## INFLATION CO-MOVEMENT BETWEEN INDIA AND NEPAL

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---

### Stylized facts
- Food-inflation co-movement between India and Nepal is relatively strong; core inflation co-movement is much weaker, especially in the recent period.
- For countries with strong trade ties to India (high import share from India), headline inflation correlations tend to be higher; this is driven almost exclusively by higher correlation in food inflation.
- Key country-level statistics (import share from India; correlations with India):
  - Bhutan: 74.3; Food CPI 0.45; Headline CPI 0.52; Core CPI 0.09
  - Nepal: 57.8; Food CPI 0.73; Headline CPI 0.65; Core CPI 0.18
  - Sri Lanka: 20.4; Food CPI 0.27; Headline CPI 0.24; Core CPI N/A
  - Bangladesh: 14.0; Food CPI 0.17; Headline CPI 0.40; Core CPI 0.25
  - Pakistan: 3.2; Food CPI 0.74; Headline CPI 0.51; Core CPI 0.50
  - Indonesia: 2.2; Food CPI 0.02; Headline CPI 0.01; Core CPI 0.17
  - Singapore: 2.1; Food CPI -0.37; Headline CPI 0.31; Core CPI 0.42
  - Vietnam: 1.9; Food CPI -0.20; Headline CPI 0.02; Core CPI 0.50
  - Hong Kong SAR: 1.8; Food CPI -0.54; Headline CPI -0.17; Core CPI 0.02
  - Malaysia: 1.6; Food CPI -0.15; Headline CPI 0.11; Core CPI -0.16
  - Thailand: 1.3; Food CPI 0.27; Headline CPI 0.09; Core CPI 0.14
  - China: 1.1; Food CPI -0.45; Headline CPI -0.32; Core CPI -0.08
  - Philippines: 1.1; Food CPI 0.08; Headline CPI 0.12; Core CPI 0.39
  - South Korea: 1.1; Food CPI -0.21; Headline CPI -0.15; Core CPI 0.21
  - Cambodia: 1.0; Food CPI 0.50; Headline CPI 0.35; Core CPI 0.38
  - Laos: 0.4; Food CPI 0.40; Headline CPI 0.14; Core CPI N/A
  - Mongolia: 0.4; Food CPI -0.23; Headline CPI -0.04; Core CPI N/A

### Empirical analysis of inflation co-movement determinants
- Methodology:
  - Instantaneous quasi-correlation measure comparing deviations of inflation from equilibrium and normalizing by volatility (quasi-correlation).
  - Panel regression framework: dependent variable is quasi-correlation of inflation between India and each country; food and core inflation estimated separately.
  - Key explanatory variables: each country’s share of imports from India; quasi-correlations of M2 growth, industrial production growth (IP), deviations of rainfall from seasonal norms between India and the country; time (monthly) fixed effects.
- Regression results (robust standard errors in parentheses; significance stars preserved):
  - Food Inflation (column 1):
    - Rainfall co-movement: 1.095* (0.580)
    - Exchange-rate co-move: 0.056* (0.030)
    - Import share, from India: 0.003* (0.002)
    - Observations: 870
    - Number of countries: 16
    - Time fixed effects: yes
  - Core Inflation (column 2):
    - Rainfall co-movement: 0.651 (0.443)
    - Exchange-rate co-move: 0.052 (0.032)
    - Import share, from India: -0.002 (0.002)
    - Observations: 556
    - Number of countries: 11
    - Time fixed effects: yes
  - Note: In both food and core regressions, M2 and IP co-movement have no statistically significant impact on inflation co-movement (results not shown in Table 2).

### Key findings
- Food inflation co-movement between India and other Asian countries is higher where:
  - Rainfall deviations from seasonal norms co-move more strongly between India and the partner country.
  - Trade integration with India (import share from India) is greater.
  - Nominal effective exchange-rate co-movement is stronger.
- Core inflation co-movement is much less precisely estimated; rainfall, trade integration, and exchange-rate co-movement are not statistically significant determinants for core inflation co-movement.
- Core inflation appears to be primarily driven by domestic (idiosyncratic) factors.

### Policy implications and recommendations (inflation)
- The apparent strong headline inflation co-movement between India and Nepal is driven almost exclusively by food-inflation co-movement; common weather shocks (e.g., rainfall patterns) are partly responsible, not only price spillovers from India.
- The role of inflation spillovers from India in driving non-food (core) inflation in Nepal appears limited.
- Monetary policy implications:
  - Domestic monetary policy should be the primary tool to tackle domestic inflationary pressures, especially core inflation.
  - Nepal cannot necessarily rely on stable inflation in India to achieve stable domestic inflation; monetary policy needs to be calibrated to domestic conditions (economic slack, exchange-rate movements, passthrough from food- and energy-price shocks).
- Fiscal and broader policy context:
  - While headline inflation co-movement is notable, nuance is required: strong food inflation co-movement versus weak core inflation co-movement implies policy efforts should focus on domestic sources of core inflation and on measures to manage food-price volatility (including responses to weather-related shocks and trade-related channels).

*Prepared by Patrick Blagrave (APD); methodology based on Blagrave, 2018, “Inflation Co-Movement in Asia: Blame it on the Rain?” IMF Working Paper, forthcoming.*

---

### Overview of Nepal’s fiscal federalism transition

### Institutional and legal framework
- Nepal transitioned from a unitary government to a federal democratic republic under the 2015 Constitution, creating federal, provincial, and local governments.
- The 2015 Constitution, the Local Government Operations Act (2017), and the Inter-Government Fiscal Transfers Act (2018) establish the framework for revenue/expenditure assignments, local consolidated funds, and intergovernmental transfers.
- The National Natural Resources and Fiscal Commission (NNRFC) was established to recommend arrangements related to inter-governmental fiscal transfers, internal borrowing, and natural resources utilization.

### Structure of subnational finances and revenue instruments
- Four categories of fiscal transfers:
  - (i) Equalization grants: allocated based on population, development status, and gap between expenditure needs and revenue potential. Transfers are effected in four installments (10th August, 19th October, 16th January, and 15th April);
  - (ii) Conditional grants: a quarter of the total budgeted amount is to be transferred on July 17. The rest is to be transferred on the first day of each trimester depending on implementation progress;
  - (iii) Complementary grants: transfer of funds to provincial and local governments to match the resources;
  - (iv) Special grants: to support special projects, emergency needs, and activities related to national development priorities.
- Revenue-sharing arrangements:
  - VAT and internal excise tax revenues shared at the ratio of 70:15:15 (federal:provincial:local).
  - Royalties shared at the ratio of 50:25:25.
- Local revenue collection: taxes on property, rent and lease income, and vehicle registration fees collected by local governments.
- Internal borrowing: legal framework not finalized; NNRFC administrative decision suggests an upper limit for internal borrowing at 5 percent of GDP per annum for the federal government. Provincial and local governments could borrow up to 10 percent of the sum of their share of VAT and excise revenue locally-collected revenue.

### Fiscal outcomes and macro-fiscal risks
- Implementation and fiscal transfers:
  - The operation of fiscal federalism commenced partially in FY2017/18 with conditional and equalization grants determined ad hoc.
  - The NNRFC developed a revenue sharing formula; FY2018/19 budget envisages total financial resources for subnational governments of 14 percent of GDP.
- Consolidated fiscal impact:
  - Consolidated fiscal deficits reached 6.5 percent of GDP in FY2017/18 and are budgeted to expand to about 8 percent of GDP in FY2018/19.
  - Public debt projected to rise to 33 percent of GDP in FY2018/19, up from 26 percent of GDP in FY2016/17.
  - Staff baseline projects public debt to reach 35 percent of GDP in the medium-term (up from 22 percent of GDP in the staff report for the 2017 Article IV Consultation).
- Vertical fiscal imbalance and incentives:
  - Subnational share of total general government spending in the FY2018/19 Budget is about 36 percent.
  - Subnational own-source revenue share is very low, creating large vertical fiscal imbalance (VFI) and weak incentives for subnational revenue mobilization.
  - Risks include overspending, relaxation of tax collection, low revenue, and weakening fiscal balance.
- Pro-cyclicality:
  - Revenue-sharing with fixed distribution coefficients can make fiscal policy more pro-cyclical.

### Capacity and institutional design issues
- Rapid devolution risks:
  - Rapid devolvement of spending responsibilities and augmentation of resources to subnational governments may stretch subnational capacity and risk disruption of public services.
  - Subnational limited implementation capacity evidenced by a substantial share of transferred resources often kept in government deposit accounts and surge of government deposits during the fiscal year.
- Public financial management gaps:
  - Absence of well-developed public financial management systems at subnational levels, including expenditure reporting and control systems, increases risk of misallocation and waste.
- Uncertainty over cost alignment:
  - Comprehensive costing of subnational governments’ expenditure assignments has not been completed; alignment between transfers/revenue-sharing and actual cost of service delivery remains unclear.
- Internal borrowing framework:
  - Framework for internal borrowing, criteria, and borrowing limits remain to be developed; cross-country experience suggests such conditions are crucial to enforce fiscal discipline.

### Policy implications and recommendations (fiscal federalism)
- Key short-term priorities:
  - Strengthen subnational governments’ policy implementation capacity through training, standardization, and use of technology.
  - Establish public financial management systems at subnational levels: effective and transparent budgeting, accounting, and reporting systems at all levels.
  - Intensify efforts by Nepal’s Financial Comptroller General Office to improve financial reporting at subnational levels.
  - Establish local consolidated funds and configure them to act as stabilization funds—absorbing excess resources during booms and boosting spending during busts—to reduce procyclical fiscal policy resulting from fiscal decentralization.
- Key medium-term priorities:
  - Gradually adjust expenditure allocation to reconcile responsibilities and needs.
  - Adopt Fiscal Responsibility and Budget Management Bill (FRBMB) to ensure fiscal discipline and increase accountability.
  - Reinstate a realistic medium-term expenditure framework and develop medium-term budget planning to ensure fiscal prudence and consistency with broader macroeconomic management; annual budgets should be guided by the medium-term framework.
  - Conduct periodic spending reviews to refine methodology and formulas for revenue sharing and fiscal transfers.
  - Strengthen fiscal discipline at subnational levels by better aligning subnational taxation powers with spending obligations to narrow vertical fiscal imbalances.
  - Clarify functional and revenue responsibilities at all government levels to avoid overlapping responsibilities, duplication, waste, and to warrant better service quality.
  - Conduct a review of costs of delivering services in the federal structure as a matter of priority.

### Key statistics and table extracts (verbatim)
- "Transfers are effected in four installments (10th August, 19th October, 16th January, and 15th April)"
- "A quarter of the total budgeted amount is to be transferred on July 17."
- "VAT and internal excise tax revenues will be shared among federal, provincial, and local governments at the ratio of 70:15:15."
- "Royalties will be shared at the ratio of 50:25:25."
- "NNRFC’s administrative decision suggest an upper limit for internal borrowing at 5 percent of GDP per annum for the federal government."
- "Provincial and local governments could borrow up to 10 percent of the sum of their share of VAT and excise revenue locally-collected revenue."
- "FY2018/19 budget envisages total financial resources for subnational governments of 14 percent of GDP."
- "Deficits reaching 6.5 percent of GDP in FY2017/18 and budgeted to expand further to about 8 percent of GDP in FY2018/19."
- "Public debt is projected to rise to 33 percent of GDP in FY2018/19, up from 26 percent of GDP in FY2016/17."
- "Staff’s baseline scenario... public debt is projected to rise sharply and reach 35 percent of GDP in the medium-term, up from 22 percent of GDP in the staff report for the 2017 Article IV Consultation."
- Verbatim table extract:
  - "Table 1. Nepal: General Government Operations Under Fiscal Federalism
    NPR million%GDPNPR million%GDP
    III. General government
    Revenue76725.51,04531.1
    Expenditure96332.01,31439.2
    Fiscal balance-196-6.5-269-8.0
    I. Central government
    Revenue51717.256216.7
    Expenditure71323.783124.8
    Fiscal balance-196-6.5-269-8.0
    II. State/local governments
    Revenue2508.348314.4
    Fiscal transfers2508.33289.8
    Fiscal equalization grants1555.11364.0
    Conditional grant953.21735.2
    Complementary grant00.0100.3
    Special grant00.0100.3
    of which: Fiscal transfer to local level2468.22056.1
    Fiscal equalization grants1505.0852.5
    Conditional grant953.21103.3
    Complementary grant00.050.1
    Special grant00.050.1
    Fiscal transfer to states40.11233.7
    Fiscal equalization grants40.1501.5
    Conditional grant00.0631.9
    Complementary grant00.050.1
    Special grant00.050.1
    Revenue sharing00.01143.4
    Own revenue collection00.0411.2
    Internal borrowing 00.000
    Expenditure2508.348314.4
    Fiscal balance00.000.0
    Sources: Nepali authorities and IMF staff projection
    FY18/19 BudgetFY17/18 Actual"

---

### Sustainable finance to support long-term growth — Key findings and recommendations

### Context and objectives
- Nepal aims to graduate from less developed countries (LDC) status by 2022 and achieve middle income countries (MIC) status by 2030; sustainable financial sector development is necessary to support sustained broad-based growth.

### Financial sector vulnerabilities and drivers
- Credit growth averaged about 21 percent over the past three years.
- Credit-to -GDP ratio of 80 percent.
- Real estate related lending accounts for about 70 percent of total lending.
- Nearly half of banks’ loan books comprise overdraft and working capital loans (18.1 percent Overdraft; 20.3 percent Demand & Other Working Capital Loan).
- Reported commercial bank NPLs are lower than peers but may be understated.
- Large inflows of remittances have been a major funding source and a liquidity risk driver.

### Past reform actions and supervisory context
- 2014 FSAP highlighted macro-financial and legal/supervisory weaknesses.
- A special inspection program (SIP) in 2015 evaluated credit portfolios of 54 BFIs (representing more than 50 percent of total banking sector assets); 26 out of 54 were found to have CARs below minimum required in 2014/15.
- Nepal Rastra Bank announced a four-fold increase in minimum paid-up capital phased in between 2016 and 2018, effected mostly through issuance of outright shares, retained profits, and bank mergers.
- NRBAA and DCGF Acts approved by Parliament in September 2016 clarified bank resolution powers and enhanced deposit insurance framework, but NRBAA curtailed central bank autonomy and did not grant explicit consolidated supervision powers nor clarify emergency liquidity assistance provisions.
- Amendments to the Bank and Financial Institutions Act (BAFIA) passed in January 2017 to strengthen commercial bank governance.
- NRB adopted risk-based banking supervision in 2018 and is gradually proceeding to full implementation; a Supervisory Information System is being developed.
- Transition to Nepali Financial Reporting Standards (NFRS) consistent with IAS; payments and clearing modernized, including introduction of RTGS.

### Stress and simulation results
- A simulation exercise (modeled in line with Nepal’s 2014 FSAP) suggests that a shock propagated from a real estate bust could cause non-performing loans to rise sharply.
- A liquidity stress test by NRB (NRB, 2018a) suggests 19 out of 28 commercial banks are vulnerable under scenarios of customer deposit withdrawals of 2, 5, and 10 percent for five consecutive days.

### Sustainable finance — Policy recommendations
- Tightening macroprudential policies:
  - Strengthen CCD ratio, loan-to -value ratio, and limits to real estate exposures.
  - Phase out carve-outs to the calculation of the CCD ratio over time.
- Strengthening banking supervision:
  - Continue upgrading supervision, risk assessments, and monitoring.
  - Empower supervisors to follow up on inspection findings and enforce corrective measures promptly.
- Building buffers:
  - Additional capital and provisioning may be required given data and supervisory weaknesses.
- Updating crisis management:
  - Clarify and align central bank lender-of-last-resort policy (last updated in 2011) with international central bank practices concerning emergency liquidity assistance.
- Upgrading financial infrastructure:
  - Urgently develop an accessible collateral registry.
  - Improve the Credit Information Bureau and the Supervisory Information System.
  - Effectively implement debt enforcement and insolvency laws.

---

### Financial inclusion in Nepal — Key findings and recommendations

### Coverage, gaps, and potential gains
- Deposit accounts rose from 446 to 657 accounts per 1000 adults between 2012 and 2016.
- Nepal ranks within the second quartile among 30 Asia-Pacific countries on an access-focused composite measure.
- About two-thirds of adults have access to formal financial services; 21 percent use only informal services; 18 percent use no financial services.
- Formal credit concentrated in few districts: Kathmandu, Parsa, and Kaski.
- Per capita credit: Kathmandu about NPR550,000; Nuwakot about NPR1,300.
- Metropolitan areas average nearly 3 accounts per person; rural areas average 0.16 accounts per person.
- Savings account penetration: Kathmandu is 10 times higher than Baitadi.
- Gender gap: 26 percent of women have a bank account versus nearly 50 percent of men.
- IMF (2018) estimates bringing Nepal’s financial inclusion level to Singapore’s frontier is associated with a cumulative 1.1 percentage point increase in per capita income growth and lifting about 350,000 people out of poverty over a five-year period.
- Raising Nepal’s inclusion to India’s level could raise per capita income growth by 0.2 percent over a five-year period.

### Financial inclusion — Policy recommendations
- Focus on underserved groups:
  - Target rural population, low-income households, women, and geographically-remote communities.
- Product design and digital channels:
  - Ensure a wide range of financial products and services are appropriately designed and priced to be widely used.
  - Leverage mobile banking and digital payments to complement traditional channels.
- Move away from quantity-based policies:
  - Shift from priority sector and deprived sector lending policies toward price-based mechanisms to correct market failures.
  - Build financial sector infrastructure: credit information systems and secured-transactions registries for movable property.
- Credit guarantees and SME support:
  - Operationalize the Deposit and Credit Guarantee Fund (DCGF).
  - Implement credit guarantee schemes to support SME lending, ensuring proper design and monitoring.
- Coordination and governance:
  - Establish an organization to improve coordination across financial inclusion agencies in Nepal.
- Minimize trade-offs with stability:
  - Maintain adequate bank supervision, robust risk management, and more stringent loan classification and underwriting standards.
  - Implement financial inclusion supervision for cooperatives consistent with new federalism: local/provincial authorities to supervise local cooperatives; Department of Cooperatives to supervise nationwide cooperatives; NRB to supervise savings and credit cooperative banks licensed by NRB.

*Source: 1nplea2019002 - References*

### References ______________________________________________________________________________ 7

### INFLATION CO-MOVEMENT BETWEEN INDIA AND NEPAL

### Stylized facts
- Food-inflation co-movement between India and Nepal is relatively strong; core inflation co-movement is much weaker, especially in the recent period.
- For countries with strong trade ties to India (high import share from India), headline inflation correlations tend to be higher; this is driven almost exclusively by higher correlation in food inflation.
- Key country-level statistics (import share from India; correlations with India):
  - Bhutan: 74.3; Food CPI 0.45; Headline CPI 0.52; Core CPI 0.09
  - Nepal: 57.8; Food CPI 0.73; Headline CPI 0.65; Core CPI 0.18
  - Sri Lanka: 20.4; Food CPI 0.27; Headline CPI 0.24; Core CPI N/A
  - Bangladesh: 14.0; Food CPI 0.17; Headline CPI 0.40; Core CPI 0.25
  - Pakistan: 3.2; Food CPI 0.74; Headline CPI 0.51; Core CPI 0.50
  - Indonesia: 2.2; Food CPI 0.02; Headline CPI 0.01; Core CPI 0.17
  - Singapore: 2.1; Food CPI -0.37; Headline CPI 0.31; Core CPI 0.42
  - Vietnam: 1.9; Food CPI -0.20; Headline CPI 0.02; Core CPI 0.50
  - Hong Kong SAR: 1.8; Food CPI -0.54; Headline CPI -0.17; Core CPI 0.02
  - Malaysia: 1.6; Food CPI -0.15; Headline CPI 0.11; Core CPI -0.16
  - Thailand: 1.3; Food CPI 0.27; Headline CPI 0.09; Core CPI 0.14
  - China: 1.1; Food CPI -0.45; Headline CPI -0.32; Core CPI -0.08
  - Philippines: 1.1; Food CPI 0.08; Headline CPI 0.12; Core CPI 0.39
  - South Korea: 1.1; Food CPI -0.21; Headline CPI -0.15; Core CPI 0.21
  - Cambodia: 1.0; Food CPI 0.50; Headline CPI 0.35; Core CPI 0.38
  - Laos: 0.4; Food CPI 0.40; Headline CPI 0.14; Core CPI N/A
  - Mongolia: 0.4; Food CPI -0.23; Headline CPI -0.04; Core CPI N/A

### Empirical analysis of inflation co-movement determinants
- Methodology:
  - Uses an instantaneous quasi-correlation measure comparing deviations of inflation from equilibrium and normalizing by volatility (quasi-correlation).
  - Panel regression framework (dependent variable: quasi-correlation of inflation between India and each country) estimated separately for food and core inflation.
  - Key explanatory variables: each country’s share of imports from India; quasi-correlations of M2 growth, industrial production growth (IP), deviations of rainfall from seasonal norms between India and the country; time (monthly) fixed effects.
- Regression results (Table 2; robust standard errors in parentheses; significance stars preserved):
  - Food Inflation (column 1):
    - Rainfall co-movement: 1.095* (0.580)
    - Exchange-rate co-move: 0.056* (0.030)
    - Import share, from India: 0.003* (0.002)
    - Observations: 870
    - Number of countries: 16
    - Time fixed effects: yes
  - Core Inflation (column 2):
    - Rainfall co-movement: 0.651 (0.443)
    - Exchange-rate co-move: 0.052 (0.032)
    - Import share, from India: -0.002 (0.002)
    - Observations: 556
    - Number of countries: 11
    - Time fixed effects: yes
  - Note: In both food and core regressions, M2 and IP co-movement have no statistically significant impact on inflation co-movement (results not shown in Table 2).

### Key findings
- Food inflation co-movement between India and other Asian countries is higher where:
  - Rainfall deviations from seasonal norms co-move more strongly between India and the partner country.
  - Trade integration with India (import share from India) is greater.
  - Nominal effective exchange-rate co-movement is stronger.
- Core inflation co-movement is much less precisely estimated; rainfall, trade integration, and exchange-rate co-movement are not statistically significant determinants for core inflation co-movement.
- Core inflation appears to be primarily driven by domestic (idiosyncratic) factors.

### Policy implications and recommendations
- The apparent strong headline inflation co-movement between India and Nepal is driven almost exclusively by food-inflation co-movement; common weather shocks (e.g., rainfall patterns) are partly responsible, not only price spillovers from India.
- The role of inflation spillovers from India in driving non-food (core) inflation in Nepal appears limited.
- Monetary policy implications:
  - Domestic monetary policy should be the primary tool to tackle domestic inflationary pressures, especially core inflation.
  - Nepal cannot necessarily rely on stable inflation in India to achieve stable domestic inflation; monetary policy needs to be calibrated to domestic conditions (economic slack, exchange-rate movements, passthrough from food- and energy-price shocks).
- Fiscal and broader policy context:
  - While headline inflation co-movement is notable, nuance is required: strong food inflation co-movement versus weak core inflation co-movement implies policy efforts should focus on domestic sources of core inflation and on measures to manage food-price volatility (including responses to weather-related shocks and trade-related channels).

*Prepared by Patrick Blagrave (APD); methodology based on Blagrave, 2018, “Inflation Co-Movement in Asia: Blame it on the Rain?” IMF Working Paper, forthcoming.*

### References

### 1nplea2019002 - References

### References
- Auer, R., and A. Mehrotra, 2014, “Trade Linkages and the Globalisation of Inflation in Asia and the Pacific,” Journal of International Money and Finance, Vol. 49, pp. 129–151. 
- Blagrave, P., 2018, “Inflation Co-Movement in Asia: Blame it on the Rain?” IMF Working Paper, forthcoming. 
- Duval, R., N. Li, R. Saraf, and D. Seneviratne, 2016, “Value-Added Trade and Business Cycle Synchronization,” Journal of International Economics, Vol. 99, pp. 251–262.

### Overview of Nepal’s fiscal federalism transition
- Nepal transitioned from a unitary government to a federal democratic republic under the 2015 Constitution, creating federal, provincial, and local governments.
- The 2015 Constitution, the Local Government Operations Act (2017), and the Inter-Government Fiscal Transfers Act (2018) establish the framework for revenue/expenditure assignments, local consolidated funds, and intergovernmental transfers.
- The National Natural Resources and Fiscal Commission (NNRFC) was established to recommend arrangements related to inter-governmental fiscal transfers, internal borrowing, and natural resources utilization.

### Structure of subnational finances and revenue instruments
- Four categories of fiscal transfers:
  - (i) Equalization grants: allocated based on population, development status, and gap between expenditure needs and revenue potential. Transfers are effected in four installments (10th August, 19th October, 16th January, and 15th April);
  - (ii) Conditional grants: a quarter of the total budgeted amount is to be transferred on July 17. The rest is to be transferred on the first day of each trimester depending on implementation progress;
  - (iii) Complementary grants: transfer of funds to provincial and local governments to match the resources;
  - (iv) Special grants: to support special projects, emergency needs, and activities related to national development priorities.
- Revenue-sharing arrangements:
  - VAT and internal excise tax revenues shared at the ratio of 70:15:15 (federal:provincial:local).
  - Royalties shared at the ratio of 50:25:25.
- Local revenue collection: taxes on property, rent and lease income, and vehicle registration fees collected by local governments.
- Internal borrowing: legal framework not finalized; NNRFC administrative decision suggests an upper limit for internal borrowing at 5 percent of GDP per annum for the federal government. Provincial and local governments could borrow up to 10 percent of the sum of their share of VAT and excise revenue locally-collected revenue.

### Fiscal outcomes and macro-fiscal risks
- Implementation and fiscal transfers:
  - The operation of fiscal federalism commenced partially in FY2017/18 with conditional and equalization grants determined ad hoc.
  - The NNRFC developed a revenue sharing formula; FY2018/19 budget envisages total financial resources for subnational governments of 14 percent of GDP.
- Consolidated fiscal impact:
  - Consolidated fiscal deficits reached 6.5 percent of GDP in FY2017/18 and are budgeted to expand to about 8 percent of GDP in FY2018/19.
  - Public debt projected to rise to 33 percent of GDP in FY2018/19, up from 26 percent of GDP in FY2016/17.
  - Staff baseline projects public debt to reach 35 percent of GDP in the medium-term (up from 22 percent of GDP in the staff report for the 2017 Article IV Consultation).
- Vertical fiscal imbalance and incentives:
  - Subnational share of total general government spending in the FY2018/19 Budget is about 36 percent.
  - Subnational own-source revenue share is very low, creating large vertical fiscal imbalance (VFI) and weak incentives for subnational revenue mobilization.
  - Risks include overspending, relaxation of tax collection, low revenue, and weakening fiscal balance (cited: Eyraud and Lusinyan, 2011; Sow and Razafimahefa, 2017).
- Pro-cyclicality:
  - Revenue-sharing with fixed distribution coefficients can make fiscal policy more pro-cyclical (Ter-Minassian, 1997). Fiscal decentralization associated with increased fiscal policy pro-cyclicality or reduced counter-cyclicality (Sow and Razafimahefa, 2017).

### Capacity and institutional design issues
- Rapid devolution risks:
  - Rapid devolvement of spending responsibilities and augmentation of resources to subnational governments may stretch subnational capacity and risk disruption of public services.
  - Subnational limited implementation capacity evidenced by a substantial share of transferred resources often kept in government deposit accounts and surge of government deposits during the fiscal year.
- Public financial management gaps:
  - Absence of well-developed public financial management systems at subnational levels, including expenditure reporting and control systems, increases risk of misallocation and waste (Ahmad et al, 2006).
- Uncertainty over cost alignment:
  - Comprehensive costing of subnational governments’ expenditure assignments has not been completed; alignment between transfers/revenue-sharing and actual cost of service delivery remains unclear.
- Internal borrowing framework:
  - Framework for internal borrowing, criteria, and borrowing limits remain to be developed; cross-country experience suggests such conditions are crucial to enforce fiscal discipline.

### Policy implications and recommendations
- Key short-term priorities:
  - Strengthen subnational governments’ policy implementation capacity through training, standardization, and use of technology.
  - Establish public financial management systems at subnational levels: effective and transparent budgeting, accounting, and reporting systems at all levels.
  - Intensify efforts by Nepal’s Financial Comptroller General Office to improve financial reporting at subnational levels.
  - Establish local consolidated funds and configure them to act as stabilization funds—absorbing excess resources during booms and boosting spending during busts—to reduce procyclical fiscal policy resulting from fiscal decentralization.
- Key medium-term priorities:
  - Gradually adjust expenditure allocation to reconcile responsibilities and needs.
  - Adopt Fiscal Responsibility and Budget Management Bill (FRBMB) to ensure fiscal discipline and increase accountability.
  - Reinstate a realistic medium-term expenditure framework and develop medium-term budget planning to ensure fiscal prudence and consistency with broader macroeconomic management; annual budgets should be guided by the medium-term framework.
  - Conduct periodic spending reviews to refine methodology and formulas for revenue sharing and fiscal transfers.
  - Strengthen fiscal discipline at subnational levels by better aligning subnational taxation powers with spending obligations to narrow vertical fiscal imbalances (Eyraud and Lusinyan, 2011).
  - Clarify functional and revenue responsibilities at all government levels to avoid overlapping responsibilities, duplication, waste, and to warrant better service quality (Ter-Minassian (1997) and Ahmad et al (2006)).
  - Conduct a review of costs of delivering services in the federal structure as a matter of priority.

### Key statistics and table extracts (verbatim from source)
- "Transfers are effected in four installments (10th August, 19th October, 16th January, and 15th April)"
- "A quarter of the total budgeted amount is to be transferred on July 17."
- "VAT and internal excise tax revenues will be shared among federal, provincial, and local governments at the ratio of 70:15:15."
- "Royalties will be shared at the ratio of 50:25:25."
- "NNRFC’s administrative decision suggest an upper limit for internal borrowing at 5 percent of GDP per annum for the federal government."
- "Provincial and local governments could borrow up to 10 percent of the sum of their share of VAT and excise revenue locally-collected revenue."
- "FY2018/19 budget envisages total financial resources for subnational governments of 14 percent of GDP."
- "Deficits reaching 6.5 percent of GDP in FY2017/18 and budgeted to expand further to about 8 percent of GDP in FY2018/19."
- "Public debt is projected to rise to 33 percent of GDP in FY2018/19, up from 26 percent of GDP in FY2016/17."
- "Staff’s baseline scenario... public debt is projected to rise sharply and reach 35 percent of GDP in the medium-term, up from 22 percent of GDP in the staff report for the 2017 Article IV Consultation."
- Verbatim table extract:
  - "Table 1. Nepal: General Government Operations Under Fiscal Federalism
    NPR million%GDPNPR million%GDP
    III. General government
    Revenue76725.51,04531.1
    Expenditure96332.01,31439.2
    Fiscal balance-196-6.5-269-8.0
    I. Central government
    Revenue51717.256216.7
    Expenditure71323.783124.8
    Fiscal balance-196-6.5-269-8.0
    II. State/local governments
    Revenue2508.348314.4
    Fiscal transfers2508.33289.8
    Fiscal equalization grants1555.11364.0
    Conditional grant953.21735.2
    Complementary grant00.0100.3
    Special grant00.0100.3
    of which: Fiscal transfer to local level2468.22056.1
    Fiscal equalization grants1505.0852.5
    Conditional grant953.21103.3
    Complementary grant00.050.1
    Special grant00.050.1
    Fiscal transfer to states40.11233.7
    Fiscal equalization grants40.1501.5
    Conditional grant00.0631.9
    Complementary grant00.050.1
    Special grant00.050.1
    Revenue sharing00.01143.4
    Own revenue collection00.0411.2
    Internal borrowing 00.000
    Expenditure2508.348314.4
    Fiscal balance00.000.0
    Sources: Nepali authorities and IMF staff projection
    FY18/19 BudgetFY17/18 Actual"

*International Monetary Fund — 1nplea2019002 - References*

### References

### 1nplea2019002 - References

### Bibliographic listings
- Ahmad, E., G. Brosio, and M. Gonzalez, 2006, “Uganda: Managing More Effective Decentralization,” IMF Working Paper No. 06/279.
- Eyraud, L., and L. Lusinyan, 2011, “Decentralizing Spending More than Revenue: Does it Hurt Fiscal Performance?” IMF Working Paper No. 11/226.
- International Monetary Fund, 2012, “Pakistan: 2011 Article IV Consultation and Proposal for Post Program Monitoring,” IMF Country Report No. 12/35.
- National Natural Resources and Fiscal Commission, 2018, Fiscal Federalism in Nepal: Journey so Far, Official Presentation.
- Sow., M., and I. Razafimahefa, 2017, “Fiscal Decentralization and Fiscal Policy Performance,” IMF Working Paper No. 17/64.
- Ter-Minasian, T., ed., 1997, Fiscal Federalism in Theory and Practice (World Bank).
- International Monetary Fund, 2014, “Nepal—Financial System Stability Assessment,” (Washington), unpublished.
- Nepal Rastra Bank, 2018a, Financial Stability Report of 2017 (Kathmandu).
- Nepal Rastra Bank, 2018b, Bank Supervision Report of 2017 (Kathmandu).
- International Monetary Fund, 2018, “Financial Inclusion in Asia-Pacific,” IMF Departmental Paper No.18/17.
- Nepal Rastra Bank, 2018, Nepal Financial Inclusion Action Plan, UNNATI-Access to Finance (A2F) Project (Kathmandu).

### Sustainable finance to support long-term growth — Key findings
- Context and objectives:
  - Nepal aims to graduate from less developed countries (LDC) status by 2022 and achieve middle income countries (MIC) status by 2030; sustainable financial sector development is necessary to support sustained broad-based growth.
- Financial sector vulnerabilities and drivers:
  - Credit growth averaged about 21 percent over the past three years.
  - Credit-to -GDP ratio of 80 percent.
  - Real estate related lending accounts for about 70 percent of total lending.
  - Nearly half of banks’ loan books comprise overdraft and working capital loans (18.1 percent Overdraft; 20.3 percent Demand & Other Working Capital Loan; see product-wise lending shares).
  - Reported commercial bank NPLs are lower than peers but may be understated.
  - Large inflows of remittances have been a major funding source and a liquidity risk driver.
- Past reform actions:
  - 2014 FSAP highlighted macro-financial and legal/supervisory weaknesses.
  - A special inspection program (SIP) in 2015 evaluated credit portfolios of 54 BFIs (representing more than 50 percent of total banking sector assets); 26 out of 54 were found to have CARs below minimum required in 2014/15.
  - Nepal Rastra Bank announced a four-fold increase in minimum paid-up capital phased in between 2016 and 2018, effected mostly through issuance of outright shares, retained profits, and bank mergers.
  - NRBAA and DCGF Acts approved by Parliament in September 2016 clarified bank resolution powers and enhanced deposit insurance framework, but NRBAA curtailed central bank autonomy and did not grant explicit consolidated supervision powers nor clarify emergency liquidity assistance provisions.
  - Amendments to the Bank and Financial Institutions Act (BAFIA) passed in January 2017 to strengthen commercial bank governance.
  - NRB adopted risk-based banking supervision in 2018 and is gradually proceeding to full implementation; a Supervisory Information System is being developed.
  - Transition to Nepali Financial Reporting Standards (NFRS) consistent with IAS; payments and clearing modernized, including introduction of RTGS.
- Stress and simulation results:
  - A simulation exercise (modeled in line with Nepal’s 2014 FSAP) suggests that a shock propagated from a real estate bust could cause non-performing loans to rise sharply.
  - A liquidity stress test by NRB (NRB, 2018a) suggests 19 out of 28 commercial banks are vulnerable under scenarios of customer deposit withdrawals of 2, 5, and 10 percent for five consecutive days.

### Sustainable finance — Policy recommendations
- Tightening macroprudential policies:
  - Strengthen CCD ratio, loan-to -value ratio, and limits to real estate exposures.
  - Phase out carve-outs to the calculation of the CCD ratio over time.
- Strengthening banking supervision:
  - Continue upgrading supervision, risk assessments, and monitoring.
  - Empower supervisors to follow up on inspection findings and enforce corrective measures promptly.
- Building buffers:
  - Additional capital and provisioning may be required given data and supervisory weaknesses.
- Updating crisis management:
  - Clarify and align central bank lender-of-last-resort policy (last updated in 2011) with international central bank practices concerning emergency liquidity assistance.
- Upgrading financial infrastructure:
  - Urgently develop an accessible collateral registry.
  - Improve the Credit Information Bureau and the Supervisory Information System.
  - Effectively implement debt enforcement and insolvency laws.

### Financial inclusion in Nepal — Key findings
- Coverage and trends:
  - Deposit accounts rose from 446 to 657 accounts per 1000 adults between 2012 and 2016.
  - Nepal ranks within the second quartile among 30 Asia-Pacific countries on an access-focused composite measure.
- Gaps and disparities:
  - About two-thirds of adults have access to formal financial services; 21 percent use only informal services; 18 percent use no financial services.
  - Formal credit concentrated in few districts: Kathmandu, Parsa, and Kaski.
  - Per capita credit: Kathmandu about NPR550,000; Nuwakot about NPR1,300.
  - Metropolitan areas average nearly 3 accounts per person; rural areas average 0.16 accounts per person.
  - Savings account penetration: Kathmandu is 10 times higher than Baitadi.
  - Gender gap: 26 percent of women have a bank account versus nearly 50 percent of men.
- Potential gains from inclusion:
  - IMF (2018) estimates bringing Nepal’s financial inclusion level to Singapore’s frontier is associated with a cumulative 1.1 percentage point increase in per capita income growth and lifting about 350,000 people out of poverty over a five-year period.
  - Raising Nepal’s inclusion to India’s level could raise per capita income growth by 0.2 percent over a five-year period.

### Financial inclusion — Policy recommendations
- Focus on underserved groups:
  - Target rural population, low-income households, women, and geographically-remote communities.
- Product design and digital channels:
  - Ensure a wide range of financial products and services are appropriately designed and priced to be widely used.
  - Leverage mobile banking and digital payments to complement traditional channels.
- Move away from quantity-based policies:
  - Shift from priority sector and deprived sector lending policies toward price-based mechanisms to correct market failures.
  - Build financial sector infrastructure: credit information systems and secured-transactions registries for movable property.
- Credit guarantees and SME support:
  - Operationalize the Deposit and Credit Guarantee Fund (DCGF).
  - Implement credit guarantee schemes to support SME lending, ensuring proper design and monitoring.
- Coordination and governance:
  - Establish an organization to improve coordination across financial inclusion agencies in Nepal.
- Minimize trade-offs with stability:
  - Maintain adequate bank supervision, robust risk management, and more stringent loan classification and underwriting standards.
  - Implement financial inclusion supervision for cooperatives consistent with new federalism: local/provincial authorities to supervise local cooperatives; Department of Cooperatives to supervise nationwide cooperatives; NRB to supervise savings and credit cooperative banks licensed by NRB.

*Source: 1nplea2019002 - References*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1nplea2019002.pdf_