Public Information Notice No. 02/102

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Nepal

September 12, 2002

On September 4, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Nepal.¹

Background

Despite decades of development efforts supported by substantial foreign aid, Nepal remains among the poorest countries in the world with 40 percent of the population living in poverty. The Poverty Reduction Strategy Paper, expected to be finalized soon, identifies slow growth (especially of agriculture) and poor infrastructure and social service delivery as key causes of poverty, and proposes an economic program that primarily aims at improving the financial sector and correcting public sector inefficiencies.

An already difficult economic situation has been complicated by an intensification of the Maoist insurgency, political uncertainties, and adverse external developments. Violence has intensified since November 2001 when the insurgents walked away from peace talks, and the economy was further affected by the events of September 11 and the global economic slowdown. Near-term political uncertainty has also risen as leadership disputes within the ruling party resulted in the dissolution of Parliament in May and the scheduling of general elections for November.

Reflecting these adverse internal and external developments, real GDP growth is estimated to have slowed to 0.8 percent in 2001/02 from 5 percent in the previous year (fiscal year ending mid-July). Agricultural growth slowed to less than 2 percent from over 4 percent, reflecting irregular rainfall. The output of nonagricultural sectors was largely stagnant, with manufacturing and tourism sectors particularly hit hard by the domestic security situation as well as the global slowdown. Inflation was subdued at around 3 percent, reflecting weak domestic demand and stable Indian prices for most of the year.

Notwithstanding slowing exports and tourist receipts, the external current account surplus was maintained at 1 percent of GDP in 2001/02, reflecting a drop in imports and expanding remittances from Nepalese working abroad. Nevertheless, foreign aid flows declined and contributed to turning the overall balance to a small deficit. Gross official reserves stood at over $1billion, covering 6½ months of imports. Reflecting the concessional nature of the external debt and high remittances, the debt service ratio remains at about 5 percent of current receipts.

The fiscal deficit (after grants) was contained to 4 percent of GDP, but domestic financing was higher than budgeted. The revenue shortfall of 1½ percent of GDP would have been larger had it not been for the intensified collection efforts through a voluntary disclosure of income scheme and special revenue measures to fund higher security spending. To accommodate higher current expenditure, capital spending was cut back by 3 percent of GDP relative to the budget. However, this also affected foreign aid disbursements and financing. As a result, net domestic financing amounted to nearly 3 percent of GDP, 1 percentage point higher than budgeted.

Monetary aggregates grew slowly while monetary policy has accommodated fiscal needs and the need to bail out depressed industries. Broad money growth in 2001/02 slowed to 6 percent from 15 percent a year earlier due mainly to a weaker economy. Net claims on government rose by 19 percent, and domestic credit grew by 10 percent—reflecting sizable demand for refinancing loans to troubled borrowers. In response to a liquidity shortage at some commercial banks, the Nepal Rastra Bank (NRB) lowered cash reserve requirements by 1.2 percentage points on average to around 9 percent and also lowered refinancing rates by 100-200 basis points. In addition, from February 2002, the NRB provided a refinancing facility at 3 percent interest to encourage commercial banks to provide concessional loans to "sick" industries (mostly hotels and garment industry). Interest rates on deposits and treasury bills (91 days) declined during 2001/02 to around 4 percent.

The peg of the Nepalese rupee to the Indian currency has provided a suitable nominal anchor and enabled Nepal to benefit from the close ties with India. The real effective exchange rate has been relatively stable, and the informal market premium has been minimal. Exporters also report that they do not face significant wage pressure.

Structural reform has advanced in the financial sector. To provide a sound basis for strengthening the NRB's regulatory and supervisory capacities, new banking regulations were issued and the new NRB Act was enacted in 2002 that granted the central bank greater autonomy. The authorities are preparing an action plan to "re-engineer" the NRB through reorganization, strengthening of supervision, and human resource enhancement based on stronger performance incentives for the professional staff. External managers were selected in early 2002 for the two largest commercial banks, Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL), with funding from the World Bank and the United Kingdom. To take over management of the majority privately-owned NBL, the NRB invoked provisions of the new NRB Act and suspended its board. However, an international management firm that signed a contract in January to manage the RBB has decided to pull out, citing security risks and ambiguities in the contract.

Progress was uneven in public sector reforms. A medium term expenditure framework was introduced, in which fiscal resources are allocated to programs in accordance with national and sector priorities in a three-year rolling framework and a realistic revenue forecast considered as a hard budget constraint. To reduce overstaffing among lower-level employees and improve performance incentives for professional staff, the authorities introduced a hiring freeze, completed a civil service census, increased relative wage of higher level staff, started to eliminate temporary and vacant posts at lower levels, and implemented the first phase of a voluntary retirement scheme. However, there has been little visible progress in public enterprise reform. Public enterprise finances continue to deteriorate but poor accounting practices prevent accurate measurement of the size of the wage and other liabilities of individual enterprises. No public enterprises were privatized during the last three years.

Executive Board Assessment

Noting that the deteriorating security situation and adverse external shocks had contributed to the recent weakness in growth, Executive Directors welcomed the authorities' efforts to maintain macroeconomic stability and to push ahead with structural reforms under difficult circumstances. However, Directors noted that the economy remained vulnerable to downside risks in the near term, including the impact of the insurgency on production, exports, and tourism, as well as a weaker than expected global recovery. In view of the widespread poverty, they called on the authorities to demonstrate a firm and sustained commitment to reforms in order to reinvigorate growth.

Directors agreed that sound fiscal management was key to maintaining macroeconomic stability, and stressed the need to contain domestic borrowing, prioritize spending, and mobilize revenue in implementing the 2002/03 budget. They welcomed the recent steps taken to prioritize development spending within a multiyear framework and to strengthen expenditure control. In light of the budget's optimistic revenue and foreign financing assumptions, the achievement of the targeted overall deficit will probably require additional efforts during the course of the fiscal year, focused on raising revenue and cutting low priority spending, so that domestic borrowing can be contained.

Over the medium term, Directors endorsed the authorities' intention to strengthen revenue mobilization further, with an emphasis on improving tax and customs administration through increasing the frequency of audits, raising staffing resources, and tightening enforcement. This would permit higher spending for poverty reduction and growth—and success in these areas could contribute to the resolution of the civil conflict.

Directors considered that the exchange rate peg to the Indian rupee remains broadly appropriate given Nepal's close economic links with India, and they endorsed the focus on maintaining monetary conditions consistent with the peg. They encouraged the authorities to maintain an open trade and investment regime, while noting the adverse effects of trade barriers on Nepal's exports. A few Directors drew attention to the need to remove the exchange restrictions that limit payments for personal travel.

Directors encouraged the authorities to remain vigilant about the quality of new bank credit at a time of weakening bank loan portfolios, and to build on the progress made in financial sector reform—especially by addressing the problems of the two largest commercial banks. They looked forward to the preparation and implementation of plans to divest these banks' state assets, and to recapitalize the banks after they had been appropriately restructured under new management. Directors also encouraged the authorities to proceed with the restructuring of the two large development banks. They welcomed the progress in strengthening the central bank, including the passage of the new central bank law that gives the bank greater autonomy, and the authorities' commitment to establish an anti-money laundering regime consistent with the recommendations of the Financial Action Task Force.

Directors urged the authorities to strengthen public sector reforms. They welcomed the initial steps to reduce the overemployment of lower-level civil servants, but said that further efforts will be needed to eliminate vacant positions and improve incentives for professional staff. Directors recommended that the authorities revive their efforts to privatize public enterprises listed for early sale and assess the financial position of other enterprises with a view to making decisions on future privatization.

Directors welcomed the recent efforts to improve governance and enforce anti-corruption policy, focused on those responsible for the misuse of public funds. They stressed the need to increase fiscal transparency by fully monitoring central and local government finances, as well as extrabudgetary activities, such as those of the Poverty Alleviation Fund. The importance of the adoption of international accounting and auditing standards for large private and public firms was also emphasized, as an element of progress toward legal, institutional, and administrative reforms that will foster an environment that is supportive of private sector activity.

Directors welcomed the government's commitment to a comprehensive reform program, as described in the government's Poverty Reduction Strategy Paper, to maintain macroeconomic stability and promote more efficient resource allocation in the financial sector and better public service delivery, especially in the rural areas, together with strengthened governance. Such a program would lay the foundation for sustained growth once a more stable political and security environment is established. They looked forward to Nepal making progress toward designing and implementing a program that could be supported by the Poverty Reduction and Growth Facility.

Directors encouraged the authorities to continue to improve the macroeconomic database to eliminate deficiencies in official statistics that currently impair effective monitoring and policy formulation. They stressed the importance of implementing past technical assistance recommendations on statistics.

Directors welcomed the authorities' support for international efforts to combat the financing of terrorism.