Nepal and the IMF

Press Release: IMF Executive Board Completes First Review Under Nepal's Three-Year PRGF Arrangement and Approves US$10.6 million Disbursement
October 20, 2004

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NepalLetter of Intent, Memorandum of Economic and Financial Policies, and Technical Memorandum of Understanding

October 4, 2004

The following item is a Letter of Intent of the government of Nepal, which describes the policies that Nepal intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Nepal, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Mr. Rodrigo de Rato
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. de Rato:

His Majesty's Government of Nepal is committed to implementing the program supported by the three year Poverty Reduction and Growth Facility (PRGF) Arrangement approved by the Executive Board in November 2003. The attached Memorandum on Economic and Financial Policies (MEFP) reviews progress in implementation during 2003/04 and sets out the objectives and policies for 2004/05. More broadly, the government is fully committed to its reform agenda detailed in the 10th Plan/PRSP, which aims to reduce poverty through private-sector led growth and social inclusion.

In support of its objectives and policies, the government requests completion of the first review, disbursement of the second loan under the PRGF of SDR 7.13 million (10 percent of quota) and a rephasing of the third disbursement. All quantitative performance criteria and benchmarks for the first review were met. However, some structural reform actions were delayed beyond the target dates. In this regard, we request waivers for nonobservance of two structural performance criteria: (i) finalization of 2002/03 audited accounts of Nepal Rastra Bank (NRB) by an international firm; (ii) implementation of voluntary retirement schemes (VRS) at NRB and Rastriya Banijya Bank (RBB). These actions have now been completed.

The Government believes that policies set forth in the MEFP are adequate to achieve the objectives of its program, but it will take any further measures that may become appropriate for this purpose. Nepal will consult with the Fund on the adoption of these measures, and in advance on the adoption of the policies contained in the MEFP, in accordance with the Fund's policies on such consultation. The government will provide the Fund with all the required information in a timely manner to monitor progress of the PRGF-supported program. The Government also intends to make this letter, the MEFP, and the staff report on the first review of the PRGF, available to the public and authorize their posting on the IMF website subsequent to Board completion of the first review.

Sincerely yours,

Hon. Mr. Bharat Mohan Adhikari
Deputy Prime Minister and
Minister of Finance
Dr. Tilak Rawal
Governor, Nepal Rastra Bank

Memorandum of Economic and Financial Policies Under the PRGF Arrangement, 2003/04-2004/05

1. The government is implementing its 10th Plan/PRSP and the policies agreed for the first-year program under the PRGF Arrangement. The Poverty Reduction Strategy Paper (PRSP), finalized in July 2003, lays out the government's economic objectives and policy agenda for 2002/07. The strategy has broad-based support from domestic stakeholders and the international community. The first annual progress report on PRSP implementation will be finalized soon. This memorandum reviews progress of the first year program under the PRGF Arrangement. The memorandum also updates the macroeconomic framework and structural reform agenda for 2004/05. In particular, it details structural reform actions to be taken until January 15, 2005, which is the test date for the third review.

2. The newly formed coalition government has made restoration of peace its priority. Economic activity and social life in the country continues to be disrupted by the insurgency. To counter these disruptions, the government has strengthened security arrangements, especially in the worst affected districts. At the same time, we continue to seek a peaceful solution to the insurgency. Furthermore, general elections are expected to start by April 2005.

3. On the economic front, the new government remains firmly committed to implementing PRSP/PRGF policies. As a signal of this commitment, the government has already implemented some difficult and overdue policy measures in three key areas. First, administrative prices have been adjusted to stem operating losses of Nepal Oil Corporation (NOC) and to recoup accumulated losses. Further adjustments are in the pipeline to safeguard its financial position in the future. These price adjustments and efforts to improve governance at the NOC are described in ¶29. Second, the cabinet approved a number of long awaited ordinances at end-July (¶32). Third, the government has moved quickly to reinvigorate public sector reform, including privatization/liquidation of loss-making state owned enterprises (¶28).

4. All structural performance criteria and benchmarks for the first review have been completed, albeit with delays in some cases. The international audit of NRB's 2002/03 accounts was delayed in large part by the need to ensure consistency with local auditing laws; implementation of the second phase of the voluntary retirement scheme (VRS) at the RBB had to await availability of World Bank financing; and privatization of SOEs was often hampered by the difficult security situation and legal actions by employees.

5. The NRB and the government wish to reiterate their commitment to accurate data reporting under the PRGF-supported program, especially in view of the recent international audit of NRB accounts. In this context, the NRB intends to follow through fully with IMF recommendations made in the context of the Safeguards Assessment, based on the international audit of NRB's 2002/03 financial accounts (¶33). In particular, the NRB has already made a strong effort to ensure that quarterly data for the test dates reported for observance of quantitative performance criteria is accurate, fully reconciled, and consistent with program definitions. Based on the reconciled data, all quantitative performance criteria for January 14, 2004 were met. Also, all indicative targets for April 15, 2004, except the ceiling on reserve money, were observed.

I. Achievements of the 2003/04 Program

A. Macroeconomic Objectives and Policies

6. Macroeconomic performance in 2003/04 was broadly in line with program objectives, the domestically financed deficit was lower than budgeted, and monetary developments remained favorable.

  • Real GDP is estimated to have grown by 3½ percent, with strong growth in agriculture, resilient manufacturing, and a rebound in tourist arrivals; CPI inflation was 4 percent (period average), reflecting price developments in India; robust remittances supported an international reserves buildup, even as the trade deficit widened, reflecting weak export performance to nonIndian markets and rising imports.

  • On the fiscal front, while revenue collections exceeded the revised budget target, total expenditure was lower than programmed as the security situation constrained spending (current and capital) on development activities. Regular spending has been in line with the budget framework. Security spending has been contained at 3 percent of GDP, a similar level to 2002/03. Large foreign aid inflows, robust revenue growth, and low spending resulted in minimal (net) domestic financing of the budget (0.1 percent of GDP).

  • Monetary and exchange rate policy remained geared to supporting the peg to the Indian rupee. Remittances contributed to robust growth in bank deposits while private sector credit grew as banks diversified their loan portfolios, including into financing consumer durables. The flow of remittances through the banking system created room for foreign exchange market intervention and helped generate a higher-than-projected growth in NRB's net foreign assets (NFA). At the same time, constrained government spending limited net domestic assets (NDA) growth. Broad money and reserve money grew broadly as programmed. The real effective exchange rate was stable.

7. Significant progress was made in improving tax administration, fostering money and foreign exchange market development, and improving public debt management.

  • A Large Taxpayer Office (LTO) was established in the Inland Revenue Department. The LTO covers audit, taxpayer service, and collection functions. For high quality operations of the LTO, the appointment and service requirements have been approved to recruit and retain qualified staff and additional allocation for the office was made from the budget. There has also been significant progress in customs administration reform. A three-year customs time-bound modernization action plan was developed based on IMF and World Bank recommendations, and a number of actions were implemented.

  • The NRB eliminated restrictions on permissible spread limits on commercial bank lending rates and limits on foreign exchange buy/sell spreads in December 2003, as agreed. To promote interbank transactions, the NRB started quoting buy/sell rates around the mid-rate for foreign exchange market intervention. To expand the maturity spectrum of public debt, one-month and six-month treasury bills were introduced.

B. Structural Reforms

Financial Sector Reform

8. Steps were taken to improve the banking framework and loan recovery, further NRB reengineering, and restructure troubled commercial and development banks.

9. The Banking and Financial Institutions Ordinance was promulgated in February 2004 and key steps were taken to resolve nonperforming loans. This BFI ordinance unifies five separate banking laws under a single umbrella act and strengthens the NRB's supervisory powers over the financial sector. Blacklisting directives were strengthened in September 2003 to penalize willful defaulters. These directives were modified in June 2004, in consultation with the IMF and World Bank, to streamline information requirements for blacklisting and to make the provision of these directives consistent with limited liability provisions of the Company Law, without diminishing their effectiveness. The Debt Recovery Tribunal (DRT) was established in July 2003 to rule on cases of loan defaults on a time-bound basis. The appointment in February 2004 of an Appellate Judge rendered the DRT fully operational. The DRT has ruled on a number of cases and is now committed to moving expeditiously to execute the decisions and clear the backlog of cases. However, loan recovery from large, willful defaulters remained difficult.

10. Re-engineering of the central bank has continued with support from the IMF and the World Bank. An improved organizational structure of the NRB along functional lines was approved in December 2003. As agreed under the PRGF-supported program (albeit with some delay), the NRB implemented in May 2004 a VRS to reduce overstaffing. The scheme led to a staff reduction of about 100, mostly at the nonofficer levels. To set an example for other VRS schemes, the incentive component of the scheme remained unchanged.

11. Bank supervision and accounting were strengthened to improve NRB oversight over the financial sector. An amended off-site supervision manual was approved in January 2004. The amended manual includes a number of provisions, including the development of CAELS ratings. The new manual formed the basis for the preparation of the second quarter supervision reports in April 2004. As regards on site supervision, the NRB issued by-laws on July 14 which establish clear timeframes for finalization of on site supervision reports (three months from the on site inspection to the submission of the report to bank management) and streamlined review and clearance procedures to achieve this timeframe.

12. Commercial Banks. The external management teams at NBL and RBB made progress in restructuring the banks and are estimated to have generated operating profits in 2003/04. The first phase of their VRSs were implemented in January 2004 to right size the banks. Both commercial banks prepared their financial accounts for 2002/03 on a timely basis. To facilitate its restructuring, shares of NBL were delisted from the stock exchange in March 2004.

13. Development Banks. The Cabinet approved external audits and restructuring plans for Agriculture Development Bank of Nepal (ADBN) and Nepal Industrial Development Corporation (NIDC) in January and February 2004, respectively, along the lines suggested by AsDB financed consultants. For the ADBN a VRS with a reduction in 340 staff was implemented in April; a VRS was initiated at the NIDC in mid-July.

Public Sector Reforms, Governance and Private Sector Development

14. Progress was made in state owned enterprises (SOEs) and civil service reform. Privatization/liquidation of two SOEs was envisaged under the program. A sales and purchase agreement for Bhaktapur Brick Factory was signed in January 2004 and the company has been handed over to the purchaser. Liquidation of another enterprise was completed in July 2004. Nepal Telecommunications Corporation (NTC) was converted into a public limited company in April 2004 and an international consultant is evaluating the assets and liabilities of Royal Nepal Airlines Corporation (RNAC). The government eliminated over 7,500 vacant civil service posts.

15. The anti-corruption strategy approved by cabinet in early 2003 was developed into a strategic action plan. The Commission for Investigation of Abuse of Authority (CIAA) continued its strong anti-corruption efforts with capacity building support from DfID/DANIDA. A National Vigilance Center in the Office of the Prime Minister and Council of Ministers was made operational. A commission on fiscal decentralization produced its report on ways to clarify and enhance the responsibilities of local governments while strengthening accountability.

16. Several laws were amended to foster private sector development. A Build-Own-Operate-Transfer (BOOT) Ordinance was issued in September 2003 and several projects were opened for private sector participation. Nepal became a member of the WTO in April, and a legislative action plan for compliance with accession commitments was developed.

II. Macroeconomic Objectives and Policies, 2004/05

A. Macroeconomic Objectives

17. The macroeconomic program for 2004/05 is in line with the PRGF medium-term framework. Real GDP in 2004/05 is projected at around 4½ percent, driven by agriculture and continued recovery in manufacturing and tourism; inflation is projected to be 4-5 percent; and the NRB will maintain international reserves around seven months of imports of goods and services.

B. Fiscal Policy

18. The government's principal fiscal policy objectives over the medium term remain raising the revenue-to-GDP ratio, improving the efficiency of public spending, and reducing domestic borrowing. In line with understandings reached with the IMF, the medium-term fiscal framework aims to raise the revenue-to-GDP ratio to 13½ percent of GDP (HMG format) by 2006/07. Over this period, expenditure (including principal repayments) is projected to rise to 20 percent of GDP. The bulk of the increase will be in capital expenditure and poverty reduction spending, in line with the prioritization set out in the Medium-Term Expenditure Framework. With higher aid inflows, net domestic financing of the budget will remain limited. This path of budget financing will help to stabilize and then reduce the public debt ratio and create room to meet contingent liabilities from the ongoing banking sector and public enterprise reforms.

19. The 2004/05 budget adopted on July 15 is consistent with the medium-term fiscal policy objectives. The budget targets an increase in the revenue-to-GDP ratio of around ½ percent to 13 percent (HMG format) based on strong revenue administration efforts to check excise leakages and collection of income tax arrears. Total expenditure is projected to rise with a substantial increase in the capital spending allocation. Social sector spending (health, education, drinking water and local development) is also set to rise (from about 4¾ percent in 2003/04 to about 6 percent). Security-related spending in 2004/05 is budgeted to remain broadly unchanged as a share of GDP compared to 2003/04 (3 percent of GDP). The overall deficit (after grants) would be contained to around 4¾ percent of GDP and (gross) domestic financing to 1¾ percent of GDP. Looking forward, any increase in government employees' wages would be linked to responsibility levels. Such an increase would need to be financed by an increase in tax rates, including the VAT rate, in consultation with the IMF. More generally, an increase in the VAT rate and elimination of tax exemptions is required to mobilize revenue over the medium term.

20. Further steps in reforming both revenue administration and expenditure management are being taken to achieve fiscal policy objectives. To help improve revenue administration, we have requested IMF and other donor assistance.

  • The Large Taxpayer Office is to be fully operational by November 15, 2004. A key element of the effort to improve its operations is the provision for performance-based incentives to recruit and retain highly qualified staff. Further, actions are contemplated by January 15, 2005 to strengthen the LTO, as specified in the TMU. On customs administration, reform actions are to be taken by mid-November 2004 and January 15, 2005, as specified in the TMU. As in the case of the LTO, the government is committed to a provision for performance based pay incentives for staff at the Customs Department.

  • To improve expenditure management, the 2004/05 budget adopted a reclassification of expenditure into current and capital, along GFS lines. Moreover, expenditures are fully prioritized, by ministry, and by objective (sustainable broad based growth, social sector and infrastructure development, targeted programs, governance, and general administration).

C. Monetary and Exchange Rate Policies

21. Monetary policy will remain geared to supporting the exchange rate peg to the Indian rupee which has served Nepal well given its close ties with India. Consistent with this objective and the 2004/05 monetary policy statement, 12-month broad money growth is projected to be around 12-13 percent by end-2004/05, assuming real GDP growth of 4-4½ percent and a small decline in velocity. This growth would accommodate domestic financing needs of the budget while allowing private sector credit growth of about 9 percent in real terms. Reserve money growth is projected at 9-10 percent, with a targeted increase in the NFA of the NRB by US$95 million. The current level of the peg remains appropriate.

22. The monetary policy statement also outlines steps to improve policy implementation, and foreign exchange reserves and public debt management.

  • The NRB has adopted a new framework for its monetary operations, in line with IMF recommendations, to facilitate market determination of short-term interest and repo rates through buy, sell, and repo (and reverse repo) auctions and provide greater control over market liquidity. These auctions are to be complemented by a standing credit facility for commercial banks at the NRB on a lender-of-last resort basis by November 15, 2004. Furthermore, to help determine quantities for open market and repo auctions, a liquidity monitoring and forecasting framework is being operationalized also by November 15, 2004. The high-frequency analysis from this framework will inform the discussions of the recently established high-level monetary management committee.

  • To enhance its foreign exchange reserve management capabilities, the NRB has been provided technical assistance by the IMF.

  • To further improve public debt management, auctions of long-term government bonds will be introduced. The government has committed itself to a domestic borrowing schedule and intends to stick to the announced auction calendar. Preparations for the introduction of a comprehensive book entry system of electronic records and accounting of ownership of government securities have been initiated.

D. Structural Reforms

Financial Sector Reforms

23. Steps will be taken to improve the banking framework and loan recovery, further NRB re-engineering and restructure troubled commercial and development banks. The government and NRB are fully committed to further improving the banking framework, effective loan recovery from willful defaulters, and to resolution of nonperforming loans. The BFI Ordinance will be revised, taking into consideration the concerns of IMF and the World Bank, including for consistency with the new Company Ordinance by February 15, 2005. We will fully support the actions of NBL and RBB management teams, especially against large, willful defaulters. The government is committed to providing additional resources to ensure that the DRT functions effectively including for the expeditious execution of the DRT's decisions. The DRT decisions and their rationale will be available to the public. To widen the instruments available to commercial banks to resolve nonperforming loans, the cabinet intends to approve an Asset Management Company (AMC) ordinance by January 15, 2005.

24. The NRB has an ambitious "re-engineering" agenda for 2004/05. The NRB will achieve its long-term organizational structure by end 2004/05, with a reduction in the number of departments from 20 to 13/15. As regards human resource policies, NRB by-laws will be amended to improve recruitment, transfers, performance appraisal, and promotion procedures, in line with recommendations of the World Bank financed consultants. The NRB will amend the employee rules and regulations to make provision for a tenure-based Compulsory Retirement Scheme (CRS) by November 15, 2004 and further staffing reduction will be made with the CRS to right size the NRB. Improvements in the NRB's information technology (IT) platform and process automation, especially in the branch offices, with World Bank support, will also help achieve staff reductions. The hiring freeze at nonofficer levels will be maintained.

25. Bank supervision, accounting, and auditing are to be further strengthened. All commercial banks will be inspected at least once every two years and a system of monitoring follow up actions developed. An IFRS (formerly IAS)-compliant accounting manual and upgraded auditing manual will be prepared by July 2005. To further enhance NRB oversight over the financial system, a strong effort will be made to improve financial sector accounting. This will involve reducing substantially the amounts in the interbank reconciliation and interest suspense accounts, as recommended by the World Bank financed consultants. Furthermore, to facilitate interbank reconciliation on a high frequency basis, the banks will be instructed to shift their accounting practices from an account to bank basis.

26. Commercial banks. External managers will continue to prepare NBL and RBB for privatization. The government has extended external management at NBL, and expects to do the same for RBB. The cabinet has approved amendments to the NRB Act to provide the NRB sufficient powers to restructure ailing commercial banks. The external managers are expected to further improve the financial condition of the banks, as agreed, groom local counterparts, and increase staff productivity through training and full use of the new IT platforms. Operating costs would be further reduced by the Phase II VRSs at the two banks. As regards the overall strategy for these banks, we have discussed various options with the IMF and the World Bank including liquidation, merger, and privatization as separate entities. It is expected that the two banks can be sold as separate entities, but the government is open to other modalities should separate privatization prove to be difficult. The government will move to privatize the banks as rapidly as possible and aims to accomplish this objective by the end of the PRGF arrangement in 2005/06. To this end, sales advisors will be recruited under Phase II of the financial sector reform program supported by the World Bank.

27. Development banks. The ADBN is to be restructured by January 15, 2005, including through introduction of professional management and staff reduction, and actions will be taken to place the bank on a sound commercial footing. Despite the poor financial condition of the NIDC, the government has, for the time being, decided to attempt a restructuring as specified in the TMU—vigorous loan recovery, no gross lending, closure of regional offices, and a VRS has been introduced mid-July to achieve a significant staff reduction—with the aim of privatization. However, should privatization not be possible by end 2004/05, liquidation proceedings will be initiated. In the meantime, no further capital injections will be made in NIDC.

Public Sector Reforms, Governance and Private Sector Development

28. The government is committed to staying the course in SOE reform. All known liabilities have been settled for Cottage and Handicrafts Emporium and Nepal Coal Limited. As decided earlier, privatization/liquidation of five additional SOEs is expected to be completed in the first half of the fiscal year. The government is committed to continuing with the settlement of liabilities/privatization of all SOEs identified in the TMU and is committed to not incurring any new direct or contingent liabilities or providing any off-budget support. The sale of NTC shares to the public is expected to be completed by January 15, 2005; private participation will be invited in RNAC; and the internal unbundling of Nepal Electricity Authority completed. More generally, the cap on the aggregate employment in SOEs will be continued and lowered to reflect divestment that has been completed; performance contracts will be introduced with all major SOEs and efforts to update audits of all SOEs to international accounting standards will continue to determine the full extent of their contingent liabilities.

29. Efforts are under way to improve the financial condition of NOC.

  • Steps are to be taken to improve governance at the NOC, raise efficiency, and significantly reduce leakages following the recommendations of a high-level committee. The Board has been professionalized and an international audit of the NOC's 2003/04 accounts will be completed by February 15, 2005. The procurement arrangement with IOC will be revisited. Legal preparations are underway to issue the Petroleum Products Sale and Distribution Ordinance to open up the petroleum sector to private importers by mid-February 2005. The government will undertake an extensive program of public education of these reform measures and of the rationale for the proposed price adjustments.

  • As noted above, to stem and eliminate NOC's financial losses, the government has already begun upward adjustments in prices of petroleum products. Recently, aviation fuel prices were fully adjusted to international levels; and prices of petrol, diesel, LPG and kerosene were adjusted up. Should adulteration between petroleum products persist even after prices are raised towards international levels, the price differentials will be modified to address the problem; prices will be adjusted further, as needed. To ensure smoother adjustment in NOC pricing in the future, the automatic pricing formula recommended by the Petroleum Price Fixing and Monitoring Committee—which builds in an element of cost recovery for NOC's accumulated losses—will be implemented by end-December 2004. The formula will be published and prices will be adjusted monthly by the NOC Board.

30. Civil service reform will be reinvigorated. One half of the nongazetted civil service vacancies will be eliminated by mid-January 2005, and the freeze on recruitment for nongazetted positions will be maintained. A personnel information system for teachers will be completed. Based on the experiences at the LTO and the Customs Department, performance based incentive systems will be introduced at other selected government ministries and agencies. The government has also drafted amendments to the Civil Service Act, including provisions for VRS, annual personnel assessment, and merit based/gender sensitive recruitment and promotion, and cabinet intends to approve the ordinance by November 15, 2004. The Governance Ordinance is to be approved by cabinet.

31. Governance can be improved by a series of measures envisaged in 2004/05. The anti-corruption strategy will be translated into a prioritized, time bound, monitorable action plan with quarterly progress reports on implementation. The government will provide adequate resources to enhance the CIAA's operations to complement DfID/DANIDA technical assistance. The government will also seek to enhance the capacity of the Special Court to ensure a more accelerated processing of cases. To enhance disclosure of fiscal operations, the cabinet will approve by January 15, 2005 the Fiscal Transparency Ordinance, which will provide the public with information on public contracts and privatization transactions. Further improvements in the ordinance will be undertaken following the IMF Fiscal ROSC mission in November 2004. A Procurement Ordinance will address the issues raised in the World Bank's Country Procurement Assessment Report.

32. Measures to foster private sector participation and labor market flexibility are envisaged. Cabinet approved at end-July a Secured Transactions Ordinance and an Insolvency Ordinance. The Company Ordinance is at final stages of cabinet approval. A new Competition Ordinance to eliminate monopolistic practices is also close to finalization. Cabinet intends to approve an anti-money laundering ordinance by December 2004. The Ministry of Labor is working to build consensus on amendments to labor legislation. We believe understandings can be reached with stakeholders in key areas such as regulations against dismissal, on minimum wages, and other employment conditions by December 2004 and labor legislation finalized at that time. The government also intends to liberalize recruitment and retrenchment provisions of labor laws in special economic zones.

Safeguards and Statistical Issues

33. The NRB intends to fully implement the recommendations of the IMF safeguards mission. The recommendations from the international audit of the NRB's 2002/03 accounts and IMF recommendations will be implemented fully. In particular, early preparations will be made for a follow up audit of the 2003/04 accounts by an international audit firm, in consultation with the Auditor General to ensure that the benefits from the 2002/03 audit are internalized.

34. The government will continue to strengthen the quality, coverage, and timeliness of its macroeconomic statistics and implement IMF technical assistance recommendations. In particular, PRGF program data will be reconciled with NRB's accounts for all test dates.

III. Program Monitoring

35. The program will be monitored using the definitions, data sources, and frequency of monitoring set out in the attached Technical Memorandum of Understanding. The government will make available to Fund staff all core data, appropriately reconciled and on a timely basis, as specified in the TMU.

36. Performance criteria. Table 1 shows quantitative performance criteria and benchmarks until mid-July 2005. In addition, the nonaccumulation of external payment arrears will constitute a continuous performance criterion, as will the standard injunctions against overdue financial obligations to the IMF, imposition or intensification of restrictions on current payments, introducing or modifying multiple currency practices, conclusion of bilateral payments agreements inconsistent with Article VIII, and imposition or intensification of import restrictions for balance of payments purposes. Structural performance criteria and benchmarks for second and third reviews are identified in Table 2.

37. Program review. The second review of the program under the PRGF arrangement will be completed by mid-January 2005. This review will focus on: (i) progress in financial sector reform, including the debt recovery framework; (ii) the implementation of administration reforms at the Inland Revenue Department and Customs; (iii) safeguards issues; and (iv) progress in SOE reform. The third review under the arrangement is expected to be completed by end-April 2005.

Table 1. Nepal: Quantitative Performance Criteria and Indicative Targets
(In billions of Nepalese rupees, unless otherwise stated)

July 15,

October 16, 2004

Jan 13,

Apr 13,

July 15,







Performance criteria (PC) and indicative targets (IT )1


Floor on net foreign assets of the NRB
(in millions of U.S. dollars)23






II.  Ceiling on net domestic assets of the NRB24 -15.7 -20.1 -22.6 -16.1 -14.2
III.  Ceiling on change in net domestic financing of central government budget4,5 Cumulative from July 15, 2004 . . . 0.5 1.4 2.2 3.5
IV.  Ceiling on contracting or guaranteeing of new nonconcessional medium- and long-term external debt by the central government and NRBCumulative from July 15, 2004 (in millions of U.S. dollars)6 0.0 0.0 0.0 0.0 0.0
V.  Ceiling on short-term external debt contractedor guaranteed by the central government and NRB
(in millions of U.S. dollars)6
0.0 0.0 0.0 0.0 0.0
VI.  Accumulation of external payments arrears
Continuous performance criterion during the program period
(In millions of U.S. dollars)
0.0 0.0 0.0 0.0 0.0
Indicative targets (IT)          
I.  Ceiling on reserve money 93.0 89.4 89.1 97.5 101.6
II.  Floor on central government revenue5 . . . 10.8 25.0 43.1 68.3
  Cumulative from July 15, 2004          

1Mid-October 2004 and mid-January 2005 are performance criteria test dates. Figures for mid-April 2005 and mid-July 2005 are indicative targets.
2Valued at the program exchange rates. Monetary gold valued at program prices (US$360 per oz.).
3To be adjusted upward/downward by excess/shortfall of foreign program financing. Details specified in the Technical Memorandum of Understanding.
4To be adjusted upward/downward by shortfall/excess of rupee equivalent of foreign financing. Details specified in the Technical Memorandum of Understanding.
5To be adjusted upward/downward by excess/shortfall of privatization receipts. Details specified in the Technical Memorandum of Understanding.
6External debt as defined in the Technical Memorandum of Understanding.

Table 2. Nepal: Structural Performance Criteria and benchmarks
under the PRGF Arrangement1,2

Measures Timing

Prior Action for First Review  
1.  Implement VRS at the RBB (Phase II)  
Structural Performance Criteria  
A.  Fiscal and Monetary Reforms  
1.  Implement time-bound action plan to improve customs administration November 15, 2004 and January 15, 2005
2.  Fully operationalize the large tax payer office (LTO) in the Inland Revenue Department November 15, 2004 and January 15, 2005
3.  Implement new framework for monetary operations, including a liquidity monitoring framework November 15, 2004
B.  Financial Sector Reforms  
1.  Finalize audit of NRB's 2003/04 accounts by an international auditor January 15, 2005
2.  Strengthen the Nepal Rastra Bank (Provide for compulsory retirement
in NRB employee rules and regulations)
 November 15, 2004
C.  Public Sector Reform  
1.  Finalize audit of NOC 2003/04 accounts by international auditor February 15, 2005
2.  Implement automatic pricing mechanism for oil products December 31, 2004
Structural Benchmarks  
1.  Cabinet approval of Fiscal Transparency Ordinance January 15, 2005
2.  Amend BFI ordinance including for consistency with other legislation February 15, 2005
3.  Cabinet approval of Asset Management Companies Ordinance January 15, 2005
4.  Strengthen the Nepal Rastra Bank (Revise Human Resource Policies) November 15, 2004
5.  Prepare a time bound action plan to strengthen Financial Management and Internal Audit Depts. of NRB November 15, 2004
6.  Implement restructuring plans for ADBN and NIDC November 15, 2004 and January 15, 2005
7.  Adopt Petroleum Products Sale and Distribution Ordinance February 15, 2005
8.  Complete liquidation/privatization of five SOEs November 15, 2004 and January 15, 2005
9.  Cabinet approval of amended Civil Service Ordinance November 15, 2004
10.  NRB to reconcile accounting data with program monitoring data Quarterly test dates (Table 1)

1The actions are to be described in the Technical Memorandum of Understanding.
2November 15, 2004 actions relate to the second review. December 31, 2004, January 15, 2005, and February 15, 2005 actions relate to the third review. 

Technical Memorandum of Understanding for PRGF Arrangement

October 4, 2004

This memorandum sets out the framework for monitoring the PRGF-supported program for 2004/05. It specifies quantitative performance criteria and indicative targets and the content and frequency of the data to be provided for monitoring the financial program. All foreign currency nondollar denominated quantities under the program will be converted into U.S. dollars at program exchange rates specified in Table 1. A description of selected structural performance criteria and benchmarks is also provided.

Table 1. Program Exchange Rates and Gold Prices1
Foreign currency Nepalese rupees/
Foreign currency

Indian rupee     1.6
SDR 104.0
U.S. dollar   75.0
Japanese yen       0.64
Euro   83.0
Pound sterling 120.0
Gold prices (U.S. dollars per ounce) 360.0

1Currencies not shown here will be converted first into U.S. dollars using official exchange rates used by the IMF's Finance Department on July 15, 2004.

I. Quantitative Performance Criteria and Indicative Targets

A. Net Foreign Assets of Nepal Rastra Bank

1. Net foreign assets (NFA) of the Nepal Rastra Bank (NRB) is defined as the difference between the market value of gross foreign assets and liabilities, at program exchange rates. Gross foreign assets of the NRB consist of monetary gold, foreign currency balances at the NRB, foreign exchange balances held outside Nepal, foreign securities (valued at market prices), foreign bills purchased and discounted, IMF reserve position and SDR holdings. Excluded from gross foreign assets will be participation in international financial institutions and holdings of precious metals other than monetary gold. Gross foreign liabilities are all foreign currency denominated liabilities and use of Fund credit.

2. The NFA floor will be adjusted downward/upward by the shortfall/excess of the identified foreign program financing as set out in Table 2. Foreign program financing is defined to include adjustment loans from multilateral creditors other than the Fund, budget support from bilateral creditors, loans (if any) from private creditors (including commercial banks) and rescheduling of medium- and long-term public and publicly-guaranteed debt.

Table 2. Program Foreign Financing, 2004/05
(In millions of U.S. dollars)
  Oct 16, 2004 Jan 13, 2005 Apr 13, 2005 July 15, 2005

Foreign financing (cumulative) 0.0 0.0 0.0 70.0

B. Net Domestic Assets of NRB

3. Net domestic assets (NDA) of the NRB is defined as the difference between reserve money and rupee value of NFA of the NRB, at program exchange rates. NFA of the NRB is defined above; reserve money is defined in Section C.

4. The NDA ceiling will be adjusted downward/upward by the excess/shortfall of the identified foreign program financing as set out in Table 2. External program financing received for financial and public sector reforms over the amounts identified in Table 2 would not lead to a downward adjustment of the NDA ceiling. The upward adjustment in the ceiling due to a shortfall in external program financing compared to Table 2 would be capped at Nrs. 5 billion (around 1 percent of GDP).

C. Reserve Money of the NRB

5. Reserve Money (RM) of the NRB consists of currency in circulation outside the NRB, deposits of commercial banks at the NRB, and other deposits at NRB. As of mid-July 2004, RM defined in this manner stood at Nrs. 92.97 billion.

D. Net Domestic Financing of the Central Government Budget

6. Net domestic financing (NDF) of the budget is defined as net credit to the government (NCG) by the banking system (NRB and deposit money banks (DMBs)) and net change in holdings of treasury bills and other government securities by the nonbank sector. The flow NDF of the budget would be the cumulative change in book value from mid-July 2004 in the sum of the following government debt instruments: (i) treasury bills; (ii) development bonds; (iii) national and citizen savings certificates; (iv) special bonds (including duty drawback bonds); and (iv) loans and advances from the NRB and deposit money banks (DMBs) minus government deposits with NRB and DMBs. This stock stood at Nrs. 83.9 billion at mid-July 2004. Central government is defined here to include line ministries, departments and public institutions.

7. The ceiling on net domestic financing will be adjusted upward/downward by the shortfall/excess of rupee equivalent of foreign program financing as set out in Table 2. External program financing received for financial and public sector reforms over the amounts identified in Table 2 would not lead to a downward adjustment of the NDF ceiling. The upward adjustment in the ceiling due to a shortfall in external program financing compared to Table 2 would be capped at Nrs. 5 billion (around 1 percent of GDP). The ceiling on net domestic financing will be adjusted upward/downwards by 50 percent of the amount of any shortfall/excess in privatization receipts beyond the programmed amounts (Table 3).

Table 3. Program Privatization Receipts, 2004/05
(In millions of Nepalese rupees)
  Oct 16, 2004 Jan 13, 2005 Apr 13, 2005 July 15, 2005

Privatization receipts (cumulative) 0.0 50.0 260.0 620.0

E. Central Government Revenue

8. Central government revenue is defined as reported in the treasury accounts (economic classification), excluding principal repayments to the budget by corporations and including privatization receipts. The floor on central government revenue is cumulative from the start of the fiscal year. The central government revenue benchmark will be adjusted upwards/downwards by 50 percent of the excess/shortfall in privatization receipts.

F. Contracting or Guaranteeing of New Nonconcessional External Debt

9. Contracting or guaranteeing of new medium- and long-term nonconcessional external debt is defined as contracting or guaranteeing new nonconcessional external debt by the central government and the NRB with an original maturity of more than one year (valued at program cross exchange rates as defined in Table 1). Nonconcessional debt is defined as borrowing containing a grant element of less than 35 percent on the basis of currency-specific discount rates based on the OECD commercial interest reference rates. For maturities of less than 15 years, the grant element would be calculated based on six-month CIRR averages, while for maturities longer than this, the grant element would be based on ten-year CIRR averages. This performance criterion applies not only to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85), August 24, 2000) but also to commitments contracted or guaranteed for which value has not been received. Excluded from this performance criterion are credits extended by the IMF and financing from the World Bank and Asian Development Bank (AsDB), and government counter guarantees on project loans from both the World Bank and AsDB, as well as changes in indebtedness resulting from rescheduling operations or rollovers. Debt falling within the limit shall be valued in U.S. dollars at the exchange rate prevailing at the time the contract is entered into, or guarantee issued.

G. Contracting or Guaranteeing of Short-Term External Debt

10. Stock of short-term external debt outstanding is defined as debt with original maturity of up to one year owed or guaranteed by the NRB and central government (valued at programmed cross exchange rates as defined in Table 1). The term debt is defined as set forth in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85), August 24, 2000), but excludes normal import-related credits.

H. Accumulation of External Payment Arrears

11. The program's performance criterion on nonaccumulation of external payment arrears is continuous throughout the program period. External payments arrears are defined as overdue payments (interest and principal payments) on short-term debt in foreign currencies with an original maturity of up to and including one year (spot, money market, letters of credit) and medium- and long-term debt contracted or guaranteed by the government. As of mid-July 2004, there were no reported external payment arrears.

II. Data Reporting Requirements

12. For the purpose of monitoring the performance under the program, data will be provided in the format shown in Tables 4-9. Nepal shall provide the Fund, through reports at intervals or dates requested by the Fund, with such information as the Fund requests in connection with the progress of Nepal in achieving the objectives and policies set forth in the letter. All the program monitoring data would be provided by the Ministry of Finance and the NRB. In addition, a written reconciliation of NRB program data (NFA, NDA and Reserve Money) with the accounting records will be prepared for all test dates under the PRGF arrangement. Data on gross foreign assets and gross foreign liabilities would be provided at market prices. All the data relating to the above programmed targets will be furnished within eight weeks after the end of each test date.

Table 4. Net Foreign Assets of the Nepal Rastra Bank, 2004/05
(In millions of U.S. dollars)
  Oct 16, 2004 Jan 13, 2005 Apr 13, 2005 July 15, 2005

Net foreign assets1        
   Foreign exchange        
   Monetary gold        
   Reserve position in the Fund        
   SDR holding        
   CSI credit accounts        

1At program exchange rates and prices.    

Table 5. Balance Sheet of the Nepal Rastra Bank, 2004/051

(In billions of Nepalese rupees)
  Oct 16, 2004 Jan 13, 2005 Apr 13, 2005 July 15, 2005

Net foreign assets1        
Net domestic assets        
   Claims on public sector        
      Net credit to government        
         Claims on government 2        
         Less: Deposits        

      Claims on public enterprises


   Claims on private sector


   Claims on commercial banks


   Other items (net)


Reserve money


   Currency outside banks


   Currency held by banks


   Bankers' deposits


   Private sector deposits


1For program monitoring purposes.
2Excluding IMF promissory notes.

Table 6. Net domestic financing of the Budget, 2004/05
(In millions of Nepalese rupees)
  Oct 16, 2004 Jan 13, 2005 Apr 13, 2005 July 15, 2005

Net claims on government (stock)        
      NRB (net)        
            Treasury bills        
            Development bonds        
            National saving certificates        
            Citizen saving certificates        
            Special bonds        
            Loans and advance        
         Less: Deposits        
            Treasury bills        
            Development bonds        
            National saving certificates        
            Citizen saving certificates        
            Special bonds        
         Treasury bills        
         Development bonds        
         National saving certificates        
         Citizen saving certificates        
         Special bonds        

Table 7. Central Government Revenue, 2004/05
(In millions of Nepalese rupees)
  Oct 16, 2004 Jan 13, 2005 Apr 13, 2005 July 15, 2005

Total revenue (HMG)        
   Less: Principal repayment by corporations        
Total revenue 1        
Tax revenue        
   Taxes on goods and services        
      VAT/sales tax        
      Excise taxes        
   Taxes on international trade        
      Import taxes        
      Indian excise refund        
      Export taxes        
      Agriculture reform fee and other        
   Taxes on income and profits        
   Taxes on property        
Nontax revenue1        
   Charges, fees, and fines        
   Sales of goods and services        
   Royalty and fixed asset sales        
   Interest receipts        

1 Excluding principal repayments by corporations.

Table 8. Contracting or Guaranteeing of New Nonconcessional Medium- and Long-Term External Debtby the Central Government and the NRB
(In millions of U.S. dollars)
      Date of   Maturity Grace Interest    
Date Creditor Project Agreement Currency Period Period Rate Amount Disbursement


Table 9. Contracting or Guaranteeing of New Short-Term External Debt
by the Central Government and the NRB
(In millions of U.S. dollars)
      Date of   Maturity Grace Interest    
Date Creditor Project Agreement Currency Period Period Rate Amount Disbursement


III. Structural Performance Criteria and Benchmarks

A. Fiscal and Monetary Reforms

1. Operationalize Large Taxpayer Office (LTO) in Inland Revenue Department

The following actions would constitute observance of the performance criterion.

By November 15, 2004

  1. MOF to ensure full staffing;
  2. LTO to clarify job descriptions of officials;
  3. LTO to publish a code of conduct for its officials; and
  4. LTO to prepare an audit manual.

By January 15, 2005

  1. LTO to develop performance indicators for staff;
  2. MOF to provide for performance based incentives to recruit and retain highly qualified staff in the LTO;
  3. LTO to establish a database to improve its audit capabilities; and
  4. LTO to prepare a strategy for audit, collection, and taxpayer compliance.

2. Implement Time-Bound Action Plan to Improve Customs Administration

By November 15, 2004

  1. MOF to approve the model customs office plan proposal of Customs Department, including a provision for performance based incentives.

By January 15, 2005

  1. Customs Department to operationalize one model customs office; and
  2. Customs Department to prepare valuation database.

3. Monetary Policy Operations and Public Debt Management

By November 15, 2004

  1. NRB to introduce repo (and reverse repo) operations on an auction basis;
  2. NRB to introduce a standing credit facility for commercial banks at the NRB. The facility would be automatic, fully collateralized, with individual bank quotas, and carry a penalty rate over short-term interest rates; and
  3. MOF, in consultation with NRB, to announce a domestic borrowing schedule for 2004/05.

B. Financial Sector

1. Strengthening Nepal Rastra Bank

a. Human Resource Policies

By November 15, 2004

The NRB Board will approve new polices on human resource management. The following points will be included:

  • Performance appraisal, recruitment and promotion: Performance appraisal, especially of department heads and other senior officers, will be conducted at least once a year. The NRB will move towards ensuring that all new openings at higher levels are announced both internally and externally to attract qualified people. Provisions will be made for merit-based recruitment and promotion. It is expected that less preference will be given to seniority in internal promotion decisions. A new code of staff conduct, including provisions on staff rules on taking external assignments, will be developed.

  • Transfers: Specialist positions and career paths in the NRB will be clearly identified to maintain functional continuity and build expertise. Tenure requirements in these positions will also be clearly identified. Assurances will be provided that satisfaction of the tenure requirements, subject to satisfactory performance, will not adversely affect the staff member's promotions and compensation prospects.

  • Training: Candidates for internal and external training would be selected based on relevance of training for the candidates' current or announced future assignments. Following training, the candidates would remain in the originating department for at least two years to utilize and disseminate acquired expertise.

b. Compulsory Retirement Scheme

By November 15, 2004

    NRB to include a provision for compulsory retirement in its employee rules and regulations.

2. Banking Framework

By February 15, 2005

    The Banking and Financial Institutions Ordinance will be revised in consultation with IMF and World Bank staffs.

3. Commercial and Development Banks

Definition of Actions

Implementation of the VRS comprises all of the following:

  1. Announcement of the scheme, including benefits, eligible staff, and an application deadline;
  2. Receipt of applications from employees; and
  3. Notification to accepted applicants, including terms of severance.

If, in any entity implementing the VRS, the number of applications received is less than the expected reductions in staff, the entity's scheme would be revisited at the time of the second review. A decision would be made to extend the scheme, change its coverage, or other means of staff reduction (including compulsory retirement) will be identified. In this context, the performance criteria for the third review will be set.

a. Rastriya Banijya Bank (RBB)

Prior Action

Implement a VRS scheme. The expected staff reduction is 100.

b. Agricultural Development Bank of Nepal (ADBN)

By January 15, 2005

  1. Complete financial audit of 2003/04 accounts;
  2. Prepare Memorandum and Articles of Association. Incorporate ADBN under the new Company Act. Transfer assets and liabilities to the new company;
  3. File for banking license; and
  4. Prepare business plan consistent with restructuring plan.

c. Nepal Industrial Development Corporation

By November 15, 2004

Implement a VRS scheme. The expected staff reduction is 50.

By January 15, 2005

  1. Close regional offices, dispose their fixed assets, and transfer debt related transactions to the Head Office; and
  2. ettle employee liabilities, including under VRS.

Continuous until January 15, 2005

No capital injection by government.

C. Public Sector Reforms

a. Liquidation/Privatization of State-Owned Enterprises (SOEs)

SOEs Under Consideration

Nepal Transport Corporation; Hetauda Textile Factory; Birgunj Sugar Factory; Agriculture Tools Factory; Nepal Rosin and Turpentine Limited; Himal Cement Company; Lumbini Sugar; Janakpur Cigarettes; NCCN; and NEPECON.

Definition of Actions

Liquidation: Settlement of all liabilities. Commencement of liquidation means appointment of a liquidator and initiation of settlement of liabilities.

Cabinet approval of privatization: Cabinet approval of sale and purchase agreement (SPA). The SPA must include the chosen buyer, final price and other financial and technical understandings between the government authority and the private buyer. The SPA would have been previously endorsed by the Privatization Committee. Commencement of privatization means endorsement of the SPA by the Privatization Committee.

By November 15, 2004

    Liquidation or Cabinet approval of privatization of two SOEs.

By January 15, 2005

    Liquidation or Cabinet approval of privatization of a total of five SOEs.

b. Nepal Oil Corporation

By December 31, 2004

    Implement automatic petroleum pricing formula recommended by the Petroleum Price Fixing and Monitoring Committee. The formula is expected to have the following key elements: (a) a provision for monthly adjustment of petroleum products' prices; and (b) reflect international prices of petroleum products, transactions costs, NOC overheads, VAT and other applicable taxes, and a margin for NOC profits that allows for recovery of past losses.

By January 15, 2005

    Finalize audit of 2003/04 NOC accounts by an international firm.

By February 15, 2005

    Cabinet approval of Petroleum Product and Sales and Distribution Ordinance.