## Nepal—Assessment Letter for the Asian Development Bank

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### Macroeconomic overview and recent performance
- Real GDP growth in 2009/10 is expected to be resilient at 4 percent, slightly down from 4.7 percent in 2008/09 due to power shortages, difficult labor relations, and adverse weather conditions.
- Current account and balance of payments remain in surplus supported by continued growth of remittances.
- Foreign exchange reserves have increased to a level sufficient to cover 8 months of imports.
- The 2008/09 budget deficit (after grants) was contained to 1.5 percent of GDP owing to strong revenue growth and underspending.
- Up to May 2009, M2 continued to grow by more than 20 percent on a year-on-year basis.
- Credit growth, which in recent years has been particularly rapid to the real estate sector, rebounded compared to the first quarter of 2009.
- Inflation has remained high at about 13 percent for 2008/09, driven mostly by food prices increases as has been the case for India’s CPI, and has yet to decline.

### Outlook and key risks
- The exchange rate peg with the Indian Rupee remains appropriate in the near term and keeps Nepal’s inflation rate close to Indian CPI.
- Main near-term risks:
  - Lower remittances.
  - Financial sector weaknesses related to exposure to the real estate sector.
- Structural reforms and infrastructure investments are key to maintaining competitiveness over the medium term.
- Fiscal discipline is essential to underpin the peg and maintain macroeconomic stability.

### Fiscal policy assessment and risks
- Fiscal policy has been prudent over the past several years, but risks are rising.
- Authorities remain committed to containing domestic borrowing to about 2 percent of GDP in line with previous IMF staff recommendations.
- The 2009/10 budget envisages revenue growth of 24 percent compared to the 2008/09 outturn, which will be difficult to achieve.
- Current outlays are budgeted to increase by 32 percent from the 2008/09 outturn and new expenditure pressures are emerging.
- The deficit is thus likely to exceed the budget by a considerable amount (about 1 percent of GDP, entailing domestic borrowing of 3¼ percent of GDP) and, over time, such fiscal slippage could undermine macroeconomic stability.
- While at current oil prices the Nepal Oil Corporation (NOC) is still covering its costs, the absence of an automatic fuel pricing mechanism implies that its financial position will be threatened should international fuel prices rise.
- Footnote: The last IMF/World Bank Debt Sustainability Analysis (May 2008) concluded that Nepal’s external debt was subject to a moderate risk of debt distress, a change from the previous DSA that had classified Nepal at high risk of debt distress reflecting improved debt indicators.

### Monetary policy stance
- A modest tightening of monetary policy is advisable.
- Real interest rates on bank deposits remain negative.
- Inflationary pressures have not yet eased and loose monetary conditions are likely to have contributed to the rapid rise in real estate prices.
- Given stringent capital controls and lower deposit rates compared to those of India, there remains room to raise interest rates.

### Structural reform priorities and status
- Progress on structural reform continues to be held back by the fragile political situation.
- Priority areas and observations:
  - Banking sector
    - Recent attempts to liquidate the Nepal Development Bank and stop registration of new banks are welcome steps.
    - Enforcement of prudential regulation remains weak.
    - The proliferation of financial institutions and rapid credit expansion in recent years pose significant challenges for the authorities.
  - Price adjustment mechanism for oil products
    - Introducing an automatic fuel pricing mechanism remains an important measure to contain quasi-fiscal costs.
    - Such a mechanism would serve to depoliticize the setting of fuel prices and prevent a recurrence of the fuel shortages and subsidies of last year.
  - Public sector
    - Accounting, auditing, and reporting of public sector operations are inadequate.
    - Budget coverage is confined to the central budget with very limited information on quasi-fiscal activities.
    - Internal control procedures are not fully effective and expenditure management is weak.

### IMF relations and next steps
- The 2008 Article IV consultation was discussed by the Executive Board in May 2008.
- A staff visit is planned for late August and the next Article IV consultation is preliminarily scheduled for the Spring of 2010.

*Source: Nepal—Assessment Letter for the Asian Development Bank, August 17, 2009.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2009/_081709.pdf_