Nepal: Fourth Review Under the Extended Credit Facility Arrangement—Debt Sustainability Analysis
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NEPAL

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NEPAL

FOURTH REVIEW UNDER THE EXTENDED CREDIT FACILITY ARRANGEMENT—DEBT SUSTAINABILITY ANALYSIS

June, 21 2024

Approved By

Rupa Duttagupta and Fabian Valencia (IMF) and Manuela Francisco and Mathew Verghis (IDA)

Prepared by the staffs of the International Monetary Fund and the International Development Association.

Joint Bank-Fund Debt Sustainability Analysis

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Both external and overall public debts In Nepal are assessed at low risk of debt distress, unchanged from the last year's Debt Sustainability Analysis (DSA).1 Present value (PV) of external debt-to-exports ratio and external debt service-to-exports ratio breach the indicative thresholds under an export shock scenario, suggesting a mechanical rating of moderate risk of debt distress. Still, similar to last year's DSA, staff has applied judgement to override the mechanical signal due to Nepal's exceptionally high level of remittances, making the high debt-to-exports ratio a less relevant signal of debt distress in Nepal compared to most other countries. At over three times the exports, remittances are the major source of foreign exchange earnings in Nepal, which along with concessional external financing, help the country maintain an adequate level of reserves and meet its debt obligations despite a sizeable trade deficit. All other external and public debt risk indicators are below their respective indicative thresholds in all stress-tests. Public debt stood at 47 percent of GDP in FY2022/23: in line with the projection in last year's DSA despite much slower GDP growth and a sharp drop in revenue. The better-than-expected result is due to a favorable valuation effect in external debt, lower net acquisition of financial assets, as well as fiscal consolidation efforts by the authorities. Despite continuing macroeconomic headwinds, debt is projected to peak at 50 percent of GDP in FY2025/26 and to gradually subside afterwards. The assessment, however, is contingent upon continued fiscal consolidation effort by the authorities (as envisaged in the ECF-supported program as well as in the FY2023/24 mid-year budget review)—including tax revenue and spending reforms— and continued utilization of external borrowing at concessional terms. Nepal also needs structural reforms to diversify exports, improve productivity and competitiveness, and enhance resilience to shocks, in particular natural disasters.

Public Debt Coverage

1. Public debt in this DSA comprises debt from the general government, central bank (borrowing on behalf of the government) and government guarantees (Text Table 1). Nepal's provincial and local governments have no debt. Their borrowing is permitted by the Public Debt Management Act of 2022 but has not yet commenced, apart from on-lending by the central government. The social security fund and other extra budgetary funds currently are not allowed to borrow, and thus do not have debt either. IMF disbursements in 2020-2023 were used for direct budget support, and bond issuances by the central bank were only for the purpose of monetary policy operations. The government has provided guarantees for the debts of State-Owned-Enterprises (SOEs), and the current stock of guarantees—totaling NPR 46 billion (0.9 percent of GDP)—is included in the debt stock.2 The majority of the medium- and long-term SOE loans are from the central government, and thus are already covered under central government debt. SOE liabilities not covered by public debt are part of the contingent liability stress test.

2. Public debt is defined in the LIC DSF to include the negative balance of the T reasury Single Account (TSA).3 According to the Government Finance Statistics Manual and Public Sector Debt Statistics Guide, the negative cash balance of the TSA should be considered as government gross debt. The TSA receives central government revenue inflows and pays expenditure outflows. However, extra-budgetary funds, provincial, and local governments are not integrated into the TSA system, thus complicating cash management and reducing transparency. The net balance across all government accounts is positive— standing at about 5 percent of GDP in Q3 of FY2023/24. But other cash balances cannot be used to offset the negative cash balance of the TSA for the purposes of measuring gross debt in the LIC DSF, in part because it is not always clear how liquid these financial assets are and whether they can be used for servicing debt.4 The negative TSA balance stood at 3.4 percent of GDP in FY2022/23, sharply up from 1.2 percent of GDP in FY2021/22, reflecting the authorities' efforts to reduce borrowing in the domestic bond market amid high interest rates and binding domestic borrowing limit. The increase in the negative TSA balance indicates elevated debt pressures in FY2022/23, which would have been harder to identify had the TSA balance not been included in the LIC DSF public debt definition.5

Text Table 1.

Nepal: Public Debt Coverage

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3. The contingent liability stress test is based on the default setting and includes contingent liabilities stemming from SOE debt (2 percent of GDP), PPP projects (2.1 percent of GDP) and financial market (5 percent of GDP). PPP projects have not been formally compiled by the government. According to the PPI database of the World Bank, Nepal's PPP contracts are estimated to account for 6 percent of GDP as of 2022. Already incorporated in the baseline debt figures is the Net Acquisition of Financial Assets (NAFA), which represents mostly loans and capital injections to SOEs from the government. The NAFA has averaged 1.4 percent of GDP annually since 2009, but dropped sharply to -0.9 percent of GDP in FY2022/23 as part of government consolidation efforts. The program baseline assumes NAFA to pick up and remain close to its long-term average in the foreseeable future. The stress test on contingent liabilities from SOE debt is thus in addition to the NAFA assumed in the baseline. The standard default risk of 2 percent of GDP is appropriate at this stage, as it covers about a fifth of total financial liabilities in all non-financial SOEs and all of the financial liabilities in Nepal Airlines Corporation, which is the highest risk at present, still running losses despite the post-pandemic tourism rebound.6 Nevertheless, SOE risks remain high and need to be carefully monitored. This should be aided in part by timely publication and audit of SOE financial statements, as envisaged in the ECF program (end-August 2024 SB) and expanding the fiscal risk registry to include subnational governments and PPPs and publication of a comprehensive fiscal risk statement with the FY2025/26 budget (end-August 2025 SB). Likewise, given that Nepal's banks are adequately capitalized at the moment, the standard financial market default risk of 5 percent of GDP remains appropriate. However, Nepal's financial sector, including savings and cooperative organizations (SACCOs), is showing signs of stress—as manifested by the growing share of non-performing loans, lower capitalization, and stagnant private sector credit growth—and should be monitored (SR 112). The upcoming loan portfolio review (LPR) in the ten largest banks by the NRB is an important step in the right direction (SR H15). Once ready, its results will be used to calibrate the financial market default risk value.7

4. Public debt management practices are steadily improving, but space for progress remains. The Public Debt Management Act (PDMA), enacted in October 2022, consolidates debt management functions in the Public Debt Management Office (PDMO). The act also sets the limit on external public debt at one third of past fiscal year's GDP. As per the act, the PDMO took over the domestic debt issuance functions from the Nepal Rastra Bank (NRB) in April 2024, and made significant progress towards dematerializing debt securities. The transition process so far has been smooth and efficient. The Debt Management Committee, which decides on the debt issuance calendar and other matters, is now chaired by the Revenue Secretary, thereby seeking to separate domestic debt management—previously conducted within the NRB—from monetary policy operations. The Medium-Term Debt Strategy (MTDS) has now been published at the PDMO's website, with the intention to update it annually and use it as an input in the budget process. In August 2023, the Ministry of Finance implemented a fiscal risk register to identify, disclose, and manage fiscal risks, including those emanating from SOEs and guarantees. Despite the good progress, further strengthening fiscal risk and public debt management remains critical. Resource constraints and frequent rotation of the staff at the PDMO slow down the implementation of the PDMA. The middle- and back-office functions could be improved too, including though mainstreaming cash flow forecasting, integrating it with debt management and anchoring annual borrowing and issuance plans on the MTDS and market considerations.

Background On Debt

5. Nepal's total public debt has been on an increasing trajectory (Text Figure 1). Public debt began to rise in 2016 amid the country's transition to fiscal federalism and the need to rebuild after the earthquake of 2015. It jumped up further in FY2019/20 during the pandemic and continued to climb up as the post-pandemic recovery in credit and imports turned into a bust, slowing GDP growth and denting tax revenue. As a result, debt has almost doubled from 25 percent of GDP in FY2015/16 to 47 percent in FY2022/23.

6. External public debt is highly concessional, but has not increased much since the pandemic. Multilateral creditors, such as the World Bank's International Development Association (IDA) and the Asian Development Bank (ADB) represent most of Nepal's external debt (87 percent of the total external debt) (Text Table 2). Their loans have low interest rates (1 percent on average) and long maturities (around 36 years on average). The present value (PV) of external debt is estimated at 14.5 percent of GDP in FY2022/23, reflecting a high degree of concessionality. Bilateral loans—with the largest creditors being Japan, India, China, and Korea—have been concessional too. Nevertheless, external debt-to-GDP ratio has been nearly constant since the pandemic, largely reflecting political and capacity constraints in the government to implement externally financed capital projects.

Text Table 2.

Nepal: Decomposition of Public Debt and Debt Service by Creditor, 2023-25

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1/ As reported by country authorities according to their classification of creditors, including by official and commercial. Debt coverage is the same as the DSA. Debt levels in this table may differ from those in other tables as the calculations here are based on US$. A year indicates the end of the corresponsing fiscal year, e.g. 2023 stands for FY2022/23 2/ Multilateral creditors" are simply institutions with more than one official shareholder and may not necessarily align with creditor classification under other IMF policies (e.g. Lending Into Arrears) 3/ Loans here refer to the negative Treasury Single Account (TSA) balance and SOE debt guarantees 4/ Debt is collateralized when the creditor has rights over an asset or revenue stream that would allow it, if the borrower defaults on its payment obligations, to rely on the asset or revenue stream to secure repayment of the debt Collateralization entails a borrower granting liens over specific existing assets or future receivables to a lender as security against repayment of the loan. Collateral is "unrelated" when it has no relationship to a project financed by the loan. An example would be borrowing to finance the budget deficit, collateralized by oil revenue receipts. See the joint IMF-World Bank note for the G20 "Collateralized Transactions: Key Considerations for Public Lenders and Borrowers" for a discussion of issues raised by collateral. 5/ Includes other one-off guarantees not included in publicly guaranteed debt (e.g. credit lines) and other explicit contingent liabilities not elsewhere classified (e.g. potential legal claims, payments resulting from PPP arrangements).

7. Domestic public debt has been increasing faster than external debt in recent years. Domestic public debt rose from 10.1 percent of GDP in FY2015/16 to 25 percent in FY2022/23—much faster than external debt. About one-third of domestic debt is in short-term treasury bills with a maturity of up to 1 year, and close to sixty percent of domestic debt is in medium- to long-term development bonds with maturities of 3-7 years (Text Table 2). The debt is held mainly by domestic financial institutions. As all domestic public debt is held by residents, it is unlikely that there would be a material difference between currency- and residency-based measures of external debt. The interest rates on domestic borrowing are subject to significant volatility. Reflecting an uptick in inflation and consequent monetary policy tightening, the rates increased by over 6 percentage points in FY2021/22. Over 85 percent of total government interest spending in FY2022/23 (1.3 percent of GDP) was to pay interest on domestic debt. Interest rates have since gone down to 3-4 percent (depending on the debt instrument)—in line with the interbank rate and much lower than policy rates.

8. The stock of private external debt in Nepal is relatively low, but has been on the rise lately. While the government and the NRB are encouraging commercial banks to access external loans, bank external borrowing has been constrained by limited access, high relative cost, and regulations by authorities, such as a maximum spread limit on banks' foreign loans and limits on the set of potential lenders. Apart from trade credit, the external debt by banks and other sectors in FY2019/20 was relatively low at about 0.5 percent of GDP, but the external borrowing picked up in 2021-23, with the debt reaching estimated 2.2 percent of GDP in FY2022/23, driven by the NRB's monetary policy tightening and increased cost of funding in Nepal versus the rest of the world. Reflecting this recent trend, private medium-and long-term external debt is assumed to increase to 3 percent of GDP in the long term, with the total private external debt (including trade credit) reaching 4.5 percent of GDP. Most of the private external borrowing so far has been by banks and hydropower projects, which is likely well-covered in the standard contingent liabilities stress test for financial market and PPPs. The dynamics of the private external debt may change and has to be monitored, as the authorities have been signaling their increasing openness to foreign capital inflows, in part by engaging with international credit agencies to issue the country's first sovereign credit risk rating.

Background On Macro Forecasts

9. Nepal’s post-pandemic rebound came to a halt in FY2022/23, and the country is facing significant structural challenges. Both real GDP growth, credit growth, and imports declined considerably in FY2022/23 after a post-pandemic credit boom, on the back of import restrictions, and monetary and financial sector tightening, which the government introduced to stem inflation, contain financial sector risks, and halt falling international reserves.8 Growth was also hit by a post-pandemic rebound in emigration and under-execution of capital spending. External pressure subsided and reversed as a result of falling imports and buoyant remittances. The recovery will likely be subdued in FY2023/24, as credit growth remains low, capital spending is weaker-than-planned, and imports continue to contract, albeit at a slower pace. Going forward, the economy is helped by buoyant tourism and energy sectors, but at the same time the present macroeconomic challenges are being compounded by Nepal's structural constraints, such as low domestic job creation, vulnerability to natural disasters—including those caused by climate change and environmental degradation—and large infrastructure gaps.

10. Growth and inflation. The latest estimates suggest that the economy grew considerably slower in FY2022/23 than anticipated a year ago—at 2.0 percent versus 4.4 percent as was projected in the last DSA (Text Table 3). Inflation increased to 7.8 percent in FY2022/23 in the aftermath of FY2021/22's booming domestic demand combined with the global surge in commodity prices. It is projected to subside to 5.6 percent in FY2023/24 and then converge to around 5.4 percent in the medium and long term—largely in line with the last DSA's projections—helped by cautious data-driven monetary policy by the NRB and favorable price developments abroad, particularly in India. Real GDP growth is projected to pick up in FY2023/24 but remain subdued at 3.1 percent amid weak credit growth, low capital spending, and fragile import recovery.9

11. Medium and long-term growth drivers. Growth is projected to gradually revert to around 5 percent over the medium to long-term. The growth forecast is contingent upon Nepal's steady progress on structural reforms, including those envisaged by the ECF, as well as adequate take-up of concessional external financing to boost the level of high quality social and capital spending. Growth will be driven by tourism-related service activities with the ongoing construction of over 20 new five-star hotels, adding to the existing 16. The NRB's increase in the loan-to-value ratio for real estate loans and a higher lending ceiling (NPR 20 million) for first-time homebuyers may provide some support to real estate prices. The industrial sector is also expected to contribute to growth in the medium term, fueled by a significant expansion of hydropower production and exports. This increased and more reliable power supply will create a more favorable environment, as businesses will have better access to electricity to operate, expand, and increase productivity. In addition, the National Project Bank's integrated guidelines, issued in March 2023, as well as Public Investment Management Assessment action plan issued by the National Planning Commission in June 2024, are expected to streamline project development, selection, and prioritization, leading to better capital spending over the medium term. At the same time, with increased evidence of more severe climate change impacts, Nepal's medium and long-term growth forecast is revised slightly downwards compared to the last year's DSA. The forecast is contingent upon comprehensive and scaled-up climate action, building on policy successes such as community forestry and hydropower investments, as well as managing climate-smart urbanization, strengthening low-carbon, resilient connectivity, improving disaster risk management, and prioritizing and utilizing climate finance, including through Green, Resilient, and Inclusive Development (GRID) approach and action plan, adopted by the government of Nepal and 16 development partners in November 2023.10

Text Table 3.

Nepal: Selected Macroeconomic Assumptions 1/

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Note: MT (medium term) is the average over the next 5 years, and LT (long term) is the average over the following 6-19 years. Sources: Nepalese authorities; and IMF staff estimates 1/ Nepal's fiscal year starts in mid-July. For example, FY2022/23 runs from mid-July 2022 to mid-July 2023. 2/ Previous DSA refers to ECF Combined 1st and 2nd Review IMF CR 2023/158.

12. Fiscal: The primary deficit in FY2022/23 came in at 4.5 percent of GDP, sharply up from 2.2 percent in FY2021/22 and larger than projected in the last DSA. Slower growth and a sharp drop in imports deflated government revenue, resulting in a wider-than-expected deficit despite government efforts to consolidate spending. Despite the continued stagnation in revenue, the primary deficit is projected to shrink to 3 percent in FY2023/24—not far above the last DSA’s projection—amid sizeable spending cuts of about 3.5 percent of GDP announced by the government during the January 2024 mid-term budget review. Part of the cuts are to capital spending, weighing on the private sector and undermining economic recovery. The other part is mainly related to administrative spending, such as abolishing incentive allowances, additional time allowances, purchasing new vehicles and furniture, as well as restructuring and reducing vacancies in government agencies. Such consolidation efforts are likely to have minimal spillovers to the private sector in the short-term, and a negligeable, if not positive, effect on growth in the medium-term.

13. Fiscal developments over the medium-term: The deficit is projected to subside further over the medium term to 1.4 percent of GDP, consistent with the consolidation path set out in the ECF program framework (Text Figure 2). The improvements in fiscal balances are contingent upon continued revenue mobilization efforts by the government—guided by the Domestic Revenue Mobilization Strategy adopted by the authorities in June 2024—and less duplication of spending responsibilities across levels of government. Capital spending is projected to pick up over the medium term, in part helped by the public investment management action plan, prepared by the authorities in April 2024 in the context of the ECF program. The FY2024/25 budget, announced in May 2024, is broadly consistent with the projected consolidation path. It includes additional revenue measures such as green tax on petroleum products, higher taxes on vehicles, increased excise duties on alcohol and tobacco, and measures to improve tax compliance. More capital spending has been budgeted, but current spending will be contained, resulting in a projected further reduction of the primary deficit by about 0.5 percent of GDP from the FY2023/24 level.

14. Net acquisition of financial assets: The dynamics of the existing debt stock and the fiscal path suggest a debt-stabilizing primary deficit of around 3.2 percent of GDP, but the continuation of the sizeable NAFA implies a much lower level of about 1.9 percent. The authorities sharply reduced NAFA in FY2022/23 to reduce fiscal pressure, but the proposed fiscal path is expected to stabilize public debt assuming the NAFA remains broadly at historical average—consistent with the levels observed in the last few years (net of the changes in the TSA balance).

15. External sector: The current account (CA) deficit shrank from 12.7 percent in FY2021/22 to just 1.4 percent in FY2022/23 and is projected to reverse into a surplus in FY2023/24—reflecting a sharp drop in imports amid slowing economy coupled with continued post-pandemic recovery in remittances and tourism services. The CA is projected to revert back to a deficit of about 3.6 percent of GDP in the medium term as the economy recovers and pent-up demand for imports catches up. Exports as a share of GDP have performed better-than-projected in the previous DSA in FY2022/23 and (projected) in FY2023/24, despite an abrupt slowdown of palm and soybean oil re-export to India. The growth is mainly due to a stronger-than-expected recovery in tourism, which comprises over forty percent of total exports, and a healthy growth in exports of agricultural and industrial items, including cement and clinker and, notably, hydropower. Exports are expected to gradually reach around 7.7 percent of GDP in the medium-term, supported by further growth of the hydropower sector.11 Remittances are expected to decline as a percent of GDP—including because of growth underperformance in migrant-hosting countries, return migration, and fewer new workers traveling abroad— but will remain sizeable at about 21 percent of GDP over the medium term. International reserves are projected to reach 9.4 months of prospective imports in FY2023/24, and remain high in the medium term at 7-8 months of prospective imports.

16. Financing: External government financing decreased in 2021-23 both in nominal terms and as a share of GDP as the authorities increasingly relied on domestic borrowing and tapped the TSA. Nonetheless, concessional loans from development partners, mainly multilateral development banks, are expected to remain a key source of funding to cover the BOP and fiscal financing needs next year and in the medium term (Text Table 4). At the same time, reflecting upon the dynamics of the last few years, the size of external financing is now projected at about 1.4 percent of GDP in the medium term—lower than 1.9 percent of GDP as was projected in the last DSA. Domestic borrowing is now projected to cover about two thirds of fiscal financing needs over the medium and long term, while remaining a costlier and generally riskier alternative to external concessional funding. The interest rates on domestic borrowing are projected to pick up from presently low levels to reach about 5-6 percent over the medium-term—in line with the projected inflation and an assumption of less financial repression. The interest rate on newly issued external debt, as well as other elements of concessional financing such as maturity and grace periods, are projected to remain broadly unchanged. External borrowing is subject to exchange rate risk (low so far), but the borrowing terms are extremely favorable for Nepal especially compared to Frontier and Emerging Market economies attempting to access international bond markets. About a third of the newly-issued domestic debt is assumed to be short-term—in line with the recent trend and current government practices, and subject to a significant refinancing risk.

Text Table 4.

Nepal: External Borrowing Program, FY2023/24

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Sources: Nepalese authorities; and IMF staff estimates. 1/ Contracting and guaranteeing of new debt. The present value of debt is estimated using the terms of recent individual loans and applying the 5 percent program discount rate. 2/ Debt with a grant element that exceeds 35 percent. 3/ Debt with a positive grant element which is lower than the minimum grant element of 35 percent. 4/ Debt without a positive grant element.

17. Realism of the baseline is broadly corroborated by the realism checks and debt dynamics tools.

  • Unexpected changes in both public and external debt over the last five years are well within the 25-75 percent interquartile range of the distribution across all LICs.

  • The public debt-creating flows over the next five years are similar to the 5-year historical average. The contribution of future GDP growth is somewhat lower considering that the 5-year historical average includes the pandemic. The contribution of primary deficit is lower too, reflecting the authorities' commitment to stabilize debt over the medium-term, already demonstrated during the FY2023/24 mid-year budget review. The external debt-creating flows over the next five years show a much smaller contribution of the current account partly offset by the accumulation of reserves—in line with the dynamics of the last two years (Figure 3).

  • The projected 3-year fiscal adjustment is marginally above the 75th percentile across all LICs with Fund-supported programs since 1990. However, close to half of the adjustment is already visible 10 months into the fiscal year, and likely to materialize in FY2023/24.

  • The impact of the adjustment on economic growth is projected to be lower than implied by conventional assumptions about fiscal multipliers. Part of the projected fiscal adjustment reflects a reverse causality as economic recovery and a rebound in imports contribute to higher government revenue. Nevertheless, it is important to make sure that the projected fiscal consolidation is gradual and growth-friendly: focused on increasing revenue while protecting the most vulnerable and boosting public investment.

  • The implied projected impact of public investment on economic growth is more conservative than what has been likely the case historically (Figure 4). Should the capital spending turn out more targeted and efficient, as is the authorities' ambition, it would present an upside to the current DSA projections and reduce potential negative spillovers from fiscal consolidation to economic growth.

Country Classification and Determination of Scenario Stress Tests

18. Nepal’s debt carrying capacity is strong. A composite indicator (CI) is used to capture the different factors affecting a country's debt carrying capacity. The CI is a weighted average of the World Bank's Country Policy and Institutional Assessment (CPIA) score, the country's real GDP growth, remittances, foreign exchange reserves, and global growth. The calculation of the CI is based on 10-year averages of the variables, across 5 years of historical data and 5 years of projections. Nepal's CI score is calculated at 3.14, based on the October 2023 World Economic Outlook and the 2022 World Bank CPIA index, which lies in a range of a strong rating (Text Table 5).

19. Tailored stress tests: The LIC-DSF includes stress tests to assess the sensitivity of projected debt burden indicators to adverse changes in the baseline projections as well as to materialization of contingent liabilities. All stress tests were kept at their default settings. In addition, to reflect Nepal's vulnerability to natural disasters, such as the 2015 earthquake, a natural disaster shock was applied as one of the stress tests. A one-off shock of 10 percentage points of GDP to the debt-to-GDP ratio in the second year of the projection period (FY2024/25) is assumed, and real GDP growth and exports were lowered by 1.5 and 3.5 percentage points, respectively, in the year of the shock for the stress test.

Text Table 5.

Nepal: Debt Carrying Capacity and Thresholds

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External Debt Sustainability

20. All external debt indicators remain below their indicative thresholds under the baseline (Figure 1, Table 1, Table 3). External debt in FY2022/23 was significantly lower than projected in the last DSA despite worse-than-expected automatic dynamics (e.g. lower GDP growth). This can be attributed to two reasons. Firstly, a stronger US dollar in 2022, in particular vis-a-vis the SDR, played in Nepal's favor, as over three quarters of Nepal's external debt is nominated in SDR, and another ten percent is denominated in currencies other than US dollar or SDR. Secondly, external financing in FY2022/23 was lower-than projected. Lower reliance on external borrowing is projected to continue into the medium and long-term, and as a result PPG external debt is projected to decline gradually to about 18 percent of GDP by FY2033/34. Correspondingly, the PV of PPG external debt-to-GDP ratio—hovering at about 12-14 percent in the medium term—is well below its respective threshold of 55. The PV of PPG external debt-to-exports ratio is below the threshold too, though it is relatively high due to Nepal's very low exports-to-GDP ratio. Other indicators (debt service-to-exports ratio, and debt service-to-revenue ratio) are all below their respective thresholds.

21. External debt is most vulnerable to export shocks. The PV of PPG external debt-to-exports ratio and external debt service-to-export ratio breach the thresholds in an export shock stress test scenario.12 In the case of the external debt service-to-export ratio, the breach is marginal (close to 5 percent) and temporary, though not one-off (lasting 2 years, FY2025/26 and FY2026/27). The shock to exports is particularly large for Nepal as it is calibrated based on export volatility in the last ten years, a period that includes the earthquake in 2015 and the pandemic in 2020, both having had a devastating effect on the country's tourism sector. The calibration period also includes a one-off 46 percent spike in exports in FY2021/22 due to a massive increase in the palm oil re-export driven by a now-removed loophole in custom tariffs between Nepal, India, and Indonesia.13 In the case of the external debt service-to-exports ratio, the breach is a new adverse development compared to the last year's DSA. Because of a small denominator (exports), the indicator is highly sensitive to macroeconomic assumptions. It breaches the threshold primarily because of a larger implied volatility of exports in the export shock stress test compared to the last year's DSA, as well as because of the SDR's appreciation against the US dollar and hence larger-than-projected repayments on SDR-denominated debt compared to the last year's projection. Even though the breach is marginal, it needs to be monitored going forward. The other indicators are all below the respective thresholds even in their most extreme stress tests.

Overall Risk of Public Debt Distress

22. Under the baseline scenario, the PV of public debt-to-GDP ratio remains firmly below the 70 percent benchmark during the projection period (Figure 2, Table 2, Table 4). Public debt in FY2022/23 turned out lower than projected in the last DSA, despite slower GDP growth, a sharp drop in imports, and a reduced reliance on concessional external financing. Besides fiscal consolidation effort by the authorities, one factor which helped is the valuation effect due to a strong US dollar, which reduced the external debt-to-GDP ratio. Another factor is a sharp drop in NAFA as the authorities sought to reduce domestic borrowing amid high interest rates. Overall, the public debt has so far been lower-than-projected during the ECF program request in January 2022, but above the pre-pandemic projections and still rising (Text Figure 3). Gradual fiscal consolidation coupled with economic recovery is projected to stabilize public debt dynamics in the medium-term: the debt is projected to peak at around 50 percent of GDP in FY2025/26, and gradually subside after. The PV of the debt-to-GDP ratio is expected to increase from 40 to a peak of 43 percent of GDP—well below the 70 percent benchmark. At the same time, Nepal's debt service-to-revenue ratio is relatively high at over 50 percent because close to a third of domestic debt is short-term and the revenue-to-GDP ratio has recently fallen.

23. Public debt is most vulnerable to a growth shock. The growth shock is defined as a temporary shock to real GDP growth in the second and third year of the projection period and is set to either the 10-year historical average growth minus one standard deviation or projected growth minus one standard deviation, whichever is lower. The shock would raise the PV of debt-to-GDP ratio close to the threshold of 70 percent in the last year of the projection period, 2034. The PV of debt-to-revenue ratio and the debt service-to-revenue ratio also rise significantly under such a shock. However, none of the thresholds are breached. Like with exports, the shock to growth is calibrated to be particularly large for Nepal as the calibration period includes both the earthquake of 2015 and the pandemic. Under all other shock scenarios, the PV of debt-to-GDP ratio remains well below the indicative threshold.

Other Factors to Account For

24. Judgment is applied in interpreting the risk signal from stress tests on the PV of debt-to-exports and debt service-to-exports in light of the exceptionally high level of remittances and the resilience to shocks of all other debt burden metrics. Remittances are the major source of foreign exchange in the country (Text Figure 4). Nepal's remittance-to-GDP ratio (averaging 24 percent of GDP in 2018-2023) is the fourth largest in the world, and its remittance-to-exports ratio is by far the largest in the world (2018-22 averages), indicating an exceptionally high role of remittances in the economy. Remittances have also been less volatile than exports—with standard deviation of remittance growth being 7.4 percent versus 19.3 percent for export growth in the last 10 years—providing an important cushion in times of economic adversity.14 The high level of remittances is also a major contributor to Nepal's Composite Indicator and the country's strong rating of debt carrying capacity. However, the current level of remittances is well above 7 percent of GDP—the minimum that is needed, everything else equal, to maintain the strong rating. The exceptional role of remittances, combined with the fact that all other debt burden metrics remain below their sustainability thresholds, mitigates the risk signal from stress tests on the PV of debt-to-exports and debt service-to-exports. Nepal's low level of exports and their volatility is, however, a major vulnerability requiring committed policy attention. Boosting exports and reducing structural trade imbalances will become increasingly important over the medium and long-term as the role of remittances in the economy is projected to diminish.

Risk Ratings and Vulnerabilities

25. The risk of both public external debt distress and overall debt distress are assessed as low. All debt indicators remain below the relevant indicative thresholds under the baseline. The PV of public debt remains below the threshold under all stress tests. The PV of PPG external debt-to-exports ratio and external debt service-to-exports ratio breach the indicative thresholds under an export shock scenario, suggesting a mechanical rating of medium risk of debt distress. However, staff applied judgment to assess both external and public debt to be at low risk of debt distress given the exceptionally high level of remittances, the major source of foreign exchange, to balance the current account and service external debt. The fact that the PV of PPG external debt is 14.5 percent of GDP in FY2022/23, well below the indicative threshold of 55, is reassuring. In case of external debt service-to-exports ratio, the threshold breach is marginal and temporary. External debt is also below thresholds in baseline and shock scenarios across other metrics (PV of debt-to-GDP and external debt service-to-revenues), reflecting to a large extent the high level of concessionality of external borrowing and the low cost of debt servicing.15 Nepal's high and increasing international reserves, projected to remain well above the adequacy level in the medium and long term, also supports the assessment. Besides, the authorities have achieved a considerable fiscal consolidation despite challenging macroeconomic environment in FY2022/23 and (projected) FY2023/24, and kept the public debt broadly in line with the previous DSA's projection, thus demonstrating their commitment to fiscal prudence. At the same time, exports of goods and services in FY2022/23 and (projected) FY2023/24 grew faster than projected in the previous DSA, and there are good prospects for an upside going forward, especially in the hydropower sector. Nevertheless, uncertainty around the baseline projections, the calibration of the shocks, and the debt risk assessments is exceptionally high in light of the major global shocks that hit Nepal in the last couple of years, and in light of climate-related shocks that are bound to increase in size in the future at the same time as the role of remittances in the economy is projected to diminish.

26. While debt remains sustainable in the medium term, a number of steps could be taken to mitigate any potential risks. To build resilience to shocks and boost exports, the authorities should continue to make efforts to improve productivity and competitiveness through stepping up investment in resilient and sustainable infrastructure, as well as streamlining regulations and administrative processes, accompanied also by sustained stronger domestic revenue mobilization. It is also important to pursue rigorous analysis of the risks related to contingent liabilities, for example, related to non-guaranteed commercial SOE debt or unfunded pension liabilities, PPP projects, and budget support for the financial sector, including SACCOs. Improvements are needed in subnational governments' public financial management and reporting. The authorities will also need to make significant progress in mainstreaming the medium-term debt strategy (MTDS) and cash flow forecasting—developing the government bond market further to facilitate domestic borrowing and moving towards longer maturity debt replacing short-term bills. At the same time, the authorities need to boost their effort to utilize external borrowing at concessional terms, which is readily available and much-needed to close infrastructure gaps. Finally, the findings in this assessment are contingent upon prudent execution of medium-term fiscal consolidation strategy, including the tax revenue and spending reforms envisaged in the ECF arrangement.

Authorities’ Views

27. The authorities broadly agreed with the assessment. They reiterated their commitment to stabilizing debt over the medium term and pointed to the legislative limit on external debt set by the Public Debt Management Act (at 33 percent of the previous year's GDP), as well as to the annual limits on domestic borrowing set by the Natural Resource Commission as key anchors. They also pointed to Nepal's strong external position, which serves as a mitigating factor and strengthens the country's ability to serve its debt, but fully agreed with the need for policies to boost exports and reduce trade deficits. The authorities acknowledged the importance of utilizing concessional external borrowing, while noting the risk that its availability and conditions will worsen as Nepal graduates from Least Developed Country status, scheduled for 2026.

Table 1.

Nepal: External Debt Sustainability Framework, Baseline Scenario, 2021-2044

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Table 2.

Nepal: Public Sector Debt Sustainability Framework, Baseline Scenario, 2021-2044

(In percent of GDP, unless otherwise indicated)

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Figure 1.
Figure 1.

Nepal: Indicators of Public and Publicly Guaranteed External Debt Under Alternatives Scenarios, 2024-2034

Citation: IMF Staff Country Reports 2024, 225; 10.5089/9798400282331.002.A002

Sources: Country authorities; and staff estimates and projections. A year indicates the end of the corresponsing fiscal year, e.g. 2023 stands for FY2022/231/ The most extreme stress test is the test that yields the highest ratio in or before 2034. The stress test with a one-off breach is also presented (if any), while the one-off breach is deemed away for mechanical signals. When a stress test with a one-off breach happens to be the most exterme shock even after disregarding the one-off breach, only that stress test (with a one-off breach) would be presented.
Figure 2.
Figure 2.

Nepal: Indicators of Public Debt Under Alternatives Scenarios, 2024-2034

Citation: IMF Staff Country Reports 2024, 225; 10.5089/9798400282331.002.A002

Sources: Country authorities; and statt estimates and projections. A year indicates the end of the corresponsmg fiscal year, e.g. 2023 stands for FY2022/231/ The most extreme stress test is the test that yields the highest ratio in or before 2034. The stress test with a one-off breach is also presented (if any), while the one-off breach is deemed away for mechanical signals. When a stress test with a one-off breach happens to be the most exterme shock even after disregarding the one-off breach, only that stress test (with a one-off breach) would be presented.
Figure 3.
Figure 3.

Nepal: Drivers of Debt Dynamics-Baseline Scenario

Citation: IMF Staff Country Reports 2024, 225; 10.5089/9798400282331.002.A002

Figure 4.
Figure 4.

Nepal: Realism Tools

Citation: IMF Staff Country Reports 2024, 225; 10.5089/9798400282331.002.A002

Table 3.

Nepal: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2024-2034

(In percent)

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Sources: Country authorities; and staff estimates and projections. A year indicates the end of the corresponsing fiscal year, e.g. 2023 stands for FY2022/23 1/A bold value indicates a breach of the threshold. 2/ Variables include real GDP growth, GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt creating flows. 3/ Includes official and private transfers and FDI.
Table 4.

Nepal: Sensitivity Analysis for key Indicators of Public Debt, 2024-2034

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Sources: Country authorities; and staff estimates and projections. A year indicates the end of the corresponsing fiscal year, e.g. 2023 stands for FY2022/23 1/ A bold value indicates a breach of the benchmark. 2/ Variables include real GDP growth, GDP deflator and primary deficit in percent of GDP. 3/ Includes official and private transfers and FDI.
1

Nepal's debt carrying capacity remains strong, based on Nepal's composite indicator (CI) score. The CI is calculated at 3.14, based on the October 2023 World Economic Outlook (WEO) and the 2022 World Bank Country Policy and Institutional Assessment (CPIA) index.

2

The stock of guarantees increased by NPR 12 billion since the last DSA, as the interest due to be paid on the loan was amortized.

3

Negative TSA balance is not part of the public debt as reported by the authorities.

4

These cash balances can only be counted to reduce net debt.

5

The negative balance of government accounts at the NRB cannot exceed 5 percent of the previous year's government revenue. However, there is legal uncertainty as to whether the limit applies to the consolidated balance across all accounts or to the TSA only.

6

Other major SOEs, including Nepal Oil Corporation, were profitable in FY2022/23. For more details on SOE risks in Nepal, see the 2023 Selected Issues Paper on "Public Enterprises and Fiscal Risks".

7

The LPR may also shed some light on the spillovers to the banking sector from the SACCOs, where vulnerabilities are rising (SR A16). The focus of the LPR however is not on SACCO exposure, and banks have little information on whether they have provided loans to clients that also are exposed to SACCOs as the latter don't do any credit information reporting.

8

Nepal introduced restrictions to curb imports during the second half of FY2021/22, but these were subsequently lifted in end-December 2022.

9

The projection is more conservative but broadly in line with the estimate by National Statistics Office of 3.9 percent real GDP growth in FY2023/24.

10

More details on Nepal's climate policies and vulnerabilities in the World Bank's Country Climate and Development Report on Nepal (August 2022).

11

The projection of hydropower export is fairly conservative—assuming a quadrupling over the next 10 year from a relatively low base in FY2022/23. Exports of hydropower are projected to grow by 50 percent already in FY2023/24. Efforts are also ongoing for boosting the hydropower export further, with the recently signed agreement for exporting 10,000 MW to India in 10 years—about a ten-fold increase from the current levels. Should this ambition be realized, it would present a significant upside to the current DSA projections.

12

The PV of PPG external debt-to-GDP ratio also breaches the threshold in the combined shocks scenario, where the culprit is again the shock to exports.

13

The calibrated volatility of exports would decrease by one third if FY2021/22 is excluded from the calculation. The PPG external debt-to-exports ratio would still breach the indicative threshold, but the breach would be marginal and temporary (4 years).

14

Besides, Nepal's net errors and omissions have been consistently positive in the last decade and large (averaging over 2 percent of GDP in the last 5 years), indicating large unaccounted foreign exchange inflows into Nepalese economy, and thus contributing to large residuals in the external debt dynamics (Table 1). The positive errors and omissions could be due to informal exports, especially in the tourism sector, or due to informal (and possibly in-kind) remittances. The authorities are in the process of transitioning the BoP accounts to the BPM6 standard, helped by an IMF TA mission in June 2024. The new accounting rules should improve the official estimates and, everything else equal, reduce net errors and omissions, and possibly increase exports and/or remittances.

15

In reference to the LIC DSF guidance note, the use of staff judgement is based on the general provision to take into account country-specific factors that are not fully accounted for in the model.

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Nepal: Fourth Review Under the Extended Credit Facility Arrangement-Press Release; Staff Report; and Statement by the Executive Director for Nepal
Author:
International Monetary Fund. Asia and Pacific Dept