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Statement by Der Jiun Chia, Executive Director for Nepal and Chaipat Poonpatpibul, Senior Advisor November 16, 2012

Author(s):
International Monetary Fund
Published Date:
December 2012
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1. Our Nepalese authorities would like to thank the IMF mission team for the comprehensive assessment of the economy as well as the constructive policy dialogue during the 2012 Article IV consultation. Risks in the financial sector have abated, and macroeconomic conditions have improved since the last assessment. Notwithstanding these positive developments, our authorities are cognizant of the remaining challenges on both the economic and political fronts and continue to be committed to pursue policies to achieve sustained and inclusive growth and foster economic and financial stability.

Recent Developments and Macroeconomic Outlook

2. Despite the adverse prospects and sharply rising risks in 2010/11 particularly from the intensified stress in the banking sector and the prolonged political transition, the efforts by our authorities to restore confidence in the banking sector through liquidity provision, accommodative monetary policy, and strengthened supervisory framework together with favorable remittance proceeds helped prevent the problems that were concentrated in small financial institutions from spreading to the other parts of the system. The banking sector has since started to stabilize and the economy has begun to move back to its normal trajectory.

3. In addition to receding stress in the banking sector and strong remittances, robust growth in the services sector and favorable weather for agricultural production contributed to the 4.6 percent economic expansion in 2011/12 after a dip to 3.9 percent in 2010/11. For 2012/13, although staff’s growth projection is 3.8 percent, our authorities expect that it would not be lower than 4 percent as the services sector has continued to perform well, significant progress has been made in resolving the banking sector problems, and remittances have continued to be at high levels albeit with relatively softer growth.

4. On the economic stability side, average inflation declined to 8.3 percent in 2011/12 and is expected to remain within the NRB’s target of 7.5 percent in 2012/13, assuming the likely economic slowdown in India, stable exchange rate, and slower money growth. The primary fiscal balance recorded a lower deficit in 2011/12 than in 2010/11, owing to slower capital spending relative to rising revenue mobilization as a result of reform efforts. However, the recent data show that both government revenue and spending in the first month of 2012/13 grew significantly from the same period in the previous year. With the strong outturn of remittances, the current account shifted to a notable surplus and the import coverage of Nepal Rastra Bank (NRB)’s foreign exchange reserves at mid-July, 2012 rose to as high as 8.8 months of imports of goods and services.1

5. Notwithstanding the prospects of continued growth and some moderation of inflation, the authorities remain cautious about the risks on both the external and internal fronts. They recognize that India’s as well as global slowdown is a major external risk to growth with potentially sizeable impact on remittances, exports, as well as foreign investment. It is also still not clear if the real estate sector is out of the woods. In addition, they are aware that the prolonged political uncertainty can affect fiscal budget implementation and investment decisions of the private sector. Fragility in the financial sector also continues to be an important risk. On the inflation front, they see that higher global fuel prices and some supply-side bottlenecks could emerge as significant drivers of inflation in the future.

Fiscal policy

6. Our authorities are fully committed to maintaining fiscal discipline even during the ongoing political transition period. They recognize that an immediate priority is to pass a full-year budget to ensure timely execution of the envisaged spending in the remaining period of the fiscal year 2012/13. The ruling political parties are exerting full efforts to gather support to pass this budget and, in the case further delay, the current administration will consider to authorize spending through executive orders. Against the shortfall in 2011/12, capital spending is expected to increase in 2012/13 with its declaration as “Nepal Investment Year” to attract foreign investment and the establishment of the new Investment Board in charge of promoting large investment projects.

7. On the revenue side, with the enhanced efforts on revenue mobilization assisted by the Fund experts, the ratio of tax to GDP has reached 15.7 percent in 2011/12. Further efforts will focus on expanding the tax base, executing tax law compliance, controlling revenue leakage, and strengthening human resource development. Our authorities recognize that there is scope to further enhance revenue and view that the main challenge is to increase domestic taxation and reduce reliance on import taxes. The Fund’s further technical support in this area is highly appreciated and it will continue to be crucial for further progress.

8. With significant quasi-fiscal implications, continued deficits at the National Oil Corporation (NOC) and the National Electricity Authorities (NEA) need to be addressed. Tackling this problem through implementing an “automatic price mechanism” together with providing well-targeted subsidies to the vulnerable groups is an option; however, this is not an ideal choice under the current political transition period. Likewise, our authorities are open to discuss pension reform and the desirable modalities but this area of reform also needs to await decisions of the new government.

Monetary and exchange rate policy

9. Monetary policy in Nepal has been formulated with the objectives of maintaining price, external sector, and financial sector stability, as well as promoting financial access to the general public and facilitating sustainable economic growth. In 2012/13, the targets include limiting inflation at 7.5 percent, maintaining foreign reserves equivalent to at least 8 months to imports, and attaining credit growth of 15 percent to support economic growth. Monetary management would be carried out cautiously by closely taking into account the risks to inflation from volatile oil prices in the international market and increasing domestic demand on one hand and possible adverse impact on economic growth and financial sector stability from inadequate liquidity and credit growth on the other hand.

10. Our authorities view that maintaining the pegged exchange rate with the Indian Rupee is still appropriate as a means to maintain economic stability as it provides a transparent and stable anchor for the conduct of monetary policy. They would closely monitor interest rate differentials between India and Nepal and cross-border flows. They view that deposit rate differentials are the main factor behind cross-border capital flows rather than interbank rate differentials. As the former is significantly less than the latter, they assess that an occurrence of capital flight is less likely than in the staff’s assessment. In this regard, they regard the peg as appropriate, but are open to review this if conditions change and no longer support it.

Financial Sector

11. Our authorities view that the actions to resolve the problems in 2011/12 in effect have helped stabilize the banking sector. Nonetheless, they still see the need to push forward with further financial sector reforms to address the remaining challenges and strengthen the system as a whole, while taking into account impact on the real sector during the course of the reforms. They view that the reform pace needs to be appropriate to the circumstances and the financial landscape in Nepal. Further initiatives will focus on ensuring timely amendment of the relevant acts, bylaws and licensing policies, strengthening the capital base of financial institutions, implementing risk-based supervision system, enhancing regulatory and supervisory capacity, and promoting financial access to the general public especially in the rural areas.

12. For the key legal reforms, both the amended draft of Nepal Rastra Bank Act, 2002 to increase effectiveness of NRB as a financial institution regulator and the revised draft Bill of the Bank and Financial Institutions Act (BAFIA), 2006 that addresses major issues related to liquidation procedures of financial institutions have been submitted to the parliament. However, due to an absence of parliament, the authorities are trying to legalize these laws through issuing ordinance. Being cognizant that the proliferation of banks has continued to overstretch supervisory capacity of the NRB, moratorium of licensing to commercial banks, development banks and finance companies has been extended except to “D” class financial institutions (micro finance). Meanwhile, the threshold of deposit insurance has been increased to NPR 300,000 from 200,000 to protect the small depositors and enhance depositor’s confidence towards financial institutions whereas a modified Deposit Guarantee Act that would incorporate the explicit procedure of deposit payments would be drafted and presented to the future parliament.

Structural Policies

13. Structural reforms on various fronts will continue to be further strengthened. Removing structural bottlenecks especially in electricity generation will help raise potential output of the country. In this regard, a total of 70 megawatt of electricity would be increased in 2012/13 from the completion of six different hydropower projects. In addition, the authorities have decided to form a steering committee across the government and with the private sector and development partners to further accelerate hydropower development. The formation of the new Investment Board under the chairmanship of the Prime Minister and the recent Bilateral Investment Promotion and Protection Agreement (BIPPA) with India are the major new steps to increase investment in infrastructure and improve the business climate.

Final Remark

14. Although tail risks have abated, and the overall macroeconomic prospects have improved, our Nepalese authorities recognize that the period ahead will continue to be challenging with significant risks on both the internal and external fronts. Hence, the focus of policies will be on ensuring economic and financial sector stability and simultaneously pursuing inclusive growth through enhanced efforts on structural reforms. Our authorities view that continued engagement with the Fund has been very helpful in keeping policies in Nepal on a sound footing and therefore are open to discuss a potential IMF program if the need arises.

This number differs from the number in the Staff Report of 6.8 months of imports as the NRB used the current year’s imports of goods and services as a denominator while the staff used the projected imports of goods and services of next year.

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