Nepal Development Update APRIL 13, 2022 Global Challenges and Domestic Revival Standard Disclaimer Copyright Statement This volume is a product of the staff of the The material in this publication is copyrighted. International Bank for Reconstruction and Copying and/or transmitting portions or all of Development/The World Bank. The findings, this work without permission may be a violation interpretations, and conclusions expressed in of applicable law. The International Bank for this paper do not necessarily reflect the view of Reconstruction and Development/The World Bank the Executive Directors of the World Bank or the encourages dissemination of its work and will governments they represent. The World Bank normally grant permission to reproduce portions does not guarantee the accuracy of the data of the work promptly. included in this work. The boundaries colors, For permission to photocopy or reprint any part denominations, and other information shown on of this work, please send a request with complete any map in this work do not imply any judgement information to the Copyright Clearance Center, Inc., on the part of The World Bank concerning the 222 Rosewood Drive, Danvers, MA 01923, USA, legal status of any territory or the endorsement telephone 978-750-8400, fax 978-750-4470 http:// or acceptance of such boundaries. www.copyright.com/. All other queries on rights and licenses, including Photo credits subsidiary rights, should be addressed to the Office Cover Concept and Design by Kazi Studios of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, All photos by Mr. Nabin Baral e-mail: pubright@worldbank.org Global Challenges and Domestic Revival Nepal Development Update NEPAL DEVELOPMENT UPDATE April 13, 2022 April 2022 World Bank Group i Global Challenges and Domestic Revival Nepal Development Update Acknowledgements The Nepal Development Update is produced once a year to report on key economic developments that occurred during the year, placing them in a longer-term and global perspective, and to examine topics of particular policy significance. The Update is intended for a wide audience including policy makers, business leaders, the community of analysts and professionals engaged in economic debate, and the general public. This Update was produced by the World Bank Macroeconomics Trade and Investment (MTI) team for Nepal consisting of Alice J. Brooks (Senior Economist, MTI), Nayan Krishna Joshi (Economist, MTI), and Florian Blum (Senior Economist, MTI). Inputs were also received from Nethra Palaniswamy (Senior Economist, POV). The team thanks Zoubida Allaoua (Regional Director, Equitable Growth, Finance, and Institutions (EFI), South Asia Region), Faris Hadad-Zervos (Country Director for Maldives, Nepal and Sri Lanka), Lada Strelkova (Manager, Operations), Shabih Mohib (Practice Manager, MTI), and Tae Hyun Lee (Lead Country Economist, EFI) for their guidance and comments on the report. Akash Shrestha managed media relations and dissemination. Anima Maharjan managed the publication process. The cutoff date is March 31, 2022, and includes data released up until that date. ii World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update Abbreviations BFIs Banking and Financial Institutions CY Calendar Year DSA Debt Sustainability Analysis ECF Extended Credit Facility FDI Foreign Direct Investment GRID Green, Resilience, and Inclusive Development H1FY First Half of Fiscal Year INR Indian Rupee IRC Interest Rate Corridor kWh Kilowatt hour LPG Liquefied Petroleum Gas M2 Money Supply NPR Nepali Rupee NPB National Project Bank REER Real Effective Exchange Rate SDR Special Drawing Rights USD United States Dollar VAT Value Added Tax April 2022 World Bank Group iii Global Challenges and Domestic Revival Nepal Development Update iv World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update Table of Contents Acknowledgement...............................................................................................................................................................i Abbreviations.......................................................................................................................................................................iii Executive Summary............................................................................................................................................................ix A. Recent Economic Developments............................................................................................................................... 1 1. Context..................................................................................................................................................................... 1 2. Real Sector............................................................................................................................................................ 3 3. Monetary and Financial Sector Developments............................................................................................7 4. External Sector....................................................................................................................................................10 5. Fiscal sector.........................................................................................................................................................13 B. Outlook, Risks, and Challenges.................................................................................................................................19 April 2022 World Bank Group v Global Challenges and Domestic Revival Nepal Development Update Figures Figure 1 Daily COVID-19 cases fell sharply by March 2022….................................................................................. 2 Figure 2 … supported by acceleration of the vaccination drive.............................................................................. 2 Figure 3 GDP is estimated to have expanded by 1.8 percent in FY21................................................................... 3 Figure 4 Private consumption and investment supported growth on the demand side in FY21................... 4 Figure 6 Mobility to nonresidential locations has been increasing during H1FY22. ........................................ 4 Figure 5 Main season paddy production contracted in H1FY22............................................................................ 4 Figure 7 Tourism has begun to recover but is still below the pre-pandemic level............................................. 5 Figure 9 H1FY22 witnessed a revival of new domestic business openings....................................................... 5 Figure 8 Installed capacity of electricity grew by 598 MW in H1FY22.................................................................. 5 Figure 10 Average consumer price inflation increased in H1FY22........................................................................ 6 Figure 11 M2 growth was high in FY21 but moderated in H1FY22.......................................................................... 8 Figure 13 Significant amounts of private credit were used for overdraft, real estate lending, and margin lending............................................................................................................................................................. 8 Figure 12 Credit to the private sector grew strongly in H1FY22............................................................................. 8 Figure 14 By contrast, deposit growth slowed in H1FY22........................................................................................ 8 Figure 15 The interbank rate was close to the upper bound of the interest rate corridor in H1FY22........... 9 Figure 16 Lower remittances and a higher trade deficit widened the current account deficit in H1FY22...11 Figure 18 Imports of goods and services rebounded strongly …...........................................................................11 Figure 17 …which was largely financed by the drawdown of reserves.................................................................11 Figure 19 …partly due to the appreciation in the real effective exchange rate...................................................11 Figure 20 Domestic inflation relative to the major trading partners drove the real exchange rate appreciation.........................................................................................................................................................................12 Figure 21 Exports also expanded...................................................................................................................................12 Figure 22 Remittance inflows declined in H1FY22…................................................................................................13 Figure 23 …putting downward pressure on foreign exchange reserves............................................................13 Figure 24 Nepal’s fiscal balance has been in deficit since FY17 due to earthquake reconstruction spending, the transition to federalism, and COVID-19 ............................................................................................14 Figure 25 The federal fiscal balance recorded a surplus in the first half of FY22 …….....................................15 Figure 27 Low capital expenditure dampened total spending… ..........................................................................15 Figure 26 …as revenue collection remained strong.................................................................................................15 Figure 28 …contributing to a deceleration of growth in the debt stock..............................................................15 Figure 29 Nepal’s trade with Russia and Ukraine is low…......................................................................................20 Figure 31 The war is projected to increase commodity prices by more than 20 percent… ..........................20 Figure 30 … but Nepal imports many commodities whose prices will be affected by the war.....................20 Figure 32 …which will impact Nepal’s growth, inflation, and current account deficit......................................20 vi World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update Tables Table 1 Revenue and spending performances of federal, provincial and local governments.......................18 Table 2 Macroeconomic projections of selected key indicators..........................................................................22 April 2022 World Bank Group vii Global Challenges and Domestic Revival Nepal Development Update EXECUTIVE SUMMARY Recent Economic Developments Nepal continues to struggle with the COVID-19 been a primary driver of growth in the first half pandemic, but the ongoing COVID-19 vaccination of FY22, with mobility data indicating a strong drive has helped to reduce the fatality rate. The recovery in wholesale and retail trade, transport, country experienced a first wave in March 2020, and financial services, supported by an increase in a second wave in mid-April 2021, and a third wave vaccinations and continued COVID-19 related fiscal in January 2022. In response, social distancing and monetary stimulus packages. Tourism and measures were imposed but gradually became less tourism-related activities have also recovered with stringent as COVID-19 progressed from the first a rise in international tourist arrivals, although they to the third wave, driven in part by the COVID-19 remain below pre-pandemic levels. The industrial vaccination drive that began in January 2021. sector also contributed to growth on the back of Vaccination also contributed to a reduction in higher installed capacity of electricity, including the fatality rate. As of March 2022, more than 60 from the recently completed Upper Tamakoshi percent of the population has received two doses Hydropower Project (456 MW). However, the of COVID-19 vaccines. agricultural sector is estimated to be a drag on the growth due to a significant drop in main season High frequency indicators suggest that the paddy production following unseasonal rains in economy continued to recover in the first half of October 2021. FY22 after rebounding in FY21 from a contraction in FY20. The services sector is estimated to have April 2022 World Bank Group ix Global Challenges and Domestic Revival Nepal Development Update Labor market exposures to the COVID-19 crisis in and consequently a liquidity shortage for banking Nepal were significant, and vulnerable households and financial institutions. In response, the central in Nepal face the risk of falling back into poverty. bank raised its policy rate by 2 percentage points New analysis based on the SAR COVID-19 phone in February 2022 to 5.5 percent, higher than the monitoring survey1 suggests that job recovery, for pre-pandemic rate of 5 percent. those who lost jobs during the pandemic, was low Higher merchandise imports and lower and accompanied by a decline in job quality and remittances contributed to a widening of the earnings. Of those employed in January 2020, 52 current account balance. The current account percent experienced a job or earnings loss during deficit widened in the first half of FY22 to 7.9 the first COVID-19 wave in 2020, the highest in percent of projected GDP, up from 1.2 percent of the region. While men and women experienced GDP in the same period of FY21, as remittances a similar overall shock, more women reported declined, and imports continued to grow. In the permanently losing a job (30 percent versus a 23 absence of significant FDI inflows, the current percent for male workers), and the employment account deficit was largely financed by trade effects were concentrated amongst women and credits, external concessional loans, and reserves younger age cohorts. Inflation will increase the drawdowns. As a result, foreign exchange reserves cost of basic needs, which will adversely impact the fell to United States dollar (USD) 9.9 billion in mid- poor and vulnerable, although this may be partially January 2022 from USD 11.8 billion in mid-July mitigated by rising remittances. 2021, equivalent to 6.6 months of imports and Inflation is accelerating due to higher non-food below the central bank’s target of 7 months. inflation. Non-food price inflation rose with higher Fiscal revenue growth remained relatively transportation prices associated with the increase in strong in the first half of FY22, the fiscal balance global fuel prices, alongside increased educational improved, and debt declined as a percentage of fees, and housing prices. However, food inflation GDP. Revenue collection expanded on the back slowed reflecting a continuation of lower vegetable of strong import growth and a recovery in housing price increases. Government policies to subsidize and stock markets. Recurrent spending also the electricity tariff for lower-income households expanded as public social assistance payments – and liquefied petroleum gas prices has helped including those for senior citizens, single women, to keep inflation manageable despite increasing widows, and child protection – were increased global commodity prices. by 33 percent, and more conditional grants were Private sector credit growth remained strong in the devolved to subnational governments. However, first half of FY22, and efforts have been taken to capital spending declined marginally due to a delay reduce the pace of credit growth. Credit expansion in FY22 budget implementation, thereby limiting was broad-based with credit to the agriculture, overall spending growth. As a result, the federal industry, and services sectors all increasing in an fiscal balance recorded a surplus, as in the first half environment of accommodative monetary policy. of previous fiscal years. Following the fiscal surplus, At the product level, overdraft, real estate loans, debt declined to 38.2 percent of projected FY22 and vehicle loans were primary drivers of private GDP from 48.1 percent of GDP in end FY21. Nepal sector credit growth. However, deposit growth continues to remain at low risk of debt distress. remained low in the first half of FY22, leading to a considerable gap between credit and deposits, 1  onducted during the latter half of 2020. The data covers 6389 individuals in Nepal, about half of which were a follow up C to previous representative rural panel survey, the Household Risk and Vulnerability Survey implemented over 2016-18. x World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update Outlook, Risks, and Challenges The Russia-Ukraine conflict presents new The current account deficit is projected to narrow challenges. While Nepal’s direct trade with Russia over the medium term after widening in FY22. and Ukraine is limited, higher global commodity The current account deficit is expected to widen prices are expected to increase the costs of fuel, in FY22 reflecting higher merchandise imports agricultural products, metal, and mineral imports. and lower remittances, and narrow thereafter. The These higher prices are expected to widen the forecast anticipates a moderation in merchandise current account deficit, reduce the growth rate, imports, reflecting the completion of most post- and increase inflation. A conservative estimate is 2015 earthquake reconstruction and the gradual that the current account deficit as a share of GDP replacement of imported fossil fuels by electricity will widen by around 1.5 percentage points in FY22 use in households and firms as the country and FY23 relative to the January 2022 forecast. generates an additional 4,000 MW of hydropower Transportation prices, construction costs, and other electricity. Remittances are expected to stabilize as consumer prices are rising which will dampen a share of GDP, supported in part by new overseas overall demand and in turn reduce the real GDP employment opportunities. Goods exports are growth rate by an estimated 0.2 and 0.6 percentage expected to grow in FY22 as Nepal continues to points in FY22 and FY23, respectively. Services take advantage of tariff exemptions on exports exports are expected to be less affected given the of palm and soybean oil to India under the South relatively low share of tourist arrivals from these two Asian Free Trade Area agreement. An increase in countries. On the bright side, higher fuel prices may electricity exports under an energy exchange and lead to stronger demand for migrant workers in the trade agreement with India is expected to drive oil exporting GCC countries, and consequently an merchandise export growth from FY23 onwards. increase in remittances. Services exports and imports are expected to recover robustly but remain below their pre- Taking into account the impact of the war, the pandemic levels through FY24. Nepali economy is expected to recover gradually over the medium-term under a baseline scenario. The fiscal deficit is projected to continue falling in Assuming the absence of new nationwide strict the medium term. Revenues are expected to remain containment measures, a near complete vaccination strong due to growing import-related revenues, of the eligible population by the end of FY22, and efforts to widen domestic tax bases, stronger a gradual increase in international migration and economic activity including the recovery of tourism, tourist arrivals, the economy is projected to grow and a rollback of COVID-19 related tax breaks by 3.7 percent in FY22, accelerate to 4.1 percent beginning in FY23. Expenditures are likely to peak in FY23, and rise further to 5.8 percent in FY24 in FY23 due in part to electoral spending, and then close to its estimated long-term potential growth decline from FY24 onwards as COVID-19 related rate. Higher commodity prices, recently spurred support programs are unwound and measures to by the war in Ukraine, are expected to increase reduce duplication of spending responsibilities construction costs as well as consumer prices, across levels of government are enacted. As a dampening overall demand and in turn reducing result, the fiscal deficit is projected to narrow in the growth by an estimated 0.2 and 0.6 percentage medium term. Total public debt is expected to reach points in FY22 and FY23 as compared to previous 43.1 percent of GDP in FY22 and rise further to 44.5 projections. Inflation is expected to average around percent of GDP by FY24. However, the country’s 6 percent annually in the medium term. debt is expected to remain sustainable. April 2022 World Bank Group xi Global Challenges and Domestic Revival Nepal Development Update A downside scenario highlights growth and fiscal Revenues are expected to remain risks. A downside scenario considers a situation strong due to growing import- in which the central bank uses stronger import control measures to maintain foreign exchange related revenues, efforts to widen reserve cover at 7 months of imports and in which domestic tax bases, stronger expenditure consolidation progresses less swiftly economic activity including than projected under the baseline. This scenario the recovery of tourism, and a results in adverse growth impacts following the import contraction, depressing domestic output rollback of COVID-19 related tax as well as consumption. Limited spending breaks beginning in FY23. consolidation could also result in reduced capital non-performing assets and provide clear guidance on spending to compensate for persistent elevated restructuring and rescheduling. Maintaining traction recurrent spending, which could depress growth on these and other ongoing reforms is important as further. The fiscal deficit would be larger under this the country’s fiscal space has been reduced and scenario reflecting higher spending and a decrease households are yet to fully recover from the past two in import-related revenues, which would jointly lead years’ job losses and border closings. to substantially higher debt levels. The economic scars from two years of the pandemic The economic outlook is subject to additional run deep, and the policy response must be bold. downside risks. A new COVID-19 variant reducing Recovery of tourism and services exports remain vaccine effectiveness could require the re-imposition muted, job losses have been extensive, and buffers of stricter containment measures, weakening the have been reduced to meet large financing needs. rebound momentum. Climate-related and natural The government has done an admirable job providing disasters are a perennial risk which could impact vaccinations to a large swath of the population, but agricultural production, government finances, and more can be done on economic reforms to stimulate consumer prices. The unwinding of accommodative the domestic economy. Encouraging foreign direct fiscal and monetary policy will need to be carefully investment (FDI) inflows, currently the lowest in the sequenced to avoid large shocks to the private sector. region, would not only support foreign exchange Staying the course on policy reforms to address reserves but also make the private sector more fiscal imbalances, improve spending efficiency, competitive through skill transfers and know-how. accelerate private sector growth and bring into A more dynamic and competitive private sector will focus the pandemic’s impact on the financial sector boost production for both domestic and external can help mitigate downside risks. The government markets and create jobs. FDI has the added benefit has committed to efforts to improve revenues and of not adding to the country’s debt2 and reducing reduce spending while continuing to protect the pressure on foreign exchange reserves, thus vulnerable. Efforts are underway to allow subnational mitigating the risks that further import and capital flow governments greater flexibility in their use of restrictions could have on growth. As households conditional grants, which can raise their low budget and firms confront the challenges of a warming execution rates and provide greater responsiveness climate and a nascent economic recovery, the to local needs. Simplified approval procedures can government’s commitment to a green, resilient, and help attract foreign direct investment to Nepal to inclusive development (GRID) approach should build support job creation and growth. Revised financial a foundation for greener and more resilient growth sector regulations will strengthen identification of ensuring that no one is left behind. 2 Excluding the portion of FDI represented by inter-company loans. xii World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update A. Recent Economic Developments A.1 Context Global activity rebounded in 2021 after a COVID- the economic impact is highly uncertain, and will induced contraction in 2020. The global economy depend on the duration and severity of the war. is estimated to have expanded by 5.5 percent in In addition to volatile global growth, Nepal 2021, the highest rate in 80 years.3 South Asia continues to struggle against the COVID-19 and the Gulf Cooperation Council countries – pandemic. Nepal was first hit by the pandemic the main recipients of labor migrants from Nepal in March 2020 which led to a strict nationwide - are also estimated to have recovered from the lockdown through July 2020. Localized lockdowns pandemic, with growth estimated at 7 and 2.6 followed in various municipalities including percent, respectively, in 2021.4 Prior to the war the Kathmandu Valley in late August 2020 in Ukraine, the global recovery was forecast to with restrictions on land and air transportation, continue in 2022 with an expected growth of 4.1 educational institutions, and tourism. Movement percent.5 Current estimates suggest that the war restrictions and other social distancing measures will lower global growth and increase inflation due helped to reduce the number of daily new cases to the two countries’ significant share in the global from 3,000 in October 2020 to less than 100 cases market for select commodities.6 The magnitude of 3 World Bank. 2022. Global Economic Prospects, January 2022. Washington, DC. 4 World Bank. 2022. Global Economic Prospects, January 2022. Washington, DC. 5 World Bank. 2022. Global Economic Prospects, January 2022. Washington, DC. 6 R  ussia and Ukraine account for about 30 percent of global wheat exports, 20 percent of corn, mineral fertilizers, and natural gas exports, and 11 percent of oil exports. April 2022 World Bank Group 1 Global Challenges and Domestic Revival Nepal Development Update in mid-March 2021 (Figure 1). The country saw a During the third wave in January 2022, movement severe second wave starting mid-April 2021 leading restrictions were reintroduced in the Kathmandu to renewed but less strict containment measures. Valley through March 2022, with a focus on contact- These were gradually phased out by mid-October intensive services to reduce pressures on the 2021 in accordance with a drop in new cases. health system. Figure 1 Daily COVID-19 cases fell sharply by March 2022… Source: Ministry of Health and Population and World Bank staff calculations. Figure 2 …supported by acceleration of the vaccination drive Source: http://ourworldindata.org 2 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update The COVID-19 vaccination drive that started in Recognizing the challenges ahead, the January 2021 has helped to reduce the fatality Government of Nepal (GoN) has transitioned to rate. As of March 30, 2022, 74.2 percent of the a green, resilient, and inclusive development population has received at least one vaccination (GRID) path through the Kathmandu Declaration dose and 64.2 percent of the population has in September 2021. The Declaration notes that received full dose of vaccine (Figure 2). Vaccination achieving GRID outcomes requires an increase in efforts have relied on a variety of vaccines that were quantity and quality of financing from all sources, either procured directly or received as donations coordination across institutional and sectoral from abroad, including VeroCell, Covishield, boundaries, and an enabling policy and institutional AstraZeneca, Moderna, Pfizer, and Johnson & environment. The GoN is preparing a GRID Strategic Johnson. The World Bank, the Asian Development Action Plan backed by 17 Development Partners to Bank, COVID-19 Vaccines Global Access, the address the inter-related challenges of a sustainable World Health Organization, and the United Nations economic recovery from COVID-19, climate risks, Children’s Fund have been supporting Nepal in its natural capital depletion, and continued exclusion vaccination efforts. of vulnerable people from economic opportunities and development benefits. A.2 Real Sector Figure 3 GDP is estimated to have expanded by The recovery’s momentum 1.8 percent in FY21 continues in FY22 The economy continued to recover in the first half of FY22 (H1FY22).7 Real GDP is estimated to have rebounded in FY21, growing 1.8 percent after a 2.1 percent contraction in FY20 (Figure 3). The recovery in FY21 includes a low base effect, a recovery in domestic demand (Figure 4), and the limited economic impact of the second wave of the pandemic in the last quarter of FY21 as compared to the first wave in FY20. While the recovery continued in H1FY22 as indicated by four Sources: Central Bureau of Statistics and World Bank staff calculations. rounds of firm surveys8 conducted by the central bank through November 2021, production and However, a significant contraction is estimated transactions undertaken by businesses remain during H1FY22 due to a drop in main season lower than observed prior to the pandemic. paddy9 production following unseasonal rains in October 2021 (Figure 5). A recovery is expected despite a recent contraction in agricultural output. The agricultural By contrast, mobility data suggests that services sector is estimated to have grown by 2.7 percent in carried growth in H1FY22. In FY21 the services FY21 on the back of favorable summer monsoons. sector is estimated to have grown by 1.6 percent 7 The Nepali fiscal year begins in mid-July. 8 https://www.nrb.org.np/contents/uploads/2021/11/20780808-3rd-Follow-Up-Final.pdf 9  he share of rice paddy in agricultural GDP is around 20 percent. Main season paddy production in H1FY22 is estimated to T have contracted by 9.5 percent (y-o-y), leading to an estimated decline of total paddy production in FY22 of 8.7 percent. April 2022 World Bank Group 3 Global Challenges and Domestic Revival Nepal Development Update Figure 4 Private consumption and investment Figure 5 Main season paddy production contracted supported growth on the demand side in FY21 in H1FY22 Sources: Central Bureau of Statistics and World Bank staff calculations. Sources: Ministry of Agriculture and Livestock Development and World Bank staff calculations Note: I, C, X, and M stand for investment, consumption, exports, and imports Figure 6 Mobility to nonresidential locations has been increasing during H1FY22 Source: https://www.google.com/covid19/mobility/ after contracting by 4 percent in FY20. Beginning tourism-related activities which were greatly in FY22, the Google mobility index registered affected by the pandemic have also begun to significant improvements in visits to non-residential recover as shown in increased international tourist locations as indicated by tracked mobility indicators arrivals, but they remain below pre-pandemic levels (Figure 6), consistent with the relaxation of social (Figure 7). Real estate activities have also increased distancing measures, an increase in vaccinations, as indicated by the rise in land title registrations of and continued COVID-19 related fiscal and around 50 percent (y-o-y).10 monetary support. Increased mobility suggests Increased installed electricity capacity indicates a strong recovery in wholesale and retail trade, that the industrial sector also contributed transport, and financial services. Tourism and to growth in H1FY22. The industrial sector is 10 Department of Land Management and Revenue 4 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update Figure 7 Tourism has begun to recover but is still Figure 8 Installed capacity of electricity grew by below the pre-pandemic level 598 MW in H1FY22 Sources: Department of Tourism and World Bank staff calculations. Sources: Nepal Electricity Authority and World Bank staff calculations. Note: Data for FY22 is for the first six months. Figure 9 H1FY22 witnessed a revival of new domestic business openings The industrial sector is estimated to have grown by 0.9 percent in FY21, up from a contraction of 3.7 percent in FY20, driven by an expansion of hydroelectric power. Sources: Department of Industry and World Bank staff calculations estimated to have grown by 0.9 percent in FY21, monetary and fiscal policy supported private up from a contraction of 3.7 percent in FY20, driven investment (Figure 4). In H1FY22, a surge in digital by an expansion of hydroelectric power. Momentum transactions11 and a rapid expansion of new continued in H1FY22 when 598 MW of installed businesses indicate that private consumption and capacity of electricity was added to the national investment have continued expanding. However, grid, including 456 MW from the Upper Tamakoshi while the registration of new businesses rose to Hydropower Project, the largest jump on record 154 in H1FY22 as compared to 103 in H1FY21 (Figure (Figure 8). 9), the structure of new firm openings experienced a divergence: while the opening of domestically Private consumption and investment supported owned firms reached an all-time high, foreign- growth on the demand side. In FY21, private owned firm openings continued to decline and consumption expanded on the back of increased stood at an all-time low. remittance inflows, while accommodative domestic 11 Monthly Macroeconomic Report, Nepal Rastra Bank. April 2022 World Bank Group 5 Global Challenges and Domestic Revival Nepal Development Update Figure 10 Average consumer price inflation increased in H1FY22 Sources: Nepal Rastra Bank and World Bank staff calculations. Inflation has begun to accelerate inflation rose to 5.6 percent (y-o-y) in H1FY22, the highest price increase since H1FY17, due largely Consumer price inflation fell significantly and to higher transportation prices12 associated reached a record low in FY21. Average inflation with the increase in global fuel prices. Additional decreased to 3.4 percent in FY21, considerably factors behind the increase in non-food prices are below the FY20 inflation rate of 6.3 percent and increased educational fees and housing prices. the central bank’s FY21 ceiling of 7 percent. The low inflation rate was driven by a decline in both Government policies have contributed to keeping food and non-food inflation. Average food inflation inflation manageable despite increasing global fell to 4.6 percent in FY21 from 8.6 percent the upward pressure on commodity prices. Key year before, mainly due to slower vegetable price measures include the government’s policy of increases and the easing of pandemic-induced waiving monthly electricity fees for households supply disruptions. Non-food inflation also fell to consuming up to 20-Kilowatt hour (kWh) and 2.5 percent from 4.6 percent in FY20, chiefly due to reducing monthly tariffs for households consuming a significant fall in housing and utilities costs. between 150 to 250 kWh to incentivize the usage of electric appliances. The Nepal Oil Corporation Over the first half of FY22, average inflation – the state-owned fossil fuel import monopoly – increased to 5 percent driven by higher non-food has continued to sell liquefied petroleum gas (LPG) inflation. Food price inflation slowed to 4.2 percent below market prices, using a combination of cross- (y-o-y) from 5.5 percent in the same period of FY21, subsidies and drawdowns from a price stabilization reflecting a continuation of lower vegetable price fund to finance the difference. This has kept LPG increases (Figure 10). However, non-food price prices in check. In contrast to previous practice, 12  To account for the rise in global fuel prices regulated domestic prices for petroleum products were increased four times in H1FY22. The federal government raised public transportation fares operating at the inter-provincial level in July 2021, and Bagmati province raised the fares of public transportation operating within its area in October 2021. 6 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update the government also did not raise the price of skill requirements. During this time, job losses in the unprocessed milk at the beginning of the fiscal year, service sector were highest with 29 percent of jobs keeping it constant for 2.5 years and only adjusting lost. While men and women experienced a similar the price on January 30, 2022. This contributed to overall shock, more women reported permanently lower-than-normal price increases for milk. losing a job (30 percent versus a 23 percent for male workers), and the employment effects were Job losses have been significant concentrated amongst women and younger age cohorts. Among the self-employed, 31 percent of Labor market exposures to the COVID-19 crisis in household-based enterprises and own-account Nepal were significant, and vulnerable households workers operating in January 2020 shut down, in Nepal face the risk of falling back into poverty. with new firm openings being concentrated in the New analysis based on the SAR COVID-19 phone non-services sectors. While the negative labor monitoring survey13 also suggests that job recovery, market effects define a risk to increasing poverty for those who lost jobs during the pandemic, was and inequality in the short to medium term, new low and accompanied by a decline in job quality data on jobs and recovery from January 2022 will and earnings. Of those employed in January help better understand the longer-term outlook for 2020, 52 percent experienced a job or earnings poverty.14 Inflation will increase the cost of basic loss during the first COVID-19 wave in 2020, the needs, which will adversely impact the poor and highest in the region. For those who recovered vulnerable, although this may be partially mitigated from a job loss, 45 percent also reported switching by rising remittances. sectors and taking jobs with lower earnings and A.3 Monetary and Financial Sector Developments Money supply growth surged in assets - largely foreign exchange reserves - offset FY21, driven by high credit growth much of the strong credit growth in the first half of the year. The credit expansion was broad-based Money supply (M2) growth was very high in FY21, with credit to the agriculture, industry, and services driven by credit growth to the private sector. M2 sectors all increasing (Figure 12). At the product grew by 21.8 percent in FY21, higher than the FY21 level, overdraft, real estate loans, and vehicle monetary policy target of 18 percent, on the back of loans explained 40 percent of private sector credit 27.1 percent growth in credit to the private sector.15 growth16 (Figure 13). Credit to the private sector stood at 105.6 percent of GDP at the end of FY21. M2 growth moderated Private sector credit surged on the back of in H1FY22 to a low 2.8 percent, compared to the accommodative monetary policy. Major policies end of FY21 (Figure 11), well below the FY22 annual enacted by the monetary authority focus on target of 18 percent, as a contraction in net foreign supporting the recovery of COVID-19 affected 13 Conducted during the latter half of 2020. The data covers 6389 individuals in Nepal, about half of which were a follow up to  previous representative rural panel survey, the Household Risk and Vulnerability Survey implemented over 2016-18. 14 Analysis will be completed before the next PEB. 15 Credit to the private sector grew faster than that observed in FY20 (12.4 percent) and the central bank’s FY21 target of 20  percent growth. 16 See footnote 16. April 2022 World Bank Group 7 Global Challenges and Domestic Revival Nepal Development Update Figure 11 M2 growth was high in FY21 but Figure 12 Credit to the private sector grew strongly moderated in H1FY22 in H1FY22 Sources: Nepal Rastra Bank and World Bank staff calculations. Sources: Nepal Rastra Bank and World Bank staff calculations. Figure 13 Significant amounts of private credit Figure 14 By contrast, deposit growth slowed in were used for overdraft, real estate lending, and H1FY22 margin lending Sources: Nepal Rastra Bank and World Bank staff calculations. Sources: Nepal Rastra Bank and World Bank staff calculations. sectors and consist of an expansion of a loan gradually recovering, uptake of these programs refinancing facility17 by the central bank that supports has slowed. During H1FY22, 24,267 borrowers credit allocation to cottage, micro, small, and took advantage of the refinancing facility and 15,381 medium-sized enterprises, and a facility that helped borrowers of the repayment period facility. expand loan repayment periods for sectors affected Monetary policy remained accommodative by COVID-19. In FY21, 48,890 borrowers benefited relative to before the pandemic, but efforts have from the refinancing facility of Nepali rupee (NPR) been taken to slow credit growth more recently. 148.8 billion (3.6 percent of outstanding credit) and Since FY17, Nepal’s central bank has been using 41,403 borrowers from the extension of the loan an interest rate corridor (IRC) to manage liquidity repayment period facility of NPR 222.8 billion (5.3 and short-term interest rates. The corridor is percent of outstanding credit). With the economy 17 Under the existing refinancing facility, the central bank provides funds to BFIs at lower interest rate (1-3 percent). The BFIs  disburse these funds to debtors affected by COVID-19 at a maximum interest rate of 5 percent on their existing loans. 8 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update Figure 15 The interbank rate was close to the upper bound of the interest rate corridor in H1FY22 Sources: Nepal Rastra Bank and World Bank staff calculations. centered around the interest rate on the overnight had remained below pre-pandemic levels until a repo auction, which is referred to as the policy 2-percentage point increase in the policy rate and rate. The lower bound of the IRC is defined as the the bounds on February 23, 2022.19 interest rate on 7-day deposit auctions, designed to absorb excess liquidity from the market if short-term Deposit growth slowed, leading to interest rates fall below it. The upper bound of the liquidity shortages in banks IRC is defined as the interest rate on the standing Deposits also expanded, albeit at a lower rate, liquidity facility. The central bank injects liquidity to and were outpaced by credit growth. Deposits the market if the short-term interest rate exceeds increased to 107.3 percent of GDP in H1FY22, from the upper bound.18 To slow credit growth and begin 101.6 percent of GDP in H1FY21 (Figure 14), despite unwinding accommodative policy, the central bank rising deposit interest rates.20 Institutional deposits raised the policy rate by 0.5 percentage points in (non-banking financial institutions and corporations) August 2021 after having kept it unchanged at 3 grew sluggishly, in part due to deposit drawdowns percent for a year. This was accompanied by a 1 by the Nepal Oil Corporation to import petroleum percentage point increase in the lower bound to products at higher prices. Individual deposit 2 percent. Despite the recent rise in rates, both growth also fell slightly on the back of declining the policy rate and the bounds of the corridor 18 T  he interbank rate is not expected to exceed the upper bound rate as BFIs can borrow from the central bank at SLF rate if the interbank rate is above the SLF rate. 19 On February 23, 2022, the central bank introduced a risk weight of 150 percent for real estate loans for land acquisition  and development, individual overdrafts, and consumer vehicle loans; 120 percent for trust receipts of trading firms; and increased the risk weight on margin lending to 150 percent from the existing 100 percent. The impact of these measures is to raise the capital BFIs must hold against these assets in the event of unexpected losses and increase the provisioning to be held against expected losses. 20 BFIs are allowed to change the interest rate on deposits once a month. In October 2021, the central bank set the  maximum increase in the deposit interest rate to 10 percent of the interest rate of the previous month. In November 2021, this limit was revised such that the maximum and minimum increase in interest rates on deposits of BFIs could be at most 10 percent of the average of maximum and minimum interest rates of BFIs of previous month. April 2022 World Bank Group 9 Global Challenges and Domestic Revival Nepal Development Update remittances. As a result, the credit to deposit ratio Despite liquidity shortages, official statistics climbed to around 90 percent during H1FY22, suggest that BFIs remain well capitalized, and that which is the regulatory maximum for BFIs. asset quality is sound. The capital adequacy ratio of BFIs fell from 14.2 to 13.4 percent H1FY22 but was The growing gap between credit and deposits well above the regulatory requirement of 11 percent. resulted in a liquidity shortage for banking and In addition, the total volume of non-performing financial institutions (BFIs). As a result, interbank loans of BFIs - loans that are overdue by 90 days interest rates started to rise, leaving them above or more –also declined marginally, driven by the the policy rate and closer to the upper bound rate of extension of loan repayment schedules as part of the interest rate corridor for most of H1FY22 (Figure the central bank’s repayment period facility. As a 15). In response, the central bank injected liquidity of result, the ratio of nonperforming loans to total loans NPR 3.4 trillion in the banking system through repos was in the low single digits (1.3 percent). Efforts to (overnight, 7-, and 14-day repos), outright purchases, enhance the accuracy of asset quality assessments and the standing liquidity facility (7 days). In addition, are being supported by the government’s Extended the central bank provided targeted liquidity support Credit Facility (ECF) agreement with the IMF, to to BFIs through the refinancing facility and allowed better capture existing risks, provide an accurate BFIs on January 3, 2022, to increase the percentage assessment of BFI asset quality, and enhance the of local governments’ funds that BFIs can count as quality of supervision. deposits from 50 to 80 percent.21 A.4 External Sector The current account deficit widened markedly Rapid import growth widened the trade deficit. in H1FY22 as the trade deficit widened and Total imports of goods and services increased by remittances fell. The current account deficit 6 percentage points of GDP in FY21 and continued widened from 0.9 percent of GDP (USD 340 expanding to 23.5 percent of projected GDP in million) in FY20 to 8.1 percent of GDP in FY21 (USD H1FY22 (Figure 18). Similarly, exports of goods and 2.8 billion), as higher remittances only partially services rose to 3.8 percent of projected GDP in offset a larger trade deficit. The current account H1FY22, after dropping by 1.4 percentage points of deficit widened further in H1FY22 to 7.9 percent of GDP in FY21. With import growth outpacing export projected GDP (USD 3 billion), up from 1.2 percent growth, the trade deficit widened by 7.4 percentage of GDP (USD 441 million) in H1FY21, as remittances points to 34.5 percent of GDP in FY21. The trade declined, and imports continued to grow (Figure deficit continued expanding during H1FY22 and 16). In the absence of significant FDI inflows (0.3 stood at 19.7 percent of projected GDP, up from 14.8 percent of projected GDP, USD 95 million), the percent of GDP in H1FY21. current account deficit was primarily financed by Imports of goods and services rebounded strongly trade credits, external concessional loans, and and surpassed pre-pandemic levels in the first reserves drawdowns (Figure 17). half of FY22. Merchandise import increased by 5.9 percentage points to 36.3 percent of GDP in FY21, Import growth was the main driver boosted by a revival in domestic demand and a of the current account deficit 21 Fiscal deposits are not counted as deposits unless an exception is made by the government and the central bank to allow  those for credit expansion. As such, this measure led to the temporary increase of deposits in BFIs. The measure will be effective only until the end of FY22. The central bank allowed BFIs to use those additional funds for extending credit to only productive sectors and not to import and trading businesses. 10 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update Figure 16 Lower remittances and a higher trade Figure 17 …which was largely financed by the deficit widened the current account deficit in H1FY22 drawdown of reserves Sources: NRB and World Bank staff calculations. Sources: NRB and World Bank staff calculations. Figure 18 Imports of goods and services rebounded Figure 19 …partly due to the appreciation in the strongly… real effective exchange rate Sources: Department of Customs and World Bank staff calculations. Source: IMF higher remittance. The increase was broad-based points in FY21. Services imports in H1FY22 were and was strong for industrial supplies (Figure 18), aided by an easing of travel restrictions which reflecting the recovery in construction activities, facilitated travel for study and work. and the policy measures that include an expansion An appreciation of the real effective exchange of the daily import quota of gold by the central bank rate (REER) in H1FY22 further contributed to from 20 kg to 30 kg and the purchase of COVID-19 strong import performance by lowering import vaccines. The growth momentum also continued in prices. The NPR is pegged to the Indian rupee H1FY22, with merchandise imports expanding from (INR) at a fixed rate of NPR 1.60 per INR. This rate 15.6 percent of GDP in H1FY21 to 21.4 percent of has remained unchanged since February 12, 1993. projected GDP in H1FY22, the highest in more than a With the nominal exchange rate to Nepal’s main decade. Services imports also rose to 2.1 percent of trading partner fixed, REER movements are driven projected GDP in H1FY22 from 1.6 percent of HDP in by domestic price changes in each country and, H1FY21, after declining marginally by 0.3 percentage April 2022 World Bank Group 11 Global Challenges and Domestic Revival Nepal Development Update Figure 20 Domestic inflation relative to the major Figure 21 Exports also expanded trading partners drove the real exchange rate appreciation Sources: Department of Customs and World Bank staff calculations. Sources: Department of Customs and World Bank staff calculations to a lesser extent, variation in the INR’s exchange of GDP in H1FY21 to 1.1 percent of projected GDP in rate with other currencies. Following a period of H1FY22, a sharp improvement from the contraction continued depreciation between August 2019 of 2.1 percentage points in FY21, as international to December 2020 the REER appreciated by 1.2 tourist arrivals resumed gradually. percent in H1FY21 (Figure 19). This was driven by Remittance inflows declined in H1FY22. higher domestic inflation in Nepal when compared Remittances continued to show remarkable to price increases in India (Figure 20).22 resilience in FY21,24 growing by 0.9 percentage Exports also expanded and reached an all-time points to 23.2 percent of GDP, helped in part by a high in H1FY22 but remain significantly lower strong economic recovery in migrant destination than imports. Merchandise exports climbed by 0.7 countries and a repatriation of savings by returnees. percentage points to 3.5 percent of GDP in FY21, However, remittances fell from 12 percent of GDP in primarily due to higher exports of refined soybean H1FY21 to 10.4 percent of projected GDP in H1FY22 oil which have remained relatively resilient during (Figure 22) as remittances began switching back the pandemic. This complemented the resumption towards informal channels after the pandemic and of exports of refined palm oil from July 2021 – which relied increasingly on digital currencies, reducing had been stalled for 14 months due to a restriction on official remittances recorded in the current account. imports by India – and contributed to an expansion of merchandise exports to 2.7 percent of projected The widening current account GDP in H1FY22 from 1.5 percent of GDP in H1FY21 deficit is exerting downward (Figure 21). Nepal achieved record-high growth for pressure on reserves these products even though India had reduced their The combination of a rising trade deficit and import duties for countries other than Nepal23 in late declining remittance flows exerted downward 2021. Services exports also rose from 0.9 percent pressure on foreign exchange reserves. Foreign 22 T  he nominal effective exchange rate depreciated by 0.6 percent in H1FY22, lower than the depreciation of 1.3 percent in H1FY21. 23  epali traders have been importing crude oils from third world countries at lower tariff rates and exporting the refined oils N to India at zero-tariff under South Asia Free Trade agreement. 24 T  he remittance data presented in this analysis do not include remittances sent through informal channels, as they are not registered by the central bank. 12 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update Figure 22 Remittance inflows declined in H1FY22… Figure 23 …putting downward pressure on foreign exchange reserves Sources: Nepal Rastra Bank and World Bank staff calculations. Sources: Nepal Rastra Bank and World Bank staff calculations. exchange reserves fell to USD 9.9 billion in mid- the foreign exchange quota of USD 1,500, limiting January 2022 from USD 11.8 billion in mid-July the number of withdrawals to two per year. 2021, covering 6.6 months of imports (Figure 23). The current account deficit was mostly financed While foreign exchange reserves declined, they by a drawdown of reserves in H1FY22. In FY21, remained close to the policy target of 7-months of the current account deficit was mainly financed import coverage. In an effort to support reserves by concessional long-term borrowing (net) and and ensure the credibility of the exchange rate trade credits (Figure 18). However, in the first half peg, the central bank adopted several measures of FY22, the drawdown of reserves was the primary to curtail imports. These include a reduction in source of current account financing (5.3 percent of the daily import quantity of gold from 20 kg to 10 project GDP, compared to reserve accumulation of kg and the restriction on one-time silver imports 3 percent of GDP in H1FY21). Concessional long- to less than USD 35,000. The central bank also term borrowing (net) also contributed 1.5 percent of made it mandatory for importers to deposit 50 to projected GDP, including disbursement under the 100 percent of imports value in their banks25 when IMF’s Extended Credit Facility (0.8 percent of GDP) opening Letters of Credit for the import of various (Figure 17). FDI remained marginal, after having consumption and luxury goods. The central bank contributed only 0.5 percent of GDP in FY21. also introduced a cap on the frequency with which Nepalis traveling abroad for tourism can withdraw A.5 Fiscal sector Nepal has historically maintained a balanced global peers, fueled by a high reliance on import- budget, but this legacy has been overturned by based taxes (Figure 24). Following discrete jumps earthquake reconstruction spending, COVID-19, in expenditure in FY17 and FY18 related to higher and the transition to federalism. Between FY13 spending needs for earthquake reconstruction, and FY16 Nepal recorded a budget surplus driven increased administrative costs associated with the by revenue collections that exceeded regional and transition to federalism, and a collapse of imports 25  his provision is expected to discourage imports by raising the cost of imports, since importers do not earn interest on T such deposits. April 2022 World Bank Group 13 Global Challenges and Domestic Revival Nepal Development Update Figure 24 Nepal’s fiscal balance has been in deficit since FY17 due to earthquake reconstruction spending, the transition to federalism, and COVID-19 Sources: Ministry of Finance and World Bank staff calculations. Note: Data for FY22 is projected. during the pandemic in FY20, deficits rose and percent of GDP from FY20 to FY21 reflecting higher reached 5.3 percent of GDP in FY20. Large deficits recurrent spending, including expenditure targeted led to debt rising from 22.7 to 36.3 percent of GDP specifically for COVID-19 related economic recovery between FY17 and FY20. and relief programs. To ramp up subnational service delivery, the federal government also The fiscal deficit narrowed in FY21 increased conditional grants to local and provincial governments. Capital expenditures also rose, Beginning in FY21, Nepal turned a corner, and the reflecting higher spending on buildings and public fiscal deficit has started to narrow on the back of construction. However, capital expenditure remains a strong post-COVID recovery of import-based below its pre-pandemic level as social distancing taxes. The fiscal deficit of the central government measures slowed the progress of government narrowed to 4.6 percent of GDP in FY21. Underlying funded construction work during the second wave the narrowing deficit was a strong rebound in of COVID-19, leading capital expenditure execution revenues, with total revenue and grants increasing rates to remain low at 64.7 percent. from 22.1 to 24.2 percent of GDP between FY20 and FY21. This was driven by a recovery in trade-related The fiscal balance is cyclical taxes including Value Added Tax (VAT), excise, and during the year, registering custom duties in line with higher goods imports. By surpluses in the first half of each contrast, non-tax revenues declined due largely fiscal year to lower dividends, tourism-related royalties, and visa fee collections, as tourism remained subdued As in the first half of previous fiscal years, the throughout FY21. federal fiscal balance recorded a surplus in H1FY22. During the first six months of the FY22, Expenditures also rebounded in FY21. Total Nepal’s federal government collected 2 percentage federal expenditure increased from 27.4 to 28.8 14 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update Figure 25 The federal fiscal balance recorded a Figure 26 …as revenue collection remained strong surplus in the first half of FY22… Sources: Ministry of Finance and World Bank staff calculations. Sources: Ministry of Finance and World Bank staff calculations. Figure 27 Low capital expenditure dampened total Figure 28 …contributing to a deceleration of spending… growth in the debt stock Sources: Ministry of Finance and World Bank staff calculations. Sources: Ministry of Finance and World Bank staff calculations. points of GDP more revenue and grants than expanded on the back of increased individual expenditure (Figure 25). While a fiscal surplus capital gain taxes, driven by higher returns in is common for the first half of the fiscal year, the housing and stock markets26. Non-tax revenues positive fiscal balance in H1FY22 was larger than also rose, chiefly due to higher royalties, dividends, in previous years (Figure 25). and passport and visa fee collections, as tourism gradually began to resume. The continued strong recovery of revenues underlies this performance. Revenue collection Capital expenditure decreased marginally due expanded from 10.2 percent of GDP in H1FY21 to to a delay of the FY22 budget implementation. 12 percent of projected GDP in H1FY22 (Figure Nepal frequently records a fiscal surplus in the first 26). This was driven primarily by continued strong half of the fiscal year as expenditure is bunched in import growth. At the same time, income tax also the last quarter. In FY21, more than 50 percent and 26 n FY21 and H1FY22, the secondary stock market contributed in the form of capital gain taxes around 1.5 percent of I federal government revenue. April 2022 World Bank Group 15 Global Challenges and Domestic Revival Nepal Development Update 35 percent of actual capital spending occurred in is paid in USD and is composed of multilateral the last quarter and last month of the fiscal year, and bilateral concessional debt. The World Bank respectively. This pattern is likely to continue in and the Asian Development Bank are the largest FY22 as well, given that in H1FY22 only 11.6 percent creditors. Interest rates are low, averaging only 1 of budgeted capital expenditure was spent, a percent across the portfolio, and external debt also decrease from 13.4 percent for H1FY21. The lower benefits from long average maturities of 14.1 years. budget execution in H1FY22 also led to midyear In addition to beneficial financing terms, the external downward revision of the budget, as has happened debt stock also benefited from the appreciation of in past years. As a result, capital expenditure stood Nepali rupee against the US dollar in the first half at 1.1 percent of projected GDP, down from 1.2 of FY22, leading to a 0.3 percentage points of GDP percent of GDP in H1FY21. reduction in the debt stock expressed in US dollars over the same period. Due to limited growth in capital expenditure, total expenditure only grew marginally. Total Domestic debt includes mostly treasury bills expenditure rose from 9.5 percent of GDP in and development bonds.27 Treasury bills account H1FY21 to 10.1 percent of projected GDP in H1FY22 for 16 percent of the domestic debt stock and (Figure 27). Compared to previous years, higher development bonds account for 30 percent. spending was recorded for social security as all Treasury bills have a maturity period of less than publicly distributed social assistance payments – a year, and development bonds have a maturity including those for senior citizens, single women, period of 3 to 15 years. Domestic debt carries an widows, and child protection – were increased by average interest rate of 4.6 percent and average 33 percent. The federal government also devolved time to maturity of 3.8 years. more resources to subnational governments The risk of debt distress remains low. New through conditional grants to ramp up social service domestic borrowing by the federal government in delivery in the aftermath of the pandemic. Nepal is regulated by the National Natural Resource and Fiscal Commission, which stipulated a ceiling Public debt continues to rise, of 5.5 percent of GDP of new domestic borrowing albeit more slowly for FY21. This is complemented by a medium-term Due to the narrowing fiscal deficit, the public debt debt strategy that aims to maintain total public stock rose at a slower pace in H1FY21 as compared debt below 50 percent of GDP for FY21-FY24 and to H1FY20. Public debt stood at 41.8 percent of which was approved by Cabinet in November 2021. GDP at the end of FY21. Following the (temporary) Despite rising in recent years, debt levels have not surplus in H1FY22, debt decreased to 38.2 percent breached these limits. The most recent Joint Bank- of projected FY22 GDP. However, this is higher than Fund Debt Sustainability Analysis (December 2021) 37.1 percent of GDP in H1FY21 (Figure 28). finds that the risk of debt distress is low for both external and public debt.28 Nepal’s external public debt stock remains largely concessional. In FY21, external debt and domestic debt constituted 54 and 46 percent of total public debt, respectively. This composition remained similar in H1FY22. Long term external debt is primarily denominated in Special Drawing Rights (SDR) but 27 Domestic debt also includes a small amount of citizen saving bonds and foreign employment bonds. 28 Private external debt figures are not published by the government and are not included in external debt figures. 16 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update In addition to grants, subnational governments Subnational governments also collect own-source revenue. The latest continue to assume expenditure available data on own-source revenue31 covers responsibilities FY21 and highlights that the ability of provincial and Subnational governments are primarily financed local governments to independently finance their through federal grants and revenue sharing.29 expenditure is still limited. During FY21, provinces Federalism is composed of three tiers of government collected revenues equivalent to 2.4 percent of – municipal, provincial, and federal – and was GDP, and local governments jointly collected 6.1 established with the promulgation of Nepal’s new percent of GDP. constitution in 2015. In FY21, total federal transfers These revenue sources are used to finance the to subnational governments, including grants and gradual absorption of expenditure responsibilities. revenue sharing, accounted for 12.3 percent of Nepal’s 2015 constitution has devolved spending GDP (Table 1). The main sources of grant financing responsibilities for key service delivery sectors to include fiscal equalization and conditional grants. subnational governments, including for primary Fiscal equalization grants are not earmarked and healthcare and education. In FY21, provinces spent are intended to help subnational governments meet 4.6 percent of GDP on fulfilling these mandates, 0.6 their expenditure needs. In FY21, total equalization percentage points more than in the previous fiscal grant transfers accounted for 3.5 percent of GDP. year. Local governments play a more significant Conditional grants are earmarked grants for role in general government spending. Their joint specific sectors and expenditure items to enable expenditure amounted to 9.7 percent of GDP in subnational governments to meet service delivery FY21, 1.5 percentage points higher than in FY20. standards. In FY21, they accounted for 5.6 percent of GDP.30 The federal government also shares 30 Subnational governments continue to struggle percent of revenue from VAT and domestic excise with low budget execution rates. In FY21, provincial duties and 50 percent of all natural resource royalty and local governments spent 62.9 and 75.4 percent receipts with subnational governments. Revenue of their approved budgets, lower than the federal sharing accounted for 2.7 percent of GDP in FY21. budget execution rate of 82.9 percent. Persistent low subnational budget execution continued in Federal grants and revenue sharing to subnational H1FY22. During this period, provincial and local governments increased in H1FY22. Total grants governments spent 15 and 24.3 percent of their transferred increased from 3.7 percent of GDP in total FY22 budgets, compared with 32.9 percent for H1FY21 to 4 percent of projected GDP in H1FY22, the federal government (Table 1). The lower budget primarily due to an increase in fiscal equalization executions of provincial and local governments grants from 1.4 percent to 1.6 percent of projected reflect not only a lack of technical capacity but GDP. Revenue sharing also rose to 1.3 percent of also mirror many of the problems observed at the projected GDP from 1.2 percent of GDP in H1FY21, federal level, including the bunching of spending on the back of a strong recovery of federal revenue towards the end of the fiscal year. (Table 1). 29  lease refer to the World Bank’s 2021 Public Expenditure Review for Nepal, entitled “Fiscal Policy for Sustainable P Development”, which contains a description and analytical assessment of the intergovernmental framework. 30 Subnational governments also receive complementary and special grants, but their value is comparatively small.  31 T  his includes revenue sharing between provinces and local governments and miscellaneous revenues (consisting of opening cash balances). April 2022 World Bank Group 17 Global Challenges and Domestic Revival Nepal Development Update Table 1 Revenue and spending performances of federal, provincial and local governments Actual (share of GDP, percent) Budget execution Expenditure/Revenue (percent) FY18 FY19 FY20 FY21 H1FY21 H1FY22 H1FY21 H1FY22 A. Federal Expenditure 28.0 27.3 27.4 28.7 10.7 11.5 31.1 32.9 Recurrent 20.2 21.1 22.6 23.2 9.5 10.3 36.6 39.1 o/w: Fiscal transfer to SNGs 7.0 8.3 9.0 9.6 3.7 4.0 42.1 46.3 o/w: Revenue sharing to SNGs 0.0 2.5 2.6 2.7 1.2 1.3 40.5 47.0 Capital 7.8 6.3 4.8 5.5 1.2 1.1 14.4 13.4 Revenue 21.0 21.8 21.5 23.7 10.9 12.7 44.5 48.8 Tax revenue 18.5 19.1 17.9 21.1 9.3 10.9 42.3 46.3 o/w: Trade-related 9.4 9.6 8.0 10.6 4.7 5.9 44.2 50.4 o/w: Non-trade related 9.2 9.5 9.9 10.5 4.6 5.0 40.6 42.1 Non-tax and other revenue 2.5 2.7 3.6 2.6 1.5 1.8 64.3 73.0 Grants 1.1 0.6 0.6 0.5 0.1 0.1 9.3 10.4 Fiscal balance -5.8 -5.0 -5.3 -4.6 0.3 1.4 B. Provincial Expenditure 0.1 2.9 4.0 4.6 0.9 0.9 14.9 15.0 Recurrent 1.3 1.7 0.5 0.5 15.8 19.8 Capital 1.6 2.3 0.5 0.3 14.1 11.0 Revenue 0.2 4.8 5.9 6.4 Fiscal balance 0.1 1.9 1.9 1.8 C. Local Expenditure 6.4 7.9 8.2 9.5 2.5 2.8 21.5 24.3 Recurrent 5.7 Capital 3.8 Revenue 7.6 9.9 10.3 11.9 Fiscal balance 1.2 2.0 2.2 2.5 Sources: Ministry of Finance, Financial Comptroller General Office, and World Bank staff calculations 18 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update B. Outlook, Risks, and Challenges The war in Ukraine presents new challenges. metal, and mineral prices 20 percent higher in 2022 Nepal’s trade with Russia and Ukraine is limited and 2023 than they were projected in January to less than 2 percent of total imports – including 2022 (Figure 31), a conservative estimate is that mostly sunflower oil, dried peas, and colza the current account deficit as a share of GDP will seeds - but the share of fuel, agriculture, metals, widen by around 1.5 percentage points in FY22 and and minerals in total imports is large (Figure 29, FY23 relative to the January 2022 forecast (Figure Figure 30). As such, Nepal is less likely to face 32). Higher prices will be reflected in increased an immediate negative supply shock because of construction costs as well as consumer prices, the direct trade linkage. Instead, higher global dampening overall demand and in turn reducing the commodity prices are expected to increase the real GDP growth rate by an estimated 0.2 and 0.6 import bill indirectly. Services exports are expected percentage points in FY22 and FY23, respectively to be less affected given the relatively low share of (Figure 31). The direct impact of higher global tourist arrivals (less than 3 percent) from these two fuel and edible oil prices on consumer inflation is countries. On the bright side, higher fuel prices may expected to be low given that the share of these lead to stronger demand for migrant workers in the products is only around 5 percent of consumers’ oil exporting GCC countries, and consequently an expenditure. As such most of the higher inflation increase in remittances. is likely to come from indirect effects, for example, through an increase in transportation prices and Higher commodity prices are expected to widen other food and non-food items. the current account deficit, reduce the growth rate, and increase inflation. If the war pushes fuel, April 2022 World Bank Group 19 Global Challenges and Domestic Revival Nepal Development Update Figure 29 Nepal’s trade with Russia and Ukraine Figure 30 …but Nepal imports many commodities is low… whose prices will be affected by the war Sources: Department of Customs and World Bank staff calculations. Sources: Department of Customs and World Bank staff calculations. Note: Data of FY22 is for first six months. Note: Data of FY22 is for first six months. Figure 31 The war is projected to increase Figure 32 …which will impact Nepal’s growth, commodity prices by more than 20 percent… inflation, and current account deficit Sources: Global Economic Prospects, World Bank Sources: World Bank staff calculations. Note: CY refers to calendar year. Taking into account the impact of the war, the percent in FY24 close to its estimated long-term Nepali economy is expected to recover gradually potential growth rate. over the medium-term under a baseline scenario. In the services sector, the deployment of effective The baseline scenario assumes: i) that no new vaccines to the eligible population is expected to nationwide strict containment measures are unleash pent-up demand and aid a recovery of the imposed; ii) a near complete vaccination of the wholesale and retail trade, transportation, financial, eligible population by the end of FY22; and iii) a insurance, real estate, and education sectors. The gradual increase in international migration and ongoing war in Ukraine may lower travel demand tourist arrivals, reaching pre-pandemic levels by globally through the negative impact on global FY24. In this scenario, the economy is projected to growth and dampen the recovery of tourism and grow by 3.7 percent in FY22 (Table 2), accelerate tourism related sectors in FY22 and FY23. Service to 4.1 percent in FY23, and rise further to 5.8 20 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update sector growth is expected to average 5.7 percent Inflation is expected to average around 6 percent over FY22-FY24, below the pre-pandemic average in the medium term. Inflation during FY22 is annual growth rate of 6 percent. expected to increase to 6 percent due to higher global oil prices, most recently spurred by the war Growth in agriculture is projected to decelerate in Ukraine. However, the increase is expected to in FY22. Key drivers are a decrease in paddy be partially moderated by government policies to production from unseasonal rains in October ensure low-income households receive lower utility 2021 and projected transitory increases in global and LPG prices. A decline in paddy production fertilizer prices that may cause domestic shortages. and higher deposit requirements on the import The domestic shortage is expected to be partially of select goods through Letter of Credit are also mitigated by a five-year agreement signed likely to push prices upward. Inflation is expected between the governments of Nepal and India in to remain elevated at 5.7 percent in FY23 under the February 2022, whereby India would supply a fixed expectation of continued higher oil prices before quantity32 of chemical fertilizers to Nepal on an declining to 5.2 percent in FY24. annual basis. Considering this, agricultural sector growth is projected to average 2 percent per year The central bank is expected to continue over FY23-FY24. unwinding accommodative monetary policy in the medium term. The exchange rate peg with the The industrial sector is expected to continue Indian Rupee will continue to serve as a nominal supporting growth. The manufacturing and anchor of the monetary policy in the medium term. construction sub-sectors are projected to drive Through monetary policy, the central bank aims industrial sector growth over the medium- to maintain price and foreign exchange reserve term. The recently completed 456-MW Upper balances while supporting the economic growth Tamakoshi Hydropower plant, the targeted target set out in the government’s fiscal policy increase in hydropower production to 6500 statement. As the economy continues to recover MW from the existing 1900 MW by FY24, and from the pandemic, the central bank is expected the completion of the Melamchi Drinking Water to continue tightening monetary policy as signaled Project by FY22 are expected to accelerate recently through increasing the policy rate during growth in the industrial sector. the mid-term review of its FY22 monetary policy The ECF program with the IMF provides a policy and beyond. anchor. Key policy actions under the program, approved in January 2022, include measures to boost revenues and public spending efficiency, strengthen financial sector regulation and supervision, and support fiscal transparency, as well as measures to enhance governance and combat corruption. 32 For FY22, this is set at 150,000 tons. April 2022 World Bank Group 21 Global Challenges and Domestic Revival Nepal Development Update Table 2 Macroeconomic projections of selected key indicators         FY19 FY20 FY21 e FY22 f FY23 f FY24 f Real GDP growth, at constant market prices   6.7 -2.1 1.8 3.7 4.1 5.8   Private Consumption   8.1 3.6 2.4 2.1 1.9 2.5   Government Consumption   9.8 3.8 -5.0 23.6 0.8 -4.1   Gross Fixed Capital Investment   11.3 -12.4 1.2 7.6 5.5 9.6   Exports, Goods and Services   5.5 -15.9 -19.8 30.7 12.5 15.1   Imports, Goods and Services   5.8 -15.2 16.9 10.2 2.3 3.1 Real GDP growth, at constant factor prices   6.4 -2.1 1.8 3.7 4.1 5.8   Agriculture     5.2 2.2 2.7 1.3 1.8 2.3   Industry     7.4 -3.7 0.9 5.1 5.3 6.9   Services     6.8 -4.0 1.6 4.7 5.0 7.4 Inflation (Consumer Price Index)   4.6 6.1 3.4 6.0 5.7 5.2 Current Account Balance (% of GDP)   -6.9 -0.9 -8.1 -11.9 -9.5 -6.8 Fiscal Balance (% of GDP)   -5.0 -5.3 -4.6 -3.7 -3.5 -3.4 Debt (% of GDP)     27.2 36.3 41.8 43.1 44.2 44.5 Primary Balance (% of GDP)   -4.5 -4.7 -3.7 -2.8 -2.5 -2.3 Sources: Ministry of Finance, Nepal Rastra Bank, and Central Bureau of Statistics for history. World Bank staff for estimates and forecasts. Notes: e = estimate; f = forecast. Nepal’s large trade deficit is expected to persist in expected to remain below their pre-pandemic the medium term. The trade deficit is expected to levels through FY24. widen from 34.5 to 36.4 percent of GDP between The current account deficit is projected to widen to FY21 and FY22 and then decline to 35.1 percent of 11.9 percent of GDP in FY22 and narrow thereafter. GDP in FY23. Merchandise imports are expected Remittances are expected to stabilize at around 22 to grow at a more moderate pace from FY23 percent of GDP over the next two years, supported onwards, reflecting the completion of most post- by new overseas employment opportunities. This 2015 earthquake construction and the gradual development, together with new incentives for replacement of imported fossil fuels by electricity formal remittance transfers announced through use in households and firms as the country FY22 monetary policy, is projected to contribute to generates an additional 4,000 MW of hydropower narrowing the current account deficit beginning in electricity. Goods exports are expected to grow FY23. In the absence of significant FDI inflows, the in FY22 as Nepal continues to take advantage of current account deficit will continue to be primarily tariff exemptions on exports of palm and soybean financed by external borrowing and reserves oil to India under the South Asian Free Trade Area drawdowns. Gross foreign exchange reserves are agreement. An increase in electricity exports expected to fall to 4.8 months of imports by FY24 under an energy exchange and trade agreement under the business-as-usual scenario.33 with India is expected to drive merchandise export growth from FY23 onwards. Services exports and The fiscal deficit is projected to continue imports are expected to recover robustly but are narrowing in the medium term. The fiscal deficit is 33 The target has been adjusted in the past following pressure on external reserves. 22 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update projected to narrow from 4.6 to 3.7 percent of GDP of moderate risk of debt distress, staff judgement between FY21 and FY22, as the growth rebound was applied to assess Nepal’s external debt to be continues supporting revenue collection. Fiscal at low risk of debt distress noting that remittances, policy is projected to provide continuous support rather than exports, are the major source of to households and firms in FY23 but tighten from foreign exchange to finance the current account FY24 onwards as support programs are unwound and service external debt. Stress tests show a and measures to reduce duplication of spending vulnerability to growth and export shocks.34 The responsibilities across levels of government findings from the DSA stress the importance of are enacted. Expenditures are also likely to implementing reforms to increase the economy’s peak in FY23 due in part to electoral spending. resilience to external shocks through, for example, Revenues are expected to recover with a rollback encouraging diversification, improving productivity of COVID-19 related tax breaks, growing import- and competitiveness, and enhancing the monitoring related revenues, efforts to widen domestic tax of risks related to contingent liabilities. bases (including through reforms supported by A downside scenario highlights growth and fiscal the IMF ECF program), and stronger economic risks. A downside scenario considers a situation in activity, including the recovery of tourism. The which the central bank uses stronger import control deficit is expected to be financed partly through measures to maintain the foreign exchange reserve concessional bilateral and multilateral borrowing, coverage at 7 months of imports and in which including from the IMF, the World Bank, and the expenditure consolidation progresses less swiftly Asian Development Bank, and partly through than projected under the baseline. This scenario domestic sources. Total public debt is expected to results in adverse growth impacts following the reach 43.1 percent of GDP in FY22 and rise further import contraction, depressing domestic output to 44.5 percent of GDP by FY24. as well as consumption. Limited spending The government is taking measures to limit the consolidation could also result in reduced capital bunching of expenditure in the last quarter of the spending to compensate for persistent elevated fiscal year. To improve the capital project selection recurrent spending, which could depress growth and enhance their execution, the government further. There would be a mechanical increase in has established the national project bank (NPB). the fiscal deficit as well as a decrease in import- All capital projects costing more than NPR 500 related revenues, which would jointly lead to million are required to be included in the NPB prior substantially higher debt levels. to their inclusion in the budget. To operationalize The economic outlook is subject to additional the NPB, the unified guidelines are being currently downside risks. A slower than expected vaccine developed. The guidelines will lay out detailed rollout or a new COVID-19 variant reducing sector-specific technical preparation and selection vaccine effectiveness could require the re- requirements, including climate considerations. imposition of stricter containment measures, Debt is expected to remain sustainable. The most weakening the rebound momentum. Climate- recent Joint Bank-Fund Debt Sustainability Analysis related and natural disasters are a perennial (DSA, December 2021) finds that the risk of debt risk which could impact agricultural production, distress is low for both external and public debt. government finances, and consumer prices. While the analysis resulted in a mechanical rating Depending on the pace of policy tightening, the 34  he short and medium-term macroeconomic projections used in the DSA assume (i) a larger near-term primary deficit, (ii) a faster T consolidation of primary deficits and (ii) a larger current account deficit in the near term than in the preceding section of this World Bank macroeconomic outlook. Considering the application of staff judgement, the conclusion of the DSA is unlikely to change if the World Bank macroeconomic outlook was applied. April 2022 World Bank Group 23 Global Challenges and Domestic Revival Nepal Development Update unwinding of accommodative fiscal and monetary policy will need to be carefully sequenced to avoid large shocks to private sector activity. Staying the course on policy reforms to address fiscal imbalances, improve spending efficiency, accelerate private sector growth and bring into focus the pandemic’s impact on the financial sector can help mitigate downside risks. The government is examining the cost of tax exemptions and reporting on government spending for the COVID-19 response to inform adjustments to fiscal spending and revenues while continuing to protect the vulnerable. Efforts are underway to allow subnational governments greater flexibility in their use of conditional grants, which can raise their low budget execution rates and provide greater responsiveness to local needs. The government is also evaluating options to attract more growth-enhancing investment to Nepal. Central bank amendments to financial sector regulations will strengthen identification of non-performing assets and provide clear guidance on restructuring and rescheduling. Maintaining traction on these and many other reforms is especially important as the country navigates higher global commodity prices, the potential of a protracted war in Ukraine, and the possibility of new COVID-19 variants leading to renewed movement restrictions and border closings. 24 World Bank Group April 2022 Global Challenges and Domestic Revival Nepal Development Update April 2022 World Bank Group 25 Global Challenges and Domestic Revival Nepal Development Update The World Bank Group Nepal Country Office, PO Box: 798 Yak and Yeti Hotel Complex Durbar Marg, Kathmandu, Nepal Tel: 4236000, Fax: 4225112 www.worldbank.org/np Email: infonepal@worldbank.org www.facebook.com/WorldBankNepal 26 World Bank Group April 2022