On July 3, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Nepal.
Nepal’s economy has stabilized, though growth remains low, following elections for a new Constituent Assembly which has reduced political uncertainty. Growth is projected to recover to 4¾ percent in 2013/14, from below 4 percent the year before, supported by agriculture, increased fiscal spending, and continued strong remittance inflows. Inflation moderated to 8.9 percent year on year in March 2014 after increasing by double-digits following the depreciation of the Indian rupee (to which the Nepali rupee is pegged). Remittances grew by 17.5 percent in the first eight months of 2013/14 and are set to reach nearly 30 percent of GDP in 2013/14. This has led to a sizeable current account surplus and further build-up of international reserves, which stood at $5.8 billion in March. With limited sterilization of remittance inflows, nominal interbank and treasury bill rates remain close to zero and excess reserves in the financial system persist. A debt sustainability analysis indicates that Nepal is now at a low risk of debt distress.
Medium-term prospects hinge on improving the investment environment. Growth is projected to remain at around 4.5 percent, with gradual improvements in implementation of the capital expenditure and budget supporting activity as remittance growth moderates. Inflation is expected to decline in line with developments in India. Downside risks to the outlook stem from a possible weaker than expected recovery in India, and/or a slowdown in countries hosting Nepali migrant workers.
Progress has been made in addressing financial sector weaknesses, with efforts to enhance supervision, consolidate the sector, and strengthen the legal framework for crisis management and bank resolution. Nonetheless, Nepal’s first-ever assessment under the Financial Sector Assessment Program (FSAP) identified significant financial sector vulnerabilities. Bank supervision remains largely compliance-based, fragmented, and under-resourced. Concerns about the reliability of financial soundness indicators remain, and stress tests suggest banking system strains if asset quality deteriorates moderately. Interconnections within the financial system and to other sectors are substantial, adding to concerns about lending practices. A largely unsupervised cooperatives sector is growing rapidly, partly fueled by directed lending policies, and poses a significant risk to the stability of the financial system.
Executive Directors welcomed Nepal’s strong fiscal and external positions and progress in raising living standards, supported by large remittance inflows. Directors noted nevertheless that economic growth remains subdued, with downside risks from a weaker-than-expected recovery in India or a slowdown in countries hosting Nepali migrant workers. In this context, Directors emphasized the need for continued sound macroeconomic management and deeper structural reforms to boost competitiveness and longer-term prospects.
Directors agreed that, given a low risk of debt distress, Nepal has fiscal room to support growth, particularly by improving the execution of capital expenditure budgets and social programs. Building on the gains made in revenue administration, they recommended that additional fiscal space be created by reducing implicit subsidies to the state oil and electricity companies. More broadly, Directors encouraged further improvements to the legal and institutional framework, including the passage of a Fiscal Responsibility and Budget Management Act.
Directors noted that the elevated level and volatility of liquidity in the financial system, generated by remittance inflows, call for active management by the central bank, with a view to reducing financial sector risks and improving monetary policy transmission. In this regard, Directors considered it important that the central bank be adequately equipped with government securities to mop up excess liquidity, and that cooperation with the Ministry of Finance be strengthened. They also supported the planned introduction of an interest rate corridor to improve monetary management. Directors encouraged the authorities to phase out directed lending and caps on interest spreads.
Directors welcomed progress in strengthening the financial sector and stressed the need to address remaining vulnerabilities by fully implementing the recommendations from the Financial Sector Assessment Program. Key policy priorities include: further consolidating the banking sector through closure of insolvent banks and tightened licensing standards; expediting the adoption of risk-based supervision; enhancing the oversight of credit cooperatives; and improving the legal framework, particularly for bank resolution. Directors noted that further development of Nepal’s financial infrastructure would help harness the sector’s potential to support growth and reduce risks.
Directors underscored that structural reforms to boost competitiveness and inclusive growth would help increase employment and reduce dependence on workers’ remittances. They encouraged the authorities to step up efforts to address infrastructure bottlenecks, improve labor relations, increase competition, and reduce the regulatory burden.