NEPAL: GDP growth and inflation forecast for FY2015

This blog post is adapted from Macroeconomic Update, August 2014, Vol.2, No.2.

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GDP growth

The outlook for FY2015 is a bit less optimistic than that for FY2014, mainly due to the subnormal monsoon forecast and the likelihood of moderate El Nino conditions, which result in deficient rainfall and droughts. Not only did the monsoon rains arrive late this year[1], the overall rainfall also is expected to be lower— around 93% of the long term average[2]. This will potentially lower agriculture production in FY2015. It will be further exacerbated by the impact of natural disasters, particularly floods and landslides. However, with the gradual improvements in the political environment and the resurgence of investor confidence following the government’s commitment to unveil ‘second generation’ reforms to stimulate private investments, the industry sector s expected to perform much better than in the previous years. While he improved private sector confidence will likely boost manufacturing activities, the timely full budget with higher planned capital expenditures along with better project readiness, as well as increases in bank credit to personal housing may boost construction activities. The high inflow of remittances will continue to support robust service sector activities, especially wholesale and retail trade; transport, storage and communications; and real estate, renting and business activities.

Considering these developments, GDP growth (at basic prices) is forecast at 4.6% in FY2015, lower than both the FY2014 estimated growth rate and the government’s target of 6% set in the budget. Over six-tenths of the contribution to this growth rate is expected to come from the services sector, followed by one-tenth from the industry sector and the rest from the agriculture sector. Overall, the continuing robust services sector growth and a potential strong recovery of the industry sector will be partially offset by the anticipated decline in agricultural production, lowering the GDP growth rate in FY2015 compared to an estimated 5.2% in FY2014. In order to reach a 6% growth rate, assuming agriculture sector growth of 4.7% (which in reality in unlikely given the unfavorable monsoon), the non-agriculture sector has to grow by at least 6.7%, more than one percentage point higher than the growth rate in FY2014. Furthermore, assuming constant agriculture and services sectors growth as recorded in FY2014, the industry sector has to grow by a whopping 9% to achieve the government’s growth target. This would be challenging as industrial sector growth has averaged just 2.7% in the last three years.

Inflation

The expected low agriculture harvest, potential rise in administered fuel prices and transport cost, increase in public sector salary and allowance for two consecutive years, and disruptions in domestic distribution systems as a result of natural disasters and strikes will likely push up general prices of goods and services to 9.5% in FY2015. Furthermore, the heightened inflationary expectations will potentially exert further pressures on prices, especially that of key food products and clothing imported from PRC. The unfavorable monsoon will not only lower production and put pressures on food prices, but it might also encourage hoarding of major food products, creating additional pressures and further heightening inflationary expectations. That said, there is a high likelihood of a moderation of prices that pass-through imported goods from India and third countries as the ongoing stabilization of foreign exchange markets and increasing investors’ confidence on the Indian economy—thanks to the anti-inflationary stance by Reserve Bank of India Governor Raghuram Rajan and the credible, investor-friendly government led by Prime Minister Narendra Modi— might result in strengthening of the Indian currency in FY2015. Food and beverage, and non-food and services will likely account for about 60% and 40%, respectively, of the overall CPI inflation.

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[1] Monsoon rains were late by around two weeks. Normally monsoon rains enter on June 10 from the Eastern region, and gradually covering the entire country within a week. Approximately, 80% of total rainfall occurs between June and September.

[2] Indian Meteorological Department’s forecast in the second week of June 2014. Long term average refers to the 50-year average. For more, see: http://www.imd.gov.in/section/nhac/dynamic/weeklypress.pdf

Nepal Macroeconomic Update, August 2014

Here is the presentation on Macroeconomic Update Nepal, August 2014 from today’s media briefing.

Macroeconomic Update August 2014_2014-09-07

Global Competitiveness Report 2014-15: Nepal ranks 102 out of 144 countries

According to the latest Global Competitiveness Report 2014-15, Nepal ranked 102 out of 144 countries. This is an improvement from 117 in GCR 2013-14, and 125 in the two years before that.

In the three main components of GCI, Nepal ranks 100 out of 144 countries in basic requirements for competitiveness (institutions, infrastructure, macroeconomic management, and health and primary education); 115 in efficiency enhancers (higher education and training, goods market efficiency, labor market efficiency, financial market development, technological readiness, and market size); 124 in innovation and sophistication (business sophistication and innovation).

The major contributors to the improved overall ranking are good progress on macroeconomic management (rank 37), health and primary education (rank 75), and financial market development (rank 75). Within macroeconomic management, the major contributors are the low government budget balance (rank 11) and low public debt (rank 38). Within health and primary education, the major contributor is the high net primary education enrolment (rank 19). Within financial market development, the major contributors are financing through local equity market (rank 47) and legal rights index (rank 29).

[The numbers are impressive, but the mechanics of getting there is not that straightforward. For instance, the good budget balance is not due to impressive fiscal management, but because of the inability of the government to spend allocated money combined with robust revenue mobilization, thanks to rising revenue from taxes on imported goods financed by remittances. For a low-income country like Nepal, which has huge financing need to close the infrastructure deficit, running a modest fiscal deficit without jeopardizing fiscal sustainability and macroeconomic stability is generally a good option.]

Nepalese businessmen think that the top five problematic factors for doing business are government instability, corruption, inadequate supply of infrastructure, policy instability, and inefficient government bureaucracy.

Financial stability in Nepal – 2014 v.1

The Nepal Rastra Bank (NRB) biannually publishes financial stability report (FSR), which comes out with a lag of about six months. The latest FSR reports developments up to mid-January 2014.

Below are key highlights of the report.

Financial system:

• The financial system in Nepal consists of banking and non-banking systems. Banking system includes commercial banks, development banks, finance companies, and micro-finance financial institutions, and NRB permitted cooperatives and FINGOs. Non-banking system includes CIT, EPF, postal saving bank, insurance companies, cooperatives, Nepse, and merchant banking institutions.
• These together total 285 BFIs and other financial institutions. BFIs total 211 and represent 88.7% of total assets and liabilities.
• Total assets and liabilities of NBL, RBB and ADB— the three state-owned commercial banks— are equivalent to 15.9% of GDP. They serve 26% of total deposit account holders and 44% of total borrowers. Their combined branch network cover 33.9% of total commercial bank branches. However, they just have 80 ATMs.

Liquidity:

• Excess liquidity due to a surge in remittance inflows and the sluggish growth in private sector credit. It suggests a general lack of favorable investment climate.
• Excess liquidity adding costs as banks have to pay interest on deposits, and hence are disinclined to lower lending interest rates.
• Liquid assets to deposit ratio is higher than the regulatory requirement.
• Repeated OMO through reverse repos and outright sale auction to mop-up excess liquidity not effective to resolve the issue beyond the short-term.
• All BFIs restricted from accepting institutional deposit over 60% of their total deposit.
• Prompt Corrective Action (PCA) now based on capital adequacy and liquidity situation. Liquidity Monitoring and Forecasting Framework (LMFF) covers class A, B, and C BFIs.

Non-performing loan (NPL):

• Overall, NPL level is about 4.3%, but there are significant variations within BFIs. Total NPL of commercial banks and development banks stood at 2.6% and 4.6%, respectively by mid-July 2013. NPL of finance companies stood at 15.7%.
• Real estate concentration is still high even though it is coming down as old real estate investments are gradually maturing. Residential housing loan is expanding.
• 44.5% of total loan is backed by actual real estate.

Capital adequacy ratio (CAR):

• Regulatory CAR for commercial banks, development banks and finance companies is 11%, 10% and 10%, respectively.
• Regulatory requirement of paid-up capital is NRs2 billion, NRs640 million and NRs200 million for commercial banks, development banks and finance companies, respectively.
• CAR of commercial bank stands around 11.3%. CAR of development banks and finance companies stand at 15.4% and 15.9%, respectively. It suggests that these are well capitalized.
• Commercial banks and development banks are reporting under Basel II framework. Finance companies are following Base I format for reporting.

Financial stability:

• BFIs are not adequately capitalized to absorb the shocks— hold higher percentage of deposits on their total liabilities portfolio.
• Low business volume, rising funding costs, increased regulatory costs of higher capital requirements and liquidity buffers have become normal features.
• Paid-up capital and total capital increased due to mergers, IPO issuance by new banks, and further increment in paid-up capital by banks.
• As a share of GDP, total deposit and total credit have expanded. So has total credit to total deposit ratio, but this is still below the regulatory requirement, suggesting more room for BFIs to extend further credit for economic activities. But, credit to deposit ratio of B and C class institutions in totality exceeds the regulatory provision.
• 22 commercial banks remain vulnerable in case of deposit withdrawal by 15% and more. Overall vulnerability test suggests that commercial banks are in less vulnerable position than other types of BFIs.
• Only foreign banks and financial institutions can invest in shares of Nepalese banking sector. Foreign non-BFIs have to sell shares to Nepalese citizen or institution by mid-July 2015.

Governance:

• Lack of sound corporate governance practices, strong interconnectedness among financial institutions and promoters
• Poor assessment of risks (credit, liquidity, foreign exchange and operation)
• Growing risk from shadow banking activities.
• BFIs failing to establish a sound link between risk management, capital structure and lending.
• Lack of professional management, increasing unproductive assets, loan recovery problems, discouraging pay incentives, unsustainable profit targets, inadequate risk management practices, etc.
• Sound regulatory and supervisory authority needed to control malpractices of cooperatives.
• Stress testing mandatory for class A, B and C BFIs. It has to be reported back to the NRB.
• BFIs need to audit their information system and submit audit report by January 2015.
• No concrete provision to address interconnectedness so far. Interconnectedness occurring through inter-bank deposits and lending, investment by single promoter in more than one BFI, private placements, consortium lending, investment in government bonds, debentures, national certificate of savings, national debentures, etc.

Consolidation of BFIs:

• Small and financially poor BFIs merging with stronger ones.
• Moratorium on licensing of new Class A, B and C BFIs.
• Merger promoted to lower operating costs, bring about economies of scale, and diversify market share. Following the merger bylaws, 55 financial institutions have merged with each other and formed 23 institutions.

Interest rates:

• BFIs need to bring interest spread rate to 5% by FY2014. Base rate need to be reported by class A, B and C BFIs.
• Inflation is eating up, on an average, 4% return on deposits, i.e. real interest rates have fallen.
• The repo rate, 91-day T-bill rate, and inter-bank rate— important measure of short-term money market rate and indicate liquidity situation— remained low.

Labor productivity and wages in Nepal

Labor strikes in manufacturing and services sector have intensified in Nepal, especially after 2006. The strikes are usually organized by left-leaning trade unions, who get substantial backing from their affiliated political parties. Nepal probably has one of the forceful and unionized labor, at times displaying militant behavior, in South Asia. The repeated manufacturing and services sector strikes are based on demands for wage hikes, allowances, better facilities, etc. Minimum wages are reviewed every two years and fixed trilaterally (unions, employers and government). At the moment, manufacturing sector minimum wage in Nepal one of the highest in the region, but productivity growth has not kept pace with it, resulting in erosion of cost competitiveness. More on this here and here.

In this blog post, I wanted to share a simple chart that shows the disconnect between wage growth and productivity growth in the manufacturing sector. Especially between 2007 and 2012, while labor productivity (measured by value added per employee) increased at an annual rate of 11.4%, wages, salaries & other benefits per employee increased by 12.2%. The data comes from the latest census of manufacturing establishments.

Here is another chart showing the comparatively high minimum wage in Nepal relative to its per capita GDP and the regional economies. One of my friends (Brad) shared this chart.

Nepal’s manufacturing sector has been shrinking over the past several years. Its share of GDP declined to an estimated 5.6% in FY2014 from 8.2% of GDP in FY2002.

Nepal’s poverty based on various poverty lines

There is an ongoing debate on whether the most widely used $1.25 per day (PPP 2005) poverty line truly reflects the cost of basic needs. There are other measures of poverty such as the Multidimensional Poverty Index and the national poverty line.

Anyway, the point here is to show the percentage of population living below the various poverty lines, and let folks make their own judgment about the adequacy of this to cover the cost of basic needs.

Here I have used five poverty lines (all PPP 2005 $) and the corresponding poverty percentage in 2010/11 is given below:

• $1.25 a day: 24.8%
• $1.50 a day: 36.5%
• $2.00 a day: 57.2%
• $2.50 a day: 71.8%
• $3.00 a day: 81.2%

The striking thing about this is that despite the remarkable progress in absolute poverty reduction, as measured by $1.25 a day, (thanks mainly to remittances, agricultural wages, urbanization and improved access to social services), almost 60% of the folks are living below $2 a day poverty line. Alternatively, most folks are earning between $1.25 a day and $2.00 a day. It implies a high probability (and subdued/latent vulnerability) of sliding below the absolute poverty line in case of income shock such as the disruption in remittance inflows. To reduce the vulnerability, per capita income growth and jobs have to be driven by high and sustainable GDP growth, which could be achieved by investing in critical infrastructures (energy, transport, irrigation, ICT, etc). Else, the dent in poverty reduction is not going to be deep and wide enough.

Interested folks can compute here the percentage of population living below various poverty lines . In order to get the monthly poverty line, multiple the poverty figure a day by 365 and divide it by 12. Here I have used the monthly poverty line with one decimal point. You might get slightly different figures if the decimal points are larger. Anyway, it won’t make much difference.

Costs of climate change and adaptation to Nepal

A new ADB report on the costs of climate change and adaptation (full report here) argues that Nepal would see economic losses equivalent to up to 2.2% of annual GDP by 2050, widening to 9.9% by the end of the century. If mitigation and adaptation steps are taken, the damage could be limited to around 2.4% of GDP by 2100.

The report states that Nepal’s agriculture sector may reap short-term gains from warmer temperatures and melting snow and ice, (annual rice production could increase by as much as 16% in Nepal’s hills and mountains by 2080) but the glacial retreat and uncertainty about the summer monsoon’s start and end dates may reduce crop yields, causing food insecurity. Furthermore, melting glaciers, if suddenly breached, could cause catastrophic flooding downstream, posing risks to both human settlements and hydropower systems. In mountainous areas, landslides are likely to increase, threatening lives and infrastructure. Deteriorating and dwindling forests will result in habitat losses for some of the country’s rich flora and fauna, including snow leopards, undermining the country’s appeal for ecotourists.

• The regional climate model projections indicate temperature increases of 1.6°C -2.0°C in 2030, 2.3°C–2.9°C in 2050, and 3.4°C–5.0°C in 2080.
• For the terai region, the temperature change is likely to be 1.9°C in 2030, 2.5°C in 2050, and 4.6°C in 2080.
• The ensemble mean from GCMs indicates a temperature change of about 3.0°C–4.0°C by the end of the 21st century with high agreement (high confidence level).
• The country is likely to have negative precipitation departure over the three periods: –3.9% to –5.0% in 2030, –1.7% to –2.0% in 2050, and –0.9% to +2.9% in 2080.
• The A1B scenario indicates that precipitation departure for the terai region is likely to be –2.60% in 2030, –0.04% in 2050, and +3.72% in 2080.
• Precipitation projections for the 21st century from the GCM ensemble mean indicate wide variations and low level of agreement among models. Hence, there is very little confidence in the rainfall projections for the country.

In South Asia, the Maldives and Nepal would be the hardest hit, losing up to 12.6% and 9.9% of their economies, respectively, every year, by 2100. Meanwhile, Bangladesh would lose 9.4%, India 8.7%, Bhutan 6.6%, and Sri Lanka 6.5%.

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The cost of climate change adaptation measures in South Asia will depend largely on how the global community tackles the issue, the report says, noting that if the world continues on its path, the region will need to spend at least $73 billion, or an average of 0.86% of its GDP, every year between now and 2100 to adapt to the negative impacts. On the other hand, if countries act together to keep the rise in global temperatures below 2.5°C, the cost of South Asia shielding itself from the worst of the impacts would be nearly halved to around $40.6 billion, or 0.48% of GDP.

The report does not provide detailed adaptation cost projections on a country basis, although in the energy sector it notes that a rising gap between demand and supply could see Nepal face an annual adaptation bill of over $118 million in the 2030s, rising by another $100 million in the 2050s.

Almost all areas of South Asia will suffer as temperatures rise. While farmers in some parts of the region may benefit from warmer weather, overall the impact on agriculture will be negative. Annual rice production could increase by as much as 16% in Nepal’s hills and mountains by 2080, but drop as much as 23% in Bangladesh, Bhutan, India, and Sri Lanka by that time.

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Other highlights:

• Without global deviation from a fossil-fuel-intensive path, South Asia could lose an equivalent 1.8% of its annual gross domestic product (GDP) by 2050, which will progressively increase to 8.8% by 2100 on the average under the business-as-usual (BAU) scenario.
• The model suggests that the Maldives will be hardest hit in GDP loss, while Bangladesh, Bhutan, India, Nepal, and Sri Lanka are projected to face 2.0%, 1.4%, 1.8%, 2.2%, and 1.2%, respectively, loss of annual GDP by 2050.
• Should the global community take actions along the Copenhagen–Cancun agreements to keep the global mean temperature rise below or within 2oC, the region would only lose an average of 1.3% of GDP by 2050 and roughly 2.5% by 2100.