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Statement by Perry Warjiyo, Executive Director for Nepal and Sushil Mathema, Senior Advisor to Executive Director May 16, 2008

Author(s):
International Monetary Fund
Published Date:
June 2008
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1. On behalf of the Nepalese authorities, we wish to express our sincere gratitude and appreciation to Mr. Brian Aitken and his able team for the fruitful dialogue during the Article IV Consultation held in Kathmandu on March 1-14, 2008. The authorities also find the staff reports a fair and balanced reflection of the discussions and are in broad agreement with the thrust of staff’s appraisal.

2. The macroeconomic performance of Nepalese economy since the fifth and final review of the three-year PRGF-supported program on November 9, 2007 has remained stable. The growth momentum has been maintained with considerable level of both internal and external stability. Going forward, with an election internationally acknowledged as free and fair on April 10, 2008, Nepal has now entered into a new phase of peace and democracy, which is expected to result in greater macroeconomic stability and strengthen growth prospects. The continuation of the Fund program will further cement the success of these challenging political and economic transitions.

Recent Political Developments

3. On April 10, 2008, Nepal successfully held the Constituent Assembly (CA) election. The historic People’s Movement of April 2006 ended the decade-long civil conflict. The CA election was a part of comprehensive peace agreement (CPA) reached among the seven-party alliance (SPA), in which the Maoist party has emerged as the largest party in the CA, with a simple majority. With this, one phase of political transition in Nepal has ended and the second phase has begun.

4. The CA elections have paved the way for the drafting of a new constitution. The political parties are making concerted efforts to reach an understanding to form a new government. It will take place following the first meeting of CA, slated within 21 days of the final announcement of the CA election results. The political parties have expressed their commitment to peace process and stressed the need for political consensus going forward. Furthermore, they are united in stressing the need for accelerating economic growth through improving the investment climate and initiating the necessary reforms.

Macroeconomic Developments

5. Despite the difficult political situation, Nepal managed to maintain stable macroeconomic conditions. Under the PRGF-supported program, annual economic growth averaged 3.4 percent. The growth in real GDP decelerated somewhat to 2.5 percent in 2006/07 compared to 2.8 percent in 2005/06. The slowdown was largely on account of adverse weather conditions, though a number of impediments relating to the political transition also constrained the growth.

6. The fiscal discipline, prudent monetary policy and, on top of that, the exchange rate peg helped to keep inflation at a moderate level. Consumer price-based inflation remained at a moderate level of 5.5 percent on average during the last five years. Inflation rates accelerated to 8 percent in 2005/06 and 6.4 percent in 2006/07 on account of the rise in energy prices and food prices.

7. Nepal’s overall balance of payments (BOP) remained in surplus. The performance of merchandise exports has been less than satisfactory, mainly due to the removal of the multi-fiber agreement in 2005, poor labor relations, electricity shortages and infrastructure bottlenecks. The main driving factor behind the surplus was the elevated level of workers’ remittances. In recent months, the growth in remittances accelerated further. As a result, Nepal’s international reserves remained at the comfortable level. As of mid-March 2008, the accumulation of official international reserves stood at US$ 2.2 billion, sufficient to cover 7.1 months’ imports of goods and services.

Macroeconomic Outlook

8. Going forward, the authorities expect a higher rate of economic growth in 2007/08 and beyond. They believe the growth will be on the upper end of the staff’s projection of 3.5–4 percent in 2007/08 compared to a growth of 2.5 percent in 2006/07. Notwithstanding weaker performance of merchandise exports and in the manufacturing sector, a satisfactory rate of growth in agriculture, an encouraging increase in tourist arrivals and some improvements in services sector underpin the growth outlook for 2007/08. Improvements in the investment climate and a continuation of structural reforms are expected to pave the way for more robust economic performance over the medium term.

9. Although risks to the inflation outlook exist, the authorities expect inflation to stabilize at around 7 percent in 2007/08. As in other countries, inflationary pressures emanate from higher energy, commodities and food prices. Of these, the greatest impact on headline inflation is likely to be the result of an overdue adjustment in oil prices. The authorities also note that the exchange rate peg plays a crucial role in anchoring prices in Nepal.

10. On the external front, the trade deficit is expected to widen with the higher growth of merchandise imports relative to exports. However, workers’ remittances are expected to sustain the recent growth of 28 percent. This is likely to more than offset the trade deficit, leading to a modest surplus in the BOP.

Fiscal Policy

11. The Nepalese authorities continue to adopt fiscal discipline as they have shown during the PRGF program period. The net fiscal deficit remained at a lower level of 1.4 percent of GDP in 2006/07, on account of a pick up in revenue growth and a controlled expansion in government spending. The net domestic financing of budget deficit was lower at 0.9 percent of GDP in 2006/07. The government finance data as of May 2, 2008 showed a significant amount of cumulative cash balances maintained by the government with the NRB. As the revenue is showing an encouraging growth of 25.3 percent, the government’s domestic borrowing is expected to remain within the budgeted limit, ensuring macroeconomic stability.

12. Going forward, the authorities concur with the staff that maintaining fiscal discipline is likely to be a key policy issue in the face of rising public expectations. The threat to fiscal imbalance may arise from the growing public aspirations and the increasing demand for public expenditure on rehabilitation, relief measures and reconstruction of infrastructures. The significant risk to the fiscal accounts also comes from the persistent losses from Nepal Oil Corporation (NOC). The authorities had made an attempt to recoup the losses in recently by adjusting in oil prices upwards. However, the proposed increase was aborted in the face of strong public protest. In the current fiscal year alone, the government extended loans of 4 billion rupees to NOC to help maintain the domestic supply of petroleum products. The reform in oil sector remains a key policy challenge.

Monetary and Exchange Rate Policy

13. The Nepalese authorities concur with staff’s assessment that the level of Nepalese real exchange rate is in line with fundamentals, thus supporting the external stability. In particular, given the specific nature of Nepalese workers abroad, they note that it is paramount to take into account the worker remittances in judging the current account norm for assessing the real exchange rate. The public debt-to-GDP ratio has also dropped significantly in recent years, contributing further to external stability. The ratio declined from 61.7 percent in 2002/03 to 43.9 percent in 2006/07. Likewise, total foreign debt has fallen from 45.4 percent of GDP in 2002/03 to 30.1 percent in 2006/07. As pointed out in the staff report, limited foreign borrowing and the nominal appreciation of Nepalese rupee against the U.S. dollar contributed to a significant drop in the public debt.

14. The authorities believe that the exchange rate peg has been an anchor that has contributed significantly in sustaining macroeconomic stability in Nepal. With the continued appreciation of Indian Currency (IC) vis-à-vis U.S. dollar, the nominal appreciation of Nepalese currency (NC) against US dollar has attracted public attention over the past year. The authorities have taken note of the staff’s views in the selected issue paper that this is not the appropriate time to change the level and the regime of exchange rate. They are also of the view that risks to macroeconomic stability outweigh any potential benefits from a regime change.

15. With the exchange rate peg, the authorities concur with the staff on the need to maintain monetary policy discipline. Nonetheless, they would like to make a number of points with regard to staff’s analysis. It is true that monetary growth has been in excess of what was initially projected. With the establishment of new banks, commercial banks in Nepal have expanded their activities in a more competitive environment. As some these commercial banks were recently established, there is an uneven distribution of liquidity. Given the political transition and fragile financial situation, a cautious monetary policy stance has been put in place. As stated in the staff report, the NRB intervened in the case of margin lending for investment in share market by the financial institutions. On January 22, 2008, the NRB issued a directive to banks and financial institutions to manage margin lending in an effective manner, which has ensured an orderly development in the stock market. The current thrust of monetary policy has also been to facilitate the orderly development of the financial sector.

16. The NRB is also focusing on open market operations to manage the liquidity of the system. Open market instruments such as outright sale auctions, outright purchase auctions, repo auctions and reverse repo auctions are being used for this purpose. The liquidity monitoring and forecasting framework (LMFF) based on the weekly balance sheet of the NRB is employed to guide the open market operations. Besides this, the authorities are monitoring the banking sector liquidity on a daily basis and necessary interventions are being made accordingly. The authorities are committed to take appropriate policy actions to modulate the liquidity.

Structural Reforms

17. Our authorities are also of the view that continuation of structural reforms and maintaining financial sector stability are the keys in accelerating economic growth and thereby in helping alleviate poverty. A number of structural reforms relating to government finances, public enterprises and the financial sector were introduced during the recently-concluded PRGF program period. The establishment of a large tax office (LTO), wide area network (WAN) between headquarters and regional customs offices and expansion of the ASYCUDA system are some examples of fiscal sector reforms. In addition, a new custom act was enacted in September 2007, which includes a variety of broader reforms such as the implementation of an improved valuation system according to GATT principles, provision and permission for offsite declaration and clearance, declaration before the arrival of goods, provision of import return on re-export, special provision for Special Economic Zone (SEZ), post clearance audit, and risk-based audit.

18. The authorities have made a number of commendable efforts to increase fiscal transparency and accountability in the program period. The major steps taken by the government to improve transparency were the creation of CIAA (Commission for Investigation of Abuse of Authority), a National Vigilance Centre (NVC) to enforce accountability of politicians and bureaucrats, published guidance material for tax payers and organized public hearings in the tax and customs administrations, reclassification of expenditures into recurrent and capital, formulation and implementation of budget in line with MTEF, the publication of annual and mid-term review of the budget and the publication of financial performance of public enterprises.

19. The authorities have also taken a number of measures aimed at maintaining financial sector stability in the face of the growth in the number of banks and financial institutions in recent years. The NRB doubled the minimum paid-up capital required for the establishment of new banks and financial institutions in April 2007. Similarly, a number of measures relating to fit and proper test for promoters, board of directors and chief executive officers of banks and financial institutions have been issued. With a view to remove distortions created by the system of cross-lending of shares by the financial institutions, the NRB has issued a directive asking all the banks and financial institutions to divest promoter shares in other banks and financial institutions by mid-July 2008. As a measure to enforce regulatory capital, the NRB has issued recently a directive relating to prompt corrective actions to be effective from October 16, 2008. The Cabinet has already approved a revised draft of the Banks and Financial Institutions Act (BAFIA), incorporating 25 core principles of bank supervision, clear guidelines for mergers and acquisitions, and procedures for voluntary and involuntary liquidation. As a step forward to move to a Basel II framework by July 2008, the NRB has announced the parallel implementation of Basel II for the current fiscal year, and a trial reporting under the new system has been initiated.

20. On bank restructuring, the authorities have resorted to operational and financial restructuring the two largest public banks under a World Bank FSRP. During the five-year restructuring period in both banks, substantial progress has been achieved. The banks have registered operational profits, a significant proportion of the NPAs have been reduced and 80 percent of the banks’ operations are now computerized and incorporate a more modern approach. The authorities are of the opinion that the restructuring process should be continued further for an additional three years at the minimum, and that this process will be carried out by local professional bankers under the control of the NRB with concurrence from the World Bank.

21. In an effort to stem the losses of the NOC, the authorities made upward revisions in the price of petroleum products twice in the year. In the wake of the continuous rise in global oil prices, the authorities feel that the adjustment is still inadequate. Given that the country is passing through a political transition and the issue of energy price is politically sensitive, the authorities are considering a different approaches that allows gradual but steady price adjustments be made by introducing an automatic pricing mechanism, and will seek the private sector’s participation both in the importation and distribution of oil.

Conclusion

22. Nepal’s macroeconomic performance remains stable. The authorities acknowledge the important role played by the recently-concluded PRGF program in maintaining macroeconomic stability even under difficult political conditions. They are committed to safeguarding macroeconomic stability. As Nepal is in a critical juncture in its history, our authorities continue to solicit the support from the donor community to take the country forward to the path of sustainable peace and stable economic growth. A successor to the PRGF program would play another key role in anchoring the overall macroeconomic policy going forward. The authorities would like to thank the Executive Board and staff for their continued support and constructive advice.

23. Finally, we are pleased to inform the Board that the Nepalese authorities have consented to the publication of the staff report.

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