Nepal: Request for an Arrangement Under the Extended Credit Facility -Press Release; Staff Report; Debt Sustainability Analysis; Staff Supplement; Statement by the Executive Director for Nepal
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
27 Jan 2022
eISBN:
9798400200380
Language:
English
Keywords:
concessional budget support loan; project loan disbursement; loan disbursement; shock strains Nepal; financing gap; COVID-19; Credit; Fiscal risks; Global
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1. Before the COVID-19 shock, strong growth in Nepal had been supported by greater political stability, improved electricity supply, and earthquake reconstruction. Large remittance inflows (mainly from Gulf Cooperation Council (GCC) countries, India, and Malaysia) were also helping to alleviate poverty and unemployment. Buffers built before the COVID-19 pandemic— including a modest fiscal deficit, relatively low public debt to GDP, and a comfortable level of gross official reserves—provided some policy space to respond.

Abstract

1. Before the COVID-19 shock, strong growth in Nepal had been supported by greater political stability, improved electricity supply, and earthquake reconstruction. Large remittance inflows (mainly from Gulf Cooperation Council (GCC) countries, India, and Malaysia) were also helping to alleviate poverty and unemployment. Buffers built before the COVID-19 pandemic— including a modest fiscal deficit, relatively low public debt to GDP, and a comfortable level of gross official reserves—provided some policy space to respond.

Background

1. Before the COVID-19 shock, strong growth in Nepal had been supported by greater political stability, improved electricity supply, and earthquake reconstruction. Large remittance inflows (mainly from Gulf Cooperation Council (GCC) countries, India, and Malaysia) were also helping to alleviate poverty and unemployment. Buffers built before the COVID-19 pandemic— including a modest fiscal deficit, relatively low public debt to GDP, and a comfortable level of gross official reserves—provided some policy space to respond.

2. The COVID-19 pandemic is taking a heavy toll on Nepal’s economy. Faced with immediate healthcare and economic shocks, in FY2019/20, Nepal met financing needs with the Rapid Credit Facility (100 percent of quota), support from the World Bank, Asia Development Bank and other development partners, debt relief under the Catastrophe Containment and Relief Trust (CCRT) and debt reprofiling under the G20 Debt Service Suspension Initiative (DSSI). However, additional financing gaps have emerged as the pandemic has persisted, with Nepal hit by a second wave at the end of FY2020/21, and livelihoods are at risk due to job and income losses.

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COVID-19 Developments in Nepal

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Source: outworldlindata.org/coronavirus/country/MNpal omkoronaviruq/counttvflxleml

3. Implementation of COVID-19 response measures is taking place amid a transition to fiscal federalism. As mandated by the Constitution of Nepal, responsibility for many public services is being devolved to 7 provincial and 753 local governments (MEFP, H17). While federalism can improve service delivery and strengthen accountability, weak capacity of subnational governments (SNGs) is a challenge that has been exacerbated by the COVID-19 shock.

4. The new government has committed to comprehensively address the health, economic, and social impact of the pandemic. On July 18, 2021, Prime Minister Deuba obtained a vote of confidence from Parliament and took office, and his government is now expected to remain until the next elections in late 2022. The authorities issued a Status Paper on the economy in August 2021, and its vision and priorities are consistent with the polices supported by the ECF, including the prioritization of the pandemic response. In September 2021 a revised 2021/22 budget was approved, which kepttotal expenditure broadly unchanged—increasing COVID-19 vaccine expenditures while cutting administrative expenses. Poverty reduction and social protection were also prominent.

Recent Developments, Outlook and Risks

A. Recent Developments

5. The pandemic continues to impact health and livelihoods. From April to July 2021, Nepal suffered a devastating second wave of COVID-19, interrupting a gradual recovery in economic activity. There have been over 800,000 confirmed cases and over 11,000 recorded COVID-19 deaths, the majority of which were during the second wave, and healthcare capacity remains very low. GDP contracted 2.1 percent in FY2019/20, and staff estimate a partial recovery at 2.7 percent growth for FY2020/21. The drop in tourism and services led to a collapse of a key growth industry that will take time to recover. Households are experiencing an ongoing shock to income and social assistance programs have limited coverage, implying a likely setback to poverty alleviation gains in recent years. Vaccine procurement is increasing, however widespread vaccination is not expected until well into calendar year 2022.

6. The authorities responded proactively. Despite implementation difficulties related to the lockdown, disease prevention, containment, and health management policies were strengthened, with implementation by both the federal and subnational governments. Existing cash transfer programs were maintained and, in some cases increased, while temporary measures included daily food rations to the most vulnerable and utility bills subsidies. Measures to mitigate job loss included an expansion of the Prime Minister’s Employment Program and skills training. Several federally financed measures have been implemented by local governments. Tax relief measures included extension of tax deadlines, VAT and customs duty exemptions for COVID-19 related imports, and income tax rebates for MSMEs and highly affected industries. Liquidity and credit measures were implemented and macroprudential policies eased, while the NRB is allowing for loan deferral programs. The authorities enhanced the refinance facility and concessional loan program to support entrepreneurs, MSMEs, and affected businesses including in the tourism industry.

7. The COVID-19 shock affected both revenues and expenditures. Temporary factors led to a narrowing of the overall fiscal deficit from 5.3 percent of GDP in FY2019/20 to 4.2 percent of GDP in FY2020/21. Specifically, increases in import related taxes and deferred tax receipts raised revenues by 2.2 percent of GDP. Concurrently, budget execution, which usually increases in the 2nd half of the fiscal year, was severely constrained by the second wave and associated lockdown measures. Public debt in FY2020/21 was 47.2 percent and Nepal remains at low risk of debt distress. Nepal’s external and domestic debt are roughly equal (Annex V). External creditors are mainly multilateral (88 percent of all external debt including the World Bank’s International Development Association and the Asian Development Bank). Japan is the largest bilateral creditor, followed by China, India, and Korea.

8. Banks’ financial performance has likely been impacted by the COVID-19 shock, but the reported impact is masked by COVID-19 related support measures and regulatory forbearance. Deposits increased year-on-year by 17.2 percent as of October 2021 and despite a 29.7 percent increase in total loans, by October 2021 the NPL ratio had decreased to 1.4 percent (from 1.8 percent in January 2021 and 1.5 percent as of August 2021), reflecting the high level of masking effects of COVID-related forbearance measures. The NRB does not yet have any concrete plans for unwinding the temporary COVID-mitigating measures, and full exit from these measures and recognition of COVID-impacted loans are likely to lead to an increase in the overdue loans and NPL ratios.

9. After an initial collapse in 2020, imports have rapidly grown, fueling a large current account deficit (8.3 percent of GDP). Buoyed by formalization and the ongoing global recovery, remittances remained robust, and combined with accommodative monetary policy they supported consumption, driving import growth of 25.7 percent year-on-year in FY2020/21. Goods exports have grown at 30.0 percent year-on-year but remain an order of magnitude smaller than imports. Tourism, which fell 90 percent during the pandemic, is forecast to only partially recover in FY2021/22 and not reach pre-pandemic levels until later in FY2022/23. Q1 data for FY2021/22 shows that import growth has further increased, while remittances have begun to soften.

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Exports and Imports

(Growth, in percent)

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Sources: Nepali authorities; IMF staff estimates.

10. Gross international reserves remain adequate but have begun to decline in recent months. In October 2021, gross official reserves stood at US$10.22 billion (7.9 months of prospective imports), a decrease from $10.56 billion in July 2020. Reserves accumulated during the first three quarters of FY2020/21 due to temporary factors such as strong trade credit, COVID-19 related official loans, the 2021 SDR allocation of SDR 150.4 million (US$214 million, 0.18 months of imports1), as well as the limited expenditure capacity due to the lockdowns and remittance formalization. However, as the import recovery strengthened, reserve coverage has begun to fall in recent months and is projected to continue its downward path through the program period. External and fiscal financing will be needed to support the response to the pandemic, which remains uncertain in duration and intensity—as well as to facilitate a continued recovery. Structural issues also give rise to a protracted BoP need unrelated to the pandemic, given Nepal’s high import and remittance dependence, and narrow export base. Maintaining a comfortable level of reserves is key to protecting the credibility of the exchange rate peg, and to maintain buffers in case other possible risks materialize (including natural disasters).

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Total Foreign Employment

(Thousands of workers)

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Sources: Nepali authorities; IMF staff estimates.
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Remittances

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Sources: Nepali authorities; IMF staff estimates.

B. Outlook and Risks

11. The trajectory of the pandemic is extremely uncertain, weighing on the economic outlook. Movement restrictions were maintained through much of 2021 as COVID-19 cases remain elevated. The acute phase of the pandemic is assumed to be over by mid-2022/23 as local transmission is reduced to low levels. Nepal however remains vulnerable to further infection waves. The recent global emergence of the omicron variant poses immediate risks, as does the impact of potential further new variants, especially if vaccination rates remain low.

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Containment Measures, Stringency Index

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Source: https://ourworldindata.org/covid-stringency-index
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Community Google Mobility Index

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Source: https://ourworldindata.org/covid-google-mobility-trends

12. Growth is expected to gradually resume in FY2021/22, with a deterioration in the external and fiscal accounts.

  • Growth. Growth is forecast at 4.4 percent in FY2021/22 driven by a tepid recovery in sectors hard hit by pandemic shut downs, such as construction, manufacturing and services. The outlook for tourism—a bedrock of the Nepali economy and key source of employment— remains fragile. Growth in the following years will be supported by greater and more efficient public infrastructure and development spending, and expansion of hydropower.

  • Inflation. With the peg to the Indian rupee, inflation in Nepal is expected to broadly follow developments in India. Inflation is expected to rise to 5.7 percent during-FY2021/22, as higher oil and food prices globally exert moderate inflationary pressures.

  • Fiscal accounts. The overall fiscal deficit is expected to widen to 6.3 percent of GDP in FY2021/22 as higher expenditure needs arise from the resumption of capital projects and the governments’ pandemic response.

  • Current account. Nepal’s current account deficit is expected to remain wide at -9.1 percent in FY2021/22. Imports are projected to remain at high levels given significant fiscal and monetary support for the economic recovery, as well as higher oil and food prices, COVID-19 related health spending, inventory rebuilding, and government capital spending. However, while the outlook is uncertain, the very large increases in imports seen in Q1 FY2021/22 are expected to dissipate somewhat as some of these temporary factors unwind. At the same time, given recent increases in the number of Nepali migrant workers seeking employment abroad, remittances should also begin to recover, providing further support to the current account. The external position of Nepal in FY2020/21 was moderately weaker than the level implied by fundamentals and desirable policies

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Annual Growth Projections

(In percent; year-on-year)

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Sources: IMF staff projections
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Real GDP Growth and External Sector Development

(In percent; year-on-year)

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Sources: Nepali Authorities; IMF staff estimates.1/ For FY 2020/21 showing the IMF staff estimates.

13. The depth and duration of the pandemic are the main risks to the outlook. The economic impacts of the pandemic and associated physical distancing measures are expected to gradually decline during FY2021/22 under the baseline. Should the pandemic intensify more than expected through the program period (including because of new variants and uncertainty regarding the widespread availability of COVID-19 vaccines), it will weaken recovery prospects in major economic partners, and create disruptions to Nepal’s domestic activity, remittances, and tourism, resulting in larger and more protracted balance of payments and fiscal financing needs. If financing were not available to fill such increased external and fiscal needs, growth would be weaker than in the baseline, given the insufficient support to the economy, further hurting poverty alleviation efforts. Rising vulnerabilities in the banking system generate additional risks to the outlook, as well as those related to implementation capacity and fiscal pressures from the transition to fiscal federalism. The global response to rising inflation also weighs on the outlook. Rising commodity prices, risk of social and political instability also weigh on the outlook, and Nepal is vulnerable to climate related shocks and natural disasters (flooding, landslides, earthquakes).

The Extended Credit Facility

A. Program Objectives and Policies

14. The ECF program has three main objectives, aligned with the government’s Relief, Restructuring, and Resilience (3R) plan to address the economic and social impacts of the pandemic and the medium-term recovery:

  • Mitigate the COVID-19 impact on health and economic activity, and protect vulnerable groups, including by making room in the budget for health, social assistance, and job support, while enhancing fiscal transparency and governance.

  • Preserve macroeconomic and financial stability, including by maintaining a prudent fiscal stance, preserving reserve adequacy, and strengthening financial sector regulation and supervision.

  • Support a reform agenda that leads to sustained growth and poverty reduction over the medium-term, including by implementing cross-cutting institutional reforms that improve governance and reduce corruption vulnerability. Specifically, upgrading the tax system, strengthening public spending efficiency, advancing fiscal federalism, improving fiscal risk and public debt management, and strengthening the NRB institutional framework.

15. Strong ownership, sustained support from development partners, and the appropriate prioritization and sequencing of reforms is critical. Nepal continues to face considerable uncertainties as the COVID-19 shock strains Nepal’s pre-existing institutional and capacity constraints, with the pandemic’s magnitude, duration and impact still unclear. The program therefore aims at careful prioritization and parsimony, focusing first on attending the most urgent needs and critical reforms to effectively and sustainably tackle the pandemic shock, followed by a gradual stepping up in the pace of reforms during the program period. The program also supports a consistent, well-articulated policy mix based on all policy levers. The program will seek complementarity with other development partner programs whenever possible, and implementation of reforms will be supported by IMF technical assistance, including through HQ and SARTTAC. Table 10 provides an overview of the conditionality under the program.

B. Fiscal Policy

16. Fiscal policy in the early part of the program accommodates spending to address health needs, support the economy, and protect the most vulnerable, but fiscal deficits will gradually decline once the health crisis wanes. The FY2021/22 budget kept many COVID-19 response measures of FY2020/21 and further increased all types of social security allowance and Child Protection Grants by one third, expanded grants and free lunch program to poor families, and increased COVID-19 vaccine purchases. The budget also provides tax relief to sectors adversely impacted by COVID-19 pandemic, in addition to measures of strengthening invoice monitoring and control to reduce tax leakage and introducing digital service taxes to expand tax bases. These measures together will widen the overall fiscal deficit to 6.3 percent of GDP in FY2021/22, though it is still less than the budgeted deficit in part due to underspending of the capital budget. However, fiscal deficits are expected to decline to 3.5 percent of GDP by FY2024/25. Revenues will improve with the rebound in economic activity and upgrades to the tax system, including the reduction of ineffective tax exemptions, improving revenue administration efficiencies, and modernizing tax policy framework. Are venue mobilization strategy (MEFP HI5) will be developed, building on the existing efforts to enhance tax administration and drawing on recommendations from FAD TA (SB, 3rd review). The authorities have taken steps to estimate tax expenditures related to international trade and will report tax expenditures comprehensively after the domestic component is also estimated to enhance transparency and allow for a cost-benefit analysis (SB, 2nd review, MEFPH15). Spending will be lower, facilitated by roll-off of temporary support measures and less duplication of spending responsibilities across levels of governments. The federal government primary deficit in the program period (indicative target (IT)) has been calibrated at a level consistent with stabilizing the debt by the end of the program period while preserving priority expenditures, including social spending and support for the economic recovery. The authorities have expanded social programs in FY2021/22, and an indicative target will be introduced in the second review, which will initially focus on child grant spending (MEFPH20). Staff will continue to actively engage with other development partners (including World Bank, UNICEF, FCDO) on social spending issues.

17. The fiscal deficit trajectory under the program will help stabilize public debt. Nepal continues to be assessed at low risk of distress. Public debt is projected to peak at 55.3 percent of GDP in FY2024/25, declining thereafter, as the primary deficit moves below the debt-stabilizing level of 2.1 percent of GDP (similar to the five-year average prior to the COVID-19 pandemic). Debt-to-GDP would stabilize much earlier if Net Acquisition of Financial Assets (NAFA), mostly loans and capital injections to SOEs, incorporated in the baseline forecast were to be smaller2.

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Debt-Stabilizing Primary Deficits

(In percent of GDP)

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Source: IMF staff estimates.

18. The program supports a comprehensive fiscal structural reform agenda—with both revenue mobilization and public financial management reforms. The key measures (MEFPH14–18) include: i) An action plan to address the public investment efficiency gap (SB, 2nd review), drawing on recommendations from the public investment management assessment (PIMA) and its climate change component (PIMA CC) conducted in March and April 2021. ii) A fiscal risk register will be developed (SB, 2nd review) followed by a comprehensive fiscal risk statement to be published with the budget speech (SB, 4th review), iii) A fiscal risk monitoring system for subnational governments will also be established, supported by Fund TA(SB, 3rd review), iv) All operational funds will be reported to the Financial Comptroller General Office (FCGO) for inclusion in the consolidated financial statements (SB, 1st review), cash flow forecasting will be prepared and shared with the PDMO and the NRB on a regular basis (SB, 2nd review), and debt management function transferred from NRB to the PDMO (SB, 6th review).

19. The program will also support fiscal transparency and measures to enhance governance and combat corruption (MEFP H33–34). The program includes several cross-cutting institutional reforms that address governance, vulnerability to corruption, and efficiency of the public sector. In addition, the authorities continue to implement spending transparency commitments, including that the Office of the Auditor General (OAG), an independent Constitutional body, audits the government accounts on an annual basis, as per its mandate, and publishes the results on the OAG website. The latest OAG report for FY2019/20 was published in August 20213. In addition, spending from the COVID-19 Fund—an extra-budgetary fund with financing from government, development partners, and the private sector—is being published monthly and the OAG is also expected to audit this Fund in 20224. In the context of commitments made at the time of the Rapid Credit Facility disbursed in May 2020, the authorities have since published a quarterly report on federal government spending on the COVID-19 response, and a further report will be published by March 2022 (SB, 1st Review). Furthermore, the authorities have issued a Public Information Notice (PIN) on the collection and publication of beneficial ownership information5. Consistent with the published PIN, implementation agencies will publish on a government website large public procurement documentation, ex-post validation of delivery, the name of awarded companies, and the name of their beneficial owner(s) for all new, large, COVID-19 related procurement contracts (Prior Action).

C. Monetary and Financial Sector Policies

20. Inflation has remained generally stable despite some heightened risk factors. The year-on-year consumer price inflation and wholesale price inflation stood at 4.2 percent and 3.8 percent, respectively as of October 2021. Heightened risk factors on inflation are the appreciation of Indian rupee, increase in the prices of petroleum products and disruptions to the agricultural production due to climate related factors such as monsoons and floods. The authorities remain committed to having price and external sector stability as overarching objectives of monetary policy and preserving the credibility of the exchange rate peg by maintaining an adequate level of reserves (MEFPU22).

21. The NRB is gradually unwinding accommodative monetary policy. The accommodative monetary policy adopted in FY2020/21 resulted in high credit growth with generally stable inflation. The NRB announced moving to a more neutral monetary policy framework for the current fiscal year (FY2021/22). Within this framework, the NRB increased the deposit collection rate (the lower boundary for the interest rate corridor) from 1 percent to 2 percent and policy rate from 3 percent to 3.5 percent while keeping the Standing Liquidity Facility (SLF -the upper boundary for the interest rate corridor) constant at 5 percent.

22. Credit growth remains high, leading to greater liquidity needs in the banking system. With the gradual lifting of restrictions on economic activities after the first quarter of FY 2020/21 coupled with the availability of refinance facilities at concessional rates, imports, supported by high credit growth, increased substantially. Given the lower level of remittance inflows, the surge in imports have mostly been financed by loans. Despite the 17.2 percent year-on-year increase in deposits, loans increased by 29.7 percent as of October 2021. As of October 2021, the cash balances of Banking and Financial Institutions (BFIs) at the NRB are only marginally above the cash reserve requirement and around 7 percent of its level in the previous year. In the first three months of the current fiscal year, the NRB injected over Rs. 1 billion of liquidity in the market and interbank transactions across commercial banks have substantially increased with interbank interest rates approaching the SLF rate. The NRB remains committed to restricting annual credit growth to 19 percent while the expected deposit growth is around 15 percent in FY 2021/22. Additionally, the NRB stands ready to provide liquidity in the system, where necessary, through SLF and repo facilities while the refinancing facility will gradually be scaled back. The authorities will also continue to closely monitor inflation developments and credit supply and stand ready to adjust policy settings in case signs of overheating appear (MEFPH23). Staff reiterated that the interest rate corridor framework should be strengthened in the medium term.

23. The reported capital adequacy levels are above the regulatory minima and NPL ratios are at low levels, but the banking system requires close monitoring. As of October 2021, the capital adequacy ratio of the banking system is 13.5 percent, and despite the high level of credit growth (evident even before the pandemic), the NPL ratio stands at 1.4 percent. The high share of revolving loans, evergreening practices, the difficulty in monitoring consolidated borrower exposures, unavailability of bank-level forbearance data, and insufficient level ofCOVID-19 related monitoring raise concerns that NPLs are understated, provisioning for loan losses is inadequate, and capital adequacy is overstated. At the same time, there are ongoing COVID-19 related borrower support and regulatory forbearance measures, which are likely to hide the vulnerabilities in asset quality (Annex I)6. The authorities have a firm intention to gradually phase them out. Concrete plans, yet to be announced, should be based on a fuller view of potential impacts. Further clarity is needed for the assessment of the health of the banking sector. Staff will work with the authorities ahead of the first review to analyze the banking system using bank level forbearance data7.

24. The NRB should continue to closely monitor the impact of COVID-19 on the financial sector. The effects of the potential deterioration in the asset quality, as well as the rising level of loan loss provisions, on the profitability and capital adequacy levels of banks should be assessed. The effects of rising leverage on the real sector should also be monitored. It is welcome that the NRB stands ready to tighten macroprudential policies8 to curb credit growth and mitigate the buildup of financial vulnerabilities (MEFP H24), and staff will further discuss with the authorities the calibration of macroprudential measures. COVID-19 related support measures in the financial sector should however be gradually unwound, and the remaining ones should be targeted and time bound (MEFPU32).

25. The program follows a carefully sequenced strategy to further strengthen financial sector regulation and supervision. The strategy (1) prioritizes actions to ensure the provision of adequate and timely supervisory data, including those relating to COVID-19 response measures; (2) updates the regulatory framework to enable more accurate assessment of the asset quality of banks and that better captures existing risks; (3) provides an accurate assessment of the banks’ asset quality based on the new regulation through auditor-assisted on-site inspections; and (4) continues to enhance the quality of supervision, supported by the data and regulatory upgrades. Specific actions include the following and the authorities remain committed to implementing these actions (MEFPU28–31):

  • To enhance monitoring of the impact of COVID-19 and related policy measures on asset quality, the NRB will enhance and customize its current reporting template to regularly collect information on forbearance, provisioning levels, asset classifications, and payback capacity of borrowers (SB, 1st review). The NRB’s analyses of this information will be used to inform future on-site inspections to further increase its effectiveness and planning of the phase-out of the COVID-19 measures as well as taking appropriate supervisory and enforcement actions.

  • The NRB will approve an action plan (SB, 1st Review) and complete the full implementation of the Supervisory Information System (SIS) for class A banks (SB, 2nd review) and proceed in a second stage with the implementation of SIS for Class B and C banks9.

  • Asset classification in Nepal, including NPLs, is mostly defined in terms of the days past due and does not adequately incorporate qualitative factors that could affect borrowers’ creditworthiness. Additionally, the current regulatory framework does not include clear definitions of forborne loans and NPLs, and guidance on how these loans should be treated in reclassifications. The NRB will draft amendments to the regulatory framework to address these shortcomings (SB, 1st review), in line with MCM recommendations. The new regulation will be issued while allowing an adequate transition period for the banks to implement (SB, 2nd review).

  • The NRB will launch (SB, 3rd review) and complete (SB, 4th review)—for the 10 largest banks—in-depth on-site inspections assisted by independent third-party auditors to review loan portfolios in line with the new regulatory framework and with special attention to loan and collateral valuation, evergreening, group borrowing, concentration risks, and the impact of COVID-19 on loan portfolios and reclassification of loans. Any banks found to be undercapitalized based on the diagnostics will be required to present a recapitalization plan.

26. The authorities have expressed their commitment to ensuring a stable and well-capitalized banking system. Enhanced monitoring and the updated regulatory framework will facilitate an accurate assessment of the health of the financial sector. To ensure the effectiveness of the supervisory process, the NRB have committed to take relevant and timely enforcement actions where necessary. If any bank becomes undercapitalized, the NRB will use the set of relevant early intervention measures, including further suspension of dividend payments and taking other corrective measures10such as limitations in loans, deposits, and investments, requiring changes in the business structure and the removal of management. The NRB will ensure that banks’ loan classification correctly reflects the asset quality of the banking system and regulatory forbearance measures will be gradually withdrawn. Once the acute phase of the pandemic is over, the authorities will develop a strategy to continue strengthening financial sector regulation and supervision, with support from IMF technical assistance and a potential Financial Sector Stability Review (FSSR) (MEFP 1B2).

27. Strengthening the AML/CFT framework remains a priority. The authorities have committed to make progress on the implementation of their AML/CFT framework, while remaining vigilant and ready to act upon any new or emerging AML/CFT risks (MEFP 1135). The authorities have also committed to continuing their efforts to increase access to financial services and to develop financial markets, while maintaining financial stability (MEFP 1136).

28. The program will seek to improve the autonomy and accountability framework of the NRB. Specific reforms will be guided by key recommendations from the 2021 safeguards assessment. The assessment found limited progress in implementing previous safeguards recommendations and emphasized needed reforms related to the current shortcomings in the external audit of NRB’s accounts, financial reporting processes that fall short of international standards, and the need for modernization of the central bank framework to strengthen the autonomy and accountability of the NRB. The authorities will therefore submit to the Parliament amendments to modernize the NRB Act, addressing key recommendations of the safeguards assessment report (SB, 2nd review). Furthermore, the Auditor General will appoint reputable international auditors with experience in applying International Standards on Auditing and auditing central banks to audit of the NRB financial statements starting with FY2021/22 (SB, 1st review, MEFP U25).

Text Table 1.

Nepal: Sequencing of Reforms under the ECF Arrangement, FY2021/22-FY2024/25

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Financing and Program Modalities

29. Staff considers access of 180 percent of quota (SDR 282.42 million; US$398.8 million) under the 38-month ECF to be appropriate. The ECF would help Nepal address immediate BOP and fiscal financing needs (Text table 2) related to the pandemic that have been compounded by a pre-existing protracted balance of payments need resulting from high import-dependency, a narrow export base and a heavy reliance on remittances. Waves of the COVID-19 pandemic and the economic disruptions from prolonged periods of lockdown therefore give rise to balance of payments and fiscal financing gaps in the near term.

Text Table 2.

Nepal: Projected Financing Gap in FY2021/22 (percent of GDP)

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Sources: Nepali authorities; and IMF staff estimates.

Current account excludes official transfers

IMF-CCRT debt relief (US$4.9 mil) is included.

IMF-ECF (US$166.2 mil), WB (US$350 mil), and ADB (US$100 mil).

Note: Current baseline forecast is as of December 7, 2021.

30. The program is fully financed, with firm commitments in place for the next 12 months and there are good prospects for the remainder of the program. The pandemic response, including the urgent procurement of vaccines and continued economic support measures, have created an immediate balance of payments gap, estimated at 4.9 percent of GDP in FY2021/22, which would be financed with the ECF and budget support from development partners (1.2 percent of GDP in firm commitments so far) and a drawdown of reserves (3.1 percent of GDP). Alternative budget financing options are not available, particularly given the limited absorptive capacity of domestic markets.

31. Phasing will be somewhat frontloaded to match the timing of acute COVID-related needs. The fiscal financing gap is large in the first year of the program and insufficient financing would directly hinder the government’s COVID-19 response, which would have a lasting impact on poverty and the economy. Fiscal and external financing needs will decline over the medium term supported by the economic recovery process, the gradual dissipation of uncertainty related to the pandemic, and the authorities’ steadfast implementation of policies to promote macroeconomic stability and inclusive growth. Further, development partners are supportive of Nepal’s reform commitments under the ECF arrangement, thus providing policy assurances that could catalyze additional support over the medium term. In this context, a combined access of 100 percent of quota will be available within the first 12 months (50 percent at Board approval, and 25 percent at the first and second reviews), with the remaining 80 percent distributed in the subsequent reviews (table 7).

32. Program performance will be monitored by semi-annual reviews. Indicative targets (Us) will be set on the primary deficit of the federal government (a deficit ceiling, converting to QPCs in the 3rd review), and tax revenues (a floor, to be incorporated in the second year of the program). Applying ITs before their conversion to QPCs would support the authorities’ capacity building efforts and effective implementation of the strong fiscal indicators. The ITs on the primary deficit would be adjusted (i) upward (downward) to accommodate revenue shortfalls (windfalls) and (ii) upward (downward) if concessional project loans disbursed exceed (fall short of) the programmed amounts (TMU, 119 and 1110). Quantitative performance criteria (QPCs) will be set on net international reserves, and the standard continuous QPCs on non-accumulation of external arrears and non-introduction of exchange restrictions and multiple currency practices will apply. The QPCs on net international reserves would be adjusted (i) downward to accommodate revenue shortfalls and (ii) downward if concessional budget support loans disbursed fall short of the programmed amounts. Any downward adjustment to the QPC on net international reserves is capped to maintain reserve adequacy levels (TMU, 115). Structural benchmarks (SBs) for the first year of the program will be tightly focused on actions critical to addressing urgent needs in the face of the pandemic, with a broader structural reform agenda implemented once the recovery phase takes hold. The design of structural benchmarks complements other development partner programs where possible. A Poverty Reduction and Strategy Paper (PRSP) will be prepared (SB, 2nd review).

33. The program helps anchor and leverage the Fund’s capacity development strategy with Nepal. Fiscal policy support will focus on domestic revenue mobilization, public investment, and fiscal risk management. Financial sector technical assistance will include work on financial sector supervision, as well supporting the authorities’ efforts on central bank governance and modernization. A Financial Sector Stability Review is also envisaged.

34. A new safeguards assessment of the central bank has been completed. Its findings (see para 28 above) form the basis for structural conditionality related to institutional reforms. An agreement between the NRB and the MOF clarifying responsibilities for servicing obligations to the Fund will be put in place.

35. Capacity to repay remains adequate. IMF credit outstanding is projected to peak at 282.3 percent of quota in FY2024/25 (SDR 442.9 million), within the cumulative normal access limit of the PRGT. This amount corresponds to 7.9 percent of official reserves and 1.3 percent of GDP in FY2024/25. The authorities’ track record of servicing IMF debt is strong.

36. Staff and the authorities discussed contingency plans for a possible adverse scenario. The outlook is subject to considerable uncertainty from the depth and duration of the pandemic. Nepal’s buffers provide an important first line of defense, but additional fiscal and monetary policy measures could be needed, alongside further measures and financing to support the financial sector, should BoP pressures continue for longer than projected. The current fiscal framework includes 0.8 percent of GDP to support the financial sector, but given the vulnerabilities in the system, a significantly larger fiscal allocation would be needed in the event of a downside scenario materializing. Close engagement will allow for consultation with Fund staff if these shocks were to materialize.

Staff Appraisal

37. The COVID-19 pandemic severely impacted Nepal’s economy. Tourist arrivals collapsed, domestic activity plummeted, remittances have been volatile, and growth was lower than expected in 2019/20. The authorities reacted proactively, implementing a wide-ranging set of fiscal, monetary and financial sector policies, as well as disease prevention, containment, and health management measures.

38. A gradual resumption in economic activity and a corresponding surge in imports and related tax receipts led to higher growth and improved fiscal outturns in 2020/21. However, important fiscal and external financing needs remain, and the trajectory of the pandemic remains extremely uncertain, weighing on the economic outlook, and risks remain high. Both external and overall debt in Nepal are assessed at low risk of debt distress, while the external position of Nepal in FY2020/21 was moderately weaker than the level implied by fundamentals and desirable policies.

39. The ECF arrangement supports the government’s priorities. The arrangement would help mitigate the pandemic’s impact on health and economic activity and protect vulnerable groups; preserve macroeconomic and financial stability; implement reforms to support sustained growth and poverty reduction; and catalyze additional external financing.

40. Fiscal policy in the early part of the ECF would accommodate spending to address health needs, support the economy, and protect the most vulnerable. Fiscal deficits would gradually decline once the health crisis wanes, helping to stabilize public debt, while accommodating the authorities’ commitment to further enhance social safety nets. The program will also support a comprehensive fiscal structural reform agenda, with both revenue mobilization and public financial management reforms to address the public investment efficiency gaps, strengthen fiscal risk management, improve public debt and cash management, and help advance fiscal federalism in a fiscally prudent manner.

41. Fiscal transparency and measures to enhance governance and combat corruption will also be prominent. Several cross-cutting institutional reforms that address governance, vulnerability to corruption, and efficiency of the public sector will be taken forward, in addition to the continued implementation of spending transparency commitments.

42. The NRB should prudently monitor the level of liquidity in the banking system. They should stand ready to provide liquidity in the system where necessary while gradually scaling down the refinance facility. The NRB’s gradual unwinding of accommodative monetary policy and commitment to remain vigilant toward emerging risks in the external and financial sectors due to high levels of increase in the credit supply are welcome, and they should stand ready to adjust policy settings in case signs of overheating appear.

43. Financial sector regulation and supervision needs to be strengthened. The carefully sequenced strategy defined in the ECF will help preserve the stability of the financial system and support growth though ensuring the provision of adequate and timely supervisory data, updating the regulatory framework to enable more accurate assessment of the asset quality of banks and that better captures existing risks, providing an accurate assessment of the banks’ asset quality, and enhancing the quality of supervision, supported by the data and regulatory upgrades. The NRB should stand ready to tighten macroprudential policies to prevent overheating in the economy. Measures to improve the autonomy and accountability framework of the NRB would support this agenda.

44. Based on the protracted balance of payment need and policy commitments, staff supports the authorities’ request for a 38-month arrangement under the ECF, with access equivalent to 180 percent of quota (SDR 282.42 million).

Figure 1.
Figure 1.

Nepal: Recent Macro-Economic Developments

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Figure 2.
Figure 2.

Nepal: Recent Monetary Sector Developments

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Figure 3.
Figure 3.

Nepal: External Sector Developments

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Figure 4.
Figure 4.

Nepal: Recent Fiscal Developments

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Figure 5.
Figure 5.

Nepal: Socio-Economic Indicators

Citation: IMF Staff Country Reports 2022, 024; 10.5089/9798400200380.002.A001

Table 1.

Nepal: Selected Economic Indicators, 2018/19–2025/261/

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Sources: Nepali authorities; and IMF staff estimates and projections.

Fiscal year ends mid-July.

2/ The UN Human Development Index is a composite index measuring average achievement in three basic dimensions of human development—a long and healthy life, knowledge and a decent standard of living.3/ CCRT debt relief is included in grants and net incurrence of liabilities (foreign). The first tranche of CCRT debt relief covering the period April 14, 2020 to October 13, 2020 for SDR 2.9 million in FY 2019/20 was approved on April 13, 2020. The second tranche of CCRT debt relief covering the period October 14, 2020 to April 13, 2021 for SDR 3.6 million was approved on October 2, 2020. The third tranche of CCRT debt relief covering the period April 14, 2021 to October 15, 2021 for SDR 3.6 million was approved on April 1, 2021. The fourth and fifth (final) tranche of CCRT debt service relief covering the period from October 16, 2021 to January 10, 2022 and January 11 to April 13, 2022 was approved on October 6, 2021 and December 15, 2021 respectively for SDR 3.6 million.Note: Current baseline forecast is as of December 7, 2021.
Table 2.

Nepal: Summary of Central Government Operations, 2018/19–2025/26 1/

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Sources: Nepali authorities; and IMF staff estimates and projections.

Fiscal year ends mid-July.

CCRT debt relief is included in grants and net incurrence of liabilities (foreign). The first tranche of CCRTdebt relief covering the period April 14, 2020 to October 13, 2020 for SDR 2.9 million in FY 2019/20 was approved on April 13, 2020. The second tranche of CCRT debt relief covering the period October 14, 2020 to April 13, 2021 for SDR 3.6 million was approved on October 2, 2020. The third tranche of CCRTdebt relief covering the period April 14, 2021 to October 15, 2021 for SDR 3.6 million was approved on April 1, 2021. The fourth and fifth (final) tranche of CCRTdebt service relief covering the period from October 16, 2021 to January 10, 2022 and January 11 to April 13, 2022 was approved on October 6, 2021 and

30 percent of VAT and domestic excise revenues are shared with sub-national governments.

Note: Current baseline forecast is as of December 7, 202 1.FY2020/21 budget is as of May 28, 2020; FY2021/22 budget is as of September 10, 2021.
Table 3.

Nepal: Monetary Indicators, 2018/19–2025/261/

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Sources: Nepali authorities; and IMF staff estimates and projections.

Fiscal year ends mid-July.

Net international reserves program definition, see Technical Memorandum of Understanding.

Note: Current baseline forecast is as of December 7, 2021.
Table 4.

Nepal: Balance of Payments, 2018/19–2025/261/

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Sources: Nepali authorities; and IMF staff estimates and projections.

Fiscal year ends mid-July.

The first tranche of CCRT debt relief covering the period April 14, 2020 to October 13, 2020 for SDR 2.9 million in FY 2019/20 was approved on April 13, 2020. The second tranche of CCRT debt relief covering the period October 14, 2020 to April 13, 2021 for SDR 3.6 million was approved on October 2, 2020. The third tranche of CCRT debt relief covering the period April 14, 2021 to October 15, 2021 for SDR 3.6 million was approved on April 1, 2021. The fourth and fifth (final) tranche of CCRT debt service relief covering the period from October 16, 2021 to January 10, 2022 and January 11 to April 13, 2022 was approved on October 6, 2021 and December 15, 2021 respectively for SDR 3.6 million.

Official loans only includes firm financing commitments so far. This includes IMF-ECF (US$166.2 mil), WB (US$350 mil), and ADB (US$125 mil) in FY2021/22. The ECF is expected to catalyze additional financing from development partners.

Net international reserves program definition, see Technical Memorandum of Understanding.

The authorities define gross foreign exchange reserves as follows: Gross official reserves – go Id/SDR/IMF reserve position + bank and financial institutions’

Note: Current baseline forecast is as of December 7, 2021.