Against the backdrop of disappointing national accounts estimates recently released by the National Statistics Office (NSO) and an unsatisfactory fiscal performance but improving external sector situation so far this year, the government is busy preparing the budget for the next fiscal year 2023-24. While tight monetary and fiscal policy measures mitigated external sector risks, particularly the fast-depleting foreign exchange reserves, they also squeezed aggregate demand as banking sector lending slowed, industrial capacity utilisation decreased, and revenue mobilisation shortfall widened as obligatory spending on salaries and social spending increased. It indicates a weak economy with unresolved structural issues and macroeconomic imbalances, which the upcoming budget must focus on.

Economic slowdown

The NSO projected gross domestic product (GDP) to grow by 1.9 percent in 2022-23, down from the 5.6 percent revised estimate for 2021-22 and 4.8 percent for 2020-21. The growth estimate for this fiscal is also lower than the 8 percent target in the budget and recent estimates by multilateral institutions. The NSO estimate is based on data and information up to the first nine months of this fiscal (mid-July 2022 to mid-April 2023) and the assumption of normal economic activities during the rest of the fiscal, This is unlikely given the lower private sector confidence and the lack of pick up in capital spending in the last quarter. Consequently, the statistics office may downscale estimates while releasing data next year. Seasonally unadjusted data show that the economy grew at just 1.7 percent in the first quarter and contracted by 1.1 percent in the second. Seasonally adjusted quarterly GDP estimates show two consecutive quarters of economic contraction.

The lower growth projection is attributed to contractions in manufacturing, construction, and retail and wholesale trade activities, which account for about 28 percent of GDP. Specifically, manufacturing activities contracted by 2 percent owing to a lack of adequate electricity supply during the dry season, despite the electricity subsector registering the largest growth, 19.4 percent, in 2022-23 due to the addition of new run-of-the-river type hydroelectricity to the national grid, a high interest rate, import restrictions and generally low government and consumer demand. The Nepal Electricity Authority cut supply by almost 12 hours to industries due to a slump in power generation during the dry season. It increased the cost of production—including those of the cement, rods, and steel industries—leading to lower output and demand.

Similarly, construction activities contracted by 2.6 percent as capital spending slowed, and residential housing and real estate were hit by policy restrictions on real estate plotting and tight as well as high-interest rates. This subsector previously benefitted from a highly accommodative monetary policy and lax supervision. Meanwhile, wholesale and retail trade activities fell by 3 percent owing to restrictions on imports of goods, a slowdown in domestic industrial output, and lower income growth as a lack of adequate electricity supply, inflation, and high input costs hit businesses and households.

Overall, the tight monetary policy to maintain external sector balance, especially to narrow the current account deficit and increase foreign exchange reserves, and lower public spending dampened aggregate demand, resulting in lower-than-expected real GDP growth. While public and private investments contracted by 20.2 percent and 7.6 percent respectively, consumption expenditure grew by just 3.7 percent. The external sector and, to some extent, the financial sector indicators have improved, but at the cost of a slowdown in imports and overall economic activities.

Budget focus

Against this background, the next federal budget should focus on propping up aggregate demand while rectifying short-term macroeconomic imbalances. These include reducing the fiscal deficit in view of the large revenue expenditure gap, boosting private sector investment, reducing inflationary pressures, lowering interest rate volatility, maintaining financial stability, and maintaining external sector balance even after the withdrawal of policy restrictions on imports.

Expenditure-based fiscal consolidation through rationalising subsidies and general government expenses, and better targeting of social protection programmes, including the pension system, are urgently needed. Otherwise, managing recurrent spending with revenue mobilisation will be difficult. On revenue measures, the focus at the federal level could be on avoiding an inverted tax regime where the tax rate on inputs is higher than that for final goods. Rationalising distortionary tax expenditures such as exemptions, concessions, preferential rates, amnesties, and deferrals could also be prioritised. At the sub-national level, strengthening the revenue system and administration to bring more activities, including property levies, under the tax net could be helpful to reduce the overreliance of subnational governments on the federal government to meet their expenditure needs.

The budget should also prioritise capital budget execution, which has receded to less than 60 percent in recent years. A public investment management regime that focuses on systematic identification, appraisal, approval and monitoring of investment projects and a procurement regime that prioritises strict contract management could be helpful.

Meanwhile, a single fiscal budget cannot resolve all structural issues, but it can take corrective steps as a part of a medium-term reform agenda to sustain high, inclusive, and sustainable growth. These include long-running structural issues such as boosting overall productivity, inducing an industry-oriented structural change from low value-added services activities, promoting high-value and climate-smart agricultural sector, enhancing governance of and lowering fiscal risk from public enterprises, ensuring effective contract management and good governance, rationalising as well as the targeting of social protection programmes, enhancing quality and climate-resilient infrastructure, and boosting human capital development.

The budget could take preparatory steps to facilitate industry-oriented structural change by overhauling our energy generation and use strategy. The share of the industry sector will naturally increase as more hydroelectricity projects connect to the national grid. Hydroelectricity output now accounts for about 2.1 percent of GDP, a sharp spike from less than 1 percent a decade ago. It should be thought of both as a final product as well as an input to enhance economy-wide output and productivity. The budget could facilitate the strategic use of excess electricity during the non-dry season to boost output and productivity in the manufacturing and services sectors. This will not only reduce imports and lower the current account deficit but also boost growth and employment. Exporting electricity should be a second priority for now. Furthermore, given the risk from climatic hazards, it is prudent to start working on diversifying energy sources to wind and solar and to increase the peaking or reservoir-type hydroelectricity projects. An adequate year-round supply of electricity needs to be managed well so that industries do not face shortages during certain months and that consumers are incentivised to shift to electric goods and appliances.