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p. 37 of 69 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions 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. Foreign Direct Investments in Developing Asia

Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia : South Asia

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Nepal

A cease-fire between the Government and insurgents from January to August 2003 fostered a moderate economic recovery in FY2003, following the downturn a year earlier. The outlook is for continued recovery based on a strong agricultural performance and a further rebound in trade and tourism. However, the tense security situation continues to weigh heavily on the economy.

Economic Assessment

The cease-fire between the Government and the insurgents in effect during the second half of FY2003 (ended 15 July 2003) induced economic recovery. GDP grew moderately by 2.6% over the full year, representing a marked improvement from the 0.4% decline in FY2002. The cease-fire particularly helped hard-hit manufacturing and the trade and tourism subsectors, which rebounded from a contraction in FY2002. The rebound boosted growth in transport and communications services output. Agriculture sector growth was limited to 2.4% due to an inadequate monsoon. Gross fixed capital formation at 19.2% of GDP showed no significant improvement from FY2002. While private investment strengthened marginally by 0.6% of GDP from the FY2002 level, public investment declined by 0.7% of GDP, reflecting the difficult peace and order environment in parts of the country.

The budget deficit narrowed in FY2003 to a record low of 1.8% of GDP, from 3.9% in FY2002, due to improved revenue collection and low development spending (Figure 2.18). The former, climbing to 11.9% of GDP, was only marginally short of the budget target and 11.1% higher than in FY2002. The latter was caused by the security situation and weak local government administration (the term of elected local bodies expired in July 2002 and, as an interim measure, the Government itself appointed committees of civil servants to act on their behalf). Key sectors with significant underspending were health, water supply, and power, where only about half of the respective budget allocations were disbursed.

Reflecting improved economic activity in the second half of FY2003, growth of broad money (M2) nearly doubled to 8.1% from a year earlier. Interest rates fell in FY2003 due to high liquidity in the banking sector caused by the lowering of the cash reserve requirement by 1 percentage point in August 2002 and due to moderate loan demand stemming from investment uncertainties. Given the exchange rate peg of the Nepalese rupee to the Indian rupee and Nepal’s large trade with that country, inflation in Nepal generally follows price developments there. CPI inflation picked up to 4.8% in FY2003, from 2.9% a year earlier, reflecting price developments in India, short-term supply constraints of some agricultural products, and upward adjustment of certain administered prices, such as oil products.

The trade deficit widened significantly in FY2003 to $925.9 million. Greater economic activity in the second half of the year boosted growth in total imports to 8.1%. Total exports declined by 14.9% during FY2003, mainly because there were no reexports of oil products to India during the year. (Excluding such reexports, exports increased by 3.3% in FY2003, having declined by about 19% in FY2002.)

This sluggish export performance stemmed largely from four diverse developments: (i) exports to India, which had been growing robustly until FY2000, declined by 5.2% in FY2003, reflecting the more restrictive provisions of the revised 2002 Nepal-India Trade Treaty; (ii) exports to other countries rebounded and rose by 15.9% after their sharp drop of nearly 40% in FY2002; (iii) readymade garment exports, on a downward trend since FY2000, rose markedly by about 58%, mainly due to the upturn in external demand; and (iv) exports of woolen carpets and pashmina continued to decline due to quality problems, lack of market diversification, and increased competition from neighboring countries.

Worker remittances, including unrecorded flows, reached about $820 million (14.1% of GDP) in FY2003, from about $750 million in FY2002, and exceeded exports of $642.8 million. With growing migration, remittances are forecast to steadily strengthen and remain a key resource fostering macroeconomic stability. Tourism receipts rose from about $110 million (2.1% of GDP) in FY2002 to $150 million (2.6%) in FY2003, as tourist arrivals went up by about 9% during the second half of the year thanks to the improved security environment. However, the current account surplus dropped to $107.5 million (1.8% of GDP) in FY2003 from $233.8 million (4.2%) in FY2002 due to the burgeoning trade deficit. Foreign exchange reserves remained adequate at $1.1 billion, equivalent to 7 months of imports. Convertible currency reserves grew by about 33%, on the back of higher remittances, while nonconvertible (Indian currency) reserves collapsed, by about 58%, reflecting the widening trade deficit with India.

At end-FY2003, external public debt stood at around $2.9 billion (50% of GDP). Historically, the external debt service ratio has been low-about 6% of current receipts-primarily because of the highly concessional terms of external loans. However, the ratio has increased in the last 2 years, to exceed 9%, as a result of both the decline in exports and tourism receipts and of higher amortization payments due on past loans. External debt is still manageable though.

Policy Developments

The Government announced its poverty reduction strategy (PRS) in June 2003 based on the Tenth Plan (FY2003-FY2007) approved by the Government earlier in February 2003. The Tenth Plan aims to reduce the current poverty level of about 40% to 30% by FY2007 and sets out a reform and investment program to achieve higher and broad-based economic growth, improve delivery of basic services, promote social inclusion, implement targeted programs for poor and disadvantaged groups, and strengthen governance. The Tenth Plan macroeconomic framework envisages annual average GDP growth of 6.2% under its normal scenario assumption of rapid restoration of political stability and an alternative lower-case scenario of 4.3% if there is prolonged political instability.

The PRS/Tenth Plan has been linked with the Medium-Term Expenditure Framework (now extended to the development budget of all line ministries), which prioritizes public investments based on poverty reduction criteria and realistic resource estimates. Based on the results of the initial Immediate Action Plan (IAP) 2002, the Government prepared and carried out the 2003 IAP to effectively implement the core elements of the PRS/Tenth Plan, particularly measures to strengthen the fiscal position, improve delivery of basic services through devolution, and promote social inclusion in the development process.

The FY2004 budget aims to strengthen domestic revenue mobilization, improve efficiency of public expenditures, and reduce domestic borrowing. The budget targets revenue collection of 12.5% of GDP through improved tax administration and revision of key tax rates and fees based on the recommendations of the Fiscal Reform Task Force constituted in January 2003. The budget deficit (including grants) is forecast at 3.1% of GDP, based on an expenditure target of 18.7% of GDP. The projection for current expenditures is an increase of 12.0% from the FY2003 level, and for development expenditures an ambitious rise of nearly half.

After being stalled for many years, the privatization program has gained momentum with the privatization of the Butwal Power Company and the initiation of privatization or liquidation of nine public enterprises. The budget announced divestment plans for other key public enterprises, such as Nepal Telecom, Royal Nepal Airlines Corporation, and the National Life Insurance Corporation. An unbundling of the Nepal Electricity Authority is slated for FY2004. It is also planned to open up oil product imports to the private sector, to generate competition and improve the efficiency of the Nepal Oil Corporation.

The autonomous Nepal Accounting Standard and the Nepal Auditing Standard boards have been established to upgrade corporate accounting and auditing to international standards. The three new Secured Transactions, Insolvency, and Company laws are being promulgated to advance corporate and financial governance reforms. Efforts are under way to increase trade and competitiveness. The Government has ratified the WTO accession agreement, as a result of which Nepal now faces two difficult challenges: to cope with the elimination of the MFA quotas in 2005 and to comply with WTO accession commitments.

Following the enactment of the Nepal Rastra Bank (NRB) Act in 2002, which enhances NRB’s autonomy and strengthens its supervisory and regulatory functions, a new Banking and Financial Institutions Ordinance has been adopted to further strengthen NRB’s oversight on all institutions in the financial system. A debt recovery tribunal has been established, providing a time-bound process for recovering debts. NRB also issued a new blacklisting directive naming major loan defaulters.

NRB issued directives to end limits on commercial banks’ interest rate and foreign exchange rate spreads. The ceiling of a 1% spread between the buying and selling rates of foreign currencies was revoked, effective 17 December 2003, and the regulation setting a maximum spread of 0.5% from a bank’s declared lending interest rate was withdrawn, with the aim of better accounting for risk and enhancing competition among commercial banks.

To strengthen governance, the Government continues to implement anticorruption measures. A Judicial Investigation and Probe Commission was constituted to investigate properties of public officeholders, providing a basis to initiate anticorruption actions. With regard to civil service reforms, the current personnel information system has been enhanced with an integrated payroll management system. Steps are also being taken to identify vacant civil servant positions for elimination.

Outlook for 2004-2005

Despite the breakdown of the cease-fire in August 2003, the economic recovery is likely to continue in FY2004, mainly due to the strong performance of the agriculture sector and continued improvement in the trade and tourism sectors. However, economic performance in the medium term will fundamentally depend on a lasting resolution of the insurgency and the political impasse between the Government and political parties. The underlying assumptions of the projections are that (i) there will be no significant deterioration in security conditions in FY2004 and some improvement in them in FY2005, facilitating both private and public sector investment; (ii) the global economic recovery will continue; (iii) the Indian economy will expand by about 7%; and (iv) weather conditions will be normal. On this basis, the economy is projected to grow by about 4.0% in FY2004 and by about 5.0% in FY2005.

Agricultural output growth is likely to improve to about 3.4% in FY2004 and then moderate to 2.9% the following year. In FY2004, agriculture will be buoyed by a nearly 8% rise in paddy production due to the strong monsoon, while output of standing crops, such as maize and millet, is also expected to exceed the FY2003 growth rate.

The industry sector is likely to grow by 3.5% in FY2004 and by 6.9% in FY2005. Growth in 2004 will be supported by the commissioning of three new hydropower plants, a continued increase in construction activities, and improved manufacturing performance. The services sector can be expected to expand by 4.9%, bolstered by further recovery of trade and tourism and continued strengthening of transport, communications, finance, and real estate services. Despite the breakdown of the cease-fire in August 2003, the number of tourist arrivals has grown by 39% during the first 8 months of FY2004-underpinning the likely considerable boost in the services sector.

The fiscal deficit is projected to be about 2.7% of GDP and below the FY2004 budget target of 3.1% due to a likely shortfall in development spending. The security tensions, coupled with the disruption in local government administration, will continue to constrain development spending. The fiscal deficit could widen to about 4-5% in FY2005 if these tensions are relaxed sufficiently, allowing major reconstruction work to be carried out.

Inflation is expected to be contained at below 5.0% in FY2004-FY2005, reflecting the price situation in India and the expected strong agricultural production in both countries. Given the likely impact of the security situation on business activity, the Government’s 11.2% target for money supply (M2) growth in FY2004 appears high and a 9.3% expansion is projected. However, money growth could reach 11.0% in FY2005 if the situation improves and business activity picks up.

The trade deficit is forecast to widen in FY2004 without a significant improvement in export performance. The inflow of remittances is expected to continue at the present rate and underpin the country’s balance of payments. Tourism receipts are likely to increase moderately. The current account surplus is likely to further shrink to 1.0% of GDP in FY2004 and 0.5% of GDP in FY2005 but higher aid and other capital inflows should offset the usual negative errors and omissions item and expand Nepal’s international reserves to maintain a cover of about 7 months of imports.

The economy is projected to continue its recovery in FY2004-FY2005. The security situation however continues to present a substantial risk to the economy, and urgent efforts are required to resolve the present crisis. In this context, the Government needs to find ways to accelerate development activities, especially at the local level, and build political consensus.

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