Nepal: Staff Report for the 1999 Article IV Consultation

Nepal has maintained macroeconomic stability under the Poverty Reduction and Growth Facility Arrangement. Executive Directors commended the low inflation, strong macroeconomic stability, and international reserves. They stressed the need to improve fiscal position, enhance private and foreign investment, accelerate project implementation, and strengthen rural infrastructure. They encouraged the authorities to strengthen the efforts in eliminating the weaknesses in the macroeconomic database, reform the banking system, mobilize budgetary revenue, improve fiscal transparency, and tackle problems of governance and corruption.

Abstract

Nepal has maintained macroeconomic stability under the Poverty Reduction and Growth Facility Arrangement. Executive Directors commended the low inflation, strong macroeconomic stability, and international reserves. They stressed the need to improve fiscal position, enhance private and foreign investment, accelerate project implementation, and strengthen rural infrastructure. They encouraged the authorities to strengthen the efforts in eliminating the weaknesses in the macroeconomic database, reform the banking system, mobilize budgetary revenue, improve fiscal transparency, and tackle problems of governance and corruption.

I. Introduction and Political Setting

1. At the conclusion of the last Article IV consultation in February 1999, Executive Directors emphasized that the stable macroeconomic conditions should provide a platform for accelerating structural reforms to improve Nepal’s development prospects and to reduce poverty. In recent years, efforts to advance structural reform had little result. Nepal’s earlier ESAF expired in October 1995 and discussions for a successor ESAF stalled. Successive coalition governments were unable to formulate a comprehensive reform package. Over the past year, the authorities have maintained macroeconomic stability and there has been an improvement in the external position. However, structural reforms remain delayed, pervasive fiscal weaknesses impair development efforts, and financial sector distortions impede the efficient allocation of resources. The 1999 Article IV consultation focused on these issues, and discussed how they could be addressed in the context of a growth-oriented program of reforms. The authorities wished that such a program could eventually be supported by a Poverty Reduction and Growth Facility (PRGF) arrangement.

2. The new government has an opportunity to pursue a stronger reform program. The Congress Party won a clear majority in the May general elections. The July Budget Speech highlighted the priorities of raising growth levels, promoting employment generation, and reducing poverty across all regions. However, strong internal conflicts within the Congress Party exist and continued perceptions of mismanagement and corruption together with the lack of improvement of economic conditions have led to strikes and further problems with the Maoist insurgency. Following a disagreement with the Prime Minister, Minister Acharya resigned on January 31 and was succeeded by Foreign Minister, Dr. Mahat (Finance Minister 1997–98).

3. In the mission’s view, without a substantial reduction in the structural impediments to private sector-led growth, poverty would not decline. Only a dramatic increase in spending on education and infrastructure and significant inflows of foreign capital over the long term could tap into the country’s potential and eventually permit sufficiently fast growth 1. Critical to these objectives would be a reduction in low priority spending and increases in fiscal revenue to raise public savings to finance higher public investment while maintaining macroeconomic stability.

II. Recent Economic and Policy Developments

4. Growth has picked up and inflation steadied. Real GDP growth improved marginally to 3½ percent in 1998/99 led by increases in exports, manufacturing (carpets and garments) and financial services (Table 1).2 Although agricultural GDP increased, its gains were modest because of fertilizer supply problems and adverse weather. Per capita GNP remains very low in dollar terms (US$220). Inflation has recently come down, similar to developments in India. After accelerating to nearly 20 percent in 1998 because of temporary food shortages, the 12-month rate of inflation declined to 2 percent by December 1999, as food prices fell.3 The inflation differential with India, which widened in 1999, has disappeared (Figure 1).

Table 1.

Nepal: Selected Economic Indicators, 1995/96–1999/20001/

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

The fiscal year starts on July 16.

Cumulative, excluding re-exports.

Cumulative, excluding gold.

Ratio is in terms of projected imports of goods and services.

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

Minus sign indicates depreciation of the Nepalese rupee.

Figure 1
Figure 1

Inflation, 1995-2000 1/

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

1/ Indian indices are recalculated as two-period moving averages to correspond with the Nepalese month. WPI for India is re-weighted using food and nonfood shares from nepal’s consumption basket.

5. External developments have been broadly favorable, allowing for sizeable reserve accumulation and a stable exchange rate. (Figures 2 and 3). Pegged to the Indian rupee, the Nepalese rupee broadly maintained its nominal rate with respect to the U.S. dollar, appreciating in real effective terms by about 7 percent for 1998/99. Nevertheless, the current account balance improved dramatically, shifting by 6 percent of GDP to a surplus (excluding grants) because of low recorded imports and increased remittances following the global recovery (Table 2 and Figure 4). Exports, excluding gold, increased by 21 percent in dollar terms, following a 12 percent increase in the previous year, mainly on account of rising sales of ready-made garments and increased trade with India. Total imports declined, with delays in capital spending and lower gold imports (mainly for re-export to India) following liberalization of gold imports in India.4 Estimated total private remittances also increased sharply following the recovery in Asian economies and increases in pensions of retired Gurkhas.5 Official loan disbursements declined in line with imports of capital goods, and foreign direct investment remained insignificant. In the first half of 1999/2000, the appreciation of the real effective exchange rate in 1998/99 has been reversed and the level is close to that of early 1997, before the Asian crisis. Official reserves have remained stable, standing at 4¾ months of imports or 35 percent of broad money.

Figure 2
Figure 2

Real and Nominal Effective Exchange Rates

(1990=100)

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

Sources: International Financial Stastics, and Information Notice System: IMF
Figure 3
Figure 3

Gross Official Reserves, 1995-2000

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

Table 2.

Nepal: Balance of Payments, 1995/96–1999/2000 1/

(In millions of U.S. dollars, unless otherwise indicated)

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

Beginning in 1996/97, the presentation incorporates improved coverage of the re-export trade, and more accurate accounting of private remittances and official transfers. As a result, errors and omissions are sharply lower than in previous presentations.

Includes re-exports of oil beginning in 1996/97.

NRB assets and liabilities are calculated at constant exchange rates beginning in 1996/97.

Short-term debt in the form of outstanding trade credits and amortization due the following year.

In percent of current account receipts excluding Indian excise refund.

Figure 4.
Figure 4.

Nepal: Selected External Indicators, 1995-99 1/

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

Sources: Data provided by Nepalese authorities; and IMF, International Financial Statistics.1/ Beginning of fiscial year indicated by a dotted line.2/ Three-month moving average.3/ End of period.

6. A passive monetary policy, intended to foster private sector growth, led to accommodation of higher budget financing and some overshooting of the monetary targets. Under pressure from the Nepal Rastra Bank (NRB), commercial banks reduced nominal interest rates and broad money growth accelerated, peaking in February 1999 at 26 percent (on a 12-month basis), before slowing in recent months to 21 percent in November (Table 3 and Figures 5 and 6). As reserves built up, the NRB did not sterilize their foreign exchange purchases. However, faced by limited domestic lending opportunities, and a short supply of treasury bills, excess liquidity in the commercial banks continued to build up. Banks were forced to place their surplus funds abroad or in excess reserves held at the NRB. Although bank financing of the budget has been higher than projected, such financing was mainly through the NRB overdraft facility.

Table 3

Nepal: Monetary Accounts, 1996–2000

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

Estimated figures adjusted for sample bias.

A projection based on a stable exchange rate against U.S. dollar, and a nominal GDP growth of 13½percent.

Adjusted for the impact of exchange rate changes on the value of net foreign assets and other items, net.

Figure 5.
Figure 5.

Nepal: Selected Financial Indicators, 1995-99 1/

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

Source: Data provided by the Nepalese authorities; and staff estimates.1/ Beginning of fiscal year is indicated by a dotted line.2/ Adjusted for valuation effects of exchange rate changes; in percent of broad money at beginning of period.
Figure 6.
Figure 6.

Nepal: Real Interest Rate Comparisons, 1997-99

(In percent per annum, three-month moving average)

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

Source: IMF, Economist Information System.1/ For India, the WPI is used as the primary measure of inflation.2/ Call rate.3/ 6-month short-term federal bond rate.

7. The interest rate on treasury bills remained considerably lower than in India and has been negative in real terms since December 1997 (Figure 7).6 The government had been reluctant to allow treasury bill rates to rise substantially because of the impact on debt service. The NRB converted the accumulated Government overdraft (Nrs 6 billion) into one-year treasury bills in March 1999, to be sold to mop up the excess liquidity in the commercial banks. However, so far only half of these securities have been sold.

Figure 7.
Figure 7.

Treasury Bill Interest Rales, 1995-2000

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

8. While the overall budget deficit remained sustainable, financed primarily by foreign aid, fiscal performance was disappointing in 1998/99 as revenue and development spending were below target. The deficit (before grants) was 6¼ percent of GDP, unchanged from the previous year (Table 4). Total revenue amounted to 10 percent of GDP; lower than budgeted and than in the previous two years—receipts from the recently introduced VAT were below expectation because of the resistance of the business community. Current expenditures were contained at just below budgeted levels, as increases in spending on law and order and election-related activities offset underspending by other ministries. Development expenditures, however, were substantially below budgeted amounts because of delays in project implementation. As in previous years, domestic bank financing of the deficit was considerably higher than budgeted and foreign financing (closely tied to project implementation) was less than anticipated. In the first four months of the current fiscal year, faster development spending and an increase in civil service allowances have led to further domestic financing needs and the government’s central bank overdraft has increased sharply (Figure 8). VAT receipts have been less than targeted, with problems processing tax returns.

Table 4.

Nepal: Summary of Government Operations, 1995/96–1999/2000 1/

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

Fiscal years start on July 16. Table confined to central government operations as contained in the budget.

Public savings are adjusted for the recurrent component of development expenditure.

Conservative estimate highlighting the risks to revenue collection stemming from administration problems.

Figure 8.
Figure 8.

Nepal: Selected Fiscal Indicators, 1995-99 1/

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

Source: Data provided by the Nepalese authorities.1/ Beginning of fiscal year is indicated by a dotted line.2/Three-period moving average.3/ The government’s central bank overdraft balance was converted to treasury bonds in March 1999.4/ Cumulative from start of fiscal year.

9. Little concrete progress was achieved on structural reform, although some steps have been taken that could bode well for the pace of reforms to come:

  • Assisted by the World Bank, Fund, and Asian Development Bank (AsDB), the NRB has started its financial sector reform, with consultants in place reviewing the operations of the main financial institutions and supervision requirements.

  • Progress in privatization has been slow. However, the sale of the tea company is now in the final stages and bids have been submitted for Butwal Power Company.7

  • As part of the program to improve fertilizer distribution through greater private sector participation, agreed with the AsDB, fertilizer subsidies have been reduced.

  • As part of public enterprise restructuring, electricity prices were raised in November to improve the finances of Nepal Electricity Authority (NEA).8

III. Short-Term Prospects and Risks

10. Prospects remain uncertain in the current economic and political environment, but a pick-up in growth is projected in 1999/2000, possibly reaching 6 percent, based primarily on good weather, better fertilizer distribution, and an export recovery. Inflation is expected to average 5–6 percent for 1999/2000 as a drop in agricultural prices would offset the rises in fuel and other utility prices.

11. With a narrow export base and closely linked to the Indian economy, external developments remain subject to some risk. Merchandise exports are projected to increase significantly but the current account is expected to worsen as imports rise sharply (by more than 30 percent) with the pick-up in economic activity, increased project-related imports, and higher oil costs. Nevertheless, the authorities expected foreign reserves would continue to increase, although at a slower rate, provided the outlook for India remains stable (also the staffs current assessment).9

12. Foreign debt is not a pressing problem, but financial system weaknesses continue and foreign currency receipts are vulnerable to adverse regional developments (Table 5). Public external debt is 50 percent of GDP and is almost entirely on concessional terms: the debt service ratio is below 6 percent. Nepal is not a HIPC-eligible country.

Table 5.

Nepal: Vulnerability Indicators, 1995/96–1998/99

(In percent of GDP, unless otherwise indicated)

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Sources: Data provided by the Nepalese authorities; Special Audit Report by R. Bajracharya &Company;and staff estimates.

Staff estimates.

From Special Audit Report by an accounting firm, R. Bajracharya &Company. Capital comprises core capital and supplementary capital, including provision for loss, redeemable preference shares and other reserves.

Consists of public and public guaranteed external debt, domestic claims on public sector by banking sector, and domestic credits to the central government by non-financial sector.

Including private sector credit by NRB.

Including re-exports.

Including gold.

Excluding SAF and ESAF.

Foreign currency liabilities as a percent of foreign currency assets.

Short-term debt in the form of outstanding trade credits and amortizations due in the following year.

IV. Policy Discussion

13. Discussions focused on the steps needed to ensure macroeconomic stability while addressing the long-standing constraints to significantly higher growth. Apart from the problems of a small domestic market and poor transport links, identified growth constraints include a weak financial sector and inefficient public expenditures and state enterprises. Compared with other Asian countries foreign direct investment remains negligible (Figure 9). Moreover, low agricultural productivity growth combines with a population growth rate of 2½ percent and high illiteracy to perpetuate widespread, especially rural, poverty (Box 1 andTable 6).

Figure 9.
Figure 9.

Foreign Direct Investment Inflows, 1997-1999

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

Table 6.

Nepal: Social Indicators

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Sources: Staff reports, EDSS, World Bank 1999 World Development Indicators CD-ROM.

A. Exchange Rate and Monetary Policies

14. The authorities noted that the exchange rate peg with the Indian rupee provided a useful anchor. Formal and informal trade with India remained the cornerstone of the economy. The strong performance of exports—particularly non-traditional items—and tourism receipts, and the build-up in official reserves, suggest that the current exchange rate level is not out of line and competitiveness has been maintained.10 In view of the low inflation and stable outlook in India, the mission supported the authorities’ decision to maintain the current arrangement. However, the team cautioned the NRB to revisit the appropriateness of the peg regularly and urged them to enhance export competitiveness through structural reforms and improved infrastructure.

15. With a fixed exchange rate regime, inflation in Nepal is closely linked to price development in India. Thus, the focus of monetary policy is the control of credit expansion consistent with a satisfactory evolution of international reserves and projected money demand. Achieving the targeted build up in international reserves will require prudent monetary conditions. The mission discussed an indicative financial program for 1999/2000, with an inflation target for 1999/2000 of 5–6 percent, similar to projections for India. The NRB noted that the focus had been on targeting narrow money because of the impact of increased monetization on the growth of bank deposits (Figure 10). However, in response to the greater stability now exhibited by broad money velocity, it was agreed that the NRB would also monitor closely broad money developments. With projected GDP growth of 6 percent and a decline in velocity, the program would be based on broad money growth in the range of 15–16 percent. The mission stressed the need to restrict bank financing of the budget to enable room for reasonable growth of credit “to the private sector”.

Figure 10.
Figure 10.

Velocity of Money, 1995-2000

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

The Challenge of Overcoming Deep-Rooted Poverty

Overcoming widespread and deep-rooted poverty is Nepal’s greatest challenge. Recent estimates suggest that the proportion of the population living below the nutrition-based poverty line (defined at somewhat less than $1 per day in PPP terms) is 42 percent and that 70 percent have incomes less than 1½ times the poverty line. As would be expected, income inequality is low, but disparities do exist, particularly in terms of access to health services and basic infrastructure, and with respect to education and income opportunities. Female literacy is less than half that of men, and primary school enrollment for girls less than half that of boys. As seen in Table 6, virtually all Nepal’s social indicators are well below those of neighboring and other Asian countries.

Poverty is more acute and pervasive in rural areas and varies across regions. Regionally, the Mid and Far Western Development Regions, and the Mountain Belt are much poorer than the Eastern Region. Around 80 percent of the poor farm small and dispersed plots of low-quality land. Many must seek scarce low-wage agricultural employment to supplement their income. Limited work opportunities have maintained underemployment at around 50 percent. Many poor struggle as bonded laborers to pay off debts and the caste system constrains prospects for labor mobility. Health services are less accessible and more costly in rural areas. Eight percent of Nepali households have access to piped water, 9 percent are connected to sanitary drains, 15 percent have electricity access, and 24 percent live within a half hour of a paved road.

Lack of broad-based sustained growth is the primary factor behind Nepal’s failure to reduce poverty in recent decades. Growth has averaged less than 4 percent with population growth exceeding 2½ percent over the past 25 years; employment has grown at a slower pace than the labor force. Much of the employment opportunities stem from banking, real estate, trade and services—with stagnating agriculture and few jobs in rural areas. The low domestic savings rate leaves Nepal highly dependent on foreign aid.

Additionally, political instability and corruption has slowed the pace of economic reform and wasted scarce economic resources and foreign aid. The low-paid bureaucracy has become increasingly more politicized with frequent allegations of corruption at all levels of government. Waste through weak governance and corruption has limited the effectiveness of fiscal policies and of poverty alleviation programs. Recognizing this problem, government initiatives and donor projects increasingly incorporate steps that involve local stakeholders in the design and implementation of projects and a comprehensive reform of civil service is to be undertaken.

The Ninth Plan (1997–2002) specifically aims to improve access to basic infrastructure and social services in deprived areas with specific targets, similar to the International Development Goals adopted by the OECD. Public spending on social and poverty alleviation programs is constrained by the low level of public revenues and its composition determined by donor assistance programs. Nepal cannot afford to significantly expand social safety net through domestic resources. Although social expenditure has increased from 3½ percent of GDP in the mid-eighties to nearly 6 percent of GDP, the allocation remains inadequate, particularly with respect to funding of priority areas.

Grass-roots ownership and participation are being enhanced by decentralizing development spending and project management to the district, municipality, and village level. Several participatory poverty assessments were recently carried out by local and international NGOs (e.g., Action Aid Nepal, Plan International Nepal, New Era, and part of the 1995/96 Nepal Living Standard Survey (NLSS)). A National Workshop on Poverty was hosted by NPC in January 1998. Government initiatives are widely discussed in committees and public debate. A Poverty Alleviation Fund has been created to facilitate program design and implementation. Projects with successful community participation include community forestry, fanner managed irrigation and the Food for Work program in the Churia region, as well as a number of UNDP and GTZ sponsored projects. However, it is doubtful that community mobilization efforts can be effectively replicated in more remote areas. There is also a risk that decentralization and revenue sharing arrangements could weaken overall resource mobilization and budgetary control.

Sources: World Bank Poverty Assessment,1998 and UNDP Human Development Report, 1999 based on NLSS.

16. The authorities recognize the need to reduce the excess liquidity in the banking system. To help mop up this excess liquidity (estimated at Nrs 4 billion, 2½ percent of M2), the mission recommended further sales of the central bank’s treasury bill holdings. The NRB and Ministry of Finance accepted the proposal (the NRB does not have full independence on monetary policy), which would also correct the negative real interest rate on treasury bills. However, there were still legal and operational problems to selling the securities.11 The NRB was not contemplating any adjustment of the reserve requirements.

17. Given the decline in inflation, NRB officials were in favor of a reduction in commercial bank lending rates. However, the mission argued that interest rates would need to remain near to their current levels to be consistent with a cautious monetary stance. Moreover, the mission noted that there was little room to reduce deposit rates, given the rates prevailing in India and the need to avoid capital flight. The spread between deposit and lending interest rates would remain high until the problems of the large banks were resolved.12

B. Fiscal Policy

18. There was agreement that fiscal policy should be directed at raising revenues, reducing low-priority spending, and providing for higher and more effective development and social spending. Thus, the key focus was not only the size of the overall deficit, which might increase in the short term, but on the structure of the budget. The aim was to increase public savings and lower domestic financing requirements, combined with efforts to improve project implementation so as to take advantage of the available investment financing. For the current year, discussions focused on efforts to realize the Budget goals announced in July—an increase in public savings of ½ percent of GDP and an increase in tax revenue to 9 percent of GDP mainly through improved VAT implementation.13

19. On the revenue side, there was concern that the pace of receipts was starting to lag. The authorities were optimistic that the budget targets could be reached, with income tax receipts on track, but noted that both VAT and customs duty collection needed to be strengthened. The mission stressed that for VAT to become the primary tax substantial efforts were needed to improve the administration, clear the filing backlog, collect arrears and intensify audit activity. In that regard, the authorities explained that they would fill most of the key vacancies in the VAT department as soon as possible and not transfer out existing personnel. Another major area of concern was customs receipts, where problems with the introduction of the invoice valuation system, combined with growing problems of barter trade from Tibet, seemed to have undermined the anticipated collection improvement. The authorities intended to conduct post-clearance audits soon to help resolve these difficulties, though the problems of monitoring the long borders with India and China would continue.

20. The mission recommended that additional measures be taken to ensure that the revenue targets in the 1999/2000 budget are achieved and to set the stage for a further increase in public savings in 2000/2001. In particular, administrative measures should include improved taxpayer registration, collection enforcement and audit. Performance should be reviewed at mid-term (in mid-February 2000). The government should take further action, as needed, at that time. For 2000/2001 there was discussion (but no final agreement) on revocation of exemptions on import duties; extension of excises to petroleum products, other than kerosene; and major revisions of the income tax law (LEG providing TA) (Figure 11).

Figure 11.
Figure 11.

Fiscal Indicators, 1993/94-2000/01

Citation: IMF Staff Country Reports 2000, 039; 10.5089/9781451829884.002.A001

21. The authorities believed that current spending was under control.14 The increase in allowances granted in August should be accommodated in the overall budget target for current expenditure, offset by normal underspending and some likely savings on interest payments. However, there was pressure for further security-related spending. The mission noted the authorities’ resolve not to implement any further general pay rise in advance of the proposed civil service reform (see para. 31). The authorities explained that some populist expenditure measures mentioned in the Budget Speech had not been funded and might not take place. The mission stressed that other nonessential spending should be eliminated. There was also discussion of the payments of arrears to the NEA. The Ministry of Finance acknowledged that such arrears exceeded Nrs 700 million for the central government and local municipalities.

22. The expansion of development spending envisioned by the authorities was seen as appropriate and the mission supported the resulting increase in the overall deficit to 7 percent of GDP, primarily foreign-financed. However, efforts must be made to improve the absorptive capacity of the government. Although the current pace of development spending was well above that of the previous year, aid financing was lower, and donors noted concerns about implementation of several key projects. Moreover, the authorities anticipated the need to increase net lending to some public corporations in order to cover government guarantees on earlier bank loans.

23. The mission emphasized the importance of improving overall budgetary management and fiscal transparency. The authorities indicated that they planned to present the budget one month earlier than previously and prepare the development budget within a 3–year rolling investment framework. Early preparation of next year’s budget would allow sufficient time to incorporate meaningful revenue and expenditure measures. To improve transparency, the mission proposed that the authorities avoid shifting taxes and expenditure out of the budget. The mission suggested they develop more comprehensive fiscal accounts that include the local municipalities and other offbudget funds.15

C. Medium-Term Macroeconomic Framework

24. Significantly reducing poverty in Nepal will require decades of high economic growth. Nepal’s comparative advantage lies with tourism and hydropower potential, while the fertile lowlands could support much larger agricultural production and exports. With a low-wage workforce, there are also opportunities to increase exports of goods and services to India. The staff discussed two medium-term scenarios to illustrate the possible impact of reform on growth (Annex V). In the current policy scenario, the failure to put into effect a strong structural program would limit growth prospects to the current annual trend of about 3½percent. Aid would be expected to diminish, though there is still a considerable pipeline of projects to be completed. The fiscal position could become less sustainable in the longer term and poverty would likely not decline.

25. An ambitious high-growth reform scenario, in addition to macroeconomic stability, would require rising agricultural output (through higher fertilizer usage and road construction) and a take-off in non-agricultural output, including manufacturing, tourism and power generation.16 Much higher levels of investment would need to be financed, including from domestic savings. Thus, the key fiscal objective would be to reduce spending in nonpriority areas and increase revenue mobilization significantly to raise public savings (to 4 percent of GDP), while allowing higher expenditures on health, education, and capital investment. Fiscal decentralization will also pose a challenge to ensure gains not losses of revenue and efficiency. Foreign aid levels would be expected to increase, but not sharply, focussing on implementing the key public investment projects. Equally important, scale exports of electricity to India remain only in the planning stage and are not expected to affect the investment program significantly until 2004 at the earliest. Such exports would then provide the resources to finance broad-based expansion. Nepal would need to improve dramatically the environment for foreign investment to support the expansion envisaged of the private sector.

26. Achievement of the high-growth scenario would require a major change by the authorities, both in commitment to structural change and improved implementation. If implementation problems continue, donors and foreign investors would be more cautious in their support and the envisaged increase in investment and growth would be delayed.

D. Poverty Reduction Strategy

27. The authorities reviewed measures being taken to address poverty and other social problems. They were considering the steps needed to adopt a Poverty Reduction Strategy Paper (PRSP), including key goals and policy measures and possible outcome based monitoring indicators (see Box 2). This work would be combined with the AsDB’s poverty reduction strategy project. The mission encouraged early elaboration of a timeline for civil society and donor participation. These issues will be the focus of the next Nepal Development Forum, hosted by the World Bank in Paris on March 15–17,2000. The authorities and donors are also reviewing the effectiveness of aid-financed projects—there has been much public debate about the high cost of such projects and the lack of ownership by the community.

E. Financial Sector

28. The financial sector is weak, leading to high intermediation costs and inefficient allocation of resources. The central bank has limited operational independence. After much discussion, the authorities have agreed with the World Bank and the AsDB a program of bank restructuring and reform of financial sector regulation and supervision. The strategy, reflected in their Financial Sector Strategy Statement, involves:

  • Restructuring plans for Rastriya Banijya Bank (RBB), Nepal Bank Limited (NBL), the Agricultural Development Bank (ADBN), and the National Industrial Development Corporation (NIDC), with changed management, branch rationalization, and improved control mechanisms.17

  • Improved prudential regulation, accounting, and auditing practices.

  • Strengthened regulatory and oversight functions of the central bank and the phasing out of directed lending.

  • Strengthened legislative and institutional framework for loan recovery.

Elements of a Possible Poverty Reduction Strategy

The authorities welcomed the PRSP approach and indicated their willingness to take immediate steps for its development, including through broad-based consultation. Although there is no detailed and integrated “poverty reduction strategy” as such, elements of such a strategy are apparent in a number of documents developed by the authorities, IFIs and local groups and are summarized below.

  • Accelerating broad-based economic growth through sound macroeconomic policies and accelerated structural reforms.

  • Improving governance and removing waste through civil service reform aimed at transforming the public administration into a service and result-oriented system and strengthening the capacity of civil servants at the local level to improve service provision and respond to local demands.

  • Increasing community consultation and involvement in poverty programs. For example, the Food for Work project in the Churia area is based on adopting local norms for payment of workers, an “open books” accounting system and community involvement, helping limit leakage.

  • Improving institutional delivery mechanisms for programs that target the poor and improve the effectiveness of public expenditure. A World Bank Public Expenditure Review (PER), soon to be completed, identified the following recommendations:

    • Implementation of the Agriculture Perspective Plan (1997–2017), including more effective public expenditure in agriculture and greater efforts to ensure that public spending (on fertilizer distribution, irrigation, extension services and credit) actually reaches the poor.

    • Expansion of the rural road network to facilitate access to markets and agricultural inputs, and making public health and education services more accessible to the poor.

    • Shift of public resources from post-primary to primary education, which more effectively reaches the poor. Providing incentives for parents to send children to schools, (including feeding programs for children in remote areas). Increasing the number of female teachers and improving teacher attendance.

    • Shift from building hospitals to increasing the number of lower-level health posts. Improving incentives for doctors to work in rural areas and increasing the number of paramedics to improve the poor’s access to health services.

    • Public work schemes (e.g., the Food for Work Program) to be expanded if they can be done in such a way as to limit the possibilities for leakage, which are currently high.

    • No expansion of income transfer schemes (e.g., widow’s pensions), which are very limited due to resource constraints and tend to reach the better off more than the poor.

  • Improving data collection and analysis of poverty indicators and of the impact of national policies and local projects. Follow-ups to the 1995/96 Living Standards Survey are to be conducted every 4–5 years with shorter surveys in between—subject to financing. Improving information available at the local level, local capacity for policy formulation and implementation, such as under UNDP’s Participatory District Development Program and the NPC’s district-level poverty monitoring projects.

  • An interim PRSP could be ready by end-June 2000 and a final draft available for Board discussion in early 2001.

Sources: Extracted from the Ninth Plan, Annual Budget Speeches, and World Bank Poverty Assessment.

29. The mission strongly supported the position of the World Bank that large-scale financial support for the RBB should not be provided until the restructuring and other reforms are underway. The extent of the fiscal costs of the various possible restructuring approaches will be determined, following the evaluation of RBB and NBL operations currently being conducted by the international audit firm KPMG (see also Annex VI).

30. Nonbank financial institutions are playing an increasingly important role in the highly segmented financial sector, heightening the urgency of strengthening the regulatory and supervisory framework covering such institutions. Technical assistance and extensive training are planned through World Bank and AsDB projects currently underway. The mission urged the authorities to press ahead with these reforms, which may also require organizational changes in the NRB and to the NRB Act, in parallel with measures to increase competition in the financial sector.

F. Other Structural Reforms

31. Public sector reform would give priority to preparations for civil service reform, public enterprise restructuring and governance.

  • Assisted by the AsDB, the authorities are planning to streamline the civil service and then adjust the low level of public sector wages. There are proposals to reduce the number of ministries and the labor force—many services are now provided by the private sector or devolved to the regional councils. The mission suggested interim steps be taken during preparation of the reform, including continuing the hiring freeze, eliminating vacant positions, and early retirement programs.

  • The mission urged the authorities to accelerate enterprise restructuring and privatization, continuing with divestiture of small enterprises while tackling the inefficient and loss-making public enterprises such as fertilizer distribution and commercial aviation.18

  • Weak financial discipline and widespread corruption in both the public and private sectors drain economic resources. Anti-corruption agencies have been ineffective and unsupported by the courts. The mission supported the AsDB’s governance initiative aimed at streamlining regulations, enforcing loan collection, and combating corruption.

32. The authorities have proposals to simplify the legal framework affecting private sector activity and tackle environmental problems.19 In addition to the changes required in financial sector and tax legislation, the focus of legal reform was on resolving land right issues and removing impediments to entrepreneurship. The regulatory framework for foreign investment was a priority. The key environmental issues identified were unsustainable utilization of natural resources in the countryside and air pollution in the urban areas. The authorities were now working with donors to address both problems.

33. Nepal has a relatively open trade regime, when compared with regional partners.20 The authorities noted that the high tariff structure of India imposed constraints for tariff policy in Nepal. Nevertheless, over the medium term and with prospective membership of the World Trade Organization in mind, the mission encouraged the authorities to bring the simple average tariff from its current level of 12¼ percent to below 10 percent and to sharply reduce maximum tariff rates—replacing them, where appropriate, with excise duties.21 These proposals, and elimination of export taxes, were being considered by the new Revenue Advisory Committee, which comprised representatives of the public and private sector.

34. Nepal’s capital account remains closely regulated, particularly with respect to short-term capital and foreign commercial borrowing. The mission noted that phasing in more liberal rules for foreign borrowing should await the implementation of the reforms to the financial institutions and their supervision. The authorities were encouraged, however, to improve the scope and environment for foreign direct investment, including through amendment of relevant legislation.

V. Fund Financial Support

35. The authorities indicated their desire to formulate a structural program that could be supported by the PRGF. They saw such support as important in providing credibility for a more focused and integrated approach compared with the project-based measures taken in the past, It was agreed that they would be expected to take measures to ensure the realization of the 1999/2000 budget targets, prior to formal program discussions. A range of possible key actions for a PRGF-supported program was discussed during the mission.22 A main component would be preparations for the 2000/2001 budget with measures to improve revenue performance and amend the allocation of expenditures in line with the PER. The mission indicated that the authorities could tailor the structural reform package in terms of its scope, so long as measures were included to reform the financial sector (with restructuring of RBB and ADBN and strengthening of the NRB) and to refocus, streamline and upgrade the public administration. A timetable for the PRSP would be set and broad-based discussion of priorities was encouraged to ensure effective implementation of all measures.

VI. Other Issues

36. The mission reviewed efforts being made to improve the statistical database: the range of information produced is quite extensive but the authorities acknowledged the need to improve quality and consistency. The mission encouraged the publication of the balance of payments statistics based on the revised coverage and classification proposed by STA. Work is underway to improve the presentation of the fiscal accounts and the coverage of data on the financial sector. The authorities also noted the need to improve the national accounts and savings/investment data and analysis.

37. Discussions also included assessment of the effectiveness of past technical assistance provided by the Fund and possible future needs (Annex VIII). Technical assistance from FAD was considered to have played an important role in the building of institutional capacity in the Ministry of Finance. In addition, advice from MAE and STA had helped improve the coverage and accuracy of money and banking statistics and balance of payments statistics, respectively. The mission considered that technical assistance has generally been well received and successfully implemented, though often after considerable delay. The authorities identified the following areas for future assistance: fiscal—income tax legislation, rules for indirect tax and its administration, customs administration, budget monitoring and management; financial sector—legislation on the central bank, insolvency and debt recovery; and statistics—national accounts, fiscal statistics, and balance of payments.

VII.Staff Appraisal

38. The fundamental challenge for policy remains to achieve and sustain growth rates sufficient to make meaningful progress toward poverty alleviation. While the overall fiscal deficit is currently sustainable, financed primarily by aid flows, the budget remains structurally unsound, with persistently low revenue receipts and delayed implementation of key development projects. The much-discussed overall reform agenda has yet to be put in motion. Without a significant shift in policies, it will be difficult to achieve the government’s growth objectives while maintaining low inflation and a comfortable external position. Moreover, the economy is vulnerable to external shocks.

39. However, despite little policy contribution, the Nepalese economy has performed reasonably well in the past 12 months and the near term outlook is broadly positive. Growth is increasing and could be around 6 percent for 1999/2000. Inflation is expected to remain low. Although the current account (excluding grants) is projected to shift back into deficit in 1999/2000, aid inflows should sustain reserves.

40. The government should move quickly to adopt a bold and comprehensive reform agenda supported by improved microeconomic management; one based on a PRSP and that could be supported by a PRGF arrangement. The government is encouraged to continue the ongoing process of wide consultation in its preparation of the PRSP. Poverty reduction will be the central objective of the programs supported by the Fund and will guide the formulation of budgetary and other policies. A PRGF-supported policy package would be anchored by a front-loaded fiscal program based on reforms of the tax and expenditure systems. This would be accompanied by measures to improve both the effectiveness of foreign aid and the governance in public sector operations. Over the longer-term, only a dramatic and sustained increased in investment and infrastructure and large inflows of foreign capital could permit eventual annual growth rates sufficiently large to reduce significantly poverty across the country.

41. The great advantages of close integration with India and the latter’s stable outlook continue to argue strongly for maintaining a fixed exchange rate regime based on a peg to the Indian rupee, supported by consistent financial policies. The strong performance of exports and the continued accumulation of official reserves suggest the level of the exchange rate remains broadly appropriate. The government should, however, continue to enhance export competitiveness.

42. The fixed exchange rate requires that domestic monetary conditions be consistent with the peg and monetary policy be broadly harmonized with that of India. The authorities are urged to target average inflation in the range 5–6percent, in line with the rates currently projected for India. There is a need to lower domestic financing of the budget, particularly by the central bank, and make interest rates on treasury bills more competitive with Indian instruments. The sale of some of the central bank’s holding of treasury bills would reduce the current excess liquidity in the banking system, without restricting availability of credit to the private sector.

43. The staff supports the government’s commitment to take measures to achieve the ambitious budget targets for 1999/2000 and to set the stage for an increase of public savings in 2000/2001. On the revenue side, the key measures needed to establish VAT as an effective tax include increased staffing of the VAT office. The post-clearance audits should help to reduce the current problems with implementation of the new customs valuation system and undeclared imports. Current spending seems to be on track but there could be pressures on the wage bill. The proposed growth of capital spending is justified by the development needs and the resulting increase in the deficit should be primarily foreign-financed.

44. Looking ahead, the broad fiscal strategy should aim to mobilize higher tax revenues and improve the quality of expenditures, providing scope for higher social spending. The fiscal stance could be relaxed if additional foreign financing is secured and the feasibility of more enhanced social sector spending demonstrated. It is important that a comprehensive budget framework be developed, bringing together budget and nonbudget revenue items, to improve transparency and accountability. The staff supports the early preparation of next year’s budget and consideration of measures to raise revenue.

45. Spending in 2000/2001 should be based on established priorities, linked to the proposed 3-year rolling investment program. Rural education and health and essential infrastructure will need increased provisions and improved targeting. Spending on some other items will have to be curtailed. The budget should also provide for clearing of government arrears, retrenchment schemes, and the fiscal costs of financial sector reform.

46. The authorities are encouraged to press ahead with their financial sector strategy, taking steps also to increase the independence of the central bank. Some form of recapitalization of RBB will be necessary, but should only be undertaken when the bank has been properly restructured and management improved. Of equal importance are the enhancement of accounting and auditing practices and strengthened regulatory and oversight functions of the central bank, including supervision of nonbank financial institutions. A complete overhaul of the NRB Act would aid these improvements.

47. Public administration reform should focus on rationalizing the civil service, improving public enterprise operations, and privatization. Once a retrenchment is achieved, the level and structure of wages should be corrected. The public debate about the recent price increases in utilities serve to highlight management problems that also exist in other public institutions. The government should accelerate divestiture of small institutions while tackling the inefficient and loss-making public enterprises.

48. The staff supports the efforts to simplify the existing legal framework and encourage private sector investment and growth. The staff welcomes the efforts to streamline regulations, enforce collection of delinquent loans, and combat corruption in the collection and expenditure of public resources.

49. Although extensive data are compiled in a timely manner, there remain serious weaknesses in economic statistics that impair effective monitoring and policy formulation. The authorities are urged to improve further the coverage and presentation of the balance of payments and the fiscal and monetary accounts. To facilitate these steps, the staff encourages requests for further technical assistance, as well as for help to improve the compilation of the national accounts.

50. During the Technical Assistance Consultation, the usefulness of past assistance has been noted. The Fund looks forward to providing further assistance where needed. The authorities are urged to ensure that such assistance is implemented in a timely manner.

51. Finally, the government should continue to ensure an open trade and investment regime and access to world markets. The authorities are encouraged to lower import tariff rates. Efforts to enhance the performance of the financial sector and strengthen supervision should be pursued before opening up the capital account. The government is urged, moreover, to improve the receptiveness for foreign direct investment.

52. The staff recommends that the next Article IV consultation remain on the 12-month cycle.

ANNEX I NEPAL: Fund Relations

(As of December 31, 1999)

I. Membership Status: Joined 9/06/61; Article VIII

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans:

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V. Financial Arrangements:

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VI. Projected Obligations to fund (SDR Millions;based on existing use of refrences and present holdings of SDRs):

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VII. Exchange Rate Arrangement In February 1993, Nepal unified its exchange rate and eliminated the multiple currency practice associated with the previous dual exchange rate arrangement. In October 1997, the exchange arrangement of Nepal was reclassified as that pegged to a single currency unit from pegged to a currency composite. Currently, all merchandise imports (except for a few goods restricted for security or related reasons) are freely available through an open general license system, with foreign exchange provided through the banking system at the market exchange rate. Nepal’s exchange system is presently free of restrictions on the making of payments and transfers for current international transactions.

Exchange rate: $1=68.73 Nepalese rupees (as of December 31, 1999).

VIII. Last Article IV Consultation

  1. Staff discussions were held in Kathmandu in November 1998.

  2. The Executive Board discussed the staff report (SM/99/17) on February 10,1999.

IX. Consultation Cycle

Nepal is on the standard 12–month consultation cycle.

X. Technical assistance since 1996

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XI. Resident Representative/Advisor

The Fund has provided staff members as resident representatives since 1977.

Mr. Lawrence DeMilner began his term in August 1999.

ANNEX II Nepal: Relations with the World Bank Group

The World Bank’s strategy is designed to assist Nepal in making progress towards poverty alleviation/The Country Assistance Strategy (CAS) of December 1998 aims at (a) bringing resources closer to the beneficiaries, where they are most likely to be productively used and (b) collective donor action to foster the stronger governance needed to reduce waste and mismanagement, while (c) further improving economic and fiscal management. The level of future assistance will be determined by progress in overall economic management and institutional reform. The Bank’s current dialogue with the Government is focused on public resource management issues, governance and financial sector reform.

As of December 31,1999, the Bank’s portfolio in Nepal included 72 IDA credits of which 10 are active (see table). Of the closed credits, two were Structural Adjustment Credits (approved in March 1987 mid June 1989) which supported policy reforms in trade, finance and agriculture. In FY1999, two new projects were approved: Basic and Primary Education II (March 1999) and Rural Infrastructure (May 1999). The latter is a Learning and Innovative Lending operation (LIL). A Road Maintenance and Development project was approved in November 1999. Projects in the telecommunications, finance, power, urban and rural water, and health sectors are at various stages of preparation and discussion with Government.

As of December 31, 1999, IFC’s commitments in Nepal included U.S.$49 million in loans, concentrated in the power sector. MIGA’s portfolio in Nepal consists of three guarantee contracts with a net exposure of U.S.$18.2 million, mainly in the infrastructure sector.

Lending by the World Bank Group, FY 1994–2000

(In millions of U.S. dollars)

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Source: Data provided by the World Bank.

The Bank has been providing technical assistance in energy planning, road infrastructure, irrigation, industrial finance, cottage industry and municipal development, planning and financial management, and remote area access. Nonlending activities of the Bank include preparation of a CAS (12/98), a Poverty Assessment Report (8/98), a Country Economic Memorandum (11/97), and a Health Sector Report (1999). A Public Expenditure Review is scheduled for completion in FY2000.

ANNEX III Nepal: Relations with the Asian Development Bank

Lending Program

As of December 31,1999, total commitments by the Asian Development Bank (AsDB) consisted of 90 loans amounting to U.S.$1.7’billion covering projects in agriculture (including forestry), energy, transport, industry, social infrastructure, and tourism. Undisbursed funds of U.S.$302 million represent about 21 percent of the total net loan amount as of end-December 1999. For the period 2000–2002,11 projects amounting to U.S.$340 million are tentatively programmed.

Loans by the Asian Development Bank, 1969–1999

(as of December 31,1999)

(In millions of U.S. dollars)

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Source: Data provided by the Asian Development