Statement at Donor Meeting

Statement by the International Monetary Fund at the 2004 Nepal Development Forum, Kathmandu

May 6, 2004

Statement by the International Monetary Fund
Hisanobu Shishido
Asia and Pacific Department
At the 2004 Nepal Development Forum
Kathmandu, May 6, 2004

We are meeting at a time when the political and security situation has unfortunately become more difficult and continues to impose a high human and economic cost. The insurgency has taken a heavy toll on human life and undermined human rights. It has also had significant economic costs, adversely affecting development efforts, particularly in remote areas of the country. While there is support within and outside Nepal for multiparty democracy, recent political developments and the street demonstrations have also raised the level of uncertainty. The standoff among the constitutional forces also appears to have complicated the path towards a peaceful, negotiated settlement of the insurgency. Economic activity continues to be disrupted by frequent "bandhs" and roadblocks organized by the insurgents and political parties. At the same time, progress has been made with implementation of economic reforms, even though some donor-funded infrastructure projects have been slowed due to security concerns. Also, macroeconomic performance has been good despite the security and political situations adversely affecting investment and business confidence.

Nepal has made progress in a number of areas since the last NDF in 2002. Reform implementation was particularly strong in the financial sector, where a new Nepal Rastra Bank Act was adopted, new prudential regulations were promulgated, and external management teams were installed at the two large, financially troubled commercial banks. These teams embarked on intensive efforts to recover non-performing loans and reduce operating costs. As regards the budget, the Medium-Term Expenditure Framework (MTEF) was prepared, providing a means of more effectively prioritizing expenditures. The elimination of civil service vacancies was initiated and efforts to privatize and/or liquidate public enterprises to improve public sector resource allocation received renewed attention. Alongside these reforms, the authorities finalized the 10^th Plan/Poverty Reduction Strategy Paper (PRSP) in July 2003 to provide an overall framework for reform efforts. The strategy represents a coherent plan to break the vicious cycle of low growth, poverty, and insurgency, and was prepared by a series of governments over 2000-2002 after consultations with civil society and other stakeholders.

Based on a demonstrated track record of policy implementation and commitment to reform, the IMF's Executive Board approved a three-year Poverty Reduction and Growth Facility (PRGF) Arrangement for Nepal in November 2003. The program covers the period 2003/04-2005/06. Consistent with the priorities set out in the PRSP, the PRGF-supported program focuses on: (i) achieving higher growth to help reduce poverty; (ii) implementing a medium-term fiscal strategy to mobilize revenue, prioritize expenditure, and reduce domestic financing; (iii) reforming the financial and public sectors to improve intermediation and resource allocation; and (iv) improving governance to reduce corruption, increase accountability, and enhance implementation capacity. The IMF is providing technical assistance in a number of these areas.

Despite the difficult political and security situation, the PRGF-supported program is broadly on track. Discussions for the first semi-annual review of the arrangement are currently underway and, pending completion of some structural reform actions, the IMF's Executive Board is tentatively scheduled to discuss the authorities' request for completion of this review around end-May. All quantitative performance criteria and indicative targets for the review were met and most structural reform measures were taken on a timely basis.

Let me elaborate on the key elements of the PRGF-supported program.

Much to its credit, Nepal maintained stable macroeconomic policies during the 1990s. The fiscal position remained manageable, as current spending was largely limited to domestic revenue collection, while capital spending was kept at levels that could be financed by any current surplus, foreign aid, and limited domestic borrowing. In the second half of the 1990s, the amount of aid flows declined, but this was more than offset by expenditure cuts and an increase in revenue. During 2000/01-2001/02, the fiscal position deteriorated, partly due to higher security spending, and domestic borrowing rose. However, in 2002/03, overall spending levels were adjusted to reduce domestic borrowing to sustainable levels.

Under the PRGF-supported program, macroeconomic developments are unfolding broadly as expected. In 2003/04, agricultural growth has so far been satisfactory with favorable weather, manufacturing has been resilient, strong remittances have offset weak exports, and tourist arrivals have revived somewhat. As a result, real GDP is expected to grow by about 4 percent. Inflation has remained around 4-5 percent (12-month basis), and international reserves, buoyed by remittances, are currently around 6½ months of imports of goods and services.

The 2003/04 budget is also broadly on track. Revenue growth has been satisfactory, and regular spending continues to remain within the budget framework. However, development spending remains low, largely reflecting the security situation. Requests for additional security spending were accommodated using a contingency allocation in the original budget (total security related spending for the fiscal year is projected to be around 3 percent of GDP). For 2003/04, the fiscal deficit is projected to be 2½ percent of GDP, compared with a budget target of 3 percent.

Beyond 2003/04, policies should focus on raising the revenue-to-GDP ratio, improving the efficiency of public spending, and reducing domestic borrowing to maintain fiscal sustainability over the medium term. To mobilize revenue, it is important that tax administration be reformed--both by making the recently established large taxpayer office (LTO) fully functional and vigorously implementing the customs modernization plan. In this regard, it is important to provide for performance-based incentives at both LTO and Customs. The IMF is prepared to extend technical assistance in these areas. While tax policy in Nepal is relatively well designed, further streamlining--reducing exemptions and export taxation--and consideration of some increase in tax rates is needed. Spending should remain focused on poverty reduction through better prioritization and targeting in the context of the MTEF. Achievement of fiscal goals and aid flows which are included in PRSP/PRGF medium term projections--grants and concessional loans are projected to be at least 4½-5 percent of GDP per year during the coming years--would be contingent on improvements in the security situation. The projected aid flows are subject to renewed commitment to the existing pipeline and would require additional support of about US$90-100 million a year.

B. Structural Reforms

To achieve poverty reduction goals, PRSP/PRGF reforms are expected to create conditions for high and sustained private sector led growth through better resource allocation and through increased investment in human and physical capital. The reforms would generate efficiency and productivity gains through better financial intermediation and more flexible labor markets so that Nepal can compete effectively in an increasingly global marketplace. But growth would need to be broad-based, with an important contribution from agriculture, to include the poor and disadvantaged sections of society. Furthermore, to improve efficiency and social service delivery to the poor, governance needs to be enhanced, including through promoting decentralization and improving the quality of the civil service.

Since the approval of the PRGF arrangement, significant progress has been made in financial and public sector reforms. In the financial sector, steps were taken on three fronts--improved loan recovery and banking environment (establishing the Debt Recovery Tribunal, issuing strengthened directives for blacklisting defaulters, and promulgating the Banking and Financial Institutions Ordinance), strengthening of the NRB (improving its organizational structure and reducing overstaffing), and restructuring of commercial and development banks (reducing nonperforming loans and overstaffing at commercial banks and designing restructuring plans for the major development banks). In the public sector, the prioritization exercise of the MTEF now covers all development spending and preparation is under way to extend the coverage to include regular spending.

Looking forward, PRSP/PRGF policies would address key reform issues, and it is imperative that they be fully implemented.

· Financial sector reforms have made significant progress, but debt recovery from large and well-connected defaulters remains difficult. The borrowers have so far successfully resisted commercial banks' debt recovery efforts using political influence and a judicial system that is not seen to be transparent. The authorities' commitment to the sector reform would lose credibility if significant progress in this area is not made. Going forward, successful privatization of the ailing commercial banks and restructuring of the development banks are important steps that need to be taken.

· On private sector development, external competitiveness should be enhanced through cost reduction based on labor market reform and infrastructure investment. The loss of protected access to overseas markets due to the phasing out of the Agreement on Textile and Clothing by end-2004 poses important challenges for export growth. These challenges are best addressed through steps to make Nepal's exports more competitive, including reduced labor and nonlabor costs and by infrastructure investment to ease supply and transport bottlenecks. In this regard, legislation needs to be modified to make labor recruitment and retrenchment more flexible. Nepal already has an open trade regime, and last month, it became the first low-income country to join the WTO by accession. It now needs to follow through with its accession commitments, including by opening new sectors to foreign participation.

· Governance reforms are required to reduce corruption and increase accountability. These reforms would directly contribute to reducing unfairness--real and perceived--and would help erode the support base for the insurgency. Particularly important is the implementation of the government's anti-corruption strategy, including strengthening of the Commission for the Investigation of Abuse of Authority and the Special Corruption Court. The proposed Fiscal Transparency Ordinance is also a welcome measure. Continued implementation of civil service reforms--involving downsizing and introduction of merit-based recruitment and promotion--and decentralization with good monitoring will enhance public sector efficiency.

III. Risks and Opportunities

The authorities have expressed their strong commitment to the reform agenda during recent discussions with the IMF, but downside risks remain significant. It is laudable that the authorities have established a good track record of reform implementation despite a very difficult political and security environment. But, downside risks are significant. In particular, Nepal's reform implementation and prospects for growth and poverty reduction are closely linked to a resolution of the insurgency and the current political impasse. An absence of improvement in the security situation could undermine growth and revenue targets, restrict development activities including those funded by donors, and seriously impede poverty alleviation efforts.

We wish Nepal well in this difficult situation. We look forward to working with the authorities, in coordination with the donor community, to help achieve Nepal's ambitious growth and poverty reduction targets to help improve living standards, especially of the poor. We hope that strong support for the reform agenda across the political spectrum will continue to help ensure implementation. Finally, we also hope that a strong effort is made to resolve the current political and security situation.