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p. 33 of 54 BACK | NEXT I. Developing Asia and the World - Economic Developments and Prospects II. Economic Trends and Prospects in Developing Asia Newly Industrialized Economies Central Asian Republics, Azerbaijan, and Mongolia People’s Republic of China Southeast Asia South Asia Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka The Pacific III. Asia's Globalization Challenge

Asian Development Outlook 2001 : II. Economic Trends and Prospects in Developing Asia : South Asia

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Nepal

The continued recovery in agricultural production in 2000 boosted the economy’s short-term prospects. However, to sustain growth, the Government needs to push forward with its broad-based reform agenda, particularly in the areas of governance and economic reforms. Poverty reduction remains an urgent priority.

Recent Trends and Prospects

Real GDP growth rose to 6.4 percent in 2000 from 4.4 per- cent in the previous year, led by agriculture and industry (see Figure 2.16). A favorable monsoon season and wider use of fertilizer led to a strong agricultural recovery in 2000 of 5.0 percent growth. This met the projections of the Agriculture Perspective Plan, which details the Government’s agricultural development strategy for two decades. However, this rate needs to be sustained, and the annual variation in agricultural performance reduced. Production of food grain increased in 2000, particularly that of rice, which rose by 8.6 percent. The industry sector grew by 8.7 percent, led by manufacturing, which expanded by 13.0 percent. Trade with India, and the tourism, carpet, and garment industries registered strong performance. However, with no large projects undertaken in 2000, electricity and construction growth remained slow.

Consistent with an economy dominated by subsistence agriculture, the labor force participation rate was high and the unemployment rate low. About 86 percent of the working-age population (aged 15 and above) were economically active, with 76 percent employed in agriculture. The unemployment rate for the country as a whole was less than 2 percent, but the rate in urban areas was higher than 7 percent.

Moderated by declines or only slight rises in food prices, inflation rose by just 3.5 percent in 2000, compared with 11.4 percent in the previous year. Favorable monsoon conditions led to stability in prices of food grains and vegetables. A surplus of rice also contributed to lower prices after the main harvest, and the food and beverages index rose by less than 1 percent. Inflation of nonfood items, however, was 7.0 percent, up from 5.8 percent in 1999, because of increases in key administered prices, notably kerosene, electricity, and diesel. High money growth continued with a 4.1 percent increase in inflows of foreign assets. Broad money (M2) expanded by about 21.8 percent in 2000, slightly more than 20.9 percent in 1999.

The budget deficit remained stable at 3.9 percent of GDP in 2000. Domestic revenue collection was lower than budgeted, with actual revenues of about 11 percent of GDP, roughly the same as in 1999. The shortfall in revenues was balanced by the slower than budgeted growth in development expenditures of 17 percent rather than the 48 percent envisaged in the 2000 budget. Even with slower growth, foreign grants and loans financed about 50 percent of development expenditures, a proportion that has remained largely unchanged since the early 1990s.

Nepal’s current account balance, which registered a surplus in 1999 of 0.1 percent of GDP, switched to a deficit in 2000 of 1.5 percent of GDP, largely due to strong growth in imports. Non-aid imports increased in 2000. Loan disbursements from aid agencies decreased slightly from the 1999 level, but foreign exchange reserves continued to rise. By the end of the year, such reserves amounted to $981 million (sufficient to cover more than six months of imports). External debt as a proportion of GDP declined slightly in 2000 to 48.0 percent. However, because of the concessionary nature of this lending, the debt-service ratio for external debt declined and remained a manageable 5.3 percent of exports in 2000.

Over the next few years, the economy should remain stable. The country has potential for growth rates exceeding 5 percent a year, but actual performance is still quite vulnerable to changes in the weather and the Indian economy, given India’s dominance as a trading partner and Nepal’s narrow industrial base. An overall growth rate of 5–5.5 percent, if supported by appropriate policies, is forecast for 2001 and 2002. Agricultural growth may decline somewhat to about 4 percent, depending on weather conditions, but the sector’s recovery is expected to continue. Growth in the industry sector will moderate slightly to 7–8 percent, and will be determined by export growth rates. Growth in the services sector will be similar to the past at about 6 percent, boosted by a recovery in tourism revenues but moderated by slower growth in community and personal services. The transport sector, where growth is linked to export performance, should perform well.

In the absence of any external shocks to the economy, inflation is likely to be moderate over the next few years. In 2001, it is projected at 5.5 percent, and is likely to benefit from favorable monsoon weather throughout South Asia. The price of rice, which dominates the price index, will probably decline after the harvest. Nonfood prices, however, are expected to rise. The Nepalese rupee, depreciating against the dollar, is likely to make imported manufactures dearer, while the fuel price has already been raised. The Government can maintain these levels only as long as India, its main supplier, does not alter its prices. Electricity tariffs will also need to be put up to maintain that sector’s viability.

Monetary policy will be geared to supporting the exchange rate peg with the Indian rupee. As such, interest and inflation rates need to be kept in line with those in India. Continuing monetization of the economy will provide some leeway in monetary policy, but the 20 percent annual money supply growth rates in recent years cannot continue without fueling inflation. Given projections for real growth and inflation, targets for broad money growth need to be in the range of 12–14 percent in the medium term. To support the central bank’s efforts to control inflation and maintain the exchange rate peg, further development of the market for government securities is required to break the link between budget deficits and monetary expansion. Moreover, the limit of NRs1 billion on the Government’s overdraft with the central bank needs to be strictly enforced.

The Government’s ambitious development expenditure and revenue targets in 2001 will be difficult to achieve, especially since pay rises and a voluntary early retirement scheme were introduced for civil servants. Development expenditures in the 2001 budget are projected to grow by 45 percent. These will be financed mainly by foreign grants, which are forecast to increase by 100 percent. Domestic revenue estimates in the 2001 budget are similarly optimistic, with a projected growth rate of 24 percent. Actual revenue performance will depend on the effective implementation of the value-added tax. The minimum revenue level for firms covered by the value-added tax was lowered from NRs4.5 million to NRs2 million, and the registration of firms was accelerated to widen the tax base. The number of registrations doubled between 1999 and 2000. As in previous years, development expenditures will probably bear any shortfalls in domestic revenues and foreign grants. The fiscal deficit for 2001 is projected to reach 4.5 percent of GDP and rise slightly in 2002.

The current account deficit will rise slightly in 2001 as aid-related inflows continue to increase, particularly if the Government achieves most of its development agenda. Strong economic growth in India will continue to bolster Nepal’s exports but probably not to the extent seen in 2000. In exports to other countries, garments have been strong, but are subject to a gradual removal of quotas in the US as part of the World Trade Organization’s (WTO) Agreement on Textiles and Clothing. Another area that is difficult to predict is exports of carpets and pashmina shawls as the popularity of these products is based on current fashions. However, business owners are confident of further expansion in the medium term, and estimates of 12–15 percent export growth mirror this view. Depreciation of the Nepalese rupee against the dollar should also help support exports. Imports are expected to grow as rapidly as exports, with some acceleration over time, as domestic growth lifts demand for foreign products and higher public investment raises the inflow of aid-related goods, in particular for a water supply project in Melamchi. Overall, increased aid-related investment inflows will drive the widening of the current account deficit in the coming years. The expanding public expenditure program will lead to higher external debt as a proportion of GDP, but debt service should remain manageable at about 5.5 percent of GDP, assuming that export growth stays strong and given the concessionary nature of the Government’s borrowings.

Issues in Economic Management

Nepal still has a predominantly agrarian economy, and the majority of the country’s poor people live in rural areas. The Government’s continued commitment to the Agriculture Perspective Plan is, therefore, critical, including its ability to coordinate the various government departments properly and monitor implementation. Although the completion of the removal of fertilizer subsidies in mid-2000 was an important step in fostering private sector involvement in the trade in agricultural inputs, it is important that the Government does not reinstate market distortions, but rather, further encourages private sector participation in the agriculture sector.

Given the economy’s limited access to foreign capital markets, the savings rate is too low to support the investment needed for sustainable reductions in poverty. Inefficiencies in the financial sector, which is dominated by state-owned financial institutions, hamper the mobilization of domestic resources. The financial sector is, therefore, another key area where extensive reforms are needed, in order to strengthen accounting and auditing standards, deregulate the sector to increase competition, strengthen the role of the central bank, and restructure publicly owned banks.

Commercial banking, the largest segment of the financial sector, is dominated by the state-owned Rastriya Banijya Bank and the formerly state-owned Nepal Bank Limited, which together account for more than half of all commercial bank deposits. However, a recent audit showed them to be technically insolvent. Under government management, these banks had developed extensive, but costly, branch networks and staff resources. For the two banks, reforms are now needed to achieve the following: (i) enhance the commercial orientation, as well as the operational autonomy and accountability, of bank management; (ii) reduce overheads, including measures for staff retrenchment and consolidation of bank branches; and (iii) improve the quality of their portfolios and their loan recovery rates. In addition, the state-owned development banks (Agriculture Development Bank of Nepal and Nepal Industrial Development Corporation) need to be included in the financial sector reform agenda. To do this, independent audits are first required.

To reduce the economy’s dependence on foreign assistance for development expenditures, the Government needs to continue its efforts to mobilize domestic resources. While full implementation of the value-added tax is one area that may have an immediate payoff, more broad-based tax reforms are necessary to integrate the value-added tax with income and customs tax administration to produce a more buoyant and responsive tax system. The efficiency of income tax law needs to be improved, and exemptions on income taxes need to be rationalized.

To maintain fiscal stability, reforms must also extend to the expenditure side of the budget. Government expenditure control and better-targeted spending are needed. Preparation of a three-year rolling expenditure plan should be expedited to raise the efficiency of public sector investments.

Nepal has benefited from the quotas on garments imported by the US, but the quotas will be reduced over time and eliminated by 1 January 2005 as part of the WTO’s Agreement on Textiles and Clothing. Sudden removal of the quotas would be devastating for this nascent industry, as Nepal would then have to compete directly with garments made in the People’s Republic of China and India in this important market. The garment industry must now take steps to be ready for the removal of this protection in 2005.

Policy and Development Issues

With a per capita GDP of $244, Nepal ranks among the poorest countries in Asia. Reducing the level of poverty thus remains the Government’s major development challenge. About 42 percent of the population remain below the poverty line, and this rate has not changed significantly in over 30 years, partly because of the high population growth rate in the country (2.4 percent in recent years). Income distribution is skewed in geographical, social, and gender terms. The current Ninth Five-Year Plan (1998–2002) aims to reduce poverty incidence by 10 percent at the end of the plan period. However, the wide scope of the Plan’s targets means that the impact on poverty is often lost when the relevant programs are implemented. The Government recently prepared an Interim Poverty Reduction Strategy Paper, which provides a more focused and comprehensive framework for poverty than the Plan. The Paper emphasizes that the Government should consider the impact on poverty when it prioritizes development projects. The Paper will need to be further focused though, and the resulting priorities incorporated into the Tenth Five-Year Plan, for which planning begins in 2001. In addition, improved information for monitoring the impact of specific projects on poverty is necessary for planning purposes.

The Government has indicated its strong commitment to introducing meaningful civil service and governance reforms. It has already reduced the number of ministries, and has indicated that it will also introduce governance reforms to tackle and reduce political interference in the civil service. The Government in the 2001 budget stated unequivocally that Nepal needs a civil service that is both results and people oriented. A coherent approach to improving the performance of the civil service is required, and one that will give the public a voice in determining the services desired and how they will be delivered. Success of this effort will depend both on the degree of consensus that the political leadership can build, and on its own resolve.

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