Public Information Notice No. 10/75

Public Information Notice: IMF Executive Board Concludes 2010 Article IV Consultation with Nepal

June 17, 2010

On May 28, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Nepal.¹

Background

Four years after the end of the civil conflict, Nepal remains in political transition, with a new constitution being drafted and fresh elections expected once the constitution is approved. Despite being one of the poorest countries in Asia, Nepal is making progress on social outcomes.

Macroeconomic stability has been maintained in the past few years, but the global crisis is having a delayed impact on Nepal’s economy and exposing its structural weaknesses. The exchange rate peg and prudent fiscal policy have been anchors of stability. By end 2008/09², public debt had declined to 40 percent of GDP from 64 percent in 2001/02, and foreign exchange reserves had increased to 6 months of import cover due to robust remittance inflows. In the first half of 2009/10, however, remittances growth slowed and exports declined by 14 percent which combined with soaring imports caused reserves to decline by about 13 percent. A liquidity crunch ensued in the banking system as banks have overextended themselves over the past years in an environment of accommodative monetary policy, weak supervision, and proliferation of financial institutions.

The near-term economic outlook is challenging. Real GDP growth is expected to slow to 3 percent in 2009/10 from an estimated 4¾ percent in 2008/09, due to a poor monsoon, softer remittances, and tighter monetary conditions. The external current account is projected to record a deficit of 2 percent of GDP in 2009/10 due to a deteriorating trade deficit and decelerating remittances. At the same time, inflation is projected at 12 percent by end 2009/10. Fiscal policy remains prudent, and the authorities plan to reduce the 2009/10 net domestic financing to 1.6 percent of GDP from the budgeted 2.1 percent. However, capital spending remains low, owing mainly to capacity constraints. It is anticipated that real GDP growth will recover to 4 percent in 2010/11 reflecting expected stronger remittances on the back of the recovery in the Gulf countries and Malaysia (the main host countries of Nepalese workers) and that the current account will move close to balance, although the situation remains fragile.

In the near term, risks are on the downside and stem mainly from weaker remittances, continued high imports, capital flight, heightened financial sector vulnerabilities, and political instability. Credit and liquidity risks in the banking system are high. Tackling structural problems remains essential to achieve high growth over the medium term. While Nepal’s potential is high, progress is required in addressing the poor business climate, power shortages, inadequate infrastructure, weak governance, and difficult labor relations. Political stability and improved security are necessary conditions for progress in several of these areas.

Against this background, the 2010 Article IV consultation focused on (i) maintaining continued macroeconomic stability in the context of a deteriorating external position and how Fund financial assistance could contribute to this end; and (ii) managing financial sector risks and reducing vulnerabilities.

Executive Board Assessment

Executive Directors observed that, after years of macroeconomic stability, Nepal’s economy is experiencing a substantial, albeit somewhat delayed, impact of the global crisis, which is exposing the country’s structural weaknesses. External and financial sector risks have risen as evidenced by the significant deterioration of the current account, the reserve decline, wavering confidence, and banking sector liquidity stress.

Against this background, Directors welcomed the authorities’ commitment and efforts to safeguard external and financial stability. They viewed maintaining the exchange rate peg as a key short-term objective to shore up confidence, observing that it has served Nepal well so far by providing macroeconomic stability. In the medium term, a number of Directors recommended a reconsideration of the type of peg as well as alternative options for a nominal anchor. Directors stressed the need for monetary policy to support the peg by maintaining short-term interest rates above those of India, and suggested that liquidity management be strengthened to avoid abrupt fluctuations in interest rates. They also stressed that emergency liquidity support needs to be consistent with the peg. Directors encouraged the authorities to phase out the import and foreign exchange restrictions.

Directors took note of significant credit and liquidity risks in the financial sector. They welcomed the recent macroprudential measures adopted by the Nepal Rastra Bank to limit banks’ liquidity risk and exposure to the real estate sector, but stressed that enforcement will be crucial for their effectiveness. Directors encouraged the authorities to strengthen the bank resolution framework, including through the passage of the amended Banks and Financial Institutions Act, enhance contingency planning, and expand regulatory oversight over savings and credit cooperatives.

Directors noted that bank licensing policy needs to be tightened and financial sector consolidation facilitated. They observed that the rapid proliferation of financial institutions has stretched the authorities’ supervisory capacity, and welcomed the recent licensing moratorium. Directors also encouraged the authorities to proceed with the restructuring of the two state-controlled banks.

Directors commended the authorities’ fiscal prudence, and supported its continuation. They noted that, although improved debt dynamics have created room for higher spending, a tight fiscal stance remains justified in the short term to support the exchange rate peg. They encouraged further efforts to curb tax evasion and broaden the tax base.

Directors reiterated that tackling long-standing structural problems remains essential to achieve high growth over the medium term. Key areas for improvement are the business climate, governance, infrastructure and labor relations.

Directors viewed the arrangement under the Rapid Credit Facility (RCF) as helpful in cushioning the shock from the global crisis and boosting confidence. They hoped that the RCF would serve as a bridge to a program addressing Nepal’s structural challenges that could be supported by an arrangement under the Extended Credit Facility.