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Nepal

Author(s):
International Monetary Fund
Published Date:
December 2012
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Context

1. Nepal is a post-conflict state seeking to formalize democracy in a challenging environment. Significant headway toward a new state has been made since the 2006 peace accord. Progress on a range of technical issues (including public financial management, monetary policy, and financial sector supervision) has also been achieved. However, the failure of the constituent assembly to meet an end-May 2012 deadline to ratify a new constitution is a serious setback, and a major impediment to macroeconomic management and prospects for growth. The subsequent dismissal of the constituent assembly in June 2012 has left day-to-day operations in the hands of a caretaker government. New elections are notionally slated for April 2013, but will require fractured political parties to agree on an interim consensus government. In the meantime, key articles of legislation (such as the government budget) have been delayed. More broadly, the lack of a consensus government and functioning parliament appear to be dampening investment (foreign and domestic), keeping potential donor support at bay, and undermining prospects for sensitive financial sector and state enterprise reforms.

2. The political transition and a gradual approach to reform in some areas appear to have come at some macroeconomic cost. Real GDP growth has slowed from an average of 5 percent over 1990–2000 to around 4 percent over 2001–2012. Concurrently, the share of industry in GDP has fallen by nearly 5 percentage points—with most of the decline in the manufacturing sector. In the meantime, services have grown, and now account for nearly 50 percent of total real GDP, with the remainder in agriculture. Progress has been made on the Millennium Development Goals (MDGs), but an important adjunct to reform efforts in social services has been the rise in inward remittances—which has also fueled some of the growth in the services sector. While there are some benefits from emigration and remittances (knowledge transfer and higher household incomes) the scale of remittances—doubling since 2001 to almost one-quarter of GDP—also represents a source of vulnerability in times of external shocks.

Sectoral Share of GDP

(Average, in percent)

Political Risk and Average Growth 1/

Sources: IMF, World Economic Outlook; and World Bank, Worldwide Governance Indicators.

1/ Political risk represents the political stability and absence of violence/terrorism ranking from the Worldwide Governance Indicators database. SAARC is calculated as a simple average of data in South Asian Association for Regional Cooperation member countries.

Recent Developments and Outlook

3. Growth accelerated while average inflation declined. Real GDP growth rose to 4.6 percent in 2011/12 compared with 3.9 percent in 2010/11. A timely monsoon boosted agricultural output, while the services sector benefitted from robust growth in remittances. Industrial sector performance remained lackluster, however, largely reflecting a sharp drop in construction activity following the sharp drop in real estate prices. Average inflation declined to 8.3 percent, due largely to lower food prices. However, non-food and core inflation remained persistently high throughout the year—hovering around 9 percent on average. Rising non-food prices appear to have been driven by multiple increases in administered fuel prices, exchange-rate depreciation, and rising wages and salaries.

4. The overall budget deficit was less than expected. Revenue gains were notable, particularly in the second half of the year as tax administration reforms bore fruit. Customs, VAT, and income tax all exceeded budget targets. An early surge in current spending was contained through austerity measures, while capital spending continued to underperform the budgeted level due to capacity constraints.1 Disbursement of foreign aid was similarly lower than budgeted, mirroring the performance of recent years and reflecting lower-than-anticipated implementation of capital projects. Finally, while the official fiscal deficit was modest, quasi-fiscal liabilities continued to rise through ongoing financial losses at the Nepal Electricity Authority (NEA) and the Nepal Oil Corporation (NOC) 2—the latter financed by borrowing from public pension schemes.3

Nepal Oil Corporation: Financial Losses and Price Adjustments
Fuel productsLPGDieselKerosenePetroATF
Contribution to losses in 2011/12 (%)45740-1-18
Price increases in 2011/12 (%)837371819
Price adjustment needed for cost recovery as of August 2012 (%)207
Source: NOC and staff estimates.
Source: NOC and staff estimates.

Inflation

(Year-on-year percent change)

Sectoral Contribution to Growth

(in percent)

Remittances

(In percent of GDP)

Competitiveness

5. The balance of payments ended the fiscal year with a record surplus. The trade balance remained flat as a share of GDP in 2011/12, reflecting modest export growth and weaker-than expected imports (possibly tied to the slowdown in the construction sector and lower demand for imported building supplies). Remittances were unexpectedly strong—rising by nearly 25 percent year-on-year to a level equivalent to about 23 percent of GDP. As a result, the external current account shifted to a sizeable surplus—facilitating an increase in Nepal Rastra Bank (NRB) foreign exchange reserves to $4.3 billion (6.8 months of imports). The real effective exchange rate depreciated by 4.6 percent, in line with the decline of the Indian rupee (Box 1).

Box 1.Exchange Rate Assessment and Competitiveness

Recent depreciation of the Nepali rupee (NR) may have contributed to lower import growth in 2011/12 and a current account surplus of 4.7 percent of GDP. However, a sharp decline in construction and low execution of government infrastructure projects may be more important factors. Exports remained subdued and market share in India, the main trade partner, continued to decline. The medium term current account balance is projected to remain in deficit.

Nepal: Estimated Exchange Rate Misalignment(in percent)
Misalignment
(+ is overval.)
MB approach 19.1
ES approach under alternative benchmarks (mean) 211.6
Stabilize NFL-to-GDP at 3.4 percent2.0
Stabilize ext. debt-to-GDP at 24.1 percent17.1
Stabilize ext. debt-to-GDP at 26.9 percent15.6
PPP approach16.3

The current account norm underpinning the derived misalignment is an average estimate from pooled and fixed-effect models in CGER.

The benchmarks of 3.4, 24.1, and 26.9 represent end-2011 ratios to GDP of Nepal’s NFL, its ext. debt, and average ext. debt of LICs.

The current account norm underpinning the derived misalignment is an average estimate from pooled and fixed-effect models in CGER.

The benchmarks of 3.4, 24.1, and 26.9 represent end-2011 ratios to GDP of Nepal’s NFL, its ext. debt, and average ext. debt of LICs.

Application of select methodologies suggests the NR is modestly overvalued, albeit less than last year’s assessment. The macroeconomic balance (MB) approach suggests an overvaluation of 9 percent (compared to 14 percent in the previous assessment), and the external sustainability (ES) approach shows an overvaluation of around 11 percent (compared to a previous assessment of 20 percent), largely due to the smaller projected current account deficit in the medium term.4The PPP approach shows a decline in overvaluation from 19 to 16 percent—with due caveats on the difficulty in estimating equilibrium PPP rates.

Nepal REER and Export Share in India’s Imports

Sources: IMF INS and Direction of Trade Statistics (DOTS) database.

Overvaluation resonates with Nepal’s small export base and large trade gap. On the other hand, the NRB has accumulated reserves of six months of import cover, the balance of payments is in record surplus, and interventions to support the peg are few.

Global Competitiveness Scores

(Higher scores show greater competitiveness)

Source: Global Competitiveness Report 2011-12

6. Monetary policy was largely passive in 2011/12, signaling support for balance sheets and private credit. The influx of remittances was only partly sterilized, and the growth in net foreign assets contributed to reserve and broad money growth of 36.4 and 22.7 percent, respectively—well above nominal GDP growth of 14 percent. Excess reserves (held as non-remunerated deposits at the NRB) climbed, and interest rate spreads vis-à-vis India widened considerably. Despite ample liquidity, bank credit was weak, reflecting elevated balance sheet risks following the sharp decline in real estate prices and weak demand.

Monetary Aggregates

(Year-on-year percent change)

Central Bank Balance Sheet

(In percent)

Interbank Rates

(In percent)

Liquidity Operations of NRB

(In billions of NR)

1/ In percent of total deposits of commercial banks; based on staff estimates (for period prior to June 2011), and NRB data on excess reserves.

7. Strong inward remittances provided breathing space for the financial sector in 2011/12, but many of the underlying balance sheet weaknesses highlighted in the 2011 Article IV remain. Following a sharp liquidity squeeze in 2010/11, a surge in remittances boosted domestic deposits and allowed banks to simultaneously unwind liquidity loans from the NRB and boost interest earnings through a wider deposit/loan spreads. Reported data suggest some improvement in financial sector indicators5. However, doubts remain about the quality of this data and balance sheet risks6. The system-wide capital adequacy ratio (CAR) is reported above the regulatory minimum, and rising. Reported NPLs are low and falling. Abundant liquidity lowered banks’ funding costs, allowing for some recovery in interest-based profits. However, the level of profitability remains low overall, reflecting weak credit growth and a prolonged slump in the real estate market. Given the magnitude of the real estate decline, a higher NPL ratio might have been expected, raising some doubts as to reported data.

Nepal Banking Sector Indicators: NPLs

(In percent)

Nepal Banking Sector Indicators: Profitability 1/

(In percent)

1/ Excluding state-owned Nepal Bank Limited (NBL) and Rastriya Banijya Bank (RBB).

Number of Banks in Nepal

Stock Market Performance

(07/17/2007=100)

8. The outlook for 2012/13 is challenging. Growth is projected to decline to 3.8 percent for 2012/13. A weaker monsoon may lower agricultural production, while continued political uncertainty, a delayed budget, and potentially weak private sector credit will likely inhibit both investment and consumption. Externally, outflows of migrant workers appear to have peaked. Combined with a softening global outlook, this suggests that remittance growth will slow, and in turn dampen some service sector activities and reduce the current account surplus in the coming year.7 India’s slowdown—which increasingly appears to be a medium-term phenomenon driven by declining domestic investment—will negatively impact Nepal via lower export demand, weaker inward investment, and possibly through the remittances channel. Inflation is also projected to rise, in line with developments in India in the coming months.

9. Medium-term prospects hinge on reaching a political consensus that would serve as a base for reform and facilitate higher levels of confidence and investment. Nepal has significant potential in services, hydroelectric power generation, and basic manufacturing, but a stable policy regime backed by sound macroeconomic policies and continued reforms to the investment environment are needed. Current macroeconomic projections (Tables 14) are based on the status quo—incorporating only modest improvements to growth and investment.

Table 1.Nepal: Selected Economic Indicators, 1 2009/10-2016/17
2009/102010/112011/122012/132013/142014/152015/162016/17
Est.Proj.
Output and prices (annual percent change)
Real GDP4.83.94.63.83.93.94.04.0
CPI (period average)9.59.68.38.38.17.96.96.1
CPI (end of period)9.09.711.58.27.77.26.75.5
Non-food CPI (end of period)7.47.611.2
Fiscal Indicators (in percent of GDP)
Total revenue and grants18.017.718.318.117.917.918.118.5
Expenditure18.818.618.218.618.618.819.019.3
Expenses15.615.215.115.715.315.515.715.8
Net acquisition of Nonfinancial Assets3.23.43.12.93.33.33.33.5
Net lending/borrowing-0.8-1.00.1-0.5-0.7-0.9-0.9-0.8
Net acquisition of Financial Assets1.01.01.51.61.61.71.71.7
Net Incurrence of Liabilities1.82.01.42.12.32.52.52.5
Foreign0.0-0.3-0.1-0.20.00.20.20.2
Domestic (above the line)1.72.31.42.32.32.32.32.3
Money and credit (annual percent change)
Broad money14.112.322.712.5
Domestic credit16.814.68.014.4
Private sector credit14.213.911.313.0
Velocity1.51.51.41.4
Investment and saving (in percent of nominal GDP)
Gross investment37.132.532.832.933.433.633.934.1
Private30.025.325.726.026.026.126.326.3
Central government7.17.37.16.97.47.57.67.8
Gross national saving34.731.637.533.533.133.033.032.9
Private32.629.634.431.030.030.029.829.4
Central government2.12.03.12.63.13.13.23.5
Balance of payments
Current account (in millions of U.S. dollars)-378-181909128-63-142-221-318
In percent of GDP-2.4-1.04.70.6-0.3-0.6-0.9-1.2
Trade Balance (in millions of U.S. dollars)-4,078-4,470-4,605-5,540-6,042-6,596-7,178-7,774
In percent of GDP-25.6-23.6-23.7-27.3-27.4-27.6-27.9-28.2
Exports value growth (percent change)-6.113.25.06.98.17.97.77.9
Imports value growth (percent change)36.410.23.417.98.99.08.68.2
Gross official reserves (in millions of U.S. dollars)2,8443,0854,3074,5954,7704,9305,0205,045
In months of imports of goods and services5.45.86.86.66.36.05.75.3
Memorandum items
Public debt (percent of GDP)35.433.333.331.330.730.430.530.4
GDP at market prices (in billions of Nepalese rupees)1,1931,3681,5571,7501,9652,2022,4492,704
GDP at market prices (in billions of U.S. dollars)16.019.019.420.322.023.925.827.6
Exchange rate (Nrs/US$; period average)74.872.180.2
Real effective exchange rate (eop, y/y percent change)7.01.4-4.6
Sources: Nepalese authorities; and IMF staff estimates and projections.

Fiscal year ends mid-July.

Sources: Nepalese authorities; and IMF staff estimates and projections.

Fiscal year ends mid-July.

Table 2.Nepal: Summary of Government Operations, 2009/10-2012/13 1/
2009/102010/112011/122012/13
BudgetEst.Est. BudgetProj.
(In billions of Nepalese rupees)
Total revenue and grants214.7241.6311.8285.1374.0316.7
Total revenue176.2197.1241.7244.4288.4277.2
Tax revenue154.7171.8209.2211.7249.8244.9
Non-tax revenue21.525.332.532.638.532.4
Grants38.544.570.140.785.739.5
Expenditure224.0255.0339.1283.5382.8325.3
Expenses186.2208.2268.9234.4299.7274.3
of which:
Interest payments10.012.716.615.218.816.4
Salaries and allowances41.944.855.451.462.357.8
Net Acquisition of Nonfinancial Assets37.846.870.349.083.151.0
Operating balance28.533.442.950.774.342.3
Net lending/borrowing-9.2-13.4-27.31.7-8.8-8.6
Net Financial Transactions9.213.427.3-1.78.88.6
Net Acquisition of Financial Assets12.113.819.422.739.127.3
Net Incurrence of Liabilities21.327.246.821.047.935.9
Foreign0.5-4.316.0-1.216.9-4.1
Domestic (above the line)20.831.530.822.231.040.0
(In percent of GDP)
Total revenue and grants18.017.720.918.321.318.1
Total revenue14.814.416.215.716.415.8
Tax revenue13.012.614.013.614.214.0
Non-tax revenue1.81.82.22.12.21.9
Grants3.23.34.72.64.92.3
Expenditure18.818.622.718.221.818.6
Expenses15.615.218.015.117.115.7
of which:
Interest payments0.80.91.11.01.10.9
Salaries and allowances3.53.33.73.33.53.3
Net Acquisition of Nonfinancial Assets3.23.44.73.14.72.9
Operating balance2.42.42.93.34.22.4
Net lending/borrowing-0.8-1.0-1.80.1-0.5-0.5
Net Financial Transactions0.81.01.8-0.10.50.5
Net Acquisition of Financial Assets1.01.01.31.52.21.6
Net Incurrence of Liabilities1.82.03.11.42.72.1
Foreign0.0-0.31.1-0.11.0-0.2
Domestic (above the line)1.72.32.11.41.82.3
Memorandum items:
Primary Balance (in percent of GDP)-0.9-1.1-2.0-0.4-1.7-1.1
Net Domestic Financing (below the line, in percent of GDP)2.63.0-0.1
Public debt (in percent of GDP)35.433.333.733.332.231.3
Domestic13.414.615.512.713.013.6
External22.118.718.220.519.217.7
GDP (in Billion of Nrs)1,1931,3681,4921,5571,7571,750
Sources: Data provided by the Nepalese authorities, and Fund staff estimates and projections.

Fiscal year ends in mid-July. Table refers to central government operations as contained in the budget.

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

Fiscal year ends in mid-July. Table refers to central government operations as contained in the budget.

Table 3.Nepal: Reserve Money and Monetary Survey, 2009/10-2012/131
2009/102010/112011/12

(Est.)
2012/13

(Proj.)
(In billions of Nepalese rupees, end-period)
Reserve money218.5234.2319.3358.4
Net domestic assets of NRB15.522.6-54.3-36.9
Claims on public sector50.855.017.227.1
Claims on private sector3.54.44.54.5
Claims on banks & financial institutions4.88.30.57.6
Other items (net)-43.6-45.1-76.6-76.2
Net foreign assets of NRB203.0211.5373.7395.4
(Contribution to reserve money growth)
Reserve money (y/y percent change)11.77.236.412.3
Net domestic assets of NRB19.83.9-32.95.4
Net foreign assets of NRB-8.03.369.26.8
(In billions of Nepalese rupees, end-period)
Broad money719.6922.01,131.01,272.5
Narrow money218.2223.1264.4384.8
Quasi-money501.4699.0866.6887.7
Net domestic assets506.6706.0756.3870.6
Domestic credit649.3912.6985.91,127.4
Credit to public sector148.6185.3176.1212.6
Credit to private sector500.7727.3809.8914.8
Other items(net)-142.7-206.6-229.6-256.9
Net foreign assets213.0216.0374.6401.9
(Twelve-month percent change)
Broad money14.112.322.712.5
Net domestic assets24.816.27.115.1
Domestic credit16.814.68.014.4
Credit to public sector26.717.2-4.920.8
Credit to private sector14.213.911.313.0
Net foreign assets-5.11.373.47.3
(Contribution to broad money growth)
Broad money (y/y percent change)14.112.322.712.5
Net domestic assets16.012.05.510.1
Domestic credit14.814.18.012.5
Credit to public sector5.03.3-1.03.2
Credit to private sector9.910.88.99.3
Net foreign assets-1.80.317.22.4
Source: Nepalese authorities; and IMF staff estimates and projections.

Prior to July 2010, broad money survey consists of central bank and commercial banks only. After July 2010, broad money survey includes development banks and finance companies as well.

Source: Nepalese authorities; and IMF staff estimates and projections.

Prior to July 2010, broad money survey consists of central bank and commercial banks only. After July 2010, broad money survey includes development banks and finance companies as well.

Table 4.Nepal: Balance of Payments, 2009/10–2016/17
2009/102010/112011/122012/132013/142014/152015/162016/17
Est.Proj.
(in million US dollars)
Current account-378.0-180.9908.9128.1-62.6-142.4-221.1-317.6
Current account (excluding official transfers)-678.7-500.7514.9-209.0-312.1-402.7-484.5-585.6
Trade balance-4,077.9-4,469.6-4,604.8-5,539.6-6,041.6-6,596.3-7,177.7-7,774.3
Exports, f.o.b.848.8960.61,008.41,077.51,164.21,255.91,353.11,459.5
Imports, f.o.b.-4,926.7-5,430.2-5,613.2-6,617.1-7,205.8-7,852.2-8,530.8-9,233.7
Services (net)-220.1-121.3175.1-98.5-152.1-175.4-183.7-187.2
Receipts686.8741.2892.8877.0950.01,029.81,112.41,196.7
Of which: tourism378.1344.1380.3410.7443.6480.0519.8563.0
Payments-907.0-862.5-717.7-975.5-1,102.1-1,205.2-1,296.1-1,383.9
Income122.5105.6146.6162.2176.1191.2206.1192.9
Credit200.4244.7273.8304.1330.2358.6386.5385.8
Debit-77.9-139.2-127.2-141.9-154.1-167.3-180.3-192.9
Current transfers3,797.54,304.55,192.15,604.05,955.06,438.16,934.27,450.9
Credit, of which:3,866.34,350.65,254.35,653.26,008.56,496.26,996.87,517.9
General government300.7319.8394.0337.1249.5260.3263.4268.0
Workers remittances3,113.33,545.24,413.84,789.05,186.55,614.46,063.56,533.5
Debit-68.8-46.1-62.2-49.3-53.5-58.1-62.6-67.0
Capital account169.0222.4221.2254.0189.0192.3196.3200.9
Financial account60.5108.1302.7-80.662.6121.9134.1158.9
Direct investment38.390.0112.5101.4132.1155.4167.5179.1
Portfolio investment0.00.00.00.00.00.00.00.0
Other investment (net)22.218.1190.3-182.0-69.5-33.5-33.4-20.2
Errors and omissions46.2-49.1-193.00.00.00.00.00.0
Overall balance-102.3100.51,239.9301.4189.0171.8109.342.2
Financing102.3-100.5-1,239.9-301.4-189.0-171.8-109.3-42.2
Change in reserve assets (- =increase) 1/62.4-96.0-1,233.4-288.0-175.0-160.0-90.0-25.0
Use of IMF resources (net)39.9-4.5-6.5-13.4-14.0-11.8-19.3-17.2
IMF Disbursements42.10.00.00.00.00.00.00.0
IMF Repayment2.24.56.513.414.011.819.317.2
Memorandum items:
Current account (in percent of GDP)-2.4-0.94.70.6-0.3-0.6-0.9-1.2
Current account, excl. grants (in percent of GDP)-4.3-2.62.7-1.0-1.4-1.7-1.9-2.1
Trade balance (in percent of GDP)-25.6-23.6-23.7-27.3-27.4-27.6-27.9-28.2
Exports (in percent of GDP)5.35.15.25.35.35.35.35.3
Imports (in percent of GDP)30.928.628.932.632.732.833.133.5
Remittances (in percent of GDP)19.518.722.723.623.623.523.523.7
Exports (y/y percent change)-6.113.25.06.98.17.97.77.9
Imports (y/y percent change)36.410.23.417.98.99.08.68.2
Remittances (y/y percent change)14.813.924.58.58.38.38.07.8
Non-oil real GDP growth of GCC countries 2/3.45.76.15.55.35.35.55.6
Debt service (in percent of current account receipts)3.23.02.42.82.62.52.32.2
Gross official reserves (in millions of U.S. dollars)2,8443,0744,3074,5954,7704,9305,0205,045
In months of imports5.45.86.86.66.36.05.75.3
As a share of broad money (in percent)25.923.834.131.730.328.827.725.6
ratio over remittances0.90.91.01.00.90.90.80.8
Nominal GDP (in millions of U.S. dollars)15,95618,97719,41520,27322,01723,90425,76427,556
Sources: Nepalese authorities; and IMF staff estimates and projections.

2010/11 figure excludes valuation changes.

Real GDP-weighted average.

Sources: Nepalese authorities; and IMF staff estimates and projections.

2010/11 figure excludes valuation changes.

Real GDP-weighted average.

Managing Downside Macroeconomic Risks

The past year has provided breathing space, but macroeconomic and financial pressures are once again on the rise. Spillover effects from a slowing Indian economy, combined with the dampening effect of continued political impasse will likely dampen growth. Inflation pressures are also likely to rise in the coming months. Continued fiscal prudence, more effective use of budgetary and donor resources, and a tighter monetary policy are warranted to maintain stability.

A. Fiscal Policy and Public Financial Management

10. Continued fiscal prudence is needed to maintain fiscal and external sustainability8 over the medium-term. Given potentially large quasi-fiscal liabilities in the SOE and financial sectors, the baseline fiscal strategy should aim to keep public debt roughly constant as a share of GDP— implying annual net domestic financing of about 2 percent of GDP. Once key vulnerabilities are addressed (and their fiscal cost assessed), there may be room to moderately increase borrowing to finance key investment and social protection schemes. Scaling up should be done only if the schemes are well designed, however, and implemented on the basis of continued improvements in public financial management.

11. The near-term priority is to pass a full-year budget. Delays in passing a full-year budget could further damage business confidence, lead to under-execution of key capital projects, and create additional pressure on the banking system. Recent experience (the 2010/11 budget was passed seven months late, resulting in significant under-spending on capital projects) highlights this risk. Line ministries are reluctant to undertake expenditures in the absence of a full and approved budget. In addition to under-spending, delays also appear to exaggerate a tendency toward bunching of expenditures near the end of the year, complicating liquidity and macroeconomic management. A late-year rush to spend can also adversely affect the quality of public expenditures. In line with medium-term fiscal objectives, an overall deficit consistent with a net domestic financing of no more than 2 percent of GDP is needed. Near term measures to support these goals include:

  • Bolstering revenues through continued tax and customs administration. The three-year reform plan and the five-year strategic plan by the Internal Revenue Department (IRD) are welcome, as is the initiative to update the 2009/13 reform plan by the Department of Customs (DOC) in line with IMF TA.

  • Collecting arrears and reducing non-compliance. Further action is needed to collect arrears identified in the recently completed fraud investigation (Nrs 6.5 billion), and tax arrears (Nrs 29 billion). The large share of non-filers (22 percent for VAT, 56 percent for income tax) indicates a need to improve compliance management.

  • Using the Treasury Single Account to improve budget execution and management. With the TSA covering 95 percent of revenue and expenditure transactions, closer monitoring and more frequent adjustment is possible. The staff recommends publication of monthly financial statements and regular reviews of budget execution.

Box 2.Nepal: Potential Spillover Risks

The slowdown in India and increasing global risks raise the specter of spillover effects on Nepal. Other risks include a slowdown or loss of confidence feeding through the financial sector.

Key channels through which negative external developments might spill over to Nepal include:

  • Trade. India is Nepal’s dominant trade partner—accounting for 67 percent of Nepal’s exports and 65 percent of imports in 2011/12, up about 20 percentage points from a decade ago.

  • Remittances. Remittances are the main source of Nepal’s foreign exchange receipts, equivalent to about ¼ of GDP. GCC countries, Malaysia, and India are the main hosts of Nepalese migrant workers.

  • Financial linkages. FDI and cross-border lending may also be a conduit for India-related shocks. Reports indicate extensive involvement or interest of Indian investors in key hydroelectric projects. Most of Nepal’s financial flows (a surplus of about 1½ percent of GDP in 2011/12) take the form of trade credit and therefore are likely to be associated with India.

  • Confidence shocks—inspired by India or other events—could trigger capital flight as seen in 2009–10, possibly forming a feedback loop between external sector deterioration and escalating banking sector risks.

India and Nepal: Nonagricultural GDP Growth

(in percent)

Macroeconomic simulations highlight the potential spillover effects of three scenarios: (i) a further decline in India’s growth; (ii) slowing remittances against the backdrop of increasing global uncertainty; and (iii) a major banking sector stress (potentially triggered by external shocks) stemming from preexisting financial sector fragilities. Although India’s slowdown is the main (i.e., most likely) downside risk, the three episodes are potentially additive as elevated global uncertainty could trigger decline of remittances, and external shocks could be amplified by vulnerabilities in the financial sector. The simulations indicate external shocks represent substantial risks, and could cause a visible output loss, a rapid decline of foreign exchange reserves, and a moderate increase in public debt. Financial sector distress would instead result in a large output loss over the medium term and substantial rescue costs incurred to the public sector, ultimately leading to unsustainable debt. (See Appendix I for details).

BaselineIndia Slowdown 1/Remittance Weaken 2/Financial Stress 3/
Medium-term Output loss compared to baseline1.0%0.1%30.0%
Current account balance by 2016/17 (% GDP)-1.2%-1.4%-2.1%-1.6%
Gross international reserves by 2016/17$5.0 bn$4.7 bn$4.0bn$3.9 bn
Net domestic financing, 2013-17 average (% GDP)2.3%2.5%2.6%6.9%
Public Debt/GDP ratio by 2016/1730.4%31.1%31.6%97.2%

Assumes a one percentage point decline in India’s growth.

Assumes a one standard deviation decline in remittance growth.

Assumes an output loss of 30 percent, and a fiscal cost of 23 percent of GDP in bank rescue.

Assumes a one percentage point decline in India’s growth.

Assumes a one standard deviation decline in remittance growth.

Assumes an output loss of 30 percent, and a fiscal cost of 23 percent of GDP in bank rescue.

12. Over the medium-term, continued progress needs to be made on increasing the government’s ability to implement the budget (particularly capital expenditures), effectively utilize donor resources, and eliminate quasi-fiscal liabilities. Important steps in this regard could include:

  • Simplifying the budget release process for capital spending. The requirement for the National Planning Commission (NPC) to assess high priority projects after budget approval could be eliminated. Instead, information regarding performance benchmarks (currently addressed through the NPC’s post-budget approval assessment) would be included in budget submissions and endorsed by NPC prior to formal budget approval.

  • Implementing an automatic adjustment mechanism for fuel prices, and handling interim losses through the budget. Fuel prices should be increased gradually to levels at least consistent with cost recovery, followed by an automatic price adjustment as the final objective9. NOC’s interim financial losses should be accommodated within the 2012/13 budget (with a supplemental budget later in the year). NOC’s outstanding debts/arrears should be cleared, conditional on an audit of past claims and a strategy to prevent accumulation of new arrears.

  • Strengthening the on-budget pension system. The current public (on-budget) pension scheme is defined benefits only. Funding for this scheme needs to be secured (for example, by government employee contributions), the coverage streamlined, and an actuarial analysis undertaken.

Authorities’ Views

13. The authorities broadly agreed with staff’s recommendations, and highlighted in particular the need to pass a full-year government budget. They noted the urgency of providing line ministries with a full-year allocation for expenditures, and with the need to target net domestic financing of no more than 2 percent of GDP. A full-year budget has been prepared10, and the MOF is actively seeking support to pass this budget by presidential ordinance before the end of November. They expressed optimism that continued gains in VAT, income tax, and customs collection could be made, and highlighted the need for continued reforms at IRD and DOC, the importance of targeted incentive schemes at these agencies, and further technical assistance from the Fund. The authorities also concurred on the need for an automatic pricing mechanism for fuels, but noted that such decisions required a careful political consensus and supporting measures for public welfare. Future pension liabilities were also a shared concern. The authorities noted that an employee contribution system had been initiated in 2006, but was terminated in 2009 after public protest.

B. Monetary and Exchange Rate Policy

14. Accommodative monetary policy in 2011/12 allowed banks additional space to rebuild profitability, but inflation and exchange risks are on the rise—suggesting the need to tighten. Weak credit demand and the overhang of banks’ excess reserves at the NRB suggest that, while money growth was excessive, upward pressure on prices from monetary policy was moderate. Rather, the bulk of inflation stemmed from factors noted earlier (administered prices, higher import prices through exchange rate depreciation, and the effect of wage and salary increases). However, prices have continued to climb since the end of the fiscal year, with headline inflation reaching just under 12 percent, year-on-year, in August—the ninth consecutive year-on-year increase. Real interest rates have been negative for over a year, and the wedge between domestic and India’s one-month interbank rate has widened to almost 900 basis points on a sustained basis—suggesting a powerful financial incentive for capital flight, and a risk to the exchange rate peg. The NRB shifted policy in July 2012, signaling its intent to bring broad money growth to 15 percent in the coming year, consistent with a targeted average inflation rate of 7.5 percent.11

Contribution to Headline Inflation

Imported Goods WPI and Non-food CPI

15. The exchange rate peg has served as a pillar of stability, and although quantitative estimates suggest some overvaluation, the rupee does not appear fundamentally misaligned. The peg continues to provide a widely visible nominal anchor and support macroeconomic stability. Adjusting the peg may curb imports, but (depending on accompanying monetary and fiscal policy adjustments) could also stoke inflation. More meaningful adjustment is likely through structural reforms to address a weak business climate—particularly infrastructure and labor relations. However, the peg also complicates macroeconomic management in times of external shocks, by limiting room for adjustment. In this context, consideration should be given to exit options should external shocks bring unsustainable pressures on the external accounts. There is some evidence that while fixed regimes better control inflation, flexibility can be growth promoting, and help cope with real shocks better than a fixed rate regime.12

Authorities’ Views

16. The authorities concurred that monetary policy had been relatively loose in the past year, and that tightening was needed. They argued that from a macroprudential point of view, it had been important to provide banks with room to recover from the sharp downturn in real estate prices. They also saw inflation developments as being largely driven by external factors, supply bottlenecks (particularly the effect of strikes on movement of food products), and exchange-rate induced changes in import prices. However, they agreed that with prices already rising and the inflation already high in India, monetary tightening was needed. They noted that the interest rate wedge vis-à-vis India was a concern, and that it was important to reassert support for the exchange rate peg, which continues to serve Nepal well as a clear and widely accepted anchor.

Addressing Financial Sector Risks

The influx of remittances eliminated the 2010/11 liquidity squeeze that pressured banks’ balance sheets, and accommodative monetary policy and gradual financial sector reform have allowed some improvement in financial soundness indicators. However, risks should not be underestimated. It is unclear whether the real estate market has bottomed out. Further, little is yet understood about the inter-connectedness of financial institutions and contagion risk. Underlying balance sheet weaknesses related to real estate exposure remain—particularly in smaller institutions. A targeted acceleration of ongoing reforms, combined with a medium-term strategy for consolidation is warranted.

17. Reported financial sector indicators (Class A banks only) show modest improvement, but the sharp decline in real estate prices since 2009 continues to pose risks. Direct exposure to real estate remains above 10 percent of total assets for all classes of banks, and higher still among smaller financial institutions. Moreover, indirect exposure through collateral is nearly two-thirds of total assets. Though official data are lacking, real estate prices are said to have declined by 30 percent or more off their peak, which may have significantly damaged banks’ balance sheets but is not being reflected in reported NPLs. This raises concerns about the quality and integrity of reported data, and possible ever-greening of loans.13 Balance sheet risks may therefore be substantially higher than suggested by reported data.

18. The NRB has taken a gradual approach to financial sector reform. Some forbearance measures to address the fall in real estate and capital market are still in place. These include easing conditions for restructuring real estate and margin loans, increasing the loan-to-value ratio ceiling for loans against promoter shares, and postponement of a reduction in the limit on real estate sector loans to 25 percent of total loans. On the other hand, efforts have been made to strengthen regulation and supervision, and to facilitate mergers and credit diversification. Specifically:

  • Minimum capital adequacy will be strengthened by introducing a 1 percent capital buffer. Some Basel III elements—including 4.5 percent common equity Tier 1—are also under consideration.

  • An amended NRB Act—allowing for swift resolution of problem banks—is in the final stages of drafting by the NRB and will be submitted to the government. Nonetheless, in the absence of a constituent assembly it is unclear when this legislation could go into effect.

  • The prompt corrective action framework is being broadened to include liquidity and non-performing asset ratio triggers. Stress test guidelines were issued as well as guidelines on Internal Capital Adequacy Assessment Process (ICAAP).

  • A single department supervising both class-B and C banks was split into two dedicated departments14. On-site inspection practices have improved in line with IMF recommendations. Macroprudential monitoring has been strengthened by creation of a Financial Stability Unit in the NRB, which will create semi-annual financial stability reports.

  • The government injected capital (as part of the partial 2012/13 budget) into the two insolvent state-owned commercial banks that would partially cover their capital deficiency.15

  • The NRB introduced a requirement that banks extend at least 10 percent of total credit to the agriculture and/or energy sector. Work is also proceeding on establishment of a base (minimum) lending rate for banks, based on cost of funds.

  • A moratorium on licensing new commercial banks, development banks and finance companies will be continued for another year. To encourage mergers, regulatory forbearance and tax incentives have been extended.16

19. Recent efforts to bolster supervision and regulation are welcome, but there is a need for a targeted, well sequenced acceleration of financial sector reform. The influx of liquidity via remittances has bought time, and allowed banks to accumulate a liquidity cushion, but potentially serious balance sheet and other vulnerabilities remain. Real estate exposure remains the primary risk. However, the lack of clarity on the interconnectedness of banks is another source of concern as some banks are reported to share the same promoters (initial capital contributors). Given the widespread practice of providing loans to promoters with banks’ shares as collateral, there is a risk that problems in one bank may cause contagion in the system. The current gradual approach runs the risk of a disorderly adjustment in the financial sector, which could be magnified by banks’ inter-linkages. Reforms should proceed with a short- and medium-term vision for increasing financial sector safety and soundness. In the near-term:

  • Amendment of the NRB Act should be completed as soon as possible to strengthen the NRB’s powers to swiftly resolve banks. Enactment of a modified Deposit Guarantee Act to expedite the repayment process is also a priority. These two actions provide the necessary preconditions to decisively address problem banks.

  • Planned diagnostic reviews with World Bank and DFID assistance need to be “deep dive”, with decisive follow-up to deal with problematic banks, including resolution in case of non-viable banks. Mergers may be an option to resolve viable banks, but should not be used as an excuse for less-than-optimal restructuring and recapitalization. Thorough post-merger assessments should be conducted to assess the viability and effectiveness of the merger.

  • Supervision should continue to be strengthened, and the new PCA framework needs to be implemented. Transition to IFRS-based accounting standards for loan classification and provisioning should also proceed as planned. Supervisory resources need to be increased and new staff trained to provide sufficient resources for broader and deeper on-site inspection as well as managing bank resolutions.

  • NRB should avoid directed credit policies. Cross country experience suggests that—in the absence of bank capacity to adequately assess credit risk in targeted sectors—directed lending can decrease bank efficiency and undermine bank soundness.17 At a minimum, targets for specific sectors should only be indicative.

20. Over the medium term, a comprehensive review of financial sector policies should be considered. To this end, the liberal licensing policy that has resulted in a large number of banks needs review, even as the current moratorium on licensing is maintained. The current legal framework, with three categories of financial institutions without clear differences in their scope of business, also needs review. Supervisory resources should be increased. A possible roadmap is presented in Table 6. However, an FSAP could be useful in setting priorities.

Table 5.Nepal: Commercial Banks’ FSIs (2001–12) 1/
200120022003200420052006200720082009201020112012 1/
Capital adequacy
Capital fund to risk weighted assets-5.5-9.9-12.0-9.1-6.3-5.3-1.74.07.29.610.611.5
Tier 1 capital to risk weighted assets1.85.27.99.110.0
Asset quality
NPLs to total loans2.428.822.818.913.210.66.13.62.53.22.6
Loan loss provision to total loans20.015.112.48.25.94.64.03.6
Earnings and profitability
Return on equity (ROE) 2/31.435.234.733.925.322.5
Return on assets (ROA) 2/6.24.31.42.04.91.91.71.5
Interest income to gross income75.071.868.569.570.468.373.977.981.482.4
Non-interest expenditures to gross income65.166.371.970.970.370.460.160.253.248.0
Employees expenses to non-interest expenditures12.824.818.616.619.018.725.123.722.221.5
Liquidity
Liquid assets to total assets22.118.212.513.69.49.19.011.826.013.111.213.0
Liquid assets to demand and savings deposits52.446.230.331.323.320.520.125.031.131.731.636.6
Liquid assets to total deposits31.027.318.920.015.413.513.215.918.316.014.316.3
Exposure to real estate
Share of real estate and housing loans19.420.718.516.9
Share of loans collateralized by land and buildings71.758.468.455.9

Capital adequacy, NPLs, loan loss provisioning, ROE, ROA, and exposure to real estate indicators as of July 2012; liquidity indicators as of June 2012; and other earnings and profitability indicators as of April 2012.

Excluding state-owned banks.

Capital adequacy, NPLs, loan loss provisioning, ROE, ROA, and exposure to real estate indicators as of July 2012; liquidity indicators as of June 2012; and other earnings and profitability indicators as of April 2012.

Excluding state-owned banks.

Table 6.A Roadmap for Financial Sector Reform
Identify problems among banks and FIsStrengthen institutional capacityRestructure financial institutionsMaintain systemic stability
Identify systemically important banks and take appropriate resolution actions. Conduct “deep-dive” assessments, focusing on banks exposed to real estate, and large public sector banks, preferably by reputed international firms; with NRB to follow up with appropriate corrective strategies.
Revise legal framework, including:
Implement amendments to NRB Act to help streamline intervention and resolution procedures
Implement revised Deposit Guarantee Act.
Remove gaps, inconsistencies, and overlaps among various legislations governing the financial sector.
Strengthen prudential standards and enhance enforcement, including higher capital adequacy for systemic banks.
Strenghthen deposit guarantee, including:
Conduct deposit survey, assess capital requirements of deposit insurance corporation and strengthen its capacity.
Establish action plan for government intervention in failed banks, specifying roles and responsibilities, as well as use of deposit insurance.
Restructure insolvent state owned banks after conducting independent audits and diagnostic reviews
Phase out regulatory forbearance granted in 2010/11, reduce exposures to real-estate, tighten margin lending.
Step up on-site inspection and enhance supervisory capacity
Review and rationalize licensing framework Review and strengthen accounting / provisioning standards, in conjunction with implementation of
IFRS. Implement over selected time frame (to allow for adjustment).

Authorities’ Views

21. The authorities emphasized that the gradual approach to financial sector reform was deliberate, but that action would be taken as needed to ensure financial system stability. Legislative reform to strengthen the NRB’s resolution powers is recognized as a key priority in accelerating efforts to address weak banks. Work on amendments to the NRB Act is in an advanced stage, and will be delivered to the Government in October 2012. However, lack of a parliament is viewed as a setback, and the authorities are hesitant to implement amendments to the NRB Act and other financial sector legislation via presidential ordinance. The quality of data reporting is recognized as a problem. The authorities are more confident about Class A Banks, but the NRB is pushing for more frequent on-site examinations among Class B and C banks, as well as requiring daily liquidity reporting. The authorities expressed interest in an FSAP.

22. The authorities view a minimum level of credit to ‘productive sectors’ as a useful policy. They argued that diversification of bank credit is justified on the grounds that lending to agriculture and the power sector will support growth in these important sectors and also help diversify banks’ portfolios, which are too highly exposed to real estate. Moreover, the 10 percent requirement is broadly defined to include project finance, insurance, and refinance. Work is also underway to support directed lending with credit insurance, though further development of micro-insurance for agricultural credit would be useful. In the energy sector, risks are perceived to be already contained via power purchase agreements.

Box 3.Financial Sector Vulnerabilities

Despite recent mergers, Nepal’s financial sector still has nearly 200 entities overseen by the NRB, including 32 commercial banks, 88 development banks, 70 finance companies, and 22 micro-credit institutions. Weak licensing rules and supervision in previous years led to a proliferation of banks with unsound lending practices, resulting in high exposure to a booming real estate sector that subsequently corrected, and remains stagnant.

Share of Various Bank Classes in Banking Sector

(In percent)

Bank assets have stabilized at around 80 percent of GDP, after spiking to above 100 percent during the 2009/10 credit boom. The system is dominated by commercial banks—accounting for nearly 80 percent of assets and deposits. The remainder is split between development banks and finance companies.

Sector Share of Credit

(Commercial Banks, July 2012)

Recent stress tests conducted by NRB (for commercial banks only) echo the improvement in reported FSIs, particularly liquidity and capital adequacy indicators. Liquidity improved on the back of strong remittance inflows, and compared to 2011, commercial banks are more resilient to deposit withdrawal shocks, and to withdrawals by large individual and institutional deposits. There is also a slight improvement in response to credit shocks, particularly those calibrated to real estate loans. Direct exposure to construction and real estate has declined from 19½ percent over 2009/2010 to around 16½ percent in 2011/12. Indirect exposure through collateral has also declined from 66 percent to 56 percent over the same period. However, overall exposure is still high. A third of commercial banks see their capital drop below the regulatory minimum under a shock in which a quarter of all performing real estate loans are reclassified as loss loans.

Stress Testing Results for Commercial Banks
20122011
Credit shocksNo. of banks with CAR < 10% regulatory minimum
Standard credit shock12022
25 percent of performing loans of real estate & housing sector directly downgraded to loss loans1115
Liquidity shocksNo. of banks illiquid after 5 days
Standard withdrawal shock21419
No. of banks with liquid assets to deposits ratio < 20%
Withdrawal of deposits by 20%2627
Withdrawal of deposits by top 3 institutional depositors.1827
Withdrawal of deposits by top 5 individual depositors.16
Source: Nepal Rastra Bank

15 percent performing loans deteriorated to substandard, 15 percent substandard loans deteriorated to doubtful, 25 percent doubtful loans deteriorated to loss, 5 percent of performing loans deteriorated to loss.

Withdrawal of customer deposits by 2%, 5%, 10%, 10%, and 10% for five consecutive days respectively.

Source: Nepal Rastra Bank

15 percent performing loans deteriorated to substandard, 15 percent substandard loans deteriorated to doubtful, 25 percent doubtful loans deteriorated to loss, 5 percent of performing loans deteriorated to loss.

Withdrawal of customer deposits by 2%, 5%, 10%, 10%, and 10% for five consecutive days respectively.

Other Issues

23. Discussions continued on the potential for closer engagement with the Fund, including through an ECF or other program. The authorities continued to express interest in a program, noting the potential benefits for advancing the reform agenda, catalyzing donor support, and providing another anchor of stability in an uncertain environment. However, they noted that, in the absence of a consensus government and constituent assembly, the risks to program performance would be high. Given the absence of an urgent balance of payments need, they suggested that further time be given to come to a political situation conducive to a consistent policy framework and ambitious reform agenda. In the interim, they expressed interest in continued coordination on policy advice and technical assistance, and emphasized that the dialogue on a potential program be kept open.

24. Investment and trade policies remain open, but significant impediments remain. The current government has continued a liberal trade and investment policies. A number of significant sectors, including hydropower, have been opened to foreign investment and ownership. The government has dedicated 2012/13 to be an “investment year”, and recently created an Investment Board to coordinate domestic and foreign investors. The Board will focus on large investment projects worth more than Rs 10 billion (USD 130 million) and certain key sectors, and could help cut through bureaucratic delays and improve interagency coordination. Despite these positive steps, political instability, labor unrest, bureaucratic delays and inefficiencies, perceived corruption, and perennial power shortages create an uncertain environment for foreign and private investment.

Nepal: Governance and Doing Business IndicatorsGovernance Indicators (percentile rank; a higher value indicates better performance)
200720082009201020112012
Governance Indicators
Political Stability / Absence of Violence5.85.76.65.76.1
Voice and Accountability30.330.831.331.331.5
Government Effectiveness29.123.821.525.822.7
Regulatory Quality33.330.129.126.324.9
Rule of Law30.126.019.416.617.4
Control of Corruption25.726.228.228.723.7
Doing Business Indicators (out of 183 rated countries -- a lower rank is a better performance)
Doing Business (overall rating)100111121123116107
Starting a Business4960738796102
Dealing with Licenses / Construction Permits 112712512913113088
Registering Property252528262523
Getting Credit101971091138967
Protecting Investors606470737479
Trading Across Borders136151157161164170
Enforcing Contracts105123121122123136
Source: Worldwide Governance Indicators, World Bank; Doing Business reports for 2007-2012, World Bank. Additional data and periodic revisions available on the Doing Business website.

Reflects a change in methodology in 2012.

Source: Worldwide Governance Indicators, World Bank; Doing Business reports for 2007-2012, World Bank. Additional data and periodic revisions available on the Doing Business website.

Reflects a change in methodology in 2012.

25. Nepal’s last anti-money laundering and combating the financing of terrorism (AML/CFT) assessment in September 2010 revealed serious deficiencies. This led the Financial Action Task Force’s International Cooperation Review Group to agree on an action plan with Nepal to improve its compliance with the international AML/CFT standard—which is being supported through IMF technical assistance. This TA resulted in the adoption of an AML/CFT National Strategy in 2011. Current assistance focuses on drafting amendments to the AML/CFT law, developing the capacity of the financial intelligence unit, and creating a risk-based tool for offsite supervision.

Staff Appraisal

26. Economic outturns for the past year have been favorable, and progress on a range of structural reforms has been achieved in a difficult political environment. On the fiscal side, maintaining spending discipline, bolstering revenues, and completing reforms to public financial management (including implementation of a Treasury Single Account (TSA) during a political transition are notable achievements. Monetary policy was accommodative, but reflected a conscious decision to reduce pressure on balance sheets, and does not appear to have fueled inflation or put immediate pressure on the exchange rate peg. Financial sector reform has progressed, albeit gradually, and financial sector indicators show some modest improvement.

27. Most signs point to a more difficult year in 2012/13. On the domestic side, the continued political impasse will continue to have a dampening effect on investment and consumption. A late monsoon is likely to lower agricultural output, and negative spillover effects from India’s slowdown will also exert some negative pressure on Nepal over the coming year. The potential for lower remittances—which provided respite to fragile financial sector balance sheets and boosted services activity—also looms as a chronic risk.

28. Room for counter-cyclical macroeconomic policies is limited, and efforts should focus on more effective budget implementation. Further delays in enacting a full-year budget will complicate macroeconomic management and add to downside risks. The mission urges the authorities to move as quickly as possible to pass a full 2012/13 budget by ordinance, and to follow up with line ministries on month-to-month execution of spending plans. To maintain fiscal and debt sustainability, the budget should be consistent with net domestic financing of no more than 2 percent of GDP, and set a suitably ambitious target for investment spending. The draft full-year budget appears to be in line with this advice. However, achieving these objectives will require continued progress on tax and customs reform, as well as efforts to utilize the TSA as a tool for increasing the transparency of public financial management and highlighting areas where budget implementation may be weak.

29. Fiscal policy has generally been prudent and medium-term sustainability hinges more on maintaining space to deal with quasi-fiscal liabilities in state enterprises, public pension schemes, and potentially the financial sector. Nepal does not have a history of fiscal profligacy. However, losses at the NOC and NEA represent a current and future drain on public resources— including a large stock of outstanding arrears. The current public pension scheme, while not currently in arrears, is growing in cost and is without an independent source of funding—suggesting a steadily increasing need for budgetary resources in the years ahead. Restructuring and reform of NEA needs to proceed quickly, and an automatic adjustment mechanism for fuel prices is a necessary first step in bringing NOC to a cost-recovery basis. Complementary actions to protect the most vulnerable could be key in forging a political consensus around these reforms, and Fund technical assistance could prove useful in this regard. Similarly, a review of the public pension scheme, supported by an actuarial analysis is warranted as means of reviving discussion of sustainable financing mechanisms.

30. Monetary policy needs to be tightened to signal a clear intention to price stability and support of the exchange rate peg. Nine consecutive months of rising inflation risk embedding inflation expectations and creating additional pressures on the exchange rate peg—on top of a large interest rate differential vis-à-vis interest rates in India. Open market operations and regular auction of T-bills should be used to mop up excess liquidity (which remains high even after recent interventions). The establishment of a base rate for banks, and publication of this information, is a welcome step in increasing transparency in the financial sector.

31. A targeted acceleration of financial sector reform is needed. The staff sees the financial sector as the greatest potential source of risk, particularly if external shocks noted above exacerbate existing balance sheet vulnerabilities. Stability is important, but the mission believes the current gradual approach runs the risk of a disorderly adjustment, which could be magnified by inter-linkages between banks. Any strategy needs to be well-sequenced, as it would require the capacity-constrained supervisor to carry out multiple complicated tasks. Such key reforms as the expanded prompt corrective action framework and the amended NRB Act should be given clear priority. The latter should be enacted as soon as possible to complete an essential pillar in the authorities’ crisis resolution framework. Upcoming diagnostic reviews should be used for deep-dive assessments of the most vulnerable institutions (i.e., those most exposed to the real estate sector), and the NRB should be prepared to intervene and resolve problem institutions where necessary.

32. Tackling long-standing structural problems is essential to achieve higher, more inclusive growth over the medium term and to increase Nepal’s resilience to external shocks. The poor business climate, power shortages, weak governance, and difficult labor relations remain major impediments to growth and investment. A political consensus is essential for moving ahead in several of these areas. Progress can be made in a range of areas, and in this context the establishment of the Investment Board is a welcome step, particularly given the focus on potentially growth-enhancing infrastructure projects.

33. A renewed effort to increase transparency and good governance could give a welcome boost to government credibility and public confidence. One key step in this regard would be regular publication of fiscal, monetary, and financial sector data on the MOF and NRB websites. Another would be the appointment of an Auditor General. Finally, there are a large number of quasi fiscal operations and tax expenditures that are used to promote policy objectives, but are not transparent and often unmeasured. These include the price subsidies to fuel and electricity (estimated at 1.2 percent of GDP in 2011/12), interest rate subsidies for agriculture and other priority sectors, tax exemptions for specific industries. These should be quantified and reported, and preferably entered on the budget explicitly as expenditures. Continued progress on AML/CFT issues is encouraged.

34. Staff welcomes the authorities’ continued interest in close engagement with the Fund, including through a potential program. A political consensus and common view on economic and structural reform priorities would be an essential pre-requisite for a successful engagement. In the meantime, the staff will continue to offer advice, as needed, and facilitate technical assistance to key areas.

35. It is recommended that the next Article IV consultation takes place on the standard 12 month cycle.

Table 7.Will Nepal Achieve it’s Millennium Development Goals?
On TargetClose to TargetFar from TargetNo Data
Goal 1: Eradicate Extreme Poverty and Hunger.
1a: Halve the proportion of people whose income is less than $1.25 a day.x
1b: Achieve full and productive employment and decent work for all.x
1c: Reduce by half the proportion of people who suffer from hunger.x
Goal 2: Achieve Universal Primary Education.x
Goal 3: Promote Gender Equality and Empower Women.x
Goal 4: Reduce Child Mortality.x
Goal 5: Improve Maternal Health.
5a: Reduce the maternal mortality ratio by three-quarters.x
5b: Achieve universal access to reproductive health.x
Goal 6: Combat HIV/AIDS, Malaria and Other Diseases.
6a: Halt and reverse the spread of HIV/AIDS.x
6b: Achieve universal access to treatment for HIV/AIDS for all those who need it.x
6c: Halt and reverse the incidence of Malaria and other major diseases.x
Goal 7: Ensure Environmental Sustainability.
7a: Cliamte change and GHG emission.x
7b1: Reverse loss of forest.x
7b2: Reduce biodiversity loss.x
7c1: Halve proportion of population without sustainable access to improved water source.x
7c2: Halve proportion of population without sustainability access to improved sanitation.x
7d: Improve lives of slum dwellers.x
Goal 8: Develop a Partnership for Development.x
Sources: Global Monitoring Report, World Bank 2011 and 2010 Progress Report of Nepal’s MDGs, UNDP.
Sources: Global Monitoring Report, World Bank 2011 and 2010 Progress Report of Nepal’s MDGs, UNDP.
Appendix I. Background On Spillover and Financial Sector Risks

Spillover Risks

1. Economic links between Nepal and the rest of the world, notably India, have deepened in recent years. Growing economic integration has benefited Nepal in terms of economic development, stability, and poverty reduction (including through remittance-based increases in household income). These links, however, can also facilitate transmission of adverse shocks to Nepal.

2. This paper discusses potential spillover effects from three scenarios: (i) India’s slowing growth; (ii) slowing remittances against the backdrop of softening global outlook; and (ii) a banking sector distress that could be triggered by external shocks considering preexisting financial sector fragilities. As shown below, slower growth in India represents substantial risks to Nepal’s output, while remittance shocks could weaken the balance of payments. Financial sector distress would result in a large output loss over the medium term; substantial rescue costs incurred to the public sector, and potentially lead to unsustainable debt dynamics.

A. Links to India and Other Countries

3. India is Nepal’s single most important trading partner and also accounts for a significant share of Nepal’s remittance inflows1. The open border between the two countries allows cross-border transactions to be conducted with few restrictions. The peg of Nepalese rupee to India’s currency also provides a nominal anchor for Nepal’s monetary policy and a steady basis for cross-border exchange (the Indian rupee is common in circulation, particularly in border areas). India is also a source of know-how, providing access to better education for students from neighboring countries including Nepal.

  • Trade. India is Nepal’s dominant trading partner. Some 60–70 percent of Nepal’s exports and imports were associated with India in 2011/12, compared to below 50 percent a decade ago. Even these figures may be underestimated. Transactions across the open border tend to be underreported and there is thought to be significant unofficial trade. Some observers estimate that unofficial trade between India and Nepal was more than their official trade in the 1990s. These close links can also serve as a conduit for shocks, however. Dabla-Norris et al (2012) indicate significant spillover effects through the trade channel: a 100 percent increase in trade openness increases the elasticity to partners’ growth by 0.56.

  • Financial linkages. FDI2 and cross-border lending may also serve as a conduit for India-related shocks. India is the most important source of foreign investment to Nepal. Although bilateral data is not available, most of Nepal’s financial flows (a surplus of about 1½ percent of GDP in 2011/12) take the form of trade credit and therefore are likely to be associated with India. The size of direct bank lending across the border seems limited3, but a slowdown in India could negatively impact Indian banks’ credit lines to Nepalese banks as well as to exporters and importers. Moreover, a confidence shock could trigger capital flight. In recent years, a shock to confidence led to reserve losses reached about $400 million (15 percent of reserves at the time) within few months—forming a feedback loop between external sector deterioration and escalating banking sector risks.

  • Remittances. Remittances are the main source of Nepal’s foreign exchange receipts, equivalent to about ¼ of GDP. The GCC countries, Malaysia and India are the main host countries, although anecdotal evidence suggests that Nepali workers in India receive lower salaries than those in GCC countries and Malaysia. Although remittances are essential to smoothing consumption and supporting Nepal’s balance of payments, their impact on potential growth may be less significant.4 One explanation for the weak link is that the bulk of remittances finance consumption rather than investment and leak out through imports. Although remittances could boost consumption of non-tradable goods, inflationary pressures on these goods tend to rise as a result and jeopardize competitiveness, which are commonly seen in the cases of “Dutch disease”.

4. Nepal’s nonagricultural real GDP growth largely follows the trend of India’s, but has been consistently lower because of structural impediments such as low institutional capacity, political instability, insufficient infrastructure, impaired competitiveness, and financial system vulnerabilities. Ding and Masha (2012)5 estimate that a one percentage point decrease in India’s per capita real GDP growth would cause real per capita GDP growth in South Asian economies to fall by 0.77 percentage points. Dabla-Norris et al. (2012)6 indicate that Asian LIC’s growth will lose 0.71 percentage points over a two-year horizon given a one percentage point decrease of real GDP growth in major emerging market leaders (India in this case). A recent study by IMF staff on a few major remittance recipients including Nepal also finds visible business cycle synchronization between remittance source countries and recipients.7

B. Shock Scenarios

Scenario 1: India’s Slowdown

5. This scenario considers a further decline of India’s growth by 1 percentage point from the baseline scenario (5.6 percent) in 2012/138. In this context, Nepal’s growth path could experience an output loss of 1 percent over the medium term (although uncertainty regarding remittances and the impact on Indian investment suggests the dampening effect on growth could be higher). The current account balance would decline to a deficit of about 1½ percent of GDP over the medium term compared to a deficit of less than 1¼ percent of GDP under the baseline scenario as a result of slowing exports and remittances. Import cover of reserves is expected to fall to 5 months compared to 5¼ months in the baseline scenario by end 2016/17. Fiscal revenue and foreign grants and loans would also decline, leading to an increase of net domestic financing (NDF—the financing of the government budget deficit) to 2½ percent of GDP compared to 2¼ percent in the baseline scenario over the medium term.

Scenario 1. India Slowdown
BaselineIndia Slowdown
Medium-term Output loss compared to baseline 1/1.0%
Current account balance by 2016/17 (% GDP)-1.2%-1.4%
Gross international reserves by 2016/17 (amount and import cover)$5.0 bn (5.3 months)$4.7 bn (4.9 months)
Net domestic financing, 2013-17 average (% GDP)2.3%2.5%
Public Debt/GDP ratio by 2016/1730.4%31.1%

Calculated as cumulative losses of real GDP as a percent of baseline real GDP over the medium term.

Calculated as cumulative losses of real GDP as a percent of baseline real GDP over the medium term.

Scenario 2: Decline in Remittance Growth

6. A sudden slowdown in remittance growth, which could possibly be triggered by a slump in oil prices affecting GCC countries (through lower non-oil GDP growth, depending on the policy response) could weaken national income (through lower transfers, which effectively decreases household income), the current account balance, foreign exchange reserves, and fiscal performance.

7. Under this scenario, an assumed decline of remittance growth by one standard deviation (4 percentage points) would give rise to a widening of current account deficit over time to 2 percent of GDP by 2016/17, and a decline of import cover of reserves to 4¼ months by then. The impact of lower remittance inflows would be partly self-corrected, as imports would likely slow in the face of lower remittance inflows. Fiscal revenue will decline due to slower imports and weaker activity, leading to an increase of NDF to just above 2½ percent of GDP compared to 2¼ percent in the baseline scenario over the medium term.

Scenario 2. Weakening Remittances
BaselineRemittances Weaken
Medium-term Output loss compared to baseline 1/0.1%
Current account balance by 2016/17 (% GDP)-1.2%-2.1%
Gross international reserves by 2016/17 (amount and import cover)$5.0 bn (5.3 months)$4.0bn (4.2 months)
Net domestic financing, 2013-17 average (% GDP)2.3%2.6%
Public Debt/GDP ratio by 2016/1730.4%31.6%

Calculated as cumulative losses of real GDP as a percent of baseline real GDP over the medium term.

Calculated as cumulative losses of real GDP as a percent of baseline real GDP over the medium term.

Scenario 3: Financial Sector Distress

8. As indicated in the second section of this appendix, Nepal’s financial sector harbors significant vulnerabilities. These vulnerabilities were highlighted in recent years during downturns in remittances that contributed to a squeeze on bank liquidity. Despite a robust recovery in remittances (which relieved the liquidity stress on banks in 2012), numerous institutions remain under stress—low profitability, weak capital base, and substantial exposure (either directly or through loan collateral) to a frozen real estate market.

9. A major financial dislocation could potentially be very costly. The table below indicates the international experiences of financial crises that took place in the past few decades:

Table 1.Nepal: Impact of Banking Crises and Cost of Intervention Country
CountryStartFiscal cost 1/Reserve Loss 2/Depreciation 3/Output loss /4
Benin198817.01.9
Brazil199413.231.672.6
Dominican Republic200322.015.5
Ecuador199821.711.817.66.5
Indonesia199756.844.039.267.9
Jamaica199643.915.2-3.130.1
Malaysia199716.420.610.550.0
Mexico199419.333.943.151.3
Nicaragua200013.67.22.9
Senegal198817.025.4
Sri Lanka19895.049.29.92.2
Thailand199743.815.836.397.7
Uruguay200220.052.743.528.8
Venezuela199415.039.436.59.6
Vietnam199710.019.7
Russia199819.572.6
Average22.028.032.031.0
Maximum57.053.073.098.0
Nepal scenario23.050.033.030.0
Source: “Systemic Banking Crises: A New Database”, IMF Working Paper 08/224, November 2008; and IMF staff estimates.

In percent of GDP

Cumulative loss over first 2 quarters of reserve losses in the crisis year.

Total depreciation over first 2 quarters of depreciation in the crisis year (in percent).

Cumulative loss of real GDP over 3 years after crisis against trend.

Source: “Systemic Banking Crises: A New Database”, IMF Working Paper 08/224, November 2008; and IMF staff estimates.

In percent of GDP

Cumulative loss over first 2 quarters of reserve losses in the crisis year.

Total depreciation over first 2 quarters of depreciation in the crisis year (in percent).

Cumulative loss of real GDP over 3 years after crisis against trend.

10. A middle range estimate suggests that real GDP loss could reach 30 percent in the first four years of a financial crisis before growth recovers to the baseline trend.9 Reserves would fall by half in the first two quarters of the crisis through the widening current account balance10 and capital flight, though foreign borrowing could reverse partially the reserve losses later. The fiscal cost would be about ¼ of GDP, leading to rapid deterioration of debt dynamics. Even though the fiscal cost could be largely assumed domestically at the onset of the crisis (for bank resolution and deposit coverage), NDF has to be gradually brought down to 2¾ percent of GDP in outer years considering the capacity of domestic financial system, and foreign borrowing would be heavy over the long run.

Scenario 3. Financial Sector Stress
BaselineFinancial Stress
Medium-term Output loss compared to baseline 1/30%
Current account balance by 2016/17 (% GDP)-1.2%-1.6%
Gross international reserves by 2016/17$5.0 bn (5.3 months)$3.9 bn (4.1 months)
Net domestic financing, 2013-17 average (% GDP)2.3%6.9%
Public Debt/GDP ratio by 2016/1730.4%97.2%

Calculated as cumulative losses of real GDP as a percent of baseline real GDP over the medium term.

Calculated as cumulative losses of real GDP as a percent of baseline real GDP over the medium term.

11. The joint Bank-Fund Debt Sustainability Analysis Framework (DSA) indicates substantial worsening of debt carrying capacity after the financial stress unfolds. The present value of external debt in relation to GDP plus remittances would reach 40½ percent over the medium term, compared to the pre-stress level of 15¼ percent. The present value of external debt to revenue would more than double to 337¾ percent over the medium term. Present value of total public debt would rise to more than 90 percent of GDP or almost six times of revenue over the medium term.

Financial Sector Vulnerabilities

A. Background and Recent Developments

12. Financial sector vulnerabilities in Nepal have built up over the past several years and risks remain elevated.11 Dramatic proliferation of banks took place in an environment of weak supervision, accommodative monetary policy, and excessive lending in the real estate market driven by unsterilized remittance flows. The collapse of the real estate bubble after reaching a peak in 2008, coupled with a subsequent slowdown in remittance growth in early 2011 led to a severe liquidity squeeze in April–May 2011—bringing these vulnerabilities into sharper focus and driving fears of a potential banking crisis. Rather than intervening and closing weak and insolvent banks, the Nepal Rastra Bank (NRB) responded with large-scale liquidity support through multiple lending windows, and regulatory forbearance.12

13. A financial crisis was avoided with due largely to an influx of remittances that boosted bank liquidity, but also for reasons specific to Nepal. Regulatory forbearance, liquidity support, and generally loose monetary policy allowed breathing room for banks to rebuild capital and remain profitable as interest rates declined and spreads widened (though credit growth did not respond strongly to low interest rates). A closed capital account helped contain the risk of capital outflows despite low interest rates vis-à-vis India. In addition, general lack of investor education and low financial sector literacy among the population may have contributed to the absence of pressure on banks.

14. Structural weaknesses remain. These include: (i) resource and capacity constraints at the NRB, undermining the ability to effectively supervise nearly 200 financial institutions; (ii) the NRB’s authority to resolve weak banks is hampered by the legal framework; (iii) a potentially extended timeframe for returning two large state-owned banks to minimum capital adequacy; (iv) the real estate market remains relatively static, impairing bank assets; (v) the inter-linkages between financial institutions are not well understood, nor is ownership / interests in subsidiaries such as insurance companies; and (vi) data quality / accounting are weak, and may understate the extent of balance sheet problems.

15. The NRB has made efforts to address vulnerabilities and strengthen the financial system, but progress is slow. Recapitalization plans have been announced (and partially implemented) for two insolvent state banks.13 The NRB has sought to encourage mergers, including through regulatory forbearance,14 as a way of strengthening capital adequacy in the system. The monetary policy statement for FY2012/13 adds prompt corrective action (PCA) triggers on NPLs and liquidity ratios in addition to capital adequacy. Amendments to the NRB Act empowering the central bank to swiftly resolve problematic banks appear to be in final stages of drafting, but implementation is hampered by the lack of a Parliament. Nepal has received intensive technical assistance (TA) from the IMF to help strengthen the financial sector (Box 1). However, effective implementation will be required.

Box 1.IMF Technical Assistance in the Financial Sector

Nepal has been an intensive user of IMF technical assistance on financial sector issues. TA has focused on (i) improving monetary operations, including liquidity management and the monetary policy framework; and (ii) financial sector supervision, including prudential regulations and the legal framework for the banking sector. TA in the past year has been provided in the context of the acute liquidity stress of early 2011, including:

  • Crisis management framework: Focused on building capacity to respond to a financial crisis, through enhanced regulation and supervision, and clarification of legal authority of the central bank to intervene and resolve banks.

  • Banking supervision and diagnostics: A resident advisor provides guidance on supervision and coordinates/oversees a program to conduct diagnostic reviews of banks.

  • Guidance on deposit insurance: Focused on identifying key areas for strengthening deposit insurance, including preparation of deposit profiles and assessment of funding adequacy.

  • Legal framework for bank resolution: Focused on assisting authorities in establishing an effective legal framework for bank resolution, by providing drafting suggestions for amendments to laws and acts delineating the central bank’s powers.

  • Anti-money laundering and combating the financing of terrorism (AML/CFT): Assisting the development of a National Strategy; currently focused on amending AML/CFT legislation, improving supervision and enhancing capacity of financial intelligence unit.

B. Structure of the Financial System

16. The number of banks in Nepal increased from 85 to nearly 200 between 2002 and 2012. “Banks” refer to commercial banks (Class A), development banks (Class B), and finance companies (Class C). Other than different capital adequacy requirements and some operational restrictions on Class B and Class C institutions (foreign exchange and international transactions), there is little operational difference between these three classes. In this paper Class A, B and C institutions are referred to as the “banking system/sector”. In addition, there are 22 Class D micro-credit institutions that report to the NRB and thousands of rural credit cooperatives that are under the purview of the Ministry of Agriculture. Other financial services are available through insurance companies and the Nepal Stock Exchange.

Growth of Banking Sector in Nepal

There are 24 insurance companies and 225 listed companies, of which 80 percent are banks or non-bank financial institutions. More than 50 remittance agencies are overseen by NRB’s foreign exchange department.

17. Banking sector assets have grown rapidly—from 60 percent of GDP in 2001 to a peak of 100 percent during the height of the credit boom in 2009, before stabilizing at around 80 percent at present. Loans and advances to the private sector spiked up from 25 percent of GDP in 2004 to nearly 40 percent over the same period. The concurrent rise in inward remittances and the associated impact on the real estate market helped fuel banking sector growth.

Share of Various Bank Classes in Banking Sector

(In percent; as of May 2012)

18. The banking sector is dominated by commercial banks, which account for four-fifths of banking sector assets and deposits. Commercial banks, particularly large banks, are perceived to be safer (or subject to an implicit guarantee), as evidenced by the flight to safety during the 2011 liquidity stress. Deposits increased in almost all Class A banks, whereas nearly half the Class B and most of the Class C institutions saw deposits decline. NBL and RBB, two major state-owned Class A banks that account for 13 percent of deposits and 11 percent of banking sector assets, have been operating with negative capital for the past decade. The remainder of assets and deposits is split about evenly between Class (B) development banks and Class C (finance companies). These are smaller and more numerous than commercial banks. Problems in these banks are less well understood, but there is a commonly held perception that Class B and C institutions suffer from weaknesses in governance and asset quality.

Change in Banks’ Deposits During Liquidity Squeeze

(Over April-June 2011; in percent)

19. Regulation is split along industry lines—the NRB licenses, regulates and supervises deposit taking institutions; the Securities and Exchange Board of Nepal (SEBON) oversees stock brokers, merchant banks, and other capital market participants; and the Insurance Board under the Ministry of Finance supervises and regulates insurance companies. A government-backed deposit guarantee scheme is run by the Deposit and Credit Guarantee Corporation (DCGC), which in its present form may have limited effectiveness in maintaining public confidence in the banking system in the event of a bank closure.15 Finally, there is a High Level Coordination Committee consisting of representatives of financial sector regulators, chaired by the NRB, tasked with coordinating regulators and policy formulation.

20. There is uncertainty regarding the nature and magnitude of interconnectedness in the financial system. Due to weak licensing practices, the ownership structure of banks, as well as affiliates, subsidiaries and other related parties has not been fully identified, though the NRB has better information on ownership structure of relatively new banks. Moreover, liberal lending rules with respect to bank shares may have given further impetus to cross-shareholding. Three quarters of the margin loans in the system are against such shares, and may constitute 2 percent of total loans.16

C. Financial Stability Indicators

21. Reported financial sector indicators (FSIs) for commercial banks suggest some improvement. The shortcomings in data quality must be kept in mind while interpreting these figures. Capital adequacy among commercial banks (including NBL and and RBB) declined to the regulatory minimum of 10 percent in the past year, but has recovered subsequently to over 11 percent.17 All private commercial banks report capital at or above the regulatory minimum. Among the Class B and C institutions, most report capital levels well in excess of the regulatory requirement, although one Class B and three Class C institutions reported levels below the required minimum in January 2012.

22. Non-performing loans. Reported NPLs among all commercial banks declined to 2.6 percent in July 2012 from just over 3 percent at the end of FY 2010/1118. Among private commercial banks, NPLs are reported to be quite low at around 2.4 percent. NPLs at state owned banks are much higher: around 11 percent at RBB, 9 percent at ADBN, and 6 percent at NBL. Among development banks, NPLs increased from 4.4 percent to 5.7 percent over the same period. Data for finance companies are not as current and contain gaps. Between April and September 2011, NPLs in finance companies went up from 2.8 percent to nearly 5 percent. It is likely that actual NPLs are higher for all classes of banks, due to concerns about data quality, as well as possible ever-greening of loans.

22. Profitability. Return on equity (ROE) and return on assets (ROA) exhibited a declining trend over the past three years, likely reflecting the consequences of the real estate market bust. Credit growth has been weak despite accommodative monetary policy. Thus, even though net interest margins are relatively high at 3.8 percent in 2012, profitability is weak.

Table 2.Nepal: Commercial Banks’ FSIs(2008–12)
20082009201020112012 1/
Capital adequacy
Capital fund to risk weighted assets4.07.29.610.611.5
Tier 1 capital to risk weighted assets1.85.27.99.18.8
Asset quality
NPLs to total loans6.13.62.53.22.6
Loan loss provision to total loans8.25.94.64.03.6
Earnings and profitability
Return on assets (ROE) 2/35.234.733.925.322.5
Return on equity (ROA) 2/2.04.91.91.71.5
Interest income to gross income68.373.977.981.482.4
Non-interest expenditures to gross income70.460.160.253.248.0
Employees expenses to non-interest expenditures18.725.123.722.221.5
Liquidity
Liquid assets to total assets11.826.013.111.213.0
Liquid assets to demand and savings deposits25.031.131.731.636.6
Liquid assets to total deposits15.918.316.014.316.3
Exposure to real estate
Share of real estate and housing loans19.420.718.516.9
Share of loans collateralized by land and buildings*71.758.468.455.9

Capital adequacy, NPLs, loan loss provisioning, ROE, ROA, and exposure to real estate indicators as of July 2012; liquidity indicators as of June 2012; and other earnings and profitability indicators as of April 2012.

Excluding state-owned banks.

Capital adequacy, NPLs, loan loss provisioning, ROE, ROA, and exposure to real estate indicators as of July 2012; liquidity indicators as of June 2012; and other earnings and profitability indicators as of April 2012.

Excluding state-owned banks.

D. Vulnerabilities

23. Exposure to real estate. One of the main issues confronting the banking system is over-exposure to the real estate sector. Loans for housing and non-housing construction, together with real-estate loans account for 15 percent of the loan portfolio of commercial banks—going up to 20 and 30 percent for development banks and finance companies, respectively. Taking into account both direct lending and indirect exposure through collateral, more than two-thirds of the loan portfolio of commercial banks, and up to 90 percent of that of development banks and finance companies is exposed to real estate. Real estate transactions continued to fall last year, after dropping sharply in 2010/11. Real estate prices are reported to have dropped by 30 percent from their peak, and more for poorer quality projects. This gives reason to be cautious about reported NPLs.19

Sector Share of Credit

(Commercial Banks, July 2012)
Table 3.Kathmandu Real Estate Market Trends1
2009/102010/11Q1:2010/11Q1:2011/12
Transactions (sale/purchase)135900655451682412544
% change-14.0-51.8-25.4
Residential construction permits631651181221958
% change-8.5-19.0-21.5

As of December 2011

As of December 2011

24. Liquidity. Supported by increased remittances, systemic liquidity is currently high. Banks’ excess reserves with the NRB are nearly 90 percent of required reserves (compared to 28 percent a year ago), and interbank rates hover at or below 1 percent. Credit/deposit (C-D) ratios have also declined on account of weak credit growth and remittance-fueled deposits, but remain high. Further, liquidity conditions can change rapidly in response to external shocks, such as a decline in remittances. Unlike some LICs, the Nepali banking system intermediates and benefits from the flow of inward remittances. A negative shock to remittances, due to a slowdown in India and/or the GCC states could lead a re-intensification of liquidity stresses observed last year. Moreover, on account of weak assets, and a tiered interbank market, liquidity management can be a problem for banks in times of stress.

Liquidity Indicators

(In percent)

25. Stress tests. The latest stress tests conducted by the authorities for commercial banks show some improvement compared to the previous year’s results, but weaknesses persist. Among the 32 existing commercial banks, a standard credit shock would push capital below the regulatory minimum in 20 banks, and a third of commercial banks would be under-capitalized if real estate and housing loans are downgraded20. Sustained deposit withdrawals over five consecutive days would render 14 banks illiquid, and liquidity ratios at a number of banks would fall below 20 percent in the event of sudden large withdrawals, or withdrawals by institutions.

Table 4.Stress Testing Results for Commercial Banks
20122011
Credit shocksNo. of banks with CAR < 10% regulatory minimum
Standard credit shock12022
25 percent of performing loans of real estate & housing sector directly downgraded to loss loans1115
Liquidity shocksNo. of banks illiquid after 5 days
Standard withdrawal shock21419
No. of banks with liquid assets to deposits ratio < 20%
Withdrawal of deposits by 20%2627
Withdrawal of deposits by top 3 institutional depositors.1827
Withdrawal of deposits by top 5 individual depositors.16
Source: Nepal Rastra Bank

15 percent performing loans deteriorated to substandard, 15 percent substandard loans deteriorated to doubtful, 25 percent doubtful loans deteriorated to loss, 5 percent of performing loans deteriorated to loss.

Withdrawal of customer deposits by 2%, 5%, 10%, 10%, and 10% for five consecutive days respectively.

Source: Nepal Rastra Bank

15 percent performing loans deteriorated to substandard, 15 percent substandard loans deteriorated to doubtful, 25 percent doubtful loans deteriorated to loss, 5 percent of performing loans deteriorated to loss.

Withdrawal of customer deposits by 2%, 5%, 10%, 10%, and 10% for five consecutive days respectively.

E. Fiscal Impact of Banking Stress21

26. International experience has shown that fiscal costs of a banking crisis can be severe.22 In Nepal, the magnitude of fiscal costs including recapitalization of banks could be as high as one-quarter of GDP, based on experience in other countries that have endured financial crises. A crisis in Nepal could be triggered by another liquidity squeeze, depending on the relative strength of balance sheets one year on from the last liquidity crunch, and three years on from the sharp drop in the real estate market. The intensity of such a crisis would also depend on whether the impact is contained among Class B and C institutions (where exposure to real estate is the heaviest), or whether it spreads to Class A banks as well. The former, which account for a fifth of all deposits, are especially prone to flight, as evidenced during the 2010/11 liquidity crisis.

27. If only those Class B and Class C institutions with liquidity levels below the median for their respective class were subject to deposit flight, roughly NR 100 billion ($1.2 billion, about 6 percent of GDP) of deposits could be at risk. Assuming that all of the banks’ liquid assets are exhausted in paying out deposit withdrawals, and institutional deposits are not paid, this would still leave about half the deposits (NR 40-50 billion, about 3 percent of GDP) in depositor’s claims which the deposit insurance scheme could not cover without further capitalization.

28. Should a genuine crisis materialize, it is unlikely that damage would be contained to only Class B and Class C institutions. A sudden drop in remittances is likely to squeeze liquidity across the banking system. Moreover, systemic financial crises can be triggered by failures in a few institutions that spread quickly due to erosion of confidence and interconnectedness among banks. While the extent of interconnectedness is currently unknown, contagion effects could substantially raise the price tag of a financial crisis.

29. Costs would increase dramatically if the crisis spreads to Class A banks. Table 5 shows the potential fiscal costs of a scenario where an escalating financial crisis initially afflicts smaller and weaker banks, causing deposit runs, and then spreads to larger banks. This represents an extreme loss of confidence, given past history of deposit flight to Class A institutions (including the two net negative state banks) during times of distress. However, to illustrate magnitude, deposit runs at NBL and RBB alone could add more than 5 percent of GDP to fiscal costs. If all banks including large Class A institutions were affected, initial fiscal costs could rise to as high as one-third of GDP. Though final costs to the government will depend on recoveries from problem loans and collateral, weaknesses and inefficiency in the bankruptcy process may significantly erode prospects of good cost recovery.

Table 5.Potential Liquidity Needs During Crisis
Affected group:Share in System Deposits (%)Liquidity Needs (% GDP)
Deposits in all B and C class banks outside top 10 by assets11.75.0
Deposits in all B and C class banks outside top 10 by assets, NBL and RBB24.611.3
Deposits in all banks outside top 10 by assets, NBL and RBB51.926.1
Deposits in all banks outside top 10 by assets, and 50 percent of deposits in top 10 banks75.836.2
Source: Staff calculations.
Source: Staff calculations.

Over-performance relative to the budget was due mainly to a small over-performance in revenue (0.2 percent of GDP more than projected in tax and non-tax revenues), combined with a shortfall of 1.3 percent of GDP in current spending (mainly goods, services, and operations and maintenance), lower-than-budgeted capital expenditure (2 percent of GDP less than expected)—offset by lower grant disbursements. Staff estimates the 2011/12 capital budget execution at about 73 percent, compared with 81 percent in 2010/11.

NOC and NEA incurred losses of Nrs 13 billion (0.8 percent of GDP) and Nrs 6 billion (0.4 percent of GDP) in 2011/12, respectively. NOC’s debts stand at Nrs 27 billion (1.7 percent of GDP), including Nrs 10 billion owed to the government, and Nrs 10 billion borrowed from pension funds with a government guarantee. The NOC has stopped servicing the loans owed to the government and the pension funds, and requested to write off these debts. NEA’s debts stand at Nrs 61 billion (3.9 percent of GDP), which is owed to the government and not serviced.

The pension schemes include the Provident Fund and Citizen Investment Trust, both backed by government guarantees.

These results should be interpreted with caution, due to data limitations and variation in norms across methodologies. The MB approach yields a norm of ½ percent of GDP, while the ES norm is 1¼ percent of GDP.

Reported data covers Class A (commercial banks) only. Aggregate financial sector indicators for Class B (development banks) and Class C (finance companies) are not yet available.

The accounting framework for non-performing assets in Nepal, in which interest payment is a primary factor in loan classification, may partly explain this lack of impact on financial outcome. If an interest payment is overdue up to 3 months, the loan is classified as “good” and provisioning rate is 1 percent; overdue interest of 3 to 6 months, the loan is “substandard” (25 percent provisioning); for 6 months to 1 year, “doubtful” and 50 percent provisioning; more than 1 year is “bad”, with 100 percent provisioning. The term non-performing loans cover all loans except “good”.

Growth in outgoing workers slowed to 8 percent in 2011/12, and the growth rate of remittances in 2012/13 is thus expected to moderate. Import growth fell sharply last year, but is expected to normalize in relation to remittances (there is also a strong lagged relationship between import growth and remittances, which suggests a recovery in imports in 2012/13). In addition, given the interest rate gap vis-à-vis India, there is a risk of capital flight (including through unrecorded channels), which is reflected in reversal of other investments (net) on the financial account.

The debt sustainability analysis framework (see Appendix) classifies Nepal has having a moderate risk of debt distress.

A move to market cost would need to be accompanied by measures to protect the poor. There is not currently in place the administrative architecture needed to enact a direct cash transfer system.

The draft full-year budget was not shared with the mission. However, the major spending and financing elements were discussed, and these are reflected in the projections for 2012/13 in Table 2.

Reserve requirements were raised in July (one percentage point for commercial banks and a half percentage point for development banks), and NRB reverse repurchase operations have absorbed some NR 8.5 billion between July and September 2012. More frequent open market operations, would serve to mop up excess liquidity,

Occasional Paper #270, Exchange Rate Regimes and the Stability of the International Monetary System.

An additional factor weakening the reliability of reported data is the relative strength of supervisory resources. With over 200 financial institutions under its purview, the NRB is stretched to adequately monitor the financial system. Each supervisory department has only about 40 personnel. For development banks, on-site inspections tend to cover the top 20–30 borrowers. For commercial banks coverage of their loan assessment is around two percent, which is comparatively low.

Class B banks are “development banks” and Class C banks are “financial companies”. They have broadly similar operations as Class A banks (commercial banks) but are generally smaller in scale.

According to latest available data (June 2012), Nepal Bank Limited and Rastriya Banijya Bank have net negative capital of NR 4.4 billion and NR 8.7 billion, respectively. The government recently injected NR 1.4 billion via subscription to a rights issue in NBL, and NR 4.3 billion in RBB. NBL and RBB are 45.5 percent and 100 percent government owned, respectively.

Since May 2011, 40 out of nearly 200 financial institutions have approached NRB for approval to merge, of which 19 cases have been approved.

Experience with directed lending in the transition and Central Asian countries is potentially relevant for Nepal, given some similarities. See Zoli, IMF Working Paper 01/157, Cost and Effectiveness of Banking Sector Restructuring in Transition Economies.

Remittance inflows from India are not well covered by official statistics, but it is generally believed that there are 1½–2 million Nepalese workers in India, who account for about 20 percent of Nepal’s receipts of remittances.

According to government statistics there were 2,108 foreign investment projects in Nepal at the end of 2010/11, worth a total of approximately $2.6 billion. India was the most important foreign investor with 501 ventures, accounting for nearly 47.6 percent of total foreign investment. Ten of the 20 largest foreign enterprises in Nepal had Indian investment. China with 401 ventures ranked second, accounting for 10.3 percent, and U.S. with 174 ventures ranked third, accounting for 7.3 percent of total foreign investment.

BIS data shows foreign bank loans and deposits with Nepalese banks amount to $80 million (0.4 percent of GDP).

A stream of literature suggests that remittances have marginal impact on economic growth (Jonwanich (2007) and Barajas et al (2009)). Data limitations hinder meaningful empirical work, but staff estimates of the relationship between remittances and growth in Nepal suggest that a shock to these inflows would have a limited impact on growth.

Ding, Ding and I. Masha, “India’s Growth Spillovers to South Asia,” IMF Working Paper 12/56 (Washington: International Monetary Fund).

Dabla-Norris, Era, R. Espinoza and S. Jahan, “Spillovers to Low-income Countries: Importance of Systemic Emerging Markets,” IMF Working Paper 12/49 (Washington: International Monetary Fund).

A. Barajas et al (2012), “Remittances and Business Cycle Synchronization: Evidence from Aggregate and Bilateral Panel Data,” IMF Working Paper (to be published).

This is a one-off shock rather than a step-decrease in growth. It assumes a dip in India’s growth by 1 percentage point in 2013 compared to the baseline, with growth recovering gradually to the baseline level of 6.9 percent by 2016. In the medium term, the output loss in India would be 1.3 percent (calculated as cumulative losses of real GDP in 2013-2016 as a percent of the 2013–16 baseline real GDP).

The assumption of output loss is based on the average level of crisis episodes in the past few decades. In low income countries, macro-financial linkages tend to be lower compared to more advanced economies, and therefore output loss may be smaller. However, Nepal’s financial sector is relatively large, standing at 80 percent of GDP, which is comparable to many emerging economies.

The widening of the current account balance is consistent with recent experience in Nepal. Remittances appear to decline in times of uncertainty. Further, when there is “flight to safety” the general population tends to import gold as a store of value—increasing imports.

See IMF Country Reports 10/184 and 08/182 for a description of the evolution of banking sector problems.

Twenty banks accounting for 26 percent of banking system deposits received liquidity assistance. Prudential criteria relating to real estate lending, margin loans, and loans against promoter shares were relaxed, and a 13-month accounting year in FY 2010/11 was allowed for banks to report income, without which two-thirds of the banks would not have reported a profit for the financial year. Intervention options were rarely exercised even though solvency concerns are likely widespread; two finance companies were placed under Prompt Corrective Action (PCA), one development bank was declared problematic, and one finance company was liquidated.

NBL, RBB, and Agricultural Development Bank of Nepal (ADBN) are the three major state owned commercial banks. Only ADBN meets minimum CAR.

An NRB bylaw on mergers relaxed capital requirements, extended grace periods to bring violations of limits on promoter shares, loans to single borrowers, loan to deposit ratios, and controlling ownership into conformity. Some of the forbearance extends beyond prudential considerations, and includes liberalized refinancing conditions with the NRB. Restrictions on opening new branches within Kathmandu valley, as well as requirements for lending to “deprived sectors” have also been relaxed, along with tax breaks for merging institutions. Forty banks have approached the NRB for approval to merge so far, of which 19 have been granted approval to merge since May 2011, and the remaining are in various stages of the approval process.

At present, the repayment process is subject to delays and could take several months. An important legislation to expedite the process of repayment, which follows recommendations made by the World Bank, is on hold due to the current political circumstances.

NRB estimates that margin loans could be as high as 5 percent of total loans, but due to data issues and possible misreporting, the cited number is the best estimate based on available data.

Based on data up to January 2012.

The fiscal year in Nepal ends in mid-July.

Previous stress tests revealed that a 30 percent fall in real estate prices could lead to a 20 percentage point increase in NPLs. See IMF Country Report 10/184 for details.

This refers to the scenario in which 25 percent of performing loans of real estate and housing are directly downgraded to loss loans.

These scenarios are based on estimates specific to the Nepal banking system, taking into account estimated values for liquid assets and resources of the deposit insurance scheme before calculating residual fiscal cost associated with coverage of remaining deposits in the event of a crisis. The fiscal cost in the previous section is an average based on cross-country experience.

For known cases in developing Asia, fiscal costs were estimated to be 5 percent of GDP in Sri Lanka in 1989, and 10 percent of GDP in Vietnam in 1997. However, costs can be much higher, as seen during the East Asian crisis (see Laeven and Valencia, IMF WP 08/224).

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