IMF Executive Board Concludes 2008 Article IV Consultation with NepalPublic Information Notice (PIN) No. 08/59
May 27, 2008
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On May 16, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Nepal.1
Years of protracted political turmoil and conflict have retarded Nepal's economic growth. Per capita GDP has barely risen in the last decade and the country remains one of the poorest in the world. However, Nepal is now undergoing a major political transition. The next step in this process, the writing of a new constitution, will be carried out by the Constituent Assembly emerging from the elections held on April 10, 2008. Despite some pre-election violence, these elections were considered largely free and fair by international observers.
Despite civil conflict and political upheavals, macroeconomic performance under the Poverty Reduction and Growth Facility (PRGF)-supported program that ended last November has been stable: growth has been maintained, albeit at relatively low levels; the peg to the Indian rupee has helped keep inflation below 8 percent during the program period; the budget stance has been cautious; and foreign exchange reserves have doubled since 2002, boosted by a strong inflow of remittances.
The macroeconomic outlook for 2007/082 remains stable. The agricultural recovery, a favorable service sector performance, and a significant increase in tourist arrivals could boost real GDP growth to 3½ -4 percent in 2007/08. Anchored by the exchange rate peg, inflation is projected to remain at around 6½ percent to 7 percent. On the external side, rising oil imports and stagnant exports have led to a further deterioration in the trade deficit, but this will be more than offset by higher workers' remittances. Despite a strong revenue performance, the budget deficit could rise this year to about 3½ percent of GDP, reflecting in part the one-off costs of the elections and the clearance of most of the state oil company's arrears. However, the company continues to accumulate sizable losses as high crude prices are only partially reflected in domestic prices for petroleum products.
While the macroeconomic performance has been stable, progress on structural reforms has been held back by the fragile political circumstances. In particular, little progress has been made to address institutional weaknesses in the financial sector and public financial management.
Vulnerabilities in Nepal's financial sector remain. Loose monetary conditions have led to negative real interest rates, rapid and potentially destabilizing stock market and property price increases, and some capital flight to India. Credit growth has been high, with aggressive lending by many private banks pushing their credit-to-deposit ratios to levels above 100 percent. Other vulnerabilities include weak supervisory capability and regulatory compliance, and stalled reforms of the two large public banks.
Limited progress has been made in addressing Nepal's structural weaknesses in tax administration and public financial management. Overall, the accounting, auditing, and reporting of public sector operations remain inadequate. The budget coverage is confined to only the central budget with limited information on quasi-fiscal activities, internal control procedures are not fully effective, and the management of spending is weak.
Looking ahead, Nepal's growth prospects depend most importantly on a peaceful political transition. Steady but low growth could continue in the near term. However, insecurity, violence in the Terai region, input supply disruptions, and structural barriers continue to discourage investment, limit exports, and hamper transition to a higher growth path. With Nepal located between two of the fastest growing economies in the world, an easing of these constraints, steady progress on the political front, and the development of Nepal's vast untapped hydropower resources could lift growth to levels of 5−5½ percent over the medium term.
Executive Board Assessment
Executive Directors commended the Nepalese authorities for maintaining budget discipline and macroeconomic stability over the past several years despite civil conflict and major political upheavals. Inflation has remained stable, public debt pressures have lessened, and foreign exchange reserves have grown significantly owing to strong worker remittance inflows. At the same time, economic growth has been slow.
Directors welcomed the recent successful conclusion of the election for the Constituent Assembly. They emphasized that Nepal is now at a critical juncture, and that continued stability is a key condition for allowing the current political transformation to result in higher, broad-based economic growth. Prerequisites for faster growth—in addition to improving infrastructure and reducing supply disruptions—include maintaining budget discipline and ensuring the soundness of the banking sector.
Directors noted that increased spending in some areas to improve the provision of public goods and address the legacy of the civil conflict should be balanced carefully against the need to keep domestic borrowing at sustainable levels. Further improvements in revenue collection will remain a priority, as will continued efforts by the authorities to secure external grants and concessional assistance. Directors considered that a key short-run fiscal priority will be to limit—and eventually eliminate—the losses of the Nepal Oil Corporation. They suggested that the authorities consider introducing an automatic pricing mechanism for petroleum products, which would depoliticize price setting.
While acknowledging recent efforts to manage liquidity through open market operations, Directors encouraged the authorities to pursue a more active monetary policy. They considered that a bias toward liquidity had led to negative real interest rates, rapid credit growth, potentially destabilizing asset price increases, and some capital flight, suggesting that some monetary tightening is in order. Directors called for further improvements in liquidity management and forecasting, and for the separation of the formulation and execution of monetary policy from public debt management.
Directors agreed that the pegging of Nepal's currency to the Indian rupee has served the country well given its extensive commercial ties to India, and that maintaining the peg in the near term will provide a credible nominal anchor and support Nepal's macroeconomic stability and development. With the overall balance of payments in surplus and the reserve position strong and stable, Directors saw little sign of exchange rate misalignment. However, a widening productivity gap with India could, over time, present exchange rate management challenges.
Directors urged the authorities to give renewed impetus to strengthening financial sector supervision and regulatory enforcement to maintain stability in the face of rapid banking sector growth. They looked forward to parliamentary approval of the Banking and Financial Institutions Act, which should further strengthen the regulatory framework, but stressed that significant improvements are needed in enforcement. The application of stricter licensing requirements will be an important signal of the authorities' willingness to tighten enforcement going forward. Directors called for a clearer strategy for completing the restructuring and commercialization of the two large public banks.