How to build support for climate change policies?

 Abstract from a new NBER working paper:

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Using new surveys on more than 40,000 respondents in twenty countries that account for 72% of global CO2 emissions, we study the understanding of and attitudes toward climate change and climate policies. We show that, across countries, support for climate policies hinges on three key perceptions centered around the effectiveness of the policies in reducing emissions (effectiveness concerns), their distributional impacts on lower-income households (inequality concerns), and their impact on the respondents' household (self-interest). We show experimentally that information specifically addressing these key concerns can substantially increase the support for climate policies in many countries. Explaining how policies work and who can benefit from them is critical to foster policy support, whereas simply informing people about the impacts of climate change is not effective. Furthermore, we identify several socioeconomic and lifestyle factors – most notably education, political leanings, and availability of public transportation – that are significantly correlated with both policy views and overall reasoning and beliefs about climate policies. However, it is difficult to predict beliefs or policy views based on these characteristics only.

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Effect of carbon tax on household welfare in Asia and the Pacific

Carbon pricing or taxation is a popular climate change mitigation strategy.  However, the distributional effect seems to be different depending on how heavily households rely on carbon-intensive energy sources. In a latest IMF working paper, Alonso and Kilpatrick (2022) argue for a wide range of country-specific policies that could be implemented to compensate households, reduce inequality, and build support for adoption. 

A carbon tax is a fee imposed on the burning of fossil fuels (e.g., natural gas, coal, oil) based on their carbon content. Carbon tax implementation is politically sensitive because of the general opposition to higher energy prices, displacement of workers, and social disturbances (price increases have led to riots in Haiti, France, Kazakhstan, Ecuador, etc). Studies show that a price of $75 per ton for advanced economies, $50 for high-income emerging market economies, and $25 for low-income emerging market economies set in place by 2030 will be needed to achieve the Paris Agreement’s target of limiting warming below 2°C.

They use household surveys and input-output (IO) tables to examine the effect of a carbon tax on households in Asia and the Pacific. The Asia and the Pacific region accounts for 27% of all emissions so far, equivalent to 452 billion tons of CO2, and the region’s global share in fossil fuel combustion emissions has risen from 30% to 49% between 2000 and 2019. 

Carbon prices in the region are low based on those standards. Of the current carbon prices in place in the region, the average is around $6 per ton and only covers an average of 0.3% of yearly emissions in each country

They use IO tables to compute how higher energy prices induced by a carbon tax would lead to higher consumer prices in non-energy goods (if higher energy costs are fully passed-through). They then combine this result with household surveys to quantify the negative impact on welfare based on household consumption bundle. They also examine the extent of possible labor income loss as the carbon tax tends to lower labor demand. They study the impact of a carbon tax of $50 per ton. They use household surveys for Australia, China, Hong Kong SAR, India, Indonesia, Japan, Kiribati, Korea, Mongolia, Myanmar, New Zealand, the Philippines, Singapore, and Taiwan, Province of China.

Major findings of the paper:

Based on higher prices and lower labor income, a carbon tax of USD 50 per ton would lead to substantial losses of welfare for households amounting to around 10 percent of initial consumption in Mongolia and 7 percent in Indonesia. In China and India, the average loss would be slightly above 3 percent. It would be 2.1 percent for the Philippines and lower than 2 percent in Kiribati and Myanmar. However, the distributional impact would also be quite different. The carbon tax would be regressive in China, Indonesia, and Mongolia, but it would be progressive in India, Kiribati, the Philippines, and Myanmar. Across the region, small groups of households employed by the energy sector would be heavily exposed to labor income losses. 

They argue that the household welfare loss produced by a carbon tax can be reverted and redistributed through relatively simple and cheap compensation schemes. A wide range of country-specific policies could be implemented to compensate households, reduce inequality, and build support for adoption. They find that cash transfer targeted to the poorest 40 percent of the households through realistic proxy-means testing would cost only 16 percent of the resources raised by a carbon tax to ensure that these households are on average not worse off after the reform. It would be as cheap as 8 and 11 percent for India and Kiribati, respectively. The ratio would be around 15 percent for China and Myanmar. It would reach 17 percent for the Philippines and 23 and 24 percent for Indonesia and Mongolia, respectively.

Providing a universal cash transfer or “carbon dividend” to all households to ensure that more than half of the households are better off after the reform would cost only 23 percent of the resources raised by a carbon tax in India and 33 percent in Myanmar.

In India, they find that the burden of a carbon tax due to higher prices would be mildly progressive for households. Consumers in the poorest quintile would experience a loss of around 3.2 percent compared to initial consumption, while the richest households would lose around 3.4 percent. It reflects a strongly progressive direct effect from higher energy prices, partially offset by a regressive indirect effect from higher prices on other goods. The richest households allocate relatively more of their expenditure towards electricity, gasoline, and LPG while the bottom quintile of households consume more kerosene and to a lesser degree coal. Electricity, gasoline, and LPG would see their prices rise by 20.5, 12, and 23.6 percent, respectively in response to the carbon tax. This would add up to a burden of 0.4 percent of initial consumption for the poorest quintile, but 1.5 percent for the richest quintile. This progressivity is mitigated by the effect of higher prices of kerosene and coal, which would lead to a burden of 1 percent of initial consumption for the poorest quintile and only 0.3 for the richest. In sum, the direct effect of higher energy prices would cost 1.4 percent of initial consumption for the poorest households and 1.8 percent for the richest. The implementation of a $50 carbon tax would raise fiscal revenues by about 2.5 percent of GDP.

CBS projects Nepal's GDP to grow by 5.8% in FY2022

On 29 April 2022, Central Bureau of Statistics (CBS) estimated that Nepal’s economy will likely grow by 5.8% in FY2022, up from 4.2% growth in FY2021 (this is revised estimate). This projection is a bit more optimistic than what most have expected but is still lower than the government’s 6.5% growth target. The gradual resumption of economic activities, including tourism and hydroelectricity generation, with no disruption caused by the pandemic and the expectation of local elections related spending have driven the optimistic projection. FYI, fiscal year (FY) starts from mid-July of t-1 year and ends on mid-July of t year (for instance, FY2022 refers to the period between mid-July 2021 and mid-July 2022).

FY2021 performance (revised estimate)

GDP in FY2021 grew by 4.2%, up from a contraction of 2.4% in FY2020, thanks to a combination of base effect and resumption of economic activities as the pandemic related restrictions eased. Base effect refers to the tendency of achieving an arithmetically high rate of growth when starting from a very low base.

Agricultural output is estimated to have grown by 2.8% in FY2021 owning to favorable monsoon and a surge in agricultural workers (lockdowns forced reverse migration and contributed to more migrant workers’ engagement in agricultural work) that had a positive effect on paddy output. Industrial output grew by 4.2% from a contraction of 4% in FY2020 as mining and quarrying, manufacturing, and construction activities picked up pace after contraction in FY2020. Services output grew by 4.2% from a contraction of 4.5% in FY2020 as wholesale and retail trade, travel and tourism, financial and insurance and healthcare activities gradually recovered from severe slump in the previous year.  

FY2022 performance (provisional estimate)

The CBS projects GDP to grow by 5.8% in FY2022, up from 4.2% revised estimate for FY2021, thanks to a surge in industrial output driven by hydroelectricity generation and services output driven by travel and tourism activities. Overall, while public investment contracted, private investment and consumption increased. 

Agricultural sector will likely contribute 0.7 percentage points, industrial sector 1.6 percentage points, and services sector 3.2 percentage points to the overall projected GVA growth (basic prices) of 5.5%. GVA at basic prices + taxes less subsides = GDP at market prices.

The sectors with highest growth include electricity, gas and related utility (36.7%), followed by accommodation and food service activities (11.4%), construction (9.5%), wholesale and retail trade (9.1%), mining and quarrying (8.2%), and human health and social work activities (6.9%) among others. 

The estimates are based on data and information up to the first nine months of FY2022 (mid-July 2021 to mid-April 2022) and assumption of normal economic activity during the rest of the fiscal year (mid-April 2022 to mid-July 2022). 

Agricultural output is projected to grow at 2.3%, up from 2.8% in FY2021, largely due to unfavorable monsoon, which affected paddy output. Paddy harvest was affected by unseasonal torrential rain in October that also damaged physical infrastructure and killed over 100 people. The Ministry of Agriculture and Livestock Development said that an estimated 424,113 tonnes of paddy on 111,609 hectares had been destroyed.

Industrial output is projected to increase by 10.2%, up from 4.5% in the previous year, on the back of a substantial increase in additional hydroelectricity generation. Mining and quarrying activities grew by 8.2%, up from 7.5% in FY2021, as residential housing and real estate and development work including hydropower, picked up pace. Mining and quarrying of stones, sand, soil and concrete also get affected by construction sector. Construction activities grew by 9.5%, up from 5.2% in FY2021, as supplies of construction materials normalized (both import and domestic supply), and households, commercial and infrastructure projects picked up pace. It was aided by highly accommodative monetary policy as credit growth shot up relative to deposit growth. A part of refinancing and business continuity loans, which were rolled out as a part of relief measures to help struggling businesses, also made its way to housing and real estate sectors.

Manufacturing grew by 6.1%, up from 4.1% in FY2021, as industrial capacity utilization improved from resumption of economic activities. It has been suffering from low private sector investment, and loss of both domestic and external markets due to eroding cost and quality competitiveness. A stable supply of electricity and improved industrial relations were not sufficient to markedly boost manufacturing output as expected. Meanwhile, the addition of 456MW of electricity from Upper Tamakoshi hydroelectricity project sharply increased electricity output, propelling its growth to 36.7% from just 2.6% in FY2021. However, this has not been sufficient to bridge the electricity demand-supply gap during the dry season. The NEA recently was compelled to introduce loadshedding for industries due to large demand-supply gap and lower imports from India. This could weigh in on the sector’s eventual gross value added output. 

Services output is projected to grow by 5.9%, up from 4.2% in FY2021, thanks to pick up in travel and tourism, and wholesale and retail trade activities. The latter is expected to grow by 9.1%, up from 5.7% in FY2021 as supplies disruptions eased and consumer demand picked up pace, which was also aided by loose monetary and fiscal policies. Surge in import of agricultural and industrial goods in the first two quarters aided. Due to the deterioration of external sector stability and a decline in forex reserves, the government and the central bank started tightening import financing and, in some cases, outright ban on imports. This will affect the sector’s growth in the last quarter of FY2022. Transportation and storage activities are expected to grow by 4.5%, almost at the same rate as in the previous year, despite loosening of international and domestic travel restriction. However, travel is still expensive, which is exacerbated by the increase in fuel prices triggered by Russia’s invasion of Ukraine. Accommodation and food service activities are expected keep growing at a robust pace— 11.4%, up from 10.7% in FY2021—, thanks to a strong pick up in domestic travel and tourism.

Information and communication are expected to grow by 3.6%, up from 1.8% in FY2021. Financial intermediation is projected to grow by 6.1%, higher than 4.0% in FY2021, reflecting improved income of NRB, BFIs, insurance board and companies, securities board, social security fund, EPF and CIF. Real estate activities are expected to increase by 3.8%, up from 2.4% in FY2021, as sale, purchase, lease and other activities related to real estate picked up pace. The proposed local elections related spending on security and public administration is expected to increase public administration and defense activities by 4.4% from 2.3% in FY2021. Healthcare related demand continues to remain strong, keeping its growth rate above 5% since FY2017. 

Agriculture, industry and services sectors accounted for 29.4%, 16.3% and 54.4% of GDP in FY2022.

On the expenditure side, consumption is expected to increase by 5.4%, up from 3.7% in FY2021. While public grows fixed investment contracted by 6%, private fixed investment grew by 8.8%. They grew at 22.2% and 5.6%, respectively in FY2021. Net exports are expected to grow at 12.1%, thanks to exports growth being much higher than imports growth. In fact, imports are expected to grow at a lower rate in FY2022 than in FY2021 as the government and the central bank tightened import financing and at times imposed outright import ban. 

Here are quick takeaways from the latest GDP projection.

First, it may be a bit optimistic projection even after accounting for local elections related spending and normal economic activity in the last quarter of FY2022. The remains three months will be anything but normal in terms of economic activities. Import restrictions, deceleration of official remittance inflows, depreciation of Nepali rupee, rising energy and commodity prices, restrain in government recurrent spending to some extent, and the scheduled electricity blackouts for industries, among others, will depress output and aggregate demand. When revised or actual figures are released, it might be adjusted to around 4.5-5.0%.

Second, the outlook for FY2023 is not rosy. 

• First, despite the projection of above average monsoon (June to September 2022), the uncertainty over supply of other inputs (chemical fertilizers, access to seeds, access to finance, etc) dims agricultural sector’s growth prospects. Specifically, the shortage of chemical fertilizers will be painful because a good monsoon may increase the area of paddy plantation, but it will not necessarily increase output per hectare of land. Chemical fertilizers are key ingredients to boosting total output and output per hectare of land (productivity). 
• Second, the slowdown in residential and commercial real estate and housing will affect mining and quarrying, and construction activities. The surge in real estate and housing prices, fueled by easy financing even during the pandemic, has started to taper off as banks and financial institutions tighten lending. 
• Third, with no drastic addition of hydroelectricity to the national grid and the scheduled electricity blackouts for industries, utility and manufacturing activities may not pick up pace. In fact, industrial capacity utilization may decrease because of both high fuel prices and shortage of electricity. This will be exacerbated by the shortage of imported industrial inputs (industrial raw materials and intermediate goods) either due to outright ban on import of certain goods or tight foreign currency financing to slowdown imports. Factories are enduring up to 14 hours of blackouts due to low generation during dry season and expensive import price of electricity through the power exchange from India. Between 2007 and 2017, the country is estimated to have lost over 6% of GDP due to loadshedding. 
• Fourth, high energy and fuel prices will also affect services sector activities because a rise in cost of production and inflation will dampen consumer demand. For instance, wholesale and retail trade, and transportation and storage will get affected by both import restrictions and high energy and commodity prices, especially through lower consumer demand as real purchasing power weakens. These two sectors account for about 21% of GDP. Similarly, international and domestic travel, and accommodation and food services will remain expensive, restraining these sectors from sustained recovery.

Against the backdrop of dampening consumer demand due to high cost, deceleration of remittances and tighter monetary policy, slight pick up in travel and tourism and federal and provincial elections related spending may not be enough to sustain GDP growth above 5%. A sustained V-shaped recovery looks less likely.

Third, external sector stress is building up. Since import of petroleum fuel constitutes about 15% of total imports, the import bill is rising sharply. Import demand for petroleum products is relatively inelastic given the lack of immediate substitutes. The import bill of petroleum products in the first eight months of this fiscal year 2021/22 is already higher than the total import of petroleum products for the whole of 2019/20. Note that rise in petroleum fuel prices passes through to other goods as well because it is used in production process and transportation of the goods. Hence, import bill of other goods such as vehicles, machinery and agricultural items is also increasing. Import bill of wheat, rice, crude soya bean oil and edible oil has also increased. Despite gradual recovery in exports, the large import bill has increased import bill by 34.5% in the first eight months of this fiscal. This combined with the deceleration of remittance inflows amidst modest services recovery led by tourism sector widened current account deficit by around 200% in the first eight months of this fiscal. Consequently, balance of payments remains in negative territory with a depletion of foreign exchange reserves which are sufficient to cover 6.7 months of import of goods and services. It was 11.3 months in mid-March 2021. The rapid rise in energy and food prices poses a significant risk to external sector stability. Restricting non-essential imports is a band-aid solution to the structural issue.

Fourth, the recent deterioration of macroeconomic indicators precedes the highly accommodative fiscal and monetary policies after the pandemic started. The vulnerabilities were building up, but the accommodative policies simply masked them. As exogenous forces triggered external sector stress amplify and pandemic related support measures are gradually withdrawn, the vulnerabilities not only unmasking but also exacerbating (stagnating revenue but rising expenditure, low capital budge absorption capacity, asset liability mismatch, evergreening and non-performing loans, low exports but rising imports, sectoral bubbles, etc). For instance, fiscal profligacy led to higher deficit especially after federal, provincial, and local elections in FY2017. Total federal expenditure increased by an average 19.3% between FY2017 and FY2022 (includes budget estimates), but total federal receipts increased by only 14.2%. Consequently, average fiscal deficit was above 5% of GDP. Fiscal balance was either under 3% of deficit or outright surplus (due to low capital spending) before FY2017. This large and growing fiscal deficit increased public demand (consumption and investment) and boosted imports. Meantime, public debt also started rising rapidly. It was just 22.7% of GDP in FY2017 but rose to 40.6% of GDP by FY2021. With this also increased debt servicing costs. 

Similarly, the loose monetary policy and a weak oversight encouraged higher credit growth relative to deposit growth. It was fueled by remittance inflows as well. For instance, the average annual growth rate of deposit over FY2017-FY2021 was 18.3% compared to credit (loans and advances) growth of 21.2%. The weak banking sector oversight fueled real estate, housing, and stock markets bubbles, and encouraged imports. The increase in imports, which increased revenue that incentivized the government to ignore early warning signs of vulnerabilities build up (45% of revenue is import based), started draining foreign exchange reserves after the pandemic at a pace that is perceived to be unsustainable unless corrective actions are taken. During the first eight months of FY2022, foreign exchange reserves were sufficient to cover 6.7 months of import of goods and services. It was 11.3 month in mid-March 2021. 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. The country earns foreign exchange reserves mainly through exports, travel and tourism, investment income, remittances, grants and loans, and foreign direct investment— all of which are below the pre-pandemic level. So, the raft of measures to discourage imports recently in response to the fast-depleting foreign exchange reserves is just a band-aid solution to structural issues. The solution should start with tightening of monetary policy and measures to rein in government spending.

Fifth, the rising inflation— thanks primarily due to high prices of petroleum fuel, LNG, and imported goods— will have a disproportionate effect on the most vulnerable people. The lowest income and poorest households are hit the hardest by increase in fuel and food prices because it constitutes about 65% of their consumption expenditure. For the richest households in the consumption quintile, it is just 34.6%

Sixth, the size of Nepali economy is estimated at US$40.2 billion. Per capita GDP and per capita GNI are estimated at $1364 and $1380, respectively. GNDI (GNI + net current transfers incl remittances) is estimated to reach 123.3% of GDP. Gross domestic savings (GDP – consumption) is around 9.3% of GDP, reflecting high level of consumption. The country’s population in FY2022 is estimated to be 29.5 million.

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