Economic and social risks from declining overseas migration & decelerating remittance inflows

It was published in The Kathmandu Post, 20 September 2016. Previous posts on remittances and migration here.

---

Remittance pitfalls

Nepal needs urgent reforms to deal with challenges stemming from a deceleration in remittance inflows

If there is one consistent narrative about Nepal over the last two decades, it must be about migration and remittances. Political and development activities in the country have always remained volatile. While political culture is punctured by intra- and inter-party fighting and external interference, economic development is beset by stalled projects and implementation complexities arising from sub-standard procurement and eroding bureaucratic capacity. However, migration and remittances have been notably resilient to internal and external shocks, providing a crucial support to the economy characterised by high unemployment and slow economic growth but a significant demand for imported goods and services.

Lately, this citadel of stability is starting to crumble following the persistently low fuel prices and sluggish economic growth in most developed and emerging economies. The economic stress, at least in terms of macroeconomic numbers, arising from the gloomy global outlook is gradually being felt in Nepal too. It could soon become a prime trigger factor for economic and social instability. The almost muted response from the politicians and the bureaucracy to this distressing development is mindboggling and irresponsible.

Multiple impacts

Although statistics show unemployment in Nepal to be lower than in most developed countries (for instance, the latest annual household survey puts it at 3.6 percent), it should be noted that this does not include ‘discouraged’ workers, who are not considered as a part of the labour force. Hence, the actual unemployment is substantially higher, with some agencies estimating it to be over 45 percent. Given the low economic growth and deindustrialisation, especially after the start of the Maoist rebellion, such a high level of unemployment is unsurprising. This is one of the reasons why until last year about 1,400 working age men and women legally left the country daily to work overseas, primarily in Saudi Arabia, Qatar and Malaysia, which together account for about 80 percent of total overseas migration.

Unfortunately, the global economic slowdown (which lowers external demand), low oil prices and the subsequent decline in investment, especially in natural resources, construction and security services, are weakening economic activities in these countries. It is having a direct impact on the Nepali economy through the lower demand for migrant workers and the deceleration in remittance inflows.

The overseas migration growth averaged 14.2 percent between fiscal years 2012 and 2014. It started to decline as low fuel and commodity prices affected investment and subsequently the demand for migrant workers from countries such as Nepal. Consequently, the number of migrant workers decreased by 2.8 percent in FY2015 and then by a further 18.4 percent in FY2016. (The April 2015 earthquake also contributed to the slowdown.) The figures translate into a daily average of 1,446 migrant workers in FY2014, 1,405 in FY2015 and 1,147 in FY2016—a clear downward trend. Migration to Malaysia declined by a whopping 70 percent as it put a moratorium on new hiring and opened up foreign employment in private security services—earlier restricted to Nepali and Malaysian nationals only—to other countries as well. Furthermore, its overall economic growth is affected by low fuel and commodity prices.

The declining demand for Nepali migrant workers will have a direct impact on remittance inflows, which will then affect household and macroeconomic activities. The growth of the remittance inflows has remained robust, averaging 25.3 percent over FY2012-FY2015. It remained resilient ($6.2 billion in FY2016) compared to other inflows such as foreign direct investment and official development assistance. However, a deceleration in remittance inflows is a very likely scenario given the drastic decrease in the number of migrant workers in the last three years.

Amounting to about 29 percent of gross domestic product (GDP), remittances have been a major factor supporting economic growth, poverty reduction and household expenditure, irrespective of the household’s domestic income. A decline in remittance inflows would lower the services sector growth, which primarily depends on remittance-financed consumption of imported goods. Since services sector constitutes over 50 percent of GDP, it will bring down overall economic growth as well. Furthermore, lower remittance inflows would likely lower government revenue, which is largely generated from taxes levied on remittance-financed consumption. Another significant impact will be on current account balance, which can easily go into the negative territory like in FY2010 and FY2011. It could then lead to a negative balance of payments and lower foreign exchange reserves. Given the pegged exchange rate with India, high dependence on remittance income and the composition of imports, Nepal needs to maintain reserves to finance at least seven months of import. In FY2011, when remittance growth declined but was not negative, reserves were enough to finance just 7.3 months of import.

The deceleration in remittance income triggered by the slowdown in migration will affect household consumption expenditure (and subsequently poverty), fiscal balance (as high consumption-based revenue growth tapers off), financial stability (as deposit growth slows down), and external sector (as current account and balance of payments fall into the negative territory).

Economic and social blowback

Robust remittance inflows fostered laxity in reducing policy weaknesses and in facilitating sound investment climate as politicians and bureaucracy had to do little work to generate moderate growth of below 5 percent and to reduce poverty. This needs to change now given the deceleration in remittance inflows and the slowdown in the demand for Nepali migrant workers. Medium- and long-term reforms have to be rolled out and implemented to boost investment, lower inflation, and create appropriate investment instruments that can channel the short-term remittance deposits into long-term infrastructure financing. Meanwhile, faster post-earthquake reconstruction works could help create a modest number of unskilled and semi-skilled jobs, which match the employment needs of would-be migrants.

These reform measures could not only address the immediate economic challenges arising from the deceleration in remittance inflows, but also tackle the Dutch disease effects (which broadly refers to the decline in tradable sector, chiefly manufacturing, and an appreciation of real effective exchange rate) seen in the economy since 2000. The primary focus should be on the active facilitation of investment and on transforming from the current low value-added, low productivity activities to high value-added and high productivity activities.

Further delays in addressing these issues would make it difficult for the country to fend off the economic and social blowback arising from the slowdown in overseas migration and the deceleration in remittance inflows.

Electricity demand in Nepal in 2030

This piece is adapted from Macroeconomic Update Nepal, Vol.4, No.2, published by Asian Development Bank, Nepal Resident Mission. Executive summary is here and FY2017 economic outlook here.

---

In a report published by the Investment Board of Nepal (IBN) the total energy demand is projected to reach 33,433 gigawatt hour (GWh), which is equivalent to 6,358 mega watt (MW) at 60% system capacity factor in 2030. Additionally, accounting for transmission loss (1,211 MW), outages (2,523 MW), and the constant daily demand load curve, the required installed capacity to meet energy demand in 2030 is 10,092 MW in 2030. A lower system factor (arising from supplementary sources such as storage plants and capacity increases in renewables) would mean higher installed capacities to meet demand. At 50% system capacity factor, the required installed capacity to meet energy demand would be about 12,000 MW.

It uses the model for analysis of energy demand (MAED) to forecast energy demand in the next 15 years. This differs significantly from the linear energy demand projection. The model considers latent demand (for instance, switching from traditional cooling methods to air conditioning, from liquefied petroleum gas to electrical appliances to cook food, and from fuel to electricity to power up vehicles) in such forecast and takes into account the evolution of socio-economic, technological and demographic patterns.

While these projections may be on the higher side given the optimistic assumptions for sectoral growth and its pattern, the direction and magnitude of energy demand in the next 15 years points to a plausible scenario of large demand-supply deficit if the planned projects are not completed on time. This has to be accompanied by reform of the entire sector, including enacting and implementing the legal, regulatory, institutional and administrative reforms. NEA system losses are already one of the highest in the world. In FY2016 its system losses were 25.9%, up from 24.4% in FY2015. It largely reflecting a dated distribution system (including sub par transformers). The country faces a challenge to meet the energy demand given the slow pace of project implementation (generation, transmission and distribution).

*********

Update: Lately, it has been reported that the new Minister for Energy Janardan Sharma has ordered new estimation of electricity demand. He has refused to take ownership of the study commissioned by the IBN in collaboration with the NPC. His main argument is that IBN is not the authorized body to estimate electricity demand. It should be Water and Energy Commission Secretariat (WECS). This is a useless argument and is an indication of the maze of bureaucratic hurdles (created by self-interested bureaucrats chasing and chased by lobbyists and politicians) and lack of ownership of a report published by a agency which is chaired by the Prime Minister. There is no need for another study by WECS, which will probably lead a committee to finalize a TOR for new consultant and then lobby for funds to finance the one-year-plus long study. If it goes through, then the contract would most likely go to one of the pseudo-consulting firms close to the bureaucrats or the politicians. Just another study report to employ currently unemployed pseudo-intellects.

The need is not for a similar study report for the sake of 'ownership'. The urgent need is to accelerate project implementation, especially the stalled hydro energy projects and administrative reform of the various agencies, including NEA and the energy ministry. The country doesn't have the luxury of time and resources to commission yet another study of long-term energy projection by the energy ministry. The priority should be to do the needful to ensure that the ongoing projects are completed on time.

Some bureaucrats, politicians and energy lobbyists have been objecting to the IBN's proactive role in promoting large-scale hydro energy projects since its establishment. They are not happy with the IBN as it is taking away their business interest and is really taking forward contentious projects in a short time. The energy sector needs to be protected from this group of bureaucrats, lobbyists and politicians.

NEPAL: Growth and inflation outlook for FY2017

This piece is adapted from Macroeconomic Update Nepal, Vol.4, No.2, published by Asian Development Bank, Nepal Resident Mission. Executive summary is here.

---

FY2017 growth outlook

The outlook for FY2017 growth is moderately optimistic and hinges on the scale of recovery of agricultural output given the normal monsoon, the scope and pace of post-earthquake reconstruction and rehabilitation, budget execution, and remittance inflows. The monsoon rains were above normal and on time unlike in the past few years. Approximately, 80% of total rainfall occurs between June and September. The Ministry of Agricultural Development estimated that paddy transplantation has been higher than in previous years. Paddy transplantation averaged about 95% of 1.4 million hectares of rice field by the first week of August, much higher than 75% in FY2015. However, widespread flooding in the Terai region and mid-Hills, and landslides caused some damage to crops during the last week of July and the first week of August. The outlook for industrial and services output is contingent upon the evolving political situation, reconstruction work, pace of budget execution, recovery of tourism sector and remittance inflows. The scope and pace of reconstruction projects will affect demand for quarrying, manufacturing and construction activities, which largely dictates the trajectory of industrial output. Timely, effective and judicious budget execution, which includes both accelerated spending and reform measures, will be at the core of industrial and services sector recovery. Similarly, a slowdown in the growth of overseas migrants is bound to affect remittance inflows, which subsequently would affect the major components in the services sector.

Considering these developments and a cautiously optimistic outlook on reconstruction and political situation, GDP growth (at basic prices) is forecast at 4.8%, lower than the government’s target of 6.5% announced in the FY2017 budget speech. Agriculture, industry and services outputs are expected to contribute 0.7, 1.0 and 3.0 percentage points. A downside risk to the forecast is the more than expected damage caused by natural disasters, especially flooding and landslides, to agricultural output; slow rehabilitation and reconstruction works; the slow pace of budget execution; and depressed demand in services sector arising from the deceleration of remittance inflows.

FY2017 inflation outlook

Better agricultural harvest due to the normal monsoon, subdued inflation in India, low international fuel and commodity prices and normalization of production and supplies since February 2016 will likely lower general prices of goods and services in FY2017 despite the demand-side pressures emanating from the earthquake related fiscal stimulus. The prices of cereal grains, paddy, pulses and legume are expected to moderate on account of the favorable monsoon. However, the prices of alcoholic drinks and tobacco products will likely escalate due to the hike in its tariff rate in the FY2017 budget. Similarly, restaurant and hotel prices are also likely to increase as the rebound in tourism sector will stimulate demand. Meanwhile, normalization of supplies and cooling off of demand pressures in housing and utilities will drive the de-escalation of non-food and services inflation. Although furnishing and housing equipment may see a rise in prices on account of the increased demand arising from gradual revival of real estate and housing markets, its impact will not be large enough to offset the decline in prices of other items in the non-food and services basket. Consequently, food and non-food inflation are projected to contribute 4.3 and 4.2 percentage points, respectively to overall inflation of 8.5% in FY2017.

The state of macroeconomics in Nepal

This piece is adapted from Macroeconomic Update Nepal, Vol.4, No.2, published by Asian Development Bank, Nepal Resident Mission.

---

The lingering impact of the catastrophic earthquakes in FY2015, slow post-earthquake reconstruction, and crippling trade and supplies disruption resulted in gross domestic product (GDP) growth of just 0.8% in FY2016. The earthquake-led disruption of economic activities, especially in agricultural and industrial production, struggled to recover as reconstruction and rehabilitation efforts could not pick up speed. This was exacerbated by the trade and supply disruption between September 2015 and February 2016. The combined effect was quite disruptive for the economy as GDP growth dipped to its lowest level since FY2002. Agricultural output grew by an estimated 1.3%, marginally higher than 0.8% in FY2015. Meanwhile, industrial output registered a negative growth of 6.3% in FY2016, sharply down from 1.5% growth in FY2015. The services sector, which accounts for about 53% of GDP and is the key driver of GDP growth, grew by 2.7%, lower than 3.6% after the earthquake in FY2015 and 6.2% in FY2014. The outlook for FY2017 is moderately optimistic and hinges depending on the scale of recovery of agricultural output given the normal monsoon, the scope and pace of post-earthquake reconstruction and rehabilitation, budget execution, and remittance inflows. Considering these factors, GDP growth is forecast at 4.8% in FY2017.

The trade and supply disruption affected public spending although the pattern of spending, with heavy bunching up in the last quarter, was no different from previous years. Capital spending stalled for almost five months as the severe shortage of fuel and construction materials paralyzed project implementation as well as post-earthquake reconstruction. Budget under-execution has been a major fiscal issue in Nepal. The estimated actual capital spending was just 56.3% of planned capital spending in FY2016, sharply down from about 76% in the last five years. Meanwhile, actual recurrent spending was 75.6% of planned recurrent spending in FY2016, a significant drop compared to an average 90% in the last five years. Overall, expenditure grew by 13%, with recurrent and capital spending growth at 7.9% and 32.6%, respectively— lower than the growth rates in FY2015.

The continuous reforms in revenue administration, gradual broadening of the tax base, and the higher import bill (mostly financed by remittance income) resulted in robust revenue performance over the last decade. Total revenue grew by 18.9%, higher than the 13.7% growth in FY2015 but lower than the 20.5% growth in FY2014. Despite the five months long trade and supply disruption, revenue growth accelerated in the last five months of FY2016 as imports gradually normalized along with the clearance of the backlog of goods stuck at various customs points along the Nepal-India border. As a share of GDP, tax revenue mobilization increased significantly, reaching 18.8% of GDP in FY2016, up from 9.8% of GDP in FY2007. Non-tax revenue amounted 2.7% of GDP in FY2016. Total revenue growth averaged 20% in the last five years.

The robust revenue mobilization but disappointing expenditure performance resulted in a fiscal surplus equivalent to 1.4% of GDP in FY2016. The country ran a fiscal surplus in FY2013 and FY2014, but a fiscal deficit (of about 0.7% of GDP) in FY2015. For a country with one of the lowest per capita incomes in Asia, running a fiscal surplus indicates chronic problems associated with budget execution. A fiscal policy anchored on a modest deficit to finance productivity-enhancing infrastructure would not jeopardize fiscal sustainability. Nepal faces an estimated infrastructure financing gap of between 8% and 12% of GDP annually until 2020. Ramping up public spending on physical and social infrastructures, including those related to post-earthquake reconstruction, is essential for accelerated, employment-centric and inclusive economic growth. Primary surplus— fiscal balance before interest payment on public debt— increased to 3.8% of GDP. Nepal has been running a primary surplus since FY2012. Combined with the low and declining outstanding public debt (about 27.6% of GDP), it indicates that the government has ample fiscal space to ramp up productivity enhancing public capital investment without jeopardizing fiscal sustainability. However, a major constraint for doing that is the eroding expenditure absorption capacity.

Inflation (year-on-year average consumer price index [CPI]) increased by 9.9%, higher than 7.2% increase in FY2015, as the unfavorable monsoon affected agricultural output and the trade disruption created a severe shortage of essential goods, including cooking gas and petroleum products. Overall, food prices and non-food prices contributed 4.8 and 5.1 percentage points to overall inflation. Looking forward, the expected bumper agricultural harvest due to the normal monsoon, expected subdued inflation in India, low fuel and commodity prices and normalization of trade and supplies will likely lower general prices of goods and services in FY2017 despite the demand-side pressures emanating from the earthquake related fiscal stimulus, especially the committed $2000 grant to over half a million affected households. Consequently, food and non-food inflation are projected to contribute 4.3 and 4.2 percentage points, respectively to overall inflation forecast of 8.5% in FY2017. The possibility of supplies disruption arising from natural disasters and political instability is a major downside risk to the inflation forecast.

Money supply (M2) grew by 19.5%, reaching NRs366.8 billion, supported by a robust increase in net foreign assets. However, it is marginally lower than the 19.9% growth in FY2015 owing to the decrease in net domestic assets. The BFIs mobilized NRs328 billion (reaching a total NRs2016.8 billion) in deposits in FY2016, higher than NRs282 billion mobilized in FY2015, as higher remittance inflows (despite the decrease in the number of migrant workers) and slower government expenditure boosted deposits. Total credit (loans and advances) of BFIs increased by 23.3% (NRs360 billion) in FY2016, up from 17.5% growth in FY2015 (NRs229.3 billion). Credits by commercial banks grew by 25.9% (NRs327.9 billion), up from a rate of 18.8% in FY2015. Responding to the persistent excess liquidity in the banking sector in FY2016, the Nepal Rastra Bank (NRB) mopped up liquidity equivalent to NRs235.9 billion through reverse repo auctions— one of the short-term tools used by the central bank to manage liquidity— at weighted interest rates between 0.0001% and 1.3%; NRs9 billion through outright sale auctions at weighted interest rate between 1.06% and 2.88%; NRs297.5 billion through deposit auction at a weighted interest rate of 0.85%; and NRs49.1 billion by selling NRB bonds. The short-term interest ratesfluctuated throughout the year and were slightly higher than in the corresponding months in FY2015.

The balance of payments surplus reached $1.8 billion (8.5% of GDP) in FY2016, up from $1.4 billion in the previous year. The large merchandise trade deficit, which declined to 30.3% of GDP from 31.3% of GDP in FY2015, was partially offset by workers’ remittances, which hit a record 29.6% of GDP, resulting in a current account surplus of $1.3 billion (6.2% of GDP), up from 5.1% of GDP in FY2015. Meanwhile, FDI inflows increased to $55.8 million from $44.2 million in FY2015. Gross foreign exchange reserves increased from $8.1 billion in FY2015 to $9.7 billion in FY2016, sufficient to cover 14.1 months of import of goods and non-factor services. The Nepalese rupee continued to remain weak against the US dollar, closely following movement of the Indian rupee, to which the currency is pegged since 1993. Overall, the Nepalese rupee depreciated by 5.2% between mid-July 2015 and mid-July 2016.

This edition of Macroeconomic Update’s issue focus delves into the efficiency and integrity of public procurement and its effects on accelerating inclusive economic growth. Many medium to large-scale development projects in Nepal are plagued by implementation delays and cost overruns. At the core of such recurrent hurdles is inefficient public procurement, contributed by a slew of factors such as legal and policy complications, poor performance of contractor, lack of required human resources to manage contract and high staff turnover, political meddling at management and operational levels, weak leadership by project directors, and prolonged delays by oversight and judicial agencies to clear contentious procurement. Consequently, project implementation is slow with cost and time overruns, quality and scale of infrastructure construction is not up to the taxpayers’ expectation, and disbursement is slow and below target. All these result in sluggish economic growth and

insufficient jobs creation.

Efficiency and integrity in public procurement (of goods, works and services) accelerate project implementation, which in turn enhances capital spending and positively affects economic growth, research and development (innovation), stimulation of private sector activities and jobs creation. Furthermore, if done in the right way and on time to maximize the value for taxpayers’ money, public procurement could be used as a strategic policy tool to address the myriad of economic, social and environmental challenges faced by the country. Hence, efficiency and integrity in public procurement— equivalent to around 12% of GDP— is vital to not only accelerate project implementation, but also to achieve medium-term goal of graduation from LDC category and long-term goal to be a middle income country by 2030, which also is the target date to achieve the Sustainable Development Goals (SGDs).

Remittances and fiscal and monetary policies

High inflow of remittances limits the central bank's ability to influence through the traditional monetary policy. Here are excerpts from a recent article by Barajas et al in the latest edition Finance & Development magazine.

On fiscal policy

---

Remittances directly expand the tax base, which makes it easier for countries to maintain fiscal sustainability, in the sense of avoiding a situation of ever-expanding public debt. However, remittances can also skew the behavior of governments, in undesirable ways. First, and somewhat paradoxically, the very expansion in the revenue base could distort government incentives, lowering the costs of engaging in wasteful spending. Second, the supplemental income that remittances provide to households increases their ability to purchase goods that substitute for government services and reduces their incentive to hold the government accountable.

---

On monetary policy

---

For low-income countries, there is growing evidence that monetary policy transmission is substantially weaker than in advanced economies. While a variety of transmission channels may operate, Mishra, Montiel, and Spilimbergo (2012) argue that weak securities market development, imperfect integration with international financial markets, and highly managed exchange rates are likely to leave poorer countries with only one operable channel—bank lending. A change in the policy rate ripples through markets for short-term securities, ultimately affecting banks’ cost of funds at the margin and thus their ability to lend to private entities, whether people or firms.

However, even the bank-lending channel may be seriously weakened if there is little banking competition, the quality of institutions is poor, interbank markets in which banks deal with each other are underdeveloped, and information is lacking about the quality of borrowers. These factors conspire to short-circuit the transmission of moves in the short-term policy rate to banks’ cost of funds.

[...]remittances expand bank balance sheets by providing a stable and essentially costless source of deposits—because they are largely insensitive to interest rates. [...]because the remittance deposits increase the amount of financial intermediation (the process of banks matching up savers and borrowers), remittances might be expected to contribute to stronger monetary policy transmission.

[...]although banks might receive ample and virtually costless additional funding year after year from deposited remittances, that does not mean they will increase lending to the private sector one for one. Remittance-recipient economies—such as economies in most of the developing world—are often plagued by a number of problems, including a weak institutional and regulatory environment and a dearth of creditworthy borrowers.

[...]remittance flows may have a hand in weakening governance. This fragile lending environment reduces banks’ willingness to lend beyond a very limited pool of “qualified” borrowers, a reluctance that the additional lendable funds do nothing to counteract. Banks in recipient countries, then, tend to hold larger shares of liquid assets, excess reserves, and government securities than banks in nonrecipient countries. As a result, because banks are flush with liquidity, an interbank market—in which institutions in need of short-term funds borrow from those with excess balances—fails to develop. Because the policy rate is designed to affect the marginal cost of funds for banks, when there is virtually no interbank market, the effect of policy rate movements is weakened or nonexistent. The bank lending channel becomes impaired.

---

On transmission mechanism

---

Our empirical analysis confirms that, as remittances increase, monetary transmission through the bank lending channel weakens notably. Based on a sample of 58 countries worldwide between 1990 and 2013, we find that the strength of transmission, measured as the direct effect of a change in the policy rate on changes in bank lending rates, declines continuously as the size of remittances increases. In countries that do not receive remittances and have competitive banking systems, nearly 90 percent of a change in the policy rate is transmitted to the bank lending rate. In contrast, in an economy that receives 5 percent of GDP annually in remittances, only about 4 percent of the same change to the lending rate is transmitted, even when banking systems are competitive. In fact, when remittances reach 7.6 percent of GDP, the policy rate has no effect on bank lending rates. If the banking system is not competitive, the turning point occurs at a much lower level of remittances—1.2 percent of GDP.

[...]remittance-recipient countries may opt to scale back plans for full monetary policy independence. In fact, research suggests that greater remittance inflows are indeed associated with greater intervention in foreign currency markets, whether to fully fix the exchange rate or manage its fluctuations.

---

Macroeconomic essentials for Nepal Vision 2030

This article is adapted from Nepal Economic Forum's 25th issue of Nefport.

---

Although a bit late, the government is finally gearing up to formulate a long-term vision for economic development. The tentative targets for now are to graduate from the Least Developed Country (LDC) status by 2022 and to attain the slew of Sustainable Development Goals by 2030. However, a bold and time-bound economic development vision for the country should go beyond these goalposts that were contextualized on the basis of global targets. Nepal should aim to become a vibrant lower-middle income economy within the next two decades.

At the core, it essentially means increasing gross national income (GNI) per capita (World Bank’s Atlas method) from existing USD 730 to about USD 4,125 (the threshold between lower-middle income and upper-middle income economy). In order to achieve such a goal, it is essential that the government draw up a list of strategic flagship projects in physical and social infrastructure sectors and execute them with an efficient and workable implementation arrangement that is in sharp departure from the current discouraging project implementation ecosystem.

Given an appropriate mix of macroeconomic strategy, financial arrangement, smart project execution and supportive institutions, a meaningful structural transformation is possible and the stated goals are achievable. This piece focuses on the macroeconomic aspect of marching on that path.

Macroeconomic essentials

A large amount of public and private investment is required to increase income per capita by almost six folds within two decades. The scale and scope of public investment would depend on revenue mobilization, rationalization of ballooning recurrent spending, and foreign aid. Meanwhile, private investment would depend on investor-friendly environment, including protection of investment and returns, supportive laws and policies, mechanisms for sharing of risk, returns and technology (such as public private partnerships), and maturity of the financial market, among others.

Overall, sound macroeconomic environment will be at the heart of financing for such large scale public and private investment. At around 21% of GDP, the gross fixed investment is lower than the average for low income countries. This needs to be over 30% of GDP to accelerate growth rate (beyond the contribution by exogenous factors such as monsoon and remittances), which will then boost income per capita, and employment generation, primarily through investment in productivity-enhancing physical and social infrastructure. Specifically, public fixed capital investment has to increase to about 10% of GDP over the next decade from the existing 4.5% of GDP.

On the financing part, a combination of rationalization of recurrent expenditure, higher domestic revenue, domestic borrowing, and higher grants as well as concessional and non-concessional loans are needed. At the current level and growth of recurrent expenditure, it will be challenging to cover it sustainably by tax revenue, whose growth rate has stagnated at around 15%. Hence, trimming wasteful recurrent spending in uncoordinated programs and projects should be a priority as a part of sound fiscal management to attain the long-term vision. Second, along with efforts to expand the tax base, the revenue administration will have to be made more efficient and responsive. The present revenue system is too dependent on taxes on remittance-financed imported goods and services. Third, domestic borrowing has to be managed judiciously keeping in mind the optimum market liquidity. Finally, foreign assistance needs to be better utilized by enhancing expenditure absorption capacity. These will partly cover the required resources for public sector investment.

Additionally, fiscal and monetary policies need to be synchronized to tame inflation so that it is not persistently and prohibitively high to discourage investment. At present, inflation is mostly a supply-side phenomenon although localized sectoral inflation (such as unnatural escalation of real estate and housing prices few years back) is mostly within the ambit of monetary authorities. More generally, monetary policy can support the vision by creating appropriate incentives to channel savings into infrastructure investment that typically pay-off in the long-term. Finally, external sector stability should not be much of an issue as long as the economy is gradually diversified and production is competitive in addition to a net positive transfers and sizable foreign exchange reserves. 

Supportive environment

An investment-friendly environment is essential to increase domestic as well as foreign investment. While a slew of laws need updating, policies need rewriting to facilitate and simplify investment rules and approvals. In the meantime, drastic enhancement of capital spending absorption capacity is required to increase public spending in infrastructure, a lack of which is the most binding constraint to inclusive economic growth. Supportive institutions that can foster creative creation and creative destruction need to be promoted as opposed to the protection of business interests through syndicates and cartels. This is crucial for entrepreneurial spirit and to incentivize saving, investment and innovation. Inclusive political and economic institutions are vital to sustaining an equitable and rising income per capita. It is also important to change the course of out-migration for jobs and improved opportunities, and to enhance external sector competitiveness.

Structural transformation

A meaningful structural transformation underpins the pace and pattern of economic growth. Along with the decline of the agricultural sector, Nepal is seeing the rise of low value added, low productivity services sector activities. This structural shift is bypassing industrial sector growth (a sort of deindustrialization), which is vital for productive employment, sustained rise in income per capita, and high growth rate initially. Reversing this trend and revitalization of industrial sector along with promotion of high value added agriculture and services sector activities, with an employment centric strategy to absorb the surplus labor, should form the core of the structural transformation process, which will then lead to higher and inclusive economic growth.

With the right mix of reforms and policies, supportive institutions, enhancement of absorption capacity, and a sound macroeconomic environment to support such structural transformation, the likelihood of attaining the long-term vision is high.

How to finance large-scale infrastructure in Nepal?

It was published in The Kathmandu Post, 19 July 2016. An earlier blog post on the same issue is here.

---

Financing infrastructure

Prime Minister KP Oli led government surprised everyone few weeks ago by proposing to initiate key large-scale infrastructure projects, including the much-touted fast track road and Budigandaki hydroelectricity projects, using domestic resources. The intention was to stoke a renewed sense of nationalism high on rhetoric but low in substance, and to extricate the government from binding hooks that come with bilateral financing of such projects. One unruly leftist party even fervently argued for financing all hydropower projects with domestic resources and floated a premature idea to raise money from local shareholders. 

Some politically aligned experts are throwing their weight behind such half-baked proposal without properly analyzing the available financial and knowledge capacities. As it stand now, the economy simply does not have the required financial capacities, stock of knowledge and management capabilities, and competent institutions to initiate large-scale projects entirely on domestic resources. Acquiring such capability requires close collaboration on financing, research and management between external and domestic sources. 

Unfavorable macro

Politicians and their intellectual cheerleaders quickly point to low public debt (in other words fiscal space) to finance large-scale infrastructure projects such as hydroelectricity, roads and airports domestically. The outstanding public debt has decreased sharply from about 52 percent of gross domestic product (GDP) in 2005 to around 25.7 percent of GDP. It means Nepal could theoretically borrow more without jeopardizing fiscal stability (say up to 40 percent of GDP). However, borrowing an additional $3.5 billion or more from domestic and external sources requires the government to drastically enhance its absorption capacity, which unfortunately is eroding.

The outstanding domestic borrowing by selling government bills and bonds amounts to 9.5 percent of GDP and external borrowing, mostly on concessional terms, 16.2 percent of GDP. The government is predominantly selling treasury bills (with maturity of less than one year) to finance recurrent spending as well as multi-year infrastructure projects, and implicitly to manage excess liquidity. This is not a good fiscal practice as large-scale infrastructure projects are financed typically by issuing specific construction bonds, which have long-term maturity and lower risk of asset-liability mismatch. Higher domestic borrowing to fulfill politicians’ whims will crowd out private investment by pushing up interest rates and put unnecessary debt burden on future generation. The FY2017 budget falls in this category.

The use of excess liquidity and treasury savings are identified as alternative sources that could be tapped in to finance infrastructure projects. The persistent excess liquidity is the result of higher growth of deposit compared to the growth of credit. It arises when there is lack of investment-ready projects and unfavorable investment climate, thus constraining banks and financial institutions’ (BFI) capacity to increase credit. Meanwhile, the large growth of deposit is due to the increasing remittance inflows and the government’s inability to spend allocated capital budget on time. While the former is starting to slowdown as the demand for the migrant workers is decreasing, the latter is expected to improve due to relatively better budget execution from this year onward. Transient and volatile excess liquidity and treasury savings cannot be reliable sources for long-term infrastructure financing.

Another related argument on the adequacy of domestic resources is the potential to pool in savings. This argument has its roots in the remittance-backed large deposit growth and oversubscription of shares in the stock market. First, the remittance-backed savings are of short term in nature and using them to invest in projects with long gestation lags create asset-liability mismatch for the BFIs. This is one of the reasons why the BFIs as well as pension funds are financing medium to long term projects through a consortium, which minimizes risk arising from overexpose to one sector. Second, the oversubscription during share issuance is essentially to reap quick profits by trading the shares in the secondary market. This quest for short-term gain does not indicate that there is excess long term saving that could be used for multi-year large-scale infrastructure projects. Nepal’s financial system is not yet mature enough for that.

Regarding external financing, the government won’t be able to drastically increase borrowing because it directly depends on absorption capacity, which stands at a mere 75 percent of budgeted capital spending. Frustration is already running high among Nepal’s key multilateral and bilateral donors owing to the government’s inability to timely use the committed grants and loans. Furthermore, concessional lending from multilateral donors might be drying up. The Asian Development Bank and the World Bank are gradually phasing out concessional lending, which means Nepal might have to borrow at a rate between concessional and nonconcessional terms. The bilateral donors may not be as generous as the multilateral donors as they usually insert binding hooks on procurement and the utilization of funds.

Rhetoric vs realism

Hence, the prospect for domestic and external borrowing may not be as rosy as has been claimed by some politicians and their cheerleaders. Being ambitious on infrastructure projects and their financing is okay, but it should not depart much from what is realistically possible and most importantly it should be not be used to score political points founded on misplaced nationalism. 

The most realistic option for now is to improve investment climate to facilitate private investment (including lowering of country investment risk premium) and to enhance the absorption capacity to accelerate capital spending. It would require addressing head-on the constraints to private investment and low capital spending (including contract management) with an aim to domestically finance large-scale infrastructure projects in the future. Practically, such projects should be financed by issuing long-term construction bonds instead of relying on short-term treasury bills, and medium-term development, employment and savings bonds. An appropriate environment to boost confidence on such long-term bonds is needed.

Properly doing these would require tough reforms, which may not be politically palatable, as opposed to lofty rhetoric on economic development.