Financing development projects: Should Nepal prefer grants or loans?

When it comes to choosing between grants and loans, countries often prefer grants as they are not required to be repaid. But progress in projects funded by grants is slow in most cases.

A view of nearly completed Pokhara Regional International Airport/Photo: RSS

Prakash Maharjan

  • Read Time 4 min.

Parliament of Nepal finally endorsed the MCC grant last month after four years of being tabled. MCC grant was an infrastructure grant applied to by Nepal after realizing the need for infrastructure development in the country. The country had also applied for various grants and loans for infrastructure development prior to MCC but had never seen this level of resistance. Grants and loans act as gap-filling mechanisms that come as official development assistance (ODA) from international development partners who can be multilateral or bilateral.

Nepal aspires to become a developed country with high income by the next two decades and achieve a per capita income of $12,100 (as against the current $1,010). The country has set a goal to achieve a per capita income of $1515 by 2024 and needs to work towards high capital formation through increased investments and savings. However, the Fifteenth Periodic Plan recognizes that the gross fixed capital formation (investment in capital goods, infrastructure, etc) of the country had not been satisfactory due to the low capital expenditure from the government and identifies the cooperation of international development partners as a necessity for the development of the country.

Grants or loans?

When it comes to choosing either grants or loans, countries often prefer grants as they are not required to be repaid. However, the progress in projects funded by grants is slow in most cases. Multilateral partners such as the World Bank and ADB along with other developing partners, despite aligning their principles and policies to better address the challenges involved in project execution, found that progress on the ground is lagging. Likewise, grants can be misused very easily especially if a country does not have proper accountability measures. For grants to actually perform, there needs to be a system of high accountability which will help track the usage of funds as donors require the country to be accountable towards the funds granted and to check whether the funds are used for their intended purpose which is rarely the case in developing countries like Nepal.

On the other hand, loans need to be repaid along with interest which makes it costly for the project initiator and it takes longer to complete the project (depending on the terms of the contract). Thus, countries are obligated to be efficient regarding projects financed by loans to not make it costly.

Nepal has also focused on financing development projects through loans rather than grants. The Ministry of Finance’s Foreign Aid portal discloses that donors have committed more than $14 billion worth of loans and grants in the last two decades and in the last five years alone Nepal processed more than 42 percent of those loans resulting in a total loan worth $6 billion (see the table below).

Similarly, the second-quarter report from the Public Debt Management Office mentions that the total outstanding debt of Nepal remains at NRs 1,728.93 billion which roughly amounts to $14 billion at current exchange rates resulting in debt per capita of NRs 59,225 or NRs 300,000 per family assuming that Nepal has an average household size of five (the average household size as per Household Survey was 4.6).

The Total Debt to GDP ratio of Nepal currently stands at 40.53 percent whereas external debt to GDP stands at 18.24 percent. The foreign debt repayment is 1.56 percent of the annual budget of the country and the foreign currency balance is maintained from remittances. But the current decreasing scenario of remittances may prove to be troublesome for the country.

For any country, debt will only make sense if its contribution to the economy is positive. For Nepal, with the available data, it was found that every NRs 1 increase in public debt will cause a reduction in GDP by NRs 0.01. Though the number may be insignificant, in the last five years, the tentative reduction in our GDP has been of NRs 7.2 billion or $60 million.

Nepal should venture into forming a good policy environment that helps reduce the negative impact of rising debt on growth.

While taking loans for infrastructure development means efficiency, the country must be vigilant when doing so as there are ample cases of countries being bankrupt because of high debt. Beyond a certain threshold, debt is bad for economic growth. The higher public debt affects the economic performance by inducing higher inflation and displacing private investments that can act as an alternative to both grants and loans. Some studies suggest that in developing countries like ours, loans help increase revenue for the government but others argue that such increased revenues are the result of increased taxation. More recent studies on loans and grants as ODA provide a rather alternative solution for this discourse. These studies recommend that instead of choosing either grants or loans as ODA, a country should focus on creating a good policy environment that is conducive enough to cushion against the shocks in the economy and debt repayment. Their findings suggest that a good policy environment along with high-quality institutions will help the country ameliorate the negative effects of rising public debts.

What Nepal should do

Nepal should venture into forming a good policy environment that helps reduce the negative impact of rising debt on growth. The country should pivot its discourse into forming policies that facilitate international financial integration, promote domestic and foreign investments, and increase business development that can act as an alternative method of increasing capital formation rather than processing loans and grants.

Now that the country has become federal, subnational governments are allowed to develop infrastructures and can request the federal government to raise external loans but given the limited revenue source, repayment of such loans may be an issue. So, as an alternative way of investing in capital formation without increasing debt, sub-national governments can operate in a public-private partnership (PPP) model that benefits every stakeholder.

Prakash Maharjan is a researcher at Samriddhi Foundation, an economic policy think tank based in Kathmandu. Views expressed in this article are the author’s own and do not represent the views of the organization.

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