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Nepal

Author(s):
International Monetary Fund
Published Date:
June 2008
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I. Economic Developments and Outlook

A. Background

1. Nepal is undergoing a major political transition. The end of the decade-long civil conflict in April 2006, the interim government takeover from the monarchy, and the comprehensive peace agreement between the government and the Maoist party in November 2006 set the stage for a transition to a new democratic governance structure.

2. The next step in this process, the writing of a new constitution, will be carried out by the Constituent Assembly. After several delays the elections to determine this assembly were held on April 10, 2008. Despite pre-election violence the elections themselves were considered by and large free and fair by international observers, and the results appear to be broadly accepted. While the final results are still not known, the Maoist party is emerging as the clear victor. A new government has yet to be formed and the policy agenda that will emerge is still uncertain.

3. Despite recent progress, however, the political situation is highly fragile. Relations among major parties remain contentious. The situation in the Terai (the southern plains bordering India) remains tense as militants have increasingly agitated for more regional autonomy and a greater stake in national politics, and violence and strikes have been widespread. Given these obstacles there is a risk that the political transition will stall, with fundamental tensions remaining unresolved.

4. Nepal’s history of civil conflict, political instability, poor governance, and weak structural reform has retarded economic growth. Per capita GDP in Nepal has barely risen in the last decade and the country remains one of the poorest in the world. Nepal has largely been left behind in the region’s recent growth boom (Figure 1).

Figure 1.Nepal: Regional Comparators

(Average 2003-07)

Sources: WEO, World Development Indicators, and various Fund Staff Reports.

Real GDP per Capita in US$, 2006

Annual GDP Growth, 1996-2006

(In percent)

B. Economic Developments

5. Macroeconomic performance under the recent PRGF-supported program, which ended last November, has been stable (Tables 1-4). Despite a background of civil conflict and major political upheavals during the program period:

Table 1.Nepal: Selected Economic Indicators, 2003/04–2007/08 1/
2003/042004/052005/062006/072007/08
Est.Est.Proj.
(Percent change)
Real GDP at market prices4.73.12.82.53.8
CPI (12-month change)2.06.68.35.17.0
CPI (period average)4.04.58.06.46.5
Fiscal indicators(In percent of GDP)
Total revenue11.311.710.912.013.5
Total expenditure14.314.914.715.719.7
Current expenditure10.310.510.410.613.4
Capital expenditure and net lending4.04.44.35.16.4
Overall deficit before grants3.03.23.83.66.2
Overall deficit after grants0.90.81.61.43.6
Domestic financing (net)0.60.21.40.92.7
Public debt59.853.951.146.744.6
Money and credit(Percent change, end-of-period)
Broad money12.88.315.414.018.0
Domestic credit9.813.916.312.020.3
Private sector credit 2/14.212.917.812.118.3
Velocity1.92.01.91.81.7
Interest rates(In percent)
91-day treasury bill (end-of-period) 3/1.53.93.32.8
Central bank refinancing 3/2–5½1½–5½1½–6¼1½–6¼
Loans to industry 3/8½–13½8¼–13½8–13½8–13½
Balance of payments(In millions of U.S. dollars)
Current account balance (excluding official transfers)59-1953-146-156
In percent of GDP0.8-0.20.6-1.4-1.3
Trade balance-1,053-1,190-1,521-1,761-2,074
In percent of GDP-14.5-14.6-17.0-17.2-17.1
Gross official reserves (end-of-period)1,4571,5011,7972,0082,027
In months of imports of goods and services7.36.46.76.55.8
Export value growth 3/14.711.22.24.96.9
Import value growth15.812.217.311.914.1
External debt/GDP (in percent) 4/46.139.939.132.629.1
Debt service (in percent) 5/4.54.54.04.03.9
Exchange rate (Nrs./U.S. dollar, end-of-period)74.570.774.465.2
REER (end-of-period; percent change; negative = depreciation)-2.27.01.410.7
NEER (end-of-period; percent change)0.13.3-2.98.3
Nominal GDP at market prices (Nrs. billions)536.7589.4646.5719.5795.2
Sources: Data provided by the Nepalese authorities; and Fund staff estimates and projections.

Fiscal year begins mid-July.

Includes lending by the Agriculture Development Bank of Nepal (ABDN) since July 2006. Reflects loan write-off of Nrs. 16 billion during July to December 2006.

Excluding re-exports.

Includes estimated short-term trade credits.

In percent of exports of goods, services, and private transfers and income receipts; including debt service to the Fund.

Sources: Data provided by the Nepalese authorities; and Fund staff estimates and projections.

Fiscal year begins mid-July.

Includes lending by the Agriculture Development Bank of Nepal (ABDN) since July 2006. Reflects loan write-off of Nrs. 16 billion during July to December 2006.

Excluding re-exports.

Includes estimated short-term trade credits.

In percent of exports of goods, services, and private transfers and income receipts; including debt service to the Fund.

Table 2.Nepal: Summary of Government Operations, 2006/07–2012/13 1/
2006/072007/082008/092009/102010/112011/122012/13
BudgetEstimateBudgetProj.Projection
(In billions of Nepalese rupees)
Total revenue and grants108.2102.7129.8128.4144.2164.0186.1210.5238.4
Total revenue84.586.4102.3107.3115.2133.6152.4173.1197.0
Tax revenue69.971.281.086.095.3109.7126.5145.5167.3
Nontax revenue 2/14.515.221.321.319.923.825.927.729.7
Grants23.716.427.521.129.030.533.737.441.4
Total expenditure127.8112.6152.1156.7165.7184.3205.0228.1252.9
Current83.876.098.2106.2109.4121.2134.3148.7164.8
Of which: interest payments7.96.27.47.49.010.411.212.012.7
Capital and net lending44.136.753.950.556.363.170.779.488.1
Overall balance before grants-43.4-26.3-49.8-49.4-50.5-50.8-52.6-55.0-55.9
Overall balance after grants-19.6-9.9-22.3-28.3-21.5-20.3-18.9-17.6-14.5
Financing19.69.922.328.321.520.318.917.614.5
Net foreign loans9.43.46.66.67.68.28.910.411.2
Gross disbursements16.910.914.913.114.816.418.220.122.3
Amortization7.57.58.37.87.28.29.39.711.1
Net domestic financing10.26.515.721.613.912.110.07.23.3
(In percent of GDP)
Total revenue11.712.012.813.513.113.714.114.514.8
Grants3.32.33.42.73.33.13.13.13.1
Total expenditure17.815.719.119.718.818.919.019.019.1
Current11.610.612.313.412.412.412.412.412.4
Capital and net lending6.15.16.86.46.46.56.56.66.6
Overall balance before grants-6.0-3.6-6.2-6.2-5.7-5.2-4.9-4.6-4.2
Overall balance after grants-2.7-1.4-2.8-3.6-2.4-2.1-1.7-1.5-1.1
Financing2.71.42.83.62.42.11.71.51.1
Net foreign loans1.30.50.80.80.90.80.80.90.8
Gross disbursements2.41.51.91.61.71.71.71.71.7
Amortization1.01.01.01.00.80.80.90.80.8
Net domestic financing1.40.92.02.71.61.20.90.60.2
Memorandum items:
Primary balance-1.6-0.5-1.9-2.6-1.4-1.0-0.7-0.5-0.1
Public debt48.546.747.444.644.343.041.740.338.8
Domestic14.714.214.815.515.615.314.713.912.8
External33.832.632.629.128.727.827.026.426.0
Nominal GDP (Nrs. billions)719.5719.5796.8795.2881.3976.21081.31197.81327.0
Sources: Data provided by the Nepalese authorities; and Fund staff estimates and projections.

Fiscal years start mid-July. Table confined to central government operations as contained in the budget.

Includes privatization receipts.

Sources: Data provided by the Nepalese authorities; and Fund staff estimates and projections.

Fiscal years start mid-July. Table confined to central government operations as contained in the budget.

Includes privatization receipts.

Table 3.Nepal: Monetary Accounts, 2003/04–2007/08
2003/042004/052005/062006/072007/08
Jul.Jul.Jul.Jul.Jul.
Proj.
Monetary authorities(In billions of Nepalese rupees)
Reserve money94.496.5110.7119.3134.3
Net foreign assets108.2103.9131.6126.3127.9
Net domestic assets-13.8-7.3-20.8-6.96.4
(Change in percent of reserve money at start of period)
Reserve money16.62.214.77.812.5
Net foreign assets25.4-4.628.7-4.81.4
Net domestic assets-8.86.9-14.012.511.1
Monetary survey(In billions of Nepalese rupees)
Broad money277.3300.4346.7395.3466.5
Narrow money94.0100.2112.9126.7148.4
Quasi money 1/183.3200.2233.8268.6318.1
Net foreign assets108.8107.7139.5131.9133.9
Net domestic assets168.5192.7207.1263.4332.6
Domestic credit 1/246.0280.2325.8364.9439.0
Public sector60.370.578.787.8111.3
Government 2/57.463.974.182.7106.2
Public enterprises2.96.64.65.15.1
Private sector 3/185.7209.7247.1277.1327.6
Other items, net-77.5-87.5-118.7-101.5-106.4
(Annual percentage change)
Broad money12.88.315.414.018.0
Narrow money12.26.612.712.217.2
Quasi money13.19.216.714.918.4
Domestic credit9.813.916.312.020.3
Public sector-1.616.811.711.626.7
Government 2/-1.811.316.011.628.4
Private sector credit 3/14.212.917.812.118.3
(Change in percent of broad money at start of period)
Broad money12.88.315.414.018.0
Net foreign assets7.1-0.410.6-2.20.5
Net domestic assets5.78.74.816.217.5
Domestic credit9.012.315.211.318.7
Private sector9.48.712.48.612.8
Memorandum items:
Velocity of broad money1.941.961.861.821.70
Broad money multiplier2.943.113.133.313.47
Sources: Data provided by the Nepalese authorities; and Fund staff estimates and projections.

Commercial bank data are subject to revisions due to reporting lags.

Central Government, adjusted for local government deposits.

Includes lending by the Agriculture Development Bank of Nepal (ABDN) since July 2006. Reflects loan write-off of Nrs. 16 billion during July to December 2006.

Sources: Data provided by the Nepalese authorities; and Fund staff estimates and projections.

Commercial bank data are subject to revisions due to reporting lags.

Central Government, adjusted for local government deposits.

Includes lending by the Agriculture Development Bank of Nepal (ABDN) since July 2006. Reflects loan write-off of Nrs. 16 billion during July to December 2006.

Table 4.Nepal: Balance of Payments, 2005/06–20121/13
2005/062006/072007/082008/092009/102010/112011/122012/13
Est.Projection
(In millions of U.S. dollars, unless otherwise stated)
Current account19758801386534-79-176
Current account (excluding official transfers)53-146-156-284-378-435-574-698
Trade balance-1521-1761-2074-2425-2647-2862-3074-3333
Exports, f.o.b.8508929541,0231,0961,2061,3201,420
Merchandise exports8508929541,0231,0961,2061,3201,420
Imports, f.o.b.2,3722,6533,0283,4483,7434,0684,3944,753
Oil products465476670758782825870918
Other imports1,9062,1772,3582,6912,9623,2433,5243,835
Services (net)-94-117-193-212-235-258-359-375
Receipts366455513549585625672713
Of which: tourism132144194215238264289317
Payments4605727067618208831,0311,088
Income69105111126138152160168
Credit158206216233252272287303
Debit89100105108114120127135
Current transfers1,7441,8302,2362,6492,8083,0023,1943,364
Credit, of which:1,8091,8902,2862,7042,8693,0693,2693,448
General government 1/145204236422442469495522
Workers remittances1,3511,4211,6951,9302,0812,2422,4152,564
Debit6560505561687584
Capital account4363102108117127157189
Capital transfers4363102108117127157189
Of which: official grants4363102108117127157189
Financial account-125-30-181-49-102-910-34
Direct investment-65152529334152
Portfolio investment00000000
Other investment (net) 2/-118-35-196-74-131-125-41-86
Errors and omissions 2/18085000000
Overall balance2951761196807078-21
Financing-295-176-1-195-155-69-7425
Change in reserve assets (-=increase)-296-211-19-192-151-65-6437
PRGF Loans (net)03616-2-4-4-10-12
(In percent of GDP, unless otherwise stated)
Memorandum items:
Trade balance-17.0-17.2-17.1-18.9-19.0-18.9-18.8-19.0
Current account (excluding official transfers)0.6-1.4-1.3-2.2-2.7-2.9-3.5-4.0
Current account (including official transfers)2.20.60.71.10.50.2-0.5-1.0
Total external debt 3/39.132.629.128.727.827.026.426.0
Total PPG external debt36.430.326.926.425.424.624.023.6
PPG debt service 4/9.19.59.29.39.79.29.39.1
Debt service 5/4.04.03.93.33.43.33.33.3
Gross foreign assets (end of period)2,2432,5552,7922,7072,8682,9433,0162,989
Of which: central bank1,7972,0082,0272,2192,3702,4352,4992,462
(In months of imports of goods and services)6.76.55.85.85.75.45.14.7
Nominal GDP (in millions of U.S. dollars)8,92910,22012,12312,82013,93415,14616,30917,560
Sources: Data provided by the Nepalese authorities; and Fund staff estimates and projections.

Includes estimated NGO transfers.

Large other investments and errors and omissions reflect data weaknesses in capital account, unreported remittances and informal trade.

Includes estimated private sector debt and short-term trade credits.

As a ratio of exports of goods and services

As a ratio of exports of goods and services, private transfer and income receipts; including debt service to the Fund.

Sources: Data provided by the Nepalese authorities; and Fund staff estimates and projections.

Includes estimated NGO transfers.

Large other investments and errors and omissions reflect data weaknesses in capital account, unreported remittances and informal trade.

Includes estimated private sector debt and short-term trade credits.

As a ratio of exports of goods and services

As a ratio of exports of goods and services, private transfer and income receipts; including debt service to the Fund.

  • Growth has been maintained, albeit at low levels—output growth has averaged 3 percent since 2002. However, domestic unrest has harmed private sector activity and created an unfavorable investment climate, keeping growth below the average of the last decade. Structural impediments including poor infrastructure, input supply disruptions, and unstable labor relations have also retarded growth.

Nepal: Real GDP Growth FY1997-FY2007

(Annual percentage change)
  • Inflation has remained stable—the exchange rate peg to the Indian rupee has helped keep consumer price inflation below 8 percent during the program period. Asset prices, however, have shown signs of accelerating.

CPI Inflation, 1999-2008

(12-month average percent change)
  • The budget stance has been cautious—over the last several years domestic budget financing has been held to about 1-2 percent of GDP. Revenue growth has been strong, averaging 15 percent per year. Limited foreign borrowing and more recently the weakness of the U.S. dollar have reduced public debt to below 50 percent of GDP.

Nepal: Fiscal Deficit

(Including grants; in percent of GDP)

Nepal: Total Debt-to-GDP Ratio

  • Foreign exchange reserves are ample—reserves of the central bank have doubled since 2002 as the deteriorating trade deficit has been more than offset by growing remittances from overseas labor and to a lesser extent donor inflows. Although the rate of accumulation has recently slowed, reserves currently stand at $2 billion, or 6 months of imports.

Nepal: Remittances

(In millions of U.S. dollars)

Nepal: Official Reserves

(In millions of U.S. dollars)
  • The real exchange rate has appreciated by 20 percent over the last three years in large part driven by the decline in the dollar against the Indian rupee. With 70 percent of exports going to India, however, this measure may overstate the impact of the dollar’s decline on Nepal’s export competitiveness.1

Real Effective Exchange Rate

(2000 = 100)

6. The outlook for 2007/08 remains stable. The agricultural recovery, favorable service sector performance, and a significant increase in tourist arrivals could boost real GDP growth to 3½–4 percent in 2007/08. The authorities were somewhat more optimistic, arguing that growth could reach 4½ percent. Anchored by the exchange rate peg, inflation is projected to remain broadly stable around 6½ percent to 7 percent, although higher food prices and any adjustments to the administered prices of fuel could add upward pressure. On the external side, rising oil imports and stagnant exports have led to a further deterioration in the trade deficit, but this will be more than offset by workers’ remittances, which are expected to grow by 20 percent over last year.

7. While the macroeconomic performance has been stable, progress on structural reforms has been held back by the fragile political circumstances. In particular, little progress has been made to address institutional weaknesses in the financial sector and in public financial management.

8. Vulnerabilities in Nepal’s financial sector remain, and could be growing.

  • Loose monetary conditions have led to negative real interest rates, rapid and potentially destabilizing stock market and property price increases, and some capital flight to India seeking higher returns. Credit growth has been high, with aggressive lending by many banks pushing their credit-to-deposit ratios to levels above 100 percent.

Interest Rates on 91-day Treasury Bills

(In percent)
  • Supervisory capability and regulatory compliance remain weak. In recent years the legal framework for supervision has been overhauled, but enforcement within this framework remains a concern—decision making is slow and there has been significant and visible supervisory forbearance. Efforts to collect sizeable overdue loans from willful defaulters have yielded few results. A stricter licensing policy approved in April 2007 has been undermined by the recent proliferation of licenses granted to banking institutions whose applications had been submitted under the old licensing regime.

  • Reforms of the two large public banks have stalled. With World Bank help, progress has been made in placing their lending on a more commercial basis, operations have been restructured and modernized, and losses have been reduced or eliminated. However, the banks are still insolvent and the lack of a clear strategy on how to move forward prevents the gains of reform from becoming permanent.

9. Limited progress has been made in addressing Nepal’s structural weaknesses in tax administration and public financial management. Overall, the accounting, auditing, and reporting of public sector operations are inadequate. The budget coverage is confined to only the central budget with no information on quasi-fiscal activities, internal control procedures are not fully effective, and the management of spending is weak. Specifically:

  • While impressive progress has been made on improving tax administration through the operations of the Large Taxpayer Office, reforms are needed to modernize customs, a significant source of revenue in Nepal.

  • Around one-third of government expenditure takes place outside the budget framework in extrabudgetary funds and autonomous bodies, in part to channel spending by donors lacking trust in the transparency and accountability of the central government budget.

10. Public enterprises, and the Nepal Oil Corporation in particular, pursue quasi-fiscal activities involving significant subsidies. At current crude prices, the oil company is running an annualized deficit of about 1½ percent to 2 percent of GDP. In general the accountability and transparency of public enterprises are weak.

C. Outlook and Risks

11. Nepal’s growth prospects depend most importantly on a peaceful political transition. Steady but low growth could continue in the near term. However, insecurity, violence in the Terai region, input supply disruptions, and structural barriers continue to discourage investment, limit exports, and hamper transition to a higher growth path. With Nepal located between two of the fastest growing economies in the world, an easing of these constraints, steady progress on the political front, and the development of Nepal’s vast untapped hydropower resources could lift growth to levels of 5–5½ percent over the medium term (Table 5).

12. The unsettled political environment poses the most immediate risk to macroeconomic stability and growth. Structural reform progress during the political transition will be slow, and political risks will remain significant, even if the results of the constituent assembly elections are broadly accepted. The demands of the peace process—a sense of entitlement among stakeholder groups, and the call to address the grievances built up over decades, particularly for the underdeveloped and politically underrepresented population of the Terai—could result in pressures for greater public spending. In this environment undertaking needed structural reforms and maintaining budget discipline will be challenging.

II. Policies to Promote External Stability

In the last several years the government’s policies under the PRGF-supported program, in particular fiscal restraint and the peg to the Indian rupee, have been critical in supporting macroeconomic stability and growth despite political turmoil and civil conflict. The authorities agreed that now that the program has expired, relaxing these policies would undermine the prospects for economic recovery at a critical point in the political transition.

A. Maintaining the Favorable Macroeconomic Environment

Fiscal Policy

13. The authorities recognized the critical role that maintaining budget discipline will play in preserving macroeconomic stability. It is essential to support the robustness of the pegged exchange rate regime and maintain Nepal’s debt-to-GDP ratio on a declining path from still high levels.2 Budget discipline is also needed as a safeguard against a slowdown in revenue growth, or if higher unforeseen expenditures become necessary to absorb losses by public enterprises or to address the financial weaknesses of the public banks.

14. Despite the strong revenue performance, Nepal’s budget deficit could rise this year to about 3½ percent of GDP, reflecting in part the one-off costs of the elections and the clearance of most of the Nepal Oil Corporation’s arrears. While these additional costs can be absorbed this year, the authorities agreed that this is not a sustainable fiscal policy position going forward. Excessive reliance on domestic financing could ultimately threaten budget solvency as a growing interest bill generates additional fiscal pressure. For this reason, the authorities aim to limit domestic borrowing in the next budget to a more sustainable level of 1-2 percent of GDP.

15. Further improvement in revenue collection is essential in ensuring the sustainability of the budget. Staff recognize that in planning the next budget, there may be a need to increase spending in some areas to improve the provision of public goods and address the legacy of the civil conflict. Given this, staff urged that the impressive progress achieved by the Large Taxpayer Office with the help of FAD technical assistance be broadened to other areas of revenue administration. On the spending side, the focus should be on allowing needed increases in post-conflict and infrastructure spending, particularly where donor financing is available, while keeping recurrent spending at sustainable levels.

16. The key short-run priority is to limit and eventually eliminate the losses of the state oil company, a frequent and, at times, large drain on the budget. The setting of prices of petroleum products remains highly politicized. As a result, the government’s ability to address the company’s losses through ad hoc price increases has been limited, and the piecemeal approach taken so far has disrupted supplies for extended periods. There is broad agreement within the government that the current situation is not sustainable and the authorities were hopeful that price adjustments could be made as soon as political conditions permit following the elections. The staff argued that a permanent solution is required, with the preferred option being the introduction of an automatic pricing mechanism to bring about a phased convergence in domestic prices to world levels in a depoliticized manner. In the meantime, the staff urged that all the company’s flow losses be covered by the budget in a timely and transparent manner and any lending to the company for this purpose be reflected in public debt.

17. The staff encouraged the authorities to accelerate reforms aimed at increasing accountability, transparency, and credibility of public expenditure. Through Fund and donor technical assistance, a range of measures have been proposed to improve the coverage of financial information and the accounting system which would strengthen the government’s ability to conduct fiscal policy, monitor expenditure, and coordinate donor activity. The authorities agreed on several areas where further technical assistance would be particularly useful, including developing a chart of accounts and laying the groundwork for establishing a treasury single account.

Monetary Policy and the Exchange Rate

18. The exchange rate peg to the Indian rupee has been instrumental in anchoring inflation over the last several years. This arrangement, in place since 1993, has served Nepal well given close and increasing economic integration between the two countries.

19. In assessing whether the current level of Nepal’s peg remains appropriate, analysis must extend beyond the narrow trade balance. The merchandise trade deficit is large and has clearly trended upward over the last several years. However, a major factor driving balance of payments developments is workers’ remittances inflows, which at over $1½ billion are more important than exports as a source of foreign exchange. Since most of these inflows support consumption—a large part of which is imported—the weakening trade balance cannot be separated from growing remittance inflows. Unlike donor flows or other transfers, remittances are transfers that in effect represent an export of labor services. Indeed, the trade balance combined with remittances is much more stable than the merchandise trade balance alone. While the supply and demand factors driving remittances are in many cases different from merchandise exports, excluding remittances and focusing only on the trade balance would be misleading in any analysis of the appropriate level of the exchange rate (Box 1).

Trade Balance and Remittances

(In percent of GDP)

20. Taking the balance of payments as a whole, the current level of the exchange rate appears broadly consistent with its equilibrium level. The overall external balance has been and remains in surplus, with the trade deficit largely offset by remittance inflows. Remittances are likely to persist, and will continue to provide a large sustainable source of inflows to the balance of payments. In terms of the underlying savings-investment balance, a country at Nepal’s level of development should be running a modest current account deficit financed by official grants and loans, which it is at present.3 Under these circumstances, attempts to offset the recent real appreciation through a step devaluation are unlikely to be effective, and could be quickly eroded by a period of higher inflation both from direct pass-through effects and indirectly as inflows enter the economy adding to already high domestic liquidity.

Box 1.The Role of Remittances in Nepal’s Balance of Payments

Nepal’s persistent balance of payments surplus is a key factor in assessing whether the exchange rate is near equilibrium. The balance of payments has been in surplus for the last decade, with an annual reserve accumulation of around $150 million over the last five years. This surplus continues despite the deteriorating trade balance, primarily owing to Nepal’s unique role as a major exporter of labor services. Remittances from workers’ earnings abroad have been a dominant flow of foreign exchange, with annual flows now exceeding 15 percent of GDP.

Balance of Payments Flows

(US$ million average 2002-07)

Remittances are an integral part of the Nepalese economy, driven by a number of relatively durable supply and demand factors. On the supply side, persistent violence in the Terai region has suppressed employment opportunities, driving workers to seek labor income abroad—migration across the relatively porous border with India has been longstanding, with about one million Nepalese currently estimated to be working there. Increasingly however, demand for Nepalese workers is being fueled by large infrastructure programs in oil-rich Persian Gulf states, as well as in several Asian countries. These workers tend to earn significantly higher wages than in India.

Remittances

(Rolling 12 months; percent of GDP)

Remittances have played a major role in boosting Nepal’s imports. Although higher world oil prices have contributed somewhat, the main factor behind rapid import growth in recent years has been higher consumption as remittances raise disposable income and demand for durable goods.

At the same time exports have experienced a number of shocks. While exports to India have overall been stable (and account for about 70 percent of total exports), the growth rate of exports to other destinations has fallen. Driving this has been the decline in the textiles industry, the main Nepalese export to countries other than India. This industry has faced persistent unrest in the Terai, electricity supply shortages, poor labor relations, campaigns against child labor, and the expiration of the multi-fiber agreement in 2005.

On balance, however, growth in remittances has consistently produced balance of payments surpluses. Nepalese workers finding employment abroad has been a fortunate development given the problems facing the domestic economy—indeed, the World Bank estimates that remittances have been the main factor behind Nepal’s declining poverty rate over the last decade. But employment abroad is also likely to have significant social costs, and is not contributing to Nepal’s long-term development. Bringing production to within Nepal’s borders will require establishing political stability, reducing civil unrest, and resolving the country’s structural problems.

21. Regarding the exchange rate regime, maintaining the peg to the Indian rupee would continue to be appropriate for Nepal’s macroeconomic stability and development in the near term.

  • There are obvious advantages of the pegged regime. It provides a highly credible and simple nominal anchor by importing macroeconomic policy discipline from India, particularly important in a country like Nepal with limited central bank independence and weak institutions. Pegging to the Indian rupee is the natural choice given the extensive and growing commercial ties with India, keeping business uncertainty and transactions costs low and promoting integration with one of the world’s fastest growing economies.

  • At the same time, the advantages of a floating regime are fairly limited in Nepal at present. While it gives some monetary policy autonomy and flexibility in responding to external shocks, a successful floating rate regime has extensive institutional and operational requirements. The NRB is a long way from having the independence and discipline to conduct policy using an alternative anchor and successfully keep inflation low. The process of building the NRB’s credibility would be very costly in the current economic circumstances, and without a very strong political mandate, would not succeed.

22. While the regime remains appropriate at present, maintaining the peg could present some challenges over time if productivity in India continues to grow more rapidly than in Nepal. The peg would provide clear benefits in terms of fostering integration with a rapidly growing economy, but it would also require domestic factor markets to be sufficiently flexible to allow the real exchange rate to adjust at a different pace than India. Until now this has largely been the case, particularly through labor mobility, but going forward the productivity differential is expected to grow. In these circumstances, other more flexible regimes, including a basket peg, could help smooth domestic adjustment to a possible further appreciation of the Indian rupee.

23. Staff discussed these challenges with the authorities. The authorities agreed with the staff’s assessment of the implications of higher productivity growth in India, but underscored that they are currently not considering any alternatives to the existing pegged arrangement, arguing that any marginal benefits of a move away from the peg were outweighed by the costs of a regime change in the prevailing political and economic environment. Moreover, they maintained that the simplicity, predictability, and transparency of the current peg will continue to be a critical anchor for the economy in the period ahead, and feared that a move to a basket-like arrangement would add uncertainty and fuel speculation. They emphasized that the current regime, by allowing for changes in the parity when needed, would be robust to future external shocks. Staff agreed with the authorities’ assessment that although the regime could face challenges in the future, now would not be the right time to change the rate or the regime.

24. The staff argued that there is a clear need to tighten monetary conditions. A relatively passive monetary policy has allowed foreseeable exogenous events, such as changes in government spending, to lead to potentially disruptive swings in liquidity conditions, with an overall bias toward excess liquidity and negative real interest rates. Loose monetary conditions have fueled a credit and asset price boom, and some capital flight. The staff encouraged the authorities to take an active role in reaching and maintaining a tighter monetary policy. Better liquidity management and forecasting is needed, and will require foremost a separation of the formulation and execution of monetary policy from public debt management. The staff argued that the temporary credit squeeze in January underscored this need, and illustrated how the highly uneven distribution of liquidity among banks could undermine monetary policy, particularly with a relatively shallow interbank credit market. The authorities agreed in principle that monetary conditions could be tightened, and the NRB has the tools to do so, including through the increased use of open market operations.

B. Strengthening the Financial Sector

25. Nepal’s fast growing financial sector presents a challenge to financial stability in the near term and beyond. Some of the growth in the banking sector is expected and reflects a natural deepening of the financial system in Nepal. However, the rapid proliferation of financial institutions and credit growth has coincided with a sharp rise in stock market and property prices, and adds to the already large regulatory burden of the NRB (Box 2).

26. To address this, staff urged the authorities to give renewed impetus to recent efforts to strengthen supervision and regulatory enforcement. Much depends on the enforcement efforts backing the Banking and Financial Institutions Act once this Act is approved by parliament, which in principle should improve the legal framework for supervision and bank consolidation. High and rising credit-to-deposit ratios, weak loan classification standards, and poor asset quality at some banks call for greater vigilance on the part of supervisors. Staff urged action against those private banks which continue to operate despite violating capital adequacy requirements to prevent them from undermining the credibility of the regulatory framework. Staff also stressed that particular attention should be paid to compliance with single-borrower limits, and to assessing and monitoring the financial sector’s indirect exposure to the property and stock markets. In this regard, the staff welcomed the recent NRB directive to restrict margin lending by banking institutions using stocks as collateral. The application of the stricter licensing requirements approved in April 2007, in particular the “fit and proper” test, will be a signal of the authorities’ willingness to enforce the new regime going forward. The mission noted the NRB’s progress in moving toward risk-based supervision and implementing Basel II beginning July 2008, and encouraged further efforts to this end.

Box 2.The State of Nepal’s Financial Sector

Nepal’s financial system is underdeveloped but sizeable relative to countries in the region. The total assets of the banking system to GDP stood at 81 percent in July 2007.1 Public banks account for about one third of banking sector assets. The Nepal stock market has historically played only a marginal role, although the doubling of the stock price index between end 2006 and 2007 has increased market capitalization (90 percent of which is accounted for by banking institutions).

Banking and Stock Market Assets

(In percent of GDP)

The banking sector is characterized by a large and growing number of deposit-taking institutions. The numbers of licensed commercial banks increased from 17 to 23 in the last three years. There has also been a rapid proliferation of the number of deposit-taking nonbank financial institutions, nearly doubling in 2007 to 139 institutions.

The increase in institutions has been accompanied by rapid credit growth, currently around 25 percent. Lending by private commercial banks is particularly rapid at 36 percent, corresponding to a decline in lending growth by the two main state-owned commercial banks. While some of the lending growth reflects a natural deepening of the financial system, loose monetary conditions, competitive pressures, and intermediation of worker remittances to housing and consumer credit have also played a role. While the overall NPL ratio has been declining, this is a lagging indicator of asset quality, and the impact of the recent increase in lending growth on the health of banks’ balance sheets is not yet known. High exposure to single borrowers remains a concern.

Credit growth is increasingly driven by the aggressive lending behavior of many smaller banking institutions. System-wide, the average credit-to-deposit (CD) ratio for the banking system has increased from 60 percent over 2000–2006 to 78 percent by end-2007. Nearly 25 percent of banking assets are now held by smaller private banks with CD ratios exceeding 90 percent—very high by international standards. Although system-wide liquidity is adequate, the shallowness of the interbank market prevents a redistribution of liquidity to highly leveraged banks when shortages occur, forcing the NRB to inject liquidity through its standing liquidity facility and complicating monetary policy management.

Distribution of Assets of Commercial Banks by Credit-to-Deposit Ratios

While banks’ direct exposure to the real estate and stock market is modest, the indirect exposure could be quite large. Nearly 60 percent of bank loans are secured by real estate assets, making banks vulnerable to a sharp drop in real estate prices. In contrast to international practice, Nepalese banks can lend against stocks as collateral. While this lending remains small (about 3 percent of the loan portfolio of banks), its recent growth, likely backing additional stock purchases, is regarded as a key factor behind the recent stock market boom.

1The banking sector includes commercial banks, which account for 84 percent of total financial assets, development banks, and deposit-taking financial institutions.

27. In addition, staff encouraged the authorities to adopt a clear strategy for completing the process of commercializing the two large public banks. Although most of the politically-motivated lending appears, for the moment, to have been limited under new management teams, a strategy is needed for bringing these banks to solvency and ensuring that they will operate on a commercial basis going forward. The authorities agreed with this assessment, but observed that there is currently no political consensus on how to resolve these banks, either through privatization or other methods. They hoped a new effort to address these issues would emerge sometime after the April elections.

28. Finally, staff expressed concern that lack of progress on debt collection could be seen as signaling a lack of will to enforce existing regulations. While the debts of the willful defaulters do not represent a systemic risk, staff urged ongoing government action, including through the Debt Recovery Tribunal, to shore up the credibility of the regulatory regime.

III. Staff Appraisal

29. Over the past several years Nepal has maintained moderate inflation and budget discipline. Although output growth has been low, the preservation of macroeconomic stability despite the civil conflict and major political upheavals is a remarkable achievement for which the government deserves much credit.

30. Nepal is now at a critical juncture, and continued stability is a key condition for allowing the political transformation currently taking place to result in higher, broad-based economic growth. In addition to addressing structural impediments such as poor infrastructure and input supply disruptions, a prerequisite for higher growth will be maintaining budget discipline and ensuring the soundness of the banking sector during the challenging period ahead.

31. Maintaining budget discipline is a necessary condition for preserving macroeconomic stability. In balancing the need to increase spending in some areas to improve the provision of public goods and address the legacy of the civil conflict while maintaining domestic borrowing at sustainable levels, further improvement in revenue collection will remain a priority.

32. A key short-run priority is to limit and eventually eliminate the losses of the Nepal Oil Corporation. The introduction of an automatic pricing mechanism for petroleum products to ensure the depoliticization of pricing is the preferred permanent solution. Going forward, all the company’s flow losses should be covered by the budget in a transparent manner.

33. Nepal’s peg to the Indian rupee has served the country well, and maintaining this arrangement would continue to be appropriate in the near term for Nepal’s macroeconomic stability and development. With the overall balance in surplus and the reserve position strong and stable, there appears to be little sign of misalignment at present. The peg provides a highly credible, simple, and predictable nominal anchor, and is a natural choice given the extensive commercial ties with India. While a widening productivity gap with India could present some challenges over time for exchange rate management, now would not be the right time to consider changing the rate or the regime.

34. The authorities should take a more active role in reaching and maintaining a tighter monetary policy, as an overall bias toward excess liquidity has led to negative real interest rates, rapid credit growth, potentially destabilizing asset price increases, and some capital flight. Better liquidity management and forecasting is needed, and will require separation of the formulation and execution of monetary policy from public debt management.

35. Renewed impetus should be given to strengthening supervision and regulatory enforcement to maintain financial stability in the face of rapid banking sector growth. Parliament approval of the Banking and Financial Institutions Act should further strengthen the regulatory framework, but significant improvements are needed in enforcement. The application of the stricter licensing requirements will be an important signal of the authorities’ willingness to tighten enforcement going forward.

36. A clear strategy is needed for completing the process of commercializing the two large public banks. Although progress has been made under new management teams in restructuring these banks, a strategy is needed for bringing them to solvency and ensuring that they will be operated on a commercial basis going forward.

37. It is recommended that the next Article IV consultation take place on the 12-month cycle.

Nepal: Selected Economic Indicators, 2003/04–2007/08 1/
2003/042004/052005/062006/072007/08
Est.Proj.
(Percent change)
Output and prices
Real GDP at market prices4.73.12.82.53.8
CPI (period average)4.04.58.06.46.5
Fiscal indicators(In percent of GDP)
Total revenue11.311.710.912.013.5
Total expenditure14.314.914.715.719.7
Current expenditure10.310.510.410.613.4
Capital expenditure and net lending4.04.44.35.16.4
Overall deficit after grants0.90.81.61.43.6
Money and credit(Percent change, end-of-period)
Broad money12.88.315.414.018.0
Domestic credit9.813.916.312.020.3
Balance of payments(In millions of U.S. dollars)
Current account balance (excluding official transfers)59-1953-146-156
In percent of GDP0.8-0.20.6-1.4-1.3
Exports, f.o.b.748832850892954
Imports, f.o.b.18012022237226533028
Gross official reserves (end-of-period)1,4571,5011,7972,0082,027
External debt/GDP (in percent) 2/46.139.939.132.631.4
Exchange rate (Nrs./U.S. dollar, end-of-period)74.570.774.465.2
Sources: Data provided by the Nepalese authorities; and Fund staff estimates and projections.

Fiscal year begins mid-July.

Includes estimated short-term trade credits.

Sources: Data provided by the Nepalese authorities; and Fund staff estimates and projections.

Fiscal year begins mid-July.

Includes estimated short-term trade credits.

The measured real effective exchange rate uses trade weights which understate the current share of Nepal’s trade with India.

The debt dynamics in the revised DSA are broadly consistent with those of the previous assessment in 2007 (Appendix I, Country Report No. 07/204). At the same time the initial net present value of debt has fallen slightly with the appreciation of the Nepalese rupee and lower-than-projected loan disbursements in the interim. In view of the improved debt indicators, Nepal’s external debt dynamics are now technically assessed to be subject to a moderate risk of debt distress. This is a change from the previous DSA which classified Nepal as at high risk of debt distress.

For a country like Nepal, assessing an “equilibrium” exchange rate presents considerable challenges. Data quality is poor, the political and security situation is evolving rapidly, and donor flows are uneven. The unusually important role of remittances complicates comparisons with other countries. In these circumstances, and as in many low-income countries, a more mechanical econometric approach would yield little information about the appropriate level of the exchange rate level.

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