IMF's latest view on capital flows: CFM and MPMs can be applied pre-emptively without surge in capital inflows

The IMF has updated its view on capital flows. Specifically, it now recommends that countries should have the option to pre-emptively curb debt flows to safeguard macroeconomic and financial stability. Excerpts from a blog post:

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Economies with large external debts can be vulnerable to financial crises and deep recessions when capital flows out. External liabilities are riskiest when they generate currency mismatches—when external debt is in foreign currency and is not offset by foreign currency assets or hedges. [...]Since the beginning of the pandemic many countries have spent to support the recovery, which has led to a build-up of their external debt. In some cases, the increase in debt in foreign currency was not offset by foreign currency assets or hedges. This creates new vulnerabilities in the event of a sudden loss of appetite for emerging market debt that could lead to severe financial distress in some markets.

In a review of its Institutional View on capital flows released today, the IMF said that countries should have more flexibility to introduce measures that fall within the intersection of two categories of tools: capital flow management measures (CFMs) and macroprudential measures (MPMs). [...]these measures, known as CFM/MPMs, can help countries to reduce capital inflows and thus mitigate risks to financial stability—not only when capital inflows surge, but at other times too. 

The main update is the addition of CFM/MPMs that can be applied pre-emptively, even when there is no surge in capital inflows, to the policy toolkit. [...]Pre-emptive CFM/MPMs to restrict inflows can mitigate risks from external debt. Yet they should not be used in a manner that leads to excessive distortions. Nor should they substitute for necessary macroeconomic and structural policies or be used to keep currencies excessively weak.

CFMs to restrict inflows might be appropriate for a limited period, the Institutional View said, when a surge in capital inflows constrains the policy space to address currency overvaluation and economic overheating. It said CFMs to restrict outflows might be useful when disruptive outflows risk causing a crisis. In turn, CFM/MPMs on inflows were considered useful only during surges of capital inflows, assuming that financial stability risks from inflows would arise mainly in that context.

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Preemptive CFM/MPMs on debt inflows (primarily in FX) may be useful in the presence of private sector debt stock vulnerabilities (primarily FX mismatches), which MPMs cannot sufficiently address. Those stock vulnerabilities may have accumulated during prior inflow surges or gradually over time without an inflow surge. Preemptive inflow CFM/MPMs should be targeted, transparent and, while potentially longer-lasting, temporary, being recalibrated or removed as the vulnerabilities that led to their adoption subside, or if an effective MPM (that is not designed to limit capital flows) becomes available.

In the context of capital inflow surges, inflow CFM/MPMs may be useful to address financial stability risks arising from the surge, and CFMs on inflows may be useful in the circumstances outlined in the Venn Diagram in Figure 2 (upper panel).

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Sri Lanka’s economic crisis and unsustainable public debt

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

Macroeconomic mismanagement

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

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

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

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

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

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

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

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

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

Unsustainable public debt

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

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

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

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

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

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

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

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

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

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

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

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

Post pandemic economic recovery in Nepal

It was published in The Kathmandu Post, 14 March 2022.

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Medium-term economic recovery

A course correction beyond the band-aid nature of policy reaction is warranted.

The weaknesses of the economy, masked by pandemic-related fiscal and monetary relief measures and regulatory forbearances, are starting to unravel. Economic growth is persistently below target, the budget deficit is large and widening, public debt is increasing sharply, current account and balance of payments deficit are growing, and foreign exchange reserves are falling. The overall macroeconomic situation and growth outlook are not encouraging. A course correction beyond the band-aid nature of policy reaction is warranted to ensure the country has the available resources to finance the investment needed for medium-term economic recovery.

Deteriorating situation

The economy contracted by an estimated 2.1 percent in fiscal 2019-20, the first contraction in over four decades, as demand, supply and health shocks disrupted economic activities. A sharp and considerable economic rebound is unlikely due to a setback in agricultural output, especially a shortage of chemical fertilisers, and the continued deceleration of remittances that affect households’ purchasing power. Gross domestic product (GDP) growth may hover around 5 percent as base effect (which refers to the tendency of achieving an arithmetically high rate of growth when starting from a very low base) dissipates, and remittances decelerate (which constrains aggregate demand).

The state of public finance is also not encouraging given the large and growing fiscal deficit, which refers to expenditure net lending minus total receipts. Federal receipt, which includes foreign grants, is estimated to reach 23.7 percent of GDP this fiscal, but federal expenditure is estimated to top 34.8 percent of GDP, of which recurrent expenses account for 65 percent. Despite expenditure and revenue shortfalls relative to budget targets, the deficit will likely be over 6 percent of GDP. Note that the spending pattern has not changed much with capital spending absorption capacity still low, and over 50 percent of actual capital spending bunched in the last quarter, raising concerns over the quality of assets and fiduciary risks. It was just 16 percent of the budget estimate in the first seven months of this fiscal.

Capital spending is beset with structural weaknesses (low project readiness, weak contract management, and high staff turnover), allocative inefficiency (ad hoc allocation, lack of adherence to medium-term framework, and weak project pipeline), and bureaucratic delays (political interference at operational and management levels, weak intra- and inter-ministry coordination, and maze of approvals). Meanwhile, outstanding public debt has nearly doubled in a matter of just five years, reaching 40.7 percent of GDP in 2020-21.

The financial sector is also not in good standing. An aggressive increase in credit relative to deposits, which has fallen in tandem with the deceleration of remittances, has contributed to a chronic liquidity crisis. The liquidity situation used to be periodic in the past, that is it fluctuated in line with capital spending. However, it has been persistent in recent years, implying structural weaknesses and increased vulnerabilities in the financial sector. The outsized real estate and housing bubbles and the bullish stock market are not in sync with the macroeconomic fundamentals. It could pose a significant challenge after pandemic-related regulatory forbearances and relief measures are withdrawn. The elevated inflationary pressure, primarily due to supply disruption, rise in fuel and commodity prices, and Nepali rupee depreciation, will worsen the matter.

The external sector is in bad shape. The current account deficit in the first six months of this fiscal year is already higher than the whole of the last fiscal year. This is mainly due to the widening trade deficit and deceleration of remittances, which is not expected to recover soon. Consequently, the balance of payments is negative and foreign exchange reserves are falling steadily. Now, foreign exchange reserves are sufficient to cover 6.6 months of merchandise and services imports. It was about 14 months of import cover in mid-July 2016. Given the currency peg with the Indian rupee, vulnerability to natural disasters and the need for an additional buffer for remittances and tourism-related vulnerabilities, the optimal level of reserves is estimated to be 5.5 months of prospective import of goods and services.

Medium-term priority

Economic recovery will only be strong and sustained if medium-term priority is reoriented to reduce reliance on exogenous factors to support growth, poverty and inequality reduction, revenue mobilisation, and financial and external sector stability. For instance, the pattern and intensity of monsoon rainfall largely dictate agricultural output in the absence of reliable supply of farm inputs such as year-round irrigation, timely availability of chemical fertilisers, cheaper access to finance, and connectivity to link farmgate and retail markets, and farmers and consumers. Similarly, remittance income largely dictates consumption, especially private consumption, accounting for 90 percent of total consumption and demand in services and industrial sectors. This is neither resilient nor sustainable. Policy effort should be directed towards reorienting the sources of growth to more reliable factors through investment in physical infrastructure and human capital development, private sector development, and public sector reforms. These are essential to boost aggregate output and productivity.

Creating fiscal space required to boost spending on physical infrastructure and human capital development in the public sector is essential. This can be done through expenditure management and/or higher revenue mobilisation. Reduction of recurrent spending through expenditure consolidation or by plugging in leakages (for instance, in the distribution of allowances, unnecessary recruitment, and mundane charges), enhancing budget transparency and policy direction, accounting for fiscal risks and liabilities, and decreasing fiscal burden due to loan and share investment in non-performing public enterprises are some of the areas that require urgent attention for expenditure management. Since raising taxes is not ideal given the already high rates, efforts should be redirected at enhancing revenue administration, including reducing tax expenditures (subsidies, rebates, concessions), broadening the tax base, and divesting the government’s share in public enterprises and the monetisation of their assets. These will be helpful to create the fiscal space needed to finance medium-term recovery and promote competitive and cooperative federalism.

Similarly, financial sector volatility and vulnerabilities need to be curbed by using macroprudential tools. Credit growth needs to be consistent with deposit growth, asset-liability mismatch minimised, sectoral bubbles contained, and evergreening of troubled assets discouraged. These contribute to high volatility of liquidity and hence unpredictable interest rates. The current monetary policy and financial sector architecture do not adequately stop the misallocation of resources to sectors that do not contribute much to boosting domestic economic activities and job creation.

Another priority area should be private sector development to boost competitiveness and unshackle the economy from the grip of sectoral cartels and crony capitalists that distort factor and product markets. A holistic review of policies, rules and regulations is needed to get a clear picture of why investment is not increasing as expected despite the slew of legal changes enacted in the last five years. This review should also answer why special economic zones remain vacant and what needs to be done, the possibility of providing relatively cheaper electricity to businesses to boost cost competitiveness of industrial and services sectors, and the effectiveness of Investment Board Nepal in promoting investment and public-private partnership.

Impact of fiscal rules on subnational government spending

Interesting research by Carreri and Martinez on the impact of fiscal rules at the subnational level in Colombia. Briefly, it reduced overspending without affecting public goods or living standards, and aligned with voters' preferences. Here is another related study by Bianchi et al (2021) in Italy where they find that fiscal decentralization reduced local spending but expanded municipal services, and it also increased female labor supply.

Abstract from a recent article on VoxDev:

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[...] In recent research (Carreri and Martínez 2021), we study a sub-national fiscal rule introduced in Colombia in 2000. This rule was the national government’s response to a growing fiscal imbalance associated with the country’s decentralisation process from the early 1990s. The rule set a cap to the operating expenses of municipal governments, expressed as a share of their current revenue. For the municipalities in our sample (90% of the total), which are smaller, less developed, and have a homogeneous institutional structure, this cap was set at 80%. Compliance with the rule is determined every year by the country’s fiscal watchdog agency and non-compliers face disciplinary sanctions from the Inspector General’s office. They also lose access to financial assistance from the national government.

Current revenue includes local tax revenue, fees and fines, and some formula-determined intergovernmental transfers. This is the denominator of the fiscal outcome targeted by the rule, which we refer to as the ‘overspending indicator’. Operating expenses (i.e. the numerator) include remuneration of administrative staff, general expenses such as procurement, rent, maintenance, travel, and training, as well as pensions of former employees and payments dictated by court sentences. Importantly, all expenses associated with local public goods (education, health, water, sanitation, culture, etc.) are classified as investment and fall outside the scope of the regulation.

Even though the fiscal rule affected all municipalities de jure, only those with operating expenses exceeding the cap at the time of the reform were exposed to it de facto. Our research design exploits this variation in exposure and examines whether municipalities affected de facto by the fiscal rule experienced disproportionate changes in our outcomes of interest after the reform. These outcomes include fiscal variables, various measures of public goods and living standards, as well as electoral support for the local incumbent party and incidence of protests.

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The result:

• Fiscal rule reduced overspending in public administration
• Fiscal rule did not affect public goods or living standards
• Voters rewarded incumbent parties for fiscal restraint

Fiscal decentralization and local public services delivery

Abstract from a NBER working paper by Bianchi et al (2021): Fiscal decentralization reduced local spending but expanded municipal services, and it also increased female labor supply in Italy. 

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This paper studies how fiscal decentralization affects local services. It explores a 1993 reform that increased the fiscal autonomy of Italian municipalities by replacing government transfers with revenues from a local property tax. Our identification leverages cross-municipal variation in the degree of decentralization that stems from differences in the average age of buildings caused by bombings during WWII. Decentralization reduced local spending but expanded municipal services, such as nursery schools. These effects are larger in areas with greater political competition. The paper also investigates how the reform affected labor markets. Decentralization increased female labor supply—probably through expanded availability of nursery schools—thereby reducing the gender gap in employment.

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Briefly, in 1993, Italian municipalities saw fiscal decentralization increase when the central government replaced government grants with revenue from a newly established local property tax. Local revenue (from local taxes and service fees) increased by more than 50% relative to 1992 in just a year's time and replaced central government transfers as the major source of municipal revenues. This boosted accountability as local politicians had to be more accountable to residents for any mismanagement of funds. 

• They find that decentralization induced local politicians to cut waste and increase efficiency. After the reform measure, local administrators decreased the size of government (both expenditure and revenue), but also rebalanced spending in favor of revenue-generating and customer-facing services, thus reducing administrative processes and associated costs. 
• They also find that municipalities that raised more revenues through the local property tax dedicated a larger share of their budget to nursery schools (+18%) and had more public nursery schools (+20%). The number of pupils in nursery schools increased by an additional 24% after the reform in the same cities.
• They document that municipalities that raised more revenues through the local property tax experienced a larger increase in female participation in the labor market. Women's LFPR increased by up to 20%, leading to reduction in preexisting gender gap in employment.  

Agriculture productivity shocks and nonagricultural employment in India

Abstract from Jonathan Colmer's published paper in American Economic Journal: Applied Economics, 13(4):101-24

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To what degree can labor reallocation mitigate the economic consequences of weather-driven agricultural productivity shocks? I estimate that temperature-driven reductions in the demand for agricultural labor in India are associated with increases in nonagricultural employment. This suggests that the ability of nonagricultural sectors to absorb workers may play a key role in attenuating the economic consequences of agricultural productivity shocks. Exploiting firm-level variation in the propensity to absorb workers, I estimate relative expansions in manufacturing output in more flexible labor markets. Estimates suggest that, in the absence of labor reallocation, local economic losses could be up to 69 percent higher. 

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Short-term priorities for the economy

It was published in The Kathmandu Post, 09 August 2021.

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Short-term priorities for the economy

The focus now should be on executing the budget and curtailing wasteful spending.

The current coalition government led by Prime Minister Sher Bahadur Deuba has inherited a challenging economic situation that continues to be affected by the Covid-19 pandemic and related lockdowns. Finance Minister Janardan Sharma faces an uphill task to revive economic activities, which remain subdued with little likelihood of a convincing rebound beyond the base effect after a contraction in fiscal 2019-20. Specifically, a short-term economic recovery strategy to reap 'low hanging fruits' has to be rolled out and implemented in such a way that it does not deviate much from the 2021-22 budget ordinance and 15th Five-Year Plan.

The major constraint here is the availability of resources amidst unprecedented expenditure pressure while the country stares at a third wave of the pandemic. The government cannot drastically increase expenditure, both actuals and allocations, due to its implementation capacity and funding constraints. The latest data shows that the government fell short of targets in pretty much all fiscal indicators. In 2020-21, while recurrent spending was about 90 percent of the target, capital spending was just 65 percent. Tax revenue mobilisation was about 95 percent of the target, but foreign grants just 34 percent. A relatively slower pace of spending compared to revenue mobilisation meant that the fiscal deficit decreased to 4.8 percent of the gross domestic product (GDP) from 5.5 percent in 2019-20. In the 2021-22 budget, a large increase in expenditure compared to receipts is set to provisionally widen the fiscal deficit to about 6 percent of GDP.

Low-hanging fruits

Against the backdrop of slow economic activities, tight fiscal space, inflationary pressures and deteriorating external sector, the new finance minister faces a challenging task of stimulating broad-based and inclusive economic activity. He perhaps wants to deliver visible results in a short period of time given financing and implementation constraints. Unfortunately, the options are limited.

First, ensuring availability of funds, as and when needed, to respond effectively to the healthcare crisis should be the utmost priority. The most visible outcome for the government right now is an orderly process of testing, tracing and treatment; availability of vital medicines used for the treatment of the coronavirus; and widespread vaccination in the shortest time possible.

Second, the pandemic-hit industry and services sectors need continuous support—be it in the form of tax concessions or utility discounts or direct wage subsidy or social security contribution—until the situation stabilises. A third wave of infections and related mobility restrictions will further affect cash flows. It may actually permanently cut off the struggling small and medium enterprise from production networks. This will have long-term economic consequences as gaps in supply chains cannot be filled immediately. So, the government could prop up aggregate demand not only by increasing public spending, but also by supporting the private sector wade through the crisis so that they can achieve at least pre-pandemic levels of capacity utilisation.

Third, given fiscal and time constraints, a supplementary budget or major amendment to the budget ordinance is not ideal. The focus now should be on executing the budget and, if possible, curtailing some of the wasteful spending and ad hoc projects and programmes included in the budget. With earnest efforts, Sharma could make a difference by prioritising operation and maintenance of dilapidated roads and bridges, water supply and drainage system, electricity distribution lines, school and hospital buildings and other public infrastructure. These initiatives yield quick, visible results, and help to enhance productive efficiency of public spending. Funding for additional operation and maintenance expenses could be arranged through reprioritising and repurposing of existing budget allocations.

The finance minister could also prioritise public investment management by instituting a mechanism whereby only well vetted and prioritised projects are included in the budget and medium-term plan. This means reworking on the existing National Project Bank, which has guidelines for identification, appraisal, selection and prioritisation of projects but are hardly adhered to during implementation. This will aid in allocative efficiency of public spending.

On domestic resource mobilisation, the bulk of the work needs to be in improving revenue administration so that leakages are plugged. Note that new policy measures related to revenue are expected to contribute only 7 percent of the total estimated revenue for this fiscal. The rest 93 percent is planned to be generated from existing measures, which means increasing the taxpayer base and improving compliance. Harmonisation of IT systems of various tax wings, active risk-based audit for taxpayer compliance, and a monetisation strategy for idle public sector assets will be helpful. Furthermore, assisting sub-national governments in revenue administration as well as public investment management will also be important. On deficit financing, since the cost of external borrowing is lower than that of internal borrowing, the former may be prioritised for the interim period. However, this will require sectoral policy and institutional reform commitments, or improved budget execution capacity.

Fourth, fiscal and monetary policies have to be synced with an objective to ensure demand and supply stabilisation, and an eventual economic recovery. Moderate inflationary pressures are okay during the interim period, but a medium-term plan to tame inflationary expectations, which are trending upward, should not be overlooked. There could also be cooperation in ensuring that the existing support measures related to refinancing schemes, subsidised credit and regulatory forbearance are not prematurely withdrawn. That said, the authorities will have to carefully rein in excessive credit growth that is not consistent with indicators such as GDP growth and deposit growth. An unjustifiably bullish stock market and rising real estate and housing prices are not good signs at the moment for the sound health of the financial system.

Minimal physical interface

Fifth, external sector needs to be monitored carefully, especially the direction of remittance inflows amidst a decline in the number of outgoing migrant workers as well as weak demand for them in the destination countries. This, along with widening trade and current account deficits, could put external sector stability at risk. Adjusting import tariffs and tightening bank financing to dissuade demand for expensive foreign vehicles and gold could be considered.

Finally, the finance minister can push for new measures that could have an immediate impact on struggling households and businesses, and aid the recovery process. For instance, a partial credit guarantee scheme with an umbrella framework to cover all guarantees, including credit subsidy to various sectors is helpful. Similarly, digitisation of public services so that there is minimal physical interface between the public and businesses and bureaucrats is another promising area for quick results. Addressing youth unemployment through reskilling, vocational training and temporary employment guarantee schemes is also going to be fruitful.