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)

Airport, Debt and Development

An interesting article on Pokhara International Airport, financed with Chinese loans and built by Chinese firms, in the NYT. Key highlights from the article included below: 

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The expensive airport, built largely by Chinese companies and financed by Beijing, was a diplomatic victory for China and a windfall for its state-owned firms. For Nepal, it was already an economic albatross, saddling the country with debt to Chinese creditors for years to come.

Nepal had sought to build an international airport in Pokhara since the late 1970s, hoping that it would catapult the city into a global tourist destination. But the project had stalled for decades, mired in political turmoil, bureaucracy and money problems, until China stepped in.

After the airport’s construction, Beijing began declaring that it had been part of the Belt and Road Initiative, President Xi Jinping’s signature infrastructure campaign, which has doled out an estimated $1 trillion in loans and grants around the world. This designation, which Nepal has quietly rejected, has thrust the airport into the middle of a diplomatic tug of war between China and India.

The Pokhara airport highlights the pitfalls for countries that import China’s infrastructure-at-any-cost development model, which spins off money for Chinese firms, often at the expense of the developing country.

In Nepal, China CAMC Engineering, the construction arm of a state-owned conglomerate, Sinomach, imported building materials and earth-moving machinery from China. The airport, built to a Chinese design, is packed with security and industrial technology made in China. Chen Song, China’s ambassador to Nepal, said it “embodied the quality of Chinese engineering.”

But an investigation by The New York Times, based on interviews with six people involved in the airport’s construction and an examination of thousands of pages of documents, found that China CAMC Engineering had repeatedly dictated business terms to maximize profits and protect its interests, while dismantling Nepali oversight of its work. This has left Nepal on the hook for an international airport, at a significantly inflated price, without the necessary passengers to repay loans to its Chinese lender.

In 2011, a year before China officially agreed to lend the money for the airport, Nepal’s finance minister signed a memorandum of understanding to support CAMC’s proposal, before any bidding process had even started. The Chinese loan agreement allowed only Chinese firms to bid on the work. CAMC’s winning bid of $305 million, almost twice what Nepal had estimated the airport would cost, raised the ire of some Nepali politicians, who called the price outrageous and the bidding process rigged. CAMC then lowered the price about 30 percent, to $216 million.

China and Nepal signed a 20-year agreement in 2016; a quarter of the money would be an interest-free loan. Nepal would borrow the rest from the Export-Import Bank of China, a state-owned lender that finances Beijing’s overseas development work, at 2 percent interest. Nepal agreed to start repaying the loans in 2026.

The initial construction budget had earmarked $2.8 million for Nepal to hire consultants to make sure CAMC was abiding by international construction standards, according to documents. As the project went on, the Chinese firm and Nepal lowered that allocation to $10,000, using the money elsewhere.[...]There was also no paperwork ensuring the quality of Chinese-made building materials or information on the Chinese vendors providing the components. [...]The contractor was able to inflate the cost of the project — to double the market rate, by his estimate — and “quality had been compromised.”

CAMC squeezed more money from the project while eliminating oversight. China’s Export-Import Bank, which had provided the loan, had appointed China IPPR International Engineering, a consulting firm, to track the quality, safety and timetable of the construction while ensuring that Nepali officials were satisfied with CAMC’s work. The consulting firm and the construction company are subsidiaries of Sinomach, a machinery giant ranked in the Fortune Global 500. The potential for conflicts of interest became even more pronounced in 2019 when CAMC acquired IPPR, turning it from a sister company into a direct subsidiary. The fees to pay IPPR came from Nepal, as part of its loan from the Chinese bank.

A 2014 feasibility study commissioned by CAMC projected that the airport would be able to repay loans from its profits. That forecast, however, was based on an estimated 280,000 international passengers traveling through the airport starting in 2025. As of now, there are no international flights.

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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.

Ecuador seals debt-for-nature swap selling blue bond (Galapagos Bond)

Ecuador has sealed a debt-for-nature swap selling a new 'blue bond' of $656 million (Galapagos Bond) with 5.645% coupon. Ecuador sovereign bonds currently yield 17%-26%. It means the country brought back roughly $1.6 billion of debt at a near 60% discount. Ecuador will invest at least $12 million a year into conservation of the Galapagos Islands and an additional $5 million a year into a fund that will last decades.

Excerpts from a Reuters news report:

Ecuador sovereign bonds currently yield from 17% to 26%, but the new bond has an $85 million 'credit guarantee' from the Inter-American Development Bank and $656 million of political risk insurance from the U.S. International Development Finance Corp (DFC), effectively making it less risky. Debt-for-nature swaps have proved successful in Belize, Barbados and the Seychelles in recent years, but Ecuador's deal is by far the largest to date, cutting the country's debt by over $1 billion once the $450 million of total conservation spending is taken into account. The driver has been the remote Galapagos Islands, some 600 miles (970 km) off Ecuador's mainland coast, that inspired Charles Darwin's Theory of Evolution.

While Quito will pocket more than $1 billion worth of savings from the buyback for other purposes, the key appeal has been the environmental benefits and the hope it will be a catalyst for other highly indebted but nature-rich countries. 

Conservation funding there now protects a 200-mile (322-km) radius around the archipelago. It has helped revive local tuna and other fish stocks, but also increased catches further out where local fishing is still allowed. The hope is for similar results from a new 11,500-square mile (30,000-sq km) reserve Ecuador set up last year between the Galapagos and Costa Rica's maritime border used as a migratory corridor by sharks, whales, sea turtles and manta rays.