Countries and Regions

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p. 2 of 7 BACK | NEXT Executive Summary I. Current Development Trends and Issues II. The Government's Development Strategy III. ADB's Development Experience IV. ADB's Strategy V. ADB's Assistance Program VI. Risks, Performance Monitoring, and Evaluation

Country Strategy and Program 2005-2009: Nepal

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I. Current Development Trends and Issues

1. Nepal has made steady improvements in economic and social conditions over the past four decades. There is now a far better transport and communications network, and the population has greater access to safe drinking water, schooling, and basic health care. Still, Nepal remains one of the poorest countries in the world, with two out of every five Nepalese living in absolute poverty.

2. Nepal’s development challenges are immense. Delivering services and fostering economic activity in a landlocked country with rugged topography is both difficult and costly. About 80% of Nepal's population live in rural areas, and the country is characterized by small landholdings, rapid population growth, and a fragile ecology, which make poverty chronic in many parts of the country.¹

3. Compounding these development challenges is a violent insurgency launched by the Communist Party of Nepal, Maoist (CPN/M) in 1996. The insurgency has escalated sharply in recent years, undermining Nepal's development and poverty reduction efforts. It is clear that a lasting solution to the conflict can be found only in addressing its root causes—social exclusion (characterized by caste, gender, and ethnic discrimination), large economic and regional inequalities, lack of opportunity, poor governance, and the failure of successive political regimes to deliver expected development results. The presence of a radical communist party able to capitalize on these issues, push a populist agenda and, take advantage of Nepal's topography is also an important factor explaining the emergence and growth of the insurgency.

4. This new country strategy and program (CSP) for Nepal covers the period 2005–2009 and will be implemented in perhaps the most challenging environment in Nepal’s recent history. This is the first pilot results-based CSP of the Asian Development Bank (ADB). It identifies the development results that ADB will help the Government achieve as well as outcomes expected during implementation of the CSP. The CSP draws on important lessons from ADB’s past operations in Nepal, makes a comprehensive assessment of the present conflict and evolving political situation, and is based on wide consultations with the Government, private sector, civil society, local communities, and Nepal’s development partners.

A. Political Environment

1. Conflict

5. The insurgency, which started in the hill districts of Rukum and Rolpa in the Midwestern Development Region (Midwestern Region),² has now spread to most parts of the country with varying degrees of intensity. The economic benefits following the restoration of democracy in 1990 fell well short of meeting the aspirations of the general public, causing widespread disillusionment. In 1996, the extreme left questioned the effectiveness of the democratic order established 6 years previously, opted out of the political mainstream, and declared a “people’s war” against the Nepalese state to achieve their 40-point agenda. Since 1990, persistent political instability, infighting and power struggles, corruption, inadequate social and economic benefits, and weak governance—all of which contributed to a loss of confidence in government and the political system—further contributed to widespread discontent, and CPN/M capitalized on these failings.

6. Over the past year, the conflict has spread. At present, 36 of the 75 districts are classified as Phase III districts under the United Nations’ security system. Since 1996, about 10,000 people have been killed, 300,000–400,000 rural families displaced, and infrastructure facilities estimated to cost about $400 million destroyed. Development activities have slowed significantly, especially after 2001 when Parliament was dissolved, the elected Government was dismissed, the elected local governments’ term expired and no attempt was made to hold local elections, and the insurgency took a sharp turn for the worse. The insurgents have targeted government and security installations, and bank branches, usually in sparsely populated rural areas in rugged terrain, where access for the security forces and maintenance of law and order are difficult.

7. Efforts have been made to resolve the conflict: three major, but inconclusive, rounds of peace negotiations between the Government and CPN/M have been held since 2001. The first, in July 2001, was initiated by the elected Government of Prime Minister Deuba but broke down in November 2001, leading to the imposition of a state of emergency. The second time, the Chand Government, which had been appointed by the palace, conducted two rounds of negotiations during April–May 2003. The subsequent Thapa Government, also appointed by the palace, resumed negotiations for the third time in August 2003, but it too was unsuccessful. However, after the breakdown of the latest cease-fire in August 2003, the Government took a more offensive military stance against the CPN/M insurgents, resulting in a significant containment of CPN/M’s violent activities to their traditional strongholds in the Farwestern and Midwestern regions, and parts of the Eastern Region. Nonetheless, since early 2004, taking advantage of the agitation of the “constitutional political parties”³ against the Government and the palace, CPN/M has stepped up targeted armed attacks on security personnel and civilians. In a major act of defiance, CPN/M also imposed blockades in different parts of the country, seriously restricting the movement of people and commodities. These incidents indicate that the rebels’ military capabilities remain significant, and underscore the daunting challenge of seeking a military solution to the conflict. A lasting resolution to the conflict can only be achieved by addressing its root causes.

2. Crisis in the Constitutional Parties

8. Continued political instability and its adverse consequences have contributed to fueling the insurgency and weakened the Government’s ability to resolve the conflict. The period since the restoration of democracy in 1991 has been marked by constant inter- and intra-party fighting, and frequent changes in government—13 governments in 13 years—many of which were fragile coalitions. A complex political setting with the palace, Government, political parties, and CPN/M vying for state control and power made it more difficult for Government to focus on the country’s development challenges.

9. Infighting within the ruling Nepali Congress Party prompted the Prime Minister to dissolve Parliament in May 2002. This eventually led to an abrupt end to democratic rule in October 2002 when the palace dismissed the Prime Minister for failing to hold parliamentary elections as scheduled and appointed a new Prime Minister. These two crucial events sparked the constitutional crisis, which remains unresolved. The political parties refused to join a government led by a palace-appointed Prime Minister, and forced his resignation. However, the palace appointed another Prime Minister in June 2003. Since November 2002, the political parties have been protesting against the palace’s move, questioning the legitimacy of the governments appointed by it and demanding formation of an all-party government and/or reinstatement of the dissolved Parliament. In April 2004, professional groups and students joined with the political parties and escalated the political agitation sharply, forcing the second palace-appointed Prime Minister to resign in May 2004. The palace then appointed S.B. Deuba of the Nepali Congress Party (Democratic) as the new Prime Minister on 2 June 2004, with tacit support of some major agitating political parties. Notably, he was the democratically elected Prime Minister dismissed in 2002. He has won the backing of one of the major agitating political parties, and has been able to form a coalition Government with the participation of four parties. However, some other political parties, including the Nepali Congress Party, continue to question and oppose the legitimacy of the new Government. The new Government has committed to initiate Parliamentary elections by mid-April 2005 and peace negotiations with CPN/M as soon as possible.

10. There have been no elected local bodies in the country since July 2002, when their term expired and elections could not be held due to the security situation. In addition to slowing development activities, the absence of elected local officials has weakened the decentralization efforts and ceded vital political space to the insurgents, thus worsening the security situation.

B. Economic Development

11. Nepal’s economy is characterized by a low and fluctuating growth rate. Agriculture still contributes about 40% of its gross domestic product (GDP) and employs about 60% of the labor force. While progress in agriculture has contributed to food security, the subsistence orientation of highland producers limits contribution to income growth and poverty reduction. Services have evolved as a major sector in the past two decades, growing from 25% to more than 40% of GDP. They have been driven by expansion in trade, finance, tourism, and transport and communications. Tourism growth has been slowed significantly in recent years by internal security concerns and external shocks, although it has recently shown signs of recovery. The industry sector has remained stagnant, contributing only about 20% of GDP, and is constrained by the deteriorating security situation, in addition to the challenge it already faces in terms of inadequate infrastructure facilities, unfavorable investment climate, and growing global competition.⁴

12. The introduction of market-oriented reforms and restoration of democracy in the early 1990s raised expectations that higher economic growth would substantially benefit the poor. In response to market reform, the investment-to-GDP ratio increased significantly in the 1990s, reaching an average of 25% of GDP. Growth accelerated from 2.5% in the 1960s and 1970s to about 5% per annum in the 1990s, while poverty incidence fell by about 2%. But with the escalation of the conflict, economic performance worsened. Productivity of investment has been low both for investment as a whole, and in key industries.

13. GDP growth declined to negative 0.4% in FY2002. It then recovered moderately and grew by 2.7% in FY2003. Aided by the January–August 2003 cease-fire and a recovery in the global economy, the manufacturing, trade, and tourism sectors recovered significantly. Despite the breakdown of the cease-fire in August 2003, it is estimated that real GDP has grown by about 3.6% in FY2004 and inflation has been contained at about 4.0% in FY2004 compared with 4.8% in FY2003.

14. The fiscal position strengthened in FY2004 with a significantly low budget deficit of 1.5% of GDP. However, the low deficit was mainly due to sharply lower development spending caused by a combination of factors. The security situation, lingering political uncertainty, and absence of elected local governments have slowed the government decision-making process. Lower development spending has weakened delivery of public services in rural areas, aggravating the existing social and economic disparities. Low development spending will also have serious implications for achieving sustained and higher economic growth essential for poverty reduction. These factors could aggravate the conflict. While regular expenditure has been kept reasonably under control, security expenditures increased to 3% of GDP and development spending fell to about 6% of GDP in FY2004 compared with 1.7% and about 10% of GDP, respectively, before the conflict.⁵ Nepal’s tax-to-GDP ratio is one of the lowest in South Asia, and at 10% of GDP, tax revenues are barely sufficient to finance current expenditures.

15. Despite volatile domestic economic conditions and a narrow fiscal base, Nepal's external payments position remains sound, buoyed by a sustained increase in migrant workers’ remittances.⁶ The external debt service ratio⁷ increased to about 10% in FY2004 from 8.5% in FY2002, reflecting the effects of depreciation, a decline in merchandise exports, and maturity of past external loans. Given Nepal's narrow revenue base and limited room for fiscal maneuver, the economy needs prudent external debt management and a much stronger domestic resource mobilization effort.

16. The generally sound macroeconomic indicators, however, mask some important disruptions that will have long-term, lingering effects. The most serious adverse economic impact of the conflict appears to be the cumulative loss of potential output—the overall economic growth rate has been significantly lower than what it could have been since 1996. In the 1990s, for example, GDP growth averaged 5%. However, since 2001, GDP growth has dropped to an annual average of 2.6% against population growth of 2.3%. This has serious negative implications for poverty reduction. The investment climate for domestic and foreign private sectors has deteriorated. At the micro level, the adverse economic impacts are more pronounced, especially in the heavily conflict-affected areas. In these areas, labor mobility, financial services, and commodity markets have been disrupted, adversely affecting rural livelihoods. Delivery of basic public services in rural areas has deteriorated. This, together with rising rural insecurity, has led to an upsurge in rural-urban migration. An estimated 1.9 million people now live in Kathmandu Valley, putting pressure on delivery of drinking water, sanitation, and other essential services.

C. Poverty

17. Nepal is one of the poorest countries in the world with a per capita GDP of around $270 in FY2004, an estimated overall poverty incidence of 38%,⁸ an increase in the absolute number of poor since the mid-1980s, and widening interregional and national income inequality. Poverty is more prevalent and severe in rural areas where poverty incidence (44%) is almost double that in urban areas (23%). The incidence of poverty in the Midwestern and Farwestern regions (72%) and in the mountain districts (56%) greatly exceeds the national average. There are large differences in living standards between those in Kathmandu Valley and the rest of the country. In Kathmandu Valley, poverty incidence is estimated to be approximately 4%, i.e., one tenth of the national average.⁹

18. While official data imply that income poverty prevalence has changed little in the past two decades, indirect poverty indicators suggest that improvements may well have been made. Between 1985 and 2002, per capita food availability in calorie terms increased by 31% while real agricultural incomes rose by 12%. In the Terai and eastern Nepal, surveys report a substantial increase in rural real wages during the 1990s. Growth in overseas employment and remittances has likely contributed the most to improved livelihoods. According to official sources, some 700,000 Nepalese work in other countries on a long-term basis, with another 2 million–2.5 million workers engaged in seasonal work abroad. This excludes several million more Nepalese who have migrated and work in India permanently. There has also been significant in-migration of Indians, especially in the southern Terai region of Nepal. The bulk of those working abroad are from rural areas, and overseas earnings, much of which goes unrecorded, help sustain consumption and augment rural investment.

19. Despite low incomes, Nepal has registered steady progress in various aspects of human development. The prevalence of underweight children (less than 5 years of age) was reduced from 57% in 1990 to 48.3% in 2000. Primary school net enrollment increased from 61% in 1990 to 80.4% in 2002. Over the same period, the adult literacy rate increased from 31% to 43%, life expectancy rose from 54 to 60 years, infant mortality fell from 102 to 66 per 1,000 live births, maternal mortality declined from 850 to 540 per 100,000 births, and the share of the population with access to drinking water increased from 66% to 72%. Since 1985, the fertility rate has been gradually declining and the proportion of the population using family planning has increased to 39%. Despite these significant improvements, Nepal still ranks 140th out of the 177 countries in the United Nations Development Programme’s human development index ranking in 2004.

20. Various factors combine to cause income poverty, namely slow overall growth in the face of a rapid increase in population, weak linkages between urban and rural growth, low rates of productivity improvement in agriculture, and limited economic and social infrastructure in rural areas. These explain why poverty remains high. In rural areas, there is inequitable access to resources: the poorest quarter of the population has average landholdings of half a hectare, little of which is irrigated or otherwise suitable for paddy cultivation.

21. Geographic isolation and development programs that failed to transfer adequate resources to rural and remote areas also contributed to poverty. Large parts of the country are effectively cut off from major markets in and around urban areas. The hilly and mountainous districts of the Midwestern and Farwestern regions, and the mountainous districts of the Central Region, are ranked lowest in terms of socioeconomic and infrastructure development. Road density, access to drinking water, and access to banking services are substantially lower in these areas than in the Terai and the central and eastern hill zones of Nepal.¹⁰ Low levels of literacy, poor access to and quality of public education and health care, a limited skills base, and high levels of maternal morbidity and mortality add to human poverty and low productivity.

22. Demographic realities also exert a powerful influence on living standards in Nepal. Nepal's population doubled from 11.6 million to 23.2 million between 1971 and 2001. This led to an increase in the average population density from 79 to 157.3 persons per square kilometer. Population densities on land suitable for farming increased to more than 600 people per square kilometer, making rural Nepal one of the most densely populated farming areas in all of Asia. Over time, as pressure on the natural resource base increased, Nepal’s population shifted to the regions that had the best market connections and natural resource endowments, including the fertile Terai, Kathmandu Valley, Pokhara Valley, and the better endowed hilly regions of the Central and Eastern regions. Temporary migration to India through the long and open border has served to ease economic pressures, particularly in the poorer Farwestern, Midwestern, and Central hilly and mountainous regions.

D. Governance and Institutional Capacity

23. Political instability and weak governance have lowered the returns to government’s poverty reduction efforts. The voice of the poor and excluded groups in public decision making has been limited: politics and public institutions have been dominated by a narrowly based elite, resulting in little attention to the interests of the poor and excluded. This, together with poor service delivery, overcentralized government, weak institutional capacity, poor public participation at grassroots level, and systemic corruption, has contributed to social tension and fueled the insurgency. Political instability and the conflict have also adversely affected governance. Public service delivery has been further impeded by an increase in lawlessness and insecurity. Governance suffered a further setback with the dissolution of Parliament and de facto dissolution of elected local bodies, which seriously impeded decentralization—a major plank of good governance—as well as regulatory and legislative reform. A law can now be passed only in the form of an ordinance, which requires promulgation under royal authority. Since 2002, the number of ordinances promulgated has declined, and some political parties have opposed such promulgations.

24. While reforms have not been rapid and extensive enough to contribute significantly to poverty reduction, important reform measures have been taken to improve governance, mainly in the areas of public expenditure management, anticorruption, public enterprise reform, facilitation of local community participation, and private sector development. Over the past 2 years, the Government has made progress in prioritizing development expenditures through the medium-term expenditure framework based on the priorities of the Tenth Plan. Progress has been made in civil service reform and the broader reform of the public sector, including the elimination of about 7,200 vacant civil service positions, establishment of an automated personnel information system, and privatization or liquidation of public enterprises. Enactment of several anticorruption laws¹¹ and establishment of a special tribunal to prosecute corruption cases provide new mechanisms for combating corruption. While devolution of responsibility of key services (primary education, primary health care, and agricultural extension) to local governments was initiated and a Local Body Fiscal Commission was established, progress in decentralization has been hampered by the absence of local government representatives. The Government has taken action to streamline its role and to open up more areas for private investment by dismantling monopolies and privatizing, liquidating, and introducing contract management in public enterprises.

25. The Government has recognized that failure of governance is one of the underlying causes of the conflict. It has recently refocused reforms in this area to make governance more people centered and to enhance participation at grassroots level, particularly focusing on women and excluded groups.

E. Gender, Ethnicity, and Caste

26. The low status of women in Nepal can be traced to sociocultural, economic, legal, and politico-institutional factors, which are interrelated and mutually reinforcing. The gender dimension of poverty is reflected in women’s unequal access to food, education, and health care; long working hours; and exclusion from productive resources and community activities.¹² The social system that defines access to resources and opportunities leaves women more disadvantaged than men.¹³ Poor rural women have only limited opportunities to earn incomes and limited access to productive resources, and little effective legal protection, despite constitutional guarantees of equal treatment. There is inconsistency between the constitution and important laws with regard to property rights, marriage, and inheritance, which discriminates against women. Moreover, women are further disadvantaged by their lack of awareness of their legal rights and opportunities. The dual burden of productive and reproductive roles leaves women not only cash poor but also time poor. In practice, women continue to be poorly represented in public institutions including the civil service at all levels. Moreover, women’s low self-esteem inhibits their participation, while their low social status leaves them vulnerable to abuse within their households and communities. Households headed by women have lower incomes than those headed by men. Women's control over financial resources is severely limited as indicated by the low ownership rates of land (10%) and homes (6%) for women. About two thirds of Nepalese women are classified as illiterate, compared with one third of men. Similarly, the number of years of schooling for females is only about half that for males. While there has been some progress in reducing gender disparities—e.g., life expectancy, literacy levels, and school completion rates—substantial progress is needed to overcome a long legacy of gender bias and stereotyping.

27. Nepalese society is characterized by complex variations in ethnicity, caste, language, and religion, which influence access to schooling, employment, and resources. Few caste and ethnic groups dominate the power structure, and enjoy disproportionate access to resources and opportunities. The deep-rooted structured inequalities and exclusionary practices also impede upward mobility of disadvantaged ethnic groups and castes. For example, Dalits earn less than half of what the upper-caste groups earn and their life expectancy is 13 years lower. There are also ethnic and caste disparities in human development. The human development index rankings for disadvantaged ethnic groups in rural areas are about 30–40% lower than in urban areas; those for Dalits and disadvantaged ethnic groups are only about half of those for the upper-caste groups.

F. Private Sector

28. Nepal’s private sector accounts for nearly 70% of overall investment and 68% of credit outstanding in the banking sector. However, public enterprises continue to occupy a privileged position in the economy, and due to favorable fiscal treatment and regulatory preference, their activities impede competition and boost costs adversely, affecting the private sector as a whole. The Government has privatized 16 public enterprises to date, and envisages corporatizing the larger remaining public enterprises and privatizing or liquidating nine of the rest by 2005 under the Public Sector Management Program supported by ADB.

29. Despite economic liberalization and growth of trade in the 1990s, Nepal's economy is still the least competitive of all South Asian economies. Productivity levels are just 3–5% of those in the Organization for Economic Co-operation and Development countries. A mix of factors impedes private initiatives. These include the conflict, poor infrastructure, overly bureaucratic public administration, overregulation, capricious and ineffective enforcement of existing laws and regulations, corruption, inadequate consultative mechanisms for addressing labor concerns, and a perceived lack of clarity and vision in government policy and strategy. Efforts are being made to improve the environment for private sector development by restoring the health and soundness of the financial system, improving the management and financial sustainability of public utility providers, and fostering public-private partnerships to develop economic infrastructure.¹⁴ Maintaining liberal trade relations, improving strategic infrastructure links between Nepal and neighboring countries, and reforming both the regulatory environment and its implementation are central to improving the investment climate in the long run.

G. Environment

30. Population growth, together with urbanization and the spread of transport links, has contributed to deforestation, overuse of limited available land for agricultural purposes, increased congestion and urban sprawl around towns, and degradation associated with the disposal of solid waste and other forms of pollution. Air and water pollution in Kathmandu Valley is particularly severe. Much of the forested area between the Himalayas and the Terai has been cleared to provide space for crops, livestock, and human settlement. Consequently, soil erosion, landslides, and floods are becoming more serious. On the positive side, considerable success has been achieved in community forestation projects, which have restored some forests and enhanced cover. The Government has also achieved significant success in protecting natural forests in the past decade.

H. Regional Cooperation

31. As a landlocked country, situated between two of the world's most populous and most rapidly growing economies, Nepal has much to gain from regional cooperation. Nepal’s total trade ratio is 50% of GDP, compared with Sri Lanka's 80%. While adoption of an outwardoriented trade policy in the early 1990s boosted regional trade and investment, Nepal’s locational advantages remain untapped. The Government is making efforts to foster deeper regional and global economic integration. Nepal’s recent accession to the World Trade Organization; participation in the South Asia Free Trade Agreement; the commitments made under the Islamabad Declaration adopted at the 12th South Asian Association for Regional Cooperation (SAARC) summit; and its membership in the Bay of Bengal Initiative for Multi- Sectoral Technical and Economic Cooperation, all pave the way for Nepal to accelerate regional cooperation with other SAARC member countries.¹⁵

32. The trade and transit treaties agreed to with India in the mid-1990s have provided Nepal with access to the vast Indian market and to Kolkata port. In recent years, efforts have been made to improve transport links to other countries, most notably the People’s Republic of China and Bangladesh. Restoration of Nepal as the traditional trade corridor between India and the People’s Republic of China has enormous potential benefits for the country. Nepal has also assumed an active role in ADB’s South Asia Subregional Economic Cooperation (SASEC) program, which is designed to foster cooperation among Bangladesh, Bhutan, India, and Nepal, initially in the areas of transport, energy, trade, industry and the private sector, environment, tourism, and information and communications technology (ICT).

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