Sri Lanka’s economic crisis and unsustainable public debt

The IMF’s latest 2021 Article IV Consultation report on Sri Lanka sheds light on the challenging public debt position and deteriorating macroeconomic indicators. Brief highlights from the report.

Macroeconomic mismanagement

Sri Lanka’s economic outlook is constrained by debt overhang, and large fiscal, current account and balance of payments deficits. Foreign exchange shortage and macroeconomic imbalances are negatively affecting GDP growth, which is expected to be below 3% through 2026. Inflation is expected to be above the target band of 4-6%. High external debt burden mean that international reserves remain inadequate to cover near-term debt service needs (forecast to be enough to cover only 1 month of imports of goods and services till 2026).

Fiscal consolidation with improvements in expenditure rationalization, budget formulation and execution, SOE reforms, cost-recovery energy pricing, and adherence to fiscal rule; and boosting income tax and VAT rates, minimizing exemptions, and revenue administration reforms to raise revenue are recommended. Monetary tightening to control inflation, phasing out of direct financing of budget deficit by the central bank, and a gradual transition to market-determined flexible exchange rate to facilitate external adjustment and to rebuild forex reserves are also recommended.

A large drop in tourist arrivals and contraction in manufacturing and services activity contracted real GDP by 3.6% in 2020. Temporary restriction on the use and importation of chemical fertilizer (which affects agricultural output) and the adverse effect of foreign exchange shortages and import restrictions on goods used in industrial activity will mute economic recovery, leading to just 3.6% growth in 2021. 

The 2019 tax cuts, the pandemic’s impact on revenue, and rising expenditures widened fiscal deficit to 12.8% of GDP in 2020 and 11.4% of GDP in 2021. Public debt shot up to 114% of GDP in 2020Q3 owing to large fiscal deficits and new sovereign guarantees to cover losses of Ceylon Petroleum Corporation (CPC). Public debt comprises central government debt, guaranteed debt and the CBSL’s foreign liabilities. 

The central bank (CBSL) has financed a part of large fiscal deficits. As the government’s net domestic financing requirements increased to about 12.3% of GDP in 2021, up from an average of 3.4% over 2010-19, the authorities temporarily introduced explicit interest rate caps for the primary market in mid-2020 with auction shortfalls covered by the central bank. Consequently, net credit to the government increased by 9% of GDP between March 2020 and November 2021. Banks’ claims on the government and SOEs is around 40% of total bank assets. The interest rate caps on treasury securities auctions were removed in August 2021. 

Exchange rate deprecation, supply shortages, increase in administered fuel and food prices (reflecting higher international prices), and a recovery in demand thanks to expansionary fiscal and monetary policies have overshot inflation to beyond the target band of 4-6%. Private sector wages and inflation expectations are on the rise. A rise in fuel prices and a recovery in imports demand amidst recovering tourism income and flat remittance inflows widened current account deficit, which is expected to be 3.1% of GDP in 2021. 

The CBSL fixed the official exchange rate at LKR 200-203 per US dollar since April 2021. It required surrendering of forex earnings through exports and converted remittances, and direct forex sales to cover essential imports. However, it led to sizable imbalances in spot and forward markets, forex hoarding, and severe dollar shortages for importers. Parallel market exchange rate is 20% higher than the fixed rate.

Foreign exchange reserves are critically low, reflecting pre-pandemic fiscal slippage, preexisting debt vulnerabilities, and the impact of the pandemic. Sri Lanka’s sovereign credit rating is CCC and lower, leading to loss of access to international capital markets to roll over maturing international sovereign bonds. Gross international reserves declined from $7.6 billion at end-2019 to $3.1 billion at end-2021 and then to $2.4 billion at end-January 2022. Net international reserves position is negative since November 2021.  

Note that Sri Lanka underwent an adjustment program with IMF (Extended Fund Facility) in 2016 due to unbalanced macroeconomic policies and difficult external environment. Prudent monetary policymaking, fiscal consolidation, income tax law, and an automatic fuel pricing mechanism were rolled out. However, the 2017 drought, the 2018 political crisis, and the 2019 terrorist attack created complications in EFF implementation. Fiscal consolidation was reversed in 2019, currency depreciated in 2018, and a real interest rate shock shot up public debt to GDP ratio from 84% in 2016 to 94% in 2019. Income tax and VAT rates were cut in 2019 (revenue losses exceeded 2% of GDP), automatic fuel pricing mechanism was discontinued, leading to high fiscal risks from SOE losses. 

Unsustainable public debt

The IMF considers that Sri Lanka’s public debt is unsustainable. Public debt and gross financing needs are estimated to reach 118.9% of GDP and 30.1% of GDP, respectively, in 2021. The country will have to undergo substantial adjustment for fiscal consolidation. External debt service is projected to remain around $7-8 billion over the medium-term. $1 billion international sovereign bonds are maturing in July 2022. Large debt overhang, and persistent fiscal and BOP financing shortfalls will constrain growth and jeopardize macroeconomic stability. Without permanent revenue measures and market access, the binding fiscal constraint will force the government to cut capital spending. Fiscal deficit will remain elevated above 9% of GDP, gross reserves will be critically low at around 1 month of imports over 2022-26, growth will stay below the potential (estimated in the range of 3.1-4.1% absent structural reforms) through 2026, and inflation will exceed the CBSL’s target band in 2022-24 and put pressure on exchange rates. 

The IMF concludes that Sri Lanka cannot refinance its debt in an orderly manner and its current fiscal policies are unsustainable. Public debt will increase to 125.3% of GDP in 2026 and interest payments will remain above 70% of tax revenue. Fiscal financing needs exceed the domestic financial system’s capacity. Sovereign spreads have increased the international rating agencies have downgraded its bonds to CCC or lower. The CBSL provided 3.5% of GDP in direct financing in 2020 and around 5% of GDP in the first three quarters of 2021. Meanwhile, contingent liabilities of SOEs could materialize soon. CEB and CPC’s balance sheets remain highly exposed to currency fluctuations. Their operational losses are going to increase if retail prices are not reflective of cost. Sri Lankan Airlines is already in distress. Excessive adjustment is required to take fiscal consolidation to a level that will make debt sustainable but is unlikely (primary deficit has to come down from 4.9% of GDP in 2021 to 2.8% of GDP in 2022 and then 1.8% of GDP in 2026 under the baseline scenario).

The IMF recommends implementation of a credible and coherent strategy to restore fiscal and debt sustainability and regain macroeconomic stability over the medium-term. Specifically,

1) Revenue-focused fiscal consolidation, tight monetary policy, transitioning to a market-determined exchange rate, mitigating adverse impact of macroeconomic adjustments on vulnerable groups by strengthening social safety nets, revamping fiscal rule, etc.

• Fiscal consolidation should achieve a primary balance of zero by 2024. 
• Strengthen corporate and personal income tax (CIT and PIT) by minimizing exemptions, raising rates, and reinstating mandatory withholding requirements under the Inland Revenue Act 2017. Multitude indirect taxes renders tax system unpredictable and complex, and high para-tariffs hinder competitiveness and growth. 
• Shift towards risk-based compliance management, strengthen large-taxpayer unit, and digitize revenue administration. Strengthen Customs and Excise Departments. 
• Expenditure rationalization by scaling-back of non-priority expenditure, greater spending efficiency, and an overarching strategy to manage public wage bill are also helpful, but higher revenue mobilization is more critical. 
• Cost-recovery based energy pricing is needed to mitigate fiscal risks from SOEs. Retail fuel and electricity prices are set below cost-recovery levels on discretionary basis, resulting in high debt overhang of CPC and CEB and restricting new investment. Automatic fuel and electricity pricing mechanism are recommended. An overarching strategy is needed to address high SOE debt and growing currency mismatches on energy SOEs’ balance sheets.
• Improvements in budget formulation and execution procedures are needed to support fiscal consolidation. Revenues should not be overestimated and interest payments underestimated to provide unrealistic assessment of resource availability. Expenditure arrears are high due to weak internal reporting and commitment control mechanisms. Strengthen the Macro-Fiscal Unit at MOF and adopt the GFSM 2014 fiscal reporting standards. Current fiscal rule should be revamped in line with international best practice to anchor fiscal sustainability.

2) A comprehensive strategy to restore debt sustainability. The IMF notes that fiscal consolidation and macroeconomic policy adjustments alone cannot restore Sri Lanka’s debt sustainability. 

3) Preserve hard-earned price stability and restore a market-based exchange rate.

• Monetary policy tightening is warranted in the near-term to ensure price stability. Private sector wages and inflation expectations are rising, and public sector wage increases are exerting price pressures. 
• CBSL should phase out its direct financing of budget deficits to lower inflation risks. 
• Returning to a market-determined and flexible exchange rate will facilitate external adjustment. This should be carefully sequenced and implemented as a part of a comprehensive macroeconomic adjustment package. This will help in inflation targeting as well.
• External position is weaker than the level implied by medium-term fundamentals and desirable policies. External debt vulnerabilities are high, and the level of reserves remain precariously low. A strong growth-friendly fiscal consolidation, debt sustainability, prudent monetary policy accompanied by exchange rate flexibility, boosting forex reserves to adequate level, structural reforms to boost export capacity and to encourage FDI are helpful.

4) Ensure financial sector stability. Debt overhang and persistent fiscal and BOP financing shortfalls post significant financial stability risks. 

• Sovereign-bank nexus is strong due to the banks’ large exposure to the government and SOEs. Large public borrowing needs could constrain banks’ lending to the private sector and affect growth prospect.
• Sovereign rating downgrades have constrained banks’ access to external financing and import credit.
• Unwinding pandemic related relief measures, monitoring of quality of loans, proactively identifying vulnerabilities through stress testing, and maintaining restrictions on bank profit distribution to ensure capital adequacy are helpful.

5) Strengthen social safety nets in view of needed macroeconomic adjustments. 

• Sri Lanka spends around 0.4% of GDP in social safety nets. There is scope for improving coverage and targeting, but revenue mobilization is critical for creating fiscal space needed for higher social safety net spending. 
• Growth-enhancing structural reforms are needed, especially promoting female labor force participation, creating job opportunities for youth, reducing trade barriers, and improving investment climate. 

Brief highlights from IPCC's Sixth Assessment Report

AR6 Climate Change 2021: The Physical Science Basis, the IPCC’s Sixth Assessment Report submitted by Working Group I is out now. The report includes the most updated physical understanding of the climate system and climate change, and includes regional climate simulations as well. It provides evidence on how and why climate has changed and the effects attributable to human actions. 

Excerpts from the report:

The evidence regarding human influence on warming of atmosphere, ocean and land is unequivocal. Widespread and rapid changes in the atmosphere, ocean, cryosphere and biosphere have occurred.  Observed increases in well-mixed greenhouse gas (GHG) concentrations since around 1750 are unequivocally caused by human activities. Each of the last four decades has been successively warmer than any decade that preceded it since 1850. Global surface temperature in the first two decades of the 21st century (2001-2020) was 0.99 [0.84-1.10] °C higher than 1850-1900. Global surface temperature was 1.09 [0.95 to 1.20] °C higher in 2011–2020 than 1850–1900. 

The likely range of total human-caused global surface temperature increase from 1850–1900 to 2010–2019 is 0.8°C to 1.3°C, with a best estimate of 1.07°C.

Globally averaged precipitation over land has likely increased since 1950, with a faster rate of increase since the 1980s (medium confidence). It is likely that human influence contributed to the pattern of observed precipitation changes since the mid-20th century, and extremely likely that human influence contributed to the pattern of observed changes in near-surface ocean salinity.

Human influence is very likely the main driver of the global retreat of glaciers since the 1990s and the decrease in Arctic sea ice area between 1979–1988 and 2010–2019 (about 40% in September and about 10% in March).

It is virtually certain that the global upper ocean (0–700 m) has warmed since the 1970s and extremely likely that human influence is the main driver. It is virtually certain that human-caused CO2 emissions are the main driver of current global acidification of the surface open ocean.

Global mean sea level increased by 0.20 [0.15 to 0.25] m between 1901 and 2018. It increased by .7 [3.2 to 4.2] mm yr–1 between 2006 and 2018 (high confidence). Human influence was very likely the main driver of these increases since at least 1971.

Global surface temperature has increased faster since 1970 than in any other 50-year period over at least the last 2000 years (high confidence). Temperatures during the most recent decade (2011–2020) exceed those of the most recent multi-century warm period, around 6500 years ago13 [0.2°C to 1°C relative to 1850–1900] (medium confidence).

Human-induced climate change is already affecting many weather and climate extremes in every region across the globe. Evidence of observed changes in extremes such as heatwaves, heavy precipitation, droughts, and tropical cyclones, and, in particular, their attribution to human influence, has strengthened since AR5. It is virtually certain that hot extremes (including heatwaves) have become more frequent and more intense across most land regions since the 1950s, while cold extremes (including cold waves) have become less frequent and less severe, with high confidence that human-induced climate change is the main driver of these changes.

The frequency and intensity of heavy precipitation events have increased since the 1950s over most land area for which observational data are sufficient for trend analysis (high confidence), and human-induced climate change is likely the main driver. Human-induced climate change has contributed to increases in agricultural and ecological droughts15 in some regions due to increased land evapotranspiration (medium confidence).

Decreases in global land monsoon precipitation from the 1950s to the 1980s are partly attributed to human-caused Northern Hemisphere aerosol emissions, but increases since then have resulted from rising GHG concentrations and decadal to multi-decadal internal variability (medium confidence). Over South Asia, East Asia and West Africa increases in monsoon precipitation due to warming from GHG emissions were counteracted by decreases in monsoon precipitation due to cooling from human-caused aerosol emissions over the 20th century (high confidence).

Heating of the climate system has caused global mean sea level rise through ice loss on land and thermal expansion from ocean warming. Thermal expansion explained 50% of sea level rise during 1971–2018, while ice loss from glaciers contributed 22%, ice sheets 20% and changes in land water storage 8%. The rate of ice sheet loss increased by a factor of four between 1992–1999 and 2010–2019. Together, ice sheet and glacier mass loss were the dominant contributors to global mean sea level rise during 2006-2018.

Global surface temperature will continue to increase until at least the mid-century under all emissions scenarios considered. Global warming of 1.5°C and 2°C will be exceeded during the 21st century unless deep reductions in CO2 and other greenhouse gas emissions occur in the coming decades. Global warming of 1.5°C relative to 1850-1900 would be exceeded during the 21st century under the intermediate, high and very high scenarios considered in this report (SSP2-4.5, SSP3-7.0 and SSP5-8.5, respectively).

Many changes in the climate system become larger in direct relation to increasing global warming. They include increases in the frequency and intensity of hot extremes, marine heatwaves, and heavy precipitation, agricultural and ecological droughts in some regions, and proportion of intense tropical cyclones, as well as reductions in Arctic sea ice, snow cover and permafrost. Every additional 0.5°C of global warming causes clearly discernible increases in the intensity and frequency of hot extremes, including heatwaves (very likely), and heavy precipitation (high confidence), as well as agricultural and ecological droughts in some regions (high confidence).

Monsoon precipitation is projected to increase in the mid- to long term at global scale, particularly over South and Southeast Asia, East Asia and West Africa apart from the far west Sahel (high confidence). A warmer climate will intensify very wet and very dry weather and climate events and seasons, with implications for flooding or drought (high confidence). It is very likely that rainfall variability related to the El Niño–Southern Oscillation is projected to be amplified by the second half of the 21st century.

From a physical science perspective, limiting human-induced global warming to a specific level requires limiting cumulative CO2 emissions, reaching at least net zero CO2 emissions, along with strong reductions in other greenhouse gas emissions. Strong, rapid and sustained reductions in CH4 emissions would also limit the warming effect resulting from declining aerosol pollution and would improve air quality.

The likelihood of an outcome is expressed in the following way: virtually certain 99–100% probability, very likely 90–100%, likely 66–100%, about as likely as not 33–66%, unlikely 0–33%, very unlikely 0–10%, exceptionally unlikely 0–1%. Additional terms such as extremely likely 95–100%, more likely than not >50–100%, and extremely unlikely 0–5% are also used. A level of confidence is expressed using five qualifiers: very low, low, medium, high and very high.

South Asia

• Heatwaves and humid heat stress will be more intense and frequent during the 21st century (medium confidence)
• Both annual and summer monsoon precipitation will increase during the 21st
• century, with enhanced interannual variability (medium confidence).
• Over most of the Hindu Kush Himalayan region, snow cover has reduced since the early 21st century, and glaciers have retreated and lost mass since the 1970s.
• The Karakoram glaciers have remained either in a balanced state or slightly gained mass. During the 21st century, snowcovered areas and snow volumes will decrease in most of the Hindu Kush Himalayan, and snowline elevations will rise and glacier volumes will decline (high confidence).
• A general wetting across the whole Tibetan Plateau and the Himalaya is projected, with increases in heavy precipitation in the 21st century.
• Extreme precipitation is projected to increase in major mountainous regions (medium to high confidence, depending on location), with potential cascading consequences of floods, landslides and lake outbursts in all scenarios (medium confidence).
• With few exceptions, mountain glaciers have retreated since the second half of the 19th century (very high confidence). This retreat has occurred at increased rates since the 1990s, with human influence very likely being the main driver. This behaviour is unprecedented in at least the last 2,000 years (medium confidence). Furthermore, glaciers will continue to lose mass at least for several decades even if global temperature is stabilized (very high confidence).
• Mountain glaciers will continue to shrink and permafrost to thaw in all regions where they are present (high confidence). Mountain glaciers are projected to lose more mass in higher greenhouse gas emissions scenario over the 21st century (medium confidence).
• It is virtually certain that snow cover will decline over most land regions during the 21st century, in terms of water equivalent, extent and annual duration.

Differences in consumption aggregates and poverty estimates in South Asia

In a paper published in the latest edition of Asian Development Review (Vol.38. No.1), Islam, Newhouse and Yanex-Pagans study how differences in the construction of consumption aggregate in South Asian countries contribute to total error (arising out of nonsampling error and the error in the process of determining the international poverty line) in international extreme poverty measurement. Methodology and questionnaire for household survey differ among the countries, contributing to total error of the subsequent international extreme poverty line obtained for each country. They examine how sampling and survey design; spatial deflation to account for cost-of-living differences and intertemporal deflation; and construction of nominal consumption aggregate contribute to total error. 

Some factors that affect total error are incomplete coverage of the country’s population, errors in measuring consumption data, errors in calculating the poverty line, use of the consumer price index (CPI) to deflate prices in a manner that may not be consistent with the consumption patterns of the poor, and geographic differences in prices.

On sampling and survey design, the paper examines (i) sampling design, (ii) monetary welfare measure, (iii) food consumption questionnaire and data collection methods, (iv) self-production and meals outside home, (v) nonfood durables, (vi) durables, (vii) housing expenditures, and (viii) health and education expenditures. 

Among these, there exists significant differences in the way food consumption data are collected, especially the number of food items in the consumption questionnaire. Inclusion of more food items tend to increase levels of reported consumption, leading to lower reported poverty rate. While Pakistan has the lowest number of food items (69) listed in the survey, Sri Lanka has the highest (227). Bangladesh has 141, Bhutan 130, India 143, Maldives 92, and Nepal 74. For nonfood items, Afghanistan has the lowest number of items (38) and Maldives has the highest number of items (483). India has 338 and Nepal 95. 

Consumption data are collected either using diary method (households record all consumption data over a certain period in a notebook) and/or recall method (households list what they consumed over a specific past reference period). Length of consumption recall is also different. Lowering the recall period have increased reported consumption by households, which resulted in poverty rates falling by half in India. The authors note that “this simple change in the method of collecting data “lifted” 175 million Indians out of poverty”. 

The South Asian countries also have different questionnaires for the value of consumption of self-produced food and meals from outside home. For instance, Bangladesh, Pakistan and Sri Lanka do not account for food expenditures on meals outside the household as a part of their consumption aggregate. Note that consumption of food eaten outside the home is shown to raise extreme poverty rate. Similarly, Maldives and Pakistan do not account for consumer durables, and in Afghanistan and Nepal it is imputed. In the case of housing, all countries except Maldives include actual rent for urban and rural areas. They also include imputed rent except for (India and Maldives). All countries include health and education expenditure (except for Nepal in the case of health expenditure). 

Spatial deflation is used to adjust cost-of-living differences, which lowers the possibility of overestimation of poverty in rural areas and underestimation in urban areas (since an urban household needs to spend more to maintain the same standard of living as that of a rural household). Use of appropriate regional price indexes is important in this regard, but this could be challenging to construct. All South Asian countries do spatial deflation when they calculate their national poverty estimates, but when calculating international extreme poverty rates, the World Bank spatially deflates consumption aggregates in Bhutan and Nepal only. Bhutan uses survey-based price index to deflate prices, but Nepal and Bangladesh use an implicit spatial price index to deflate prices. The authors show that using spatial deflation is important in the case of international extreme poverty estimates, especially given the fact that without spatial deflation urban areas have less poverty and rural areas have more poverty. They recommend collecting regional price data for different durable and nondurable goods, and services. They also suggest collecting rental cost of housing at regional level so that imputation for rental rate of owner-occupied housing could be done suitably. 

A third source of total error is the way standardized consumption aggregates are computed compared to the national consumption aggregates. Here, standardized consumption aggregate refers to the one obtained from the standardized consumption datasets created by the World Bank. It basically reclassifies expenditure items into the various categories used in the International Comparison Program (ICP). However, note that the method of data collection and questionnaire design affect standardization. The authors show slightly different average per capita consumption using the standardized and the national consumption aggregates. Not much difference, but in the case of India there is notable difference because of imputed rents for home owners. Also, standardization decreases housing expenditure in Nepal, Bhutan and Sri Lanka. 

The authors shows that standardization of consumption aggregate also changes share of particular item on total consumption expenditure. In Nepal, while food items account for 57% of national consumption expenditure, the standardized value is a bit less at 53%. Standardization reduces the share of food expenditure in consumption aggregate in all South Asian countries except Sri Lanka. 

The standardization of consumption aggregates increases poverty rate in Bangladesh, Bhutan Pakistan, and Sri Lanka. However, they authors show that it decreases the international extreme poverty rate in India, Maldives and Nepal.  

Developing Asia to grow at the slowest pace since 1961

In the latest edition of ADO Supplement (June 2020), Asian Development Bank projected that developing Asia will grow by 0.1% in 2020 and then by 6.2% in 2021, thanks to a low base effect. This is a sharp downward revision from 2.2% projected in April edition of ADO 2020. 

Lockdowns and the associated decline in mobility outside home have constrained economic activities. External sector also doesn’t look that good because of a deeper contraction in the major advanced economies (the US, the Euro area, and Japan). 

The latest growth projections for developing Asia will be the lowest regional growth since 1961. Contraction is expected in all subregions except East Asia, where PRC and Taipei, China are projected to growth at a positive rate. 

However, recovery in 2021 will not be a V-shaped recovery as continued social distancing may be required amidst recurrent outbreaks. Furthermore, even if an economy succeeds in normalizing domestic activity, external demand will remain weak. ADB states that sovereign and financial crises cannot be ruled out, and social unrest is possible. US-PRC trade tension further exacerbates the situation. 

Uncertainty over the COVID-19 pandemic and the global recession will dampen economic sentiment in many economies. Some key drivers of growth such as tourism and exports (manufacturing) remain subdued.  

ADB projects growth in South Asia to contract by 3% and then recover at a rate of 4.9% in 2021. 

• The Indian economy is expected to contract by 4% in FY2021 and then growth by 5% in FY2022.  PMI index fell to the lowest level in April, reflecting not so rosy outlook for FY2021. Unemployment and exodus of migrant workers from urban areas have dampened demand (perhaps, turn out to be structural as reverse migration may not again reverse as in the pre-COVID era).
• Dip in export earnings and remittances will affect growth in Bangladesh, whose economy is expected to grow at 4.5% in FY2020 and recover to 7.5% in FY2021 (thanks to manufacturing output). 
• Tourism, manufacturing and construction activities are expected to get hit in Bhutan, resulting in growth projection of 2.4% in FY2020 and then 1.7% in FY2021 (as labor shortages hit construction sector, which gets migrant workers from India). 
• In Nepal, the government’s provisional estimate of growth for FY2020 is 2.3%, which will further decline as lockdown continue. Growth in FY2021 is projected at 3.1%.

Inflation will remain at low levels due to depressed demand and lower oil prices.

Remittances to South Asia projected to decline by 22.1% in 2020

The latest Migration and Development Brief from the World Bank projects that global remittances will decline by 19.9% in 2020 due to the economic crisis induced by the COVID-19 pandemic and shutdown. Remittances to low and middle-income countries (LMICs) are projected to fall by 19.7% to $445 billion. The fall in FDI is expected to be much larger. 

South Asia is projected to see 22.1% decline in remittances. It is expected to see mild recovery in 2021 but medium-term downside risks persist. The deceleration of remittance inflows is due to COVID-19 outbreak and oil price decline. 

• In India, remittances are projected to fall by about 23% in 2020, to $64 billion, from a 5.5% growth and receipts of $83 billion seen in 2019.
• Remittances to Nepal are expected to decline by 14%, dropping to about US$7 billion in 2020.
• Remittances to Sri Lanka are expected to decline by 19%, dropping to about US$5.5 billion. 
• In Bangladesh, remittances are projected at $14 billion for 2020, a likely fall of about 22%.
• In Pakistan, the projected decline is also about 23%, totaling about $17 billion, compared with a total of $22.5 billion in 2019, when remittances grew by 6.2%.

The COVID-19 presents particular challenges:

1. Economic crisis could be longer, deeper and more pervasive than the recent growth estimates. The decline in fuel prices and lockdowns have affected sectors that depend on migrant workers in host countries. Migrant workers are more vulnerable to employment and wages losses in host countries.
2. It has disproportionately affected food and hospitality, retail and wholesale, tourism and transport, and manufacturing. 
3. Developed countries that depend on migrant workers in agriculture sector will face labor shortages when farming season begins. 
4. Cross-sectoral mobility of workers is affected. It is hard for low-skilled migrant workers to move to other sectors. During the global financial crisis in 2009, many migrant workers moved from construction to agriculture and retail. Now, health and information technology require high and specific skills, which is missing among many migrant workers.
5. Internal migrants without access to housing, basic water and sanitation, health facilities, or social safety nets are more vulnerable to the crisis, especially lockdowns, travel bans, and social distancing measures.

COVID-19 induced recession worst since the Great Depression

In the latest World Economic Outlook (April 2020), the IMF projected global growth to contract sharply to -3% in 2020. The cumulative loss to global GDP over 2020 and 2021 from the pandemic crisis could be around 9 trillion dollars, greater than the economies of Japan and Germany, combined. For the first time since the Great Depression both advanced economies and emerging market and developing economies are in recession. It argues that many countries face a multi-layered crisis comprising a health shock, domestic economic disruptions, plummeting external demand, capital flow reversals, and a collapse in commodity prices.

Under the assumption that the pandemic and required containment peaks in the second quarter for most countries in the world, and recedes in the second half of this year, in the April World Economic Outlook the IMF projects global growth in 2020 to fall to -3 percent. This is a downgrade of 6.3 percentage points from January 2020. This makes the Great Lockdown the worst recession since the Great Depression, and far worse than the Global Financial Crisis.

Assuming the pandemic fades in the second half of 2020 and that policy actions taken around the world are effective in preventing widespread firm bankruptcies, extended job losses, and system-wide financial strains, the IMF projects global growth in 2021 to rebound to 5.8 percent.

In an adverse scenario, the pandemic may not recede in the second half of this year, leading to longer durations of containment, worsening financial conditions, and further breakdowns of global supply chains. This could mean even greater fall in global GDP: an additional 3 percent in 2020 (below the baseline in 2002) if the pandemic is more protracted this year, while, if the pandemic continues into 2021, it may fall next year by an additional 8 percent compared to our baseline scenario.

The IMF recommends that countries continue to spend generously on their health systems, perform widespread testing, and refrain from trade restrictions on medical supplies. It also recommends continued support to households and businesses throughout the containment period: credit guarantees, liquidity facilities, loan forbearance, expanded unemployment insurance, enhanced benefits, and tax relief. During the recovery phase, policies should shift to supporting demand, incentivizing firm hiring, and repairing balance sheets in private and public sector. It recommends moratoria on debt repayments and debt restructuring to be continued during the recovery phase too. 

Substantial targeted fiscal, monetary, and financial measures to maintain the economic ties between workers and firms and lenders and borrowers is required to keep intact the economic and financial infrastructure of society. Meanwhile, broad-based stimulus and liquidity facilities to reduce systemic stress in the financial system can lift confidence and prevent an even deeper contraction in demand by limiting the amplification of the shock through the financial system and bolstering expectations for the eventual economic recovery.

INDIA: 

• The IMF has projected India’s economy to grow at 4.2% in 2019/20, 1.9% in 2020/21 and then quickly recover to 7.4% in 2021/22. 
• Inflation is projected to remain low at 3.3% in 2020/21 and 3.6% in 2021/22. 
• Current account balance is projected to narrow to -0.6% of GDP in 2020/21 and then increase to -1.4% of GDP in 2021/22.

NEPAL:

• The IMF has projected Nepal's economy to grow at 2.5% in 2019/20 and 5% in 2020/21. 
• Inflation is projected to remain at 6.7% in FY2020 and FY2021. 
• Current account balance is projected to be -6.5% in FY2020 and -6.2% in FY2021.

Policy measures for the immediate-term:

• Sizable, specific, temporary, and targeted fiscal measures to cushion the impact on the most affected households and businesses, and to preserve economic relationships (by reducing firm closures). Digital payments may improve the delivery of targeted transfers to the informally employed.
• Central banks can provide ample liquidity to banks and nonbank finance companies, and credit guarantee on loans to SMEs. It could also encourage banks to renegotiate loan terms for distressed borrowers without lowering loan classification and provisioning standards. Beyond conventional interest rate cuts, expanded asset purchase programs may be helpful. 
• Broad-based fiscal stimulus such as public infrastructure investment or across-the-board tax cuts can help to boost confidence, stimulate aggregate demand, reduce bankruptcies and avert an even-deeper downturn. 
• Flexible exchange rates should be allowed to adjust as needed. Temporary capital flow measures on outflows could be useful.

Policy measures for the recovery phase:

• Secure swift recovery as even after the containment phase, uncertainty about contagion could subdue consumer demand. Firms will hire staff and utilize capacity gradually. Hiring subsidies may be required and worker retraining programs may alleviate labor market friction. Scaling back targeted, temporary measures may be warranted. 
• Balance sheet repair and debt restructuring may be required. Banks and regulators should encourage early and proactive recognition of nonperforming loans. Steps to strengthen the insolvency and debt enforcement framework, and measures to facilitate the development of a distressed debt market could be helpful.
• Strong multilateral cooperation is a must, especially on international trade and multilateral assistance.

GDP growth to decline 2.8% in FY2020 in Nepal and in FY2021 in India

In its latest South Asia Economic Focus (April 2020), the World Bank projects a sharp economic slump in South Asia, caused by halting economic activity, collapsing trade, and greater stress in the financial and banking sectors. The WB estimates that regional growth will fall to a range between 1.8 and 2.8 percent in 2020, down from 6.3 percent projected six months ago. Prolonged and broad national lockdowns will push growth in the negative territory. In 2021, growth is projected to hover between 3.1 and 4.0 percent, down from the previous 6.7 percent estimate. 

The WB notes that “the impact of the pandemic will hit hard low-income people, especially informal workers in the hospitality, retail trade, and transport sectors who have limited or no access to healthcare or social safety nets.” It recommends stablishing temporary work programs for unemployed migrant workers, enacting debt relief measures for businesses and individuals, and easing inter-regional customs clearance to speed up import and export of essential goods during the short-term. Over the medium-term, it recommends expansionary fiscal policies combined with monetary stimulus to keep credit flowing in their economies. 

Because of the drying up of tourism, disruption of supply chains, collapsing demand for garments, deteriorating consumer and investor sentiment, withdrawal of international capital, and decreasing remittance inflows, the effect of COVID-19 on South Asian economies is particularly severe. The report argues that the crisis has increased inequality in South Asia because the poor people have a higher likelihood of losing work, and domestic migrant workers are being pushed back to rural areas from where they moved to cities to escape poverty. Food security risks have increased. 

Here is an update on GDP forecast for FY2020:

For Afghanistan a deep recession is expected this year, with a contraction between 3.8 and 5.9 percent. With population growth of 2.3 percent, this implies a dramatic drop in per capita income.

In Bangladesh, with a population growth of 1 percent per year, a limited increase in per-capita GDP is projected for two years. That would be an abrupt change from high growth rates in recent years. Given the variation within the country, it means that significant parts of the population would lose income during these two years. GDP is expected to growth at 2.0% to 3.0%.

In Bhutan, growth is still expected, but the downward revision from Fall forecast is large in both years.

In India, GDP growth in FY2021 is expected to range between 1.5 and 2.8 percent, implying per-capita GDP growth of between 0.5 and 1.8 percent. In FY2020, GDP is expected to grow at 4.8% to 5%.

Most affected is the Maldives, where tourism directly and indirectly contributes two-thirds of GDP, 80 percent of exports and 40 percent of revenues. A contraction of the economy between 8.5 and 13.0 percent is expected in 2020. With population growth of 1.8 percent in 2019, the per-capita income loss will be significant.

Nepal, with population growth of 1.1 percent per year, would experience low per-capita growth for two years in a row. GDP is expected to grow at 1.5% to 2.8% in FY2020. In FY2021, GDP is expected to grow at 2.7% to 3.6%.

For Sri Lanka a recession is anticipated, with annual growth estimated between -3.0 and -0.5 percent.

Pakistan, which has already experienced low growth rates in recent years, could well fall into a recession. With 1.8 percent population growth, that would imply a painful decline in per-capita income.

Latest trade policy review of Nepal

The WTO has released the latest trade policy review of Nepal (prepared by WTO here and by Nepal here). The last review was done in 2012. Nepal has updated its trade policy and export strategies and investment as well as labor legislation since then. However, there is not much to show in terms of its effect on industrial output and exports growth, which suffers from supply-side constraints and inadequate trade facilitation measures. 

Nepal became a member of the WTO on 23 April 2004 when it became the first LDC to join the WTO through the full working party negotiation process. It is also a member of two overlapping regional free trade agreements: South Asia Free Trade Area (SAFTA), and Framework Agreement on the Bay of Bengal Initiative for Multi-Sectoral Technical and Economic Cooperation (BIMSTEC). Nepal has bilateral trade agreement with 17 countries. The transit and trade treaty, railways services agreement and an agreement on cooperation to control unauthorized trade with India are the most consequential ones. The transit treaty with India allows Nepal to trade with other countries through Kolkata/Haldia ports and Vishakapatnam port (since 2016).

Here are some of the highlights from the TPR:

1. Exports have declined since the last review, but imports have more than doubled. Almost two-thirds of export and imports occur with India. As a share of total imports, agricultural (19%), iron & steel (9.7%), non-electrical machinery (8.5%), and transport equipment (8.9%) imports increased. Manufacturing import's (i.e. total minus agricultural and mining imports) share increased from 54.3% to 59.2% over the review period. 

2. Nepal updated its trade policy in 2015 and Nepal Trade Integration Strategy in 2016. MoICS is responsible for implementing trade policy, but MOF has the final say in setting tariffs. Trade related legislation covers customs, export and import licensing, TBTs, SPSs, competition policies, investment regimes, competition policies, government procurement, and intellectual property rights.

3. NTIS 2016 provides the foundation for the implementation of trade policy 2015. It identifies 12 strategic area goods and services: large cardamom, ginger, tea, medicinal and aromatic plants, fabrics textiles yarns and ropes, leather, footwear, chyangra pashmina, knotted carpets, skilled and semi-skilled professionals, IT services and BPO, and tourism. Seven cross costing areas are trade capacity (including trade negotiations), trade and investment environment, trade and transport facilitation, standards and technical regulations, sanitary and phytosanitary standards, intellectual property rights, and trade in services. NTIS 2016 identified 190 actions to be implemented by 2020. 

4.  The bilateral trade and transit treaty with India allows each other unconditional MFN treatment and exemption from customs duties and quantitative restrictions on a reciprocal basis on a mutually agreed list of primary products. Nepal gets non-reciprocal access (no customs duties and quantitative restrictions) of its industrial products to the Indian market except for vegetable fats, acrylic yarn, zinc oxide and copper products under HS headings 74 and 8544. These four products face tariff quotas. The EU provides duty-free and quota-free access to Nepalese exports under its Everything But Arms (EBA) initiative. Nepal is beneficiary under the GSP schemes of Australia, Canada, the European Union, the Eurasian Economic Union, Iceland, Japan, Kazakhstan, New Zealand, Norway, Switzerland, Turkey and the United States. The US is providing duty-free treatment for 779 products to help the country expand its trade and economic development following the devastating earthquakes in 2015. This unilateral preferential agreement started on 30 December 2016 and will last until 21 December 2025. China and Nepal also signed a bilateral agreement on transit transport in March 2016.

5.  FITTA 1992 and IEA 2016 provide the legal basis for regulating, administering and facilitating FDI. There many other laws related to banking, environment, and labor among others that also affect investment. The Company Act, 2006 (as amended in 2017) simplifies and makes the process of establishing, managing and administering companies more convenient and transparent. The Industrial Enterprises Act (amended in 2016) is simplifies and clarifies the procedures for the entry, operation and exit of industrial enterprises. The SEZ Authority Act 2016 provides incentives for investors establishing firms within a SEZ: full tax exemption for first five years, income tax rebates, dividend tax exemption, VAT facility, and custom duty exemptions among others. Investment Board of Nepal and Department of Industry facilitate and approve investment proposals depending on the amount of investment or as specified in respective laws.

6.  There are eight MFN tariff bands: duty-free, 1%, 5%, 10%, 15%, 20%, 30% and 80%. As of 2018/19, there are 5,572 tariff lines at the eight-digit level based on HS2017 nomenclature. The simple average applied MFN tariff (excluding ad valorem equivalents for specified duties) decreased from 12.2% in 2011/12 to 12% in 2018/19. Including ad valorem equivalents, the simple average applied MFN tariff in 2018/19 is 12.4%. The highest ad valorem rate of 80% applies to two tariff lines related to tobacco, along with motor vehicles, and arms and ammunition products.  

7. Tariffs have been increasing, with an average tariff of 9.3% on raw materials (first stage of processing), 11.4% on intermediate goods, and 13.8% on finished goods.  

8. Nepal bound 54 tariff lines at HS eight-digit level, with overall average bound tariff of 26.6%. The average bound tariff for agricultural products is 42.9% and for non-agricultural products 23.9%. However, applied tariffs (average 12.4%) are much lower than the average bound rate except for 38 tariff lines. These are mainly chemical products and some machinery including motor vehicles. 

9. The simple average tariff rate for SAARC members is 9.5% (for non-SAARC members its 12.4%). For agricultural products the average preference margin is 2.2 percentage points compared to the applied MFN tariffs, and for non-agricultural products its 2.9 percentage points. 

10. Other duties and charges imposed by Nepal include an agricultural reform fee of 5% (or 8% on some products) on selected agricultural products imported from India and Tibet Autonomous Region of China; and a road maintenance and reform fee of NRs4 per liter for import of petrol and NRs2 per liter for diesel. A customs service fee of NRs565 per declaration is charged o import consignments worth over NRs5,000. VAT and excise duties are also levied at customs points.

Nepal ranked 109 out 140 economies on economic competitiveness

The World Economic Forum has published an updated version of its global competitiveness rankings by including potential of and opportunities from rapid technological change (dubbed as the Fourth Industrial Revolution [4IR]), which is also one of the critical factors for higher productivity and an important determinant of long-term growth and income.

The new report is named Global Competitiveness Report 2018 (GCI 4.0 2018) and includes a number of new, critically important factors such as entrepreneurial culture, companies embracing disruptive ideas, multistakeholder collaboration, critical thinking, meritocracy, social trust. These factors complement traditional components such as ICT and physical infrastructure, macroeconomic stability, property rights, and years of schooling. They together enhance human capital, innovation, resilience and agility. This year’s report also introduces a new benchmark that scores an economy from 1 to 100 (the largest figure being called the frontier that each country should aspire to reach).

The index includes 98 indicators grouped into 12 pillars of competitiveness: Institutions; Infrastructure; ICT adoption; Macroeconomic stability; Health; Skills; Product market; Labour market; Financial system; Market size; Business dynamism; and Innovation capability. Some of the pillars of competitiveness are the same as in the previous reports, but some are different or regrouped (especially those to do with ICT and innovation).

The 2018 ranking is not compatible with rankings in the past. However, they include backcasting estimation for 2017 that can be compared with 2018 edition. The logic behind the change in competitiveness scoring is that the pathway to prosperity through progressive industrialization by leveraging low-skilled labor is now diluted by the advent of the 4IR. The cost of technology and capital is lower than ever (but would still require a number of other factors for adoption). It calls for a holistic approach to competitiveness, as a good performance in one pillar doesn’t make up for a poor performance in another (investing in technology without investing in digital skills will not yield meaningful productivity gains). All pillars are weighted equally rather than according to a country’s current stage of development.

With a score of 85.6, the United States is the closest economy to the frontier, the ideal state (100), where a country would obtain the perfect score on every component of the index. The other in top 10 are: Singapore, Germany, Switzerland, Japan, Netherlands, Hong Kong SAR, the United Kingdom, Sweden and Denmark.

South Asia

In South Asia, all economies need to enhance innovation capacity, technological readiness and address the usual development constraints related to institutions, infrastructure and skills. In ICT adoption and innovation capability, the region lags behind from the rest of the world (although India is an outlier with 31st rank).

India leads the region in all areas of competitiveness except for health, education and skills, where Sri Lanka boasts the highest life expectancy (67.8 years) and the workforce with the highest amount of schooling (9.8 years). The report notes that India has invested more heavily on transport infrastructure and services, while Sri Lanka has the most modern utility infrastructure. The quality of Indian research institutions stands out in the region.

In South Asia, India ranks 58th (up five places compared to 2017 backcast edition), followed by Sri Lanak (rank 85), Bangladesh (rank 103), Pakistan (rank 107), and Nepal (rank 109). All countries in the region, except India, saw their rank deteriorate compared to the 2017 backcast estimate. 

Nepal

Nepal is the least competitive country in South Asia. It ranks 109 out of 140 economies included in the report. In none of the four broad components it ranked below 100. Its overall comparable rank in 2017 was 108.

In enabling environment component, it ranks 108 out of 140 economies. Within this component, the ranking on institutions is 98, infrastructure 117, ICT adoption 101, and macroeconomic stability 96.

• Within institutions pillar, the worst ranking is on quality of land administration (133) and intellectual property protection (122). The ranking on organized crime is also pretty bad. The beast ranking is on shareholder governance.
• Within infrastructure pillar, the ranking is the worst: above 100 in all of the subcomponents (except for airport connectivity, on which it ranks 75).
• Within ICT adoption pillar, the best ranking is on mobile cellular telephone subscriptions per 100 people (57) but fares worst in internet subscriptions and users.
• Within macroeconomic stability pillar, it ranks 116 in inflation and 82 in debt dynamics (this one was one of the best in previous reports but looks like the fast accumulation of debt is a factor here)

In human capital component, it ranks 103 out of 140 economies. Within this component, the ranking on health is 102 and skills 106.

In markets component, it ranks 105 out of 140 economies. Within this component, the ranking on product market is 130, labor market 125, financial system 58, and market size 84.

In innovation ecosystem component, it ranks 105 out of 140 economies. With this component, the ranking on business dynamism is 98 and innovation capacity 110.

Despite the importance of 4IR now, for many of the low-income countries (also least competitive ones), the main causes of slow growth and low level of prosperity continues to be ‘old’ development issues such as institutions (security, property rights, social capital, checks and balances, transparency and ethics, public-sector performance and corporate governance), infrastructure (road, rail, air, electricity, water connectivity) and skills (education, critical thinking). They cannot ignore these issues and hope to achieve technology-based leapfrogging.

For non-least competitive economies, the policy approach should incorporate 4IR. For instance, investment in broader measures of competitiveness today to sustain growth and income in the future; enhancing the fundamentals of competitiveness today to improve resilience to shocks; supporting those who lose out to globalization; enhancing agility and future-readiness; ensuing effecting institutions to promote competitiveness; strengthening financial system; and proactive, far-sighted leadership.