Public Information Notice No. 06/12

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Nepal

February 2, 2006

On January 18, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the 2005 Article IV consultation with Nepal.¹

Background

Growth has been affected by the political turmoil and conflict, although inflation has remained moderate and international reserves are adequate. Real GDP growth averaged 2 percent during 2000/01−2004/05, compared to the 1990s when growth in agricultural productivity and a significant trade liberalization contributed to average real GDP growth of 5 percent. Inflation has remained in the low single digits, although it rose to 7¾ percent in mid-October 2005 (12-month basis) due to weak agricultural performance following erratic weather conditions, a VAT rate increase in January 2005, and partial pass-through of higher international oil prices by Nepal Oil Corporation.

The overall and domestically financed deficits remained limited in 2004/05. The VAT rate was raised in the revised budget from 10 percent to 13 percent in early-2005, and helped raise revenue by ¾ percentage point of GDP to 13 percent of GDP. Even so, revenue fell short of the revised budget target due to weaker than projected growth and imports, continued excise leakages and delayed excise duty refunds from India. Current spending was lower than the revised budget: the higher civil service wages and allowances, and security-related expenditures were more than offset by lower spending on development and social sector projects, especially in the conflict-affected areas. The overall deficit was significantly lower than budgeted (1 percent of GDP compared to 2½ percent of GDP). As a result, although external loans fell short of the budget, as assistance from the World Bank, Asian Development Bank, and donors dwindled, the domestically financed deficit was also lower than budgeted (at ½ percent of GDP).

Monetary and exchange rate policies remained geared to supporting the exchange rate peg to the Indian rupee. Broad money growth slowed from 12¾ percent in 2003/04 to 8 percent in 2004/05 reflecting substantially lower Net Foreign Assets accumulation by the Nepal Rastra Bank (NRB). While budget financing from the banking system was limited, private sector credit grew by 13¼ percent, mainly in consumer lending. Balance sheet consolidation by the two largest banks undergoing restructuring limited the growth of loans for manufacturing and services sectors. With high remittances, liquidity was ample, T-bill rates remained low, and interest rates edged lower.

The current account and overall balance of payments remained in surplus. Despite disruptions related to the insurgency and the elimination of textile quotas, total exports rose by 10 percent in 2004/05. This was mainly due to booming exports to India which rose by 30 percent, while exports to other countries declined by over 15 percent. Export performance in traditional sectors—garments, carpets, and pashmina—remained weak. Total import growth was stagnant due to weak economic activity—a 35 percent increase in oil imports reflecting higher international prices was offset by a 6 percent decline in non-oil imports. Reflecting continued strong remittances, the current account surplus (excluding official transfers) increased from 1 percent of GDP in 2003/04 to 3 percent of GDP in 2004/05. A small overall surplus in the balance of payments led to an increase in international reserves to around US$1.5 billion (7¾ months of imports of goods and services) at end-2004/05.

Financial soundness indicators have broadly improved in recent years due to banking reforms. External management teams at Nepal Bank Limited (NBL) and Rastriya Banijya Bank (RBB)—the two largest banks which account for 50 percent of banking system deposits—have made notable progress over the past three years. They have turned the banks around from loss-making entities in 2000/01 by lowering cost of funds and eliminating excess staffing through voluntary retirement schemes. Both banks made profits in 2003/04 and 2004/05. Management and credit evaluation practices in the banks have also improved significantly. In addition, Asian Development Bank supported restructuring plans for Agricultural Development Bank of Nepal have proceeded well. In contrast, the financial condition of Nepal Industrial Development Corporation remains dismal.

The share of Non-performing assets in NBL and RBB remains high. Improvements in the legal framework over the last two years and new debt recovery mechanisms (blacklisting directives, the Debt Recovery Tribunal, and an Appellate Tribunal) have helped recoveries from small and medium-sized defaulters. However, recoveries from large, willful and politically-connected defaulters remain limited. Recoveries from these defaulters are required to improve NBL and RBB balance sheets, reduce contingent liabilities for the budget, and pave the way for their privatization. The banks have been reluctant to pursue these cases in the Debt Recovery Tribunal due to concerns about its limited staff and capacity.

Nepal's growth prospects are contingent on political stability and improved security, and risks remain. Staff project real GDP growth of 2½−3½ percent in 2005/06. In this scenario, if political stability and better security conditions can be established and structural reforms are implemented, Nepal could see a gradual return to growth rates of 5−5½ percent through 2009/10. This would require a rebound in manufacturing and service sectors, higher tourism earnings, and a larger contribution from agriculture and government activity. With the peg, inflation is expected to broadly follow price developments in India. The balance of payments surplus is projected to broadly decline. Export growth is projected to average 8 percent assuming Nepal can further diversify its exports beyond traditional sectors. Imports (both oil and non-oil) are projected to pick up with economic activity. Trade deficits could be covered by remittances and aid. International reserves are projected to remain around 6−7 months of imports of goods and services. If the conflict persists and the political impasse stalls reform implementation, low growth rates are likely to become entrenched, security-related spending pressures will remain high, and development spending low. In these conditions, the fiscal and external position could deteriorate, and international reserves could be lower. Key risks going forward include slow reform implementation which would jeopardize external assistance and higher global oil prices.

Nepal provided inaccurate information related to the second disbursement made in November 2004 under the Poverty Reduction and Growth Facility arrangement due to weaknesses in its debt recording system. As a result of this misreporting, the disbursement was noncomplying. The disbursement was made on the basis of a finding that all conditions applicable to the disbursement, including on the nonaccumulation of external payment arrears, had been met. This finding later proved incorrect, as Nepal had accumulated external payment arrears to Austria, including between November 2003 (when the arrangement was approved) and October 2004 (when the first review under the arrangement was completed). However, corrective actions have been taken. The arrears which led to the noncomplying disbursement have been cleared. The arrears are attributable to weak debt management and coordination problems, which the authorities are now addressing.

Executive Board Assessment

Executive Directors noted that Nepal is currently at a critical juncture, as political uncertainties and the ongoing insurgency continue to dampen economic growth. They encouraged the authorities to resolve these uncertainties, improve security, and make progress toward peace as essential steps to support poverty reduction efforts and private sector led growth.

Directors commended the authorities for maintaining macroeconomic stability under a difficult environment and for progress made in reform implementation until mid-2004. They encouraged the authorities to reinvigorate the implementation of policies in Nepal's Poverty Reduction Strategy Paper, which remains an appropriate framework to address key constraints on growth, maintain macroeconomic stability, and reduce poverty. This would also help mobilize external assistance by bringing the PRGF arrangement and donor programs back on track, as well as lay the basis for possible debt relief under the HIPC Initiative and the Multilateral Debt Relief Initiative.

On fiscal policies, Directors commended efforts to mobilize revenue, prioritize expenditure, increase social sector spending, and limit domestic budget financing. They encouraged further efforts to improve tax administration to raise collection levels. Directors expressed concern that security-related spending pressures remain high, and development spending is low relative to budget targets, especially in conflict-affected areas. They encouraged efforts to raise spending on infrastructure and social sector projects to achieve PRSP goals, while limiting domestically financed deficits to levels consistent with medium-term fiscal sustainability. Directors also favored early implementation of an automatic pricing mechanism for petroleum products in order to improve the financial condition of the Nepal Oil Corporation so that it does not pose an additional burden on the budget.

Directors emphasized the need to increase fiscal transparency, improve public expenditure management, and address donor concerns about the quality of spending. To this end, they suggested implementation of the fiscal ROSC recommendations, including broader coverage of off-budget activities. In this context, Directors called for more comprehensive reporting of security-related spending.

Directors agreed that the exchange rate peg to the Indian rupee remains appropriate. They noted that the peg enables the economy to benefit from close ties with India and helps to keep inflation at low levels. Directors considered that the level of the peg should be kept under review, given Nepal's growing integration in the world economy through its membership in the WTO and regional trading arrangements. External competitiveness should be raised through structural reforms and infrastructure investments to lower transactions and transportation costs.

Directors commended the progress made in financial sector reforms, while observing that much remains to be done. They welcomed the measures taken to improve the debt recovery framework, raise efficiency at the Nepal Rastra Bank, and to restructure commercial and development banks. Going forward, Directors noted that the legal framework for financial sector activity can be further improved through amendments to the Banking and Financial Institutions Ordinance. They encouraged the NRB to enhance financial sector supervision, and raise its internal audit and accounting standards. Directors emphasized that significant loan recoveries from large, willful defaulters are required to improve the balance sheets of ailing commercial banks. The delay in the restructuring of the Nepal Industrial Development Corporation should be addressed by privatizing it promptly and transparently. Given the important role played by remittances in strengthening the country's external position and reducing poverty, Directors encouraged the authorities to facilitate remittances through formal channels by reducing transaction costs and to help redirect remittances for investment and employment creation in Nepal. They called on the authorities to press forward with implementation of a strong anti-money laundering and combating the financing of terrorism regime.

Directors recommended an acceleration in the pace of public enterprise and governance reforms. They stressed that liquidation of unviable loss-making enterprises should proceed decisively, and encouraged mechanisms—such as share sales and management contracts—to improve the efficiency of large public enterprises. Directors welcomed adoption of the Civil Service Ordinance to improve governance, and urged early promulgation of the Governance Ordinance. They emphasized that anti-corruption efforts need to focus on large, prominent offenders to yield measurable results.

Directors encouraged creation of an enabling environment for private sector activity by upgrading the regulatory framework and making labor markets more flexible. They welcomed the promulgation of the Secured Transactions, Company, Securities, and Insolvency Ordinances. Directors urged early promulgation of the draft Labor Ordinance.

Given the importance of agriculture and the high level of rural poverty, Directors encouraged progress with implementing Agricultural Perspective Plan policies to raise agricultural productivity. This involves providing complementary inputs to land and improving rural infrastructure to promote commercialization and market access for agricultural products.

Directors regretted the misreporting of external payment arrears related to the second disbursement under the PRGF arrangement. They welcomed the clearance of these arrears and efforts to strengthen external debt management. With the corrective actions, Directors approved the request of a waiver for Nepal's nonobservance of the performance criterion on the nonaccumulation of external payment arrears.

Directors stressed the need to address data deficiencies to improve policy formulation and monitoring, and urged full implementation of Fund technical assistance recommendations.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.