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Asian Development Outlook 2002 : II. Economic Trends and Prospects in Developing Asia : South Asia

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Nepal

Overall economic performance remained generally favorable in 2001, though the economy experienced a sharp downturn in the first part of 2002 following both internal and external shocks, including the deaths of members of the royal family in June 2001 and a rise in insurgency. The outlook for 2002 has been further clouded by the impact of the September 11th events in the US.

Macroeconomic Assessment

GDP growth slowed to 5% in 2001 from 6.1% in 2000, mainly because of agriculture’s slightly weaker performance after an exceptional year in 2000, a sharp deceleration in manufacturing, and continued weakness in tourism. Agricultural output slowed to 4% growth in 2001 from 5% in 2000, while industry sector growth fell to 2.5% from over 8% during the same period. Tourism-related services were hit by the escalating insurgency and the shocking circumstances surrounding the deaths of members of the royal family. These factors contributed to a 21% drop in tourist arrivals by air during the year. Labor market conditions, characterized in 1999/2000 by a 47% underemployment rate and a 7% urban unemployment rate, likely deteriorated somewhat in 2001, given the slowing pace of urban expansion and the rapid enlargement of the labor force.

The budget deficit widened to 4.2% of GDP in 2001 from 3.3% in 2000 (Figure 2.18). Domestic revenue collections recorded a 16% gain due to improved tax administration. However, this was more than offset by a 26% rise in expenditures, resulting mainly from higher spending on security, a salary increase for civil servants, and the implementation of a voluntary early retirement scheme.

Broad money supply (M2) showed slower growth of 14.9% in 2001, down from 21.8% in 2000; a sharp slowdown in the rise of net foreign assets was a key factor. Because of the exchange rate peg to the Indian rupee and the active trade across the relatively open border between the two countries, inflation in Nepal generally tracks India’s. It was low at 2.4% in 2001—the lowest rate in more than 20 years—compared with 3.5% in the previous year. Increased agricultural production, due to a balanced monsoon, kept prices of food items in check and helped counteract rising prices in the nonfood and services group, including fuel, power, water, and education.

Growth in merchandise exports fell sharply to 3.7% in 2001 from the substantial rate of 42% in 2000. Most of the decline was due to the sharp drop in the growth rate of exports of ready-made garments and woolen carpets. Imports, meanwhile, declined by nearly 1%, following expansion of 20% in 2000. The poor import performance reflected a deceleration of growth in manufactured imports. The current account deficit remained at 4.4% of GDP in 2001. While net services receipts continued to fall that year, this was offset by an increase in net transfers, mainly due to rising remittances from overseas workers.

At the end of 2001, foreign exchange reserves amounted to $1 billion, or sufficient to cover more than 7 months of imports of goods and services. Dependence on foreign assistance became more pronounced in 2001, with foreign grants and loans financing 58% of development expenditures, a sharp increase from the 47% level of the previous 5 years. External debt as a proportion of GDP declined to less than 47%. The debt service ratio also fell and, due to the concessional nature of Nepal’s external debt, was at a manageable 3.9% of exports in 2001.

Policy Developments

Although the 2002 budget is not as ambitious as 2001’s, it is still expansionary, with a total outlay of NRs90.1 billion, representing an increase of 22% over an estimated NRs74 billion in the previous year. The budget calls for a 27% increase in development expenditures to be financed in greater part by grant assistance. Nevertheless, the budgetary target will be very difficult to achieve.

While the Middle Marshyangi hydropower project and the Melamchi water supply project entail a high level of investment and resource transfers, development spending is likely to be severely curtailed due to increasing expenditures on security operations and the adverse impact of the insurgency on development projects and programs. The Government has recently indicated that about 25% of the 2002 development budget will be reallocated to additional security expenditures. Estimates for domestic revenues in the 2002 budget, with a projected growth rate of 22%, also appear optimistic, given the sharp downturn in the main tax sources of manufacturing and services.

To support the central bank’s efforts to control inflation and maintain the exchange rate peg, further development of the market for government securities is required to break the link between budget deficits and monetary expansion. Moreover, the Government needs to keep its overdraft with the central bank within prudent limits.

Outlook for 2002-2003

The underlying assumptions of the following projections are that (i) the recent resurgence in domestic political unrest will stabilize somewhat, (ii) the global economic slowdown and the impact of the events of September 11th on the global economy will be modest and relatively shortlived, (iii) the Indian economy will grow at about 5.6% in 2002 and 6% in 2003, and (iv) the weather in Nepal and neighboring regions in India will be normal. On this basis, economic growth is projected to slow further to 3.5% in 2002, but to pick up to about 5% in 2003.

Growth in the agriculture sector may decline somewhat to about 3% because of the uneven monsoon from June to August 2001 in the Eastern Region, which will adversely impact agricultural growth in 2002. Growth in the industry sector may slightly increase to 3.5% in 2002, before further strengthening to 5.9% in 2003 as prospects for exports improve. The services sector is projected to decline sharply to 3.5% in 2002, but may strengthen in the following year to 5.5%, boosted by a recovery in tourism. In the absence of any external shocks to the economy, inflation is likely to be moderate over the next few years, and in 2002 and 2003 is projected at 5%, despite rising nonfood prices.

As a result of the anticipated sharp downturn in the economy in the early months of 2002 and the increase in security expenditures associated with the insurgency, the budget deficit in 2002 is likely to widen to 6%. Monetary policy will be geared to supporting the exchange rate peg with the Indian rupee. Continuing monetization of the economy will provide some leeway in monetary policy, but the 20% annual money supply growth rates in some recent years cannot be repeated without fueling inflation. Given projections for GDP growth and inflation, targets for broad money supply growth need to be in the range of 12–14% in the medium term.

While the recent renewal of the 1996 bilateral Trade and Transit Treaty with India in March 2002 has revived export prospects to India, the global economic slowdown will continue to undermine Nepal’s exports. Among exports to other countries, garments, carpets, and pashmina shawls used to be strong, but exports of these products have sharply declined and will be further subject to a gradual removal of quotas in the US as part of WTO’s Agreement on Textiles and Clothing. As a result, the trade and current account deficits should rise.

Historically, high population growth rates and low economic growth rates have limited progress in poverty reduction. To achieve the level of growth necessary to reduce poverty in the country, Nepal needs to restore law and order. It must also accelerate the reforms that began in the early 1990s and were agreed on during the National Development Forum in 2000 to provide an environment conducive to private sector development.

Given the fiscal problem that the Government is now facing, public resource management reform is needed both to ensure macroeconomic stability and to effectively use the limited public resources. It will require major improvements in budget planning, in domestic and external resource management, and in expenditure management. These improvements should begin with redefining the role of the Government versus the private sector in the economy. Prioritization of development expenditures and civil service reform is also vital, while to reduce dependence on foreign assistance for the country’s development expenditures, continued efforts are required to mobilize domestic resources and reduce the fiscal deficit.

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