As Nepal prepares for an ambitious shift from a unitary to a federal system of government, closer attention to sequencing political, financial and administrative decentralization will be key, says the World Bank in its latest Nepal Development Update. Starting in FY 2018, a large proportion of federal spending is expected to be passed on to sub national governments, ultimately increasing public spending. However, the Update cautions that unresolved issues surrounding the implementation of the new federal architecture could challenge budget execution, particularly during the upcoming year.

Nepal’s new fiscal federalism system suggests a marked asymmetry between stronger decentralization of spending responsibilities and relatively unchanged low decentralization of tax collection powers, notes the Update.  Similar imbalances hold true between regions across the country.

“The sub national governments will play an increasingly critical role in Nepal’s public expenditures,” said Takuya Kamata, the World Bank’s Country Manager for Nepal. “A system of fiscal transfers that is designed for transparency and predictability and supported by a small set of simple rules, could go a long way in helping meet the development objectives of federal Nepal,” he said.

The Update makes four key observations. Many functional assignments are “shared” among the three levels of government. A negotiated delineation of devolved responsibilities are critical first steps. A detailed costing of devolved responsibility will also be critical.

 Revenue collection and tax administration remain relatively unchanged and highly centralized, with limited existing tax bases for sub national governments.

 The resulting mismatch between revenue collection and service provision could be closed through inter-governmental transfers.  Having a transparent, evidence-based formula for equalization among provinces is critical to design an effective depoliticized process.

According to a press release issued by the World Bank, Nepal Country Office, the constitution makes adequate provisions for prudent debt management in a decentralized system. However, these provisions could be developed in greater detail though a fiscal responsibility-type law that provides clear, simple, yet flexible rules for behavior of different levels of government. In addition, the creation and deployment of accounting and debt reporting systems should remain critical short-term priorities.

Floods Impact Economic Growth

Meanwhile, in its semi-annual assessment of economic performance, the Update notes that economic activity in Nepal, which rebounded strongly in FY 2017, has been impacted once again by severe floods affecting over a third of the country. Damaging floods in mid-August are likely to affect agriculture, economic activity, and poverty reduction efforts even up to FY 2018.

 “Economic growth is expected to be lower than earlier forecast and is expected to average 4.5 percent over the next two fiscal years” says Sudyumna Dahal, World Bank Economist and principal author of the Update. The floods have affected over 5 percent of the total population, with several districts recording the heaviest rainfall in 60 years. Over 80 percent of land in the southern Tarai, country’s food basket, was affected. Estimates of destroyed crops at 64,000 hectares will likely lead to a weak agricultural output in FY 2018.

Government revenue collection in FY 2017 reached a new record, while government spending accelerated as well. However, more than 60 percent of the capital budget was spent in the last quarter of the fiscal year while expenditure remained significantly below the planned budget, a perennial problem in Nepal. The era of balanced budgets has ended with the fiscal deficit reaching an estimated 3.3 percent of GDP in FY 2017 and expected to increase going forward as well.

Additionally, the current account, which turned into a deficit in FY 2017, is also expected to deteriorate further in FY 2018. Import growth should remain strong, while growth of exports and remittances are expected to remain sluggish. Recorded departures of migrant workers have continued to slow, reaching a five-year low in FY 2017. Given the geopolitical tensions between Gulf Cooperation Council countries and Qatar—a major destination of migrant workers—departures are not expected to improve significantly.