Public Information Notice No. 01/97

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Nepal

September 21, 2001

On August 31, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Nepal.¹

Background

During the past decade, Nepal has grappled with daunting economic and social challenges. Poverty remains widespread, with nine out of every ten Nepalese living in rural areas and depending on subsistence farming. Nepal's primary goal has been to achieve and sustain higher levels of growth in order to improve conditions for the poor. However, growth has been impeded by weak infrastructure, low saving and investment rates, fiscal constraints and inefficient public resource management.

Nevertheless, the macroeconomic performance of the Nepalese economy has been satisfactory during the past two years. Overall real GDP growth (at market prices) surged from 4½ percent in 1998/99 (fiscal year ending July 15) to 6½ percent in 1999/2000, led by improved agricultural performance and strong exports. Growth is estimated to have eased to 5½ percent in 2000/01, owing to the dampening effects of higher oil prices and a marked decline in tourism due to domestic disturbances. Consumer price inflation fell to under 1 percent in the 12 months to mid-2000 and remained below 4 percent during the following year, with abundant food supplies offsetting the effects of higher energy prices.

The external position was generally favorable in 1999/2000 and 2000/01, with the current account close to balance and a steady increase in reserves. The current account (excluding grants) registered a small surplus of ½ percent of GDP in both years as strong growth in remittances compensated for the deterioration of the trade deficit. The overall balance remained strong despite declines in capital transfers and foreign direct investment (FDI). Aided by strong exports and increased remittances, gross official reserves reached $946 million in 1999/2000 and $1,014 million in 2000/01, equivalent to five months of imports in both years.

Recent monetary developments were in line with the authorities' target. The growth rate of broad money decelerated to 15 percent in the 12 months to July 2001 after approaching 22 percent in 1999/2000. Private sector credit increased by 20 percent during 1999/2000 and by about 17 percent in the 12 months to July 2001, owing to the strength of the economy. Nominal interest rates declined during the past two years, with the yield on treasury bills falling to 5 percent. The spread between lending and deposit rates remained high at 5 percent, reflecting weaknesses in the banking system.

Fiscal performance was generally favorable. The overall deficit (before grants) declined to 4¾ percent of GDP in 1999/2000. The fiscal position improved in 1999/2000 as the ambitious revenue targets were nearly achieved and current expenditures were contained. However, the overall deficit widened to 6¾ percent of GDP in 2000/01, owing to a significant overrun in the current expenditure budget, even though domestic revenue remained close to the budget target. With lower-than-anticipated disbursement of foreign grants and concessional loans, net domestic financing rose from ½ percent of GDP in 1999/2000 to 2 percent of GDP in 2000/01.

Progress in the area of structural reform was limited. The financial performance of public sector enterprises continued to be disappointing, with virtually no progress on the privatization of public sector entities. Although the government formulated and published its financial sector strategy, developments in the financial sector were overshadowed by uncertainties surrounding two large ailing banks. Similarly, while notable progress was achieved in improving the timeliness and coverage of fiscal accounts, the budget formulation process remained weak. Nonetheless, steps were taken to initiate civil service reforms and develop a comprehensive poverty reduction strategy.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They observed that macroeconomic developments in Nepal during the past two years have been broadly satisfactory, despite difficult political circumstances. Growth was accelerating, inflation was declining, and international reserves remained at a comfortable level. Directors agreed that the primary challenge facing the authorities will be to achieve strong growth on a sustainable basis to reduce the continued high level of poverty. This will require comprehensive structural reform and substantial foreign aid, together with political stability and internal security.

Directors welcomed the authorities' adoption of a reform agenda, which focuses on maintaining macroeconomic stability and removing structural impediments to growth. These impediments include inadequate provision of public services, an ineffective and segmented financial sector, and weak governance. Directors looked forward to seeing this agenda addressed in the forthcoming Interim PRSP and PRGF program.

Directors welcomed the emphasis of the 2001/02 budget on revenue improvements and high priority development spending, but emphasized that achievement of the budget targets and the planned increase in public savings will likely require efforts additional to those included in the budget. Noting last year's shortfalls in revenue collection, they cautioned that the planned improvements in tax auditing might be insufficient to attain the targeted revenue levels. Directors also urged the authorities to take steps to ensure that possible overruns in some spending categories are offset by savings in other items, while safeguarding priority social sectors. They noted that tighter control over project implementation will be necessary to achieve the desired increase in the level and effectiveness of environmentally sustainable capital spending.

Over the medium term, Directors encouraged the authorities to strengthen revenue mobilization and improve the targeting of budget allocations so as to allow for higher social spending. They also underscored the importance of incorporating in budget targets in future years the fiscal cost of bank restructuring. They noted that mechanisms are needed to ensure full reporting of the Poverty Alleviation Fund, off-budget revenue, and foreign aid.

Directors urged the authorities to continue the process of streamlining the civil service and prioritizing public expenditures. The ongoing review of the pension system was welcomed, but Directors noted that further efforts will be needed to improve expenditure control of state and local governments and strengthen wage discipline in the public sector. They also recommended that the authorities step up the divestiture of small institutions and tackle the growing problems of inefficient and loss-making enterprises, in order to reduce the burden on the budget.

Directors agreed that the exchange rate peg to the Indian rupee remains broadly appropriate. They supported Nepal Rastra Bank in its focus on maintaining monetary conditions that are consistent with the pegged exchange rate. Directors encouraged the authorities to take steps to improve the liquidity of official reserves; and to lower excess liquidity in the banking system and contain central bank financing of the budget.

Directors encouraged the authorities to maintain an open trade and investment regime and access to world markets.

Directors highlighted the urgency of addressing the balance sheet problems of the two largest banks. They looked forward to the installation of new management teams in these banks as soon as possible, noting that their recapitalization would need to be preceded by proper restructuring under the new management. Directors also welcomed the proposed bank legislation which will increase the independence of the central bank, strengthen its regulatory and oversight activities, and introduce proper accounting, auditing, and disclosure practices.

There are significant weaknesses in official statistics that impair effective monitoring of the economy and policy formulation. Directors encouraged the authorities to implement the recommendations of the Fund's multi-sector statistics mission and improve the macroeconomic database by strengthening statistical legislation and institutional capacity.