Nepal: Staff Report for the 2003 Article IV Consultation

Poverty in Nepal remains pervasive owing to insufficient growth and inadequate targeting under the poverty alleviation programs. Executive Directors stressed the need to implement strong fiscal and monetary policies and accelerate structural reforms. They welcomed the Poverty Reduction Strategy Paper (PRSP), social sector development, targeted programs for the poor and deprived groups, and improved governance. They emphasized the need to improve revenue mobilization, prioritize spending, and contain domestic borrowing for economic growth.

Abstract

Poverty in Nepal remains pervasive owing to insufficient growth and inadequate targeting under the poverty alleviation programs. Executive Directors stressed the need to implement strong fiscal and monetary policies and accelerate structural reforms. They welcomed the Poverty Reduction Strategy Paper (PRSP), social sector development, targeted programs for the poor and deprived groups, and improved governance. They emphasized the need to improve revenue mobilization, prioritize spending, and contain domestic borrowing for economic growth.

I. Introduction

1. Nepal remains among the poorest countries in the world due to insufficient growth and inadequate targeting under poverty reduction programs. Around 40 percent of the population lives below the poverty line (roughly unchanged for more than a decade). Health, education, and other development indicators also remain low compared to other South Asian countries. Poverty is more intense in the distant mid- and far-western regions of the country and among female-headed households. Growth during the 1990s—modest but insufficient for poverty reduction—remained constrained by financial sector weaknesses, weak public sector management, and poor governance. During 2000/01–2001/02, growth fell due to the intensification of the seven-year old insurgency and adverse external developments.1 Furthermore, the effects of modest growth on the rural poor have been limited, as it has been relatively rapid in the nonagricultural sector and centered in urban areas. Agricultural growth itself has been constrained by low productivity gains due to poor irrigation and infrastructure. Moreover, social and poverty alleviation programs have had limited impact on the poor due to insufficient targeting and weak implementation.

Nepal: Growth Rates

(Annual average, in percent)

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Source: WEO; and staff estimates.

2. The ceasefire agreed in January 2003 has renewed hopes for peace and efforts have been made to sustain the reform momentum. Progress in achieving lasting peace would facilitate more effective implementation of policies contained in the recently issued Poverty Reduction Strategy Paper (PRSP) with senior officials intent on furthering the reform agenda. Donors have expressed their support for the peace process and their readiness to increase aid to help implement the PRSP agenda. The World Bank and AsDB are preparing adjustment operations, in addition to their project loans. The authorities have expressed a strong interest in a Fund supported program, and PRGF negotiations were resumed in April. The government has agreed to posting the PRSP on the IMF’s external website. A Joint Staff Assessment of the PRSP was initiated in June.

3. However, political uncertainties persist. Key political parties continue to maintain that the appointment of Prime Minister Thapa by King Gyanendra in early June was a continuation of his earlier unconstitutional moves.2 The political parties have also refused to join the peace talks which were initiated by the previous government—two rounds of peace talks were held, with some success. While the new government intends to continue the peace talks, the timeframe and modalities remain uncertain. It is also unclear what role the insurgents may seek to play in future governments.

II. Stocktaking

4. During the 1990s, the fiscal position was manageable and macroeconomic conditions were broadly stable. In the first half of the decade, current spending was limited to domestic revenue collection, and capital spending was kept at levels financed by foreign aid, the current surplus, and limited domestic borrowing. In the second half of the decade, as the amount of external loans declined, this decline was more than offset by expenditure cuts and an increase in the revenue-to-GDP ratio (due to introduction of the VAT and improved tax administration). As a result, the domestically financed deficit relative to GDP declined.

Nepal: Government Operations

(Annual average, percent of GDP)

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Sources: GFS, IFS; and staff estimates.

5. Since 2000/01, the fiscal position has deteriorated partly due to higher security spending, and budgetary pressures are rising. During 2000/01–2001/02, the domestically financed deficit doubled to 2¾ percent of GDP with the escalation of security-related expenditures, a wage adjustment in the context of civil service reform, further declines in external financing, and less-than-targeted revenue collection. The fiscal pressures were reflected in debt service payments (domestic and external) which absorbed a fourth of revenues. Looking forward, the persistence of low growth, unchanged fiscal policies, and the potentially large contingent liabilities from financial sector and public enterprise reforms could lead to rising public debt levels over the medium term.3

6. The factors behind slow growth—inefficient resource allocation and weak governance—are related to continued structural problems in key sectors.

  • In the financial sector, NRB oversight is weak, and intermediation is inadequate despite the proliferation of institutions largely due to a banking environment in which loan default is endemic.4 Currently, the NRB is overstaffed at lower levels, understaffed in key areas, and its pay structure makes it difficult to attract qualified personnel. The two largest commercial banks—the Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL)—are now insolvent with large nonperforming assets.5 This is a result mainly of a culture of nonrepayment of bank loans, especially by well-connected borrowers. These banks are also overstaffed. Similar problems exist at the two large development banks—Agricultural Development Bank of Nepal and the Nepal Industrial Development Corporation.6 In addition, NRB directives related to commercial banks’ operations restrict banks’ ability to price credit risk and limit profit opportunities.7

  • In the public sector, investment has been spread thinly over projects—without prioritization and with low completion rates—and enterprises suffer from weak management and accountability. A number of public enterprises are potentially unviable, make losses and have accumulated large contingent liabilities (including debt service arrears to the budget).8

  • Poor governance reflects corruption, incentive problems and weak accountability in the public sector. Some of these problems are being addressed by decentralization and increased local involvement in policymaking and implementation.9

7. Other structural impediments reduce labor market flexibility, prevent orderly exit, and raise export costs. A number of regulations restrict labor shedding and deficiencies in bankruptcy procedures prevent orderly and timely production cuts or shutdown of unviable firms. Also, despite low wages and a liberal trade regime, administrative procedures and supply constraints impede export growth (see box).10

Structural Impediments to Export Growth

Structural impediments contribute to higher export costs. Unit labor costs are higher than in competitor countries, with low labor productivity more than offsetting low wage levels. Other costs, including transportation and transaction costs, are also estimated to be high.

  • Labor market. Current labor legislation makes it difficult to retrench permanent workers if needed, impedes a supply response, and raises incentives to hire temporary, unskilled workers. As a result, labor productivity and product quality are low.

  • Infrastructure. Transportation costs for exports are high due to Nepal’s landlocked location and poor roads and railway infrastructure. Import costs of inputs for garment industry are also significantly higher than for competitors in India or Bangladesh. Electricity and water costs are higher than in many other Asian countries.

  • Trade regime. Customs procedures are cumbersome, export taxation distorts production incentives, and duty drawback procedures are inefficient.

8. In the past, the authorities have been receptive to Fund policy recommendations, although structural reform implementation has been delayed by political uncertainties:11

  • Macroeconomic policies have generally been in line with Fund advice. The authorities implemented a number of Fund tax policy recommendations. In particular, a VAT was introduced in 1997 at the rate of 10 percent and the Income Tax Act has been amended as suggested by Fund staff. Some measures were also taken to strengthen tax and customs administration, but significant weaknesses persist. The Fund staff has endorsed the exchange rate peg to the Indian rupee as a nominal anchor.

  • Structural reform implementation was slow in the latter half of the 1990s because of political uncertainties related to successive coalition governments. Although understandings were reached on the elements of a possible PRGF-supported program in 2001, the program was not finalized as some prior actions, especially installation of external managers at financially-troubled commercial banks, could not be undertaken. These actions were taken in 2002/03—with donor financial support—providing a basis for resumption of PRGF negotiations.

III. Recent Economic Developments

9. A modest economic recovery is underway. The ceasefire has helped restore some normality in agriculture, transport and service sectors. There are signs that some exports and manufacturing production are rebounding and the decline in tourism may have halted. Overall, staff expects real GDP growth of 2 percent in 2002/03 (Table 1 and Figure 1).

Table 1.

Nepal: Selected Economic Indicators, 2000/01–2005/06 1/

Nominal GDP (2001/02): US$5,549 million

Population (2001/02): 23.2 million

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

Fiscal year ends mid-July.

As of May 2003.

Cumulative, excluding re-exports.

Cumulative, excluding gold.

Includes estimated private sector debt and short-term trade credits.

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

Figure 1.
Figure 1.

Nepal: Real and Fiscal Sector Developments

Citation: IMF Staff Country Reports 2003, 283; 10.5089/9781451829914.002.A001

Sources: Data provided by the Nepalese authorities; IMF, International Financial Statistics; and staff estimates.

10. Inflation rose due to price developments in India, administrative price changes and supply shortfalls, but can be expected to moderate. CPI inflation rose to about 7½ percent in mid-May (12-month basis) reflecting wholesale price rises in India, shortfalls of agricultural commodities and upward adjustments in administered prices (educational fees and petroleum products). As the pass-through effect of these price increases fades and the recent decline in international and domestic fuel prices takes effect, inflation should settle down to modest levels by early 2003/04.

11. The 2002/03 budget is estimated to have met revised targets set in a mid-term review with better-than-expected revenue performance. The 2002/03 budget aimed to reduce the overall and domestically financed deficit to 3½ and 2 percent of GDP, respectively (Table 2). Based on weak revenue performance due to lower activity during the first half of the year and external aid shortfalls relative to budget targets, the authorities took compensatory measures, in consultation with staff. Specifically, the tax revenue target and external financing were revised down. To compensate for these shortfalls, total expenditure was also revised down with significant cuts in capital expenditure; current spending was also reduced while making room for additional security personnel and clearance of pension and utility arrears. The revised budget set a net domestic financing target of Nrs 8¾ billion (2 percent of GDP).12 In the event, activity picked up after the announcement of the ceasefire and the revenue performance improved. However, capital spending is estimated to have been below the revised budget, reflecting continued implementation constraints at the local level. As a result, domestic financing was around 1¾ percent of GDP.

Table 2.

Nepal: Summary of Government Operations 1/

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

Fiscal years start mid-July, Table confined to central government operations as contained in the budget.

Includes privatization receipts.

Current and capital and net lending expenditures are based on new economic classification provided by the authorities and staff estimates. The traditional presentation is in terms of regular and development expenditures (using Fund definitions).

Provisional.

The Cross Differential and Reserve Accumulation

Since mid-2002, the Nepalese rupee has appreciated less than the Indian rupee relative to the U.S. dollar. At the official exchange rate of Nrs 1.6/Irs, this led to the cross differential,1 which had been negative earlier, turning positive and becoming greater than 2 percent at times (without taking into account the NRB’s service fee for U.S. dollar purchases). The differential was possibly sustained by capital controls and commercial banks’ intention to accumulate foreign assets. The differential also helped the NRB to accumulate reserves. To reduce arbitrage opportunities, the NRB raised the service fee charges for U.S. dollar purchases by 1 percentage point to 2 percent in February 2003 and tried to persuade the Foreign Exchange Dealers Association of Nepal to appreciate their Nrs buy/sell rates relative to the U.S. dollar to close the differential. The differential has since moderated.

1/ The cross differential arises from the difference between the midpoint spot exchange rate for the Indian Rupee (Irs) and the U.S. dollar implied from their respective rates against the Nrs (i.e., the Nrs/U.S. dollar mid-rate quoted by the NRB, which is a simple average of the commercial banks’ buy/sell rates and the official Nrs 1.6/Irs exchange rate) and the midpoint spot exchange rate for the Irs and the U.S. dollar in their principal markets. Staff examined whether this differential indicated a multiple currency practice (MCP) subject to Fund jurisdiction. Based on available evidence, staff did not determine the existence of an MCP since official action by the NRB causing this differential was uncertain.

12. Monetary policy has been accommodative and the real exchange rate has depreciated. To help spur the recovery, the NRB lowered cash reserve requirements by 1 percentage point in August 2002. The NRB has also continued to extend refinancing to commercial banks for onlending to “sick” industries in the hotel and garment sectors.13 Partly, as a result of these measures, private sector credit growth appears to have revived (Table 3). At the same time, higher remittances and a positive cross rate differential between the Nepalese rupee and the Indian rupee against the U.S. dollar (see box) contributed to a rise in banking system foreign assets, helping to improve banking sector liquidity. Lending, deposit and T-bill interest rates have all declined relative to 2001/02 levels reflecting easier liquidity conditions. Reflecting the Nepalese rupee’s peg to the Indian rupee, which has appreciated only somewhat against the weakening U.S. dollar, the nominal and real effective exchange rates depreciated by 12½ percent and 6 percent, respectively, between January 2002 and April 2003 (Figure 2).

Table 3.

Nepal: Monetary Accounts, 2001-2004

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

Commercial bank data are subject to revisions due to reporting lags.

Figure 2.
Figure 2.

Nepal: Monetary and External Sector Developments

Citation: IMF Staff Country Reports 2003, 283; 10.5089/9781451829914.002.A001

Sources: Data provided by the Nepalese authorities; and IMF staff calculations.1/ Indian rupees per U.S. dollar reference rate at the official exchange rate of 1.6 Nrs per Indian rupee.2/ An increase indicates an appreciation.

13. Balance of payments developments turned favorable around mid-2002/03 and external reserves are adequate. Large and increasing remittances—estimated at over 125 percent of merchandise exports—have helped to buoy the current account (see box, Table 4). Recorded exports to India declined reflecting the revised, more restrictive trade treaty with India in March 2002 and exports to other countries have been mixed. Garment exports began recovering in late 2002 while carpets and pashmina exports continue to stagnate. Notwithstanding the depreciation of the real effective exchange rate, export performance remained hampered by high unit costs, weak external demand, and supply constraints. Anecdotal evidence suggests that unrecorded exports may have increased recently. At the same time, the recovery raised imports. Overall, the staff expects that the current account (excluding official transfers) will move into a deficit of about ⅔ percent of GDP in 2002/03. Together with higher aid flows and unrecorded inflows, the overall balance of payments is expected to be in surplus and official foreign exchange reserves are expected to rise to over US$1 billion (6¼ months of imports of goods and services).

Table 4.

Nepal: Balance of Payments, 2000/01–2007/08

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

Includes official transfers that are channeled through the budget only.

Large net other investments aid errors and omissions reflect data weaknesses in capital account, unreported remittances and large informal trade.

Provisional. The financing gap is expected to be filled by bilateral and multilateral donors.

Includes estimated private sector debt and short-term trade credits.

Public sector debt service only, as a ratio of exports of goods and services (excluding reexports of oil) and private transfer receipts.

Remittances and Economic Management

Remittances are now likely the largest source of foreign exchange inflows. Recent estimates suggest that there are 3-3½ million Nepalese migrant workers (over 10 percent of population). Of these, 2½-3 million are in India, and the remainder in the Middle East, South East and East Asia.1/ As a result of these substantial labor flows, remittances are now estimated to be larger than commodity exports or external aid. Owing to data weaknesses, including on account of informal transfer channels, estimates of remittances are subject to a wide margin of uncertainty. Nevertheless, evidence suggests that remittances have increased in recent years and NRB and commercial banks expect them to grow further.

Remittances have implications for economic management and policy:

  • Remittances have contributed to external reserve accumulation, and more generally, supported Nepal’s balance of payments in the face of an adverse external environment in recent years.

  • Remittances help improve living standards. A large portion of the remittances is used to service loans (substantial amount of loans usually needed to finance the migration) and finance home construction.

  • Remittances could impart pressures toward appreciation of the real exchange rate.

  • Financial sector reform would help route remittances increasingly through formal channels.

  • Labor market reforms related to overseas employment agencies and contractual arrangements would help protect migrants’ interests and help ensure that remittance inflows are sustained.

1/ Seddon, D. (2003), Migration and Remittances, Report for the World Bank, mimeo.

14. Significant progress was made in financial sector reform implementation, with Bank/Fund policy advice and financial assistance. The NRB launched a voluntary retirement scheme (VRS) in March to reduce overstaffing at the nonofficer level.14 In addition, the Banking and Nonbank Financial Intermediaries Regulation Departments were merged. Progress was also made in NBL and RBB restructuring. The external managers prepared management plans for the banks, made progress in assessing their financial status, and proposed VRSs to reduce overstaffing. Financial performance has also improved somewhat with better loan recovery and branch rationalization. However, loan recovery from well-connected defaulters continues to be difficult. It is expected that the Debt Recovery Tribunal, which was operationalized in mid-July under the Debt Recovery Act, should aid loan recovery, although much would depend on effective enforcement of the tribunal’s rulings, with NRB and government support.

15. Prioritization of budgetary spending improved and public enterprise reform implementation progressed. To improve prioritization, a medium term expenditure framework (MTEF) was introduced with World Bank assistance to help align development spending with national and sectoral priorities. As regards public enterprises, administered price increases for petroleum products were announced in March 2003 to stem losses of the state-owned Nepal Oil Corporation (NOC), although some price increases were partially rolled back in April under public pressure.15 16 Liquidation procedures were initiated for four enterprises under the AsDB-supported Public Sector Management Program (PSMP); preparations for the privatization of one enterprise were brought to an advanced stage. The Country Financial Accountability Assessment was conducted, jointly with the World Bank, to strengthen accounting practices.

16. Governance reforms progressed and anti-corruption efforts were boosted. The cabinet approved in September 2002 the elimination of 7,500 vacant civil service positions.17 The cabinet also issued an order freezing new recruitment for other vacant positions in the context of the AsDB-supported Governance Reform Program and the PSMP. To tackle corruption in public life, the Commission for Investigation of Abuse of Authority (CIAA) initiated investigations against politicians and revenue officials perceived to have accumulated unaccountable assets. Similarly, a Judicial Commission to investigate assets holdings of politicians and senior government officials was established, and the Anti-Corruption Strategy was adopted.

IV. Policy Discussions

17. The policy discussions focused on PRSP policies to generate high, sustainable growth and alleviate poverty. The PRSP’s strategy, which is based on the Tenth Plan (2002/03–2007/08), consists of four pillars: broad-based economic growth; social sector development; targeted programs for the poor and deprived groups; and good governance. The authorities believe that the growth strategy should be rooted in macroeconomic stability and that a reduction in the domestically financed deficit over the medium term would help achieve this goal. The authorities have plans for financial sector, public sector, and governance reforms to improve intermediation, create room for the private sector, and generate efficiency gains to improve growth prospects. Legal and trade policy reforms are also envisaged. Among the priority social sectors, the PRSP places special emphasis on health and education where decentralization could help enhance service delivery without undue increases in spending. Within these sectors, interventions are to be targeted at vulnerable and deprived groups through the proposed Poverty Alleviation Fund.

A. Medium-Term Outlook and Risks

18. The authorities’ objectives are to raise GDP growth to 5-6 percent over the medium term, keep inflation low, and maintain a manageable balance of payments position. If peace talks progress and the security situation do not deteriorate, the economic recovery could gather momentum, and growth could rise to 3¾ percent in 2003/04. Beyond 2003/04, growth rates could rise further if a strong program of structural reforms can be implemented. The authorities recognize that their medium term objective for growth is ambitious, but maintain that it is feasible in light of the annual average growth rate of 5 percent experienced during the 1990s. In particular, they recognize that strong agricultural growth is a prerequisite for broad-based growth and poverty reduction by 5-8 percentage points over the medium term.18 With the exchange rate peg, inflation is expected to follow price developments in India. The current account deficit is projected to increase, but higher aid, remittances, and other inflows should allow international reserves to be maintained at six months of imports of goods and services.

Sources of Growth1/

In the latter half of the 1990s, real GDP growth fell to an annual average of 4¾ percent (from 5¼ percent in the first half). In this period, average annual agricultural and nonagricultural sector growth rates were 3½ percent and 6 percent, respectively. The intensification of security problems in 2000/01-2001/02 had a significant impact on the nonagricultural sector where growth fell to around 1 percent. The manufacturing and tourism sectors were especially hard hit with average annual declines of 3 percent and 4½ percent, respectively (these sectors had average annual growth rates of 6½ percent and 5 percent, respectively, during 1995/96-1999/00).

uA01fig01

Nepal: Supply Contributions to GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2003, 283; 10.5089/9781451829914.002.A001

Looking forward, real GDP growth could rise to 3¾ percent of GDP in 2003/04 with a pickup to the trend growth rate of 5-6 percent over the medium term. Underlying these growth rates, agricultural growth is projected to increase steadily through implementation of the Agricultural Perspective Plan—higher utilization of fertilizers, expansion of year-round irrigation, extension of the road network, diversification into cash crop and livestock production in the hill areas, and credit availability—which could help raise productivity.2/ As a result of these productivity gains, average annual agricultural growth is projected to be about 3¼ percent during 2003/04-2005/06. Manufacturing and tourism are expected to experience a rebound. In addition, with higher donor aid and infrastructure spending, construction, water, electricity, and gas sectors would also grow. Overall, nonagricultural growth is projected to average 6 percent during 2003/04–2005/06.

1/ Significant deficiencies in national accounts data preclude a comprehensive analysis of growth sources. GDP data by industry of origin are available for supply side analysis, albeit with significant shortcomings. However, constant price expenditure data and saving-investment balances are not available. A decomposition analysis into factor accumulation and total factor productivity is also not possible due to absence of data on factors of production.2/ See Koeva, P. (2002), “The Determinants of Agricultural Productivity,” IMF Country Report No. 02/206.

19. The authorities are aware that the economy faces downside risks.

  • Failure of peace talks and resumption of violence would mire the country in low growth with continued pervasive poverty. Moreover, although some of the insurgents’ basic goals—provision of better social and economic services and representation for the poor—are consistent with the PRSP, it is still uncertain how specific demands will be incorporated into future policies. In addition, uncertainties remain on how the standoff between the new government and major political parties would be resolved.

  • It may be difficult to sustain the fiscal framework if there is strong resistance to revenue mobilization measures and tax administration cannot be strengthened adequately. External aid shortfalls would also make fiscal management difficult.

  • An adverse external environment would dampen growth prospects. The key risks include an increase in oil prices, reduction in remittances and tourism, and a prolonged global slump.

  • Weak implementation capacity and governance pose continuing constraints to full utilization of development budgets and poverty alleviation.

B. Macroeconomic Policies

Fiscal Policy

20. The medium term fiscal strategy is to boost revenue performance, reorient and reprioritize social and infrastructure spending, and reduce domestic financing. By 2005/06, revenue is targeted to increase by 1¼ percentage points to 13½ percent of GDP, based on revenue administration reforms, a 2 percentage point increase in the VAT rate, and rationalization of VAT and customs exemptions. Reduction in current spending could be achieved through demobilization of security forces and downsizing of the civil service. Capital spending could rise to 6 percent of GDP in a prioritized manner stipulated in the medium term expenditure framework (MTEF). To improve resource allocation, the MTEF is to be extended to regular expenditure.19 As a result, spending on key sectors—agriculture, irrigation, roads, electricity, health, education, drinking water, and local development—will account for 75 percent of total spending (roughly 11-13 percent of GDP). With aid disbursements averaging 4¼ percent of GDP, domestic financing could be reduced to ½ percent of GDP. The authorities noted that further increases in the VAT rate could be considered or spending cuts undertaken to sustain the framework in the event of revenue shortfalls or lower aid inflows.

21. The 2003/04 budget has been formulated in line with the medium term fiscal strategy. Compared to 2002/03, revenue is projected to rise slightly to 12⅓ percent of GDP based on a long overdue increase in a wide range of charges and fees. The increase in current spending reflects a combination of higher wage allocation for security personnel and larger health and education spending, mostly under donor funded programs to decentralize service provision.20 Capital expenditure is projected to rise on the assumption that improvements in the security situation would permit higher spending. The development budget is fully prioritized in line with the MTEF. Poverty-related spending is to increase by 5 percentage points to 45 percent of the development expenditure budget. Despite higher spending needs, domestic financing is to be limited to 1¾ percent of GDP, thanks to higher revenue mobilization and aid commitment by multilaterals and bilateral donors. Staff stressed that achieving the budget targets would require a determined effort to reach the revenue target and to keep spending within stipulated limits.

22. A significant tax reform effort would underpin the 2003/04 budget. The staff welcomed measure to streamline the tax system, promote exports, and reduce the personal income tax burden at lower income levels, based on the government’s Fiscal Reform Task Force and Fund technical assistance recommendations. These measures include: (i) removal of export service charges and significant reduction in export taxes; (ii) elimination of one-half of the special security levy by integrating it into customs duties and excises; (iii) reduction in import duty rates (consistent with WTO accession requirements) offset by increases in excises; (iv) an increase in the income tax threshold together with a widening of the lowest tax bracket; and (v) elimination of VAT exemption for edible oils. This package of measures is expected to be broadly revenue neutral. To strengthen revenue administration, the authorities have requested further FAD technical assistance to expand an existing unit in the Inland Revenue Department into a full service large taxpayer unit and to improve customs administration.

23. The medium term framework will help maintain fiscal sustainability, although some risks remain. The debt-to-GDP ratio—without accounting for contingent liabilities—is projected to stabilize around 55 percent of GDP in a baseline scenario. Stress tests suggest that public debt dynamics would remain manageable under this framework. Under a combination of plausible shocks to growth, interest rates, and the primary balance (or a 10 percent increase in debt creating flows, for example, to meet contingent liabilities from financial sector and public enterprise reforms), the debt-to-GDP ratio is projected to remain around 60 percent of GDP by 2006/07. Along similar lines, a smaller reduction in the domestically financed deficit (for example, to ¾ percent of GDP) would not jeopardize fiscal sustainability (Table 5). As regards external debt, preliminary computations suggest that the net present value of public debt at end-2002/03 was relatively low (22 percent of GDP), reflecting its concessional nature. However, given the large proportion of external financing, the debt profile is vulnerable to large exchange rate depreciations and to low export growth. Moreover, the full extent of contingent liabilities will only be revealed as financial and public enterprise reforms unfold.

Table 5.

Nepal: Public Sector Debt Sustainability Framework, 1992-2007

(In percent of GDP, unless otherwise indicated)

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

Central government gross debt as reported in IFS. Differences between this external debt data series and staff estimates are attributable to differences in coverage and valuation.

Derived as [(r - π(1+g) - g + αε(1+r)]/(1 + g + π + gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π(1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

Defined as public sector deficit plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

Real depreciation is defined as nominal depreciation (measured by percentage tall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Table 5.

Nepal: Public Sector Debt Sustainability Framework, 1997-2007

(In percent of GDP, unless otherwise indicated)

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

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Gross financing under the stress test scenarios is derived by assuming the same ratio of short-term to total debt as in the baseline scenario and the same average maturity on medium- and long term debt. Interest expenditures are derived by applying the respective interest rate lo the previous period debt stock under each alternative scenario.

Real depreciation is defined as nominal depreciation (measured by percentage tall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Monetary and Exchange Rate Policy

24. The authorities believe that the exchange rate peg to the Indian rupee continues to be appropriate and that policies should be geared to supporting the peg. The peg has enabled the economy to benefit from close economic ties with India and helped keep inflation at low levels. Looking forward, this requires monetary growth that is consistent with domestic inflation broadly in line with prospective price developments in India. With this in mind, broad money growth should be contained to 11-12 percent in 2003/04, assuming a continued small decline in velocity and a targeted real GDP growth rate of 3¾ percent. This growth in broad money could accommodate domestic financing needs of the budget while allowing real private credit growth of about 9-10 percent. With limited NRB financing of the budget, reserve money growth was projected at around 7 percent.

25. The authorities agreed that the level of the peg would have to be kept under review in light of prospective external sector developments. The removal of protected access to advanced country markets in the context of phasing out of the MFA quotas by January 2005 could affect exports adversely. Similarly, while the pending WTO accession could confer benefits through expanded access to overseas markets, it could also generate balance of payments pressures due to opening up of domestic markets. The authorities agreed that the likely impact of these developments and their implication for the level of the exchange rate peg need to be assessed with a view to maintaining competitiveness. In this context, staff suggested that the pace of structural reforms could be accelerated to raise manufacturing productivity and constraints associated with transportation and other infrastructure facilities alleviated to reduce costs and improve competitiveness.

C. Structural Reforms

Financial Sector Reforms

26. The authorities outlined next steps to strengthen the NRB, restructure insolvent commercial and development banks, and to improve the banking environment.

  • The NRB noted that beyond the separations under the current voluntary retirement scheme (VRS), further downsizing would be undertaken by outsourcing general services, reducing the number of departments, and possibly privatizing payments system operations. The NRB intends to strengthen financial sector supervision. Adoption of the Banking and Financial Institution Ordinance, prepared with Fund technical assistance, would help achieve this objective. The NRB also intends to improve performance incentives by introducing decompressed and merit-based pay scales, and strengthen internal audit and accounting practices, based on World Bank-financed external consultants’ recommendations.

  • On commercial bank restructuring, the staff suggested that NRB facilitate early initiation of VRSs at NBL and RBB to reduce overstaffing by providing financial backing.21 The NRB noted that it could provide only partial financing and that banks should make use of their own resources until donor financing comes through. The staff welcomed NRB efforts to strengthen the blacklisting mechanism against loan defaulters (and their connected parties) and greater disclosure requirements by the Credit Information Bureau to facilitate loan recovery by the banks. The staff also underlined the need for effective implementation of the Debt Recovery Tribunal’s rulings to achieve this goal. On development banks, the staff urged the government to finalize AsDB-funded audits of the Agriculture Development Bank of Nepal and Nepal Industrial Development Corporation and begin preparing restructuring plans to address the banks’ weakening financial condition.

  • The NRB agreed to consider modification of its directives related to commercial banks’ operations. The “priority” sector lending requirement could be eliminated within three years (instead of the currently planned five years) but this timetable is subject to political constraints. In addition, the NRB agreed, in principle, that “deprived” sector lending should be channeled through microcredit institutions which are better placed than commercial banks to conduct these operations. The NRB also agreed to review restrictions on commercial banks’ lending rates and foreign exchange buy/sell spreads. On the investment ban in Indian T-bills, the NRB responded that easing would loosen capital controls and could diminish its ability to set interest rates in line with domestic economic conditions.

Public Sector and Governance Reforms

27. Public sector ownership needs to be reduced and accountability and governance of public enterprises improved. The staff urged the authorities to make rapid progress on liquidation/privatization of public enterprises as envisaged under the AsDB’s Public Sector Management Program. As regards other large public enterprises, updated audits should be completed soon to international accounting and auditing standards. After these audits have been completed, strategic decisions are required to restructure viable enterprises, liquidate those that are unlikely to be turned around, and privatize those which can be better managed by the private sector.

28. Civil service reform and decentralization need to be accelerated to reduce budgetary pressures and improve effectiveness of policy implementation. The staff noted that, as a first step, the cabinet’s decision of September 2002 to eliminate 7,500 vacant positions needs to be implemented in full soon. In addition, the authorities indicated (and staff agreed) that a substantial number of other remaining vacant positions could be eliminated. The staff welcomed these plans as well as others to maintain a hiring freeze, expand outsourcing, introduce merit-based recruitment and promotion systems, and to decompress the wage scale. Early amendment of Civil Service Act would facilitate increased transparency in civil service personnel policies and insulate civil servants from political interference. The authorities agreed that a strong effort is required over the medium term to reduce wage and pension payments, especially in the education sector. This could be achieved through devolution of schools to local management committees which are better placed to identify staffing needs and ensure service delivery, in consultation with the World Bank.

29. The staff urged the authorities to sharpen their anti-corruption efforts, with AsDB and World Bank assistance. The staff noted that the Anti-Corruption Strategy needed to be made more effective by focusing on ways to secure prosecutions. The staff was encouraged by strong efforts of the CIAA to initiate investigations against former ministers and revenue officials, and looked forward to these investigations leading to expeditious court ruling against offenders. The authorities noted their intent to follow through on the Country Procurement Assessment Report, prepared with World Bank assistance, to increase transparency and reduce leakages in public procurement through passage and implementation of a new law based on international standards.

Legal and Trade Policy Reforms

30. Legal reforms are to be undertaken to improve labor market flexibility and to improve the business climate. Given political sensitivities, the authorities are designing a strategy to ease inflexibilities in labor retrenchment, in consultation with business groups and labor unions. Other ongoing legal reforms, including amendments of the Company and Insolvency Acts (with AsDB technical assistance), should help improve the regulatory framework for private sector activity.

31. Nepal maintains an open trade regime but further reforms are planned to improve transparency and help prepare for WTO accession. The staff supported the authorities’ plans to reduce high tariff rates and to integrate the security levy into the custom duty. The authorities agreed that it would be desirable to consolidate all import levies into a single customs duty to enhance transparency and that customs administration should be reformed to reduce administrative barriers to trade, with Fund and donor technical assistance. Moreover, substantial legislative reforms are required, including in intellectual property rights and customs valuation.

D. Other Issues

32. The Auditor General agreed to address NRB safeguards issues. Specifically, a foreign auditing firm experienced in central bank audits is expected to be appointed, jointly with a local firm, to conduct an audit of the NRB’s 2002/03 financial accounts.

33. Nepal accepted the obligations of Article VIII, Sections 2, 3, and 4 in May 1994. It maintains an exchange restriction arising from quantitative limits on foreign exchange availability for travel abroad. The NRB informed staff that it would waive these limits for bona fide requests.

34. The staff recommended improvements in statistics to enhance policy formulation and monitoring. The staff welcomed the NRB’s decision to publish the balance of payments in the format recommended by Fund technical assistance, but noted that some other recommendations were yet to be fully implemented. The staff also urged the authorities to implement fully existing and future STA technical assistance recommendations.

V. Staff Appraisal

35. Poverty in Nepal remains pervasive due to insufficient growth and inadequate targeting under poverty alleviation programs. While macroeconomic conditions remained broadly stable during the 1990s, growth remained constrained by inefficient resource allocation linked to structural weaknesses in key sectors and poor governance. More recently, intensification of security problems and adverse external conditions reduced economic growth significantly. Insufficient growth, inadequate investment in health and education, and lack of income generation opportunities for the poor, have limited poverty reduction in Nepal.

36. Progress in the peace talks is essential to sustain the nascent economic recovery currently under way. The effects of a ceasefire agreed with the insurgents in early 2003 are already evident in higher economic activity. Continued peace will help sustain the recovery, including through effective implementation of priority social and infrastructure projects. A buildup of confidence should also help relieve budgetary pressures for security spending.

37. The staff looks forward to implementation of the recently issued PRSP. The PRSP’s strategy to alleviate poverty—broad-based growth, social sector development, targeted programs for the poor and deprived groups, and improved governance—is appropriate. Progress in these areas is critical for poverty reduction. Staff underscores the need for a determined effort to mobilize revenue and resist spending pressures, including in fiscal year 2003/04. The staff looks forward to discussing with the authorities an economic program based on their medium term fiscal framework that could be supported by the Poverty Reduction and Growth Facility to help implement the PRSP strategy.

38. Prudent fiscal policies will help maintain macroeconomic stability. Revenue should be mobilized through tax policy measures including changes in the VAT rate and reduced exemptions. Tax administration, especially customs administration, needs to be strengthened significantly. On expenditure, the staff welcomes plans to prioritize all spending by extending the medium term expenditure framework (MTEF), raise allocations for priority sectors and increase poverty-related development spending. A strong effort is required to ensure higher development spending through enhanced local level implementation capacity, but the authorities need to be prepared to cut back spending in line with the MTEF to cover revenue and external aid shortfalls. Over the medium term, reductions in domestic borrowing will help maintain fiscal sustainability. Contingent liabilities from banking and public enterprise reforms should be addressed early with donor support.

39. Monetary and exchange rate policies should remain geared to supporting the exchange rate peg to the Indian rupee. The peg has served Nepal well given its close ties to India and helped keep inflation at low levels. However, prospective external developments, such as loss of protected access to overseas markets due to the phasing out of the MFA by 2005, pose challenges for export growth and will likely have implications for the appropriate level of the peg. These challenges can also be addressed by measures to reduce labor and nonlabor inputs costs and make Nepal’s exports more competitive and by infrastructure investment to alleviate supply bottlenecks.

40. Financial sector reforms have progressed, but much remains to be done. The NRB itself needs to be strengthened and its supervision of the financial sector enhanced significantly. External managers at the two largest and insolvent commercial banks have started to improve the financial condition of the banks. However, their efforts—in particular, at loan recovery and to reduce staffing through voluntary retirement schemes—require strong NRB and government support. Specifically, loan recovery requires that the strengthened criteria for blacklisting loan defaulters and the Debt Recovery Tribunal’s rulings be implemented effectively and on a timely basis.

41. Public enterprise and governance reforms will help improve public sector resource allocation. Public enterprise reforms would strengthen the budgetary contribution of viable enterprises through improved management accountability, restructuring, and privatization. Unviable enterprises should be liquidated to reduce resource drain. Better governance—through civil service reforms, steps to curb corruption, and decentralization—will improve policy implementation through greater accountability and enhanced implementation capacity at the local level would help improve service delivery.

42. Legal and trade policy reforms can improve the business climate for private sector development. Labor legislation needs to be revised to make labor hiring more flexible; modifications of the Company and Insolvency Acts can make exit of unviable firms more orderly and timely. The authorities’ efforts to gain early WTO accession are commendable. Accession would increase credibility and predictability of the trade regime and help secure access to foreign markets.

43. Data deficiencies need to be addressed to improve policy formulation and monitoring. Data provision to the Fund is adequate for policy surveillance. While the authorities’ efforts to improve statistics are noted, key gaps remain and the staff encourages full implementation of STA technical assistance recommendations.

44. The staff urges the NRB to eliminate the exchange restriction arising from quantitative limits on payments for personal travel for bona fide reasons. Board approval is not recommended.

45. It is recommended that Nepal remain on the 12-month consultation cycle.

Table 6.

Nepal: Vulnerability Indicators, 1997/98–2003/04

(In percent of GDP, unless otherwise indicated)

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

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

External managers of RBB and NBL.

Consists of public and public guaranteed external debt, domestic claims on government by banking sector, and domestic credits lo the central government by nonbanking sector.

Including private sector credit by NRB.

Including re-exports.

Includ