Nepal: Staff Report for the 2001 Article IV Consultation
Author: International Monetary Fund
Publication Date:
03 Oct 2001
eISBN:
9781451829891
ISBN:
9781451829891
Language:
English
Keywords:
ISCR; CR; new land reform law; alcohol restriction; land reform; staff appraisal; government; reform program; debt service; private sector; broad money; public expenditure
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Nepal showed satisfactory macroeconomic performance despite difficult political circumstances. Executive Directors welcomed the comprehensive program of structural reforms that aimed at poverty reduction, and stressed the need for prudent macroeconomic policies. They appreciated the authorities' strategy to address the negative net worth of the two largest banks, and strengthen the financial sector. They encouraged the authorities to maintain an open trade and investment regime, encourage access to world banks, implement the recommendations of the IMF's multisector statistics mission, and improve the macroeconomic database.

Abstract

Nepal showed satisfactory macroeconomic performance despite difficult political circumstances. Executive Directors welcomed the comprehensive program of structural reforms that aimed at poverty reduction, and stressed the need for prudent macroeconomic policies. They appreciated the authorities' strategy to address the negative net worth of the two largest banks, and strengthen the financial sector. They encouraged the authorities to maintain an open trade and investment regime, encourage access to world banks, implement the recommendations of the IMF's multisector statistics mission, and improve the macroeconomic database.

I. Background

1. Nepal remains one of the poorest countries in the world, with two fifths of the population below the poverty line.1 Large segments of the poor survive in subsistence, living on fragile ecosystems, while much of the country lacks even the most basic infrastructure. There are also wide variations of poverty, based on the rural-urban divide, geography, ethnic group, and occupational caste. Key factors have been inadequate agricultural growth and a failure to develop sufficiently the nonagricultural sector to provide jobs and incomes for the rapidly growing population. Over the past three decades, Nepal’s economy has been growing at an annual pace of about 4 percent, and output growth in the agricultural sector has been only 2.5 percent, not much above the 2.4 percent rate of population growth.

2. Since Nepal opened up to the outside world several decades ago, donors have sought to improve economic conditions through extensive aid programs. However, there has been relatively little supporting foreign investment in the economy, and many aid projects have faltered because of weak institutional capacity and poor public resource management in an environment of political uncertainty. The nonagricultural economy has developed in an uneven manner, reflecting the effects of the economy’s strong ties to India. Land-locked but with a long, open border with her large neighbor, Nepal relies on India for most imports, and nationals from each country work in large numbers across the border. Many Nepalese private sector firms are closely linked with Indian businesses, and many of the manufacturing or other trade ventures that have been set up in the past years focus on taking advantage of the rigidities existing in the Indian economy. However, frequent changes in Indian trade policy have resulted in considerable adjustment costs for Nepalese companies, and discouraged investment.

3. Nepal’s primary challenge is to achieve and sustain higher growth levels in order to improve conditions for the poor. A substantial reduction in the structural impediments to broad-based private sector-led growth would require a substantial increase in spending on education and infrastructure, as well as significant inflows of foreign capital over the long term, to tap the country’s potential and eventually permit sufficiently fast growth. Improvements are also critical in the financial sector, where weaknesses impede efficient intermediation of savings into the financing of viable investments. Public sector inefficiencies, weak governance, and the overlapping of donor-driven projects have so far limited the impact of foreign aid on poverty alleviation. To address these concerns, the authorities are developing a comprehensive reform program, which places poverty reduction as the overarching objective, targeting a reduction of the proportion of the population living below the poverty line to 10 percent over the next two decades (Box 1).

Nepal: Poverty Reduction Strategy Paper

The authorities’ objective is to prepare one key poverty reduction strategy document by next year, endorsed fully by the government and all the major donor agencies. The full PRSP will form the core of the Tenth Five Year National Plan and would be presented to Parliament in late 2002. In the past, the government has presented its own five-year plan for economic development, while each of the main donor agencies drew up separate assistance strategy documents, often with conflicting priorities.

Consultation on the I-PRSP was extensive with all levels of civil society and donors. The I-PRSP was posted on the National Planning Commission’s website on July 16, 2001 (www.npc.gov.np) and will be the subject of a final discussion at a donor group meeting in Kathmandu in September 2001.

The draft has identified the main causes of poverty as primarily:

  • inadequate broad-based economic growth,

  • poor performance by the agricultural sector, with low and decreasing productivity,

  • poor rural infrastructure,

  • insufficient provision of education and health services, especially in the rural areas, and

  • a lack of sufficient priority to poverty reduction measures.

The main goal of the poverty reduction strategy is to reduce the percent of population living below the poverty line from 38 percent to 10 percent over two decades.

Key intermediate targets that have been established to support this objective include:

  • overall GDP growth to increase to 6½ percent by 2003/04, with agricultural output rising by 4 percent each year,

  • a reduced birth rate, while increasing life expectancy,

  • diversification of tourism activities to rural areas,

  • extension of electricity and irrigation to rural areas,

  • nationwide road access,

  • universal primary education, and

  • fiscal decentralization.

The current version of the I-PRSP has not yet been linked to the budget allocations because of delays in preparing the ministerial submissions for the 2001/02 Budget and in developing the three-year budget allocation program.

The implications of the most recent political events have not been reflected, including weakened security and the disruption of banking, post and social services.

4. Political events have complicated policy implementation in the past year. Despite winning a clear majority in the May 1999 general elections, the Nepal Congress Party (NC) leadership has faced stiff opposition including from dissident factions within the party. The opposition obstructed all parliamentary proceedings in the winter session, and the ruling party lost its majority in the upper house of parliament in June 2001. The presentation of the 2001/02 Budget was delayed by six weeks following the slaying of the royal family in June, which also precipitated wide-scale demonstrations and further reduced confidence in the government. In July, Prime Minister G.P. Koirala resigned and was replaced by Sher Bahadur Deuba.

5. The political situation has also been adversely affected by stepped-up activity by Maoist insurgents. The insurgents, who have been waging a war against the constitutional monarchy and the system of multi-party democracy since the mid-1990s, had been active principally in the midwestern region of Nepal. More recently, however, the Maoists have encouraged “bandhs” (forced shut-downs), violent demonstrations, and deadly attacks on government officials, police, and other targets. Moreover, the insurgency has spread to the economically important Kathmandu valley, raising concern regarding the potential impact on tourism and manufacturing activity. A 1999 Conflict Assessment Report by the U.K. development agency (DfID) stressed the importance of strengthening development and poverty alleviation policies in conflict-affected areas, and the authorities have sought to take a number of steps in this regard.

6. At the conclusion of the last Article IV consultation in February 2000, Executive Directors expressed the hope that the prevailing, stable macroeconomic conditions could provide a platform for accelerating structural reforms to improve Nepal’s development prospects and to reduce poverty. Nepal’s earlier ESAF expired in October 1995, but structural reform efforts stalled due to political uncertainties during a succession of coalition governments. Recently, the majority-led Nepal Congress Party government has been seeking Fund support and continued project assistance from donors to support its reform program. There has been intensive discussion between the authorities and the staff on a possible PRGF arrangement, which would focus on several key elements of the government’s poverty reduction strategy, namely financial sector reform, public administration reform, and improvements in governance and the legal framework.2 The staff has worked very closely on these issues with the World Bank, other donor agencies, and elements of civil society.

II. Recent Economic Developments

7. Macroeconomic performance continues to be favorable, but not sufficient to reduce poverty significantly. Growth slowed from 6½ percent in 1999/2000 to an estimated 5–5½ percent in 2000/01, but inflation remains subdued, below 4 percent (Table 1).3 The main reasons for the slowdown was weaker agricultural performance compared with the exceptionally strong growth in the previous year, the dampening effects of higher oil prices on export demand, lower tourist activity, and frequent work stoppages due to strikes and power shortages. A decline in food prices helped lower inflation to 2 percent despite the hike in domestic fuel prices at end-2000.

Table 1.

Nepal: Selected Economic Indicators, 1997/98–2001/02 1/

Nominal GDP(2000/01):US$568 million

Population(2000/01):23.2 million

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

Fiscal year ends July 15. Data reflect GDP deflator revisions made by the authorities for the period between 1997/98 and 1999/2000.

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.

8. The external position is broadly satisfactory—reserves have remained at comfortable levels and the debt service ratio is low because of the concessional nature of external debt.

  • The current account surplus is estimated to have declined slightly in 2000/01, with the trade balance widening on account of the impact of the increased cost of oil imports and a slowdown in exports from the very high growth rate achieved in the previous year (in particular a slowing of the rapid expansion of pashmina sales) (Figure 1).

  • The services account surplus narrowed for a second consecutive year, as strong growth in worker remittances was more than offset by disappointing levels of tourism (Table 2).

  • During 2000/01, gross official reserves were maintained at 5¼ months of imports ($1.01 billion). However, the size of these reserves held in the form of Indian rupees increased from $160 million to $300 million. This development reflected an increase in trade with India, in part because of efforts to circumvent Indian import duties levied on goods from other countries, and remittances from Nepalese workers in third countries channeled through India. A large part of imports from India requires dollar payment, while much of Nepalese exports to India and remittances of Nepalese workers in third countries are settled in Indian rupees.4

  • The external debt-to-GDP ratio has increased over the past two years because of large aid disbursements related to hydropower and other investments. However, because of the concessional nature and long maturity of these loans, and the sharp increase in exports in 1999/2000, the debt service ratio was only around 5 percent at the end of 2000/01.

  • The Nepalese rupee—which has been pegged to the Indian rupee since 1993—has remained stable in real and nominal effective terms during the past year. In particular, the exchange rate depreciated by only about 2½ percent in real effective terms during the 12 months ending in June 2001, mainly owing to the depreciation of the Indian rupee against the dollar and a favorable inflation differential against India. This differential, however, appears to mainly reflect temporary factors, including more modest adjustments of administered energy prices and favorable agricultural supply shocks in Nepal, rather than a structural difference in inflation trends.

Figure 1.
Figure 1.

Selected External Indicators, 1995–2001

Citation: IMF Staff Country Reports 2001, 172; 10.5089/9781451829891.002.A001

Sources: Etta provided by the Nepalese authorities; and the IMF, International financial Statisitics.1/ Three-month moving average.
Table 2.

Nepal: Balance of Payments, 1997/98–2001/02

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

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

Includes re-exports of oil and gold.

NRB and commercial bank assets and liabilities are calculated at period-end NRB buying rate.

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

In percent of exports of goods and services and private transfer receipts.

Change derived from the monetary survey.

9. Monetary developments were generally in line with the authorities’ indicative target. During 2000/01, broad money growth, which had accelerated during the previous year to nearly 22 percent, was contained to 15 percent, within the authorities’ 15–16 percent target range and in line with lower nominal GDP growth and the trend decline in velocity (Table 3. Figure 2). However, nominal interest rates eased somewhat, with the yield on treasury bills falling to 5 percent, partly in response to lower interest rates abroad, including India—nonetheless, debt market rigidities and other constraints continue to allow interest rates in Nepal to remain considerably lower than in India.

Figure 2.
Figure 2.

Nepal: Selected Financial Indicators, 1995-2001

Citation: IMF Staff Country Reports 2001, 172; 10.5089/9781451829891.002.A001

Table 3.

Nepal: Monetary Accounts, 1998–2001 and Targets for 2001/2002

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

Commercial banking deposit and lending data is typically subject to upward revision due to some reporting lags.

Assuming constant exchange rate in 2001/2002 at the July level of Nrs 75 per U.S. dollar.

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

10. Balance sheet problems among the major banks and structural rigidities continue to affect interest rate spreads and bank reserve positions. In particular, the two largest commercial banks—the state-owned Rastriya Banijya Bank (RBB) and the partly-private Nepal Bank Limited (NBL), representing roughly 60 percent of banking sector assets—have large stocks of nonperforming loans and recent reports have identified them as having significantly negative net worth. Problems in these specific institutions, as well as more widespread weaknesses in administrative and legal provisions for debt recovery, have limited both the ability and willingness of banks to lend and have contributed to a buildup of significant excess reserves. Accordingly, spreads between lending and deposit rates have remained wide at around 5 percent.

11. Some elements of fiscal performance have improved in the past two years, and the overall deficit remains sustainable because of aid flows; however, the structure of the budget is weak.

  • After declining in the previous two years, the overall central government deficit (before grants) is estimated to have widened to 6¾ percent of GDP in 2000/01, still below the original budget projection (Figure 3).5

  • However, while net domestic financing rose, it remained below 3 percent of GDP and public saving, which reached 1½ percent of GDP in 1999/2000, turned slightly negative during the past year.

  • Strong collection efforts brought significant improvements in the past two years, though tax revenues remained below 10 percent of GDP (Table 4). Revenue collections in 2000/01 were much affected by the large number of lost working days, including because of the royal mourning period, which coincided with the critical year-end revenue collection period.

  • Current expenditures increased by 36 percent, higher than budgeted, principally because of the impact of a large pay increase.6 Interest costs increased only modestly because of the large share of concessional financing and low nominal interest rates on government securities.

  • Continued slow project implementation and associated slower-than-anticipated disbursement of foreign grants resulted in a shortfall of 1¾ percent of GDP in development spending. Capital spending is estimated to have reached 6½ percent of GDP, but there remain significant concerns regarding the quality of these outlays and little progress was made in streamlining projects.

Figure 3.
Figure 3.

Nepal: Selected Fiscal Indicators, 1995–2001

Citation: IMF Staff Country Reports 2001, 172; 10.5089/9781451829891.002.A001

source: Data provided by the Nepalese.1/ Three-month moving average.2/ The government’s central bank overdraft balance was converted to treasury bonds in March 1999.3/ cumulative from start of fiscal year
Table 4.

Nepal: Summary of Government Operations 1997/98–2001/02 1/

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

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

Based on the Budget Speech 2001/02 presented to Parliament on July 9, 2001.

Current and capital and net lending expenditures arc based on new economic classification provided by the authorities and staff estimates. The traditional presentation is in terms, of regular and development expenditures.

Foreign financing assumes an additional $20 million donor support to finance the VERS.

12. Although the government has set out a comprehensive structural reform agenda—which it hopes will be supported by donors, including the Fund—implementation has been uneven, partly reflecting political difficulties.7

  • The legislative agenda was placed on hold because of the opposition’s blocking of the February-April parliamentary session: the new central bank law, income tax law, and bankruptcy laws had been stalled, but these have now been tabled for the current parliamentary discussion.

  • Financial sector reforms have advanced, albeit at a slow pace. The government published a broad-ranged and ambitious Financial Sector Strategy Statement in December 2000. New prudential regulations, based on international practice, came into force in July 2001 raising capital adequacy requirements and imposing tighter loan classification guidelines. Progress, however, on the World Bank-assisted program to address the problems of RBB and NBL was slow—they still operate with large levels of nonperforming loans, and no proper accounting or loan management.8

  • Public administration reforms also have proceeded slowly. There have been notable improvements in expenditure monitoring and control, but the budget preparation process remains rudimentary. The establishment of a high-level PERC in September 2000 signaled the government’s intention to tackle long-standing inefficiencies in the public sector.

  • The authorities have initiated a Voluntary Early Retirement Scheme (VERS) for the civil service by providing lump-sum early benefits to approximately 2,000 civil servants.9 However, delayed completion of the civil service census precluded further progress toward developing a rationalization strategy.

  • Although the authorities have identified a large range of public enterprises in need of major restructuring, in the past two years only the national tea company was sold, and there were no liquidations. Efforts to complete the sale of Butwal Power Company continue.

III. Policy Discussions

13. Policy discussions centered on the authorities’ medium-term policy framework and the key changes needed to accelerate economic growth and promote poverty reduction. Specifically, the focus was on:

  • Improving public resource management through redefining the role of the state and reforms to strengthen expenditure management and enhance revenue mobilization.

  • Promoting private sector development by improving the enabling environment for both domestic and foreign investment, undertaking much-needed reforms in the financial sector, and further improving trade policies.

  • Addressing a range of overarching systemic issues, including governance and institutional capacity, which affect performance of the economy at every level.

A. Policy Framework for 2001/02-2004/05

14. The authorities’ medium-term objective is to achieve and sustain annual growth of 6–6½ percent, bolstered by the implementation of structural reforms. In addition to maintaining macroeconomic stability, this would require raising agricultural productivity as well as exploiting more fully Nepal’s comparative advantage—tourism, hydropower, and a low-wage workforce.10 Faster growth would require: (i) increases in the level of gross investment to accommodate the buildup of infrastructure and expanded private sector activity; (ii) continued export growth, spurred by economic restructuring; (iii) maintenance of low inflation and a comfortable reserve level; and (iv) continued foreign aid with improvements in project implementation and prioritization. This framework forms the basis for the mission’s high growth scenario (see Annex V).

15. The government’s medium-term fiscal strategy seeks to boost tax revenue and improve the quality of expenditure to allow for higher social spending, and the containment of the domestic financing requirement. There would be an increase in public savings and the overall deficit would decline gradually, as nonessential spending is reduced and both regular and development budgets concentrate on key priority areas. Tax revenues as a share of GDP would be targeted to reach more than 11 percent of GDP by 2004/05 through the broadening of the tax base. Total current spending would be constrained, while spending on rural education and health would be increased.11 Aid would finance much of the increase in public expenditure; thus, the debt-service ratio would remain at around 5½ percent of GDP.

16. The team supported this fiscal approach, noting that the overall deficit was not the critical constraint as long as aid continued to keep debt service costs low. The overall deficit before grants (5–7 percent of GDP) would be sustainable at current growth rates. Grants constitute one-third of total foreign financing of the deficit, with the remaining two-thirds is in the form of concessional loans. Thus, although the public debt to GDP ratio has increased from about 50 percent to 57 percent in the past two years—owing to large loan disbursements for infrastructure projects—the external debt service ratio would remain low while domestic interest payments are expected to remain below 1½ percent of GDP. Interest payments would continue to be only about 12 percent of total revenue.12

17. There could even be scope for relaxing the fiscal stance, if warranted to support the poverty reduction objective. Key prerequisites, however, would be to ensure that higher spending could be efficiently utilized and that additional concessional foreign financing is secured, in order to avoid unsustainable debt levels. In particular, it would be essential to address weaknesses in governance and implementation capacity that have contributed to recent overruns in wage expenditure and persistent shortfalls in development spending.13

18. These medium-term objectives are vulnerable to various risks, stemming from both adverse external events and from shortfalls in implementing the reform agenda. The balance of payments could deteriorate if conditions in Nepal’s main trading partner India worsen, or if the demand for Nepal’s primary exports—garments, carpets, and tourism—is affected by a slowing of the world economy or a change in taste for Nepali goods and services. The outlook would also be worse if agricultural productivity does not increase and other reforms were stalled due to continued political uncertainty. Such an environment would likely limit prospects for the sharp increase in public and private investment anticipated under the high growth scenario, and as a result growth rates could be considerably lower, averaging about 3–4 percent of GDP. Official reserve accumulation would be much slower and the external debt service ratio could rise to nearly 7 percent of GDP (see the low growth scenario in Table 6 and Annex V).

Table 5.

Nepal: Vulnerability Indicators, 1996/97–2000/01

(In percent of GDP, unless otherwise indicated)

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Source: Data provided by the Nepalese authorities.

Fund staff estimates.

From Special Audit Report by an accounting firm, R. Bajracharya & Company.

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

Table 6.

Nepal: Medium-Term Scenarios, 1997/98–2004/05

(In, percent of GDP, except where indicated)

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

Public savings and investment estimate derived from fiscal accounts. Gross investment derived from national income accounts (adjusted).

Historical totals include changes in stocks.

For 2000/01, capital and development includes partial cost of voluntary retirement scheme. Staff estimate for 2001/02, not the budget target.

From 2002/03, current includes interest cost of restructuring bonds and capital includes remaining cost of voluntary retirement scheme.

Excluding re-exports.

Excluding gold.

Excludes balance sheet impact of restructuring RBB and NBL.

B. Macroeconomic Policies for 2001/02

19. The authorities expected growth to reach 6 percent in 2001/02 as business confidence improves and domestic security is significantly restored. Economic activity is anticipated to be buoyed with the coming on stream of hydropower projects (which are estimated to have increased domestic capacity by 50 percent over the last two years) and a recovery in tourism back to the level of 1999. Inflation is expected to remain in the 4–5 percent range, provided world oil prices do not rise and there are no domestic food shortages. The current account is expected to move to a deficit of about 1½ percent of GDP reflecting a pick up in capital good imports for donor-financed projects. Reserves would be maintained in terms of imports. The team broadly endorsed the projection but cautioned that growth could be lower if agricultural production is adversely affected by the late monsoon, domestic disturbances do not subside, or the global economic slowdown affects export demand.14

Exchange Rate and Monetary Policies

20. The mission broadly endorsed the authorities’ policy of pegging the Nepalese rupee to the Indian rupee. During the discussions, the authorities noted their view that both the pegged arrangement (as well as the current level of the exchange rate) remain appropriate, as it enabled Nepal to benefit from the close economic ties with India. The team agreed, observing that available indicators suggested that competitiveness had been maintained—in real effective terms, the exchange rate has remained broadly stable, average wages had not increased in real terms in either of the main export sectors, and the economy’s recent export performance had been satisfactory.15 The apparent lack of pressure in the exchange market in the aftermath of recent political events also suggests market confidence in the arrangement.

21. However, the mission expressed concern regarding the increase in the NRB’s reserves held in the form of Indian currency. These holdings had increased to roughly 30 percent of total reserves and were poorly remunerated and relatively illiquid. Against this background, the team encouraged the central bank to approach the Reserve Bank of India to arrange for their exchange into reserve currencies or to facilitate the NRB’s participation in the Indian foreign exchange market.16 The NRB broadly shared the team’s assessment, but noted that the situation would need to be resolved in a manner that avoided jeopardizing Nepal’s close trade and other relations with India.

22. The authorities explained that broader monetary policy objectives would continue to be framed in a manner consistent with the exchange rate peg. This, in turn, meant ensuring that monetary growth was consistent with a domestic inflation rate that was broadly in line with that in India. Against this background, the NRB’s financial program for 2001/02 had set the objective of containing broad money growth to 14–15 percent which, given real GDP growth of around 6 percent and the downward trend in velocity, would be consistent with inflation of around 4–5 percent.

23. Although the mission endorsed these objectives, it stressed the importance of containing excess liquidity in the banking system. In particular, reserve money growth had accelerated early in the financial year to well above the NRB’s target because of higher-than-anticipated financing by the NRB of the government and strong growth in credit to the private sector, in the latter case possibly reflecting rollovers of nonperforming loans. Reserve money growth was estimated to have slowed by the end of 2000/01, once the government authorized the issuance of new debt instruments, which allowed a reduction in its overdraft with the NRB.

24. Against this background, the mission and the NRB agreed that measures were needed to contain reserve money growth in the coming year. The staff team endorsed the NRB’s intention to mop up liquidity by selling its remaining treasury bills and encouraged action to improve debt management practices and to ensure that limits on the government’s overdraft were applied on an intra-year basis. The staff and the NRB agreed that these efforts could require some further upward movement in interest rates—the mission suggested that yields on treasury bills could be expected to increase to at least 6½–7 percent in view of the prevailing inflation rate and market conditions.

25. The mission also noted that the monetary program would need to be reviewed in the light of efforts to restructure the two large commercial banks. The restructuring was expected to get underway in early 2002 and, coupled with recently introduced prudential regulations, could affect the behavior of the monetary aggregates given the large size of these institutions’ loan portfolios and deposit base.17 Against this background, the mission stressed the importance of steps to reduce lags and errors in reporting by the commercial banks, in order to ensure timely policy corrections.

Fiscal Policy and the 2001/02 Budget

26. Discussions of the fiscal framework for 2001/02 took place during the early stage of budget preparations. The mission and the authorities agreed that the budget should contain measures to increase the amount and effectiveness of development and social spending, while containing the domestic borrowing requirement through revenue enhancement. Against this background, the mission broadly endorsed the authorities’ intention to contain the fiscal deficit to around 7 percent of GDP, which would be financed primarily by foreign grants and loans. This objective would be achieved by boosting revenues by 1 percent of GDP, principally from (i) extension of VAT to handicraft shops and other small businesses generating profits and a 10 percent capital gains tax on the sale of securities, (ii) higher excises on cigarettes and liquor, and (iii) improved tax administration.

27. The mission noted the critical importance of improvements in the efficiency of the income tax, VAT, and customs administrations for meeting the overall fiscal objective. The authorities responded that the recent merging of the VAT and Income Tax Departments into an Inland Revenue Department should yield considerable efficiency gains, especially with regard to taxpayer registration and audits. While customs collections had been adversely affected by problems with the invoice valuation system and the prevalence of informal and barter trade from Tibet, the latter situation had improved in April after army troops were mobilized to patrol the borders.

28. The authorities noted that civil service reforms would underpin the expected containment of current expenditure. Although wage costs had risen sharply in 2000/01, owing to a revision to the salary structure, personnel expenses were expected to decline in terms of GDP, with the implementation of the proposals of the PERC.18 These included (i) the transformation of the pension system into a funded scheme and an increase in the minimum number of years required for early retirement from the army and police; (ii) the abolition of low-grade posts and contracting out of related services;19 (iii) continued downsizing under the voluntary early retirement scheme (VERS); and (iv) the maintenance of a freeze on hiring and the elimination of vacant posts.

29. The authorities cautioned, however, that some measures in the area of civil service reform would need to follow the budget. For example, a cabinet decision would be needed to enforce the elimination of all vacant posts, and this would only follow the completion of the civil service census, expected by August 2001. Nevertheless, some reduction in the wage bill would be expected in 2001/02, since ministries were now required to verify their filled positions before release of the budgeted wage allocations. The mission stressed the importance of containing personnel-related outlays, suggesting that there seemed scope for reducing the generosity of the VERS scheme, and also cautioned that the Citizens Investment Fund, which would manage the pension contributions under the new system, would need to be subject to appropriate accountability and investment guidelines.

30. The staff agreed that an increase in capital spending was justified in view of Nepal’s development needs. However, increased spending would need to be coupled with measures to ensure greater consistency between the development budget and implementation capacity, improved project prioritization, and the elimination of low-priority projects that were not critical for growth and poverty alleviation.20 The newly established Poverty Alleviation Fund (PAF) should also be included in the budget process and subject to proper scrutiny and accountability. In addition, the mission noted that the significant shortcomings in the authorities’ ability to monitor donor-financed projects within the fiscal year would need to be addressed to implement the PRSP effectively.21 The authorities agreed, noting that there was an urgent need to improve the timeliness of reporting on donor-financed projects. They also expected that development planning would be improved in the context of 2002/03 development budget, which would be presented on a three-year basis, reflecting an ongoing detailed review of development projects and social programs.

31. The authorities also recognized the need to overhaul the management of public debt. Legal restrictions constrained the government from issuing debt beyond statutory limits, and have forced it to rely excessively on overdrafts from the NRB, especially within the fiscal year.22 The mission stressed the importance of easing the debt limits, since large overdrafts with the NRB had undermined the central bank’s ability to undertake open market operations and to manage reserve money growth in line with its overall monetary policy objectives.

32. The authorities agreed that additional fiscal measures would be taken if the budget was off track. They explained that corrective action would now be feasible at the time of the Mid-Term Review in February 2002, since recent improvements in fiscal monitoring would allow an assessment based on full revenue data for six months, and expenditure information from the largest 20 districts for five months.

33. In the event, the 2001/02 Budget, which was presented to Parliament on July 9, appears broadly in line with the earlier discussions (Box 2). Despite the fact that economic prospects for 2001/02 have worsened somewhat and there have been expenditure pressures related to the security situation, the budget aimed to increase public savings to 1 percent of GDP and achieve an overall deficit, before grants, of 7 percent of GDP. The expected increase in revenues has been targeted, measures to streamline expenditure were announced, and many of the recommendations of the PERC were introduced. The budget took steps to accelerate the decentralization program by transferring management of primary schools and health care facilities to local governments, and to improve infrastructure policies by inviting and establishing private participation in power and telecommunications. A ways and means bill has been passed to authorize spending, pending the parliamentary approval of the budget.

34. Nonetheless, several factors suggest that it may be difficult to achieve the budget targets. Specifically:

  • The revenue targets appear somewhat ambitious. Notably, the projected 23 percent increase in collections of VAT and income tax would seem difficult to achieve given the measures announced and the possibility that the 2000/01 disruption in collections will spill over into the current year. Moreover, the budget introduced a number of new tax concessions with an uncertain budgetary impact—including a duty reduction for “sick” industries and rebates of 80 percent and 50 percent on import duties for pashmina wool and cotton yarn.23

  • There are risks of current expenditure overruns. Personnel-related expenses may be difficult to contain given that steps appear not to have been taken to eliminate vacant positions, even in some pilot ministries, and modifications were not made to reduce VERS costs. The budget also introduced a number of credit schemes targeting the agriculture, industry, and export industries, which appear to run counter to the broad thrust of financial sector reform and do not seem to have received budgetary allocations to cover the associated interest subsidies.

  • The proposed increase in development spending—to 8 percent of GDP—may also exceed implementation capacity. Moreover, while the budget espoused greater project prioritization, it did not provide the details of expenditure plans to suggest that the necessary pruning had taken place.24

Nepal: The 2001/02 Budget

The 2001/02 budget speech announced an overall fiscal deficit target (before grants) of 7 percent of GDP, a l¼ percent increase from last year. Improved tax administration measures, coupled with a special fee for strengthening security arc expected to increase total revenue by 1¼ percent of GDP. Current expenditures are projected to remain around 11½ percent of GDP, whereas the budget provides an increase of 1¾ percent of GDP in capital expenditures to 8 percent of GDP.

Revenue measures

  • Merger of VAT and Taxation departments and creation of Inland Revenue Department.

  • Introduction of 10 percent capital gains tax.

  • Broadening of VAT.

  • Extension of the Automated System for Customs Data to more customs posts.

  • Increased import tariffs on milk, oil, and video equipment.

  • Increased export taxes on vegetable ghee, plastic products, and copper wire.

  • Special fee of 1 percent on customs duties and income tax payments for funding the Internal Security and Development Plan (ISDP).

  • Increased excise taxes on cigarettes and liquor.

Expenditure measures

  • Implementation of the recommendations of the Public Expenditure Review Commission for expenditure management, including civil service reform, pension system reform, and prioritization of development projects.

  • Establishment of Poverty Alleviation Fund to bring various scattered poverty programs into a unified framework for efficient monitoring and evaluation of programs.

  • Security spending increased to 2½ percent of GDP to cope with the worsening security situation.

  • Health and education spending budgeted to reach 4½ percent of GDP.

  • Spending on power sector to increase by 17½ percent over the estimated spending in 2000/01, including the completion of the Kaligandaki ‘A’ hydroelectricity project (Nrs 2.9 billion).

Low interest credit facilities

  • Agriculture sector: interest rates lowered by (i) 1 percent for exportable farming and cash crops, (ii) 2 percent on credit extended by the Agricultural Development Bank to tea plantation areas, and (iii) 2 percent on credit for horticulture farming in areas receiving ISDP funding.

  • Industry: a refinancing scheme at 7.5 percent interest for troubled, but qualified industries to be financed by a provision of Nrs 1.0 billion as source funds from the NRB.

  • Export promotion: interest rates on export credits lowered by 1.5 percent in convertible foreign currency and by 1 percent in Nepalese currency.

Foreign investment & trade promotion

  • Simplification of the licensing process, permitting foreign-based Nepalis to investment and repatriate profits, and allowing private sector participation in the forthcoming Special Industrial Zone.

  • Simplification of the duty drawback scheme for exporters, including facilities to exporters whose duty drawback is overdue for several years.

Civil Service Reforms

  • The minimum service period for volunteer retirement for army and police personnel will be extended from 16 to 20 years and the minimum age of eligibility extended from 40 to 45 years.

  • Certain services, such as cleaning, gardening, and maintenance will be contracted out.

C. Structural Reforms

Financial Sector

35. The team noted that bank restructuring and financial sector regulation and supervision were critical to the success of the government’s reform program. In this context, the mission welcomed the publication of the government’s Financial Sector Strategy Statement, which outlines the main areas of focus for legislative, regulatory, supervisory, and institutional reforms. During the discussions, the team also encouraged the authorities to implement policies geared toward further opening up the banking sector to competition—the authorities subsequently increased the limit on foreign ownership of banks from 49 percent to 66 percent. However, foreign interest in Nepalese banks has been limited, and two foreign banks have recently sold their interests in the sector to Nepalese banks for strategic reasons.

36. The authorities have taken halting steps to address the problems of the two large troubled banks. In light of estimates—based on July 1998 accounts—that these two institutions had a negative net worth amounting to 5-9 percent of GDP, the authorities decided to insert independent management teams, financed by the World Bank. The authorities also indicated that recapitalization of the RBB and NBL would be considered only after the new management teams had completed a thorough review of the banks’ viability and adopted a restructuring program.25 In order to limit asset stripping before arrival of the new management teams, the authorities have issued directives to the banks that would require them to inform the NRB of transactions involving any large loans, recruitment or other major personnel changes, and otherwise strengthen their reporting mechanisms.

37. The team welcomed these initiatives, but expressed concern over the delays in meeting the initial timetables for contracting the management teams. Although the process was under way for the state-owned RBB, the technical evaluation of bids for the contract for the NBL (a majority privately-owned bank) did not meet the World Bank’s procurement guidelines and will have to be restarted.26 The mission cautioned against further delays, which would risk increasing the fiscal costs of restructuring and adversely affecting the broader banking system.

38. In April 2001, new regulations were introduced that established a code of ethics, enforcement procedures, and risk management guidelines.27 While welcoming these steps, the mission urged the NRB to resist apparent pressures from some banks to extend the timetable for their implementation and calls for their dilution. In particular, the team stressed the need to maintain the limits on connected lending and requirements for reporting of transactions with family relatives. Staff also emphasized the need to avoid conflicts of interest by discontinuing the practice of assigning NRB and government officials to the Boards of private financial institutions, and by phasing out NRB’s equity participation in a wide range of financial institutions. To strengthen enforcement, the mission recommended that the NRB issue rules-based guidelines for remedial action in cases of non-compliance with the new regulations.

39. A number of other pieces of financial legislation have been tabled for the current parliamentary session. Building on World Bank and MAE/LEG technical assistance, a new central bank law has been proposed, which would increase the NRB’s independence and more clearly define its role in the area of monetary policy. Also, new legislation governing deposit-taking institutions would replace existing overlapping laws and clarify and streamline regulations and reporting requirements. The Asian Development Bank (AsDB) also is providing assistance in amending the Insolvency and Secured Transactions Act, which would address the weaknesses in the legal enforcement mechanism and judicial capacity, and the Debt Recovery Act, which would help establish debt recovery tribunals to facilitate loan recoveries by banks. The mission strongly supported these legislative reforms, and encouraged the authorities to seek parliamentary passage as soon as possible.

40. The mission argued for limits on lending to priority sectors by the central bank and commercial banks. For example, commercial banks are required to direct 12 percent of their loans to “priority” small-scale borrowers, and these loans tend to be at lower-than-market-rates, given that the banks compete with development finance institutions that are able to provide subsidized credits. The central bank is likely to be required to recapitalize development finance institutions and provide subsidized credits to commercial banks in order to promote their lending to priority sectors. The mission cautioned that these regulations and practices distorted credit allocation in a manner that undermined overall economic efficiency and the strength of the financial sector, and was a nontransparent manner for delivering fiscal subsidies. The team suggested that, over the medium term, responsibility for such activities should be shifted to specialized agencies such as the development banks, whose quasi-fiscal activities should be clearly identified.

41. The authorities suggested that priority lending could be an effective method of addressing poverty, but indicated their willingness to review the current system. As a first step, they agreed that it would be useful to prepare an accounting of the cost of priority/subsidized lending, which could be followed possibly by the preparation of a reform plan. This approach could be taken in tandem with efforts of the AsDB in their rural micro-financing project, which seeks to stem the growing losses of the regional development banks and to establish an efficient mechanism for the distribution of micro credit. Since the discussions, however, the 2001/02 budget introduced a number of new subsidized credit facilities without a clear budgetary allocation for interest subsidies.

Public Sector Reforms

42. The authorities’ public sector agenda focuses on tax administration reforms, public expenditure efficiency, civil service reform, and public enterprise restructuring and privatization. The mission welcomed the attempt to set priorities for the development program through a comprehensive screening of projects, as well as streamlining government offices and reducing wasteful expenditures. Although progress has been achieved in improving expenditure monitoring and control, the team advised that fiscal transparency would be enhanced if the budget discussions incorporated the small, off-budget funds and local governments. The mission supported the work of DfID to accelerate privatization, which had slowed considerably in the past two years, and advised the authorities to develop a program to phase out budgetary transfers and directed lending to enterprises.28

Governance and Legislative Reforms

43. The team noted that, while progress has been made in recent months to enhance governance and legislative effectiveness, corruption and procurement problems persist. Notable progress has been achieved in the area of fiscal transparency by greatly improving the coverage and scope of the budget presentation, but increased fiscal and public enterprise monitoring is essential. In particular, there is a need to enforce debt-servicing obligations by the public enterprises—several such agencies have defaulted on loans in the past. The team hoped that donor support would facilitate action on these fronts in the context of a strengthening of the Public Accounts Committee, which is investigating various public sector governance issues.

44. The authorities have committed to further improving governance by strengthening public procurement procedures and combating widespread corruption in both the public and private sectors. As a first step, the authorities have started to pay off arrears owed to the utility companies by the central and local governments. The team welcomed these efforts, but stressed the need to remove impediments to entrepreneurship and improve the regulatory framework, especially for foreign investment. A World Bank assessment found deficiencies in both the regulations themselves and their implementation—with companies facing conflicting requirements and very slow processing of applications. If the envisaged reform measures are to succeed, the political leadership will need to resist union interference in the public sector, which inhibited reforms in the past.

D. Other Issues

Trade and Capital Account Regulations

45. Nepal maintains a trade system that is broadly free of restrictions and has applied to join the WTO.

  • Nepal has no substantive non-tariff barriers in place; the only ones in place are retained for religious, health, and security purposes.

  • The tariff structure includes five basic standard rates (5, 10, 15, 25, and 40 percent); the simple average tariff rate remains at around 13 percent.

  • In 2000, in a move intended to simplify the tax system, the authorities replaced excise duties on vehicles with two exceptional tariff bands (80 percent and 130 percent). The team urged the authorities to reverse the measure, since it undermined tariff rationalization.29

  • In the medium term, the government has stipulated its intention to reduce the number of tariff bands, in addition to lowering their levels. However, the authorities indicated that they could not take decisions on this issue without fully assessing the direction that India, its major trading/political partner, would take in this area given the possibility that large tariff differentials could promote smuggling.

  • Nepal submitted to the WTO a Memorandum on the Foreign Trade Regime in August 1998; progress was made in bilateral negotiations with various WTO members, and the working party that deals with Nepal’s accession met early this year.

46. Nepal’s capital account remains closely regulated, particularly with respect to short-term capital flows and foreign commercial borrowing. The staff advised that liberalization of the rules governing foreign borrowing should await implementation of key structural reforms including measures to strengthen financial institutions and supervision.

Data Issues

47. Although the Nepalese authorities publish extensive data in a timely manner, there remain severe weaknesses in economic statistics that impair effective monitoring and policy formulation. The staff was encouraged, however, by recent improvements in the presentation of the fiscal accounts and the coverage and classification of the balance of payments statistics.

48. The team recommended that the authorities provide adequate resources to the data compiling agencies and enhance effectiveness of the National Statistical Council in setting statistical priorities and ensuring coordination among the compiling agencies. A STA multisector mission in January 2001 assisted the statistical authorities with identifying and addressing methodological weaknesses as well as enhanced interagency coordination. The mission also assisted with the preparation of metadata required for Nepal’s participation in the General Data Dissemination System (GDDS). The authorities agreed in principle with the mission’s recommendations, but noted that considerable long-term technical assistance will be needed to support their limited technical and institutional capabilities (see Annex IV). A TGS mission in July provided advice on the establishment of a database of macroeconomic indicators.

IV. Staff Appraisal

49. Macroeconomic performance has been satisfactory in Nepal over the past two years, but the challenge remains to set the stage for strong growth and poverty alleviation. Near-term prospects for growth and inflation appear broadly favorable while the external position should be sustainable with aid inflows sustaining reserves even as the current account remains in deficit. However, there are important downside risks to achieving a strong growth rate, associated with the adverse impact of the regional slowdown, lower agricultural production due to the late monsoon, and slower recovery in tourism. Moreover, reform and substantial foreign aid—in turn, requiring political stability and internal security—are needed to achieve and sustain growth rates sufficiently high to reduce poverty significantly.

50. Encouragingly, the government has developed a comprehensive program of structural reforms that promises to lay the foundation for both growth and poverty reduction. The program, based on a forthcoming I-PRSP, appropriately focuses on maintaining macroeconomic stability and removing the constraints on growth: a weak and segmented financial sector, inadequate revenue, poor provision of public services, and weak governance. The initial task facing the authorities, while completing the full PRSP, will be to continue with the broad participatory framework already in place and to link budgetary allocations to expected outcomes.

51. Attainment of the authorities’ objectives requires continued pursuit of prudent demand-management policies. Nepal’s close economic links with India and the latter’s stable outlook continue to argue in favor of maintaining the peg to the Indian rupee. The strong performance of exports and the continued buoyancy of official reserves—albeit with a lower share of convertible currencies—also suggest that the level of the exchange rate remains broadly appropriate. However, the authorities are encouraged to find ways to adjust the currency composition of their reserves to improve the liquidity of these assets.

52. The pegged exchange rate requires that monetary policy be broadly harmonized with that of India, and the staff endorses the NRB’s financial program for 2001/02. However, it will be important to review the monetary program to avoid risks related to potential excess liquidity in the banking system, and to take into account the impact of the restructuring of the two large commercial banks, given the size of their loan portfolios and deposit base.

53. The budget targets for 2001/02 and the planned increase in public savings are appropriate, but additional efforts will likely be needed to achieve them. Increased tax auditing should help boost collections, but may be insufficient to deliver the targeted revenue levels. Steps may also be needed to ensure that overruns in some spending categories can be offset by savings in other line items. To achieve the desired increase in both the level and the effectiveness of capital spending, it will be necessary to implement tighter control over project spending and implementation.

54. As soon as possible, the government should put into effect the remaining recommendations of the PERC for streamlining the civil service and prioritizing public expenditure within a three-year rolling budget. Further efforts will be needed to improve expenditure control of the line ministries and local governments. The staff supports the ongoing review of the existing pension system, and the initiation of a new funded pension scheme. To improve transparency and accountability, mechanisms are needed to ensure full reporting of the Poverty Alleviation Fund, off-budgeted revenue, and foreign aid. To reduce the burden on the budget, the government should accelerate divestiture of small institutions while tackling the problems of the large, loss-making enterprises.

55. Looking toward the medium term, the broad fiscal strategy should aim to mobilize higher tax revenues and improve the quality of expenditures, providing scope for higher social spending. If additional foreign financing was secured, governance improvements achieved, and the feasibility of more effective social sector spending demonstrated, the fiscal stance could be relaxed. In this regard, rural education, health, and essential infrastructure would warrant both increased budget allocations and improved targeting. However, budget targets will also need to make adequate provision in future years for the fiscal cost of financial sector reform.

56. The authorities’ strategy to address the negative net worth of the two largest banks and the steps to improve the regulatory environment in the financial sector are welcome and overdue. The authorities will need to overcome the administrative and other obstacles that are delaying recruitment of management teams for RBB and NBL. Some form of recapitalization will be necessary, but should only be undertaken when each bank has been properly restructured and its management improved. The proposed new central bank act will provide needed scope for increased independence, as well as introduce proper accounting, auditing and disclosure practices and strengthen the regulatory and oversight activities.

57. The government should continue to ensure its open trade and investment regime and encourage access to world markets. The authorities are urged to reverse the recent imposition of exceptional tariffs on vehicles and rationalize the tariff structure by reducing the number of bands. Efforts to enhance the performance of the financial sector and strengthen supervision should be pursued before opening up the capital account. Further simplifying the existing legal framework and improving governance will also be important.

58. Although extensive data are compiled in a timely manner, there remain serious deficiencies in official statistics that impair effective monitoring and policy formulation. The authorities are encouraged to implement the recommendations of the STA multi-sector mission and strengthen statistical legislation, survey methodologies, and data gathering. Considerable donor assistance will be needed to strengthen the limited capacities of the national statistical office over the long term.

59. The staff recommends that the next Article IV consultation remain on the 12-month cycle. The authorities have consented to the publication of the staff report.

Table 7.

Nepal: Social Indicators

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Sources: Staff reports, EDSS, World Bank 2000 World Development Indicators CD-ROM.