Nepal
Recent Economic Developments
Author:
International Monetary Fund
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Publication Date:
13 Aug 1997
eISBN:
9781451829860
Language:
English
Keywords:
ISCR; CR; private sector; broad money; sales tax; balance of payments; current account; financial system; foreign exchange; bank deposit
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This paper reviews economic developments in Nepal during 1990–97. With a new government coming to office in December 1994, progress on structural reforms stalled in 1994/95 and financial policies weakened. GDP growth slowed to 2.9 percent, reflecting adverse conditions in agriculture. The external situation deteriorated further in the first quarter of 1995/96 in part because interest rates in Nepal did not rise in line with rates in India, where monetary policy had tightened. Following a further change in government in September 1995, steps were taken to address the emerging macroeconomic imbalances.

Abstract

This paper reviews economic developments in Nepal during 1990–97. With a new government coming to office in December 1994, progress on structural reforms stalled in 1994/95 and financial policies weakened. GDP growth slowed to 2.9 percent, reflecting adverse conditions in agriculture. The external situation deteriorated further in the first quarter of 1995/96 in part because interest rates in Nepal did not rise in line with rates in India, where monetary policy had tightened. Following a further change in government in September 1995, steps were taken to address the emerging macroeconomic imbalances.

I. Introduction

1. After the transition to democracy in 1991, the Nepalese government launched an ambitious program of reforms and adjustment. Initially, satisfactory progress was made, both in terms of macroeconomic stabilization and the implementation of reforms. Over the three-year period ending 1993/94, real GDP growth averaged 5.7 percent, while inflation declined to single digits (Table 1). Tax reform measures introduced in 1992/93 helped boost revenue while the overall fiscal deficit was contained and the government’s net domestic borrowing was reduced to 1 percent of GDP over two years. On the external front, international reserves increased in each year as exports (mainly carpets and garments) grew rapidly and the current account deficit was largely financed by concessional borrowing and grants.

Table 1.

Selected Economic and Financial Indicators, 1992/93-1995/96 1/

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Sources: Nepalese authorities; and staff estimates and projections.

The fiscal year starts on July 16.

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

Minus sign indicates depreciation of the Nepalese rupee.

2. With a new government coming to office in December 1994, progress on structural reforms stalled in 1994/95 and financial policies weakened. GDP growth slowed to 2.9 percent, reflecting adverse conditions in agriculture, and the balance of payments surplus disappeared as Nepal’s exports of carpet and garments faltered and import growth accelerated. The external situation deteriorated further in the first quarter of 1995/96 in part because interest rates in Nepal did not rise in line with rates in India, where monetary policy had tightened.

3. Following a further change in government in September 1995, steps were taken to address the emerging macroeconomic imbalances. Administered prices for fertilizer, petroleum products and electricity were increased, and monetary conditions were initially tightened. However, tight credit policies could not be sustained during the remainder of the year as government domestic borrowing increased to 1.4 percent of GDP, reflecting both a weakening of revenues and a pickup of spending. While the external position stabilized in the second half of the year as import growth slowed markedly, the balance of payments registered a significant deficit for the year as a whole. Economic activity rebounded to 6.1 percent as favorable weather conditions boosted agricultural output, while inflation remained in single digits.

4. In the first eight months of 1996/97, financial policies were kept tight. While revenue growth has remained sluggish despite budget tax measures, government domestic borrowing has been moderate as spending was restrained. Domestic credit growth has decelerated sharply, in part due to structural problems in the banking system as well as reduced government reliance on borrowing from the central bank. Growth of economic activity has continued to be robust following another good monsoon and a pickup in the growth of manufacturing, as problems in the carpet and garment industries were overcome. Inflation rose temporarily, owing to earlier adjustments in administered prices and pressures on food prices, and declined subsequently to single digits. The external situation improved as demand for Nepal’s exports of carpets and garments has revived, and non-gold imports remained low.

5. Progress over the past year in the structural area should improve Nepal’s long-term growth prospects. Several new hydro projects have been initiated which, taken together, would imply a doubling of Nepal’s power capacity over the next five years. The new Nepal-India trade treaty signed in December 1996 greatly simplifies conditions for access of Nepalese goods to the Indian market, and should boost export prospects. In other reform areas, the record is more mixed. Preparations have continued toward introduction of a VAT in 1997/98. Some progress has been made on privatization—two enterprises have been sold, long-term leases have been arranged for two others and the government has reduced its ownership in the Nepal Bank Limited (NBL), making it majority private-owned. On reform in the banking sector, first steps have been taken to improve loan recovery in the Rastriya Banijya Bank (RBB), although its lending capacity remains impaired by a high proportion of non-performing assets.

II Macroeconomic Developments

A. Output

6. With agriculture still accounting for 40 percent of the economy, fluctuations in real GDP growth rates are mainly caused by fluctuations in agricultural output which, in turn, depend largely on weather-related factors. Real GDP (at market prices) grew by 6.1 percent in 1995/96 (Table 2), reflecting a recovery in agricultural output, as well as strong growth in the service sector. This can be compared with a GDP growth rate averaging 5.3 percent in the first half of the 1990s and 4.8 percent in the 1980s. In 1996/97, GDP growth is projected to slow to about 5 percent, with growth rates in the agriculture and service sectors moderating, but with output strengthening in the manufacturing sector.1

Table 2.

Real GDP Growth Rates, 1980/81-1996/97

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Sources: Central Bureau of Statistics; and IMF staff estimates.

Agriculture

7. After a poor monsoon in 1994/95, agricultural output rose strongly in 1995/96, in the wake of more favorable weather conditions. With another good monsoon in 1996/97, output growth is expected to be above the average of the past five years. The increase in agricultural output is reflected both in an increase in yield (in particular for paddy,2 wheat, and sugarcane), as well as an increase in cultivated area (Appendix Table 3).

8. Agricultural growth in the first half of the 1990s averaged only 2.2 percent per year, compared with 4.6 percent in the 1980s. Reasons for the slowdown include soil erosion and depletion, with a rapidly growing population farming increasingly marginal areas. Nepal’s agriculture sector is still quite underdeveloped, with shortages of rural credit and fertilizer, and only limited use of new technologies. Other impediments include weak transportation and trading infrastructures, poor irrigation systems and flaws in land tenure arrangements. In order to improve productivity and reduce the large fluctuations in agricultural output, the authorities are planning to implement an Agriculture Perspective Plan (APP) as a key component of the Ninth Plan. The APP—developed with technical assistance from the AsDB—targets (i) increased spending on rural infrastructure (particularly irrigation and feeder roads); (ii) improvements in fertilizer supply and distribution through increased private participation (while phasing out fertilizer subsidies);3 and (iii) increased emphasis on agriculture research.

Services and tourism

9. The service sector grew on average by 7½ percent per year during the 1990s, reflecting both a steady increase in tourism and a response to liberalization measures in a number of areas including banking, domestic transportation, and telecommunication. In 1995/96, output in the service sector increased by 7.3 percent, driven mainly by strong growth in the trade and transportation sectors. In particular, there was a large increase in the number of companies offering transportation and travel services following a temporary discount on custom tariffs given to such firms for importing vehicles.4

10. The tourism sector is estimated to account for 2-3 percent of recorded GDP, and contributes about 10 percent of foreign exchange earnings. Tourist arrivals have increased by 11 percent per year over the last three years (Appendix Table 7). However, expenditures per tourist have declined, reflecting an increasing share of Indian tourists and little growth at the high-income end of the market. Factors inhibiting tourism include environmental degradation in the Kathmandu valley and difficulties in serving major airline routes, particularly to Europe. The latter reflects financial and management problems of the national airline carrier—the Royal Nepal Airline Corporation (RNAC)—as well as limited growth among international carriers serving Kathmandu. Since the sector was opened to private participation in the early 1990s, Nepalese private airlines have accounted for a rising share of domestic air travel.

11. In early 1996, a number of telecommunications companies pre-qualified to apply for licences to provide “wireless” telephone services. However, auctions of licences have been delayed by legal challenges to the Government’s right to privatize such activity.

Industry

12. Output growth in the industrial sector has averaged 8½ percent per year thus far in the 1990s, substantially higher than in the 1980s. The improved growth rate reflects a positive response to various structural reforms in the early 1990s—including the Industrial Enterprise Act which simplified industrial licencing and registration procedures and the Foreign Investment Act which liberalized investment policy and allowed 100 percent foreign investment in large- and medium-scale industries. Growth in manufacturing sector has been particularly strong, led by food manufacturing (e.g., noodles, biscuits, and animal feeds), beverage production, and cement production. However, industrial growth slowed in 1994/95 and early 1995/96, following a significant slowdown in production of carpets and garments related to loss of export markets. Demand for Nepalese carpets plummeted in the wake of stories of use of child labor and health hazards in the chemical dyes used in carpet production. The demand for garments fell as the new arrangements of the Uruguay Round removed the earlier incentive of shifting production from India to Nepal which still had room under its export quotas.

13. Based on observations from the first half of 1996/97, growth of industrial output is expected to rebound to about 7 ½ percent this year, led by a strong recovery in production of carpets (as earlier problems were addressed) and garments, as well as continued robust growth in other areas, including food manufacturing, chemical production, and beverage production. However, growth of cement and vegetable ghee has slowed, as two major cement factories were closed for repairs and maintenance for several months early in the year, and as Indian export demand for vegetable ghee has decreased.

B. Investment and Saving

14. Gross domestic investment increased to 22 ½ percent of GDP in 1995/96 from 21 percent in 1993/94. While private investment was buoyant in the early 1990s, public investment has been the main source of the increase in recent years, reflecting in part the development of several small- and medium-scale hydropower projects (Table 3).

Table 3.

Investment and Saving, 1991/92-1995/96

(In percent of GDP)

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Sources: Central Bureau of Statistics; and IMF staff estimates.

15. Developments in savings are difficult to assess as savings figures are subject to large measurement problems—private sector savings are calculated residually and are directly affected by measurement errors related to the external current account.5 Measured national savings have not kept pace with the increase in investment, and the external current account deficit widened to 12 ½ percent of GDP in 1995/96 from 5 ½ percent in 1993/94. Although public sector savings increased slightly during this period, private sector savings dropped from 14 percent of GDP in 1993/94 to 8 percent in 1995/96. The decline in private savings in Nepal may be partly related to persistent negative real deposit rates that reflect structural problems in the banking sector which have led to wide spreads between lending and deposit rates (see Section IV.B).

C. Prices and Wages

16. Inflation in Nepal is heavily influenced by price developments in India, as the Nepalese rupee is pegged to the Indian rupee. Inflation in Nepal increased faster than in India in 1995/96, reflecting adjustments to administered prices for petroleum products, fertilizer, and electricity in Nepal. In early 1996/97, inflation rose further, peaking at 10 ½ percent in September, mainly on account of higher food prices in both Nepal and India (Appendix Table 8 and Chart 1).6 However, since January 1997, food prices have eased owing to a good winter crop, and the 12-month inflation rate came down to 8 ½ percent in March 1997.

Chart 1.
Chart 1.

Inflation (12 month rate)

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

17. Although no comprehensive information on actual wage and salaries is available, partial data suggest that wages and salaries have kept pace with inflation during the 1990s (Appendix Table 9). However, salary scales have been compressed in the public sector, and as a result, wages and salaries are generally much higher in the private sector for higher skilled jobs.7

18. Minimum wages—which vary with respect to region, sector, and degree of skill—have increased by 60-70 percent since 1990/91, and are currently in the range of Nrs 1,400 to 1,700 per month, including dearness allowances (cost of living increases). Although minimum wage requirements apply to both public and private sector workers, they are not strongly enforced among smaller private enterprises, and they do not apply to agriculture sector workers. Hence, minimum wage requirements have not been regarded as an important impediment to employment growth.

III. Fiscal Developments

A. Overview

19. In the early 1990s, the fiscal stance tightened and the government’s domestic borrowing declined in relation to GDP, as tax reform helped to raise revenues and expenditure management was tightened. However, against the backdrop of political change, revenue growth stagnated and new spending programs were initiated toward the end of 1994/95 and in 1995/96, and the fiscal deficit and domestic borrowing requirements increased (Table 4).

Table 4.

Fiscal Position, 1992/93-1996/97

(In percent of GDP)

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Source: Nepalese authorities; and staff estimates

Cash basis only: excludes direct payments and aid-in-kind

20. Fiscal targets were missed by a wide margin in 1995/96. The overall budget deficit (after grants) increased by 1.3 percent of GDP to 4.6 percent, reflecting an increase in spending of 1.6 percent of GDP, and a sharp slowdown in revenue growth. A mid-year budget review was initiated by the government but its completion was delayed by political events. As a result, austerity measures introduced in the last two months of the year—including cutbacks of nonpriority spending, measures to curb travel and entertainment expenses, and tightening of expenditure releases—came too late in the year. In the final months of the year, domestic borrowing rose sharply—with heavy reliance on overdraft borrowing from the NRB—reaching 1 ½ percent of GDP for the year as a whole, well above the ½ percent target.

21. In the 1996/97 budget, the government aimed to reduce domestic borrowing, mainly through tax measures aimed at raising revenue collections by 1 percent of GDP. In the first eight months of the year, the deficit (after grants) was 0.8 percent of GDP compared with 1.9 percent of GDP for the same period last year, despite continued lackluster revenue growth, as the pace of spending slowed. Cumulative domestic financing was broadly similar in relation to GDP as net foreign financing declined, but reliance on the NRB was greatly reduced, partly reflecting issuance of new longer term government securities.

B. Expenditures

22. Total expenditures were fairly constant as a percent of GDP over 1990/91-1994/95 (Chart 2).8 However, expenditures rose by 1.6 percent of GDP in 1995/96, largely as a result of higher spending on development. In particular, spending on several new hydropower projects accounted for 0.5 percentage points of the increase, while social programs introduced by the UML government—including the village development programs—gamed momentum (Appendix Table 10).9 Regular spending rose by 0.3 percent of GDP mainly due to wage increases.10 Foreign financing increased by about 1 percent of GDP, supported by improved administration of foreign-aided projects, which facilitated reimbursements by donors at a faster rate, allowing a net reduction of Nrs 800 million in the outstanding stock of claims to Nrs 3.6 billion by end 1995/96.

Chart 2:
Chart 2:

Expenditures

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

23. The 1996/97 budget provided for a further 1 ½ percent of GDP increase in development spending. More than half of this increase was accounted for by hydropower projects,11 while planned spending on health and drinking water projects was also raised following the successful Nepal Aid Group meeting in April 1996. Implementation of these projects was expected to imply a further sharp increase in foreign financing. Grants to VDC programs continued to be substantial, despite evidence that a large portion of funds transferred to VDCs last year remained unspent. Regular spending was budgeted to decline relative to GDP, mainly reflecting salary restraint12 and a continuation of austerity measures introduced toward the end of 1995/96.

24. Despite the budgeted increase, expenditure growth was flat in the first eight months of 1996/97 (Chart 3). Austerity measures introduced at the end of 1995/96 reduced “freeze” expenditures (spending carried into the new year from the previous year’s budget) by some Nrs 300 million. Moreover, development spending (excluding freeze) grew by only 4 percent, as releases were tightly controlled,13 and implementation of a number of foreign-aided projects slowed in the uncertain political environment. Cash reimbursements by external donors has been about Nrs 1 billion lower than in the same period last year, reflecting mainly the lower level of the initial stock of reimbursable claims. Regarding locally financed spending, releases to and the audit control of VDCs were tightened.14 In addition, the pace of regular spending has been below budget projections. Debt service costs are likely to be less than projected with the strengthening of the Nepalese rupee against third currencies.

Chart 3
Chart 3

Nepal: Selected Fiscal Indicators, 1994-97 1/

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

Source: Data provided by the Nepatese authorities.1/ Beginning of fiscal year is indicated by a dotted Line.2/ 3-period moving average.3/ Cumulative from start of fiscal year.

C. Revenues

25. Revenues rose strongly in 1993/94-1994/95 reflecting a combination of tax reforms and rapid import growth (Chart 4). However, in 1995/96 total revenues were flat in relation to GDP, falling well short of budget projections, as import growth decelerated and the benefits from earlier tax reforms faded. Custom duties declined by 0.3 percent of GDP, reflecting a slowdown in import growth and a shift in the composition toward Indian goods which attract lower tariffs. Direct taxes did better partly as a result of successful administrative efforts which added about 51,000 new tax payers to the tax rolls.

Chart 4:
Chart 4:

Revenues

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

26. In the 1996/97 budget, the government aimed to boost revenues by about 1 percent of GDP (about Nrs 3 billion) based on the following measures.

  • The sales tax rates of 10 and 20 percent were unified at 15 percent (with the exception of essential commodities which are exempt from sales tax).15 This was an important transitional step toward introducing the VAT as well as a significant revenue-enhancing measure as the larger share by value of sales tax was previously taxed at the lower rate. Other sales tax measures included introduction of taxes (5 percent) on air travel abroad (excluding India); an additional surcharge of 4 percent on cement and light beverages; and application of sales tax on timber sales (and removal of excise tax).16 In addition, the system of liquor administration was unified and brought under the sales tax.

  • Selected excise taxes and customs tariffs were increased to maintain the overall revenues on a number of upper-end consumer products for which the sales tax rate was lowered, leaving the total indirect tax rate broadly unchanged.17

  • New charges and fees were introduced to boost nontax revenues. Charges for new telephone installation were introduced; postal and firm registration fees were increased; passport fees were increased from Nrs 1,000 to Nrs 1,500; and fees for awarding telecom licenses were introduced (receipts of Nrs 220 million were anticipated from the auction of mobile telephone licenses).18

  • Administrative measures that would expand the tax net by a further 20,000 as well as increased use of advance taxes were expected to improve buoyancy of income taxes.19

27. Through the first eight months of 1996/97, the cumulative year-over-year growth of revenues was only 14 percent, well short of budget projections of 22 percent. Exogenous factors explain some of the shortfall. The sales tax base has been reduced owing to low production of some key commodities—especially cement—and a slowing of imports (excluding gold), especially from third countries,20 while sales of telecom licenses have not materialized because of legal challenges. However, part of the shortfall is policy related. Under pressure from textile trade groups, the government offered sales tax rebates on textile-related products to cushion the tax rate increase. Furthermore, rebates on the sales tax rate were maintained for diesel, petrol, and some other goods. In addition, revenues from new taxes—such as the new system for liquor taxation and fees for airline travel—have been less than expected because of slow implementation.

D. Public Enterprises

28. The performance of the public enterprise sector has shown a gradual improvement during the 1990s. The net income position turned around from about -0.6 percent of GDP to 1.1 percent of GDP in 1995/96 (Appendix Table 25), mainly reflecting strong increase in profitability of the Nepal Electricity Authority (NEA) and containment of losses of the Nepal Oil Corporation (NOC) and the Nepal Food Corporation (NFC). In addition, the number of loss-making enterprises has been reduced by seven. Some of this improvement can be attributed to the privatization program as a total of 12 enterprises have been transferred to the private sector and three were closed. The proceeds from privatization—cumulative of Nrs 620 million—have been held off the budget and reserved for restructuring: nearly Nrs 250 million of liabilities of privatized industries have been paid, leaving net privatization proceeds of about Nrs 370 million.21

29. Prices of certain key commodities—electricity, fertilizer, and petroleum products—are administered; supply of these commodities is mainly channeled through specialized public sector enterprises, including the NEA, the NOC, and the AIC. By contrast, food prices are not controlled and the NFC supplies only a small fraction of the market (mainly in hill areas at subsidized prices).

30. The NEA’s financial performance improved markedly from the early 1990s. Higher profits in recent years reflect substantial price increases aimed at raising internal resource generation for power sector investment and steps taken to reduce high operating costs and over staffing (over the past five years, staffing has been reduced by 15 percent). Since 1990, tariffs have been increased by 244 percent in nominal terms—the most recent increase was 20 percent in May 1996 following a two year gap—and by 74 percent in real terms. According to estimates of the Asian Development Bank, the NEA’s current average tariff level is about 78 percent of the estimated average long-run marginal cost of production and distribution of electricity in Nepal. Current tariffs in Nepal are significantly higher than in India where electricity is heavily subsidized, especially to farmers (Table 5).

Table 5:

Comparison of Fertilizer, Electricity, and Petroleum Product Prices

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Sources: NOC; International Energy Agency; Bloomberg Commodities Service; the Asian Development Bank; and staff estimates.

Import cost of fertilizer purchased by AIC.

NEA’s long run marginal cost of production.

Based on price of electricity in Rajasthan.

Average retail price in five industrialized countries—United States, Japan, France, Germany and the United Kingdom.

Wholesale cost of kerosene purchased by the NOC from vessels on the open seas.

31. The AIC was set up to supply fertilizer inputs to farmers at a low cost with budgetary support to cover losses. However, budgetary support has not been sufficient to cover operating losses reflecting delays in adjusting prices to reflect changes in international prices; the AIC has accumulated a debt of Nrs 383 million at year end 1995/96 (Appendix Table 26).22 Moreover, the fertilizer supplied by the AIC has fallen significantly short of farmers’ requirements; this shortfall is partially made up by supplies smuggled from India. At present, the price of urea is only 43 percent of the break-even level (taking account of internal costs as well as import costs), and the price of DAP is 84 percent of the break-even costs, despite an increase of 20 percent in urea and 35 percent in DAP in April 1996 (the first increase in three years). In the context of the Agricultural Perspective Plan, the government plans to phase out fertilizer subsidies and encourage private sector participation to supply fertilizer. A complicating factor is that Indian prices remain heavily subsidized and are at present below the price of fertilizer in Nepal (Table 5).

32. The NOC purchases petroleum products from world markets and re-exports those products to the Indian Oil Corporation (IOC). The IOC then delivers a range of petroleum products to Nepal.23 The import cost charged by the IOC—which is set semi-annually in October and April—is linked to the NOC’s purchase costs plus a margin for IOC’s storage and delivery costs. The retail cost of petroleum products in Nepal is adjusted by the NOC with the approval of the Ministry of Supplies on an ad hoc basis; price adjustments in excess of ten percent require approval by the government cabinet. In 1995/96, NOC earned profits of about Nrs 108 million, as revenues were boosted by an increase in retail petroleum product prices (weighted average) of 11.8 percent in April 1996.24 However during 1996/97, NOC’s input costs have increased by 15-30 percent as international prices have risen. The domestic prices of petroleum products in Nepal are low compared to world industrialized country prices, while the price of petrol is below that in India. As a result, NOC’s operating margins are now negative.

IV. Monetary and Financial System Trends

A. Monetary Developments

33. With Nepal’s fixed exchange rate regime, inflation is largely determined by developments in India; thus, the main objective of the NRB is to ensure that growth of domestic credit is consistent with maintaining international reserves at a comfortable level and with anticipated money demand. However, in 1995/96, the monetary stance was not kept consistently tight reflected in a Nrs 5 billion rise in the NRB’s net domestic assets (excluding valuation adjustments) (Table 6).25 Early in the year, Nepalese interest rates did not rise in line with comparable Indian rates (where monetary conditions had tightened since January 1995) (Chart 5)26 and the NRB’s overdraft to the government rose rapidly as domestic demand for treasury bills weakened. The resultant easing in credit conditions helped to fuel imports and led to a sharp deterioration of gross international reserves. In response, the NRB boosted interest rates on treasury bills in primary auctions in the second quarter of 1995/96, closing the interest gap to India by January 1996 and allowing a paydown in government overdraft that helped to tighten credit conditions. However, large borrowing requirements in the final quarter again led to a rapid increase in the government’s use of overdraft27 and credit conditions again eased despite NRB sale of its own bonds to absorb liquidity.

Table 6.

Monetary Accounts, 1993/94-1996/97

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Sources: Data supplied by the authorities; and staff estimates and projections.
Chart 5
Chart 5

Nepal: Selected Financial Indicators, 1994-97 1/

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

Source: Data provided by the Nepalese authorities.1/ Beginning of fiscal year is indicated by a dotted line.2/ Positive figure indicates injection of liquidity.3/ NRB purchases of T-bills.4/ Redemptions of Central Bank securities less new sales.

34. In the first eight months of 1996/97 the monetary stance tightened significantly, as the NRB’s net domestic assets were broadly unchanged. The main contributing factors have been subdued government borrowing requirements, plus a much more aggressive market borrowing program. Treasury bill rates, although declining, have been kept well above those in India, while the NRB successfully introduced two new debt instruments with longer maturities in the form of 364-day treasury bills and three-year development bonds. These instruments helped broaden the government securities market by attracting nonbank buyers (including large pension funds) that traditionally held term deposits with commercial banks.28

35. Growth of monetary aggregates declined during 1995/96 as deposit mobilization by banks slowed. Broad money growth declined to 14.7 percent from 16.1 percent in the previous year, while a shift from currency holdings into savings and time deposits implied a slowdown of narrow money growth to 11 ½ percent. The shift towards interest-earning deposits partly reflected an increase in time deposit rates by 1-1 ½ percentage points following the rise in interest rates on government securities (Chart 6), as well as increasing deposit mobilization efforts by nonbank finance companies. These institutions offered attractive interest rates on deposits for two years or more and attracted a total of Nrs 1.1 billion in deposits during 1995/96.29 In the first eight months of 1996/97, broad money growth slowed further to 10.6 percent. Narrow money growth has continued to be particularly weak.

Chart 6:
Chart 6:

Bank Deposit and Treasury Bill Rates

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

36. Credit growth slowed markedly from 23 percent during 1995/96 to 13 ½ percent in the first eight months of 1996/97. The deceleration has been particularly striking for private sector credit growth, which declined from 30 percent during 1995/96 to 15 percent in March 1997. In addition to monetary tightening, this decline has also been related to the increasingly limited capacity of commercial banks to lend, as the aggregate loan-deposit ratio rose above 90 percent in January 1997 (Chart 7a) after several years of rapid credit growth.30 The shortage of liquidity has been particularly acute in the wholly government-owned Rastriya Banijya Bank (RBB)—which accounts for about one third of deposits of the banking system.31 The RBB’s emphasis on longer term project lending has created a funding gap, as returns on many projects have not generated sufficient resources to meet scheduled repayments. In response, the RBB has intensified its efforts to recover overdue loans and has strictly limited further credit extension beyond prior commitments;32 accordingly, net credit extension by the RBB contracted in the first half of the year (Chart 7b). The RBB’s problems and the inability of the banking system to respond elastically has its roots in the structure and poor progress made to reform the banking system (Box 1).

Chart 7a:
Chart 7a:

Loan to Deposit Ratio

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

Chart 7b:
Chart 7b:

RBB’s Contribution to Net Lending

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

Banking System Performance 1/

The banking system in Nepal is dominated by government-owned banking institutions. Nepal’s first bank—the Nepal Bank Limited (NBL)—was formed in 1937 and was majority government-owned from 1956 until February 1997 when divestment reduced government ownership to 41 percent. The wholly government-owned RBB was formed in 1966 to provide investment capital Taken together, these two banks represent 63 percent of total commercial bank deposits.

For most of the last three decades, Nepal’s commercial banks were strongly influenced by government policies that emphasized development and social objectives ahead of commercial viability. Explicit targets were set for bank branching into rural areas; bank credit was directed to priority sectors; and public sector enterprises borrowed heavily. In addition, employment ranks swelled, much of it made up of nonprofessional staff. The profitability of these government-owned banks plummeted, nonperforming loans mounted and the quality of banking suffered.

Toward the end of 1980s and early 1990s, the government took steps to address these emerging problems. Both government-owned banks underwent a program of institutional strengthening and restructuring, with technical support from the World Bank. Fresh capital was injected and nonperforming loans of public sector enterprises paid. Private ownership of NBL was increased through new share issues. Competition was enhanced by licensing new joint venture banks, and later finance companies.

Helped by the greater private role in its ownership, NBL made significant strides under the restructuring program. Credit policies were revamped; loan recovery improved; branch operations and employment were reduced; and the overall balance sheet growth was curtailed. By contrast, the wholly goveverment-owned RBB made less progress. It continued to expand branches and employment. Emphasis on project lending for long terms (five to seven years) widened the maturity mismatch between assets and liabilities. As returns on many projects did not generate sufficient resources to meet scheduled repayments, the liquidity of the bank has been gradually absorbed.

Without more fundamental improvement in the RBB and change in the structure of the banking system, the overall performance of the banking system improved little in the 1990s. While private banks more than doubled there market share to 37 percent as the NBL retrenched operations, the share of RBB in the banking system remained unchanged at about 32 percent. Spreads between lending and deposit rates continued to widened (Chart 8). With low banking system efficiency, deposit growth tended to lag behind credit extension, contributing to the dramatic rise in the loan to deposit rate.

Chart 8
Chart 8

Banking System Intermediation Spread

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

1/ See also Nepal-Selected Issues Chapter III: Banking System and Capital Market Reforms (SM/96/117)

B. Financial System Developments

37. Nepal’s financial system has expanded greatly since liberalization in the early 1990s. The number of financial institutions has increased from 19 in July 1994 to 94 in January 1997, including co-operative societies, rural and development banks, commercial banks, and finance companies. The most rapid growth has been in the number of finance companies which have increased to 37 since the sector was opened in the early 1990s. This expansion has helped boost competition for funds, as finance companies have spurred innovation offering new and more flexible investment options (including transferable investment certificates) to the public. Although total finance company deposits are still small at Nrs 2,264 million (about 3 percent of total bank and finance company deposits), they have grown rapidly. On the asset side, finance company activity includes hire purchase, housing loans, term loans, and to a lesser extent leasing. Over the past year, the share of term loan financing increased from 30 to 40 percent of loans and advances, partly because such needs are not being met fully in the banking system.

38. With the rapid expansion in the financial sector, the NRB has taken steps to strengthen supervision. In particular, the staff of the bank inspection department has been increased and the number of bank branches and finance companies covered by on-site supervision has been increased; off site inspection has been made more regular. Nevertheless, much more effort is needed to adequately supervise the greatly expanded financial system. In this context, the NRB is seeking to increase the level of staff expertise through training and to strengthen off-site supervision. As well, the NRB has also slowed the process of providing new finance company licenses.33 The NRB has raised the minimum capital threshold for banks from Nrs 150 million to Nrs 500 million (to be phased in within five years for existing banks) to deepen the capital of banks in the system.

39. The government has also taken steps to strengthen the regulatory framework of capital markets, while opening them to foreign investment. The Securities Exchange Act (second amendment) was passed in Parliament and made effective in January 1997. It provides for a clearer separation of capital market regulatory authority and functions between the Securities Board and the Nepal Stock Exchange, and establishes the Securities Board as the apex capital market regulator. In addition, the Securities Investment Trust Act, which has been passed in Parliament, should help to develop the mutual fund industry and make available a wider range of savings instruments to the public and deepen capital markets. Steps have also been taken to restructure the NIDC mutual fund which has been closed for several years following a collapse in share prices in 1994.34 Under the new foreign exchange law passed in August 1996, foreign portfolio investment is allowed on the Nepal Stock Exchange, subject to an investment limit of 25 percent of a company’s paid up capital. Moreover, foreign securities firms are now permitted to hold up to 40 percent of the equity in joint venture brokerage firms.

V. External Developments

40. Nepal achieved substantial balance of payments surpluses during 1990/91-1993/94, and official reserves rose to an equivalent of six and a half months of imports. During these years, both exports and imports rose rapidly in response to a substantial liberalization in the trade regime, and trade shares of GDP almost doubled. The current account deficit averaged 6 ½ percent of GDP over this period (Table 7), but the large deficits were financed by inflows of official grants and concessional aid, as well as substantial unrecorded inflows reflected in errors and omissions.35

41. The external position weakened in 1994/95 and the first half of 1995/96, due to a slowdown in exports of carpets and garments (the two major export items), while rapid credit growth encouraged continued strong import growth (Chart 9). At the same time, a widening of the interest rate differential between India and Nepal encouraged net private capital outflows. The current account deficit widened to nearly 12 ½ percent of GDP in 1995/96 and official reserves fell by $104 million to $611 million in July 1996, the equivalent of 4 and a half months of imports.

Chart 9
Chart 9

Nepal: Selected External Indicators, 1994-1997 1/

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

Source: Data provided by the Nepalese authorities; and staff estimates.1/ Beginning of fiscal year is indicated by a dotted line.2/ 3-month moving average.

42. Starting in the second half of 1995/96 and continuing through the first eight months of 1996/97, the external position has stabilized. Non-gold import growth has slowed considerably, as monetary policy was tightened and interest rates were sharply increased. At the same time, export growth picked up following a revival in export demand. As a result, the current account deficit has narrowed, and foreign reserves have increased to about $624 million as of March 1997 (about five months of imports).

A. Exports

43. Nepal’s exports are highly concentrated, with carpet exports to Europe and garment exports to the United States representing over 70 percent of the total (Appendix Table 19). However, the export base has become more diversified in recent years as a result of rapid growth in exports to India—which consist of a mix of agricultural items and light manufactured goods. Such exports accounted for 20 percent of total exports in 1995/96, up from less than 10 percent in the early 1990s (Appendix Table 21).

Table 7.

Balance of Payments, 1992/93-1996/97

(In millions of US dollars)

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Source: Data provided by Nepalese authorities; and staff estimates
Table 8:

Cross-Country Comparison of Trade Regimes

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Sources: IMF; World Bank, “Trade Policy Reform in Bangladesh,” 1996; Francis Ng, Alexander Yeats, “Open Economies Work Better! Did Africa’s Protectionist Policies Cause Its Marginalization in World Trade?” World Bank Policy Research Working Paper, Appendix, 1996; National Bureau of Statistics, Bangladesh Government.

Normal maximum rate excluding other charges.

Non-tariff measures include QRs in the form of all types of licences and import authorizations, quotas, import prohibitions, advance import deposits, foreign exchange restrictions, that is affected by an non-tariff measure applied to a tariff line item.

According to World Bank estimates, in 1995/96 the import weighted average tariff rate was 21 percent.

44. After registering growth rates of over 20 percent in the early 1990s, exports fell by 10 ½ percent in 1994/95, reflecting both weakness in demand for carpets and garments in key markets, as well as other structural factors.36 The weakness continued in the first half of 1995/96, but export growth recovered in the second half of that year. In the first seven months of 1996/97, exports were 16 ½ percent higher than a year earlier, with exports of carpets and garments and exports to India growing strongly. The recovery was partly due to efforts by local manufacturers to improve quality and design of the carpets, including introduction of “child-labor free” certificate. At the same time, demand for Nepalese garments picked up in the United States, while the government has helped to reduce costs by allowing access to dollar denominated letters of credit for imported raw materials, and providing bonded warehouse facilities.

B. Imports

45. Imports of manufactured goods, machinery, and transport equipment account for nearly 60 percent of Nepal’s total imports (Appendix Table 20). Many of these products are related to various development projects and financed by foreign aid. Food products and medical products are also imported, mainly from India, while raw materials and minerals are imported from third countries. The latter includes imports of gold and silver, which have provided a route for workers’ remittances (e.g., by ghurka soldiers stationed abroad). In recent years, gold imports have surged and now account for more than 20 percent of total imports. However, less than 5 percent of the gold imports are estimated to be for domestic use in Nepal, while the rest is believed to be smuggled to India.37,38

46. Import growth slowed to 9 percent in 1995/96, after registering growth rates of over 20 percent in each of the earlier three years. The slowdown was due to a number of factors including a lightening of monetary conditions; a weakening of the stimulus from import liberalization in the early 1990s; and reduced imports of certain products such as ball bearings and computer parts that often were smuggled to India, following cuts in Indian tariff rates for those items.

47. Many of these factors continued to affect imports in 1996/97. In addition, there was a marked slowdown in aid-related imports, as implementation of foreign-aided projects slowed. However, imports of gold rose substantially in the first four months of 1996/97. A possible explanation for this increase is that ghurkas stationed in Hong Kong are sending money back to Nepal in light of uncertainty in advance of Hong Kong’s transfer back to China.

C. Services

48. The service account is mainly driven by fluctuations in the travel account and gold-related receipts (Appendix Table 22). The service account improved steadily in the early 1990s, mainly reflecting a strong growth in the tourism sector. However, the surplus in the service account declined in 1995/96, in part because of a fall in gold-related receipts and a decline in net receipts from travel. The latter reflected a strong increase in travel expenditures abroad, combined with only a small increase in travel receipts (although tourism arrivals increased, there was a decline in expenditures per tourist). Indications are that the weakness in the service account in 1995/96 has been reversed in the first half of 1996/97, as gold imports—and corresponding service receipts—again increased sharply.

D. Capital Account

49. Data on the capital account are particularly weak. Data on official aid flows are unreliable, while there is little information on private capital flows, including capital movements between India and Nepal and foreign direct investment.

50. Official grants and loans increased quite steadily throughout the first half of the 1990s, reaching $283 million (6 ½ percent of GDP) in 1994/95, with grants accounting for a rising share of total disbursements. Disbursements are reported to have slowed in 1995/96, although this weakness may be partly attributable to lags in reporting, since budget information shows a substantial rise in foreign financing of the government in 1995/96.39 A further slowdown of official disbursements so far in 1996/97 is consistent with the fiscal accounts which also reflect a slowdown in foreign financing.

51. The authorities have started to collect data on private capital flows. Although these capital flows are still very low, about $7 million in 1995/96, they have recently started to grow. Increased foreign investment in the hydropower sector is expected to contribute to more sizeable private capital flows in the future. For example, the Khimti Kola project alone implies foreign investment of $34 million. The liberalization of limits on small direct investments and for portfolio investment should also encourage rising inflows.

E. Exchange Rate Developments and Exchange System

52. The Nepalese rupee has been pegged to the Indian rupee at the rate of Nrs 1.6 per Indian rupee since March 1993, and movements in the value of the Nepalese rupee reflect movements in the Indian rupee against third currencies. The Nepalese rupee depreciated sharply along with the Indian rupee against the U.S. dollar in 1995 (Chart 10). The nominal effective exchange rate remained relatively stable over February - December 1996 and appreciated slightly in the first two months of 1997. The real effective exchange rate appreciated during 1996 and early in 1997; in February 1997 it was 5 ½ percent above its average value since March 1993. In terms of Nepal’s position vis-à-vis the main export competitors, there has been a small loss of competitiveness versus Bangladesh over the past two years, white Nepal has gained ground relative to China.

Chart 10
Chart 10

Nepal: Exchange Rate Developments, 1991-1997

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

Source: Data provided by the Nepalese authorities; and IMF, Information Notice System.1/ End of period.

53. Nepal formally accepted the obligations of Article VIII in 1993 and continues to maintain a liberal trade and payments regime. There have been no substantive changes to Nepal’s payments system since then. Indicative limits for allowances with respect to travel to several non-industrialized countries were tightened to prevent abuses in June 1996,40 but all bona fide requests for travel continue to be met.

VI. Structural Developments

A. Power Sector

Meeting domestic power needs

54. Only 15 percent of the population in Nepal has access to electricity, and the country’s per capita consumption of energy is among the lowest in the region. The shortage of power hinders developments in the industrial sector and impedes economic growth. To address this problem, the government has in recent years focused on further development of Nepal’s enormous hydropower potential: the hydropower capacity is currently about 280 MW, but the economically exploitable potential is estimated at about 43,000 MW.

55. The development of the hydropower sector encountered a setback in 1995 when the World Bank decided to cancel its involvement in the 200 MW Arun III project. However, the authorities have since then mobilized several new small- and medium-scale projects, which taken together would surpass the size of Arun III, and more than double Nepal’s power capacity over the coming five years. Construction has begun on the largest of these projects—the 144 MW Kali Gandaki project—which is being financed on concessional terms by the AsDB and OECF. In order to generate resources to meet local costs related to these investment projects, the Nepal Electricity Authority (NEA) has more than doubled electricity tariffs since 1992.41 The latest increase in May 1996 was 20 percent.

56. In addition to the public sector projects, a key aspect of the government’s energy strategy is to promote private sector participation and attract foreign investors. To encourage such investment, the government passed legislation in 1992 which included the Hydropower Development Policy; the Electricity Act; the Industrial Enterprise Act; and the Foreign Investment and Technology Transfer Act. These acts and regulations allow full private ownership (either foreign or local); prohibits nationalization of private sector projects; guarantees availability of foreign exchange for debt service and equity repatriation; and provides various fiscal incentives, such as income tax exemptions, and low custom duty (1 percent) on imported equipment. Also, a one-window service system for foreign investors has been established through the Electricity Development Center. Initially, private investment was very small scale, related mainly to captive power projects. More recently, the momentum has increased and memoranda of understanding have been signed for several private sector projects. Of these, the Khimti Khola (60 MW) and Bhotekoshi (36 MW) projects are most advanced: power purchase agreements have been signed; financial closure has been reached for Khimti Khola; and both should begin operation in 1999/2000-2001/02.

57. Domestic demand for power is estimated to grow by at least 10 percent per year in the medium term, and further developments in the power sector is necessary. To this end, a list of feasible small- and medium-scale projects have been developed through a screening and ranking process, involving technical assistance from the World Bank. The intention is that these projects would be taken up by the private sector, with financing support from a power development fund to be set up by the World Bank.

Potential for power exports

58. Looking beyond the domestic market, Nepal has enormous potential for power exports to India, which increasingly suffers from power shortages. In this respect, two important agreements were reached with India during 1996: (i) the Mahakali treaty, which is an agreement to jointly develop the hydro potential of the Mahakali river that runs between India and Nepal; and (ii) the power trade agreement, which states that any party (government or private) in either country can enter into a power trade agreement, and autonomously determine agreement parameters such as quantities, tariffs etc. The export-oriented projects could be very large scale, and given the scale of funding involved would need to be financed and operated by foreign investors. Several potential projects have been under consideration by foreign power companies, notably the 750 MW West Seti project (for which a survey license has been issued), the 400 MW Arun project, and the 10,800 MW Chisapani project. The government’s policy is to allocate licenses for these projects through open and transparent bidding procedures. The pace at which these projects can be implemented will crucially depend on the rehabilitation of the financially weak state electricity boards in India, which would be the main purchasers.

59. While these projects are still far from fruition, the potential impact on the Nepalese economy of the prospective export-oriented projects could be very large. The government would earn revenues from the sale of electricity abroad through an export tax and royalties, and (after 15 years) by way of corporate income tax. For example, preliminary estimates indicate that for a 5,000 MW project, the fiscal revenues could amount to 1-1½ percent of GDP per year during the first 15 years of operation, and up to 5-7 percent per year thereafter.

B. Trade Reforms

60. Nepal’s trade and payments system was significantly liberalized between 1991/92-1993/94. The tariff structure was simplified and the number of bands were reduced. Nontariff barriers were liberalized by eliminating quantitative restrictions with a few exceptions and all imports were brought under an open license system. Full current account convertibility was introduced in July 1994.42 In response to this substantial liberalization, both exports and imports rose rapidly, and trade shares of GDP almost doubled (Chart 11).

Chart 11:
Chart 11:

Import and Export Shares in GDP

Citation: IMF Staff Country Reports 1997, 062; 10.5089/9781451829860.002.A001

61. Nepal’s current trade regime is relatively open by South Asian standards (Table 8). With the rationalization of tariffs, Nepal’s average tariff (weighted) is significantly lower than the other countries in the region, although it is still high when compared to countries in Southeast and East Asia. The number of tariff bands in Nepal has been reduced from 100 to 5, and compares favorably with other South Asian countries. While Nepal maintains the highest maximum tariff in the region, this rate applies to only selected luxury goods, such as automobiles, for which there is no local manufacturing, and thus it is designed to enhance revenues rather protect domestic industry.43 In terms of average non-tariff coverage, the Nepalese regime is much more open than India’s, and compares well to countries in East and Southeast Asia.

62. An important recent development on the trade front has been the signing of the Nepal India Trade Treaty in December 1996 (see Box 2). The treaty will provide Nepal greater access to the Indian market, and could encourage increased Indian direct investment in Nepal. In addition, understandings have been reached with India on improved transit facilities for Nepalese goods through India, which could significantly reduce costs of transportation of products to third countries. New transit arrangements are to be finalized in a revised transit treaty, when the current treaty expires in 1997.

63. Nepal has obtained observer status at the World Trade Organization (WTO) and took part in the ministerial conference of the WTO held in Singapore in 1996. A government-appointed task force is preparing a membership application in consultation with the WTO.44

Nepal-India Trade Treaty

Background

Since 1950, trade between India and Nepal has been conducted under the umbrella of a series of treaties. The Nepal-India Trade and Commerce Treaty of 1950 granted Nepal unrestricted right of commercial transit of goods through the territory and ports of India. Until the late 1960s, these treaties were comprehensive, in that they covered both trade and transit arrangements. Since 1978, trade and transit issues have been covered in two separate treaties. The trade treaty was renewed at the end of 1996, while the transit treaty will be renewed at the end of 1997.

Main features of the new Nepal-India trade treaty

The new treaty contains a number of features that should substantially broaden Nepal’s access to Indian markets:

  • Removal of 50% material content requirement: The provisions requiring 50 percent of Nepalese labor, Nepalese materials and Indian material in order for exports from Nepal to qualify for preferential duty free treatment have been removed.

  • Procedures for preferential treatment simplified: According to the new provisions goods, from Nepal which are accompanied by a certificate of origin will not be subject to delays and detentions. The certificate itself is to be issued by a committee located in Nepal which would include representatives of the Nepal Chamber of Commerce.

  • Negative list for exports shortened from seven to three: The negative list comprises of alcoholic liquor and beverages and their concentrates (except industrial spirits), perfumes and cosmetics of non-Nepalese-Indian brand names, and cigarettes and tobacco. Export of beer is to be allowed but not on duty-free terms.

  • Application of countervailing duty eased: Nepalese goods will be subject to an effective rate of countervailing duty that is equivalent to the effective rate of excise duty that is applicable to similar Indian goods, rather than be subject to India’s highest duty rate for each class of goods. This is a significant benefit for Nepal because small-scale industries in India are subject to a lower duty rate; thus, Nepal’s small scale manufacturers can compete on a level playing field with those in India.

  • Clearance for transit cargo to be expedited: The provisions allow for “one time lock” on containerized goods entering Nepal. Under this simplified procedure the Indian authorities will expedite transportation of cargo, provided the container lock has not been opened. This should reduce time delays in forwarding which arose from the necessity to inspect containers that arrived in Indian ports destined for Nepal.

C. Tax Reforms

64. Since the start of the 1990s, the Nepalese authorities have pursued an ambitious set of tax reforms with the aim of raising public savings, reducing reliance on trade taxation and improving the efficiency and fairness of the tax system. Reforms were undertaken to broaden the tax base, lower income tax rates, and simplify the rate structure across a range of taxes with a view to increasing the role of direct taxes and to eventually establishing a broad-based VAT.

Indirect taxes

65. The introduction of a VAT is the centerpiece of the government’s tax reform effort. The VAT will be broad-based: it will replace sales taxes, as well as existing taxes on services, including entertainment, hotel, and contract taxes which presently account for nearly 40 percent of total tax revenue. The importance of good administration for the successful launch of a VAT are recognized by the government, and preparations for its introduction have continued over the past two years with technical assistance from USAID and DANIDA, including:

  • VAT legislation was passed in December 1995; Rules and regulations were issued in February 1997;

  • Unification of rates of sales tax at 15 percent for most products was accomplished in the 1996/97 budget, although some rebates and exceptions have continued (see section II. C);

  • Recruitment has been ongoing. 25 officer level staff were hired in March 1997 and their training has begun; and

  • Premises. The sales and excise department was converted into the VAT department in July 1996, and relocated to new premises in March 1997. Recently, the government has announced that registration will start on August 16, 1997 and that VAT will be collected from November 16, 1997.45

66. Introduction of the VAT should also help to strengthen administration of custom duties. At present, imports are valued according to book price; considerable discretion is given to customs officers, while many book valuations are below true invoice values of the goods. With the introduction of VAT, incentives to under-invoice will be reduced, which will facilitate the government’s plans to shift in a phased manner (beginning with lower value items) to an invoice-based system of customs collection; draft amendments to the customs act have been prepared. In support of this shift, preparations are advanced for installation of a computerized data entry and record keeping—the ASCUDYA system—which would improve transparency and provide the basis for cross-checking in support of an invoice-based system.

Corporate taxes

67. In 1992, the Industrial Enterprise Act provided significant tax holidays to the corporate sector in an effort to encourage investment. However, these tax holidays have progressively led to an erosion of the tax base,46 while the impact on new investments has not been clear. Against this backdrop, the government has presented an amendment to the Industrial Enterprise Act to Parliament to eliminate new tax holidays, while lowering tax rates. The government is also considering comprehensive tax reform proposals presented by an international team of experts (funded by the USAID) to the Federation of Nepalese Chambers of Commerce and Industry and the government. In the area of corporate taxes, the report recommended significant base broadening measures, inter alia a phasing out of tax exemptions to certain sectors (export,47 agricultural and cottage industries); restricting deductions (including streamlining and trimming of depreciation allowances); introducing standardized accounting practices and use of tax installments; and strengthening tax administration.

Local taxes

68. Municipalities in Nepal currently levy a local transit tax called “Octroi,” which distorts costs and creates disincentives to inter-regional trade. In the October 1996 budget, the government announced that Octroi would be eliminated and a draft changes in the municipality act have been prepared. To replace the consequent loss of revenues, a special 1 percent surcharge in customs duties would be levied until alternative taxes are developed. Increased powers for municipalities powers to raise alternative sources of revenue are to be provided in the context of a local government act.

D. Privatization

69. In 1992, the government launched a comprehensive privatization program. Ten enterprises were privatized under the program before a change in government in 1994 led to a hiatus in the program. Since September 1995, the privatization program has been revived. Two companies—Ragupati Jute Mill and Nepal Foundry—have been sold, and leasing arrangements have been agreed for two other enterprises—the Bhaktapur Brick Factory and the Biratangar Jute Mill—while agreement has been reached with employees to transfer the ownership of Nepal Coal Limited to them. Cigarette and agricultural tools factories have also been offered for bidding, and negotiations have advanced for their sales. Looking further ahead, the government has slated an additional 25 enterprises for privatization, including some large scale enterprises such as the RNAC, and Nepal Telecommunication Corporation. Technical support has been mobilized to assist in the evaluation and to advise on privatization modalities.

70. Regarding financial enterprises, the government has successfully sold 10 percent of NBL—five percent to employees in August 1996 and five percent by way of public subscription in February 1997—lowering government ownership to 41 percent. The RBB and the Nepal Housing and Development Finance Company are also on the privatization list.

Table 1.

Nepal: Gross Domestic Product by Origin at Current Prices, 1990/91-1995/96

(In millions of Nepalese rupees)

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Sources: Data provided by the Nepalese authorities; and staff estimates.
Table 2.

Nepal: Gross Domestic Product and Expenditure at Current Prices, 1990/91-1995/96

(In millions of Nepalese rupees)

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

Exports and imports of goods and nonfactor services.

1984/85 = 100.

Table 3.

Nepal: Agricultural Production and Yields, 1990/91-1995/96

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Source: Data provided by the Nepalese authorities.

Areas cultivated with more than one crop are included under each crop.

Table 4.

Nepal: Irrigation and Agricultural Inputs, 1990/91-1995/96

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Source: Data provided by the Nepalese authorities.
Table 5.

Nepal: Production of Principal Industries, 1990/91-1995/96

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Source: Data provided by the Nepalese authorities.

Public sector production only.

Table 6.

Nepal: Energy Consumption, 1990/91-1995/96

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Source: Data provided by the Nepalese authorities.
Table 7.

Nepal: Tourism Indicators, 1990-96

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Source: Data provided by the Nepalese authorities.

By air only.

Excluding Indian tourists.

Table 8.

Nepal: Changes in the Consumer Price Index, 1990/91-1996/97

(Annual percentage change, unless otherwise indicated)

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Source: Data provided by the Nepalese authorities.

6 months average

Table 9.

Nepal: Monthly Wages in Major Sectors, 1990/91-1995/96

(In Nepalese rupees)

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Source: Data provided by the Nepalese authorities.

Minimum monthly wage, including allowances. No allowances were in effect prior to 1992/93.

Carpenters and masons.

Table 10.

Nepal: Summary of Government Operations, 1992/93-1996/97

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Source: Nepalese authorities; and staff estimates

Cash basis only: excludes direct payments and aid-in-kind

Table 11.

Nepal: Central Government Revenue. 1991/92-1996/97 1/

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

Components may not add to totals due to rounding.

Includes entertainment tax, hotel tax, air flight tax, and road and bridge maintenance tax.

Table 12.

Nepal: Excise Duty Revenue from Major Industrial Products, 1990/91-1996/97

(In millions of Nepalese rupees)

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Source: Department of Excise, Ministry of Finance.

Alcohol includes excise revenue from liquor, beer and molasses.

Excise is levied but it is not possible to distinguish from other industrial product’s head

Table 13.

Nepal: Composition of Imports and Import Dutiea, 1990/91-1996/97

(In millions of Nepalese rupees)

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Source: Department of Customs, Ministry of Finance.

Figures include 5 major customs offices only.

Table 14.

Nepal: Central Government Expenditure, 1991/92-1996/97

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

Excluding allowances.

Including net lending and non-budgetary receipts.

Table 15.

Nepal: Structure of Interest Rates, 1993-97

(In percent per annum)

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Source: Data provided by the Nepalese authorities.
Table 16.

Nepal: Monetary Survey, 1991/92-1996/97

(In millions of Nepalese rupees)

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Sources: Data provided by the Nepal Rastra Bank; and staff estimates.

Includes credit to financial public enterprises.

Table 17.

Nepal: Assets and Liabilities of Nepal Rastra Bank, 1991/92-1996/97

(In millions of Nepalese rupees)

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

Includes Treasury IMF account.

Includes claims on financial public enterprises.

Table 18.

Nepal: Assets and Liabilities of Commercial Banks, 1991/92-1996/97

(In millions of Nepalese rupees)

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Source: Data provided by the Nepalese authorities.
Table 19.

Nepal: Balance of Payments by Area, 1991/92-1995/96

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Sources: Data provided by the Nepalese authorities; and staff estimates.
Table 20.

Nepal: Composition of Foreign Trade, 1992/93-1995/96

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

Includes unclassified exports and imports, and adjustments to reconcile figures with summary balance of payments data.

Table 21.

Nepal: Exports of Major Commodities, 1991/92-1996/97

(In millions of Nepalese rupees)

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Sources: Data provided by the Nepalese authorities; and staff estimates.
Table 22.

Nepal: Services and Transfers, 1992/93-1995/96

(In millions of Nepalese rupees)

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Sources: Data provided by the Nepalese authorities; and staff estimates.
Table 23.

Nepal: International Reserves, 1992-97

(In millions of Nepalese rupees)

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

January 15.

In months of imports of goods and services.

Table 24.

Nepal: External Public Debt and Debt Service, 1990/91-1995/96 1/

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

Medium- and long-term public and publicly guaranteed debt, excluding foreign liabilities of the banking system other than liabilities to the IMF.

Excluding IMF Trust Fund.

Including commercial and short-term debt.

In relation to exports of goods and services and private transfers, excluding Indian excise refund.

Break in data due to introduction of new methodology on balance of payments.

Table 25.

Nepal: Performance of Nonfinancial Public Enterprises, 1990/91-1995/96

(Profits and losses in millions of Nepalese rupees)

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Source: Data provided by the Nepalese authorities.

Includes contractual, temporary, and part-time employees.

Table 26.

Nepal: Outstanding Bank Credit to Major Public Enterprises, 1990/91-1995/96

(In millions of Nepalese rupees at end-period)

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Source: Data provided by the Nepalese authorities.
Table 27.

Nepal: Nonperforming Bank Loans of Public Enterprises, July 1993-JuIy 1996

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Source: Data provided by the Nepalese authorities.
Table 28.

Nepal: Interest and Dividend Payments of Public Enterprises to the Government, 1992/93-1995/96

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Source: Ministry of Finance.
Table 29.

Nepal: Finance Company Activity, 1995-96

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Source: Nepal Rastra Bank.
Table 30.

Nepal: Rastriya Banijya Bank and Nepal Bank Limited Income Statements 1990/91-1995/96

(In millions of Nepalese rupees)

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Sources: Rastriya Banijya Bank, Nepal Bank Limited and the World Bank. Notes: Interest income inclusive of interest income from loan and investments. Other income includes other service charges.
1

The agriculture sector includes “fisheries and forestry”; the industry sector includes the subsectors “manufacturing”, “mining and quarrying”, “construction”, and “electricity and gas”; and the service sector includes the subsectors “trade, restaurants, hotels”, “transportation and communication”, “financial services”, and “social services”.

2

Paddy is the most important crop—accounting for 21 percent of the weight in agriculture output—followed by maize, fruits, wheat, and vegetables.

3

Under the current supply system—by which fertilizer is supplied almost entirely through the government-owned Agricultural Inputs Corporation (AIC)—it is estimated that farmers receive only half of their requirements.

4

A 50 percent discount was applied to firms which imported at least 10 vehicles to be used for taxi services for at least five years.

5

See Nepal—Selected Issues, IMF Country Report No. 96/63, Chapter I.

6

To facilitate comparison between India and Nepal, wholesale price inflation in India is adjusted using the Nepalese weights for food and non-food products.

7

For example, the basic salary for a government employee at the Director or Secretary level is only about Nrs 6,000 per month, as compared with Nrs 40,000-50,000 per month in the private sector for a comparable position.

8

The Nepal government budget presentation classifies expenditures between “regular” and “development”, rather than “current” and “capital”. In 1994/95 about 18 percent of development expenditures (1.8 percent of GDP) were reclassified as regular expenditures.

9

Village Development Committees (VDCs) (numbering 4,000) have been empowered to establish and carry out spending programs. Resources totaling about 1 percent of GDP were transferred to VDCs in 1995/96. The VDC program is largely or fully government financed, with little foreign aid available.

10

The UML increased wages and allowances of civil servants and teachers in two rounds—first in the revised budget of 1994/95 and then in the interim budget of 1995/96, boosting spending on wages and salaries over 1994/95 by 39 percent (Appendix Table 14).

11

Several projects have entered the construction phase, the most notable of which is the Kali Gandaki project (allocated 0.8 percent of GDP in the 1996/97 budget).

12

The 1996/97 budget sanctioned new dearness allowances: 7.2 percent of the basic wage for lower level civil servants and a 4.4 percent increase for upper level civil servants.

13

Release of funds to low-priority programs had been shifted from bi-monthly to monthly, while releases to core projects—traditionally done on a four-monthly basis—were treated on a case-by-case basis.

14

Before second- and third-tranche releases to VDCs are made by the Financial Comptroller General’s Office (FCGO), spending from the prior year must be audited and statements of expenditures demonstrating that releases in 1996/97 had been spent must be submitted.

15

Commodities deemed essential include food items, kerosene, sugar, cotton textiles, medicine, pencils and utensils made of copper, brass and aluminum.

16

In total, these sales taxes measures were projected to raise Nrs 1,383 million—Nrs 923 million from unification and about Nrs 460 million from additional measures.

17

Increases in excise and customs duties and additional measures were projected to raise net about Nrs 690 million. Broadly speaking, excise duties—which apply to domestically produced goods only—and custom duties were increased on luxury items such as alcohol and cigarettes, while customs duties were also increased by 6-10 percentage points on a number of products that are not locally produced including cars, ball bearings, cosmetics, color television, video equipment, linoleum, etc.

18

Nontax measures were projected to increase revenues by Nrs 617 million.

19

These measures were projected to increased direct taxes by Nrs 385 million.

20

In part this is caused by a fell in the import of selected goods from third countries as a cut in Indian tariffs on items such as ball bearings, plastic granules, and computer parts made it less worthwhile to import such goods for re-export to India.

21

The liabilities of Raghupati Jute Mill to the banking system were settled separately by the government with Nrs 420 million in bank debt settled for Nrs 90 million; nonbank debt of Nrs 20 million is being negotiated.

22

In these circumstances, banks are increasingly reluctant to lend new resources to AIC.

23

The IOC supplies five petroleum products to the NOC: gasoline (MS), high speed diesel (HSD), superior kerosene oil (SKO), airplane fuel (ATF), and liquid petroleum gas (LPG).

24

Petrol was increased by 7 percent; diesel by 12.5 percent; and kerosene by 11.8 percent. The price of LPG was also increased by 33 percent.

25

The main monetary instrument available to the NRB is government securities. Each week, high level NRB representatives meet at the joint NRB-MOF open market committee which determines the quantity of government securities offered at the upcoming auction and the price of securities accepted at the current auction. The NRB also has two other market-related instruments: from time to time, it offers central bank securities (known as NRB bonds) and conducts secondary market operations through a window. In practice, NRB’s instruments offer only limited leverage as government securities markets are thin and the range of debt instruments narrow. However, the introduction of longer term government securities in 1996/97 and subdued borrowing requirements provided the NRB with greater operational autonomy in influencing credit developments.

26

Although capital mobility is incomplete, avenues for movement of capital between Nepal and India exist and such movements can become significant when interest rate differentials widen beyond a threshold. For example, in early 1995/96 repatriation of export proceeds were delayed while evidence pointed to increased Nepalese holdings of deposits in Indian banks, earning higher returns.

27

The finance act imposes a ceiling on market borrowing by the government but no such limit exists on access to overdraft borrowing from the NRB (or its subsequent conversion into special bonds). Thus, when domestic borrowing exceeds budget limits, additional financing is exclusively met by the NRB. In this way, monetary discipline is undermined just when it is needed most to counter fiscal over-runs.

28

The government introduced one-year treasury bills (holding three auctions for a total of Nrs 689 million) and three-year development bonds (one issue sold by subscription that raised about Nrs 500 million). The coupon rate for the development bond was fixed by the NRB at 12 percent which was less than deposit rates posted by commercial banks for similar terms. Strong demand for this instrument suggested that an intention by institutions to diversify and reduce credit risk.

29

Finance companies account for about 9 percent of total deposit mobilization (section IV.2).

30

Commercial bank borrowing from the NRB increased sharply in 1995/96 by Nrs 360 million (Appendix Table 18).

31

Secondary factors that have slowed credit growth have been a tightening of conditions by the NRB for letter of credit (L/C) approvals following a scandal involving issuance of L/Cs which were not backed by bills, and a lengthy strike at the second largest bank, the NBL.

32

RBB management has declared 1996/97 the “year of loan recovery.” A special loan recovery committee chaired by the NRB has been set up to facilitate recovery. However, the process of loan recovery has yet to build significant momentum.

33

A degree of concern has been raised by regulators and financial market participants that there may be insufficient business to support growing numbers of finance companies. Only 68 percent of existing companies are showing positive profits (although this may partly reflect start-up costs), while applications for an additional 20 finance company licenses have been received by the NRB.

34

See Nepal—Selected Issues IMF Country Report No. 96/63, Chapter III for more detail on capital market structure and developments.

35

Errors and omissions have averaged 4 percent of GDP since 1991/92. These flows relate to unrecorded transactions including repatriation of receipts from gold and other items smuggled to India; unrecorded aid flows; and private investment inflows (See Box 1 in Nepal—Selected Issues, IMF Staff Country Report No. 96/93).

36

Exports of carpets to Europe were adversely affected by reports of child labor use, as well as reports of the use of toxic dyes in the wool (see Nepal—Background Paper, SM/95/99, Chapter VI).

37

Despite a recent liberalization of regulations for gold imports in India, the Indian regime is still restrictive relative to the regulations in Nepal. Both countries allow 10 kilograms of gold imports from foreign currency earnings, but the length of stay abroad required to undertake such imports is one month in Nepal, while it is six months in India. In addition, the enforcement of these regulations may be less tight in Nepal.

38

In the balance of payments, gold imports have an offsetting line in the invisible account corresponding to implicit workers’ remittances. The re-export of gold to India is reflected in errors and omissions.

39

Loans from Japan appear in particular low in the detailed statistics in 1995/96. The capital account data is based on statistics of the FCGO and recording delays of one year or longer are possible under the system, as the FCGO does not record a cash loan until it receives notification of the disbursement by the donor. For further information on this issue, see the discussion on Foreign Aid in Nepal—Background Paper, SM/95/99, Chapter IV.

40

Travel allowances range from US$300 to US$1,500 depending on the destination.

41

The NEA is committed to meeting about 75 percent of the local costs of the Kali Gandaki project. The rest is to be contributed from the government budget.

42

See Nepal—Selected Issues, chapter II, SM/96/117.

43

Changes in tax legislation would be needed to permit an excise tax on imported luxury goods, as this tax can only apply to domestically produced goods.

44

For detailed discussion on the implications of WTO membership see Nepal: Selected Issues SM/96/117, Chapter V.

45

Under the VAT, registrants should increase from about 2,000 entities now registered in the sales and services tax net to about 8,000.

46

According to a study by FIAS (Foreign Investment Advisory Service), the effective corporate tax rate is 9 percent (compared with the statutory rate of 33 percent). They estimate that tax holidays and other tax concessions to the corporate sector—including nontaxation of dividends, capital gains, as well as generous depreciation allowance—cost the government about 3 percent of GDP a year in forgone revenues.

47

As mentioned above, Nepal is in the process of joining WTO. Under WTO rules, any financial advantage or tax break specifically provided for exports is regarded as a prohibited subsidy. Member-developing countries already providing such export subsidies are expected to phase them out within ten years from 1995.

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Cover IMF Staff Country Reports
Nepal: Recent Economic Developments
Author:
International Monetary Fund
Volume/Issue:
Volume 1997: Issue 062
Publisher:
International Monetary Fund
ISBN:
9781451829860
ISSN:
1934-7685
Pages:
73
DOI:
https://doi.org/10.5089/9781451829860.002
Chart 1.

Inflation (12 month rate)
Chart 2:

Expenditures
Chart 3

Nepal: Selected Fiscal Indicators, 1994-97 1/
Chart 4:

Revenues
Chart 5

Nepal: Selected Financial Indicators, 1994-97 1/
Chart 6:

Bank Deposit and Treasury Bill Rates
Chart 7a:

Loan to Deposit Ratio
Chart 7b:

RBB’s Contribution to Net Lending
Chart 8

Banking System Intermediation Spread
Chart 9

Nepal: Selected External Indicators, 1994-1997 1/
Chart 10

Nepal: Exchange Rate Developments, 1991-1997
Chart 11:

Import and Export Shares in GDP