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p. 32 of 68 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia South Asia Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Central Asia The Pacific III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia : South Asia

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Nepal

The economy contracted for the first time in two decades in FY2002, mainly due to escalation of the insurgency, an irregular monsoon, and weak external demand. A ceasefire announcement in January 2003 offers hope that the economy may strengthen, as well as an opportunity for the Government to undertake key economic reforms and to begin implementing a program targeted at poverty reduction.

Macroeconomic Assessment

The economic performance of Nepal was exceptionally weak in FY2002 (ended 15 July 2002). GDP contracted by 0.6% compared with growth of 4.6% in FY2001. A series of domestic and external shocks, especially an intensification of the insurgency, but also an irregular monsoon and weak external demand, combined to produce a broad downturn in production and external trade. Agricultural growth slipped to 2.2% in FY2002 from 5.5% a year earlier, while industrial output fell by 3.3%, largely due to a nearly 10% drop in manufacturing production. Tourist arrivals fell by 40%, resulting in an estimated 34% fall in tourism receipts and a 1.8% decline in services sector output.

Labor market conditions, characterized in FY2000 by a 47% underemployment rate, likely deteriorated during the year, given the high rate of annual population growth of 2.3% and the economic downturn. The downturn had a major negative impact on the FY2002 budget; however, the overall deficit including grants was contained at 3.3% of GDP, although domestic financing of the deficit was higher than planned (Figure 2.16). Budgetary adjustment was achieved by a large 40% cut in planned development expenditures.

Revenues increased by only 4.5%, after a 13.2% increase a year earlier, but this figure would have been lower had it not been for intensified collection measures, including the introduction of a voluntary disclosure of income scheme and the raising of special fees on imports and income tax surcharges to fund higher security expenditures.

The growth of broad money (M2) slowed sharply to 6.3% in FY2002, from 15.2% in the previous year. This reflected the weaker economy and deposit withdrawals prompted by the verification efforts of the tax and anticorruption authorities associated with the voluntary disclosure of income scheme. Given the exchange rate peg to the Indian rupee and active trade across the relatively open border, inflation in Nepal generally follows that of India. In FY2002, consumer prices rose by 2.9%, or slightly faster than 2.4% in the previous year.

The current account deficit widened significantly to 7.0% of GDP in FY2002 from 5.4% in FY2001. (The value of officially recorded remittances from abroad is known as a significant underestimate of the total value of remittances. It is estimated that the current account would be in surplus at 2.5% of GDP in FY2002 if informal remittances were taken into account.) The increase in the deficit was due to a drop in net services receipts, stemming from the plunge in tourism receipts, as recorded net transfers and remittances from workers abroad rose and the trade deficit narrowed somewhat, to 14.1% of GDP from 14.7% in FY2001.

Despite this narrowing, the external trade sector suffered as both exports and imports sharply declined. Exports fell by 18.0% with most of the decline due to the sharp drop in exports of readymade garments, woolen carpets, and pashmina shawls. Production disruptions, weak external demand, and intensified competition were factors in the weak performance.

Imports fell by 11.4% during the year, reflecting the decline in manufacturing activity, sluggish development activities, and lower aid inflows. Foreign exchange reserves at the end of FY2002 stood at about $1 billion, sufficient to cover about 8 months of imports of goods and services. External debt at that time amounted to $2.8 billion, or about 51% of GDP. While the debt is mostly on concessional terms, the debt service ratio increased to 9.7% in FY2002 from 6.8% in the previous year due to a sharp drop in foreign exchange receipts.

Policy Developments

The Tenth Plan (2003-2007), approved by the Planning Commission in December 2002, aims to reduce poverty from 38% to 30% of the population by 2007, with a strategy focused on broad-based and sustainable economic growth, social sector development, targeted programs for the poor and disadvantaged, and good governance. The poverty reduction objective is to be focused through a rolling 3-year medium-term expenditure framework, designed to anchor the Plan to a realistic resource estimate and the annual budgets.

To expedite and monitor the implementation of the core elements of the Tenth Plan, the Government prepared and implemented the Immediate Action Plan 2002. This focused on improving public expenditure management, basic service delivery, and governance.

The FY2003 budget focuses on addressing security issues and implementing an "immediate action plan" to prioritize and expedite reform programs. The overall deficit including grants is projected to be limited to 3.7% of GDP, with even heavier reliance on financing from the banking system. Domestic revenues are envisaged to be 13.0% of GDP, or 14.0% stronger than in FY2002; the budget proposes total expenditures of 20.0% of GDP (a 21.0% increase), of which regular expenditures are about 11% of GDP and development expenditures about 9% of GDP.

Security expenditures associated with the insurgency are planned at about 16% of total expenditures. While the FY2003 development expenditure program has been significantly restructured by dropping or amalgamating 160 low-priority projects and prioritizing the remaining projects based on poverty-reduction selection criteria, the development budget is still ambitious: it calls for a 25% increase in development expenditures, and needs to be further streamlined to maximize the development impacts and to ease the fiscal burden. Although the budget incorporates several reforms, domestic revenue estimates appear optimistic, as do the projected grant disbursements of 3.4% of GDP.

With the likely shortfalls in domestic revenue collection and external financing, and the increased expenditures, the budget deficit including grants in FY2003 is likely to widen to about 4.0%. It would therefore require a strong fiscal adjustment effort.

A new Nepal Rastra Bank Act granting the central bank greater autonomy and duties was passed in 2002; new banking regulations were also issued. Nepal Rastra Bank is now reengineering itself to cope with its expanded responsibilities, especially improving its supervision capabilities. In the financial sector, after considerable delays, external management contracts to manage and develop restructuring plans for the two largest commercial banks Rastriya Banijya Bank and Nepal Bank Limited have been completed. These state-owned banks account for about 52% of banking system assets and because of a very large amount of NPLs are technically insolvent, with a combined estimated negative net worth of 7-9% of GDP. External audit and operational review of the Agricultural Development Bank and Nepal Industrial Development Bank are under way to address similar issues. Although SOE finances have continued worsening in recent years, little progress in reforming their operations is evident.

Various governance reform measures have been introduced. Installation of the computerized civil service personal information system to improve accountability and transparency of the service has been completed, and some 7,500 of 17,500 vacant posts have been eliminated.

In the area of decentralization, progress was mixed. While a decentralization implementation plan was approved and responsibility for key services (primary education, agricultural extension, and health service delivery) was devolved to local bodies, the suspension of the locally elected bodies in July 2002 significantly undermined these decentralization efforts. With no system for civil servants to declare their assets annually, the accountability and transparency of the civil service have been frequently questioned.

To contain corruption, the Government passed four anticorruption bills in April 2002, requiring the declaration of property and income by all senior public officials.

Outlook for 2003-2004

Economic performance will depend heavily on the domestic security and political scenario, the vagaries of the weather, and developments in the global economy and India's particularly. While the announcement of a ceasefire on 29 January 2003 is clearly a welcome breakthrough, any positive impact on the economy will likely take some time to be felt. The underlying assumptions of the economic projections are that (i) law and order will be restored to allow some expansion in both private and public sector investment, (ii) the global economic recovery will continue, (iii) India's economy will grow by about 5-6% over the forecast period, and (iv) the weather will be normal. On this basis, GDP is projected to grow by about 1.5% in FY2003 and by about 3.5% in FY2004.

Agricultural growth may slow to about 2% in FY2003, but recover to about 3% in FY2004. The irregular monsoon in July-August 2002 will adversely affect summer crop production in FY2003. The industry sector is likely to grow by only 0.2% in FY2003 and then may recover to 3.5% in FY2004. The extent of the recovery will be largely determined by export growth and domestic political stability. A major upturn in the services sector is unlikely unless the ceasefire leads to a significant improvement in the security situation. The services sector is projected to show no growth in FY2003 but to expand by 3.5% in FY2004. Despite a possible increase in the prices of agricultural imports from India in FY2003 and the likely hike in domestic fuel prices, inflation is projected to be moderate at about 5% over the next 2 years.

Monetary policy is geared to supporting the exchange rate peg with the Indian rupee. Consequently, interest and inflation rates need to be kept in line with those in India. Given the projections for real growth and inflation, targets for broad money growth need to be in the range of 12-14% over the medium term. Given the optimistic estimates of revenues and grants in the FY2003 budget, it is important that central bank finance of the deficit be within monetary program limits.

The current account deficit is projected to return to around 5% of GDP, as seen in recent years, but this will require economic recovery in the country's major export markets, no major domestic security problems, a quick revival in tourism, and continued high levels of worker remittances. It will be crucial to accelerate export diversification and increase competition.

The insurgency has seriously exacerbated the daunting challenges that the country already faces. While the recent ceasefire announcement holds good prospects for social and economic development, it is still uncertain if this will eventually lead to a credible peace process, an end to the insurgency, and lasting peace. Addressing the insurgency—in large part a consequence of continued rural poverty and the failure to spread the benefit of development more widely—is critical for development.

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