a meaningful structural transformation, whereby high-value added sectors (such as industry, high value agriculture, ICT, travel and tourism, healthcare, education) dominate the economic structure, resulting in higher jobs-centric and inclusive growth and higher productivity. Adequate supply of affordable and competitive hydroelectricity, better connectivity including logistics network, human resources development through investment in education and healthcare, social protection, and political as well as policy stability would be critical for that.  Else, this demographic bulge will continue to be a burden to the economy, resulting in large-scale outmigration for work or study overseas. The benefits of a demographic dividend are not unconditional.

Given the decreasing population growth rate, this could also be an indication that the working age population will soon peak because the population below 15 years of age is decreasing. The 65 years and above population will gradually increase, burdening the public social protection scheme. 

New entrants to the labor market

About 2.0% to 2.5% of the total population enter the job market annually. In 2021, about 607,128 entered the labor market (basically those who turned 15 years old in 2021). There were already 18.4 million population in the job market (basically those between 16-64 years old). About 246,944 exited the job market (basically those above 64 years of age). In 2011, 652,525 youths entered the labor market. 

The lack of adequate job opportunities or better career prospects and higher wage premium abroad are some of the push factors for large-scale outmigration of working age population. More on this specific topic in the next blog post.  

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. 

A budget amid economic slowdown

It was published in The Kathmandu Post, 06 June 2023.

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A budget amid economic slowdown

Achieving revenue target to meet expenditure needs will continue to be challenging.

Finance Minister Prakash Sharan Mahat presented the budget for the next fiscal year 2023-24 against the backdrop of weak aggregate demand, slowdown in revenue mobilisation, high inflation, low demand for credit, stabilising external sector, and low confidence in the private sector. Political constraints in expenditure allocation for certain schemes aside, the budget has tried to address the core economic issues while maintaining fiscal discipline. It also attempts to reorient economic reforms to finetune public service delivery and to enhance private sector confidence.

As with previous budgets, the main hurdle will be on the implementation of the promises as they are easier to make than deliver on time with the current state of bureaucracy and politics. This will be particularly true for higher capital budget execution and meeting the revenue target.

Balancing act

A few weeks before the finance minister delivered his budget speech, the National Statistics Office released national accounts estimates that detailed a surprisingly unexpected level of economic slowdown. It estimated that the real gross domestic product (GDP) will grow by just 1.9 percent in 2022-23, much lower than the 5.6 percent in 2021-22 and the government’s initial target of 8 percent. This was mostly due to tight fiscal and monetary policies that slowed public spending and credit disbursement.

Accordingly, both public and private demand fell. The private sector complained of factory closures, issues in cash flow management, and decreased capacity utilisation. The slowdown was stark in the first two quarters of 2022-23, as seasonally adjusted quarterly GDP data pointed to two consecutive quarters of economic contraction. The lower growth projection was attributed to a contraction in manufacturing, construction, and retail and wholesale trade activities, which together account for about 28 percent of GDP.

Given the dilemma of boosting aggregate demand amidst the limited fiscal space and spending capacity, the finance minister took a balanced approach. The expenditure outlay is Rs1751.3 billion, which is 16.4 percent higher than the revised estimate but 2.4 percent lower than the budget estimate for 2022-23. Of the total expenditure outlay, 65.2 percent is for recurrent expenses, 17.3 percent for capital expenditure, and 17.5 percent for financing provision. As a share of GDP, recurrent expenditure allocation is lower than the 2022-23 revised estimate, but capital budget allocation is slightly higher. Overall, fiscal deficit will likely fall from the estimated 3 percent of GDP this year.

The government plans to meet 71.3 percent of the expenditure needs by increasing domestic revenue, 2.9 percent from foreign grants, 12.1 percent from foreign loans, and 13.7 percent from domestic borrowing. The general direction is on expenditure rationalisation where possible, but there are deviations as well. For instance, the government has decided to either close or merge 20 offices and boards that are not relevant or have identical roles and functions. It has committed to not purchasing new vehicles, curbing the construction of new buildings and foreign trips, and providing cash to entitled officials instead of fuel allowance.

The finance minister has committed to overhauling contract management to boost capital spending, reviewing the viability of public enterprises to save resources, lowering fiscal risk, and promoting fiscal federalism, including restructuring Town Development Fund. However, succumbing to political pressure, he has revived the controversial constituency development fund, which was rife with governance issues.

Four issues

The expenditure plan and reform agenda of the government are broadly in line with the evolving macroeconomic situation and the direction of reforms needed to address them. However, this was also generally true of most previous budgets. They simply could not deliver as promised, owing to implementation shortfalls. Four issues will be particularly important for improved budget execution and the realisation of committed reforms.

First, achieving revenue target to meet expenditure needs will continue to be challenging. The budget targets revenue growth of around 20 percent over the revised estimate for 2022-23, which looks ambitious given that economic activities have still not picked up pace and private sector confidence continues to be weak. The last time revenue growth was this high was in 2016-17. The focus on marginal increases in most tax rates in most categories but not on improving tax administration with concrete measures to boost efficiency gains may require reconsideration if monthly targets are not as per expectation.

The budget estimates tax changes and administrative reforms to contribute just 6.4 percent of the total estimated revenue, implying that most of the expected increase in revenue will be through existing measures and sources. Revenue buoyancy, which refers to revenue growth relative to nominal GDP growth, of about 2 percent is also not realistic. In fact, the upward revision of tax rates may discourage private sector investment and dampen consumer demand. It will also put upward pressure on inflation.

Second, enhancing capital budget execution is going to be the key in boosting aggregate demand. Public capital spending affects construction, mining and quarrying, and manufacturing sectors, which are currently performing poorly. It also indirectly affects a few key activities in the services sector.

While higher capital spending allocation compared to the revised estimates is encouraging, the government should come up with a concrete, enforceable implementation plan that decisively tackles three key issues that are contributing to a chronically low capital budget absorption rate: Bureaucratic delays (project approval delays and weak inter- and intra-ministry coordination), structural weaknesses (limited planning and implementation capacity, weak contract management, and delayed procurement), and allocative inefficiency (lack of project readiness and the lack of a strong pipeline of bankable projects). The capital budget absorption rate was just 57.2 percent last fiscal and is estimated to be about 68 percent this fiscal.

Third, the allocation for financing provision (5.2 percent of GDP) has drastically increased in 2023-24 and is also slightly higher than the capital budget. To make room for more capital spending, it needs to be decreased gradually. Increasing government share and loan investment in public enterprises and amortisation of external and internal borrowings are driving expenses in this category. A judicious fiscal and debt management and cash flow strategy is required to control the rising public borrowing. Note that outstanding public debt is over 42 percent of GDP, up from just 23.8 percent in 2016-17.

Finally, constant engagement with the private sector to enhance their confidence is vital. While the budget commits to introducing several private sector-friendly reforms—lower export requirements for firms operating inside special economic zones, lower cost of company registration and simple entry and exit rules, removal of foreign investment threshold in the IT sector, and promotion of micro, small and medium enterprises—the private sector itself is not fully convinced.

Economic outlook and fiscal budget in Nepal

It was published in The Kathmandu Post, 11 May 2022. Background details are in this blog and Twitter thread.

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Economic outlook and fiscal budget

On the backdrop of disappointing national accounts estimates recently released by National Statistics Office (NSO), and an unsatisfactory fiscal performance but improving external sector situation so far this year, the government is busy in budget preparation for next fiscal year 2023/24. While tight monetary and fiscal policy measures mitigated external sector risks, particularly fast depleting foreign exchange reserves, they also squeezed aggregate demand as banking sector lending slowed down, industrial capacity utilization decreased and revenue mobilization shortfall widened as obligatory spending on salaries and social spending increased. It indicates a weak economy with unresolved structural issues and macroeconomic imbalances, which the upcoming budget will have to focus on.

Economic slowdown

The NSO projected gross domestic product (GDP) to grow by 1.9% in 2022/23, down from 5.6% revised estimate for 2021/22 and 4.8% for 2020/21. The growth estimate for this fiscal is also lower than the 8% target in budget and the recent estimates by multilateral institutions. The NSO estimate is based on data and information up to the first nine months of this fiscal (mid-July 2022 to mid-April 2023) and assumption of normal economic activities during the rest of the fiscal, which is not likely given the lower private sector confidence and lack of pick up in capital spending in the last quarter. Consequently, the statistics office may revise down estimates when it releases data next year. Note that seasonally unadjusted data show that the economy grew at just 1.7% in the first quarter and contracted by 1.1% in the second quarter of this fiscal. Seasonally adjusted quarterly GDP estimates show two consecutive quarters of economic contraction. 

The lower growth projection is attributed to contraction in manufacturing, construction, and retail and wholesale trade activities, which together account for about 28% of GDP. Specifically, manufacturing activities contracted by 2% owing to lack of adequate electricity supply during dry season— this despite electricity subsector registering the largest growth, 19.4%, in 2022/23 due to addition of new run-of-the-river type hydroelectricity to national grid, high interest rate, import restrictions and generally low government and consumer demand.  Nepal Electricity Authority cut supply by almost 12 hours to industries due to a slump in power generation during dry season. It increased the cost of production— including those of cement, rods, and steel industries—, leading to lower output and demand. 

Similarly, construction activities contracted by 2.6%, because capital spending slowed down and residential housing and real estate was hit by policy restrictions on real estate plotting and tight as well as high interest rates. This subsector previously benefitted from a highly accommodative monetary policy and lax supervision. Meanwhile, wholesale and retail trade activities contracted by 3% owing to restrictions on imports of goods, a slowdown in domestic industrial output, and lower income growth as lack of adequate electricity supply, inflation, and high input costs hit businesses and households. 

Overall, the tight monetary policy to maintain external sector balance, especially to narrow current account deficit and increase foreign exchange reserves, and lower public spending dampened aggregate demand, leading to lower-than-expected real GDP growth. While public and private investments contracted by 20.2% and 7.6% respectively, consumption expenditure grew by just 3.7%. The external sector situation and to some extent the financial sector indicators have improved but this has come at the cost of a slowdown in imports and overall economic activities.

Budget focus

Against this background, the next federal budget should focus on propping up aggregate demand while rectifying short-term macroeconomic imbalances. These include reducing fiscal deficit in view of large revenue expenditure gap, boosting private sector investment, reducing inflationary pressures, lowering interest rate volatility, maintaining financial stability, and maintaining external sector balance even after the withdrawal of policy restrictions on imports.

Expenditure-based fiscal consolidation through rationalization of subsidies and general government expenses, and better targeting of social protection programs including pensions system are urgently needed. Else, it will be difficult to manage recurrent spending with revenue mobilization. On revenue measures, the focus at the federal level could be on avoiding an inverted tax regime where tax rate on inputs is higher than that for final goods. Rationalizing distortionary tax expenditures such as exemptions, concessions, preferential rates, amnesties, and deferrals could also be prioritized. At the subnational level, strengthening revenue system and administration to bring more activities, including property levies, under the tax net could be helpful to reduce the overreliance of subnational governments on the federal government to meet their expenditure needs.

The budget should also focus on capital budget execution, which has receded to less than 60% in recent years. A public investment management regime that focuses on systematic identification, appraisal, approval and monitoring of investment projects, and a procurement regime that also priorities strict contract management could be helpful in this regard. 

Meanwhile, a single fiscal budget cannot resolve all structural issues, but it can take corrective steps as a part of a medium-term reform agenda to sustain high, inclusive, and sustainable growth. These include long running structural issues such as boosting overall productivity, inducing an industry-oriented structural change from low value-added services activities, promoting high-value and climate-smart agricultural sector, enhancing governance of and lowering fiscal risk from public enterprises, ensuring effective contract management and good governance, rationalizing as well as targeting of social protection programs, enhancing quality and climate-resilient infrastructure, and boosting human capital development. 

The budget could take preparatory steps to facilitate industry-oriented structure change by overhauling our energy generation and use strategy.  The share of the industry sector will naturally increase as more hydroelectricity projects get connected to the national grid. Hydroelectricity output now accounts for about 2.1% of GDP, sharply up from less than one percent a decade ago. It should be thought of both as a final product as well as an input to enhance economy-wide output and productivity. The budget could facilitate strategic use of excess electricity generation during non-dry season to boost output and productivity in manufacturing and services sectors. This will not only reduce imports and lower the current account deficit, but also boost growth and employment. Export of electricity should be a second priority for now. Furthermore, given the risk from climatic hazards, it is a good idea to start working on diversifying energy sources to wind and solar, and to increase the peaking or reservoir type hydroelectricity projects. Year-round adequate supply of electricity needs to be managed well so that the industries do not face shortage during certain months, and that consumers have incentive to shift to electric goods and appliances.

Revenue shortfalls in Nepal

Nepal is facing a very large revenue shortfall in FY2023. According to FCGO, revenue mobilization in the first seven months of this fiscal (mid-January 2022 to mid-March 2023) is just 40% of the target. In the previous fiscal years, the revenue mobilized by this time was always higher than 50% of target. The following is the progress by the seventh month of respective fiscal:

• FY2019: 61%
• FY2020: 50%
• FY2021: 57%
• FY2022: 58%
• FY2023: 40%

The budget projection on revenue mobilization was too ambitious in the first place. It projected about 29.5% increase over FY2022 revised estimate for total federal receipts (revenue, inclusive of revenue sharing with subnational governments, and foreign grants). Revenue was projected to increase by 25.7% and tax revenue by 31.6% over the revised estimates. 

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 mobilization. Faced with the reality of a revenue shortfall, the Finance Ministry proposed a cut in expenses, especially recurrent spending, by 20% 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.

According to news report, the government suspects that informal activities have also reduced revenue mobilization. For instance, based on business operations, some have paid VAT and customs duties, but not paid income tax.

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.

India: Recent developments and economic outlook

In its 2022 Article IV consultation report on India, the IMF noted that the economy rebounded strongly from the pandemic-related downturn, supported by fiscal policy targeted at vulnerable groups and to mitigate the economic impact of commodity price increases. Front-loaded monetary policy tightening is addressing elevated inflation and a robust public digital infrastructure is facilitating innovation, productivity improvements and access to services. 

However, the India economy is facing new headwinds, including the adverse effect of climate change. These include high fiscal deficit that requires consolidation anchored on stronger revenue mobilization and spending efficiency; monetary policy tightening to rein in inflation and financial sector vulnerabilities; and financing and technology transfer to move to a carbon-neutral economy. This blog post includes key highlights from the report.

Recent developments

The economy benefited from broad-based recovery from the deep pandemic-related downturn. Real GDP grew by 8.7% in FY2022. All sectors recovered to pre-pandemic levels by end-FY2021/22 except for contact-intensive services, which remained 11% below FY2019/20 levels.

Due to growing domestic demand, commodity and food price shocks, and supply chain disruptions, inflation has been at or above the RBI’s inflation band of 4±2% since January 2022. The report notes that long-term inflation expectations remain relatively well anchored, but the risk of second-round effects from fuel and commodity price shocks remains high.  

Credit growth increased following relatively subdued growth over the past two years. Non-food bank credit growth was driven by stronger credit growth by private banks, mostly to MSMEs in the industry sector. However, credit gap (credit to GDP gap) remains negative, i.e. credit-to-GDP ratio remains below its long-term trend.

The external position in FY2022 was considered broadly in line with that implied by medium-term fundamentals and desirable policies (level of per capita income, favorable growth prospects, demographic trends, and development needs). Current account surpluses and large capital inflows boosted international reserves during the pandemic. The IMF assessed current account gap at 1% of GDP after accounting for transitory impacts of the COVID-19 shock. Current account deficit in FY2022 was 1.2% of GDP, reflecting recovering domestic demand and rising commodity prices. The widening current account deficit and portfolio investment outflows have depleted foreign exchange reserves in FY2023.  External shocks such as global financial tightening and the Russian invasion of Ukraine, and recovering domestic demand have put pressure on the exchange rate. Reserves are enough to cover around 7 months of prospective imports. 

General government fiscal deficit is estimated to decrease to 9.9% of GDP in FY2023 from 10% of GDP in the previous fiscal. Central government fiscal deficit declined to 6.7% of GDP in FY2022 (in its definition of central government deficit, the IMF also includes NSSF loans to central government PSUs and fully serviced bonds). The phasing out of some pandemic-related expenditures contributed to 1% of GDP reduction in spending. Buoyant GST and income tax revenues, thanks to improvements in tax administration and additional taxes on domestic crude oil production and fuel exports, helped boost revenue. The state government’s deficit is estimated to decline close to the medium-term target of 3% of state-level GDP, but variations in fiscal performance persist.  

The pandemic-related disruptions reduced access to education and trainings, adversely impacting human capital accumulation. Most affected were vulnerable groups, including females, youth, less skilled and educated, and daily wage and migrant workers. 

Economic outlook

Growth is projected to moderate amid higher oil prices, weaker external demand, and tighter financial conditions. The IMF projected GDP growth at 6.8% in FY2023 and 6.1% in FY2024. Growth is projected at around 6% over the medium-term. 

General government fiscal deficit is projected to moderate but will remain high: 9.9% of GDP in FY2023, 9% of GDP in FY2024 and then around 7-8% of GDP over the medium-term.

Inflation is projected to moderate to 6.9% in FY2023 as core inflation remains sticky and near-term uncertainties in food prices and input costs affect prices. Inflation is projected to return to the tolerable band over the medium-term. 

Current account deficit is projected to increase to 3.5% of GDP in FY2023 owing to higher commodity prices and import demand, and will decline to about 2.5% of GDP over the medium-term. 

Foreign exchange reserves are projected to cover about 6.5 months of imports over the medium-term. Net FDI inflows are estimated to be about 1.4% of GDP.

Risks to outlook: Uncertainty about the economic outlook is considered high and risk tilted to the downside. A materialization of these risks would worsen the economic outlook (lower growth and trade). 

External risks include a sharp global growth slowdown (affects India through trade and financial channels), and intensification of spillovers from the Russian invasion of Ukraine combined with supply and demand shocks in the global food and energy markets. These can worsen inflation and de-anchor inflation expectations. Over the medium-term, broadening of conflicts and reduced international cooperation can disrupt trade, increase volatility of commodity price, and fragment technological and payments systems. 

Domestic risks include rising inflation impacting vulnerable groups, emergence of more contagious COVID-19 variants, tighter financial conditions (weaken asset quality and result in financial sector stress), high financing costs due to weakening of fiscal position, climate change. 

However, upside risks include a resolution of the war in Ukraine and de-escalation of geopolitical tensions (will boost international cooperation, moderate commodity price volatility, and promote trade and growth). Also, successful implementation of structural reforms and greater than expected dividends from ongoing digital advances could increase medium-term growth potential. 

Fiscal policy: India’s fiscal space is at risk and debt sustainability risks have increased. The government will need to improve targeting to lower public spending. For instance, the reduction in fuel excise taxes and additional fertilizer subsidies are not well targeted. Revenue have been improving due to buoyant GST and income tax revenues. High debt levels (84% of GDP in FY2022) and substantial gross financing needs (15% of GDP) due to higher effective interest rates together with monetary policy tightening have increased debt sustainability risks. These risks are somewhat mitigated as the bulk of public debt are fixed-rate instruments denominated in domestic currency and predominantly held by residents per regulatory requirements. DSA shows that debt dynamics remain favorable in the medium-term and support a sustainable debt path. 

The government has targeted 4.5% of GDP central government deficit, implying a general government deficit of 7.5% of GDP (down from 9.9% of GDP in FY2023). The IMF recommends a clearly communicated medium-term fiscal consolidation plan to enhance policy space and facilitate private sector-led growth. It will also reduce uncertainty, lower risk premia, and help to maintain price stability. 

Fiscal consolidation should be facilitated by stronger revenue mobilization and improving expenditure efficiency. General government primary consolidation of around 1% of GDP and debt of around 80% of GDP by FY2028 could be targeted. 

Expenditure efficiency is possible through better targeting of subsidies, greater utilization of the existing social support infrastructure (DBT) to reduce leakages, rationalization of central schemes, reforming electricity tariffs and improving the financial viability of electricity distribution companies. 

Revenue measures can include reversing the fuel excise tax cuts, further broadening the corporate and personal income tax bases, simplifying the goods and services tax (GST) rate structure, rationalizing the items subject to preferential GST treatment, and continued improvements in tax administration, in line with international good practice. These measures would help narrow India’s tax gap, estimated at around 5% of GDP. Asset monetization and privatization agenda could generate additional receipts. 

Fiscal transparency will improve PFM. For instance, recognizing previously off-budget expenditure at the center and state level has improved transparency. Digital solutions have helped streamline PFM processes, advancing transparency and governance, including through e-procurement, faceless income tax assessments and the recent rollout of e-bills. Integrated Government Financial Management System along with a dedicated platform for central, state, and local governments to share fiscal information will support timely production of consolidated fiscal reports and identification of fiscal risks at the subnational level.