Effect of countercyclical investment on employment

An interesting paper by Buchheim and Watzinger (2023) published in AEJ: Economic Policy [15(1)] shows that investments in public buildings in Germany can quickly and cost-effectively increase employment in the short run. They can be a viable tool for counteracting an economic slowdown. 

They explore if the renovation of public buildings create jobs quickly and cost-effectively? Their paper estimates the causal impact of a sizable German public investment program, which provided 0.16% of GDP for upgrading public buildings, on employment at the county level. The program focused on improving the energy efficiency of school buildings, making it possible to use the number of schools as an instrument for investments. It also enforced tight deadlines, reducing potential implementation lags. The program was cost-effective, creating, on average, one job for one year for an investment of €24,000. The employment gains are detectable after nine months and are accompanied by an unemployment reduction amounting to half of the job creation. Employment grew predominately in the directly affected industries.

They addressed the endogeneity problem (governments may target regions that are hardest hit by the recession) by exploiting the legal structure of the stimulus bill. The bill prescribed that 65 percent of funds had to be spent on investments in the educational infrastructure, in particular on improving the energy efficiency of existing buildings. This implies that the local scope for investments was closely linked to the historically predetermined number of schools. Since the number of schools is a predetermined stock variable and thus unrelated to the magnitude of the recession in a county, it constitutes an ideal instrument for local investments. To put the cost of one job per year in perspective, the average labor costs in the construction industry was at least €45,000. The employment gains translate into a fiscal multiplier of about 1.5. 

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.

High cost of geoeconomic fragmentation

Geoeconomic fragmentation, a policy-driven reversal of global economic integration, may be caused due to trade restrictions, barriers to the spread of technology (technology diffusion), restrictions on cross-border migration, reduced capital flows, and a sharp decline in international cooperation. These will affect various segments of the population and country differently. For instance, lower income consumers in advanced economies will lose access to cheaper imports, and economies heavily reliant on trade will suffer and per capita income catch up becomes challenging and adjustment costs rise.

According to a new IMF staff discussion note, the cost to global output from trade fragmentation could range from 0.2 percent (in a limited fragmentation / low-cost adjustment scenario) to up to 7 percent of GDP (in a severe fragmentation / high-cost adjustment scenario); with the addition of technological decoupling, the loss in output could reach 8 to 12 percent in some countries.

The IMF recommends a pragmatic approach to increasing geoeconomic fragmentation. These include strengthening international trade system including diversification of supply; helping vulnerable countries deal with debt as fragmentation makes it harder to resolve sovereign debt crises if key official creditors are divided along geopolitical lines; stepping up climate action including setting a floor on international carbon price and innovative use of public balance sheets—such as credit guarantees, equity and first-loss investments— to help mobilize funds for private financing. 

About 15 percent of low-income countries are already in debt distress and an additional 45 percent are at high risk of debt distress. Among emerging markets, about 25 percent are at high risk and facing default-like borrowing spreads.

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.  

Development beyond country averages

McKinsey Global Institute has an interesting article that highlights the importance of microregions as opposed to country averages to account for changes in growth and development. 

The concentration of global economic activity looks very different under a microregional lens. For instance, India and Portugal at the country level might have large difference (5x) in per capita GDP, but if we look at Goa (India) and Porto (Portugal) there is not much difference (GDP per capita of $33,000 in 2019).  We will see similar pattern in other countries and their cities in terms of life expectancy. 

MGI's analysis shows that half of the additional GDP generated from 2000 to 2019 came out of 3,600 microregions from a total of 40,000 as ranked by the increase in GDP per square kilometer. These 3,600 microregions were scattered across 130 countries but cover just 0.9% of the world’s land mass. 27% of the global population lived in them in 2019, totaling two billion people.

In India, they found 270 microregions home to 114 million people in 2019 where GDP per capita grew more than $7,100. The country average excluded them. Microregions with GDP per capita gains of at least $7,100 (or the top 30% globally) were considered. 

They also regressed five-year moving average annual growth rates at the microregional level on annual growth at the country level to estimate the explanatory power of country-level growth. The result showed that a country’s GDP per capita growth rate can explain only 20% of the variation in the microregional growth rates in that country.

Nepal's top remittance source countries in 2021

The KNOMAD/World Bank released new estimates of bilateral remittance flows for 2021. The top remittance corridors were: United States – Mexico: $52 billion; United Arab Emirates- India: $20 billion; Unites States – India: $6 billion; and Saudi Arabia – India: $13 billion. Note that these are not actual inflows, but estimates based on inward remittances to a country being allocated to various source countries in proportion to its stock of migrants in those countries, the per capita income (in purchasing power parity terms) in the destination countries, and the per capita income (again in PPP terms) in the origin countries.

Low- and middle-income countries (LMICs) (“Global South”) received about 56% of their remittances from high-income OECD (“Global North”), 27% from the GCC and other high-income countries (outside the OECD), and about 17% from the other LMICs. Interestingly, low-income countries received a larger share of remittances from the LMICs (including 15% from other LICs) than from the high-income countries. 

Some caveats regarding the estimates:  Informal inflows of both remittance income and migrant flows are not accounted for. Estimates may also be affected due to miscalculation of trade and tourism receipts as remittances, and vice versa; wrong attribution of the source of remittance to countries where the financial intermediaries (correspondent banks) have headquarters; and ban on outward remittance flows by countries. 

So, what were Nepal's top remittance source countries in 2021? According to the estimates, of the total $8.2 billion remittance inflows, Saudi Arabia accounted for 20.6%, Malaysia 20.5%, India 19.3%, Qatar 13.4% and United States 8.3%. The chart below shows remittances inflows to Nepal from 44 countries.

The chart below shows remittance inflows and stock of migrants. The stock of migrants in 2021 was estimated at 2.7 million. 

Meanwhile, the top remittance source countries have not changed much in the last decade. Korea, UAE and Kuwait have become important destination lately. Saudi Arabia and Malaysia have become prominent destinations for Nepali migrants. India has always been an important destination for employment, education, healthcare, etc.

The data also includes information on remittances from Nepal to other countries. It is estimated that $1.7 billion was sent from Nepal to India ($1.6 billion, which is close to remittance inflows from India), China ($82 million), Bhutan ($25 million), Pakistan ($1 million), and Bangladesh ($1 million). 

The chart below shows the stock of migrants and remittance inflows in 2021.

Note that the remittance inflows estimate by Nepal Rastra Bank (central bank) might differ. In FY2018, it estimated that 22.8% of total remittance inflows was from the USA, 13.4% from Saudi Arabia, 11.6% from Qatar, 10.1% from UAE and 10% from Japan.