Impact of COVID-19 on Nepali economy

It was published in The Kathmandu Post, 09 March 2020.

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Coronavirus onslaught

It makes sense for the government to lower its GDP growth target in light of the impact of the outbreak.

During the mid-year review of the 2019-20 budget, Finance Minister Yuba Raj Khatiwada asserted that the government would meet the 8.5 percent growth target despite acknowledging that actual public spending would fall short of the earmarked budget for this fiscal. However, he did not explain the reasons behind the unchanged growth target in the face of lower capital spending and agricultural output. The recent outbreak of Covid-19—a new disease caused by novel coronavirus that originated in Wuhan, the capital city of Hubei province in China—and its effect on the economy is making the growth target more elusive than ever.

In fact, economic performance was already below expectation before the coronavirus outbreak, which is wreaking havoc on global value chains and threatening the global economic outlook. Agricultural output, especially paddy production, is expected to decrease this year due to a delayed monsoon, shortage of fertilisers, use of substandard seeds and an armyworm invasion. Slow public spending has hit industrial output, especially construction, and mining and quarrying activities. During the first half of this fiscal, the government was able to spend only 15 percent of the Rs408 billion capital budget. These factors coupled with the continuing slowdown in the Indian economy—the largest source of investment commitment and inbound international tourists, and to whose currency the Nepali rupee is pegged—mean that a growth target higher than the provisional growth in 2018-19 is ambitious in the first place.

Four effects

The coronavirus outbreak is severely affecting global as well as regional economic outlooks. This epidemic is bound to affect the Nepali economy much more than the effect of the global financial crisis in 2008 and the food price spikes in 2010. Specifically, the Nepali economy will be impacted on four major fronts, affecting economic growth and employment opportunities.

First, the travel and tourism industry, which was gearing up for an expected tourist surge in 2020, is feeling the brunt of Covid-19. This has put a lid on any chance of achieving the ambitious two-million tourist target in 2020, an ill-conceived numerical target that was not in sync with the state of the tourism infrastructure. Investors who borrowed money from financial institutions to establish new hotels and restaurants or refurbish the existing ones will likely face cash flow problems. The expected business bonanza has almost evaporated with the slump in tourist arrivals. All flights from China are suspended now, and inbound visitors from the country have come to a screeching halt. It was partly because of the surge in Chinese tourists—who accounted for 14 percent of the 1.2 million visitors in 2019—that Nepal's travel and tourism industry did not really have an offseason market. The year-round business supported economic activities and employment.

Note that of the total visitors, 70 percent come for holiday and recreation, 8 percent for trekking and mountaineering, and 15 percent for pilgrimage. The increasing fear of catching Covid-19 as it spreads globally will limit visitors from other countries too. Some researchers are already predicting an outbreak in Kathmandu soon, partly owing to Nepal’s poor ability to manage infectious disease. This is going to specifically affect economic growth through a lower than expected services output. The direct contribution of the travel and tourism sector (economy activity generated by hotels, travel agents, airlines, and passenger transportation services) is estimated to be about 4-5 percent of GDP. The sector also contributes about 6 percent of the total foreign exchange earnings.

Second, setbacks in project execution and completion is likely in several large infrastructure projects in the airport, hydropower and road transport sectors. In the immediate term, it will affect projects led by Chinese contractors that are employing some Chinese workers and managers. They include the Narayanghat-Butwal road improvement project supported by the Asian Development Bank, Rasuwagadhi-Syabrubesi road project and detailed project review of the Kathmandu outer ring road supported by the Chinese government, and hydropower projects such as Khimti-2 and Langtang Khola, among others. It will directly affect public capital spending, which in turn will exacerbate the finances of some companies saddled with excess installed capacity (anticipating accelerated capital spending), but low capacity utilisation (in reality slow capital spending). It includes the cement industry, whose capacity utilisation had already dropped to 40 percent in 2018-19. Accommodating requests for time and cost overruns for the affected projects may be warranted.

Third, the coronavirus outbreak will disrupt supplies of raw materials and intermediate goods because of China’s central role in global value chains. The manufacturing and services sectors in Nepal too will feel the brunt because of reliance on imported goods—be it raw materials, intermediate or final goods. China accounts for about 15 percent of Nepal’s total trade. Nepal’s top exports to China are handicraft, woollen carpets, noodles and readymade garments. Meanwhile, the top imports from China are telecommunication equipment, readymade garments, electrical goods, machinery parts and chemical fertilisers. Nepal’s flagging exports sector will further suffer as a synchronised global economic slowdown will weaken demand for our goods and services beyond China.

Fourth, outmigration for work and remittance inflows will get affected. Outmigration to attractive destinations like South Korea is already suspended. A sharp global economic slowdown due to supplies and economic disruptions will gradually lower investment in migration destinations (such as the Middle East). This will eventually decrease demand for Nepali migrant workers, leading to a deceleration of remittance inflows and potential external sector stress. It happened already when global fuel prices tanked a few years ago.

What next

Unlike in the past, the Nepali economy is not immune to the global outbreak of Covid-19. Unfortunately, there is little the government can do to mitigate the economic impact owing to limited fiscal space and budget execution capacity.

For now, prioritising preparedness and vigilance by deploying resources as well as allocating more funds to the concerned agencies must be the priority. The goal should be to effectively contain the spread within the country in the most cost-effective way, but without compromising quality and standard healthcare procedures. The government will also have to intensify market monitoring to ensure that suppliers and sectoral cartels do not artificially raise prices taking advantage of market uncertainty. It will aggravate cost-push inflation in the face of supply disruption. Perhaps it also makes sense for the government to lower its GDP growth target in light of the impact of the coronavirus, and lower than anticipated capital spending and agricultural output. 

Incentives to make India a hub for manufacturing of electronics and components

From The Times of India "Government plans Rs 42,000 crore Make in India boost for mobile phones"

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In one of the biggest incentive schemes to boost domestic manufacturing of mobile phones and their components, the government has worked out a production-linked incentive (PLI) package of nearly Rs 42,000 crore for those making in India, planning to offer a benefit of 4-6% on incremental sales (of goods manufactured locally) for a period of five years.

[...]The electronics hardware manufacturing sector faces the lack of a level-playing field vis-à-vis competing nations… (and) suffers from a disability of 8.5% to 11% on account of lack of adequate infrastructure, domestic supply chain and logistics; high cost of finance; inadequate availability of quality power; limited design capabilities and focus on R&D by the industry; and inadequacies in skill development...

[...]The government plans to offer incentives under the scheme to large contract manufacturers (as defined in the FDI policy circular of 2017) on sale of phones above the invoice value of $200 (a little over Rs 14,000). Those to benefit will include global contract manufacturers such as Foxconn, Flex and Wistron, all of whom are making products in India. However, some companies such as Oppo, Vivo and even Samsung are not too happy as the incentive is for devices with ex-factory price of above $200, and the majority of phones sold by them are below this cost.

[...]The government wants to cut the ballooning bill of electronics imports. It hopes that incentives through the scheme will help create incremental production of Rs 8.2 lakh crore worth of mobile phones and their parts, generate exports of Rs 5.8 lakh crore, while creating 2 lakh fresh jobs and contributing Rs 4,782 crore to the exchequer through direct tax revenue.

[...]The total incentive planned to be given in the first year is around Rs 4,030 crore, in second Rs 6,395 crore, in third Rs 8,760 crore, in fourth Rs 11,790 crore and in fifth Rs 10,820 crore. “With the demand for electronics hardware expected to rise rapidly to approximately $400 billion (approximately Rs 26 lakh crore) by 2025, India cannot afford to bear the rapidly increasing foreign exchange outgo on account of electronics imports...

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Coronavirus affects travel, trade and supply chains worldwide

Eswar Prasad writes in NYT that there is little hope for a global economic rebound in 2020.  Excerpts:

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The spread of the virus is hurting travel, trade and supply chains worldwide. The Baltic Dry Index, a forward-looking indicator of global trade, has fallen by half and oil prices are down by about a quarter so far this year. U.S. stock markets, after initially taking the epidemic’s fallout in stride, are now experiencing a major sell-off.

[...]Financial markets are prone to large, sentiment-driven swings that sometimes seem out of line with economic fundamentals. But the news of the last few days suggests that, rather than coming under control and being confined to China, the outbreak is spreading and could get far worse. Stock markets in the United States and elsewhere are reflecting this reassessment of the epidemic’s future trajectory and the risks it poses.

The notion of this outbreak being a short-lived negative shock to global demand now looks unrealistic. It is not just spending on restaurants and travel that is suffering, but also investment by businesses while they wait for the uncertainty to be resolved. This will have long-term effects on growth even if the outbreak proves short-lived.

The disruption of supply chains, especially those that pass through Asia, is hurting businesses in multiple dimensions. Countries such as China, South Korea and Japan are critical to the supply chains for products ranging from plastic toys to iPhones to high-tech machinery. In these countries, manufacturers can’t get raw materials delivered reliably, are facing worker shortages and are having difficulty shipping out products. Rejiggering supply chains takes months, if not years. If the coronavirus spreads and causes disruptions to other major economies, it could wreak further havoc on supply chains.

[...]There is no easy way out. The Federal Reserve and other central banks could cut interest rates. This might not do much good, as uncertainty will restrain consumer spending and business investment even if cheap loans were available. Government spending might be more potent. Any assistance that reaches small businesses and allows them to stay afloat or goes directly into the hands of low-income consumers will help. But consumers and businesses are as likely to stash away any extra cash as they are to spend it.

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Rethinking advise to emerging markets

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

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

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

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

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

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

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PPP in infrastructure: How and when to use?

In a recent NBER working paper, Engel, Fischer and Galetovic outline when and how to use public private partnerships (PPPs) in infrastructure. Broadly, they argue that PPPs can be used to increase spending and efficiency gains— better maintenance, reduced bureaucratic costs, and filtering white elephants among others. However, governance of PPPs is important, especially appropriate risk allocation and avoiding opportunistic renegotiations.  

PPPs allow governments to increase spending in infrastructure because: (i) investment via PPPs does not contribute to fiscal deficit and add to public debt in the short run, and (ii) such investment is not subject to regulatory oversight and budgetary controls. 

There are tradeoffs too as government has to forgo future stream of tax/toll revenue from projects that are financed via PPPs, which do not require large upfront investment by the government. PPPs are also used to promote private investment in infrastructure to replace an incompetent public sector. Large infrastructure projects require stronger capabilities to mange contracts and execute projects. 

According to the authors of the working paper, the main reasons for opting for PPPs over public provision are:

• Narrow focus and dedicated management (contract with employees governed by private law, incentives to manage infrastructure per contract with public authority, SPV to build and manage projects)
• Bundling (quality of service is contractible and life-cycle approach toward maintenance reduces maintenance and operations costs
• Fewer construction delays (because of the opportunity to charge user feeds or receive government transfers once project is operations)   
• Filtering white elephants (private players will not opt for projects where user fees cannot pay for capital and operational expenditures)
• Avoiding bureaucratic costs (related to rigidities in public spending and corruption)
• Advantages of private financing (mitigate moral hazard by tightly controlling changes in the project’s design and disbursing funds by banks according to project construction timeline/stages)
• Better and less expensive maintenance (continuous maintenance is efficient as intermittent maintenance incurs 1.5 to 3 times the cost of continuous maintenance)

For PPPs to succeed, government should have higher capabilities as financing is more complex and there is scope for opportunistic behavior (long-term contract and dealing with government entities). 

Sometimes government has to bail out PPP projects, thus absorbing all the downside risks. There are also cases of contract renegotiation, which opens up avenue for corrupt practices. This can be avoided by using contracts with better risk allocation (concessionaire bears all the exogenous demand risks but renegotiation is allowed in the case of low realization of demand). For instance, Present-Value-of-Revenue (PVR) contracts have built-in renegotiation condition if demand realization is low, in which case contract term is extended but contract itself is not modified. They authors suggest that careful planning, project design, and project management are vital for successful PPPs. 

On the fiscal implications of PPP projects, they argue that PPPs have been used as a means of evading fiscal spending constraints. The use of off-balance sheet expenditure is often termed as “fiscal illusion”. The debt is recorded as financial liability but does not become a part of budget itself over short to medium term. The authors argue that the advantage of PPPs should lie in efficiency gains, not only fiscal accounting gimmickry to increase spending.

India’s GVC integration

Despite having immense possibilities in manufacturing sector (large and relatively cost competitive workforce, domestic market, etc), India is still lagging behind and is not well integrated into global value chains. Manufacturing sector accounts for about 18% of GDP. 

A recent ICRIER working paper asserts that the low integration into GVCs is due to the focus on domestic market, and the limited role played by lead firms. On a flipside, since India is less integrated in GVCs, it is also relatively less affected by the GVC disruptions caused by the COVID-19 outbreak. However, second round investment effects may still affect the Indian economy. 

GVC forms the bedrock of trade in intermediate goods and services and fragmentation of production across factories and countries. Trade in intermediate goods account for about two-third of international trade. However, only a limited number of emerging economies take a lead in supplying intermediate inputs. Size of a country and natural resources endowment, skills and competitiveness, industrialization level and structure, exports composition, standards, policy and institutional environment (including trade and infrastructure) and the positioning in value chain determines how well a country is integrated in GVC. 

The authors use findings from primary survey of 98 firms across six states conducted between August 2014 and February 2015 in India to argue that the reasons for low participation in GVC are policy focus on the domestic market and the weak lead firms, which essentially define the entire value chain (backward or forward linkages) and sales of final goods and services. Government policy also does not actively promote lead firms. They argue that in 2011 India’s domestic value added in exports was 20% (forward linkages) and foreign value added in gross exports was 25% (backward linkages). Participation index (a combination of the two indicators) was 40%. Unlike its competitors India is not heavily involved in international supply chains of countries such as Japan and the US.  

Integration into and upgrading of GVC is industry-specific. For instance, in chemical industry transfer of production processes and knowledge of technical know-how is proprietary and upgrading requires direct investment in research and development. But in garment industry production processes are standardized and upgrading is enabled by the use of new inputs/raw materials. That said, also note that labor cost arbitrage accounts for only 18% of global goods trade, implying that knowledge-based trade of goods and services is crucial to stay competitive.

The chart below depicts integration and upgrading across sectors and the role of lead firms.

Lead firms speed up lead time (time between placing of order and delivery), standardize production process, and secure preferential transportation and logistics by forging long-term relationship.  They form a network of forward and backward linkages with micro, small and medium enterprises (MSMEs). Think of this one as MNCs such as Ford in automobile and Levi’s in garment. These lead firms nurture backward linked firms by helping them enhance production that meets global standards and is competitive. They do this by supplying product, market and technical information along with skills, specialization and innovation. Better integration into GVCs triggers structural transformation, whereby developing countries move from low value-added to high value-added production (both in terms of output and employment). 

Based on the survey, the authors list some of the barriers to integrating into GVC. These include:

• Regulatory processes: Unfavorable business environment, long delays at ports
• Lack of incentives: Logistics inefficiency, inverted duty structure, access to finance, lack of stable and regular power supply
• Approvals regime: Environment approvals, standards regime
• Others: Labor laws, high taxes, skills shortage

Here is an earlier blog post on services-driven global value chains.

India and “secular dynamism”

Delivering the 8th C.D. Deshmukh Memorial Lecture, IMF first DMD David Lipton argues that the world economy is changing and is continuously facing new threats—2008 global economic upheavals, US-China trade conflict, hard Brexit, secular stagnation in advanced economies but with spillovers in other economies to, aging societies in some economies, etc. Reinvigorating global growth would require structural reforms to boost confidence and investment— from infrastructure investment to tax incentives for innovation, education and health spending, and product and labor market reforms. 

India affects global growth and is affected by global growth too. For instance, India’s sharp slowdown during the first half of FY2020 meant that global growth was also affected. India’s slowdown has most to do with weak domestic demand, falling credit and problems in the financial system. He argues that with right policies and supportive global growth, India could be a source of “secular dynamism”.

Secular stagnation in the advanced economies is caused by “lagging productivity and flagging investment opportunities”. Secular stagnation refers to long-term slowdown or no economic growth in a market-based economy. He argues that we will soon see the next phase of the IT revolution— the impact of big data, artificial intelligence and other innovations on productivity. 

Lipton states that developing countries need to attract capital and technology, but for that they need to be truly "investable". Obstacles for this include opaque and inadequate legal frameworks, corruption and governance shortcomings, and onerous regulations including import restriction. 

In India’s case, services (particularly ITC) have been the driver of productivity growth, and that the economy has the potential to exploit the demographic dividend. 

Currently, Indian economy is constrained by credit availability, financial sector bottlenecks, impaired balance sheets of corporate and finance sectors, slow export growth, and lagging agricultural sector. Unemployment has risen and labor force participation has fallen. 

India take advantage of its comparative advantage in manufacturing by deeper linkages to global value chains. 

• Promote use of foreign intermediate goods in producing exports (lower tariffs on intermediate goods).
• Opportunity to emerge as manufacturing hub as companies assess their production base in China. But, India is lagging ASEAN. 
• A combination of infrastructure investments, a reduction of tariffs and non-tariff barriers, and reforms to encourage the emergence of larger and more productive manufacturers are helpful. 
• Global trade tensions have not affected much but the potential for reverberations through the investment channel is significant over the medium term