Foreign aid suspension Hard choices for the decision makers
Raghab D. Pant
The suspension of foreign aid will hit Nepal’s economic growth and the poverty level, especially of the rural sector.
I will limit myself to the implementation of the budget for the fiscal year 2004/05. The question of suspension of foreign aid and its impact on the overall performances of the Nepali economy have dominated the news. The development programmes are said to depend on the funds from both bilateral and multilateral donors which together were supposed to finance the total capital expenditure of Rs. 31.6 billion proposed in the budget. The government revenue is not sufficient to cover the regular expenditure, defined to include debt service, and the budget has proposed borrowing Rs. 9.1 billion from the market to meet its recurrent expenditure. Unfortunately, the current situation is not as clear as it is claimed to be.
According to press reports, some of the bilateral donors, for example, Denmark, have decided to suspend economic aid while others like the UK and India have stopped only the military aid after the political change of February 1. The World Bank’s board of directors is reported to have summoned its Nepal country director to brief it on Nepal’s situation. It is said that the Bank has even warned the government that it could suspend its budgetary support of about Rs. 5 billion if no visible progress is seen in the areas that the government has promised to reform. The suspension of foreign aid will lead to a decline in development expenditure with negative impact on Nepal’s economic growth rate and the poverty level, especially of the rural sector.
If the government can increase the development expenditure financed from domestic sources either by mobilising additional resources or by reducing regular expenditure, it can neutralise the negative economic impact even if aid is suspended. The main question is: Is this a viable alternative? My answer is definitely no. The other extreme is to borrow money from the market at the prevailing interest rate, which is now low. This option, however, will disturb the fiscal balance, leading to the possible devaluation of the Nepali rupee with commensurate adverse impact on the price level.
The government revenue in recent years has gone up at a satisfactory rate, despite the dismal performance of the economy on the development front. This was made possible by an increase in domestic consumption, at a rate higher than the rise in national income, financed by an increase from remittances, which was expected last year to total Rs.100 billion or 25 per cent of GDP. The rise in remittances, in particular, has, in the absence of the rise in domestic production, led to an increase in import of goods from India and other countries. This has widened Nepal’s trade deficit, but it has also boosted the revenue from customs duties.
Unfortunately, the same trend may not hold true this year. The Nepal Rastra Bank (NRB) data shows that income from remittances in the first four months of the current year declined by 17 per cent relative to last year. As a result, deficit in trade balance in the first five months of the year has also declined because of the slow growth in domestic consumption. These processes, if we study the performances of the economy in an integrated form, will affect the government revenue, specially from customs duties, adversely. Also, it is generally agreed that this year’s budget has over-estimated the revenue for noneconomic reasons. Perhaps the government has to borrow more than the original estimate of Rs. 9 billion from the market to meet its recurrent expenditure. Therefore, the possibility of financing the extra development expenditure from domestic sources except borrowing can remain only a dream.
The extra borrowing from the market or from the NRB to finance development expenditure will, as stated, destroy the fiscal balance. This will first affect the balance of payments (BoP) with India. Notwithstanding the high level of convertible foreign exchange reserves — enough to finance merchandise import for almost a year — NRB’s Indian currency reserve is not sufficient even to finance import from India for fifteen days; and it is declining fast. It has declined by almost 75 per cent in the first five months of this year, according to NRB data. The authorities, however, are committed to maintaining free and full convertibility of the Nepali currency into Indian currency and vice versa at the prevailing exchange rate. They have also pledged to IMF to maintain “international reserve to cover about six months of import of goods and services”
The extra borrowing from the banking system to meet development expenditure will cause money supply to exceed money demand. This will increase the domestic inflationary pressure. It will also create a rise in imports with negative impact on the BoP position, which, in the year’s first five months, shows a deficit for the first time in almost a decade. The foreign exchange position of the banking sector in recent months has declined due largely to a decline in the Indian currency reserve. The prospects are not encouraging also because of the decline in income from remittances, decline in garment export and, according to a few reports, capital outflow. The impact of extra borrowing from the banking system on BoP and, subsequently, on the exchange rate, needs to be considered carefully.
Nepal’s economy is in a difficult stage with output declining, price increasing and BoP deteriorating. The suspension of foreign aid will worsen the problem, and the choices available to the government are not easy to follow.
Dr Pant is former acting vice chairman, NPC