Public Information Notice No. 97/4

Press Information Notice: IMF Concludes Article IV Consultation with Nepal

June 13, 1997

The IMF Executive Board on May 28, 1997 concluded the 1997 Article IV consultation ¹ with Nepal.

Background

Nepal’s economic growth has been strong during the last two years. Favorable weather conditions have boosted agricultural output, contributing to real GDP growth of 6 percent in 1995/96 and 5 percent in 1996/97 (the Nepalese fiscal year starts on July 16). Inflation rose during 1995/96 and early in 1996/97 reflecting increases in administered prices and higher food prices, but has come down to a 12-month rate of 7 percent in April 1997, as the good monsoon has alleviated food price pressures.

Following an overrun in domestic borrowing in 1995/96, the fiscal stance was tightened in the first eight months of 1996/97. The overall budget deficit (after grants) widened to 4.6 percent of GDP in 1995/96 from 3.3 percent in 1994/95, reflecting increased spending and a sharp slowdown in revenue growth as imports decelerated. Net domestic borrowing increased to 1.4 percent of GDP, exceeding the government’s target of 0.5 percent, and compared with 0.8 percent in 1994/95. In 1996/97, the government aimed to reduce its borrowing requirements, mainly through tax measures targeted at raising revenues by 1 percent of GDP. During the first eight months of the year, revenue performance has remained flat in relation to GDP; nevertheless, net domestic borrowing has been contained as development spending has slowed markedly.

In response to a weakening external position, credit conditions were tightened in early 1995/96. However, credit policies eased in the final quarter of the year as large borrowing requirements led to a rapid increase in the government’s use of its overdraft with the Nepal Rastra Bank. In the first eight months of 1996/97, the monetary stance tightened again, as government borrowing requirements moderated and the introduction of longer-term government securities expanded the scope for nonbank financing. Private sector credit growth slowed sharply as the impact of the tighter policy stance was accentuated by the financial difficulties of the government-owned commercial bank, the Rastriya Banijya Bank (RBB).

The external position deteriorated in 1994/95 and early 1995/96 as export growth faltered and a widening differential in interest rates with India encouraged net capital outflows. Since that time, the external situation has stabilized because of tighter monetary conditions and an improving trade position. After two years of weak performance, exports have revived, buoyed by the carpet and garment sectors (Nepal’s principal exports), which have benefited from improved quality standards and stronger demand in key markets. At the same time, nongold import growth has slowed sharply. After a loss of $85 million in 1995/96, gross reserves increased by $25 million in the first eight months of 1996/97.

Progress over the past year in structural reforms should, if continued, improve long-term growth prospects. Several hydropower projects have been initiated which, taken together, would double Nepal’s power-generating capacity over the next five years. The Nepal-India trade treaty signed in December 1996 greatly simplifies access to the Indian market, and should strengthen exports. In other areas, progress has been mixed. Preparations have continued toward introduction of a value-added tax (VAT) in 1997/98. Some progress has been made on privatization, with two enterprises sold and long-term leases being arranged for two others. The government has also reduced its ownership in the Nepal Bank Limited, making it majority private-owned. To address structural weakness in the banking system, which is characterized by high intermediation spreads, initial steps have been taken to improve loan recovery of the RBB and to overhaul its financial accounts, although its lending capacity remains impaired by a high proportion of nonperforming loans.

Executive Board Assessment

Executive Directors welcomed the progress made during the year in tightening macroeconomic policies and with structural reforms. They noted that economic activity remained robust and inflation performance had been satisfactory, while the recent trade and power treaties with India had improved Nepal’s long-term growth prospects. Notwithstanding those achievements, Directors considered that deepening and accelerating the pace of structural reforms were needed to improve Nepal’s development prospects and to reduce poverty. They urged the new government to re-invigorate the reform program, and they welcomed its commitment in that regard. Key priorities included: ensuring a stable growth-oriented macroeconomic environment; boosting public savings through stronger revenue mobilization; establishing a sound and efficient financial system; ensuring the efficient use of public resources; strengthening project implementation; and moving forward with the privatization program.

Directors emphasized that fiscal and monetary policies would need to be managed prudently. They expressed concern about the sizable fiscal deficit and urged determined efforts toward fiscal consolidation. Directors urged the government to cut low-priority projects in order to contain domestic borrowing in 1996/97. That effort would also provide a basis for greater prioritization of spending in the 1997/98 budget. Directors recommended that subsidies be limited by raising administered prices.

Directors supported the authorities’ goal to raise domestic savings as a key element of Nepal’s development strategy, especially in view of Nepal’s large current account deficit. They stressed that the tax system would need to be reformed, and they urged the government to introduce a value-added tax (VAT) in 1997, as scheduled, emphasizing the need to ensure that the VAT was administered effectively. Directors also urged the authorities to follow through with additional measures to broaden the tax base, including curtailment of tax holidays and elimination of tax exemptions granted to specific sectors.

Directors underscored that monetary policy would need to remain tight to safeguard the build-up in international reserves and to keep inflation low. They also called for a formal limit on overdraft borrowing from the central bank, which would impose greater discipline on fiscal management and increase the Nepal Rastra Bank’s operational independence. Directors generally supported continued adherence to the fixed exchange rate peg with India, which had provided a strong framework for financial discipline and had encouraged regional economic integration. It was observed that, as the Indian economy was undergoing liberalization and moving toward capital account convertibility, the Nepalese authorities might wish to revisit the question of the appropriateness of the peg over time.

Directors expressed concern that the banking system had become strained by the increasing financial difficulties of Nepal’s largest and wholly government-owned bank--the RBB. While they supported the authorities’ efforts to improve loan recovery and to restore order to the financial accounts, they noted that the results so far had been limited. Directors therefore urged the authorities to act promptly and decisively to prevent a further deepening of the problems of the bank and to develop a plan to restructure the bank and eventually to privatize it. Directors recommended that measures also be taken more generally to further liberalize restrictions on commercial banking activity and to encourage a deepening of capital in the banking system.

Directors endorsed government plans to focus expenditures on priority areas, particularly to develop power and agricultural infrastructure and to improve education. They observed that the privatization program should be strengthened, and that control and ownership in the telecommunications, transportation, and financial sectors should be shifted to private hands. Directors also recommended that the government continue to ensure an open trade and investment regime.

Directors welcomed the new government’s intentions to continue discussions with the staff on a reform program that could be supported by an ESAF arrangement with the Fund. In this context, Directors stressed the need for strong measures to re-invigorate the structural reform program.