Tuesday, July 26, 2016

Macroeconomic essentials for Nepal Vision 2030

This article is adapted from Nepal Economic Forum's 25th issue of Nefport.

Although a bit late, the government is finally gearing up to formulate a long-term vision for economic development. The tentative targets for now are to graduate from the Least Developed Country (LDC) status by 2022 and to attain the slew of Sustainable Development Goals by 2030. However, a bold and time-bound economic development vision for the country should go beyond these goalposts that were contextualized on the basis of global targets. Nepal should aim to become a vibrant lower-middle income economy within the next two decades.

At the core, it essentially means increasing gross national income (GNI) per capita (World Bank’s Atlas method) from existing USD 730 to about USD 4,125 (the threshold between lower-middle income and upper-middle income economy). In order to achieve such a goal, it is essential that the government draw up a list of strategic flagship projects in physical and social infrastructure sectors and execute them with an efficient and workable implementation arrangement that is in sharp departure from the current discouraging project implementation ecosystem.

Given an appropriate mix of macroeconomic strategy, financial arrangement, smart project execution and supportive institutions, a meaningful structural transformation is possible and the stated goals are achievable. This piece focuses on the macroeconomic aspect of marching on that path.

Macroeconomic essentials

A large amount of public and private investment is required to increase income per capita by almost six folds within two decades. The scale and scope of public investment would depend on revenue mobilization, rationalization of ballooning recurrent spending, and foreign aid. Meanwhile, private investment would depend on investor-friendly environment, including protection of investment and returns, supportive laws and policies, mechanisms for sharing of risk, returns and technology (such as public private partnerships), and maturity of the financial market, among others.

Overall, sound macroeconomic environment will be at the heart of financing for such large scale public and private investment. At around 21% of GDP, the gross fixed investment is lower than the average for low income countries. This needs to be over 30% of GDP to accelerate growth rate (beyond the contribution by exogenous factors such as monsoon and remittances), which will then boost income per capita, and employment generation, primarily through investment in productivity-enhancing physical and social infrastructure. Specifically, public fixed capital investment has to increase to about 10% of GDP over the next decade from the existing 4.5% of GDP.

On the financing part, a combination of rationalization of recurrent expenditure, higher domestic revenue, domestic borrowing, and higher grants as well as concessional and non-concessional loans are needed. At the current level and growth of recurrent expenditure, it will be challenging to cover it sustainably by tax revenue, whose growth rate has stagnated at around 15%. Hence, trimming wasteful recurrent spending in uncoordinated programs and projects should be a priority as a part of sound fiscal management to attain the long-term vision. Second, along with efforts to expand the tax base, the revenue administration will have to be made more efficient and responsive. The present revenue system is too dependent on taxes on remittance-financed imported goods and services. Third, domestic borrowing has to be managed judiciously keeping in mind the optimum market liquidity. Finally, foreign assistance needs to be better utilized by enhancing expenditure absorption capacity. These will partly cover the required resources for public sector investment.

Additionally, fiscal and monetary policies need to be synchronized to tame inflation so that it is not persistently and prohibitively high to discourage investment. At present, inflation is mostly a supply-side phenomenon although localized sectoral inflation (such as unnatural escalation of real estate and housing prices few years back) is mostly within the ambit of monetary authorities. More generally, monetary policy can support the vision by creating appropriate incentives to channel savings into infrastructure investment that typically pay-off in the long-term. Finally, external sector stability should not be much of an issue as long as the economy is gradually diversified and production is competitive in addition to a net positive transfers and sizable foreign exchange reserves. 

Supportive environment

An investment-friendly environment is essential to increase domestic as well as foreign investment. While a slew of laws need updating, policies need rewriting to facilitate and simplify investment rules and approvals. In the meantime, drastic enhancement of capital spending absorption capacity is required to increase public spending in infrastructure, a lack of which is the most binding constraint to inclusive economic growth. Supportive institutions that can foster creative creation and creative destruction need to be promoted as opposed to the protection of business interests through syndicates and cartels. This is crucial for entrepreneurial spirit and to incentivize saving, investment and innovation. Inclusive political and economic institutions are vital to sustaining an equitable and rising income per capita. It is also important to change the course of out-migration for jobs and improved opportunities, and to enhance external sector competitiveness.

Structural transformation

A meaningful structural transformation underpins the pace and pattern of economic growth. Along with the decline of the agricultural sector, Nepal is seeing the rise of low value added, low productivity services sector activities. This structural shift is bypassing industrial sector growth (a sort of deindustrialization), which is vital for productive employment, sustained rise in income per capita, and high growth rate initially. Reversing this trend and revitalization of industrial sector along with promotion of high value added agriculture and services sector activities, with an employment centric strategy to absorb the surplus labor, should form the core of the structural transformation process, which will then lead to higher and inclusive economic growth.

With the right mix of reforms and policies, supportive institutions, enhancement of absorption capacity, and a sound macroeconomic environment to support such structural transformation, the likelihood of attaining the long-term vision is high.

Thursday, July 21, 2016

How to finance large-scale infrastructure in Nepal?

It was published in The Kathmandu Post, 19 July 2016. An earlier blog post on the same issue is here.

Financing infrastructure

Prime Minister KP Oli led government surprised everyone few weeks ago by proposing to initiate key large-scale infrastructure projects, including the much-touted fast track road and Budigandaki hydroelectricity projects, using domestic resources. The intention was to stoke a renewed sense of nationalism high on rhetoric but low in substance, and to extricate the government from binding hooks that come with bilateral financing of such projects. One unruly leftist party even fervently argued for financing all hydropower projects with domestic resources and floated a premature idea to raise money from local shareholders. 

Some politically aligned experts are throwing their weight behind such half-baked proposal without properly analyzing the available financial and knowledge capacities. As it stand now, the economy simply does not have the required financial capacities, stock of knowledge and management capabilities, and competent institutions to initiate large-scale projects entirely on domestic resources. Acquiring such capability requires close collaboration on financing, research and management between external and domestic sources. 

Unfavorable macro

Politicians and their intellectual cheerleaders quickly point to low public debt (in other words fiscal space) to finance large-scale infrastructure projects such as hydroelectricity, roads and airports domestically. The outstanding public debt has decreased sharply from about 52 percent of gross domestic product (GDP) in 2005 to around 25.7 percent of GDP. It means Nepal could theoretically borrow more without jeopardizing fiscal stability (say up to 40 percent of GDP). However, borrowing an additional $3.5 billion or more from domestic and external sources requires the government to drastically enhance its absorption capacity, which unfortunately is eroding.

The outstanding domestic borrowing by selling government bills and bonds amounts to 9.5 percent of GDP and external borrowing, mostly on concessional terms, 16.2 percent of GDP. The government is predominantly selling treasury bills (with maturity of less than one year) to finance recurrent spending as well as multi-year infrastructure projects, and implicitly to manage excess liquidity. This is not a good fiscal practice as large-scale infrastructure projects are financed typically by issuing specific construction bonds, which have long-term maturity and lower risk of asset-liability mismatch. Higher domestic borrowing to fulfill politicians’ whims will crowd out private investment by pushing up interest rates and put unnecessary debt burden on future generation. The FY2017 budget falls in this category.

The use of excess liquidity and treasury savings are identified as alternative sources that could be tapped in to finance infrastructure projects. The persistent excess liquidity is the result of higher growth of deposit compared to the growth of credit. It arises when there is lack of investment-ready projects and unfavorable investment climate, thus constraining banks and financial institutions’ (BFI) capacity to increase credit. Meanwhile, the large growth of deposit is due to the increasing remittance inflows and the government’s inability to spend allocated capital budget on time. While the former is starting to slowdown as the demand for the migrant workers is decreasing, the latter is expected to improve due to relatively better budget execution from this year onward. Transient and volatile excess liquidity and treasury savings cannot be reliable sources for long-term infrastructure financing.

Another related argument on the adequacy of domestic resources is the potential to pool in savings. This argument has its roots in the remittance-backed large deposit growth and oversubscription of shares in the stock market. First, the remittance-backed savings are of short term in nature and using them to invest in projects with long gestation lags create asset-liability mismatch for the BFIs. This is one of the reasons why the BFIs as well as pension funds are financing medium to long term projects through a consortium, which minimizes risk arising from overexpose to one sector. Second, the oversubscription during share issuance is essentially to reap quick profits by trading the shares in the secondary market. This quest for short-term gain does not indicate that there is excess long term saving that could be used for multi-year large-scale infrastructure projects. Nepal’s financial system is not yet mature enough for that.

Regarding external financing, the government won’t be able to drastically increase borrowing because it directly depends on absorption capacity, which stands at a mere 75 percent of budgeted capital spending. Frustration is already running high among Nepal’s key multilateral and bilateral donors owing to the government’s inability to timely use the committed grants and loans. Furthermore, concessional lending from multilateral donors might be drying up. The Asian Development Bank and the World Bank are gradually phasing out concessional lending, which means Nepal might have to borrow at a rate between concessional and nonconcessional terms. The bilateral donors may not be as generous as the multilateral donors as they usually insert binding hooks on procurement and the utilization of funds.

Rhetoric vs realism

Hence, the prospect for domestic and external borrowing may not be as rosy as has been claimed by some politicians and their cheerleaders. Being ambitious on infrastructure projects and their financing is okay, but it should not depart much from what is realistically possible and most importantly it should be not be used to score political points founded on misplaced nationalism. 

The most realistic option for now is to improve investment climate to facilitate private investment (including lowering of country investment risk premium) and to enhance the absorption capacity to accelerate capital spending. It would require addressing head-on the constraints to private investment and low capital spending (including contract management) with an aim to domestically finance large-scale infrastructure projects in the future. Practically, such projects should be financed by issuing long-term construction bonds instead of relying on short-term treasury bills, and medium-term development, employment and savings bonds. An appropriate environment to boost confidence on such long-term bonds is needed.

Properly doing these would require tough reforms, which may not be politically palatable, as opposed to lofty rhetoric on economic development.

Tuesday, July 5, 2016

असारे बिकास: The pitfalls of shoddy and bunching up of capital spending

The media is awash with stories (here, here, here and here) about hasty capital spending throughout the country as FY2016 ends on mid-July. Government agencies, especially the local authorities, tend to award contract for repetitive projects to contractors in the last quarter of fiscal year to avoid freezing of the allocated fund. 

The (politically affiliated) local contractors rush to spend money when the monsoon starts (easy to blame the rain and the ensuing floods and landslides for tawdry work). Consequently, a bloated bill is presented at the end of the fiscal year for shoddy development projects, which need to be redone for the next several years. The same pattern of spending is happening amidst the erosion of bureaucratic and institutional capacities along with politicization of the project level decision-making and operational processes. 

The upshot: (i) the delay in awarding contracts after necessary review of investment projects lowers actual capital spending relative to the planned level; and (ii) the shoddy construction by unscrupulous contractors, who usually bid for projects that are beyond their own financial and technical capacities, rip off the treasury and force the government to continue such projects for a number of years. 

For instance, in the last three months of FY2015, 63% of the capital expenditure (which itself is dismally low) was spent. In the last month, it was 44%. This pattern is not new, irrespective of natural or political shocks (in effect, the bureaucracy blames politicization by coalition governments, and the government blames the tardy bureaucracy). See the monthly spending figure below (unit is in NRs billion). Here I have highlighted six major issues behind this kind of slow spending and bunching of such spending in the last quarter. More on capital spending here and here.

Such low quality of capital spending tends to increase recurrent spending in consecutive years. Especially, the use of goods and services and grants to local bodies-- the two major components of recurrent spending-- tend to swell up. The use of goods and services consists of (i) rent & services; (ii) operation and maintenance of capital assets; (iii) office materials and services; (iv) consultancy and other services fee; (v) program expenses; (vi) monitoring, evaluation and travel expenses; (vii) recurrent contingencies; and (viii) miscellaneous. Grants to local bodies (or fiscal transfers) are used to cover a mix of local development projects and recurrent/administrative costs. These together account for about 8.5% of GDP, which is far larger than capital spending of about 4% of GDP. The governance of such spending has been a major public finance management issue in Nepal.

The figure below provides a snapshot of such jerry-built capital projects on recurrent spending in ten successive years. A shock to capital spending sharply increases recurrent spending till the second year, after which it gradually declines and finally dies out after fourth year. It loosely means that shoddy capital spending (“असारे बिकास” in local lingo) is costly to the treasury as its effect is seen in higher recurrent spending in the next four years (in operations and maintenance costs and larger transfer to local bodies without acceptable spending norms). This result comes from the orthogonalized impulse response function of a VAR model (with sample data of about 40 years and endogenous real variables as GDP, capital and recurrent spending, and private investment). If we use SVAR model, where we can allow for contemporaneous effects as well and also put restrictions on some variables (such as capital spending does not contemporaneously affect recurrent spending, but has lagged effect), we also get pretty much the same result. Despite fiscal data quality issues, the result is quite revealing. 

Final points: (i) low capital spending constrains potential economic growth by depriving the economy of necessary physical infrastructure (& meaningful structural transformation) and also affects economic growth contemporaneously; and (ii) shoddy capital spending increases recurrent spending for several years as such projects need to be continuously repaired and maintained. It will have negative fiscal consequences because recurrent spending is surpassing tax revenue. A higher recurrent spending will further squeeze prospects for higher quantum of capital spending (without bunching towards the last quarter).