Public Information Notice No. 00/20

Public Information Notice: IMF Concludes Article IV Consultation with Nepal

March 14, 2000

On February 18, 2000, the Executive Board concluded the Article IV consultation with Nepal.¹

Background

During the period since the last Article IV consultation, Nepal has maintained broad macroeconomic stability and there has been an improvement in the external position. However, in the absence of a strong political consensus, structural reforms remain delayed, pervasive weaknesses impair fiscal performance, and problems in the banking sector persist.

Real GDP growth improved to 3½ percent in 1998/99 (fiscal year ending July 15), led by growth in exports, manufacturing and finance sectors. Inflation has recently come down in a similar manner to developments in India. After accelerating to nearly 20 percent in 1998, the 12-month rate of inflation declined to 2 percent by December 1999, as food prices declined. As a result, the inflation differential with India, which widened in 1999, has disappeared. A pick-up in growth is projected in1999/2000 to around 6 percent of GDP based primarily on good weather, better fertilizer distribution and an export recovery.

External developments have been favorable, with the current account balance shifting by 6 percent of GDP to a surplus (excluding grants) in 1998/99. Pegged to the Indian rupee, the Nepalese rupee broadly maintained its dollar rate, and appreciated in real terms by about 7 percent for 1998/99 (before declining by December 1999 to the levels of early 1997, pre-Asian crisis). Aided by strong exports and increased remittances, gross official reserves increased in 1998/99 to nearly US$ 800 million, equivalent to 4¾ months of imports or 35 percent of broad money. In 1999/2000, merchandise exports are projected to increase significantly but the current account is expected to worsen as imports rise sharply with the pick up in economic activity, increased project-related imports, and higher oil costs. Nevertheless, foreign reserves are expected to continue to increase, although at a slower rate, provided the regional outlook remains stable.

A passive monetary policy led to excess liquidity in commercial banks, much of which has been placed in foreign currency assets. After converting the accumulated overdraft of the government into treasury bills, the Nepal Rastra Bank (NRB) has disposed of over half of these securities. Led by NFA accumulation, broad money expansion accelerated, peaking in February 1999 at about 26 percent, before slowing to 21 percent in November 1999. Reflecting the limited lending opportunities and excess liquidity, the interest rates on treasury bills have been negative in real terms since December 1997.

While the overall budget deficit remained stable, financed primarily by foreign aid, fiscal performance was disappointing in 1998/99 as revenue and development spending were below target. The overall deficit before grants was 6¼ percent of GDP. Total revenue amounted to 10 percent of GDP; lower than budgeted and than in the previous two years—receipts from the recently introduced VAT were below expectation because of the initial resistance of the business community. Current expenditures were contained at just below budgeted levels, as increases in spending on law and order and election-related activities offset underspending by other ministries. Development expenditures, however, were substantially below budgeted amounts because of delays in project implementation. In the first four months of the current fiscal year, faster development spending and an increase in civil service allowances have led to higher-than expected domestic financing.

The challenges facing Nepal relate to maintaining economic stability while addressing the long-standing constraints to significantly higher growth—the key to poverty reduction in Nepal. Identified growth constraints include a weak financial sector and inefficient public expenditures and state enterprises. Moreover, low agricultural productivity growth combines with a population growth rate of 2½ percent and high illiteracy to perpetuate widespread poverty.

Executive Board Assessment

Executive Directors regarded recent economic developments as broadly positive: international reserves had continued to increase, inflation was low, and the short-term growth outlook was encouraging. These improved macroeconomic conditions should give the authorities an opportunity to shift policies decisively. A front-loaded fiscal adjustment and a comprehensive package of structural reforms would be essential to realize Nepal's growth potential and provide a favorable basis for improving social indicators. Directors stressed that a substantial increase in per capita income would be required to achieve a meaningful reduction in poverty.

Directors emphasized the importance of maintaining an appropriately strong fiscal position. They welcomed the mid-term review of the budget and the recent steps to strengthen value-added tax and customs collections, and encouraged the authorities to take additional measures as needed to achieve the 1999/2000 budget targets. In the medium term, and notwithstanding the potentially important role of foreign financing, Nepal would have to raise its exceptionally low revenue-to-GDP ratio in order to finance necessary public expenditure—notably, on poverty reduction and other well targeted social programs, infrastructure, and bank restructuring. High priority should be given to broadening the tax base, especially by reducing tax concessions, and strengthening tax administration. At the same time, efforts to improve the efficiency of public spending should continue. In addition, Directors attached particular importance to increasing the transparency of fiscal operations. The formulation of fiscal policy would benefit from a more comprehensive budget framework incorporating all fiscal operations.

Directors noted that the exchange rate peg with India had so far served Nepal well and should continue to do so—as long as supported by appropriate financial policies. In this connection, they welcomed the recent move to positive real interest rates on treasury bills and encouraged the authorities to lower domestic budgetary financing, especially from the central bank.

Directors stressed the importance of providing greater autonomy to the central bank and encouraged efforts to strengthen regulation and supervision of the financial system. Concerted efforts would be needed to fully elaborate and implement the authorities' strategy to promote the efficiency and health of the banking system. The recapitalization and privatization of the troubled large state bank should be preceded by improved management and proper restructuring. Subsidized credit schemes should be funded transparently through the budget, not the banking system.

Regarding structural measures to promote broad-based growth, Directors considered that priority should be given to enhancing private and foreign investment, accelerating project implementation, and strengthening rural infrastructure. Wide-ranging reform of the public sector would be very important in this regard—to improve administration, promote good governance and accountability, streamline the civil service, and tackle the problems of inefficient and loss-making enterprises, including through privatization. Directors were encouraged by the recent policy initiatives to adjust public sector prices and tariffs, and by the authorities' commitment to an open trade and investment regime. They noted the desirability of diversifying exports, as well as the importance of productivity boosting reforms in promoting export competitiveness. While stressing the importance of a comprehensive development strategy, Directors noted Nepal's limited administrative capacity. Reform measures should therefore be well-sequenced and prioritized, and supported with adequate technical assistance from the donor community.

Directors encouraged the authorities to strengthen their efforts to eliminate significant weaknesses in the macroeconomic database that impair effective monitoring and policy formulation.

Directors welcomed the authorities' plan to adopt a broad and comprehensive agenda of structural reforms, which could be supported by a financial arrangement under the Poverty Reduction and Growth Facility (PRGF). The ongoing process of wide consultation in the preparation of a Poverty Reduction and Strategy Paper (PRSP)—together with planned and ongoing measures to reform the banking system, mobilize budgetary revenue, improve fiscal transparency, and tackle pervasive problems of governance and corruption—should create a favorable environment for mobilizing international support, including through a PRGF arrangement.