Overview of Nepal’s FY2015 budget

Here is brief snapshot of the FY2015 budget, which has rightly focused on two fundamental issues: (i) public infrastructure investments, and (ii) enacting new Acts and amending existing ones to accelerate public expenditure and to attract private sector investments. However, given the coalition government and its constraints, understandably the budget could not give much attention to rationalization of expenditures.

The total planned outlay is NRs618.1 billion, of which 64.5% is recurrent, 18.9% is capital and the rest 16.6% is financial provision. The total expected revenue is NRs497.3 billion, of which 85% is expected to come from revenue mobilization, 14.8% from foreign grants, and the rest 0.2% from principal repayment. This leaves with a gross budget deficit of Nrs120.8 billion. Now, this is to be financed by a combination of foreign loans, domestic borrowing and FY2014 savings in the ratio 41:43.7:15.3.

FY2015 budget overview
GDP growth target (%)	6
Inflation target (%)	8
Budget allocation for FY2015	FY2015BE
	Rs billion	%
Budget allocation	618.1	100
Recurrent	399.0	64.5
Capital	116.8	18.9
Financial provision	102.4	16.6
Projected total revenue	497.3	100
Revenue	422.9	85.0
Foreign grants	73.4	14.8
Principal repayment	1.0	0.2
Projected budget surplus (+)/deficit (-)	-120.8
Projected deficit financing	120.8	100
Foreign loans	49.5	41.0
Domestic borrowing	52.8	43.7
FY2014 savings	18.5	15.3

On the composition of expenditure, revenue and deficit financing, two issues merit attention:

First, FY2014’s expenditure absorption rate was lower than FY2013’s despite the full budget. Okay, election related assignments slowed down expenditure related activities, but this doesn’t fully justify the lower absorption rate during better times. It indicates bureaucratic and government slackness and complacency— not good for a developing country with tremendous infrastructure investment needs.

About 89.6% of planned recurrent expenditure was spent in FY2014. Worse, about 75.1% of planned capital expenditure (lower than 82.6% in FY2013) was spent in FY2014. Hence, without much changes in the existing budget approval and execution setups, it is hard to believe that all of the planned capital expenditure will be spent in FY2015. And, the promised reform measures and amendment to Acts will take time (i) to complete the web of processes required to be before it reaches for debate in the CA, and (ii) after that implementation would also take time as policy and institutional arrangements are need for execution. So, it will set the stage for coming years, but potentially not impact this year’s expenditure figures.

Second, the most important thing that is missing in the FY2015 budget discussion is the accounting aspect. The government is using FY2014 fiscal savings equivalent to NRs18.5 billion to finance a part of the deficit, as mentioned in the budget speech. But then in the annex, this portion is included in the revenue heading (see the screenshot above). In FY2014’s budget, this was not the case even if there was a budget surplus in FY2013.

Now, as far as I understand, it is a bad practice to include last year’s fiscal savings as this year’s revenue. Ideally, this kind of savings should go to a trust fund to finance big infrastructure projects that face financing gap, and should be handled separately and independently. Or it could go to clear outstanding debt if debt burden is high, which for now is not the case as total public debt is just about 30% of GDP.

Treating such fiscal savings as revenue lowers deficit figures even when the government has to finance ballooning expenditure that are not met by usual trend of revenue growth. Note that lower deficit is a common yardstick for fiscal stability. Playing with numbers without much public clarity on the processes in order to show good fiscal standing may not be a standard practice.

Most of the expenditure items in FY2015 are recurrent in nature (even shoddy capital expenditure this year drains out a lot of money next year as more money has to be put in for asset maintenance—eventually becomes recurrent expenditure). If there are no fiscal savings this year then there will be pressures to bear more deficits in FY2016 (unless expenditure growth slows down along with higher growth rate of revenue mobilization—both unlikely as things stand right now).

Furthermore, the higher public expenditure threshold each year elevates inflationary expectation even if the actual expenditure is lower than planned expenditure at the end of the year. Higher inflationary expectations are already embedded in people’s consumption behavior, and household financial decision-making. Hence, the sticky prices at high levels for the last few years.

The baseline is that by treating last year’s savings as revenue this year, I think, a potentially bad fiscal accounting precedent is being set. Last year’s revenue mobilization were governed by last year’s finance bill, and this year’s revenue mobilization will be guided by this year’s finance bill, unless the latter explicitly specifies FY2014 savings as FY2015 revenue. Even this this is not a good practice. It creates issues with net fiscal deficit and net borrowing computations as well. These savings should not be used to finance uncontrollable recurrent expenditures. Correct me if I am wrong.

That said, there are a lot of good stuff in the budget. No point listing them all here in short blog post. Read them all here. For more specifics on expenditure headings, see this.

Twin troubles in Nepal’s tourism sector

Here is an article, written by Deepak Adhikari, about the troubles faced by the travel and tourism sector following the deadly avalanche on Everest’s Khumbu Icefall and the closing down of casinos.

Excerpts from the article:

---

[…]The unprecedented halt to climbing on Everest, the world's highest mountain, has dealt a serious blow to Nepal's tourism industry, still recovering from a decade-long Maoist insurgency which ended only in 2006. But the mountaineering dispute is not the only area of conflict in the country's troubled travel and tourism sector.

Hopes of a casino-led gambling boom have faded as all 10 of the country's casinos have either shut for lack of business or closed their doors in a row over government regulations. The national tourism board has only recently reopened after months of conflict with private businesses alleging official corruption and incompetence.

[…]According to the tourism ministry's mountaineering industry division, 300 climbers from 32 expedition teams were at the Everest base camp when the avalanche struck. They promptly left the country. Another 500 had received permits to climb Everest and nearby mountains Lhotse and Nuptse in the spring season. These cancelled their Nepal visits outright.

[…]Chandan Sapkota, a Kathmandu-based economist, said the Everest problems could even force some Nepalis to emigrate. "The slowdown in this sector affects government revenue, foreign exchange earnings, seasonal employment, hotel and restaurant businesses in key tourist hubs around the country, trekking activities, and the aviation sector," he said. "If the slowdown persists, then in the absence of alternative employment opportunities, low-skilled workers might be forced to seek employment abroad."

Travel and tourism contributed more than 8% to Nepal's gross domestic product in 2013, according to the World Travel and Tourism Council, based in London. By some estimates, more than a million Nepalis are directly or indirectly employed by the travel and tourism sectors.

[…]Alongside the problems in the mountaineering industry, however, Nepal is also facing a crisis in its 40-year-old gaming industry. Seven of the 10 casinos shut in April after the operators failed to comply with new regulations introduced in 2013. Three closed last year -- two because of the revised rules and one after a labor dispute.

The new rules require casinos to have paid-up capital of at least $2.5 million, with a minimum of $1.5 million for the country's 17 slot parlors, known as mini-casinos, which are located along the porous Indian border. All of these also shut their doors because of the new regulations. There is also a new annual license fee, paid to the tourism ministry, set at about $207,000 for casinos and just over $100,000 for mini-casinos.

[…]Bhatta said the overstaffing was worsened by further hiring forced by the Maoists, who in the case of one casino forced it to hire 200-300 people from 2008 to 2009. The Maoists' demands "proved damaging to an already overstaffed operation," Bhatta said, estimating the excess labor force at about 40%.

[…]Officials say that about 11,000 casino employees have lost their jobs. But there is also a serious impact on the wider tourism industry. The casinos drew an estimated 150,000 tourists a year, filling about 15% of rooms in five-star hotels in Kathmandu. Occupancy levels are down by about 10%, according to analysts.

---

Macroeconomic performance of Indian economy in FY2014

This blog post discusses FY2014 macroeconomic performance of the Indian economy. For macroeconomic update on Nepalese economy, see this and this.

Real sector (growth rate of real GDP, factor cost 2004-05 prices): The Indian government has projected the economy to grow by4.7% in FY2014 (ends 31 March 2014), marginally higher than 4.5% in FY2013 and reflecting the hard reforms needed to weed out the structural constraints constraining particularly agricultural and industrial sector. This below 5% growth rate for successive two years is the first time in the last 25 years. Agriculture sector growth of 4.7% is mostly due to the favorable monsoon rains, which increased agriculture production.

Industrial sector remains the vital to the recovery of the Indian economy as it: (i) accounts for 24.3% of total employment; (ii) it contributes about 21.4% and 45.1% of total inputs requirement in agriculture and services sector; and (iii) it accounts for 59.6% of total inputs employed in the economy. Rejuvenating growth in manufacturing is vital as it remains the core of intra and inter sectoral backward and forward linkages.

In expectation of a better manufacturing performance, the government is forecasting FY2015 GDP growth between 5.4% and 5.9% in FY2015 (expectation that growth will remain on the lower side).

Fiscal sector: Gross fiscal deficit is forecast at 4.5% of GDP, slightly down from 4.9% of GDP in FY2013. Revenue deficit is forecast at 1.2% of GDP and primary deficit at 1.2% of GDP in FY2014. The fiscal consolidation is largely a result of reduction in public expenditure. Further fiscal consolidation is required especially on two fronts: (i) raising tax-GDP ratio; and (ii) rationalization of subsidy regime.

Monetary sector: The Indian government is expecting inflation to moderate somewhat in FY2014, but it states that this rate is still above the comfort zone. Average headline WPI and CPI (IW) are forecast at 6.0% and 9.7% respectively (marginally down from 7.4% and 10.4%, respectively in FY2013), thanks to elevated food price pressures. There was a general credit slowdown with commercial bank credit growth of 13.9%, lower than a rate of 14.1% in FY2013.

In FY2015, inflationary pressures could come from two fronts: (i) lower agriculture production due to sub-normal monsoon; and (ii) higher prices of oil as a result of volatile geo-political situation in the Middle East.

External sector: As a share of GDP, current account balance is forecast at 1.7% deficit, substantially down from a deficit of 4.7% of GDP in FY2013. The average exchange rate stood at IRs 60.5 = $1, a depreciation from IRs 54.41 = $1 in FY2013. Foreign exchange reserves stood at $304.2 billion. As the rupee weakened, export recovered by registering 4.1% growth rate, much higher than a negative 1.8% growth in FY2013. Meanwhile, import decreased by 8.3% in FY2014, attributed to the measures taken by the government and RBI to discourage import of non-essential items, particularly gold.

Global growth drivers and policy challenges for the next 50 years

A latest OECD Economics Department policy note argues that growth in the next few decades will slow down and most of the growth will come from developing and emerging economies. The main drivers of growth will be innovation, skills and knowledge-based assets as population growth will continue to decline. 

Excerpts:

---

While growth will be more sustained in emerging economies than in advanced economies, it will still slow down due to less population growth and less scope for catching up to the standards of living of the most advanced countries (Figure 1). Even if the retirement age is increased, population ageing will result in a declining or at best a stable labour force in most economies. Against this backdrop, future gains in GDP per capita will become more dependent on accumulation of skills and, especially, gains in productivity driven by innovation and the accumulation of knowledge-based assets -- such as organisational know-how, databases, design and various forms of intellectual property (OECD, 2013).

Global exports will continue to outpace GDP growth over the next half century with an increasing role of non-OECD economies in the global market. Exports in relation to GDP will on average rise by 60% between 2010 and 2060, and relatively closed (and large) economies as the United States and Japan will in 2060 be as open as the United Kingdom is today. As a result trade integration will keep rising, though at a slower pace than in recent decades.

---

The major policy challenges identified in the report are:

• Dynamism in labor and product markets, and re-designed IPR policies
• Shift from mobile tax bases (labor and corporate income) to immobile ones (consumption, housing and use of natural resources)
• Public investment on pre-tertiary education and life-long learning
• International cooperation in providing global public goods (basic research, IPR, competition policy, climate change)

Agricultural Transformation in Nepal

Here is a presentation on the state of agricultural transformation in Nepal. The baseline is that the agricultural sector has to be linked to non-agricultural sector for a meaningful transformation, i.e. transformation cannot happen with operations done in silos. Intra-sectoral linkages (or inter-product linkages within agricultural sector) and inter-sectoral linkages (or linkages between agricultural and non-agricultural sectors) are essential.

Agricultural Transformation in Nepal

Hydropower projects with PPA in dollars in Nepal

Given the long load-shedding hours, the inability of domestic BFIs to fund large hydropower projects, and the government’s limited (usable) fiscal space considering the scale and scope of investment needed, there is no doubt that foreign investment is essential to generate and supply enough hydroelectricity that can eventually revitalize the economy (through supply of adequate power domestically) and also export surplus to India (would be a good source of revenue).

However, the main sticking point for any deal is power purchasing agreement (PPA) in dollars (or foreign currency). Investors want PPA in foreign currency to avoid foreign exchange risks as they have to raise money outside and then repay it in foreign currency after generating revenue from investment projects in Nepal. It is also related to financial and institutional soundness of NEA, the dysfunctional and politicized institution that is at the center of all deals. No investor would ideally want to make a deal with a bankrupt and institutionally weak entity. Hence, the other sticking point related to this one is sovereign guarantee. Again, the investors see it as an important assurance of returns to their multi-year investments, but the government is not ready to offer such guarantee (technically, the government cannot provide sovereign guarantees for SOE’s borrowings/investments expect for the purchase of aircraft— however, exceptions have been made such as the guarantee of repayment of NOC loans to EPF and CIT). The government argues that since NEA has not defaulted so far, the government is implicitly guaranteeing its agreements anyway. However, from investor's perspective, they want credible assurances embedded in legal framework.

NEA has a bad experience with PPA signed in dollars (foreign currency). The two such projects in operation with PPA in dollars are Khimti Hydropower (60 MW) and Upper Bhotekoshi (45 MW). NEA spends around 40% of its revenue in payments to these two hydropower projects. NEA feels the heat particularly when Nepalese rupee depreciates with respect to the US dollar. Here is a nice article published on Republica (by Rudra Pangeni). Below is a list of projects, sourced from the Republica article, with which NEA has signed PPA in dollars.

NEA recently came up with a hybrid scheme: PPA in dollars for a certain percent of total hydroelectricity generated, and the rest in local currency. For the 82 MW Lower Solu project, NEA will pay only 55% in US dollar and the rest 45% in local currency. Currently, the leadership at the Ministry of Energy is against signing PPA in dollars (even some parliamentarians are opposed to it) without first assessing the liabilities to be incurred by NEA over the years. 

NEA has fixed the PPA rate for run-of-the-river projects under 25 MW at Rs 8.40 per unit during the dry season, and Rs 4.80 per unit during the wet season. The PPA rate for projects bigger than 25 MW is set after negotiations between NEA and developers.

Now, Nepal needs foreign investment (plus technology and know-how) to undertake sizable hydroelectricity projects. Investors ideally want PPA in dollars and sovereign guarantee. But, some at the leadership position are neither willing to do both nor are credibly committed to the needed unpalatable reforms at NEA (and the entire energy sector). It is up to the government to find an equilibrium that can accommodate these diverging views, and move ahead with an urgency to sustainably exploit the natural resources to power up houses and manufacturing plants.

Four binding constraints to growth in Nepal

The government and MCC have jointly published the constraint analysis report, which identifies four main binding constraints to economic growth in Nepal:

1. Policy implementation uncertainty
2. Inadequate supply of electricity
3. High cost of transport
4. Challenging industrial relations and rigid labor regulations

The analysis draws on the ‘growth diagnostics’ methodology developed by Hausmann, Rodrik and Valesco in Harvard, and builds on an earlier similar study jointly done by ADB/DFID/ILO, which also found similar constraints to economic activities in Nepal.  I had also followed the same methodology in 2009 and came up with similar constraint (mainly inadequate supply of infrastructure, including transport). 

The constraint analysis points out that protracted political transition and instability results in policy implementation uncertainty, rigid labor regulations and challenging industrial relations, and reduced government effectiveness and capital expenditures (the last one in turn leads to inadequate supply of electricity and high cost of transport). 

Below are the major highlights of the report:

---

Policy implementation uncertainty: Frequent changes in government leadership have resulted in policy implementation that has been unpredictable for firms in Nepal. While much of Nepal’s bureaucratic structure and policy documents have remained the same, changes in leadership of a ministry often leads to significant shifts in the implementation of government policy. This lack of continuity and predictability of policy implementation is consistently cited by firms as a major constraint to making investments in Nepal.

Inadequate supply of electricity: Nepal suffers from the worst electricity shortages in South Asia. Only half of the demand for electricity can be met by the nation’s grid. This results in load shedding of up to 18 hours a day during the dry winter months, when hydropower generation is low. The low availability of electricity creates significant costs for businesses which have to run generators on expensive imported fuel.

High transport costs: Nepal ranks 147th out of 155 countries in the Logistics Performance Index (World Bank LPI). While Nepal’s rugged terrain and landlocked geography contribute to this poor performance, the high of cost transportation in Nepal is also driven by poor quality and quantity of roads, a lack of competitiveness in the trucking sector, and by costly customs procedures. The result is that transporting goods within Nepal and reaching international markets is expensive and unreliable

Challenging industrial relations and rigid labor regulations: Nepal’s labor code is complex. Implementation of the code and mediation by the government between labor and business is both challenging and inadequate. The Federation of Nepalese Chambers of Commerce and Industry (FNCCI) Employers’ Council summary report identifies three primary reasons why the labor code needs revision: poor implementation, protracted court rulings, and long firing. These difficulties appear to alter the hiring and firing practices of firms in costly ways that include firm size remaining small to avoid the difficulties of labor negotiations. However, evidence from focus group discussions in Nepal suggest that these issues are improving and thus the team has categorized this constraint as less severe

---