Abstract
KEY ISSUES Context: Nepal has been trapped in a low-investment, low-growth equilibrium. The authorities' aim is to graduate from least-developed country status within 7 years. Macroeconomic situation and outlook: The earthquakes in April and May have held back growth. Together with the recent unrest and disruptions to trade routes, they also pushed up inflation. Growth is expected to gradually rebound as economic activity recovers and reconstruction gains momentum. High remittance inflows are supporting a strong external position, as well as high broad money growth. The outlook is subject to considerable downside risk, involving continued political and economic instability and slower-than-expected growth of government capital spending. Medium-term prospects: While remittances are expected to continue to support the external position, the outlook for growth depends importantly on the authorities' reform efforts. Experience in other fragile states shows that natural disasters can have permanent effects on potential growth. This underscores the importance of a decisive boost to public capital spending and reforms to strengthen the business climate. Key policy recommendations: Fiscal policy needs to support post-earthquake reconstruction and medium-term growth through higher public investment. Stronger public financial management (PFM) will be key to the swift and efficient implementation of higher capital spending. Along with efforts to improve the business climate, this should support private investment needed to generate sustained higher economic growth and employment opportunities. The exchange rate peg to the Indian rupee provides a useful nominal anchor to the economy, and the real exchange rate is broadly in line with fundamentals. Money growth should be contained to a level consistent with supporting the peg. The monetary operations framework needs to be strengthened to put the central bank in a position to better control the growth of broad money in the face of strong inflows of remittances and aid. Financial sector reforms should continue to focus on bolstering regulation and supervision, and improving financial infrastructure, to reduce risk and increase access to finance.
1. The Nepalese authorities express their appreciation to staff for the constructive engagement and policy dialogue during the 2015 Article IV Consultation. The authorities found that the discussions were appropriately focused on macroeconomic and financial sector policies, as well as structural reforms that struck the right balance between supporting Nepal’s post-earthquake reconstruction efforts while maintaining macroeconomic and financial stability. They are broadly in agreement with the thrust of the staff appraisal and would take staff’s policy recommendations into consideration in the implementation of their macroeconomic policies and post-earthquake development agenda.
Recent Economic Developments and Outlook
2. The earthquakes in April and May 2015 resulted in significant loss of lives and property. The total damages and losses in production are estimated at about US$7 billion, equivalent to nearly one-third of GDP. Real GDP, which has grown by an average of 4.5 percent in the last five years, grew by only 3.0 percent in 2014/2015 as a result of the devastation caused by the earthquakes, with the tourism, infrastructure, real estate, agriculture and finance sectors adversely affected. Inflation moderated to 7.2 percent in 2014/2015, on account of lower oil prices, lower inflation in neighboring countries, and effective liquidity management by the Nepal Rastra Bank (NRB). The headline inflation for the first two months of 2015/2016 (mid-July to mid-September 2015) averaged 7.05 percent.
3. Despite the growing import requirements of post-earthquake reconstruction, Nepal’s external sector situation further strengthened in 2014/2015 with the balance of payment surplus reaching US$1.43 billion, from US$1.29 billion in the previous fiscal year, due mainly to the current account surplus, supported by sustained overseas remittances. This has enabled Nepal to maintain adequate gross foreign exchange reserves of US$8.28 billion as of mid-September 2015, which is more than 11 months of imports of goods and services.
4. The authorities earlier projected a GDP growth of 6.0 percent for 2015/2016 on account of the expected significant public and private sector investments in reconstruction and expansion in economic activities. However, the prolonged drought, the trade blockadelike situation in the southern part of the country and the ensuing fuel crisis have delayed the start of recovery and reconstruction-related projects, posing risks to the growth and inflation outlook. Nonetheless, the authorities are optimistic that the effective and inclusive implementation of the new constitution and the measures to accelerate government spending would reap significant growth dividends from the restored political stability and facilitation of economic growth.
Fiscal Policy
5. The authorities agree with staff’s recommendation that fiscal policy needs to support post-earthquake reconstruction and medium-term growth through higher public investment. As announced in the 2015/2016 budget in July 2015, the authorities will establish a National Reconstruction Authority (NRA) to coordinate the implementation of rehabilitation and reconstruction activities over the next five years. The authorities remain committed to ensuring the passage of a new bill in parliament that will allow the establishment of the NRA and put recovery efforts back on track.
6. On improving revenue performance, the authorities agree with staff on the need to enhance enforcement of tax compliance and further strengthen tax administration to strengthen the fiscal position. However, given the substantial development requirements and available fiscal space, the authorities can increase domestic borrowing while putting in place measures to avoid crowding out private investment.
7. While the fiscal position remains strong, the budget surplus reflects modest revenue growth and continued underspending. The authorities therefore recognizes that there is an urgent need to accelerate post-earthquake reconstruction, provide assistance to earthquake-affected households and businesses, increase priority social spending and improve the effectiveness of safety nets. In the annual budget for 2015/2016, more than US$8 billion was allocated for reconstruction and development, with US$740 million for the National Reconstruction Fund. The authorities have also prioritized budget allocation to agriculture, education, health, tourism, infrastructure development, connectivity and the construction of hydroelectric power plants.
8. To accelerate capital expenditure, the authorities announced steps to expedite the approvals process and simplify administrative procedures. A Public Financial Management (PFM) reform action plan was also developed, in line with past Fund PFM technical assistance. Budget allocation for unimplemented and slow-moving projects will be redirected to ongoing and better performing projects. Likewise, projects that have detailed feasibility studies and whose environmental assessment and land acquisition requirements have been completed will be prioritized for implementation.
Monetary and Exchange Rate Policy
9. The authorities are in favor of an accommodative monetary policy stance to support economic recovery. In 2015/2016, monetary policy is aimed at supporting the attainment of a GDP growth of 6.0 percent, containing inflation within 8.5 percent, and maintaining foreign exchange reserves equivalent to at least 8 months of imports of goods and services. Once economic conditions normalize, the authorities will aim to keep inflation close to that of India. The exchange rate peg to the Indian rupee will help to ensure that India’s disinflation gains would lead to lower inflation in Nepal.
10. On liquidity management, the NRB will continue to conduct deposit auctions, introduced in August 2014, to effectively mop up excess liquidity. The authorities agree with staff’s recommendation to refine the liquidity monitoring and forecasting framework, building on suggestions made in the context of past technical assistance from the Fund. The NRB is currently studying various approaches, including the interest rate corridor framework, to refine the monetary operations framework in implementing monetary policy to strengthen the monetary transmission mechanism. They expressed interest in receiving IMF technical assistance on systemic liquidity management, which would involve developing an appropriate liquidity forecasting framework, defining monetary operations consistent with monetary policy objectives, identifying instruments, and laying out the operational modalities.
11. The authorities welcome staff’s assessment that the exchange rate remains in line with macroeconomic fundamentals. Staff’s assessment have taken into account country-specific factors that are relevant to Nepal, such as the significant role of remittances, notwithstanding the conflicting results and wide range of estimates of the External Balance Assessment. The authorities will continue to maintain a pegged exchange rate to the Indian rupee, which has served Nepal well by providing a transparent and stable anchor for the conduct of monetary policy.
Financial Sector Policy
12. To help ease the impact of the devastating earthquakes, the NRB has put in place temporary regulatory relief for banks in the affected areas to enable them to continue to extend credit to borrowers. Among others, the limited and time-bound relief measures cover loan-loss provisioning, loan rescheduling and restructuring, and provision of grace periods for loan repayment. As announced in the 2015/2016 budget in July 2015, the NRB helped to establish an Economic Rehabilitation Fund to provide a refinancing facility and interest subsidy on loans extended to earthquake-affected areas covering residential construction, agriculture, and tourism.
13. The authorities broadly agree with staff’s recommendations on further improving the stability and resilience of the financial sector and will continue to implement reforms to further enhance the legal and supervisory framework governing banks and financial institutions (BFIs), in line with the 2014 FSAP recommendations. As announced in the 2015/2016 monetary policy statement in July 2015, the NRB seeks to consolidate the banking industry by encouraging the merger of BFIs through an increase in paid-up capital requirements. Further, NRB directives were issued on the buying and selling of branches of problem banks and on the migration to chip-based card from magnetic strip card for debit and credit cards, as part of security and risk mitigation measures for card protection and electronic payment transactions.
14. The authorities are cognizant of the importance of financial inclusion and have pursued various policies and programs to improve access to financial services. These include: (a) branching policy outside of Kathmandu; (b) provision of interest-free loans to facilitate the establishment of branches in underserved areas; (c) reinstatement of bank branches closed during the conflict period; (d) licensing of new microfinance institutions; (e) introduction of branchless banking and mobile banking; and (f) implementation of financial literacy and financial consumer protection initiatives. The NRB will likewise continue its directed lending facilities to achieve the government’s inclusive growth objectives.
15. The NRB also expressed interest in receiving technical assistance in developing a strategic plan to implement the 2014 FSAP recommendations on various areas of BFI supervision such as bank licensing and regulation, implementation of the Nepal Financial Reporting Standard, further enhancements to prudential regulations and development of a reformulated corrective and enforcement actions framework.
16. The NRB welcomes the preliminary findings of the ongoing Safeguards Assessment in connection with the 2015 Rapid Credit Facility (RCF) disbursement, which gives due recognition to the authorities’ significant progress in adopting a new accounting system and improving financial reporting practices. The authorities will continue to pursue further reforms in strengthening the NRB’s governance and control frameworks as recommended by the safeguards assessment mission in September 2015, particularly on the internal and external audit mechanisms, currency and vault operations, and the NRB’s legal framework.
Structural Reforms
17. Notwithstanding the setback to growth from the devastating earthquakes, the authorities remain committed to implementing its ambitious structural reform agenda under Nepal’s 13th Development Plan (2013–2016), which aims to transition Nepal from least developed country status by 2022. The authorities remain steadfast in accelerating economic reforms to promote higher and more inclusive growth and achieve faster poverty reduction.
18. The authorities are undertaking the necessary structural reforms to remove major bottlenecks to public and private investment and improve competitiveness and the business environment. This necessitates substantial investments in transport infrastructure to expand connectivity within Nepal and with neighboring countries, and in energy infrastructure to increase energy supply through hydroelectric power generation. The authorities recently announced the policy framework for public-private partnership in order to facilitate private sector participation in the development of much needed infrastructure, such as roads, bridges, hydroelectric power plants and transmission lines.
19. As announced in the 2015/2016 budget and monetary policy statement, the authorities are prioritizing the submission and/or passage of key legislations in order to deliver on its structural reform agenda: (a) law on foreign investment and technology transfer to improve the investment climate; (b) laws on a unified tax code, revenue leakage control, and central revenue board to strengthen revenue administration; (c) laws on foreign exchange regulation, restriction on investments abroad, regulation and supervision of savings and credit cooperatives and microcredit institutions, and social security to enhance the efficiency and regulation of the financial sector; and (d) law on land use as part of efforts to strengthen risk and disaster management.
Concluding Remarks
20. The authorities would like to extend their gratitude for the continuing provision of humanitarian aid and allocation of grants and concessional loans by the international community for the rehabilitation and reconstruction efforts. The authorities would also like to thank the Fund for its ongoing support through policy advice, technical assistance and the swift RCF disbursement of SDR 35.65 million. This has greatly assisted the authorities in addressing Nepal’s growing balance of payments need and catalyzes further resources for post-earthquake reconstruction and development.
21. Nepal has achieved important progress over the past years in implementing sound macroeconomic policies and critical structural reforms to facilitate economic growth, improve economic conditions and reduce poverty. The country is recovering from the impact of the earthquakes in April and May. The new government is forging a stronger consensus among key stakeholders to implement the new constitution and lay the foundations for supporting Nepal’s post-earthquake reconstruction and drive towards high, sustained and inclusive growth. The authorities recognize the challenges ahead and are determined to pursue the structural transformation of their economy and boost economic growth and competitiveness by removing bottlenecks to public and private investment in key sectors.
22. The authorities look forward to continued discussions with the Fund on a comprehensive package of macroeconomic and financial sector policies and structural reforms that could be supported by an Extended Credit Facility. Therefore, the Fund’s appointment of a full-time IMF Resident Representative in Nepal would be timely and critical to reinforce the effectiveness of the Fund’s engagement with Nepal.