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p. 41 of 77 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. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : South Asia

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Nepal

The economy continued to recover from the downturn in FY2002 on the basis of improved performance in agriculture and services, though the recovery is fragile. Increased political uncertainties following the royal proclamation imposing emergency rule in February, the complex security scenario, and agriculture’s continued dependence on the weather pose significant risks for higher economic growth over the short to medium term.

Macroeconomic assessment of 2004

The economy has been adversely affected by exacerbation of the insurgency and political instability since the second half of 2001. Economic growth slowed to an average of 1.2% during FY2002-FY2003, which was well below the annual average of 4.7% in the decade before FY2002. In FY2004 (ended 15 July 2004), GDP growth recovered moderately to 3.3% from 2.9% in FY2003, supported by improved performance in agriculture and services, which offset the conflict-induced weak performance in industry.

Agriculture grew by 3.9% in FY2004 from 2.5% in the previous year, contributing 1.5 percentage points to GDP growth (Figure 2.18). The improvement in output was due mainly to favorable weather, which helped increase paddy production by 7.8% year on year. The impact of lower growth in cash crop output, which suffered from declines in sugarcane, tobacco, and jute production, was thereby largely mitigated. However, the prospect of marked expansion in agriculture is limited by inadequate irrigation, an insufficient transport network, and lack of access to modern technology and credit.

Growth in industry declined to 1.0% in FY2004 from 3.0% a year earlier, reflecting sharply lower gains in the manufacturing and construction subsectors. Manufacturing grew by only 1.7%--much lower than the average rate of 7.5% in the decade before FY2001--due to conflict-related disruptions such as frequent bandhs (general strikes), forced closure of businesses, and restrictions on the movement of people and goods. Construction activity (about 50% of industrial output) was a particularly heavy drag on the industry sector, recording only 0.2% gain in the year. Besides suffering the effects of the conflict, the sector, especially manufacturing, remains constrained by poor infrastructure, lack of easy access to seaports, inflexible labor laws, and a weak legal and institutional framework for business.

The services sector grew by 4.3% in FY2004 from 3.3% in the previous year. The gain was driven by improved performance in the tourism, transport, and communications subsectors. Despite the conflict, tourist arrivals picked up by 35% due to competition-stimulated low prices and promotional efforts by the private sector and the Nepal Tourism Board. High growth in transport and communications services reflected investment in the stock of vehicles and a significant expansion of mobile telephone services.

On the demand side, both public and private investment was sluggish in FY2004, reflecting the weak investment climate in the country. At 19.2% of GDP, the gross fixed investment rate was below the average investment rate for FY1991-FY2001. The economic recovery in FY2004 was led by remittance-driven consumption expenditure, which accounted for almost all of the growth in GDP. The sustainability of such an expansion, however, will depend on continued buoyancy in remittances and a pickup in other sources of personal income.

On the fiscal side, government spending was 12% below the budget target due to constraints imposed on capital spending by the conflict. The capital spending shortfall, together with an 11% improvement in revenue mobilization, held the budget deficit to 1.5% of GDP in FY2004, about half the forecast. Foreign loans financed two thirds of the deficit while domestic loans financed the remainder. Despite the conflict, Nepal’s fiscal deficit has narrowed since FY2001, as the increase in security spending has been more than outweighed by underspending of the capital budget and improvement in revenue collection. However, a further worsening of the insurgency could change this outcome.

The financial sector was flush with liquidity due to continued growth of remittances and significantly higher flows of foreign loans. Broad money (M2) grew by 12.8% in FY2004, somewhat above the central bank’s 11.2% target. However, domestic credit rose slowly, reflecting the weak investment demand, tighter credit control by the two large government-controlled commercial banks undergoing restructuring, and a sharp decline in the Government’s domestic borrowings. Urban inflation was contained at 4.0% in FY2004, aided by higher food production and some appreciation of the local currency.

Interest rates fell for the second consecutive year in FY2004. The average weighted interest rate on the Government’s 91-day treasury bills fell to 2.9% in FY2004 while commercial bank deposit rates dropped to 2.2-5.0% in July 2004 from 2.5-6.3% in July 2002--both items negative in real terms. The average lending rate of commercial banks for industry remained unchanged during the year at about 11%. The large spread between lending and deposit rates is indicative of both the inefficiency in financial intermediation and the credit risk in the present conflict environment.

On the external side, exports rebounded, rising by 12.4% to $733 million, and imports jumped by 18.4% to $1.8 billion. Export growth was based on a recovery in exports of woolen carpets and leather goods, which overcame a decline in exports of readymade garments. Import growth reflected strong demand for consumer durables, while the appreciation of the domestic currency was also a contributing factor. The larger trade deficit during the year was, however, more than offset by improvements in tourism receipts, workers’ remittances, and foreign grants. In dollar terms, the current account surplus at $163 million was marginally higher than in FY2003 but was marginally lower in terms of GDP (2.4%). Apart from the current account surplus, foreign exchange reserves were buoyed by aid inflows, and stood at $1.4 billion or around 8 months of import cover at end-FY2004.

Garment exports face the threat of a sharp decline following the abolition of the MFA quota system on 1 January 2005. To cope with the threat, Nepal needs to shift its export strategy from quota utilization to one that makes use of preferential trading arrangements, such as the EU’s Everything But Arms initiative and Canada’s Market Access Initiative.

The economy also faces difficult challenges in reducing poverty and achieving the Millennium Development Goals. The results of the 2004 Living Standards Survey show that nominal per capita income has grown by 97% since 1996, with farm, nonfarm, and remittance incomes contributing 33%, 45%, and 19%, respectively. Remittance and nonfarm incomes have increased much faster than farm income, revealing a structural shift in the economy. Income levels of both the poor and the rich are reported to have risen proportionately. The results show that Nepal is making some progress in reducing income poverty despite the challenges posed by the conflict and political instability.

Human development indicators remain unsatisfactory. Nepal ranked 140 out of 177 countries on the human development index in 2004--lower than all other South Asian countries except one. The country presents significant regional disparity in human development, with the conflict-affected Far-Western and Mid-Western regions faring the worst. The economy is unable to provide gainful employment to all of its rapidly growing population, though the situation has been ameliorated somewhat by migration of labor to India, Southeast Asia, and the Middle East.

Macroeconomic policy developments

The Government’s fiscal policy objective over the medium term is to raise the revenue-to-GDP ratio and improve efficiency of public spending. The FY2005 budget aims to boost capital spending, especially in rural areas, by improving utilization of block grants to local governments along with community-led development projects in the areas of health, education, and rural infrastructure. However, this is proving increasingly difficult in the current environment.

To raise the revenue-to-GDP ratio, the Government is improving administration of VAT, simplifying the income tax law, and implementing a 3-year customs reform and modernization program. It also announced a 3 percentage point increase in the VAT rate to 13% during the midterm review of the FY2005 budget, though much of the additional revenue will finance increases in civil service allowances and security spending.

As part of the Government’s public enterprise reforms, the Bhaktapur Brick Factory was privatized in FY2004. Petroleum prices were adjusted to better reflect international prices in January 2005 and to fully offset the financial losses of Nepal Oil Corporation. The Government intends to adopt the Petroleum Products Sale and Distribution Ordinance in FY2005 to allow private sector participation in oil imports and distribution.

Nepal Rastra Bank is continuing its accommodative monetary policy to stimulate the economy. It has reduced the mandatory cash-reserve ratio from 6% to 5% for FY2005, aiming to narrow the widening differential between deposit rates and lending rates. It is targeting broad money growth of 12.5% and an inflation rate of 4% to facilitate the maintenance of the current parity peg with the Indian rupee.

Under financial sector reforms initiated by the Government, the NPLs of the two government-controlled banks being restructured under external management--Nepal Bank Limited and Rastriya Banijya Bank--have declined, respectively, from 61% and 60% in FY2003 to 52% and 56% in FY2004. The effort to improve the deteriorating financial health of these two banks has, however, substantially reduced banking services in rural areas, further concentrating them in urban locations. The Government has initiated restructuring of the Agriculture Development Bank to provide improved and affordable banking services in rural areas.

A new agriculture policy was adopted in November 2004, aimed at increasing productivity and commercialization. Based on the Government’s 20-year Agriculture Perspective Plan, the new policy envisages provision of modern technology inputs and credit to farmers to purchase land (for productivity), and supports tariff incentives for establishing agroprocessing industries and the promotion of contract and leasehold farming (for commercialization).

Recognizing that weak governance is one of the underlying causes of the conflict, the Government has recently refocused reforms to make governance more inclusive by enhancing participation of excluded and disadvantaged groups (i.e., women, dalits, and janjatis). It has approved reservation of 45% of vacant civil service positions for these groups. It also continues to pursue reforms to rightsize the civil service, establish an automated personnel information system (for civil servants and teachers), and facilitate community participation in government projects.

To achieve its estimated growth potential of 5-6%, the Government needs to focus on several areas. First, peace and stability must be restored. Second, it must improve the investment climate by strengthening the legal, institutional, and regulatory framework for the private sector. This has become increasingly important in the liberal trade regime brought about by the expiration of the MFA and Nepal’s entry into international trading arrangements such as WTO, the South Asia Free Trade Area agreement, and the Bay of Bengal Initiative for Multi-sectoral Technical and Economic Co-operation. Third, efforts must be made to foster stronger links with the country’s rapidly growing neighbors to tap the economic benefits of integration with their economies. Fourth, Nepal must accelerate the pace of ongoing governance reforms.

Outlook for 2005-2007 and medium-term trends

The royal proclamation on 1 February 2005 and the imposition of emergency rule have increased political uncertainty. Together with the complex security situation and agriculture’s continued dependence on the weather, they pose significant risks for economic expansion over the medium term. Growth will likely ease in FY2005, mainly due to the anticipated weaker performance in agriculture, tourism, and transport activities, and deterioration of the conflict in the second half of the year. Beyond FY2005, it will hinge on credible progress toward a lasting resolution of the insurgency. The underlying assumptions of the ADO 2005 projections are that: there will be no further deterioration of the insurgency and that progress will be made toward a lasting resolution in FY2006; stronger growth will be seen in both private and public sector investment in FY2006-FY2007; the global economic expansion will be maintained; the Indian economy will grow by about 6%; and weather conditions will be normal in FY2006-FY2007. Based on these assumptions, GDP is forecast to increase by 3.0% in FY2005, 3.7% in FY2006, and 4.3% in FY2007.

On the output side, agricultural growth is expected to moderate to 3.0% in FY2005 as the overall expansion will be limited by the weather-related decline in the production of paddy, which accounts for almost a quarter of agricultural output. Industry is forecast to grow by 2.4%, mainly on account of a remittance-driven recovery in depressed construction activity. Growth in services is projected to slow to 3.2%, reflecting an easing in tourism and transport. On the demand side, the gross fixed investment rate is projected to fall to about 18%, as a result of sluggish public and private investment in the conflict situation.

The fiscal deficit is projected at 1.7% of GDP in FY2005 compared with the Government’s midterm budget target of 2.5%, signaling the difficulty in implementing development projects. Broad money is likely to increase by 11.7%, or lower than the Government’s target of 12.5%. Growth in credit to both the government and private sectors will remain sluggish. The current account surplus is likely to shrink to 1.9% of GDP on account of the projected decline in tourism receipts, but foreign exchange reserves will continue to expand. Inflation is likely to rise to 4.5% due to the upward adjustment in petroleum prices, the increase in the VAT rate, and the decline in paddy production.

Agricultural growth will average about 3.5% over FY2006-FY2007; a rate higher than that is unlikely given the numerous structural weaknesses in the sector. Industry is projected to expand by 3.5% in FY2006 and 4.0% in FY2007, with improved growth in both construction and manufacturing driving the industrial recovery. Growth in services is likely to pick up to 4.3% in FY2006 and 5.0% in FY2007. Expansion in tourism, transport, and communications services is expected to strengthen, on the assumption that the security situation improves. An improvement in the security situation would also fuel a rebound in investment over FY2006-FY2007.

The fiscal deficit is forecast to widen to 3.0% in FY2006 and 3.5% in FY2007. Government expenditures are projected to grow strongly in both years on the assumption that an improvement in the security situation will allow the Government to undertake major reconstruction work. The revenue-to-GDP ratio is forecast to improve further over FY2006-FY2007, with better revenue management, efforts to check excise leakages, stronger collection of income tax arrears, and the increase in the VAT rate. Monetary policy will stay geared to maintaining the peg with the Indian rupee and to being accommodative to aid economic recovery. Accordingly, broad money growth is likely to remain in the range of 12-14% over FY2006-FY2007. Growth in credit to the government and private sectors is forecast to pick up. The discount rates on government treasury bills are therefore expected to rise. Consumer inflation is projected to fall to 4.0% in both years, as the effects of upward adjustment in petroleum prices and VAT subside and food production returns to normal levels.

The current account surplus is projected to further narrow in FY2006 and a deficit is seen in FY2007, as imports pick up. Export growth will be limited by the loss of MFA quota access and increased external competition. Foreign exchange reserves are likely to fall slightly in FY2006-FY2007, but should remain in excess of 6 months of imports.

Actual performance of the economy will be subject to significant downside risks. In particular, an exacerbation of the conflict could further restrict development spending, undermine the growth in industry and services, and impede poverty reduction efforts. The targets set out in the current Tenth Plan/Poverty Reduction Strategy of the Government and the Millennium Development Goals could then remain unattained. However, if Nepal can resolve the conflict and make progress toward peace and political stability, there is significant potential for the economy to achieve higher growth.

The economy remains well inside its production possibilities frontier, which makes further acceleration of the growth rate perfectly feasible. With 71% of its labor force in agriculture and underemployed, Nepal can hasten its transformation from an economy based primarily on agriculture to one based primarily on services and industry. If labor-intensive services and industry grow and pull even a quarter of the rural labor force into more productive employment, the economy can be expected to grow much faster. Simultaneously, the accompanying reduction in the population pressure on farmland will help raise agricultural productivity and wages.

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