The cash cow is drying upDon’t be fooled by the better-than-expected results from the external sector, the effects are only temporary.
The latest provisional data for the fiscal year 2019-20 released by the Nepal Rastra Bank provide interesting insights on the impact of Covid-19 and the subsequent lockdowns on the economy. Almost all areas, except for the external sector, have been hit hard since the first lockdown began in late March. Specifically, unlike projections of a sharp drop, the data shows just a small deceleration in remittances.
This has led some to argue that Nepal’s external sector is sound as well as resilient and that vulnerabilities are on the downside. However, the reality is that it only appears sound owing to a larger import contraction than export contraction, and slower than expected deceleration of remittances. Remittances are an important household coping strategy when faced with an adverse income or consumption shock. Migrant workers tend to use precautionary savings to remit more after such shocks. This should not be construed as a sign of resilience.
A sudden supplies disruption was expected to hit imports and remittances, resulting in an improvement in the current account balance, which is a record of Nepal’s transactions with the rest of the world. Exports pretty much stalled after the pandemic spread globally. Imports, except for medical equipment and supplies, were also severely curtailed due to disruptions and logistical hurdles. Further, oil imports, which normally account for 15 percent of the total import bill, decreased on account of a drop in internal demand, particularly for transportation and development projects.
Declining global oil prices also contributed to a lower oil import bill. Consequently, imports decreased much faster than exports. For instance, in US dollar terms, merchandise exports and imports contracted by 7.9 percent and 18.9 percent, respectively. In a reversal of the previous trend, merchandise trade deficit actually dropped to 28.2 percent of the gross domestic product in 2019-20 from 37.1 percent of GDP in 2018/19.
Similarly, the trade imbalance in services also improved as services import (which includes outbound travel and foreign educational expenses) decreased much more than services export (which includes inbound travel and tourism). A sharp contraction of imports but a small contraction of remittances (by just 3.4 percent) improved the current account balance. This is what the analysts meant when they argued that the external sector remained stable despite the adverse external environment.
Meanwhile, the balance of payments reached a record $2.4 billion as a large contraction of imports but a lower than expected deceleration of remittances and an increase in foreign direct investment and foreign emergency loans all played crucial roles. Similarly, gross foreign exchange reserves have also hit record levels. The Nepali rupee depreciated by 9.2 percent against the US dollar at the end of 2019-20.
The improvement in the current account balance, a large balance of payments surplus and record foreign exchange reserves might have given a misplaced assurance that all is sound and stable. But regardless of the pandemic being contained or the country choosing to simply live with the virus, as the economy opens up after the lockdowns and supply chains are restored, the situation might quickly change.
Most prominently, the import of commodities (oil, food and raw materials) as well as intermediate capital goods will increase. Meanwhile, given the lack of price competitiveness, an unfavourable policy environment, distortionary incentives and generally subdued external demand, exports will likely not recover soon. Travel and tourism activities may not also recover quickly. These will deteriorate the tenuous external sector stability and put a strain on foreign exchange reserves.
A short respite
The problem will be compounded by the expected deceleration of remittance inflows. Apart from its positive effect on reducing poverty and boosting consumer demand, government revenue and financial sector liquidity, large remittance inflows have been a saving grace for external sector stability in the face of a large and growing trade deficit. The number of Nepali migrant workers has been continuously declining since 2014-15. The persistent deceleration of remittances will be coupled with a smaller expatriate workforce, with fewer outbound migrant workers and a reduction in the work hours of those already working abroad.
There are three main reasons why remittances did not decelerate as expected in 2019-20. First, remittances tend to increase immediately after a shock in receiving countries. For instance, remittances increased by 12.2 percent in 2014-15 as migrant workers, drawing from their precautionary savings, remitted more income to their earthquake-affected families. However, the following fiscal it only grew by 0.8 percent. Second, the depreciation of the Nepali rupee against the US dollar also provides an incentive for migrant workers to remit more money. The rupee depreciated by 9.2 percent in mid-July 2020, much higher than 0.02 percent depreciation in mid-July 2019. Third, the use of formal banking channels to remit income has increased along with the rise in the number of money transfer agencies and the crackdown on informal inflows.
The Nepali economy entered the Covid-19 era with pre-existing weaknesses: a weak foundation for meaningful structural transformation, volatile GDP growth and inflation, mounting fiscal stress due to a large fiscal deficit and increasing public debt, persistent asset-liability mismatches and high credit growth by financial institutions, and decelerating remittances. It was exacerbated by weak governance and contract management in public projects, political infighting within the ruling party, over-politicisation of the Millennium Challenge Corporation’s compact programme and geopolitical discord. The potential deceleration of remittances will exacerbate these trends, and heighten external sector stress.