Nepal: Staff Report for the 2023 Article IV Consultation, First and Second Reviews Under the Extended Credit Facility Arrangement, Requests for Waivers of Nonobservance of Performance Criteria, Extension of the Arrangement, and Rephasing of Disbursements-Press Release; Staff Report; and Statement by the Executive Director for Nepal

1. Global developments have impacted Nepal’s recovery from the COVID-19 pandemic mainly through higher commodity prices. The pandemic took a heavy toll on the economy and some sectors, such as tourism, may take longer to fully recover. The health crisis has now receded. However, the increase in global energy and food prices stemming from Russia’s war in Ukraine coupled with the strong U.S. dollar has exerted inflationary and balance-of-payments pressures (Annex I). While inflation remains elevated, external sector pressures have subsided, thanks to the authorities’ policy response, including monetary policy tightening. Reform progress has been slower than expected owing in part to political uncertainty, including the process leading up to the November 2022 elections and subsequent changes in the government coalition.

Abstract

1. Global developments have impacted Nepal’s recovery from the COVID-19 pandemic mainly through higher commodity prices. The pandemic took a heavy toll on the economy and some sectors, such as tourism, may take longer to fully recover. The health crisis has now receded. However, the increase in global energy and food prices stemming from Russia’s war in Ukraine coupled with the strong U.S. dollar has exerted inflationary and balance-of-payments pressures (Annex I). While inflation remains elevated, external sector pressures have subsided, thanks to the authorities’ policy response, including monetary policy tightening. Reform progress has been slower than expected owing in part to political uncertainty, including the process leading up to the November 2022 elections and subsequent changes in the government coalition.

Background

1. Global developments have impacted Nepal’s recovery from the COVID-19 pandemic mainly through higher commodity prices. The pandemic took a heavy toll on the economy and some sectors, such as tourism, may take longer to fully recover. The health crisis has now receded. However, the increase in global energy and food prices stemming from Russia’s war in Ukraine coupled with the strong U.S. dollar has exerted inflationary and balance-of-payments pressures (Annex I). While inflation remains elevated, external sector pressures have subsided, thanks to the authorities’ policy response, including monetary policy tightening. Reform progress has been slower than expected owing in part to political uncertainty, including the process leading up to the November 2022 elections and subsequent changes in the government coalition.

2. The post-pandemic recovery allows renewed focus on poverty reduction, strengthening macroeconomic institutions and addressing vulnerability to climate change. Nepal is a landlocked low-income country that relies heavily on income from remittances to overcome domestic growth hurdles. Remittances helped reduce poverty dramatically over the last decade, but there remains substantial scope to improve living standards. Climate change is already exacerbating poverty and food inequality, and strengthening institutions is needed to help the population adapt.

uA001fig01

Key Medium-Term Challenges

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Recent Developments, Outlook and Risks and Program Performance

A. Recent Developments

3. The economy has stabilized, thanks in part to monetary policy tightening, although inflation remains elevated. Real GDP growth is estimated at 5.8 percent in fiscal year (FY) 2021/22 (from July 16, 2021 to July 15, 2022), reflecting a strong post-pandemic rebound in credit growth and domestic demand, a return of tourists, and new hydropower supply coming online. While the direct impact from the war in Ukraine has been relatively modest, higher global commodity prices and strong domestic demand created external and inflationary pressures in FY2021/22. Headline inflation averaged 6.3 percent during the last fiscal year. High frequency indicators for FY2022/23 show that domestic demand has slowed down and credit growth, a leading indicator of output growth, has fallen to single digits as the authorities tightened monetary policy and unwound pandemic-related support measures. Remittances—a key driver of consumption and growth—have been buoyed by high oil prices and a post-pandemic pickup in outward migration. Inflation remains elevated at 7.9 percent in February 2023, down from a peak of 8.6 percent in September 2022.

uA001fig02

High Frequency Indicators

(Year-on-year growth)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Sources Nepal authorities; and IMF staff calculations.

4. Monetary policy tightening began in February 2022 amid external pressures and rising inflation. The post-pandemic resumption of economic activity increased demand for credit and banks’ appetite for credit risk. This increased demand for central bank liquidity and pushed up the weighted average lending rate. To support external stability (see ¶7) and control inflation, the Nepal Rastra Bank (NRB) raised the interest rate corridor (IRC) in February 2022 and again in July (by 350 bps in total) and increased the cash reserve ratio (CRR) in August, further raising lending rates.1

uA001fig03

Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Source: NRB.

5. Macroprudential tools have effectively complemented monetary policy, but non-performing loans (NPL) are increasing. Monetary policy tightening and introduction of a 90 percent cap on the credit-to-deposit (CD) ratio contributed to a decline in credit growth.2 Bank deposits have increased, aided by remittance inflows, allowing NRB to reduce liquidity provided through the Standing Liquidity Facility (SLF). Pandemic-related support measures such as payment moratoria and forbearance contributed to already low, but owing to long-standing evergreening practices, likely understated, NPL levels. NPLs increased to 2.6 percent as of January 2023, reflecting the slowdown in domestic demand and decline in the repayment capacity of borrowers due to rising lending rates. Further rise in NPLs could raise concerns about capital-adequacy ratios, which are currently above regulatory minimum.

6. Fiscal policy in FY2021/22 was less expansionary than expected, but a fall in revenues this fiscal year is adding to fiscal pressures. While fiscal revenue growth was strong in FY2021/22 (at 14.2 percent y-o-y), expenditures grew by less (9.5 percent), resulting in a fiscal deficit at 3.3 percent of GDP, much smaller than expected. The revenue increases were driven mainly by an overperformance in import-related taxes. On the expenditure side, capital expenditure significantly underperformed with only 57.2 percent of the budgeted amount executed in FY2021/22 as political uncertainty and the third wave of the pandemic affected execution rates. However, revenue collection has significantly slowed thereafter. In the first six months of FY2022/23, revenues declined by 16.5 percent, mostly driven by a slowdown of import-related taxes, which declined by 30.9 percent. At the same time, expenditures increased by 11.2 percent, reflecting an increase in public wages, more goods and service purchases, and surging interest payments.

uA001fig04

Central Government Finances

(Cumulative in FY terms, Billions of Nepali Rupees)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Sources: Nepali authorities; and IMF staff estimates.

7. The current account weakened substantially in FY2021/22, leading to a loss of reserves, but external sector dynamics have improved since then. Imports surged in FY2021/22 amid strong credit growth and elevated commodity prices. Exports also increased but remain an order of magnitude smaller than imports. Remittance growth was slower, providing less support for the deteriorating trade balance, and resulting in a current account deficit of 12.9 percent of GDP in FY2021/22 and a loss of international reserves. The external position in FY2021/22 was assessed to be substantially weaker than implied by fundamentals and desirable policies (Annex II). The external sector dynamics improved later in the year and in FY2022/23. Both oil and non-oil imports declined. Remittances have picked up and gross reserves have stabilized at around 6.8 months of prospective imports, above the estimated reserve adequacy level.

uA001fig04a

Dynamics of Imports

(In 3mma, indexed Aug 2019 = 100)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Sources: Nepali authorities; and IMF staff estimates.Note: Petroleum Imports are defined as imports of minerals, fuels and lubricants.

8. The authorities introduced import bans and mandatory use of letters of credit (LCs) and cash margins for a broad set of imports in FY2021/22. While these measures likely slowed down import growth somewhat, they are distortionary and not a sustainable solution to external pressures (Box 1). These measures were gradually eased in the first half of FY2022/23 and the remaining restrictions removed completely in January 2023.

Economic Impact of Import Restrictions

December 2021 and April 2022. These included mandatory use of letters of credit (LC) and cash margins for a broad set of imports, as well as outright import bans for several items, including luxury goods.

Recorded imports affected by the import restrictions slowed in 2022. Evidence from trade data suggests that total imports excluding essential goods slowed after the monetary policy tightening in February and July, but imports in the categories impacted by restrictions slowed more than other imports (text figure).1 A simple difference-in-difference regression controlling for category-specific trends suggest that the bans reduced imports by about 22 percent, and the mandatory LC and margins by about 11 percent since these restrictions were first enacted.

uA001fig05

Nepal’s Imports in Selected Categories

(In 3mma, indexed, Aug 2021 = 100)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Sources: Nepali authorities; and IMF staff calculations.Note: Aggregation at HS-2 classification level. Essential imports include oil, cereals, pharmaceuticals and fertilizers.

Import restrictions cannot be a sustainable solution to balance of payments pressures. The restrictions affect a relatively small share of goods imports. The banned import items comprise at most 5 percent of total imports, and imports affected by the mandatory LC and margins about 23 percent of total imports. Overall, the difference-in-difference regressions suggest that the restrictions reduced imports by about USD 80 million per month.2 This is not enough to arrest the FY2021/22 loss of international reserves, which amounted to USD 220 million per month in the first half of the year. Enforcing the restrictions is also likely to get harder over time as the restricted items, such as vehicles or smartphones, become scarcer in the economy. Likewise, the effectiveness of the mandatory LC and margins may be undermined by under-invoicing as importers are incentivized to use informal payments mechanisms. The import restrictions also do not address the fundamental drivers of the external pressures: global commodity prices that are expected to remain elevated throughout 2023, and booming domestic demand. Overall, research from other countries confirms that trade barriers have no discernible effect on trade balances over the medium term.3

Trade barriers have adverse macroeconomic implications, lead to lower government revenue and provide opportunities for rent-seeking. Larger trade barriers are associated with persistent declines in domestic output and productivity, increasing resource misallocation, uncertainty, and the cost of production for businesses.4 In Nepal, import restrictions also erode an important source of government revenue. While vehicles represent a small share of imports, they yield more than one third of custom duty revenues. As a result, while overall customs revenue remained buoyant in FY2021/22, they fell 51 percent short of the Department of Customs target in the first six months of FY2022/23. The restrictions also add to inflation and create opportunities for misreporting and rent-seeking, contributing to corruption and social distrust.

1 At the HS-2 imports classification level, for reasons of data availability, whereas some restrictions are more granular (HS-6).2 Likely an upper boundary as the restrictions were introduced at about the same time as the monetary policy tightening, and some restricted imports, e.g. durable consumption items such as vehicles, are more likely to be purchased on credit, and so are more responsive to higher lending rates than other imports.3 Furceri D. et al. 2022. “The Macroeconomy After Tariffs”. The World Bank Economic Review 36(2).4 Estefania-Flores J. et al. 2022. “Measurement of Aggregate Trade Restrictions and their Economic Effects”. IMF Working Paper WP/22/1.

B. Outlook and Risks

9. Growth is projected to moderate in FY2022/23, but the medium-term outlook remains broadly favorable.

uA001fig06

Contribution to Real GDP Growth by Sector

(In percent)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Sources: Nepal Central Bureau Of Statistics; and IMF Staff calculations.1/ Mining & quarrying; Electricity, gas, steam & air conditioning supply; Water supply, sewage, waste management & remediation activities.2/ Accommodation & food service activities; Information & communication; Financial & Insurance Activities; Real Estate activities; Professional, scientific & technical activities; Administrative & support service activities; Public administration & defence, compulsory social security; Education; Human health & Social work activities; Arts, entertainment and recreation; Other service activities.3/ Includes taxes, subsidies and statistical discrepancy.*IMF staff estimates.
  • Growth and inflation. Real GDP growth is forecast to moderate to 4.4 percent in FY2022/23 before increasing to 5.1 percent in FY2023/24 as headwinds from global commodity prices dissipate, creating space for gradual domestic policy normalization. Tighter monetary policy, lower global oil and food prices, moderating Indian inflation and slowing domestic demand is expected to pull Nepal inflation down to 7.1 percent, close to the NRB target of 7 percent, by the end of FY2022/23. In the medium-term, public infrastructure and development spending, hydropower projects and the ongoing recovery in tourism are projected to generate growth close to potential (estimated at just above 5 percent).

  • Fiscal. The overall fiscal deficit is expected to reach 4.5 percent of GDP in FY2022/23. Revenue collection has been disappointing, owing largely to lower import-related taxes, and interest payments are surging driven by higher interest rates on short-term domestic borrowing (with treasury bills accounting for one third of domestic debt). Nonetheless, lower capital spending and substantial expenditure rationalization announced in the mid-year budget review is expected to help contain the deficit.

  • External. The current account deficit is expected to narrow to 5.2 percent of GDP in FY2022/23 due to weaker import demand, lower commodity prices, and buoyant remittances reflecting a post-pandemic increase in outward migration. Tourism is projected to recover, but is more than counterbalanced by an increase in students leaving to study overseas. Reserve coverage is expected to remain above estimated adequacy levels through the medium term.

    10. The Debt Sustainability Analysis shows that both external and overall debt remain at low risk of debt distress. Despite a challenging global environment, developments since the ECF request had limited effect on public debt dynamics, as the increase in the current account deficit in FY2021/22 has been absorbed by a drawdown in reserves rather than accumulation of external debt. Public debt is projected to stabilize (at about 50 percent of GDP) in the medium term, and present values of both the public debt-to-GDP and external debt-to-GDP ratios are projected to remain below their indicative thresholds. The results are nevertheless sensitive to growth, exports, and natural disaster shocks, underscoring the importance of reforms to diversify Nepal’s economy and increase its resilience. The sustainability of public debt is also contingent upon prudent execution of the medium-term fiscal consolidation strategy, and continued utilization of external borrowing at concessional terms as envisaged in the Medium-Term Debt Management Strategy.

11. The outlook remains uncertain and subject to downside risks (Annex III).

  • External risks. High and volatile commodity prices, including from a protracted war in Ukraine, could slow down the recovery in energy-intensive sectors, aggravate food insecurity, and impose high fiscal costs. At the same time, Nepal’s limited direct trade and financial linkages with Russia, Ukraine and global financial markets could buffer against spillovers. A global growth slowdown, especially in India or the Gulf Cooperation Council (GCC) countries, could weigh on remittances, trade and growth. On the upside, a decline in global commodity prices would have a large impact, relieving fiscal, external and inflationary pressures.

  • Domestic risks. Slow public expenditure execution for growth enhancing capital projects could weigh on economic activity. Nepal remains vulnerable to natural disasters and climate shocks. Further, macro-financial risks—likely to have accumulated during the pandemic-related monetary accommodation, rapid credit growth and regulatory forbearance—could materialize in response to tightening in financial conditions or slowdown in remittances. Finally, social and political instability could weigh on the economic outlook.

12. The authorities largely shared staff’s economic outlook and risk assessment. The authorities agreed that growth will slow down in FY2022/23 but expect growth to recover next year and over the medium-term. The government’s macro forecast does not differ substantially from staff projections, though the Ministry of Finance expects that a stronger rebound in revenue will result in a somewhat lower fiscal deficit in FY2022/23. The authorities considered that domestic risks are most salient, as they aim to avoid financial sector stress and a further slowdown in economic activity.

C. Program Performance

13. Program implementation has been mixed, given a difficult environment. The ECF has helped mitigate the impact of the pandemic and global shocks on economic activity and achieve program objectives of protecting vulnerable groups, preserving macroeconomic and financial stability, and sustaining growth and poverty reduction.

  • Performance criteria (PCs), indicative targets (ITs): The first review PC on net international reserves (floor) and the IT on the fiscal deficit (ceiling) based on the January 14, 2022 test date were met comfortably (Table 8). Three of the standard continuous PCs—on imposition of import restrictions, exchange restrictions, and multiple currency practices (MCPs)—were not observed.3 The second review net international reserves PC based on the July 14, 2022 test date, as planned at program approval, was met, albeit with support from the import restrictions that violated the continuous PCs. The ITs for the test date were also met. The continuous PC on external payments arrears was met.

  • Structural benchmarks (SBs): The authorities made progress towards implementing structural conditionality for the first review with one prior action and two SBs met and four SBs implemented with delay. This includes commissioning the external audit of the NRB in September 2022. The SB on the Financial Comptroller General Office’s (FCGO) consolidation of operational funds was not ready for inclusion in the FY2020/21 annual financial statements published in May 2022, so it will be reset for completion by end-August 2023. None of the second review SBs with October 2022 test dates, as planned at program approval, were met, though the Poverty Reduction and Growth Strategy paper was issued with delay.

Towards a More Resilient, Inclusive, and Greener Economy

After waves of external shocks, the Article IV discussions center around three main longer-term themes: (i) safeguarding fiscal resilience to deal with short- and medium-term pressures; (ii) developing monetary policy and financial sector practices that will preserve macroeconomic and financial stability; and (iii) pursuing reforms that foster sustainable and inclusive growth and increase resilience to climate change. Some topics cut across multiple themes. Efforts to improve governance and reduce corruption vulnerabilities—key to inclusive growth—cuts across fiscal (e.g. procurement) and monetary/financial (e.g. NRB governance) policies. Likewise, improving public investment management can expedite efforts to build climate change resilience.

14. Nepal’s significant capacity developments (CD) needs frame the policy discussions (Box 2). Since the start of the program, extensive technical assistance (TA) has been provided—along with development partners—to support the program objectives and reforms in multiple areas, such as tax policy, fiscal transparency, central bank governance, monetary policy implementation, financial regulation/supervision and strengthening statistics.

Capacity Development

Approval of the ECF-supported program has catalyzed extensive Fund CD support. A large CD agenda has facilitated achieving program objectives. TA activities have ramped up significantly since January 2022, under different modalities. IMF departments (FAD, MCM, FIN and LEG) conducted 6 TA missions, and provided desk reviews on multiple issues. SARTTAC, based in New Delhi, India, conducted 4 TA missions in the areas of monetary policy, statistics, and fiscal risks.

The CD agenda supports the ECF objectives by accelerating reform progress in key areas. (Table 1) TA on tax policy, tax and customs administration helps support the fiscal structural reform agenda on revenue mobilization and public financial management reforms. Fiscal transparency and measures to enhance governance and combat corruption are aided by TA on aligning fiscal reporting with GFS standards and strengthening the central bank’s governance. These projects help sustain growth and poverty reduction over the medium-term. TA on asset classification and the LOLR facility bolsters the strategy to strengthen financial sector regulation and supervision, while the FSSR is expected to provide a roadmap for financial sector TA looking forward.

Other development partners have also provided support, in coordination with the Fund. Coordination and discussion on TA needs was strengthened through thematic working groups, with participation by the IMF Resident Representative. On the financial sector, the UK Foreign, Commonwealth and Development Office (FCDO) has supported development of the SIS, critical to enhancing supervisory framework. The World Bank and IMF support amendments to the asset classification regulation. The World Bank also provides TA on related-party lending and consolidated supervision. The World Bank also provided TA on VAT exemptions and financed the TADAT mission together with the Fund and ADB. Germany’s Gesellschaft für Internationale Zusammenarbeit (GIZ) promotes digitalization of the tax system. The ADB supports PFM reforms (i.e., debt management, SOE restructuring, among others) and trade facilitation.

Fund CD continues to support reforms guided by the ownership and preferences of the authorities. In the near term, CD will include workshop on NRB risk management with NRB Board Members on identification of risks and design of mitigation strategies, and SARTTAC TA on a cash flow monitoring and forecasting framework and a full-fledged Medium-Term Fiscal Framework. The FSSR CD roadmap will result in additional financial sector TA. The authorities have also expressed interest in receiving TA on areas that are not directly related to the ECF-supported program, including the adoption of a CBDC. The authorities have expressed significant appreciation for Fund CD support. However, the timing and sequencing of TA activities should fully account for absorptive capacity and ensure appropriate follow up to maintain reform momentum.

CD in Support of Program Objectives and Conditionality

article image

A. Safeguarding Fiscal Resilience

Near-Term

15. The government is addressing near-term fiscal pressures through expenditure rationalization. The announced deficit target in the FY2022/23 budget is aligned with program objectives. However, given the significant portion of import-related taxes in revenues (45.9 percent in the FY2022/23 budget), the decline in imports has reduced revenue collection and led to near-term fiscal pressures.4 At the same time, implementation of capital projects remains slow (14.1 percent of the annual target in the first six months of FY2022/23) and is expected to result in significant under-execution for the year as a whole. In response to near-term pressures and to maintain fiscal discipline in line with program objectives, the government has announced, in the February 2023 mid-year budget review, expenditure rationalization to reduce administrative and non-essential recurrent spending (estimated at about 1.4 percent of GDP); lower fiscal transfers to subnational governments that are slow to execute (about 1.6 percent of GDP); and set aside capital expenditures which lack sufficient preparation and are unable to be spent (about 1.2 percent of GDP).

uA001fig07

Imports and Import-Related Revenue

(In millions of Nepali Rupees)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Sources: Nepali authorities; and IMF staff estimates.

16. Policies should focus on prudent formulation of the FY2023/24 budget, while protecting high-quality infrastructure and social spending. A revenue advisory committee has been established to advise the government on tax reforms. Clearing tax arrears can help partly offset revenue shortfalls in the near term. Furthermore, the development of a comprehensive revenue mobilization plan should be advanced to guide subsequent steps and identify tax reforms (see ¶18). In the FY2023/24 budget, building on efforts in the mid-year budget review, the federal government should accelerate its efforts to reduce expenditures that are duplicated with subnational governments, which will likely reduce budgeted grants and subsidies, spending on goods and services and the wage bill. The remaining COVID-19 relief measures (mainly tax rebates to small taxpayers and business severely impacted by pandemic) should be removed in the FY2023/24 budget. High quality infrastructure and social spending should be protected to support economic growth and enhance social inclusion. Seeking more concessional financing and enhancing debt management will help reduce financing risks.

17. Supporting the most vulnerable against elevated food and energy prices remains a near-term priority. In the context of the international food price shock, measures were announced in the FY2022/23 budget to increase agriculture production, including establishing a fund to provide agriculture credit to farmers and increasing fertilizer subsidies (to 0.7 percent of GDP). In response to the increase in global oil prices, the government limited price passthrough, resulting in large Nepal Oil Corporation (NOC) losses (estimated at 1 percent of GDP), and provided NOC a loan (0.15 percent of GDP). Recently NOC has started to make profits again as international fuel prices have come down faster than domestic sale prices. The social safety net can be strengthened through better-targeted, temporary and transparent measures, with priority given to cushioning households from the adverse effects of elevated food and energy prices.

uA001fig08

Nepal Oil Corporation Fifteen Days Profits/Losses

(In NPR Millions)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Source: Nepal Oil Corporation website.

18. The authorities have continued to make progress on fiscal transparency. The authorities published their fourth COVID-19 Active Response and Expenditure (CARES) report (end-April 2022 SB, met).5 The authorities have also begun collecting and publishing beneficial ownership information for COVID-19-related health procurement (first review prior action, met).6 Maintaining momentum on governance reforms will be critical to cementing recent gains. The full use of the electronic government procurement system would ensure real-time monitoring of contractual commitments, time and cost overruns, and better control of the contracting process. Regular publication of procurement reports online would further enhance transparency.

Medium-Term

19. Fiscal consolidation is needed to ensure medium-term fiscal sustainability. While public debt is still assessed at low risk of distress, debt has increased rapidly in recent years, largely due to an expansionary fiscal stance since the transition to fiscal federalism coupled with the 2015 earthquake and pandemic shocks. A significant portion of fiscal resources and responsibility have been transferred to subnational governments. However, federal government expenditures have not come down sufficiently to fully offset the transfer. Reducing federal government deficits to around the pre-fiscal federalism level will help put public debt on a medium-term downward trajectory and is critical to ensuring fiscal resilience. Based on Fund TA, estimates suggest that full implementation of the revenue mobilization effort could raise an additional 3.7-4.1 percentage points of GDP of revenue over the next five years. This reform should be guided by a comprehensive revenue mobilization strategy with an appropriate balance of tax policy, law, and revenue administration reforms (end-April 2024 SB).7 Staff currently projects a conservative 1.7 percentage point of GDP tax revenue increase over the next five years, assuming gradual implementation of reforms on value added tax, personal and corporate income taxes, and excises.

uA001fig09

Fiscal Federalism

(In millions of Nepali Rupees)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Sources: Nepali authorities; and IMF staff estimates.1/ Federal government expenditures are calculated as the redisual by substracting fiscal transfers and revenue sharing from total expenditure.2/ includes fiscal transfers and revenue sharing.

Impact of Tax Reforms (percent of GDP)

article image

20. Further actions are needed to continue progress on the structural fiscal reform agenda. The authorities have received Fund TA on strengthening fiscal risk management and revenue mobilization, which underpin the program’s structural reform agenda. To capture major fiscal risk of the central government, the Ministry of Finance (MoF) is currently preparing to implement a fiscal risk registry (end-October 2022 SB, reset to end-August 2023). The Inland Revenue Department has also estimated non-customs tax exemptions which can be published later (end-October 2022 SB, reset to end-August 2023). MoF will publish a comprehensive report on tax expenditures (end-April 2024 SB) and has established a working group to develop cash flow forecasting (end-October 2022 SB, reset to end-September 2023).

21. The fiscal federalism framework needs to be strengthened. The fiscal reporting of subnational governments has improved. All provincial and local governments have now implemented their financial management information systems, which represents a step forward towards expanding fiscal data to cover the general government. Due to capacity constraints subnational governments have been underspending their budgets, resulting in a cash balance of 2.8 percent GDP by the end of FY2021/22. Nevertheless, the Public Debt Management Act approved in 2022 has laid out provisions for subnational government borrowings, which require federal government’s approval. The establishment of a fiscal risk monitoring system for subnational governments (end-April 2024 SB) will support federal government decision making in this regard and improve identification and management of emerging risks.

22. Some public enterprises (PEs) have been negatively impacted by the pandemic as well as global commodity price shocks. NOC incurred large, but temporary, losses, while the pandemic-related travel restrictions negatively impacted the already-struggling Nepal Airline Corporation (NAC). While the profits of the largest PE, Nepal Electricity Authority (NEA), reached a record high in FY2021/22 due to increased electricity sales and generation, its unfunded liabilities (mainly pension fund liabilities) increased (Selected issues paper: Public Enterprises and Fiscal Risks). This has resulted in fiscal costs (e.g. mainly through increased subsidies, reduced taxes and dividends as well as erosion of government equity holdings) and increased fiscal risks (e.g. additional risk exposure through loans and loan guarantees). PEs’ selling prices should be gradually adjusted to reflect their full costs, and any policy-driven price reductions should be compensated transparently through the budget. For NOC, the automatic fuel price adjusting mechanism should be revised to accommodate large scale commodity price shocks and to avoid the emergence of protracted and elevated cost-recovery gaps. These reforms should be accompanied by improvements in the social safety net to protect vulnerable groups. The financial oversight and governance frameworks should be strengthened to limit fiscal risks, and to enhance operational autonomy, efficiency, and transparency. Having the four priority nonfinancial PEs (NEA, NOC, NAC, and Nepal Telecom’s) FY2022/23 financial statements audited (end-April 2024 SB) and all PEs’ annual financial statements published (end-April 2024 SB) will support achieving these reform objectives.8

23. Public Investment management needs to be strengthened to enhance capital expenditure efficiency and climate resilience. The 2021 public investment management assessment (PIMA) found that Nepal scores lower than peers in terms of the perceived quality of infrastructure. Estimates suggest that with the same capital spending, infrastructure outcomes could be almost twice as high if investment efficiency was enhanced. The FY2022/23 budget announced several measures to expedite project implementation. However, in addition to slow project implementation, issues stem also from lack of adequate planning and effective resource allocation. A more comprehensive reform action plan should be developed to ensure that the underlying weakness are addressed (end-October 2022 SBs, reset to end-April 2024). Furthermore, the public investment management process should further integrate climate considerations to support building climate change resilience.

24. The authorities agreed with the need to address near-term fiscal pressures and to implement medium-term fiscal consolidation. They acknowledged on-going revenue pressures and viewed stronger revenue mobilization as important to funding priority spending and ensuring debt sustainability. The government aims to address near-term fiscal pressures by rationalizing administrative expenditures while protecting social spending and prioritizing capital spending for projects that are critical for growth. The authorities expressed concerns about the high interest burden of domestic debt and plan to access more external concessional financing. They agreed that it is important to closely monitor fiscal risks from PEs and have identified six high priority PEs to be included in the fiscal risk register. They requested IMF technical assistance to support their reforms.

B. Preserving Macroeconomic and Financial Stability

Near-Term

25. Monetary policy, supported by macroprudential tools, should take a cautious, data-driven approach to maintaining external stability and addressing elevated inflation. Headline inflation is expected to decline towards the NRB’s target of 7 percent by year end, domestic credit growth to the private sector to stabilize at 7.4 percent in FY2022/23, and pressure on reserves to subside further. Nonetheless, inflation remains elevated. A cautious and data-driven monetary policy stance, supported by macroprudential measures, can help avoid large boom-bust credit cycles, which can create financial sector instability and are not supportive of sustainable growth. The NRB plans to implement the Basel III liquidity coverage ratio to help strengthen banks’ liquidity risk management. A countercyclical capital buffer (CCyB) originally intended to be introduced in 2019 is now slated to take effect in July 2023 (starting at the default level of zero). Going forward, gradually phasing in the CCyB can help moderate credit cycles where necessary and discourage excessive risk taking.

26. Net international reserves have stabilized and remain adequate. The tightening monetary policy stance helped moderate domestic demand, eased pressure on reserves and supported the exchange rate peg. A cautious and data-driven monetary policy stance alongside ECF financing and budget support by development partners should continue to help replenish foreign exchange reserves going forward without the need to resort to distortionary trade restrictions.

uA001fig10

Net International Reserves

(In USD mn)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Sources: NRB; and IMF staff calculations.

27. The NRB should prioritize the asset quality of banks, ensuring appropriate reclassification of loans and discouraging evergreening practices. Prudent monitoring of the impact of unwinding pandemic-related support measures and deterioration in repayment capacity of borrowers on asset quality is critical. The NRB should ensure banks vigorously differentiate viable borrowers with temporary liquidity shortages from nonviable ones. This will help the NRB to get a better overview of the health of the loan portfolio of Class A banks prior to launching loan portfolio reviews of the ten largest banks assisted by independent international auditors (end-April 2024 SB). Streamlining the prompt corrective action framework with a clear escalation process across various states of distress and early interventions can help avoid any delays in addressing possible weaknesses. The authorities need to assess the impact of directed lending on the business models of banks and on financial stability, closely monitor loan quality and consider gradually reducing them as needed. Furthermore, given the concerns about the ability of the Deposit Credit and Guarantee Fund to meet future bank claims on guaranteed loans, the authorities should effectively redesign the credit guarantee mechanism, enhance governance and increase funding through guarantee fees (Selected issues paper: Public Enterprises and Fiscal Risks).

28. Efforts to ensure asset quality in the banking system require support by regulatory initiatives. The NRB drafted amendments to asset classification regulations to improve definitions and clarify concepts (end-April 2022 SB, implemented with delay) and is expected to publish the asset classification regulation, in line with IMF recommendations (end-October 2022 SB, reset to end-August 2023). The delay in introducing the asset classification regulation entails tradeoffs, including a deferred assessment of the full health of the banking system. In order to mitigate risks, the NRB should implement a strong supervisory framework to ensure robust lending standards to avoid buildup of vulnerabilities, combined with timely deployment of crisis management tools. The NRB also issued working capital loan guidelines effective from October 2022 and amendments to the guidelines in January 2023.9 The NRB should ensure that implementation of the new working capital guidelines is fully in line with the amended asset classification regulations.

29. Significant progress has been made towards advancing the financial sector reform strategy. In addition to the amendments to asset classification regulations, the NRB approved the Supervisory Information System (SIS) action plan in December 2022 (end-April 2022 SB, implemented with delay). The implementation of the SIS components is progressing at different paces, with implementation among class A banks—strengthened to include class B, and C banks— for supervisory follow up, regulatory reporting and publication of financial data purposes expected by August (end-Oct 2022 SB, reset to end-August 2023), and the onsite module for Class A banks expected by April 2024 (end-October SB, reset to end-April 2024). The recent Financial Sector Stability Review (FSSR) report has identified several areas where further reforms are needed, with support from IMF CD.

30. While progress has been made, most of the 2021 safeguards assessment recommendations remain outstanding. Progress on most safeguards assessment recommendations related to internal audit and controls in key operations has been limited.10 The NRB has been strengthening its financial reporting practices. The contract to commission the external audit of the NRB was signed in September 2022 (end-April 2022 SB, implemented with delay), therefore outsourcing the FY2021/22 audit to international auditors with experience in applying International Standards on Auditing. As envisaged, this was later finalized by the Office of the Auditor General in November 2022. Going forward it will be important for the NRB to have its annual financial statements independently audited by external auditors in accordance with international standards on auditing (MEFP ¶30). Amendments to the NRB Act were drafted, in consultation with the Fund, to modernize the NRB Act and strengthen its autonomy and governance practices in line with SGA recommendations in July 2022. The amendments are undergoing internal review and, following review by Fund staff, should be submitted to the Parliament (end-October 2022 SB, reset to end-August 2023).

Medium-Term

31. The evolving array of instruments used to implement monetary policy requires refinement. (Box 3) The IRC consists of a 150-basis point band bounded by liquidity facility rates, plus another 50-basis point band bounded by repo/reverse repo auction triggers. In addition to the IRC, the NRB actively adjusts foreign exchange intervention, the CRR and Statutory Liquidity Ratio, limits on lending to deposit interest rate spreads and base rate premia, and parameters for use of refinance and a lender-of-last-resort (LOLR) framework, though not all are binding. Frequent use of regulatory and administrative measures also impacts overall monetary conditions. The NRB continues to refine its instruments, including efforts to reduce reliance on the SLF as a source of liquidity to meet banks’ demands. Greater reliance on open market operations to balance liquidity conditions has improved the NRB’s ability to steer the interbank rate towards the midpoint of the band. Less active use of instruments other than the IRC would further improve the clarity and effectiveness of monetary policy. This will help reduce the volatility of short-term interest rates, encourage interbank market development and facilitate commercial banks’ liquidity management practices.

Monetary Policy Implementation

NRB is operating in a complex environment. The NRB operates in a context of a peg to the Indian rupee; a largely closed financial account; constraints on capacity and operational independence; and multiple instruments to support multiple objectives. The economic policy response to recent global shocks has relied heavily on monetary measures, creating challenges implementing the IRC and strong monetary and credit cycles.

Monetary policy targeting of both quantities (money and credit) and prices (interest rates) has produced volatile domestic interest rates. The IRC framework is formally the main tool of monetary policy. However, monetary policy aims at several objectives including external, price and financial stability; sectoral credit allocation; and foreign exchange reserves, credit and broad money growth targets, amongst others.1 Pursuing multiple targets with multiple instruments and incomplete implementation of the IRC contributes to a misalignment of (short-term) interbank market interest rates with the announced policy rate. For instance, during the pandemic in 2020 substantial prudential loosening compounded reductions in policy rates, leading to excess liquidity in the financial system and interbank rates falling below the floor of the IRC. Starting in 2021, resumption of economic activity helped to drain excess liquidity from the system. Interbank rates spiked in the absence of active liquidity provision through open market operations, and have since been pinned at the SLF rate as borrowings under the SLF increased.

The NRB has reiterated its commitment to the IRC framework in line with recent IMF recommendations. The NRB has begun implementing Fund TA recommendations on monetary policy implementation. Specifically, the NRB is strengthening its technical capacity in high-frequency forecasting of liquidity needs and key macroeconomic indicators to help set the policy rate consistently with its objectives of price stability and maintaining the peg. Second, the NRB has begun taking a more active liquidity management framework, using repo auctions to steer the interbank rate closer to the policy interest rate under both a liquidity surplus and deficit. Further, the amendment of the NRB Act will enhance the autonomy of the NRB in making monetary policy decisions and streamline its objectives.

To improve interest rate transmission, the NRB should reduce the frequency of regulatory and administrative adjustments. The effect on credit conditions of adjusting regulations on interest rate levels, spreads, and directives to channel credit to select sectors can be inconsistent with the direction of monetary policy. Active use of instruments other than the IRC can effectively undo “headline” monetary policy decisions via other measures. These measures can lead to mixed signals about the monetary policy stance and impede monetary policy transmission, ultimately necessitating larger interest rate changes.

1 The NRB publishes its annual monetary policy statement and periodic reviews within the fiscal year, e.g. NRB 2022, “Monetary Policy for 2022/23”. https://www.nrb.org.np/contents/uploads/2022/08/Monetary-policy-in-English-2022_23-Full-text.pdf.

32. Advancing digitalization can play an important role in enhancing financial inclusion and modernizing the financial system. Access to financial services has more than doubled to 54 percent over the past ten years, reflecting the efforts of the NRB and financial service providers to reach the unbanked population. The role of microfinance institutions (MFIs) and credit cooperatives as financial service providers is increasing, calling for closer monitoring of risks, including through linkages to banks and other financial institutions. Payment system modernization has gained momentum, reflecting the Payments and Settlement Act and the implementation of real time gross settlement system, but more needs to be done (text table). The NRB also issued a concept paper on Central Bank Digital Currency (CBDC) for public consultation in August 2022. NRB’s key policy goals for a CBDC are better access to payments, increasing payment system resilience and reducing cash handling costs. The potential financial stability implications require prudent consideration and measures to safeguard financial integrity.

Next Steps on Financial Inclusion and Payments Systems

article image

33. Nepal should step up efforts to enhance effectiveness of the AML/CFT framework. The Asia/Pacific Group on Money Laundering is currently undertaking a mutual evaluation (peer review) to assess Nepal’s compliance with global AML/CFT standards, with the results due to be published in mid-2023. More progress is needed to amend AML/CFT laws and regulations to ensure compliance with the international standards. Steps to ensure that a robust legal framework is in place should be prioritized, along with measures to address gaps in the effectiveness of the AML/CFT regime.

34. The authorities shared the emphasis on strengthening the toolkit for preserving macroeconomic and financial stability. The NRB plans to maintain a cautious and data-driven approach to monetary policy. The NRB remains committed to prudently monitoring banks to ensure that loans are appropriately classified and adequately provisioned, and that banks remain well capitalized. They expect these efforts to be supplemented by the ongoing regulatory and supervisory reforms under the ECF-supported program. The authorities requested Fund support in identifying development partner financing for implementation of the in-depth loan portfolio review of the largest ten banks assisted by an international audit firm. They underscored the importance of directed lending for access to finance in priority sectors, including agriculture. The authorities recognize emerging risks associated with MFIs and large cooperatives and plan to enhance monitoring. The authorities underlined their efforts to amend laws to ensure compliance with international standards, but agreed on the need to improve the effectiveness of implementing the AML/CFT framework.

C. Fostering Sustainable, Inclusive and Green Growth

35. An ambitious structural reform agenda can help establish sustainable long-run growth following the pandemic.

uA001fig12

FDI Inflows

(% of GDP)

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Source: UNCTAD.
  • Business/Investment Climate. Despite significant potential for growth, the cost of doing business remains high. Reforms to improve the business climate could focus on reducing the cost of land, strengthening the framework for insolvency and bankruptcy, improving logistics and reducing transportation costs, as well as strengthening anti-corruption efforts. Full implementation and enforcement of the Competition Act, higher public investment, creating a conducive environment for private investment, and strengthening the regulatory framework would help boost competition and growth.

  • Foreign Direct Investment (FDI). Nepal has the lowest level of FDI as a proportion of GDP in the region. Taking a positive step forward, regulations to implement the Foreign Investment and Technology Transfer Act were completed in January 2021. More recently, the authorities removed a minimum limit required for foreign investment for non-resident Nepalis and lowered the limit for foreign investors. Removing other barriers including burdensome regulatory approval procedures and restrictions on foreign investment in sectors including agriculture, tourism and consultancy services as well as gradually reducing capital controls would help increase investment.

  • Remittances. To boost domestic investment and address AML/CFT concerns related to informal means of money transfer, the authorities have incentivized sending remittances via the formal financial system, including use of mandatory bank accounts, migrant bond and deposit schemes, and by allowing cross-border digital transactions and mobile banking for smaller transactions. Further reforms could include developing financial instruments tailored to migrant workers, strengthening the AML/CFT framework (including risk-based supervision of financial institutions), better access to finance, and efforts to improve digital and financial literacy.

  • Governance. Recent positive governance reforms include commissioning an external audit of the NRB by a reputable audit firm with international experience (¶29) and improving fiscal transparency and procurement (¶17-20). Future reforms could include a greater use of digital public services, single window systems, and strengthening anti-corruption institutions. The SGA (2021) recommends strengthening NRB independence, mandates, transparency and accountability, and the oversight role of the NRB Board, addressed in the amendments to the NRB Act (¶29).

uA001fig13

Governance Indicators

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

36. Nepal is vulnerable to the impact of climate change, climate shocks and natural disasters, which can hamper poverty reduction and exacerbate food insecurity. Average annual temperatures have risen, rainfall has become increasingly unpredictable, and the frequency and cost of climate-related shocks is on the rise (Figure 1). Households rely on remittances, access to imports, and drawing down savings to cope.11 However, shocks have persistent effects on poverty and food security and disproportionately harm vulnerable households, including those not able to access finance, living in remote areas, and unable to migrate (Selected Issues Paper: Climate Change, Food Insecurity and Remittances in Nepal). The government plays a large role in the agricultural sector, including through fertilizer subsidies, a minimum support price and a government monopoly on fertilizer imports and distribution which can create shortfalls. Economic policy can focus on:

  • Better-targeted social assistance (e.g. through the child grant scheme).

  • Boosting agricultural productivity through adoption of modern farming practices and efficient allocation of fertilizers, including by removing restrictions on private sector provision of agricultural inputs.12

  • Climate-resilient infrastructure to facilitate trade and migration.

  • Diversifying the domestic economy to rely less on remittances and agriculture.

37. Despite relatively low carbon emissions, pollution from industry and transportation harms health outcomes and lowers productivity. Although overall emissions are relatively low and most electricity is produced via hydropower, Nepal’s mountainous geography worsens pollution outcomes. Pollution damages health outcomes, lowers productivity, and could affect tourism and FDI. Encouraging the use of electric vehicles and restrictions on waste burning, brick kilns and construction sites could lower impacts. As a fossil fuel importer with a high share of renewables in total energy production and consumption, Nepal is not directly vulnerable to a global transition to a low carbon economy. However, fewer employment opportunities in the GCC countries during the transition could significantly lower remittances, contributing to poverty and food insecurity.

The authorities concurred that structural reforms will be needed to foster sustainable, inclusive and green medium-term growth. The authorities emphasized new strategies, including the Trade Logistics Policy and forthcoming Trade Policy and Nepal Trade Integration Strategy, and argued that Nepal’s trade openness has helped address competition issues. The authorities highlighted business-climate reforms including removing the threshold on foreign investment, increased use of digital platforms and a one-stop center for investment-related business services, but acknowledged that their full benefits will take time to be realized. The authorities are making efforts to improve migrants’ financial and digital literacy and to encourage greater use of formal remittance channels. The authorities acknowledged Nepal’s climate vulnerability and stressed the need for comprehensive reforms, including on agriculture and food security, outlined in the National Adaptation Plan. To address food insecurity and poverty, the authorities highlighted broad-based grants, subsidies, and concessional loans to farmers and social support to vulnerable groups. They plan to improve social assistance targeting through an integrated social registry and making use of survey information.

Figure 1.
Figure 1.

Nepal: Climate Change and Pollution in Nepal

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Financing and Program Modalities

38. The authorities have requested a 10-month extension of the ECF arrangement with unchanged total access. To accommodate the delays in program implementation and to provide additional time for the government to design and implement reforms under the ECF-supported program, the authorities are requesting an extension of the current arrangement until January 11, 2026.

39. Given the program extension, a rephasing, as well as modifications and waivers to program conditionality are proposed:

  • Waivers for nonobservance of the standard continuous PCs on exchange restrictions, MCPs, and import restrictions are requested.

  • Rephasing the program with new test dates starting from July 16, 2023 and availability in November 2023, with semi-annual reviews. Starting with the amount of SDR 39.20 million originally envisaged for disbursement at the second review, the original profile of disbursements is proposed to shift out by one review, with the addition of one final review (Table 8). The present combined first and second review would therefore entail a disbursement of amount of SDR 39.20 million originally envisaged for the first review.

  • Establishment of new quantitative PCs and ITs for all relevant indicators through January 14, 2024 test date (Table 9). The primary deficit, currently an IT, is proposed as a quantitative PC from the January 14, 2024 test date onwards. The revised quantitative PC targets on net international reserves reflect the revised and uncertain global outlook, including to account for significant oil price volatility (Annex 1).

  • Resetting and modifying some pending SBs, to allow for time to implement reforms, and introducing new SBs (Table 11).

  • Modification of the primary deficit target and adjustors. Longer than expected lags in collecting data on grants and foreign-financed project loans pose a misreporting risk going forward. To mitigate this risk, grants, which are a relatively small share of financing, have been removed from the definition of the primary balance from the July 16, 2023 test date onwards. In addition, the adjustors to the primary deficit target are proposed to be modified by (1) making the adjustor for foreign-financed project loans symmetric from the January 14, 2024 test date onwards and (2) as the major uncertainty from exogeneous shocks diminishes, by narrowing the symmetric revenue adjustor.

40. Capacity to repay remains adequate. IMF credit outstanding is projected to peak at 262.3 percent of quota in FY2024/25 (SDR 411.6 million), within the cumulative normal access limit. This amount corresponds to 16.2 percent of exports and 1.2 percent of GDP (Table 10). The authorities’ track record of servicing IMF debt is strong.

41. 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. Pledges of budget support financing for FY2022/23 through FY2024/25 are above the level recorded at the ECF approval stage, narrowing the near-term balance of payment need and supporting the proposed program extension and rephasing of disbursements. The World Bank expects to provide an additional USD 80 million, while the planned budget support by the ADB has been largely unchanged (text table and Table 5). The slow execution of capital spending has reduced actual disbursements of programmed project financing, and other inflows, including FDI, have been small in FY2022/23. Additional concessional financing would reduce the need for domestic financing, which may be particularly constrained by higher domestic interest rates, and help authorities replenish reserves. The authorities intend to use ECF financing for budget support. The limited available external financing and continued need for budget support suggest the overall access level remains appropriate under the proposed phasing of the program.

Projected Financing Gap (in percent of GDP)

article image
Sources: Nepali authorities; and IMF staff estimates.

Current account excludes official transfers.

Note: Current baseline forecast is as of March 07, 2022.

42. The program continues to face important external and financial risks. A large commodity price shock would require monetary policy tightening if the shock is not expected to be short-lived. Fiscal restraint, following the guardrails provided by the program, would help preserve macro stability. Should external concessional financing fall short of expectation, further reduction of low priority expenditures would be needed. Likewise, a significant reduction in remittances related to disruptions in external labor markets could lead to an inter-linked decline in growth, reserves and revenues. The program includes some flexibility through adjustors on program targets. Nonetheless, a large remittance and/or a large natural disaster decline would require greater external support from development partners to help replace lost income among vulnerable populations without risking unsustainable fiscal outcomes. The NRB has been maintaining tight macro-prudential measures and developing liquidity facilities to stave off potential problems, but an episode of elevated bank stress due to rising NPLs could raise solvency problems. The NRB stands ready to provide liquidity support to prevent wider systemic concerns. Such a scenario may require government intervention with significant fiscal implications, but intervention should ensure that investors bear the burden of costs appropriately.

Staff Appraisal

43. Global shocks have impacted Nepal’s import-dependent economy through higher commodity prices. Following a strong post-pandemic recovery, the current account weakened, and reserves declined in the first half of 2022. Pressure on reserves has since subsided, thanks in part to monetary policy tightening, strong remittances and cooling domestic demand. However, inflation remains elevated. Risks are on the downside. Reform progress has continued in a difficult environment, albeit at a slower than expected pace.

44. Fiscal policies should focus on addressing near-term fiscal pressures, while protecting high-quality infrastructure and social spending. In response to lower-than-expected revenue collection and to maintain fiscal discipline in line with program objectives, the government has announced expenditure rationalization focused on administrative spending and fiscal transfers to subnational governments. Fiscal consolidation and further structural reforms, including to advance tax reforms, strengthen the fiscal federalism framework, address fiscal risks and strengthen public investment management, are needed to support medium-term fiscal sustainability. Maintaining momentum on governance reforms is critical to cementing recent gains in fiscal transparency.

45. Monetary policy should take a cautious, data-driven approach to maintain external stability and address elevated inflation. The much-needed monetary policy tightening by the NRB last year helped stabilize the external position and is contributing to lower inflation. Looking forward, a cautious and data-driven monetary policy stance supported by macroprudential measures will help avoid large boom-bust credit cycles, which can create financial sector instability and are not supportive of sustainable growth.

46. The NRB should prioritize bank asset quality, including through regulatory initiatives to ensure appropriate classification of loans. Capital adequacy ratios remain above regulatory minima, but non-performing loans are increasing. Progress towards advancing the financial sector reform strategy and improving the autonomy and accountability framework of the NRB should continue. Advancing digitalization can play an important role in improving financial inclusion. Strengthening ongoing efforts to improve the anti-money laundering/combatting the financing of terrorism (AML/CFT) framework and its effectiveness remain crucial.

47. An ambitious structural reform agenda is needed to achieve sustainable long-run growth following the pandemic. Sustainable growth will require fiscal reforms in line with debt sustainability, advancing reforms on banking regulations and supervision, reducing the cost of doing business, lowering barriers to FDI and enhancing governance and anti-corruption efforts. Nepal is vulnerable to climate shocks and natural disasters, which can hamper poverty reduction and exacerbate food insecurity. Policies can focus on better-targeted social assistance, boosting agricultural productivity and climate-resilient infrastructure to facilitate trade and migration and diversify the domestic economy.

48. Staff recommends completion of the first and second reviews of the ECF and supports the authorities request for extension of the arrangement and rephasing of disbursements. Staff supports the request for waivers of nonobservance of performance criteria as the deviations were temporary and corrective action was taken through removal of the measures.

49. Staff recommends that the next Article IV consultation for Nepal be held on the 24-month cycle in accordance with the Executive Board decision on consultation cycles for members with Fund arrangements.

Figure 2.
Figure 2.

Nepal: Recent Macro-Economic Developments

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Figure 3.
Figure 3.

Nepal: Recent Monetary Sector Developments

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Figure 4.
Figure 4.

Nepal: External Sector Developments

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Figure 5.
Figure 5.

Nepal: Recent Fiscal Developments

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Figure 6.
Figure 6.

Nepal: Socio-Economic Indicators

Citation: IMF Staff Country Reports 2023, 158; 10.5089/9798400241222.002.A001

Table 1.

Nepal: Selected Economic Indicators 2019/20-2027/28 1/

article image
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 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 Note: Current baseline forecast is as of March 07, 2023.

Table 2.

Nepal: Summary of Central Government Operations 2019/20-2027/28 1/

article image
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 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.

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

Note: Current baseline forecast is as of March 07, 2023. FY2022/23 budget is as of May 29, 2022.
Table 3.

Nepal: Monetary Indicators 2019/20-2023/24 1/

article image
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 March 07, 2023.
Table 4.

Nepal: Balance of Payments 2019/20-2027/28 1/

article image
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.

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

Note: Current baseline forecast is as of March 07, 2023.