IMF Executive Board Concludes 2015 Article IV Consultation with Nepal
The earthquakes in April and May and protests and trade disruptions following the promulgation of a new constitution in September have exacerbated the macroeconomic policy challenges facing the Nepalese economy. Real GDP growth is estimated to have decelerated to 3.4 percent in 2014/15 (mid-July 2014 to mid-July 2015) from 5.5 percent in 2013/14. Inflation had been moderating from a high base but the recent acceleration to 6.9 percent in August (y/y) widens the wedge over Indian CPI, thereby undermining Nepal’s competitiveness given the exchange rate peg to the Indian rupee. The financing data indicates that the budget was in surplus for the third year in a row, even as revenues fell short of the budget for the first time in several years. As a result, public debt remained on a declining path, falling to 26 percent of GDP in 2014/15, from 32 percent of GDP in 2012/13. The external current account surplus reached 5.0 percent of GDP in 2014/15, aided by a surge in remittances following the earthquake and lower oil import prices. Reserves rose to US\\$7.2 billion, or 33 percent of GDP, covering almost eight months of prospective imports.
Growth is expected to gradually rebound to around 5.5 percent by 2016/17, as economic activity recovers from the earthquake and reconstruction gains momentum. Inflation is projected to rise to about 8.5 percent over the next 12 months as losses in agricultural production and damage to transport systems represent a large shock to the supply of agricultural products. However, over time, inflation pressures should decline as supply bottlenecks ease. Stepped-up foreign aid and higher inflows of remittances will further boost liquidity pressures in the financial system, necessitating active liquidity management to avoid excess inflation relative to India. The medium-term outlook depends importantly on the authorities’ reform efforts. Experiences in other fragile countries show that natural disasters can have permanent effects on potential growth, thus highlighting the need for ambitious macroeconomic and structural policies. This underscores the importance of a decisive boost to public capital spending and reforms to strengthen the business climate.
Recent developments have heightened the downside risks to the staff’s baseline scenario. Continued political instability and a continuation of the recent disruptions to economic activity and transportation and trade routes to and from the country’s southern border and the related fuel crisis could severely affect growth and inflation in this fiscal year. Another important downside risk relates to the government’s capacity to boost capital spending owing in part to the delay in setting up the National Reconstruction Authority (NRA).
Executive Board Assessment2
While macroeconomic management has been broadly satisfactory, Executive Directors noted that Nepal’s macroeconomic performance has been held back by the earthquakes and the recent unrest and disruptions to transportation and trade routes. While growth is expected to gradually rebound as reconstruction gains momentum, the outlook is subject to downside risks.
Directors called for policy action to boost capital spending, maintain macroeconomic stability, and lift potential growth.
Directors emphasized that fiscal policy needs to support post-earthquake reconstruction spending and medium-term growth through higher public investment. Swiftly operationalizing the National Reconstruction Authority and strengthening the government’s capital budget implementation capacity by establishing proper and transparent planning, selection, and implementation for major capital projects remain priorities. Directors agreed that continued improvements in revenue performance and anchoring fiscal policy by a ceiling on net domestic financing of the budget would help to maintain a strong fiscal position. They noted that concessional external financing can finance the bulk of a sustained increase in capital spending needed to address infrastructure gaps.
Directors concurred that the peg to the Indian rupee continues to serve as a transparent anchor and that monetary policy should be geared toward supporting the peg. While a temporary increase in inflation as a result of the recent supply shocks should be accommodated, Directors recommended that, as conditions normalize, monetary policy be reoriented to keeping Nepalese inflation close to that in India. Strengthening the central bank’s liquidity management capacity will be important in this regard.
Directors called for intensified efforts to safeguard the financial sector’s stability and resilience. They looked forward to the implementation of the high-priority FSAP recommendations, including a further strengthening of bank supervision and the development of a bank resolution framework. Noting that financial sector risks may have been amplified by the earthquakes and the recent disruption to economic activity, they welcomed the authorities’ intention to conduct a diagnostic of these events’ impact on banks and insurance companies. Directors also encouraged the authorities to enhance the quality of the central bank’s external audit and legal framework to further support its autonomy and governance.
Directors stressed the importance of unlocking the country’s hydropower generation potential and sustained reforms to improve the investment climate to help achieve Nepal’s goal of becoming a middle-income country by 2030. They also recommended that state-owned enterprises in the energy sector be put on a sound financial footing to reduce losses and contingent liabilities.
Directors encouraged the authorities to continue to collaborate closely with the Fund, including on capacity development. They welcomed the authorities’ interest in discussing a longer-term engagement, possibly through the Extended Credit Facility, which could support macroeconomic and structural reforms to accelerate the post-earthquake recovery and foster sustainable and inclusive growth.
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