The Nepalese economy, which was slowly returning to normalcy in the aftermath of Covid-19, has been dealt a heavy blow by the ongoing liquidity crisis, supply disruptions created by the Ukraine War, depletion of foreign reserves, and rising interest rates and inflation. The nation has taken several measures to check the deterioration of economic indicators by restricting or banning certain imports, introducing a tighter monetary policy, and so forth. The tensions exhibited by the macroeconomic indicators could stretch into the foreseeable future if thought-through reforms are not brought about.

Macro-fiscal challenges

Five years of federalism have seen the federal budget expand by 36.29 percent on the fiscal front. However, capital expenditure has only grown by 20 percent over the same period. As a result, government revenue has consistently hovered around 20.92 percent of GDP. Between 2017 and 2021, average capital spending as a percentage of capital expenditure remained at 67.12 percent. This shows that citizens generally pay a higher share of their income in taxes, but only a smaller fraction is directed toward capital expenditure. And even though the debt level looks safe at the moment (38.25 percent of GDP), in the lack of fiscal disciplinary measures, it could go to unsustainable levels in little time. Therefore, correcting the economy in the short run is not the only matter of concern for Nepal. There are multiple macro-fiscal challenges that cannot be looked at in isolation.

This article focuses on the challenges and some possible ways forward, focusing more on the latter. At present, some of the key challenges on this front are: i) discrepancies in the grants transfer mechanisms, ii) lack of a clear framework for public debt in the federal context, iii) insufficient leveraging of public-private partnerships, iv) inefficient and inefficacious public procurement provisions and practices, and v) weak state-owned enterprises that are draining the treasury.

Policy reforms with implementation

Grant transfer mechanisms need to be made more transparent and efficient to incentivise sub-national governments to spend well. The current grant transfer mechanism has limitations regarding its ability to do so. A potential improvement to the current mechanism could be to give a higher weight to performance on fiscal equalisation grants, revisit existing revenue-sharing frameworks, and tie up other non-discretionary grants with objective performance standards to build an incentivising environment for sub-national governments. It should also be ensured that the mid-term development plans connect with fiscal budgets through sound “mid-term fiscal frameworks” and “mid-term expenditure frameworks” to ensure consistency and predictability in the government's priorities.

In terms of public debt, the debt framework should be improved to enable governments to leverage it better while preserving fiscal sustainability. Public debt offers an alternative means to finance the country’s appetite for increased expenditure since raising taxes are less-preferred instrument from a political point of view. Public debt can yield positive results for the entire economy if done right. However, that also requires debt-financed expenditures to be tracked and reported to the public promptly. As the constitution of Nepal assigns many expenditure powers to the sub-national governments, public debt could be a crucial factor for them to deliver development. Continuing the spirit of federalism would also mean devolving powers related to debt management to sub-national levels. The same is not adhered to by the current framework. This highlights the centralised tendency of the federal government.

Additionally, having one federal institution administer and manage debts of all levels of government could result in delays. Hence, a new structural framework that could yield better coordination between various government bodies while enabling sub-national governments to operationalise their public debts could add value. Furthermore, as public debt continues to grow in Nepal, servicing those debts needs to be thought out carefully, and provisions like hedging to mitigate potential market risks should be built further into the existing legal framework.

Public-private partnerships can release fiscal space at sub-national levels. To leverage them, the Ministry of Finance needs to take the lead in developing the “fiscal commitments and contingent liabilities framework”. Nepal then must ensure that all projects go through the fiscal commitment and contingent liabilities assessment before they are approved. Approval should be subject to the assessment showing a positive effect, or at least a neutral effect, on the country’s balance sheet.

Public procurement policy and practices should be improved in a way that they support infrastructure development. Sub-national governments need to be made able to practice procurement as per their local contexts instead of following federal legislation. This means enabling local governments to develop their legislation instead of just the regulation based on federal legislation. This is also important because following the current procedures as mandated by the federal legislation has been seen to push the project implementations late into the fiscal years, resulting in most of the spending happening in the last quarter, thereby compromising the quality of work.

Finally, weak state-owned enterprises should undergo structural reforms to lower their burden on the government, allowing it to focus on other priority areas. The eighth-periodic plan of the government of Nepal has pointed out the inefficiency of public enterprises due to overstaffing, political intervention and lack of accountability. The same challenges have been identified by later research as well. Therefore, the government of Nepal should explore structural reform alternatives like privatisation, management contract, strategic partnerships, etc., depending on the nature and appraisal of non-essential service-providing enterprises. As has been witnessed before, reform plans will be met with many political challenges from stakeholders like political leaders, labour unions, and special interest groups. Therefore, the government should engage and look to educate and secure the buy-ins of all of these groups.

Conclusion

If implemented, benefits of the said reforms will accrue to the Nepalese economy in the form of incentives for sub-national governments to focus on local needs and aspirations, improved resource-sharing frameworks between the federal and sub-national governments, improved efficiency of government spending, and freeing up of the fiscal space at sub-national levels. Similarly, aligning the annual budgets with the periodic development plans through the “mid-term fiscal framework”, “fiscal rules”, and “mid-term expenditure framework” will ensure that programmes are put in the budget based on national priority instead of on an ad-hoc basis based on the interests of the policymakers. Furthermore, when merged with increased incentives for government actors, this will help significantly improve the budget implementation records of the federal and sub-national governments.

When national priorities guide the budgets and the expenditure capacities of federal and sub-national governments are improved, the taxpayers' resources will be spent on meaningful areas. Every area of government spending has a default trade-off of whether to scatter resources and secure inept results or focus on a few key areas and create an impact therein. As clear legal frameworks to pool resources from the public and private sectors are laid out, it will enhance Nepal's capacities to make targeted spending on not just infrastructures but also on education, health, and social protection, laying a foundation for development.