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The International Bank for Street NW, Washington, DC 20433, USA, fax 202- Reconstruction and Development/The World 522-2422, e-mail pubrights@worldbank.org. Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, http://www.copyright.com/. Photo Credits: Cover photo by Damir Cosic/World Bank; Page i photo by Infopark/World Bank; Page 1 photo by Gajendra Shrestha/World Bank; Page 13 photo by Kamran Akbar/World Bank; Page 17 photo by Laxmi Prasad Ngakhusi. Acknowledgements The Nepal Development Update is produced twice a financial sector. Mona Prasad provided helpful year with the following two main aims: to report on comments. Rajib Upadhya, Richa Bhattarai and key economic developments over the preceding Gayatri Sharma managed media relations and months, placing them in a longer-term and global dissemination. Diane Stamm edited the document. perspective; and to examine (in the Special Focus Sunita Kumari Yadav and Alina Thapa managed section) topics of particular policy significance. The the publication process. Update is intended for a wide audience including policy makers, business leaders, the community of The team is grateful for insights and data from analysts and professionals engaged in economic various agencies in Nepal. In particular, we would debates, and the general public. like to thank Narayan Paudel, Maheshwor Shrestha, and Pradeep Paudyal (all from Nepal This Update was produced by the World Bank Rastra Bank); and Sajina Shakya and Anand Macroeconomics and Fiscal Management (MFM) Pradhananga (Department of Hydrology and team for Nepal consisting of Damir Cosic, Meteorology). Sudyumna Dahal, Roshan Bajracharya, Saurav Rana and Fernando Blanco under the guidance of Cut-off date for data included in this report was Manuela Francisco and Takuya Kamata. Sabin September 11, 2017. Shrestha contributed to the analysis of the iv Table of Contents ACKNOWLEDGMENTS .............................................................................................................. iv EXECUTIVE SUMMARY ............................................................................................................ vii A. RECENT ECONOMIC DEVELOPMENTS ............................................................................. 1 1. Global growth is picking up and the growth in the South Asia region continues to remain strong.. ................................................................................................................................................. 1 2. Economic activity in Nepal, which had strongly rebounded in FY2017, has been affected by one of the worst floods in decades ................................................................................................. 1 3. High inflation in the last two years moderated sharply, reaching a 13-year low...................... 3 4. Government revenue continued to remain robust while spending increased significantly, but underspending of budget continues......................................................................................... 3 5. Imports have reached a new high while exports have permanently declined .......................... 5 6. External sector pressure mounts as trade deficit expands and remittances slow .................... 6 7. Credit growth has moderated but deposit mobilization continues to slow.............................. 7 B. OUTLOOK, RISKS, AND CHALLENGES.............................................................................. 13 C. SPECIAL FOCUS: FISCAL ARCHITECTURE FOR FEDERAL NEPAL…………………..17 REFERENCES ..............................................................................................................................26 BOX Box 1 Indirect tax reforms in India and impact on Nepal’s economy ................................................7 FIGURES Figure 1 Monsoon rains had been slightly less than the long-term average before the floods .............2 Figure 2 After two years, housing reconstruction was also finally picking up .........................................2 Figure 3 The spring season has seen record tourist arrivals .......................................................................2 Figure 4 Consumption slowed while imports of industrial and capital goods picked up ......................2 Figure 5 However, severe floods have caused severe damage especially in the southern plains ..........3 Figure 6 Inflation has further slowed primarily due to low food prices ...................................................4 Figure 7 And is trailing India’s inflation.........................................................................................................4 Figure 8 Revenue collection reached a record high .....................................................................................4 Figure 9 On the back of strong revenue collection throughout the year .................................................4 Figure 10 FY2017 expenditure increased significantly, as well.....................................................................5 Figure 11 Capital spending reached a record high despite underspending ................................................5 Figure 12 A large share of capital expenditure in the last quarter has raised quality concerns ...............6 Figure 13 Imports have reached a record high ...............................................................................................6 Figure 14 Averaging US$750 million per month in FY2017 ........................................................................6 Figure 15 Goods exports may have permanently declined ...........................................................................7 Figure 16 As exports to India are not recovering ...........................................................................................7 Figure 17 …And the continued appreciation of the real effective exchange rate .....................................8 Figure 18 Service exports are performing well ................................................................................................8 Figure 19 But are being offset by Nepalese traveling abroad .......................................................................8 Figure 20 Controlling for seasonality, remittance growth is low .................................................................8 Figure 21 Migrant worker outflow has contracted for three consecutive years ........................................9 Figure 22 As worker outflow seems to have declined to a new lower level ...............................................9 v Table of Contents (continued): Figure 23 A surging trade deficit and slowing remittances are pressuring the current account ............. 9 Figure 24 Leading to slower accumulation of foreign reserves ................................................................... 9 Figure 25 Credit growth has slowed steadily after the rapid surge ............................................................ 10 Figure 26 As bank lending to all sectors declined ........................................................................................ 10 Figure 27 Deposit growth, which had somewhat picked up, has slowed.... ............................................ 10 Figure 28 CCD ratio lowered due to slowdown in credit growth and relaxation in calculating the ratio ............................................................................................................................................. 10 Figure 29 Large government deposits have soaked up liquidity ................................................................ 11 Figure 30 As a result, interest rates have remained sticky at higher rates ................................................ 11 Figure 31 GDP growth after a strong rebound is expected to moderate ................................................ 15 Figure 32 Agriculture was particularly impacted by the floods of 2017 ................................................... 15 Figure 33 Components of fiscal federalism .................................................................................................. 18 Figure 34 Components of fiscal federalism analyzed in this note ............................................................. 18 Figure 35 Vertical fiscal gap varies among countries ................................................................................... 20 Figure 36 Nepal’s vertical fiscal gap is going to be one of the largest among federal countries .......... 20 Figure 37 Fiscal decentralization diamond: pre- and post-federal constitution ...................................... 24 TABLES Table 1 Selected fiscal indicators ................................................................................................................... 5 Table 2 Nepal macroeconomic outlook .................................................................................................... 14 Table 3 Fiscal decentralization trends in Nepal, FY2010 through FY2018 ......................................... 22 vi Fiscal architecture for federal Nepal Nepal Development Update Executive Summary Recent Economic Developments availability of loanable funds because the banks had committed to offer higher interest rates to Global growth is picking up and the growth in the attract new deposits during credit crunch. South Asia region continues to remain strong. A recovery in industrial activity has coincided with a As imports continue to surge and exports to falter, pickup in global trade, after two years of marked the trade deficit has further increased. weakness. Growth in South Asia remains strong, Remittances, which financed almost all imports in with regional output projected to grow by 6.8 previous years, have continued to slow. percent in 2017 and an average of 7.2 percent in Consequently, the current account has narrowed 2018–19. significantly from 6.2 percent of GDP in FY2016 to a deficit of -0.4 percent of GDP in FY2017. Economic activity in Nepal, which rebounded strongly in FY2017, reaching 7.5 percent (year-over Annual revenue growth has been robust, with -year [y/y]) following two challenging years, has government exceeding the revenue target. Public again been impacted by severe flood affecting spending has also significantly picked up in real more than one-third of the country terms, with capital spending reaching a record high at almost 8 percent of GDP in FY2017. The High inflation in the last two years induced by fiscal deficit reached 3.3 percent of GDP in disruptions moderated sharply by early 2017 and FY2017. further slowed, reaching decade-low inflation by the end of FY2017, due to moderating inflation in Outlook, Risks, and Challenges India. Economic activity, which was expected to Credit growth soared during the first half of the progress well in FY2018, has been set back by fiscal year and, coupled with a simultaneous slow another natural disaster. Severe floods in mid- deposit mobilization, which had led to a squeeze August, the third major shock in three consecutive on the availability of loanable funds at banks, had years, has caused severe disruptions and damage eased off by the end of the fiscal year. However, especially in the southern plains. Over 1.7 million interest rates have not come down despite the people have been affected by flood and landslides. September 2017 THE WORLD BANK GROUP vii Fiscal architecture for federal Nepal Nepal Development Update Houses, bridges, roads, and other infrastructure Despite improvements, the overall pace of have also been damaged. earthquake reconstruction remains modest, which is now compounded by flood recovery as the While the estimates of damage remain government needs to manage response to two preliminary, the growth for FY2018 is expected separate natural disasters. be lower than earlier forecasted and moderate thereafter, in line with the potential averaging 4.5 The external environment is likely to pose a risk, as percent in the forecast period. well. The decline in migrant workers’ outflow has been compounded by Qatar’s political woes—a With increased government spending due to a major destination of Nepalese migrants—which transition to new federal structure and may cause a sharper deterioration in balance of earthquake and flood-related spending, the fiscal payments. deficit is expected to widen in FY2018 to 4.3 percent of GDP. Financing is not expected be a Special Focus problem given ample fiscal space with a low debt -to-GDP ratio and a large cash balance at hand. In this edition of the Update, we take a closer look at the main emerging issues and potential risks in Meanwhile, the current account, which turned the design of fiscal architecture for the new federal into a marginal deficit in FY2017, is expected to Nepal. widen as import growth is expected to remain high, while remittances and exports growth are In general, issues regarding the transition to expected to grow slowly. federalism can be grouped into three categories: the functions category (that is, which level is Both domestic and external risks predominate responsible for delivering which service), the and are on the downside. The political finance category (that is, which level or levels environment remains fluid as the term of the collect revenue and raise debt), and the new government—which was sworn in in July functionaries category (that is, how will the existing 2017 as part of the power-sharing agreement civil service be transformed). All the issues under among the coalition partners —will come to an these three categories need to be resolved end in late 2017, after the provincial and federal effectively for government service delivery not to elections. get disrupted. Transition to a new federal structure and smooth In sum, while the constitutional provisions and service delivery are also going to be new risks laws currently under consideration in the and challenges. With local elections expected to Parliament will create a mismatch between the be completed by September 2017 and provincial levels that collect revenue and those that are and federal elections by December 2017, FY2018 responsible for service delivery, this does not have will be a transitional year in implementation of to be problematic if the system of inter- the new federal constitution. governmental transfers is designed properly. September 2017 THE WORLD BANK GROUP viii Fiscal architecture for federal Nepal Nepal Development Update A. Recent Economic Developments 1. Global growth is picking up and the growth risks include an increase in global financial in the South Asia region continues to remain volatility, a slowdown in remittance inflows, and strong rising geopolitical tensions (World Bank 2017). Global growth is firming, contributing to an 2. Economic activity in Nepal, which had improvement in confidence. A recovery in strongly rebounded in FY2017, has been industrial activity has coincided with a pickup in affected by one of the worst floods in decades global trade, after two years of marked weakness. In emerging market and developing economies, Economic activity rebounded strongly in obstacles to growth among commodity exporters FY2017, reaching 7.5 percent (y/y) according are gradually diminishing, while activity in to the first estimate by the Central Bureau of commodity importers remains generally robust. As Statistics (CBS). On the supply side, all three a result, and despite substantial policy uncertainty, major sectors grew at above-trend rates in global growth is projected to accelerate to 2.7 FY2017. Rice production reached a record high at percent in 2017, up from a postcrisis low of 2.4 5.2 million tons, on the back of one of the best percent in 2016, before strengthening further to monsoons in recent years, boosting agricultural 2.9 percent in 2018–19 (World Bank 2017). output. Industry’s growth was high as well, due in part to the electricity subsector with a record-high Growth in South Asia remains strong, with hydropower capacity addition (more than 100 regional output projected to grow by 6.8 MW) and construction on the back of earthquake percent in 2017 and an average of 7.2 percent reconstruction gathering speed. Growth in the in 2018–19. Excluding India, growth is projected service sector was aided by the wholesale/retail to average 5.8 percent in 2017–19, with some cross trade and hotels subsectors fully normalized from -country variation. Robust domestic demand, an the shocks of the previous two years. Tourist uptick in exports, and strong foreign direct arrivals rebounded strongly and reached a record investment inflows underpin this forecast. high in FY2017. On the demand side, gross Domestic risks to the outlook include policy investments contributed the most to headline uncertainty related to upcoming elections and growth. Gross fixed capital formation is estimated possible setbacks to reform progress. External to have reached 25 percent of GDP in FY2017, up September 2017 THE WORLD BANK GROUP 1 Fiscal architecture for federal Nepal Nepal Development Update from 21 percent the year before, with both private years of slow progress, postearthquake housing and public investment rebounding strongly. reconstruction picked up some speed. Of the Consumption, however, slowed, most likely in 646,419 beneficiaries eligible for housing grants, light of the slowdown in remittances. over 90 percent have been enrolled and received the first tranche in July 2017 (Figure 2). After a strong rebound in FY2017, economic However, while many houses are under activity was expected to perform well in construction as beneficiaries start receiving FY2018. A normal paddy output was expected grants, disbursement of the second and third on the back of the 2017 monsoon that was only tranches is still slow. As in previous years, the slightly less than the long-term average, and was service sector was performing well. Tourist expected to catch up in August (Figure 1). arrivals in the first half of 2017 reached more Construction-related activities had been picking than 450,000 (Figure 3), a record high indicating up, aided by reconstruction works. After two the sector had recovered from the adverse Figure 1 Monsoon rains had been slightly less than Figure 2 After two years, housing reconstruction the long-term average before the floods was also finally picking up (millimeter, monthly average, cumulative) (thousands) 1200 700 Long-Term Eligible Households in Average 600 11 surveyed districts 1000 2016 2014 500 Enrolled 800 Received First 400 Tranche 2017 2015 600 300 200 400 100 Received Second 200 Tranche Received Third Tranche 0 Aug-16 Sep-16 Aug-17 Jun-16 Oct-16 Nov-16 Dec-16 Feb-17 Mar-17 Apr-17 Jul-16 Jan-17 May-17 Jun-17 Jul-17 0 June July August Source: Department of Meteorology. Source: Ministry of Urban Development. Figure 3 The spring season has seen record tourist Figure 4 Consumption slowed while imports of arrivals industrial and capital goods picked up (thousands, 3-month moving average) (percent change, 3-month moving average, yly) 100 200 Imports of Tourist Arrival Industrial Supplies 90 150 80 Imports of Capital Goods 70 100 60 Imports of Consumer Goods 50 50 40 0 30 20 -50 10 0 -100 Sep-15 Sep-16 Nov-14 Jan-15 Mar-15 Nov-15 Nov-16 Mar-17 May-15 Jul-15 Jan-16 Mar-16 May-16 Jul-16 Jan-17 May-17 Jul-17 Mar-13 Sep-13 Dec-13 Mar-14 Sep-14 Dec-14 Mar-15 Dec-15 Mar-16 Sep-16 Dec-16 Mar-17 Jun-13 Jun-14 Jun-15 Sep-15 Jun-16 Jun-17 Source: Ministry of Tourism. Source: Department of Customs. September 2017 THE WORLD BANK GROUP 2 Fiscal architecture for federal Nepal Nepal Development Update impacts of the earthquakes and the trade Figure 5 However, severe floods have caused se- blockade during the last two years. Despite a vere damage, especially in the southern plains slowdown in consumption, most likely due to a slowdown in remittances, trade, which is the largest contributor of the service sector, grew robustly on the back of reconstruction, industrial, and capital goods imports (Figure 5 ). However, severe floods in mid-August, the third major shock in three consecutive years, caused severe disruptions and damage especially in the southern plains (Figure 4). Over 1.7 million people have been affected by flooding and landslides affecting more than one-third of the country. This includes over 460,000 people displaced and Source: United Nations. nearly 65,000 homes destroyed by floodwaters. Bridges, roads, and other infrastructure have also been severely damaged. Several districts recorded the heaviest rainfall in 60 years, and 3. High inflation in the last two years over 80 percent of land in the southern Terai moderated sharply, reaching a 13-year low region was inundated by floodwaters (United Nations 2017). Inflation slowed to 2.7 percent (y/y) in July 2017, averaging 4.5 percent for whole of FY2017 Economic activity has also been affected. (Figure 6). This is the lowest rate since FY2004 and While the estimates of damage and losses well below the FY2017 monetary policy target of caused by the floods are being carried out, 7.5 percent. Food and beverage inflation declined preliminary estimates show that agriculture is dramatically in the last 12 months, from expected to be most affected. Agricultural contributing 4.1 percentage points to headline sector output, which was earlier expected to be inflation in August 2016 to -0.4 percentage points average, has been severely hit by major floods in July 2017. Very low inflation of cereal grains in the Terai plains, the breadbasket of Nepal. It (0.04 percentage points in July 2017) has been a is estimated that 64,000 hectares of standing boon to Nepal’s population, whose main diet is crops have been destroyed. The manufacturing rice. Although nonfood items are driving inflation, sector is also expected to suffer temporarily, as they too have moderated from contributing 4.5 most of the industries are also located in the percentage points in August 2016 to 3.1 percentage Terai region. Some of the major tourist points in July 2017. destinations, like Chitwan, have also been affected by the floods. Nepal’s inflation divergence with India declined in July after picking up in recent Poverty reduction efforts are likely to be months. The overall inflation differential reached affected, too. The floods have had a 0.3 percentage points in July 2017 from a low of — significant impact on critical infrastructure, 1.7 percentage points in March 2017 (Figure 7). with 80 schools across 28 districts destroyed Moving forward, implementation of the Goods and and 710 damaged. Ten health posts have been Services Tax (GST) in India might lower inflation destroyed and 64 partially damaged (United in India, especially as many staple food items have Nations 2017). Due to crop damage, the been exempt from the tax (Box 1). In the short livelihoods of farmers are also likely to be term, this will increase the Nepal-India inflation impacted and food insecurity increased, differential due to prices declining faster in India because food stocks have also been destroyed. but remaining sticky in Nepal. However, in the long As a result, poverty reduction efforts are also run Nepal is likely benefit from low inflation in likely to be affected. India as prices in Nepal adjust accordingly. September 2017 THE WORLD BANK GROUP 3 Fiscal architecture for federal Nepal Nepal Development Update 4. Government revenue continued to remain previous years. Similarly, customs duties and robust while spending increased significantly, income taxes also registered healthy growth at but underspending of budget continues 36.7 percent and 26.6 percent, respectively, in FY2017. Revenue collection in FY2017 exceeded the government’s annual target and reached a Government spending saw a massive jump in record high of 24.8 percent of GDP (Figure 8). FY2017 driven by both recurrent and capital Driven by improved tax collection, revenue expenditures. However, nearly 27 percent collection was consistently strong throughout (NPR 137 billion) of the recurrent budget was FY2017 (Figure 9). Value-added tax (VAT) spent during the last month of the fiscal year collection, the largest tax source, grew by 31.3 (Figure 10). Overall, government expenditure percent in FY2017 to reach NPR 160 billion grew by nearly 6 percentage points of GDP over supported by the large import bill, as in the FY2016, reaching 29.3 percent of GDP overall in Figure 6 Inflation has further slowed primarily due Figure 7 And is trailing India’s inflation to low food prices… (contribution to headline inflation, percentage points, y/y) (percentage points) 13 Food & Beverage 10 Nonfood & Service Overall Total Inflation Differential with India 8 11 Food & Beverage Differential 6 9 4 7 2 5 0 3 -2 Nonfood & Services Differential 1 -4 -1 -6 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Source: NRB. Source: NRB and CSO India. Figure 8 Revenue collection reached a record Figure 9 On the back of strong revenue collection high… throughout the year (percentage of GDP) (NPR billions, 3-month moving average) (percent change y/y) 30 80 120 Total Revenue Revenue Growth (right) Domestic Revenue 100 25 60 80 40 60 20 40 20 15 20 0 0 10 -20 -20 5 -40 -40 -60 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 0 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 Source: MoF. Source: NRB and World Bank staff calculations. September 2017 THE WORLD BANK GROUP 4 Fiscal architecture for federal Nepal Nepal Development Update Table 1 Selected fiscal indicators (percent of GDP unless noted otherwise ) FY2014 FY2015 FY2016 FY2017 b FY2017 e FY2018 b FY2018 f Total Revenue and Grants 20.6 20.8 23.2 25.9 26.1 27.8 26.6 Total Domestic Revenue 18.8 19.3 21.6 21.8 24.8 25.3 25.3 Tax 15.9 16.7 18.7 19.6 22.1 23.1 22.8 Nontax 2.6 2.3 2.7 2.1 2.7 2.2 2.5 Grants 2.1 1.8 1.8 4.1 1.3 2.5 1.3 Total Expenditure 18.8 20.1 23.7 38.3 29.3 42.1 30.9 Recurrent 15.5 15.9 16.5 23.7 19.9 27.9 20.6 Capital 3.4 4.2 5.4 12.0 7.9 11.6 8.7 Net Lending 1.1 1.8 1.7 2.6 1.6 2.6 1.6 Fiscal Balance 0.6 -1.1 -0.4 -12.4 -3.3 -14.3 -4.3 Sources: MoF, NRB for history and estimates; WB staff for forecasts. Note: b=budget, e=estimate, f=forecast. FY2017. Capital budget execution was a record Quality of expenditure continues to be a high at almost 8 percent of GDP (Figure 11) problem. FY2017 once again saw a large despite significant underspending that was at bunching of capital expenditure. About 61 percent only 65 percent of planned expenditures. of the capital budget was spent in just the last quarter (Figure 12). The deterioration of the Hence, the expenditure target was missed as quality of public expenditure is a major concern before and remained significantly below the and can impose higher costs in the future. planned budget. Budget underspending has become a systemic issue in Nepal, primarily 5. Imports have reached a new high while because of unrealistic budget targets (Table 1). exports have permanently declined Furthermore, allocation of public funds to large infrastructure projects that are not ready for Imports surged to a record high of 37 percent of implementation also leaves large chunks of GDP in FY2017 (Figure 13). Imports increased government funds unspent. consistently throughout FY2017 averaging US$768 Figure 10 FY2017 expenditure increased signifi- Figure 11 Capital spending reached a record high cantly, as well despite underspending… (NPR billions, 3-months moving average) (percent change y/y) (percentage of GDP) Total Expenditure Expenditure Growth 9 90 (right) 90 Total Capital Spending 8 70 70 7 50 50 6 30 30 5 10 10 4 -10 -10 3 -30 -30 2 1 -50 -50 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 0 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 Source: NRB and World Bank staff calculations. Source: MoF. September 2017 THE WORLD BANK GROUP 5 Fiscal architecture for federal Nepal Nepal Development Update Figure 12 A large share of capital expenditure in activity and the economy registering high growth in the last quarter has raised quality concerns FY2017, exports have remained below the five-year (percentage, share of total capital spending) average (Figure 15). This is mainly due to lower and 75 Capital Spending in Last Quarter declining exports to India, as exports to other countries have reached predisruption levels (Figure 70 16). In addition, the continued appreciation of the 65 real effective exchange rate (REER) of the Nepalese rupee is also having a negative impact on Nepalese 60 exports (Figure 17). The REER appreciated by 18.8 percent in FY2017 from the average level in 55 FY2014. 50 Service exports are performing well. The 45 continued arrival of tourists is pushing service exports up (Figure 18). However, this is being 40 offset by service imports as more Nepalese are Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 traveling abroad, including for education (Figure 19). Source: MoF. 6. External sector pressure mounts as trade deficit expands and remittances slow million per month (Figure 14). This is well above the US$557 million per month average registered over Remittances picked up slightly in FY2017, but the previous five years, and higher imports seem to growth remains slower than the double-digit be the new normal. Unlike in the last two years, growth of the past. The volume of remittance imports have been driven by industrial supplies, inflow is still large, at US$6.5 billion in FY2017. capital goods, and fuel imports, while consumption Using a standard statistical technique developed by and food imports have slowed. the U.S. Census Bureau, we adjust the data to remove the effect of seasonal variation (Figure 20). Exports have structurally declined after Analyzing the seasonally adjusted data we observe remaining below the five-year average for two that remittance growth was only 2 percent in July consecutive years. Unlike imports, Nepal’s exports 2017. However, as in the past, a large amount of never fully recovered following the end of the trade remittances are received through informal channels blockade. Even after a full year of normal economic that are not captured in the balance of payments. Figure 13 Imports have reached a record high… Figure 14 Averaging US$750 million per month in FY2017 (US$ billions) (US$ millions, 3-month moving average) (percent change, y/y) 10 1,400 140 Oil Imports Nonoil Imports 9 1,200 120 8 1,000 100 7 800 Nonoil Imports 80 6 600 5-Year Average 60 5 400 40 4 200 20 3 0 0 Total 2 -200 Oil Imports -20 Imports, 1 Growth -400 (right) -40 0 -600 -60 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Source: NRB. Source: NRB and World Bank staff calculations. September 2017 THE WORLD BANK GROUP 6 Fiscal architecture for federal Nepal Nepal Development Update Box 1 Indirect tax reforms in India and impact on Nepal’s economy India launched the Goods and Services Tax credits, putting them at a disadvantage vis-à-vis (GST) in July 2017 which replaces and subsumes registered vendors. As more sellers register in the 17 central and state taxes. It reduces rates of over GST chain and record economic transactions, it 50 percent of items, with many essential items may have a strong positive impact on tax exempt from tax, and charges standard rates of 5 collection and lead to higher revenues. percent, 12 percent, and 18 percent, while a higher tax rate of 28 percent is charged on luxury and Although the exact impact on Nepal’s economy “sin” goods. The GST provides taxpayers a is yet to be ascertained, Nepalese exporters may refund against their sales within 60 days. Similarly, suffer from a loss of competitiveness in the exporters will get refunds within seven days. To Indian market as goods produced in India protect consumer rights, the new law includes become cheaper due to the new lower tax rates. antiprofiteering provisions. This is especially likely for agricultural exports, many of which have been exempt of taxes in the The GST is expected to have a positive and GST regime. In contrast, since Indian exporters significant impact in India as it simplifies the will get a tax refund against their sales, Indian indirect tax regime. It is expected to yield growth export goods will be cheaper, which may increase dividends, but the magnitude is difficult to imports from India in Nepal. In the short run it quantify. The GST is also intended to be revenue may affect Nepalese producers adversely as they neutral, which should ensure that impact on now have to compete with cheaper goods from inflation is minimal. However, in the long term, India. However, in the long run it should catalyze the GST is expected to increase formalization of Nepalese producers to improve their efficiency to the economy because sellers who are not in the regain their competitiveness and adjust to the GST chain will be unable to claim input tax new environment. Migrant worker outflow has contracted three The initial decline in the last two years came from years in a row and reached a five-year low in workers going to Malaysia, followed by Saudi FY2017. Less than 400,000 Nepalese migrant Arabia and other Gulf Countries. However, workers went abroad in FY2017, leading to growth workers leaving for Qatar also contracted by a contraction for three consecutive years (Figure 21). third in July 2017—likely a reflection of the Figure 15 Goods exports may have permanently Figure 16 As exports to India are not recovering… declined … (US$ millions, 3-month moving average) (percent change, y/y) (US$ millions, 3 months moving average) (percent change, y/y) 110 110 90 Exports to Other Countries 90 Exports to Exports to India Exports 90 90 China (5-Year Average) 5-Year Average 70 70 70 70 50 50 50 50 30 30 30 30 10 10 10 10 -10 Exports to India Growth of -10 -10 -10 Exports to Exports Growth -30 India (right) -30 -30 -30 (right) -50 -50 -50 -50 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Source: NRB and World Bank staff calculations. Source: NRB and World Bank staff calculations. September 2017 THE WORLD BANK GROUP 7 Fiscal architecture for federal Nepal Nepal Development Update Figure 17 …And the continued appreciation of the Figure 18 Service exports are performing well… real effective exchange rate (index number, 2010=100) (thousands) (percentage change, 3-month moving average, y/y) 120 Tourist Arrival Service Export 90 Growth (right) 90 115 Real Effective 110 Exchange Rate 70 70 105 50 50 100 30 30 95 Nominal Effective 10 10 90 Exchange Rate -10 -10 85 80 -30 -30 Jan-12 Jan-14 Jul-11 Jul-12 Jan-13 Jul-13 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Mar-13 Nov-13 Mar-14 Nov-14 Mar-15 Nov-15 Mar-16 Nov-16 Mar-17 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Source: World Bank staff calculations. Source: NRB and World Bank staff calculations. economic blockade imposed on Qatar by its few years. The trade deficit reached a historic neighbors (Figure 22). There was also a reduction high of US$8.4 billion in FY2017. However, in the number of workers migrating to Saudi remittance inflow of only US$6.5 billion was Arabia and Kuwait. This may be due to these oil- unable to offset the large trade deficit. producing countries cutting back on public Consequently, the current account has spending to ease fiscal pressures from the significantly narrowed to a deficit of -0.4 percent persistently low crude oil prices in international of GDP compared to a huge surplus averaging 5 markets. percent of GDP in the last five years (Figure 23). As a result, although still high at US$10.5 billion, Slower remittances and a surging trade foreign reserves accumulation has slowed, deficit have begun to put pressure on the covering 11.4 months of merchandise and current account. The trade deficit has been services imports down from the peak of 18.7 financed by ever increasing remittances in the last months one and half years ago (Figure 24). Figure 19 But are being offset by Nepalese travel- Figure 20 Controlling for seasonality, remittance ing abroad growth is low (US$ millions, 3-month moving average) (US$ millions, 3-month moving average, (percentage change, 3m/3m SAAR) 200 seasonally adjusted) Balance of Trade 700 Remittances 70 in Services Remittances 150 Growth, SAAR 600 (seasonally 60 Exports of Services (right) adjusted) 100 500 50 400 40 50 300 30 0 200 20 -50 100 10 0 0 -100 -100 -10 -150 -200 -20 -200 -300 -30 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Source: NRB and World Bank staff calculations. Source: NRB and World Bank staff calculations. September 2017 THE WORLD BANK GROUP 8 Fiscal architecture for federal Nepal Nepal Development Update Figure 21 Migrant worker outflow has contracted Figure 22 As worker outflow seems to have de- for three consecutive years… clined to a new lower level (thousands) (thousands) 700 70 Malaysia Qatar Saudi United Kuwait Others Migrant Workers Arabia Arab 600 60 Emirates 500 50 400 40 300 30 200 20 100 10 0 0 FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 Jan-13 Jul-13 Jan-14 Jan-15 Jul-14 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Source: Department of Foreign Employment (DoFE). Source: DoFE and World Bank staff calculations. 7. Credit growth has moderated but deposit more than 50 percent of the value of vehicles mobilization continues to slow through auto loans. This impacted credit growth, which slowed from a peak of 31.9 percent (y/y) in Credit growth after a surge has slowed steadily February 2017 to 18.1 percent (y/y) in July 2017 over the last six months. Credit growth soared (Figure 25), as banks curtailed lending on all their during the first half of the fiscal year, and coupled loan products (Figure 26). However, with the with a simultaneous slow deposit mobilization led adoption of the FY2018 monetary policy, most of to a squeeze on the availability of loanable funds at these measures have expired or eased. The banks. In response, the NRB (the Nepal Rastra provision on auto loans has been relaxed to allow Bank, the central bank of Nepal), introduced banks to finance up to 65 percent of the value of temporary restrictions on bank lending, such as the vehicles. Most importantly, the expiration of reducing the limit on personal overdrafts by NPR the provision allowing banks to calculate their 2.5 million and restricting banks from financing Credit to Core Capital and Deposit (CCD) ratio by Figure 23 A surging trade deficit and slowing re- Figure 24 Leading to slower accumulation of for- mittances are pressuring the current account … eign reserves (US$ millions, 3-month moving average) (US$ millions) (months) 800 12,000 20 Trade Deficit Total Reserves Import Coverage (right) 18 700 10,000 16 600 14 500 8,000 Remittances 12 400 6,000 10 300 8 Current 200 4,000 Account 6 100 4 2,000 0 2 -100 0 0 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Source: NRB. Source: NRB. September 2017 THE WORLD BANK GROUP 9 Fiscal architecture for federal Nepal Nepal Development Update applying only 50 percent risk weightage to surge of credit, deposit mobilization has not picked productive sector loans resulted in the availability up. In fact, deposit growth slowed to 14.5 percent (y/ of more loanable funds. The NRB has, however, y) in July 2017 from 19.6 percent (y/y) in February increased the limit on home loan financing to 2017 (Figure 27). The contributions to deposit NPR 15 million from NPR 10 million, which may growth from all sectors declined during the last six increase credit uptake in the residential months, leading to an overall slowdown in deposit construction sector. growth. Deposit mobilization continues to slow. Slower The CCD ratio of banks has lowered due to deposit growth vis-à-vis credit growth was the other decline in credit growth and some relaxation in reason for the squeeze on banks’ CCD at the the definition of calculating the CDD ratio. The midpoint of FY2017. While NRB’s interventions to slowdown in credit growth has helped lower the restrict credit growth succeeded in controlling the CCD ratio of banks from 78.1 percent at the end of Figure 25 Credit growth has slowed steadily after Figure 26 As bank lending to all sectors declined the rapid surge… (contribution to growth, percentage points) (percent change, y/y) (percent change, yly) 35 Agriculture Industry Construction Service Others 35 80 Lending to Overdraft Residential Real Estate Total Credit Commercial Home Loan 30 30 70 Growth (right) Margin Vehicle 25 25 60 Lending 20 20 50 15 15 40 10 10 30 5 5 20 0 0 10 -5 -5 0 Nov-15 Mar-16 Nov-16 Mar-17 Jul-15 Jul-16 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Source: NRB and World Bank staff calculations. Source: NRB and World Bank staff calculations. Figure 27 Deposit growth, which had somewhat Figure 28 CCD ratio lowered due to slowdown in picked up, has slowed… credit growth and relaxation in calculating the ratio (contribution to growth, percentage points) (percentage change, y/y) (ratio) 30 30 82 Foreign Nonbank Corporations Individuals Deposits Deposits Financial Growth 80 25 Institution (right) 25 Regulatory Limit 78 20 20 CCD Ratio 76 15 15 74 10 72 10 5 70 5 0 68 Others 0 66 -5 -10 -5 64 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Apr-17 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Oct-16 Jan-17 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Source: NRB and World Bank staff calculations. Source: NRB and World Bank staff calculations. September 2017 THE WORLD BANK GROUP 10 Fiscal architecture for federal Nepal Nepal Development Update Figure 29 Large government deposits have soaked Figure 30 As a result, interest rates have remained up liquidity sticky at higher rates (NPR billions, 3-month moving average) (percentage, weighted average) 300 14 250 12 Lending Rate 200 10 Government Credit 150 8 Government Deposit 100 6 Deposit Rate 50 4 0 2 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Source: NRB. Source: NRB. Q2 FY2017 to 71.4 percent at the end of Q3 FY2017 Despite improvement in the availability of (Figure 28). This is also because the NRB has allowed loanable funds, deposit and credit rates banks to calculate the CCD ratio by reducing the continue to rise. As government spending weightage applied to “productive purposes” by 50 significantly increased toward the end of the fiscal percent until the end of FY2017. While this has year, some of the balance held by the government created some space for banks to extend credit, the came back into the banking system. However, as slowing deposit growth continues to be a challenge. the banks had already offered higher interest rates to attract deposits during the credit crunch, the The government’s inability to manage the cash cost of funds has already increased. As a result, the balance is impacting the financial sector. Despite weighted average deposit rose to 6.2 percent in the increase in capital spending, FY2017 ended with July 2017, as banks seek to attract more deposits government deposits at nearly 8.5 percent of GDP in (Figure 30). Similarly, the weighted average lending its NRB account (Figure 29). As this balance is held rate has also remained sticky, reaching a high of by the NRB and out of the banking system, it has in 11.3 percent in July 2017, due to an increase in the effect “mopped up” an equivalent amount of liquidity cost of funds during the credit crunch. This is from the domestic market, which also played a role in indeed a challenge in doing business particularly at creating the credit crunch in the financial system (see a time when Nepal is recovering from series of Nepal Development Update, May 2017). shocks and disruptions. September 2017 THE WORLD BANK GROUP 11 Fiscal architecture for federal Nepal Nepal Development Update B. Outlook, Risks, and Challenges Outlook expected to continue in the forecast period, as some of the damage done by the floods in Looking ahead, economic growth is places like Chitwan is expected to be restored expected to be lower than earlier forecasted by the fall tourist season. The damage to the and is expected to moderate in line with the harvest of agricultural products as a result of country’s potential, averaging 4.5 percent floods, however, is expected to hamper over the next two fiscal years (Figure 31 and, agricultural output in FY2018. Industry is Figure 32). Particularly agricultural output, likely to get some boost in FY2018, as the which was expected to be normal, will be electricity generation and construction impacted by the floods. The impact on industry subsectors continue to perform relatively well. sectors is expected to be temporary, while However, manufacturing is expected to face construction is likely to remain strong driven by some temporary setbacks as the Terai region, earthquake and flood reconstruction. Activity where most of the industries are located, has in the remaining sectors is expected to be been severely affected by floods. With the affected by uncertainty stemming from the Upper Tamakoshi (465 MW) expected to be transition to the federal structure, several delayed until FY2019, hydropower generation elections, and the possibility of a further will be lower than earlier expected. slowdown in remittances. Nonetheless, small hydropower projects will continue to provide some boosts to the On the supply side, the service sector is electricity subsector. Hence, internally expected to continue driving growth, albeit generated electricity and additional imports more slowly than in previous years. Services from India are expected to keep the are expected to grow at 5.8 percent, on average, manufacturing sector running smoothly in during the forecast period, driven by trade, FY2018, as well. Reconstruction activities are transport, and tourism. The outlook in services expected to pick up at a relatively faster pace is also dependent on remittances stabilizing at in FY2018, as they had begun to speed up by the present level, particularly given the large the last quarter of FY2017. This will benefit share of wholesale and retail trade subsectors. the construction sector. However, the boost in tourism, in particular, is September 2017 THE WORLD BANK GROUP 13 Fiscal architecture for federal Nepal Nepal Development Update Table 2 Nepal macroeconomic outlook (annual percent change unless noted otherwise) FY2014 FY2015 FY2016 FY2017 e FY2018 f FY2019 f Real GDP Growth, at Constant Market Prices 6.0 3.3 0.4 7.5 4.6 4.5 Private Consumption 4.1 2.9 -0.8 2.4 2.0 3.0 Government Consumption 10.0 7.4 -0.4 21.5 20.9 12.8 Gross Fixed Capital Investment 11.4 19.6 -12.3 34.0 15.1 10.5 Exports, Goods and Services 18.8 6.8 -13.7 16.9 10.1 6.3 Imports, Goods and Services 20.9 9.6 2.8 22.0 8.0 8.0 Real GDP Growth, at Constant Basic Prices 5.7 3.0 0.0 6.9 4.6 4.5 Agriculture 4.5 1.1 0.0 5.3 2.7 3.0 Industry 7.1 1.4 -6.3 10.9 5.0 3.2 Services 6.1 4.8 2.0 6.9 5.8 5.8 Inflation (Consumer Price Index) 9.1 7.2 9.9 4.5 5.5 6.5 Current Account Balance (% of GDP) 4.6 5.1 6.2 -0.4 -2.0 -2.8 Fiscal Balance (% of GDP) a/ 0.6 -1.1 -0.4 -3.3 -4.3 -4.6 Debt (% of GDP) 28.3 25.6 28.0 27.6 29.4 31.0 Sources: CBS, NRB, MoF for history and estimates; World Bank staff for forecasts. Notes: a/ fiscal balance includes net lending, e = estimate, f = forecast. On the demand side, gross investments are demonetization and GST affect subsides, but are expected to drive growth, while slower expected to moderate in line with their long-term growth in consumption is expected to average thereafter. continue. Growth in gross fixed capital formation is expected to remain strong during the The fiscal deficit is expected to widen during forecast period. Public investment is likely to face the forecast period; however, given the large challenges as the country implements a new cash balance on hand, financing is not political and bureaucratic structure, but is still expected to be a problem, yet. The FY2018 expected to remain robust as capital spending by budget called for an expenditure increase of local governments is expected to increase as a nearly 11 percent of GDP over actual result of the successful local government expenditures in FY2017. However, as in previous elections in more than two decades. Private years, significant underspending of the budget investment is also expected to remain strong will continue. Nevertheless, government spending given that the power supply remains regular, will grow substantially in FY2017, owing to which will help spur investments in other private increases in earthquake- and flood-related cash activities. Growth in private consumption is assistance and proposed election-related expected to moderate during the forecast period spending. The government’s recurrent in line with a more sanguine outlook for growth expenditure is expected to continue to grow of remittances. Government consumption, substantially in the forecast period, particularly as however, is expected to grow substantially, as a result of implementation of the new federal FY2018 is the first “de-facto year” in terms of constitution, which calls for creation of an implementing a federal structure. In addition, the entirely new provincial level of government. final phase of local elections in province number two, followed by federal and provincial elections The FY2018 budget envisions a substantial expected to be held by early 2018, will further add increase in transfers to the newly elected local to government consumption. Exports of services governments, which will increase government are expected to continue as tourism continues to spending (see the discussion of fiscal federalism pick up. Exports of goods are also expected to in the Special Focus section, below). The growth grow, albeit modestly in FY2018, in light in revenues is expected to continue on the back of continued power availability in Nepal, and of strong capital imports, but may slow if the with the normalization of demand in India as the inflow of remittances slows further, particularly September 2017 THE WORLD BANK GROUP 14 Fiscal architecture for federal Nepal Nepal Development Update Figure 31 GDP growth after a strong rebound is Figure 32 Agriculture was particularly impacted by expected to moderate the floods of 2017 (percentage points, contributions to growth) (percentage change, y/y) (percentage points, contributions to growth) (percentage change, y/y) 20 Private Government GFCF Statistical 20 8 Agriculture Industry Services 8 Consumption Consumption Discrepancy 7 7 15 15 GDP Growth, Market Prices 6 (right) 6 10 10 5 5 4 4 5 5 3 3 0 0 2 2 -5 -5 1 1 0 0 -10 -10 Net Exports GDP Growth, Market -1 -1 Prices (right) -15 -15 -2 -2 FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 FY2018 FY2019 FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 FY2018 FY2019 Source: CBS and World Bank staff calculations. Source: CBS and World Bank staff calculations. hampering consumption-related taxes. With Challenges and Risks increased government spending as a result of a new federal structure and earthquake- and flood- There are an increasing number of downside related reconstruction, the fiscal deficit is risks to this forecast, with both domestic and expected to widen in FY2018. Meanwhile, the external risks increasing. The political current account, which had remained in surplus environment in Nepal remains fluid as the term of over the last several years but turned into a the current government—which was sworn in in deficit in FY2017, is expected to continue in July 2017 as part of the power-sharing agreement deficit as import growth is expected to remain among the coalition partners—will come to an high, while remittances and exports growth are end after the federal-level election scheduled to be expected to slow. If the large trade deficit conducted by early 2018. In addition, a series of continues to persist and remittance slowdown elections—provincial and federal —needs to be continues, it is likely to start putting pressure on held by early 2018, as stipulated in the new Nepal’s foreign reserves, too. constitution. From a significantly moderated rate of With the difficulties surrounding the FY2017, inflation is expected to pick up implementing architecture of the new federal modestly during the forecast period. Inflation structure, budget execution is going to be was at a 13-year low during all of FY2017. particularly challenging in FY2018. Budget However, it is expected to pick up somewhat in execution has been a persistent problem in the FY2018, as the effect of demonetization tapers past and has been exacerbated since the FY2016 off in India. Also, due to severe floods in Nepal budget, which called for a substantial increase in and India affecting agricultural products and expenditures, driven to a large extent by increased connectivity, food prices are likely to see some needs in postearthquake reconstruction. However, uptick, albeit temporarily. The sharp uptick in the actual spending has been significantly below the prices of rental housing and utilities following the planned budget for the last two fiscal years . An earthquake, which continued in FY2017 due to overly ambitious budget has continued into slow reconstruction, is expected to moderate FY2018 as well which is going to pose a somewhat in FY2018, as housing reconstruction challenge because of the lack of clarity around is expected to gather speed. However, some spending in the federal structure and several pressures are likely to emerge in FY2018 as a upcoming elections. Normally, the government result of the houses damaged by floods, stops all major activities in the run-up to particularly in the Terai region elections. Moreover, as the country moves to a September 2017 THE WORLD BANK GROUP 15 Fiscal architecture for federal Nepal Nepal Development Update federal structure, there is lack of clarity regarding of nondelivery from the Government of Nepal is the fiscal architecture in the federal context , increasing. The recent floods affecting more than which can cause unintended interruptions in one-third of the country have further service delivery and execution of capital projects. compounded this problem. Despite improvements, the pace of The external environment is likely to be less earthquake reconstruction remains a concern, favorable, as well. Continued which is now compounded by flood recovery underperformance of exports despite the end of and reconstruction. The delay in disbursement disruptions remains a persistent challenge. of the second and third tranches of the housing Remittances account for 30 percent of GDP, reconstruction grant has meant that fewer than with the majority of migrants going to oil- 10,000 households have received all three exporting Gulf Cooperation Council (GCC) tranches of government subsidy for housing countries. Significant spending cuts, including in reconstruction more than two-and-a-half years capital spending announced in the GCC after the earthquake. Reconstruction in other countries, and persistent contraction in sectors (cultural heritage, schools, hospital, public departures of migrants, contributed to lower buildings, and so forth) has barely started. The growth of remittances. The recent blockade of Ministry of Finance has confirmed that nearly all Qatar and the sharp slowdown of migrants going the money pledged during the donor conference there increase the risk of a further slowdown of has been committed by the donors, and the risk remittances during the forecast period. September 2017 THE WORLD BANK GROUP 16 Fiscal architecture for federal Nepal Nepal Development Update C. Special Focus: Fiscal architecture for federal Nepal Background The constitution calls for elections at the three levels to be completed by January 2018, Following adoption of a new federal which will be a historic step towards constitution in September 2015, Nepal implementation of the federal system of embarked on an ambitious reform path to government. After a period of 20 years, citizens shift from a unitary to a federal government of Nepal enthusiastically embraced the system. The constitution adopts a “big bang” opportunity to vote in the local government approach to decentralization, envisaging three elections in two rounds on May 14 and June 28, tiers of government —federal, provincial, and 2017. The third and final phase of local elections local—with significant devolution of decision- is expected to take place on September 18. Two making powers and resources. The seven rounds of elections for the provincial and federal provinces created in the constitution, with levels of government were announced for executive, legislative, and judicial powers, November 26 and December 7, 2017, the represent a completely new type of subnational successful implementation of which will fulfill structure in the history of Nepal. Local the constitutional requirement for holding governments have existed in the form of elections. district and village development committees and municipalities. Under the new system, they Restructuring of the state to a federal model will be consolidated from more than 3,000 is a complex task, but issues can be grouped village development committees and into three broad categories. In general, issues municipalities into 753 local governments that regarding the transition to federalism can be also have executive, legislative, and judicial grouped into three categories: the functions powers. Seventy-five districts that had played category (that is, which level is responsible for important administrative and service delivery delivering which service), the finance category functions will cease to exist as a separate tier of (that is, which level or levels collect revenue and government; however, they are expected to play raise debt), and the functionaries category (that a coordinating role for local governments is, how will the existing civil service be during the transition period. transformed). All the issues under these three categories need to be resolved effectively for September 2017 THE WORLD BANK GROUP 17 Fiscal architecture for federal Nepal Nepal Development Update government service delivery not to get disrupted. generation, (iii) intergovernmental transfers, and (iv) public borrowing. These facets of fiscal The aim here is to assess what are the main federalism influence each other in complex ways. emerging issues and risks in the design of For example, as the economic costs of raising fiscal federalism (that is functions and finance subnational taxes tend to be higher than for raising categories) that warrant attention as Nepal federal broad-base taxes, the more taxes collected transitions to a federal country. This is by the federal government and then transferred to important because fiscal federalism arrangements subnational governments is, in principle, an will have a strong impact on the quality of public efficient arrangement. However, the asymmetry service delivery. Starting in FY2018, a large between the ability to generate own revenues and proportion of federal spending is expected to be expenditure responsibilities causes a vertical fiscal passed on to subnational governments, which will gap, which increases the reliance of subnational be automatic, constitutionally mandated, and once governments on intergovernmental transfers or transferred will be beyond the control of the borrowing. This in turn may affect revenue federal government. A “big bang” decentralization collection incentives of recipient governments and to a nonexistent level of state and local impact the quality of subnational spending. governments carries both opportunity to do things differently and improve outcomes of service Functional assignments delivery as well as risks in a low-capacity environment. Going forward, the subnational governments will play a critical role in Nepal’s public Analytical framework expenditure system. Following the principle of subsidiarity, the 2015 Constitution mandates Fiscal federalism deals with the financial substantial responsibility for the provision of relationships among different tiers of essential public services such as education, health government in a federal country. There are care, and basic infrastructure to the local seven major components of fiscal federalism, as governments and provinces. If we take the outlined in Figure 33. However, the analysis FY2018 budget as an indication, transfers to the presented in this note will examine the relationship subnational governments are expected to be five among the four key dimensions of public finance times larger than the previous year. From an in decentralized systems, also known as the estimated spending of about NPR 50 billion in “decentralization diamond” (Figure 34 and Figure FY2016, the FY2018 budget has proposed NPR 37): (i) expenditure responsibilities, (ii) revenue 242 billion in transfers to subnational Figure 33 Components of fiscal federalism Figure 34 Components of fiscal federalism analyzed in this note 1) Institutional Structures 2) Functions and Responsibilities 3) Revenue Assignments Functional Transfers Public Assignments Revenue and Revenue Borrowing and Spending Assignments 4) Transfers and Sharing and Debt Revenue Sharing Responsibilities 5) Borrowing and Debt 6) Budgeting, Accounting and Accountability Systems 7) Functional and Managerial Capacity and Authority Source: Adapted from Dafflon (2014). Source: World Bank staff. September 2017 THE WORLD BANK GROUP 18 Fiscal architecture for federal Nepal Nepal Development Update governments, much of which are transfers to the poses significant risks. If there is limited capacity, or local government. inadequate funding, of the local governments service delivery could be affected. However, there are several issues with the expenditure assignments. First, many Revenue assignments responsibilities have been assigned as “shared or concurrent responsibilities” of the federal, Low subnational tax revenues are likely going provincial, and local governments. For example, to be a persistent key feature of fiscal primary and secondary education is assigned by the federalism in Nepal. The 2015 Constitution has constitution as a responsibility of local not noticeably enhanced the ability of subnational governments, but education is also listed in the governments to collect tax revenues or other concurrent or shared list of responsibilities for sources of own revenues. Subnational own-source federal, and provincial governments as well. revenue amounted to less than 0.5 percent of Concurrent powers are common in federations, but GDP in pre-federal Nepal and is likely to remain a large set of concurrent responsibilities dilutes in this range in the current federal structure. Major accountability, as there is no clarity on which level sources of revenue—income tax, VAT, custom, of government is ultimately responsible for which excise—are all to be collected by the central concurrent responsibility. Hence, a clear government, with limited own-source revenues expenditure and functional assignment is a first step provided to provinces and local bodies. in fiscal decentralization. Lack of clarity in functions Consequently, approximately 80 to 85 percent of was a problem even when Nepal had a unitary the existing revenues is likely to remain with the system (World Bank 2013). Consequently, timely center. Hence, revenue collection will not change resolution and clear delineation of responsibility is much in pre- and post-federal Nepal. In recent needed to prevent potential duplication and lack of years, the dependence of the local bodies on accountability that can be exacerbated in a federal central transfers did not decrease. In the federal system. structure, the dependence on central transfers is likely to increase. Second, there is a need to be watchful about the size of the local government and provinces and The limited revenue base available to the the associated costs. In the pre-federal structure subnational governments and their general of Nepal, local governments—particularly the low collection efficiency are not going to help village development committees—were too small to the decentralization of tax revenues. effectively deliver services like health and education. Consumption or indirect tax bases are typically the About 3,300 local governments served an average most important sources of state and local tax population of 7,000 to 9,000 people. In the current revenue, but in Nepal these sources are exclusively federal setup, there would be 753 local governments listed in the schedules of the central government in serving an average of 35,000 people per local the constitution, while subnational governments government, which is better than the previous are left with the authority to levy taxes with small arrangement. This is comparable to the size of local bases. As a result, subnational taxes in Nepal will governments in other countries. However, there are not be significantly different from the unitary two potential issues. First, if the number of local system, that is, less than 1 percent of GDP, and governments were to increase in future, it could likely to represent less than 2 to 3 percent of total lead to many local governments with a less-than- general government revenue. This is low average population size. Second, lack of clarity in compared to other federal countries like Argentina the functioning of wards (units making up local (where subnational taxes account for 5 percent of governments) and districts (units coordinating local GDP and 16 percent of total tax revenue), Brazil governments) with the current 753 local (11 percent of GDP and 30 of total tax revenue), governments adds complexity. In general, lack of and Canada (16 percent of GDP and 50 percent of government capacity is an issue in Nepal, and total tax revenue). transformation of the bottom tier of government from administrative units that had some capacity Revenue collection will continue to be highly (districts, municipalities, villages) to new ones that uneven between local governments and do not (wards, local governments, and councils) provinces in Nepal. In pre-federal Nepal, September 2017 THE WORLD BANK GROUP 19 Fiscal architecture for federal Nepal Nepal Development Update because of considerable differences in revenue spending needs as devolved by the potential across village development committees constitution, which will result in a so-called (VDCs) in the country, revenue collection was “vertical imbalance” or “vertical fiscal gap.” highly skewed among the VDCs of a few districts. Major tax revenue sources, such as personal and Most VDCs had extremely low internal revenue corporate income taxes and consumption taxes, generating capacity. In FY2012/13, 80 percent of can often be more efficiently levied at the federal VDCs collected less than 10 percent of their level. Meanwhile, spending on public services is revenue from own sources (LBFC 2014). For often better managed by subnational governments, instance, in the same year, the internal revenue of which are more intimately familiar with regional VDCs in Kathmandu district (the wealthiest) and local needs and conditions. The resulting amounted to NPR 179 million, while the internal combination of centralized tax collection and revenue of VDCs in Bajura district (the poorest) decentralized service provision creates vertical was only NPR 0.38 million (LBFC 2014). fiscal gaps. While, centralized tax collection combined with transfers to subnational Finally, capacity is going to be a major factor governments can maximize efficiency on the for subnational governments, resulting in low revenue side, increasing own-source revenue revenue collection efficiency. Even when the collection by subnational governments can assigned taxes could be a good source of income, promote expenditure efficiency by improving it would be difficult for the subnational accountability and strengthening taxpayer governments, which are yet to be established to oversight. Moreover, the appropriate balance determine the optimal tax policy and effective tax between subnational taxation and administration. Hence, subnational revenue intergovernmental transfers will vary from country collection is going to be much below the average to country (Figure 36). of 10 percent of GDP observed in other large federations. Even unitary states in Latin America, However, while Nepal’s vertical fiscal gap is such as Chile and Colombia, collect more tax going to be very large it does not have to be revenue at the regional and local levels. problematic. The FY2018 budget indicates that subnational governments are going to already Creating a large vertical fiscal gap in addition account for around 23 percent of general to a long-standing horizontal fiscal gap government spending, which is likely to increase as more expenditure assignments are devolved to the Given large functional responsibilities, own- subnational government as mandated in the source revenues will be insufficient to cover constitution. However, in a federal structure with Figure 35 Vertical fiscal gap varies among coun- Figure 36 Nepal’s vertical fiscal gap is going to be tries one of the largest among federal countries 80 Nepal Peru Percentage of General Government Spending Mexico Netherlands CAN Great Britain South Korea DNK Hungary 60 Norway CHE Belgium Denmark SWE Poland MEX ESP USA Luxembourg PER KOR Italy Estonia 40 FIN DEU Ireland BEL Czech Republic NOR NLD POL Slovenia ITA AUT Slovakia ISL GBR CZE Portugal NEPAL EST HUN Finland 20 FRA Spain SVN SVK Sweden IRL PRT Israel ISR France LUX Austria Switzerland CAN 0 Germany Iceland 0 20 40 60 80 USA Percentage of General Government Revenues 0 10 20 30 40 50 60 70 80 90 100 Sources: OECD; MoF; LBFC; and World Bank staff calculations Sources: OECD; MoF; LBFC; and World Bank staff calculations September 2017 THE WORLD BANK GROUP 20 Fiscal architecture for federal Nepal Nepal Development Update only 2 to 3 percent of total general government Nepal are: revenue likely to be collected by the subnational governments, the vertical fiscal gap is going to be one Revenue sharing: to address vertical fiscal imbalances of the largest among federal countries (Figure 36). among the central, provincial and local governments. While it is difficult to determine the optimal vertical fiscal gap for each federal system, Royalty sharing: Nepal needs to be careful in the recent empirical studies indicate that sharing of natural resource royalties, because they incentives for expenditure efficiency are can exacerbate horizontal imbalances if the reduced when fiscal gaps are very large, or distribution criteria give excessive weight to the when subnational own-source revenues are location in which the natural resource (for very low. A heavy dependence on transfers can example, hydropower) is placed. reduce efficiency among subnational governments by externalizing the cost of raising revenue. Fiscal-equalization grant: designed to address Transfers can also weaken fiscal discipline, as horizontal imbalances among subnational subnational governments and their creditors may governments. expect the central government to bear the ultimate responsibility for deficits and debt. Finally, limited Conditional, matching, or special transfers: that revenue autonomy reduces the ability of incentivize subnational governments to provide subnational governments to implement fiscal public services that generate positive externalities adjustments, because in the absence of revenue- or contribute to national development priorities. side measures, spending cuts are their only available policy instrument. Large vertical and horizontal fiscal gaps on one hand, and the decentralization of In addition to vertical imbalances, so-called expenditure assignments on the other hand, horizontal imbalances have also been will make intergovernmental transfers a historically high in Nepal. Large disparities in central element of Nepal’s fiscal federalism socioeconomic development among various parts framework. Transfers financed by revenue of Nepal have existed throughout history. Poverty sharing mechanisms in the draft IGFM bill as and other socioeconomic indicators follow a discussed in the Parliament try to mitigate some of similar pattern, and these differences are reflected the significant vertical and horizontal gaps. in the strong spatial concentration of tax bases and Revenue sharing comprises fixed percentages of a the even wider differences in tax collection. Own- pool of federal revenues from the VAT and excise source revenue per capita in Kathmandu district is tax that will be channeled to states and local 10 times higher than in Darchula district in pre- bodies. However, it is hard to judge whether such federal Nepal (LBFC, 2014), and this will continue revenue sharing is enough to continue service in the federal context too. delivery by subnational governments given that detailed costing of devolved service delivery has Increased dependence of subnational not been done. The draft bill proposes that 15 governments on intergovernmental transfers percent of the VAT and 7 percent of the internal excise tax go to local governments and provinces. The 2015 Constitution and the draft Inter- Governmental Fiscal Management (IGFM) Hence, intergovernmental transfers in federal bill as discussed in the Parliament has defined Nepal are likely to be high, at about 10 percent four broader types of intergovernmental of GDP, and will finance around 80 to 85 transfers. These transfers are principally designed percent of all spending by subnational to address vertical and horizontal imbalances and governments. Transfers had already started to ensure the effective provision of public goods and increase in pre-federal Nepal, following the services at the subnational level. In addition, decentralization of social services in the early transfers are to provide appropriate incentives for 2000s after enactment of the Local Self- expenditure efficiency, fiscal discipline, and tax Governance Act (LSGA). Demand from the collection among subnational governments. The parliamentarians to increase their constituency four major categories of transfers proposed in fund further fueled the increase of transfers. September 2017 THE WORLD BANK GROUP 21 Fiscal architecture for federal Nepal Nepal Development Update However, the effort to increase the tax base and Condition (MCPM) grants. However, the share of efficiency was virtually nonexistent. this equalization grant was very small in the overall grants to the local bodies. Also, despite However, transfer systems can be designed in the inclusion of “tax collection performance a way that mitigates negative aspects of criteria” in the distribution formula, these vertical fiscal gaps. Own-tax sources will rarely transfers did not provide substantial incentives to meet the funding requirements of subnational enhance tax collection efficiency among recipient governments, nor does the theory of fiscal local governments. The constitution and the draft decentralization suggest that each tier of bill on the Fiscal Commission mandate that the government should be self-sufficient. Fiscal National Natural Resources and Fiscal transfers typically have a conditional and an Commission devise the formula based on certain unconditional portion. The former leads to a more principles. It is important for the formula to be hierarchical system of accountability—the center simple, and numerous criteria will only have a holding the subnational accountable for proper use marginal impact on their respective goals, that is, of central transfers. The latter falls in the category (i) a fiscal-equalization transfer to reduce of discretionary resources, for which subnational horizontal imbalances, and (ii) a transfer to governments are directly accountable to their incentivize tax collection efficiency at the state constituencies. Also critical is the predictability of level. fiscal transfers, essential in allowing subnational governments to plan local service delivery more In addition, it will be important to design effectively. Predictability is enhanced using a equalizing distribution criteria for all or a formula-based allocation systems driven by simple large part of the fiscal revenues related to the measures of equity and efficiency. In general, the exploitation of natural resource royalties. use of unconditional, formula and block transfers International experience shows that the enhances both the predictability and “own- distribution of resource revenues among regional revenue” properties of such fiscal flows. and local governments is one of the most disruptive factors negatively affecting the The constitution stipulates that the design of achievement of the equalizing objectives of equalization formula is a key mandate of the transfer systems, as they are usually distributed National Natural Resources and Fiscal based on origin or derivation principles. The Commission. A form of equalization formula compensation for the exploitation of natural was already introduced in pre-federal Nepal for a resources to the regions or local jurisdictions small share of transfers provided by the central where the natural resources are located is justified governments to district and local governments, by the negative externalities generated by such known as Minimum Condition and Performance activities in the affected regions. However, Table 3 Fiscal decentralization trends in Nepal, FY2010 through FY2018 2010 2011 2012 2013 2014 2015 2016 2017 e 2018 p Direct Subnational Spending Percent of GDP 2.5 2.9 2.8 2.4 2.5 2.5 2.7 3.5 11.1 Percent of Total General Government Spending 13.2 14.2 12.9 12.5 12.5 11.3 11.1 11.9 23.6 Subnational Own-Source Revenue Percent of GDP 0.3 0.4 0.3 0.3 0.4 0.4 0.4 0.5 0.5 Percent of Total General Government Revenue 1.8 2.4 1.9 1.9 1.8 2.1 2.0 2.0 2.1 Intergovernmental Transfers Percent of GDP 2.5 2.4 2.3 2.0 2.1 2.1 2.2 3.1 9.6 Percent of Total Subnational Government Revenue 90.0 87.3 84.5 82.2 83.0 80.2 79.4 82.4 84.5 Percent of Total General Government Spending 13.2 11.6 10.6 10.1 10.5 9.5 9.2 10.3 20.5 Sources: MoFALD, LBFC, MoF Note: e = estimate, p = projected based on FY2018 budget September 2017 THE WORLD BANK GROUP 22 Fiscal architecture for federal Nepal Nepal Development Update distribution rules based on the origin of the revenues, provinces and local governments natural resources are excessively generous, with are likely to relatively increase their normally few beneficiaries, and tend to eliminate borrowing in federal Nepal. While the overall any equalization effects of other transfers. Hence, stock of subnational debt remained virtually with equalizing transfer formulas, it is important nonexistent in the pre-federal era, this may to prevent natural-resource-rich regions or change going forward. localities that receive substantial amounts of royalties from also receiving equalizing transfers. A clause that enables the federal level to regulate subnational indebtedness has been Finally, it is important to consider the rightly included in the constitution (Article incentives that the transfer system is 59, section 7). The details of borrowing or debt expected to generate, especially in the rules for lower levels of government have rightly efficiency of tax collection and on the not been included in the constitution and can be spending side. As in other federal systems, defined by law and regulations. This is a key transfers in Nepal can negatively affect the aspect, because in many countries, national fiscal behavior of both federal and state governments. rules cannot be applied to subnational For example, both theoretical and empirical governments and can be problematic as analyses have demonstrated that subnational debt starts to threaten the overall intergovernmental transfers inhibit tax collection macroeconomic stability. The IGFM draft bill as efforts by recipient governments. A single fund discussed in the parliament proposes that only the that rewards the revenue-collection efficiency of federal government seek foreign debt and aid, provinces and local governments would help while all three levels of government can borrow eliminate perverse incentives. domestically. However, the lower levels need the consent of the central government. Whether subnational governments finance their spending through own-source tax A small number of highly focused fiscal rules revenues, federal transfers, or borrowing has will be important in federal Nepal. For important implications for the efficacy and example, appropriately defined “rules of the accountability with which public goods and game” build in resilience by avoiding costly debt services are provided. Intergovernmental crises. It is important to define fiscal rules that are transfers seek to bridge the gap between local clear and implementable, and that avoid governments’ limited capacity to raise revenues micromanagement by the federal government and their much larger expenditure responsibilities. while preserving some flexibility at the However, they can also create perverse incentives. subnational level. Enactment of a comprehensive Overreliance on intergovernmental transfers can fiscal responsibility law can help establish such undermine expenditure efficiency, and clear “rules of the game.” However, such international experience has shown that a large subnational fiscal rules should be simple and share of transfers in state or local budgets tends limited to the two or three most necessary to to undermine the collection of own-source achieve the government’s objectives in the revenues. Moreover, recent research on fiscal current environment, where institutional capacity decentralization suggests that a heavy reliance on is limited. transfers is also associated with excessive subnational indebtedness. In this context, the One of the main weaknesses of the increasingly prominent role of subnational subnational indebtedness framework in governments in Nepal’s public expenditure federal countries is the lack of reliable and system underscores the importance of their fiscal uniform financial information. Ensuring the behavior to the country’s overall macroeconomic transparency and timeliness of fiscal indicators is stability. especially important to conduct policy adequately in a decentralized system. It is crucial to establish Borrowing and Debt criteria for public accounting and financial reporting from the outset, and to make it Faced with large spending obligations and a mandatory for states and local governments to limited capacity to boost own-source adopt its uniform methodology as principally September 2017 THE WORLD BANK GROUP 23 Fiscal architecture for federal Nepal Nepal Development Update guided by the 2015 Constitution, as well. Revenue assignments: revenue collection and tax Improvements in financial accounting and administration remain relatively unchanged and reporting are critical to the effectiveness of fiscal highly centralized, with limited existing tax bases rules and the continued development of the for subnational governments. subnational credit market. Fiscal rules also require accurate subnational financial and debt Transfers and revenue sharing: the resulting mismatch information. between revenue collection and service provision (vertical imbalance) can be closed through Conclusion intergovernmental transfers. This is one more reason why proper delineation of responsibilities In sum, from a previous centralized fiscal and realistic and impartial costing of devolved system, the projected trends of Nepal’s new responsibilities are critical. Without them, the fiscal federalism system depicted in the fiscal debate on the size of transfers is not made on the decentralization diamond (Figure 37) suggest a grounds of what subnational units require to marked asymmetry between a stronger provide services. The same holds for horizontal decentralization of spending responsibilities and imbalances (that is, differences between different relatively unchanged low decentralization of tax regions of Nepal). Having a transparent, evidence- collection powers, which are expected to remain based formula for equalization among provinces is highly concentrated at the central or federal level. critical to design an effective depoliticized process. Thus, intergovernmental transfers will be the main financing revenue source of provincial and local Public borrowing and debt: The constitution has governments. Due to nonexistent credit markets adequate provisions for prudent debt management for subnational governments, it is expected that in a decentralized system. However, these borrowing will be restricted to finance their provisions should be developed in greater detail spending responsibilities, too. though a fiscal-responsibility-type law that provides clear, simple, yet flexible rules for Sequencing of political, fiscal and behavior of different levels of government. In administrative decentralization matters . addition, the creation and deployment of Ideally, subnational governments should first be accounting and debt reporting systems remains a given clarity about their functions and associated critical short-term priority. expenditure responsibilities and, based on these, the proper assignment and design of tax instruments and transfer systems should be made. The rule that finance follows function Figure 37 Fiscal decentralization diamond: pre- appropriately defines this sequencing. In addition, and post-federal constitution to ensure service delivery and the exercise of Transfers devolved powers in general, decentralization of the 4 civil service should be implemented along with 3 expenditure and fiscal arrangements. Function, finance, and functionaries all need to be sequenced 2 properly. 1 Spending 0 Taxes The following are the critical emerging issues in the design of fiscal architecture for federal Nepal: Functional assignments: too many responsibilities are “shared” among the three levels of government. A Borrowing negotiated delineation of responsibilities and Pre-2015 Post-2015 (Federal) adequate costing of devolved responsibilities are Source: World Bank staff. Note: On the horizontal axis, a greater distance from the critical first steps. Detailed costing of devolved origin point indicates higher tax revenues and spending decentralization. On the vertical axis, a greater distance from the origin point represents increased reliance services to be delivered is critical. on intergovernmental transfers and borrowing. September 2017 THE WORLD BANK GROUP 24 Fiscal architecture for federal Nepal Nepal Development Update References Dafflon, B. 2014. The Political Economy of Decentralization: Fiscal Federalism in Practice. Addis Ababa: Horn of Africa Economic and Social Policy Institute and Intergovernmental Authority on Development. Local Body Fiscal Commission Secretariat. 2014. “Fiscal Situation Analysis of Local Bodies.” Local Body Fiscal Commission Secretariat, Government of Nepal, Kathmandu. Local Body Fiscal Commission Secretariat. Various Years. “Local Body Fiscal Situation Analysis.” Local Body Fiscal Commission Secretariat, Government of Nepal, Kathmandu. United Nations Nepal. 2017. “Nepal Flooding Response Plan.” United Nations, Kathmandu. World Bank. 2013. “Local Service Delivery in Nepal.” World Bank Group, Washington, DC. World Bank. 2017. Global Economic Prospectus. World Bank Group, Washington, DC. September 2017 THE WORLD BANK GROUP 25