Thursday, August 17, 2017

India after demonetization (growth, public finance and inflation)

A lot has been written about the impact of the demonetization shock on 8 November 2016 in India. PM Narendra Modi's government took a surprise decision to withdraw IRs1000 and IRs500 denomination currency notes (about 86% of value of total notes in circulation) to rein in corruption, counterfeiting, terrorist financing, and accumulation of black money (income that’s hidden from tax authorities). While the move is generally good for the economy over the medium and long terms (higher GDP growth, tax compliance, tax revenues, digitization, lower interest rates as liquidity in banking sector increases, etc), it had significant impact on economic activity in the short term, especially due to the botched implementation (shortages of cash, confusion, temporary withdrawal limits, sporadic bank closure due to the inability to withstand demand, etc).

Here are some charts that depict the partial impact of demonetization on economic activities. Note that others factors are also at play here and it is hard to isolate just the impact of demonetization. However, one thing is clear: this shock increased the slope of deceleration for at least two to three quarters.

Provisional estimates show that economic activities (at basic prices) decelerated to 7.1% in FY2017 (April 2016 – March 2017) from 8% in FY2016. GVA growth (at basic prices) was 6.6% in FY2017. While the favorable monsoon boosted agricultural output by 4.9%, industrial and services outputs grew by 5.6% and 7.7%, respectively. These are lower than 8.8% and 9.7%, respectively, in the previous year. Within industrial sector, mining and quarrying and construction outputs decreased the most as demonetization (mainly through shortage of cash to conduct daily transactions) dented transactions and payments (both formal and informal ones). Mining and quarrying grew by just 1.8% compared to 10.5% in FY2016. Similarly, construction activities grew by 1.7%, sharply down from 9.7% in FY2016. Manufacturing activities also slowed down compared to the previous year. Meanwhile, within services sector, wholesale and retail as well as hotel and restaurant activities slowed down. Same with financial and real estate activities. Note that, agriculture, industry and services sectors constitute 15%, 31% and 54%, respectively, of gross value added. 

If we look at the quarterly estimates of GDP, the deceleration is faster after Q2 of FY2017 (November falls in Q3). Economic activities are usually robust in the first two quarters as the government tends to front-load spending and households tend to purchase goods ahead of the festival season in the third quarter. However, in FY2017, economic activities, especially industrial and services, slowed down in all the four quarters. In a way, the economy was starting to cool off even before the shock in the third quarter and then demonetization accelerated the downward slide. Also, note that in FY2016 India updated the way GDP is computed, especially moving from GDP at factor cost to reporting GVA at basic prices plus base year was changed to 2011-12 for GDP, IIP, CPI, and WPI as well. As such, nominal GDP growth (market prices) in FY2017 is provisionally estimated at 11%, which is marginally lower than the no-demonetization scenario of about 11.9% (CSO’s estimate before demonetization).

Now, the expenditure side data reveal kind of similar narrative. Consumption grew by 10.5% (compared to 5.7% in FY2016) led by a notable growth of government consumption (20.8% vs. 3.3% in the previous year). Private consumption, which constitutes about 84% of total consumption and 56% of total GDP at market prices, grew slightly higher than in FY2016. Demonetization seems to have dented investment the most, pulling down overall GDP growth. Gross capital formation grew by just 1.7%. Within it gross fixed capital formation grew by 2.4% (compared to 6.5% in the previous year), led by a dip in private fixed capital formation across all sub-sectors (particularly investment in dwellings and building structures, and machinery and equipment— these together account for about 91% of private GFCF). 

There was some improvement in net exports (as export growth outstripped import growth), but it was not sufficient to compensate for the dip in investment. The big gap between the GDP growth (market prices) line and the stacked up bars in FY2016 is due to the large discrepancies, which shot up drastically in that particular year (remember the data revision mentioned above and the statistical discrepancies associated with it).

If you look at the quarterly GDP data on expenditure side, the narrative is similar to the one mentioned above for quarterly GDP data on supply side. After the demonetization, government consumption increased drastically but gross investment and net exports slowed down. In fact, gross capital formation and net exports registered negative growth in Q4. 

Now, let us look at the impact on public finance. The rush to declare hidden income and deposit it in banks after November 2016 seems to have favored the government (increase in revenue) and banking sector (increase in liquidity). Revenue (tax and non-tax) increased by 19.1%, the highest in the last six years (surprisingly, share of monthly revenue between Nov-Mar remained pretty much unchanged: 49.5% in FY2017 vs. 50.8% in FY2016— folks definitely paid more taxes in the last five months of FY2017 compared to FY2016, but the distribution was same).

As a share of GDP, center’s revenue increased to an estimated 9.4% of GDP (quite low considering the revenue mobilized by other comparable emerging economics, but then we need to also look at combined revenue of center and state, which is around 20% of GDP), up from 8.7% of GDP in the previous year. Recurrent spending grew by 12.8%, up from 4.8% (this complemented to some extent the slowdown in private consumption) but capital spending growth slowed down to 10.6% from 28.6% in the previous year. Overall, fiscal deficit is estimated to be within 3.5% of GDP and primary deficit 0.3% of GDP (both an improvement compared to previous year). 

Demonetization seems to have had a favorable effect (together with bountiful harvest due to good monsoon, and low fuel prices among others) on inflation by dampening consumer demand. Inflation has been decelerating in recent months and is far below 6.1% recorded in July 2016. Food prices, which has 45.9% weight in CPI basket, have cooled off substantially, but consumer prices of tobacco have grown pretty consistently, and housing and fuel prices are heating up. Demand for durables and everyday items (under miscellaneous heading) is cooling off. Overall, annual average (monthly) inflation of 4.5% for FY2017 is between RBI’s lower and upper bounds of 2% and 6%, respectively (average of 4%). The largest contribution to CPI inflation in FY2017 came from food & beverage prices, followed by miscellaneous items; housing; clothing and footwear; fuel and lighting; and pan and tobacco products. 

The wholesale price index shows a bit different picture. It was on a downward spiral since July 2104 until August 2015, and then started to pick up till February 2017 before declining. The WPI inflation for three months following the demonetization shock shows no sign of modereation. However, after that it seems to have had an impact. 

If we look at IIP, then there seems to be an impact after November as demand for manufacturing goods (which has 77.6% weight in IIP basket) moderated substantially. Specifically, demand for primary, and capital goods, and consumer durables slumped (in other words, contraction of urban demand). In May, IIP growth was negative. This might have come from both demand and supply sides. The depressed consumer demand may be caused first by the immediate drop in formal sector demand and then by a (second round) drop in informal sector demand (official statistics pick up the first one faster and then the slowdown in formal sector is reflected as further dip in formal sector demand after few months). In other words, the demand shock in informal sector takes some time to reflect as demand depression in formal sector. This might have slowed down supply of investment. Meanwhile, demand for investment may also be slowing down (and consequently bank credit has contracted) due to waning confidence about returns and consumer demand. 

Anyway, both CPI and WPI inflation are expected to rise (but still stay between the RBI’s lower and upper bounds) as demand depressing effect of demonetization dissipate and consumer demand for both perishable as well as durable goods gain some momentum (especially coming from the hike in public salary and allowance, and heating up of vegetable prices). Also, GST may lubricate the rusty industrial engines and boost both production and investment. Government, meanwhile, needs to enhance capital spending by accelerating project implementation (stuck by a myriad of bureaucratic as well as legislative factors— land, environment, tax incentives clearance, etc). Both private and public capital formation needs to increase. It needs to be seen how overly leveraged companies will increase investment and how government speeds up capital spending (especially in rural housing, roads & bridges, and other infrastructure projects; but potential farm loan waivers by states mean that they will have less fiscal space to increase capex).

GVA growth (at basic prices) is targeted at 7.3% for FY2018.

Wednesday, August 9, 2017

Nepal's central bank needs younger talents

It was published in The Kathmandu Post, 07 August 2017

Nepal Rastra Bank needs to be objective and pragmatic to maintain institutional credibility

The Nepal Rastra Bank (NRB) should ideally operate without courting much controversy over its internal management, operational modality, assessment of the economy, and the regulatory and supervisory mandate. Staying above reproach would ensure financial stability as well as the achievement of its two main macroeconomic targets—curbing inflation and boosting the growth rate. NRB needs to be as objective and pragmatic as possible to maintain institutional credibility and integrity on the execution of monetary policy.

Unfortunately, this supposedly impartial autonomous institution is in the news these days for all the bad reasons; including the leadership’s ill-intentioned plan to do away with the 30-year employment limit, ad hoc changes to monetary rules and regulations, and weak monitoring and evaluation of banks and financial institutions (BFIs).

One of the most controversial issues faced by the central bank currently is internal lobbying to do away with the 30-year employment limit for its employees. This has been a recurring issue since 2001, when such a provision was introduced under the financial sector reform project. Currently, employees are mandated to retire if they have served for 30 years or are above 58 years of age. NRB recently formed a new committee to suggest amendments to its employment regulations. Many suspect this to be a pretext to end the threshold on the years of service. This has generated mixed reaction within and outside of NRB. While some have expressed strong reservation over the intention to form the committee, others either have remained silent or are actively lobbying to end the limit on years of employment. 

There is no justifiable logic in changing current terms and conditions for employment. Some argue that ending the age limit on years of employment will ensure that a large proportion of senior employees will be able to retain their jobs for the time being, avoiding disruption to service delivery caused by retirement of old employees and loss of institutional capacities.

This is hogwash, as the NRB needs young talent in all its departments to effectively execute its policies, undertake research activities, and fulfil its regulatory and supervisory mandate. The marginal benefit of retaining old employees is far less than the marginal cost of hiring young people and training them to take on the required job responsibilities.  The central bank needs to attract top talent from domestic as well as foreign universities by offering attractive entry-level research or management positions. Importantly, a fresh breath of air is needed at NRB so that its actions are proactive rather than reactive. The latter has been the case for the past few years as NRB has repeatedly missed clear signals of disruptive credit flows and accumulation of unbalanced portfolio by BFIs.

NRB’s gain as well as the gain for the entire financial sector will be higher if the old guns follow the current employment regulation and make way for younger talent. The constant tussle among its old and new employees, politically-affiliated unions, and rolling out ad hoc management regulations undermines NRB’s credibility and distracts it from focusing on its main tasks: helping the government achieve growth and inflation targets without jeopardising financial stability, enhancing access to finance, and effectively supervising and regulating the financial sector.

Drifting away

The other important issues that are bogging down NRB are changes to set monetary rules and regulations, and weak monitoring and evaluation of BFIs. First, responding to the sudden credit squeeze—a result of the BFIs repetitive practice to accelerate credit growth more than deposit growth—NRB became overly accommodative by tweaking accounting rules in computing the credit to core capital-cum-deposit (CCD) ratio in its mid-year review of the fiscal year (FY) 2017 monetary policy. This ad hoc policy change was in effect a reward for the BFIs struggling to mend their ways after recklessly increasing credit to few unproductive sectors.

NRB allowed BFIs to discount 50 percent of productive lending, plus lending to deprived sectors and the agro sector at subsidised interest rates, while computing the CCD ratio. It gave some breathing space to BFIs to rework on their lending practices and meet the mandatory threshold of 80. However, NRB rolled back this provision in its FY2018 monetary policy. This kind of overly accommodative ad hoc measure has fostered a moral hazard, whereby BFIs continue to act recklessly , anticipating a reprieve from NRB in case of negative consequences. In doing so, they privatise profits and socialise losses. NRB has acted on behalf of the BFIs rather than acting as their supervisor and regulator, and committing to protect people’s deposits and return on savings. 

Second, the central bank failed to stabilise interest rates, which have remained volatile in recent years. Retail interest rates have gone up sharply, a result of the reactive working culture at NRB. Its monetary instruments to smooth liquidity flows have so far been ineffective. Recently, it changed its approach to maintaining retail interest rates between 3 and 7 percent. As long as NRB uses selling and buying of treasury bills and bonds as its main instrument to manage liquidity and monetary policy, retail interest rates will continue remain volatile. It’s a management problem as well as being a demand-supply problem. NRB needs to be more creative in liquidity management, and monitoring and evaluation of BFIs.

Lastly, in its monetary policy for FY2018 the central bank is aimlessly throwing arrows in all directions to achieve economic growth and inflation targets of 7.2 percent and 7 percent, respectively. NRB is yet to explain how it is going to achieve a higher growth rate than in FY2017, which itself was largely a ‘base effect’ blessing, by virtually keeping unchanged money supply growth and policy rates. Liquidity will likely be tight soon owing to the continuing deceleration of remittance income and the slow as well as uneven pattern of government spending

Meanwhile, a bloated budget dependent on large deficit financing is going to put upward pressure on interest rates. This is going to increase borrowing costs for businesses and individuals and eventually slow down economic activities, especially if the government is unable to spend the money it collects from taxes and borrowing. Given past experience, the FY2018 budget will likely be under spent. 

Orderly house

NRB needs to keep its house in order so as to be an effective regulator of the financial sector, a catalyst for enhanced financial inclusion, and a vibrant knowledge hub. Specifically, it needs to set an example by not tinkering its employment regulations to benefit old employees. Instead, it should allow young talent to take up challenging roles, thus fostering creativity, policy innovation and better service delivery.

It should also desist from rolling out ad hoc policy measures to reward moral hazard behaviour in the financial sector. A stop-gap, ad hoc policy as well as management style undermines its credibility and trust.

Sunday, August 6, 2017

Why does the government under-execute capital budget?

Towards the last quarter of fiscal year, pretty much everyone talks about slow capital spending. Parliamentary committees issue notices/instructions to government agencies to accelerate spending. Ministry of Finance summons line ministries’ representatives to review progress on stated milestones every quarter. The media also gives ample space to spending level and pattern, raising questions over hasty spending on shoddy works before the end of fiscal year. The same reasons are debated and recycled during each quarterly review meeting. The cycle of issuing notices, review of quarterly portfolios and pondering over the same reasons for slow capital spending keeps on rotating each year. Unfortunately, nothing substantial comes out of it (with respect to achieved outputs).

The government and MOF said FY2017 (mid-July 2016 to mid-July 2017) would be different because budget was announced one-and-a-half months prior to the start of the fiscal year. They said it will give ministries adequate time to get approval for spending and initiate preparatory project planning (especially procurement documents), all of which were expected to accelerate capital spending. Specifically, the idea was to finish all preparatory work and start issuing tender notices and in some cases finalize contractors before the start of festival season (September-November). 

So, was the result? Pretty much the same or even worse: 
  • First, the spending pattern (i.e. quality of spending) hardly changed despite the early approval of budget. Almost 60% of the actual capital spending happened in the last quarter and 41.2% in the last month. It raises doubt over the quality of spending. Often, spending (and approval of payments for completed as well as some pending works) is accelerated in the last month by doing shoddy work. The haste in spending without any quality control by the ministries (what is the monitoring and evaluation unit doing?) leads to cheapjack construction. This in turn increases operation and maintenance budget (which is a part of recurrent spending) for the next few years. 
  • Second, capital spending absorption capacity has receded. Just 65.5% of planned capital budget was spent in FY2017 (NRs204.3 billion spent vs NRs311.9 billion planned). Although it is slight higher than 58.6% in FY2016 (when the economy was crippled by trade and supplies disruptions), it is still lower than 76% in FY2015 (when earthquakes struck around the last quarter of fiscal year). As a share of GDP, capital spending increased to 7.9% of GDP, up from 5.4% of GDP. The planned capital spending in FY2017 was 12% of GDP.
Now, the MOF sometimes points to the National Reconstruction Authority (NRA) for slow capital spending as reconstruction work did not pick up steam as expected. However, NRA itself was burdened with approval from Cabinet, lack of cooperation from line ministries, and the hooks kept by the MOF on NRA’s discretion in spending the allocated budget (including to cover procedural administrative costs). These exerted an inertia on NRA’s speed and efficiency. Nevertheless, preliminary data from the MOF’s ‘Red Book’ itself show that NRA did quite well in FY2017. It was asked to spend around NRs140 billion in housing grants, reconstruction, and administrative expenses. It seems to have kept the promise for now as per preliminary data. We will have to look at the full year data to see how close NRA was to the spending target. The pick up in reconstruction activities boosted growth of construction, real estate and housing, and mining & quarrying activities in FY2017. In FY2018, NRA is asked to spend NRs146.2 billion on reconstruction of infrastructure and housing grants. 

So, it seems the same factors have been constraining capital spending and approving budget early is not going to change that unwanted steady equilibrium drastically. Budget execution is affected by: (i) structural weaknesses in project preparation and implementation (i.e. lack of initial planning); (ii) low project readiness (no feasibility studies, land acquisition, environment clearance, detail design and procurement milestones); (iii) bureaucratic hassle in project approvals and sanctioning of spending; (iv) weak project and contract management (high staff turnover and inability to rein in errant contractors); and (v) political interference at planning, management and operational stages. FY2017 budget spending was also affected by local elections as government staff were deputed to conducting and monitoring elections instead of managing projects. 

These key issues that slow down spending have more to do with the capacity of government staff and the strength of their offices (institutional memory, motivation, etc) than early release of budget. Of course, early approval of budget provides certainty of spending but it does not directly address the above mentioned issues. 

For project readiness, the NPC should be assisting line ministries and local bodies to conduct pre-feasibility studies. Importantly, it should be appraising the project proposals prepared by line ministries and local bodies keeping in mind factors such as land acquisition, rate of return, cost-benefit analysis, implementation modality, etc. These then should be aligned with medium term expenditure/revenue framework. The NPC should be playing a pro-active role in assisting line ministries and local bodies in project planning and appraising (a sort of localized ‘project bank’). 

Meanwhile, the MOF should be keeping tab on expenditure allocation, especially restraining the temptation to allocate budget for projects that are not ready or are not sanctioned by the NPC. This usually happens because of political pressure. Furthermore, MOF should closely collaborate with NPC and OPMCM (especially their M&E units) to monitor progress and unwind constraints faced during the implementation phase (including speedy resolution of constraints by taking the issues up the political chain and if necessary the cabinet). The obsession with meeting revenue targets has meant that these crucial tasks are delegated as ceremonial undertakings. The MOF and NPC need to be more agile, responsive and cooperative.

Then comes the line ministries. These are primarily responsible for project conception, design and execution. The onus of faster and quality spending lies in project directors (mostly those at joint secretary level). If the government staff at project offices are lethargic, then no project will see accelerated spending. 

The role of multilateral and bilateral donors, who implement projects through the government mechanism, is also crucial as sometimes approvals or endorsements or disbursements are stuck at their offices. Again, being proactive in smart project and contract management is the key to accelerating capital spending. The hassle created by Acts and policies are not going to be solved overnight. Low hanging fruits should be harvested first.

Same applies to the various parliamentary committees that are increasingly infringing on project management (by ordering halt to procurement process, summoning multiple times for hearing but without any tangible outcome, etc) and issuing orders after orders for faster capital spending. How about these committees also give some attention to the need for project readiness, the resources needed for it, and monitoring and evaluation (in collaboration with NPC, MOF, OPMCM and local experts)? Negligence by politically-affiliated local contractors (who bid for projects that are beyond their financial and management capacity) is costing the taxpayers dearly. A strong M&E system is needed in addition to enhancing capacity of project offices to design, appraise and implement projects. 

Overall, the government met the revenue target (more on this in later blog posts), but failed to accelerate capital spending as expected. What will be the fate of FY2018 budget? Note that accelerated capital spending is one of the pillars for rapid structural transformation given Nepal's stage of development right now.

Monday, July 31, 2017

NEA's improving balance sheet, excess liquidity, & justified CA deficit in India

After years of very high net losses, NEA was able to decrease losses to NRs970 million in FY2017, down from NRs8 billion in FY2016, thanks to its efforts to plug leakages and the hike in tariff.
  • NEA slashed electricity leakage (power theft and tempering of reading meter in collaboration with NEA employees) by around 3 percentage points in the last fiscal year, resulting in savings of at least Rs2 billion
  • Revenues increased significantly to Rs40 billion in the last fiscal year, up Rs8 billion from the previous year’s Rs34 billion
  • Cheaper imports through the Dhalkebar-Muzaffarpur cross-border transmission line (IRs3.60 per unit) were increased and imports from Bihar state-controlled entities (IRs5.50 per unit) were decreased

Faster disbursement in the last month of FY2017 boosted liquidity in the in the banking sector. Excess liquidity stood at around NRs94 billion in the last week of July 2017. This is a good news for BFIs struggling to entice deposits and meet the regulatory credit to deposit threshold of 80%. Government disburses almost 45% of capital spending in the last month of fiscal year. 

However, this sudden bump in liquidity is not going to lead to lower retail interest rates. The deceleration of remittances means slower deposit growth and the BFIs need to balance their books to meet the CCD ratio after aggressively expanding credit in the last three quarters of FY2017. 

Level of current account deficit in India justified for now

According to External Sector Report 2017, excess current account imbalances (deficits or surpluses in excess of levels deemed consistent with medium-term fundamentals and desired policies) represented about one-third of total global imbalances in 2016. The other sources of external imbalance are real exchange rates, external balance sheets, capital flows and international reserves. Key messages: 
  • Increase subdued demand: Excess surplus countries with fiscal space need to have more fiscal stimulus as well as structural reforms to spur domestic demand and foster competition
  • Depress excess demand: Excess deficit countries need to have more fiscal consolidation, gradually normalize monetary policy in line with inflation developments, and implement structural reforms to boost competitiveness and savings

Here is the IMF’s assessment of India’s external sector (pp.23-24):

Overall Assessment

The external sector position in 2016/17 is broadly consistent with medium-term fundamentals and desirable policy settings. India’s low per capita income, favorable growth prospects, and development needs justify running CA deficits. External vulnerabilities remain, although they have been reduced since 2013. India’s economic risks stem from intensified global financial volatility including from a faster-than-anticipated normalization of monetary policy in key advanced economies, longer-than-expected cash normalization following the currency exchange initiative, as well as slower global growth. Like other EMs, too great a reliance on debt financing and portfolio inflows would create significant external financing vulnerabilities. Therefore, there is need to remain vigilant to safeguard the Indian economy. The flexible exchange rate policy followed by the Reserve Bank of India is sound, and the current policy of at times smoothing exchange rate volatility is appropriate. It is also important to maintain adequate levels of international reserves.

Potential Policy Responses

An increase in non-debt creating capital flows through FDI will help improve the CA financing mix and contain external vulnerabilities. In particular, further efforts to revamp the business climate and ease domestic supply bottlenecks are essential to improve investment prospects, attract FDI, and boost exports. Further liberalization of ECBs should proceed cautiously and be carefully monitored, given continuing corporate vulnerabilities. Monetary policy framework has been strengthened, but further supply-side reforms and continued fiscal consolidation are key requirements to achieve a low and stable rate of inflation in the medium-term as well as to keep gold imports contained. Continued fiscal consolidation is needed, including by implementation of the goods and services tax and further subsidy reforms. Safeguarding financial stability and enhancing the ability of the financial sector to contribute to growth are also necessary policy steps.

Wednesday, June 7, 2017

Bloated budget, challenging implementation

It was published in The Kathmandu Post, 5 June 2017. Here is an earlier blog post on FY2018 budget (same in NEF blog). The latest issue of Himal magazine includes an analysis on the same in Nepali language. 

Bloated budget

Fiscal transfer to local bodies warranted a bigger budget, but its implementation will be challenging

On May 29, Finance Minister Krishna Bahadur Mahara presented the budget for fiscal year (FY) 2017-18 to Parliament. The projects and programmes are pretty much a continuation of last year’s budget, since the election code of conduct barred the government from rolling out new initiatives that could influence the outcome of the second phase of the local elections.

Some of the notable features of the budget are its focus on the devolution of spending authority to local bodies, the progress of, and adequate funds for, large-scale infrastructure projects, and post-earthquake reconstruction.

Macro overview

The total expenditure outlay is capped at Rs1.3 trillion, which is equivalent to an estimated 45.5 percent of gross national product (GDP) in FY2018. This is an increase of 36.7 percent over the revised expenditure estimate for FY2017. The government argued that the increase in the size of the budget is justified owing to the fiscal transfers to local bodies in the federal setup. These transfers are clubbed under recurrent spending, which constitutes 62.8 percent of the total budget.

Meanwhile, 26.2 percent of the budget is earmarked for capital spending, which includes public expenditure on new buildings, bridges, roads and civil works, among others. The government is planning to meet 64 percent of expenditure from tax and non-tax revenue, foreign grants and principal repayment.

This leaves a budget deficit of NRs461.3 billion, which the government expects to cover by a combination of foreign loans, domestic borrowing and cash balance from FY2017.

Unrealistic targets

At the aggregate level, three important issues in the budget require scrutiny. First, GDP and revenue targets of 7.2 percent and 25.7 percent respectively are ambitious. The economy grew by an estimated 6.9 percent in FY2017 due to a low base effect, favourable monsoon, improved power supply and normalisation of supplies after two years of disruption. Achieving 7.2 percent growth from such a high base would be challenging, because the usual drivers of growth have to be much stronger than last year. 

Even with good monsoon rains, continued improvement in power supply, acceleration of reconstruction works and capital spending and election-related expenses, GDP growth may be restricted between 5 and 6 percent. Furthermore, expecting revenue growth higher than in FY2017 with pretty much the same revenue policy is a bit of a stretch. FY2017 revenue was higher because of the normalisation of imports, which faced an unexpected dip following the trade embargo in FY2016. The expectation that tax revenue from trade will be the same as in FY2017 (47.5 percent of total tax revenue) is a bit misplaced. 

Second, since the likelihood of meeting revenue growth is pretty slim, the government will aggressively engage in domestic borrowing, which is expected to be about 4.3 percent of GDP. This will undoubtedly put upward pressure on retail interest rates, which will increase the borrowing cost of households and businesses, as deposit growth is still sluggish (amidst higher credit growth) due to the deceleration of remittance inflows and the government’s inability to spend the mobilised revenue on time. A large deficit financing also tends to exert inflationary pressures.

Third, recurrent expenditure is ballooning too fast and needs to be contained. It is expected to be a whopping 110 percent of revenue in FY2018. The previous government sharply increased recurrent budget by inserting all sorts of pet projects and distributive programmes in the ‘red book’, which is a catalogue of all approved projects and programmes. It would be difficult to discontinue such projects once they make their way into the red book and hence this government had no option to exclude them. This, combined with the need for large unconditional fiscal transfer to local bodies, led to an almost 43 percent increase in recurrent spending. It is now time to curb recurrent spending in real terms and cull unproductive, repetitive and “zombie” projects to maintain fiscal prudence.

Execution challenges

In the absence of a Natural Resource and Fiscal Commission to oversee fiscal transfer to local bodies, this budget allocated transfers based on a number of factors such as population, development status and cost of operation. Fiscal transfer and conditional grants to local bodies now constitute about 50 percent of total recurrent spending. This is unprecedented in the sense that the transfers will now be directly credited to the bank accounts of local bodies—bypassing the maze of bureaucratic approvals needed at Singh Durbar—and the local bodies will have the authority to prioritise, design and implement their own projects. These include programmes and projects on agriculture, livestock, irrigation, roads, drinking water and sanitation, schools (including payment for teachers), tourism and sports, among others. 

Despite such large transfers and early spending authority to line ministries, execution of the budget will be challenging. The budget mandates project offices to award contract by mid-October to accelerate capital spending, which averaged 75 percent of planned budget in the last five years. This particular reform addresses expenditure delays attributable to lengthy and repetitive approvals needed at various layers of ministries and the National Planning Commission.

However, other issues contributing to chronically low spending pattern such as lack of project readiness, high staff turnover and poor contract management will need to be addressed swiftly to accelerate capital spending. Furthermore, most of the local bodies do not have the capacity to design, assess, appraise and execute projects at the local level. Hence, an unconditional fiscal transfer to local bodies could be an asset or a liability. If spent in the right way and with proper accountability, it could be an asset and a significant contributor to economic development.

However, with weak oversight, lack of capacity to plan and execute projects and misappropriation of funds, it could become a liability and eventually contribute to fiscal stress. The centre needs to be careful in providing handholding support to local bodies to address execution issues, but it should not try to micromanage projects as in the past.

Overall, the budget gives a mixed picture: bloated in size justified by the compulsion to continue previous projects and direct fiscal transfer to local bodies; ambitious GDP and revenue growth targets; large deficit financing, which would potentially increase interest rates; faster spending authorisation by cutting down lengthy and repetitive approvals; and unsustainable pattern as well as size of recurrent budget. The nature of this budget would also mean that there is no room and justification for a supplementary budget after the local elections.

Thursday, June 1, 2017

Quick thoughts on Nepal’s FY2018 budget

Here are my quick thoughts on the FY2018 budget.

Deputy Prime Minister and Minister of Finance Krishna Bahadur Mahara presented FY2018 budget (mid-July 2017 to mid-July 2018) to the parliament on 29 May. The budget focuses on implementation of federalism (particularly at this stage, providing initial financing to local bodies), post-earthquake reconstruction, continuation of previous programs and policies (because the government cannot roll out distributive programs and pet projects during the election time), and ensuring adequate funds for large infrastructure projects.

The budget is unique in three ways: 
  • First, it tries to bypass the usual Singha Durbar related procedural hassles by directly transferring funds to local bodies so that they can initiate institutional setup and some local level projects. Local bodies are supposed to get NRs225.1 billion and provinces are supposed to get NRs7.1 billion. On top of this, there is the usual transfer to local bodies (as grants under recurrent expenditure), which is about NRs174.7 billion.  
  • Second, the budget is pretty much a continuation of the FY2017 programs and policies as the ongoing local election bars the government from introducing new projects that are of distributive nature or that can influence the outcome of elections.
  • Third, the expenditure level is growing very fast and needs to be stabilized until the ministries figure out what is working and what is not (zombie and unnecessary/duplicate projects need to be culled line by line). Time has come now to seriously rationalize recurrent spending. The FY2017 budget was prepared in an irresponsible way by substantially jacking up expenditure. It will be hard to remove such expenditures from the 'Red Book' once included. The FY2018 budget has become a victim of that fiscally irresponsible/populist move. Recurrent expenditure in FY2016 was 16.5% of GDP, which was jacked up to 23.7% of GDP in FY2017 (revised estimate) and in FY2018 budget it is around 27.4% of GDP (see the figure below). 
FY2018 budget overview
GDP growth target (%)

Inflation target (%)

Budget allocation 

Rs billion
Budget allocation
Financial provision

Projected total revenue
Foreign grants
Principal repayment

Projected budget surplus (+)/deficit (-)

Projected deficit financing
Foreign loans
Domestic borrowing
FY2017 cash balance

1. Budget outlay:

The total expenditure outlay for FY2018 is NRs1,279 billion (an estimated 43.5% of GDP), which is 21.9% higher than the budget estimate for FY2017. The FY2018 outlay comprises NRs803.5 billion for recurrent expenditures (62.8% of the total outlay), NRs335.2 billion for capital expenditures (26,2%), and NRs140.3 billion for financial provision (11%).

The substantially larger size of the budget is due the sharp increase in recurrent and capital spending, particularly the increase in recurrent spending (which as stated earlier includes large transfer to local bodies). The outlay for recurrent expenditure (equivalent to 27.8% of GDP) is 43.1% higher than the revised estimated expenditure in FY2017. The planned capital spending has been increased by 27.9% over the FY2017 revised estimate (an estimated 11.4% of GDP). About NRs146 billion is set aside for post-earthquake rehabilitation and reconstruction.

2. Revenue target:

A total revenue target of NRs817.7 billion (27.8% of GDP) has been set for FY2018, including projected foreign grants of NRs72.2 billion (2.5% of GDP) and principal repayment of NRs15 billion. The revised estimate for revenue mobilization (including grants) in FY2017 is 25.2% of GDP. Revenue (tax and non-tax) growth target is 25.7%.

3, Deficit financing:

The budget deficit is to be financed by foreign loans equivalent to NRs214.4 billion, domestic borrowing of NRs145 billion, and FY2017 cash balance of NRs102.7 billion. Net foreign loans and net domestic borrowings are projected to be 6.3% and 4.3% of GDP, respectively. Overall, fiscal deficit is projected to be about 3.5% of GDP.

4. Where is the recurrent budget going?

Almost 29% of planned recurrent expenditure of NRs803.5 billion is going to local bodies (plus provincial bodies)  as fiscal transfer and another 23% is going as grants (including some social service grant) to local bodies (some of this money is used for local level capital projects as well, but then it also includes scattered pet projects of politicians).  The other big ticket item is the compensation of employees, which takes up about 16% of total recurrent budget. These amount to an estimated 14.2% and 4.4% of GDP respectively.

6. Where is the capital budget going?

Almost 60% of the planned capital budget of NRs335.2 billion is going for civil works. About 23% is allocated for building work. These amount to an estimated 6.8% and 2.6% of GDP, respectively.

7. How much are the local bodies getting?

The government has not formed Natural Resource and Fiscal Commission to oversee fiscal transfer, revenue distribution and grants to local bodies. So, a number of factors (population, development status, cost of operation, etc) has been considered to allocate transfer to local bodies. The distribution is as follows (see the details here):
  • Rural municipalities: NRs100 - NRs390 million (plus conditional grant NRs12 - NRs172.2 million)
  • Municipalities: NRs150 - NRs430 million (plus conditional grant NRs39.5 - NRs312.7 million)
  • Sub-metropolitan cities: NRs400 - NRs630 million (plus conditional grant NRs148 - NRs310 million)
  • Metropolitan cities: NRs560 - NRs1,240 million (plus conditional grant NRs281.2 - NRs783.9 million)
The local bodies will directly get the budget in their bank account by mid-August. A local council will approve the programs to be initiated by local bodies in their locality. These include program and projects on agricultural, livestock, irrigation, roads, drinking water and sanitation, schools (payment for teachers as well), tourism and sports, among others.

These are substantial fiscal transfers and grants that were approved and monitored by at Singha Durbar in the past, leading to substantial delays in project completion. Now, these can be directly used by the local bodies, which means the local residents will need to keep an eye on project selection, contract award and project progress. The local residents now have to point their fingers first at their local representatives instead of the bureaucrats and politicians at Singh Durbar.

These transfers are clubbed under recurrent spending. Fiscal transfer and grants to local bodies together constitute about 50% of planned recurrent spending in FY2018. In FY2017 grants to local bodies alone accounted for about 44% of estimated recurrent expenditure. So, in a way there isn't much increase in transfer to local bodies. It just that a little bit more has been added and some of the conditional grants to local bodies has been diverted as unconditional fiscal transfer so that the local bodies are not at the mercy of the lethargic bureaucracy at Singha Durbar. Some of it is used in capital accumulation or capital maintenance projects. But, a large portion of this for now will go to meeting recurrent expenses of local bodies. 

8. What about implementation?

Budget under-execution is a chronic issue. This budget tries to facilitate budget execution by cutting away several approvals needed even after the projects are included in the Red Book
  • Expenditure authorization will now be approved based on trimester work plan outlined in LMBIS of the MOF. Spending authority will be given to line ministries prior to the start of FY2018.
  • The government commits to establish project offices by mid-August. There will be a detailed work plan for project chiefs and relevant staff (this is nothing new, but it hardly get followed). 
  • Project preparation and tender calls should be completed by mid-August and contract should be signed by mid-October (after completing bid evaluation). Contracts will be canceled if the contractor does not adhere to the timeline agreed beforehand. Contractors will be barred from sub-contracting works (beyond their capacity but they nevertheless bid for the project) unless approved by project chief. 
Capital spending is affected by six major factors. First, structural weaknesses in project preparation and implementation remains unresolved. Barely any substantial homework is done before the inclusion of projects and programs in budget, leading to allocative inefficiencies to begin with. 

Second, low project readiness is another recurring problem as pork barrel and populist projects are inserted without feasibility studies and detail design, and time bound procurement plans and land acquisition plans. 

Third, bureaucratic hassle in approving and reapproving projects at various layers (sector ministries, Ministry of Finance and National Planning Commission) and weak intra and inter ministry coordination delay the full and effective realization of planned capital spending. This is the issue FY2018 budget is trying to resolve by directly transferring funds to local bodies and by doing away with approvals needed even after projects are listed in Red Book

Fourth, infrastructure projects of any scale and nature are riddled with poor project management, especially due to high staff turnover (which erodes institutional memory), lack of staff capacity to administer project implementation, lengthy procurement process, subpar capacity of contractor and weak contract management.

Fifth, high fiduciary risks in project implementation in suburban and rural areas when projects are implemented through local government having limited human resources and administration capacity not only delays spending, but also makes it inefficient. The funds allocated to parliamentarians to spend in their constituencies fall in this category.

Finally, political instability and interference both at planning and operational levels hinder timely completion of projects.

9. Here are the main takeaways from FY2018 budget:

The budget is introduced one and a half months prior to the start of FY2018, as per the constitutional provision. It is expected to boost capital spending. However, looking at last year's expenditure absorption rate, the progress is not as expected. Although the government is estimating 84% of the planned capital budget in FY2017 will be spent, the progress so far points to a much slower absorption rate. As of 29 May, only 34.1% of the planned capital budget is spent. 

This raises doubt over the commitment by the government to accelerate capital spending even though the government has committed adequate funds for infrastructure projects. The FY2018 budget commits to approve spending for projects from the beginning of the fiscal year and also directly transfer funds to the local bodies, bypassing the lengthy approvals needed at various layers of line ministries, NPC and MOF. However, the funds cannot be spent just like that. The local bodies need to follow procurement guidelines and develop project proposals. It is going to take time as the local bodies lack human resources and expertise to design, appraise, approve and execute project. Completing procurement by mid-October will be a huge challenge. The pace of capital spending, hence, depends on how well the center facilitates the local bodies in tackling these issues. Furthermore, the two more rounds of elections by January 2018 (on top of second phase of local elections on June 28) will require government employees to focus on conducting elections, which will deprive them of properly assessing and execute projects outlined in the budget. 

A robust, credible and a time-bound implementation plan to spend the earmarked money is partially addressed (the MOF says it is somehow included in the LMBIS, the inter-ministry budgetary information system). We will have to wait and see until the first trimester to evaluate its efficacy. 

The GDP growth target of 7.2% is a bit ambitious because it is easy to grow from a low base than from a higher base. FY2017 growth rate was high because of the low base effect, good monsoon, improved supply of electricity, some pickup in reconstruction and capital expenditure, and normalization of supplies. However, maintaining a high growth rate will be much more challenging. The rationale for 7.2% growth rate is not convincing even with a good monsoon, prospect of continuation of improved power supply, expected acceleration of reconstruction works and capital spending, and election-related expenses (provincial and federal elections after the local elections by January 2018). These drivers need to be much stronger than in FY2017 to attain a higher growth rate. This is unlikely to be the case as of now. A growth target between 5% and 6% looks reasonable if budget execution (including those at the local level), monsoon rains and elections-related expenditures happen as expected. 

The target to limit inflation within 7% is seems reasonable. Inflation are expected to be subdued in India and global oil prices are not projected to rise dramatically. General prices may heat up due to the increased recurrent budget (but then if the past is any guide not all of the planned budget will be spent). The downside risk to inflation target could be supplies disruption due to political tension in Terai region (as election day approaches and constitution amendment bill does not materialize). We need to see what kind of monetary policy the central bank will roll out in the coming months. 

Furthermore, net borrowing of about 4.3% of GDP (higher than 3.6% in FY2017) may put upward pressure on interest rates (especially when bank liquidity is drying up due to the deceleration of remittance inflows and the large government savings in NRB) and inflation (if actual spending is close to the planned one, which in all likelihood won’t be the case). Overall, fiscal deficit is projected to be about 3.5% of GDP. Net foreign loans are projected to be about 6.3% of GDP. 

The problem with such a large spending plan (met through increasing deficit financing) is that revenue is increased by all means, but then actual spending falls far short of planned one. This leads to substantial government savings, which are used to bloat the budget in the next  period (by committing to finance a part of it using cash balance). This is a bad budgetary practice. The government savings from previous years should ideally be used as a basket fund to finance large-scale infrastructure projects instead of financing a part of recurrent expenses. Budgetary practices should be clear to avoid ambiguity and misappropriation. FY2017 cash balance used in FY2018 budget is almost 22.2% of total planned deficit financing. 

There is no substantial change to existing tax policy. So, achieving revenue growth of 25.7% looks ambitious. If the revenue target is not met, then the government will for sure try to borrow a large amount of money from the market (usually it doesn’t exhaust its borrowing target unless there is a necessity to tweak the budget figures: for instance, to ensure that the fiscal budget is not in surplus like in the past).

Macroeconomy-wise, its a mixed picture: (i) a bloated budget justified to ensure reasonable initial financing and grants to local bodies in the federal setup; (ii) ambitious GDP and revenue growth targets; (iii) widening of net domestic and foreign borrowing; and (iv) a potential surge in interest rate due to the sharp increase in net domestic borrowing. 

With this kind of a bloated budget, which is practically beyond the absorption capacity of the bureaucracy and institutions, the government should not try to bring a supplementary budget after the local elections are over. The priority should be to fully execute the budget. Furthermore, time has come to stabilize the recurrent budget at this level and then start culling unproductive, repetitive and zombie projects. Revenue (tax and non-tax) is not even able to finance recurrent expenditure: in FY2017 recurrent expenditure was 97% of revenue and in FY2018 it is expected to be 110% of revenue.