Sustaining high growth rateGrowth rates in the last three years are above the historical average, beyond the economy’s estimated productive capacity, and are not supported by strong economic fundamentals.
The Central Bureau of Statistics estimated that the economy would likely grow at 6.8 percent in 2018-19, up from 6.3 percent last year. Since this is the third consecutive year the economy grew by over 6 percent, some analysts and the government are arguing that the economy is on a solid footing and that double-digit growth is within reach. Finance Minister Yuba Raj Khatiwada recently argued that the government’s economic outlook is realistic and that it is natural to have large fiscal and current account deficits in an emerging economy like ours.
However, the reality is different. Growth rates in the last three years are above the historical average, beyond the economy’s estimated productive capacity, and are not supported by strong economic fundamentals. The estimated growth rate for the fiscal year 2018-19 is well below the government’s ambitious 8 percent target. Expansionary fiscal and monetary policies are increasing external and financial sector vulnerabilities. An unsustainably high current account deficit and large balance of payments shortfall along with declining foreign exchange reserves may compel the government to go for an abrupt policy adjustment in the near future. Fiscal and monetary policies should be sound and geared toward increasing private sector investment along with public capital spending absorption capacity to sustain high growth rates.
In the fiscal year 2018-19, a bumper agricultural harvest, and a pickup in the activities of the services sector and reconstruction related works, contributed the most to maintain high GDP growth. Specifically, robust agricultural output is underpinned by favourable monsoon, and high services sector output is supported by wholesale & retail trading, tourism and real estate activities. Wholesale and retail trade activities, whose share of GDP is equal to that of the entire industrial sector (composed of mining and quarrying; manufacturing; electricity, gas and water; and construction), mainly depend on remittance-financed imported goods. These drivers of growth are not sustainable and are pretty much exogenously driven.
Instead, industrial output grew at a lower rate than last year because manufacturing and construction activities have slowed down. Within this sector, the electricity, gas and water industries grew at the fastest rate: 12.4 percent, up from 9.6 percent in the fiscal year 2017-18 as additional electricity was connected to the national grid and a favourable monsoon increased water flow, which then boosted hydroelectricity generation of projects that depend on run-of-the-river type production. Similarly, mining and quarrying activities are projected to grow at 9.5 percent, up from 8.9 percent in the fiscal year 2017-18, as mining and quarrying of stones, sand, soil and concrete intensified in response to a large, and growing, demand for reconstruction related materials. The haphazard mining and quarrying of riverbeds and hills, sometimes at the initiation of local governments, is one of the factors for this sub-sector’s robust growth.
However, slow public capital spending, especially the setback in Melamchi water supply and the delay in the Upper Tamakoshi hydroelectricity project, both of which were expected to be completed by this year after multiple time extensions, dragged construction sector growth down to 8.9 percent, from 10 percent last year. Similarly, manufacturing activities are projected to grow by 5.8 percent, much lower than the 9.2 percent in the fiscal year 2017-18, indicating the lack of private sector investment as well as a loss of both domestic and external markets due to eroding cost and quality competitiveness. The stable supply of electricity and improved industrial relations were not sufficient to jack up manufacturing output.
Despite the unveiling of the budget one-and-a-half months before the start of the fiscal year, this shows that there has not been much improvement in increasing capital spending. The fiscal transfers to subnational governments (which come under the recurrent budget of the federal government but capital budget of provincial and local bodies) are not used to create productive capital assets, but on activities that increase unproductive imports (such as vehicles) and on petty projects with high transaction cost but low productive value. No wonder, public gross fixed capital formation is projected to decrease by 8.1 percent, from 29.4 percent growth in the fiscal year 2017-18. Furthermore, despite all the talk about investment-friendly legal and operational environment, growth in the manufacturing sector tanked. Repeated talk of improvements in the business climate and adequate supply of inputs (such as electricity and the road network) is not translating into action on the ground.
The foundation for sustaining high economic growth is not solid yet. The 7.7 percent growth in the fiscal year 2016-17, the highest since 7.9 percent growth in in the fiscal year 1993-94, was largely due to a base effect and high spending during the first two phases of local elections. In in the fiscal year 2017-18, spending during the local and parliamentary elections gave a temporary boost to aggregate demand along with notable progress in the industrial sector, as better electricity supply and a pickup in post-earthquake reconstruction work increased economic activities. In the fiscal year 207-18, it was the favourable monsoon, reconstruction works and robust services output underpinned by wholesale and retail trade, tourism and real estate activities. These factors do not alone sustain a high growth rate, as they are susceptible to exogenous shocks beyond the control of the government. Furthermore, elections won’t happen every year and the reconstruction related temporary fiscal stimulus won’t last forever.
We need to expand the supply capacity of the economy to sustain high growth rates, and this expansion should be in line with our capacity to manage fiscal and monetary policies. For instance, an expansionary fiscal policy has led to large increase in the budget deficit, which in turn is increasing imports and subsequently the current account deficit. In addition, it is either crowding out private investment or raising their cost of borrowing. Similarly, expansionary monetary policy has increased credit growth more than deposit growth and that it is flowing mostly to support higher consumption and import. Imports and capital goods accumulation have grown at such a rate that the private sector is worried about slowdown in sales and the rapid building up of inventory or stocks. Overly accommodative monetary policy has raised non-performing assets, decreased credit flows to productive sectors, and increased financial sector vulnerabilities.
To sustain a high growth rate, monetary policy should be tightened to ensure that credit growth is in line with deposit growth, consistent with regulatory requirements, and that it goes to productive sectors to augment supply capacity. Meanwhile, fiscal policy should rationalise recurrent spending, but increase the quantity and quality of capital spending. On a regulatory and institutional front, the government should foster competition rather than sectoral cartels. Structural reforms should be implemented, including revising procurement laws and easing procedures to doing business.
The efficiency gains from these measures will contribute to accelerated economic activities on a high and sustainable path, and are better than expansionary fiscal and monetary policies designed to boost short-term aggregate demand at the cost of medium-term fiscal and monetary soundness. Furthermore, they will ensure that the productive or supply capacity too increases in a sustainable way.
Sapkota is an economist based in Tokyo.