Hardware and software of economic reforms in India

Subramanian and Felman on the inherited problems, macro-economic stability, and "hardware" and software" of economic reforms (detailed analysis here):

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The infrastructure investment boom of the early 2000s ran into major difficulties, especially after the GFC. But bankrupt firms were not allowed to exit, resulting in overcapacity that dragged down profits for the entire sector and led to burgeoning non-performing assets (NPAs) at the banks. This Twin Balance Sheet (TBS) crisis undermined growth because it meant that many firms weren’t sufficiently strong enough to expand—even if they were, banks were reluctant to lend. Real credit growth—the lubricant of any economy—consequently slid to historically low levels, and turned negative in recent years.

Summing up, the government has still not been able to overcome the problems it inherited. Now covid-19 has dealt another blow. Currently, 2020 growth estimates are being upgraded as economies are normalizing, but even revised IMF forecasts are likely to show India’s growth to be amongst the worst in the world. At the same time, macro-economic stability has been set back, as the fiscal position and inflation have deteriorated significantly. So, the RBI forecast that under the baseline scenario, the NPA ratio will almost double to 13.5% by September 2021.

[…] What then needs to be done? Consider why the government’s measures have so far failed to achieve the desired results. Transformational measures always require tweaking to ensure that they work properly. […] One possibility is that the “hardware" of reform measures has not been accompanied by sufficient “software". What is the software of economic reforms? Traversing the sequence from planning to implementation sound policies require accurate data, fair decisions, statecraft to win support, policy consistency over time, and rule of law in implementation.

[…] In the fiscal accounts, despite improvements, increasing off-budget expenditures have rendered the deficit figure less meaningful.

[…] The current government has made extensive efforts to create a level playing field, including a reliance on auctions and use of technology to automate public procurement and tax filing. But certain decisions—in retail, telecom, airports—have been perceived as demonstrating favouritism, reinforced by the reduction in Parliamentary discussion of policy initiatives. Stigmatized capitalism remains a serious problem.

[…] Once a policy is formulated, statecraft is needed to gain support of the stakeholders, especially the states, because nearly every major issue requires joint action.

[…] Once consensus is achieved and a major policy initiative launched, governments need to ensure that subsequent measures remain in line with the strategic objective. Often this does not occur. […] Widening the tax base was set back when in 2019 the income tax threshold was raised dramatically, removing about three-quarters of taxpayers from the tax net.

[…] this government, like all its predecessors, is embroiled in contract disputes with its contractors, especially on infrastructure projects. Its arrears to suppliers run high and there is anxiety about arbitrary tax enforcement.

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Indian economy to contract by 7.7% in FY2021

The first advance estimate of economic activities in FY2021 (April 2020 to March 2021) released by Ministry of Statistics and Programme Implementation shows that the Indian economy will likely contract by 7.7% in FY2021. GVA (at basic prices) contraction is expected to be 7.2%. This is due to the severe economic disruptions— supplies as well as demand shocks— caused by the pandemic and the ensuing lockdowns that started from March 25 and was relaxed in a phased manner since June. The Indian economy had been slowing down even before the pandemic, especially since FY2017, when the economy grew by 8.3%. 

The only saving grace is agricultural sector, which is expected to grow by 3.4% on the back of favorable monsoon and the output surge as labor reverse migrated to villages after the lockdowns. All other sectors are expected to contract. Industry sector, which accounts for about 30% of the economy, as a whole will likely contract by 9.6%. The pandemic accelerated its slowdown as it was already losing steam, especially since FY2017. For the 2011-12 national accounts data, industrial sector growth peaked at 9.6% in FY2016. Within the industry sector, manufacturing activities have slowed down the most. It barely grew last fiscal (0.03%). In FY2021, it is expected to contract by 9.4%. Mining & quarrying activities are expected to contract by 12.4% and construction by 8.8%. However, electricity, gas, water supply and other utilities are expected to post a 2.7% growth. 

Services sector, which accounts for about 54% of the economy, is expected to contract by 8.8%, with the largest contraction in trade, hotels, transport and communications activities (-21.4%). These were severely affected during the lockdowns and continue to be partially affected even after relaxation of lockdowns. Financial services were not that affected compared to other activities (-0.8% growth). The slowdown in public spending is reflected in 3.7% contraction in public administration, defense and other services. 

On the expenditure side, consumption and investment are expected to contract sharply, but net exports are expected to improve largely because of slower deceleration of exports compared to imports. While public consumption is expected to grow by 5.8%, private consumption is expected to contract by 9.5%. Similarly, gross fixed capital formation is expected to contract by 14.5%, and change in stocks by 4.3%, indicating that the surge in pent-up demand has not been strong enough yet to clear and restock inventories. Exports and imports are expected to contract by 8.3% and 20.5%, respectively.  

The current forecast is based on the expectation of pickup in economic activities in the second half of FY2021. The economy contracted 23.9% and 7.5% in the first and second quarters, respectively. As expected, the most severe contraction was in services sector. 

Overall, the already slowing economy is expected to slowdown even faster due to the lockdowns and the lingering effect of the pandemic. Specifically, the slowdown in industrial sector since FY2017 is concerning. This is even more concerning in the case of manufacturing activities, which account for about 17% of the economy (one percentage point higher than the agriculture sector). This slowdown is actually reflected as a drop in capital formation, which contracted by 2% in FY2020 and is expected to further contract by 15.3% in FY2021. Note that first advanced estimate of GDP is based on data available (and its extrapolation) up to the first six to eight months of the fiscal year. 

Historically, FY2021 is going to be the worst fiscal year in terms of GDP growth (2011-12 constant prices series starting from FY1952). Previously, the economy contracted five times: FY1958 (-0.4%), FY1966 (-2.6%), FY1967 (-0.1%), FY1973 (-0.6%), and FY1980 (-5.2%).

The FY2022 central budget will focus on economic recovery and vaccine rollout. All eyes will be on how the government manages to increase public capital investment as well as secure financing for vaccine and its eventual coordinate, distribution and administration right up to the last mile. Gradual normalization of economic activities, income earnings and government’s fiscal support in terms of social security payments will prop up consumption. 

The expected slow pace of vaccine rollout in the initial phase and myriad challenges in its distribution and eventual administration might drag growth prospects, especially that of travel and tourism sector, in addition to the impending financial and fiscal sector stresses, which are expected to hit private as well as public investment. 

A sharp recovery in FY2022’s GDP growth inherently will have a large base effect component. The pace of the recovery in the following years may not be that fast without a sharp pick up in capital spending/investment (watch out for the additional NIP investment). 

In its January 2020 GEP, the World Bank estimated that the Indian economy will grow at 5.4% in FY2022 as “the rebound from a low base is offset by muted private investment growth given financial sector weaknesses”.

What induces inclusive growth?

In an article in VoxEU, Jalles and de Mello argue (related paper in Review of Development Economics) that episodes of inclusive growth are more likely to occur where human capital is high, tax-benefit systems are more redistributive, productivity grows more rapidly, and labor force participation is high. Trade openness and a range of institutional factors, including political system durability and electoral regimes, also matter. They define inclusive growth as increases in GDP per capita without a concomitant deterioration in the distribution of household disposable income.

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In fact, data from the World Bank World Development Indicators show that inclusive growth is not a rare event: between 1980 and 2013, there are 268 episodes of increases in GDP per capita without an associated deterioration in the distribution of household disposable income in the sample of up to 78 countries for which information is available. These episodes include, for instance, France between 1985 and 1989, Germany between 1995 and 1997, Brazil between 2004 and 2006, and India between 1998 and 2000. 

[…] In an average episode, real GDP per capita grows at about 3.3% per year, and the Gini coefficient of household disposable income falls by about 0.8 over the same period. While duration does not seem to have much influence on the magnitude of changes in real GDP per capita during inclusive growth episodes, the reduction in the Gini coefficient tends to be more pronounced in episodes that last four years or less.

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They argue that inclusive growth episodes are more likely to occur where:

• Population is better educated
• Tax-benefit systems are more redistributive
• Labor force participation and multifactor productivity growth are higher
• Economies are more open to trade 
• Share of population working in industry is higher
• Durable political systems exist with regular parliamentary elections and electoral regimes based on proportional representation (not exactly durability of governments per se though)
• Some degree of fiscal decentralization exists

But then, inclusive growth episodes are less likely where:

• Inflation is high
• Output growth is more volatile
• Unemployment is widespread
• Financial deepening is more (higher probability of banking and financial crises occurring)

So, redistribution through tax-benefit systems, human capital accumulation, and a sound macroeconomic framework seem to be important for inclusive growth. However, note that results may change slightly depending on the definition of inclusive economic growth. For instance, some define inclusive economic growth (prosperity) as the annualized growth in average real per capita consumption or income of the bottom 40 per cent. Others define it as rapid and sustained economic growth, access to education and health opportunities, and social protection. 

Fiscal policies to address COVID-19 pandemic

In its latest Fiscal Monitor (October 2020), the IMF argues for flexible fiscal measures to respond to lockdowns and tentative reopenings, and facilitation of structural transformation to a new post-pandemic economy. The report outlines a roadmap for the overall fiscal strategy to promote a strong recovery. The idea is to facilitate the transformation to a more resilient, inclusive and greener economies. The IMF recommends full transparency, good governance, and proper costing of all fiscal measures, especially given their size, exceptional nature, and speed of deployment.

Going forward, interest rates will remain low for a long time in advanced and some emerging market economies due to high levels of precautionary savings by households and limited private investment amidst the uncertainties. It means there is scope and motivation for fiscal policy (thanks to negative interest-growth differential) to remain a crucial and powerful tool for recovery. For instance, scaling up of quality public investment will boost employment and economic activities, crowd-in private investment, and absorb excess private savings without increasing borrowing costs. Some emerging market economies and low-income developing countries that face tight financing constraints may need to reprioritize expenditures, enhance efficiency of spending, and seek further official financial support and debt relief.  

On the nature of fiscal policy during and after the pandemic, the IMF recommends:

• No premature withdrawal of crucial household and business support measures
• Ensure social protection systems are targeted and able to deliver benefits to vulnerable people
• During the recovery phase, help workers find new jobs and facilitate vulnerable firms to reopen
• Support structural transformation toward the post-pandemic recovery including building resilience against future epidemics and other shocks. Policies to ensure that all people have access to basic goods (food) and services (health and education) are useful. Similarly, increasing carbon pricing and catalyzing investment in low-carbon technologies would help reduce emissions.
• When the pandemic is under control, focus on addressing the legacies of the crisis such as elevated private and public debt levels, high unemployment, and rising inequality and poverty.
• Countries with limited fiscal space should consider increasing progressive taxation and ensuring that highly profitable firms are appropriately taxed. This should be a growth-friendly and equitable adjustment.
• Develop well-resourced and better-prepared healthcare systems, expand digital transformation, and address climate change and environmental protection. 

Recovery strategy

To boost immediate-term growth, the IMF recommends transfers and public investment, which when faced with uncertainty combined with very low interest rates, weak private investment, and a gradual erosion of public capital stock over time yield a high fiscal multiplier. The fiscal response strategy depends on at what stage of the recovery a particular country is in, i.e. lockdown, partial reopening or post-pandemic phases. These generally include the following

• Lockdown phase: The objective is to save lives and livelihoods by continuing projects where safe (especially maintenance/repair).
• Start planning or reviewing portfolio of planned and active projects
• Partial reopening phase: The objective is to ensure safe reopening and to provide lifelines and targeted support. 
• Public investment could focus on job-rich projects, reassess priorities and prepare pipeline
• Maintenance works and ready for implementation projects should be the priority
• Review, reprioritize and restart feasible projects put on hold, plan for new projects or prepare pipeline of appraised projects that can be implemented in the next two years
• Post-pandemic phase: The object is to transform to a more inclusive, smart and sustainable economy. 
• Depending on fiscal space, countries could implement large, transformational projects with large long-term multiplier in healthcare, climate change adaptation and mitigation and digitization sectors.
• Strengthen project planning, budgeting, and implementation practices to improve public investment efficiency

Fiscal multiplier

The pandemic focused fiscal strategy calls for strengthened public investment management practices and governance to avoid delays, cost overruns, and disappointing project execution. Countries facing tight fiscal conditions could borrow at a low interest rates, which are expected to remain low through the medium-term. 

In advanced and emerging market economies, fiscal multiplier can be as high as 2 in two years. The IMF finds that increasing public investment by 1% of GDP in these economies would create 7 million direct jobs, and between 20 million and 33 million jobs indirectly. Similarly, GDP could grow by 2.7%, and private investment by 10%. The estimate is based on an empirical exercise covering 72 AEs and EMs with data on economic uncertainty regarding GDP forecasts (proxied by disagreements among forecasters). 

Public investment has larger short-term multipliers than public consumption, taxes or transfers. Macroeconomic conditions, institutional quality, and the quality of investment undertaken affect the size of multiplier. 

• First, higher levels of public debt could yield lower fiscal multipliers if deficit-financed investment leads to greater sovereign spreads thus higher private financing costs (essentially, crowding-out the private sector). 
• Second, if an economy faces supply constraints, then fiscal multipliers tend to be smaller (social distancing measures limit output capacity). 
• Third, uncertainty over the trajectory of the virus and the economy could affect multiplier if private spending does not react to a fiscal stimulus (due to uncertainty and precautionary savings). Alternatively, multiplier could be higher if private spending reacts positively to higher public investment amidst mounting uncertainties. 
• Fourth, weak balance sheet of firms (as they are unable to repay debt) and default risks limit their investment and hence the size of fiscal multiplier. 

Generally, multipliers tend to be larger in countries less open to trade because low propensity to import reduces leakage of the demand gains to other countries. Similarly, multipliers tend to be large in countries with fixed exchange rate regimes or where central banks are facing an effective lower bound. Also, when resources are underutilized (like in recessions), fiscal multipliers tend to be high – could be through direct public investment or through a combination of direct public investment and crowding-in of private spending through confidence boosting measures. 

Crowding-in private investment is possible in communications and transport (to respond to healthcare crisis), and construction and manufacturing (during recovery). Investment in health and education, and digital and green infrastructure can improve connectivity, economy-wide productivity, and resilience to climate change and future pandemics. Right government policies and initial investment can crowd-in private investment when faced with uncertainties.

 

Sizable fiscal support

The IMF notes that fiscal actions in response to COVID-19 amounted to $11.7 trillion (12% of global GDP) as of 11 September 2020. Half of this was additional spending or foregone revenue (such as temporary tax cuts and liquidity support including loans). In 2020, government deficits will likely surge by an average 9% and global public debt will approach 100% of GDP. Sizable discretionary support, a sharp contraction in output and an ensuing fall in revenues along with a rise in expenditure (beyond preexisitng automatic stabilizers) have increased government debt and deficits. 

Fiscal space

The ability of countries to respond to the pandemic is determined in part by their fiscal space, and by public and private debt levels. In advanced economies, massive liquidity provision and asset purchases by central banks have facilitated fiscal expansions. In some low-income countries, financing constraints have been high due to debt distress. 

Countries with limited fiscal space need to weigh in the benefits, costs and risks of additional fiscal support measures in the face of limited fiscal space. Evidence so far suggest that public health policies that quickly contain the spread of the disease also allowed for an earlier and safer reopening, restoration of confidence, and economic recovery. 

Popular fiscal support measures included the following:

• Household income support (targeted cash transfers or/and in-kind transfers, unemployment benefits/stimulus checks)
• Employment support (wage subsidies, hiring or retention subsidies)
• Tax support measures (temporary tax deferrals, social security payments, income tax cuts, progressive tax, increase in excise duty, VAT refunds, utility subsidies)
• Liquidity support (loans, guarantees, equity injections/solvency support, debt restructuring) 
• Support for innovation, green growth and digitization

Financing public spending

Some EMDEs have met increasing financing needs from borrowing internationally, drawing down buffers or extrabudgetary funds (India) or sovereign wealth funds (Chile, Russia), purchasing of government debt by central banks through quantitative easing (many AEs and some EMs), and increasing taxes (especially fuel excise tax in India and VAT rate in Saudi Arabia). Low income countries are relying on external assistance (grants or concessional loans).

Fiscal risks: Fiscal risks are high. They stem from

• A protracted economic downturn (private sector demand may remain subdued, bank balance sheets may deteriorate, high fiscal resources needed to support and retain unemployed workforce) 
• Tightening global financial conditions (rapid growth of sovereign debt and nonfinancial corporations debt expose countries to sudden change in financing conditions, especially borrowing costs, and subsequently issues with sustainability of corporate credit and sovereign debt)  
• Commodity market volatility (price fluctuations impact commodity exporters and importers differently)
• Contingent liabilities (new guarantees increase liabilities and debt vulnerabilities)

Post pandemic recovery strategy

It was published in The Kathmandu Post, 19 October 2020.

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Everything is not okay

A series of impractical and confusing recovery policies have heightened business, investment and employment uncertainties.

Owing to a prolonged combination of health, supply and demand shocks, and a botched response to containing the spread of the novel coronavirus, the pandemic is severely affecting the economy. These shocks, along with preexisting economic and governance weaknesses, have increased the likelihood of subdued economic activities well into the medium-term; that is, the ongoing economic pain may not be a temporary phenomenon. The poorest households, informal sector workers, and those working in contact-intensive services have been disproportionately affected. Consequently, both poverty and inequality are expected to increase. Furthermore, many micro, small and medium enterprises are expected to face bankruptcy, as consumer demand remains muted and supplies continue to be disrupted.

Against this backdrop, a sustained and inclusive economic recovery hinges on pragmatic stabilisation policies over the short to medium term, followed by coherent structural reforms across sectors over the medium to long term. The economic strategy should focus on propping up aggregate demand over the medium term through public spending on quality, shovel-ready projects; or through the repair and maintenance of public assets. In order to bridge the short-term financing gap amidst high fiscal stress, the government may need to rely more on policy-based external borrowing, which comes as budget support conditional on fulfilling certain committed reforms.

Not so rosy

Economic output growth in the fiscal year 2020-21 will most likely be only slightly better than in 2019-20, thanks to a base effect, which refers to a tendency of achieving an arithmetically high rate of growth when starting from a very low base. Gross domestic product (GDP) growth might actually contract in 2019-20 as labour and capital mobility were curtailed in the last quarter of 2019-20 as well. Third quarter estimates released by the Central Bureau of Statistics in September show that GDP growth plunged to 0.8 percent even though lockdowns started in the middle of the quarter. This is the slowest pace of quarterly GDP growth since the second quarter of 2015-16, when the Indian economic blockade contracted the economy. The fourth quarter GDP data for 2019-20 will probably show a contraction. Cumulative full year GDP will also likely contract due to the severe disruptions in industry and services owing to lockdowns, a shortage of inputs in the agricultural sector and a lack of effective fiscal response to prop up consumer demand. The Bureau’s 2.3 percent growth projection for 2019-20 has no relevance now. The International Monetary Fund projects the economy to grow by 0.02 percent in 2019-20 and 2.5 percent in 2020-21.

The other statistics are also not that rosy. Despite subdued demand for consumer goods, continued supplies disruptions, as well as higher logistics costs, will likely keep inflation above 6 percent. The surge in banking sector liquidity is temporary, as credit growth has slowed down significantly due to a drop in new loan applications. This is benefitting the government as it is able to borrow at a record level with lower interest rate. The current account deficit is narrowing down as imports decelerate more than exports and remittances’ deceleration is below expectation. These indicators will quickly deteriorate as businesses and household activities pick-up pace. Overall, the outlook is not at all rosy.

Effective recovery

What went wrong since the first confirmed Covid-19 positive case on January 23 and the lockdown that started on March 24 but was relaxed in September? The uncontrolled outbreak and the lack of healthcare infrastructure are now considered a basket case of bad pandemic mismanagement. The lockdowns were an opportunity to prepare necessary healthcare infrastructure—which includes the availability of personal protective equipment, hospital beds, Covid-19 care centres for those unable to stay in home isolation, an active network of contract tracers, and widespread testing, among others—to respond to the eventual rise in infections. Not only was healthcare response mismanaged, the economic response too was patchy and demoralising. A series of impractical and confusing recovery policies heightened business, investment and employment uncertainties. These need to be rectified for sustained and inclusive recovery.

The priority should be the healthcare sector. Without controlling the spread of the novel coronavirus and providing necessary medical care to the infected, a full recovery to pre-crisis output growth is a foregone conclusion.

The government should then implement effective short-term measures to support struggling households (through cash transfers and in-kind food subsidies) and businesses (with subsidised low interest loans, credit guarantee schemes, tax deferrals, moratoria on debt services, and equity injections in promising firms). This calls for both a growth-enhancing revenue policy and an expenditure policy designed to stabilise the economy in the short term, followed by structural reforms to boost long term growth potential.

However, since this entails additional fiscal burden amidst limited resources, the third priority should be a smarter fiscal strategy. For instance, expenditure should be reprioritised to address the healthcare crisis. It means investing in temporary Covid-19 care centres, increasing hospital beds and ventilators, increasing availability of affordable and hassle-free testing, and tracing potentially exposed people effectively, among others.

Similarly, to boost short-term aggregate demand, the government could prioritise shovel-ready projects that can be completed within the next two to three years, or simply focus on the maintenance of existing assets (especially water supply, irrigation canals, bridges, rural roads and highways, transmission and distribution lines, etc) and the completion of ongoing projects. It will not only give an immediate-term boost to public sector-led demand at a time when private sector demand is subdued, but will also create badly needed manual and low skilled jobs for returning migrant workers. Initiating new projects that are short of project readiness should not be the priority for the short-term. To save scarce resources, the government could think of ending subsidies on fuel and all discretionary handouts.

To generate more resources to finance short-term needs, the government could also focus on securing policy-based loans from development partners. A well-planned set of sectoral reforms with clear policy, regulatory, institutional and legal framework would serve as a basis for securing policy-based loans. The post-Covid-19 era is a defining moment to initiate consequential structural reforms similar to the ones rolled out in 1992. Public financial management reforms, such as in robust medium-term expenditure and revenue frameworks, streamlined processes across the three tiers of government, and legal cap on central and provincial fiscal deficit, are important. The digitisation of government services, integrated social protection platform for better identification and to control leakages, and core sectoral reforms in energy, water supply, roads, education and health sectors are other key areas. Another key avenue for development is an overhaul of the vocational training curriculum to provide reskilling to shrinking sectors such as travel and tourism. In business, the promotion of economic corridors to boost enterprise on the one hand, and a facility to resolve bankruptcies sooner for struggling organisations on the other would both go a long way to boost growth and recovery.

Remittances and external sector stability in Nepal

It was published in The Kathmandu Post, 02 September 2020. Related Twitter thread with charts here. 

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The cash cow is drying up

Don’t be fooled by the better-than-expected results from the external sector, the effects are only temporary.

The latest provisional data for the fiscal year 2019-20 released by the Nepal Rastra Bank provide interesting insights on the impact of Covid-19 and the subsequent lockdowns on the economy. Almost all areas, except for the external sector, have been hit hard since the first lockdown began in late March. Specifically, unlike projections of a sharp drop, the data shows just a small deceleration in remittances.

This has led some to argue that Nepal’s external sector is sound as well as resilient and that vulnerabilities are on the downside. However, the reality is that it only appears sound owing to a larger import contraction than export contraction, and slower than expected deceleration of remittances. Remittances are an important household coping strategy when faced with an adverse income or consumption shock. Migrant workers tend to use precautionary savings to remit more after such shocks. This should not be construed as a sign of resilience.

Still unstable

A sudden supplies disruption was expected to hit imports and remittances, resulting in an improvement in the current account balance, which is a record of Nepal’s transactions with the rest of the world. Exports pretty much stalled after the pandemic spread globally. Imports, except for medical equipment and supplies, were also severely curtailed due to disruptions and logistical hurdles. Further, oil imports, which normally account for 15 percent of the total import bill, decreased on account of a drop in internal demand, particularly for transportation and development projects.

Declining global oil prices also contributed to a lower oil import bill. Consequently, imports decreased much faster than exports. For instance, in US dollar terms, merchandise exports and imports contracted by 7.9 percent and 18.9 percent, respectively. In a reversal of the previous trend, merchandise trade deficit actually dropped to 28.2 percent of the gross domestic product in 2019-20 from 37.1 percent of GDP in 2018/19.

Similarly, the trade imbalance in services also improved as services import (which includes outbound travel and foreign educational expenses) decreased much more than services export (which includes inbound travel and tourism). A sharp contraction of imports but a small contraction of remittances (by just 3.4 percent) improved the current account balance. This is what the analysts meant when they argued that the external sector remained stable despite the adverse external environment.

Meanwhile, the balance of payments reached a record $2.4 billion as a large contraction of imports but a lower than expected deceleration of remittances and an increase in foreign direct investment and foreign emergency loans all played crucial roles. Similarly, gross foreign exchange reserves have also hit record levels. The Nepali rupee depreciated by 9.2 percent against the US dollar at the end of 2019-20.

The improvement in the current account balance, a large balance of payments surplus and record foreign exchange reserves might have given a misplaced assurance that all is sound and stable. But regardless of the pandemic being contained or the country choosing to simply live with the virus, as the economy opens up after the lockdowns and supply chains are restored, the situation might quickly change.

Most prominently, the import of commodities (oil, food and raw materials) as well as intermediate capital goods will increase. Meanwhile, given the lack of price competitiveness, an unfavourable policy environment, distortionary incentives and generally subdued external demand, exports will likely not recover soon. Travel and tourism activities may not also recover quickly. These will deteriorate the tenuous external sector stability and put a strain on foreign exchange reserves.

A short respite

The problem will be compounded by the expected deceleration of remittance inflows. Apart from its positive effect on reducing poverty and boosting consumer demand, government revenue and financial sector liquidity, large remittance inflows have been a saving grace for external sector stability in the face of a large and growing trade deficit. The number of Nepali migrant workers has been continuously declining since 2014-15. The persistent deceleration of remittances will be coupled with a smaller expatriate workforce, with fewer outbound migrant workers and a reduction in the work hours of those already working abroad.

There are three main reasons why remittances did not decelerate as expected in 2019-20. First, remittances tend to increase immediately after a shock in receiving countries. For instance, remittances increased by 12.2 percent in 2014-15 as migrant workers, drawing from their precautionary savings, remitted more income to their earthquake-affected families. However, the following fiscal it only grew by 0.8 percent. Second, the depreciation of the Nepali rupee against the US dollar also provides an incentive for migrant workers to remit more money. The rupee depreciated by 9.2 percent in mid-July 2020, much higher than 0.02 percent depreciation in mid-July 2019. Third, the use of formal banking channels to remit income has increased along with the rise in the number of money transfer agencies and the crackdown on informal inflows.

The Nepali economy entered the Covid-19 era with pre-existing weaknesses: a weak foundation for meaningful structural transformation, volatile GDP growth and inflation, mounting fiscal stress due to a large fiscal deficit and increasing public debt, persistent asset-liability mismatches and high credit growth by financial institutions, and decelerating remittances. It was exacerbated by weak governance and contract management in public projects, political infighting within the ruling party, over-politicisation of the Millennium Challenge Corporation’s compact programme and geopolitical discord. The potential deceleration of remittances will exacerbate these trends, and heighten external sector stress.

The impact of COVID-19 on Africa

Paul Collier explains how four shocks (drop in commodity prices, remittances, tourism, and international capital) due to the overarching COVID-19 shock are threatening Africa's progress.

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Two in three jobs in sub-Saharan Africa are in the informal sector. There are no economies of scale or specialisation. Small is not beautiful, it is unproductive. Africa needs more companies capable of organising a workforce into specialised, collaborative teams, disciplined by competition. Yet even the firms that Africa has are bleeding from the economic impact of coronavirus.

This shock is not predominantly a result of Africa’s health crisis. The causes are the sharp downturns in advanced economies. Commodity prices have dropped and Africa is a major net exporter.

Senegal and Ethiopia are major recipients of remittances from citizens working abroad. Normally, these rise during a domestic crisis, but in this global emergency Africa’s diaspora are losing their jobs. This also hits the most desperate places such as Yemen.

Finally, the retreat of international capital to safety is hitting hardest the countries that were most promising for investors. Ghana was attracting US pension fund money and major companies such as Volkswagen and Bosch. All four shocks are eroding Africa’s scarce organisational capital and are likely to persist for the medium term.

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