Medium-term economic recovery

Weaknesses in the economy, masked by pandemic-related fiscal and monetary relief measures and regulatory forbearance, are beginning to dissipate. Economic growth is consistently below target, the budget deficit is large and widening, public debt is rising sharply, the current account and balance of payments deficit is rising, and foreign exchange reserves are declining. The overall macroeconomic situation and growth prospects are not encouraging. A course correction beyond the band-aid nature of the political reaction is warranted to ensure that the country has the resources available to finance the investments needed for economic recovery in the medium term.

Deterioration of the situation

The economy contracted by around 2.1% in the 2020-21 fiscal year, the first contraction in more than four decades, as demand, supply and health shocks disrupted economic activities . A sharp and substantial economic rebound is unlikely due to a decline in agricultural production, notably a shortage of chemical fertilizers, and the continued deceleration in remittances which affect household purchasing power. Gross domestic product (GDP) growth can hover around 5% as the base effect (which refers to the tendency to achieve an arithmetically high growth rate from a very low base) dissipates and that remittances slow down (limiting aggregate demand).

The state of public finances is also not encouraging given the large and growing budget deficit, which refers to net financing expenditure less total revenue. Federal revenue, which includes foreign grants, is expected to reach 23.7% of GDP this fiscal year, but federal spending is expected to exceed 34.8% of GDP, of which recurrent spending accounts for 65%. Despite spending and revenue falling short of fiscal targets, the deficit is likely to exceed 6 percent of GDP. Note that the structure of spending has not changed much with capital spending absorptive capacity still weak, and more than 50% of actual capital spending has been consolidated in the last quarter, raising concerns about asset quality and fiduciary risks. It was only 16% of the budget estimate in the first seven months of this fiscal year.

Capital expenditure is plagued by structural weaknesses (weak project preparation, poor contract management and high staff turnover), allocative inefficiency (ad hoc allocation, lack of respect for the medium-term framework and low pipeline of projects ) and bureaucratic delays (political interference at operational and management levels, weak intra- and inter-ministerial coordination, and maze of approvals). Meanwhile, the stock of public debt has nearly doubled in just five years, reaching 40.7% of GDP in 2020-21.

The financial sector is not in order either. An aggressive increase in credit relative to deposits, which declined alongside the deceleration in remittances, contributed to a chronic liquidity crisis. The liquidity situation used to be periodic, that is, it fluctuated according to investment expenditure. However, it has persisted in recent years, implying structural weaknesses and heightened vulnerabilities in the financial sector. The outsized real estate and real estate bubbles and bullish stock market are out of step with macro fundamentals. This could pose a significant challenge after regulatory forbearance and pandemic relief measures are withdrawn. High inflationary pressure, mainly due to supply disruption, rising fuel and commodity prices and depreciation of the Nepalese Rupee, will aggravate the situation.

The exterior sector is in poor condition. The current account deficit for the first six months of this financial year is already higher than for the whole of the last financial year. This is mainly due to the widening trade deficit and decelerating remittances, which are not expected to pick up any time soon. Consequently, the balance of payments is negative and foreign exchange reserves are steadily decreasing. Foreign exchange reserves are now sufficient to cover 6.6 months of imports of goods and services. This was approximately 14 months of import cover as of mid-July 2016. Given the peg of the currency to the Indian rupee, vulnerability to natural disasters and the need for an additional buffer to remittances and tourism-related vulnerabilities, the optimal level of reserves is estimated to be 5.5 months from the future importation of goods and services.

Medium term priority

Economic recovery will only be strong and sustainable if the medium-term priority is shifted to reduce dependence on exogenous factors to support growth, reduction of poverty and inequality, revenue mobilization and stability of financial and external sectors. For example, the pattern and intensity of monsoon rains largely dictate agricultural production in the absence of a reliable supply of agricultural inputs such as year-round irrigation, timely availability of fertilizers chemicals, cheaper access to finance and connectivity to link on-farm and retail markets, and farmers and consumers. Similarly, remittance income largely drives consumption, especially private consumption, which accounts for 90% of total consumption and demand in services and industrial sectors. It is neither resilient nor durable. The policy effort should aim to redirect the sources of growth towards more reliable factors through investments in physical infrastructure and human capital development, private sector development and public sector reforms. These are key to boosting overall production and productivity.

It is essential to create the fiscal space necessary to stimulate spending on physical infrastructure and the development of human capital in the public sector. This can be done through expenditure management and/or increased revenue mobilization. Reduction of recurrent expenditure through consolidating expenditure or plugging leaks (e.g. in the distribution of allowances, unnecessary recruitments and mundane charges), improving budget transparency and political orientation, taking into account risks and fiscal liabilities and reducing the fiscal burden due to loans and equity investments 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 towards improving revenue administration, including reducing tax expenditures (subsidies, rebates, concessions) , the broadening of the tax base and the sale of the State’s share in public companies and the monetization of their assets. These will be useful in creating the fiscal space needed to finance the medium-term recovery and promote competitive and cooperative federalism.

Similarly, financial sector volatility and vulnerabilities need to be controlled using macroprudential tools. Credit growth must be consistent with deposit growth, the asset-liability mismatch must be minimized, sector bubbles contained and the persistence of troubled assets discouraged. These contribute to high liquidity volatility and thus to unpredictable interest rates. The current monetary policy and financial sector architecture does not adequately prevent the misallocation of resources to sectors that do not contribute much to stimulating national economic activities and job creation.

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

Michael J. Chiaramonte