## INTRODUCTION (IMF Staff Report — Nepal, _cr14214) ## Source details **Canonical URL:** [INTRODUCTION (IMF Staff Report — Nepal, _cr14214)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14214.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14214.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14214.pdf.json) --- ### Recent developments - Political environment: - Constituent Assembly (CA) elections November 2013: Maoist party 14 percent of seats; Nepali Congress 34 percent; United Marxist-Leninists (UML) 30 percent. - Remittances and living standards: - Estimated 2.2 million workers abroad (8 percent of the population). - Remittances projected to rise to almost 30 percent of GDP in 2013/14, up from 9 percent of GDP in 2000. - Poverty headcount fell from 55 percent in 1995 to 25 percent in 2011. - Concerns that remittances may erode competitiveness (rising wages; declining shares of exports and industry in GDP). - Macroeconomic performance (selected): - GDP growth: below 4 percent in 2012/13; output growth expected to pick up to around 4¾ percent in 2013/14. - Inflation: rose to over 10 percent y/y in December 2013; moderated to 8.9 percent y/y in March 2014; projected at 8 percent (y/y). - Remittances growth: 17½ percent in the first eight months of 2013/14. - International reserves: $5.8 billion (8.1 months of prospective imports) in March. - Reserve money growth: 30½ percent y/y in March. - Private sector credit growth: 15½ percent y/y. - Capital expenditure: remained low despite efforts to accelerate spending. - Policy implementation and reforms: - Financial sector consolidation underway; NRB strengthening supervision with IMF and donor TA. - Full budget passed on time for 2013/14; treasury single account (TSA) rolled out to all 75 districts. - Revenue administration reforms ongoing (with IMF TA). - Monetary policy remained loose; non-transparent implicit subsidies to Nepal Oil Corporation (NOC) and Nepal Electricity Authority (NEA) continue. ### Outlook and risks - Near-term projections: - Output growth: around 4¾ percent in 2013/14. - Inflation: 8 percent (y/y). - Current account surplus: forecast to rise to over 4 percent of GDP due to remittances. - Net incurrence of financial liabilities: projected at 1¼ percent of GDP as capital spending accelerates. - Private sector credit growth: expected to accelerate slightly. - 2014/15: growth projected to increase somewhat; inflation to moderate with India’s inflation; current account surplus expected to decline as remittance growth slows. - Medium-term outlook: - Growth: projected to remain at around 4½ percent absent decisive boost in public capital spending and structural reforms. - External position: expected to remain strong with high international reserves. - Risks (Annex 1 highlights): - External: slower-than-projected recovery in India; slowdown in countries hosting Nepali workers. - Domestic: financial sector vulnerabilities (many weak smaller banks; largely unsupervised cooperatives sector). - Political: potential failure to further improve the political climate. - Upside: decisive reform push and increased public investment could boost private investment and raise growth beyond baseline. - Debt sustainability: - Nepal assessed at low risk of debt distress (improvement from previous DSA indicating moderate risk) due to reduced estimates of potential banking crisis cost and increase in discount rate for LIC DSAs. ### Authorities’ views (summary) - Authorities broadly concurred with staff assessment; believed growth could be higher due to stronger services growth. - Plan to accelerate capital spending and spur credit to productive sectors (agriculture, hydroelectric power, industry, tourism). - Emphasized further political improvement as prerequisite for higher private sector investment. ### Box 1 — Spillovers from India (summary) - Close economic relationship with India; open border facilitates movement of goods and labor. - Remittances from India estimated to account for only 10 percent of total remittances; 90 percent originate from other destinations (primarily Persian Gulf states and Malaysia). - Econometric evidence: impact on Nepal from a shock to India’s growth highest among South Asian peers but overall modest. ### Exchange rate policy - Exchange rate assessment: - Level broadly in line with fundamentals. - Remittances skew domestic activity toward non-tradables, reducing competitiveness of agriculture and industry. - Reserve adequacy: - Reserve coverage projected to stabilize at around 8½ months of prospective imports in the medium term after peaking in 2015/16. - Peg to the Indian rupee: - Peg serves as transparent anchor given close ties with India. - An “engineered depreciation” against the Indian rupee would likely boost remittance inflows and reserves but trigger inflationary pressures and require sharp monetary tightening, stressing a weak financial system. - Exchange rate assessment quantitative notes: - Macroeconomic Balance: -32.3 -8.7 8.3 (1/ + (-) is over(under)valuation.) - External Sustainability: ---2.4--- - Reserve indicators (gross international reserves, millions of U.S. dollars): - Jul-11: 3,085; Jul-12: 4,307; Jul-13: 4,972; Mar-14: 5,846. - Reserves in months of prospective GNFS imports: - Jul-11: 5.8; Jul-12: 7.2; Jul-13: 7.4; Mar-14: 8.1. - Reserves in percent of foreign currency deposits: 1,070 / 2,233 / 1,780 / 1,614 (Jul-11 / Jul-12 / Jul-13 / Mar-14). - Reserves in percent of broad money: 24 / 34 / 36 / 39 (Jul-11 / Jul-12 / Jul-13 / Mar-14). - Reserves in percent of reserve money: 94 / 120 / 134 / 153 (Jul-11 / Jul-12 / Jul-13 / Mar-14). - Change in gross international reserves since mid-July of previous year (Jul-11 / Jul-12 / Jul-13 / Mar-14): 25 / 31 / 1,222 / 665 / 875 (table presentation). ### Monetary policy - Recent actions and conditions: - Excess liquidity built up rapidly, undermining monetary policy. - After tightening in late 2012/13, excess liquidity rose again in 2013/14 due to remittance inflows and government balances. - Interbank and t-bill interest rates fell to very low levels and began to affect retail rates. - NRB reverse repo operations used Nrs 19.5 billion worth of treasury bills (stock of around Nrs 22 billion). - Excess liquidity reduced from a peak of Nrs 70 billion in November 2013 (7 percent of total deposit) to around Nrs 40 billion in March 2014. - NRB credit policies: - Regulations mandating minimum shares of lending to deprived and productive sectors. - Cap on spread between lending and deposit rates. - Staff recommendations: - Control volatility and level of excess liquidity via sterilization and/or raising required reserves; consider cost sharing between financial system and budget. - Use OMOs more actively; reduce level of excess liquidity; injections may be appropriate at times. - Government debt securities: additional issuance of treasury bills and bonds to NRB needed for OMOs and yield curve development; NRB-issued securities alternative though may fragment market. - Strengthen NRB–Ministry of Finance cooperation in forecasting revenue and expenditure; separate monetary from debt management; consider establishing a monetary policy committee at NRB. - Introduce an interest rate corridor to limit interest rate volatility and improve transmission; could reduce interest rate differential with India. - Review, modify, and eventually phase out directed lending and spread caps; promote access to finance and investment lending by other means. ### Box 3 — Inflation determinants (regression summary) - Key finding: Indian inflation is the key driver of Nepali inflation. - Econometric estimates (Sample: March 2001–December 2013; Observations 152; R-squared 0.41): - ∆ln(CPI)t-1: Coeff 0.37*** (SE 0.06) - ∆ln(CPI_India)t: Coeff 0.45*** (SE 0.08) - ∆ln(Broad Money)t-1: Coeff 0.12** (SE 0.05) - ∆ln(NEER)t-1: Coeff -0.06 (SE 0.019) - Constant: -0.010 (SE 0.04) - Interpretation: - A 1 percent increase in India’s inflation leads to a 0.45 percent increase in Nepali inflation (estimated). - Lagged CPI (inflation expectations) significant. - Broad money has limited impact: 1 percent increase in broad money growth corresponds to 0.1 percent increase in inflation (estimated). - Lagged NEER effect small and not statistically significant. --- ### Role of the NRB and Monetary Policy (authorities and staff views) ### Authorities’ stance - Authorities viewed excess reserves as resulting from banks failing to seek lending opportunities and did not want to reward inactivity via remunerated reserves or debt issuance to mop up liquidity. - Ministry of Finance had reservations about interest cost of sterilization bonds. - Authorities did not regard excess liquidity as a cause for concern because it had not translated into excessive lending or higher inflation. - Authorities considering introducing an interest rate corridor and issuance of sterilization bonds. ### Staff recommendations (specific) - Monetary policy should focus on controlling liquidity. Specific actions: - Use OMOs more actively to control level and volatility of liquidity. - Equip NRB with adequate amounts of sterilization bonds. - Step up cooperation between NRB and Ministry of Finance. - Strengthen institutional set-up for monetary policy (consider monetary policy committee). --- ### Financial Sector Structure, Vulnerabilities, and FSAP Findings ### Financial sector structure (as of April 2014) - NRB-regulated institutions: - 30 Class A commercial banks - 86 Class B development banks - 56 Class C finance companies - 35 Class D microfinance banks - About 17,000 credit cooperatives outside NRB supervisory perimeter. - Access to finance remains limited in remote areas and for SMEs despite large increase in bank branches. ### NRB supervisory efforts and legal reforms - Special review of risk management practices in 20 banks (deficient); special review of 54 banks representing over 50 percent of financial sector assets ongoing. - Supervision Coordination Committee established to monitor cooperatives sector. - Draft amendments to NRB Act and process to amend BAFIA begun. - New Deposit Insurance and Credit Guarantee Corporation Bill drafted. - AML/CFT ordinances enacted by newly-elected parliament may facilitate removal from enhanced FATF scrutiny. ### Key FSAP findings (summary) - Vulnerabilities identified: - Bank supervision largely compliance-based, fragmented, underresourced. - Nonperforming loans likely underreported; evergreening widespread. - Stress tests suggest banking system strains if asset quality deteriorates moderately. - Rapidly growing largely unsupervised cooperatives sector poses significant risk. - FSAP high-level recommendations: - Thorough asset quality review to identify problem loans. - Actively guide bank consolidation to ensure stronger banks emerge. - Strengthen licensing, fit-and-proper criteria, risk management, related-party and intra-group exposure standards. - Grant NRB special resolution powers and explicit consolidated supervision powers; amend legal framework. - Expedite risk-based supervision; integrate off- and on-site supervision. - Use NRB corrective and sanctioning powers proactively; amend prompt corrective action framework. - Increase NRB staffing and analytical capacity; limit staff rotation; develop IT and management systems. - Bring EPF and CIT under joint supervision of NRB and Insurance Board. - Significantly strengthen supervision of cooperatives by Department of Cooperatives. - Develop and coordinate contingency plans; carry out crisis simulations. - Clarify mandate and reduce number of state-owned banks. - Modernize payments system; create collateral registry; eliminate reporting threshold to Credit Information Bureau. - Improve debt enforcement and insolvency systems. ### Authorities’ views on reforms - Broad agreement with staff but highlighted resource constraints and difficulty of closing financial institutions. - Noted decline in number of financial institutions due to mergers among development banks and finance companies. - Re-licensing now would be disruptive and should be gradual. - Joint supervision of EPF and CIT requires legal and institutional amendments under review. --- ### Fiscal Policy: Position, Risks, and Recommendations ### Fiscal background and status - Public debt projected to decline to 30½ percent of GDP in 2013/14. - Revenue growth strong due to high import growth and administrative reforms. - Grant inflows strengthened (mainly related to election spending). - Capital budget significantly raised in 2013/14, but execution remains difficult and overall level low. - Capital spending underrecorded as some transfers to local governments, accounted as expense, used for capital formation. ### Staff views and recommendations - Fiscal policy should support growth through higher public investment, especially in power generation/distribution and transport. - Maintain spending on health and education. - Monitor expenditures executed through local bodies. - Fiscal space assessment: - Room for further revenue growth, even if at decreasing rates. - With public debt low, modest expansion of fiscal deficits is affordable without endangering sustainability. - Further fiscal space could be created by reducing/eliminating implicit subsidies to NOC. - NOC losses: - NOC currently has Nrs 34 billion in debt (1¾ percent of GDP). - Prices should be adjusted to avoid recurrent losses and interruptions, ideally via automatic pricing mechanism while protecting the poor; any subsidies should be transparently recorded. - Raising public investment requires reforms to budget planning and execution: - Use planned Fiscal Responsibility and Budget Management Act (FRBM) to remove obstacles to efficient capital budget execution (e.g., spending authorization from Planning Commission after budget approval; no multi-year spending authorizations). - Better prioritize within sectors to ensure completion of key projects. - Following TSA rollout, pursue public financial management reforms to enhance cash management and improve revenue and expenditure forecasts. ### Authorities’ actions - Authorities agreed on need to boost capital spending and intend to pass the 2014/15 budget one month ahead of fiscal year to facilitate execution. - Examining other obstacles to public investment, including provisions in the Procurement Act. - Political constraints noted regarding fuel pricing. --- ### Boosting Sustainable and Inclusive Growth (policies and priorities) ### Human development and inclusion - Poverty reduced significantly but human development indicators remain low. - Continued expenditures on health and education could reduce human effects of poverty and improve workforce productivity. - Cellular phone subscriptions: 85 percent of the population; estimated to cover 65-70 percent of individuals — mobile telephony offers opportunity to extend financial services and promote inclusion. ### Structural reforms recommended - Financial sector policies and higher public investment to support private investment, but comprehensive reforms required: - Labor market reforms. - Market efficiency improvements through competition (e.g., fuel distribution; goods and passenger transport). - Consider creation of dedicated competition authority. - Offer one-stop shop for investors (not only for large investments). ### Hydroelectric potential - Accelerate exploitation of hydroelectric power potential given long lead times. - Power expansion through current projects should alleviate shortages; demand expected to increase. - Power export to India could diversify foreign exchange sources. - Develop large-scale projects with foreign investment to generate power and build infrastructure for power trade with India expeditiously. - Shorter-gestation domestically financed projects may kick-start growth despite larger projects’ higher long-term impact. --- ### Other Issues: Safeguards, Statistics, and IMF/Donor Engagement ### Safeguards and treasury management - New accounting software installed; all government transactions monitored through TSA; controls over reserve management strengthened. - Safeguards assessment of NRB concluded May 2011: external audit mechanism needed improvement; financial reporting strengthened by resolving external auditors’ qualifications. ### Statistics and data quality - Continue strengthening macroeconomic statistics under National Strategy for Development of Statistics. - IMF TA provided to improve statistics in national accounts, fiscal accounts, balance of payments, and monetary accounts. - Identified data issues: national accounts rebasing; quarterly national accounts; coverage and quality of BOP and remittances; improvement plans in progress. ### Technical assistance since 2010 (by area) - MCM, FAD, LEG, STA activities listed (monetary policy, bank supervision, tax and customs administration, AML/CFT, BOP statistics, national accounts, monetary statistics, GFSM migration, etc.). --- ### Staff Appraisal: Key Judgments and Policy Priorities ### Macroeconomic and fiscal assessment - Macroeconomic situation broadly stable; external position strong due to remittances which increase reserves but also fuel excess liquidity and skew activity to non-tradables. - Fiscal position solid with low public debt but public investment modest. - Poverty reduction progressed; growth weak due to low public investment, weak business climate, and eroding external competitiveness. ### Monetary policy priorities - Emphasize liquidity control via OMOs, adequate sterilization bonds, stronger NRB–MoF cooperation, and institutional strengthening. ### Financial sector priorities - Strengthen supervision, reduce vulnerabilities, and increase system efficiency: - Substantially reduce number of banks with strengthened licensing; close insolvent banks where appropriate. - Expedite move to risk-based supervision; enhance legal framework, staffing, and IT. - Expand and strengthen supervision of cooperatives. - Develop financial infrastructure (collateral registry, credit bureau) to reduce risks and increase access. ### Fiscal policy priorities - Support growth and poverty reduction given rising revenues and low public debt: - Remove implicit NOC subsidies. - Pass FRBM Act and other institutional changes to improve capital spending execution. - Increase public investment (power, transport) while maintaining debt sustainability. ### Urgent reforms to boost inclusive growth - Improve competitiveness in industry and agriculture. - Enhance labor relations and competition. - Reduce regulatory burden. - Accelerate large privately financed infrastructure projects to boost investor confidence. --- ### Risk Assessment Matrix (Annex I) — Highlights ### Domestic risks - Financial sector distress: Likelihood: Medium; Impact: Medium/High. - Policy response: Move to pro-active risk-based supervision; exercise corrective and sanctioning powers earlier; increase resources for supervision. - Political instability: Likelihood: Medium; Impact: Low/Medium. - Policy response: Preserve fiscal and external policy space. - Decisive reform push and increase in public investment (upside): Likelihood: Low; Impact: High. ### External risks - Slower-than-projected recovery in India: Likelihood: Medium; Impact: Low. - Policy response: Accelerate structural reforms and boost public investment. - Protracted slower growth in countries hosting Nepali workers (Persian Gulf, Malaysia): Likelihood: High; Impact: Medium/High. - Policy response: Preserve fiscal and external policy space short term; boost public investment and pursue structural reforms long term. --- ### Debt Sustainability Analysis (selected findings) ### Overall assessment - Nepal assessed at low risk of debt distress (improvement from previous moderate risk). - Reasons: reduced estimates of potential financial sector shock cost; increase in discount rate (unified at 5 percent for LIC DSAs); grant element of foreign borrowing in range 53–55 percent. ### Baseline macro and fiscal assumptions (selected) - Real GDP growth: 2012/13: 3½ percent; 2013/14: 4¾ percent; medium/long run: 4½ percent. - Remittances: poised to touch nearly 30 percent of GDP in 2013/14. - Public investment: increase from 3.7 percent of GDP in 2014 to 5.2 percent in 2034. - Net incurrence of liabilities: projected to rise from 1¼ percent of GDP in 2013/14 to 2¼ percent over next five years and to 2½ percent toward end of DSA horizon. - Financing tilt: increasing toward domestic sources, rising to 1½ percent of GDP in long term. ### External and public debt indicators (baseline) - External debt: 20 percent of GDP by end-2013 ($3½ billion); 85 percent concessional borrowing from World Bank and ADB. - Public debt: declined to 31¼ percent of GDP in 2013 (from 36 percent in 2012). - Baseline external debt outcomes: indicators well below sustainability thresholds; PV of external debt stabilizes at 8 percent of GDP + remittances, 25 percent of exports + remittances, 50 percent of revenues. - Debt service-to-exports + remittances stabilizes at 1½ percent; debt service-to-revenues stabilizes at 3¼ percent. ### Contingent liabilities and fiscal risks (selected) - NOC and NEA combined average losses: 1½ percent of GDP a year (requiring frequent bail-outs). - NOC outstanding loans: nearly NR 34 billion (1¾ percent of GDP). - NEA outstanding loans from Government: nearly NR 69 billion (3½ percent of GDP). - Other SOE contingent liabilities: another 2 percent of GDP. - Pension liabilities: civil service pension liabilities currently 1¼ percent of GDP, rising to 1½ percent by 2025. - FSAP stress test: recapitalization needs if NPLs increase by 2 percentage points could amount to 4¾ percent of GDP. ### Policy implications - Maintain prudent fiscal policy while enhancing revenue mobilization through tax administration reforms. - Continue public financial management improvements to support tilt toward domestic financing as external loans decline. - Address SOE contingent liabilities through stronger governance and cost recovery measures. - Implement parametric pension reforms to contain rising pension costs. - Improve execution of capital spending via earlier budget timing, procurement reforms, and FRBM law. --- ### Selected Key Numerical Indicators (from tables and projections) - Real GDP growth (selected): 2010/11: 3.4; 2011/12: 4.8; 2012/13: 3.9; 2013/14: 4.8; 2014/15: 5.0 (projection). - CPI (period average): 2010/11: 9.6; 2011/12: 8.3; 2012/13: 9.9; 2013/14: 8.8; 2014/15: 7.8 (projection). - Total revenue and grants (percent of GDP): 2010/11: 17.7; 2011/12: 18.7; 2012/13: 19.3; 2013/14: 21.1; 2014/15: 21.3 (projection). - Expenditure (percent of GDP): 2010/11: 18.7; 2011/12: 19.3; 2012/13: 17.9; 2013/14: 20.8; 2014/15: 21.1 (projection). - Net lending/borrowing (percent of GDP): 2010/11: -1.0; 2011/12: -0.6; 2012/13: 1.4; 2013/14: 0.2; 2014/15: 0.2 (projection). - Public debt (percent of GDP): 2010/11: 34.5; 2011/12: 36.3; 2012/13: 31.5; 2013/14: 30.5; 2014/15: 29.7 (projection). - Workers’ remittances (percent of GDP): 2010/11: 18.6; 2011/12: 23.4; 2012/13: 25.6; 2013/14: 29.4; 2014/15: 31.0 (projection). - Gross official reserves (millions of US$): 2010/11: 3,085; 2011/12: 4,307; 2012/13: 4,972; 2013/14: 6,082; 2014/15: 7,120 (projection). - Reserves in months of prospective GNFS imports: 2010/11: 5.8; 2011/12: 7.2; 2012/13: 7.4; 2013/14: 8.2; 2014/15: 8.6. - Reserve money (in billions of NRs, selected): 2010/11: 234; 2011/12: 319; Mar 2014: 354; 2013/14: 375; 2014/15: 494 (table entries). - Broad money (in billions of NRs, selected): 2010/11: 922; 2011/12: 1,131; Mar 2014: 1,315; 2013/14: 1,458; 2014/15: 1,585; projected 1,900. - Broad money (12-month percent change): 2010/11: 12.3; 2011/12: 22.7; 2012/13: 16.3; 2013/14: 20.5; 2014/15: 19.9. - Private sector credit growth (12-month percent change): 2010/11: 13.1; 2011/12: 11.3; 2012/13: 20.2; 2013/14: 16.4; 2014/15: 18.7. - Financial soundness indicators (commercial banks, selected): - Capital fund to risk weighted assets (percent): 2010: 9.6; 2011: 10.6; 2012: 11.5; 2013: 12.3. - NPLs to total loans (percent): 2010: 2.5; 2011: 3.2; 2012: 2.6; 2013: 2.7. - Return on assets (ROA): 2010: 1.9; 2011: 1.7; 2012: 1.5; 2013: 1.7. - Liquid assets to total assets (percent): 2010: 13.1; 2011: 11.2; 2012: 15.2; 2013: 14.7. --- *Source: IMF staff report — INTRODUCTION (Nepal) and associated annexes and tables, as provided in content unit _cr14214.* ### INTRODUCTION __________________________________________________________________________________ 3 ### INTRODUCTION ### Recent developments - Political environment: Political uncertainty has receded after successful elections for a new Constituent Assembly (CA) in November 2013. The Maoist party won 14 percent of seats; Nepali Congress won 34 percent; United Marxist-Leninists (UML) won 30 percent. - Remittances and living standards: - An estimated 2.2 million workers abroad (8 percent of the population). - Remittances projected to rise to almost 30 percent of GDP in 2013/14, up from 9 percent of GDP in 2000. - Poverty headcount fell from 55 percent in 1995 to 25 percent in 2011. - Concerns that remittances may erode competitiveness, suggested by rising wages and declining shares of exports and industry in GDP. - Macroeconomic performance: - GDP growth slowed to below 4 percent in 2012/13, driven by a weather-related weakening in agricultural output and delayed budget execution resulting in low capital spending and a fiscal surplus. - Inflation rose to over 10 percent y/y in December 2013 after the depreciation of the Indian rupee, moderating to 8.9 percent y/y in March 2014. - Growth of remittances rose to 17½ percent in the first eight months of 2013/14. - International reserves stood at $5.8 billion (8.1 months of prospective imports) in March. - Reserve money growth: 30½ percent y/y in March. - Private sector credit growth: 15½ percent y/y. - Capital expenditure remained low despite efforts to accelerate spending. - Policy implementation and reforms: - Progress toward consolidating the financial sector; NRB has begun to strengthen supervision with IMF and donor TA. - A full budget was passed on time for 2013/14; the treasury single account (TSA) rolled out to all 75 districts. - Reforms in revenue administration ongoing (with IMF TA). - Monetary policy remained loose; non-transparent implicit subsidies to Nepal Oil Corporation (NOC) and Nepal Electricity Authority (NEA) continue. ### Outlook and risks - Near-term projections: - Output growth expected to pick up to around 4¾ percent in 2013/14, driven by a recovery in agriculture, strong services, and higher public spending. - Inflation projected at 8 percent (y/y). - Current account surplus forecast to rise to over 4 percent of GDP due to remittances. - Net incurrence of financial liabilities projected at 1¼ percent of GDP (as capital spending accelerates in the last quarter). - Private sector credit growth expected to accelerate slightly. - 2014/15: growth projected to increase somewhat as confidence improves; inflation to moderate with India’s inflation; current account surplus expected to decline as remittance growth slows. - Medium-term outlook: - Growth projected to remain at around 4½ percent in the medium term absent a decisive boost in public capital spending and structural reforms (financial sector, telecommunications, competition, labor market, business regulation). - External position expected to remain strong with high international reserves. - Risks (Annex 1): - External risks mainly from a slower-than-projected recovery in India or a slowdown in countries hosting Nepali workers (Box 1). - Domestic risks from the financial sector: many weak smaller banks and a largely unsupervised cooperatives sector. - Political risk: potential failure to further improve the political climate. - Upside scenario: decisive reform push and increased public investment could boost private investment and raise growth beyond baseline. - Debt sustainability analysis: Nepal is at low risk of debt distress due to reduced estimates of the cost of a potential banking sector crisis and an increase in the discount rate used to assess LICs’ debt burden (significant improvement from previous DSA indicating moderate risk). ### Authorities’ views (summary) - Authorities broadly concurred with staff assessment but believed growth could be higher due to stronger services growth. - They plan to accelerate capital spending and spur credit to productive sectors (agriculture, hydroelectric power, industry, tourism). - They emphasized that further political improvement is a prerequisite for higher private sector investment. ### Box 1 — Spillovers from India (summary) - Close economic relationship with India; open border facilitates movement of goods and labor. - Trade and remittance flows do not suggest large spillovers from India to Nepal: - Exports constitute a small share of Nepal’s GDP. - Remittances from India estimated to account for only 10 percent of total remittances; 90 percent originate from other destinations (primarily Persian Gulf states and Malaysia). - Closed capital account limits international financial linkages. - Econometric evidence: the impact on Nepal from a shock to India’s growth is highest among South Asian peers but the overall effect is modest (Cashin and Raissi, IMF Country Report No. 14/58). ### Exchange rate policy - Exchange rate assessment: - Level of the exchange rate appears broadly in line with fundamentals (Box 2). - Remittances skew domestic activity toward non-tradables, reducing competitiveness of agriculture and industry. - Reserve adequacy: - Reserve coverage, after peaking in 2015/16, projected to stabilize at around 8½ months of prospective imports in the medium term as remittance growth moderates and investment increases gradually. - Peg to the Indian rupee: - The peg serves as a transparent anchor and benefits Nepal given close economic ties with India. - Recent Indian rupee depreciation boosted Nepal’s competitiveness vis-à-vis third countries. - An “engineered depreciation” against the Indian rupee would likely lead to additional remittance inflows, boosting international reserves and liquidity beyond baseline projections, but would trigger inflationary pressures and necessitate a sharp tightening of monetary policy—potentially causing additional stress in a still-weak financial system. - Exchange rate assessment quantitative notes (as presented): - Macroeconomic Balance: -32.3 -8.7 8.3 (1/ + (-) is over(under)valuation.) - External Sustainability: ---2.4--- - Indicators: - Real effective exchange rate (index: 2005=100) and bilateral real exchange rate (vis-à-vis India) trends noted. - Trade with India: imports from India and exports to India (percent) shown historically. - Gross international reserves (Jul-11 / Jul-12 / Jul-13 / Mar-14): 3,085 / 4,307 / 4,972 / 5,846 (in millions of U.S. dollars). - Reserves in months of prospective GNFS imports (same dates): 5.8 / 7.2 / 7.4 / 8.1. - Reserves in percent of foreign currency deposits: 1,070 / 2,233 / 1,780 / 1,614. - Reserves in percent of broad money: 24 / 34 / 36 / 39. - Reserves in percent of reserve money: 94 / 120 / 134 / 153. - Change in gross international reserves since mid-July of prev. year (Jul-11 / Jul-12 / Jul-13 / Mar-14): 25 / 31 / 1,222 / 665 / 875 (presented in table). - Change in percent of reserve money at mid-July of prev. year: 9 / 37 / 19 / 24 (sources: Nepali authorities and IMF staff estimates). ### Monetary policy - Background and recent actions: - Excess liquidity has built up rapidly again, undermining monetary policy. - After tightening in late 2012/13, excess liquidity rose in 2013/14 due to remittance inflows and accumulation of government balances. - This pushed interbank and t-bill interest rates to very low levels and began to affect retail interest rates. - NRB reverse repo operations used Nrs 19.5 billion worth of treasury bills, out of a total stock of around Nrs 22 billion. - Excess liquidity reduced from a peak of Nrs 70 billion in November 2013 (7 percent of total deposit) to around Nrs 40 billion in March 2014. - NRB credit policies: - Regulations mandating minimum shares of lending to deprived and productive sectors. - Cap on the spread between lending and deposit rates intended to improve efficiency. - Staff views and recommendations: - Challenges: harnessing remittances and the financial sector to support development while preserving financial soundness. - Excess liquidity and its volatility undermine monetary management, could hurt asset quality, and increase lending spreads. - Monetary policy cannot compensate for lack of infrastructure and structural impediments to growth. - Policy focus: control volatility and level of excess liquidity via sterilization and/or raising required reserves, with consideration of cost sharing between the financial system and the budget. - NRB should smooth short-term fluctuations in excess liquidity through open market operations (OMOs) and aim to reduce its level; injections of liquidity may also be appropriate. - Key steps: - Government debt securities: additional issuance of treasury bills and bonds to the NRB is needed to provide room for OMOs and to build a yield curve. Alternatively, NRB-issued securities could be used, though this may fragment an already shallow market. - Strengthen institutional settings: enhance cooperation between NRB and Ministry of Finance in forecasting revenue and expenditure flows to improve liquidity forecasts; separate monetary from debt management considerations; consider establishing a monetary policy committee at NRB. - Interest rate corridor: - Would limit interest rate volatility, facilitate liquidity management, and improve monetary policy transmission. - Could help reduce interest rate differential with India and incentives for capital flight (currently a small problem). - Effect on inflation and competitiveness: - These measures would help tighten very loose monetary conditions. While the impact on inflation would be modest (Box 3), there is some room for leaning against still-high inflation to support competitiveness. - Higher interest rates could curb relatively cheap consumer credit and, with it, imports. - Policies to direct lending and cap spreads: - Of limited effectiveness and can have unintended consequences: may undermine asset quality by pushing lending to weakly supervised micro-finance institutions and unsupervised cooperatives, reduce quality standards for lending, impede longer-term lending, and discourage bank expansion into remote areas with higher operating costs. - Recommendation: review, modify, and eventually phase out directed lending and spread caps; promote access to finance and investment lending by other means. ### Box 3 — Inflation determinants (regression summary) - Key finding: Indian inflation is the key driver of Nepali inflation; Nepal effectively imports India’s inflation via the currency peg and close trade relations. - Econometric estimates (Sample: March 2001–December 2013; Observations 152; R-squared 0.41): - Dependent variable: ∆ln(CPI) - ∆ln(CPI)t-1: Coeff 0.37*** (SE 0.06) - ∆ln(CPI_India)t: Coeff 0.45*** (SE 0.08) - ∆ln(Broad Money)t-1: Coeff 0.12** (SE 0.05) - ∆ln(NEER)t-1: Coeff -0.06 (SE 0.019) - Constant: -0.010 (SE 0.04) - Interpretation: - A 1 percent increase in India’s inflation leads to a 0.45 percent increase in Nepali inflation (estimated). - Inflation expectations (lagged CPI) also significant. - Changes in broad money have a limited impact: a 1 percent increase in broad money growth corresponds to only a 0.1 percent increase in inflation. - Effect of lagged NEER is small and not statistically significant. *Source: IMF staff report — INTRODUCTION (Nepal), as provided in the content unit.* ### 21. The authorities saw a significant role for the NRB in promoting growth. In their view, ### _cr14214 - 21. The authorities saw a significant role for the NRB in promoting growth. In their view, ### Role of the NRB and monetary policy - Authorities viewed excess reserves as resulting from banks failing to seek out lending opportunities and actively contribute to economic development; they did not want to reward such inactivity through remunerated reserves or debt issuance to mop up liquidity. - The Ministry of Finance had reservations about the interest cost of sterilization bonds. - Authorities did not regard excess liquidity as a cause for concern because it had not translated into excessive lending or higher inflation. - Authorities indicated they were considering introducing an interest rate corridor, as well as issuance of sterilization bonds. - Staff recommendation: monetary policy should focus on controlling liquidity. Specific actions recommended: - Use OMOs more actively to control both the level and volatility of liquidity in the financial system. - Equip the NRB with adequate amounts of sterilization bonds. - Step up cooperation between the NRB and the Ministry of Finance. - Strengthen the institutional set-up for monetary policy. ### Financial sector structure and vulnerabilities - As of April 2014, the NRB regulated: - 30 Class A commercial banks - 86 Class B development banks - 56 Class C finance companies - 35 Class D microfinance banks - There are about 17,000 credit cooperatives outside the NRB’s supervisory perimeter. - Despite a large increase in bank branches over the last decade, access to finance remains limited, especially in remote areas and for small and medium enterprises. - The number of financial institutions is declining slowly; NRB is encouraging mergers and a recently approved by-law on acquisitions should broaden consolidation options. - NRB supervisory efforts and legal improvements: - NRB conducted a special review of risk management practices in 20 banks (found to be deficient) and is conducting another special review of 54 banks representing over 50 percent of financial sector assets. - NRB is gradually developing crisis management capability; a Supervision Coordination Committee has been established to monitor the cooperatives sector. - Draft amendments to the NRB Act to enhance crisis management and supervision powers are being prepared; the process of amending the Banking and Financial Institutions Act (BAFIA) has begun. - A new Deposit Insurance and Credit Guarantee Corporation Bill has been drafted. - AML/CFT ordinances enacted by the newly-elected parliament may facilitate removal from enhanced Financial Action Task Force scrutiny (review in June). ### Key FSAP findings and recommendations (summary) - FSAP identified significant financial sector vulnerabilities: - Bank supervision largely compliance-based, fragmented, and underresourced. - Nonperforming loans likely underreported; evergreening widespread. - Stress tests suggest banking system strains if asset quality deteriorates moderately. - Interconnections within the financial system and to other sectors are substantial. - Rapidly growing largely unsupervised cooperatives sector poses significant risk. - FSAP recommendations (high-level): - Undertake a thorough asset quality review to identify problem loans. - Actively guide the bank consolidation process to ensure stronger banks emerge. - Strengthen bank licensing regulations, fit-and-proper criteria, risk management requirements, and standards for related parties and intra-group exposures. - Grant NRB special resolution powers to close insolvent banks and explicit consolidated supervision powers; amend legal framework for related parties and controlling interests. - Expedite risk-based supervision and integrate off- and on-site supervision. - Exercise NRB corrective and sanctioning powers proactively; amend prompt corrective action framework. - Increase NRB staffing and analytical capacity; limit staff rotation; develop IT and management systems. - Bring the Employment Provident Fund (EPF) and Citizens Investment Trust (CIT) under joint supervision of the NRB and the Insurance Board. - Significantly strengthen supervision of cooperatives by the Department of Cooperatives. - Develop and coordinate agency-specific contingency plans and carry out crisis simulations under the Interagency Coordination Committee. - Clarify mandate and reduce the number of state-owned banks. - Accelerate modernization of the payments system. - Create a collateral registry and eliminate the reporting threshold to the Credit Information Bureau. - Improve and implement debt enforcement and insolvency systems. ### Authorities’ views on financial sector reforms - Authorities broadly agreed with staff recommendations but highlighted: - Resource constraints and difficulty of closing financial institutions. - That the number of financial institutions has fallen due to mergers among development banks and finance companies. - Re-licensing now would be disruptive and should be gradual. - Joint supervision of EPF and CIT requires legal and institutional amendments under review. ### Fiscal policy: position and recommendations - Fiscal background and status: - Public debt projected to decline to 30½ percent of GDP in 2013/14. - Revenue growth remained strong due to high import growth and administrative reforms in Inland Revenue and Customs Departments. - Grant inflows strengthened, mainly related to election spending. - Capital budget was significantly raised in 2013/14, but execution remains difficult and overall level remains low. - Capital spending is underrecorded as some transfers to local governments, accounted as expense, are used for capital formation. - Staff views and recommendations: - Fiscal policy needs to support growth through higher public investment, especially in power generation and distribution, and transport. - Continued spending on health and education should be maintained. - Monitor expenditures executed through local bodies. - There is ample fiscal space to finance additional investment and social spending: - Room for further revenue growth, even if at decreasing rates. - With public debt low, a modest expansion of fiscal deficits is affordable without endangering debt sustainability. - Further fiscal space could be created by reducing or eliminating implicit subsidies to the NOC. - NOC losses need to be addressed to avoid further liabilities; the NOC currently has Nrs 34 billion in debt (1¾ percent of GDP). - Prices should be adjusted as needed to avoid recurrent losses and interruptions in supply, ideally through an automatic pricing mechanism while protecting the poor; any subsidies should be transparently recorded. - Raising public investment requires reforms to budget planning and execution: - Use the planned Fiscal Responsibility and Budget Management Act (FRBM) to remove obstacles to efficient capital budget execution (e.g., requirement for spending authorization from the Planning Commission after budget approval; no multi-year spending authorizations). - Better prioritize spending within sectors to ensure completion of key projects. - Following rollout of the TSA, pursue public financial management reforms to enhance cash management and improve revenue and expenditure forecasts. - Authorities’ actions: - Authorities agreed on the need to boost capital spending and intend to pass the 2014/15 budget one month ahead of the fiscal year to facilitate execution. - They are examining other obstacles to public investment, including provisions in the Procurement Act. - Political constraints were noted regarding fuel pricing. ### Boosting sustainable and inclusive growth - Human development and inclusion: - Poverty has been reduced significantly but human development indicators remain low. - Further expenditures on health and education could reduce human effects of poverty and improve workforce productivity. - Cellular phone subscriptions amount to 85 percent of the population and are estimated to cover 65-70 percent of individuals; mobile telephony offers an opportunity to extend financial services and promote inclusion. - Structural reforms recommended: - Financial sector policies and higher public investment help support private sector investment, but comprehensive reforms are required. - Labor market reforms and improvements in market efficiency through competition (e.g., fuel distribution and goods and passenger transport) would support broader economic development. - Consider creation of a dedicated competition authority. - Offer a one-stop shop for any investor, not only for large investments. - Hydroelectric potential: - Accelerate exploitation of Nepal’s large hydroelectric power potential, given long lead times. - Expansion of power supply through current projects should alleviate shortages, but demand is expected to increase as well. - Power could be exported to India, diversifying foreign exchange sources. - Develop large-scale projects with foreign investment to generate power and build infrastructure for power trade with India expeditiously. - Authorities noted some domestically financed hydroelectric projects showed good execution; shorter-gestation projects may help kick-start growth even if large projects have higher long-term impact. ### Other issues and statistical capacity - Safeguards and treasury management: - New accounting software installed and all government transactions are monitored through the TSA; controls over reserve management are being strengthened. - Statistics: - Efforts to strengthen macroeconomic statistics should continue under the National Strategy for Development of Statistics. - IMF TA is being provided to improve statistics in national accounts, fiscal accounts, balance of payments, and monetary accounts. ### Staff appraisal: summary of key judgments - Macroeconomic situation is broadly stable and the external position strong, supported by robust remittance inflows which increase reserves but also fuel excess liquidity and skew activity to non-tradables, reducing competitiveness of agriculture and industry. - Fiscal position is solid with low public debt, but public investment remains modest. - Poverty reduction has progressed, but economic growth is weak due to low public investment, weak business climate, and eroding external competitiveness. - Monetary policy should emphasize liquidity control via OMOs, adequate sterilization bonds, stronger NRB-MoF cooperation, and institutional strengthening. - Financial sector policies should aim to strengthen supervision, reduce vulnerabilities, and make the system more efficient: - Substantially reduce number of banks with strengthened licensing; close insolvent banks where appropriate. - Expedite move to risk-based supervision and enhance legal framework, staffing, and IT. - Expand and strengthen supervision of cooperatives. - Develop financial infrastructure to reduce risks and increase access to credit. - Fiscal policy can support growth and poverty reduction given rising revenues and low public debt; remove implicit NOC subsidies and pass FRBM Act and other institutional changes to improve capital spending execution. - Urgent reforms needed to boost inclusive growth: improve competitiveness in industry and agriculture, enhance labor relations and competition, reduce regulatory burden, and accelerate large privately financed infrastructure projects to boost investor confidence. *IMF staff report content as provided in the supplied source.* ### 48. It is proposed that the next Article IV consultation take place on the standard 12- ### It is proposed that the next Article IV consultation take place on the standard 12-month cycle. ### Recent developments - Economic growth slowed in 2012/13, largely due to weak agricultural output and anemic public investment due to delay of the 2012/13 budget. - Inflation: after spiking in December, is gradually decelerating but remains high. - Exchange rate: The Nepalese rupee has weakened reflecting the peg to the Indian rupee, and the REER has depreciated. - Workers’ remittances are still growing, albeit at a reduced pace, fueling continued accumulation of international reserves. - Real GDP growth (selected annual percent changes): 2010/11: 3.4; 2011/12: 4.8; 2012/13: 3.9; 2013/14: 4.8; 2014/15: 5.0. - CPI (period average): 2010/11: 9.6; 2011/12: 8.3; 2012/13: 9.9; 2013/14: 8.8; 2014/15: 7.8. - CPI (end of period): 2010/11: 9.7; 2011/12: 11.5; 2012/13: 7.7; 2013/14: 8.0; 2014/15: 7.5. ### Fiscal developments and government operations - Fiscal year ends in mid-July. - Fiscal indicators (in percent of GDP): - Total revenue and grants: 2010/11: 17.7; 2011/12: 18.7; 2012/13: 19.3; 2013/14: 21.1; 2014/15: 21.3. - Expenditure: 2010/11: 18.7; 2011/12: 19.3; 2012/13: 17.9; 2013/14: 20.8; 2014/15: 21.1. - Net lending/borrowing: 2010/11: -1.0; 2011/12: -0.6; 2012/13: 1.4; 2013/14: 0.2; 2014/15: 0.2. - Table 2 (central government operations, selected levels in billions of NPR): - Total revenue and grants (2010/11–2014/15, selected): 242; 285; 327; 424; 407; 490; 465 (presented across columns). - Total revenue (2010/11–2014/15, selected): 197; 244; 296; 354; 353; 421; 409. - Expenditure (2010/11–2014/15, selected): 255; 295; 302; 439; 402; 491; 461. - Memorandum items: - Public debt (in percent of GDP): 2010/11: 34.5; 2011/12: 36.3; 2012/13: 31.5; 2013/14: 30.5; 2014/15: 29.7. - GDP at market prices (in billions of Nepalese rupees): 2010/11: 1,367; 2011/12: 1,527; 2012/13: 1,693; 2013/14: 1,931; 2014/15: 2,183. ### Monetary and financial developments - Deposit growth supported by workers’ remittances, leading to increases in banks’ excess reserves. - Interbank rates spiked on temporary tighter liquidity but fell back as remittances continued to rise. - Broad money is relatively stable while reserve money is volatile due to seasonality of the public sector balance. - Credit to private sector is decelerating but remains robust; some lending is flowing to the real estate sector. - Monetary indicators (end-period levels and growth): - Reserve money (in billions of NRs): 2010/11: 234; 2011/12: 319; Mar 2014: 354; 2013/14: 375; 2014/15: 494; 46; 23 (table includes multiple columns). - Broad money (in billions of NRs): 2010/11: 922; 2011/12: 1,131; Mar 2014: 1,315; 2013/14: 1,458; 2014/15: 1,585; 1,900. - Broad money (12-month percent change): 2010/11: 12.3; 2011/12: 22.7; 2012/13: 16.3; 2013/14: 20.5; 2014/15: 19.9. - Domestic credit (12-month percent change): 2010/11: 13.7; 2011/12: 8.0; 2012/13: 16.9; 2013/14: 15.5; 2014/15: 18.0. - Credit to private sector (12-month percent change): 2010/11: 13.1; 2011/12: 11.3; 2012/13: 20.2; 2013/14: 16.4; 2014/15: 18.7. - Banks’ excess reserves and open market operations: excess reserves (in bil NPR) and measures (outright purchase/sales, repo/reverse repo) show liquidity injections (+) and withdrawals (-) over 2009–Jan-2014. ### External sector, remittances, and reserves - Balance of Payments (in million US$; selected years): - Current account: 2010/11: -181; 2011/12: 909; 2012/13: 635; 2013/14: 801; 2014/15: 676. - Trade balance: 2010/11: -4,470; 2011/12: -4,605; 2012/13: -5,247; 2013/14: -5,961; 2014/15: -6,760. - Exports, f.o.b.: 2010/11: 961; 2011/12: 1,008; 2012/13: 977; 2013/14: 1,041; 2014/15: 1,088. - Imports, f.o.b.: 2010/11: -5,430; 2011/12: -5,613; 2012/13: -6,224; 2013/14: -7,002; 2014/15: -7,848. - Current transfers (credit): 2010/11: 4,351; 2011/12: 5,254; 2012/13: 5,732; 2013/14: 6,586; 2014/15: 7,247. - Workers' remittances (in millions of US$): 2010/11: 3,545; 2011/12: 4,414; 2012/13: 4,931; 2013/14: 5,671; 2014/15: 6,297. - Remittances (in percent of GDP): 2010/11: 18.6; 2011/12: 23.4; 2012/13: 25.6; 2013/14: 29.4; 2014/15: 31.0. - Gross official reserves (in millions of US$): 2010/11: 3,085; 2011/12: 4,307; 2012/13: 4,972; 2013/14: 6,082; 2014/15: 7,120. - Gross official reserves (in months of prospective GNFS imports): 2010/11: 5.8; 2011/12: 7.2; 2012/13: 7.4; 2013/14: 8.2; 2014/15: 8.6. ### Macroeconomic framework and projections (selected) - Real GDP (annual percent change) projection path: 2014/15: 5.0; 2015/16: 4.7; 2016/17: 4.5; 2017/18: 4.5; 2018/19: 4.5. - CPI (period average) projections: 2014/15: 7.8; 2015/16: 7.0; 2016/17: 6.3; 2017/18: 5.9; 2018/19: 5.9. - Fiscal indicators (in percent of GDP), projected: - Total revenue and grants: 2014/15: 21.3; 2015/16: 21.6; 2016/17: 21.7; 2017/18: 21.9; 2018/19: 22.1. - Expenditure: 2014/15: 21.1; 2015/16: 21.6; 2016/17: 21.8; 2017/18: 22.0; 2018/19: 22.3. - Net lending/borrowing: 2014/15: 0.2; 2015/16: 0.0; 2016/17: -0.1; 2017/18: -0.1; 2018/19: -0.2. - Balance of payments projections (current account in millions of US$): 2015/16: 475; 2016/17: 202; 2017/18: -115; 2018/19: -429. ### Business environment and governance - Ease of Doing Business: Nepal’s overall ranking improved between 2008 and 2014 but deteriorated along several dimensions; infrastructure and higher education remain key impediments. - Global Competitiveness Index (2013-14): Nepal scores indicate room for improvement across multiple dimensions. - Governance: Voice and accountability have risen but there remains ample room for further improvements. - Labor markets seem less efficient than regional peers; regulatory quality also indicates room for further improvement. - Note: Indicators are to be interpreted with caution due to limited respondents, limited geographical coverage, and standardized assumptions on business constraints and information availability. ### Inclusive growth and social indicators - Economic growth has been stable but low; income poverty has declined dramatically, largely due to remittances. - MDG poverty reduction target: the MDG poverty reduction target has already been met. - Income distribution has improved, but output per capita remains among the lowest in the region and further efforts are needed to improve human welfare. - Selected comparative levels: - Change in poverty headcount ratios (examples): Nepal (1996-2011) compared to regional peers (various periods) at $2/day and $1.25/day PPP. - Per capita GDP (PPP, 2000–2012): Nepal listed among lower per capita countries in regional comparison. - Human Development Index (HDI, 2012): Nepal lower than many peers; exact HDI values displayed in figures. ### Financial soundness indicators (commercial banks) - Capital adequacy: - Capital fund to risk weighted assets (percent): 2006: -5.3; 2007: -1.7; 2008: 4.0; 2009: 7.2; 2010: 9.6; 2011: 10.6; 2012: 11.5; 2013: 12.3. - Tier 1 capital to risk weighted assets (percent, where shown): 2008: 1.8; 2009: 5.2; 2010: 7.9; 2011: 9.1; 2012: 10.0; 2013: 10.7. - Asset quality: - NPLs to total loans (percent): 2006: 13.2; 2007: 10.6; 2008: 6.1; 2009: 3.6; 2010: 2.5; 2011: 3.2; 2012: 2.6; 2013: 2.7. - Profitability: - Return on equity (ROE): 2006: 31.4; 2007: 35.2; 2008: 34.7; 2009: 33.9; 2010: 25.3; 2011: 22.5; 2012: 28.2. - Return on assets (ROA): 2006: 4.3; 2007: 1.4; 2008: 2.0; 2009: 4.9; 2010: 1.9; 2011: 1.7; 2012: 1.5; 2013: 1.7. - Liquidity: - Liquid assets to total assets (percent): 2006: 9.1; 2007: 9.0; 2008: 11.8; 2009: 26.0; 2010: 13.1; 2011: 11.2; 2012: 15.2; 2013: 14.7. - Exposure to real estate (where reported): - Share of real estate and housing loans (percent): 2010: 19.4; 2011: 20.7; 2012: 18.5; 2013: 16.9; 2014: 14.6 (table series). ### Millennium Development Goals (selected indicators and status) - Goal 1 (Eradicate extreme poverty and hunger): - Proportion of population below the national poverty line: earliest 55(95); most recent 25.2(11); 2015 target 27.5; Status: Achieved. - Proportion of population below minimum dietary energy consumption: earliest 49(90); most recent 22.5(10); 2015 target 25; Status: Achieved. - Goal 2 (Universal primary education): - Net primary enrollment ratio: earliest 64(90); most recent 93.7(10); 2015 target 100; Status: Likely. - Literacy rate of 14–24 age: earliest 49.6(90); most recent 86.5(10); 2015 target 100; Status: Possible. - Goal 3 (Gender equality): - Ratio of girls to boys in primary education: earliest 56(90); most recent 99(11); 2015 target 100; Status: Achieved. - Ratio of females to males in tertiary institutes: earliest 32(90); most recent 63(10); 2015 target 100; Status: Unlikely. - Goal 4 and 5 (Child and maternal health): - Under-five mortality rate (per 1,000 births): earliest 162(90); most recent 54(11); 2015 target 38; Status: Unlikely. - Maternal mortality ratio (per 100,000 live births): earliest 850(90); most recent 229(08); 2015 target 213; Status: Likely. - Goal 6 (Combat HIV/AIDS, malaria, and other diseases): - HIV prevalence among population aged 15–24 years: earliest 0.29(90); most recent 0.3(11); 2015 target 0.35; Status: Achieved. - Annual parasite incidence of malaria per 100,000 people: earliest 119(90); most recent 16(10); Status: Achieved. - Goal 7 (Environmental sustainability) and sanitation indicators: - Proportion of population with access to an improved drinking water source: earliest 46(90); most recent 80(08); 2015 target 73; Status: Achieved. - Proportion of population with access to improved sanitation: earliest 6(90); most recent 43(08); 2015 target 53; Status: Unlikely. *Source: Nepalese authorities; and IMF staff estimates and projections (extracted from the provided IMF staff report content).* ### Annex I. Risk Assessment Matrix ### Annex I. Risk Assessment Matrix ### DOMESTIC RISKS - Financial sector distress - Likelihood: Medium - Impact: Medium/High - Policy Response to Minimize Impact: Move to pro-active and risk-based supervision and exercise corrective and sanctioning powers more forcefully, and earlier. Increase resources for supervision. - Political instability - Likelihood: Medium - Impact: Low/Medium - Policy Response to Minimize Impact: Preserve fiscal and external policy space. - Decisive reform push and increase in public investment (upside) - Likelihood: Low - Impact: High - Policy Response to Minimize Impact: (No additional policy response text provided in source.) ### EXTERNAL RISKS - Slower-than-projected recovery in India - Likelihood: Medium - Impact: Low - Policy Response to Minimize Impact: Accelerate structural reforms to improve the investment climate and boost public investment. - Protracted period of slower growth in emerging economies - Risk description: An economic slowdown in countries (Persian Gulf countries, Malaysia) hosting Nepali overseas workers could weaken remittance inflows. This would reduce demand and growth; tighten liquidity and expose weaknesses in the financial system; and reduce government revenues due to slower import growth. - Likelihood: High - Impact: Medium/High - Policy Response to Minimize Impact: Preserve fiscal and external policy space to cope with adverse shock in the short term. In the longer term, boost public investment, and pursue structural reforms to improve the investment climate to reduce dependency on remittances. ### Risk Assessment Matrix note - The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly. *Source: Annex I. Risk Assessment Matrix, NEPAL — STAFF REPORT FOR THE 2014 ARTICLE IV CONSULTATION—INFORMATIONAL ANNEX* ### 2011. The Industrial Enterprises Act places a 75 percent limit on the conversion and transfer to ### _cr14214 - 2011. The Industrial Enterprises Act places a 75 percent limit on the conversion and transfer to ### Exchange restriction and legal implication - The Industrial Enterprises Act places a 75 percent limit on the conversion and transfer to foreign currency of salaries of non-residents from countries where convertible currency is in circulation. - Since the limit applies to amounts that may be less than net salaries, it gives rise to an exchange restriction under Article VIII. ### Safeguards Assessments - A safeguards assessment of the NRB was concluded in May 2011. - Key findings: - The external audit mechanism needed improvement because the audit procedures did not meet international standards. - NRB’s financial reporting would be strengthened by resolving the many qualifications raised by the external auditors each year. ### 2012 Article IV Consultation - The Executive Board discussed the staff report for the 2012 Article IV consultation (IMF Country Report No. 12/326) on November 16, 2012. - Consultations with Nepal are held on the standard 12 month Article IV consultation cycle. ### Technical Assistance Since 2010 (by area and year) - MCM: - Monetary Policy/Operations: Continuous - Monetary Policy Operations and Enhancing Banking Supervision: 2010 - Bank Supervision and Crisis Management: 2011 - Conduct Bank Diagnostics: 2012 - Banking Supervision and Regulation: 2012 - Migration to GFSM 2001: 2012 - Exchange Rate and Capital Account Liberalization: 2013 - FAD: - Tax and Customs Administration Reforms/Modernization: 2006–12 - Follow up on the LTO and Customs Administration Reform: 2010 - PFM Stocktake: 2010 - Capacity Building Workshop: 2009–10 - Revenue Administration: 2011–13 - Extension of LT Treasury Advisor: 2011 - Long Term Revenue Administration: 2011 - Side trip of LT Advisor to Kailali, Kanchanpur: 2011 - Side trips to Bhairwah and Palpa: implementation of TSA: 2011 - Side trip to Gorkha, Tanahu and Kaski: 2011 - Treasury Roadmap: 2011 - Visiting district Lomjun—discussions with the DTCO's and staffs relating to TSA progress: 2012 - Visiting districts Pokhara, Kasi, Tanahu, and Sindhupal Chowk: 2012 - Implementation of a Large Tax Payer Unit: 2013 - Review of Tax Policy and VAT Administration: 2013 - Public Financial Management: 2014 - Pension reform: 2014 - LEG: - AML/CFT National Strategy: 2010, 2011, 2014 - Work-at-Home Assignment: 2011 - Bank Resolution: 2012 - AML/CFT Legal Drafting Mission: 2012, 2013, 2014 - AML/CFT Structures and Tools: 2012, 2013, 2014 - STA: - Balance of Payments Statistics: 2010, 2012, 2014 - Monetary Statistics: 2011, 2014 - National Accounts: 2012, 2014 ### Resident Representative - Mr. Thomas Richardson has been the Senior Resident Representative since August 6, 2012. - He is based in New Delhi. ### Relations with the World Bank Group — Partnership and strategic priorities (As of April 10, 2014) - Development context and priorities: - Poverty reduction: percentage living on less than $1.25 a day fell from 53 percent in 2003/2004 to 25 percent in 2010/2011. - Political transition: peaceful transfer in power after November 2013 elections. - Economic constraints: growth reliant on remittances and basic services; need to remove bottlenecks to private and public investment. - Hydropower potential: estimated potential 84,000 MW, at least half economically viable, only 746 MW currently developed. - WBG strategic shift: - New Country Partnership Strategy (CPS) covering FY2014-2018 focusing on long-term support. - Two pillars: - Pillar 1: increasing economic growth and competitiveness (hydropower, transport connectivity, business environment). - Pillar 2: increasing inclusive growth and shared prosperity (agriculture productivity, health care access, skills, social protection). - Cross-cutting: improve effectiveness, efficiency and accountability of public expenditure. - Principles: balancing risks and rewards, selectivity, flexibility. ### IMF–World Bank collaboration areas - Bank-led areas with no direct IMF involvement: - Social sectors, infrastructure, environment, and agriculture; examples: SSRP, Second Higher Education Project, Enhanced Vocational Education and Training Project, Second HNP and HIV/AIDS Project, Community Action for Nutrition Project, Road Sector Development Project, Bridges Improvement and Maintenance Program, Kabeli Transmission Project, Kabeli-A Hydroelectric Project, Urban Government and Development Program, Nepal Irrigation and Water Resources Management Project, Modernization of Rani Jamara Kulariya Irrigation Scheme, RAIDP, Agriculture Commercialization and Trade Project, Social Safety Net Project, Peace Support Project, Poverty Alleviation Fund (PAF). - Bank-led input into IMF program: - Public expenditure analysis, development of a Medium Term Expenditure Framework (MTEF) applied since FY04. - Shared responsibility: - Macroeconomic aggregates management, debt management (technical assistance, joint Debt Sustainability Analysis), revenue growth support, financial sector strengthening (joint FSAP), crisis management, bank resolution, deposit insurance. - FY13 Development Policy Operation (DPO) developed with DFID and the IMF; follow-up DPO planned. ### World Bank Group strategy and lending operations (FY14 and portfolio) - WBG focus areas (IDA, IFC, MIGA) per CPS pillars. - FY14 Lending Program: - IDA committing US$222 million in new commitments including: - Strengthening National Rural Transport Project (U$100 million) - Irrigation and Water Management Additional Financing (US$50 million) - Third Rural Water Supply and Sanitation Project (US$72 million) - Bank Assistance Program in Nepal: - Current portfolio: 17 projects with net commitments of $1.5 billion, and three regional projects with net commitments of about $240 million. - Average project size: $86 million (near Bank-wide IDA average of about $87 million). - Cumulative disbursements as of January 31, 2014: - National projects: $633 million (about 46 percent of net commitments). - Regional projects: about $15 million (about 6 percent of net commitments). - Economic and Sector Work: - Support to Living Standards Survey (NLSS 3) with UK DFID and Denmark; core data on poverty trends and access to services. ### IFC activities and pipeline (as of March 4, 2014 and February 2014) - Committed investment portfolio in Nepal: $40 million as of March 4, 2014 (power, transport, banking, microfinance, tourism, trade finance lines). - Recent investment activity: - 14 projects for $57 million over FY12 and FY13. - 6 projects for around $4 million in FY14 as of March 4, 2014. - Advisory services: - Investment climate, access to finance, sustainable business advisory, PPP transaction advisory (MoU with Investment Board of Nepal). - Advisory portfolio growth: $1.3 million in FY09 (three projects) to $12.8 million as of February 2014 across 12 projects. - Strategic focus going forward: - Align with IFC South Asia Strategy pillars: (a) inclusive growth; (b) climate change; (c) regional and global integration. - Priorities: hydropower, financial sector, agribusiness. - Instruments: SME Venture Fund, Infraventures, PPP transaction advice, risk-sharing facilities, local currency financing in partnership with IDA and the GON. ### IDA Projects — Selected numerical snapshot (Table II.1) - IBRD/IDA totals: - Total Disbursed (Active): 675.32 - of which has been repaid: 0.00 - Total Disbursed (Closed): 762.54 - of which has been repaid: 419.19 - Total Disbursed (Active + Closed): 1,437.86 - of which has been repaid: 419.19 - Total Undisbursed (Active): 711.52 - Total Undisbursed (Closed): 16.04 - Total Undisbursed (Active + Closed): 727.55 - Active Projects (selection, Amounts in US$million — Cancel./Undisb. shown): - P132289 Kali Gandaki Rehab: 27.3 / 27.8 - P125495 NP: Bridges Program Support: 60.0 / 43.3 - P120265 NP: Emerging Towns Project: 25.0 / 6.4 / 10.9 - P104015 NP: Enhanced Vocational Educ & Trng: 50.0 / 10.4 / 26.2 - P099296 NP: Irrig & Water Res Mgmt Proj: 114.3 / 59.8 - P112893 NP: Kabeli Transmission Project: 38.0 / 28.3 - P105860 NP: PAF II: 245.0 / 0.0 / 82.0 - P110762 NP: Peace Support Project: 50.0 / 13.1 / 11.9 - P118179 NP: Rani Jamara Kulariya Irrigation Proj: 43.0 / 31.1 - P095977 NP: Road Sector Development Project: 117.6 / 28.5 - P113441 NP: School Sector Reform Program: 230.0 / 103.4 - P090967 NP: Second Higher Education Project: 60.0 / 14.6 - P117417 NP: Second HNP and HIV/AIDS Project: 129.2 / 57.2 - P113002 NP: Social Safety Nets Project: 64.5 / 5.2 / 7.8 - P087140 NP: Agriculture Commercialization & Trade: 60.0 / 50.7 - P125359 NP: Community Action for Nutrition Project: 40.0 / 37.7 - P132750 SNRTP: 100.0 / 100.2 - Overall Result line: 1453.8 / 35.17 / 711.5 ### Relations with the Asian Development Bank (ADB) — key figures (as of 31 December 2013) - Historical lending to Nepal since 1969: - 128 sovereign ADF loans: $3,103.38 million - 5 non-sovereign loans: $58.64 million - 34 ADF grants: $823.75 million - Total: $3,985.77 million - Nepal CPS 2013–2017 priorities: energy, transport, urban infrastructure and services, agriculture, education; mainstreaming: gender equality and social inclusion, environmental sustainability, good governance, regional cooperation and integration, private sector development. - Active sovereign ADF loans and grants as of 31 December 2013: 47 loans and grants with net amount $1,553.75 million. - 2013 assistance program comprised seven projects totaling $330.5 million in ADF loans and $45.5 million in ADF grants; projects included Tanahu Hydropower Project (loan $150.0 million), Skills Development Project (grant $20.0 million), Kathmandu Valley Waste Water Management Project (loan $80.0 million), SASEC Road Connectivity Project (loan $75.0 million), Project Preparatory Facility for Energy (grant $21.0 million), Bagmati River Basin Improvement Project (loan $25.5 million and grant $4.5 million). - Technical Assistance: approved TAs totaling $180.30 million; 24 ongoing TAs amounting to $32.8 million. - Private sector cumulative approvals: $58.6 million across four projects as of 31 December 2013; notable: 60-MW Khimti Hydropower project. ### Statistical Issues — data quality and coverage - Overall: Economic and financial data broadly adequate for surveillance but scope for improvement in fiscal (external financing) data, more detailed price statistics, and timeliness and quality of balance of payments data. - GDDS participation since May 2001; metadata last updated January 2009. - Real Sector Statistics: - CBS compiles national accounts using 1993 SNA. - STA 2011 mission: expenditure side does not separately estimate change in inventories; inventories plus statistical discrepancy treated as residual, risen to more than 13 percent of GDP. - Issues: low quality extrapolators, lack of benchmark surveys in construction and trade; planned rebasing considerations to 2004/05 or 2010/11 for reference year 2013/14 or 2014/15. - Quarterly national accounts progress for 2004/05 to 2012/13; planned publication March or April 2014 but data require review. - Lack of annual household consumption expenditure data; CBS launched annual household survey to improve this. - Quarterly manufacturing production index exists but not updated since Q1 of 2010/11. - Price statistics: - NRB compiles CPI with base year 2005/06; CPI basket revision survey underway expected to be completed in 2013/14 to produce a new CPI series by 2015/16. - WPI published with weights based on 1999/2000: agricultural commodities 49.6 percent, domestic manufactured goods 20.4 percent, imported goods 30 percent. - PPI currently restricted to manufacturing; TA provided to expand coverage. - Index of wages and salaries compiled with base year 2004/05. - Government Finance Statistics: - Fiscal data compiled according to GFSM 2001 since 2011. - Budget classification needs improvement: exclude financing transactions from functional classification, clarify distinction between revenue and transactions in nonfinancial assets, subsidies and capital payments to enterprises. - TSA rolled out to all 75 districts including Kathmandu. - Some fees collected outside budget, foreign aid directly paid by donors, extrabudgetary entities and local governments not reported in annual budget; no government balance sheet compiled per GFSM 2001. - Government finance statistics reported for the GFS Yearbook but not in International Financial Statistics. - Monetary and Financial Statistics: - NRB broadened monthly monetary statistics coverage to include development banks and finance companies; publishes expanded broad money survey. - Interest rate reporting gaps: deposit and lending rates of commercial banks not well reported; development banks and finance companies rates not reported. Currently maximum and minimum rates reported; suggestion to report prime lending rate of top 5 commercial banks and average deposit rates of same. - Data inconsistency: NRB’s claims on ODCs not consistent with ODCs’ liabilities due to omission of NRB deposits at ODCs. - External Sector Statistics: - NRB compiles BOP per BPM5 but shortcomings in coverage, classification, and data sources: - (i) underestimation of imports (and to lesser extent exports); - (ii) significant problems measuring remittances; - (iii) incompleteness of data on foreign grants making classification difficult; - (iv) absence of direct investment data; - (v) unrecorded financial flows. - Participation in JSA project on Improvement of External Sector Statistics; since 2012 NRB receiving ESS TA. - 2013 STA mission noted progress: preliminary draft of IIP compiled, resumed external sector debt statistics, improved direct investment compilation; drafts submitted to NRB management for approval. - Continued redesign of ITRS and improved surveys for direct investment and trade credit data. - Overall BOP data quality has improved with IMF STA TA and training. ### Common Indicators Required for Surveillance (as of April 30, 2014) — frequency and latest observation examples - Exchange rates: Date of Latest Observation Mar. 2014; Date Received Apr. 2014; Frequency of Data D and M; Frequency of Reporting W and M; Frequency of Publication W and M. - International reserve assets and reserve liabilities of the Monetary Authorities: Date of Latest Observation Mar. 2014; Date Received Apr. 2014; Frequency M / M / M. - Reserve/base money, Broad money, Central bank balance sheet, Consolidated balance sheet of the banking system: Date of Latest Observation Mar. 2014; Date Received Apr. 2014; Frequency M / M / M. - Interest rates: Date of Latest Observation Mar. 2014; Date Received Apr. 2014; Frequency of Data D and M; Frequency of Reporting W and M; Frequency of Publication W and M. - Consumer price index: Date of Latest Observation Mar. 2014; Date Received Apr. 2014; Frequency M / M / M. - Revenue, expenditure, balance and composition of financing – general government and central government: Date of Latest Observation Mar. 2014; Date Received Apr. 2014; Frequency M / M / M. - Stocks of central government and central government-guaranteed debt: Date of Latest Observation Mar. 2014; Date Received Apr. 2014; Frequency A/M / A/M / A/M. - External current account balance; Exports and imports of goods and services: Date of Latest Observation Mar. 2014; Date Received Apr. 2014; Frequency M / M / M. - GDP/GNP: 2012/13 (Date of Latest Observation); Date Received Sep. 2013; Frequency A / A / A. - Gross external debt: Jul. 2013 (Date of Latest Observation); Date Received Sep. 2013; Frequency A / A / A. ### Debt Sustainability Analysis (STAFF REPORT FOR THE 2014 ARTICLE IV CONSULTATION—DEBT SUSTAINABILITY ANALYSIS) - Overall assessment: - Nepal is assessed to be at low risk of debt distress compared to the previous assessment of moderate risk. - Main reasons: reduced estimates of the cost of a potential financial sector shock and the increase in the discount rate used. - Fiscal and debt dynamics: - Generally prudent fiscal policy and low execution of capital spending budgets have underpinned declining levels of public debt. - Baseline external public debt indicators show external debt dynamics are broadly sound and resilient to standard stress tests. - Policy implication noted: - Efforts to raise capital investment would enhance long term growth. - Raising net incurrence of liabilities to around 2½ percent of GDP over the medium term would help boost domestic capacity while maintaining a stable debt profile. *IMF staff report content as provided in the source PDF.* ### 1. The total stock of public debt in Nepal declined in 2013 to 31¼ percent of GDP from ### _cr14214 - 1. The total stock of public debt in Nepal declined in 2013 to 31¼ percent of GDP from ### Debt stock and composition (2013) - Total public debt: declined to 31¼ percent of GDP in 2013 (from 36 percent in 2012, and from around 60 percent a decade ago). - External debt: 20 percent of GDP by end-2013 ($3½ billion); 85 percent of external debt is concessional borrowing from World Bank and Asian Development Bank (ADB). - Largest bilateral creditors: Japan, followed by Korea, India and China. - Domestic debt: declined from 13½ percent of GDP in 2012 to 11½ percent by end-2013, reflecting low budget execution and a budget surplus in 2012/13. ### Macroeconomic assumptions and projections - Real GDP growth: - 2012/13: 3½ percent - 2013/14: 4¾ percent - Medium and long run: projected at 4½ percent (slightly higher than 4 percent assumed previously). - Remittances: - Poised to touch nearly 30 percent of GDP in 2013/14. - Remittance growth captured explicitly in external analysis. - Fiscal policy stance: - Expected to remain prudent. - Public investment: increase from 3.7 percent of GDP in 2014 to 5.2 percent in 2034. - Net incurrence of liabilities: projected to rise from 1¼ percent of GDP in 2013/14 to 2¼ percent over the next five years, and to 2½ percent towards the end of the DSA horizon. - Financing tilt: increasing toward domestic sources, rising to 1½ percent of GDP in the long term. - Grant element and discount rate: - Discount rate unified at 5 percent for LIC DSAs. - Grant element of foreign borrowing remains in the range of 53–55 percent throughout the DSA horizon (compared to 32–36 percent in the previous DSA). - Future disbursements assumed mostly concessional IDA and ADB loans, with enhancement of total IDA assistance by at least 10 percent. - Selected macro table highlights (as presented in source; values preserved as shown): - Real growth (%) series: 4.6 3.9 4.0 4.0 4.8 4.7 4.5 0.7 0.5 - Inflation (GDP deflator, %) series: 8.7 8.1 7.7 5.1 8.8 7.1 5.0 -0.6 -0.1 - Revenues and grants (% GDP) series: 18.3 17.9 18.1 19.2 21.1 21.7 22.5 3.6 3.3 - Grants (% GDP) series: 2.6 2.0 2.1 1.8 2.8 2.5 2.3 0.4 0.5 - Primary expenditure (% GDP) series: 18.7 19.2 19.3 21.3 21.4 22.9 24.0 3.6 2.7 - Net acquisition of non-financial assets (% GDP) series: 3.1 3.3 3.3 4.2 3.7 4.4 5.2 1.1 1.0 - Primary deficit (% GDP) series: 0.4 -0.6 1.2 2.1 0.3 1.1 1.5 -0.1 -0.6 - Net incurrence of liabilities series: 1.4 2.3 2.5 3.6 1.3 2.1 2.5 -0.4 -1.1 - Net domestic financing (% GDP) series: 1.4 2.3 2.4 2.7 1.0 1.0 1.5 -1.4 -1.2 - Exports of G&S (y/y growth) series: 11.7 8.2 7.7 7.1 4.1 7.2 6.0 -0.5 -1.1 - Imports of G&S (y/y growth) series: 0.6 9.4 9.3 7.4 10.9 10.2 6.1 0.9 -1.3 - Remittances (y/y growth) series: 24.5 8.3 10.9 7.5 15.0 7.9 6.0 -3.0 -1.5 - Current account balance (% GDP) series: 4.7 -0.3 -0.5 -0.5 4.2 0.9 -0.8 1.4 -0.3 - Note: MT stands for medium term (average over next 5 years); LT refers to long term (end of projection period). ### External debt sustainability (baseline and stress) - Baseline outcomes: - External debt indicators remain well below indicative sustainability thresholds. - PV of external debt stabilizes at: - 8 percent of GDP + remittances, - 25 percent of exports + remittances, - 50 percent of revenues. - Debt service-to-exports + remittances stabilizes at 1½ percent. - Debt service-to-revenues stabilizes at 3¼ percent. - Stress tests: - Standard shocks considered: GDP growth, exports, non-debt creating flows (remittance shock), combination shocks, and a one-time 30 percent nominal depreciation shock. - Most severe shock (non-debt creating flows / remittance shock): PV of debt to exports + remittances rises rapidly over next 2 years but stays below threshold and then declines. - Overall, debt dynamics remain resilient to standard shocks. ### Public debt sustainability (baseline and stress) - Baseline projections: - Public debt-to-GDP ratio: increases slightly from 31¼ percent in 2013 to 32½ percent in 2034. - PV public debt-to-GDP: declines from 25½ percent in 2013 to 23¾ percent by 2034. - PV public debt as a ratio of revenues and grants: declines from 132 percent in 2013 to 103 percent by 2034. - Composition shift: domestic debt share projected to rise from 36 percent in 2013 to 40 percent of total public debt in 2034. - Stress tests: - Most extreme shock: a 30 percent one-time depreciation in 2015 — does not lead to a breach of the threshold for PV public debt-to-GDP. - A 10 percent of GDP increase in debt-creating flows (mimicking domestic debt-financed bank recapitalization) raises PV public debt-to-GDP to a peak of 29 percent in 2015, remaining well below the 56 percent threshold. - Previous financial-sector-shock scenarios that led to sustained breaches are considered unlikely given FSAP stress test findings and progress on financial sector reforms. ### Contingent liabilities and fiscal risks - Main contingent liability sources: operations of state owned enterprises (SOEs) and rising pension costs. - SOE losses and government exposure: - Nepal Oil Corporation (NOC) and Nepal Electricity Authority (NEA) combined average losses: 1½ percent of GDP a year, requiring frequent government bail-outs. - NOC outstanding loans from accumulated past losses: nearly NR 34 billion (1¾ percent of GDP). - NEA outstanding loans from the Government: nearly NR 69 billion (3½ percent of GDP). - Other contingent liabilities of SOE sector (debt arrears, accumulated losses, government guaranteed debt, unfunded employee liabilities): another 2 percent of GDP. - Government guaranteed debt (mainly pension fund loans to NOC): estimated at ¾ percent of GDP; does not appear to pose a risk to debt sustainability. - Pension liabilities: - Civil service pension liabilities currently modest at 1¼ percent of GDP, rising to 1½ percent by 2025. - Can be addressed through adequate parametric reforms in the medium term (per recent IMF TA mission on pension reforms). - Financial sector recapitalization reference: - FSAP stress test: recapitalization needs for entire banking sector from a shock where nonperforming assets increase by 2 percentage points (50 percent increase) could amount to 4¾ percent of GDP. ### Authorities’ views and policy actions - Authorities broadly concurred with DSA findings and policy messages. - Concerns raised: - Change in IDA assistance from a mix of loans and grants to loans only (triggered by low risk of debt distress) — authorities felt penalized for their success. - Measures to improve capital spending execution: - Introducing the budget a month earlier in FY2015 to speed release of appropriations for investment projects. - Amendments to the Procurement Act. - Drafting a Fiscal Responsibility and Budget Management Law to enhance budgeting and expenditure processes. ### Key policy implications and recommendations (implicit in source analysis) - Maintain prudent fiscal policy while enhancing revenue mobilization through tax administration reforms. - Continue emphasis on improving public financial management to support a tilt toward domestic financing as external loans decline relative to GDP. - Address contingent liabilities from SOEs through stronger governance, periodic automatic cost recovery measures, and measures to limit fiscal bail-outs. - Implement parametric pension reforms to contain rising pension costs. - Improve execution of capital spending via budget timing, procurement reforms, and fiscal responsibility legislation to support higher public investment without compromising sustainability. *Prepared by the staffs of the International Monetary Fund and the World Bank; June 17, 2014.* ### 9. The DSA suggests Nepal’s risk of debt distress is low. This changes the assessment of ### _cr14214 - 9. The DSA suggests Nepal’s risk of debt distress is low. This changes the assessment of ### DSA finding and implications - The DSA indicates Nepal’s risk of debt distress is low, changing the previous assessment of moderate risk of debt distress. - Moderately improved medium term growth path and a higher discount factor in the current DSA imply a lower PV of public debt path than the previous assessment. - This lower PV of public debt holds even with a moderate increase in fiscal deficits to enable higher capital spending in the medium term. - The change implies that the mix of IDA assistance to Nepal will change to 100 percent IDA loans. - The level of IDA assistance will increase by about 10 percent because the 20 percent discount applied to grants will not apply to a fully loan-based allocation. ### Policy recommendations to maximize growth and fiscal space - Improve public financial management to boost public investment by: - Enhancing project appraisal. - Streamlining the budget release process. - Strengthening monitoring of capital budget execution. ### Executive Board assessment and recommendations - Directors welcomed strong fiscal and external positions and progress in raising living standards, supported by large remittance inflows. - Directors emphasized need for continued sound macroeconomic management and deeper structural reforms to boost competitiveness and longer-term prospects. - Given a low risk of debt distress, Nepal has fiscal room to support growth, particularly by improving execution of capital expenditure budgets and social programs. - Recommended creating additional fiscal space by reducing implicit subsidies to state oil and electricity companies. - Encouraged improvements to legal and institutional framework, including passage of a Fiscal Responsibility and Budget Management Act. - Monetary and financial sector recommendations: - Active management by the central bank to reduce financial sector risks and improve monetary policy transmission. - Ensure the central bank is adequately equipped with government securities to mop up excess liquidity. - Strengthen cooperation between the central bank and the Ministry of Finance. - Introduce an interest rate corridor to improve monetary management. - Phase out directed lending and caps on interest spreads. - Financial sector stability priorities: - Fully implement Financial Sector Assessment Program (FSAP) recommendations. - Consolidate the banking sector through closure of insolvent banks and tightened licensing standards. - Expedite adoption of risk-based supervision. - Enhance oversight of credit cooperatives. - Improve the legal framework, particularly for bank resolution. - Develop financial infrastructure to support growth and reduce risks. - Structural reform priorities to boost competitiveness and inclusive growth: - Address infrastructure bottlenecks. - Improve labor relations. - Increase competition. - Reduce regulatory burden. ### Macroeconomic outlook and key indicators (selected) - Growth and inflation: - Growth projected to recover to 4¾ percent in 2013/14. - Growth projected to remain around 4.5 percent in the medium term. - Inflation moderated to 8.9 percent year on year in March 2014. - Remittances and reserves: - Remittances grew by 17.5 percent in the first eight months of 2013/14. - Remittances are set to reach nearly 30 percent of GDP in 2013/14. - International reserves stood at $5.8 billion in March. - Financial conditions: - Limited sterilization of remittance inflows; nominal interbank and treasury bill rates remain close to zero; excess reserves persist. - FSAP identified significant financial sector vulnerabilities; bank supervision largely compliance-based and under-resourced. - Risks: - Downside risks include a possible weaker than expected recovery in India and/or a slowdown in countries hosting Nepali migrant workers. ### Selected numerical fiscal, external, and macro indicators (from tables) - Public sector debt and related indicators: - Public sector debt: 34.5 (2011), 36.3 (2012), 31.5 (2013), 30.5 (2014), 29.7 (2015), 29.1 (2016), 28.8 (2017), 28.7 (2018), 28.8 (2019), 30.4 (2024), 32.5 (2034). - Of which: foreign-currency denominated: 19.9 (2011), 22.7 (2012), 20.1 (2013), 19.5 (2014), 18.9 (2015), 18.4 (2016), 18.4 (2017), 18.4 (2018), 18.6 (2019), 19.4 (2024), 19.4 (2034). - PV of public sector debt (selected): 25.5, 24.6, 23.8, 23.1, 22.5, 22.1, 21.9, 22.2, 23.7 (table excerpts). - Gross financing need: 6.4 (2011), 6.2 (2012), 4.5 (2013), 4.4 (2014), 4.8 (2015), 5.0 (2016), 5.1 (2017), 5.0 (2018), 5.1 (2019), 5.2 (2024), 6.1 (2034). - Debt service-to-revenue and grants ratio (in percent): 14.5, 12.4, 15.0, 14.6, 13.5, 13.7, 13.4, 12.9, 12.6, 12.1, 14.9. - Primary deficit that stabilizes the debt-to-GDP ratio (selected): 3.8, -0.5, 3.4, 1.3, 1.7, 1.7, 1.4, 1.4, 1.2, 1.2, 1.0. - Macroeconomic assumptions and outcomes: - Real GDP growth (in percent): 3.4 (2011), 4.8 (2012), 3.9 (2013), 4.2 (2014), 0.9 (2015), 4.8 (2016), 5.0 (2017), 4.7 (2018), 4.5 (2019), 4.5 (2024), 4.7 (2020-34 average), projection figures listed across tables include 4.5 repeatedly. - Average nominal interest rate on forex debt (in percent): 0.9 (2011), 1.0 (2012), 1.9 (2013), 1.1 (2014), 0.3 (2015), 1.0 (2016), 1.0 (2017), 1.1 (2018), 1.2 (2019), 1.2 (2024), 1.2 (2034). - Average real interest rate on domestic debt (in percent): -3.9 (2011), -0.4 (2012), -2.8 (2013), -3.1 (2014), 3.2 (2015), -1.3 (2016), -0.6 (2017), 0.3 (2018), 1.0 (2019), 1.3 (2024), 1.7 (2034). - Inflation rate (GDP deflator, in percent): 10.8 (2011), 6.6 (2012), 6.7 (2013), 8.6 (2014), 4.0 (2015), 8.8 (2016), 7.8 (2017), 7.0 (2018), 6.3 (2019), 6.0 (2024), 5.5 (2034). - Grant element of new external borrowing (in percent): around 54.2, 53.7, 54.5, 54.8, 53.5, 53.9, 54.1, 54.6, 54.6 (table entries). - External debt and balance of payments highlights: - External debt (nominal): 20.1 (2011), 22.9 (2012), 20.2 (2013), 19.5 (2014), 18.9 (2015), 18.4 (2016–2019), 18.6 (2019 average), 19.4 (2024), 19.4 (2034). - PV of external debt: 14.2, 13.6, 13.0, 12.4, 12.1, 11.8, 11.7, 11.3, 10.6 (table excerpts). - PV of PPG external debt (in percent of exports): 131.4, 122.5, 116.1, 111.4, 108.3, 105.5, 103.8, 102.1, 94.2 (selected years). - Debt service-to-exports ratio: 11.1, 10.6, 9.5, 9.4, 9.3, 9.0, 8.6, 8.1, 7.7, 6.7, 6.2. - Workers' remittances (Billions of U.S. dollars): 3.5 (2011), 4.4 (2012), 4.9 (2013), 5.7 (2014), 6.3 (2015), 6.9 (2016), 7.4 (2017), 7.8 (2018), 8.3 (2019), 11.1 (2024), 19.9 (2034). - Gross official reserves (in millions of U.S. dollars): 3,085 (2010/11), 4,307 (2011/12), 4,972 (2012/13), 6,082 (2013/14), 7,120 (2014/15). - Selected annual indicators (table "Nepal: Selected Economic Indicators, 2010/11–2014/15"): - Real GDP: 3.4 (2010/11), 4.8 (2011/12), 3.9 (2012/13), 4.8 (2013/14), 5.0 (2014/15 proj.). - CPI (period average): 9.6 (2010/11), 8.3 (2011/12), 9.9 (2012/13), 8.8 (2013/14), 7.8 (2014/15 proj.). - Total revenue and grants (percent of GDP): 17.7, 18.7, 19.3, 21.1, 21.3. - Expenditure (percent of GDP): 18.7, 19.3, 17.9, 20.8, 21.1. - Net acquisition of nonfinancial assets (percent of GDP): 3.4, 3.4, 3.2, 3.7, 3.9. - Net lending/borrowing (percent of GDP): -1.0, -0.6, 1.4, 0.2, 0.2. - Broad money growth (annual percent change): 12.3, 22.7, 16.3, 20.5, 19.9. - Private sector credit growth (annual percent change): 13.1, 11.3, 20.2, 16.4, 18.7. - Gross investment (percent of nominal GDP): 30.0, 30.0, 29.8, 29.4, 29.8. - Workers' remittances (in percent of GDP): 18.6, 23.4, 25.6, 29.4, 31.0. - Current account (in percent of GDP): -1.0, 4.8, 3.3, 4.1, 3.3. - Trade balance (in percent of GDP): -23.5, -24.4, -27.3, -30.9, -33.3. - Nominal GDP (billions of Nepalese rupees): 1,367 (2010/11), 1,527 (2011/12), 1,693 (2012/13), 1,931 (2013/14), 2,183 (2014/15 proj.). - Public debt (percent of GDP): 34.5, 36.3, 31.5, 30.5, 29.7 (2010/11–2014/15). - Exchange rate (NRs/US$, period average): 71.9 (2010/11), 81.0 (2011/12), 88.0 (2012/13). ### Stress tests and sensitivity analysis (high-level) - Figures and tables include a range of alternative scenarios and bound tests for 2014–2034 assessing indicators such as: - PV of Debt-to-GDP+remittances ratio. - PV of Debt-to-exports+remittances ratio. - PV of Debt-to-Revenue ratio. - Debt service-to-exports+remittances ratio. - Debt service-to-revenue ratio. - Stress tests identify the most extreme shock by the highest ratio on or before 2024; several tests correspond to a Non-debt flows shock or one-time real depreciation, and scenarios include: - A1. Real GDP growth and primary balance at historical averages. - A2. Primary balance unchanged from 2014. - A3. Permanently lower GDP growth. - B1–B6 bound tests including one-time 30 percent real depreciation in 2015 and a 10 percent of GDP increase in other debt-creating flows in 2015. - Sensitivity analysis tables report projected indicator values under baseline and alternative scenarios (numerical matrices provided in the source tables). _Italic: IMF staff report and DSA excerpts as provided in the source content._ ### 1. This statement summarizes the main developments since the staff report was ### 1. This statement summarizes the main developments since the staff report was ### Context Setting - Elections and political environment: - Successful election for a new Constitutional Assembly (CA) in November 2013 and formation of a new coalition government thereafter. - Government and CA committed to promulgate constitution, complete the peace process and undertake local election within a year while making political consensus. - IMF/World Bank engagement: - 2014 Article IV Consultation and first Financial Sector Assessment Program (FSAP) for Nepal undertaken during normalization of political uncertainty. - Broad agreement with staff on major policy thrusts; some reservations on parts of FSAP assessment. ### Recent Economic Development and Outlook - Growth and sector performance: - Economy estimated to grow by 5.2 percent in 2013/14 (slightly higher than staff projection), compared to 3.9 percent in the previous year. - Growth driven by improved agriculture sector performance and stronger services growth. - Inflation: - CPI inflation expected to improve from 9.9 percent in 2012/13 to 8.8 percent in 2013/14, aligning with staff projection. - Latest available data: CPI inflation in Nepal rose to 9.7 percent (year on year) in May, largely due to weather-related food price hikes; India CPI inflation was 8.3 percent (year on year) in May. - External sector and reserves: - Current account surplus strengthened despite widening trade deficit due to improvements in service incomes, grants and remittances. - Accumulated foreign exchange reserves at mid-May 2014 sufficient for 9.9 months of merchandise goods and service imports. - International reserves reached $6.1 billion at end-May, with reserve cover at 8.2 months of prospective imports. - Growth of remittances slowed to 14.5 percent in May (year on year, year to date). - Risks: - External risk: global economic slowdown affecting remittances, exports, and foreign investment. - Financial risk: rapid remittance growth creating excess liquidity and potential banking sector stability concerns if remittances fluctuate. - Inflation risk: monsoon effects on agriculture, higher global fuel prices, and supply-side bottlenecks. ### Fiscal Policy - Debt and fiscal position: - Debt sustainability analysis: debt distress remains low. - Fiscal position characterized by budget surplus, strong revenue growth and slow execution of capital expenditure. - Public investment and reforms: - Authorities accelerating capital investment on key infrastructure and social spending; amending public spending legislation to remove impediments and create “fast-track” route for key “national-pride” projects. - Public finance management measures: - Preparing Fiscal Responsibility and Budget Management Act (FRBM) to strengthen transparency and accountability. - Reducing budget preparation and implementation lag time to ensure timely disbursement and minimize year-end fiscal pressure. - Revenue mobilization: - Authorities will continue strengthening revenue mobilization via broadening tax base, reducing tax exemptions and improving grant mobilization. - Fiscal statistics: - Revenue grew by 19.4 percent in May (year on year, year to date). - As of June 26, capital budget execution reached 51 percent of planned spending; recurrent spending reached 75 percent of budgeted amounts. ### Budget preparation for FY 2014/15 - Status and objectives: - Annual budget for FY 2014/15 (commencing mid-July, 2014) in final stage of preparation. - Budget aims to transition Nepal to become “Developing Country” by 2022 by optimizing investment, improving socioeconomic situation, and reducing poverty. - Government to unveil annual budget after parliament approves guiding principles, objectives and programs. ### Monetary and Exchange Rate Policy - Objectives and targets: - Main objective: stabilize price and external sector while facilitating high and sustainable growth; focus on financial sector stability and enhancing rural financial access. - Monetary targets for FY 2013/14: maintain CPI inflation below 8 percent and secure foreign exchange reserves sufficient for at least 8 months of imports of goods and services. - Monetary performance close to targets up to mid-May, 2014. - Monetary aggregates and liquidity: - Reserve money growth reached 28.4 percent in May (year on year). - Excess reserves in banking system rose to NRs 54 billion after earlier decline, despite Nepal Rastra Bank mopping up liquidity mainly through reverse repo operations. - Policy stance and instruments: - Authorities agree excess liquidity prevails but consider it not as alarming as stated by staff; private sector credit growth remained sluggish and fiscal stance tight. - Introducing Base Rate system since last fiscal year to make interest rate structure more transparent and predictable. - Developing legal, technical and operational framework to adopt interest rate corridor policy in the near future. - Agree with staff recommendation to separate public debt management and monetary policy operations; two separate committees recently established. - Exchange rate: - Authorities agree real exchange rate remains in line with fundamentals. - Continue to view peg to the Indian rupee as an appropriate anchor given close economic and social ties with India. ### Financial Sector - Overall assessment: - Banking sector adequately capitalized, liquid and profitable with low level of NPLs; access to finance improved but remains low and uneven. - Authorities welcome FSAP’s recognition of progress in enhancing access to finance and financial sector dynamism. - Supervision, regulation and restructuring: - Need to strengthen risk management for banks; enhancement of credit information system and regulatory/supervisory framework for EPF, CIT and Saving and Credit Cooperatives. - Pursuing financial sector consolidation via mergers and acquisitions while strengthening regulation and supervision. - Amending Nepal Rastra Bank Act, 2002 and Banking and Financial Institution Act, 2006 (BAFIA) to strengthen supervisory framework and empower central bank on problem-banks and crisis management. - Reviewing legal and institutional arrangements for supervision of Employee's Provident Fund (EPF) and Citizen Investment Trust (CIB); temporary supervisory team created. - Asset quality and provisioning: - Authorities emphasize asset quality as a key focus in onsite and off-site supervision; banks classify assets into categories and monitor loan recovery and provisions regularly. - Public sector banks restructured over past decade; overall non-performing loans improved; authorities disagree with staff’s prospect of loan ever-greening. - Market imperfections and targeted policies: - Some FSAP recommendations assume perfect market mechanisms; authorities justify policy interventions (e.g., cap on interest rate spread) to correct market imperfections and protect depositors and borrowers. - Deprived sector lending and productive sector lending requirements viewed as relevant to foster financial inclusion, stimulate real economy and support long-run financial sector sustainability. - Scope of FSAP: - Authorities note FSAP scope could have included assessment of remittance and other capital flow related risks, exchange rate and capital account liberalization risks, and more adequate inclusion of authorities’ views on critical issues. ### Structural Reform and Capacity Enhancement - Priority reforms: - Accelerating economic reforms to promote high and inclusive growth, reduce poverty and unemployment, and improve business environment. - Removing structural bottlenecks, especially electricity generation, to raise potential growth; encouraging private investment in hydropower with objective to overcome power-shortage within three years. - Investment Board chaired by the Prime Minister supporting infrastructure investment, focusing on hydropower projects. - Public enterprises and pricing: - Addressing losses of Nepal Oil Corporation (NOC) critical; oil price deregulation initiated by introducing automatic price adjustment mechanism. - NOC directed to make petroleum transport and distribution more transparent following Parliamentary Studies and Recommendation Committee report. - Reconsidering electricity pricing policy to reduce losses of Nepal Electricity Authority. - Donor engagement and investment promotion: - Discussions underway for a second generation of reforms; donor meeting organized to share economic agenda; international investment symposium held to attract foreign investors. - Institutional arrangements: - High level Financial Sector Coordination Committee established to monitor progress and recommend policy actions. - High level committee under Finance Minister to formulate Financial Sector Development Strategy (FSDS); drafting underway. - Technical assistance and IMF presence: - Authorities appreciate Fund’s technical assistance in fiscal, monetary, legal and statistics; seek continued support. - Authorities view reinstating a full-time IMF Resident Representative in Nepal (position abolished in October 2010) as beneficial. ### AML/CFT Framework - Legal progress: - Significant progress made in improving AML/CFT framework; recently enacted AML/CFT ordinances into law. - Nepal removed from Financial Action Task Force Committee’s list of enhanced scrutiny following improvements. ### Final Remarks - Authorities’ concurrence with staff: - Authorities concur macroeconomic situation remains solid and outlook favorable. - Committed to remove bottlenecks to enhance private and public investment and move toward higher growth while maintaining stability. - Committed to strengthen financial sector stability and enhance access to financial services. - Appreciation: - Authorities thank the Fund and World Bank for successful conclusion of Article IV consultation and first FSAP in Nepal and for continued policy advice, technical assistance and donor support. *Statement by Abdul Ghaffour, Alternate Executive Director for Nepal and Ram Sharan Kharel, Advisor to Executive Director — July 3, 2014* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14214.pdf_