The Debt Ceiling and Challenges with Internal Borrowing in Nepal

KATHMANDU: The term ‘ceiling’ connotes a threshold or limit that constraints an outcome. In this regard, debt ceiling can be understood as an upper limit that restricts the amount of money that can be borrowed by an entity. Debt ceiling, in generally used in the context of public finance management where it refers to a statutory or constitutionally mandated restriction on the maximum amount of debt that can be incurred by a government to fulfill its’ financial obligations. The restriction can be set for the various levels of government, and also to the forms of debt, including domestic and foreign borrowing.

Public debt is a key macroeconomic variable for the developing and developed countries. Borrowing entails meeting the obligations of the present by levying a cost on the future generations. As such, there is a generic disenchantment towards mushrooming public-debt. Furthermore, excessive public borrowing has exacerbated some past and recent economic crises1, prompting a generic undesirability of high levels of public debt Cadenillas and Huamán-Aguilar (2015). Management of public debt has been a concern for policy makers and research enthusiasts across the globe and Nepal is no exception. With the advent of federalism in 2015, the concerns surrounding public-debt management that were earlier limited to the union government were equally applicable to the newly formed subnational governments who were entrusted with borrowing powers as per the constitutional provisions (Articles 59(3) and 59(7)). The National Natural Resources and Fiscal Commission (NNRFC) was formed to ensure the effective implementation of fiscal federalism in Nepal in accordance with Articles 60 and 251 of the Constitution of Nepal, 2015.

The Commission conducts an overall assessment of the economic indices before exercising its constitutional right to recommend the internal borrowing limits to the federal, provincial and local governments. Additional key responsibilities of the Commission include recommending guidelines for fiscal transfers to subnational governments, developing formulae for distribution of natural resource royalties and setting limits to other intergovernmental transfers. According to Section 23 of the Intergovernmental Financial Management Act 2074, all three tiers of government can present their budget deficit and can present plans to manage the deficit through internal loans. The NNRFC reserves the right to determine and recommend the debt ceiling for internal borrowing and all governments can borrow within the prescribed limits. Loans can be availed only upon presenting a suitable plan, benefits and returns from implementing the plan, plan for loan repayment, and defined source of the loan.

Internal Borrowing for Local Governments

As per limits prescribed by NNRFC for the fiscal year 2077/78, Local Governments may raise internal loans up to 12% of the sum of the amount received from revenue distribution from Federal Government and Provincial Reserve Fund and its Own Source Revenues i.e. royalty receivable by the Local Governments from its internal sources. The NNRFC provides yearly recommendations on the debt ceiling based on an estimated amount of internal revenues that can be generated by the Local Governments , the amount received through Federal and Provincial revenue distribution and their ability to meet debt service obligations. NNRFC revised this debt ceiling to 12% in this fiscal year from 10% in the last fiscal after estimating an increase in internal revenues and revenue transfers. NNRFC states that in absence of segregated data and statistics at the local units, an estimate of revenues is used to prescribe this ceiling.

However, NNRFC regulations allow loans to be utilized strictly in projects where it is ensured that the project’s revenue and profits are adequate to pay back the principal and interest components of the loan. According to the NNRFC, this cap to borrowing of local governments is set to ensure macro-economic stability and to maintain fiscal discipline.

For the current fiscal year, this limit entails a borrowing limit amounting to NPR 11 Arab 60 Crores 2 Lakh can be availed by Local Governments. To get an estimate of the borrowing limits for local government units, we have computed the municipal budgets of three of our partner municipalities under the IDFS program. The calculations have been outlined in Figure 3 Since the debt-ceiling for local governments was recommended at 10% of OSR and Revenue Distribution for FY 2076/2077 by the NNRFC, the estimate is calculated on this basis.

For instance, it can be seen that Bharatpur Metropolitan City could avail approximately up to 13 Crores 32 lakhs in form of internal loans (see Figure 1) in the last fiscal year. While smaller municipalities like Birendranagar and Damak could borrow only up to 3 crores 24 lakhs and 5 crores 52 lakhs respectively (approx.). The 2-percentage point increase in the debt ceiling from last fiscal year does not increase the borrowing limit significantly unless there is an exponential increase in the OSRs and Revenue distribution shares of these municipal bodies. Considering the infrastructural needs and services of growing urban centers, this amount seems grossly inadequate. For instance, a
recent estimated construction cost of a commercial building in Bharatpur is NPR 1.25 Billion Given the scale and high investment requirement of such infrastructural projects, financing them through fiscal grants or through loans from TDF is highly unlikely. While internal borrowing could have been a viable alternative, due to the current restrictions on borrowing this is not feasible. Since the provision of issuing municipal bonds is not applicable yet in Nepal, financing such large-scale municipal projects through internal borrowing purely from domestic banking and financing institutions would be unconceivable.

Setting caps to borrowing is critical to prevent the problem of mushrooming subnational debt and to avoid the risk of spreading moral hazard. However, it is not pertinent to set uniform guidelines and plug-in formulas to calculate debt ceiling for a diverse country like Nepal. A one size fits all approach currently adopted by NNRFC does not create a conducive environment for borrowing for even relatively better-to-do municipalities. Deriving a debt ceiling for local governments based on data and evidence would provide a more accurate and context specific representation of their capacity to repay. A more scientific derivation of debt ceiling would be able to limit some governments from defaulting on their debt without choking another government’s potential for growth.

Current challenges in internal borrowing

With the increase in expenditure responsibilities but relatively slow progression of subnational revenue generation, the critical gap of subnational financing is uncontested. However, there are other factors that are contributing to the lackluster internal borrowing scene in Nepal. While borrowing limits are already set low, borrowing hasn’t been a major source of municipal financing in Nepal, as current borrowing, on average, comprises only 0.85% of municipal total revenue (or 3 % of municipal internal revenue).3 This borrowing rate is far below the prescribed rate set by the NNRFC. A survey with 7 municipalities conducted by VRock on the impact of COVID-19 depicted that most municipalities have not utilized loans from BFIs to support municipal project needs. However, they exhibited an interest to borrow internally through BFIs, if lending practices were favorable and criteria were eased.

This reluctance to borrow can be a result of an inherent problem on both the demand and supply sides. On the demand side, borrowing is impeded due to a serious capacity gap in these newly formed municipalities. Inadequate planning, lack of capacity to mobilize resources and serious limitations on timely budgetary allocation and project implementation fronts have led to lower demand for borrowing. Apart from this, the culture of relying on fiscal grants and revenue transfers for budgetary requirements and a generic lack of capacity to properly plan and invest in long term revenue generating projects are additional detriments that discourage borrowing at the local government level. The Local Governance Operation Acts specifies that there are 7 steps of planning and budgetary process and the budget manual specifies a clear annual budget calendar.

Reviewing the annual planning and budgetary processes for the local governments, one can observe that the local budgets are source-driven and not driven by development requirements. As such, adjustments are made to the annual budgets based on availability of revenue resources. In the absence of a targeted development effort, there is a general lack of willingness to budget for projects using innovative sources of financing, including borrowing. It is observed that local planning of projects and subsequent plans for borrowing for deficit are plagued by a number of issues. First, Local governments allocate resources and submit plans for projects based on the budget and the size of this budget is primarily determined by the fiscal transfers from Federal and Provincial government. In absence of a long-term vision and prior plans, high cost projects that may exceed the allotted budget and can be financed through borrowing are not included within the plans. Plans are limited to medium term projects that can be financed through fiscal transfers (grants and revenue transfers) and by staying within the prescribed ceiling. When available funds dictate policy priorities of Local governments rather than vice versa, the alternative of financing projects through internal borrowing is not explored adequately by any Local government. Despite the authority provided by the constitution to Local governments, excessive reliance on merely transfers for budgeting and planning impedes long term development objectives and autonomy in local governance.

Second, while physical infrastructure development has remained a key priority across municipalities, funds are allocated arbitrarily and disproportionately across different sectors and thematic areas.4 From the very beginning, project identification and prioritization process is flawed. Political influence and self-interest of elected representatives affects the process of project selection and decision making. Actual infrastructural needs of the municipality often gets side-lined amongst political infightings between political leaders leading to ad-hoc selection of projects. Third, local and sector specific plans lack credibility due to inadequate or weak assessment of project feasibility. With weak provisions to address potential conflicts of interests, moral hazards such as these can be detrimental to the project outcome. Also try and link limited budget to conduct feasibility studies which are poorly done in the anticipation that such projects won’t actually be implemented. Apart from the prerequisites set by NNRFC, attaining loans through BFIs also require municipalities to submit suitable project plan along with necessary due diligence and projections of returns and most municipalities have not proactively sought for these loans.

On the supply side, banks and financial institutions in Nepal do not have a history of providing debt financing directly to municipalities for project implementation. VRock’s series of discussions with BFIs revealed that, even with municipalities, borrowing was limited to borrowing against a Fixed Deposit, for an interim period to cover working capital until fiscal transfers from the federal and provincial governments were received. BFIs are as equally reluctant to provide debt financing for municipal projects due to lack of experience of transacting with the Local governments and due to absence of sponsor guarantees and collateral. Since the land title of municipal land cannot be transferred in the name of the banks, the project land itself cannot be treated as a collateral, raising problems in municipal project financing.

Local governments have acquired substantial responsibility for the provision of essential public services such as education, health care, and basic infrastructure, however, their capacity to generate their own tax revenue

or other source revenues is still very limited. The asymmetry between expenditure responsibilities and the ability to generate own revenues has created a ‘vertical fiscal gap’ which has resulted in an increased reliance of subnational governments on intergovernmental transfers (predominantly fiscal equalization grants and conditional grants). This heavy reliance on transfers may reduce efficiency of subnational governments as it externalizes the cost of collecting revenue and can also weaken fiscal discipline as the federal government will have to bear the responsibility of potential deficits. Exclusive reliance on market discipline is not enough and administrative constraints such as the debt ceiling and procedural requirements set by NNRFC are justified to prevent burgeoning deficits and maintain macroeconomic stability. However, instead of imposing a uniform debt ceiling, constitutional bodies like the NNRFC are uniquely positioned to promote or at least facilitate subnational borrowing by putting data driven controls in place.

While it is imperative to set proper guidelines and limits to internal borrowing, the culture of fiscally responsible internal borrowing to finance municipal deficit should be fostered rather than discouraged. Similarly, the focus should be shifted towards enabling municipalities and the leadership to identify, create, plan and implement long term projects with sustainable returns that can be financed through internal borrowing. Better managed debt in fact shoulders the responsibility of local socio-economic development to respective municipalities and increases accountability of elected representatives. Furthermore, the equity and efficiency benefits of subnational borrowing, if appropriately regulated, can even outweigh the costs associated with macroeconomic risks. After all, adequate fiscal autonomy is a key tenant of effective decentralization which should not be undermined by poorly designed federal controls.

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Nishu Baral & Prashant Raj Pandey |
Thursday May 19, 2022, 02:54:11 PM |

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