## Nepal’s Remittances: Trends and Projections (_cr10185)

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### Executive summary and key findings
- Major political transition with unresolved army integration and constitution drafting; end-May drafting deadline likely to be missed.
- Global crisis has a substantial, somewhat delayed impact, exposing structural weaknesses despite prior macro stability.
- Exchange rate peg and prudent fiscal policy have been anchors; remittances drove reserve accumulation until recent declines.
- Remittances are currently 21 percent of GDP.
- Public debt declined to 40 percent of GDP, creating fiscal space conditional on spending quality.
- Staff supports a Rapid Credit Facility (RCF) disbursement request of 40 percent of quota (SDR 28.52 million).

### Remittances: composition, recent slowdown, and projections
- Importance and composition
  - By end-2008/09: remittances 21 percent of GDP; three times exports; covered two thirds of imports.
  - Over 80 percent of remittances come from the Gulf countries (GCCs) and Malaysia.
  - Remittances sustain consumption and, to a lesser extent, investment.
  - Remittances from India are less than 15 percent of the total.
- Recent slowdown and short-term outlook
  - Outflow of workers declined by 12 percent in 2009.
  - Remittance growth decelerated to 17 percent in the first half of 2009/10 from 31 percent in the previous year.
  - Remittance growth in 2009/10 projected to slow to 9 percent from 31 percent in 2008/09.
  - Recent pickup in outflow workers due to demand from GCCs and Malaysia and agreements with Japan and Korea expected to boost remittances in the second half of 2010.
- Medium-term outlook and determinants
  - Staff study projects remittances could grow by 10–12 percent annually over the medium term (2010/11–2014/15).
  - Most important determinants: non-oil GDP of GCC countries and the stock of migrants.
  - GCC non-oil GDP growth projected to recover to 5½ percent over the medium term (below pre-crisis average of 7 percent).
  - RER has a negative coefficient (not significant); real appreciation would deter remittances.
  - Remittances estimated to grow moderately by 10–12 percent annually in 2010/11–2014/15.

### Macro outlook, trade, reserves, inflation, and balance of payments
- Growth projections
  - Real GDP growth expected to slow to 3 percent in 2009/10 from 4¾ percent in 2008/09.
  - Growth expected to strengthen to about 4 percent in 2010/11.
  - Medium-term growth projected to reach 4¾ percent by 2014/15 assuming incremental reform progress.
- Trade and external flows
  - Exports declined by 14 percent in first half of 2009/10; exports to India down 6 percent; exports to other countries down 26 percent.
  - Imports soared by 46 percent in same period; gold imports almost tripled.
  - Trade deficit widened to 28 percent of GDP.
  - Current account projected to record a 2 percent of GDP deficit in 2009/10 (first deficit since 1997/98).
- Reserves and liquidity
  - International reserves declined by 13 percent (US$400 million) from July 2009 peak to US$2.5 billion (5 months of imports) in March 2010.
  - Reserve drain triggered liquidity squeeze and tighter monetary conditions.
  - Reserves projected to remain around 5 months of imports by year-end conditional on restored confidence and Fund support reversing capital outflows.
  - RCF would cover $43 million of a $85 million balance of payments gap (staff estimate).
- Inflation
  - Inflation was 13.2 percent in 2008/09 and 11.8 percent (y/y) in January 2010.
  - Inflation projected to average 12 percent in 2009/10 and 8 percent in 2010/11.

### Exchange rate assessment and monetary policy implications
- Real effective exchange rate
  - RER is 15 percent above its 10-year average.
  - Standard methods yield a wide range of overvaluation estimates; lower end occurs when remittances are included.
- Policy guidance
  - Maintain the peg as a key near-term objective to underpin macro and financial stability.
  - Monetary policy needs to support the peg by keeping short-term interest rates above those of India and strengthening liquidity management.
  - Over the medium term, consider a basket that includes the Indian rupee as well as the dollar to reflect remittance sources.

### Financial sector risks, prudential measures, and recommended actions
- Risks and indicators
  - Rapid credit growth persisted up to March 2010 at 30 percent y/y.
  - Credit-to-deposit (CD) ratios climbed to nearly 90 percent by January 2010, with several banks above 100 percent.
  - Stock market fell 60 percent from its September 2008 peak.
  - Financial institutions other than commercial banks are weaker and more vulnerable.
  - Stress tests indicate high vulnerability to liquidity and credit risks and likely deterioration in asset quality.
- NRB prudential measures (selected)
  - July 2009 moratorium on bank license applications; moratorium lifted April 2010 for microfinance banks (class D) and eased for development banks (class B).
  - Single borrower limits to be lowered to 25 percent of capital from 50 percent (initially by July 2010; deadline moved to January 2011).
  - Real estate exposure limits: lower exposure to real estate loans to 25 (real estate) and 40 (housing) percent of total loans by end-2009/10; further reductions by end-2011/12 and end-2012/13.
  - Loan-to-value limit: loans not to exceed 60 percent of fair market value.
  - Credit-to-deposit ratio ceilings: 95 percent by end-2009/10, 85 percent by end-2010/11, 80 percent by end-2011/12.
  - Loans above limits penalized by provisioning with a risk weight of 150 percent.
  - NRB began liquidation of Nepal Development Bank (NDB) and restructured Nepal Bangladesh Bank (NBB).
- Immediate supervisory and crisis-management recommendations
  - Strict enforcement of NRB directives; step up supervision and use stress tests and on-site inspections to identify vulnerable institutions.
  - Emergency liquidity support to be consistent with the peg: liquidity to individual institutions at penalty rates or via bank rate window under heightened supervision.
  - Pass amended Banks and Financial Institutions Act (BAFIA) to strengthen bank resolution framework; prepare contingency plans for systemic bank crisis.
  - Bring savings and credit cooperatives under regulatory oversight.
  - Maintain licensing moratorium; adopt more stringent fit-and-proper criteria; incentivize consolidation by raising minimum paid-up capital and facilitating trading of promoter shares.
  - Proceed with reforms and recapitalization of state-controlled banks, with losses absorbed by existing shareholders; estimated cost of bringing capital to zero for state banks is 2–3 percent of GDP (to be borne by government and existing shareholders).

### Fiscal policy stance, use of fiscal space, and revenue/expenditure issues
- Fiscal stance and space
  - Fiscal discipline during political transition notable.
  - Public debt at 40 percent of GDP creates fiscal space for infrastructure, human capital, and peace process if spending quality is ensured.
  - Short run: peg calls for containing domestic borrowing close to current levels.
  - Domestic revenues rose from 10¾ percent of GDP in 2005/06 to 14½ percent of GDP in 2008/09.
- Recent fiscal developments
  - First half of 2009/10: revenue grew 34 percent year-on-year; current spending rose by over 40 percent; overall deficit only slightly higher due to slow capital project implementation.
  - Government plans to reduce domestically financed deficit for 2009/10 to 1.6 percent of GDP; staff judges deficit likely closer to 2 percent of GDP.
- Fiscal policy options and recommendations
  - Overall deficit may be expanded if funded with external grants or concessional debt; domestically financed deficits should remain close to current levels to support the peg.
  - Protect room for higher capital expenditure, particularly transport and power; enhance implementation capacity, financial information, accounting, and donor coordination.
  - Introduce an automatic fuel pricing mechanism to contain quasi-fiscal costs at Nepal Oil Corporation (NOC); NOC currently running a small deficit and is vulnerable if international fuel prices rise.
  - Public debt target around 40 percent of GDP appropriate to anchor policy; to stabilize public debt at this level, overall deficit could rise to 3½ percent of GDP, with domestically financed deficit in range 2¼–2½ percent of GDP.

### Debt sustainability, stress tests, and country-specific vulnerability scenarios
- Joint IMF/World Bank DSA (May 14, 2010) key points
  - Overall risk: moderate risk of debt distress under LIC-DSA framework; remittances incorporated.
  - Total public debt stock end-2008/09: 40 percent of GDP (down from 64 percent in 2001/02).
  - NPV of external debt-to-exports-and-remittances ratio currently 63 percent.
- Baseline projections (selected)
  - Real GDP growth: decline to 3 percent in 2009/10; gradual pick up to 4¾ percent over medium term; long-run 5½ percent.
  - Remittances projected to slow to an annual average of 12 percent over medium term and about 8 percent thereafter.
  - PV of public debt-to-GDP declines slightly from 33 percent in 2009/10 to 31 percent by 2029/30.
- Standard stress tests
  - Debt indicators do not breach indicative thresholds on a sustained basis under standard shocks (slower GDP, softer remittances/exports, lower US dollar GDP deflator, one-time depreciation), except PV debt-to-exports-and-remittances exceeds threshold for one year.
- Country-specific scenario (combining remittances slowdown, 30 percent one-time depreciation, and financial restructuring costs)
  - Potential net fiscal costs of financial restructuring estimated at 8–12 percent of GDP.
  - Under this scenario:
    - PV of debt-to-GDP-and-remittances peaks at 47 percent in 2011/12 and remains above threshold for seven consecutive years.
    - PV of debt-to-revenue breaches threshold for nine years.
    - PV of debt-to-exports-and-remittances breaches threshold for four years.
  - Liquidity indicators (debt service-to-revenue and debt-service-to-exports-and-remittances) remain below thresholds in this scenario.
- Policy implications from DSA and stress tests
  - Contain financial sector risks; maintain tight fiscal stance in short run.
  - Fiscal policy could be more accommodative in medium term if financial vulnerabilities are addressed.
  - Secure foreign financing on favorable terms (preferably grants) and pursue stronger, more stable growth to meet MDG targets while containing debt sustainability risks.

### IMF support: Rapid Credit Facility (RCF) request and role
- Authorities requested RCF access of 40 percent of quota (SDR 28.52 million).
- Staff assessment and terms
  - Access of SDR 28.52 million below 50 percent of quota ceiling permissible under exogenous shocks window.
  - RCF would cover $43 million of a $85 million balance of payments gap (staff estimate).
  - RCF features: zero interest rate; grace period of 5½ years; final maturity of 10 years.
- Intended use and sequencing
  - RCF support to cushion shock, boost confidence, stabilize reserves, and provide policy support during political transition; could serve as bridge to a longer Fund-supported program (possibly an Extended Credit Facility).
  - Nepal has adequate capacity to repay and moderate risk of debt distress; access of SDR 28.5 million would not jeopardize debt sustainability.

### Monetary policy, liquidity measures, and exchange restrictions
- NRB liquidity measures
  - Repo terms lengthened from 28 to 45 days.
  - Commercial banks’ call deposits can count toward statutory liquidity ratio.
  - New refinancing facility for export, power and tourism sectors.
  - Blanket repos normalized interbank rates during squeeze; going forward, individual banks’ needs met through Supplementary Liquidity Facility at penalty rates; bank rate window used under heightened oversight for solvent banks without collateral.
  - Modalities for bank rate window access to be clarified by July 2010.
- Exchange restriction determination
  - Fund staff determined Nepal maintains an exchange restriction under Article VIII due to quantitative limits on passport foreign exchange facility: limit of US$2,000 and no more than two times per year; reduced to US$1,000 for travelers to Tibet and SAARC (excluding India).
  - Staff does not recommend approval of retention of this restriction as it is discriminatory.
  - Authorities committed to removing any restrictions that may give rise to Article VIII issues by March 2011 as balance of payments improves.

### Data, statistical issues, and institutional capacity
- Data adequacy and gaps
  - Economic and financial data generally adequate for surveillance but need improvements in timeliness and coverage of fiscal data and BOP compilation of remittances and private flows.
  - National accounts compiled on 1993 SNA; rebased to 2000/01 with STA support; shortcomings in source data and extrapolations.
  - CPI limited in coverage and weights; WPI and PPI improvements under way.
  - Monetary statistics: revisions with lags up to 12 months; recommendation to update to MFSM 2000 and expand institutional coverage.
  - BOP compiled in BPM5; net errors and omissions large; remittances and private capital flow source data need improvement.
- Data dissemination (Common Indicators Required for Surveillance — as of March 25, 2010)
  - Selected latest observation dates: exchange rates Jan. 2010; international reserve assets Jan. 2010; reserve/base money Jan. 2010; broad money Jan. 2010; CPI Feb. 2010; government finance Jan. 2010; external current account Jan. 2010.
- Joint IMF/World Bank DSA key statistics and projections (selected)
  - Gross official reserves (end-of-period, US$ millions): 1,996; 2,473; 2,907; 2,670; 2,876 (2006/07–2010/11 series).
  - Workers remittances (US$ millions): 1,535.7; 2,071.6; 2,712.0; 2,956.0; 3,325.5; 3,724.6; 4,134.3; 4,589.1; 5,093.9 (2006/07–2014/15 series).
  - Remittances (percent of GDP): 14.9; 16.5; 21.5; 20.1; 21.3; 22.2; 22.9; 23.6; 24.2 (2006/07–2014/15 series).
  - Current account (percent of GDP): -0.1; 2.7; 4.3; -2.1; 0.0; -0.1; -0.6; -1.1; -1.4 (2006/07–2014/15 series).

### Authorities’ commitments, program conditionality, and safeguards
- Policy commitments and measures
  - Authorities committed to tight monetary and fiscal policies to support the peg and to measures addressing exogenous shock impacts.
  - Indicative targets include NRB net international reserves, NRB net domestic assets, and government net domestic financing for end-2009/10 (selected table figures provided in LOI).
  - Authorities committed to a safeguards assessment and external audit of NRB in line with international standards; Fund staff to have access to audit reports.
  - NRB to begin thorough financial sector assessment (stress testing and on-site inspections) before end-July 2010; NRB welcomes possible Fund resident technical assistance.
- Signatories and publication
  - The Government of Nepal and the NRB agree to publish the letter of intent.
  - Signatories: /s/ Surendra Pandey — Minister of Finance; /s/ Yuba Raj Khatiwada — Governor, Nepal Rastra Bank.

*Source: IMF staff appraisal and summary, “Nepal’s Remittances: Trends and Projections” (IMF staff report excerpts from _cr10185).*

### 1.   Nepal’s Remittances: Trends and Projections .....................................................................9

### 1.   Nepal’s Remittances: Trends and Projections

### Executive summary and key findings
- Nepal is undergoing a major political transition with unresolved issues on army integration and the form of the state; the end-May drafting deadline for a new constitution was likely to be missed.
- After years of macroeconomic stability, the global crisis is having a substantial, albeit somewhat delayed, impact on Nepal’s economy and exposing structural weaknesses.
- The exchange rate peg and prudent fiscal policy have been anchors of stability; high remittances resulted in rising reserves until recent declines.
- Remittances are currently 21 percent of GDP.
- Public debt has declined to 40 percent of GDP, creating fiscal space for priority spending if spending quality is ensured.
- Staff supports a Rapid Credit Facility (RCF) disbursement request of 40 percent of quota (SDR 28.52 million).

### Recent developments: remittances, trade, reserves, and inflation
- Remittances and labor migration
  - The number of Nepalese workers leaving to work abroad declined by 12 percent in 2009.
  - Remittance growth decelerated to 17 percent in the first half of 2009/10 from 31 percent in the previous year.
- Trade balance and imports/exports
  - Exports declined by 14 percent in the first half of 2009/10.
  - Exports to India declined by 6 percent; exports to other countries shrank by 26 percent.
  - Imports soared by 46 percent in the same period, with gold imports almost tripling.
  - The trade deficit widened to 28 percent of GDP.
- International reserves and liquidity
  - International reserves declined by 13 percent from the July 2009 peak to US$2.5 billion (5 months of imports) in March 2010.
  - Recent reserve decline triggered a liquidity squeeze and tighter monetary conditions.
- Inflation and monetary conditions
  - Inflation was 13.2 percent in 2008/09.
  - Inflation was 11.8 percent (y/y) in January 2010.
  - Broad money growth decelerated to 20 percent (y/y) in March 2010 from 28 percent in September 2009.
  - Interbank rates rose to 15 percent in January from 2 percent in September, later reduced to about 9 percent after NRB injections.

### Economic activity and outlook
- Growth
  - Real GDP growth is expected to slow to 3 percent in 2009/10 from 4¾ percent in 2008/09.
  - Growth is expected to strengthen to about 4 percent in 2010/11 as remittances and external demand recover.
  - Assuming incremental reform progress, medium-term growth is projected to reach 4¾ percent by 2014/15.
- Balance of payments and reserves
  - The current account is projected to shift to a 2 percent of GDP deficit in 2009/10.
  - Reserves are projected to remain at around 5 months of imports by year-end, conditional on restored confidence and Fund support reversing capital outflows.
  - Remittances are estimated to increase by only 9 percent in 2009/10.
  - Imports are projected to grow by 30 percent in 2009/10; exports are anticipated to decline by 11 percent.
- Inflation projections
  - Inflation is projected to average 12 percent in 2009/10 and 8 percent in 2010/11.

### Exchange rate assessment and monetary policy implications
- The Nepalese rupee appears modestly overvalued:
  - The real effective exchange rate is 15 percent above its 10-year average.
  - Standard methods give a wide range of overvaluation estimates; the lower end occurs when remittances are included.
- Policy guidance
  - Maintaining the peg should remain a key near-term policy objective to underpin macroeconomic and financial stability.
  - Monetary policy needs to support the peg by maintaining short-term interest rates above those of India and strengthening liquidity management.
  - Over the medium term, consider a basket that includes the Indian rupee as well as the dollar to reflect remittance sources.

### Financial sector risks and recommended actions
- Vulnerabilities and stress indicators
  - Rapid credit growth persisted up to March 2010 at 30 percent y/y, fuelling asset price booms in real estate and the stock market.
  - Credit-to-deposit (CD) ratios climbed to nearly 90 percent by January 2010, with several banks above 100 percent.
  - The stock market fell 60 percent from its September 2008 peak.
  - Financial institutions other than commercial banks are weaker and more vulnerable.
  - Stress tests indicate high vulnerability to liquidity and credit risks and likely deterioration in asset quality.
- Immediate supervisory and crisis-management recommendations
  - The NRB’s recent directives are welcome, but strict enforcement is crucial.
  - Supervision should be stepped up to detect deterioration and to intervene when needed.
  - Emergency liquidity support must be consistent with the peg: provide liquidity to individual institutions experiencing shortages at penalty rates or via the bank rate window under heightened supervision.
  - The amended Banks and Financial Institutions Act should be passed to strengthen the bank resolution framework.
  - Prepare contingency planning in case a systemic bank crisis develops.
  - Savings and credit cooperatives should be brought under regulatory oversight.
- Structural banking sector reforms
  - Maintain the licensing moratorium and adopt more stringent fit-and-proper criteria.
  - Incentivize banking sector consolidation, including by raising minimum paid up capital requirements and facilitating the trading of promoter shares.
  - Proceed with reforms and recapitalization of state-controlled banks, with losses absorbed by existing shareholders.

### Fiscal policy and use of fiscal space
- Fiscal stance and constraints
  - Maintaining fiscal discipline during the political transition has been a notable achievement.
  - Public debt is 40 percent of GDP, creating fiscal space for infrastructure, human capital, and the peace process—subject to spending quality.
  - In the short run, the peg calls for containing domestic borrowing close to current levels.
- Recent fiscal developments
  - In the first half of 2009/10, revenue grew 34 percent over the same period in the previous year, driven primarily by import-related taxes and duties.
  - Current spending rose by over 40 percent, but slow capital project implementation kept the overall deficit only slightly higher than last year.

### Structural challenges and policy priorities for medium-term growth
- Binding constraints
  - Poor business climate, power shortages, inadequate infrastructure, weak governance, and difficult labor relations impede higher growth.
  - Political stability and improved security are necessary preconditions for progress on structural reforms.
- Opportunities
  - With progress on political stability, easing supply-side constraints and developing hydropower potential could lift growth given Nepal’s location between two fast-growing economies.

### IMF support and financing
- Staff supports the authorities’ request for a disbursement under the Rapid Credit Facility (RCF) to address crisis impacts:
  - The request is for access of 40 percent of quota (SDR 28.52 million), below the 50 percent of quota ceiling permissible under the shocks window.
  - RCF support would help cushion the shock, boost confidence, and provide policy support during the political transition and could serve as a bridge to a program with upper credit tranche conditionality.
- Capacity to repay and debt risk
  - Nepal has adequate capacity to repay the Fund and its risk of debt distress is moderate.

*Source: IMF staff appraisal and summary, “Nepal’s Remittances: Trends and Projections.”*

### Box 1. Nepal’s Remittances: Trends and Projections

### Box 1. Nepal’s Remittances: Trends and Projections

### Overview: importance and composition
- Remittances have become Nepal’s most important source of foreign exchange and have supported domestic demand.
- By the end of 2008/09:
  - Remittances were 21 percent of GDP.
  - Remittances were three times exports.
  - Remittances covered two thirds of imports.
- Remittances have sustained consumption and, to a lesser extent, investment.
- Over 80 percent of remittances come from the Gulf countries (GCCs) and Malaysia.
- Migrants are employed mainly as construction workers, security guards, drivers and cooks.
- Remittances from India are less than 15 percent of the total (estimates of the number of migrants to India vary widely).

### Recent slowdown and short-term projections
- Nepal’s remittances began to slow in the second half of 2009.
- The outflow of workers started declining in early 2009 and was down by 12 percent in 2009, although it picked up modestly in recent months.
- The delayed impact of the global crisis on remittances reflects the link to the employment cycle in host countries, which lags the production cycle.
- Recent pickup in outflow workers reflected increased demand from GCCs and Malaysia and employment agreements with a few countries (Japan and Korea) that should boost remittances in the second half of 2010.
- Remittances and the stock of migrant workers lagged by 1 year are highly correlated.
- Remittance growth in 2009/10 is projected to slow to 9 percent from 31 percent in 2008/09, owing to the slower buildup in the stock of migrants abroad.
- Other low-income countries (LICs) have seen remittance flows drop significantly due to the global recession; remittances are projected to recover somewhat but remain below pre-crisis levels in 2010.
- South Asia may hold up better than other regions due to strong connection with GCC countries.

### Determinants and medium-term outlook
- A staff study suggests that Nepal’s remittances could grow by 10–12 percent annually over the medium term.
- The most important determinants of remittances identified are:
  - The non-oil GDP of GCC countries.
  - The stock of migrants.
- The real effective exchange rate (RER) has a negative coefficient (though not significant), implying that a real appreciation would deter remittances.
- Projections and assumptions:
  - GCC countries’ non-oil GDP growth is projected to recover to 5½ percent over the medium term, but remain below its average of 7 percent preceding the global crisis.
  - The RER has been appreciating in the past few years.
  - Hence, Nepal’s remittances are estimated to grow moderately by 10–12 percent annually in 2010/11–2014/15.

### Authorities’ views on remittances and implications for policy
- Authorities’ outlook for 2009/10:
  - Recently lowered growth projections to below 4 percent from 5½ percent, mainly reflecting the poor harvest but anticipating solid growth in industry and services.
  - They agree that remittances will be soft in 2009/10 but expect them to improve in coming months as more migrants are leaving and the government has negotiated new agreements with Saudi Arabia and Malaysia.
- Government officials emphasize:
  - Progress on structural reform is essential to move to a higher growth path over the medium term.
  - Need to improve the business climate, but stress that the political transition must progress before a comprehensive structural reform agenda can be adopted.

*IMF staff report excerpt: Box 1. Nepal’s Remittances: Trends and Projections*

### 32.      The NRB recently issued a set of prudential measures aimed at containing credit and

### _cr10185 - 32.      The NRB recently issued a set of prudential measures aimed at containing credit and

### Prudential measures issued by the NRB
- Licensing policy
  - In July 2009, the NRB imposed a moratorium on bank license applications while the licensing policy is being reviewed.
  - The moratorium was lifted in April 2010 for microfinance banks (class D) and eased for development banks (class B), with the aim to promote banking service provision in rural areas.
- Single borrower and real estate loan exposure limits
  - Single borrower limits will be lowered to 25 percent of capital from 50 percent initially by July 2010, but the deadline was later moved to January 2011.
  - Banks are required to gradually lower exposure to real estate loans (real estate and housing) to 25 (40) percent of total loans by end of 2009/10.
  - Both limits will be lowered by 10 percentage points by end-2011/12 and by an additional 5 percentage points by end-2012/13.
  - Loans above the limit will be penalized by provisioning on the basis of a risk weight of 150 percent.
- Loan-to-value limit
  - Banks are limited to issuing loans of no more than 60 percent of fair market value of collateral or project.
- Credit-to-deposit ratio limit
  - Each bank’s credit-to-deposit ratio is not to exceed 95 percent by end of 2009/10, 85 percent by end of 2010/11 and 80 percent by end-2011/12.
- Bank restructuring actions
  - The NRB has begun liquidation of Nepal Development Bank (NDB) after a lengthy court approval.
  - The NRB has completed the restructuring of the Nepal Bangladesh Bank (NBB), but has restored the equity of the anchor investors, albeit diluted.

### Assessment: enforcement and urgency
- Enforcement is crucial for effectiveness
  - The loan-to-value limit hinges on realistic valuations and the real estate exposure restrictions on correct classification.
  - Lower credit-to-deposit ratios are appropriate, but if they prove too stringent because overall deposit growth slows substantially, bank-by-bank time bound action plans would become necessary; failure to comply with such plans should be penalized.
- Immediate actions recommended to safeguard financial stability
  - Thoroughly assess solvency and liquidity risks of banks; use stress tests to identify vulnerable institutions and prioritize intensified supervision.
  - Provide NRB with adequate resources; in the short run, supervision could be assisted by international organizations or independent qualified firms.
  - Promptly apply corrective action where needed.
  - Strengthen NRB credibility: avoid deferral of regulatory dates and dilution of regulations; NRB needs backing at the highest political level and strong, stable leadership.
  - Additional measures:
    - Make the Prompt Correction Action framework more automatic by decreasing MOF discretion and strictly implement it.
    - Ban pledging of promoters’ shares and devise a plan to phase out existing pledges.
    - Reverse the postponement of the minimum paid up capital for new banks.
    - Bring savings and credit cooperatives under regulatory oversight.

### Contingency planning, resolution framework, and licensing stance
- Contingency planning imperative
  - Key elements: clear framework for emergency liquidity support using existing tools (as advocated in paragraph 14), strengthen bank resolution framework, develop an action plan for crisis management.
  - The amended Banks and Financial Institutions Act (BAFIA), if approved by Parliament, would bolster the bank resolution framework and resolve inconsistencies between existing laws regarding liquidation of financial institutions.
- Licensing and consolidation
  - Maintain the licensing moratorium given NRB’s stretched supervisory capacity; postpone issuance of any new licenses.
  - International experience suggests expanding rural service through mobile and agent banking rather than increasing the number of financial institutions.
  - Adopt more stringent fit and proper criteria for bank owners, applied to new and existing banks.
  - Encourage consolidation by raising minimum capital requirements substantially in a short time frame and facilitating public trading of promoters’ shares.
  - Government needs a strategy to ensure state-controlled banks are adequately capitalized under appropriate management; the cost of bringing the capital to zero is estimated at 2–3 percent of GDP and should be borne by the government and existing shareholders.

### Authorities’ views on financial risks and reforms
- NRB perspective
  - Acknowledge increased risks to financial stability but view them as manageable.
  - Concerned about real estate exposure mainly for financial institutions other than commercial banks, especially credit and savings cooperatives.
  - Anticipate that new regulations would limit banks’ risk taking; note institutions have become more cautious in extending loans and have raised interest rates to mobilize deposits.
  - Share view that asset quality is likely to deteriorate, but point to banks’ high reserve coverage and that loans are mainly short term and well collateralized.
  - Deem liquidity to be the main risk and see need for improved asset/liability management.
- Planned measures by authorities
  - Maintain moratorium on commercial bank applications, although applications already in the pipeline will be processed (could add up to four commercial banks).
  - Consider rural development bank licenses more favorably to enhance financial inclusion.
  - Draft guidelines on risk management have been produced and should be issued to banks soon.
  - Open to options to penalize pledging of promoter shares, including by deducting them from capital.
  - Reaffirm commitment to passing the amended BAFIA, but timeframe for parliamentary approval is highly uncertain.
  - Agree on need for contingency plans and have requested the World Bank to provide technical assistance.

### Fiscal policy: stance, constraints, and recommendations
- Fiscal discipline and outlook
  - Maintaining fiscal discipline during the political transition described as a remarkable achievement.
  - Government plans to reduce the domestically financed deficit for 2009/10 to 1.6 percent of GDP are welcome; however, as revenue targets appear ambitious, the deficit is likely to be close to 2 percent of GDP.
- Debt and fiscal space
  - Debt sustainability analysis: Nepal is at moderate risk of debt distress (see Annex 1).
  - External debt within thresholds; public debt reduction has created fiscal space that could be used for infrastructure, human capital, and the peace process, provided spending quality is ensured.
  - In the short term, worsening external position requires domestically financed deficits remain close to current levels; overall deficit could be expanded if funded with external grants or concessional debt.
- Main considerations in determining fiscal stance
  - Debt level target:
    - Nepal’s external debt, with an NPV of debt-to-GDP ratio of 21¾ percent, and an NPV of debt-to-exports-and remittances ratio of 63 percent, is well within DSA thresholds.
    - Contingent liabilities of some 2–3 percent of GDP from recapitalization of state-owned banks, and potential additional liabilities from the weak financial sector, suggest maintaining adequate cushions.
    - A public debt target of around 40 percent would be appropriate to anchor fiscal policy.
    - To stabilize public debt-to-GDP at this level, the overall deficit could rise to 3½ percent of GDP, and the domestically financed deficit would be in the range of 2¼–2½ percent of GDP.
  - Support for the peg and demand management:
    - Expected slowdown in output growth suggests a more expansionary fiscal stance in short term, but inflationary pressures and the peg to the Indian rupee require domestically financed deficits remain contained.
  - Crowding out and borrowing costs:
    - High money-to-GDP ratio suggests longer-run accommodation of a somewhat higher domestic debt burden.
    - In the short run, expected slowdown in money growth due to deteriorating external position means public sector borrowing may need to be contained to leave room for private credit and control interest costs.
- Revenue and expenditure
  - Domestic revenues increased from 10¾ percent of GDP in 2005/06 to 14½ percent of GDP in 2008/09, driven by reforms and higher imports as a share of GDP; Fund TA contributed.
  - To finance significant spending needs while maintaining an overall deficit consistent with objectives, revenue would need to be bolstered further.
  - Composition of spending increasingly tilted towards current expenditure; authorities should protect room for higher capital expenditure, particularly investment in infrastructure (transportation and power).
  - Enhance implementation capacity to better execute larger investments; reforms to improve financial information, accounting, expenditure monitoring, and donor coordination should help.
- Quasi-fiscal entities and pricing mechanisms
  - Introduction of an automatic fuel pricing mechanism remains important to contain quasi-fiscal costs of Nepal Oil Corporation (NOC).
  - NOC is running a small deficit at current prices; past declines in international fuel prices were not fully passed through to consumers, allowing partial repayment of private sector and government loans.
  - If international fuel prices rise, NOC’s financial position would be threatened again.
  - Nepal Electricity Authority suffering losses as electricity tariffs have not been adjusted for several years.
- Authorities’ fiscal views
  - MOF officials confident the budget deficit will remain broadly in line with budget targets; they lowered projected inflows of foreign grants and loans to a level closer to staff projections but remain confident about meeting revised revenue targets.
  - A supplementary budget will regularize higher current expenditure for security sector reform and civil service wage increases.
  - Authorities committed to maintaining a prudent fiscal stance and agree fiscal policy needs to remain tight in near term due to external situation.
  - Authorities attribute low capital spending primarily to capacity constraints and emphasize higher spending on health and education should also be considered investment.

### Reserves, balance of payments need, and Rapid Credit Facility (RCF) request
- Reserve position and risks
  - International reserve position of the NRB declined by US$400 million over six months as the balance of payments turned into deficit after years of surpluses.
  - When compared with other LICs, Nepal’s reserves offer adequate import cover (five months), but are relatively low in percent of broad money, a key indicator given risks of capital flight.
  - Decline in reserves triggered liquidity stress in the financial system and sharply higher interest rates; stabilizing reserves is imperative to boost confidence in the currency peg and financial sector and to prevent deposit withdrawals that generate reserve pressures.
- Request for IMF support under RCF
  - Authorities requested a disbursement under the Rapid Credit Facility (RCF) in the amount of SDR28.52 million (40 percent of quota).
  - The level of access is below the ceiling of 50 percent of quota permissible under the exogenous shocks window of the RCF and is in line with Nepal’s immediate balance of payments need.
  - Specifically, the RCF would cover $43 million of a $85 million balance of payments gap, which is staff’s estimate of the amount needed to stabilize reserves in the short term.
  - The remaining gap is expected to be met through other sources, including donor support, which could be catalyzed with the approval of an RCF.

*Source: IMF staff report content provided in the supplied PDF excerpt.*

### 52.      The authorities’ policy commitments in the attached letter of intent appropriately

### _cr10185 - 52.      The authorities’ policy commitments in the attached letter of intent appropriately

### Policy commitments and immediate measures
- The authorities’ policy commitments in the attached letter of intent appropriately address the impact of the shocks.
- Although the authorities are not in a position to implement fundamental structural reforms at present because of the political transition, the NRB and the MOF have taken measures and made commitments that are sufficient to address the exogenous shock and put the balance of payments on a sustainable path.
- Authorities’ view: see attached LOI.

### Capacity to repay and debt sustainability
- Nepal has adequate capacity to repay the Fund and has committed to safeguard Fund resources.
- Access of SDR 28.5 million would not jeopardize Nepal’s debt sustainability.
- At 24 percent of GDP, Nepal’s external debt is low by international standards.
- Nepal remains at moderate risk of debt distress as headline debt indicators have improved recently.
- The NPV of external debt-to-exports-and-remittances is currently at 63 percent.
- The debt service-to-revenue has declined in recent years as a result of prudent fiscal policy and impressive revenue gains.
- Note: While a higher reserve level may be desirable in light of the pegged exchange rate regime, the short-term target of US$2.7 billion would signal an improved external position and help boost confidence.

### Role of the RCF and prospects for a longer program
- The RCF could also serve as a bridge to an upper credit tranche arrangement that could support reforms to address some of Nepal’s entrenched structural challenges.
- Once the new Constitution is approved and after the elections, the authorities intend to address also the structural challenges that Nepal is facing and would like to progress to a longer Fund-supported program, possibly an Extended Credit Facility.
- Rapid Fund assistance under the RCF would provide financial and policy support to help address financial and external sector vulnerabilities in a critical phase of the political transition until a longer-term structural adjustment policy agenda can be formulated.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10185.pdf*

### 55.      The Financial Action Task Force (FATF)’s International Cooperation Review Group

### 55.      The Financial Action Task Force (FATF)’s International Cooperation Review Group

### FATF findings on Nepal’s AML/CFT framework
- Key deficiencies identified by FATF:
  - money laundering and terrorist financing have not been criminalized in a way which is fully in line with the AML/CFT standard;
  - insufficient measures to freeze, seize, and confiscate the proceeds of crime or of money laundering or funds linked to a terrorist financing offense.
- Nepal has yet to enact legislation to enable the rendering of the full range of mutual legal assistance in AML/CFT investigations, prosecutions, and related proceedings.
- The Asia/Pacific on Money Laundering (APG) assessment: Nepal’s entire AML/CFT framework will be subject to assessment by the APG in September 2010; this assessment will provide a comprehensive set of recommendations to improve Nepal’s AML/CFT system.
- IMF support: The IMF, through its AML/CFT Topical Trust Fund, will initially assist Nepal by providing advice on the development of a national strategy which could lead to further technical assistance to implement the APG recommendations.

### Macroeconomic context and recent developments
- Structural features and growth drivers:
  - Economic growth has been driven mainly by consumption and, to a lesser extent, investment, with net exports contributing negatively in most periods.
  - Despite increasing trade integration with India, Nepal’s economic structure has changed little over the past two decades.
- Remittances and external balances:
  - Remittances have reached 20% of GDP and have allowed the country to maintain a strong reserve position, but remittances have fuelled credit growth, inflated asset prices, and created vulnerabilities.
  - Recent trends (Jan-07 to Jan-10 series shown): migrants and remittances growth dipped starting in mid-2009, with import demand surging and export performance remaining lackluster.
  - A widening trade deficit ensued, financed by a drawdown in reserves; trade deficit (in millions of U.S. dollars) series shown: -1,977; -2,265; -2,707; -3,890; -3,980 (2006/07–2010/11 table entries).
- Outlook summary:
  - A slowdown in economic activity was anticipated for 2009/10.
  - Inflation, which was higher than that of India in 2008/09, was converging thereafter.

### Monetary and financial sector developments and risks
- Reserve money and central bank balance sheet (Jan-07 to Jan-10 series):
  - NRB net foreign assets and net domestic assets movements drove reserve money growth until a recent liquidity squeeze.
  - Gross official reserves (in millions of U.S. dollars) reported: 1,996; 2,473; 2,907; 2,670; 2,876 (2006/07–2010/11 table entries).
- Interest rates and real returns:
  - The liquidity squeeze drove up interest rates sharply, which have been negative in real terms (T-bill rate-real, Nepal vs India shown).
- Credit expansion, exposures, and vulnerabilities:
  - After rapid credit expansion, banks are heavily exposed to liquidity risk as CD ratios are high.
  - Banks have high exposure to real estate; real estate and housing loans share reported in exposures as of July 2009.
  - Increase of Domestic Credit since 2004 (in percent of GDP) comparisons across countries provided.
- Banking soundness indicators (as of July 2009 and January 2010):
  - Public banks reported lower CD ratios, but lower CAR and higher NPLs.
  - CD ratio, Capital adequacy ratio, NPL/total loans shown by bank type (Private banks, State-owned banks, All banks).
- Financial markets:
  - The NEPSE Index and NEPSE index for commercial banks fell sharply in late 2008 and failed to recover in step with other countries (07/17/2007=100 series).

### Fiscal sector developments
- Revenue and expenditure trends (2000/01–2008/09 series):
  - Revenues have increased significantly; expenditure has caught up.
  - Revenue components (in % of GDP) and expenditure components (in % of GDP) are shown across years.
- Deficit financing and debt:
  - Grants increasingly financed deficits; overall balances remained under control.
  - Public debt composition (in % of GDP) showed a reduction in public (mainly external) debt over time.
  - Table 3 summary (2006/07–2010/11) headline numbers:
    - Total revenue and grants (in percent of GDP): 14.0; 15.3; 16.9; 19.9; 20.0 (2006/07–2010/11 series).
    - Total expenditure and net lending (in percent of GDP): 15.9; 17.4; 17.2; 22.4; 22.8 (2006/07–2010/11 series).
    - Overall balance after grants (in percent of GDP): -1.9; -2.1; -0.2; -3.0; -2.8 (2006/07–2010/11 series).
  - Table 3 nominal and fiscal levels (in billions of Nepalese rupees) include:
    - Total revenue and grants: 102.0; 125.3; 164.2; 229.5; 222.5; 250.8 (2006/07–2010/11 Budget/Staff Proj. entries).
    - Expenditure: 115.8; 142.3; 166.4; 263.1; 249.5; 285.8 (2006/07–2010/11 entries).
    - Of which: Interest payments (in billions and percent of GDP) shown: 6.2; 6.4; 8.0; 9.7; 17.3 (nominal series) and 0.8; 0.8; 0.8; 0.9; 0.9; 1.4 (percent of GDP series).
- State oil companies:
  - After recovering from large losses in 2008, the state oil companies (NOC's) profitability again faces threats; NOC profits and losses series shown (in million NRs/month).

### External sector and balance of payments
- Balance of payments (2006/07–2014/15 projections) headline figures (in millions of U.S. dollars):
  - Current account: -13.8; 344.0; 536.3; -305.8; -0.3; -22.3; -104.1; -220.0; -305.2 (2006/07–2014/15 series).
  - Trade balance (merchandise exports and imports, f.o.b., in millions): Exports: 942.9; 899.7; 904.1; 804.5; 855.0; 908.2; 955.7; 1,005.4; 1,057.4. Imports: 2,920.3; 3,164.5; 3,611.1; 4,694.5; 5,835.3; 5,294.7; 5,797.7; 6,348.5; 6,951.6 (2006/07–2014/15 series).
  - Current transfers (credit, of which workers remittances): workers remittances: 1,535.7; 2,071.6; 2,712.0; 2,956.0; 3,325.5; 3,724.6; 4,134.3; 4,589.1; 5,093.9 (2006/07–2014/15 series).
  - Gross official reserves (end-of-period, in millions of U.S. dollars): 1,996; 2,473; 2,907; 2,670; 2,876; 3,055; 3,153; 3,134; 3,083 (2006/07–2014/15 series).
- Memorandum and ratios:
  - Remittances (in percent of GDP): 14.9; 16.5; 21.5; 20.1; 21.3; 22.2; 22.9; 23.6; 24.2 (2006/07–2014/15 series).
  - Trade balance (in percent of GDP): -19.1; -18.0; -21.5; -26.4; -25.5; -26.2; -26.9; -27.5; -28.0 (2006/07–2014/15 series).
  - Current account (in percent of GDP): -0.1; 2.7; 4.3; -2.1; 0.0; -0.1; -0.6; -1.1; -1.4 (2006/07–2014/15 series).

### Projections, macro framework, and IMF-related indicators
- Macro projections (selected, 2008/09–2014/15 from Table 6):
  - Real GDP growth (percent change): 4.7; 3.0; 4.0; 4.2; 4.4; 4.7; 4.8 (2008/09–2014/15 series).
  - CPI (period average): 13.2; 11.8; 8.0; 5.5; 5.0; 5.0; 5.0 (2008/09–2014/15 series).
  - Gross official reserves (end-of-period, in millions of U.S. dollars): 2,907; 2,670; 2,876; 3,055; 3,153; 3,134; 3,083 (2008/09–2014/15 series).
  - Public external debt (in percent of GDP): 27.0; 23.8; 21.7; 20.3; 19.2; 18.2; 17.4 (2008/09–2014/15 series).
- Fund obligations and outstanding credit (Table 7, 2010–2020):
  - Fund obligations based on existing credit (principal, in millions of SDRs): 2.9; 2.9; 6.8; 10.0; 8.6; 7.1; 7.1; 3.2; 0.0; 0.0; 0.0 (2010–2020 series).
  - Total obligations based on existing and prospective credit (SDR millions): 2.9; 2.9; 7.0; 10.2; 8.7; 10.1; 12.9; 9.0; 5.8; 5.7; 2.9 (2010–2020 series).
  - Outstanding Fund Credit (SDR millions): 74.1; 71.3; 64.5; 54.5; 46.0; 36.0; 23.2; 14.3; 8.6; 2.9; 0.0 (2010–2020 series).
  - Net use of Fund Credit (in millions of SDRs): 25.7; -2.9; -7.0; -10.2; -8.7; -10.1; -12.9; -9.0; -5.8; -5.7; -2.9 (2010–2020 series).
- Memorandum nominal items (Table 7):
  - Nominal GDP (in billions of Nepalese Rupees): 1,116.1; 1,254.1; 1,380.2; 1,513.6; 1,664.7; 1,831.0; 2,018.7; 2,225.6; 2,453.8; 2,705.3; 2,982.6 (2010–2020 series).
  - Government Revenue (in billions of Nepalese Rupees): 179.8; 200.7; 223.6; 248.0; 275.2; 304.7; 336.9; 372.6; 412.0; 455.6; 503.7 (2010–2020 series).

*Source: _cr10185 - 55.      The Financial Action Task Force (FATF)’s International Cooperation Review Group (IMF staff report content provided).*

### 1.      Nepal is in the midst of a major political transition. Following the comprehensive

### _cr10185 - 1.      Nepal is in the midst of a major political transition. Following the comprehensive

### Political context and implementation constraints
- Nepal is in the midst of a major political transition following the comprehensive peace accord which ended the 10-year armed conflict in 2006 and Constituent Assembly elections in April 2008.
- Political parties remain focused on completing the peace process and the promulgation of the new constitution, after which general elections will be held.
- The political situation remains fragile and the government’s ability to implement comprehensive structural reform is currently limited.

### Impact of the global crisis on external position
- Remittance exposure and deceleration:
  - Remittances constitute over 20 percent of GDP.
  - Outflow of Nepali workers abroad decreased by 12 percent during 2009.
  - Growth of remittances halved to 17 percent year-on-year in the first half of 2009/10 from an average of 34 percent in 2005–08.
- Trade balance deterioration:
  - Exports have declined by 14 percent so far this fiscal year.
  - Exports to India have dropped by 6 percent.
  - Exports to other countries are down by 26 percent, reflecting the appreciation of the Indian rupee.
  - Imports continued to soar by 46 percent on the assumption that remittances growth would continue in line with previous years.
  - The trade deficit has risen by 67 percent in the first half of 2009/10, reaching 28 percent of GDP.
  - The 2009/10 current account is set to record a sizeable deficit of 2 percent of GDP, the first deficit since 1997/98.
- Reserve drain:
  - International reserves fell by US$ 400 million (13 percent) from their July 2009 peak to US$ 2.5 billion in March 2010.
  - Reserves now cover only 5 months of imports compared to 6 months as recently as October 2009.

### Macroeconomic and financial sector effects
- Liquidity and financial sector:
  - Slowdown in remittance growth contributed to a financial sector liquidity squeeze, drove up interest rates, and exposed financial sector weaknesses.
  - Some banks experienced liquidity stress due to high credit-to-deposit ratios.
  - Nepal Rastra Bank’s (NRB) liquidity injections have lowered interbank interest rates; banks reported reduced new loan disbursements.
  - Asset quality is likely to deteriorate in the coming months as roll-over and liquidity risks increase.
- Economic activity:
  - Real GDP in 2009/10 is projected to fall to less than 4 percent compared to 4¾ percent in 2008/09.
  - The slowdown will make efforts to accelerate economic growth and reduce poverty on a sustainable basis more difficult.

### NRB liquidity measures
- The NRB introduced measures to improve provision of liquidity:
  - The terms for repo transactions were lengthened from 28 to 45 days.
  - Commercial banks’ call deposits can count towards meeting the statutory liquidity ratio.
  - A new refinancing facility to channel credit to the export, power and tourism sectors has been introduced.
- Expected outcome: these measures are expected to ease liquidity conditions in the coming months and promote credit provision to priority sectors, while overall liquidity conditions remain consistent with the peg.

### Prudential and supervisory measures to safeguard financial stability
- Licensing policy:
  - NRB imposed a moratorium in December 2009 on new bank licenses while the policy is being reviewed.
  - Moratorium lifted for microfinance institutions (class D) and eased for development banks (class B) to promote rural financial services.
- Single borrower limits:
  - Single borrowing limits will be lowered to 25 percent of capital by July 2010, with exceptions for some infrastructure projects (hydropower, cable cars, planned fast track road linking Kathmandu with the Terai region).
- Real estate exposure limits:
  - Banks required to lower exposure to real estate loans (and housing) to 25 (40) percent of total loans by end-2009/10.
  - Both limits will be further lowered by 10 percentage points by end 2010/11 and by an additional 5 percentage points by end 2011/12.
  - Loans above the limit will be penalized by provisioning requirements on the basis of a risk weight of 150 percent.
- Loan-to-value limits:
  - Commercial banks loans cannot exceed 60 percent of fair market value of collateral or project.
- Credit-to-deposit ratio limits:
  - Commercial banks credit-to-deposit ratios should not exceed 95 percent by end-2009/10, 85 percent by end-2010/11, and 80 percent by end-2011/12.
- Bank restructuring and risk management:
  - NRB has begun liquidation of Nepal Development Bank (NDB) and completed restructuring of Nepal Bangladesh Bank.
  - NRB drafted risk management guidelines to be issued to commercial banks by July 2010.
- Implementation stance:
  - NRB reaffirms commitment to enforcing existing regulations and developing bank-by-bank time bound action plans if necessary.
  - Acknowledgement that some prudential measures will be challenging for commercial banks to meet.

### Exchange rate peg, external restrictions, and temporary measures
- Commitment to the peg:
  - The peg to the Indian rupee remains a key anchor for Nepal’s economic stability.
- Measures to stem balance of payments deficit:
  - NRB raised margin requirements on gold and silver imports and introduced quantitative limits on gold and silver imports.
  - Government raised tariffs on gold imports.
  - Considering measures to curb imports of consumption goods to safeguard foreign exchange for capital goods.
  - NRB limited availability of the passport foreign facility to twice a year and $2,000 per transaction in the mid-term review of monetary policy.
- Article VIII consideration and timetable:
  - Authorities are aware that maintaining quantitative limits on foreign exchange for leisure travel may give rise to an exchange restriction under Article VIII of the IMF’s Articles.
  - Commitment to removing any restrictions that may arise from these measures by March 2011 as the balance of payments situation is expected to improve.
- Outlook on remittances and trade:
  - Remittance growth is expected to recover in 2010 as host countries recover; import growth should moderate in response to recent measures and tighter liquidity conditions.
  - Do not anticipate remittances growth recovering to pre-crisis levels; generating strong export growth in the near term will remain difficult.
  - Continued labor mobility is expected to offset competitiveness losses relative to India; structural reform to address the productivity gap expected once the peace process is concluded.

### Monetary policy stance and liquidity access modalities
- Monetary policy needs to remain tight and interest rates above those of India given the challenging external situation.
- NRB liquidity provision approach:
  - Blanket repos normalized interbank rates during the recent squeeze.
  - Going forward, individual banks’ liquidity needs will be met through the Supplementary Liquidity Facility at penalty rates.
  - For solvent banks without adequate collateral, the bank rate window will be used under heightened NRB oversight and conditionality.
  - Modalities for accessing the bank rate window will be further clarified by July 2010.
  - NRB remains committed to intervening insolvent banks, as demonstrated with Nepal Bangladesh Bank and Nepal Development Bank.

### Strengthening supervision, contingency planning, and legal framework
- Financial sector assessment and supervisory enhancement:
  - Before end-July 2010, NRB will begin a thorough assessment of the health of the financial sector, including solvency and liquidity risks, through stress testing and special on-site inspections.
  - NRB welcomes the possibility of a Fund resident technical assistance advisor.
  - Where shortcomings are identified, corrective action will be taken promptly and regulatory forbearance eschewed.
  - Beginning in 2010/11, NRB will introduce penalties for pledging of promoters’ shares by deducting them from bank capital.
  - Efforts to improve timeliness and accuracy of data compilation, particularly in the financial sector.
- Contingency planning:
  - With World Bank technical assistance, NRB will develop a contingency plan in case financial sector stress breaks into a crisis.
  - Authorities will seek to expedite passage by the Constituent Assembly of the amended Bank and Financial Institutions Act (BAFIA) to strengthen the bank resolution framework.

### Bank licensing, consolidation, and state-owned bank reform
- Bank licensing and consolidation:
  - Bank licensing policy will remain restrictive; further licensing of commercial banks will remain very restrictive.
  - Supervisory capacity of NRB will be strengthened commensurate with financial sector expansion.
  - To ensure rural access, NRB will work with commercial banks and microfinance institutions to encourage mobile banking and agent banking without additional banks entering the system.
  - Promote banking sector consolidation by facilitating public trading of promoters’ shares by July 2010.
- State-owned banks:
  - Committed to reforming Nepal Bank Limited (NBL) and Rastriya Banijya Bank (RBB).
  - Begin recapitalizing NBL in 2010/11 and continue efforts to strengthen management of both banks.

### Fiscal stance and public finance measures
- Fiscal prudence:
  - Fiscal consolidation over past years has created some fiscal space, but current external situation calls for continued cautious fiscal stance to support the peg and maintain macroeconomic stability.
  - Keep domestic financing to around 2 percent of GDP in 2010/11 and increase it moderately to around 2½ percent in 2011/12 provided the external situation improves.
- Revenue administration and expenditure priorities:
  - Continue improvements to increase the revenue-to-GDP ratio.
  - Comprehensive reform strategy for customs, measures to curb tax evasion, broaden the tax base, and improve audit function of the large taxpayer office, with Fund technical assistance.
  - Easing capacity constraints in capital spending; recurrent spending restrained while health, education and security expenditure safeguarded.
  - Improve coverage of financial information, the accounting system, monitoring expenditure, and systems to coordinate donor activity.
  - Ensure financial health of the Nepal Oil Corporation (NOC) and continue strategy of incremental price adjustments as needed to avoid NOC losses.

### Request for Rapid Credit Facility (RCF) support and policy conditionality
- Request:
  - Government requests access of 40 percent of quota (SDR 28.52 million) through the Rapid Credit Facility based on urgent balance of payments needs and the strength of macroeconomic adjustment policies.
  - Access motivated by need to safeguard reserve adequacy and maintain confidence amid significant external and financial sector risks.
- Conditionality and benchmarks:
  - Committed to meeting a set of Indicative Targets for end-2009/10, including NRB’s net international reserves and net domestic assets, and the government’s net domestic financing (Table 1).
  - Expect Fund financial support to serve as a bridge to an Extended Credit Facility, hoped to start negotiations later this year.
- Poverty reduction and policy support:
  - RCF will provide policy support for the poverty reduction strategy (Plan/PRSP objectives: macroeconomic stability, institution building, structural reforms to raise growth and reduce poverty).
  - Interim poverty reduction plan covers mid-2007 to mid-2010; a three-year plan covering mid-2010 to mid-2013 with special focus on employment and equity is being formulated.

### Safeguards and audit commitments
- Committed to completing a safeguards assessment.
- Liaising with Fund staff to conduct an external audit for the NRB in accordance with international standards.
- Authorities will authorize Fund staff to have access to the external audit reports and hold discussions with the auditors.

*Source: IMF staff report text as provided in the supplied content unit.*

### 17.      The Government of Nepal and the NRB agree to publish this letter.

### The Government of Nepal and the NRB agree to publish this letter.

### Agreement and Signatories
- The Government of Nepal and the Nepal Rastra Bank (NRB) agree to publish this letter.
- Signatories:
  - /s/ Surendra Pandey — Minister of Finance
  - /s/ Yuba Raj Khatiwada — Governor, Nepal Rastra Bank

### Indicative Targets (selected figures from table)
- I. Floor on net international reserves of the NRB (in millions of US dollars): 279, 225, 812,400
- II. Ceiling on net domestic assets of the NRB (in millions of Nrs.): -23,179, 14,517, 15,500
- III. Net domestic financing of the budget deficit (ceiling on cumulative flow from beginning of FY, in million Nrs): 23,174, -9,194, 23,500
- IV. Ceiling on contracting or guaranteeing of new nonconcessional external debt (in millions of US dollars): 0, 0, 0
- V. Ceiling on accumulation of external payments arrears (in millions of US dollars): 0, 0, 0

- Notes on calculations and definitions:
  - Net international reserves of the NRB: gross international reserves including holdings of nonconvertible currencies less international reserve liabilities. Holdings of Indian rupees will be converted into U.S. dollars at the program exchange rate of 45 Indian rupees per U.S. dollar; holdings of other nonconvertible currencies will be converted into U.S. dollars at market exchange rates. Assets denominated in SDRs will be converted at the program exchange rate of 1.57 U.S. dollars per SDR.
  - Gross international reserves consist of monetary gold holdings of the NRB, holdings of SDRs, Nepal’s reserve position in the IMF, cash in foreign currencies, and foreign currency assets held abroad that are under the direct and effective control of the NRB and readily available.
  - International reserve liabilities consist of all outstanding liabilities of Nepal to the IMF and any convertible currency liabilities to nonresidents with an original maturity of up to one year.
  - Net domestic assets of the NRB: difference between domestic assets and liabilities of the NRB. Domestic assets: claims by the NRB on the government, state-owned enterprises, financial institutions, banks, the private sector and other assets as reported in the NRB’s balance sheet. Domestic liabilities: government deposits, capital accounts, and other liabilities as reported in the NRB’s balance sheet.
  - Net domestic financing of the budget deficit: sum of net credit to government by the banking system (NRB and deposit money banks), net changes in holdings of treasury bills and other government securities by nonbanks, and privatization receipts by the government.
  - Definition of debt for the purposes of the program: set out in Executive Board Decision N. 12274, Point 9, as revised on August 24, 2000.
  - The indicative target on nonaccumulation of external arrears is continuous.

### IMF Staff Report and Informational Annex — key institutional and program data
- Document: INTERNATIONAL MONETARY FUND — NEPAL — Staff Report for the 2010 Article IV Consultation and Request for Disbursement Under the Rapid Credit Facility — Informational Annex — Prepared by the Asia and Pacific Department — May 17, 2010.
- Appendix I: Nepal—Fund Relations (As of February 28, 2010)
  - I. Membership Status: Joined 9/06/61; Article VIII, Sections 2, 3, and 4 on May 30, 1994.
  - II. General Resources Account: Quota 71.30 SDR Million (100.00 percent); Fund holdings of currency 71.30 (99.99 percent); Reserve position in Fund 0.01 (0.02 percent).
  - III. SDR Department: Net cumulative allocation 68.10 SDR Million (100.00 percent); Holdings 63.71 (93.56 percent).
  - IV. Outstanding Purchases and Loans: ECF arrangements 48.47 SDR Million (67.99 percent of quota).
  - V. Financial Arrangements (approval and drawn amounts in SDR Million):
    - ECF 11/19/03–11/18/07: Approved 49.90; Drawn 49.90
    - ECF 10/05/92–10/04/95: Approved 33.57; Drawn 16.79
    - SAF 10/14/87–10/13/90: Approved 26.11; Drawn 26.11
  - VI. Projected Obligations to Fund (in millions of SDRs; based on existing use of resources and present holdings of SDRs):
    - Forthcoming Principal by year: 2010: 2.85; 2011: 2.85; 2012: 6.77; 2013: 9.98; 2014: 8.55
    - Charges/interest: 2012: 0.02; 2013: 0.02; 2014: 0.12; 2015: 0.10; 2016: 0.07 (table totals: 2.87, 2.87, 6.89, 10.08, 8.63)
  - VII. Exchange Rate Arrangement:
    - Nepal unified its exchange rate in February 1993. In October 1997, reclassified as pegged to a single currency unit. The Nepalese rupee is pegged to the Indian rupee at a rate of 1.6.
    - Passport Facility: monetary limit of $2,000 and cannot be used more than two times per year; limit reduced to $1,000 for travelers to Tibet of China and SAARC countries (excluding India) if they travel by land.
    - As of February 26, 2010, exchange rate: US$1 = Nrs. 74.15.
  - VIII. Safeguards Assessments:
    - A safeguards assessment of the NRB was completed in 2002; a safeguards monitoring assessment was completed in October 2004. Findings: substantial risks in external and internal audits and internal control system; limited progress on recommendations; absence of external audit of the NRB in accordance with international standards is a key safeguards risk.
  - IX. 2008 Article IV Consultation: Executive Board discussed staff report on May 16, 2008. It was proposed that Article IV consultations take place on the 12-month cycle.
  - X. Technical Assistance Since 2001 (selected items and years):
    - MCM: Accounting 2004–06; Central bank and banking reform 2001–02; Internal Audit 2004–07; Monetary policy 2003; Monetary operations continuous; Strengthening central bank accounting and controls 2005; Foreign exchange reserves management 2003–07; Financial Sector Supervision 2006–07; Liquidity management 2003.
    - FAD: Implementation of a large tax payer unit 2003; Review of tax policy and VAT administration 2003; Tax and customs administration reform 2003–04, 2006–10; Treasury Single Account 2008–09; Capacity Building Workshop 2009–10.
    - LEG: Redrafting of income tax laws 2000–01, 2007; Income Tax Act 2003; Banking Law 2004–05; Fiscal Law 2007; Fiscal Transparency 2007.
    - STA: Multisector statistics 2001, 2003, 2008–09; Balance of payments statistics 2002–04; Producer prices statistics 2002–05; Monetary statistics 2003; National accounts 2003, 2005–06, 2008.
  - XI. Resident Representative/Advisor: Mr. Alexander Pitt since August 2006.

### Relations with the World Bank Group — key points and programs (As of March 3, 2010)
- Context and strategy:
  - Nepal’s decade-long conflict ended in November 2006; Constituent Assembly in 2008; new constitution targeted by 2010; elections planned for 2011.
  - Prime Minister since May 2009 prioritized delivering the new constitution and completing the peace process.
  - National Planning Commission preparing a new Three Year Plan focused on employment creation and short-run public works programs.
  - Thirty-eight donors operate in Nepal; need for transition to harmonized delivery through Government systems; Government capacity to manage resources efficiently needs strengthening.
- World Bank roles and focus areas:
  - Bank leads in social sectors, infrastructure, environment, and agriculture.
  - Education: support for Education for All (EFA) project and School Sector Reform Project (SSRP); EFA SWAp financed over ninety percent of primary education sub-sector expenditures.
  - Health: support for devolution of sub-health posts, Health Sector Reform Project, Avian Influenza Control Project.
  - Infrastructure: Power Development Project (PDP), Road Sector Development Project, Telecommunications Sector Reform Project.
  - Rural development: Nepal Irrigation and Water Resources Management Project; Rural Access Improvement and Decentralization Project (RAIDP); Rural Water Supply and Sanitation Project.
  - Agriculture: Agriculture Commercialization and Trade Project; Social Safety Net Project addressing food crisis.
  - Peace support: Peace Support Project providing interim cash transfers and services to conflict-affected groups.
  - Poverty Alleviation Fund (PAF): channels resources to poorest groups in rural communities; PAF project supports implementation in 75 districts.
- Bank–IMF collaboration:
  - Bank leads public expenditure analysis; a new PER delivered in FY10 focusing on education and health.
  - Joint assistance on PRS and civil service reform; shared responsibilities in financial sector reform, stress testing, central bank capacity, restructuring state banks, and legislative/institutional upgrades.
- World Bank lending and assistance (FY10 and portfolio):
  - In FY10, IDA financing approved for School Sector Reform Project and Rural Access Improvement and Decentralization Additional Financing Project for total new commitments of US$175 million.
  - Nepal country portfolio: 22 operations with net commitment value US$937 million (14 IDA projects US$905 million; 8 Trust Fund operations US$32 million).
  - Distribution of financial assistance: 5 percent state-building and peace process; 42 percent sustainable growth; 53 percent improving service delivery. About 45 percent of assistance involves community management at local level.
- Analytic and regional work:
  - Support for NLSS 3 with DFID and Denmark; analysis of migration and remittances; support for MTEF; analyses on fiscal decentralization and social protection.
  - Work on water resource management, climate change, disaster risk reduction; support for river basin modeling and GIS for WECS; collaboration with ADB, DFID, Denmark, Norway.
  - Regional programs: regional water initiative; Global Tiger Initiative; cross-border energy program for hydropower and transmission investments.
- IDA and Trust Fund portfolio (selected figures as of January 31, 2010):
  - Pillar I (State-building) Sub-total Net Commitments: 50.9 ($m); Disbursed to date: 20.1 ($m)
  - Pillar II (Sustainable Growth) Sub-total Net Commitments: 390.1 ($m); Disbursed to date: 81.0 ($m)
  - Pillar III (Service Delivery) Sub-total Net Commitments: 496.1 ($m); Disbursed to date: 154.9 ($m)
  - Total Pillars I, II, and III: 937.1 ($m) net commitments; 256.0 ($m) disbursed to date.
- IFC activities:
  - As of end January 2010, IFC outstanding portfolio in Nepal: US$31.3 million across power generation, airline, tourism, and trade finance facilities.
  - IFC considering new investments in hydropower, agri-business and financial sector; involvement in Global Trade Finance Program with Nepali banks (Bank of Kathmandu, Nepal Industrial and Commercial Bank, Himalayan Bank).
  - Advisory services: IFC-SEDF for SMEs; support for privatization/corporate advisory (possible Nepal Airlines, Kathmandu airport international terminal, Nepal Telecom); Credit Bureau Strengthening Project; SME Venture Fund.
  - Investment Climate Reform Program (ICRP, phase I): public-private dialogue, SEZ framework pending Constituent Assembly approval.
  - Contact points: IDA — Ms. Paralkar (458–9050); IFC — Mr. Paul Barbour (473−7349).

### Relations with the Asian Development Bank (Annex III) — key program facts (As of December 31, 2009)
- Cumulative lending to Nepal: $2,972.150 million, comprising 117 sovereign loans ($2,422 million), 5 non-sovereign loans ($50 million), and 16 ADF grants ($495.650 million).
- AsDB country program for Nepal in 2009:
  - Total grants: $163.5 million; Total concessional loans: $172.8 million.
  - Major 2009 operations include: Education Sector Cluster Program (loan: $25 million; grant: $70 million); Energy Access and Efficiency Improvement Project I (loan: $65 million); Air Transport Capacity Enhancement Project (loan: $70 million; grant: $10 million); Second Small Towns Water Supply and Sanitation Sector Project (grant: $45.1 million); Emergency Flood Damages Rehabilitation (grant: $25.6 million); South Asia Tourism Infrastructure Development Project national contribution (loan: $12.75 million; grant: $12.75 million).
- Undisbursed funds: $717.03 million (63 percent of total portfolio amount as of 31 December 2009).
- Loans, grants, and technical assistance (1968–2009 totals and selected year breakdowns presented in the source document).
- Technical assistance: Since 1968, ADB approved 288 technical assistance projects totaling $127.8 million; 39 ongoing TAs as of 31 December 2009, including 5 JFPR projects.
- Private sector operations: Cumulative approvals for 4 private sector projects in Nepal amounted to $58.64 million; ADB’s outstanding exposure to non-sovereign projects totaled $8.8 million (0.2% of ADB’s total non-sovereign portfolio).

*Source: INTERNATIONAL MONETARY FUND — Staff Report for the 2010 Article IV Consultation and Request for Disbursement Under the Rapid Credit Facility — Informational Annex (May 17, 2010).*

### APPENDIX IV: NEPAL—STATISTICAL ISSUES

### APPENDIX IV: NEPAL—STATISTICAL ISSUES

### Overview
- Economic and financial data are generally adequate for surveillance, with scope for improvement, particularly in the timeliness and coverage of fiscal data, and in balance of payments compilation of remittances, and official and private financial flows.
- Nepal has participated in the General Data Dissemination System (GDDS) since May 2001; metadata were initially posted in May 2001 and last updated in January 2009.
- A multisector statistics mission visited Kathmandu in January 2001; STA missions in April 2005 and July 2006 provided support for QNA development and rebasing.

### Real Sector Statistics
- National accounts
  - Compiled by the Central Bureau of Statistics (CBS) using the 1993 SNA.
  - Key estimates: GDP by industry (current and constant prices), GDP by expenditure (current prices), gross national income and savings.
  - Shortcomings: lack of comprehensive and regular source data, inconsistencies, lags, insufficient detail, record-keeping issues, and reliance on fixed ratios and ad hoc assumptions (e.g., household consumption extrapolated from the 2003/04 benchmark living standard survey).
  - Rebased annual national accounts to 2000/01 from 1994/95 with STA support; AsDB project context for strengthening national accounts.
- Price indices
  - Consumer price index (CPI): limited coverage; expenditure weights from a 1995/96 household expenditure survey; limited to urban areas; consumption basket excludes upper and lower two income deciles, single-person households, households with more than eight persons, and households obtaining >50 percent of consumption from own production or <50 percent of income in cash; aggregation uses population weights rather than expenditure weights.
  - Wholesale price index (WPI): developed by Nepal Rastra Bank (NRB), first published July 2001; weights based on 1999/2000 using commodity flow approach; CBS needs to improve price collection frequency and number of quotations, and implement quality-adjustment procedures.
  - Producer price index (PPI): CBS, with STA assistance, is developing a monthly PPI to replace the manufacturing price index (currently based on unit values); PPI expected to better measure industrial inflation and improve national accounts deflation.

### Government Finance Statistics
- Budget classification: revised in 2004/05 and refined thereafter; improved division between current and capital spending.
- Remaining issues:
  - Fiscal data by functional and economic classification provided irregularly with varying coverage.
  - Large allocations to contingency account; monthly reporting of development spending excludes amounts directly paid by donors.
  - Fees collected outside the budget and local government operations often not reported in the annual budget.
- Data timeliness: more timely revenue and expenditure data are needed; a financial management project and a ‘flash’ reporting system covering selected districts are being developed.
- Consolidation and reporting:
  - Consolidated accounts for the public enterprise sector are not compiled regularly; reporting by many enterprises is subject to long delays.
  - Government finance statistics are regularly reported for the Government Finance Statistics Yearbook, but not for the International Financial Statistics.

### Monetary and Financial Statistics
- Monetary data provided by NRB have experienced revisions with lags of up to 12 months.
- Compilation methodology: currently based on IMF’s 1984 Guide to Monetary and Financial Statistics; a 2008 STA mission recommended updating to the Monetary and Financial Statistics Manual, 2000 (MFSM).
- Key 2008 STA recommendations (summarized):
  - Include development banks and finance companies in institutional coverage and compile a monthly broad money/depository corporations survey.
  - Adopt center of economic interest criteria for resident/nonresident classification.
  - Adopt principle of effective control for public vs. private nonfinancial corporations.
  - Ensure IMF-related accounts are fully reflected in NRB balance sheet per IMF Finance Department instructions.
  - Value monetary gold, SDR holdings, securities, and shares/equities at end-period fair value/market price.
  - Incorporate accruals in outstanding financial asset/liability amounts rather than separate accounts.
  - Monitor and include smaller deposit-taking institutions (Postal Savings Bank, Micro Credit Development Banks, Savings and Credit Cooperatives, Citizens’ Investment Trust) as their deposit-taking becomes significant.
  - Use Statement of Assets and Liabilities (Form No. 1) as basis for compiling monetary accounts for commercial banks, development banks and finance companies.
  - Start regular monthly reporting of monetary data in the SRF format for the NRB (SRF-1SR) and other depository corporations (SRF-2SR).

### External Sector Statistics
- Balance of payments
  - Compiled by NRB in conformity with BPM5; international investment position not compiled.
  - Nepal benefited from five STA BOP missions since 2001; BOP dissemination in BPM5 format began September 2003.
  - Net errors and omissions remain large; work ongoing to improve remittances and private capital flow source data.
  - Further improvements needed for recording oil transactions, grants, foreign direct investment, short-term inflows, and other private capital flows.
- Trade data: compiled separately by NRB, Customs Department, and Trade Promotion Center; discrepancies exist. Export and import price indices are not compiled.
- Government external financing: incomplete and conflicting data on external grants and loans complicate estimation of foreign financing; NRB monitors cash disbursements and repayments but most commodity aid and direct payments are excluded; MoF reporting incomplete and not timely.
  - A new database on disbursements, repayments, and outstanding government debt was developed with DFID technical assistance and is being refined; reporting of direct external grants remains problematic.
- Footnote data point: ratio of deposits at development banks and finance companies relative to total deposits at deposit-taking institutions was approximately 13 percent at end-2006/2007.

### Data Availability — Common Indicators Required for Surveillance (As of March 25, 2010)
- Exchange rates: Date of Latest Observation Jan. 2010; Date Received Mar. 2010; Frequency of Data D and M; Frequency of Reporting W and M; Frequency of Publication D and M.
- International reserve assets and reserve liabilities of the Monetary Authorities1: Date of Latest Observation Jan. 2010; Date Received Mar. 2010; Frequency of Data W; Frequency of Reporting W; Frequency of Publication M.
- Reserve/base money: Jan. 2010; Mar. 2010; M; M; M.
- Broad money: Jan. 2010; Mar. 2010; M; M; M.
- Central bank balance sheet: Jan. 2010; Mar. 2010; M; M; M.
- Consolidated balance sheet of the banking system: Jan. 2010; Mar. 2010; M; M; M.
- Interest rates2: Jan. 2010; Mar. 2010; W and M; W and M; W and M.
- Consumer price index: Feb. 2010; Mar. 2010; M; M; M.
- Revenue, expenditure, balance and composition of financing3 – general government4: Jan. 2010; Mar. 2010; W; W; W.
- Revenue, expenditure, balance and composition of financing3 – central government: Jan. 2010; Mar. 2010; W; W; W.
- Stocks of central government and central government-guaranteed debt5: 2008/09; Jan. 2010; A; A; A.
- External current account balance: Jan. 2010; Mar. 2010; M; M; M.
- Exports and imports of goods and services: Jan. 2010; Mar. 2010; M; M; M.
- GDP/GNP: 2008; May 2009; A; A; A.
- Gross external debt: 2008/09; Jan. 2010; A; A; A.

Footnotes reproduced from source:
- 1 Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.
- 2 Both market-based and officially determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.
- 3 Foreign, domestic bank, and domestic nonbank financing.
- 4 The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.
- 5 Including currency and maturity composition.
- 6 Daily (D), weekly (W), monthly (M), quarterly (Q), annually (A), irregular (I); and not available (NA).

### Joint IMF/World Bank Debt Sustainability Analysis — Key Points
- Assessment date: May 14, 2010.
- Overall risk: Nepal remains at moderate risk of debt distress under the LIC-DSA framework; remittances incorporated given their importance.
- Debt stock and composition (end 2008/09):
  - Total public debt stock: 40 percent of GDP (nominal terms), down from 64 percent of GDP in 2001/02.
  - External public debt: US$3.4 billion (27 percent of GDP); about US$3.1 billion owed to multilateral institutions (mostly IDA and AsDB).
  - Bilateral debt: estimated US$0.3 billion; Japan accounts for about three quarters of bilateral debt.
  - Domestic debt: around 13 percent of GDP, 4 percentage points lower than in 2001/02.
- Macroeconomic assumptions driving PPG projections:
  - Real GDP growth: decline to 3 percent in 2009/10; pick up gradually to 4¾ percent over the medium term; reach 5½ percent in the long run.
  - Inflation: about 12 percent in 2009/10; gradually decline to 5 percent over the medium term.
  - Exchange rate: assumed pegged to the Indian rupee at the current level over the projection period.
  - Fiscal:
    - Revenue-to-GDP: projected to rise from 14½ percent in 2008/09 to 17 percent in 2020/21 and stabilize thereafter.
    - Official grants: projected to decline from 4 percent of GDP in 2008/09 to 3 percent in 2014/15.
    - Expenditure-to-GDP: projected to rise from 19¾ percent in 2008/09 to around 23½ percent in the medium term and beyond.
    - Overall fiscal deficit (including grants): projected to rise from 1½ percent of GDP in 2008/09 to 3½ percent of GDP in the medium term.
    - Net domestic financing: projected increase from 1¾ percent of GDP in 2008/09 to about 2½ percent by 2014/15, stabilizing thereafter.
  - External sector:
    - Exports of goods and services: projected average growth of about 7 percent over the projection period.
    - Remittances: after >30 percent annual growth in recent years, projected to slow to an annual average of 12 percent over the medium term, and about 8 percent thereafter.
    - Imports of goods and services: projected average growth of about 8 percent.
    - Current account: projected shift to a deficit of 2 percent of GDP in 2009/10, gradually moving close to balance in the long run.
  - Financial sector:
    - Overextension owing to loose monetary policy, weak supervision, proliferation of institutions; rapid credit growth has fueled asset price booms.
    - Two state-controlled banks, accounting for one fifth of the system, operate with significant negative capital.
    - Contingent liabilities of a financial sector restructuring could be in the order of 8–12 percent of GDP.
  - Aggregate projection differences vs previous DSA:
    - Average GDP growth over the projection period: 5 percent (previous DSA: 5½).
    - Average export growth: 7 percent (previous DSA: 8 percent).
    - Average import growth: ~8 percent (similar to last DSA).
  - Grant element of new borrowing: projected to decline gradually as hydropower development attracts commercial lenders and new non-traditional donors increase assistance.
- External debt sustainability — baseline results:
  - Under the baseline, external debt indicators are well below indicative thresholds.
  - Long-term projection improvements (selected ratios):
    - PV of external public debt-to-GDP-and-remittances: decline from 16 percent to 8 percent by 2029/30.
    - PV of external public debt-to-revenue: decline from 119 percent to 57 percent.
    - PV of external public debt-to-exports-and-remittances: decline from 63 percent to 41 percent.
- Indicative external debt burden indicators (as presented in source)
  - Row: "NPV of debt, in percent of exports and remittances" — 135.0; 63.3; 41.3
  - Row: "GDP and remittances" — 36.0; 16.0; 10.3
  - Row: "revenue" — 250.0; 119.4; 74.8
  - Row: "Debt service, in percent of exports and remittances" — 18.0; 4.3; 2.7
  - Row: "revenues" — 30.0; 8.2; 4.9
- Stress testing:
  - Standard stress tests show debt dynamics resilient; however, under a financial stress scenario reflecting banking sector vulnerabilities, debt indicators breach thresholds for a sustained period.
- Policy implications highlighted:
  - Contain risks arising from financial vulnerabilities.
  - Maintain a tight fiscal stance in the short run; consider a more accommodative stance in the medium term if financial vulnerabilities are addressed.
  - Pursue stronger and more stable growth and secure foreign financing on favorable terms to progress toward MDG targets while containing debt sustainability risks.

*Source: APPENDIX IV: NEPAL—STATISTICAL ISSUES (IMF staff report material).*

### 5. The DSA is resilient to standard stress tests. The standard shocks include slower

### 5. The DSA is resilient to standard stress tests. The standard shocks include slower

### Summary of standard stress tests and bound tests
- Standard shocks include slower GDP growth, softer remittances and exports, lower US dollar GDP deflator and a one-time exchange rate depreciation.
- Bound tests indicate that debt indicators do not breach the thresholds except that the PV of debt-to-export-and-remittance ratio exceed the threshold for one year only.
- The standard stress tests do not capture Nepal’s structural weaknesses, in particular the financial vulnerabilities and the associated risks and the country’s dependence on remittances.

### Country-specific scenario combining remittances, exchange rate, and financial restructuring
- An alternative scenario combines:
  - a slowdown in remittances and GDP growth,
  - a 30 percent one-time exchange rate depreciation,
  - and the potential cost of financial sector restructuring.
- The potential net fiscal costs of a financial restructuring is estimated to be 8–12 percent of GDP.
- Under this scenario:
  - the PV of debt-to-GDP-and-remittances ratio increases significantly, peaking at 47 percent in 2011/12 and staying above the threshold for seven consecutive years;
  - the PV of debt-to-revenue ratio would breach the threshold for nine years;
  - the PV of debt-to-exports-and-remittances would breach the threshold for four years.
- Under this country-specific scenario, liquidity indicators such as debt service-to-revenue and debt-service-to-exports-and-remittances remain below the thresholds.

### IV. PUBLIC DEBT SUSTAINABILITY — baseline projections and composition
- Baseline scenario projections:
  - PV of public debt-to-GDP ratio declines slightly from 33 percent in 2009/10 to 31 percent by 2029/30.
  - PV of public debt-to-revenue ratio declines from 165 percent to 156 percent over the same period.
  - Public debt service-to-revenue ratio declines from 12¾ percent to 12¼ percent.
- Debt composition:
  - Domestic component of public debt is projected to increase from 40 percent of the total in 2009/10 to 61 percent in 2029/30.
- Rationale:
  - Debt ratios generally stabilize as the debt level has declined and fiscal space has been created, which could accommodate a higher deficit.
  - There is room for a shift toward more domestic debt because of a fairly large financial sector and partially captive domestic market.

### Stress-test results and vulnerabilities
- A shock modeled as real GDP growth at historical average minus one standard deviation in 2011–12 causes:
  - PV of debt-to-GDP ratio to increase from 32½ percent in 2009/10 to 38¼ percent in 2029/30;
  - PV of debt-to-revenues ratio to increase from 165 to 190½ percent;
  - debt service-to-revenue ratio to increase from 12¾ percent to 19½ percent.
- The most extreme stress test in the medium-term is a 10 percent of GDP increase in other debt-creating flows in 2011, which causes:
  - PV of debt-to-GDP ratio to peak at 41½ percent in 2011 and stand at 37¾ percent in 2020;
  - PV of debt-to-revenue ratio to peak at 207¾ percent in 2011 and stand at 190¼ percent in 2020.

### V. Authorities’ view
- The authorities concurred with the overall assessment.
- They noted:
  - inclusion of remittances in the analysis was highly appropriate given their important role in the economy;
  - acknowledgement of financial sector vulnerabilities and the associated risks to debt sustainability.

### VI. Conclusion — risk assessment and policy implications
- Overall assessment:
  - Nepal’s external debt dynamics are subject to a moderate risk of distress.
  - With remittances formally included, the baseline scenario is more favorable than previously and debt burden indicators are well below the indicative thresholds.
  - Heightened financial sector vulnerabilities and the potential fiscal costs of financial sector restructuring add considerable risks.
- Interpretation of stress tests:
  - Both the baseline scenario and standard stress tests indicate resilient debt dynamics in which debt indicators do not breach the thresholds on a sustained basis.
  - However, these standard tests are likely to underestimate debt distress because financial sector vulnerabilities and associated risks are not captured.
- Policy recommendations:
  - Nepal’s fiscal policy stance should remain tight in the short run.
  - Fiscal policy could be more accommodative in the medium term to support economic growth while maintaining sound debt dynamics, provided financial sector vulnerabilities are addressed.
  - Stronger and more stable GDP growth combined with foreign financing at favorable terms—preferably through grants—would help Nepal make progress toward achieving its MDG targets while containing risks to debt sustainability.

*Source: IMF staff analysis as presented in the document excerpt.*

### 12. A Fund-supported program may help reduce macroeconomic and financial

### 12. A Fund-supported program may help reduce macroeconomic and financial

### Purpose and policy rationale
- The authorities requested Fund financial support under the Rapid Credit Facility to support reserves as they implement policies to:
  - strengthen the financial sector; and
  - mitigate risks arising from the deceleration of remittance inflows.
- Such policies would reduce the risk of the alternative financial stress scenario materializing and thereby reduce threats to debt dynamics.
- Disbursement of Fund resources of SDR 28.5million (($43.1 million) would have little impact on the baseline scenario.

### Public sector debt: baseline levels and projections (selected figures, in percent of GDP)
- Public sector debt:
  - 2007: 43.4
  - 2008: 40.3
  - 2009: 40.3
  - 2010: 37.4
  - 2011: 36.1
  - 2012: 35.7
  - 2013: 35.5
  - 2014: 35.4
  - 2015: 35.7
  - 2010-15 Average: 36.1
  - 2020: 35.2
- Foreign-currency denominated share of public sector debt:
  - 2007: 30.2
  - 2008: 27.4
  - 2009: 27.0
  - 2010: 23.8
  - 2011: 21.7
  - 2012: 20.3
  - 2013: 19.2
  - 2014: 18.2
  - 2015: 17.4
  - 2020: 14.8
  - 2030: 13.8
- Change in public sector debt (year-on-year):
  - 2007: -6.6
  - 2008: -3.1
  - 2009: 0.0
  - 2010: -2.9
  - 2011: -1.3
  - 2012: -0.4
  - 2013: -0.2
  - 2014: -0.1
  - 2015: 0.2
  - 2016-30 Average: 0.0
  - 2030: 0.1

### Identified debt-creating flows and fiscal balances (selected)
- Identified debt-creating flows (in percent of GDP):
  - 2007: -7.0
  - 2008: -1.2
  - 2009: -3.2
  - 2010: -2.6
  - 2011: -0.4
  - 2012: 0.1
  - 2013: 0.2
  - 2014: 0.3
  - 2015: 0.5
  - 2016-30 Average: 0.0
  - 2030: 0.0
- Primary deficit (in percent of GDP):
  - 2007: 0.9
  - 2008: 1.3
  - 2009: -0.6
  - 2010: 0.7
  - 2011: 1.2
  - 2012: 1.6
  - 2013: 1.4
  - 2014: 1.6
  - 2015: 1.8
  - 2016-30 Average: 2.0
  - 2020: 2.3
  - 2030: 1.8
- Revenue and grants (in percent of GDP) and grants component:
  - Revenue and grants: 2007: 14.0; 2008: 15.3; 2009: 16.9; 2010: 19.9; 2011: 20.0; 2012: 20.0; 2013: 20.0; 2014: 19.8; 2015: 19.6; 2016-30 Average: 19.9; 2020: 20.0
  - Grants (of which): 2007: 2.2; 2008: 2.5; 2009: 2.5; 2010: 3.8; 2011: 4.0; 2012: 3.8; 2013: 3.6; 2014: 3.3; 2015: 3.0; 2016-30 Average: 3.0; 2020: 3.0
- Primary (noninterest) expenditure (in percent of GDP):
  - 2007: 14.9; 2008: 16.6; 2009: 16.3; 2010: 21.5; 2011: 21.4; 2012: 21.6; 2013: 21.8; 2014: 21.9; 2015: 22.0; 2016-30 Average: 22.0; 2020: 22.2

### Automatic debt dynamics and contributions (selected)
- Automatic debt dynamics (in percent of GDP):
  - 2007: -7.9
  - 2008: -2.5
  - 2009: -2.6
  - 2010: -4.2
  - 2011: -1.9
  - 2012: -1.5
  - 2013: -1.6
  - 2014: -1.8
  - 2015: -1.8
  - 2016-30 Average: -2.0
  - 2020: -2.1
- Contribution from interest rate/growth differential:
  - 2007: -2.7
  - 2008: -3.0
  - 2009: -3.0
  - 2010: -2.0
  - 2011: -1.4
  - 2012: -1.2
  - 2013: -1.3
  - 2014: -1.6
  - 2015: -1.6
  - 2016-30 Average: -1.6
  - 2020: -1.7
- Contribution from average real interest rate and real GDP growth (selected):
  - Contribution from average real interest rate (2007): -1.0; (2008): -0.8; (2009): -1.2; (2010): -0.9; (2011): 0.0; (2012): 0.3; (2013): 0.2
  - Contribution from real GDP growth (2007): -1.6; (2008): -2.2; (2009): -1.8; (2010): -1.2; (2011): -1.5; (2012): -1.5; (2013): -1.5
- Contribution from real exchange rate depreciation (2007): -5.2; (2008): 0.5; (2009): 0.3; (2010): -2.2; (2011): -0.5; (2012): -0.4; (2013): -0.2

### Other sustainability indicators and ratios (selected)
- PV of public sector debt (in percent of GDP, selected years):
  - 2010: 35.0
  - 2011: 32.9
  - 2012: 32.5
  - 2013: 32.4
  - 2014: 32.5
  - 2015: 32.5
  - 2020: 32.8
  - 2030: 31.1
- Gross financing need (percent of GDP):
  - 2007: 4.6
  - 2008: 4.1
  - 2009: 2.2
  - 2010: 4.1
  - 2011: 4.3
  - 2012: 4.4
  - 2013: 4.5
  - 2014: 4.7
  - 2015: 5.0
  - 2016-30 Average: 4.7
  - 2020: 4.6

### External debt and external-sector dynamics (selected figures)
- External debt (nominal, percent of GDP):
  - 2007: 32.8
  - 2008: 29.6
  - 2009: 29.4
  - 2010: 26.0
  - 2011: 24.1
  - 2012: 22.7
  - 2013: 21.5
  - 2014: 20.5
  - 2015: 19.6
  - 2020: 16.8
  - 2030: 15.4
- PPG (public and publicly guaranteed) external debt:
  - 2007: 30.2
  - 2008: 27.4
  - 2009: 27.0
  - 2010: 23.8
  - 2011: 21.7
  - 2012: 20.3
  - 2013: 19.2
  - 2014: 18.2
  - 2015: 17.4
  - 2020: 14.8
  - 2030: 13.8
- Change in external debt (percent of GDP):
  - 2007: -5.3
  - 2008: -3.3
  - 2009: -0.2
  - 2010: -3.4
  - 2011: -2.0
  - 2012: -1.4
  - 2013: -1.1
  - 2014: -1.1
  - 2015: -0.8
  - 2020: -0.4
  - 2030: 0.0
- Net current transfers (negative = inflow), percent of GDP:
  - 2007: -19.1
  - 2008: -21.1
  - 2009: -25.6
  - 2010: -17.7
  - 2011: 3.6
  - 2012: -25.5
  - 2013: -26.7
  - 2014: -27.2
  - 2015: -27.6
  - 2016-30 Average: -27.9
  - 2020: -28.0
  - Selected historical averages: -26.3; -19.1; -23.8 (various contexts)
- Net FDI (negative = inflow), percent of GDP:
  - 2007: -0.1
  - 2008: 0.0
  - 2009: -0.2
  - 2010: 0.0
  - 2011: 0.1
  - 2012: -0.2
  - 2013: -0.2
  - 2014: -0.3
  - 2015: -0.3
  - 2016-30 Average: -0.4
  - 2020: -0.4
  - 2030: -0.5

### External debt burden indicators (selected)
- PV of external debt (in percent of GDP, selected):
  - 2010: 24.2
  - 2011: 21.5
  - 2012: 20.4
  - 2013: 19.4
  - 2014: 18.5
  - 2015: 17.6
  - 2020: 16.7
  - 2030: 13.2
- PV of PPG external debt (in percent of GDP):
  - 2010: 21.8
  - 2011: 19.2
  - 2012: 18.1
  - 2013: 17.1
  - 2014: 16.2
  - 2015: 15.3
  - 2020: 14.5
  - 2030: 11.2
- PV of PPG external debt in percent of exports:
  - 2010: 172.9
  - 2011: 186.4
  - 2012: 173.7
  - 2013: 164.3
  - 2014: 157.7
  - 2015: 151.9
  - 2020: 147.3
  - 2030: 129.4
- Debt service-to-exports ratio (in percent):
  - 2007: 12.5
  - 2008: 11.2
  - 2009: 9.5
  - 2010: 12.8
  - 2011: 12.2
  - 2012: 11.9
  - 2013: 11.5
  - 2014: 11.4
  - 2015: 11.2
  - 2020: 8.3
  - 2030: 6.9

### Macroeconomic and fiscal assumptions (key inputs)
- Real GDP growth (in percent):
  - 2007: 3.3
  - 2008: 5.3
  - 2009: 4.7
  - 2010: 4.1
  - 2011: 1.7
  - 2012: 3.0
  - 2013: 4.0
  - 2014: 4.2
  - 2015: 4.4
  - 2016-30 Average: 4.7
  - 2020: 4.8
  - 2030: 4.2
  - Long-term averages: 5.0; 5.5; 5.3 (various horizons)
- Average nominal interest rate on forex debt (in percent):
  - 2007: 1.3
  - 2008: 1.2
  - 2009: 1.1
  - 2010: 1.3
  - 2011: 0.1
  - 2012: 1.2
  - 2013: 1.2
  - 2014: 1.2
  - 2015: 1.3
  - 2016-30 Average: 1.3
  - 2020: 1.3
  - 2030: 1.3
- Average real interest rate on domestic debt (in percent):
  - 2007: -2.8
  - 2008: -2.4
  - 2009: -7.3
  - 2010: -0.6
  - 2011: 3.3
  - 2012: -6.2
  - 2013: 0.8
  - 2014: 2.2
  - 2015: 1.8
  - 2016-30 Average: 0.9
  - 2020: 0.9
  - 2030: 0.1
- Real exchange rate depreciation (in percent, + indicates depreciation):
  - 2007: -15.4
  - 2008: 1.8
  - 2009: 1.3
  - 2010: -2.0
  - 2011: 5.9
  - 2012: -8.3
- Inflation rate (GDP deflator, in percent):
  - 2007: 7.7
  - 2008: 6.7
  - 2009: 13.2
  - 2010: 5.9
  - 2011: 3.1
  - 2012: 11.8
  - 2013: 8.0
  - 2014: 5.6
  - 2015: 5.0
  - 2016-30 Average: 5.0
  - 2020: 5.0
  - 2030: 6.7
- Growth of real primary spending (deflated by GDP deflator, in percent):
  - Historical and projection values generally around 0.0–0.4; e.g., 2007: 0.2; 2008: 0.2; 2009: 0.0; 2010: 0.1; 2011: 0.1; 2012: 0.4; 2013–2030 mostly 0.0–0.1

### Remittances, aid, and financing composition (selected)
- Gross remittances (Billions of US dollars):
  - 2007: 1.5
  - 2008: 2.1
  - 2009: 2.7
  - 2010: 3.0
  - 2011: 3.3
  - 2012: 3.7
  - 2013: 4.1
  - 2014: 4.6
  - 2015: 5.1
  - 2020: 7.8
  - 2030: 15.4
- Aid flows (Billions of US dollars) and grants component:
  - Aid flows total (selected): 2010: 0.7; 2011: 0.8; 2012: 0.8; 2013: 0.8; 2014: 0.8; 2015: 0.9; 2020: 1.4; 2030: 4.0
  - Grants (of which): 2010: 0.6; 2011: 0.6; 2012: 0.6; 2013: 0.6; 2014: 0.6; 2015: 0.6; 2020: 1.0; 2030: 2.8
- Grant-equivalent financing (in percent of GDP, selected):
  - 2013: 4.4; 2014: 4.6; 2015: 4.5; 2016: 4.3; 2017: 3.9; 2018: 3.7; 2019: 3.7; 2020: 3.8; 2021: 3.8 (various years provided)

### Debt-stress and sensitivity analysis (highlights)
- Table 2a and Table 3b present sensitivity analyses (2010–2030) for key indicators under alternative scenarios and bound tests.
- Selected baseline and scenario outcomes (PV of debt and ratios, percent):
  - PV of debt-to-GDP ratio baseline: 2010: 33; 2011: 32; 2012: 32; 2013: 32; 2014: 33; 2015: 33; 2020: 32; 2030: 31
  - PV of debt-to-revenue ratio baseline: 2010: 165; 2011: 162; 2012: 162; 2013: 163; 2014: 164; 2015: 167; 2020: 163; 2030: 156
  - Debt service-to-revenue ratio baseline (selected): 2010: 131; 2011: 141; 2012: 141; 2013: 131; 2014: 131; 2015: 132; 2020: 172; 2030: 3 (table contains varied series for different indicators)
- Notable stress tests and their impacts include:
  - A3. Permanently lower GDP growth: marked increases in debt ratios in later years (e.g., values reaching 42 in some series)
  - B4. One-time 30 percent real depreciation in 2011: large one-year increases in debt indicators (e.g., PV ratios and debt service spikes)
  - A3. Financial Sector Stress Scenario: substantial worsening in multiple debt indicators (reported across tables and figures)
- Figure summaries indicate the most extreme stress tests vary by indicator; examples:
  - In figure panels, most extreme shocks correspond to Combination shock or Terms/One-time depreciation shocks depending on the indicator.

### Key debt-stabilizing metric
- Primary deficit that stabilizes the debt-to-GDP ratio (in percent of GDP):
  - 2007: 7.5
  - 2008: 4.4
  - 2009: -0.5
  - 2010: 4.4
  - 2011: 2.8
  - 2012: 2.0
  - 2013: 1.9
  - 2014: 2.1
  - 2015: 2.1
  - 2016-30 Average: 2.0
  - 2020: 2.1

### Memorandum and other items (selected)
- Nominal GDP (Billions of US dollars):
  - 2007: 10.3
  - 2008: 12.6
  - 2009: 12.6
  - 2010: 14.7
  - 2011: 15.6
  - 2012: 16.8
  - 2013: 18.0
  - 2014: 19.4
  - 2015: 21.1
  - 2020: 33.9
  - 2030: 93.1
- PV of PPG external debt (Billions of US dollars), selected:
  - 2007: 2.7
  - 2008: 2.8
  - 2009: 2.8
  - 2010: 2.8
  - 2011: 2.9
  - 2012: 2.9
  - 2013: 3.0
  - 2020: 3.8
  - 2030: 9.0

*Prepared by the Asia and Pacific Department; Approved by Kalpana Kochhar and Christian Mumssen; May 25, 2010.*

### 1. Fund staff has determined that Nepal maintains an exchange restriction subject

### _cr10185 - 1. Fund staff has determined that Nepal maintains an exchange restriction subject

### Exchange restriction determination
- Fund staff determined Nepal maintains an exchange restriction subject to Article VIII arising from quantitative limits on the availability of foreign exchange for leisure travel abroad.
- On April 2, 2010, the Nepal Rastra Bank (NRB) limited the use of the Passport Facility—through which residents can obtain foreign exchange for leisure travels up to US$ 2000—to no more than two times per year.
- The limit on the amount of foreign exchange that can be obtained is further reduced to US$1,000 for travelers to Tibet of China and SAARC countries (excluding India).
- The current policy of the NRB is not to provide foreign exchange beyond these limits even if the bona fide nature of the request is proved.
- These limits were judged to constitute an exchange restriction inconsistent with Nepal’s obligations under Article VIII of the Fund’s Articles.

### Staff recommendation on retention and approval
- Approval of retention of this restriction is not recommended by the staff.
- Because the restriction is discriminatory among Fund members given that there are two different monetary limits, the staff does not recommend approval of this restriction.

### Additional measures requiring clarification
- Further information was identified as needed to clarify the jurisdictional implications of several other exchange measures, including:
  - the foreign exchange facilities for entrepreneurs,
  - the foreign exchange facilities for students,
  - a potential multiple currency practice.

### Executive Board assessment and macroeconomic context (Public Information Notice No. 10/75)
Findings and outlook:
- Political context: Four years after the end of the civil conflict, Nepal remains in political transition, with a new constitution being drafted and fresh elections expected once the constitution is approved.
- Macroeconomic stability: The exchange rate peg and prudent fiscal policy have been anchors of stability.
- Debt and reserves (by end 2008/09): public debt had declined to 40 percent of GDP from 64 percent in 2001/02, and foreign exchange reserves had increased to 6 months of import cover due to robust remittance inflows.
- Short-term developments (first half of 2009/10):
  - remittances growth slowed,
  - exports declined by 14 percent,
  - reserves declined by about 13 percent,
  - a liquidity crunch ensued in the banking system.
- Near-term economic outlook and projections:
  - Real GDP growth expected to slow to 3 percent in 2009/10 from an estimated 4¾ percent in 2008/09.
  - External current account projected to record a deficit of 2 percent of GDP in 2009/10.
  - Inflation projected at 12 percent by end 2009/10.
  - Anticipated recovery: real GDP growth expected to recover to 4 percent in 2010/11 reflecting expected stronger remittances.
- Risks: weaker remittances, continued high imports, capital flight, heightened financial sector vulnerabilities, political instability. Credit and liquidity risks in the banking system are high.

Directorate views and policy priorities:
- Maintaining the exchange rate peg seen as a key short-term objective to shore up confidence.
- Recommendation to reconsider the type of peg and alternative nominal anchors in the medium term.
- Monetary policy should support the peg by maintaining short-term interest rates above those of India; liquidity management should be strengthened.
- Encouragement to phase out import and foreign exchange restrictions.
- Financial sector: note significant credit and liquidity risks; welcome recent macroprudential measures but stress enforcement; strengthen bank resolution framework and contingency planning; expand regulatory oversight over savings and credit cooperatives.
- Bank licensing policy: tighten licensing and facilitate financial sector consolidation; welcome licensing moratorium; proceed with restructuring of two state-controlled banks.
- Fiscal policy: commend fiscal prudence; keep tight fiscal stance in short term to support peg; encourage efforts to curb tax evasion and broaden the tax base.
- RCF arrangement viewed as helpful in cushioning the shock and boosting confidence; could serve as a bridge to a program under the Extended Credit Facility.

### Selected economic indicators (as presented)
- Real GDP: 2006/07 3.35.34.7 3.04.0
- CPI (period average): 6.47.713.2 11.88.0
- CPI (end of period): 5.112.111.4 12.16.0
- Total revenue and grants (percent of GDP): 14.015.316.9 19.920.0
- Total expenditure and net lending (percent of GDP): 15.917.417.2 22.422.8
- Current expenditure (percent of GDP): 10.611.211.8 15.115.6
- Capital expenditure and net lending (percent of GDP): 5.36.25.4 7.27.2
- Overall deficit before grants (percent of GDP): 4.14.62.7 6.26.8
- Overall deficit after grants (percent of GDP): 1.92.10.2 2.42.8
- Net domestic financing (percent of GDP): 1.61.90.8 2.12.2
- Broad money (percent change): 14.025.327.7 10.6..
- Domestic credit (percent change): 12.019.826.6 18.2..
- Private sector credit (percent change): 12.324.328.3 19.4..
- Current account (in millions of U.S. dollars): -13.8344.0536.3 -305.8-0.3
- Current account (in percent of GDP): -0.12.74.3 -2.10.0
- Trade Balance (in millions of U.S. dollars): -1,977-2,265-2,707 -3,890-3,980
- Trade Balance (in percent of GDP): -19.1-18.0-21.5 -26.4-25.5
- Exports value growth (percent change): 13.4-4.60.5 -11.06.3
- Imports value growth (percent change): 25.88.414.1 30.03.0
- Gross official reserves (in millions of U.S. dollars): 1,9962,4732,907 2,6702,876
- In months of imports of goods and services: 676 55
- Public external debt (percent of GDP): 30.227.427.0 23.821.7
- GDP at market prices (in billions of Nepalese rupees): 728.2818.4969.8 1,116.11,254.1
- Exchange rate (Nrs/US$; period average): 70.565.076.9 ......
- Real effective exchange rate (eop, y/y percent change): 9.5-4.37.3 ......

### Rapid Credit Facility (RCF) disbursement (Press Release No. 10/219)
- The Executive Board approved a disbursement equivalent to SDR 28.52 million (about US$ 42.05 million) under the RCF for Nepal; the full amount was approved for immediate disbursement.
- Purpose: to help address the economic impact of the global economic crisis, addressing external and financial risks and helping catalyze possible donor support.
- RCF features: zero interest rate; grace period of 5½ years; final maturity of 10 years.
- IMF view (statement by Mr. Naoyuki Shinohara): program core elements are a tight monetary and fiscal policy stance to support the exchange rate peg, and efforts to improve financial sector soundness. If fully implemented and external situation improves as envisaged, expected to restore macroeconomic stability and lay conditions for higher growth and poverty reduction; could serve as bridge to a successor Fund arrangement.

*Source: IMF staff report and associated Public Information Notice and Press Release (May–June 2010).*

### 7.      The authorities are aware of both opportunities and challenges arising from the rapid

### _cr10185 - 7.      The authorities are aware of both opportunities and challenges arising from the rapid

### Banking sector developments and financial stability
- Rapid growth of the banking sector has deepened the financial system in Nepal, aided by a rapid growth in remittances.
- Excluding the two state controlled banks, namely Nepal Bank Limited (NBL) and Rastriya Banijya Bank (RBB):
  - capital adequacy ratio for private banks has remained above 12 percent
  - non-performing loans have come down to 3.4 percent
  - profitability as reflected by return to asset ratio is relatively high
- Authorities recognize risks from:
  - proliferation of banks overstretching supervisory capacity of the central bank
  - high credit-to-deposit ratios
  - significant exposure to real estate

### Supervisory assessments and stress testing
- Authorities have taken serious note of stress test results showing high vulnerability to credit and liquidity risks.
- Authorities will continue to assess financial sector health through stress tests.

### Prudential and macroprudential measures adopted
- Moratorium on license applications imposed while licensing policy is reviewed.
  - Moratorium eased for micro finance banks and development banks to expand rural banking services.
- Measures to address excessive leverage and real estate exposure:
  - directed banks to gradually lower the credit-deposit ratio to 80 percent over the medium term
  - limit on loan-to-value fixed at 60 percent of fair market value of collateral
  - planned to lower the single borrower limit from 50 percent to 25 percent of capital with effect from January 2011
  - sectoral exposure limit for credit to real estate and housing loans fixed at 40 percent of total loans in real estate and housing loans

### Bank restructuring, resolution framework, and contingency planning
- Two large government controlled commercial banks placed under outside management with financial assistance from the World Bank.
- Central bank actions:
  - started restructuring some private sector banks
  - Nepal Development Bank has been liquidated
  - restructuring of Nepal Bangladesh Bank completed
- To establish a bank resolution framework:
  - amended Banks and Financial Institutions Act (BAFIA) readied for parliamentary approval
- Contingency planning: authorities seeking technical assistance from the World Bank

### International reserves and balance of payments measures
- Authorities consider a strong international reserve position key to financial sector stability and have taken measures to strengthen the balance of payments position.
- Measures to safeguard foreign exchange resources:
  - raised margin requirements
  - raised quantitative limits on gold and silver imports
  - temporarily limited availability of passport facility for leisure travel to twice a year and $2000 per transaction
  - authorities committed to relaxing such restriction by March 2011 when the balance of payments situation is expected to turn around

### Fiscal policy outcomes and projections
- Authorities committed to maintaining fiscal discipline despite difficult political situation.
  - overall public expenditure has been contained
  - capital spending lower than expected, but social spending maintained, resulting in relatively improved social indicators
- Revenue collection:
  - accelerated from 10.7 percent in 2005/06 to 14.5 percent of GDP in 2008/09
  - rise in imports fueled by substantial growth in remittances boosted revenue
  - revenue administration reforms and Fund technical assistance contributed to revenue growth
- Budget and debt projections:
  - domestic financing of budget deficit projected to remain at 1.6 percent
  - overall budget deficit projected to hover around 2 percent of GDP
  - public debt reduced from 64 percent in 2002/03 to 40 percent of GDP in 2008/09, creating fiscal space for social and physical capital spending

### Structural reforms and program prospects
- Past track record of structural reforms in government finance, public enterprises, and financial sector during earlier Fund programs.
- Political focus on drafting a new constitution and completing the peace process has constrained initiation of further structural reforms.
- Authorities view reforms of public enterprises, especially Nepal Oil Corporation (NOC), as key to streamlining public resources for growth and poverty reduction.
- Authorities look forward to implementing a medium term Fund program as political situation stabilizes with completion of the peace process and promulgation of a new constitution.

### Conclusion and requests
- Authorities express commitment to adopting prudent macroeconomic policies and seek Board support for their request for a disbursement under the RCF.
- Authorities broadly share staff analysis and accept policy advice presented in the Article IV report.
- Mission engagement occurred in Kathmandu during February 24- March 8, 2010.
- Authorities consent to publication of the staff report and the letter of intent.

*Source: _cr10185 - 7.      The authorities are aware of both opportunities and challenges arising from the rapid*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10185.pdf_