Nepal: 2005 Article IV Consultation—Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Nepal
Author: International Monetary Fund
Publication Date:
07 Feb 2006
eISBN:
9781451830026
ISBN:
9781451830026
Language:
English
Keywords:
ISCR; CR; government; arrears; spending; exchange rate; broad money; private sector; labor market; debt service; public expenditure; current account; resource allocation; South Asia
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This 2005 Article IV Consultation highlights that Nepal’s economic growth has been affected by the political turmoil and conflict, although inflation has remained moderate, and international reserves are adequate. Real GDP growth averaged 2 percent during 2000/01–2004/05, compared with the 1990s when growth in agricultural productivity and significant trade liberalization contributed to average real GDP growth of 5 percent. Inflation has remained in the low single digits, although it rose to 7¾ percent in mid-October 2005. The overall and domestically financed deficits remained limited in 2004/05.

Abstract

This 2005 Article IV Consultation highlights that Nepal’s economic growth has been affected by the political turmoil and conflict, although inflation has remained moderate, and international reserves are adequate. Real GDP growth averaged 2 percent during 2000/01–2004/05, compared with the 1990s when growth in agricultural productivity and significant trade liberalization contributed to average real GDP growth of 5 percent. Inflation has remained in the low single digits, although it rose to 7¾ percent in mid-October 2005. The overall and domestically financed deficits remained limited in 2004/05.

I. Introduction

1. This Article IV consultation takes place against a background of continued political tensions in Nepal. Tensions have intensified since King Gyanendra took over executive powers on February 1, 2005. While King Gyanendra has promised to restore democracy and security within three years, key political parties and civil society are engaged in street protests for immediate and full restoration of multiparty democracy. These protests have the potential—as they did in the early 1990s—to take a violent turn. Although municipal elections have been announced for February 2006 and parliamentary elections by April 2007, there is widespread skepticism as to whether the elections can be conducted in a free and fair manner, given the ongoing insurgency and security situation.

2. The royal takeover and subsequent government actions have also met with international criticism. Key countries have placed their military and bilateral assistance under review. Restrictions on the media and on activities of NGOs have also drawn international criticism. Donors have called—with no perceptible impact—for all sides to negotiate a peaceful settlement to address the root causes of the insurgency.

3. The insurgency—now a decade old—reflects widespread poverty, exclusion, and poor governance and continues to take a heavy human toll. Casualties from the insurgency now exceed 12,000 and most observers rule out a military solution. Meanwhile, the unilateral ceasefire by the insurgents which has been in place since September and a joint statement by the key political parties and insurgents in November are raising pressures on King Gyanendra to negotiate a settlement.

II. Stocktaking and Recent Developments

A. Growth and Poverty

4. The key economic policy challenge facing Nepal is to raise growth and reduce poverty. A series of governments helped finalize a poverty reduction strategy in May 2003, after extensive consultations with stakeholders and donors. The Poverty Reduction Strategy Paper (PRSP) is based on four pillars: broad-based economic growth; social sector development; targeted programs for the poor and deprived groups; and good governance.1 PRSP objectives include macroeconomic stability, institution building, and structural reforms to raise growth. Even as the current government has placed greater emphasis on security than previous governments, the PRSP continues to broadly guide its economic policies.

5. Notwithstanding a broad consensus on PRSP strategy, political uncertainties have impeded implementation since mid-2004. Prior to mid-2004, structural reforms progressed, including in the context of the PRGF arrangement, World Bank, AsDB, and other donor supported programs.2 A number of policy recommendations made during the 2003 Article IV consultation have been implemented (Annex I). The takeover by King Gyanendra appears to have pushed reforms to the backburner as the government has tried to address the security situation and political opposition to the takeover.

6. Growth has fallen significantly below the trend rate of the 1990s since the intensification of the insurgency in 2000. Real GDP growth averaged 2 percent during 2000/01–2004/05, compared to the 1990s when significant trade liberalization contributed to average real GDP growth of 5 percent3 4 Since the intensification of the insurgency, manufacturing and transportation have suffered from destruction of production capacity, work stoppages, and extortion by insurgents. Tourist arrivals remain below peak levels of the late 1990s. Progress in implementing large infrastructure and hydroelectric projects has also been impeded by security concerns.

A01ufig01

Real GDP Growth

Citation: IMF Staff Country Reports 2006, 044; 10.5089/9781451830026.002.A001

Sources: Data provided by the authorities; and IMF, World Economic Outlook.1/ Average of Bangladesh, India, and Sri Lanka.

7. Growth fell to 2½ percent in 2004/05, and inflation has risen in recent months. Growth was lower both in the agricultural and nonagricultural sectors compared to 2003/04. Inflation has remained in the low single digits, although it rose to 7¾ percent in mid-October 2005 (12-month basis), including on account of the VAT rate increase in January 2005 and partial pass-through of higher international oil prices by Nepal Oil Corporation (NOC).

8. Notwithstanding a decline in the last decade, poverty remains high and human development indicators are low. The poverty ratio fell from 42 percent in 1995/96 to 31 percent in 2003/04, including on account of rising remittances which were a mainstay of the economy in a difficult period (Box 1).5 The decline in poverty was broad based. Nevertheless, poverty in certain regions and the population living on less than $1/day is high and human development indicators are low relative to Nepal’s MDG targets.

Selected Social Indicators in Asia, 2003

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Source: Human Development Report 2005, UNDP; and World Development Indicators, World Bank.

Data is as of 2004 in Nepal, 2002 in Sri Lanka, 2001 in China, and 2000 in India and Bangladesh.

B. Fiscal Developments

9. In recent years, an increase in revenue mobilization has offset the decline in external aid to help maintain expenditure and limit domestically financed deficits. Compared to the 1990s, domestic revenue collection rose by over 2 percent of GDP during 2000/01–2004/05.6 This increase helped sustain an increase in security-related and social services spending (education, health, drinking water, and local development), while also limiting overall and domestically financed deficits even as external aid flows declined.

Nepal: Government Operations

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Sources: IMF, GFS; IMF, IFS; FCGO, Economic Survey; and staff estimates.

Social services include education, health, drinking water, and local development.

10. The overall and domestically financed deficits remained limited in 2004/05. The VAT rate was raised in the revised budget from 10 percent to 13 percent in early-2005, and helped raise revenue by ¾ percentage point of GDP to 13 percent of GDP (Table 2). Even so, revenue fell short of the revised budget target due to weaker than projected growth and imports, continued excise leakages, and delayed excise duty refunds from India. Current spending was lower than the revised budget: the higher civil service wages and allowances and security-related expenditures were more than offset by lower spending on development and social sector projects, especially in the conflict-affected areas. The overall deficit was lower than budgeted (1 percent of GDP compared to 2½ percent of GDP). As a result, although external loans fell short of the budget, as assistance from the World Bank, AsDB, and donors dwindled, the domestically financed deficit was also lower than budgeted (at ½ percent of GDP).

Table 1.

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

Nominal GDP (2004/05): US$7,359 million

Population (2004/05): 25.2 million

GDP per capita (2004/05): US$292

Poverty rate: 31 percent (2003/04)

Main exports: Textiles and clothing

Quota: SDR 71.3 million

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

Fiscal year begins mid-July. For 2004/05, figures relate to the revised January 2005 budget.

Excluding re-exports.

Includes estimated short-term trade credits.

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

Table 2.

Nepal: Summary of Government Operations, 2003/04–2007/08 1/

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

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

Includes privatization receipts.

Nepal: The Decline in Poverty

Poverty in Nepal fell dramatically between 1995/96 and 2003/04.1 During this period, the poverty headcount is estimated to have fallen from 42 percent to 31 percent. Poverty declined in both rural and urban areas, and across regions. Inequality also increased. This increase was largely due to faster growth of consumption in the highest income group.

Nepal: Growth and Redistribution Components of Decline in Poverty

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Source: The World Bank, Nepal: Draft Poverty Assessment, December 2005.

This decline in poverty is attributable to solid growth in remittances and wages, improved connectivity, urbanization, and a decline in the dependency ratio. With an estimated 1 million workers abroad in 2004, remittances to 12 percent of GDP, contributing to an increase in real per capita expenditure by 42 percent. Agricultural wages increased by about 25 percent in real terms over the period due to tighter labor market conditions and better connectivity through rural roads. The ratio of the population in urban areas—where poverty was lower to start with—rose from 7 percent to 15 percent. The larger decline in urban poverty reflects higher education levels, higher economic returns to skills, and wider opportunities for gainful employment in these areas. Increased urbanization shifted the labor force to higher productivity jobs in the urban centers.

A cross-section analysis of the 2003/04 data points to the correlates of poverty. The following factors are associated with a lower probability of a household being poor: higher levels of schooling of the head of the household; the household head’s main occupation is in trade and services; the household is female headed; households with more land; and households with a smaller number of children less than 6 years old.

This analysis of poverty points to a number of policy conclusions. It highlights that poverty alleviation requires sustained growth, improved developmental impact of remittances, better physical and social infrastructure, human capital, and asset ownership. At the same time, it suggest that the positive effects of growth on poverty reduction—most importantly through a restoration of peace and stability—can be complemented by continued decentralization and measures to combat social exclusion.

1Nepal Living Standards Survey, The World Bank, 2005.

C. Monetary and External Sector Developments

11. Monetary and exchange rate policies remained geared to supporting the exchange rate peg to the Indian rupee. Broad money growth slowed from 12¾ percent in 2003/04 to 8 percent in 2004/05, reflecting substantially lower NFA accumulation by the NRB (Table 3). While budget financing from the banking system was limited, private sector credit grew by 13¼ percent, mainly in consumer lending. Balance sheet consolidation by the two largest banks undergoing restructuring limited the growth of loans for manufacturing and services sectors. With high remittances, liquidity was ample, T-bill rates remained low, and interest rates edged lower.

Table 3.

Nepal: Monetary Accounts, 2002/03–2005/06

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

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

Includes overdraft at NRB (Nrs 2.6 billion in July 2004/05; zero elsewhere).

A01ufig02

Nepal: Composition of Trade

(In millions of U.S. dollar)

Citation: IMF Staff Country Reports 2006, 044; 10.5089/9781451830026.002.A001

12. The current account and overall balance of payments remained in surplus. Despite disruptions related to the insurgency and the elimination of textile quotas, total exports rose by 10 percent in 2004/05. This was mainly due to booming exports to India which rose by 30 percent, while exports to other countries declined by over 15 percent (Table 4). Export performance in traditional sectors—garments, carpets, and pashmina—remained weak.7 Total import growth was stagnant due to weak economic activity—a 35 percent increase in oil imports reflecting higher international prices was offset by a 6 percent decline in non-oil imports. Reflecting continued strong remittances, the current account surplus (excluding official transfers) increased from 1 percent of GDP in 2003/04 to 3 percent of GDP in 2004/05. A small overall surplus in the balance payments led to an increase in international reserves to around US$1½ billion at end-2004/05 (7½ months of imports of goods and services).

Table 4.

Nepal: Balance of Payments, 2000/01–2009/10

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

Nepal buys oil in the international market and re-exports it to India for refinery. This activity recently ceased due to deterioration in NOC finances, but are expected to resume as planned domestic oil price adjustments should improve NOC finances.

Includes estimated international NGO transfers.

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

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

As a ratio of exports of goods and services (excluding reexports of oil).

As a ratio of exports of goods and services (excluding re-exports of oil) and private transfer and income receipts.

Table 5.

Nepal: Medium-Term Macroeconomic Framework, 2001/02–2009/10 (In percent of GDP, unless otherwise 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.

Excluding re-exports.

As a ratio of exports of goods and services (excluding reexports) and private transfers and income receipts.

A01ufig03

Nepal: Remittances

Citation: IMF Staff Country Reports 2006, 044; 10.5089/9781451830026.002.A001

Sources: IMF, World Economic Outlook; and Nepalese authorities.

III. Outlook and Risks

13. Nepal’s growth prospects are contingent on political stability and improved security. Staff project real GDP growth of 2½–3½ percent in 2005/06. With the peg, inflation is expected to broadly follow price developments in India, although a full pass-through of international oil prices could temporarily add 2–3 percentage points to inflation in 2005/06. In this scenario, if political stability and better security conditions can be established and structural reforms are implemented, Nepal could see a gradual return to growth rates of 5–5½ percent through 2009/10. This would require a rebound in manufacturing and service sectors, higher tourism earnings, and a larger contribution from agriculture and government activity. The external position would be supported by export diversification, tourism, remittances, and aid flows. However, if the conflict persists and the political impasse stalls reform implementation, low growth rates are likely to become entrenched, security-related spending pressures will remain high, and development spending low. In these conditions, the fiscal and external position could deteriorate, and international reserves could be lower.

IV. Policy Discussions

14. The consultation discussions focused on two main issues. First, how to preserve macroeconomic stability by implementing a fiscal framework focused on mobilizing revenue, containing expenditure, and limiting domestic financing to levels consistent with medium-term fiscal sustainability and gearing monetary and exchange rate policies to support the exchange rate peg to the Indian rupee. Second, how to further reform implementation under the current political conditions to improve growth prospects and reduce poverty. It was agreed that the PRSP strategy remains broadly appropriate. It was also agreed that further reforms in the financial sector, public enterprises and governance, and regulation and labor market would help to address fundamental constraints on growth—inadequate financial intermediation, inefficient resource allocation in the public and private sectors, a deficient climate for business activity, and rigidities in the labor market. Reforms are also required in agriculture, the largest sector in the economy, to achieve productivity increases which can raise farm incomes and ensure that land reforms are more successful in their objective of reducing poverty. On implementation, the authorities acknowledged that reforms had been slowed by political considerations but pointed to measures taken since mid-2005, especially the promulgation of five key ordinances to improve governance and the regulatory framework, as demonstration of their resolve to implement PRSP reforms.

A. Maintaining Macroeconomic Stability

Fiscal Policies

15. The 2005/06 budget was formulated in line with medium-term fiscal objectives of improving revenue mobilization, containing expenditure pressures, and limiting domestically financed deficits. Revenue was projected to increase through the full year effect of the higher VAT rate, steps to plug excise leakages, and a step-up in privatization. The budget also made allocations for a significant step-up in development spending, including in the conflict-affected areas, and assumed that support from the World Bank would be available through a follow-up PRSC. The budget targeted an overall deficit of 2 percent of GDP and domestic financing of ¾ percent of GDP.

16. While revenue and external aid are projected to be lower than the budget, lower expenditure would help limit domestic financing in 2005/06. The authorities agreed with staff that lower growth and the unsettled security conditions would likely lead to revenue shortfalls. However, they were optimistic, more so than staff, that improvements in tax administration—the October Finance Ordinance and introduction of the security sticker regime for excisable goods—could offset some of revenue decline from lower growth.8 There was also agreement that social sector grants and foreign-financed capital expenditures would remain low due to difficulties in carrying out development activities in conflict-affected areas. Staff encouraged the authorities to further pursue higher social sector and infrastructure spending (especially for rural roads) through greater community and user group participation. The overall deficit is projected to be lower than budgeted (at 1¼ percent of GDP). While external loans would likely be lower than budgeted, the authorities believed that domestic financing could be contained to ¾ percent of GDP; staff estimated that it could be around 1 percent of GDP.

17. To alleviate donor concerns about the quality of spending, staff urged the authorities to improve fiscal transparency and public expenditure management. Within limits placed by national security considerations, the authorities agreed that reporting of security-related spending could be more comprehensive. They also intended to implement ROSC recommendations, including broader coverage of off-budget activities and integration of annual budgets into the Medium Term Expenditure Framework (MTEF). A strengthened MTEF could incorporate higher pro-poor allocations, improve unit costing, and enhance reporting of outcomes. Staff cautioned against nonconcessional external loans, government guarantees, and suppliers credits. These options were contemplated recently for some defense-related purchases.

18. For the medium term, the authorities aimed to further mobilize revenue and limit domestic financing while meeting higher expenditure needs. Improvements in administration, including lower excise leakages and elimination of VAT exemptions, would help boost revenue. The authorities were considering introduction of performance-based incentive schemes in the Large Taxpayer Office (LTO) and customs administration to improve collections, but noted implementation difficulties related to design of the schemes and resistance from other parts of the civil service. A further increase in the VAT rate could also be considered, if needed, to meet recurrent spending needs, along the lines recommended in past IMF technical assistance. On expenditure, the authorities noted that security-related spending can be expected to remain high, and characterized such spending as “an investment in peace.” They also noted that spending needs to improve physical and human capital are high. In addition, the budget would have to shoulder the carrying cost of contingent liabilities from financial sector and public enterprise reforms.9 These carrying costs (interest on bonds and liquidation costs of public enterprises) would be around ¼–¾ percent of GDP. Staff estimates suggest overall deficits would rise as development spending rises. However, with adequate external aid domestic financing could be limited to ¾ percent of GDP through 2010/11. Should aid fall short, spending on foreign-financed capital projects is likely to be commensurately lower.

19. While Nepal’s public debt is projected to decline over the medium term, external debt vulnerabilities remain. Excluding contingent liabilities, public and publicly guaranteed (PPG) debt is projected to fall toward 50 percent of GDP by 2010/11. In an alternative scenario with lower growth, the debt-to-GDP ratio would still fall, but by a smaller amount. As regards external debt, most debt indicators remain below the policy-dependent indicative thresholds (based on World Bank classification of Nepal as a medium policy performer). However, at 172 percent, the NPV of debt-to-exports of goods and services ratio at end-2004/05 exceeded the indicative threshold of 150 percent.10 This reflected a low ratio of exports of goods and services to GDP (16 percent) even as the NPV of debt-to-GDP ratio was 27¾ percent. Moreover, Nepal remains vulnerable to shocks, especially export growth slowdowns, and the sensitivity analysis indicates that external debt dynamics are subject to a high risk of distress (Annex II).

A01ufig04

Nepal: Public Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 044; 10.5089/9781451830026.002.A001

Nepal Oil Corporation

20. Notwithstanding past price hikes, the NOC has operating and accumulated losses due to inadequate pass-through of higher international oil prices. The NOC has raised prices of petroleum products by 25–65 percent since December 2003. However, prices for diesel and kerosene may have to be raised by an additional 25–30 percent to stem NOC losses.11 In September 2005, the budget provided a loan of Nrs 1 billion (¼ percent of GDP) to service payables to Indian Oil Corporation (IOC). Meanwhile, commercial banks are increasingly unwilling to lend to NOC without government guarantees.

21. The authorities recognized that an automatic pricing mechanism and full pass-through of international prices to improve NOC finances was overdue. Given that higher international oil prices are likely to persist, the authorities considered a phased, full pass-through to domestic prices unavoidable and were considering raising prices by end-2005. Staff noted that World Bank estimates suggest that the impact of the price changes on the poor would be small, given consumption patterns reported in the 2003/04 Nepal Living Standards Survey.12 The authorities also plan to allow private participation in the petroleum sector, leaving NOC only as a wholesaler. A review of NOC is also currently in progress to accurately assess its financial position and operating efficiency.

Monetary and Exchange Rate Policy

22. The staff supported Nepal Rastra Bank’s view that the exchange rate peg to the Indian rupee continues to be appropriate. Private sector representatives have asked, on occasion, whether a more flexible exchange rate arrangement could help Nepal adjust better to external shocks. The staff shared the NRB’s view that the peg has enabled the economy to benefit from its close economic ties with India. These ties include extensive trade links, free labor mobility through porous borders, and formal business links and informal family relations. In particular, the peg eliminates exchange rate risk in the large volume of current and capital account transactions with India. The peg provides credibility to policy by importing stable monetary conditions from India and has contributed to low inflation rates. The peg has also contributed to maintaining fiscal discipline, especially in the current environment where spending pressure are high.

A01ufig05

Nepal: Real Effective Exchange Rates (January 2000 = 100)

Citation: IMF Staff Country Reports 2006, 044; 10.5089/9781451830026.002.A001

Source: INS.

23. The NRB broadly agreed with the staff’s assessment that the level of the peg appears to allow sufficient competitiveness. In particular, overall exports have grown in recent years even as the real effective exchange rate (REER, CPI-based) appears to have remained broadly stable. It was agreed that external sector developments such as elimination of MFA quotas in early 2005, faster productivity growth in India, and WTO membership have implications for competitiveness and would require that the level of the peg be kept under review.13 However, improvements in the business climate and investment in infrastructure are key to raising competitiveness by raising productivity and labor market flexibility, reducing transportation and transactions costs, and easing supply bottlenecks.14

B. Structural Reforms

Financial Sector

24. The authorities have made progress in implementing their financial sector reform strategy since 2002, although much remains to be done. These reforms have been financed by the World Bank and AsDB, and cover three main areas: improvements in the legal framework for financial sector activity; NRB “reengineering” to transform it into an effective central bank; and restructuring of insolvent commercial and development banks to improve financial intermediation.

25. There was broad consensus on steps needed to further improve the legal framework and NRB reengineering. On the legal framework, the authorities are considering amendments in the Banking and Financial Institutions Ordinance (BFIO), possibly higher capital requirements, and other provisions for mergers which could help the financial system consolidate ahead of 2010 when competition would increase under WTO commitments. As regards the NRB “reengineering,” a major achievement has been staff reduction through voluntary and compulsory retirement schemes. The NRB now intends to raise professionalism through better performance evaluation and incentives. Efforts are underway to strengthen financial sector supervision, and to raise internal audit and accounting standards.

26. The legal framework for loan recovery has improved. New debt recovery mechanisms (blacklisting directives, the Debt Recovery Tribunal (DRT), and an Appellate Tribunal) have provided financial institutions with additional instruments to enforce contractual obligations, raised awareness about sound banking practices, and led to some recoveries from small- and medium-sized defaulters. However, the banks have been reluctant to pursue many cases in the DRT due to concerns about its limited staff and capacity to enforce rulings.

27. Progress has been made with restructuring of commercial and development banks. External management teams at Nepal Bank Limited (NBL) and Rastriya Banijya Bank (RBB)—the two largest banks which account for 50 percent of banking system deposits—have eliminated the losses of the banks; both banks made profits in 2003/04 and 2004/05. The managers achieved this through voluntary retirement schemes to reduce excess staff and reductions in their deposit rates to lower the cost of funds. They also made some headway in reducing the negative net worth of the banks. In addition, AsDB supported restructuring plans for Agricultural Development Bank of Nepal (ADBN) have proceeded well, including through a voluntary retirement scheme to reduce excess staff, changes in the management team, and reconstitution of its board of directors. However, no progress has been made with the restructuring of Nepal Industrial Development Corporation (NIDC) even though its financial condition is dismal.15 The development bank has NPAs over 85 percent and is a perennial loss-maker. Staff agreed that the NIDC can be privatized given the substantial undervaluation of its fixed assets, and need not necessarily be liquidated. The authorities agreed that NIDC privatization should be done early, transparently, and without any capital injection.

Nepal: Financial Sector Indicators

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Sources: Nepal Rastra Bank; World Bank, Financial Soundness Indicators; and Fund staff estimates.

Includes development banks (including rural and microcredit development banks), finance companies, and cooperatives.

28. However, loan recovery from large willful defaulters remains contentious. Recoveries from these defaulters are required to improve NBL and RBB balance sheets, pave the way for their privatization, and reduce contingent liabilities for the budget. The banks’ efforts to seize collateral from defaulters have been stalled by stay orders issued by the judiciary. At the same time, external shocks (e.g., elimination of MFA quotas and slack tourism) and domestic disturbances have made it more difficult for some borrowers to service loans. While accepting that economic conditions are difficult, staff noted that loan nonrepayment is a longstanding problem and needs to be addressed firmly. Staff supported the NRB’s view that the government should remain focused on supporting loan recovery. In this context, staff also agreed with the NRB that inconsistencies, if any, in the legal framework—such as those alleged between blacklisting directives and limited liability provisions of the new Company Ordinance—can be handled by the courts. To further the loan recovery process, staff supported full implementation of measures (such as revocation of defaulters’ passports) enumerated in a recent high-level committee report.

Public Enterprises and Governance

29. The authorities acknowledged that public enterprise reforms had lagged. Of the thirty nonfinancial enterprises—operating in industrial, trading, services, and utilities sectors—under full government ownership at end-2002/03, most of which were loss-making, three enterprises have been privatized/liquidated.16 An additional five enterprises were to be privatized by early 2005. Progress has been slow due to a combination of factors, including slow decision-making, uncertain market conditions which make potential investors reluctant to bid for enterprises, and court rulings obtained by unions against privatization/liquidation. The authorities intended to press on with privatization/liquidation of loss-making enterprises. They also noted that they were taking other actions to create space for the private sector in economic activity. These included recent market entry of a second mobile services provider and plans for share offerings in Nepal Telecommunications Corporation.

30. Some progress was made in governance reforms. After the Civil Service Ordinance which was promulgated in July 2005, the authorities are in the final stages of promulgating the Governance Ordinance, a reform supported by AsDB and World Bank programs. This ordinance would clarify responsibilities between the executive and the civil service. Decentralization is also progressing, especially in the health and education sectors through transfer of schools and sub-health posts to local level management, with support from the World Bank and donors. Progress in judicial reforms is slower. Staff encouraged the authorities to make further progress in reducing corruption, noting that domestic stakeholders and the international community believed that governance remains weak.

Regulation and Labor Market

31. Efforts to improve the regulatory framework and reform the labor market are underway. Staff welcomed the promulgation of four ordinances in September/October—Secured Transactions, Company, Securities, and Insolvency—to improve the regulatory environment. A draft Competition Ordinance is also being prepared. As regards labor markets, the government has prepared a draft ordinance with provisions for more flexible contractual hiring, and streamlined procedures for enterprise closure and layoffs. Staff welcomed the flexibility provisions of the draft ordinance, but noted the need to accommodate labor concerns about unemployment insurance and due process provisions to ensure that new provisions balance flexibility with fairness in industrial employment.

Agricultural Sector

32. Notwithstanding improved performance during the second half of the 1990s, agricultural productivity in Nepal remains low. Crop yields are low relative to neighboring states in India and Bangladesh. Limited availability and use of irrigation and complementary inputs (improved seeds, fertilizers and technical advances), and limited access to markets (especially for the mountainous regions) contribute to these low yields. The size of landholdings had also become smaller progressively during decades of population growth, making it difficult to exploit scale economies in the plains; the hilly areas present problems related to a difficult terrain. The authorities acknowledged that while land reforms have had some success in reducing inequity in landholding in the rural areas, landholders require complementary inputs to raise agricultural productivity (Box 2). They noted that the twenty-year Agricultural Perspective Plan (APP) initiated in 1995 aims to improve the delivery of these inputs and infrastructure to promote commercialization and market access. A number of the policies from the APP are included in the PRSP.

Nepal: Land Reforms and Agricultural Productivity

Land reforms have often been credited with spurring growth, reducing inequality, and inducing structural transformation. This is especially the case for East Asian countries.1 In these countries, land reforms have improved agricultural growth and productivity, raising living standards, and paving the way for a shift to industrial societies. Greater equality in landholding and lower landlessness in agricultural economies is also associated with lower social and economic conflict. By the same token, landlessness in Nepal is closely associated with the insurgency and intensity of conflict.

In Nepal, land reforms have been undertaken across five decades, with mixed results.2 Landmarks in this process include the Land Cultivation Act of 1956, the Land Act of 1957, the Agricultural Reorganization Act of 1963, the Land Reform Act of 1964, the Land Reform Commission of 1994, and the land reforms of 2001. Land reforms in Nepal, as in other South Asian countries, have mostly involved land redistribution from those that have large holdings to the landless or those with small holdings. These efforts have taken the form of a progressive reduction in ceilings on land holdings. Efforts have also been made to promote and protect tenancy rights. To some extent, these reforms have reduced land inequality and some reduction in the ratio of landless households. However, with the population increase over the decades, the absolute number of landless households has increased and landholdings have further fragmented. Moreover, other reasons for limited success include the inability of land recipients to assert their rights (due to lack of knowledge and/or illiteracy), the generally low quality of the land that was redistributed, and the lack of complementary inputs.

A01ufig06

Nepal: Landholding Lorenz Curves, 1961–2001

Citation: IMF Staff Country Reports 2006, 044; 10.5089/9781451830026.002.A001

Experience suggests that complementary inputs need to be in place to raise agricultural