## _cr12326 — Exchange Rate Assessment and Competitiveness

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---

### Context
- Political environment: constituent assembly dismissed in June 2012; caretaker government in place; elections notionally slated for April 2013.
- Growth: Real GDP growth slowed from an average of 5 percent over 1990–2000 to around 4 percent over 2001–2012.
- Sectoral composition:
  - Services ≈ 50 percent of total real GDP.
  - Industry share in GDP has fallen by nearly 5 percentage points; manufacturing declined most.
- Remittances:
  - Doubled since 2001 to almost one-quarter of GDP.
  - Source of higher household incomes and knowledge transfer, but a vulnerability to external shocks.

### Recent developments and outlook
- Growth and inflation:
  - Real GDP growth: 4.6 percent in 2011/12; 3.9 percent in 2010/11.
  - Average inflation: 8.3 percent in 2011/12; non-food and core inflation averaged around 9 percent.
- Fiscal performance:
  - Overall budget deficit was less than expected.
  - Capital budget execution (staff estimate): about 73 percent in 2011/12 (compared with 81 percent in 2010/11).
  - Quasi-fiscal liabilities rose due to NEA and NOC losses:
    - NOC losses: Nrs 13 billion (0.8 percent of GDP) in 2011/12.
    - NEA losses: Nrs 6 billion (0.4 percent of GDP) in 2011/12.
    - NOC debts: Nrs 27 billion (1.7 percent of GDP), including Nrs 10 billion owed to the government and Nrs 10 billion borrowed from pension funds with a government guarantee; NOC has stopped servicing loans and requested write-off.
    - NEA debts: Nrs 61 billion (3.9 percent of GDP), owed to the government and not serviced.
- External sector and reserves:
  - Remittances rose nearly 25 percent year-on-year to about 23 percent of GDP in 2011/12.
  - External current account shifted to a sizeable surplus; NRB foreign exchange reserves increased to $4.3 billion (6.8 months of imports).
  - Real effective exchange rate (REER) depreciated by 4.6 percent.
- Monetary and credit aggregates:
  - Reserve and broad money growth: 36.4 and 22.7 percent, respectively—well above nominal GDP growth of 14 percent.
  - Excess reserves (non-remunerated deposits at NRB) climbed; interest rate spreads vis-à-vis India widened.
  - Bank credit to the private sector remained weak despite ample liquidity.
- Financial sector indicators:
  - Reported system-wide capital adequacy ratio (CAR) is above the regulatory minimum and rising.
  - Reported NPLs are low and falling, but data quality and balance sheet risks remain concerns.
  - Profitability remains low overall.
- Outlook:
  - Growth projected to decline to 3.8 percent for 2012/13.
  - Risks: weaker monsoon, political uncertainty, delayed budget, weak private sector credit, slowdown in remittances growth, and spillovers from India’s slowdown.

### Exchange rate assessment (Box 1: key findings)
- Recent depreciation of the Nepali rupee may have contributed to lower import growth in 2011/12 and a current account surplus of 4.7 percent of GDP; sharp decline in construction and low execution of government infrastructure projects may be more important factors.
- Exports remained subdued and market share in India continued to decline.
- Medium-term current account balance projected to remain in deficit.
- Misalignment estimates (models and values as reported):
  - Macroprudential balance (MB) approach: overvaluation of 9 percent (previous assessment 14 percent). (Table later shows MB approach = 9.1)
  - External sustainability (ES) approach: overvaluation around 11 percent (previous assessment 20 percent). (Table later shows ES approach under alternative benchmarks (mean) = 11.6)
  - PPP approach: decline in overvaluation from 19 to 16 percent (table reports PPP approach = 16.3)
- Caveats: interpret results with caution due to data limitations and variation in norms across methodologies.
- Policy-relevant notes:
  - Overvaluation aligns with Nepal’s small export base and large trade gap.
  - NRB has accumulated reserves of six months of import cover; balance of payments is in record surplus; interventions to support the peg are few.

### Monetary and financial sector developments
- Monetary policy in 2011/12 was largely passive, signaling support for balance sheets and private credit; the influx of remittances was only partly sterilized.
- Liquidity and reserve dynamics:
  - Excess reserves rose; reserve money and broad money expanded strongly.
  - Banks’ funding costs fell, boosting interest-based profits, but overall profitability remained low.
- Reported indicators and data caveats:
  - Some improvement reported for Class A (commercial banks) only; aggregate indicators for Class B and Class C not yet available.
  - Accounting framework: loans with overdue interest up to 3 months are classified as “good” with 1 percent provisioning, which may understate NPLs relative to international norms.

### Managing downside macroeconomic risks — fiscal policy and public financial management
- Medium-term fiscal strategy:
  - Aim to keep public debt roughly constant as a share of GDP—implying annual net domestic financing of about 2 percent of GDP.
  - Allow some moderate increase in borrowing to finance key investment and social protection once vulnerabilities are addressed and fiscal costs assessed; scaling up conditional on well-designed schemes and PFM improvements.
- Near-term priority:
  - Pass a full-year budget to avoid under-execution of capital projects, damage to business confidence, and pressure on the banking system.
- Near-term measures:
  - Bolster revenues via tax and customs administration reforms; support IRD three-year reform plan and DOC updated 2009/13 reform plan in line with IMF TA.
  - Collect arrears and reduce non-compliance:
    - Arrears identified in a fraud investigation: Nrs 6.5 billion.
    - Tax arrears: Nrs 29 billion.
    - Non-filer shares: 22 percent for VAT; 56 percent for income tax.
  - Use the Treasury Single Account (TSA):
    - TSA covers 95 percent of revenue and expenditure transactions; staff recommends publication of monthly financial statements and regular reviews of budget execution.

### Box 2 — Potential spillover risks: channels and scenarios
- Channels of potential spillovers:
  - Trade: India accounted for 67 percent of Nepal’s exports and 65 percent of imports in 2011/12.
  - Remittances: equivalent to about ¼ of GDP; main hosts: GCC countries, Malaysia, India.
  - Financial linkages: FDI and cross-border lending may transmit India-related shocks; most of Nepal’s financial flows (a surplus of about 1½ percent of GDP in 2011/12) take the form of trade credit likely associated with India.
  - Confidence shocks: slowdown or loss of confidence could trigger capital flight, forming feedback loops with banking risks.
- Scenarios analyzed:
  - India Slowdown: one percentage point decline in India's growth.
  - Remittance Weaken: one standard deviation decline in remittance growth.
  - Financial Stress: output loss of 30 percent, fiscal cost of 23 percent of GDP in bank rescue.
- Key simulated outcomes (comparisons to baseline):
  - Medium-term Output loss compared to baseline:
    - India Slowdown: -1.0%
    - Remittance Weaken: 0.1%
    - Financial Stress: 30.0%
  - Current account balance by 2016/17 (% GDP):
    - Baseline: -1.2%
    - India Slowdown: -1.4%
    - Remittance Weaken: -2.1%
    - Financial Stress: -1.6%
  - Gross international reserves by 2016/17:
    - Baseline: $5.0 bn
    - India Slowdown: $4.7 bn
    - Remittance Weaken: $4.0bn
    - Financial Stress: $3.9 bn
  - Net domestic financing, 2013-17 average (% GDP):
    - Baseline: 2.3%
    - India Slowdown: 2.5%
    - Remittance Weaken: 2.6%
    - Financial Stress: 6.9%
  - Public Debt/GDP ratio by 2016/17:
    - Baseline: 30.4%
    - India Slowdown: 31.1%
    - Remittance Weaken: 31.6%
    - Financial Stress: 97.2%
- Interpretation:
  - External shocks (notably India’s slowdown) are the main and most likely downside risk, causing visible output loss, reserve decline, and moderate public debt increase.
  - Financial sector distress would produce a large output loss and substantial fiscal rescue costs, potentially leading to unsustainable public debt.
  - Scenarios can be additive.

### Financial sector risks, vulnerabilities, and reform priorities
- Key vulnerabilities and recent developments:
  - Real estate exposure high: direct exposure above 10 percent of total assets for all bank classes; indirect exposure through collateral is nearly two-thirds of total assets.
  - Real estate prices reportedly declined by 30 percent or more off their peak.
  - Data quality and supervisory capacity concerns: reported NPLs may understate weaknesses; each supervisory department has only about 40 personnel; on-site inspection coverage for commercial banks around two percent.
  - NRB forbearance measures: easing restructuring conditions for real estate and margin loans; increasing loan-to-value ceilings for loans against promoter shares; postponement of reduction in real estate sector loan limits.
- Near-term reform priorities (staff recommendations):
  - Complete amendment of the NRB Act promptly to strengthen resolution powers; enact a modified Deposit Guarantee Act.
  - Conduct “deep dive” diagnostic reviews (with World Bank and DFID) and follow up to deal decisively with problematic banks; use mergers only where appropriate and conduct post-merger assessments.
  - Strengthen supervision, implement new PCA framework, transition to IFRS-based accounting for loan classification and provisioning, increase supervisory resources, and improve on-site inspection and bank resolution management.
  - Avoid directed credit policies; if used, targets should be indicative only due to risks to bank efficiency and soundness.
- Medium-term reforms:
  - Review liberal licensing policy and legal framework with three categories of financial institutions.
  - Increase supervisory resources and consider an FSAP.

### Directed credit policy and financial structure (authorities’ stance)
- Authorities support a minimum lending requirement of 10 percent to “productive sectors” (including project finance, insurance, refinance) to support agriculture and power and diversify portfolios away from real estate.
- Financial sector composition overseen by NRB:
  - 32 commercial banks
  - 88 development banks
  - 70 finance companies
  - 22 micro-credit institutions
- Bank assets stabilized at around 80 percent of GDP after peaking above 100 percent in 2009/10.
- Exposure to real estate:
  - Direct exposure to construction and real estate declined from 19½ percent over 2009/2010 to around 16½ percent in 2011/12.
  - Indirect exposure through collateral declined from 66 percent to 56 percent over the same period.
- Stress-test findings (commercial banks, NRB tests):
  - A third of commercial banks see their capital drop below the regulatory minimum under a shock where a quarter of all performing real estate loans are reclassified as loss loans.
  - Standard withdrawal shocks and other deposit-run scenarios show many banks become illiquid under severe runs.

### Reported financial sector indicators (selected exact values)
- Capital adequacy (selected series as presented): Capital fund to risk weighted assets 4.07.29.610.611.5
- Tier 1 capital to risk weighted assets (selected): 1.85.27.99.18.8
- NPLs to total loans (selected): 6.13.62.53.22.6
- Loan loss provision to total loans (selected): 8.25.94.64.03.6
- Reported NPLs among all commercial banks: 2.6 percent in July 2012 (from just over 3 percent at end-FY 2010/11).
- Liquidity indicators (selected): Liquid assets to total assets 11.826.013.111.213.0
- Exposure to real estate (selected shares): Share of real estate and housing loans ...19.420.718.516.9; Share of loans collateralized by land and buildings ...71.758.468.455.9
- Systemic liquidity: banks’ excess reserves with NRB are nearly 90 percent of required reserves (compared to 28 percent a year ago); interbank rates hover at or below 1 percent.
- Stress-test results (summary counts as presented):
  - Standard credit shock: would push capital below regulatory minimum in 20 of 32 commercial banks.
  - 25 percent of performing real estate & housing loans downgraded to loss loans: a third of commercial banks would be under-capitalized.
  - Withdrawal of deposits by 20%: 26 banks illiquid in scenario presented.
- Potential fiscal impact of banking stress:
  - Roughly NR 100 billion ($1.2 billion, about 6 percent of GDP) of deposits could be at risk in a deposit-flight scenario for Class B and C banks outside top 10 by assets.
  - Residual depositor claims could be NR 40-50 billion (about 3 percent of GDP) that the deposit insurance scheme could not cover without further capitalization.
  - Deposit runs at NBL and RBB alone could add more than 5 percent of GDP to fiscal costs.
  - If all banks were affected, initial fiscal costs could rise to as high as one-third of GDP.

### Debt sustainability, stress tests, and fiscal risks
- Risk rating: Nepal at moderate risk of debt distress using the LIC-DSA framework.
- Baseline public debt:
  - Total stock of public debt stable at 33¼ percent of GDP by end-2011/12.
  - External public debt: 20½ percent of GDP (US$ 3½ billion) by end-2011/12.
  - Domestic public debt: 12¾ percent of GDP by end-2011/12.
- Baseline macro assumptions:
  - Real GDP growth: projected to slow to 3¾ percent in 2012/13 from 4½ percent in 2011/12, then gradually accelerate to 4 percent in the medium term.
  - Inflation (GDP deflator): 8¼ percent in 2012/13; 5 percent over the long run.
  - Exchange rate peg to the Indian rupee assumed to remain.
  - Remittance growth projected to moderate to 7½ percent over the long run.
  - NDF at 2¼ percent of GDP over the medium term.
- Baseline projections and selected figures (table excerpts as presented):
  - Real GDP (2009/10–2016/17): 4.8, 3.9, 4.6, 3.8, 3.9, 3.9, 4.0, 4.0
  - CPI (period average, 2009/10–2016/17): 9.5, 9.6, 8.3, 8.3, 8.1, 7.9, 6.9, 6.1
  - Total revenue and grants (% of GDP): 18.0, 17.7, 18.3, 18.1, 17.9, 17.9, 18.1, 18.5
  - Expenditure (% of GDP): 18.8, 18.6, 18.2, 18.6, 18.6, 18.8, 19.0, 19.3
  - Current account (percent of GDP): -2.4, -1.0, 4.7, 0.6, -0.3, -0.6, -0.9, -1.2
  - Gross official reserves (US$ millions): 2,844, 3,074, 4,307, 4,595, 4,770, 4,930, 5,020, 5,045
  - Reserves in months of imports: 5.4, 5.8, 6.8, 6.6, 6.3, 6.0, 5.7, 5.3
  - Remittances (credit): 3,113.3, 3,545.2, 4,413.8, 4,789.0, 5,186.5, 5,614.4, 6,063.5, 6,533.5
- Stress-test highlights:
  - Standard stress tests generally keep indicators below thresholds except in most severe scenarios.
  - Non-standard (financial stress) scenario assumptions: 50 percent loss of central bank reserves; one-time exchange rate depreciation of 33 percent; output loss of 30 percent over 4 years; fiscal cost for bank resolution of 23 percent of GDP.
  - Under financial stress scenario:
    - Public Debt/GDP ratio by 2016/17: 97.2% (versus baseline 30.4%).
    - Net domestic financing, 2013-17 average: 6.9% (versus baseline 2.3%).
    - Gross international reserves by 2016/17: $3.9 bn (4.1 months) (versus baseline $5.0 bn (5.3 months)).
    - Present value of external debt in relation to GDP plus remittances would reach 40½ percent over the medium term (pre-stress level 15¼ percent).
    - Present value of external debt to revenue would rise to 337¾ percent over the medium term.
    - PV of total public debt would exceed 90 percent of GDP and approach almost six times revenue over the medium term.
- Policy implications:
  - Urgently address financial sector weaknesses to reduce debt-burden risk under stress.
  - Contain net domestic financing of deficits to around 2 percent of GDP near term to create space for contingent liabilities.
  - Enhance public financial management and monitor contingent liabilities from SOEs and the pension scheme.

### Statistical issues and data quality
- Data adequacy: generally adequate for surveillance but improvements needed in fiscal external financing data, price statistics, and BOP timeliness and quality.
- Real sector statistics:
  - Compiling authority: Central Bureau of Statistics (CBS), methodology of the 1993 SNA.
  - Shortcomings: no separate estimate of change in inventories; inventories plus statistical discrepancy treated as residual (rose to >13 percent of GDP); doubts over household final consumption and capital formation.
  - Rebasing considerations: CBS considering rebasing to 2004/05 or 2010/11 for reference year 2013/14 or 2014/15.
- Prices and wages:
  - CPI base year 2005/06; CPI basket revision survey underway; completion expected in 2013/14; new CPI series by 2015/16.
- Government finance:
  - GFS 2001 compilation started in 2011.
  - TSA rolled out to 60 districts; TSA covers 95 percent of revenue and expenditure transactions.
  - Remaining gaps: fees collected outside budget, donor direct payments, no government balance sheet in GFS 2001 format.
- Monetary and external sector statistics:
  - NRB broadened monthly monetary statistics to include development banks and finance companies.
  - BOP compiled in BPM5 but IIP not compiled; net errors and omissions large (20 percent of current account balance in 2011/12; previously nearly 40 percent).
  - Recommendations: reconcile trade data with partners, expand coverage to undeclared trade, verify remittance data with MTOs, and base remittance estimates on migrant enumeration over time.
- Table of common indicators: numerous series with latest observations around Aug.–Sept. 2012 for exchange rates, reserves, money, and CPI.

### Staff appraisal and policy recommendations (selected)
- Fiscal policy:
  - Pass a full 2012/13 budget by ordinance; execute spending plans month-to-month.
  - Budget consistent with net domestic financing ≤ 2 percent of GDP; set ambitious investment target.
  - Continue tax and customs reforms; use TSA for transparency and budget execution monitoring.
- Monetary policy:
  - Tighten to signal commitment to price stability and support the peg.
  - Use open market operations and regular T-bill auctions to mop up excess liquidity.
  - Publish a base rate for banks to enhance transparency.
- Financial sector:
  - Accelerate and sequence reforms: amend NRB Act, broaden PCA framework, strengthen supervision and data quality, implement IFRS for provisioning, conduct deep-dive diagnostics, and prepare NRB to resolve problem institutions.
  - Avoid or limit directed credit policies; if used, make targets indicative.
- Structural reforms:
  - Address competitiveness: improve business climate, remove infrastructure bottlenecks (notably power), increase transparency and governance.
  - Investment Board and hydropower initiatives to be advanced carefully.
- IMF engagement:
  - Staff welcomes authorities’ interest in closer engagement, potentially a program; a political consensus on reforms is essential.
  - In the interim, continue policy advice and technical assistance.

*Source: IMF staff report (content unit: _cr12326 - 1. Exchange Rate Assessment and Competitiveness; Boxes and annexes as provided).*

### 1.    Exchange Rate Assessment and Competitiveness ______________________________________________6

### Exchange Rate Assessment and Competitiveness

### Context
- Nepal is a post-conflict state seeking to formalize democracy; the constituent assembly failed to ratify a new constitution by end-May 2012 and was dismissed in June 2012, leaving a caretaker government in place and elections notionally slated for April 2013.
- Real GDP growth slowed from an average of 5 percent over 1990–2000 to around 4 percent over 2001–2012.
- Sectoral composition (average shares):
  - Services account for nearly 50 percent of total real GDP; remainder in agriculture; industry share in GDP has fallen by nearly 5 percentage points, with manufacturing declining most.
- Remittances:
  - Doubled since 2001 to almost one-quarter of GDP.
  - Provide benefits (knowledge transfer, higher household incomes) but represent a source of vulnerability to external shocks.

### Recent Developments and Outlook
- Growth and inflation:
  - Real GDP growth: 4.6 percent in 2011/12; 3.9 percent in 2010/11.
  - Average inflation declined to 8.3 percent in 2011/12 due largely to lower food prices.
  - Non-food and core inflation averaged around 9 percent.
- Fiscal performance:
  - Overall budget deficit was less than expected.
  - Revenue gains notable (customs, VAT, income tax exceeded budget targets); capital spending underperformed.
  - Staff estimate: 2011/12 capital budget execution about 73 percent (compared with 81 percent in 2010/11).
  - Quasi-fiscal liabilities rose due to NEA and NOC losses.
    - NOC losses: Nrs 13 billion (0.8 percent of GDP) in 2011/12.
    - NEA losses: Nrs 6 billion (0.4 percent of GDP) in 2011/12.
    - NOC debts: Nrs 27 billion (1.7 percent of GDP), including Nrs 10 billion owed to the government and Nrs 10 billion borrowed from pension funds with a government guarantee; NOC has stopped servicing loans and requested write-off.
    - NEA debts: Nrs 61 billion (3.9 percent of GDP), owed to the government and not serviced.
- External sector and reserves:
  - Remittances rose nearly 25 percent year-on-year to about 23 percent of GDP in 2011/12.
  - External current account shifted to a sizeable surplus; NRB foreign exchange reserves increased to $4.3 billion (6.8 months of imports).
  - Real effective exchange rate (REER) depreciated by 4.6 percent.
- Monetary and credit aggregates:
  - Growth in net foreign assets contributed to reserve and broad money growth of 36.4 and 22.7 percent, respectively—well above nominal GDP growth of 14 percent.
  - Excess reserves (held as non-remunerated deposits at NRB) climbed; interest rate spreads vis-à-vis India widened.
  - Bank credit to the private sector remained weak despite ample liquidity.
- Financial sector indicators:
  - Reported system-wide capital adequacy ratio (CAR) is above the regulatory minimum and rising.
  - Reported NPLs are low and falling, but data quality and balance sheet risks remain concerns.
  - Profitability remains low overall, reflecting weak credit growth and a prolonged slump in real estate.
- Outlook:
  - Growth projected to decline to 3.8 percent for 2012/13.
  - Risks: weaker monsoon, continued political uncertainty, delayed budget, potentially weak private sector credit, slowdown in remittances growth.
  - India’s slowdown may reduce export demand, inward investment, and remittances to Nepal; inflation is projected to rise in line with developments in India.

### Exchange Rate Assessment (Box 1: Key Findings)
- Recent depreciation of the Nepali rupee may have contributed to lower import growth in 2011/12 and a current account surplus of 4.7 percent of GDP; however, a sharp decline in construction and low execution of government infrastructure projects may be more important factors.
- Exports remained subdued and market share in India continued to decline.
- Medium-term current account balance is projected to remain in deficit.
- Misalignment estimates (models and values as reported):
  - Macroprudential balance (MB) approach: overvaluation of 9 percent (previous assessment 14 percent). (Table later shows MB approach = 9.1)
  - External sustainability (ES) approach: overvaluation around 11 percent (previous assessment 20 percent). (Table later shows ES approach under alternative benchmarks (mean) = 11.6)
  - PPP approach: decline in overvaluation from 19 to 16 percent (table reports PPP approach = 16.3).
- Caveats: results should be interpreted with caution due to data limitations and variation in norms across methodologies.
- Policy-relevant notes:
  - Overvaluation aligns with Nepal’s small export base and large trade gap.
  - NRB has accumulated reserves of six months of import cover; balance of payments is in record surplus; interventions to support the peg are few.

### Monetary and Financial Sector Developments
- Monetary policy in 2011/12 was largely passive, signaling support for balance sheets and private credit; the influx of remittances was only partly sterilized.
- Liquidity and reserve dynamics:
  - Excess reserves rose; substantial growth in reserve money and broad money noted.
  - Banks’ funding costs fell, boosting interest-based profits, but overall profitability remained low.
- Reported indicators and data caveats:
  - Some improvement in financial sector indicators reported for Class A (commercial banks) only; aggregate indicators for Class B and Class C are not yet available.
  - Accounting framework for non-performing assets classifies loans with overdue interest up to 3 months as “good” with 1 percent provisioning, which may understate NPLs relative to international norms.

### Managing Downside Macroeconomic Risks — Fiscal Policy and Public Financial Management
- Medium-term fiscal strategy:
  - Aim to keep public debt roughly constant as a share of GDP—implying annual net domestic financing of about 2 percent of GDP.
  - Once key vulnerabilities are addressed and fiscal costs assessed, there may be room to moderately increase borrowing to finance key investment and social protection schemes, but scaling up should be conditional on well-designed schemes and continued improvements in public financial management.
- Near-term priority:
  - Pass a full-year budget to avoid under-execution of capital projects, damage to business confidence, and pressure on the banking system.
  - Evidence: 2010/11 budget was passed seven months late, resulting in significant under-spending on capital projects.
- Near-term measures to support fiscal goals:
  - Bolster revenues through continued tax and customs administration reforms; support for the three-year reform plan and five-year strategic plan by the Internal Revenue Department (IRD) and an updated 2009/13 reform plan by the Department of Customs (DOC) in line with IMF TA.
  - Collect arrears and reduce non-compliance:
    - Arrears identified in a fraud investigation: Nrs 6.5 billion.
    - Tax arrears: Nrs 29 billion.
    - Non-filer shares: 22 percent for VAT; 56 percent for income tax—indicating a need for improved compliance management.
  - Use the Treasury Single Account (TSA) to improve budget execution and management:
    - TSA covers 95 percent of revenue and expenditure transactions; staff recommends publication of monthly financial statements and regular reviews of budget execution.

*Source: IMF staff report (content unit: _cr12326 - 1.    Exchange Rate Assessment and Competitiveness).*

### Box 2. Nepal: Potential Spillover Risks

### Box 2. Nepal: Potential Spillover Risks

### Channels of potential spillovers
- Trade: India accounted for 67 percent of Nepal’s exports and 65 percent of imports in 2011/12, up about 20 percentage points from a decade ago.  
- Remittances: Remittances are equivalent to about ¼ of GDP. GCC countries, Malaysia, and India are the main hosts of Nepalese migrant workers.  
- Financial linkages: FDI and cross-border lending may be conduits for India-related shocks. Reports indicate extensive involvement or interest of Indian investors in key hydroelectric projects. Most of Nepal’s financial flows (a surplus of about 1½ percent of GDP in 2011/12) take the form of trade credit and therefore are likely to be associated with India.  
- Confidence shocks: Slowdown or loss of confidence—potentially inspired by India or other events—could trigger capital flight as seen in 2009–10, forming a feedback loop between external sector deterioration and escalating banking sector risks.

### Scenarios analyzed in macroeconomic simulations
- India Slowdown: Assumes a one percentage point decline in India's growth.  
- Remittance Weaken: Assumes a one standard deviation decline in remittance growth.  
- Financial Stress: Assumes an output loss of 30 percent, and a fiscal cost of 23 percent of GDP in bank rescue.

### Key simulated outcomes (comparisons to baseline)
- Medium-term Output loss compared to baseline:
  - India Slowdown: -1.0%  
  - Remittance Weaken: 0.1%  
  - Financial Stress: 30.0%
- Current account balance by 2016/17 (% GDP):
  - Baseline: -1.2%  
  - India Slowdown: -1.4%  
  - Remittance Weaken: -2.1%  
  - Financial Stress: -1.6%
- Gross international reserves by 2016/17:
  - Baseline: $5.0 bn  
  - India Slowdown: $4.7 bn  
  - Remittance Weaken: $4.0bn  
  - Financial Stress: $3.9 bn
- Net domestic financing, 2013-17 average (% GDP):
  - Baseline: 2.3%  
  - India Slowdown: 2.5%  
  - Remittance Weaken: 2.6%  
  - Financial Stress: 6.9%
- Public Debt/GDP ratio by 2016/17:
  - Baseline: 30.4%  
  - India Slowdown: 31.1%  
  - Remittance Weaken: 31.6%  
  - Financial Stress: 97.2%

### Interpretation of simulation results
- External shocks (notably India’s slowdown) are the main and most likely downside risk and could cause visible output loss, a rapid decline of foreign exchange reserves, and a moderate increase in public debt.  
- Financial sector distress would produce a large output loss over the medium term and substantial fiscal rescue costs, potentially leading to unsustainable public debt.  
- Scenarios are potentially additive: elevated global uncertainty could reduce remittances, and external shocks could be amplified by financial sector vulnerabilities.

### Financial sector risks and recent developments
- Real estate exposure remains high: direct exposure to real estate is above 10 percent of total assets for all classes of banks and higher for smaller institutions; indirect exposure through collateral is nearly two-thirds of total assets. Real estate prices are said to have declined by 30 percent or more off their peak.  
- Data quality and supervisory capacity concerns: reported NPLs may understate weaknesses; supervisory resources are limited (each supervisory department has only about 40 personnel). On-site inspection coverage for commercial banks is around two percent.  
- NRB forbearance measures in place include easing restructuring conditions for real estate and margin loans, increasing loan-to-value ceilings for loans against promoter shares, and postponement of reduction in real estate sector loan limits.  
- Steps to strengthen regulation and supervision:
  - Introduce a 1 percent capital buffer; some Basel III elements—including 4.5 percent common equity Tier 1—are under consideration.  
  - Amend NRB Act to allow swift resolution of problem banks (draft in final stages).  
  - Broaden prompt corrective action framework to include liquidity and NPA triggers; issue stress test guidelines and ICAAP guidelines.  
  - Split single department supervising class-B and C banks into two dedicated departments; improve on-site inspection practices.  
  - Create a Financial Stability Unit in the NRB to produce semi-annual financial stability reports.  
  - Government injected capital into two insolvent state-owned commercial banks as part of the partial 2012/13 budget.  
  - NRB requirement that banks extend at least 10 percent of total credit to agriculture and/or energy sectors; work on a base lending rate underway.  
  - Moratorium on licensing new commercial banks, development banks and finance companies extended for another year; regulatory forbearance and tax incentives extended to encourage mergers.

### Near-term financial sector reform priorities (staff recommendations)
- Complete amendment of the NRB Act promptly to strengthen NRB’s resolution powers; enact a modified Deposit Guarantee Act to expedite repayment processes.  
- Conduct “deep dive” diagnostic reviews (with World Bank and DFID assistance) and decisively follow up to deal with problematic banks, including resolution for non-viable banks; mergers may be used for viable banks but should not substitute for proper restructuring and recapitalization. Conduct thorough post-merger assessments.  
- Strengthen supervision and implement the new PCA framework; transition to IFRS-based accounting standards for loan classification and provisioning as planned. Increase supervisory resources and train new staff for broader and deeper on-site inspection and bank resolution management.  
- Avoid directed credit policies; if targets for specific sectors are used, they should be indicative only given risks to bank efficiency and soundness.

### Medium-term financial sector reforms
- Review liberal licensing policy that produced a large number of banks while maintaining the moratorium on new licenses.  
- Review legal framework with three categories of financial institutions without clear business-scope differences.  
- Increase supervisory resources and consider an FSAP to help set priorities and a roadmap for reforms.

### Authorities’ views (as reported)
- Authorities broadly agreed with staff recommendations and highlighted the need to pass a full-year government budget and target net domestic financing of no more than 2 percent of GDP. A full-year budget has been prepared, and MOF was seeking to pass it by presidential ordinance before the end of November.  
- Authorities saw scope for continued gains in VAT, income tax, and customs collection and emphasized reforms at IRD and DOC, targeted incentive schemes, and further technical assistance from the Fund.  
- They concurred on the need for an automatic pricing mechanism for fuels but noted political and welfare-protection requirements; NOC’s interim financial losses should be accommodated within the 2012/13 budget with a supplemental budget later in the year, and outstanding debts/arrears cleared conditional on an audit and strategy to prevent new arrears.  
- On pensions, authorities noted an employee contribution system was initiated in 2006 but terminated in 2009 after public protest; funding and actuarial analysis for the on-budget defined-benefit scheme are needed.  
- On monetary policy, authorities acknowledged past looseness and the need to tighten to address rising inflation and the interest rate wedge vis-à-vis India, while continuing to support the exchange rate peg.  
- On financial sector reform, authorities emphasized a deliberate gradual approach, recognized legislative reform to strengthen NRB’s resolution powers as a priority, were advancing NRB Act amendments to be delivered to Government in October 2012, and expressed interest in an FSAP.  

*Source: IMF staff report excerpt titled "Box 2. Nepal: Potential Spillover Risks".*

### 22.      The authorities view a minimum level of credit to ‘productive sectors’ as a useful

### 22. The authorities view a minimum level of credit to ‘productive sectors’ as a useful policy

### Directed credit policy and implementation
- Authorities support a minimum lending requirement of 10 percent to “productive sectors,” broadly defined to include project finance, insurance, and refinance.
- Rationale: lending to agriculture and the power sector is expected to support growth in those sectors and help diversify banks’ portfolios that are highly exposed to real estate.
- Complementary measures under way or proposed:
  - Support for directed lending with credit insurance.
  - Further development of micro-insurance for agricultural credit highlighted as useful.
  - In the energy sector, risks are perceived to be already contained via power purchase agreements.

### Financial sector structure and vulnerabilities
- The financial sector composition overseen by the NRB includes:
  - 32 commercial banks
  - 88 development banks
  - 70 finance companies
  - 22 micro-credit institutions
- Bank assets have stabilized at around 80 percent of GDP, after spiking to above 100 percent during the 2009/10 credit boom.
- The system is dominated by commercial banks—accounting for nearly 80 percent of assets and deposits; the remainder is split between development banks and finance companies.
- Historical weaknesses:
  - Weak licensing rules and supervision in previous years led to proliferation of banks with unsound lending practices and high exposure to a booming real estate sector that subsequently corrected and remains stagnant.

### Exposure to real estate and stress-test findings
- Direct exposure to construction and real estate declined from 19½ percent over 2009/2010 to around 16½ percent in 2011/12.
- Indirect exposure through collateral declined from 66 percent to 56 percent over the same period.
- Stress-test outcomes (commercial banks, NRB tests):
  - A third of commercial banks see their capital drop below the regulatory minimum under a shock in which a quarter of all performing real estate loans are reclassified as loss loans.
- Stress-testing scenarios and shocks described:
  - Standard credit shock:
    - 25 percent of performing loans of real estate & housing sector directly downgraded to loss loans
    - Alternative formulation: 15 percent performing loans deteriorated to substandard, 15 percent substandard loans deteriorated to doubtful, 25 percent doubtful loans deteriorated to loss, 5 percent of performing loans deteriorated to loss.
  - Standard withdrawal shock:
    - Withdrawal of deposits by 20%
    - Withdrawal of deposits by top 3 institutional depositors.
    - Withdrawal of deposits by top 5 individual depositors.
    - Withdrawal of customer deposits by 2%, 5%, 10%, 10%, and 10% for five consecutive days respectively.
- Sector share of credit to commercial banks (July 2012) — numerical values shown in source:
  - 3.8
  - 0.4
  - 24.5
  - 9.8
  - 6.6
  - 4.3
  - 35.6
  - 15.0

### Other issues: IMF engagement, investment climate, AML/CFT
- IMF engagement:
  - Authorities discussed closer engagement with the Fund, including through an ECF or other program.
  - Authorities noted potential benefits for advancing reform, catalyzing donor support, and providing an anchor of stability, but highlighted high program risks in the absence of a consensus government and constituent assembly.
  - In absence of urgent BOP need, authorities preferred time to reach a political situation conducive to a consistent policy framework and ambitious reforms; interim preference for continued coordination on policy advice and technical assistance.
- Investment and trade:
  - Government continued liberal trade and investment policies; significant sectors including hydropower opened to foreign investment and ownership.
  - Government designated 2012/13 as an “investment year” and created an Investment Board to focus on large projects worth more than Rs 10 billion (USD 130 million) and certain key sectors.
  - Impediments remain: political instability, labor unrest, bureaucratic delays and inefficiencies, perceived corruption, perennial power shortages.
- AML/CFT:
  - September 2010 AML/CFT assessment revealed serious deficiencies.
  - FATF’s International Cooperation Review Group agreed an action plan with Nepal; IMF technical assistance supports improvements.
  - TA led to adoption of an AML/CFT National Strategy in 2011.
  - Ongoing assistance focuses on drafting amendments to the AML/CFT law, developing the financial intelligence unit, and creating a risk-based tool for offsite supervision.

### Staff appraisal — macroeconomic and structural priorities
- Recent performance and risks:
  - Economic outturns for the past year described as favorable, with progress on structural reforms amid difficult politics.
  - Monetary policy was accommodative but aimed to reduce pressure on balance sheets without fueling inflation or immediate pressure on the exchange rate peg.
  - Expected deterioration in 2012/13 due to political impasse, a likely late monsoon lowering agricultural output, negative spillovers from India’s slowdown, and potential lower remittances.
- Fiscal policy guidance:
  - Urged passage of a full 2012/13 budget by ordinance and prompt month-to-month execution of spending plans.
  - Budget should be consistent with net domestic financing of no more than 2 percent of GDP, and set a suitably ambitious target for investment spending.
  - Continued tax and customs reform and use of the TSA recommended to improve transparency and identify weak budget implementation areas.
- Quasi-fiscal and contingent liabilities:
  - Medium-term sustainability hinges on managing quasi-fiscal liabilities in state enterprises, public pension schemes, and potentially the financial sector.
  - Losses at NOC and NEA represent current and future drains on public resources, including a large stock of outstanding arrears.
  - Public pension scheme is growing in cost and lacks an independent funding source.
  - Recommended actions:
    - Restructure and reform NEA quickly.
    - Introduce an automatic adjustment mechanism for fuel prices to bring NOC to cost-recovery.
    - Complementary actions to protect the most vulnerable and Fund technical assistance for reform design.
    - Undertake a review of the public pension scheme supported by an actuarial analysis.
- Monetary policy recommendations:
  - Tighten monetary policy to signal a clear intention to price stability and to support the exchange rate peg.
  - Use open market operations and regular auction of T-bills to mop up excess liquidity.
  - Establishment and publication of a base rate for banks is a welcome transparency step.
- Financial sector reform recommendations:
  - Accelerate and sequence financial sector reforms to avoid a disorderly adjustment.
  - Prioritize expanded prompt corrective action framework and enact the amended NRB Act as soon as possible to complete crisis resolution framework.
  - Use upcoming diagnostic reviews for deep-dive assessments of vulnerable institutions (those most exposed to real estate), and prepare NRB to intervene and resolve problem institutions where necessary.
- Structural reforms and governance:
  - Address poor business climate, power shortages, weak governance, and difficult labor relations to achieve higher, more inclusive medium-term growth.
  - Investment Board seen as a welcome step to advance growth-enhancing infrastructure projects.
  - Increase transparency and good governance to boost credibility and public confidence:
    - Regular publication of fiscal, monetary, and financial sector data on MOF and NRB websites.
    - Appointment of an Auditor General.
    - Quantify and report quasi-fiscal operations and tax expenditures (examples include price subsidies to fuel and electricity, interest rate subsidies, tax exemptions); these include price subsidies to fuel and electricity estimated at 1.2 percent of GDP in 2011/12 and should preferably be entered on the budget explicitly as expenditures.
  - Continued progress on AML/CFT issues encouraged.
- IMF engagement going forward:
  - Staff welcomes authorities’ continued interest in close engagement, including a potential program.
  - A political consensus and common view on economic and structural reform priorities deemed essential for successful engagement.
  - In the interim, staff will continue to offer advice and facilitate technical assistance.

*Source: IMF staff report excerpt (provided content).*

### 35.      It is recommended that the next Article IV consultation takes place on the standard 12

### _cr12326 - 35.      It is recommended that the next Article IV consultation takes place on the standard 12

### Recommendation
- It is recommended that the next Article IV consultation takes place on the standard 12 month cycle.

### Macroeconomic overview: output and prices (annual percent change)
- Real GDP: 4.8, 3.9, 4.6, 3.8, 3.9, 3.9, 4.0, 4.0 (2009/10–2016/17)
- CPI (period average): 9.5, 9.6, 8.3, 8.3, 8.1, 7.9, 6.9, 6.1
- CPI (end of period): 9.0, 9.7, 11.5, 8.2, 7.7, 7.2, 6.7, 5.5
- Non-food CPI (end of period): 7.4, 7.6, 11.2, ...  ............

### Fiscal indicators (in percent of GDP)
- Total revenue and grants: 18.0, 17.7, 18.3, 18.1, 17.9, 17.9, 18.1, 18.5
- Expenditure: 18.8, 18.6, 18.2, 18.6, 18.6, 18.8, 19.0, 19.3
- Expenses: 15.6, 15.2, 15.1, 15.7, 15.3, 15.5, 15.7, 15.8
- Net acquisition of Nonfinancial Assets: 3.2, 3.4, 3.1, 2.9, 3.3, 3.3, 3.3, 3.5
- Net lending/borrowing: -0.8, -1.0, 0.1, -0.5, -0.7, -0.9, -0.9, -0.8
- Net Incurrence of Liabilities: 1.8, 2.0, 1.4, 2.1, 2.3, 2.5, 2.5, 2.5
- Foreign net incurrence of liabilities: 0.0, -0.3, -0.1, -0.2, 0.0, 0.2, 0.2, 0.2
- Domestic (above the line) net incurrence of liabilities: 1.7, 2.3, 1.4, 2.3, 2.3, 2.3, 2.3, 2.3

### Government operations (selected levels and ratios)
- Total revenue and grants (Nrs billions): 214.7, 241.6, 311.8, 285.1, 374.0, 316.7
- Total revenue (Nrs billions): 176.2, 197.1, 241.7, 244.4, 288.4, 277.2
- Tax revenue (Nrs billions): 154.7, 171.8, 209.2, 211.7, 249.8, 244.9
- Grants (Nrs billions): 38.5, 44.5, 70.1, 40.7, 85.7, 39.5
- Expenditure (Nrs billions): 224.0, 255.0, 339.1, 283.5, 382.8, 325.3
- Interest payments (Nrs billions): 10.0, 12.7, 16.6, 15.2, 18.8, 16.4
- Net Acquisition of Nonfinancial Assets (Nrs billions): 37.8, 46.8, 70.3, 49.0, 83.1, 51.0
- Net lending/borrowing (Nrs billions): -9.2, -13.4, -27.3, 1.7, -8.8, -8.6
- Primary Balance (in percent of GDP): -0.9, -1.1, -2.0, -0.4, -1.7, -1.1
- Public debt (percent of GDP, memorandum): 35.4, 33.3, 33.7, 33.3, 32.2, 31.3

### Money and credit (annual percent change and levels)
- Broad money (y/y percent change): 14.1, 12.3, 22.7, 12.5
- Domestic credit (y/y percent change): 16.8, 14.6, 8.0, 14.4
- Private sector credit (y/y percent change): 14.2, 13.9, 11.3, 13.0
- Reserve money (Nrs billions, selected): 218.5, 234.2, 319.3, 358.4
- Net foreign assets of NRB (Nrs billions): 203.0, 211.5, 373.7, 395.4
- Broad money (levels, Nrs billions): 719.6, 922.0, 1,131.0, 1,272.5

### Investment and saving (in percent of nominal GDP)
- Gross investment: 37.1, 32.5, 32.8, 32.9, 33.4, 33.6, 33.9, 34.1
- Private investment: 30.0, 25.3, 25.7, 26.0, 26.0, 26.1, 26.3, 26.3
- Gross national saving: 34.7, 31.6, 37.5, 33.5, 33.1, 33.0, 33.0, 32.9
- Private saving: 32.6, 29.6, 34.4, 31.0, 30.0, 30.0, 29.8, 29.4

### Balance of payments and external sector (in million US$ unless noted)
- Current account (levels): -378, -181, 909, 128, -63, -142, -221, -318
- Current account (percent of GDP): -2.4, -1.0, 4.7, 0.6, -0.3, -0.6, -0.9, -1.2
- Trade balance (levels): -4,078, -4,470, -4,605, -5,540, -6,042, -6,596, -7,178, -7,774
- Exports, f.o.b.: 848.8, 960.6, 1,008.4, 1,077.5, 1,164.2, 1,255.9, 1,353.1, 1,459.5
- Imports, f.o.b.: -4,926.7, -5,430.2, -5,613.2, -6,617.1, -7,205.8, -7,852.2, -8,530.8, -9,233.7
- Remittances (credit): 3,113.3, 3,545.2, 4,413.8, 4,789.0, 5,186.5, 5,614.4, 6,063.5, 6,533.5
- Gross official reserves (US$ millions): 2,844, 3,074, 4,307, 4,595, 4,770, 4,930, 5,020, 5,045
- Reserves in months of imports of goods and services: 5.4, 5.8, 6.8, 6.6, 6.3, 6.0, 5.7, 5.3
- Nominal GDP (US$ millions, memorandum): 15,956, 18,977, 19,415, 20,273, 22,017, 23,904, 25,764, 27,556

### External linkage and spillover scenarios (Appendix I: Spillover Risks)
- Three scenarios analyzed for spillovers:
  - (i) India’s slowing growth.
  - (ii) Slowing remittances against the backdrop of softening global outlook.
  - (iii) Banking sector distress triggered by external shocks given preexisting financial sector fragilities.
- Key points:
  - Slower growth in India represents substantial risks to Nepal’s output.
  - Remittance shocks could weaken the balance of payments.
  - Financial sector distress could cause a large output loss over the medium term and substantial public-sector rescue costs, potentially leading to unsustainable debt dynamics.
- Links to India and other countries:
  - Trade: Some 60–70 percent of Nepal’s exports and imports were associated with India in 2011/12.
  - Remittances: Remittances are equivalent to about ¼ of GDP. It is believed there are 1½–2 million Nepalese workers in India, who account for about 20 percent of Nepal’s receipts of remittances.
  - Financial linkages: BIS data shows foreign bank loans and deposits with Nepalese banks amount to $80 million (0.4 percent of GDP).

### Financial sector: indicators and vulnerabilities (Commercial Banks' FSIs and observations)
- Capital fund to risk weighted assets (2001–2012 sample points): -5.5, -9.9, -12.0, -9.1, -6.3, -5.3, -1.7, 4.0, 7.2, 9.6, 10.6, 11.5
- Tier 1 capital to risk weighted assets (selected): 1.8, 5.2, 7.9, 9.1, 10.0
- NPLs to total loans (selected): 2.4, 28.8, 22.8, 18.9, 13.2, 10.6, 6.1, 3.6, 2.5, 3.2, 2.6
- Loan loss provision to total loans (selected): 20.0, 15.1, 12.4, 8.2, 5.9, 4.6, 4.0, 3.6
- Return on equity (ROE) (selected): 31.4, 35.2, 34.7, 33.9, 25.3, 22.5
- Return on assets (ROA) (selected): 6.2, 4.3, 1.4, 2.0, 4.9, 1.9, 1.7, 1.5
- Liquidity indicators (selected): Liquid assets to total assets: 22.1, 18.2, 12.5, 13.6, 9.4, 9.1, 9.0, 11.8, 26.0, 13.1, 11.2, 13.0
- Exposure to real estate (selected shares): Share of real estate and housing loans: 19.4, 20.7, 18.5, 16.9; Share of loans collateralized by land and buildings: 71.7, 58.4, 68.4, 55.9

### Roadmap for financial sector reform (selected actions)
- Identify problems among banks and FIs:
  - Identify systemically important banks and take appropriate resolution actions.
  - Conduct "deep-dive" assessments, focusing on banks exposed to real estate and large public sector banks, preferably by reputed international firms; with NRB to follow up with appropriate corrective strategies.
- Strengthen institutional capacity:
  - Revise legal framework, including: implement amendments to NRB Act to help streamline intervention and resolution procedures; implement revised Deposit Guarantee Act.
  - Remove gaps, inconsistencies, and overlaps among various legislations governing the financial sector.
  - Strengthen prudential standards and enhance enforcement, including higher capital adequacy for systemic banks.
- Restructure financial institutions and deposit protection:
  - Strengthen deposit guarantee, including: conduct deposit survey, assess capital requirements of deposit insurance corporation and strengthen its capacity.
  - Establish action plan for government intervention in failed banks, specifying roles and responsibilities, as well as use of deposit insurance.
  - Restructure insolvent state owned banks after conducting independent audits and diagnostic reviews.
- Supervisory and regulatory measures:
  - Phase out regulatory forbearance granted in 2010/11, reduce exposures to real-estate, tighten margin lending.
  - Step up on-site inspection and enhance supervisory capacity.
  - Review and rationalize licensing framework.
  - Review and strengthen accounting / provisioning standards, in conjunction with implementation of IFRS. Implement over selected time frame (to allow for adjustment).

### Millennium Development Goals (MDGs) status indicators (Table highlights)
- Goal 1: Eradicate Extreme Poverty and Hunger
  - 1a: Halve the proportion of people whose income is less than $1.25 a day. — Close to Target (marked x)
  - 1b: Achieve full and productive employment and decent work for all. — Close to Target (marked x)
  - 1c: Reduce by half the proportion of people who suffer from hunger. — Close to Target (marked x)
- Goal 2: Achieve Universal Primary Education. — On Target (marked x)
- Goal 3: Promote Gender Equality and Empower Women. — On Target (marked x)
- Goal 4: Reduce Child Mortality. — On Target (marked x)
- Goal 5: Improve Maternal Health
  - 5a: Reduce the maternal mortality ratio by three-quarters. — Close to Target (marked x)
  - 5b: Achieve universal access to reproductive health. — Close to Target (marked x)
- Goal 6: Combat HIV/AIDS, Malaria and Other Diseases
  - 6a: Halt and reverse the spread of HIV/AIDS. — On Target (marked x)
  - 6b: Achieve universal access to treatment for HIV/AIDS for all those who need it. — On Target (marked x)
  - 6c: Halt and reverse the incidence of Malaria and other major diseases. — On Target (marked x)
- Goal 7: Ensure Environmental Sustainability (selected)
  - 7a: Climate change and GHG emission. — Close to Target (marked x)
  - 7b1: Reverse loss of forest. — Close to Target (marked x)
  - 7c1: Halve proportion of population without sustainable access to improved water source. — Close to Target (marked x)
  - 7c2: Halve proportion of population without sustainability access to improved sanitation. — Close to Target (marked x)
- Goal 8: Develop a Partnership for Development. — On Target (marked x)

*Sources: Nepalese authorities; and IMF staff estimates and projections.*

### 0.77 percentage points. Dabla-Norris et al. (2012)

### _cr12326 - 0.77 percentage points. Dabla-Norris et al. (2012)

### Shock Scenarios — overview
- IMF staff note that Asian LIC’s growth will lose 0.71 percentage points over a two-year horizon given a one percentage point decrease of real GDP growth in major emerging market leaders (India in this case).
- Remittance linkages create visible business cycle synchronization between remittance source countries and recipients.

### Scenario 1: India’s Slowdown
- Assumption: a one percentage point decline of India’s growth from the baseline scenario (5.6 percent) in 2012/13; characterized as a one-off shock with growth recovering gradually to the baseline level of 6.9 percent by 2016.
- Medium-term impacts for Nepal:
  - Medium-term Output loss compared to baseline: -1.0%
  - Current account balance by 2016/17 (% GDP): -1.4% (versus baseline -1.2%)
  - Gross international reserves by 2016/17: $4.7 bn (4.9 months) (versus baseline $5.0 bn (5.3 months))
  - Net domestic financing, 2013-17 average (% GDP): 2.5% (versus baseline 2.3%)
  - Public Debt/GDP ratio by 2016/17: 31.1% (versus baseline 30.4%)
- Additional notes:
  - Nepal’s growth path could experience an output loss of 1 percent over the medium term, though uncertainty regarding remittances and the impact on Indian investment suggests the dampening effect could be higher.
  - Import cover of reserves falls to 5 months compared to 5¼ months in the baseline scenario by end 2016/17.
  - Fiscal revenue and foreign grants and loans would decline, increasing NDF to 2½ percent of GDP compared to 2¼ percent in the baseline.

### Scenario 2: Decline in Remittance Growth
- Assumption: remittance growth declines by one standard deviation (4 percentage points), potentially triggered by a slump in oil prices affecting GCC countries.
- Medium-term impacts for Nepal:
  - Medium-term Output loss compared to baseline: -0.1%
  - Current account balance by 2016/17 (% GDP): -2.1% (versus baseline -1.2%)
  - Gross international reserves by 2016/17: $4.0 bn (4.2 months) (versus baseline $5.0 bn (5.3 months))
  - Net domestic financing, 2013-17 average (% GDP): 2.6% (versus baseline 2.3%)
  - Public Debt/GDP ratio by 2016/17: 31.6% (versus baseline 30.4%)
- Additional notes:
  - Import cover of reserves declines to 4¼ months by 2016/17.
  - Lower remittances would partly self-correct through slower imports.
  - Fiscal revenue will decline due to slower imports and weaker activity, increasing NDF to just above 2½ percent of GDP.

### Scenario 3: Financial Sector Distress
- Context: Nepal’s financial sector exhibits significant vulnerabilities—low profitability, weak capital base, substantial exposure to a frozen real estate market; past remittance downturns contributed to liquidity squeezes.
- Assumed crisis dynamics (middle-range estimate based on international experience):
  - Real GDP loss could reach 30 percent in the first four years of a financial crisis before growth recovers to the baseline trend.
  - Reserves would fall by half in the first two quarters of the crisis year due to a widening current account balance and capital flight.
  - Fiscal cost would be about ¼ of GDP, with heavy foreign borrowing over the long run.
- Medium-term impacts for Nepal under financial stress:
  - Medium-term Output loss compared to baseline: -30%
  - Current account balance by 2016/17 (% GDP): -1.6% (versus baseline -1.2%)
  - Gross international reserves by 2016/17: $3.9 bn (4.1 months) (versus baseline $5.0 bn (5.3 months))
  - Net domestic financing, 2013-17 average (% GDP): 6.9% (versus baseline 2.3%)
  - Public Debt/GDP ratio by 2016/17: 97.2% (versus baseline 30.4%)
- Debt sustainability impacts (joint Bank-Fund DSA estimates):
  - Present value of external debt in relation to GDP plus remittances would reach 40½ percent over the medium term (pre-stress level 15¼ percent).
  - Present value of external debt to revenue would rise to 337¾ percent over the medium term.
  - Present value of total public debt would exceed 90 percent of GDP and approach almost six times revenue over the medium term.

### International evidence on banking crises (selected metrics and Nepal scenario)
- Average (across sample): Fiscal cost 22.0 (percent of GDP); Reserve Loss 28.0 (cumulative loss over first 2 quarters); Depreciation 32.0 (total over first 2 quarters, percent); Output loss 31.0 (cumulative over 3 years).
- Maximum observed: Fiscal cost 57.0; Reserve Loss 53.0; Depreciation 73.0; Output loss 98.0.
- Nepal scenario (assumed for a major financial crisis): Fiscal cost 23.0; Reserve Loss 50.0; Depreciation 33.0; Output loss 30.0.

### Financial sector vulnerabilities and recent developments
- Key structural and recent issues:
  - Proliferation of banks: number increased from 85 to nearly 200 between 2002 and 2012 (Classes A, B, C treated as the “banking system/sector”).
  - Banking sector size: assets grew from 60 percent of GDP in 2001 to a peak of 100 percent in 2009, stabilizing around 80 percent more recently.
  - Loans and advances to private sector rose from 25 percent of GDP in 2004 to nearly 40 percent.
  - Commercial banks account for four-fifths of banking sector assets and deposits; NBL and RBB account for 13 percent of deposits and 11 percent of assets and have operated with negative capital for the past decade.
  - Real estate bubble collapse (peak in 2008) and a remittance slowdown in early 2011 led to a severe liquidity squeeze in April–May 2011.
  - NRB response to 2011 stress: large-scale liquidity support through multiple lending windows and regulatory forbearance; twenty banks (26 percent of deposits) received liquidity assistance.
- Structural weaknesses identified:
  - Resource and capacity constraints at the NRB, undermining supervision of nearly 200 financial institutions.
  - NRB’s authority to resolve weak banks hampered by the legal framework.
  - Potentially extended timeframe for returning two large state-owned banks to minimum capital adequacy.
  - Static real estate market impairing bank assets.
  - Poorly understood inter-linkages and ownership structures across financial institutions and subsidiaries.
  - Weak data quality and accounting that may understate balance sheet problems.
- Regulatory and policy actions:
  - Recapitalization plans announced and partially implemented for two insolvent state banks.
  - NRB encouraged mergers (forty banks approached NRB for merger approval; 19 approvals granted since May 2011).
  - Monetary policy statement for FY2012/13 adds PCA triggers on NPLs and liquidity ratios in addition to capital adequacy.
  - Amendments to the NRB Act to empower faster resolution are in final drafting stages, but implementation hampered by lack of Parliament.
  - IMF technical assistance focused on crisis management framework, banking supervision and diagnostics, deposit insurance guidance, legal framework for bank resolution, and AML/CFT support.

### Structure of the financial system — selected facts
- Institutional counts and market structure:
  - Nearly 200 banks (Class A, B, C) plus 22 Class D micro-credit institutions and thousands of rural credit cooperatives.
  - 24 insurance companies and 225 listed companies, of which 80 percent are banks or non-bank financial institutions.
  - More than 50 remittance agencies overseen by NRB’s foreign exchange department.
- Market shares and dynamics:
  - Banking sector assets roughly 80 percent of GDP at present.
  - Commercial banks dominate assets and deposits; Class B and C institutions are smaller, more numerous, and perceived to have governance and asset-quality weaknesses.
  - Cross-shareholding and margin lending: three quarters of margin loans are against bank shares and may constitute 2 percent of total loans.
- Regulatory fragmentation:
  - NRB licenses, regulates, and supervises deposit-taking institutions; SEBON oversees capital-market participants; Insurance Board supervises insurance companies.
  - Deposit guarantee scheme run by the Deposit and Credit Guarantee Corporation (DCGC) may have limited effectiveness.

*Source: _cr12326 - 0.77 percentage points. Dabla-Norris et al. (2012), IMF staff report content provided in the source PDF.*

### 21. Reported financial sector indicators (FSIs) for commercial banks suggest some

### _cr12326 - 21. Reported financial sector indicators (FSIs) for commercial banks suggest some

### A. Summary of reported FSIs and capital adequacy
- Capital adequacy among commercial banks (including NBL and and RBB) declined to the regulatory minimum of 10 percent in the past year, but has recovered subsequently to over 11 percent.17
- All private commercial banks report capital at or above the regulatory minimum.
- Among Class B and C institutions, most report capital levels well in excess of the regulatory requirement, although one Class B and three Class C institutions reported levels below the required minimum in January 2012.
- Extract from Table 2 (as presented in source):
  - Capital adequacy
    - Capital fund to risk weighted assets 4.07.29.610.611.5
    - Tier 1 capital to risk weighted assets 1.85.27.99.18.8
  - Asset quality
    - NPLs to total loans 6.13.62.53.22.6
    - Loan loss provision to total loans 8.25.94.64.03.6
  - Earnings and profitability
    - Return on assets (ROE) 2/35.234.733.925.322.5
    - Return on equity (ROA) 2/2.04.91.91.71.5
    - Interest income to gross income 68.373.977.981.482.4
    - Non-interest expenditures to gross income70.460.160.253.248.0
    - Employees expenses to non-interest expenditures18.725.123.722.221.5
  - Liquidity
    - Liquid assets to total assets11.826.013.111.213.0
    - Liquid assets to demand and savings deposits25.031.131.731.636.6
    - Liquid assets to total deposits15.918.316.014.316.3
  - Exposure to real estate
    - Share of real estate and housing loans...19.420.718.516.9
    - Share of loans collateralized by land and buildings*...71.758.468.455.9
- Note on data timing from Table 2: "1/ Capital adequacy, NPLs, loan loss provisioning, ROE, ROA, and exposure to real estate indicators as of July 2012; liquidity indicators as of June 2012; and other earnings and profitability indicators as of April 2012."

### B. Non-performing loans (NPLs)
- Reported NPLs among all commercial banks declined to 2.6 percent in July 2012 from just over 3 percent at the end of FY 2010/11.18
- Among private commercial banks, NPLs reported at around 2.4 percent.
- State-owned banks' reported NPLs:
  - RBB: around 11 percent
  - ADBN: 9 percent
  - NBL: 6 percent
- Development banks: NPLs increased from 4.4 percent to 5.7 percent over the same period.
- Finance companies (data April–September 2011): NPLs went up from 2.8 percent to nearly 5 percent.
- Caveat: It is likely actual NPLs are higher for all classes of banks due to data quality concerns and possible ever-greening of loans.

### C. Profitability and credit conditions
- ROE and ROA exhibited a declining trend over the past three years, likely reflecting consequences of the real estate market bust.
- Net interest margins: relatively high at 3.8 percent in 2012.
- Credit growth: weak despite accommodative monetary policy; profitability remains weak.

### D. Vulnerabilities — exposure to real estate
- Loans for housing and non-housing construction, together with real-estate loans, account for 15 percent of the loan portfolio of commercial banks—going up to 20 and 30 percent for development banks and finance companies, respectively.
- Taking into account direct lending and indirect exposure through collateral:
  - More than two-thirds of the loan portfolio of commercial banks is exposed to real estate.
  - Up to 90 percent of the loan portfolio of development banks and finance companies is exposed to real estate.
- Real estate transactions continued to fall last year, after dropping sharply in 2010/11; real estate prices are reported to have dropped by 30 percent from their peak, and more for poorer quality projects.19
- Stress test sensitivity from previous work: "Previous stress tests revealed that a 30 percent fall in real estate prices could lead to a 20 percentage point increase in NPLs."19

### E. Liquidity conditions
- Systemic liquidity is currently high, supported by increased remittances.
- Banks’ excess reserves with the NRB are nearly 90 percent of required reserves (compared to 28 percent a year ago).
- Interbank rates hover at or below 1 percent.
- Credit/deposit (C-D) ratios have declined because of weak credit growth and remittance-fueled deposits, but remain high.
- Liquidity can change rapidly in response to external shocks, e.g., a decline in remittances from India and/or the GCC states could re-intensify liquidity stresses.
- Liquidity management can be problematic for banks in stress due to weak assets and a tiered interbank market.

### F. Stress tests and fragility signals
- Results (Table 4 excerpted figures as presented):
  - Credit shocks (No. of banks with CAR < 10% regulatory minimum)
    - Standard credit shock1 20 22
    - 25 percent of performing loans of real estate & housing sector directly downgraded to loss loans 11 15
  - Liquidity shocks
    - No. of banks illiquid after 5 days: Standard withdrawal shock2 — 14 19
    - Withdrawal of deposits by 20%: 26 27
    - Withdrawal of deposits by top 3 institutional depositors: 18 27
    - Withdrawal of deposits by top 5 individual depositors: 16 2
    - No. of banks with liquid assets to deposits ratio < 20%: Standard withdrawal shock2 — 14 19
- Authority-conducted stress tests show some improvement versus prior year but persistent weaknesses:
  - Among 32 commercial banks, a standard credit shock would push capital below the regulatory minimum in 20 banks.
  - A third of commercial banks would be under-capitalized if real estate and housing loans are downgraded20.
  - Sustained deposit withdrawals over five consecutive days would render 14 banks illiquid.
  - Liquidity ratios at a number of banks would fall below 20 percent in the event of sudden large withdrawals or withdrawals by institutions.
- Stress test scenario definition noted in source: "This refers to the scenario in which 25 percent of performing loans of real estate and housing are directly downgraded to loss loans."20

### G. Fiscal impact of banking stress — scenarios and potential costs
- International experience: fiscal costs of banking crises can be severe; in Nepal, recapitalization costs could be as high as one-quarter of GDP based on experience elsewhere.22
- Crisis triggers: another liquidity squeeze, deterioration one year on from last liquidity crunch and three years after the real estate drop; severity depends on whether crisis stays within Class B/C institutions or spreads to Class A banks.
- Deposit-flight scenario (Class B and C institutions with liquidity levels below class median):
  - Roughly NR 100 billion ($1.2 billion, about 6 percent of GDP) of deposits could be at risk.
  - If banks’ liquid assets are exhausted paying withdrawals and institutional deposits are not paid, residual depositor claims could be about NR 40-50 billion (about 3 percent of GDP) that the deposit insurance scheme could not cover without further capitalization.21
- Potential escalation to larger banks:
  - Deposit runs at NBL and RBB alone could add more than 5 percent of GDP to fiscal costs.
  - If all banks including Class A institutions were affected, initial fiscal costs could rise to as high as one-third of GDP.
  - Final costs depend on recoveries from problem loans and collateral; weaknesses and inefficiency in the bankruptcy process may significantly erode recoveries.
- Table 5 scenario figures (as presented):
  - Affected group: Share in System Deposits (%) — Liquidity Needs (% GDP)
    - Deposits in all B and C class banks outside top 10 by assets: 11.7 — 5.0
    - Deposits in all B and C class banks outside top 10 by assets, NBL and RBB: 24.6 — 11.3
    - Deposits in all banks outside top 10 by assets, NBL and RBB: 51.9 — 26.1
    - Deposits in all banks outside top 10 by assets, and 50 percent of deposits in top 10 banks: 75.8 — 36.2

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

### 2.  Changes in attitudes and practices would address the key risk factors for child malnutrition and

### 2.  Changes in attitudes and practices would address the key risk factors for child malnutrition and 

### Nutrition services and supply
- Changes in attitudes and practices are identified as necessary to address the key risk factors for child malnutrition and to create demand for nutrition related services and products.
- The supply of nutrition services and products will be provided through:
  - existing public sector and donor-funded programs,
  - the private sector,
  - and, to a limited extent, financed through the Project.

### Infrastructure investments supported by the Bank
- Road Sector Development Project:
  - Provides all-season road access in select hill districts.
  - Net Commitment: part of portfolio (see Table II.1 entries).
- Bridges Improvement and Maintenance Program:
  - Utilizes a new financing instrument (Program-for-Results) linking disbursements to verifiable results.
  - First Program-for-Results approved by the World Bank’s Board under IDA.
  - Supports Nepal’s Bridge Policy and Strategy of 2004 to provide “safe, reliable and cost effective” bridges.
- Energy sector engagement:
  - Power Development Project aims to develop hydropower potential, meet electricity demand, improve rural access to electricity services, and promote private sector participation.
  - The Power Development Project will close by the end of calendar year 2012 with 45 percent of commitments remaining undisbursed.
  - Kabeli Transmission Project aims:
    - (i) to support the addition of transmission capacity to the Integrated Nepal Power System; and
    - (ii) to provide access to electricity and cooking fuel to communities in the area of the Kabeli 132 kV transmission line.

### Urban and municipal governance
- Urban Government and Development Program: Emerging Towns Project:
  - Supports improved municipal governance and municipal services to address rapid urbanization.

### Rural development, irrigation, water and sanitation
- Nepal Irrigation and Water Resources Management Project:
  - Aims to improve irrigated agriculture productivity and management of selected irrigation schemes and enhance institutional capacity for integrated water resources management.
- Modernization of Rani Jamara Kulariya Irrigation Scheme:
  - Aims to improve irrigation water delivery to, and management in, the command area.
- Rural Access Improvement and Decentralization Project (RAIDP):
  - Improves governance and service delivery for rural infrastructure, promotes agricultural and rural economic growth, and generates employment through direct investments in rural transport infrastructure.
- Rural Water Supply and Sanitation Project:
  - Aims to improve rural water supply and sanitation sector institutional performance and mainstream the “Board” (Rural Water Supply and Sanitation Fund Development Board) approach into the Government’s system.
  - Supports formation of inclusive local water supply and sanitation user groups to plan, implement, and operate drinking water and sanitation infrastructure to deliver sustainable health, hygiene, and productivity benefits to rural households.

### Agriculture, food security and social protection
- Agriculture Commercialization and Trade Project:
  - Re-engagement in the agriculture sector to improve competitiveness of smallholder farmers and the agribusiness sector in selected commodity value chains and 25 districts supported by the project.
- Social Safety Net Project:
  - Under implementation to address short and medium term implications of the global food crisis by strengthening agricultural production and safety net mechanisms on a broad scale.
  - Objective: ensure access to food and basic needs for vulnerable households in the short term in food insecure districts.
- Poverty Alleviation Fund (PAF):
  - Channels resources to the poorest groups in rural communities by creating infrastructure, employment and income-generating opportunities.

### Peace and inclusion
- Peace Support Project:
  - Aims to contribute to the peace process by providing interim cash transfers and services to conflict-affected groups.
- Bank investments support social inclusion; PAF is a direct initiative channeling resources to the poorest rural groups.

### Bank role in public expenditure and shared responsibilities with the IMF
- The Bank leads in assisting Nepal with public expenditure analysis and has supported development of a credible Medium Term Expenditure Framework (MTEF).
  - MTEF has applied since FY04 to prioritize the development budget for efficient allocations to priority projects.
- Bank and IMF jointly assist in overall management of macroeconomic aggregates, debt management, joint Debt Sustainability Analysis, policy dialogue, and provide policy advice and technical assistance to sustain revenue growth.

### World Bank Group strategy and FY12 lending program
- Interim Strategy Note covering fiscal years 2012 and 2013 was discussed by the Bank’s Board on September 15, 2011 and is consistent with the government of Nepal’s Three-Year Plan.
- Nepal selected as a pilot country to implement an enhanced joint strategy to leverage IDA and IFC resources.
- Strategy organized around three pillars:
  - Pillar 1: enhance connectivity and productivity for growth.
  - Pillar 2: reduce vulnerabilities and improve resilience.
  - Pillar 3: promote access to better-quality services.
  - Governance, accountability, gender equality, and social inclusion are cross-cutting themes.
- IDA FY12 approvals: US$143 million in new commitments, including:
  - Modernization of Rani Jamara Kularia Irrigation Project: US$43 million.
  - Sunaula Hazar Din Multi-Sector Nutrition Project: US$40 million.
  - Bridges Improvement and Maintenance Program: US$60 million.
- Nepal country portfolio:
  - 18 IDA funded projects with a net commitment value of about US$1.3 billion.
  - 17 Trust Funded recipient-executed operations (US$170 million).

### Economic and sector work, knowledge and analytic support
- Bank provides regular economic updates and advises authorities on key economic policies and poverty trends.
- Supported completion of the latest Living Standards Survey (NLSS 3) with partners to provide core data on poverty trends and access to services.
- Analytic focus areas include migration and remittances trends, medium-term public expenditure management, investment climate assessment, financial sector risk management, Right to Information implementation, food security and nutrition challenges, water resource management, river basin modeling, and forestry governance/REDD Readiness Plan preparation.
- Joint work on disaster management aims to lay basis for future program support from the Global Fund for Disaster Risk Reduction.
- Ongoing support on improving social protection systems and national social protection framework design.

### IFC activities and priorities
- Investment Services:
  - Committed investment portfolio in Nepal stood at US$27 million as of March 2011.
  - Portfolio composition: three power generation projects, one airline, one tourism project, one microfinance institution, one Financial Sector ICT service company, and four trade finance facilities.
  - In FY2011, IFC provided four trade finance facilities for US$9 million in total and signed one additional facility of US$5 million under IFC’s Global Trade Finance Program to date.
  - In FY2010 and FY2009, IFC committed US$14 million and US$15 million, respectively, including:
    - IFC’s first power investment in Nepal in a decade for US$6.5 million,
    - IFC’s first ever investment in microfinance in Nepal for US$0.3 million,
    - a US$10 million long-term debt in aviation, and trade finance facilities.
- Advisory Services:
  - Engaged in investment climate, financial market and access to finance, sustainable business, and PPPs.
  - Investment Climate Reform Project (ICRP) began in 2007; in FY11 IFC, with DFID support, embarked on a new three-year ICRP with components:
    - (i) Public Private Dialogue (PPD);
    - (ii) Regulatory Reforms;
    - (iii) Special Economic Zones (SEZ).
  - Assisted establishment of Nepal Business Forum (NBF) as a PPD mechanism.
  - Financial Markets and Access to Finance advisory focuses on credit information bureaus, secured transaction registries, sustainable energy financing, SME lending, microfinance, and support to long-term lending institutions.
  - Advisory support in Payments, Remittances and Securities Settlement Systems (PRSSS) and promotion of sustainable business practices.
  - Participation with World Bank and ADB on Strategic Program on Climate Resilience (SPCR) and Scaling up Renewable Energy (SREP) benefiting private sector.
- IFC future focus aligned with three pillars of IFC’s regional South Asia Strategy:
  - (a) Inclusive Growth;
  - (b) Climate Change;
  - (c) Regional and Global Integration.
  - Continue emphasis on investment climate, access to finance, infrastructure strengthening, PPP development, and leveraging co-location with the World Bank for collaboration.

### FY11/portfolio project figures (selected entries from Table II.1)
- Total net commitment for listed projects (IDA portfolio excerpt): 1,346.01 (US$million).
- Total Undisbursed Balance listed: 672.91 (US$million).
- Selected project net commitments and undisbursed balances (exact figures as listed):
  - Irrigation & Water Resources Mgmt. Projects: Net Comm. Amt. 64.24; Undisb. Balance 22.67.
  - Social Safety Nets Project: Net Comm. Amt. 64.47; Undisb. Balance 15.49.
  - PAF II: Net Comm. Amt. 164.97; Disb. FY13 6.17; Undisb. Balance 37.93.
  - Agriculture Commercialization and Trade Project: Net Comm. Amt. 20.00; Disb. FY13 0.06; Undisb. Balance 15.88.
  - Rani Jamara Kulariya Irrigation Project: Net Comm. Amt. 43.00; Undisb. Balance 36.42.
  - Power Development Project: Net Comm. Amt. 164.09; Disb. FY13 5.20; Undisb. Balance 74.40.
  - Kabeli Transmission Project: Net Comm. Amt. 38.00; Disb. FY13 0.07; Undisb. Balance 34.18.
  - Rural Access Improve. & Decentraliz: Net Comm. Amt. 77.00; Disb. FY13 0.90; Undisb. Balance 38.36.
  - Road Sector Development Project: Net Comm. Amt. 117.60; Undisb. Balance 44.78.
  - Rural Water Supply & Sanitation Proj: Net Comm. Amt. 48.49; Undisb. Balance 4.50.
  - Emerging Towns: Net Comm. Amt. 25.00; Undisb. Balance 19.27.
  - Second Higher Education Project: Net Comm. Amt. 60.00; Disb. FY13 3.42; Undisb. Balance 27.43.
  - School Sector Reform Program: Net Comm. Amt. 130.00; Disb. FY13 4.67; Undisb. Balance 44.14.
  - Enhanced Vocational Educ & Trng: Net Comm. Amt. 50.00; Undisb. Balance 41.84.
  - Second HNP and HIV/AIDS Project: Net Comm. Amt. 129.15; Undisb. Balance 94.53.
  - Peace Support Project: Net Comm. Amt. 45.00; Disb. FY13 1.28; Undisb. Balance 22.77.
  - Community Action for Nutrition Project (Sunaula Hazar Din): Net Comm. Amt. 40.00; Undisb. Balance 39.42.
  - Bridges Improvement and Maintenance Program Support: Net Comm. Amt. 60.00; Undisb. Balance 58.90.
- Regional Projects listed:
  - Northeast Regional Electricity Transmission: Net Comm. Amt. 99.00; Undisb. Balance 91.66.
  - Regional Wildlife Protection: BD and NP: Net Comm. Amt. 3.00; Disb. FY13 0.61; Undisb. Balance 2.26.

### Relations with the Asian Development Bank (ADB) — selected figures
- As of 31 December 2011, Nepal received:
  - 156 loans/grants—123 sovereign ADF loans ($2,731.082 million), 5 non sovereign loans ($58.64 million), and 28 ADF grants ($827.915 million) totaling $3,617.637 million.
- Portfolio of active sovereign ADF loans and grants as of 31 December 2011: 42 loans and grants with overall net amount of $1,418.94 million.
- Assistance program for 2011 comprised six projects with:
  - $116.0 million in ADF grants and $154.0 million in concessional loans.
  - Selected project amounts (2011): Electricity Transmission Expansion & Supply Project (loan $56.0 million and grant $19.0 million); High Mountain Agribusiness & Livelihood Improvement Project (grant $20.0 million); Decentralized Rural Infrastructure & Livelihood Project (Additional Financing) (loan $18.0 million and grant $7.0 million); School Sector Reform Program (grant $65.0 million); Capital Market and Infrastructure Capacity Support Project (grant $5.0 million); Kathmandu Valley Water Supply Improvement Project (loan $80.0 million).
- ADB technical assistance as of 31 December 2011:
  - Approved technical assistance projects totaling $162.69 million.
  - 45 ongoing TAs including JFPRs amounting to $43.65 million.
- Cumulative approvals for 4 private sector projects in Nepal amounted to $58.64 million (end of 2011).

*Source: IMF staff summary of World Bank/IFC/ADB assistance and project portfolio for Nepal as presented in the referenced document.*

### ANNEX IV. STATISTICAL ISSUES

### ANNEX IV. STATISTICAL ISSUES

### Overview
- Economic and financial data are generally adequate for surveillance, with scope for improvement especially in fiscal (external financing) data, more detailed price statistics, and the timeliness and quality of balance of payments data.
- Nepal provides core data to the Fund and releases data in government and central bank publications.
- Participant in the General Data Dissemination System (GDDS) since May 2001. Metadata initially posted May 2001 and last updated January 2009.

### Real Sector Statistics
- Compiling authority: Central Bureau of Statistics (CBS), using the methodology of the 1993 SNA.
- Key estimates produced: GDP by industry (current and constant prices), GDP by expenditure categories (current prices), gross national income and savings.
- Shortcomings identified by a 2011 STA mission:
  - No separate estimate of change in inventories; inventories plus statistical discrepancy treated as a residual, which has risen over time to more than 13 percent of GDP.
  - Serious doubts over reliability of other final expenditure categories, particularly household final consumption and capital formation.
  - Weaknesses on activity side due to low quality of extrapolators and lack of benchmark surveys in key areas such as construction and trade.
- Past technical assistance:
  - STA missions in 2005 and 2006 (with AsDB assistance) supported development of quarterly national accounts (QNA) and rebasing from 1994/95 to 2000/01.
- Rebasing considerations:
  - CBS considering rebasing national accounts to 2004/05 or 2010/11, for the reference year 2013/14 or 2014/15.
- Quarterly national accounts (activity side) prepared for 2004/05 to 2010/11; publication expected in year of report, two months after end of first quarter of 2012/13.
- High-frequency indicators generally lacking; quarterly manufacturing production index exists but updates not available since Q1 of 2010/11.

### Prices and Wages
- Consumer price index (CPI) compiled by Nepal Rastra Bank (NRB), base year 2005/06.
  - CPI basket revision survey underway; expected completion in 2013/14 to produce a new CPI series by 2015/16.
  - New survey will include more commodities; previous survey carried out during armed conflict may have affected responses.
  - A core inflation series is not published, although underlying data necessary to calculate such a series appear to be available.
- Wholesale price index (WPI) published by NRB, weights based on 1999/2000 data.
  - WPI coverage: agricultural commodities (49.6 percent), domestic manufactured goods (20.4 percent), and imported goods (30 percent).
- Index of wages and salaries compiled and published with base year 2004/05.

### Government Finance Statistics
- Authorities began compiling fiscal data in accordance with IMF’s 2001 Government Finance Statistics (GFS) in 2011.
- Treasury single account (TSA) rolled out to 60 districts including Kathmandu, improving timeliness and accuracy of fiscal reporting.
- Remaining gaps:
  - Several fees collected outside the budget and operations of local governments not reported in annual budget.
  - Monthly reporting of development spending often excludes amounts directly paid by donors.
  - No compilation of the government’s balance sheet in accordance with IMF’s GFS 2001.
- Reporting: Government finance statistics regularly reported for Government Finance Statistics Yearbook, but not in the International Financial Statistics.

### Monetary and Financial Statistics
- Following 2009 STA mission recommendations, NRB broadened coverage of monthly monetary statistics to include development banks and finance companies; NRB now publishes an expanded broad money survey.
- Interest rate reporting gaps:
  - Key policy rates (t-bill, interbank, NRB policy rates) available.
  - Deposit and lending rates of commercial banks not well reported; rates of development banks and finance companies not reported.
  - Current reporting of maximum and minimum rates remains relatively fixed and not very informative.
  - Recommendation: report prime lending rate of top 5 commercial banks and average deposit rates of the same.
- Following 2011 STA mission recommendations, NRB resumed reporting monthly monetary data in format SRF 1SR for central bank and SRF 2SR for commercial banks; and resumed reporting SRF 2SR covering the entire ODC sector.

### External Sector Statistics
- NRB compiles and disseminates balance of payments (BOP) statistics in conformity with BPM5, but does not compile the international investment position (IIP).
- Overall BOP data quality is weak; net errors and omissions remain large.
  - Footnote: In 2011/12, errors and omissions were 20 percent of the current account balance. In previous years, this has been as high as nearly 40 percent.
- Trade data discrepancies: compiled separately by NRB, Customs Department, and Trade Promotion Center (overseas trade only).
- Export and import price indices are not published.
- 2010 STA mission key shortcomings and recommendations:
  - Shortcomings:
    - (i) underestimation of imports, and to a lesser extent exports;
    - (ii) significant problems in measurement of remittances;
    - (iii) incompleteness of data on foreign grants, making current vs. capital and official vs. private grants difficult to classify;
    - (iv) absence of direct investment data;
    - (v) unrecorded financial flows.
  - Recommendations:
    - Reconcile trade data with main trading partners India and China.
    - Expand coverage of trade to include undeclared imports and exports using border surveys.
    - Verify remittance data in short run with money transfer operators and counterparts; in long run base remittance estimates on enumeration of migrants in different destinations.
- IIP: adequate data exist to produce annual and quarterly IIP statistics, subject to improvements in direct investment data quality.
- Aid reporting:
  - Ministry of Finance (MoF) compiles data on total grants received by government and private sector from donor agencies.
  - New Aid Management Platform (AMP) has been in use since last year to help improve foreign aid reporting.
  - Coordination between Foreign Aid Coordination Division (FACD) in MoF and Balance of Payments Division (BOPD) in NRB on external grants appears weak, complicating estimation of foreign financing.
- Footnote on coverage: Latest data provided for July 2012 indicated that 16 percent of private sector deposits are accounted for by development banks and finance companies.

### Nepal — Table of Common Indicators Required for Surveillance (As of October 5, 2012)
- Selected entries (Date of Latest Observation | Date Received | Frequency of Data | Frequency of Reporting | Frequency of Publication):
  - Exchange rates: Aug. 2012 | Sept. 2012 | D and M | W and M | W and M
  - International reserve assets and reserve liabilities of the Monetary Authorities1: Aug. 2012 | Oct. 2012 | M | M | M
  - Reserve/base money: Aug. 2012 | Oct. 2012 | M | M | M
  - Broad money: Aug. 2012 | Oct. 2012 | M | M | M
  - Central bank balance sheet: Aug. 2012 | Oct. 2012 | M | M | M
  - Consolidated balance sheet of the banking system: Aug. 2012 | Oct. 2012 | M | M | M
  - Interest rates2: Aug. 2012 | Oct. 2012 | D and M | W and M | W and M
  - Consumer price index: Aug. 2012 | Oct. 2012 | M | M | M
  - Revenue, expenditure, balance and composition of financing3 – general government4: Jul. 2012 | Sept. 2012 | M | M | M
  - Revenue, expenditure, balance and composition of financing3 – central government: Jul. 2012 | Sept. 2012 | M | M | M
  - Stocks of central government and central government-guaranteed debt5: Jul. 2012 | Aug. 2012 | A/M | A/M | A/M
  - External current account balance: Aug. 2012 | Oct. 2012 | M | M | M
  - Exports and imports of goods and services: Aug. 2012 | Oct. 2012 | M | M | M
  - GDP/GNP: 2011/12 | April 2012 | A | A | A
  - Gross external debt: Jul. 2012 | Aug. 2012 | A | A | A
- Legend: Daily (D), weekly (W), monthly (M), quarterly (Q), annually (A), irregular (I); and not available (NA).
- Footnotes clarify coverage details (e.g., reserve assets include pledged assets; interest rates include market-based and officially determined; financing categories; general government composition; domestic vs external debt reporting).

### Debt Sustainability — Key Messages and Macroeconomic Assumptions (selected)
- Risk rating: Nepal remains at moderate risk of debt distress, determined using the Low-Income Country Debt Sustainability Analysis (LIC-DSA) framework.
- Baseline public debt:
  - Total stock of public debt remained stable at 33¼ percent of GDP by end-2011/12 (same as 2010/11; down from around 60 percent a decade ago).
  - External public debt: 20½ percent of GDP (US$ 3½ billion) by end-2011/12, up from 18¾ percent of GDP (mainly due to exchange rate depreciation against U.S. dollar).
    - World Bank and Asian Development Bank account for 83 percent of external debt.
    - Japan accounts for 6¼ percent of total external debt.
  - Domestic public debt: 12¾ percent of GDP by end-2011/12, compared to 14½ percent a year ago.
- Macroeconomic projections and assumptions:
  - Real GDP growth projected to slow to 3¾ percent in 2012/13 from 4½ percent in 2011/12, then gradually accelerate to 4 percent in the medium term.
  - Inflation (GDP deflator) expected to decline to 8¼ percent in 2012/13 and further to 5 percent over the long run.
  - Exchange rate peg to the Indian rupee assumed to remain at current level over projection period.
  - Remittance growth projected to moderate to 7½ percent over the long run.
  - Exports and imports projected to grow by an annual average of 7–8 percent.
  - Fiscal policy assumed prudent; net domestic financing (NDF) at 2¼ percent of GDP over the medium term and 2¾ percent in the long run.
  - Revenue and grants projected to reach 17½ percent and 1¾ percent of GDP over the long run, respectively (compared with 15¾ percent and 2½ percent in 2011/12).
  - Primary expenditures projected at 21¼ percent over the long run; primary deficit at 2 percent of GDP in the long run.
  - Assumed grant element projected to fall to 32½ percent by 2032.
- Selected numerical macro table excerpt (as presented):
  - Real growth (%) 3.8 4.0 4.6 4.0 4.0 0.2 0.0
  - Inflation (GDP deflator, %) 7.5 5.0 8.7 7.7 5.1 0.2 0.1
  - Revenue and grants(% GDP) 18.8 19.0 18.3 18.1 19.2 -0.7 0.2
  - Grants (% GDP) 3.0 2.6 2.6 2.1 1.8 -0.9 -0.8
  - Primary expenditure (% GDP) 20.9 21.0 18.7 19.3 21.3 -1.6 0.3
  - Primary deficit (% GDP) 2.1 2.0 0.4 1.2 2.1 -0.9 0.1
  - NDF (% GDP) 2.7 2.5 -0.1 2.3 2.7 -0.4 0.2
  - Exports of G&S (y/y growth) 7.3 7.0 11.7 7.7 7.1 0.4 0.1
  - Imports of G&S (y/y growth) 11.3 8.0 0.6 9.3 7.4 -2.0 -0.6
  - Remittances (y/y growth) 12.5 7.0 24.5 10.9 7.5 -1.6 0.5
  - Current account balance(% GDP) -0.8 -2.6 4.7 -0.5 -0.5 0.3 2.1

### External Debt Sustainability — Baseline, Stress Tests, and Scenarios
- Baseline:
  - Under baseline projections, debt indicators remain below indicative sustainability thresholds.
  - Remittances formally included in analysis; remittances account for 23 percent of GDP.
  - Baseline debt ratios projected to remain sustainable over long term under conservative assumptions on growth and external borrowing.
- Stress tests:
  - Standard stress tests (shocks to GDP growth, exports, non-debt creating flows, combination shocks, and one-time 30 percent exchange rate depreciation) generally keep indicators below thresholds except in most severe scenarios.
  - Remittance sensitivity: a one standard deviation below average growth of non-debt creating flows in 2013 and 2014 would cause the “PV of external debt to export + remittance” ratio to exceed the indicative threshold by 10 percentage points in 2014.
- Non-standard (Nepal-specific) financial stress scenario:
  - Highlights financial sector fragilities as a key risk due to heightened credit risk after sharp downturn in real estate prices.
  - Hypothetical financial stress assumptions (as used in scenario): (i) 50 percent loss of central bank foreign exchange reserves; (ii) one-time exchange rate depreciation of 33 percent; (iii) an output loss of 30 percent over a 4 year horizon; (iv) fiscal cost for bank resolution and deposit coverage of 23 percent of GDP (presumably financed initially through domestic debt, later replaced by foreign debt).
  - Under this scenario:
    - Ratio of “PV of external debt-to-GDP+remittances” would rise substantially and stay above threshold in 2015–2018, peaking in 2016 at 40½ percent.
    - PV of external debt-to-revenue ratio would be above threshold across whole projection period, peaking at 337¾ percent in 2013.
    - Debt service to revenue ratio would be slightly above threshold from 2016 onwards.

*Source: ANNEX IV. STATISTICAL ISSUES (excerpt from IMF staff report provided).*

### 6. Under the baseline scenario, the PV of public debt would be moderately higher at the end of

### 6. Under the baseline scenario, the PV of public debt would be moderately higher at the end of the projection period.

### Baseline projections
- PV of public debt as a share of GDP increases from 31 percent in 2012 to 37 percent by the end of the projection period.
- PV of public debt as a percent of revenue and grants increases from 171 percent to 190 percent.

### Debt composition and fiscal risks
- Composition shift projected toward domestic debt due to constraints on the capacity to mobilize external resources.
- Domestic debt instruments include T-bills, development bonds, overdraft from the Nepal Rastra Bank, etc.
- Maturity of T-bills ranges from 28 days to a year, with T-bills of 91 days most actively traded.
- Large increases in public domestic debt could:
  - Be increasingly difficult to accommodate in the context of the current exchange rate peg, weak competitiveness, and financial sector vulnerabilities.
  - Lead to higher real interest rates—potentially crowding out private sector credit.
  - Require tighter restraint on primary fiscal expenditures, which could endanger anti-poverty and development goals.

### Stress tests and shock scenarios
- Heightened financial stress scenario: raises the PV of debt-to-GDP ratio to over 90 percent.
- Standard stress test: an increase in other debt-creating flows by 10 percent of GDP would:
  - Increase the PV of debt-to-GDP by more than 9 percentage points.
  - Leave PV of debt at higher levels for a prolonged period.
- Overall stress tests suggest vulnerability of debt dynamics to shocks.

### Contingent liabilities
- Contingent liabilities from SOE sector and pension scheme could pose risks to the debt assessment.
- NOC and NEA are making substantial losses and hold domestic debt arrears equivalent to 5¾ percent of GDP, with the majority owed to fiscal or quasi-fiscal agencies.
  - NOC is Nepal Oil Corporation; NEA is Nepal Electricity Authority.
- The on-budget pension scheme has no independent source of funding (such as employee contributions) and could over time cause the fiscal stance to deteriorate.
- Limited information on the pension scheme impedes a reliable estimate of future financing needs and their potential impact on debt dynamics.
- Clearance of SOE arrears would presumably be based on first introducing an automatic fuel pricing mechanism supplemented by a social protection scheme; the cost depends on program design.

### Authorities' views and commitments
- Authorities concurred with the DSA and its policy messages and acknowledged risks from financial sector stress and contingent liabilities.
- Authorities recognize the need to improve utilization of donors’ resources to curb the increase in domestic debt.
- Authorities commit to contain net domestic financing to 2 percent of GDP in 2012/13.
- Authorities note systemic financial sector stress is not very likely, assert that a large chunk of the banking sector is generally sound, and indicate weaknesses concentrate in a few smaller banks and financial companies.
- Authorities argue that foreign grants would be stronger than staff projection given the sizable commitments.

*Source: IMF staff report excerpt.*

### 11.      Nepal faces a moderate risk of external public debt distress but risks could arise from

### _cr12326 - 11.      Nepal faces a moderate risk of external public debt distress but risks could arise from

### Risk assessment
- Nepal faces a moderate risk of external public debt distress.
- Risks could arise from:
  - financial sector vulnerabilities;
  - a shock to remittances;
  - quasi-fiscal liabilities (contingent liabilities from SOEs and the pension scheme).

### Stress test results and scenarios
- Under the baseline scenario and most stress tests, external debt burden indicators generally do not breach thresholds.
- Under a heightened financial stress scenario:
  - the debt burden rises notably;
  - external debt breaches thresholds for prolonged periods.
- The most extreme stress test is defined as the test that yields the highest ratio in 2022; specific extreme-shock correspondences noted:
  - figure b: Non-debt flows shock;
  - figure c: Combination shock;
  - figure d: Non-debt flows shock;
  - figure e: Combination shock;
  - figure f: Financial sector stress scenario shock.

### Contingent liabilities and fiscal space
- Contingent liabilities from SOEs and the pension scheme could pose additional risks to debt dynamics.
- The analysis highlights the importance of containing net domestic financing of deficits to around 2 percent of GDP in the near term to create space for contingent liabilities.
- There is marginal room to accommodate additional capital spending if it is strengthened via enhanced public financial management.

### Key statistics and projections (selected exact values from the public sector DSA Table 1a)
- Public sector debt (2009–2017 actuals and projections):
  - 2009: 39.3
  - 2010: 35.4
  - 2011: 33.3
  - 2012: 33.3
  - 2013: 31.3
  - 2014: 30.7
  - 2015: 30.4
  - 2016: 30.5
  - 2017: 30.4
  - 2012-17 Average: 32.9
  - 2022: 39.5
- Public sector debt, o/w foreign-currency denominated:
  - 2009: 26.3
  - 2010: 22.1
  - 2011: 18.7
  - 2012: 20.5
  - 2013: 17.7
  - 2014: 16.3
  - 2015: 15.2
  - 2016: 14.5
  - 2017: 13.6
  - 2012-17 Average: 10.7
  - 2022: 11.6
- Change in public sector debt examples:
  - 2009: -1.9
  - 2010: -3.9
  - 2011: -2.1
  - 2012: 0.0
  - 2013: -2.0
  - 2014: -0.6
  - 2015: -0.3
  - 2016: 0.1
  - 2017: -0.2
  - 2012-17 Average: 0.7
  - 2022: 0.5
- Identified debt-creating flows examples:
  - Primary deficit:
    - 2009: 2.2
    - 2010: 0.9
    - 2011: 1.1
    - 2012: 0.8
    - 2013: 1.0
    - 2014: 0.4
    - 2015: 1.1
    - 2016: 1.3
    - 2017: 1.5
    - 2012-17 Average: 1.5
    - 2022: 1.4
  - Revenue and grants:
    - 2009: 16.8
    - 2010: 18.0
    - 2011: 17.7
    - 2012: 18.3
    - 2013: 18.1
    - 2014: 17.9
    - 2015: 17.9
    - 2016: 18.1
    - 2017: 18.5
    - 2012-17 Average: 18.6
    - 2022: 19.2
  - Grants (component of revenue and grants):
    - 2009: 2.7
    - 2010: 3.2
    - 2011: 3.3
    - 2012: 2.6
    - 2013: 2.3
    - 2014: 2.0
    - 2015: 1.9
    - 2016: 1.9
    - 2017: 1.9
    - 2012-17 Average: 1.8
    - 2022: 1.8
- Automatic debt dynamics and components (selected):
  - Automatic debt dynamics:
    - 2009: -3.1
    - 2010: -6.9
    - 2011: -4.5
    - 2012: 1.3
    - 2013: -2.9
    - 2014: -1.8
    - 2015: -1.7
    - 2016: -1.2
    - 2017: -1.5
    - 2012-17 Average: -1.3
    - 2022: -1.6
  - Contribution from interest rate/growth differential:
    - 2009: -2.9
    - 2010: -2.8
    - 2011: -1.9
    - 2012: -1.7
    - 2013: -1.2
    - 2014: -1.2
    - 2015: -1.3
    - 2016: -1.2
    - 2017: -1.1
    - 2012-17 Average: -1.0
    - 2022: -1.2
  - Contribution from average real interest rate:
    - 2009: -1.1
    - 2010: -1.0
    - 2011: -0.6
    - 2012: -0.2
    - 2013: 0.0
    - 2014: -0.1
    - 2015: -0.1
    - 2016: 0.0
    - 2017: 0.1
    - 2012-17 Average: 0.3
    - 2022: 0.3
  - Contribution from real GDP growth:
    - 2009: -1.8
    - 2010: -1.8
    - 2011: -1.3
    - 2012: -1.5
    - 2013: -1.2
    - 2014: -1.2
    - 2015: -1.1
    - 2016: -1.2
    - 2017: -1.2
    - 2012-17 Average: -1.2
    - 2022: -1.5
- Other headline indicators:
  - Gross financing need (Table 1a):
    - 2009: 6.0
    - 2010: 4.4
    - 2011: 4.8
    - 2012: 3.9
    - 2013: 4.5
    - 2014: 4.8
    - 2015: 5.2
    - 2016: 5.2
    - 2017: 5.2
    - 2012-17 Average: 6.6
    - 2022: 7.3
  - Debt service-to-revenue and grants ratio (in percent) (Table 1a):
    - 2009: 16.2
    - 2010: 13.2
    - 2011: 14.5
    - 2012: 12.3
    - 2013: 12.6
    - 2014: 12.8
    - 2015: 13.0
    - 2016: 13.0
    - 2017: 12.8
    - 2012-17 Average: 13.6
    - 2022: 14.2
  - Debt service-to-revenue ratio (in percent) (Table 1a):
    - 2009: 19.3
    - 2010: 16.1
    - 2011: 17.8
    - 2012: 14.4
    - 2013: 14.4
    - 2014: 14.3
    - 2015: 14.5
    - 2016: 14.5
    - 2017: 14.3
    - 2012-17 Average: 15.1
    - 2022: 15.6

### External debt DSA highlights (selected exact values from Table 3a and related tables)
- External debt (nominal) / o/w public and PPG (percent of GDP):
  - 2009: 26.3
  - 2010: 22.1
  - 2011: 18.7
  - 2012: 20.5
  - 2013: 17.7
  - 2014: 16.3
  - 2015: 15.2
  - 2016: 14.5
  - 2017: 13.6
  - 2012-17 Average: 10.7
  - 2022: 11.6
- PV of external debt (selected projected values):
  - 2012-17 Average: 11.4
  - 2022: 8.4
  - 2032: 8.6
- PV of PPG external debt in percent of exports (selected):
  - 2012-17 Average: 118.3
  - 2022: 94.6
  - 2032: 116.5
- PV of PPG external debt (in percent of government revenues):
  - 2012-17 Average: 68.7
  - 2022: 50.2
  - 2032: 49.3
- Debt service of PPG external debt (in percent of exports + remittances) (selected):
  - 2012-17 Average: 3.1
  - 2022: 1.6
  - 2032: 1.0
- Gross workers' remittances (Billions of U.S. dollars):
  - 2009: 2.7
  - 2010: 3.1
  - 2011: 3.5
  - 2012: 4.4
  - 2013: 4.8
  - 2014: 5.2
  - 2015: 5.6
  - 2016: 6.1
  - 2017: 6.5
  - 2012-17 Average: 10.1
  - 2022: 20.8
- Memorandum: Nominal GDP (Billions of U.S. dollars):
  - 2009: 12.9
  - 2010: 16.0
  - 2011: 19.0
  - 2012: 19.4
  - 2013: 20.3
  - 2014: 22.0
  - 2015: 23.9
  - 2016: 25.8
  - 2017: 27.6
  - 2012-17 Average: 42.0
  - 2022: 101.4

### Sensitivity analysis highlights (Table 2a and Table 3b selected outcomes)
- PV of Debt-to-GDP Ratio (selected projection points):
  - Baseline (2012–2032): series includes values such as 31, 30, 29, 28, 28, 28, 31, 36 (column of projections shown).
- PV of Debt-to-Revenue Ratio 2/ (selected projection points):
  - Baseline: 171, 163, 161, 159, 157, 153, 165, 190 (series shown).
- Debt Service-to-Revenue Ratio 2/ (selected projection points):
  - Baseline: 12, 13, 13, 13, 13, 13, 14, 14 (series shown).
- Sensitivity scenarios shown include:
  - A1. Real GDP growth and primary balance at historical averages.
  - A2. Primary balance unchanged from 2012.
  - A3. Permanently lower GDP growth.
  - Bound tests B1–B5 (real GDP growth shock; primary balance shock; combination; one-time 30 percent real depreciation; 10 percent of GDP increase in other debt-creating flows).
- Table 3b shows sensitivity of external-debt-related ratios under alternative scenarios and bound tests with projections for PV of external debt-to-GDP+remittances ratio, PV of external debt-to-exports+remittances ratio, PV of external debt-to-revenue ratio, and debt service ratios under shocks (specific numeric series reported in tables).

### Policy implications and recommended focus
- Urgently address financial sector weaknesses via in-depth reforms to reduce the risk of heightened debt burdens under financial stress.
- Contain net domestic financing of deficits to around 2 percent of GDP in the near term to create space for contingent liabilities.
- Enhance public financial management to create marginal room to accommodate additional capital spending if needed.
- Monitor contingent liabilities from SOEs and the pension scheme closely given their potential to affect debt dynamics.

*Source: IMF staff estimates and projections as presented in the Nepal Public Sector and External Debt Sustainability Frameworks and associated sensitivity analyses contained in the provided content.*

### 4.6 percent, reflecting a strong agricultural harvest, and a vibrant services sector—driven partly

### _cr12326 - 4.6 percent, reflecting a strong agricultural harvest, and a vibrant services sector—driven partly

### Recent developments and macroeconomic performance
- Real GDP grew 4.6 percent in 2011/12, after 3.9 percent in 2010/11, supported by:
  - a strong agricultural harvest, and a vibrant services sector—driven partly by a resurgence of inward remittances.
- Average headline inflation declined to 8.3 percent in 2011/12; nonfood inflation remained over 9 percent.
- Balance of payments registered a record surplus in 2011/12.
- Nepal Rastra Bank’s (NRB) foreign exchange reserves increased to $4.3 billion (6.8 months of imports) as reported by staff; NRB reported coverage of 8.8 months of imports when using current year imports as denominator.
- Government fiscal deficit in 2011/12 was smaller than expected; revenue targets largely achieved but capital expenditures were lower than budgeted.
- Public debt remained constant as a share of GDP in 2011/12.
- Quasi-fiscal liabilities continued to rise because of financial losses at Nepal Electricity Authority and Nepal Oil Corporation.
- Financial sector stress receded with strong remittances easing liquidity; banks unwound NRB support. However:
  - Profitability remains low.
  - Extension of new private sector credit was tepid.
  - Balance sheet and other risks persist, including concentrated exposure to a moribund real estate market.
  - Concerns remain about the reliability of reported data.
- Authorities provided accommodative monetary policy and extended forbearance, strengthened supervision and regulation, initiated revision of legal framework for bank resolution, and announced/partially implemented recapitalization plans for two insolvent state banks.

### Outlook and risks (2012/13)
- Staff projection: Real GDP growth projected to decline to 3.8 percent in 2012/13, reflecting a weaker monsoon and slower services activity as remittance growth may slow.
- Authorities’ view: Expect growth in 2012/13 not to be lower than 4 percent given continued services performance and high remittances.
- Inflation pressures: Inflation is on the rise; upward pressure on prices may increase in line with projected developments in India.
- External spillovers: Declining growth in India poses downside risks through lower export demand, weaker inward investment, and possibly less remittances.
- Political uncertainty and financial sector fragility present further downside risks.

### Executive Board assessment and policy guidance
- Directors welcomed improved macroeconomic performance and structural reform progress but noted increasing downside risks from:
  - the slowing Indian economy,
  - a protracted political transition,
  - stresses in the financial sector.
- Key Director recommendations:
  - Continue fiscal prudence to keep public debt roughly constant over the medium term.
  - Pass a full-year budget for 2012/13 expeditiously and strengthen public financial management to ensure full execution of the capital budget.
  - Address quasi-fiscal liabilities from losses at Nepal Oil Corporation and Nepal Electricity Authority.
  - Gradually adopt an automatic price adjustment mechanism and implement well-targeted subsidies to protect the vulnerable; consider pension reform.
  - Further tax and customs administration reforms to build on enhanced revenue mobilization.
  - Targeted and well-sequenced acceleration of financial sector reforms, including:
    - amendment of NRB Act to improve governance,
    - broadened prompt corrective action framework,
    - enhanced supervision and improved data quality,
    - further progress on the AML/CFT framework.
  - Tighten monetary policy to signal commitment to price stability and support the exchange rate peg; use open market operations and regular auction of T-bills to mop up excess liquidity.
  - Accelerate structural reforms to address competitiveness challenges: enhance business environment, remove infrastructure bottlenecks, increase transparency, and improve governance.

### Fiscal policy (authorities’ statements)
- Primary fiscal balance recorded a lower deficit in 2011/12 than in 2010/11 due to slower capital spending and rising revenue mobilization.
- Revenue: Tax-to-GDP ratio reached 15.7 percent in 2011/12; focus on expanding tax base, enhancing tax law compliance, controlling revenue leakage, and strengthening human resource development.
- Capital spending expected to increase in 2012/13 with declaration of “Nepal Investment Year” and establishment of a new Investment Board.
- Authorities acknowledge need to address NOC and NEA deficits with significant quasi-fiscal implications; automatic price mechanism plus well-targeted subsidies is an option but politically sensitive in transition.

### Monetary and exchange rate policy (authorities’ targets and views)
- Monetary policy objectives for 2012/13 include:
  - limiting inflation at 7.5 percent,
  - maintaining foreign reserves equivalent to at least 8 months of imports,
  - attaining credit growth of 15 percent.
- Monetary management to be cautious, weighing risks from volatile oil prices and domestic demand against risks to growth and financial stability from inadequate liquidity and credit growth.
- Authorities view maintaining the pegged exchange rate with the Indian Rupee as appropriate to provide a transparent and stable anchor; they will monitor interest rate differentials and cross-border flows and remain open to review the peg if conditions change.

### Financial sector reforms and measures (authorities’ actions)
- Actions taken in 2011/12 helped stabilize the banking sector; further reforms planned to address remaining challenges while considering real sector impacts.
- Planned initiatives:
  - Amend relevant acts, bylaws and licensing policies.
  - Strengthen capital base of financial institutions.
  - Implement risk-based supervision.
  - Enhance regulatory and supervisory capacity.
  - Promote financial access, especially in rural areas.
- Legal reforms:
  - Amended draft of Nepal Rastra Bank Act, 2002 submitted to parliament.
  - Revised draft Bill of the Bank and Financial Institutions Act (BAFIA), 2006 submitted to parliament to address liquidation procedures.
  - In absence of parliament, authorities may legalize laws via ordinance.
- Prudential measures:
  - Moratorium on licensing for commercial banks, development banks and finance companies extended (except "D" class financial institutions).
  - Deposit insurance threshold increased to NPR 300,000 from 200,000.
  - A modified Deposit Guarantee Act incorporating explicit deposit payment procedures will be drafted for future parliament.

### Structural policies and investment
- Removing structural bottlenecks, especially in electricity generation, is a priority to raise potential output.
- Power sector projects: A total of 70 megawatt of electricity would be increased in 2012/13 from the completion of six different hydropower projects.
- Institutional and investment initiatives:
  - Formation of a steering committee across government, private sector, and development partners to accelerate hydropower development.
  - Formation of a new Investment Board under the Prime Minister to promote large investment projects.
  - Recent Bilateral Investment Promotion and Protection Agreement (BIPPA) with India aimed at increasing infrastructure investment and improving the business climate.

### Key statistics (selected from table "Nepal: Selected Economic Indicators")
- Real GDP (annual percent change): 2009/10: 4.8; 2010/11: 3.9; 2011/12 Est.: 4.6; 2012/13 Proj.: 3.8
- Non-agricultural GDP (annual percent change): 2009/10: 5.4; 2010/11: 3.4; 2011/12 Est.: 4.3; 2012/13 Proj.: 3.7
- CPI (period average): 2009/10: 9.5; 2010/11: 9.6; 2011/12 Est.: 8.3; 2012/13 Proj.: 8.3
- CPI (end of period): 2009/10: 9.0; 2010/11: 9.7; 2011/12 Est.: 11.5; 2012/13 Proj.: 8.2
- Total revenue and grants (percent of GDP): 2009/10: 18.0; 2010/11: 17.7; 2011/12: 18.3; 2012/13: 18.1
- Expenditure (percent of GDP): 2009/10: 18.8; 2010/11: 18.6; 2011/12: 18.2; 2012/13: 18.6
- Net lending/borrowing (percent of GDP): 2009/10: -0.8; 2010/11: -1.0; 2011/12: 0.1; 2012/13: -0.5
- Broad money (annual percent change): 2009/10: 14.1; 2010/11: 12.3; 2011/12: 22.7; 2012/13: 12.5
- Private sector credit (annual percent change): 2009/10: 14.2; 2010/11: 13.9; 2011/12: 11.3; 2012/13: 13.0
- Current account (in millions of U.S. dollars): 2009/10: -378; 2010/11: -181; 2011/12: 909; 2012/13: 128
- Current account (percent of GDP): 2009/10: -2.4; 2010/11: -1.0; 2011/12: 4.7; 2012/13: 0.6
- Trade balance (in millions of U.S. dollars): 2009/10: -4,078; 2010/11: -4,470; 2011/12: -4,605; 2012/13: -5,540
- Gross official reserves (in millions of U.S. dollars): 2009/10: 2,844; 2010/11: 3,085; 2011/12: 4,307; 2012/13: 4,595
- Reserves (months of imports): 2009/10: 5.4; 2010/11: 5.8; 2011/12: 6.8; 2012/13: 6.6
- Public debt (percent of GDP): 2009/10: 35.4; 2010/11: 33.3; 2011/12: 33.3; 2012/13: 31.3
- GDP at market prices (in billions of Nepalese rupees): 2009/10: 1,193; 2010/11: 1,368; 2011/12: 1,557; 2012/13: 1,750
- GDP at market prices (in billions of U.S. dollars): 2009/10: 16.0; 2010/11: 19.0; 2011/12: 19.4; 2012/13: 20.3
- Exchange rate (Nrs/US$; period average): 2009/10: 74.8; 2010/11: 72.1; 2011/12: 80.2
- Real effective exchange rate (eop, y/y percent change): 2009/10: 7.0; 2010/11: 1.4; 2011/12: -4.6

*Source: IMF staff report and Nepalese authorities as presented in the 2012 Article IV consultation materials.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12326.pdf_