Global and South-Asian Economic Outlook
The world now stands in a unique situation where governments have to choose between protecting its people and salvaging their economies. As the Covid 19 pandemic increases its grip prolonging government’s lockdown, forecasts by international financial institutions are subject to change every week as new government decisions and its economic impacts are processed.
Global economic growth is now expected to sink by 3% according to the IMF. Unlike the past, low income economies that survived the global financial crisis are likely to see contraction this time around. The World Bank has forecasted Nepal's growth to stay between 1.5% and 2.8% and Nepal’s Central Bureau of Statistics has revised it to 2.27%.
In a context where the IMF has predicted the worst global recession since the great depression of the 1930s, and, The World Bank has projected the worst economic slump in South Asia in the last forty years, Nepal’s economic salvation now depends on how creatively policy makers can design a future course of action. In essence, the intellectual depth of a man in charge of Nepal’s economy will be put to test - Dr. Yuba Raj Khatiwada - The Finance Minister.
Pre-Covid Economic Outlook
Although challenged by many economists, the government set an ambitious target of 8.5% economic growth for FY 2076/77, which was 19.7% more than the growth achieved a year before. The lack of growth in credit expansion and spending were key reasonings by economists who defied this growth target. Also, the goal of reaching a per capita income of US$ 5,000 within a decade would require another questionable double-digit growth.
From the day the Finance Minister was appointed in February, 2018, he has been vocal about formalizing the informal economy. The private sector that contributes 84% of the national GDP was already under pressure as a result of the new Labor Act and the creation of the Social Security Fund. In addition, things got more challenging with new borrowing, credit rating, and income disclosure guidelines. All these new regulations were necessary but by passing so many policies so soon in a lot of sectors without incentives, have delayed their practical implementation. The inclusion of private sector sentiments in government policy formation was one of the weakest in recent times, and as a result, business confidence was severely hit, discouraging additional investment in various sectors. “Wait and Watch'' was the catchphrase in the private sector.
The reduction in agricultural output, slowing remittance, decreasing net transfer income, current account deficit, low FDI inflows, revision of the budget, and high interest rates were some challenges still to be addressed. Needless to say the high hopes that were placed on a Finance Minister with prior experience in the National Planning Commission, the Central Bank, and a Doctorate degree in monetary economics was slowly turning to despair due to his decisions that indicated his technocrat personality more than anything else.
How long will the pandemic last?
The economic revival for governments, corporations and individuals now depend on this particular question. Although there is a global race for vaccine development, it will be a while before people from Nepal can have access to it. Many scientists believe that we might not have any vaccines at all like the HIV vaccine, which has been the case in the past as well. If that is the case then our new normal will be significantly different from the world we were used to before COVID-19.
It is estimated that it will take 18 to 24 months to develop the vaccine, and a country like Nepal would be able to access it faster if companies in India were producing it. That said, even if the vaccines reach Nepal, it will take time to disseminate that to each citizen and for them to take its desired effect in preventing COVID-19. This leaves Nepal particularly vulnerable from a public health standpoint, and not to mention the effects of further curtailment of normal life and economic activity in the country.
Oil, COVID-19, and Remittance
The decrease in oil prices globally have already started hitting oil dependent economies around the world. What is particularly concerning is the presence of Nepalese migrant labour in economies in the middle east such as Kuwait, Saudi Arabia, and Qatar. It is estimated that 1.5 million Nepalese migrant workers will be coming back from these countries, which will exacerbate the ever increasing unemployment scenario the government is facing as a result of COVID-19.
As a result, the World Bank has projected a 14% drop in remittance coming into Nepal. This drop in remittance will have a multiplier effect and change buying behaviour that was being fueled by it before. The government will have to escape the ‘remittance trap’ and come up with transformational policies to fuel aggregate consumption.
Monetary Stimulus, is it enough?
In the past few weeks, the Central Bank has taken some measures to provide some relief to leveraged businesses. It has decreased the CRR requirement by 1% to 3% and halted the counter cyclical buffer requirements freeing up loanable funds up to NPR. 80 billion for commercial banks. Bank rates have been lowered by 1% to 5% lowering the cost of borrowing for banks and the interest rate corridor has been lowered paving the way for a lower base rate.
The above-mentioned directives along with the directive allowing banks to not keep the loans due for renewal in Chaitra under watch list are in favor of the banks. However, the directives related to deferral of loans until Ashar 2077, 60 days deferral on the collection of working capital loans, the provision of additional loans to tourism and travel sector (even to clients that have failed to pay installments), increasing exposure in bank guarantees, and providing additional loans to SMEs seem to imbalance the cash flow cycle of banks along with creating additional exposure in risky sectors already affected by the pandemic.
How significant are the Finance Ministry’s Directives?
The latest policies from the finance ministry have been geared towards the protection of businesses along with an attempt to increase the effectiveness of the healthcare sector. The ministry has announced a time extension for payment of TDS, VAT and Excise Duty from Chaitra 25 to Baisakh 25. VAT refund application deadlines have also been extended.
Furthermore, custom duty for the import of medical supplies and equipment removed along with a ceiling on MRP. The removal of custom duty on medical supplies and equipment will enable such supplies to be distributed at a cheaper price but the enforced MRP, even though it was an honest effort for public well being, can disrupt the supply chain by acting as price ceiling leading to creation of black market and overall deadweight loss to the nation if enforcement agency is not stringent enough. Unwillingly we have to accept that our enforcing agencies have failed multiple times. Rather than regulation through price ceiling, the ministry of health must allocate some budget to purchase supplies along with the private sector and then perform supply side intervention to push the price downwards. Reduction in the custom tariff on import of induction stoves is a good move to promote the use of electricity for cooking during times of excess electricity supply. This has another positive effect of decrease in imports of petroleum products boosting our Balance of Payment (BOP).
Then, another policy related to the optimum use of electricity is a rebate of up to 30% to 50% provided by Nepal Electricity Authority (NEA) in the specified time of wet season for manufacturing industries. This will help the manufacturers to recover financial loss from pandemic as the energy cost will decrease, also this policy will encourage them to upgrade to a capital intensive production process with positive effects on the national output in the long term. The finance ministry is looking to decrease the import of luxury goods and is poised to make import of essentials more strict through its policy of restriction of vehicle import above $50,000, reduction in daily import of gold to 10 kg, ban on import of liquor, and increase in import limit to $100,000 for importing essentials through TT (Telegraphic Transfer). Some businesses involved in the short term will suffer but this sacrifice will be for the overall benefit of the nation as it is important for a net importing country like Nepal to maintain a healthy reserve of foreign reserves. Also, the policy to restrict luxury goods import will have a negative impact, to a minimal extent, on the customs duty revenue of the government. As a way to encourage people and institutions to become socially responsible at this time of crisis the ministry has allowed tax deductible status to amounts contributed to the PM's Corona Relief Fund. Already about Rs. 2 billion has been collected and accumulation of more funds will help our government to purchase medical essentials and prepare necessary aid packages to battle the pandemic. Overall the policies provide a framework to advance towards combating the pandemic.
Passing the buck to citizens and corporations
Majority of the stimulus efforts so far from the government is basically making people and corporations pay for the economic damage. Monetary stimulus is coming at the cost of reduced return in savings of people/institutions at the bank, increased banking sector risk, and reduced profitability of banks which is the loss of millions of people who are shareholders in banks. Reduction in internet tariff, waiver of a month of school fees, request to waive a month of rent are some examples of how the government is making individuals/corporations contribute to stimulus. It is ironic to ask the needy to contribute and it shows the lack of empathy as well as financial capability of government. This inability to help from the government side in times of crisis can result in loss of faith in tax payers and might negatively hit the tax paying culture in future.
Where is the relief package for non-leveraged businesses?
Only leveraged businesses enjoying new monetary stimulus is a big betrayal to businesses who do not have loans but still employ millions of people. There are thousands of SMEs in Nepal who pay taxes and all 19 clauses of monetary stimulus announced are irrelevant to them. They are on their own now and this is expected to continue since fair distribution of relief is not in the capacity of government.
Debt Based Economy
The economies are based on debt because they are based on transactions. Issuing debt is the creation of money. Banks, or an entity acting as a bank, creates money by issuing loans. Formally, this is called fractional reserve lending.
In this context it becomes imperative to understand the composition of money supply and its component, our government’s finance and major economic fundamentals. As in the fractional reserve system, money is not just currency but also credit and all the claims on government, private sector etc. Our money supply has been growing at an average of 16% for the past 3 year with M2 money multiplier up to 5.124. As with growing economic activity, banking systems are efficiently lending to increase the money supply. The reserve currency has been pretty much at a standstill since last fiscal year with a mere 1.7% increase, but due to effective loans floated by the banking system to capitalize on their new bulkier capital base has seen money supply grow by 15.6% last fiscal year. The reserve requirement has been set by the central government to 20% of the fund collected by the bank. As with the fractional reserve system, the increase in economic activity creates a demand for loans which in turn increases the money supply. The current COVID-19 case is likely to shrink the economic activity and thus money supply leading to tighter liquidity. The government if issues bills and bonds to finance its expenditure will likely put a further pressure on our money supply. Total of ~NRs 190 billion worth of financing is required for the government to fulfill its commitments. This will likely crowd out private investment and also decrease money supply. Till Chaitra 30 billion worth of bonds has already been issued. Also a slowdown in remittance of about ~15% is projected for the coming year, which will have a negative effect on disposable income. Less income tantamount to lower spending and lower economic activity which will again have negative impact on debt and money supply.
Our country’s currency pegging with India's INR is a two-sided issue. One, we will be importing their monetary policy and two being a net importing nation, it has provided our foreign exchange to remain as par with the INR foreign exchange, having helped so far to lower our cost. It would be better to slowly reconsider our INR exchange rate and maybe even hike the rate to match the economic fundamentals between the two nations. As our trade with India has become one way, this has put a significant pressure in our BOP with regards to India. So, allowing our currency to depreciate against India will make import costlier and thereby giving an incentive to our local producer to increase the production for meeting internal demand.
For a country like ours where we need capital to pick up our economy, our domestic saving rate in terms of GDP has been 20.5% which is low. This has a lot to do with less efficient financial institutions and innovation. We need our savings to be channelized and allocated in a most efficient manner. A better equipped capital market will provide avenues for savers and borrowers to manage funds effectively. A federal system of governance has been very costlier till present date. Our nation’s recurring expenditure is about ~980 billion whereas our revenue has been ~850 billion, this will put massive stress on the nation's finances going forward. Given our overall debt to GDP has been low at ~30% and with government revenue not able to cover even the recurring expenses, this will likely shoot the figure very high in near future.
Global Stimulus Packages
COVID-19 has affected both demand and supply. Economies are expected to be hit badly. There is already news of job losses, shrinking demand, and supply chain disruptions. Countries are now using both monetary and fiscal stimulus to fend off the looming recession. Monetary measures are targeted at easing liquidity and lowering lending rates. Fiscal measures are targeted at supporting the troubled businesses, temporarily laid-off workers, and low-income households.
USA, China, United Kingdom, Australia, Japan and the ECB had lowered their interest rates. This is expected to provide relief to the existing borrowers as well as ramp us demand for credit. This will help businesses to avoid bankruptcy and in the future lower their cost of operations/production. Many countries have also lowered the capital requirement of the banks. Furthermore, USA, ECB among others are planning to expand their asset-purchase programs. These are expected to increase liquidity in the financial system. It will be interesting to see if there will be any spillover effect on Nepalese economy from the stimulus package worth USD 266 billion announced by India which is 10% of its GDP.
Almost all relief packages include loans and loan guarantees for small businesses. These are aimed at helping businesses cover their regular expenses and avoid business closures. Additionally, another common theme in these packages is extension of monthly installment deadlines. USA, China, France and the United Kingdom have also included extension of tax payment deadlines as well as tax cuts for hardest hit industries.
The lockdowns in countries have left many people unemployed. To address this, most of the relief packages include provision for paid sick leaves and expansion of unemployment benefits. Some countries are offering subsidized business loans to companies who don’t lay off their workers while others are offering grants to businesses to cover a certain portion of paid sick leaves. Japan, Australia, India and the USA have included one-time direct cash payments to its citizens on different conditions. These are provided with the expectation of preventing slowdown in consumption in the economy.
International bodies have offered their own relief packages. The World Bank expects to deploy up to $160 billion over next 15 months to help countries tackle the pandemic and its economic effects. The International Monetary Fund has offered a line of credit to fight the COVID-19 crisis. Additionally, it aims to boost its Catastrophe Containment and Relief Trust to $1.4 billion for extending the duration of debt relief. Nepal has already signed a few agreements but it will be challenging to utilize it in a way that it benefits the broad economy.
Upcoming Economic Challenges and The Way Forward
The whole nation is unsure about when the lock down will come to an end. This has halted our entire economy. Even though the government has granted permission to open industries producing essential goods, most of them remain shut. The economic growth will fall much further than the already weak expected pace due to recent events. However, as the overall impact of the pandemic is yet unknown, it is difficult to predict the outcome accurately. Whatever the forecast from multilateral organizations may be, it is guaranteed that there are many challenges that the economy will face in the upcoming days.
Upcoming budget will be challenging to design and execute as it will have to incorporate measures in line with economic impact assessment. Government revenues will dry up in the fourth quarter of this fiscal year and five sub-sectors contributing to GDP are expected to decline as well. Following conventional ways will not work, the finance minister’s thought process will need a paradigm shift on budget design in order to put our country back on the recovery track.
Radical capital market reforms will pave a way for government and companies to raise domestic as well as foreign debt. There are a lot of financial instruments yet to be introduced in Nepal and these new instruments can take away some portion of burden from banks to support the private sector. For example, Introduction of Real Estate Investment Trust (REIT) is one way we can manage distressed real estate assets coming to market resulting from the pandemic. IPO for SMEs and crowdfunding for startups could be a great start.
It is now high time to rethink about public enterprises that are burning government cash. Strengthening profitable PEs and cutting losses in loss-making PEs via strategic partnership is something the government should adopt. As per the annual performance review conducted in May 2019, there are 37 PEs in operation out of which 26 is profit-making and 11 is loss-making. Government earned Rs. 9.89 billion in cash dividend that year and around 76% of it was contributed by Nepal Telecom alone while combined dividend yield was below 5%. In a time where even small savings matter, the government should take a hard look into PEs that are burning cash and put sustainability agenda before a political one.
Two significant impacts of pandemic will be felt on unemployment level and inbound remittance causing deep socio-economic problems and massive decline in consumption. Government is expecting 1.5 million people to return to Nepal and domestic unemployment is about to skyrocket. Independent economists are expecting inbound remittance to decline by 30% to 40% which is way above the World Bank’s forecast range. Only way for the government to address this will be introducing creative protectionism policies, encouraging manufacturing industries/services using domestic resources with ability to employ domestic idle workforce.
Aggressive improvement in literacy rate (60% currently) and internet penetration rate (54% currently) in a country with the median citizen age of 25 can explode the digital revolution. In a context where internet penetration is linked with GDP growth, growth in the digital economy can balance out sub-sector contribution in GDP. Digital revolution can also compensate for limitations arising out of Nepal’s geopolitical situation.
With a debt to GDP ratio of 30.2%, Nepal has comfortable headroom for aggressive fiscal policy but it should not be exercised with short term focus. While using this fiscal space, priority should be given to long term projects that will employ a lot of local people, take time to build and generate attractive returns for the nation. Retention of cash inflow from debt and deriving economic benefits out of it should be kept in mind as well.
Nepal Law Commission mentions 294 Statutes/Acts in its website and It is now high time to revise some of them to the extent possible in order to bring about great positive economic change. For example, how can we expect FDI in manufacturing with PDTA (Patent, Design and Trademark Act) which is 55 years old? Stringent regulations in FDI in countries like Nepal which need foreign investment to thrive makes absolutely no sense. Lack of provision of virtual office in Company Act and mandatory requirement of physical office/rent contract to get registered in tax office is hindering companies to transition to virtual office which is the need of the hour to cope with pandemic. Similarly, we should review all other Acts and introduce amendments that facilitate faster economic recovery.
Delay in fiscal stimulus by the government will significantly hit tax paying culture in future since many tax paying people and corporations now feel badly betrayed. This will further deteriorate government revenues in coming days. It can be addressed by radical tax reforms that encourage domestic investment, accelerate FDI, bring more people/companies in the tax bracket, encourage startups, motivate people returning to Nepal to start new companies, make companies hire more workers and provide relief to existing companies.
Lockdown modality needs to be reviewed seriously since we share an open border with India and lockdown only buys time at the cost of the economy. There is no proven model so it is necessary for us to come up with our own model and not borrow from other countries. Striking a fine balance between saving lives and saving the economy will need fine brains at work on the government side.
If we apply reverse engineering to economic slowdown parameters, we will find economic variable links directly to pandemic forecasts and the damage to Nepalese population during that period. Since we have adopted lockdown modality like most other countries in the world, our economic fate now depends on how we will be able to open economy phase wise with minimum infections and casualties. To be straighter, our economic recovery now completely depends on how well our healthcare system can handle the pandemic. So, improving the healthcare system should be the top priority of the government.
Lastly, this is not a time to handle two ministries at once, this is a time to build an army at the finance ministry and in all ministries. We are at war here, first with the virus and then with possible economic carnage.
(Ajay Shrestha is CMD at iCapital Private Limited, an asset management company based in Nepal and can be reached at ajay@icapital.com.np)