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Country Strategy and Program Update 2004-2006: Nepal

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I. Current Development Trends and Issues

A. Recent Political and Social Developments

1. Since the latter half of 2002, Nepal has been experiencing considerable political turbulence and an escalation of the insurgency, which has adversely affected the economy and development work. In October 2002, in response to then Prime Minister Deuba’s proposal to defer the mid-term elections by a year—due to the difficult security situation—His Majesty the King relieved Prime Minister Deuba and appointed L. B. Chand, a senior leader of the Rastriya Prajantantra Party (RPP), and a Cabinet, comprising mostly members of smaller parties and independent professionals. Prime Minister Chand resigned in May 2003 under growing pressure from the political parties opposed to His Majesty’s actions. His Majesty appointed S. B. Thapa, another senior RPP leader, who has subsequently formed a small Cabinet comprising six RPP members. Dissatisfied, the political parties continue to demand reinstatement of the dissolved Parliament as a precondition for joining the new Government.

2. The cease-fire agreement between the previous Government and insurgency leaders in January 2003, followed by an agreement on a code of conduct in March 2003, has considerably improved the domestic security situation. Two initial rounds of peace talks were also held in April and May 2003 during which the insurgents put forth their demands for a roundtable, an interim government, and a constituent assembly. Although disrupted by the change in government, the peace process is expected to continue and the cease-fire remains generally effective.

3. If the peace process is sustained, this will clearly have a positive impact on the economy and rural livelihoods. The conflict has negatively affected the latter, mainly due to out migration, the dislocation of the rural population, and restrictions on the movement of goods and essential supplies. A sustained peace process would also enable the Government to undertake urgently needed postconflict rehabilitation, reconstruction, and development work, especially in previously neglected areas. This will allow the Government, by targeting development, to effectively tackle widespread poverty and other root causes of the insurgency.

B. Economic Assessment and Outlook

4. The economic performance of Nepal was exceptionally weak in FY2002. Gross domestic product (GDP) contracted by 0.5%, after growing by 4.6% in FY2001. Inflation during FY2002 remained low, at 2.9%. A series of domestic and external shocks—including an intensification of the insurgency, an irregular monsoon, and weak external demand—adversely affected production and external trade. Agricultural growth slipped from 5.5% in FY2001 to 2.2% in FY2002, 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% drop in tourism receipts and a 1.8% decline in services sector output. The downturn had a major negative impact on the fiscal position; however, the overall deficit, including grants, was contained at 3.3% of GDP, due to a 40% cut in planned development expenditures and increased domestic deficit financing. Despite the Government’s intensified revenue collection measures, including increases in special fees on imports and income tax, domestic revenue collection only increased by 4.5% in FY2002, a sharp reduction from the 13.2% increase a year earlier.

5. The short- and medium-term prospects of the economy depend on the peace process. While the cease-fire and the beginning of the peace process hold good prospects for economic recovery, they are likely to take some time to significantly impact the economy. Real GDP is forecast to grow by about 1.5% in FY2003 and 3.5% in FY2004. Despite a price increase in agricultural and petroleum products, inflation is forecast to increase moderately (by less than 5%) over the next 2 years, reflecting weak domestic demand. The FY2003 fiscal deficit, including grants, is forecast to be contained at around 4%, reflecting the difficulties in carrying out development activities, but it might reach 6% in FY2004, as development expenditure, including reconstruction and rehabilitation work, expands.

6. Given the economic slowdown and the weak fiscal position, prudent public resource and debt management reforms are urgently needed to ensure fiscal stability and the 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 resources and expenditure management. As envisaged in the Tenth Plan (FY2003–2007), the Government needs to continue its efforts to mobilize domestic resources and maximize development impact of public investments through more broad-based tax reforms, and clear prioritization of development expenditures based on realistic resource estimates.

C. Implications for the Country Strategy and Program

7. If the cease-fire continues to hold and leads to an effective peace process, the environment for those development activities adversely affected by the conflict will significantly improve. However, addressing the critical issues of persistent poverty and the lack of development in conflict-affected areas, which are among the underlying causes of the insurgency, is vital to the peace process. The Government fully recognizes this and is preparing a program to address critical humanitarian needs, rehabilitate the displaced population, and reconstruct those key rural infrastructure and administrative facilities destroyed during the conflict. In spite of this, the pressure on the economy and the fiscal position of the Government are likely to remain in the medium term and will limit the Government’s ability to fulfill rehabilitation and development needs of conflict-affected areas, which encompass large parts of the country. To meet this challenge and tackle deep-rooted development problems facing the country—including social exclusion; poor governance; and weak implementation of policies, projects, and programs—the Government will need significant program and project support from its development partners. The country strategy and priorities of the Asian Development Bank (ADB) remain fully consistent with the objective of addressing poverty and targeting development in poor and conflict-affected areas. While ADB’s proposed operational program for Nepal directly addresses these priorities, there is a need to provide further support for the Government’s rehabilitation and reconstruction program and for strengthening the fiscal position and improving governance. In addition, to ensure accountability, effective implementation, and improved service delivery, ADB will need to continue to work closely with the Government to promote the wider and stronger participation of local bodies and communities in all projects and programs. Since the peace process is still in its early stages, and since considerable political uncertainties remain, the Government and ADB will need to show flexibility in carrying forward the proposed 2004–2006 program.

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