What HMG Needs, But Should Not Have Too Soon

A broad consensus is emerging that security operations are not sufficient to counter the Maoist insurgency. The insurgency also represents an opportunity for His Majesty's Government (HMG) to improve its services to the poor, especially those living in Maoist affected areas, to build the foundation for lasting peace. Securing peace and improving public services will require more resources. Yet, HMG's revenue collection has slackened sharply. This is more than an average "fiscal crisis." How should HMG respond? Should donors step up its aid to save the day? Before answering these questions, we need to understand the nature of the fiscal problem HMG faces.

Fiscal crisis

Since the Maoist violence escalated in November 2001, HMG's spending has shot up, mostly on account of added security expenditures. In the meantime, HMG's revenue collection has slowed sharply, because the economy is suffering from low tourist arrivals and weak trade. In short, the Government coffer is rapidly becoming empty. But, what about the large aid flows that Nepal has long enjoyed? A lot of donor money is still there, but the Government may not be able to tap much of it. Here is why.

The table below shows the dramatic change in the Government's fiscal position between FY00/01 and FY02/03. In any normal year, HMG collects more revenues than it spends on its on-going expenditures, such as salaries of civil servants and teachers, and various government services. This difference, or recurrent surplus, is used then to finance development expenditures, i.e., spending on things like new roads and hospitals. In a typical year, HMG supplements the surplus with some borrowing from the domestic market (through Treasury Bills and borrowing from the central bank). In FY00/01, between the Rs. 6 billion in recurrent surplus and the Rs. 12 billion in borrowing, HMG had Rs. 18 billion in cash for development expenditures. Of this, HMG spent Rs. 10 billion on projects that are exclusively financed by HMG and another Rs. 8 billion as "counterpart funds" to finance part of donor-assisted projects. (Many donors, including the World Bank, require partial contribution by aid recipients to ensure that they are truly committed to the projects.) The domestic borrowing of Rs. 12 billion, at around 3% of GDP, was higher than what is considered a prudent limit, but it did allow a sizable development budget. So, all in all, the budget picture was not too bad.

In the current fiscal year (FY01/02), revenue growth turned completely flat, and the recurrent expenditures have increased sharply, mostly on account of a doubling in security spending (we suspect the actual recurrent expenditures may turn out to be even higher). This resulted in zero recurrent surplus. Even with expected domestic borrowing of Rs. 16 billion (nearly 4% of GDP, which is far higher than HMG's own limits), development expenditures will fall by about 14%. The basic revenue-expenditure balance is expected to be worse in FY02/03, turning into a deficit for the first time. Assuming that HMG keeps its borrowing at a more sustainable level, or around 2% of GDP, it would have only about Rs. 6 billion of its own funds for development expenditures. Even where donor funds are already committed, HMG may not be able to draw on such funds because it will not have cash to pay for its share in counterpart funds. The majority of development projects will virtually shut down. All this is before factoring in some large additional security spending that the Royal Nepal Army is reportedly wanting. If such additional spending is approved, there will be no cash for development expenditures, including very important block grants to District Development Committees (DDCs) and Village Development Committees (VDCs).

In this situation, additional projects supported by donors will not solve the fiscal problem, as they would tend to increase the need for counterpart funds that HMG does not have. Such is the nature of the fiscal problem HMG faces in the new fiscal year.

Turning a crisis into an opportunity

Several months ago, officials in the Ministry of Finance and the National Planning Commission lamented the impossible situation HMG faced. Their initial reaction was to look away from the real problem and think of ways to ease the budget constraint, i.e., mobilize more aid. However, as it became clear that no easy fix was available, I have seen that some key officials have begun to face up to the challenge. A tight budget is painful, as we all know from our personal life, but it does help make one's choices crystal clear. For HMG, it is obvious that security spending has to be met. It is also obvious that HMG must spend the remaining scarce funds wisely to deliver the best public services possible. When the money is limited, it becomes much easier to drop low priority items. It also compels everyone to think more creatively about better ways of doing the business of government.

So, where is the new budget going? Increasing revenues and cutting recurrent expenditures are difficult. (HMG has already made considerable efforts in these areas during the current fiscal year. There is not a lot of short-term options left.) Increasing government borrowing is mechanically possible, but is very risky. It could come back as high inflation after a while. This is one ill that hurt many other countries, but that HMG has astutely avoided so far. It would be a shame to throw away this discipline. The options for HMG are indeed limited.

One thing HMG should and is doing is to scrutinize all 628 development projects, and in particular 404 HMG projects. (This includes, for FY 01/02 budget, 44 projects under the Debt Relief Fund and KR2 amounting to Rs. 1.86 billion. HMG budget classifies them as "donor funded," since they do receive funding from Japan. However, these funds are given as budget support and not tied to any specific projects. Thus these projects should really be classified as HMG projects.) The benefits of these projects are questionable and this may be an opportune time to understand which of these represent the real development priorities of the people of Nepal. In FY01/02, HMG will spend about Rs. 7.5 billion on such projects (the rest, about Rs. 1.5 billion, went to DDCs and VDCs as block grants). In FY02/03, there is likely to be little money available for these projects. However, the problem is that for each of these projects, there is a project office, a few people, and associated expenses. Even without spending a rupee on actual investment itself, such overhead costs would add up to about Rs. 4 billion. This is sheer waste. It makes eminent sense to drop all these projects. (Even in FY01/02, only about Rs. 3.5 billion will be actually spent on investment, while Rs. 4 billion on overhead. Not a very efficient way to invest.) Perhaps there are some donor driven projects that should go out of window as well.

Since HMG structures its annual budget along the lines of 'regular' spending and 'development' spending, many people tend to believe that any cut in development spending will result in a slowdown in development. On the contrary, there is considerable scope to improve development impact by improving the quality of regular spending. A very important response could be to finally implement some of the bold steps that have been envisioned under the Local Self-Governance Act and the Seventh Amendment of the Education Act. Increasing community and local government involvement in primary education and primary health care services are just such ideas. For the same expenditures, one could expect much better actual service delivery, because these reforms are likely to strengthen accountability for service delivery.

Donors' role in this crisis

Cutting low priority projects/spending will allow HMG to protect high-priority projects/spending. But, it will not be enough to generate sufficient "counterpart funds" to unlock much of the donor money that is already committed. Additional project aid will not help. What HMG needs is cash aid (or "budget support"). This will increase the amount of cash HMG can put into development expenditures. Without such help, the table above shows that development expenditures could fall by nearly half in FY92/03.

However, for donors to rush in with a lot of cash would be irresponsible. The unfolding crisis seems to be finally helping HMG to overcome political resistance to setting rigorous priorities on expenditures and moving forward on some far reaching changes in the modalities of public service delivery. Offering cash aid too soon would only take away the impetus for hard decisions. No one likes to make painful choices, if they can avoid them. This is a rare opportunity that HMG should value and donors should respect.

Several donors, including the World Bank, are indeed actively discussing a possibility of providing budget support. Mindful of HMG's efforts to leverage the crisis into a spring board for reform, these donors have been very careful not to undermine HMG's own initiative. There is another important reason why these donors are cautious in offering budget support. HMG's track record in managing its expenditures and delivering quality services is poor. Since budget support is the most fungible form of aid, donors are rightly concerned with the possible misuse of their money. They will want to see HMG come up with a serious plan to improve the impact of public spending, confirm that it is actually getting implemented, and know that HMG will be taking actions to reduce waste and corruption. Only when they are satisfied, they will provide budget support.

The challenge that HMG faces is immense. For HMG to get budget support it badly needs, it must also clear some high hurdles. But, the kind of changes that are wanted by donors is exactly what any concerned Nepali citizen would want—reliable implementation of government policies, better public services, and less waste and corruption. In other words, a good government. I believe the reformers in the government are developing a very impressive response. When HMG has a plan that will impress the citizens of Nepal, I am sure donors will also be impressed.