Friday, April 25, 2014

Nepal Economic Update: FY2013 performance, FY2014 outlook and excess liquidity

This blog post is adapted from summary section of Nepal Economic Update (April 2014) published by the World Bank's Nepal office. Earlier, the ADB published Macroeconomic Update (February 2014) [presentation here] and Asian Development Outlook 2014 [presentation here]. The special focus on the WB's update is dealing with excess liquidity. ADB focused on boosting Nepal's export competitiveness

The enabling environment for development has improved but opportunities need to be effectively leveraged through focused policy action. The successful election of a new parliament and subsequent formation of a popularly mandated government provide a more conducive environment for private sector activity and economic policy. The uncertainties brought about by Nepal’s prolonged political transition and electoral period have acted as a break on private sector investment and diverted attention of the bureaucracy away from difficult and important reforms. Going forward, it will be important for the government to signal, from the start, that increased political stability will be put to profit to tackle the country’s formidable challenges. This will involve a balancing act to ensure that the arduous process of constitutional drafting can be carried-out in tandem with regular and improved government operations.

Nepal has significant resources in the form of remittances from abroad, but the economy cannot use these resources in a productive manner to enhance the overall welfare of all citizens. The budget process does not work -funds cannot be used to build decent infrastructure that would bring in the private sector- and inefficiencies in the financial sector hinder the optimal allocation of resources to private agents. In view of these challenges, the GoN should set a new course for policy and tackle emerging risks. The appointment of a new Finance Minister with deep experience and reformist credentials is a positive sign and initial declarations of Minister Mahat committing to “take forward the second round of reforms […] in partnership with the private sector” are also encouraging.

Specific priorities include:
  1. Developing a growth promotion vision/agenda: because the numerous challenges facing Nepal make achieving clarity over policy goals and priorities particularly difficult. The Nepalese authorities have formulated the aspiration of graduating to “developing country” status by 2022, but have not articulated the vision for development that would underpin it and identify those policies and reforms that are the most urgent. In the absence of such clear prioritization, the process of development planning is likely to remain un-strategic.
  2. Resolving Nepal’s ‘fiscal paradox’: Nepal, today, is in a paradoxical situation. It is the only country in South Asia to record a budget surplus (helped by buoyant revenue growth), its level of indebtedness is modest, it is flush with liquidity (thanks to large remittance inflows) and yet it struggles to maintain investment at already low levels. Fiscal discipline is a means to an end, but in Nepal it appears to be pursued as an end in itself, with the government unable to plan and implement the budget. This bottleneck needs to be addressed urgently.
  3. Boosting investment: Faster and sustained economic growth will not be possible without higher levels of investment but Nepal’s model of growth appears premised on remittance financed consumption. The public sector has a key role to play to unlock investment by: (i) providing a friendlier environment for the private sector –domestic and foreign- to find it attractive to bid for projects in Nepal, and (ii) developing the essential public infrastructure needed for firms to thrive and private funds to be crowded-in. The fate of Nepal’s “National Pride Projects” demonstrates that such synergies are not currently taking place.
  4. Tackling enduring financial sector risks and managing excess liquidity: Uncertainty over the true health of the financial sector remains the single most important macroeconomic risk for Nepal. First, although unlikely, a financial sector crisis would have devastating effects on public finances and economic growth. Second, the ability of the financial sector to provide adequate credit to deserving borrowers is currently hampered by inter alia (i) distortionary policies (ii) low levels of effective access to finance, (iii) poor risk management practices by monetary authorities and banks amplified by deficient information, and (iv) limited recourses of banks vis-à-vis delinquent borrowers. As a result, the financial sector is operating at sub-optimum and the current excess liquidity in the system is largely a reflection of this state of affairs.
After a difficult year in FY13, the economy is poised to recover, albeit modestly. In FY13, Nepal achieved only modest growth of 3.6%. This was due largely to poor performance of the agricultural sector as well as very modest levels of industrial activity. The only source of relief came from the services sector. The main difference in FY14 is expected to come from the agricultural sector with expanded production on the back of a good harvest, while strong remittance inflows will continue to drive services sector expansion.

Nepal’s internal and external balances are sound but not for the right reasons.
  • The combination of low expenditure and robust revenue growth accounted for a large budget surplus and declining debt. With a significant increase in foreign grants the overall government surplus ballooned to NRs 56.0 billon. Reflecting this comfortable fiscal position the GoN did not issue any fresh T-Bills in the first half of FY14 and domestic debt fell to NRs 217.61 billion. While much of the blame for low rates of budget execution and important bunching had been blamed, hitherto, on delayed budget approval, this was not the case in FY14 when a full budget was unveiled on day one of the fiscal year. In other words, Nepal is yet to come to grips with deep structural inefficiencies in the process of budget planning, formulation and execution.
  • Nepal’s external position is comfortable thanks to large remittance inflows. On the external side Nepal has benefited from the depreciation of the rupee but also –and much more significantly- from a sharp further increase in inward remittances, which are expected to amount to over 30% of GDP in FY14.

Monetary policy has sought to achieve a delicate equilibrium between controlling inflation and supporting economic activity but the optimal balance may evolve and call for corrections. Significant inflation, close to double digits, appears to have become a feature of the Nepali economy. While expanded agricultural output may contribute to dampen inflationary pressure, the significant growth in the money supply may eventually generate inflationary expectations and second round effects as well as translate into lower reserves. From that view point, the evolution of the quantity and quality of credit to the private sector will be important to monitor.

For FY14, the outlook is cautiously optimistic. The previous assessment estimated that growth would reach 4-4.5% in FY14, essentially driven by increased agricultural output and improved execution of the budget. While the pace of capital expenditure may be below initial expectations, inward remittance inflows have been significantly above projected levels and should provide an additional boost to the services sector. On balance therefore, growth is projected to reach 4.5%, especially if capital spending picks up in the second half of the year.

As remittances have become a defining feature of the Nepali economy the country must learn to manage excess liquidity. The significant buildup of liquidity in the financial sector reflects both strong push factors (remittance inflows translating into a build-up of net foreign assets) and weak pull factors (slowing credit growth and loose monetary policy). In the short term, the NRB will need to strike a delicate balance between encouraging sound credit growth –so as to not compromise economic activity objectives- and containing inflation. At present this balance is particularly difficult to achieve because of uncertainties over the true health of the banking sector, weak risk management systems and market failures. In the short run, the NRB may need to expand its toolset to deal with excess liquidity. In the medium run, resolving structural bottlenecks to efficient credit market functioning is a precondition for monetary policy to operate more smoothly and efficiently and for ample available resources to be allocated to grow Nepal’s productive potential.