Nepali economy needs foresight and courage

Published On: May 26, 2020 11:20 AM NPT By: Saurav Rana

Saurav Rana

Saurav Rana

Rana is an economist, and he researches macroeconomic issues.

With the Covid-19 pandemic bringing the economy to a standstill, many businesses are in immediate need for financial support. The finance committee of the Parliament has recommended the government include a NPR 188 billion financial package in FY2021 budget to mitigate the impact of the Covid-19 pandemic on the economy. The need is urgent, but the economy is in a tight squeeze and a fiscal stimulus may be easier said than done.

Fiscal stimulus is essentially increasing the government deficit. Be it from the expenditure side through cash transfers, government loans and guarantees or from the revenue side through tax reductions, the end result is a government deficit. Governments consistently run deficits and borrow to make up the shortfall. However, our case is a little different. Our constraint is not the government’s capacity to borrow, rather it is the country’s trade relations and foreign reserves that poses the limitation. 

Running a government deficit can lead to a deterioration in trade balance. This occurs because a government deficit increases the aggregate demand in the economy. Some of this increased demand will be fulfilled by imports, especially in a country with a weak industrial base like ours. Greater imports lead to a decrease in the trade balance. When the trade balance is in deficit, as is the case for Nepal, the deficit needs to be financed by foreign currency. Non-trade sources of foreign currency can be international currency transfers like remittances, FDI, international borrowing or a country’s foreign currency reserves. 

In the past, foreign currency from remittance could largely help finance Nepal’s trade deficit. This is no longer the case, with the trade deficit reaching USD 11.4 billion and remittance only amounting to USD 7.8 billion in FY2019. When FDI, other currency transfers and international borrowings are not enough to cover the deficit, Nepal has had to finance its trade deficit by dipping into its foreign currency reserves. Nepal’s foreign currency reserve declined from USD 9.3 billion in FY2017 to USD 8.3 billion in FY2019. If the trade deficit continues to remain large and remittance inflow declines, by as much as 14 percent in 2020 as predicted by the World Bank, Nepal will need to dip into its foreign currency reserves even more. 

A fiscal stimulus, therefore, becomes challenging. This begs the question: why not control the trade deficit? This can be done by either reducing imports or increasing exports. The latter is not viable for Nepal in the short term because of preexisting policy constraints which require longer time to overcome. This leaves reducing imports as the only effective near-term solution. 

The government is attempting to do this with restrictions on importing expensive vehicles. However, while import restrictions may reduce the trade deficit and ease the pressure on Nepal’s foreign reserves, it will have an adverse impact on government’s revenue as its largest revenue source is taxes on imports. Taxes on imports, including VAT and excise levied on imports, amounted to 41 percent of total government revenue collection last year. Reducing imports will have a significant impact on the government’s revenue, leading to a deficit.  

If you pursue a fiscal stimulus you do so with the risk of depleting Nepal’s foreign currency reserves. If you try to shore up the country’s foreign currency reserves by reducing imports, you decrease the government’s revenue and tighten the space for a fiscal stimulus. It is an unenviable catch-22 for Nepal’s policy makers. But being in a difficult situation is no excuse to leave businesses on the brink of bankruptcy. It would be highly unethical to allow business to fail and let thousands of Nepali citizens lose their livelihood through job losses.

Notwithstanding the squeeze on the government described above, they are best placed to support businesses. Leaving businesses to fend for themselves can lead to inefficient allocation of resources at best, and at worst it risks bankruptcies. However, the government can allocate resources more efficiently to support ailing businesses or sectors based on the need. The government can borrow cheaply from international organizations like the World Bank and ADB. The loans from these organizations will provide funds for the budget and the external balance (trade deficit) in the short term because it is an inflow of foreign currency into the country.

In the long run the only sustainable option is to enhance economic productivity. To do this Nepal needs reforms because doing business in Nepal is difficult, expensive, and riddled with bureaucratic inefficiencies. The added benefit of borrowing from the World Bank or ABD is that they can leverage their loans for reforms which can help unlock the hurdles to enhance productivity. The government must initiate reforms to make doing business and investing in Nepal easier. If we take only a shortsighted approach of borrowing without improving the economy, we are just postponing the problem. We would be leaving a legacy of bad governance and debt to our children. 

Rana is an economist, and he researches macroeconomic issues.


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