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p. 1 of 4 BACK | NEXT I. Current Development Trends and Issues II. Implementation of the Country Strategy and Program III. Portfolio Management Issues IV. Country Performance and Assistance Levels

Country Strategy and Program Update 2003-2005: Nepal

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I. Current Development Trends and Issues

A. Recent Political and Social Developments

1. Nepal is facing a serious and violent insurgency that has adversely affected the economy and development work. Despite efforts by the Government to seek a negotiated settlement with the insurgents, the latter broke off talks in November 2001 and announced an end to the cease-fire agreed in July 2001. A series of attacks in different parts of the country against the security forces followed, including for the first time direct attacks on the army. The upsurge of violence prompted the Government to declare a state of emergency on 26 November 2001, for an initial period of 3 months, and for the first time to mobilize the army against the insurgents. The Government also declared the insurgency a terrorist movement.¹ Although the insurgency was initially concentrated in the mid-west and parts of the central region, it is now a much more widespread phenomenon. Violent incidents have continued during the state of emergency. Following large-scale attacks on the security forces in Achham and Salyan districts, Parliament extended the state of emergency for a further 3 months until 25 May 2002. Shortly before the expiration of the state of emergency, the Prime Minister dissolved the Lower House of Parliament on 22 May 2002 and called for midterm elections in November 2002. This action was prompted by a difference of views within the ruling party over the proposed extension of the state of emergency. Subsequently, the state of emergency was reimposed through a royal ordinance for 3 months until 26 August 2002. The Government is now expected to focus primarily on the forthcoming elections, which face a serious challenge given the security situation.

2. The recent upsurge of violence has hindered delivery of basic services, and both public and private sector activities, adversely affecting livelihoods, particularly in rural areas. Efforts to restore law and order have to go hand in hand with renewed efforts to strengthen development activities, especially at the grassroots level and in remote areas. Despite significant progress in many areas of development in the last decade, a widespread perception remains that socioeconomic and regional inequities have worsened. Poor governance, including corruption, has also undermined Nepal’s development efforts. However, success in tackling these problems will also depend on the wider commitment of all the stakeholders, including politicians and the bureaucracy.

B. Economic Assessment and Outlook

3. Although overall economic performance of Nepal in FY2001 remained generally favorable, FY2002 performance indicates a sharp deterioration. Gross domestic product (GDP) slowed to 5.0% in FY2001 from 6.1% of FY2000, with the slowdown mainly attributed to weaker agriculture sector performance, a sharp deceleration in manufacturing, and continued weakness in tourism. Inflation remained at 2.4% in FY2001, the lowest in more than 20 years. Despite a strong 16% increase in domestic revenue, the fiscal deficit widened to 4.2% of GDP in FY2001, mainly due to increased spending on security, and a salary increase and voluntary early retirement scheme for civil servants.

4. Since the end of FY2001, however, the economy has sharply deteriorated, and the short- to medium- term prospects are uncertain. The series of domestic and external shocks,including the tragic deaths of the members of the royal family in June 2001, the upsurge of violence associated with the insurgency, the impact of 11 September events in the United States, and the state of emergency, have led to a significant downturn in the tourism and manufacturing sectors. Growth in real GDP is forecast to decline to less than 1% in FY2002, from 5.0% in FY2001. Reflecting the uneven monsoon (mainly during June-August 2001) in the Eastern region, agriculture is forecast to grow at 1.7% in FY2002, down from 4.2% in FY2001. As manufacturing and tourism-related services continue to suffer from the insurgency and external conditions, the industry and service sectors are projected to grow at less than 1% in FY2002, falling sharply from their past 5-year averages of 5.1% and 6.0%, respectively. Inflation is forecast to be less than 3%, reflecting weak domestic demand. Revenue collection has slowed to about NRs38 billion during the first 10 months of FY2002, and will be significantly below the budget target of NRs60 billion; expenditure pressures from rising security expenditures are increasing. The fiscal deficit is expected to remain around 4.5% in FY2002 almost the same as FY2001. However, the deficit has been contained only through substantial cuts in development expenditure and other expenditure prioritization measures. If the current scenario does not improve quickly, pressure on development expenditures, including the counterpart funds for foreign-aided projects, will remain intense in FY2003, and undermine medium- to long- term economic growth prospects.

5. Given the continuing economic slowdown and the deteriorating fiscal position, prudent public resource and debt management reform is urgently needed to ensure fiscal stability and effective use of the country’s limited resources to target widespread poverty, one of the root causes of the insurgency. This will require a marked improvement in domestic and external resource and expenditure management. As the Government envisaged in its Medium-Term Expenditure Framework and the approach paper to the Tenth Plan (FY2003–2007) prepared in February 2002, the Government needs to continue its efforts to mobilize domestic resources through more broad-based tax reforms, and clear prioritization of development expenditures based on realistic resource estimates must be undertaken to maximize development impact of public investments.

C. Implications for the Country Strategy and Program

6. Nepal is now at a critical juncture, facing formidable challenges from the violent insurgency, its deteriorating fiscal position, and political uncertainties. While the Government is trying to restore law and order, recent events suggest that it may take time for the situation to return to normal. Pressures on the economy, and thus the fiscal position of the Government, will remain, and have a significant impact on operations of the Asian Development Bank (ADB) in Nepal. Reducing poverty through improved delivery of services and effective governance remain essential to a lasting solution to the insurgency. ADB’s country strategy and priorities remain fully consistent with these objectives. Effective implementation of government policies, projects, and programs will also be critical in contributing to resolving the conflict. Given the worsening fiscal situation, ADB and other development partners will need to provide more program assistance to support the Government’s reform agenda. While carrying out development activities in the most seriously insurgency-affected areas is difficult, the withdrawal of development activities from these areas only exacerbates the situation. Like its other development partners, ADB will need to work with the Government to devise ways to remain engaged in supporting development activities in affected areas, rather than trying to work around the conflict. Ensuring a strong and direct antipoverty focus and strong community participation in all projects and programs, therefore, is critical. Working more closely with local government at the district level will also help, although institutional strengthening of decentralized bodies is necessary to ensure accountability and effective implementation. The future course of the insurgency is difficult to gauge. While the security forces have begun to exert considerable pressure on the insurgents, a dramatic turnaround is unlikely in the absence of a political and negotiated solution. However, given the significant uncertainty in the short to medium term, the Government and ADB will need to show flexibility in carrying forward the proposed 2003–2005 program.

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