## INTRODUCTION

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### Macroeconomic context and growth challenges
- Macroeconomic performance: low public debt and moderate inflation; growth averaged only 4 percent over the last decade.
- Government objectives:
  - graduate from least-developed country status by 2022;
  - achieve middle income country status by 2030.
- 14th Development Plan (2016/17–2018/19) targets:
  - annual average growth of 7.2 percent;
  - reduction in the share of the population living in poverty by 4.6 percent to 17 percent by 2018/19.
- Constraints: frequent changes in government, infrastructure gaps, weak institutional capacity, and difficult business climate.

### Remittances, exchange rate, and external competitiveness
- Remittances:
  - 30 percent of GDP in FY2015/16.
  - Positive effects: reduce poverty, support balance of payments, boost fiscal accounts via import-related revenues.
  - Adverse effects: contributed to appreciation of the real exchange rate, rapid wage growth, stagnant exports, and widening trade deficit.

### Political environment and recent history
- Continued political uncertainty; several elections scheduled.
- Post-2015 earthquakes: new constitution, transition to a federal system.
- Disruptions: 4½ month blockade of terrestrial trade routes.
- August 2016: new coalition—the ninth government in nine years—assumed power.
- Political timetable: local elections set for mid-May under PM Dahal, followed by handover to a PM of the Nepali Congress to oversee federal and provincial polls.
- Outstanding issues: unresolved grievances related to the new constitution.

---

### RECENT DEVELOPMENTS, OUTLOOK, AND RISKS

### 2015/16 developments
- Growth and inflation:
  - Real GDP growth: 0.6 percent in 2015/16 (mid-July to mid-July).
  - Inflation: rose to 12 percent (y/y) in January 2016; later eased.
- Fiscal:
  - Budget under-implementation worsened in 2015/16, particularly capital spending.
  - Revenues exceeded the budget due to one-off telecom sector collections (1 percent of GDP).
  - Budget was in surplus for the fourth year in a row.
  - Net public debt: fell to 22 percent of GDP, down from 34 percent of GDP in 2012.
- External:
  - Current account surplus reached 6.3 percent of GDP as trade disruption lowered imports.
  - Exports fell (primary commodities and manufactured products).
  - Remittances growth slowed to 1 percent in 2015/16, from an annual average of 15 percent during the previous 5 years.
  - Gross reserves: US$8.7 billion (10 months of imports) in December 2016.

### 2016/17 signs of recovery
- Drivers: normalization of activity, favorable monsoon, improved power supply, accommodative monetary policy, rising government spending (housing grants, wages, pensions).
- Staff growth projection: growth to reach 5.5 percent in 2016/17.
- Inflation:
  - Inflation decelerated to 3.2 percent (y/y) in January 2017; expected to remain above India’s this year and next.
- India demonetization: expected limited overall impact; small holdings of Indian rupee notes by banks; some exposure among corporates, migrant households, and border areas.

### Rising macro-financial risks
- Rapid credit growth:
  - Private sector credit growth: 31 percent (y/y) in January 2017 (7-year high).
  - Increase concentrated in overdrafts; risk of diversion to land, real estate, and stocks.
- Liquidity tightening:
  - Banks’ loan to deposit ratio close to regulatory maximum of 80 percent.
  - Temporary regulatory relief by the central bank in February would allow continued rapid credit growth and raise macro-financial risks.
  - Softening remittances and rising imports contributed to liquidity tightening, higher interbank interest rates, and correction in stock prices.

### Scenarios and medium-term outlook
- Baseline scenario:
  - Assumes persistent political uncertainty and slow institutional strengthening.
  - Private investment remains around 25 percent of GDP; growth settles somewhat below the 4 percent average of the past decade.
  - Current account projected to swing to a deficit of about 2 percent of GDP in the medium term.
- Reform scenario:
  - Assumes sustained/deepened reform momentum: improved capital budget implementation, strengthened monetary policy framework and tightening, improved regulation and supervision, better investment environment.
  - Growth: accelerates gradually to close to 6 percent in the medium term.
  - Public capital spending: 1½ percent of GDP higher than baseline, largely financed by concessional loans and grants.
  - Additional fiscal space allows raising government current spending by close to 2 percent of GDP.
  - FDI-financed hydropower projects and more moderate remittances growth are additional elements.

### Key macroeconomic projections (selected exact figures)
- Real GDP (annual percent change):
  - 2015/16: 0.6
  - 2016/17 (Est.): 5.5
  - Baseline 2017/18–2020/21: 4.5, 3.8, 3.8, 3.8
  - Reform 2017/18–2020/21: 4.8, 5.0, 5.5, 5.8
- CPI (period average):
  - 2015/16: 9.9
  - 2016/17 (Est.): 6.7
  - Reform 2020/21: 5.2
- Workers' remittances (millions of U.S. dollars):
  - 2015/16: 6,253
  - 2016/17: 6,467
  - Reform 2020/21: 7,584
- Gross official reserves (millions of U.S. dollars):
  - 2015/16: 8,574
  - 2016/17: 8,690
  - Reform 2020/21: 8,062
- Public debt (percent of GDP):
  - 2015/16: 27.3
  - 2016/17: 25.7
  - Reform 2020/21: 25.9

### Risks to the baseline
- Upside risks:
  - Stronger-than-expected capital spending and accelerated housing grant payments.
  - Sustained policy and structural reform momentum.
  - Financial closure of large foreign-financed hydropower projects.
  - Faster recovery in international oil prices boosting employment abroad.
- Downside risks:
  - Domestic political instability.
  - Failure to increase implementation capacity.
  - Financial sector vulnerabilities.
  - Slowing remittances affecting financial sector liquidity.
  - Hasty implementation of a new federal fiscal framework straining government finances given weak PFM and institutional capacity.

### Authorities’ views
- Authorities optimistic on near-term growth; target 6.5 percent growth due to reconstruction, improved power supply, and strong agricultural output.
- Agreed with staff that structural reforms and increased implementation capacity are key for sustaining higher medium-term growth.

---

### POLICY DISCUSSIONS — FISCAL POLICY TO MEET PUBLIC SPENDING NEEDS

### Fiscal position and risks
- Fiscal policy tighter than envisaged due to budget implementation bottlenecks.
- Net public debt-to-GDP: 22 percent of GDP in 2015/16 (net of government deposits).
- Joint IMF/World Bank DSA: Nepal’s risk of debt distress remains low.
- 2016/17 budget:
  - Very large envelope, unlikely to be implemented in full given limited execution capacity.
  - Aims for near doubling of total spending vs 2015/16, including a 150 percent increase in capital spending.
  - Targets an overall fiscal deficit of 10 percent of GDP, compared to a surplus of 2.4 percent of GDP (based on financing data) in 2015/16.
  - Mid-year budget review in February reduced capital spending by one-sixth, lowering the fiscal deficit target to 6.7 percent of GDP.

### Staff fiscal projection for 2016/17
- Staff projects a fiscal deficit of 1.1 percent of GDP and a fiscal impulse of about 1½ percent of GDP in 2016/17.
- Projected spending increase of 3.2 percent of GDP composed of:
  - housing grants to earthquake-affected households: 1.9 percent of GDP;
  - higher salaries and allowances: 0.8 percent of GDP;
  - capital spending: 0.5 percent of GDP.
- Underlying revenue (corrected for one-off receipts) projected to rise by 1.9 percent of GDP.

### Policy recommendations (fiscal)
- Scale up government spending to rebuild after the earthquakes and address infrastructure gaps, but:
  - Avoid exceeding the economy’s aggregate absorptive capacity.
  - Safeguard expenditure quality.
  - Ensure close policy coordination and information sharing with the central bank to prevent overheating and preserve private sector credit space.
- Short-term financing guidance:
  - Current and next fiscal years: macroeconomic framework could accommodate use of government’s accumulated cash balances.
  - Total net domestic financing (NDF) could amount to about 1½ percent of GDP per annum.
- Medium-term financing guidance:
  - Concessional external financing can finance the bulk of the 1½ percent of GDP increase in government capital spending over the medium term.
  - High-quality capital spending financed by concessional donor inflows preferable to keep debt burden in check.
  - With staff’s projections for foreign financing, overall fiscal deficits of up to 2 percent of GDP per annum are feasible in the medium term.
  - To prevent crowding out credit to the private sector, shortfalls in donor financing should not be replaced by additional domestic financing and NDF should not exceed 1 percent of GDP per annum.

---

### REVENUE PERFORMANCE, PFM, AND FISCAL RISKS

### Revenue performance and development spending
- Authorities’ reforms: prepare a unified tax code; draw up a medium-term strategic plan to strengthen customs administration; plans to set up a Revenue Board.
- Projected revenue impact: If fully implemented, could raise revenue by 1¾ percent of GDP over the medium term.
- Government revenue indicators (selected in percent of GDP):
  - Total revenue: figures shown across years include values such as 18.2, 19.1, 21.1, 21.4, 22.3, 22.3.
  - Total tax revenue: 15.9, 16.8, 19.0, 18.7, 20.2, 20.1.
  - VAT and excises and other tax components reported in the source.

### Budget preparation, project selection, and PFM
- Key findings:
  - Budgets should be more realistic and capital spending spread more evenly over the year.
  - Only well-prepared and prioritized projects should be included in the budget; expansion of spending should be anchored in an MTEF.
  - Project readiness requirements: feasibility study, environmental assessments, land acquisition completed before inclusion.
  - Authorities plan to prepare a “bank” of projects that have gone through preparatory stages to enable immediate tendering after budget adoption.
  - Need to integrate disparate PFM systems across ministries and strengthen budget coordination under the Ministry of Finance.
- Social spending and SDGs:
  - Social spending priorities need costing, inclusion in the MTEF, and translation into realistic annual budget allocations.

### Fiscal risks, SOEs, and fiscal space
- Recent support to SOEs: about 1¾ percent of GDP per annum spent on equity injections and loans to SOEs, including banks.
- Sectoral notes:
  - Oil: NOC repaid debt over past two fiscal years; full application of automatic oil price adjustment mechanism recommended.
  - Electricity: tariff reform at start of fiscal year recommended to strengthen NEA finances.
- Recommendation: Phase out financial support to SOEs to contain fiscal risks and create fiscal space for social and infrastructure gaps.

### Fiscal decentralization
- Implications:
  - Fiscal decentralization can improve service quality if based on robust and sustainable inter-governmental fiscal arrangements.
  - Developing these arrangements is a major policy challenge and should be a top priority.
  - Ideally, enabling legal framework should be in place prior to first subnational elections under new constitution.
  - Authorities requested IMF technical assistance to develop such a framework.
  - Building sub-national implementation capacity will require sustained efforts.

### Authorities’ views on fiscal management
- Authorities concurred with staff assessment and fiscal advice; expressed confidence in speeding up budget execution and advancing structural reforms.
- First-half implementation rate lower than expected; delays related to transition to new government and lack of project preparedness.
- Ministry of Finance issued a 10-point directive in November 2016 emphasizing proactive steps and intensified monitoring of capital budget implementation.

---

### MONETARY POLICY FRAMEWORK

### Current framework and issues
- Exchange rate anchor:
  - Peg to the Indian rupee serves as transparent anchor.
  - Nepal’s REER: about 13 percent more appreciated than the average for 2010-14.
  - Staff assessment: continuation of current trends would make the exchange rate somewhat overvalued.
- Monetary stance and risks:
  - Overly accommodative monetary policy has kept credit growth and inflation too high and put pressure on the peg.
  - Sterilization of remittances by NRB insufficient to stabilize money market conditions.
  - Based on authorities’ inflation target of 7.5 percent, real lending rates are about 1 percent.
  - NRB tightened loan-to-value ratios for real estate and margin lending in July 2016; introduced 50 percent LTV for automobile loans in February 2017.
- Operational changes:
  - New operational framework based on an interest rate corridor announced in July 2016, with two-week repos, two-week deposit auctions, issuance of NRB bonds.
  - Volatility of interbank rates has remained high.

### Monetary policy recommendations
- Tighten monetary policy:
  - Rationale: remittances set to slow, fiscal policy turning expansionary, current account turning to a deficit, and inflation running 2–3 percent higher than in India.
  - NRB should adopt a medium-term inflation objective consistent with eliminating the inflation wedge with India.
  - Staff: 14th Development Plan target of average inflation of 7.5 percent per annum is not ambitious enough given India’s target of 4 percent with a tolerance band of plus/minus 2 percent.
  - Recommendation: build consensus for a more ambitious inflation target and provide more monetary policy autonomy to the central bank.
  - Legal concern: NRB Act Amendment (NRBAA) Bill (approved September 2016) indicates the government may issue directives to the central bank.
- Enhance interest rate corridor operations:
  - Introduce standing overnight credit and deposit facilities.
  - Use the Standing Liquidity Facility (SLF, currently at 7 percent) as corridor ceiling; introduce a binding interest rate floor; gradually narrow the corridor.
- Directed lending:
  - Consider phasing out NRB requirements for directed lending by commercial banks.
  - Promote financial inclusion through strengthened regulation and supervision of microfinance institutions and cooperatives.
- Rapid credit growth:
  - Maintain macro-prudential measures from post-2010–11 episode.
  - Withdraw regulatory relief regarding the 80 percent LTD ratio ceiling when it lapses in mid-July to moderate credit growth and normalize interest rates.

### Authorities’ views on monetary policy
- Authorities pleased with initial experience with the interest rate corridor; framework will be gradually upgraded.
- Reiterated that the peg has served Nepal well; broadly concurred with staff’s exchange rate assessment but did not see inflation divergence threatening the peg.
- Defended directed lending as a tool to stimulate growth and financial inclusion, particularly in rural areas.

---

### FINANCIAL STABILITY — VULNERABILITIES AND REFORMS

### Legal and supervisory reforms
- 2014 FSAP highlighted weaknesses; authorities began addressing these via four World Bank DPCs with UK DFID and IMF collaboration.
- September 2016: Parliament approved NRBAA Bill and the Deposit and Credit Guarantee Fund Act (DCGF).
- January 2017: Amendments to BAFIA passed.
- NRBAA improvements: raising central bank capital and aligning accounting standards with international practice.
- NRBAA shortcomings: curtails central bank autonomy; does not address explicit consolidated supervision powers and clarify emergency liquidity assistance provisions.

### Financial soundness indicators and system health
- All 28 Class A banks meet minimum 10 percent CAR.
- Three state-owned banks (about a fifth of system assets) were undercapitalized until 2014 but have retained earnings and received capital injections.
- Banks increased paid-up capital to meet new requirement for mid-July 2017.
- Bank profits at record high in 2015/16; NPLs and loan-loss provisions at record low.
- Remaining vulnerabilities: loan classification and bank supervision need strengthening; connected lending, ever-greening, and poor risk management suggest underlying asset quality weaker than FSIs indicate.
- Regulatory forbearance: freezing of loan classification for earthquake- and trade-affected borrowers; rescheduled/restructured loans by April 2016 required no additional provisioning.
- Preliminary data: capitalized interest benefitted only a small amount of loans (about ½ percent of GDP); forbearance measures set to run out from April 2017.

### Financial sector policy recommendations
- Supervision:
  - Accelerate strengthening of bank supervision; implement supervisory information system; strengthen credit assessment tools and agencies.
  - Convert Risk Management Guideline into a Directive.
  - Upgrade NRB’s stress testing capabilities.
  - Carefully review quality of reported increase in banks’ capital ahead of mid-2017 deadline.
- Staffing:
  - Strengthen supervisory capacity by increasing continuity in job assignments; develop a program to hire, train and retain supervisory staff, possibly via a dedicated career stream exempted from staff rotation policy.
- Regulation:
  - Upgrade secondary legislation for NRBAA, DCGF, and BAFIA.
  - Strengthen banks’ risk management and disclosure standards.
  - Introduce a clean-up period for overdraft loans urgently, in line with Basel Core Principles.
  - Develop a bank resolution operational framework urgently.
- Financial inclusion and cooperatives:
  - Cooperatives account for more than 15 percent of financial system assets and have linkages to banks.
  - Remedy absence of meaningful regulation and supervision of cooperatives, for example through creation of a designated second-tier institution and resolution tools.
- AML/CFT:
  - Recent steps: completion of national risk assessment; issuance of rules operationalizing the Asset (Money) Laundering Prevention (Second Amendment) Ordinance 2013; preparations for Mutual Evaluation scheduled for 2019/20.
  - Continue rollout of risk-based offsite and onsite AML/CFT tools; enforce decisive and prompt enforcement action and sanctions.

### Authorities’ views on financial stability reforms
- Authorities committed to accelerate and strengthen financial sector reforms; viewed BAFIA and NRBAA amendments as instrumental.
- NRB planned to convert the risk management guideline into a directive and agreed stress testing capacity needed enhancement.
- Emphasized need for strong coordination among NRB, Ministry of Finance, SEBON, and Insurance Board.

---

### STRUCTURAL REFORMS TO UNLOCK GROWTH POTENTIAL

### Key constraints
- Labor market pressure: more than 500,000 persons enter the labor force each year with limited domestic employment opportunities.
- FDI flows lower than peers.
- Doing Business ranking: fell to 107th in 2017 (from 99th in 2016).
- Key difficulties: getting credit, construction permits, enforcing contracts.
- National priority projects: continue to experience extensive delays.

### Ongoing investment and reform efforts
- Power: transmission lines readied to import more power from India; preparatory work for Upper Karnali and Arun III hydropower projects; two investor groups with US$1 billion each granted extensions.
- Melamchi drinking water project nearing completion.
- Arrangements: Power Summit in December 2016; planned Infrastructure Summit and Investment Summit to attract investors.
- Laws being drafted to streamline business environment.

### Structural reform recommendations
- Power sector: draw up an ambitious medium-term power sector reform program, possibly with multilateral/bilateral assistance.
- Market deregulation: deregulate product and factor markets to reduce operating costs and spur productivity.
- One-stop shop: offer a one-stop shop to any investor, not only large investments.
- Labor and corporate regulation: modernize labor relations; conclude stakeholder consultations on the draft Labor Bill and the FITT Bill.

---

### STAFF APPRAISAL, CAPACITY BUILDING, AND STATISTICAL IMPROVEMENTS

### Capacity development and statistics
- Fund TA and training: mixed results; progress hampered by frequent rotation of staff in central bank, ministries, and agencies.
- SARTTAC launch in New Delhi expected to provide more tailored TA and training; Nepal pledged financial contribution and is on Governing Board.
- Recommendations:
  - Strengthen staff retention and specialization: review rotation policies; train and retain specialized officials longer.
  - Engage actively with SARTTAC; carefully select officials for training and act on TA recommendations.
  - Central bank governance and audit: follow up on 2015 Safeguards Assessment recommendations; enhance external audit quality; modernize central bank law; improve internal audit function with TA.
  - Statistical improvements: update base year of national accounts; compile and disseminate quarterly GDP statistics; address SDG data gaps; enhance cooperation between Financial Comptroller General Office and NRB for Government Finance Statistics.

### Staff appraisal — macroeconomic outlook and risks
- Current situation:
  - Economy rebounding after 2015 earthquakes and trade disruptions.
  - Normalization supported by good monsoon, accommodative monetary policy, and rising government spending.
  - Inflation decelerating but expected to remain above India’s.
- Medium-term outlook depends on sustaining and deepening reform momentum; without stronger policies growth likely to fall below past-decade average.
- Risks: broadly balanced. Upside from stronger reforms; downside from political instability, weak financial sector, slowing remittances, and lower growth in India.

### Staff appraisal — policy recommendations (summary)
- Macroeconomic mix:
  - Rebalance toward more accommodative fiscal position and tighter monetary stance to support recovery while maintaining macroeconomic and financial stability.
  - Scale up government spending for reconstruction and infrastructure but ensure realistic budgets and prioritize spending given limited implementation capacity; anchor scaling up in an MTEF.
- Monetary policy framework:
  - Strengthen framework; refine interest rate corridor by fixing floor to reduce interbank rate volatility; adopt medium-term inflation objective consistent with eliminating inflation wedge with India.
  - Tighten monetary policy given remittance slowdown, expansionary fiscal policy, and current account moving to deficit.
- Financial sector reforms:
  - Accelerate reforms in line with FSAP recommendations; strengthen supervision; maintain macro-prudential measures introduced after 2010-11 episode.
- Structural reforms:
  - Build implementation capacity, improve business climate, develop hydropower sector, deregulate product and factor markets, and prioritize transport infrastructure and power supply.

### Follow-up
- Proposed next Article IV consultation on the standard 12-month cycle.

*Source: IMF staff report — INTRODUCTION (Nepal).*

### INTRODUCTION __________________________________________________________________________________  4

### INTRODUCTION

### Macroeconomic context and growth challenges
- Macroeconomic performance has been broadly satisfactory, with low public debt and moderate inflation, but growth averaged only 4 percent over the last decade.
- Government objectives: graduate from least-developed country status by 2022 and achieve middle income country status by 2030.
- 14th Development Plan (2016/17–2018/19) targets:
  - annual average growth of 7.2 percent;
  - reduction in the share of the population living in poverty by 4.6 percent to 17 percent by 2018/19.
- Constraints: frequent changes in government, infrastructure gaps, weak institutional capacity, and difficult business climate have held back progress.

### Remittances, exchange rate, and external competitiveness
- Remittances are large: 30 percent of GDP in FY2015/16.
- Positive effects: reduce poverty, support the balance of payments, boost fiscal accounts via import-related revenues.
- Adverse effects: contributed to an appreciation of the real exchange rate, rapid wage growth, stagnant exports, and a widening trade deficit.

### Political environment and recent history
- Continued political uncertainty with several elections scheduled.
- Post-2015 earthquakes: new constitution, transition to a federal system.
- Disruptions: 4½ month blockade of terrestrial trade routes; in August 2016 a new coalition—the ninth government in nine years—assumed power.
- Political timetable: local elections set for mid-May under PM Dahal, followed by a handover to a PM of the Nepali Congress to oversee federal and provincial polls.
- Outstanding issues: unresolved grievances related to the new constitution.

### Policy implementation and institutional reforms
- Authorities’ policies broadly align with past Fund advice, but implementation remains weak.
- Government increased recurrent spending for post-earthquake reconstruction; inefficiencies in capital budget management and implementation hamper scaling up public investment.
- Monetary policy: introduction in mid-2016 of an interest rate corridor to strengthen the monetary policy framework and transmission, supporting the exchange rate peg by reducing the inflation wedge with India.
- Financial sector: recent amendments to legal and regulatory frameworks governing the central bank and the financial sector aim to strengthen supervision and bank governance.

---

### RECENT DEVELOPMENTS, OUTLOOK, AND RISKS

### 2015/16 developments
- Growth and inflation:
  - Real GDP growth slowed to 0.6 percent in 2015/16 (mid-July to mid-July).
  - Inflation rose to 12 percent (y/y) in January 2016 due to shortages; later eased on lower food prices.
- Fiscal:
  - Budget under-implementation worsened in 2015/16, particularly for capital spending.
  - Revenues exceeded the budget due to one-off telecom sector collections (1 percent of GDP).
  - Budget was in surplus for the fourth year in a row.
  - Net public debt (gross public debt net of government deposits held at the central bank) fell to 22 percent of GDP, down from 34 percent of GDP in 2012.
- External:
  - Current account surplus reached 6.3 percent of GDP as trade disruption lowered imports.
  - Exports fell, led by primary commodities and manufactured products.
  - Growth rate of remittances slowed to 1 percent in 2015/16, from an annual average of 15 percent during the previous 5 years.
  - Gross reserves reached US$8.7 billion (10 months of imports) in December 2016.

### 2016/17 signs of recovery
- Cyclical rebound drivers: normalization of activity, favorable monsoon, improved power supply, accommodative monetary policy, rising government spending (housing grants, wages, pensions).
- Staff growth projection: growth to reach 5.5 percent in 2016/17.
- Inflation:
  - CPI (period average) and CPI (end of period) trends shown in macro table (see source).
  - Inflation decelerated to 3.2 percent (y/y) in January 2017; expected to remain above India’s this year and next.
- India demonetization shock: expected limited overall economic impact, with small holdings of Indian rupee notes by banks but some exposure among corporates, households of migrant workers, and border areas.

### Rising macro-financial risks
- Rapid credit growth:
  - Private sector credit growth reached a 7-year high of 31 percent (y/y) in January 2017.
  - Increase concentrated in overdrafts, raising risks of diversion to land, real estate, and stocks.
- Liquidity tightening:
  - Banks’ loan to deposit ratio close to regulatory maximum of 80 percent.
  - Temporary regulatory relief granted by the central bank in February would allow continued rapid credit growth and raise macro-financial risks.
  - Softening remittances and rising imports contributed to liquidity tightening, higher interbank interest rates, and correction in stock prices.

### Scenarios and medium-term outlook
- Baseline scenario:
  - Assumes persistent political uncertainty and slow institutional strengthening.
  - Private investment remains around 25 percent of GDP; growth settles somewhat below the 4 percent average of the past decade.
  - Current account projected to swing to a deficit of about 2 percent of GDP in the medium term on higher imports and slowing remittances.
- Reform scenario:
  - Assumes sustained and deepened reform momentum: improved capital budget implementation, strengthened monetary policy framework and tightening, improved regulation and supervision, and a better investment environment.
  - Growth accelerates gradually to close to 6 percent in the medium term.
  - Public capital spending is 1½ percent of GDP higher than in the baseline, financed largely by concessional loans and grants.
  - Additional fiscal space allows raising government current spending by close to 2 percent of GDP.
  - FDI-financed hydropower projects and more moderate remittances growth are additional elements.

### Key macroeconomic projections (selected exact figures from macro table)
- Real GDP (annual percent change):
  - 2015/16: 0.6
  - 2016/17 (Est.): 5.5
  - Baseline 2017/18–2020/21: 4.5, 3.8, 3.8, 3.8
  - Reform 2017/18–2020/21: 4.8, 5.0, 5.5, 5.8
- CPI (period average):
  - 2015/16: 9.9
  - 2016/17 (Est.): 6.7
  - Reform 2020/21: 5.2
- Workers' remittances (in millions of U.S. dollars):
  - 2015/16: 6,253
  - 2016/17: 6,467
  - Reform 2020/21: 7,584
- Gross official reserves (in millions of U.S. dollars):
  - 2015/16: 8,574
  - 2016/17: 8,690
  - Reform 2020/21: 8,062
- Public debt (in percent of GDP):
  - 2015/16: 27.3
  - 2016/17: 25.7
  - Reform 2020/21: 25.9

### Risks to the baseline
- Upside risks:
  - Stronger-than-expected capital spending and accelerated housing grant payments.
  - Sustained policy and structural reform momentum.
  - Financial closure of large foreign-financed hydropower projects.
  - Faster recovery in international oil prices boosting employment abroad.
- Downside risks:
  - Domestic political instability.
  - Failure to increase implementation capacity.
  - Financial sector vulnerabilities.
  - Slowing remittances affecting financial sector liquidity.
  - Hasty implementation of a new federal fiscal framework straining government finances given weak PFM and institutional capacity.

### Authorities’ views
- Authorities more optimistic on near-term growth, hopeful of achieving 6.5 percent growth target due to reconstruction, improved power supply, and strong agricultural output.
- Authorities agreed with staff that structural reforms and increased implementation capacity are key for sustaining higher medium-term growth.

---

### POLICY DISCUSSIONS — FISCAL POLICY TO MEET PUBLIC SPENDING NEEDS

### Fiscal position and risks
- Fiscal policy was tighter than envisaged in recent years due to budget implementation bottlenecks.
- Net public debt-to-GDP declined to 22 percent of GDP in 2015/16 (net of government deposits).
- Joint IMF/World Bank Debt Sustainability Analysis: Nepal’s risk of debt distress remains low.
- 2016/17 budget:
  - Very large envelope, unlikely to be implemented in full given limited execution capacity.
  - Aims for near doubling of total spending vs 2015/16, including a 150 percent increase in capital spending.
  - Targets an overall fiscal deficit of 10 percent of GDP, compared to a surplus of 2.4 percent of GDP (based on financing data) in 2015/16.
  - Mid-year budget review in February reduced capital spending by one-sixth, lowering the fiscal deficit target to 6.7 percent of GDP.

### Staff fiscal projection for 2016/17
- Staff projects a fiscal deficit of 1.1 percent of GDP and a fiscal impulse of about 1½ percent of GDP in 2016/17.
- Projected spending increase of 3.2 percent of GDP composed of:
  - housing grants to earthquake-affected households: 1.9 percent of GDP;
  - higher salaries and allowances: 0.8 percent of GDP;
  - capital spending: 0.5 percent of GDP.
- Underlying revenue (corrected for one-off receipts) projected to rise by 1.9 percent of GDP.

### Policy recommendations (fiscal)
- Scale up government spending to rebuild after the earthquakes and address infrastructure gaps, but:
  - Avoid exceeding the economy’s aggregate absorptive capacity.
  - Safeguard expenditure quality.
  - Ensure close policy coordination and information sharing with the central bank to prevent overheating and preserve private sector credit space.
- Short-term financing guidance:
  - In the current and next fiscal years, the macroeconomic framework could accommodate the use of the government’s accumulated cash balances.
  - Total net domestic financing (NDF: net incurrence of domestic liabilities minus the change in government deposits at the central bank) could amount to about 1½ percent of GDP per annum.
- Medium-term financing guidance:
  - Concessional external financing can finance the bulk of the 1½ percent of GDP increase in government capital spending over the medium term.
  - High-quality capital spending financed by concessional donor inflows is preferable as it keeps the debt burden in check while allowing an infrastructure push.
  - With staff’s projections for foreign financing, overall fiscal deficits of up to 2 percent of GDP per annum are feasible in the medium term.
  - To prevent crowding out credit to the private sector, shortfalls in donor financing should not be replaced by additional domestic financing and NDF should not exceed 1 percent of GDP per annum.

*Source: IMF staff report — INTRODUCTION (Nepal).*

### 15.      Continued improvements in revenue performance will be important to support

### Continued improvements in revenue performance will be important to support

### Revenue performance and development spending
- Authorities’ reforms: prepare a unified tax code; draw up a medium-term strategic plan to strengthen customs administration; plans to set up a Revenue Board (Annex II).
- Projected revenue impact: If fully implemented, they could raise revenue by 1¾ percent of GDP over the medium term.
- Government revenue indicators (as reported):
  - 2013/14   2014/15 BudgetActualBudgetProj.
  - Total revenue18.219.121.121.422.322.3
  - Total tax revenue15.916.819.018.720.220.1
  - Taxes on income, profits, and capital gains 3.84.14.75.14.9...
  - Taxes on property 0.30.40.50.60.6...
  - Taxes on goods and services 8.08.59.89.110.6...
  - VAT5.15.36.35.46.5...
  - Excises2.32.52.92.93.2...
  - Taxes on international trade and transactions3.53.53.73.73.8...
  - Customs and other import duties3.33.33.53.53.6...
  - Non-tax revenue2.22.42.12.72.22.2
  - Notes: Sources: FCGO; and IMF staff estimates. 1/ Fiscal year is mid-August to mid-July 2/ Mid-year budget review released in late February 2017. 2015/16 2016/17 (In percent of GDP) Nepal: Government Revenue 1/

### Budget preparation, project selection, and PFM
- Key findings:
  - Budget realism and execution: Budgets should be more realistic and capital spending should be spread more evenly over the year. Ambitious budgets and back-loaded implementation increase the risk of low-quality spending.
  - Projects: Only well-prepared and prioritized projects should be included in the budget. Expansion of government spending should be anchored in a medium-term expenditure framework (MTEF).
  - Project readiness requirements: Projects should be included in the budget only after completion of a feasibility study, necessary environmental assessments, and land acquisition requirements.
  - Authorities’ plan: focus on project readiness and preparation of a “bank” of projects that have gone through preparatory stages so government bodies can start tendering immediately after budget adoption and not be required to obtain authorizations once the fiscal year has started.
  - PFM: Need to integrate disparate PFM systems across ministries and strengthen budget coordination under the leadership of the Ministry of Finance.
- Social spending and SDGs:
  - Building on Nepal’s early adoption of the SDGs, social spending priorities need to be costed, included in the MTEF, and translated into realistic annual budget allocations (Annex III).

### Fiscal risks, SOEs, and fiscal space
- Recent support to SOEs:
  - In recent years, some 1¾ percent of GDP was spent per annum on equity injections and loans to SOEs, including banks.
- Sectoral notes:
  - Oil: Repayment of Nepal Oil Company (NOC)’s debt over the past two fiscal years is welcome. Full application of the automatic oil price adjustment mechanism should continue to prevent recurrence of NOC losses as international oil prices rise.
  - Electricity: Reduction in electricity load shedding achieved recently reflects improvements in demand and supply management. Reform of electricity tariffs at the start of the fiscal year should further strengthen Nepal Electricity Authority finances.
- Recommendation: Phase out financial support to SOEs to contain fiscal risks and create additional fiscal space for social and infrastructure gaps.

### Fiscal decentralization
- Implications:
  - Impending fiscal decentralization can improve service quality and delivery if based on robust and sustainable inter-governmental fiscal arrangements.
  - Developing these arrangements in the coming months is a major policy challenge and should be a top priority.
  - Ideally, an enabling legal framework should be in place prior to the first subnational elections under the new constitution.
  - Authorities have requested IMF technical assistance to develop such a framework.
  - Building policy implementation capacity at the sub-national level will require sustained efforts.

### Authorities’ views on fiscal management
- Authorities generally concurred with staff assessment and fiscal policy advice.
- They expressed confidence in speeding up budget execution and advancing structural reforms.
- First-half implementation rate of the current fiscal year was lower than expected despite earlier budget introduction; delays were related to transition to the new government and lack of project preparedness.
- Ministry of Finance measures: a 10-point directive issued in November 2016 emphasizing proactive steps by line ministries and intensified monitoring of capital budget implementation; expected to show results in the second half of the fiscal year.

---

### Strengthening the monetary policy framework
- Exchange rate anchor:
  - The peg to the Indian rupee serves as a transparent anchor for monetary policy given Nepal’s close economic relationship with India and need to build policy implementation capacity.
  - Nepal’s real effective exchange rate (REER) is now about 13 percent more appreciated than the average for 2010-14.
  - Staff assessment: with continuation of current trends, the exchange rate would become somewhat overvalued (Box 1).
- Monetary stance and risks:
  - Overly accommodative monetary policy has kept credit growth and inflation too high and put pressure on the exchange rate peg.
  - Sterilization of remittances by NRB has been insufficient to stabilize money market conditions.
  - Based on the authorities’ inflation target of 7.5 percent, real lending rates are about 1 percent.
  - NRB tightened loan-to-value ratios for real estate and margin lending in July 2016 and introduced a 50 percent loan-to-value ratio for automobile loans in February 2017.
- Operational changes:
  - A new operational framework based on an interest rate corridor was announced in July 2016, supported by new instruments (two-week repos, two-week deposit auctions, issuance of NRB bonds).
  - Volatility of interbank rates has remained high.

### Monetary policy recommendations
- Tighten monetary policy:
  - Rationale: remittances set to slow, fiscal policy turning expansionary, current account turning to a deficit, and inflation continuing to run 2–3 percent higher than in India.
  - NRB should adopt a medium-term inflation objective consistent with eliminating the inflation wedge with India.
  - Current target in the 14th Development Plan: average inflation of 7.5 percent per annum — staff views it as not ambitious enough given India’s target of 4 percent with a tolerance band of plus/minus 2 percent for the next five years.
  - Recommendation: build a broad-based consensus for a more ambitious inflation target (Annex IV) and provide more monetary policy autonomy to the central bank.
  - Legal concern: NRB Act Amendment (NRBAA) Bill (approved by Parliament in September 2016) indicates the government may issue directives to the central bank on money, banking and finance and that it shall be the duty of the central bank to abide by such directives.
- Enhance interest rate corridor operations:
  - Introduce standing overnight credit and deposit facilities.
  - Existing Standing Liquidity Facility (SLF, currently at 7 percent) could act as the corridor’s ceiling.
  - Complement with a binding interest rate floor (overnight deposit standing facility) set close to current market conditions, periodically reviewed, and gradually narrow the corridor to contain interbank rate volatility.
- Directed lending:
  - Consider phasing out NRB requirements for directed lending by commercial banks, as sectoral lending targets may lower credit standards and asset quality and contribute to financial instability.
  - Promote financial inclusion through strengthened regulation and supervision of microfinance institutions and cooperatives.
- Rapid credit growth:
  - Maintain regulatory and macro-prudential measures introduced after the 2010–11 episode.
  - Relief to banks regarding the 80 percent loan-to-deposit (LTD) ratio ceiling provided in the mid-term review should be withdrawn promptly when it lapses in mid-July to moderate credit growth, normalize interest rates, discourage excessive risk taking, and reduce capital outflow impetus.

### Authorities’ views on monetary policy
- Authorities pleased with initial experience with the interest rate corridor and confident it will improve monetary management; framework will be gradually upgraded.
- Authorities reiterated that the peg has served Nepal well; they broadly concurred with staff’s exchange rate assessment but did not see inflation divergence threatening the peg.
- Authorities defended directed lending as aiming to stimulate growth in productive sectors and boost financial inclusion, particularly rural areas, and saw risks to financial stability as minor given limited scope.

---

### Addressing vulnerabilities to safeguard financial stability
- Legal and supervisory reforms:
  - 2014 FSAP highlighted weaknesses; authorities began addressing these via four World Bank DPCs with UK DFID and IMF collaboration.
  - In September 2016, parliament approved NRBAA Bill and the Deposit and Credit Guarantee Fund Act (DCGF).
  - January 2017: Amendments to the Bank and Financial Institutions Act (BAFIA) passed.
  - NRBAA improvements: raising central bank capital and aligning accounting standards with international practice.
  - NRBAA shortcomings: curtails central bank autonomy and does not address two key FSAP recommendations regarding explicit consolidated supervision powers and clarifying emergency liquidity assistance provisions. Staff is clarifying the extent and modalities of the central bank’s special resolution regime powers under the amended law (third FSAP recommendation).
- Financial soundness indicators (FSIs) and system health:
  - Reported FSIs improved: All 28 Class A banks now meet the minimum 10 percent capital adequacy ratio (CAR).
  - The three state-owned banks (about a fifth of system assets) were undercapitalized until 2014 but have retained earnings and received capital injections.
  - Banks increased paid-up capital to meet the new requirement for mid-July 2017.
  - Bank profits at a record high in 2015/16 and NPLs and loan-loss provisions at a record low.
- Remaining vulnerabilities and data caveats:
  - Weaknesses remain: loan classification and bank supervision need strengthening; connected lending, ever-greening, and poor risk management practices compounded by directed lending suggest underlying asset quality is weaker than FSIs indicate.
  - Regulatory forbearance: allowed freezing of loan classification for earthquake- and trade-affected borrowers; rescheduled/restructured loans by April 2016 required no additional provisioning.
  - Preliminary data on capitalized interest suggests only a small amount of loans (about ½ percent of GDP) benefitted from these forbearance measures, which are set to run out from April 2017.

### Financial sector policy recommendations
- Supervision:
  - Accelerate strengthening of bank supervision, implement a supervisory information system, strengthen credit assessment tools and agencies.
  - Convert Risk Management Guideline into a Directive.
  - Upgrade NRB’s stress testing capabilities.
  - Carefully review quality of reported increase in banks’ capital ahead of the mid-2017 deadline to quadruple paid-up capital from mid-2015 regulatory minimum.
- Staffing:
  - Strengthen supervisory capacity by increasing continuity in job assignments; develop a program to hire, train and retain supervisory staff, possibly via a dedicated career stream exempted from staff rotation policy.
- Regulation:
  - Upgrade secondary legislation for NRBAA, DCGF, and BAFIA.
  - Strengthen banks’ risk management and disclosure standards.
  - Introduce a clean-up period for overdraft loans urgently, in line with Basel Core Principles, in response to a recent surge in overdraft loans.
  - Develop a bank resolution operational framework urgently.
- Financial inclusion and cooperatives:
  - Financial cooperatives account for more than 15 percent of financial system assets and have linkages to banks.
  - Remedy absence of meaningful regulation and supervision of cooperatives, for example through creation of a designated second-tier institution and resolution tools.
- AML/CFT:
  - Recent steps: completion of national risk assessment; issuance of rules operationalizing the Asset (Money) Laundering Prevention (Second Amendment) Ordinance 2013; start of preparations for the Mutual Evaluation scheduled for 2019/20.
  - Continue rollout of risk-based offsite and onsite AML/CFT tools, and enforce decisive and prompt enforcement action and sanctions for non-compliance.
  - Encourage strengthened implementation of AML/CFT by cooperatives, insurance companies and securities firms.

### Authorities’ views on financial stability reforms
- Authorities committed to accelerate and strengthen financial sector reforms and viewed BAFIA and NRBAA amendments as instrumental in addressing regulatory gaps in line with FSAP recommendations.
- NRB planned to convert the risk management guideline into a directive and agreed stress testing capacity needed enhancement.
- Authorities emphasized need for strong coordination among NRB, Ministry of Finance, SEBON, and the Insurance Board to advance reforms and address vulnerabilities.

---

### Structural reforms to unlock growth potential
- Key constraints:
  - More than 500,000 persons enter the labor force each year but employment opportunities are limited.
  - FDI flows are lower than peer countries.
  - Nepal’s Doing Business ranking fell to 107th in 2017 (from 99th in 2016).
  - Getting credit and construction permits, and enforcing contracts remain difficult.
  - National priority projects continue to experience extensive delays.
- Ongoing investment efforts:
  - Transmission lines readied to import more power from India.
  - Melamchi drinking water project nearing completion after long delays.
  - Preparatory work continues for the Upper Karnali and Arun III hydropower projects; two investor groups that signed Project Development Agreements in 2014 for US$1 billion each were recently granted extensions to reach financial closure.
  - Arrangements: Power Summit in December 2016; planned Infrastructure Summit in February and Investment Summit in March to attract investors.
  - Several laws are being drafted to streamline the business environment.
- Structural reform policy recommendations:
  - Power sector: Draw up and agree on an ambitious medium-term program of power sector reforms, possibly with multilateral and bilateral donor assistance.
  - Market deregulation: Deregulation of product and factor markets to reduce operating costs and spur productivity through greater contestability and competition (e.g., goods and passenger transport).
  - One-stop shop: Offer a one-stop shop not only for large investments but to any investor.
  - Labor and corporate regulation: Modernize labor relations to enhance labor market flexibility and streamline the regulatory environment; conclude stakeholder consultations on the draft Labor Bill and Foreign Investment and Technology Transfer (FITT) Bill.

*IMF staff report content as provided in the source PDF chapter.*

### 37.      The authorities were encouraged by the results of recent power sector reforms. They

### 37.      The authorities were encouraged by the results of recent power sector reforms. They

### Recent reforms and expectations
- Authorities expressed optimism about the impact of:
  - the Specialized Economic Zones Act,
  - the draft Labor Bill,
  - the FITT Bill,
  - development of the hydropower sector.
- Expected outcomes:
  - Structural reforms in these areas would enhance the business climate and encourage new investment and job creation.

### Strengthening capacity development and statistics
- Key observations:
  - Fund’s capacity building efforts have had mixed results.
  - Progress is hampered by frequent rotation of staff in the central bank, ministries, and government agencies.
- Institutional development:
  - Upcoming launch of the South Asia Regional Training and Technical Assistance Center (SARTTAC) in New Delhi will allow for more, better-tailored, and better-integrated TA and training.
  - The government of Nepal has pledged an important financial contribution to the operation of the Center and is represented on its Governing Board.

### Policy recommendations on capacity building and statistics
- Strengthen staff retention and specialization:
  - Review existing rotation policies.
  - Train specialized officials (e.g. bank supervisors, tax inspectors, statisticians, etc.) early in their tenure, and retain them in their positions for much longer than is the current practice.
- Engage with SARTTAC:
  - Nepali authorities should participate actively in drawing up SARTTAC’s training and TA program.
  - Carefully select officials for training courses, and work with TA providers to act on their recommendations.
- Central bank governance and audit:
  - The central bank should follow up on the 2015 Safeguards Assessment recommendations.
  - Although the NRB publishes its audited financial statements, key recommendations to enhance the quality of the external audit and to modernize the central bank law remain outstanding.
  - The internal audit function should be improved, including through technical assistance.
- Statistical improvements:
  - Continue efforts to strengthen statistics.
  - Accelerate work on updating the base year of the national accounts and compiling and disseminating quarterly GDP statistics.
  - Address data gaps identified in the SDG status report.
  - Enhance cooperation between the Financial Comptroller General Office and the NRB in publishing more complete and comprehensive Government Finance Statistics.

### Authorities’ views
- The authorities agreed that capacity building was important but there were no plans to change the rotation policies.

### Staff appraisal — macroeconomic outlook and risks
- Current situation:
  - Nepal’s economy is rebounding following a slowdown caused by the 2015 earthquakes and trade disruptions.
  - Normalization is supported by a good monsoon, accommodative monetary policy, and rising government spending.
  - Inflation has been decelerating due to base effects related to last year’s trade disruption but is expected to remain above India’s inflation.
  - Authorities have advanced reforms in a number of areas.
- Medium-term outlook:
  - Critically depends on efforts to sustain and deepen the nascent reform momentum.
  - Stronger policies are needed to enhance confidence amid ongoing political uncertainty and to strengthen key institutions and administrative capacity.
  - Without stronger policies, and taking into account lower projected growth of remittances and the effects of the earthquakes and trade disruption, growth would likely fall below the average of the past decade and fall short of what is needed to substantially improve living standards and social indicators.
- Risks:
  - Broadly balanced.
  - Upside: rebound in economic activity could be more pronounced and persistent if reforms are sustained and deepened.
  - Downside: domestic political instability; weak financial sector; slowing remittances impacting financial sector liquidity; lower growth in India due to the demonetization shock.

### Staff appraisal — policy recommendations
- Macroeconomic policy mix:
  - Rebalance toward a more accommodative fiscal position and a tighter monetary stance to support recovery while maintaining macroeconomic and financial stability.
  - Scale up government spending to rebuild after the earthquakes and address infrastructure gaps to boost medium-term growth, but ensure a realistic budget that prioritizes spending given limited implementation capacity.
  - Scaling up should not exceed the economy’s aggregate absorptive capacity and should be anchored in a medium-term expenditure framework to ensure quality and fiscal sustainability.
- Monetary policy framework:
  - Further strengthen the framework; welcome the introduction of an interest rate corridor.
  - Next steps: refine the framework by fixing the floor of the interest rate corridor to reduce volatility of interbank interest rates and adopt a medium-term inflation objective consistent with eliminating the inflation wedge with India on a sustained basis.
  - With remittances set to slow, fiscal policy turning expansionary, and the current account turning to a deficit, a tightening of monetary policy is needed to prevent the exchange rate from becoming somewhat overvalued.
- Financial sector reforms:
  - Accelerate financial sector reforms in line with FSAP recommendations to mitigate macro-financial risks, including those related to rapid credit growth.
  - Strengthen financial sector supervision, building on recent amendments to aspects of the regulatory framework.
  - Maintain macro-prudential measures introduced after the 2010-11 episode of financial sector pressures to contain credit growth; these have served Nepal well and should be maintained after the temporary relief granted in February lapses in July.
- Structural reforms to raise potential growth:
  - Build policy implementation capacity, improve the business climate, and develop the hydropower sector.
  - Deregulate product and factor markets and prioritize investment to upgrade transportation infrastructure and improve power supply.

### Follow-up
- It is proposed that the next Article IV consultation takes place on the standard 12-month cycle.

*NEPAL  INTERNATIONAL MONETARY FUND*

### Box 1. Nepal: External Sector Assessment and Reserve Adequacy

### Box 1. Nepal: External Sector Assessment and Reserve Adequacy

### External sector overview
- Nepal’s balance of payments has been in surplus in recent years with rising remittances more than offsetting declining exports of goods and services and expanding imports.
- Nepal’s export performance:
  - Exports of goods and services to GDP ratio declined from 16 percent in the early 2000s to 11.7 percent in 2014/15.
  - The earthquakes and trade disruptions pushed the ratio to 9.3 percent of GDP in 2015/16.
- Competitiveness constraints beyond the REER:
  - Infrastructure gap, power shortages, and restrictive labor regulations.
- Remittances:
  - At almost 30 percent of GDP in 2015/16, remittances are among the highest in the world.
  - The bulk of remittances comes from migrant workers in Persian Gulf countries and Malaysia.

### Reserves and adequacy
- Gross international reserves:
  - Reserves have risen to US$8.8 billion.
  - About a quarter of reserves is held in Indian rupees.
  - Reserves equal to more than 9 months of imports.
- Adequacy judgment:
  - Taking into account the peg to the Indian rupee, the need to absorb external shocks, and the low opportunity cost of holding reserves, 7 months of imports would be adequate (see also Box 2 in EBS/15/83).

### Exchange rate developments and risks of overvaluation
- Real effective exchange rate (REER):
  - Reflecting the inflation differential with India, Nepal’s REER is now about 13 percent more appreciated than the average for 2010-14.
- Policy projection and risks:
  - Under current policies and continuation of recent trends, slowing remittances and a projected shift in fiscal policy are expected to cause the balance of payments to swing to a deficit.
  - In conjunction with ongoing appreciation of the REER, with inflation continuing to run 2-3 percent higher than in India, the exchange rate would become overvalued.
- Various econometric approaches do not give uniform results; more weight is assigned to the equilibrium REER approach in view of REER appreciation and weak export performance.

### Exchange rate assessment methods and results
- Current account (CA) panel regression approach:
  - The CA norm for Nepal is estimated at -2.8 percent of GDP.
  - The underlying CA in 2015/16 was 4.1 percent of GDP.
  - Assuming an elasticity of the trade balance with respect to the REER of -0.33, the difference between the two suggests an undervaluation of the REER 21 percent.
  - The CA is projected to converge to the norm over the medium term.
- Equilibrium real exchange rate approach:
  - The gap between current REER and its medium-term equilibrium indicates the REER is approximately 17 percent overvalued as of mid-2016.
- Net international investment position (IIP) perspective:
  - Nepal’s net IIP is +15 percent of GDP in 2015.
  - Nepal could afford to run a current account deficit of about 2 percent of GDP (as projected in the medium term) and still stabilize its IIP at -15 percent of GDP, suggesting the REER is in line with fundamentals from this perspective.

### Key quantitative figures and projections (selected)
- Reserves: US$8.8 billion; about a quarter held in Indian rupees.
- Reserves adequacy benchmark: 7 months of imports would be adequate.
- Exports of goods and services to GDP: 16 percent (early 2000s), 11.7 percent (2014/15), 9.3 percent (2015/16).
- Remittances: almost 30 percent of GDP in 2015/16.
- REER: about 13 percent more appreciated than the 2010-14 average.
- Inflation differential with India: continuing to run 2-3 percent higher than in India.
- CA norm (panel regression): -2.8 percent of GDP.
- Underlying CA (2015/16): 4.1 percent of GDP.
- Implied REER undervaluation (from CA gap with trade balance elasticity -0.33): 21 percent.
- Equilibrium REER approach: REER approximately 17 percent overvalued as of mid-2016.
- Net IIP: +15 percent of GDP in 2015.
- Sustainable current account deficit consistent with stabilizing IIP at -15 percent of GDP: about 2 percent of GDP.

*Source: Box 1. Nepal: External Sector Assessment and Reserve Adequacy (from the IMF staff report).*

### Annex I. Risk Assessment Matrix

### Annex I. Risk Assessment Matrix

### Domestic Risks
- Slow progress in post-earthquake reconstruction  
  - Likelihood: High  
  - Time Horizon: Short to Medium Term  
  - Impact: High  
  - Policy Response to Minimize Impact: Boost the government's ability to manage capital expenditure as well as complex reconstruction projects, underpinned by effective coordination mechanisms that will enhance the ability of line ministries to execute their capital and reconstruction budgets.

- Political instability  
  - Likelihood: High  
  - Time Horizon: Short to Medium Term  
  - Impact: Medium/High  
  - Policy Response to Minimize Impact: Preserve fiscal and external policy space. Ensure policy continulity.

- Financial sector vulnerabilites  
  - Likelihood: Medium  
  - Time Horizon: Medium Term  
  - Impact: Medium/High  
  - Policy Response to Minimize Impact: Regulatory forbearance to help deal with the aftermath of the earthquake and trade disruption should be completely phased out. Exercise corrective and sanctioning powers more forcefully. Move to pro-active and risk-based supervision. Increase resources and raise capacity for supervision.

- Natural disaster  
  - Likelihood: Low  
  - Time Horizon: Short to Medium Term  
  - Impact: Medium/High  
  - Policy Response to Minimize Impact: Prepare for future disasters by: (i) adhering to disaster-proof building codes, (ii) accelerating structural reforms to diversify the economy; (iii) building fiscal space and reserves buffers; and (iv) enhancing financial safety nets.

### External Risks
- Lower energy prices  
  - Likelihood: Low  
  - Time Horizon: Short to Medium T  
  - Impact: Medium/High  
  - Policy Response to Minimize Impact: Strengthen the financial sector and preserve fiscal and external policy space to cope with adverse shocks. In the longer term, boost public investment, and pursue structural reforms to improve the investment climate to attract higher private investment  to reduce dependency on remittances.

- Weaker-than expected global growth  
  - Likelihood: High  
  - Time Horizon: Short to Medium T  
  - Impact: Low  
  - Policy Response to Minimize Impact: Maintain sound policy frameworks and enhance financial stability.

- Slower-than-projected growth in India  
  - Likelihood: Medium  
  - Time Horizon: Short to Medium T  
  - Impact: High  
  - Policy Response to Minimize Impact: Accelerate structural reforms to improve the investment climate and boost public investment.

- Reduced financial services by global/regional banks ("derisking")  
  - Likelihood: High  
  - Time Horizon: Short to Medium Term  
  - Impact: Low  
  - Policy Response to Minimize Impact: Enhance coordinated efforts by the public and private secors to mitigate risk and promote formal remittance tranfers. Continue strengthening regulatory and supervisory frameworks to meet relevant international standards, including on AML/CFT measures, and regulate informal remittance channels that are susceptible to illegal activities.

### Risk Assessment Matrix guidance and definitions
- The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff).  
- The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent).  
- The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly. "Short Term" and "Medium Term" are meant to indicate that the risk could materialize within 1 year and 3 years, respectively.

*Source: Annex I. Risk Assessment Matrix (cr1774 - Annex I. Risk Assessment Matrix).*

### 3.      Addressing the gaps with the Principles requires building a broad-based consensus with

### 3.      Addressing the gaps with the Principles requires building a broad-based consensus with 

### Consensus and Role of the NRB
- The Principles require building a broad-based consensus with stakeholders so that they all share a common view on the NRB’s mandate and its monetary policy.
- The NRB should play a catalytic role, while the process should build on long-term commitment from all relevant authorities to facilitate understanding and acceptance of the Principles and their impact on the country’s economic structures.

### Immediate scope for enhancing conformity (areas under NRB control)
- Short-term liquidity forecasting and management (and related actions to support market development, including financial market infrastructures).
- Effective internal organizational structures.
- Analytical capacity to support the monetary policy decision making process (including inflation forecasts, analysis of the transmission channels).
- Communication strategy.
- The current benign fiscal and balance of payments position provides a favorable window of opportunity to commit to modernization of the monetary policy framework, building on the recent adoption of an interest rate corridor.

### Annex V — Progress in Implementing High-Priority FSAP Recommendations: Financial Stability (selected entries)
- Refocus monetary policy operations on domestic liquidity management to reduce excess reserves, and especially their volatility, with appropriate burden sharing of costs between the financial system and the budget. Introduce Treasury sterilization bonds.
  - Responsible Authority: NRB
  - Time Line*: ST
  - Progress to date: In process
  - Notes: An interest rate corridor was introduced in mid-2016. There is scope to strengthen the new framework further in line with IMF TA recommendations. NRB bonds were issued.
- Undertake a thorough Asset Quality Review (AQR) to identify the extent of problem loans in banks’ balance sheets (with TA support).
  - Responsible Authority: NRB
  - Time Line*: ST
  - Progress to date: In process
  - Notes: NRB supervisors are following-up on the special inspections that were done to review asset quality. Prompt corrective action was taken in some cases.
- Conduct an in-depth review and financial analysis of loan portfolios during bank examinations.
  - Responsible Authority: NRB
  - Time Line*: ST/MT
  - Progress to date: In process
  - Notes: Loan portfolio reviews are performed on-site; the reviews are guided by the outmoded asset classification and loss provisioning guidance. As the supervisors gain experience, it is expected that the review will increasingly focus on asset quality and borrowers’ financials.
- Reinforce efforts to address financial infrastructure shortcomings in the Payments System, clearing, credit information, collateral registry, and debt recovery areas.
  - Responsible Authority: NRB/MOF
  - Time Line*: ST/MT
  - Progress to date: In process
  - Notes:
    - NRB established a payment and settlement system department in July 2015, which will also oversee some of the new products such as mobile banking and branchless banking. The NRB has requested Fund TA to strengthen its payment systems oversight function.
    - Setting up of Real-time gross settlement (RTGS) is being initiated.
    - Nepal Financial Reporting Standard (NFRS) was drafted. Class A banks are required to adopt NFRS-compliant financial statements by [2016/17]. Other financial institutions are required to adopt NFRS by [2017/18].
    - Reforms have been identified to strengthen the credit information bureau, the collateral registry and debt recovery areas but action has not yet been taken.

### Financial Sector Oversight — A. Banking Sector (selected recommendations and status)
- Redefine supervisory approach by:
  - integrating risk-based off-site and on-site supervision;
  - increasing analytical capacity through training;
  - introducing supervisory management information systems (MIS);
  - developing a dedicated human resources (HR) rotation policy; and
  - streamlining the NRB board participation in operational decisions.
  - Responsible Authority: NRB
  - Time Line*: ST/MT
  - Progress to date: In process / not done
  - Notes: Supported by FIRST-funded TA (FIRST) risk-based supervision (RBS) is being implemented for Class A institutions; and is in the preliminary stage for on-site supervision. A complementary off-site RBS component is yet to be developed. A donor is assisting in procurement of MIS, and FIRST aims to support off-site RBS practices. A critical need remains for a dedicated HR policy to hire, train and retain qualified supervisors. No action taken on streamlining the NRB Board’s participation in operational decisions.
- Ensure effective compliance with supervisory directives and guidelines by:
  - performing a thorough follow up of the implementation of supervisory recommendations;
  - proactive, earlier, and stronger corrective actions.
  - Responsible Authority: NRB
  - Time Line*: MT
  - Progress to date: In process/not done
  - Notes: Corrective and supervisory actions remain largely informal; with PCA having a formal framework. Some existing provisions are being revised. The FIRST project supports the development of programs to ensure compliance.
- Review licensing regulations and policy to strengthen the licensing process and support a consolidation of the sector. Once completed, re-license all Classes A, B, and C banks that meet the new reinforced requirements, with an appropriate phase-in period, into a single-license category.
  - Responsible Authority: NRB
  - Time Line*: MT
  - Progress to date: Under review
  - Notes: The NRB has indicated its intent to review the licensing framework in due course. The consolidation of the sector may in the long run have an impact on the various classes of FI.
- Granting the NRB explicit consolidated supervision powers, amending the legal framework to incorporate a comprehensive definition of related parties and controlling interests.
  - Responsible Authority: NRB
  - Time Line*: MT
  - Progress to date: In process/Not done
  - Notes: The amendments of the NRB Act and the BAFIA Act have been endorsed by the Parliament. However, the NRB’s consolidated supervision powers were not specified in the NRB Act. Staff has not yet been able to review the BAFIA Act.

### Financial Sector Oversight — B. Non-banking Sector
- Divide the CIT into two separate legal entities, segregating the capital market business, to be placed under the supervision of the Securities Board of Nepal (SEBON), from the pension fund business.
  - Responsible Authority: MOF/SEBON
  - Time Line*: ST
  - Progress to date: In preparation
  - Notes: MOF is preparing a concept report.
- Place the EPF and CIT pension fund business under the joint supervision of the Insurance Board (IB) and NRB.
  - Responsible Authority: IB/NRB/MOF
  - Time Line*: MT
  - Progress to date: Not done
  - Notes: Regulatory and supervisory options are being explored.
- Strengthen the operational independence of the IB and SEBON.
  - Responsible Authority: SEBON/IB/MOF
  - Time Line*: ST
  - Progress to date: Not done
  - Notes: The government is first looking to strengthen the capacity of the IB and the SEBON.

### Crisis Management (selected recommendations and status)
- Revise Prompt Corrective Action (PCA) policy to require stronger supervisory action, including designation of problematic status at an earlier stage of capital depletion.
  - Responsible Authority: NRB
  - Time Line*: ST
  - Progress to date: Under consideration
  - Notes: NRB is considering including liquidity as a PCA trigger. No changes have been made on the designation of problematic status.
- Develop and implement a banking financial institution (BFI) Supervision Enforcement policy that presumes certain enforcement action based on CAMELS ratings.
  - Responsible Authority: NRB
  - Time Line*: MT
  - Progress to date: Not done
  - Notes: As the supervisory reforms are implemented, such an enforcement policy may emerge.
- Revise NRB Act to clarify emergency liquidity assistance (ELA) provisions.
  - Responsible Authority: NRB/MOF
  - Time Line*: ST
  - Progress to date: Not done
  - Notes: NRB Amendment Act passed by the Parliament does not clarify ELA provisions.
- Revise NRB Act to grant it special resolution regime powers.
  - Responsible Authority: NRB/MOF
  - Time Line*: ST
  - Progress to date: Mostly done
  - Notes: Special resolution regime powers have been granted but need further clarification, strengthening, and operationalization (Pending further assessment by Fund staff).
- Establish a national financial crisis coordinating committee comprised of all financial sector, regulatory, and supervisory agencies. Develop each individual agency’s crisis contingency plans and roll up individual agency plans into a national crisis contingency plan.
  - Responsible Authority: MOF/NRB/IB/SEBON
  - Time Line*: ST/MT
  - Progress to date: Not done
  - Notes: A high-level interagency coordination committee meets on an ad hoc basis. It would be important to formalize the mandate of this committee to include the development of a national crisis contingency plan. Crisis simulations should be conducted periodically.
  - Responsible Authority (simulation): MOF/NRB/IB/SEBON
  - Time Line*: MT
  - Progress to date: Not done
  - Notes: A simulation has not yet been conducted; the authorities are encouraged to conduct crisis simulations after passage of the relevant Acts.

### Fund Relations (as of January 31, 2017) — key figures
- Membership Status: Joined September 6, 1961; accepted Article VIII, Sections 2, 3, and 4 on May 30, 1994.
- General Resources Account:
  - Quota 156.90 100.00
  - Fund holdings of currency 140.92 89.82
  - Reserve position in Fund 15.98 10.19
- SDR Department:
  - Net cumulative allocation 68.10 100.00
  - Holdings 0.07 0.1
- Outstanding Purchases and Loans:
  - RCF Loans 55.61 35.45
  - ECF arrangements 3.21 2.04
- Financial Arrangements (In SDR Million):
  - ECF 11/19/03 — 11/18/07 — Amount Approved 49.90 — Amount Drawn 49.90
  - ECF 10/05/92 — 10/04/95 — Amount Approved 33.57 — Amount Drawn 16.79
  - SAF 10/14/87 — 10/13/90 — Amount Approved 26.11 — Amount Drawn 26.11
- Projected Obligations to Fund (in millions of SDRs; based on existing use of resources and present holdings of SDRs):
  - Forthcoming 2017: Principal 8.91; Charges/interest 0.21; Total 9.12
  - Forthcoming 2018: Principal 5.70; Charges/interest 0.22; Total 5.92
  - Forthcoming 2019: Principal 5.70; Charges/interest 0.22; Total 5.92
  - Forthcoming 2020: Principal 2.85; Charges/interest 0.22; Total 3.07
  - Forthcoming 2021: Principal 7.13; Charges/interest 0.22; Total 7.35

### Exchange Rate Arrangement (selected points)
- Nepal unified its exchange rate in February 1993.
- Since October 1997, the exchange arrangement of Nepal has been reclassified as pegged to a single currency unit.
- The Nepalese rupee is pegged to the Indian rupee at a rate of 1.6.
- As of February 14, 2017, the exchange rate of the Nepalese rupee (Nr) was US$1=Nrs. 107.13.
- The restriction on quantitative limits on foreign exchange for leisure travel was removed in early [text truncated in source].

*STAFF REPORT FOR THE 2017 ARTICLE IV CONSULTATION—INFORMATIONAL ANNEX*

### 2011. The Industrial Enterprises Act places a 75 percent limit on the conversion and transfer to

### cr1774 - 2011. The Industrial Enterprises Act places a 75 percent limit on the conversion and transfer to

### Exchange restriction under Article VIII
- The Industrial Enterprises Act places a 75 percent limit on the conversion and transfer to foreign currency of salaries of non-residents from countries where convertible currency is in circulation.
- Since the limit applies to amounts that may be less than net salaries, it gives rise to an exchange restriction under Article VIII.

### Safeguards Assessments
- An update safeguards assessment of the Nepal Rastra Bank (NRB) was completed in February 2016 with respect to the Rapid Credit Facility approved on July 31, 2015.
- Assessment findings:
  - NRB had made limited progress in improving its safeguards framework and addressing recommendations from the previous assessment (2011).
  - The quality of the external audit continued to fall short of international standards; priority should be given to engaging an auditor with requisite experience.
  - The legal framework should be enhanced to strengthen the central bank’s autonomy and governance arrangements.
  - Strong commitment from the NRB Board and management is essential to improve the internal audit function and reinforce controls in key areas, including foreign reserves management and currency operations.

### 2015 Article IV Consultation
- The Executive Board discussed the staff report for the 2015 Article IV consultation (IMF Country Report No. 15/ 317) on November 16, 2015.
- Consultations with Nepal are held on the standard 12-month Article IV consultation cycle.

### Technical Assistance (since 2012)
- Purpose and years (selection from the listed items):
  - FAD Tax and Customs Administration Reforms/Modernization 2006–12
  - Revenue Administration 2011–13
  - Visiting district Lomjun-discussions with the DTCO's and staffs relating to TSA progress 2012
  - Visiting districts Pokhara, Kasi, Tanahu, and Sindhupal Chowk 2012
  - Implementation of a Large Tax Payer Unit 2013
  - Review of Tax Policy and VAT Administration 2013
  - Public Financial Management 2014
  - Pension reform 2014
  - Customs Administration - Customs Reform and Modernization Strategies 2015
  - Strengthening LTO compliance management activities 2015
  - Strengthening capital budget management 2015
  - Designing a comprehensive tax reform plan 2015
  - Inland Revenue Department (IRD) Reforms—strengthening audit management 2015
  - IRD Reforms—moving from design to implementation phase 2015
  - Tax administration: Post-disaster review and work planning 2015
  - Tax administration: Post-earthquake compliance and risk support 2015
  - Tax Administration: Post-earthquake Large Taxpayer Office -Compliance risk management support 2015
  - Capacity development on budget management 2016
  - Strengthening customs administration (visit) 2016
  - Capacity development to manage fiscal risks via improved budget management
  - Tax policy reform and the Single Tax Code 2017
  - LEG AML/CFT National Strategy 2014
  - Bank Resolution 2012
  - AML/CFT Legal Drafting Mission 2012, 2013, 2014, 2015
  - AML/CFT Structures and Tools 2012, 2013, 2014, 2015
  - Strengthening the AML/CFT Legal, Supervisory and FIU Framework 2016
  - MCM Monetary Policy/Operations Continuous
  - Conduct Bank Diagnostics 2012
  - Banking Supervision and Regulation 2012
  - Migration to GFSM 2001 2012
  - Exchange Rate and Capital Account Liberalization 2013
  - Consultation to support a three-year banking supervision project 2015
  - Upgrade of Procedures for Licensing and Mergers Authorization 2016
  - Upgrading Off-Site Supervision to Risk-Based Supervision 2016
  - Strengthening monetary policy framework and its implementation 2016
  - STA Balance of Payments Statistics 2012, 2014, 2016
  - Monetary Statistics 2014
  - National Accounts 2012, 2014
  - Government Financial Statistics 2014, 2017

### Resident Representative
- Mr. Andreas Bauer has been the Senior Resident Representative since June 15, 2016. He is based in New Delhi.

### Relations with the World Bank Group (As of February 2017)
- Partnership in Nepal's Development Strategy:
  - Nepal achieved development progress since 2006: poverty headcount ratio at US$1.90 per day (2011 PPP) decreased from 46.1 percent in 2003 to 15 percent in 2010.
  - According to Nepal’s national poverty line, 25.2 percent of the population live in poverty.
  - Economic growth averaged at 4.5 percent (2006-2015).
  - A large portion of the 45 percent of total population that are considered vulnerable may have fallen back into poverty after the 2015 earthquakes and late-2015 to early-2016 trade disruptions.
  - Next National Living Standard Survey expected in 2017/2018 to provide updated poverty data.
  - Under the Fourteenth Periodic Plan (2017-2019), Nepal aims to achieve higher equitable and sustainable growth; removal of bottlenecks to long term growth is needed.
  - The World Bank Group supports these efforts through its Country Partnership Strategy (FY14-18) and Nepal is expected to receive an increase in allocation of IDA resources under IDA18 (FY18-20), including from its Exceptional Risk Mitigation Regime.

- IMF-World Bank Collaboration in Specific Areas:
  - World Bank leads engagement in infrastructure, social sectors, agriculture and rural development, disaster management coordination, and sustainable environment management.
  - World Bank, IFC, and MIGA carry out a Joint Implementation Plan in hydropower development; support for Kabeli-A and Upper Trishuli 1 hydropower projects is noted.
  - World Bank preparing the Energy Sector Development Policy Credit to support policy, legislation and institutional reforms in the power sector.
  - In transport, World Bank provides investment financing for all season road access and connectivity and supports a program for bridges using the program-for-results (PforR) instrument.
  - In social sectors, World Bank supports education (including school sector, higher education, technical and vocational education and training) and has approved the School Sector Development Program (FY17 approval) using PforR.
  - In health, World Bank approved the Health Sector Management Program, a PforR operation addressing governance and efficient management of public resources.
  - In agriculture and rural development, World Bank finances operations to improve agricultural productivity, irrigation, water resource management, and supports the Poverty Alleviation Fund (PAF).
  - World Bank responded to the 2015 earthquakes with the $200 million housing reconstruction project.

- World Bank Contributions to the IMF Work Program:
  - Collaboration on strengthening the financial sector, including the joint Financial Sector Assessment Program.
  - Support for Development Policy Credits (DPCs) addressing banking sector vulnerabilities and technical assistance in crisis management, bank resolution and deposit insurance.
  - Collaboration on debt management, joint Debt Sustainability Analysis, and policy dialogue to ensure fiscal and debt sustainability.
  - Public expenditure analysis and technical assistance for Medium Term Expenditure Framework; World Bank supported the Public Expenditure and Financial Accountability Assessment (second assessment) in 2015.

- World Bank Group Strategy and Lending Operations:
  - WBG Nepal Country Partnership Strategy (FY14-18) focuses on two pillars: (a) increasing economic growth and competitiveness (hydroelectric power, transport connectivity, financial sector, investment climate), and (b) promoting inclusive growth and shared prosperity (agriculture productivity, education, healthcare, skills development, social protection).
  - Cross-cutting priorities: strengthening institutional governance and capacities, mainstreaming gender and citizen engagement, addressing climate change vulnerabilities and natural disaster mitigation.
  - Near-term areas for scaling up engagement:
    - supporting the government in its transition to a federal state,
    - helping create jobs domestically given potential further decline in overseas employment opportunities and youth bulge,
    - providing assistance to strengthen resilience against natural disasters including earthquakes,
    - intensifying engagement on policy reforms to improve institutional governance.
  - Under IDA17 (FY15-17), Nepal expected to receive approximately US$1.2 billion (US$901 million from core IDA and US$300 million from Crisis Response Window for emergency needs following the 2015 earthquakes).
  - As of mid-February 2017, the portfolio consisted of 18 IDA projects with a combined net commitment of US$1.72 billion.
  - Under IDA18 (FY18-20), Nepal is expected to receive a substantial increase in IDA resources; expected WBG financing priorities include Upper Trishuli 1 hydropower project, the Fiscal DPC, the Financial Sector DPC4, the Energy Sector DPC, and the Fast Track Highway.
  - World Bank Group starting to prepare the Systematic Country Diagnostic in the second-half of FY17 and expected to prepare a new Country Partnership Framework in FY18.

*International Monetary Fund, Nepal country material (excerpts from the provided content).*

### Box 1. Activities of the International Finance Corporation (IFC) in Nepal

### Box 1. Activities of the International Finance Corporation (IFC) in Nepal

### Strategic focus
- IFC is addressing private sector opportunities and constraints through investments and advisory services to close key development gaps in Nepal.
- Priority areas: sustainable infrastructure, inclusion, and competitiveness/jobs.
- Infrastructure focus: supporting breakthrough hydropower projects with potential to turn Nepal into a power surplus country and attract significant FDI.
- Inclusion focus: increasing access to financial services for individuals and MSMEs.
- Competitiveness/jobs focus: agribusiness, tourism, manufacturing and services.

### Portfolio size and composition
- IFC’s cumulative committed portfolio stood at $52 million as of the end of FY2016.
- Advisory services portfolio totaled to $13.3 million.
- Investment portfolio sector shares:
  - Infrastructure: 68 percent
  - Telecom, Media, Technology, Venture Capital and Funds: 13 percent
  - Financial Institutions Group (FIG): 9 percent
  - Manufacturing, Agribusiness, and Services (MAS): 9 percent
- Advisory services areas: financial sector, hydro energy, agribusiness, SMEs, tourism, airport PPP, and investment climate.

### Key activities and projects
- Energy sector:
  - Helping unlock barriers for new infrastructure projects, particularly in hydropower.
  - Working closely with IDA on the joint Kabeli-A Hydroelectric Development Project.
  - Achieving significant progress on the ground-breaking 216MW Upper Trishuli 1 hydropower project.
- Financial sector:
  - Supporting banks and venture funds that finance SMEs.
  - Providing trade finance products.
  - Advisory engagements to enhance financial infrastructure, support financial product development, improve risk management in financial institutions, and strengthen payment regulations.
- Agribusiness and tourism:
  - Through a lead firm, supporting farmers with climate smart agricultural practices.
  - Helping the government of Nepal in developing new tourism destinations.
- Investment climate and private sector environment:
  - Through the joint Global Practice on Trade and Competitiveness, working with the government on broad investment climate and sector-specific regulatory reforms.

### Partnerships and future engagement
- IFC will continue to work closely with the World Bank to help address institutional capacity constraints to accelerate progress in existing private sector projects and attract more private sector engagements.

*Source: Box 1. Activities of the International Finance Corporation (IFC) in Nepal*

### 1. The 2015 earthquakes and the disruption to trade at Nepal’s southern border in

### 1. The 2015 earthquakes and the disruption to trade at Nepal’s southern border in

### Macroeconomic impact and outlook
- Real GDP at market prices is estimated to have slowed to 0.6 percent in FY2015/16.
- Real GDP growth is expected to recover to 5½ percent in FY2016/17 and 4½ percent in FY2017/18.
- Growth is forecast to moderate to 3.8 percent per annum in the medium term.
- Fiscal policy is expected to remain prudent; revenue and grants are projected to stabilize at about 24 percent of GDP.
- Net incurrence of liabilities in the medium term is projected to be smaller by 1¾ percent of GDP per annum than in the previous DSA, reflecting the drawdown of government cash balances (5.7 percent of GDP in mid-2016).
- Public debt is expected to stabilize at about 22 percent of GDP in the medium term.

### External public debt: current levels and projections
- External debt stood at US$3.6 billion or 16.9 percent of GDP at the end of FY2015/16.
- 87 percent of external debt was concessional borrowing mainly from the World Bank and the Asian Development Bank (ADB).
- Japan was the largest bilateral creditor, followed by South Korea, India and China.
- The PV of PPG external debt rose to 12.6 percent of GDP in 2016 (1 percent of GDP higher than projected in the previous DSA).
- The PV of PPG external debt is projected to decline to about 10¾ percent of GDP by 2022.
- Over the medium term, the PV of external debt stabilizes at: 8 percent of GDP and remittances, 32 percent of exports and remittances, and 45 percent of revenues.
- The ratio of debt service to exports and remittances stabilizes at 2 percent; debt service to revenues stabilizes at 3 percent.

### Public debt levels and composition
- Public debt increased to 27.3 percent of GDP in FY2015/16, from 25.2 percent of GDP in FY2014/15, despite a fiscal surplus.
- External debt composition shift: external share projected to rise from 62 percent in 2015/16 to 73 percent in the medium term, reverting to 62 percent in the long term.
- Under the baseline, public debt to GDP gradually declines from 27.3 percent in 2015/16 to 22 percent in the medium term and 20½ percent of GDP in the long term.
- PV of public debt to GDP decreases from 23 percent in 2015/16 to 15.7 percent of GDP in 2036/37.
- PV of public debt as a ratio of revenues and grants declines from 98.5 percent in 2015/16 to 62 percent in 2036/37.

### Fiscal and monetary indicators (selected figures from Box 1)
- Revenues and grants: 22.8 percent of GDP in 2015/16; projected 24.2 percent of GDP in 2016/17 and 24.2 percent (MT).
- Grants: 2.3 percent of GDP in 2015/16; projected 1.9 percent of GDP in 2016/17.
- Primary expenditure: 24.5 percent of GDP in 2015/16; projected 25.8 percent of GDP in 2016/17.
- Net acquisition of non-financial assets: 5.0 percent of GDP in 2015/16; projected 5.5 percent of GDP in 2016/17.
- Primary deficit: 1.4 percent of GDP in 2015/16; projected 1.6 percent of GDP in 2016/17.
- Current account balance: -2.0 percent of GDP in 2015/16; 1.3 percent of GDP in 2016/17.

### Debt management capacity
- World Bank’s 2014 DeMPA found improvements: cash flow forecasting, cash balance management, alignment of public debt management with macro policy.
- Recommendation: managerial oversight should be more effective; designate one entity responsible for a comprehensive debt management strategy.
- Needed actions: analyze cost and risks of the debt portfolio (including sensitivity to exchange rate variability) and make debt service forecasts more robust.
- World Bank engaged with Nepali authorities in 2016 to provide training to build capacity to formulate and update a consistent debt management strategy.

### Baseline DSA assessment
- Under the baseline, Nepal’s external debt indicators remain well below indicative sustainability thresholds.
- Remittances (close to 30 percent of GDP in FY2015/16) are formally included in the analysis; debt dynamics are susceptible to volatility in remittance flows.
- Baseline assumes approximately US$2.7 billion of additional external financing would be drawn over the next 5-year period to meet post-earthquake reconstruction-related financing needs.

### Stress tests and alternative scenarios
- Standard stress tests include shocks to real GDP growth, exports, non-debt creating flows, a combination of these shocks, and a one-time 30 percent nominal depreciation shock.
- Under the most severe shock (to non-debt creating flows, capturing a shock to remittances), the PV of debt to exports and remittances rises sharply over the next three years but stays well below the threshold and declines thereafter.
- The PV of public debt to GDP ratio remains well below the 56 percent threshold for all standard stress tests.
- Most extreme shocks for public debt dynamics: (i) real GDP growth at historical average minus one standard deviation; (ii) a 10 percent of GDP increase in other debt-creating flows in 2017/18.

### Contingent liabilities
- Major contingent liabilities originate from SOEs and civil service pension liabilities.
- Nepal Oil Corporation (NOC) and Nepal Electricity Authority (NEA) are the two largest loss-making SOEs.
  - NOC repaid 1½ percent of GDP in loans over the past 2 fiscal years by delaying pass-through of declining oil import prices.
  - NEA made a loss of ½ percent of GDP in 2015/16 and has long-term debts of close to 5 percent of GDP; NEA cash flow improved after a July 2016 electricity tariff hike and demand-side management.
- Civil service pension liabilities remain modest and can be addressed through adequate parametric reforms in the medium term (per a 2014 IMF TA mission).

### Authorities’ position
- Authorities broadly agreed with the DSA findings.
- They are focusing on strengthening capital budget implementation and mobilizing additional foreign financing to speed recovery and raise medium-term growth.
- Authorities expressed confidence that the risk of debt distress would remain low even with scaled up public investment.

*Prepared by the staffs of the International Monetary Fund and the World Bank. March 13, 2017*

### 12. The DSA suggests Nepal’s risk of debt distress is low. Weak budget execution has

### 12. The DSA suggests Nepal’s risk of debt distress is low. Weak budget execution has

### DSA main findings
- The DSA concludes Nepal’s risk of debt distress is low.
- Weak budget execution contributed to fiscal surpluses in each of the past four years.
- Recent developments:
  - There has been a pickup in government spending in recent months.
  - A large number of households affected by the 2015 earthquakes have received the first installment of housing grants.
  - The government intends to raise capital spending to address infrastructure bottlenecks and boost growth.
- Under the baseline macroeconomic projections the fiscal balance is assumed to turn to a small deficit as government spending picks up.
- Nepal’s risk of debt distress is expected to remain low because of:
  - The assumed continued high level of concessionality of official borrowing.
  - Limited scaling up of capital spending due to weak implementation capacity over the medium term.
- Under the baseline macroeconomic scenario, public external debt stock and public debt service indicators remain well below the policy-dependent indicative thresholds, even under stress tests, due to the assumed continued high level of concessionality of official borrowing.

### Baseline quantitative indicators and trends (selected)
- External debt (nominal): 18.2, 15.9, 16.9, 17.5, 16.7, 16.0, 15.8, 16.0, 16.0, 15.7, 12.9 (series in table 1a).
- PV of external debt (selected projection values): 12.6, 12.6, 11.9, 11.3, 11.0, 10.8, 10.7, 10.0, 8.1 (in percent of GDP series shown).
- PV of PPG external debt (in percent of exports): 132.7, 127.3, 120.2, 116.1, 114.2, 114.2, 114.1, 119.2, 105.3 (series shown).
- PPG debt service-to-revenue ratio (in percent): 5.6, 4.9, 4.5, 3.6, 4.1, 3.8, 3.6, 3.5, 3.3, 2.9, 2.1 (series shown).
- Total gross financing need (Billions of U.S. dollars): -0.7, -0.9, -1.2, 0.1, 0.4, 0.5, 0.6, 0.7, 0.8, 0.6, 1.6 (series shown).
- Grant element of new public sector borrowing (in percent, projection window): 51.0, 49.0, 48.9, 50.1, 49.8, 49.7, 49.7, 49.6, 49.5, 49.6 (table 1a and 2a memorandum).

### Public sector debt and fiscal variables (selected from Public Sector DSA)
- Public sector debt (percent of GDP): 28.3, 25.2, 27.3, 25.7, 23.2, 22.8, 22.5, 22.3, 22.0, 22.3, 20.5 (series in table 2a).
- Of which: foreign-currency denominated (percent of GDP): 18.0, 15.9, 16.9, 17.5, 16.7, 16.0, 15.8, 16.0, 16.0, 15.7, 12.9.
- Change in public sector debt (percent of GDP): -3.3, -3.1, 2.1, -1.6, -2.5, -0.4, -0.3, -0.3, -0.3, 0.0, -0.4.
- Primary deficit (percent of GDP): -1.0, 0.7, -0.7, 0.7, 1.3, 1.6, 1.8, 1.7, 1.2, 1.2, 1.1.
- Revenue and grants (percent of GDP): 20.4, 20.9, 23.3, 24.2, 24.1, 24.1, 24.1, 24.0, 24.0, 24.1, 25.3.
- Primary (noninterest) expenditure (percent of GDP): 19.4, 21.5, 22.7, 25.8, 26.0, 25.7, 25.3, 25.2, 25.1, 25.2, 25.7.
- Gross financing need (percent of GDP): 2.8, 5.1, 3.6, 6.1, 5.6, 4.8, 4.4, 4.3, 4.1, 4.3, 3.9.

### Key macroeconomic assumptions used in the baseline
- Real GDP growth (in percent) series shown: 6.0, 2.7, 0.6, 4.0, 1.6, 5.5, 4.5, 3.8, 3.8, 3.8, 3.8, with projection averages cited (e.g., 4.2, 3.8 in later horizons).
- GDP deflator in US dollar terms (change in percent) series examples: 0.1, 3.8, -1.3, 6.0, 8.5, 4.4, 4.6, 4.5, 4.4, 4.1, 4.1.
- Effective interest rate (percent): 1.0, 0.8, 0.9, 0.9, 0.1, 1.1, 1.3, 1.4, 1.4, 1.4, 1.3, 1.3, 1.1, 1.0, 1.1.
- Growth of exports of G&S (US dollar terms, in percent): 12.0, 7.8, -19.3, 5.9, 10.8, 14.8, 9.4, 7.0, 6.9, 6.8, 6.8.
- Growth of imports of G&S (US dollar terms, in percent): 13.2, 8.6, -6.5, 12.1, 11.3, 22.3, 9.1, 7.0, 7.0, 7.0, 6.9.
- Government revenues (excluding grants, in percent of GDP): 18.2, 19.1, 21.4, 22.3, 22.3, 22.3, 22.3, 22.2, 22.3, 22.4, 24.0.
- Aid flows (in Billions of US dollars): 0.6, 0.5, 0.5, 0.6, 0.6, 0.7, 0.7, 0.8, 0.8, 1.2, 1.9.
  - of which: Grants (Billions of US dollars): 0.4, 0.4, 0.4, 0.4, 0.5, 0.5, 0.5, 0.6, 0.6, 0.8, 1.4.
  - of which: Concessional loans (Billions of US dollars): 0.1, 0.1, 0.1, 0.2, 0.2, 0.2, 0.2, 0.2, 0.2, 0.4, 0.6.
- Grant-equivalent financing (in percent of GDP) projection examples: 3.3, 2.5, 2.4, 2.6, 2.8, 2.7, 2.3, 1.8, 2.2 (series shown).
- Gross workers' remittances (Billions of US dollars): 5.5, 6.2, 6.3, 6.5, 6.8, 7.2, 7.6, 8.0, 8.5, 11.4, 20.4.

### Stress tests and sensitivity analysis (selected)
- The most extreme stress test is identified as the test that yields the highest ratio on or before 2026; for various indicators the Combination shock or a One-time depreciation shock is the most extreme.
- Table 1b and associated figures present alternative scenarios and bound tests, including:
  - A2. New public sector loans on less favorable terms in 2016-2036 (assumes interest rate on new borrowing is 2 percentage points higher than baseline; grace and maturity same).
  - B1–B6 bound tests including real GDP growth shock, export value shock, US dollar GDP deflator shock, net non-debt creating flows shock, combination shock, and a One-time 30 percent nominal depreciation relative to baseline in 2017.
- Sensitivity results (examples from Table 1b):
  - PV of debt-to-GDP+remittances ratio under baseline and scenarios (values shown in table cells, e.g., baseline and scenario series such as 10, 9, 8, 7... displayed).
  - PV of debt-to-exports+remittances ratio and PV of debt-to-revenue ratio under alternative scenarios and bound tests (series shown in table 1b).

### Policy implications and context (as presented)
- Continued high concessionality of official borrowing is central to maintaining low risk of debt distress.
- Weak implementation capacity that limits scaling up of capital spending helps keep projected debt indicators lower than they would be under rapid capital spending increases.
- The fiscal outlook assumes a modest worsening of the fiscal balance (from surplus to a small deficit) as government spending picks up, including earthquake housing grants and planned capital spending.

*Sources: Country authorities; and IMF staff estimates and projections as presented in the chapter.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr1774.pdf_