Nepal Development Update November 2018 Maximizing Finance for Development NEPAL DEVELOPMENT UPDATE Maximizing Finance for Development November 2018 Standard Disclaimer: This volume is a product of the staff of the The World Bank does not guarantee the International Bank for Reconstruction and accuracy of the data included in this work. Development/The World Bank. The findings, The boundaries colors, denominations, and interpretations, and conclusions expressed in other information shown on any map in this this paper do not necessarily reflect the view of work do not imply any judgement on the part the Executive Directors of The World Bank or of The World Bank concerning the legal status the governments they represent. of any territory or the endorsement or acceptance of such boundries. Copyright Statement: The material in this publication is copyrighted. 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Table of Contents Acknowledgments............................................................................................vi Abbreviations..................................................................................................vii Executive Summary..........................................................................................ix A. Recent Economic Developments..................................................................1 B. Outlook, Risks and Challenges...................................................................10 C. Special Focus – Priority Reforms to Maximize Finance for Development and Crowd in the Private Sector for Accelerated Growth............................13 Improving Competitiveness and Integration with Global Markets................................13 Enhancing Financial Inclusion and Capacity for Long-Term Finance.........................16 Strengthening Public Investment Management and PPPs............................................20 Putting it all Together – Maximizing Finance for Development in Nepal....................23 Refrences.........................................................................................................26 Box Box 1. Building benchmark yield curves..............................................................................18 Figures Figure 1. Investments are increasingly contributing more to GDP growth.......................2 Figure 2. …supported by housing reconstruction, which is in full swing as the second and third tranche disbursements have picked up................................................2 Figure 3. Service sector continues to drive growth..............................................................2 Figure 4. …with tourist arrivals reaching record levels during the two FY2018 tourist seasons.................................................................................................................2 Figure 5. Inflation was driven by non-food prices but remained low throughout the fiscal year .............................................................................................................3 Figure 6. Price differential with India was largely neutral throughout FY2018 ...............3 Figure 7. Exports picked up during FY2018........................................................................3 Figure 8. …driven by exports to India, China, and Turkey.................................................3 Figure 9. Exports to these countries have grown rapidly....................................................4 Figure 10. …resulting in the increase of their shares in total exports..................................4 Figure 11. While imports continued to grow in double digits..............................................4 Figure 12. …driven by industrial supplies and capital goods...............................................4 Figure 13. Remittances (in US$, millions) continue to rise..................................................5 Figure 14. … as its share in GDP is declining.......................................................................5 Figure 15. …and migrant worker outflows to major destination countries also declined....5 Figure 16. These trends, coupled with faster growth of the trade deficit relative to remittances, are widening the CAD.....................................................................5 Figure 17. …causing a decline in the accumulation of foreign reserves, though the import cover remains adequate at 8.3 months....................................................5 Figure 18. Money supply (M2) growth picked up as private sector credit growth accelerated...........................................................................................................6 Figure 19. …due to increased credit to all sectors, especially the service sector.................6 Figure 20. Deposits growth also picked up...........................................................................6 Figure 21. The banking sector continues to push close to its regulatory limits for the CCD ratio........................................................................................................7 Figure 22. …causing the weighted average interest rates to remain high............................7 Figure 23. Revenue growth remained healthy.......................................................................7 Figure 24. …due to taxes on international trade, which accounted for nearly 10 percent of GDP......................................................................................................................7 Figure 25. Government expenditure increased significantly in FY2018...............................8 Figure 26. …but last trimester bunching of capital expenditure persists............................8 Figure 27. And underexecution of the budget, especially the capital budget, continues....8 Figure 28. …while expenditure as a share of GDP increases...............................................8 Tables: Table 1. Macroeconomic Projections of Selected Key Indicators........................................11 Table 2. Priority Reforms to Maximize Finance for Development and Crowd in the Private Sector for Nepal’s Accelerated Growth.................................................................................24 Acknowledgments The Nepal Development Update is produced Saurav Rana, and Roshan Bajracharya. Sabin twice a year to reporton key economic Shrestha, Ilias Skamnelos, Ruchita Manghnani, developments over the preceding months, placing Gonzalo Varela, Miles McKenna, and Shyamala them in a longer-term and global perspective; and Shukla contributed to the Special Focus section to examine (in the Special Focus section) topics of under the guidance of Esperanza Lasagabaster. particular policy significance. The Update is Christian Eigen-Zucchi provided extremely useful intended for a wide audience including policy comments. Oversight in preparing the report was makers, business leaders, the community of analysts provided by Mona Prasad under the overall and professionals engaged in economic debate, guidance of Manuela Francisco, Faris and the general public. Hadad-Zervos, and Qimiao Fan. Richa Bhattarai managed media relations and dissemination. Diane This Update was produced by the World Bank Stamm edited the document. Sunita Kumari Yadav Macroeconomics Trade and Investment (MTI) managed the publication process. team for Nepal consisting of Kene Ezemenari, vi Abbreviations ADB Asian Development Bank BBIN Bangladesh, Bhutan, India and Nepal CAD current account deficit CCD credit to core capital plus deposit FDI foreign direct investment GDP gross domestic product GoN Government of Nepal ICT information and communications technology IPPs independent power producers IT information technology MFD Maximizing Finance for Development MOFAGA Ministry of Federal Affairs and General Administration MTEF Medium-Term Expenditure Framework MTI Macroeconomics Trade and Investment NDU Nepal Development Update NEA Nepal Electricity Authority NPC National Planning Commission NRB Nepal Rastra Bank, the central bank of Nepal PFM public financial management PPP public-private partnership RMIS Revenue Management Information System SME small and medium-sized enterprise SRN Strategic Roads Network y/y year-over-year vii Maximizing Finance for Development Nepal Development Update ............................................................................................................................................................................................................................................................................................................................................................ Executive Summary ............................................................................................................................................................................................................................................................................................................................................................ Recent Economic Developments In FY2018, growth in Nepal remained strong inputs to support earthquake reconstruction and at 6.3 percent despite less favorable monsoons the establishment of subnational government and the easing of growth from the rebound offices. As a result, the trade deficit surged to 37.7 following the 2015 earthquake. Continued strong percent of GDP in FY2018 (from 33.9 percent in activity in construction boosted private investment. FY2017). Remittances grew by 10 percent, but as Government activities and programs geared a share of GDP declined from 26.3 percent in toward earthquake reconstruction and the FY2017 to 25.1 percent in FY2018, due to policy establishment of offices at decentralized levels actions in migrant destination countries. In underpinned public investment. Private addition, the dollar-rupee exchange rate consumption was also a key driver of growth, depreciated by 6.2 percent. Gross official reserves financed by an uptick in remittances, in the last declined slightly but remained adequate to cover quarter of 2018. These trends coupled with record 8.3 months of imports (compared to 9 months tourist arrivals, the reduction of load shedding, and in FY2017). an expansion of manufacturing capacity, all helped sustain growth. Inflation was 4 percent, anchored Driven by private sector credit, money supply by the peg to the Indian rupee. Prices for non-food growth was 19.3 percent (y/y) in FY2018, items grew at 5.5 percent, while food prices rose above the 18 percent target. Private sector credit by 3.1 percent. contributed 17.2 percentage points to money supply growth due to higher lending to all sectors. A higher trade deficit was only partially offset These trends were supported by greater capacity by higher remittances, widening the current utilization arising from increased availability of account deficit (CAD). Exports registered record electricity and investment loans. Net claims on growth due to expansions into new markets in government contributed 3.3 percentage points to China and Turkey. Imports, however, grew at a money supply growth, as government domestic faster pace due to higher oil prices, and needed borrowing rose due to increased expenditure November 2018 World Bank Group ix Maximizing Finance for Development Nepal Development Update arising from the transition to federalism. Also, growth in industry. Steady remittance inflows will better implementation and monitoring of the support growth in consumption as well as retail 5 percent subsidy policy for agricultural and and wholesale trade, and a continuation of high livestock loans together with policies to push tourist arrivals is expected under the Visit Nepal commercialization, helped boost farmers’ access 2020 program. Inflation is projected to reach 5 to and uptake of loans. As deposit growth percent over the medium term, assuming a continues to trail credit growth, the banking continued increase in oil prices and depreciation sector’s credit to core capital plus deposit (CCD) of the exchange rate. The CAD will gradually ratio was at 76.8 percent in July 2018, just shy of narrow as import growth moderates. the 80 percent regulatory limit set by the Nepal Rastra Bank (the central bank). As a consequence, The Government of Nepal (GoN) is shifting the weighted average of lending and deposit rates, from consumption- to investment-based which had shot up following the credit crunch in growth, with an emphasis on crowding in the mid-FY2017, remain high at 12.1 and 6.5 percent, private sector and raising the very low levels respectively, as of July 2018. of FDI. In addition to infrastructure investments, key reforms will be needed to strengthen and Difficulties in execution of the budget update the legal and regulatory framework for continued in FY2018, with overall spending at public-private partnerships (PPPs), one-stop 82.4 percent of the total budget (and 71.2 investor services, and e-government services for percent of the capital budget). In addition, citizens. Consolidated spending of government is 37.5 percent of total spending (or 54.6 percent of expected to reach 34 percent of GDP over the capital expenditure) was spent in the last quarter medium term, with 3 to 4 percentage points of the of the fiscal year. Revenue growth was strong due increase arising from the transition to federalism. to higher tax receipts from elevated imports (which constitute just under half of all revenue) The implementation of federalism offers coupled with collection rates that were close to transformational opportunities but also planned targets. However, higher spending to considerable challenges for crowding in private establish subnational governments and finance the investment. Urgent reforms are needed to transition to federalism has contributed to a strengthen the Public Financial Management (PFM) 3-percentage-point increase in the fiscal deficit. system to inform decentralized decision making This was financed by government deposits and a and service delivery. An annual budgeting process 4-percentage-point increase in public debt as a is in place at the subnational level with guidelines share of GDP. issued by the Ministry of Federal Affairs and General Administration (MOFAGA), including Outlook, Risks, and Challenges accounting processes to underpin the budget process. However, existing IT systems are GDP growth is projected to average 6 percent fragmented and not all local governments have over the medium term, driven primarily by adopted the subnational PFM system called total investment. Agriculture growth is expected SUTRA. Those local governments that have not to average 4.3 percent over the forecast period, yet adopted SUTRA have to manually upload their supported by programs to promote improved spending data, to report on their spending. inputs, storage facilities, and irrigation for farmers. Further more, revenue accounting, billing and The focus will be on modernization, collection are not captured in SUTRA and each commercialization, and increased mechanization as locality uses its own system. A Revenue well as connecting to agribusiness value chains. Management Information System (RMIS) is only Reconstruction activities and improved capacity fully operational at the federal level for tax utilization in the manufacturing sector (as a result collection. of improved electricity supply) will help support November 2018 World Bank Group Maximizing Finance for Development Nepal Development Update Weak or incomplete systems, processes, and implementation capacity of subnational capacity at the subnational level pose an governments to plan, budget, and execute their immediate risk to the use and management of programs, including systems for tracking spending resources, especially funds allocated for local and the appropriate level of staffing. It will be governments. For example, medium-term particularly important to implement reforms that planning or a three-year Medium-Term crowd-in the private sector to facilitate higher levels Expenditure Framework (MTEF) will take some of investment. The multiple challenges time to implement at subnational levels given the underpinning the federalism process necessitate a difficulty of recording expenditures for local comprehensive roadmap that harmonizes governments. Local governments do not know the approaches across the three tiers of government, provisions in the law or that they are required to covering reforms to enhance functions, do three-year budgets. An MTEF requires a good functionaries, and funding. overview of local revenue. But, local governments are unable to forecast revenue, and revenue Delays in reforms to crowd in private sector sharing information from the federal level will need investment could hamper the GoN’s efforts to to be solidly in place. Also, there is a heavy reliance shift to an investment-led growth model. on fiscal transfers. These weaknesses and Critical reforms will entail strengthening the shortcomings, if not addressed, could undermine financial sector, unlocking investment bottlenecks, the ability to provide the services necessary to and developing long-term finance, particularly for crowd in the private sector. closing key infrastructure gaps. These reforms are discussed under the special focus section of this Transfers to subnational governments are 8.3 edition of the “Nepal Development Update – percent of GDP in FY2018 and are expected to Maximizing Finance for Development” and aim to increase further as federalism proceeds. Setting find solutions to crowd in all possible sources of up physical infrastructure, IT systems and human finance, innovation, and expertise to support resources is expected to continue for the next two Nepal’s aspiration of achieving middle-income or three years. Raising the revenue potential of status by 2030. subnational governments will be critical, as will be their capacity to implement their projects and Special topic –Maximizing Finance for programs. Overall, tax reform, including a Development (MFD) broadening of the tax base, will help increase revenue to 29 percent of GDP over the medium Nepal is poised to embrace a new development term. Public debt as a share of GDP will increase model for a “Prosperous Nepal, Happy but will remain manageable at under 40 percent of Nepalese,” by achieving faster growth to GDP over the medium term, assuming large become a middle-income country by 2030. government deposits and continued low external Growth rates of at least 7 to 8 percent will be debt levels. imperative. To achieve these levels of growth, the government targets a 10-percentage-point increase Risks to the outlook arise primarily from the in the investment rate by 2021. But, this can only transition to and implementation of happen with a shift from remittance-led and federalism, including the resource and consumption-based growth to one that is capacity needs. Failure to raise the needed investment and productivity driven. resources to meet the projected increase in spending could undermine service delivery or lead Business as usual will not be sufficient to to a significant deterioration of the fiscal position. accelerate growth and achieve graduation to In that regard, there is a pressing need to expand middle-income-country status by 2030. The the revenue capacity of subnational governments. GoN’s new growth model aims for growth fueled Measures will also be needed to strengthen the by higher levels of investment, productivity, and November 2018 World Bank Group Maximizing Finance for Development Nepal Development Update effective public institutions to facilitate private intended firms due to the complex filing procedure, sector dynamism, and will require reforms to (a) limited resources, and a first-come, first-served improve the competitiveness of the private sector allocation mechanism. Trade facilitation efforts, and integrate with global markets; (b) strengthen including the strengthening of the Bhutan, the financial sector through development of Bangladesh, India and Nepal (BBIN) transit long-term financing instruments; and (c) agreement are also needed for Nepalese exporters strengthen the framework for infrastructure to reach ports at reduced transport costs. finance, including PPPs. Unlike other low-income countries, Nepal has Improving Competitiveness and Integration not leveraged integration into global markets with Global Markets as a means of accelerating growth. Since 2000, Nepal’s merchandise exports have grown at a Firm productivity and dynamism have been meager 0.5 percent per year and FDI inflows have stagnant, with very few firms engaged in trade remained negligible and substantially below 1 or technology transfer with other countries. percent of GDP. Specifically, in FY2017, FDI The private sector is dominated by a few large inflows were 0.79 percent of GDP or US$198 family-run businesses, but the bulk of firms are million, up 87 percent from US$106 million small and do not grow much over their lifecycle. (in 2016). This contrasts with FDI levels in Only 18 percent of Nepal’s formal firms have Cambodia of 12.55 percent of GDP or Lao PDR more than 20 employees compared to 37 percent of 4.86 percent of GDP. For these Southeast Asian and 43 percent in India and Bangladesh, countries, FDI has been truly transformative, respectively. Estimates of productivity or value helping them to turn into regional export platforms, added per worker in Nepal are less than half those by improving domestic firms’ capabilities and of Bangladesh and less than a third of India’s. market access. Moreover, only a small share of firms’ export possesses internationally recognized quality FDI could be a game changer for Nepal, certificates or use technology licensed from foreign helping it to boost productivity growth. The companies. very low inflows of FDI have been focused on the energy sector, where substantial efforts are needed Merchandise export growth has stagnated, to boost the production capacity necessary for a with exports concentrated in a narrow range stable and reliable supply of energy to households of agricultural and low-value-added and firms. FDI into other productive sectors has manufactured products, to a handful of been lackluster, but if it materialized, could have countries. Firms in Nepal face high tariffs on high impact. One high-potential niche product is intermediate and capital inputs and this, along with medicinal and aromatic plants, for which Nepal’s other supply-side constraints (such as the business biodiversity and topography offers unique environment; access to land, finance; transport opportunities. But for Nepal to become a relevant and energy infrastructure; skills), have limited their global player in this value chain and linked to participation in global value chains. Tariffs on lucrative markets, local producers need to improve inputs in Nepal are over twice those in Vietnam compliance with international standards and ensure and Malaysia, countries that are well integrated sustainability of these rare species by introducing into global value chains. Anecdotal evidence shows improved harvesting and processing practices. exporters are not benefiting from cash incentives and the duty-drawback system (where goods To increase firm productivity and exports, it is imported for manufacturing and export are exempt necessary to raise FDI through development from various duties and taxes) because these of a world-class investment and regulatory schemes are not administered effectively and framework. It also requires reforms to reduce the efficiently. Export subsidies often do not reach the infrastructure gap to support greater competitiveness November 2018 World Bank Group Maximizing Finance for Development Nepal Development Update by enacting the PPP law, developing a pipeline of In addition, the financial sector is dominated PPPs, and addressing constraints to skills and by banks that are constrained in their ability managerial capabilities especially in tourism, to intermediate and provide long-term finance. agribusiness, and information and communications Banks account for 87 percent of financial sector technology (ICT). assets in Nepal. The headline bank capital adequacy ratiois 14 percent and the nonperforming loan Enhancing Financial Inclusion and Capacity ratio is below 2 percent. However, there are for Long-Term Finance concerns over evergreening of bad loans and underprovisioning, vulnerability to exogenous factors (such as earthquakes, trade disruptions, and Improved access to finance, improved remittance slowdowns), and an underfunded safety intermediation, and the development of net. Fueled by remittances and exposed to maturity long-term finance will be crucially important mismatches, the sector is limited in its ability to to channel finance (foreign or local) to perform financial intermediation and maturity productive activities. The ongoing 14th transformation. Loan growth far exceeds deposit Development Plan estimates that 55 percent of mobilization, and the loan-to-deposit ratio has total investment required to implement the plan reached 85 percent, placing pressure on liquidity will be mobilized from the private sector. A and pushing interest rates up. Significant gaps in well-developed financial sector that supports strong the financial infrastructure (for example, limited intermediation and financing will be necessary for credit information, an unutilized secured the private sector to mobilize the needed resources transactions registry, and an underdeveloped for both small and micro-enterprises and large firms. payments system) pose a large constraint to intermediation. Yet, an estimated 40 percent of firms still report access to finance as a major constraint. Capital markets have a long way to go toward These are firms that contribute significantly to job playing a significant role in the provision of creation, but only 9 percent use banks to finance long-term finance. A well-functioning investments, compared to 17 percent on average government debt market is needed for capital nationally. Access is limited by the relatively high market development, as it sets the risk-free rate cost to financial institutions of individual screening and benchmark for pricing other instruments. and due diligence for typically modest loan The government is, however, not issuing sufficient amounts, high reliance on conventional collateral- market-based instruments and is not fulfilling the based lending approaches, and concerns that market-making function. The debt market is borrowers might be accumulating many loans from dominated by short-term government debt, and multiple lenders. A regulatory cap on the spread there is no active yield curve. There are only a few on interest rates that financial institutions (domestic investors in debt instruments, and treasury and international) can charge further reduces their instruments are bought largely by banks to satisfy ability to accurately price in risk or provide statutory liquidity requirements. The equity market long-term financing. In addition, existing legal is also shallow. The stock market needs provisions of the Country Civil Procedure (Code) modernization, and banks and financial institutions Act do not afford foreign financial institutions the make up more than 80 percent of listed companies. same protection as local banks in terms of creditors’ The Securities Board of Nepal lacks autonomy and rights. Priority reforms to support increased access capacity to provide effective risk-based supervision, to finance for SMEs will be to remove financial and a new Securities Act is under discussion. infrastructure constraints to facilitate financial Finally, private equity/venture capital is a novel intermediation, strengthen the legislative and concept (although few private equity funds are in regulatory framework for movable assets, expand operation) and does not have a specific legal and the coverage of the credit bureau, and promote regulatory framework. digital financial services. November 2018 World Bank Group Maximizing Finance for Development Nepal Development Update The assets of insurance companies, pension/ Strengthening Public Investment Management provident funds, and mutual funds can be and PPPs critical in safely funding long-term investment. There are potential domestic institutional investors, Nepal’s public investment has averaged 4 including the Employees Provident Fund, the percent of GDP, which is below average among Citizen’s Investment Trust, and the insurance sector both South Asian and low-income countries. with a combined asset size of around 15 percent There is chronic underspending of the capital of GDP. An important factor inhibiting its budget, with spending averaging about 70 to 80 development includes the capacity of the regulator, percent. According to the list of projects compiled with priority needed on risk-based supervision along from the Annual Development Plans of the with risk-based capital, as well as stronger asset National Planning Commission, projects on average liability management. Insurance companies need have been ongoing for more than 11 years. In capacity building, product diversification, and addition to delays, the budget does not sufficiently price diversity, and the sector lacks awareness support service delivery or allocate resources for and trust. development priorities. Finally, foreign investors are constrained in In addition to public investment in terms of restrictions on foreign exchange, infrastructure, Nepal has also been promoting including regulations linked to off-shore funds, private sector participation to fill its borrowing and capital repatriation. Foreign infrastructure gap. The 14th Development Plan exchange restrictions (more in practice than in the provides a policy framework for infrastructure law itself), make it difficult for small firms and projects, with a focus on the energy, roads, and individuals to open US dollar accounts to pay for airports sectors. The PPP Policy of 2015 services in US dollars. Unclear policies, complex emphasizes the role of private sector participation procedures and inadequate investment facilitation and allows for a range of PPP structures. Priority also constrain investment. For example, the sectors include physical infrastructure, the approval process for foreign loans is not clearly electricity sector, the information and delineated in written guidelines. Rules, regulations communications sector, the urban and rural and directives by NRB and other authorities are environment, education and health-related available only in the Nepalese language. infrastructure and services, and urban amenities. Requirements such as Cabinet approval to mortgage A PPP Law has been drafted and is ready to go to land in favor of foreign lenders, interest rate caps the Cabinet. on foreign currency loans (including for hedging against foreign exchange fluctuations for long Nepal has faced several constraints in its overall tenure loans), and complicated offshore repatriation governance of public investment including the rules including unclear Double Taxation implementation of PPPs; and the mobilization Agreements increase risks for foreign investors. of private participation in infrastructure. PPPs This may require addressing legislative, regulatory, have been few in number and slow to take off. and institutional constraints that disincentivize Since 1990, 37 PPP transactions have reached foreign lending by amendments to the Foreign financial closure, generating a total investment of Investment Act and the issuance or amendments US$2.5 billion. Twenty-three projects closed to notices/circulars by NRB. Establishing a between 2010 and 2017. Of the 37 PPPs, 36 are sovereign rating may also help support these active and one project, amounting to roughly reforms and signal to international investors the US$400 million in investments that achieved government’s commitment to them. financial closure in 2012, is in distress. Private participation in infrastructure is constrained by weak governance and public investment management; inadequate oversight and November 2018 World Bank Group Maximizing Finance for Development Nepal Development Update accountability of public procurement due to weak 2015 Constitution allows local governments to capacity, compliance, and enforcement; lack of borrow, but, commercial borrowing is virtually access to debt and equity financing; regulatory and nonexistent due to weak institutional and fiscal institutional issues surrounding the environment capacities of municipalities, limited capacity of for private participation in infrastructure; and domestic commercial banks and their sector-specific constraints, especially in the inexperience lending to local governments, an transport, energy, and urban sectors. underdeveloped capital market limiting their ability to raise capital, and the lack of a The above constraints are compounded by regulatory framework to facilitate borrowing. factors that deter foreign investors. These Private participation is limited by the inability include the need for multiple approvals, delays in to identify, prepare, appraise, and monitor capital repatriation above US$10,000, absence of projects, weak legal and institutional clear provisions in Nepalese law to protect rights frameworks for PPPs, and failure to adequately of foreign lenders on loan collateral assets (the articulate the role and powers of local exception being hydropower projects), challenges governments. to enforcing judicial awards against the government, wide-ranging authority of Nepalese • The energy sector is characterized by long courts to revise or revoke the enforcement of and complex project development; high costs arbitral awards (that is, Article 30 of the of connective infrastructure; inordinate delays Arbitration Act), and relatively weak corporate in forest clearances, and other approvals; an governance and quality of disclosure. unclear licensing and PPP process; and difficulties in raising debt financing. The In addition, there are sector-specific constraints National Electricity Authority’s financial that impede the efficient and effective use of performance has not been encouraging despite public investment and private participation in an improvement of late, with its financial the transport, urban, and energy sectors. obligations set to increase over the medium term. Transmission and distribution have not • The transport sector is characterized by a kept pace with generation, leading to a lack of prioritization and planning of projects, mismatch. inefficiency created by the problematic relationships between the private and public Putting it all Together – Maximizing sector, and an overall lack of capacity. Funding Finance for Development for Strategic Road Network maintenance is inadequate and capacity for procurement and Table ES.1 summarizes the key reforms contract management is weak; the problem is needed to crowd in the private sector, given exacerbated by the low capacity of the private the above outlined constraints to firm growth sector. Within the airport subsector, the Civil and competitiveness, access to finance and Aviation Authority of Nepal is affected by public investment, and PPP implementation. weak institutional and financial capacity and the The list of reforms in the table are those that are lack of a clear sector strategy and roadmap for most critical to accelerate growth and is not meant airports. to be an exhaustive list. The focus is on increasing firm growth and productivity to support links to • In the urban sector, municipalities face a global markets and higher exports. This would need severe lack of functional capacity, and limited to be underpinned by measures to improve financial processes and systems for capital investment intermediation, access to finance and long-term planning and financial management, impacting financing, including easing restrictive policies on accountability, credit worthiness, and the ability borrowing from foreign lenders, foreign finance, to plan and execute allocated budgets. The and the development of capital markets. These November 2018 World Bank Group Maximizing Finance for Development Nepal Development Update would need to be complemented with reforms to strengthen public investment management, including PPPs to support infrastructure finance and issues of contingent liability and debt management. Overall, for Nepal, Maximizing Finance for Development (MFD) will require a systematic approach to leveraging all sources of finance, expertise, and technologies to accelerate growth and enable the country to reach middle-income country status and achieve the Sustainable Development Goals. As noted in this Nepal Development Update (NDU), the financing needs far surpass available public resources and available donor funding. It is therefore necessary to find ways to crowd in all possible sources of finance, innovation, and expertise, particularly from the private sector. For the exercise to be effective and successful the GoN would need to closely engage with the private sector and take their needs into account in designing reforms. Public resources and development partner assistance could then focus on areas where private financing is not forth coming or viable. November 2018 World Bank Group Maximizing Finance for Development Nepal Development Update Table: ES.1. Priority Reforms to Maximize Finance for Development and Crowd in the Private Sector for Nepal’s Accelerated Growth Key Constraint Selected Key Recommendations and Priority Interventions Improving Competitiveness and Integration with Global Markets Complex procedures for firm • Introduce a single-window interface to facilitate regulatory compliance entry and operations • Establish mechanisms to promote public-private-sector dialogue (such as the Nepal Business Forum) High cost of trade, which • Adopt measures to facilitate trade and deepen integration by lowering import undermines exports tariffs, streamlining border processes to reduce time and cost of trading, making the duty drawback accessible to both direct and indirect exporters, simplifying certification rules and providing faster duty refunds, and providing support to firms to meet the Generalized System of Preferences rule of origin FDI restricted through limits • Adopt measures to promote FDI by reducing and rationalizing the negative on foreign exchange, foreign list; adopting a revised Foreign Investment Act aligned with international borrowing, repatriation of practice and obligations; streamlining investment approvals, repatriation, and funds; unclear FDI policies exit; and reassessing interest rate caps on foreign currency loans; and clarifying the rules on funds repatriation and Double Taxation Agreements Outdated land acquisition law; • Adopt measures that facilitate increased firm/investor access to land by poor land records; weak implementing land zoning, updating the Land Act and making it consistent institutions that make it with the Land Acquisition Policy, and developing industrial parks tailored to difficult to deploy land for specific industries productive uses Low availability of highly • Facilitate improved skills of the labor force and managerial capabilities by skilled workers investing in domestic skills, simplifying visa procedures for skilled foreign workers, and introducing publicly supported management extension programs for firms in key sectors. Sector-specific constraints • Ease sector-specific constraints by (a)Tourism: upgrading airport safety, that limit exports and improving road access to key destinations, allowing investments in protected economic growth areas that are aligned with conservation; (b) Agribusiness: allowing private sector participation in distributing fertilizers, seeds; identifying priority activities to improve food safety to facilitate access to higher-value markets; and (c) ICT: improving the existing IT park through greater private sector investment Enhancing Financial Inclusion and Capacity for Long-Term Finance Low access to finance and • Increase access to finance for SMEs by strengthening the legal and regulatory limited-to-nonexistent facility framework for movable assets; expanding coverage of the credit bureau; for long-term finance and promoting digital financial services weak capital markets • Develop a long-term capital market by regularly issuing government bonds to create and maintain a yield curve; further developing capital markets by strengthening the independence and capacity of the securities supervisor and November 2018 World Bank Group Maximizing Finance for Development Nepal Development Update updating the legal infrastructure of the securities market; adopting legal and regulatory reforms for alternative investment funds to promote private equity and venture capital • Strengthen the capacity of institutional investors by strengthening the independence of the insurance sector supervisor, the capacity for risk supervision and asset liability management • Reinforce and signal to investors government commitment to reforms by establishing a sovereign rating Strengthening Public Investment Management and PPPs Weak public investment • Establish a coordinating mechanism for infrastructure (or an infrastructure management and coordination unit) to support strategic planning, selection, prioritization, and coordination for selecting and implementing among agencies projects • Improve the quality of public investment by strengthening capital project screening, appraisal, prioritization including contingent liabilities; building capacity within NPC and selected line ministries with large capital investments; developing an integrated database of projects within the central coordinating unit Weak PPP laws and • Strengthen the PPP Law and including a contingent liability framework by framework including missing reviewing the draft PPP Law with respect to the roles of the National processes and limited Planning Commission, Investment Board of Nepal and Ministry of Finance, coordination across relevant and also in relation to the key sector-specific issues in energy, transport, and agencies urban • Develop PPP guidelines and a pipeline of PPPs clearly articulating functional roles and responsibilities and the treatment of local government projects, identification, screening, preparation, procurement and including unsolicited projects, guidelines of managing fiscal commitments and liabilities; prioritizing PPP investments and allocating financing according to risk, with commercial financing taking priority if it is available and cost-effective • Address key constraints in core infrastructure sectors by (a) preparing a transport master plan and a program that consists of a few strategically important and economically high-priority projects under the Strategic Roads Network using performance-based contracts, adopt a strategic plan for airports along with a financing plan and operations and maintenance contracts; (b) fast-tracking the pipeline of independent power producers (IPPs) in the energy sector through clarifying the licensing and permitting, facilitating land acquisition and forest clearances, supporting long-term financing and complementary investments in transmission and distribution; and (c) improving credit worthiness of local bodies and identifying projects for private participation in the urban sector Poor public and private • Increase awareness around the appropriate use and role of PPPs by sector awareness of the designing and delivering a communications strategy and capacity-building important and appropriate program for both public and private stakeholders that outlines the GoN’s role of PPPs limits their objectives, implementation timeline and approach, stakeholders, and development messages for each category of stakeholder November 2018 World Bank Group Maximizing Finance for Development Nepal Development Update ............................................................................................................................................................................................................................................................................................................................................................ A. Recent Economic Developments ............................................................................................................................................................................................................................................................................................................................................................ Recent Economic Developments only to 0.6 percent of GDP, low by international standards. Nepal’s economy grew by 6.3 percent in FY2018 despite less favorable monsoons and On the supply side, the main growth drivers the easing of rapid growth that ensued were the service and industry sectors (Figure following the trade blockade in FY2016 3). Both tourist seasons – Autumn 2017 and Spring (Figure 1). On the demand side, investment drove 2018 – during the fiscal year saw record levels of overall Gross Domestic Product (GDP) growth, tourist arrivals (Figure 4). Furthermore, with with gross fixed capital formation contributing 4.4 continued strong remittance growth (see further percentage points, led by private domestic growth analysis below), consumption continues to boost of close to 16 percent. Public sector investments the service sector, as well. Together these have were supported by post-earthquake housing supported growth in the retail (9.1 percent y/y) reconstruction, which is in full swing. Of the and hotels and restaurants (9.8 percent y/y) 707,443 beneficiaries eligible for housing grants, subsectors of the service sector. Industry grew by over 88 percent have been enrolled in the program 8.8 percent (y/y) in FY2018, well above its 25-year and received the first tranche as of August–end average of 4 percent. The elimination of load 2018 (Figure 2). More than 71 percent of houses shedding has enabled greater capacity utilization. are now under construction, with a disbursement This has been possible through better electricity rate of 67 and 40 percent, respectively, for the management by the Nepal Electricity Authority second and third tranches. Foreign direct (NEA), and the additional 102 megawatts added investment (FDI) also grew by a healthy 32 percent to the national grid through the commissioning of year-over-year (y/y) in FY2018 to reach a record new hydropowerplants and electricity trade with US$168 million. The growth in FDI suggests a India. growing appetite to invest in Nepal by international investors such as Hongshi-Shivam Cement and Huaxin Cement Narayani. Still, FDI is equivalent November 2018 World Bank Group 1 Maximizing Finance for Development Nepal Development Update Figure 1. Investments are increasingly contributing Figure 2. …supported by housing reconstruction, more to GDP growth… which is in full swing as the second and third tranche disbursements have picked up Sources: Central Bureau of Statistics and World Bank staff Source: Ministry of Urban Development. estimates. Figure 3. Service sector continues to drive growth… Figure 4. …with tourist arrivals reaching record levels during the two FY2018 tourist seasons Sources: Central Bureau of Statistics and World Bank staff Source: Department of Immigration and World Bank staff estimates. calculations. Strong growth globally and in the South Asia South Asia, India’s strong growth between 2017 Region has helped buoy growth in Nepal. and 2018, driven by the recovery of investments, Despite the tightening of financial conditions carried regional growth. However, expansionary globally and higher-than-expected oil prices, growth policies in many South Asian countries have led in advanced economies remained robust. Continued to increasing fiscal and current account deficits recovery in commodity-exporting emerging markets and inflation. and developing countries also helped keep global growth stable in 2018. Robust growth in advanced Inflation remained subdued throughout the economies should help sustain tourist arrivals. fiscal year and was 4.0 percent (y/y) in July However, a faster-than-expected rise in global interest 2018 (Figure 5). After reaching a 13-year low of rates, combined with renewed strength of the U.S. 2.3 percent (y/y) in August 2017, inflation picked dollar has moderated capital inflows to emerging up during the first half of the fiscal year driven by markets and developing economies (World Bank non-food items, which contributed 2.9 percentage 2018a). If this trend continues, it could have a points to headline inflation in July 2018, before moderating effect on remittance flow to Nepal. In moderating again during the second half of the November 2018 World Bank Group 2 Maximizing Finance for Development Nepal Development Update year. However, the contribution of food prices has mirrors the trend in India, which was -0.3 percent also grown to 1.7 percentage points in July 2018 in July 2017 but rose to 1.3 percent in July 2018, compared to -0.4 percentage points the previous since Nepal’s inflation generally follows India’s with year. This sharp increase in food inflation (y/y) a lag (Figure 6). Figure 5. Inflation was driven by non-food prices Figure 6. Price differential with India was largely but remained low throughout the fiscal year neutral throughout FY2018 Sources: NRB and World Bank staff calculations. Sources: NRB, Ministry of Statistics & Program Implementation of India, and World Bank staff calculations. Exports growth accelerated to reach 15.6 these two countries has resulted in them becoming percent (y/y) in FY2018 (Figure 7). Nepal’s the fourth and third-largest export destinations, exports are recovering from the trade disruption accounting for 5.5 percent and 5.3 percent of total of FY2016. While India continues to be the exports, respectively, as of July 2018 (Figure 10). destination of exports (Figure 8), Nepalese exports are reaching new markets such as China and Imports surged by 27.8 percent (y/y) in the last Turkey. Exports to China grew by 184.9 percent quarter of FY2018 to yield the largest import (y/y) in July 2018 (Figure 9) and exports to Turkey bill in Nepal’s history(Figure 11). With average rose by 100 percent (y/y) between April 2016 and monthly imports of US$979 million during FY2018, February 2018. The high growth of exports to monthly imports were more than one-and-half-times Figure 7. Exports picked up during FY2018… Figure 8. …driven by exports to India, China, and Turkey… Sources: NRB and World Bank staff calculations. Sources: Department of Customs and World Bank staff calculations. November 2018 World Bank Group 3 Maximizing Finance for Development Nepal Development Update greater than the average of US$614 million during reconstruction activities, increased infrastructure the previous five years. Oil imports increased over investment, and the uptick in industrial activity. the course of the fiscal year, reflecting higher oil Some of this was also driven by the federalism prices in global markets. transition, as the process of establishing local governments continues, including the construction Non-oil imports, consisting mainly of of offices and other capital investments. Consumer industrial supplies and capital goods, goods imports also grew, contributing 1.9 contributed 10.7 percentage points and 4.2 percentage points to growth, as remittance inflow percentage points, respectively, to overall into the economy continued to drive consumption import growth. This is due to ongoing (Figure 12). Figure 9. Exports to these countries have grown Figure 10. …resulting in the increase of their rapidly … shares in total exports Sources:Department of Customs and World Bank staff Sources: Department of Customs and World Bank staff calculations. calculations. Figure 11. While imports continued to grow in Figure 12. …driven by industrial supplies and double digits… capital goods Sources: NRB and World Bank staff calculations. Sources: Department of Customs and World Bank staff calculations. Officially recorded remittances rose to US$7.2 closed some agencies that process visas for billion, but eased as a share of GDP to 25.1 Nepalese migrant workers due to concerns about percent (Figure 13 and Figure 14). The gain came overcharging migrant workers. In the Gulf despite contracting outflows of migrant workers countries, 1 fiscal pressures led to expenditure cuts due to policy actions in destination countries that might adversely affect the demand for migrant (Figure 15). Malaysia, the largest destination of workers. In this context, higher remittance receipts Nepalese migrants (or 29 percent of the total), may be due to the depreciation of the Nepalese rupee 1 Bahrain, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, and theUnited Arab Emirates. November 2018 World Bank Group 4 Maximizing Finance for Development Nepal Development Update against the U.S.dollar, encouraging migrant workers Figure 13. Remittances (in US$, millions) continue to remit a greater share of their savings to benefit to rise… from the favorable exchange rate. In addition, Nepalese migrants are increasingly going to and remitting money from Japan and the Republic of Korea, where wage rates are much higher. The widening trade deficit was partially offset by remittance growth, leading to a substantial increase in the CAD to US$2.4 billion, 8.2 percent of GDP (Figure 16). With the trade deficit reaching US$10.9 billion, and remittances unable to cover it as in the past, and given that FDI and external borrowing and other financing sources remained low, Nepal’s foreign exchange reserves Sources: NRB and World Bank staff calculations. fell to US$9.3 billion in July 2018 from a peak of S$9.5 billion in January 2018. This is still equivalent to a comfortable 8.3 months of imports (Figure 17). Figure 15. …and migrant worker outflows to major Figure 14.… as its share in GDP is declining… destination countries also declined Sources: NRB and and World Bank staff calculations. Source:Department of Foreign Employment and World Bank staff calculations. Figure 16. These trends, coupled with faster Figure 17. …causing a decline in the accumulation growth of the trade deficit relative to remittances, of foreign reserves, though the import cover are widening the CAD… remains adequate at 8.3 months Source: NRB. Source: NRB and World Bank staff calculations. November 2018 World Bank Group 5 Maximizing Finance for Development Nepal Development Update Money supply (M2) growth was above target. Figure 18. Money supply (M2) growth picked up At 19.3 percent (y/y) growth as of July 2018 as private sector credit growth accelerated… (Figure 18), M2 growth was above the FY2018 monetary policy target of 18 percent. Of that growth, private sector credit was the main force, contributing 17.2 percentage points. Net claims on government contributed 3.3 percentage points to M2 growth, due to increased government domestic borrowing and increased expenditure arising from the transition to federalism, among other spending needs. Sources: NRB and World Bank staff calculations. Credit growth picked up as lending to all sectors increased. Credit growth rose steadily during the second half of the fiscal year to reach 22.4 percent (y/y) in July 2018 driven by increased Figure 19.…due to increased credit to all sectors, lending to all sectors (Figure 19). Lending to the especially the service sector service sector contributed the most to credit growth (at 10.2 percentage points), while the contribution to credit growth of lending to industry and agriculture rose to 4 and 2.3 percentage points, respectively. These trends are in line with the recent uptick in industrial activity observed during FY2018. Specifically, there may have been more take-up of working capital loans in the industrial sector as capacity utilization increased with the improved availability of electricity. In the case of agriculture, the better implementation and Sources: NRB and World Bank staff calculations. monitoring of the 5 percent subsidy policy for agricultural and livestock loans together with policies2 to push commercialization have helped farmers access more loans. Figure 20. Deposits growth also picked up Deposits picked up but continued to lag behind credit growth. Deposits grew by 18.8 percent (y/y) in July 2018 (Figure 20). Individual deposits contributed the most (11 percentage points in July 2018) to deposit growth mainly due to the uptick in remittance inflows in the last quarter of FY2018. Source: NRB and World Bank staff calculations. 2 NRB’s Productive Lending directive requires banks to invest 10 percent of their total loan portfolios in the agriculture sector. November 2018 World Bank Group 6 Maximizing Finance for Development Nepal Development Update The banking sector’s CCD ratio remains close weighted averages of lending and deposit rates, to the regulatory limit. As deposit growth which had risen sharply during the credit crunch continues to trail credit growth, the banking sector’s in mid-FY2017, remain high at 12.3 percent and CCD ratio was 76.8 percent in July 2018 (Figure 21), 6.5 percent, respectively, as of July 2018 just shy of the 80 percent regulatory limit set by the (Figure 22). Nepal Rastra Bank. As a consequence, the Figure 21. The banking sector continues to push Figure 22. …causing the weighted average interest close to its regulatory limits for the CCD ratio… rates to remain high Source: NRB and World Bank staff calculations. Source: NRB. Domestic revenue collection was largely due the target. The growth in tax collection was to taxes on growing imports (Figure 23). Tax supported by a high import bill. Taxes and levies revenues in FY2018 grew by nearly 1percentage on imports (including the value-added-tax and point of GDP to reach 21.9 percent of GDP. excise on imports) was 9.6 percent of GDP in Non-tax-revenue collection was above the target FY2018, up from 9.1 percent of GDP in FY2017 projected in the FY2018 budget. This helped (Figure 24). domestic revenue collection reach 99.8 percent of Figure 23. Revenue growth remained healthy… Figure 24. …due to taxes on international trade, which accounted for nearly 10 percent of GDP Sources: NRB and World Bank staff calculations. Sources: Ministry of Finance and World Bank staff calculations. November 2018 World Bank Group 7 Maximizing Finance for Development Nepal Development Update Expenditure has also grown but remains below total capital expenditure was spent in the final four target (Figure 25). While total expenditure grew by months of the fiscal year in FY2018 (Figure 26). 3.7 percentage points of GDP to reach 31.2 percent While this is an improvement over past years, where of GDP in FY2018, it amounted to only 82.4 on average 70 percent was spent in the final trimester percent of the budgeted expenditure. Recurrent of the fiscal year, it is still a very large proportion of expenditure reached 23.3 percent of GDP, with fiscal the budget. Further, the spending rate is well below transfers to subnational governments comprising 8.3 the planned amount. In FY2018, only 71.2 percent of percent of GDP. It is the largest budget item in the the planned capital and 82.4 percent of the total Nepal government’s budget. Even when accounting budget was spent (Figure 27). Yet, over the last few for preexisting grants to local governments that may years, capital and total expenditure have grown as a have been transferred through the new Fiscal Transfer share of GDP (Figure 28). One of the reasons for budget code, it still amounts to approximately 5.5 both last trimester bunching and underspending of percent of GDP. With such large transfers being the capital budget is that funds are not released in provided to subnational governments, it is imperative time for projects to start as scheduled in the fiscal year. for Nepal to ensure robust public financial management Another reason is that funds continue to be allocated systems are in place across all three tiers of government, to projects that are not ready for implementation. to ensure accountability and transparency in public Poor budget execution can have severe consequences expenditure. As such, the GoN is conducting a for the future growth potential of the economy. It Federalism Needs Assessment to assess capacity gaps reduces the amount of infrastructure built and ready and help inform the transition to the federal structure. to use within a given year and compromises its quality, which leads to frequent renovation, does not maximize Final trimester bunching and underspending of the value of funds spent, and hinders productivity. capital expenditure persists. About 64 percent of Figure 25. Government expenditure increased Figure 26.…but last trimester bunching of capital significantly in FY2018… expenditure persists Sources: NRB and World Bank staff calculations. Sources: NRB and World Bank staff calculations. Figure 27. And underexecution of the budget, Figure 28. …while expenditure as a share of GDP especially the capital budget, continues… increases Source: Ministry of Finance. Sources: Ministry of Finance. November 2018 World Bank Group 8 Maximizing Finance for Development Nepal Development Update Underspending of the budget coupled with reforms are needed to establish a well-functioning the achievement of revenue targets has helped capital market that supports long-term financing, contain the fiscal deficit and keep debt at particularly for infrastructure. prudent levels. However, the fiscal deficit has been on a widening trend, (driven mainly by The government will also need to ensure spending linked to the establishment of local revenue generation is efficient, transparent, governments). The fiscal deficit is largely financed and progressive. The FY2019 budget outlines by domestic debt. In FY2018, total public debt, as reforms to increase revenue through widening the a share of GDP, increased by 4 percentage points tax base and streamlining the tax system. To (Table 1). Domestic debt accounted for 72 percent expand the tax base the government will focus on of the increase in total public debt. Given the modernizing tax administration. To ensure financial remaining work and resources needed to complete transparency, the government plans to link tax the transition to federalism, it will be important payer systems and financial institutions to the for the GoN to address the ongoing problem of government’s tax administration through a digital underspending of the budget. This implies the system. Further, the development of a tax payer need to strengthen implementation of the information system is proposed to integrate the Medium-Term Expenditure Framework (MTEF) tax payer information that exists in various at the national level and to build capacity for regulatory bodies into a single system to enhance planning and budgeting/budget execution at the efficiency and transparency. To develop a more local levels, particularly public investment progressive tax system, individual income tax rates management. It will also be important to raise have been revised to 10, 20, and 30 percent from domestic revenue. the previous tax rates of 15 and 25 percent. The excise tax has been increased on alcohol and Measures to address underspending of the tobacco-based goods, as well as luxury goods. capital budget will be particularly important to effectively crowd in the private sector In the transition to federalism, timely resources needed to accelerate GDP growth. implementation of reforms is of critical Currently, public investment is insufficient to crowd importance. The focus should be on reforms to in the private sector and improve service delivery. ease infrastructure constraints and improve the Nepal is ranked 105th out of 190 countries in the business and investment environment. As noted, World Bank’s 2018 Doing Business Indicator. The the Needs Assessment (being conducted with majority of firms identify infrastructure gaps as a support from the World Bank and United Nations major impediment to the business and investment Development Programme), will help identify climate. The Special Focus section of this NDU priority areas for building capacity at local levels discusses these challenges and outlines reforms and shed more light on the additional resources needed to crowd in the private sector. While the needed. It would inform identification also of the government has recently made attempts to tackle critical bottlenecks to planning, public investment transportation syndicates and cartels, other forms management, budget execution, and revenue of cartels continue to exist, limiting competition capacity at the subnational levels. and distorting markets. Slow issuance of clearance and permits for projects continues to hinder project implementation. Outdated and ambiguous laws impede commercial arbitration, for which there needs to be trained commercial judges who can provide effective and efficient commercial dispute resolution and enforce contracts. The financial sector and dynamism need to be enhanced to support the growth of smaller firms. In addition, November 2018 World Bank Group 9 Maximizing Finance for Development Nepal Development Update ............................................................................................................................................................................................................................................................................................................................................................ B. Outlook, Risks, and Challenges ............................................................................................................................................................................................................................................................................................................................................................ Outlook GDP growth is projected to average 6 percent sector will continue as the availability of reliable over the medium term driven primarily by electricity improves and the large cement factories investments. Agriculture growth in FY2019 is come online in FY2019. Services are expected to expected to increase on the back of a good grow at an average of 6.3 percent per year over the monsoon supporting paddy output. Industry and forecast period. Steady remittance inflows will services growth rates will be sustained. Overall, support growth in retail and wholesale trade. The growth is projected to remain strong as the continuation of high tourist arrivals is expected as government shifts from consumption- to the GoN implements the Visit Nepal 2020 investment-based growth (Table 1). program with the aim of attracting 2 million visitors per year, which will boost growth in the On the supply side, services are expected to hotels and restaurants subsector. continue to drive growth, with the agriculture and industry sectors contributing more to On the demand side, gross investment is overall growth. Agriculture growth is projected expected to drive growth. The government has to reach an average 4.3 percent per year over the emphasized engaging the private sector and raising forecast period. It will be supported by new the low levels of FDI through increasing programs announced by the GoN that include investment by 4 percentage points of GDP by 2021. investments for improved inputs and storage The increase in FDI in FY2018 is a good start. facilities including irrigation, modernization, Reforms will focus on strengthening the framework commercialization, mechanization, and the for infrastructure development. Work on two expansion of value chains. Industry growth is international airports and road projects will help likely to remain a healthy 8.4 percent per year over boost investment, and gross fixed capital formation the forecast period as construction and growth is expected to remain strong during the manufacturing continue to perform well. forecast period. Government consumption is Reconstruction activities will continue through expected to grow significantly in FY2019 as the FY2019. Capacity utilization in the manufacturing fully established provincial and local governments November 2018 World Bank Group 10 Maximizing Finance for Development Nepal Development Update begin operations. However, government percent, and maintain at least eight months of consumption growth will moderate and taper off foreign reserves. in the future as the establishment of subnational governments concludes. The CAD, which grew in FY2018, is expected to narrow over the forecast period as the trade Inflation is expected to accelerate slightly in deficit moderates. Imports are expected to FY2019 but remain within the GoN’s target. continue to grow but at a slower rate, while exports The Nepalese economy is expected to face some will pickup slightly with the strengthening of the inflationary pressures during FY2019 due to manufacturing sector. While there is some public-spending-induced aggregate demand and uncertainty, remittances as a share of GDP are from rising petroleum prices in global markets. expected to ease further, given the dip in the NRB’s stated monetary policy stance is to maintain outflow number of migrant workers. The cumulative the exchange rate peg with the Indian rupee, effect will likely be slower growth of the trade ensure adequate liquidity to support growth, deficit. By 2020, the CAD is expected to moderate achieve domestic credit growth of around 22 to 6.8 percent of GDP. Table 1: Macroeconomic Projections of Selected Key Indicators 2015 2016 2017 2018e 2019f 2020f Real GDP growth, at constant market prices 3.3 0.6 7.9 6.3 5.9 6.0 Private Consumption 2.9 -0.7 2.6 2.5 4.7 4.7 Government Consumption 7.4 -0.4 10.4 9.4 30.2 7.0 Gross Fixed Capital Investment 19.6 -12.3 44.2 15.7 13.2 7.7 Exports, Goods and Services 6.8 -13.7 13.7 4.4 7.6 9.5 Import, Goods and Services 9.6 2.8 30.3 14.8 12.7 6.2 Real GDP growth, at constant factor prices 3.0 0.2 7.4 5.9 5.9 6.0 Agriculture 1.1 0.2 5.2 2.8 4.0 4.5 Industry 1.4 -6.4 12.4 8.8 8.8 8.0 Services 4.8 2.3 7.4 7.1 6.2 6.3 Inflation (Consumer Price Index) 7.2 9.9 4.4 4.0 4.7 4.7 Current Account Balance (% of GDP) 5.1 6.2 -0.4 -8.2 -7.8 -6.8 Fiscal Balance (% of GDP) 1.0 1.4 -3.1 -5.8 -5.8 -5.5 Debt (% of GDP) 25.6 27.9 26.6 30.5 32.7 35.2 Primary Balance (% of GDP) 1.5 1.8 -2.8 -4.9 -4.8 -4.2 Source: World Bank, Poverty & Equity and Macroeconomics, Trade & Incestment Global Practices. Notes: e = estimate, f = forecast Risks and Challenges Nepal is vulnerable to external pressures. Effective response mechanisms would be needed External shocks to outmigration and remittances to deal with natural disasters and mitigate the can lead to a deterioration of the balance of country’s vulnerability to climate change, which payments, a reduction in growth of savings could have serious consequences for growth deposits, and a shortage of loanable funds and overall and development of agriculture and credit. Such a shock would also lower consumption agribusiness. Also, Nepal is susceptible to and adversely affect growth and poverty reduction. earthquakes. Another earthquake of the magnitude Nepal is also vulnerable to climatic shocks that experienced in 2015 would seriously damage could disrupt growth and push vulnerable existing infrastructure, causing an even larger populations into poverty. Droughts are becoming infrastructure gap. The resulting loss of GDP more frequent in Nepal, particularly in the winter would set the country back several years in terms months and in the western Terai plains, which are of reaching its middle-income-country goal. dry due to the late arrivals of the monsoons. November 2018 World Bank Group 11 Maximizing Finance for Development Nepal Development Update The implementation of federalism offers Transfers to subnational governments are 8.3 transformational opportunities but also percent of GDP in FY2018 and are expected to considerable challenges for crowding in private increase further as federalism proceeds. Setting investment. Enhancing implementation capacities up physical infrastructure, IT systems and human of subnational governments and establishing resources is expected to continue for the next two systems to track spending is urgent, as is the or three years. Raising the revenue potential of continued transfer of functions and functionaries subnational governments will be critical, as will be to their equivalent provincial and municipal levels. their capacity to implement their projects and This is required to strengthen budget execution, to programs. Overall, tax reform, including a ensure public expenditure is efficient and broadening of the tax base, will help increase productive and improve public service delivery. revenue to 29 percent of GDP over the medium Expanding revenue to meet the resource needs of term. Public debt as a share of GDP will increase federalism will also be a challenge. but will remain manageable at under 40 percent of GDP over the medium term, assuming large Reforms are needed to strengthen the PFM government deposits and continued low external system to inform decentralized decision debt levels. making and service delivery. An annual budgeting process is in place at the subnational Risks to the outlook arise primarily from the level with guidelines issued by the Ministry of transition to and implementation of federalism, Federal Affairs and General Administration including the resource and capacity needs. (MOFAGA), including accounting processes to Failure to raise the needed resources to meet the underpin the budget process. However, existing IT projected increase in spending could undermine systems are fragmented and not all local service delivery or lead to a significant deterioration governments have adopted the subnational PFM of the fiscal position. In that regard, there is an system called SUTRA. Those local governments urgent need to expand the revenue capacity of that have not yet adopted SUTRA have to manually subnational governments. Measures will also be upload their spending data to report on their needed to strengthen the implementation capacity spending. Furthermore, revenue accounting, billing, of subnational governments to plan, budget, and and collection are not captured in SUTRA, and execute their programs, including systems for each locality uses its own system. wA Revenue tracking spending and the appropriate level of Management Information System (RMIS) is only staffing. It will be particularly important to fully operational at the federal level for tax implement reforms that crowd in the private sector collection. to facilitate higher levels of investment. The multiple challenges underpinning the federalism Weak or incomplete systems, processes, and process necessitate a comprehensive roadmap that capacity at the subnational level pose an harmonizes approaches across the three tiers of immediate risk to the use and management of government, covering reforms to enhance resources, especially funds allocated for local functions, functionaries, and funding. governments. For example, medium-term planning or a three-year MTEF will take some time to Slow implementation of reforms would implement at subnational levels given the difficulty undermine initiatives to crowd in the private of recording expenditures for local governments. sector and increase investment. Key reforms are Local governments do not know the provisions in required to increase private sector investments, the law or that they are required to do three-year especially for FDI, and the establishment of PPPs budgets. An MTEF requires a good overview of needed to close the infrastructure gap. Delays in local revenue. But, local governments are unable to reforms that crowd in private sector investment forecast revenue, and revenue sharing information could risk the GoN’s aim of shifting to from the federal level will need to be solidly in place. investment-led growth. A critical reform will entail Also, there is a heavy reliance on fiscal transfers. increasing the dynamism of the financial sector, These weaknesses and shortcomings, if not unlocking investment bottlenecks, and developing addressed, could undermine the ability to provide long-term finance. The next section outlines the the services necessary to crowd in the private sector. key reforms for scaling up private investment. November 2018 World Bank Group 12 Maximizing Finance for Development Nepal Development Update ............................................................................................................................................................................................................................................................................................................................................................ C. Special Focus - Priority Reforms to Maximize Finance for Development and Crowd in the Private Sector for Accelerated Growth ............................................................................................................................................................................................................................................................................................................................................................ Nepal is poised to embrace a new development Improving Competitiveness and Integration model for a “Prosperous Nepal, Happy with Global Markets Nepalese,” by achieving faster growth to become a middle-income country by 2030. Firm productivity and dynamism have been Growth rates of at least 7 to 8 percent will be stagnant. The private sector is dominated by a few imperative. To achieve these levels of growth, the large family-run businesses, but the bulk of firms are small and do not grow much over their lifecycle. government targets a 10-percentage-point increase Only 18 percent of Nepal’s formal firms have in the investment rate by 2021. But, this can only more than 20 employees compared to 37 percent happen with a shift from remittance-led and and 43 percent in India and Bangladesh, respectively. consumption-based growth to one that is investment Estimates of productivity or value added per and productivity driven. worker in Nepal are less than half those of Bangladesh and less than a third of India’s.3 Business as usual will not be sufficient to accelerate growth and achieve middle-income Very few firms engage in trade or technology -country status by 2030. The GoN’s new growth transfer with other countries. Only 5.1 percent model aims for growth fueled by higher levels of of Nepalese formal firms export (directly or investment, productivity, and effective public indirectly) compared to 21.8 percent and 8.8 institutions to facilitate private sector dynamism, percent in Bangladesh and India, respectively. Firms in Nepal trail behind other countries in the and will require reforms to (a) improve the region in the adoption of ICT technology. Only competitiveness of the private sector and integrate about 49 percent of formal Nepalese firms with global markets; (b) strengthen the financial regularly use computers compared to the South sector through development of long-term financing Asian average of 68 percent. Moreover, only a instruments; and (c) strengthen the framework for small share of firms’ exports possess internationally infrastructure finance, including PPPs. recognized quality certificates or use technology licensed from foreign companies. 3 Estimates in PPP terms from World Development Indicators, Staff calculations. November 2018 World Bank Group 13 Maximizing Finance for Development Nepal Development Update While trade and investment can be important inflows were 0.79 percent of GDP, or US$198 drivers of growth, Nepal has been lagging on million, up 87 percent from US$106 million in this front. Even after accounting for size, FY2016. This contrasts with FDI levels in remoteness from main markets, and its landlocked Cambodia of 12.55 percent of GDP or Lao PDR status, Nepal’s overall export and import of 4.86 percent of GDP. For these Southeast Asian performance is below average and has worsened countries, FDI has been truly transformative, relative to the 1990s. While Nepal has performed helping them turn into regional export platforms, well in exports of services in recent years, this has by improving domestic firms’ capabilities and not compensated for the poor performance in market access.4 merchandise exports. FDI could be a game changer for Nepal, Merchandise export growth has stagnated, with helping it boost productivity growth. The very exports concentrated in a narrow range of low inflows of FDI have been focused on the agricultural and low-value-added manufactured energy sector, where substantial efforts are needed products, to a handful of countries. Firms in to boost the production capacity necessary for a Nepal face high tariffs on intermediate and capital stable and reliable supply of energy to households inputs and this, along with other supply-side and firms. FDI into other productive sectors has constraints (such as business environment; access to been lackluster, but if it materialized, could have land, finance; transport and energy infrastructure; high impact. Take the example of the underexploited, skills), have limited participation in global value yet high-potential activity of medicinal and chains. Tariffs on inputs in Nepal are over twice of aromatic plants, for which Nepal’s biodiversity and those in Vietnam and Malaysia, countries that are topography offers unique opportunities. Many of well integrated into global value chains. While these plants are used as ingredients in traditional exporters in Nepal can potentially benefit from the and modern medicines, cosmetics, perfumes, and duty-drawback system (where goods imported for culinary products. But for Nepal to become a manufacturing and export are exempt from various relevant global player in this value chain and linked duties and taxes) and cash incentive schemes, to lucrative markets, local producers need to improve anecdotal evidence from exporters suggests that compliance with international standards and ensure these schemes are not administered effectively and sustainability of these rare species by introducing efficiently and that export subsidies often do not improved harvesting and processing practices. reach the intended firms due to the complex filing This is exactly what happened when the Indian procedures, limited resources, and a first-come, multinational company, Dabur International, first-served allocation mechanism. Trade facilitation invested in Nepal. A resource- and market-seeking efforts, including the strengthening of the Bhutan, investor, Dabur’s Nepal-based subsidiary introduced Bangladesh, India and Nepal (BBIN) transit higher standards and extension services to its local agreement, are also needed for Nepalese exporters suppliers, helping to improve the quality and ensure to reach ports at reduced transport costs. the sustainability of locally sourced medicinal and aromatic plants. The company now produces for Unlike other low-income countries, Nepal has both the domestic and the export market, with sales not leveraged integration into global markets growth generating new jobs for Nepalese and tax as a means of accelerating growth. Since 2000, revenues for the government. Needed reforms could Nepal’s merchandise exports have grown at a focus on creating the environment to bring in more meager 0.5 percent per year and FDI inflows have firms to invest in other viable value chains. remained negligible and substantially below 1 percent of GDP. Specifically, in FY2017, FDI 4 Instead, in Nepal, evidence suggests that exporters remain small and struggle to increase shipments once they enter new markets. In addition, they underutilize granted trade preferences, often due to limits linked to managerial and bookkeeping capabilities to comply with rules of origin. FDI could help overcome some of these challenges (Narain and Varela 2017). November 2018 World Bank Group 14 Maximizing Finance for Development Nepal Development Update Nepal needs a world-class investment and tourist destinations in Nepal. There have been regulatory framework to attract foreign investors. concerns about anticompetitive behavior in the The 2017–18 Global Investment Competitiveness transport sector, including collective price fixing Report revealed that in addition to political stability, and regional truck and bus syndicates. Besides a business-friendly regulatory environment was transport, Nepal also lags behind in other paramount in the decision of multinational dimensions of infrastructure, such as digital access, corporations to invest in a developing country. In electricity consumption per capita, and transmission Nepal, the FDI regulatory environment demands losses in the power sector. In fact, according to the some changes. First, the processes for the repatriation 2013 Enterprise Survey, two-thirds of Nepalese of funds and for hiring foreign workers needs to be firms operating in the formal sector identified simplified. Regarding the repatriation of funds, electricity as a major constraint and about a third while the law does provide foreign investors the considered transport a major constraint. right to repatriate funds related to foreign investment, in practice, repatriation is difficult, and obtaining Poor governance and a complex and opaque approvals is a lengthy process. Second, entry regulatory environment form additional barriers to foreign investment need to be lowered, deterrents to private sector growth and including foreign ownership limitations, sector caps, investment. Institutions have not been able to a long negative list, and restrictions in non-equity insulate policy making from frequent regime modes of investment. changes, and this uncertainty has discouraged private investment and made it difficult to undertake PPPs. Examples of these limitations are the 51percent Nepal ranks 105th on the 2018 edition of the World ownership limit for sectors such as legal, accounting, Bank’s Doing Business Indicators. It scores and engineering services. However, the law does particularly low on the ease of getting electricity allow up to 70 percent ownership for banking and (133rd out of 190), dealing with construction finance, with the remaining 30 percent allocated as permits (157th out of 190), paying taxes (146th public shares. More allocation can be approved by out of 190), enforcing contracts (153rd out of NRB on a case-by-case basis. Restrictions in 190), and starting a business (109th out of 190). non-equity modes of investment, such as franchising, Weak contract enforcement and regulatory hassles in which there can be significant technology, training, dampen investor confidence in Nepal’s overall and skills transfer, cause additional delays and costs business climate. during entry and operations in Nepal. Slow and arbitrary approval processes, dual registration Other constraints that undermine investment procedures, delays in trademark registration, and and firm productivity include shortages in difficulties in remitting royalties and technical fees managerial and technical skills, access to are among the obstacles faced by these types of finance, and access to land. There is a scarcity investments. of medium- to high-skilled technical and managerial workers in Nepal, and this poses a Attracting FDI will also require reforms to ease problem for firms seeking to move up the value the huge infrastructure constraints. Nepal ranks chain. Strict visa regulations for foreign workers, 130th out of 138 countries on the 2016 Global the lack of a distinction between temporary and Competitiveness Index of infrastructure of the permanent movements of workers, and the World Economic Forum, and is ranked 114th out nontransparent and expensive visa process further of 160 countries on the 2018 Logistics Performance exacerbate the situation. There are several gaps in Index. The country has a relatively low road density, Nepal’s financial infrastructure, which limit the and this presents a constraint for critical sectors system’s ability to provide capital, particularly such as agroprocessing, which are intensive in their long-term finance. According to the World Bank use of transport inputs. Limited air and land Enterprise Survey, around 40 percent of Nepalese connectivity also reduces the attractiveness of key firms in the organized sector identify access to November 2018 World Bank Group 15 Maximizing Finance for Development Nepal Development Update finance as a major constraint. An outdated land Policy,and developing industrial parks tailored to acquisition law, poor land records, and weak specific industries. institutions have made it difficult to deploy land for productive uses. Improve skills and managerial capabilities by investing in domestic skills, simplifying visa To address these roadblocks, the following key procedures for highly skilled foreign workers, and reforms are needed: introducing a publicly supported management extension program for firms in key sectors. Ease barriers to firm entry and operations by simplifying business regulations and streamlining Tourism. Upgrade airport safety, accelerate processes, introducing single-window interfaces for construction of Gautam Buddha International regulatory compliance, and using platforms like the Airport and Pokhara Airport, improve road access Nepal Business Forum for regular public-private- to key destinations, review regulations governing sector dialogue. the use of protected areas to allow investments that are not in conflict with conservation, and Facilitate trade and deepen integration by designate organizations in charge of designing and lowering tariff rates, particularly on crucial implementing plans for the integrated development intermediates, which are key to producing priority of key destinations. products; streamlining processes at key border customs stations to reduce time and cost of trading; Agribusiness. Allow private sector participation simplifying the duty-drawback system by making it in procuring and distributing fertilizers and seeds, accessible to both direct and indirect exporters; strengthen the efficiency of input subsidies, simplifying certification rules and providing faster and identify priority activities to improve food duty refunds to firms; and providing support to safety/sanitary and phytosanitary measures to firms to comply with the Generalized System of facilitate access to higher-value markets. Preferences rules of origin, through the provision of trainings on bookkeeping and management of ICT. Partner with industry to review the market input certifications. relevance of the Information Technology (IT) curriculum, and improve the existing IT park Remove constraints to FDI by reducing and through greater private sector investment and rationalizing the negative list; adopting a new draft attraction of anchor firms. Foreign Investment Act aligned with international best practice and obligations; and streamlining Enhancing Financial Inclusion and processes critical to entry and operations, such as Capacity for Long-Term Finance investment approvals, repatriation, and exit. Improved access to finance, improved Strengthen infrastructure by enacting the PPP intermediation, and the development of Law and developing a PPP pipeline, together with long-term finance will be crucially important a contingent liability framework; strengthening the to channel finance (foreign or local) to Road Board of Nepal and identifying strategic productive activities. The ongoing 14th roads to be improved through PPPs; prioritizing Development Plan estimates that 55 percent of airport development through PPPs; setting up total investment required to implement the plan Hydropower Commons for hydropower expansion; will be mobilized from the private sector. A and strengthening the NEA. well-developed financial sector that supports strong intermediation and financing will be necessary for Facilitate improved access to land by the private sector to mobilize the needed resources implementing land zoning, updating the Land Act for both small and microenterprises and large firms. and making it consistent with the Land Acquisition November 2018 World Bank Group 16 Maximizing Finance for Development Nepal Development Update Despite progress to date, significant gaps in The ability of banks, which dominate the access to finance for smaller firms, including financial sector, to intermediate and provide unequal access by gender and geography, long-term finance is constrained by several continue to hamper firm growth and factors. Banks account for 87 percent of financial productivity. An estimated 40 percent of firms sector assets in Nepal. While headline bank capital still report access to finance as a major constraint. adequacy and asset quality figures appear Significant gaps exist for small and medium-sized comfortable (a capital adequacy ratioofover 14 enterprises(SMEs), startups, women, and rural percent and a nonperforming loan ratio below 2 businesses. These are firms that contribute percent), there are concerns over evergreening of significantly to job creation, but only 9 percent use bad loans and underprovisioning, vulnerability to banks to finance investments, compared to 17 exogenous factors (such as earthquakes, trade percent on average nationally.5 Access is limited 4 by disruptions, and remittance slowdowns), and an the relatively high cost to financial institutions of underfunded safety net. Fueled by remittances and individual screening and due diligence for typically exposed to maturity mismatches, the sector is modest loan amounts, high reliance on conventional limited in its ability to perform financial collateral-based lending approaches, and concerns intermediation and maturity transformation. With that borrowers might be accumulating many loans loan growth far exceeding deposit mobilization, the from multiple lenders. A regulatory cap on the loan-to-deposit ratio has reached 85 percent, placing spread on interest rates that financial institutions pressure on liquidity and pushing interest rates up. (domestic and international) can charge further There are significant gaps in the financial reduces their ability to accurately price in risk or infrastructure (for example, limited credit provide long-term financing. information, an unutilized secured transactions registry, an underdeveloped payments system). When firms can access credit, financial There is an almost complete lack of non-recourse institutions have to rely on conventional project finance-based structures (wherein loan collateral-based lending approaches, given the repayment is from the profits of the project the loan asymmetry in credit information. 7 In addition, is funding, and not from other assets of the existing legal provisions of the Country Civil borrower). Infrastructure projects face higher Procedure (Code) Act do not afford foreign interest rates, a result of a high-risk perception. financial institutions the same protection as local Addressing these constraints is essential to promote banks in terms of creditors’ rights. 8 Finally, the financial sector development more generally, and to agriculture sector receives less than 5 percent of increase long-term finance in particular. bank loans, and agricultural finance is often impeded by ineffective government policies.Priority Capital markets have a long way to go toward reforms to support increased access to finance for playing a significant role in the provision of SMEs will be to remove financial infrastructure long-term finance. A well-functioning government constraints to facilitate financial intermediation, debt market is needed for capital market development, strengthen the legislative and regulatory framework as it sets the risk-free rate and benchmark for pricing for movable assets, expand the coverage of the other instruments. The government is, however, not credit bureau, and promote digital financial services. issuing sufficient market-based instruments and is 5 SMEs comprise more than 96 percent of the total industrial establishment, contribute 83 percent to industrial employment generation, and share 80 percent of the industrial sector’s contribution to national GDP. 6 About 45 percent of the adult population has a formal bank account (compared to 69 percent in the region). The numbers fall further for those in rural areas (43 percent) and the poorest (38 percent) (FINDEX 2017; https://www.worldbank.org/en/events/2018/04/23/global-findex- fintech-inclusion). 7 The Credit Bureau coverage is a mere 1.7 percent of the adult population (the South Asia average is 14.1 percent). 8 They typically resort to partnering with a local bank or a consortium under a pari-passu security arrangement for debt recovery. (A pari-passu agreement is one in which two or more assets, securities, creditors or obligations are equally managed without preference. This can refer to loans, bonds or classes of shares that have equal rights of payment or equal seniority.) November 2018 World Bank Group 17 Maximizing Finance for Development Nepal Development Update not fulfilling the market-making function. The debt shallow. The stock market needs modernization, market is dominated by short-term government debt, and banks and financial institutions make up more and there is no active yield curve (see Box 1).9 There than 80 percent of listed companies. The Securities are only a few investors in debt instruments, and Board of Nepal lacks autonomy and capacity to treasury instruments are bought largely by banks provide effective risk-based supervision, and a new to satisfy statutory liquidity requirements. Some Securities Act is under discussion. Finally, private development partners, such as the Asian equity/venture capitalis a novel concept (although Development Bank (ADB) and International Finance few private equity funds are in operation) and lacks Corporation, are trying to support the raising of a specific legal and regulatory framework. local currency bonds. The equity market is also Box 1. Building benchmark yield curves The sequencing of capital market South Africa), with a multiyear project in Egypt development is not straightforward, but the helping lengthen the yield curve by designing an development of a benchmark yield curve is issuance program that enabled the government considered a fundamental step. There are to use market-based funding. several determinants of capital markets development. Among structural factors, macro- Even when fiscal needs are met, governments financial stability, the level of savings, and the in many countries issue bonds to maintain a presence of institutional investors are important. functioning yield curve toward the development Regarding the enabling environment, while some of capital markets. For example, the Ministry of preconditions are common, the sequencing of Finance of Sweden announced in 2017 the reforms can be complex. Nevertheless, the intention to establish a sovereign wealth fund to existence of a deep, liquid government yield curve buy the excess debt supply (beyond funding needs) is key for the pricing of instruments, and the to provide more liquidity to government bonds. developing of government bond markets can be Singapore has the fiscal objective of a balanced a catalyst for the bond market infrastructure and budget, but issues debt totaling just under 30 the fixed income markets. percent of GDP to maintain a market. New Zealand commits to a floor ratio of 20 percent For many countries at an earlier stage of domestic-debt-to-GDP. Australia announced in development, the reform agenda involves a 2003 its intention to issue debt to maintain the fundamental set of issues that includes bearing the government bond futures market; at the time, initial cost of market development (that may be treasury bonds outstanding were around 6 percent more expensive and of shorter duration than of GDP. Brazil is also an example of a country concessional financing); developing the legal and that has systematically and successfully built regulatory framework, and institutional benchmark yield curves for domestic and external arrangements and capacity for undertaking markets. In 2008, it became an external creditor market-based financing; supporting a regular and keeps operations in the international market issuance program in a range of maturities; and, just to provide reference rates for corporate more broadly, achieving macro- and political issuers. Colombia and Panama also face the same stability to attract long-term participation. The need to build liquid benchmarks on the back of World Bank has been advising multiple countries low debt levels, and for that, liability management on developing the government bond market operations are being considered. (including Brazil, Egypt, Kenya, Nigeria, and 9 The absence of a yield curve can also make it difficult for multilaterals and corporates to pursue offshore local currency bond issuances, and can hold back the issuance of foreign-currency-denominated infrastructure project bonds. November 2018 World Bank Group 18 Maximizing Finance for Development Nepal Development Update Local institutional investors are underdeveloped Overall, the following key constraints need to and mostly invest in short-term instruments. be eased to facilitate increased access to The assets of insurance companies, pension/ finance and promote instruments for long-term provident funds, and mutual funds can be critical finance: in safely funding long-term investment. There are potential domestic institutional investors, including Financial infrastructure constraints. Removing the Employees Provident Fund, the Citizen’s financial infrastructure constraints will facilitate Investment Trust, and the insurance sector with a financial intermediation and should include combined asset size of around 15 percent of GDP. strengthening the legislative and regulatory An important factor inhibiting its development framework for movable assets, expanding the includes the capacity of the regulator, with priority coverage of the credit bureau, and promoting needed on risk-based supervision (including digital financial services. Regtech/Suptech)10 along with risk-based capital, as well as stronger asset liability management. Lack of a yield curve and weak capital markets. Insurance companies need capacity building, product The government should issue bonds to create and diversification, and price diversity, and the sector maintain a functioning yield curve. The lacks awareness and trust. independence and capacity of the securities supervisor should be strengthened, and the legal A key policy question is whether regional infrastructure of the securities market updated. capital market integration or financial hubs In addition, legal and regulatory reforms for could be the way forward; both, nevertheless, alternative investment funds could promote private are difficult endeavors with limited success equity and venture capital. where they have been attempted. Theoretically, regional integration is an attractive proposition for Weak institutional investors. In the short term, small countries whose domestic markets do not this would require strengthening the independence offer the necessary diversification of investment of the insurance sector supervisor; the capacity for opportunities to investors or of funding sources to risk-based supervision; and asset liability companies. Nevertheless, very few such projects management, including the sector’s investment have achieved any degree of “success”. Only Europe regime. has had a relative degree of capital markets integration. In all other regions, regional integration At the same time, foreign investors are projects are at a much earlier stage, including the constrained on several fronts, which could be Mercado Integrado Latinoamericano or MILA addressed by policy action. This may require (which focuses on the less ambitious integration of addressing legislative, regulatory, and institutional the equities markets of Chile, Colombia, Mexico, constraints that disincentivize foreign lending by and Peru), and the example from Central America amendments to the Foreign Investment Act and (aimed at integrating the capital markets of Costa the issuance or amendments to notices/circulars Rica, El Salvador, and Panama), or the East Africa by NRB. Establishing a sovereign rating may also Community (inspired by the experience of the help support these reforms and signal to European Union). Regional integration entails international investors the government’s complex processes that require a significant amount commitment to them. These policy actions of political support, usually involving significant include: changes and/or adjustments for market participants (for example, technology, business models) and Foreign-exchange restrictions. These significantly public authorities (for example, legal amendments, impact the entry of foreign investors and constrain supervisory approaches). 10 Regtech is a technically familiar word in the financial sector that refers to applications of innovative technologies to support compliance with regulatory and reporting requirements by regulated financial institutions.Suptech refers to technologies used by supervisory agencies. November 2018 World Bank Group 19 Maximizing Finance for Development Nepal Development Update links to international markets. Many of these and, as implemented, is subject to stringent problems derive from practice more than from the requirements for NRB approvals, including law itself. For example, although firms are formally separate approvals for loan payments (after the allowed to open U.S.-dollar-denominated accounts, loan itself has been approved). small firms and individuals report that this is difficult in practice. Even with such an account, it A complicated process for offshore capital is difficult to pay for services in U.S. dollars due to repatriation. Nepal has a fixed currency regime caps on the size of U.S.-dollar-denominated (pegged to the Indian rupee) and closely monitors contracts. This creates a difficult environment for foreign exchange reserves. Offshore funds require exporters, who often need to pay for foreign travel approval of the NRB to repatriate proceeds of or inputs from foreign suppliers. their divestments. Approvals are granted only for amounts calculated under valuation rules set by the Regulatory constraints on foreign investment. regulator, not for the actual proceeds. Strict foreign FDI inflows have been hurt by unclear policies, exchange controls create an incentive for complex procedures, and inadequate investment undervaluing transactions so that less foreign facilitation. Entry barriers to foreign investment exchange leaves the country. Furthermore, despite include sector caps, a long “negative list”of sectors numerous Double Taxation Agreements, there has barred from receiving FDI, and restrictions on been uncertainty with respect to their enforcement, non-equity modes of investment. Offshore funds which increases uncertainty for foreign investors and onshore vehicles with foreign shareholders are when exiting investments. both considered foreign investors and require FDI approval for every new investment in a Nepalese Strengthening Public Investment company. Rules, regulations,and directives by the Management and PPPs NRB and other authorities are available only in the Nepalese language. FDI approvals can take several Nepal’s public investment has averaged 4 months. Finally, there are lengthy processes needed percent of GDP, which is below average among to hire foreign workers. both South Asian and low-income countries. There is chronic underspending of the capital Restrictive policies on borrowing from foreign budget, with spending averaging about 70 to 80 lenders. While land and buildings are the main percent, over the past 5 years. According to the list forms of collateral for lending, mortgaging of land of projects compiled from the Annual Development in favor of foreign lenders needs Cabinet approval, Plans of the National Planning Commission, and enforcement of security requires a court order. projects on average have been ongoing for more As a result, foreign lenders often resort to partnering than 11 years. Aside from delays, the budget does with a local bank or a consortium under a pari- not sufficiently support service delivery or allocate passu security arrangement for debt recovery. resources for development priorities. Foreign lenders are required to set aside capital at the time of signing loan contracts, with commitment In addition to public investment in fees accruing only after NRB approval. As a result, infrastructure, Nepal has also been promoting the capital allocation remains uncompensated during private sector participation to fill its infrastructure the time lag between the signing of the contract gap. The 14th Development Plan provides a policy and disbursement of the loans. Foreign lenders are framework for infrastructure projects, with a focus subordinated to local banks in priority of repayment. on the energy, roads, and airports sectors. The Furthermore, there are interestrate caps on foreign PPP Policy of 2015 emphasizes the role of private currency loans, including those on the cost of sector participation and allows for a range of PPP hedging against foreign exchange fluctuations for structures. Priority sectors include physical long tenure. Finally, the approval process for foreign infrastructure, the electricity sector, the information loans is not clearly delineated in written guidelines and communications sector, the urban and rural November 2018 World Bank Group 20 Maximizing Finance for Development Nepal Development Update environment, education and health-related Project preparation capabilities are lacking within infrastructure and services, and urban amenities. government, and this results in projects going to A PPP Law has been drafted and is ready to go to market without adequate preparation, which in turn the Cabinet. results in projects not being able to attract private interest. A lack of capacity among institutions, Nepal has faced several constraints exacerbated by a lack of standardized processes implementing PPPs, mobilizing private and optimal risk allocation, and inadequate tender participation in infrastructure, and overall procedures, results in ineffective PPPs. governance of public investment. PPPs have been few in number and slow to take off. Since The above constraints are compounded by 1990, 37 PPP transactions have reached financial factors that deter foreign investors. These include closure, generating a total investment of US$2.5 the need for multiple approvals, delays in capital billion. Twenty-three projects closed between 2010 repatriation above US$10,000, absence of clear and 2017. Of the 37 PPPs, 36 are active and one provisions in Nepalese law to protect rights of project, amounting to roughly US$400 million in foreign lenders on loan collateral assets (the investments that achieved financial closure in 2012, exception being hydropower projects), challenges to is in distress. Private participation in infrastructure enforcing judicial awards against the government, is constrained by weak governance and public wide-ranging authority of Nepalese courts to revise investment management; inadequate oversight and or revoke the enforcement of arbitral awards (that accountability of public procurement due to weak is, Article 30 of the Arbitration Act), and relatively capacity, compliance and enforcement; lack of weak corporate governance and quality of disclosure. access to debt and equity financing; regulatory and institutional issues surrounding the environment In addition, there are sector-specific constraints for private participation in infrastructure; and that impede the efficient and effective use of sector-specific constraints, especially in the transport, public investment and private participation in energy, and urban sectors. the transport, urban, and energy sectors. Nepal lacks key features of countries with • The transport sector is characterized by a lack successful private programs in infrastructure. of prioritization and planning of projects, These include sector regulations and institutions inefficiency created by the problematic relationships conducive to private financing in infrastructure, a between the private and public sector, and an systematically created pipeline of infrastructure overall lack of capacity. Funding for SRN projects, appropriate capacity within line ministries maintenance is inadequate and capacity for to effectively prepare and implement projects, and procurement and contract management is weak, investment-friendly FDI policies and repatriation a problem exacerbated by the low capacity of the regulations. The domestic financial sector lacks private sector. Within the airport subsector, the capacity, increasing the need to attract international Civil Aviation Authority of Nepal is affected by financing from various sources. These issues are weak institutional and financial capacity and the further compounded by market distortions such as lack of a clear sector strategy and roadmap for syndicates and cartels, prolonged processes for airports. issuing clearances and permits (as in the forestry sector), land acquisition, weak strategic planning • In the urban sector, municipalities face a severe and project selection, poor project monitoring, and lack of functional capacity, and limited processes the need to address environmental and social and systems for capital investment planning and concerns in a timely manner. financial management, impacting accountability, credit worthiness, and the ability to plan and There are currently no methodologies deployed execute allocated budgets. The 2015 Constitution for early screening and prioritization of projects. allows local governments to borrow, but commercial November 2018 World Bank Group 21 Maximizing Finance for Development Nepal Development Update borrowing is virtually nonexistent due to weak other suitable PPP modalities. In addition, the institutional and fiscal capacities of municipalities, government needs to adopt a comprehensive limited capacity of domestic commercial banks and strategy for airports along with a financing plan, their inexperience lending to local governments, an and explore operation and maintenance contracts for underdeveloped capital market limiting their ability identified airports. It also needs to urgently carry to raise capital, and the lack of a regulatory out an urban transport assessment aimed at framework to facilitate borrowing. Private increasing connectivity, reducing congestion, and participation is limited by the inability to identify, addressing safety issues in the Katmandu Valley. prepare, appraise, and monitor projects, weak legal In the energy sector, the government needs to focus and institutional frameworks for PPPs, and failure on fast-tracking the pipeline of independent power to adequately articulate the role and powers of local producers through clarity in licensing and permitting, governments. facilitating land acquisition and forest clearances, supporting long-term financing, and providing • The energy sector is characterized by long and much-needed complementary investments in complex project development; high costs of supporting transmission and distribution connective infrastructure; inordinate delays in forest infrastructure. In the urban sector, it is important clearances, and other approvals; an unclear licensing to initiate key actions to improve creditworthiness and PPP process; and difficulties in raising debt of local bodies and identify projects for private financing. NEA’s financial performance has not participation in key urban sectors. been encouraging despite an improvement of late, with its financial obligations set to increase over the Establish a central coordinating mechanism medium term. Transmission and distribution have for infrastructure. An infrastructure unit, not kept pace with generation, leading to a preferably located at the Prime Minister’s Office, mismatch. should be established to support strategic planning, selection, and prioritization of investments; Several recommendations need to be coordination among government agencies; and implemented to improve public investment performance monitoring. management and public-private partnerships that crowd in the private sector: Improve the quality of investment decisions. This includes (a) strengthening capital project Develop a strong PPP pipeline in key sectors. screening, appraisal, prioritization, and fiscal and This requires the adoption of a systematized process contingent liabilities management processes, and methodologies to identify, screen, prioritize, methodologies, and practice; (b) building capacity and structure sector investments for implementation within the National Planning Commission (NPC) as PPPs. The government should integrate its public and selected line ministries with large capital investment managementand PPP processes and investment budgets; and (c) developing an integrated work on prioritizing PPPinvestments by allocating database of projects within the central coordinating financing according to risk, with commercial entity and/or the NPC to track and monitor project financing taking priority, if such financing is performance on a continuous basis. available and cost-effective. Examine the draft PPP Law vis-à-vis global Address key constraints in core infrastructure benchmarks. This will include examining the sectors such as transport, energy, and urban. roles of institutions like the NPC, Investment In the transport sector, the GoN needs to urgently Board of Nepal, Ministry of Finance, and relevant prepare a transport master plan and launch a energy, transport, and urban sector entities. With a program with a focus on a few strategically important new government in place and against the backdrop and economically high-priority projects under the of the ongoing federalism, this is an opportune SRN using performance-based contracting and time to review the law vis-à-vis the institutional November 2018 World Bank Group 22 Maximizing Finance for Development Nepal Development Update roles in this evolving landscape. and enable the country to reach middle-income status and achieve the Sustainable Development Develop guidelines to inform the PPP process Goals. As noted, the financing needs far surpass and methodologies. PPP guidelines will be available public resources and available donor important for clearly articulating functional roles funding. It is therefore necessary to find ways to and responsibilities; treatment of local government crowd in all possible sources of finance, innovation, projects; identification, screening, preparation, and and expertise, particularly from the private sector. procurement of projects, including treatment of For the exercise to be effective and successful, the unsolicited projects; guidance on disclosure of GoN would need to closely engage with the private information; and management of fiscal sector and take their needs into account in designing commitments and contingent liabilities. reforms. Public resources and development partner assistance could then focus on areas where private Design and deliver a communications strategy financing is not forthcoming or viable. and capacity-building program. The GoN should design and deliver a communications strategy and capacity-building program for PPPs for both public and private sector stakeholders. It should include the GoN’s objectives, an implementation timeline and approach, stakeholder mapping, and key messages for different stakeholders. Putting it all Together – Maximizing Finance for Development in Nepal Table 2 summarizes the key reforms needed to crowd in the private sector, given the above-outlined constraint to firm growth and competitiveness, access to finance and public investment, and PPP implementation. The list of reforms in the table are the most critical to accelerate growth, but the list is not exhaustive. The focus is on increasing firm growth and productivity to support links to global markets and higher exports. This would need to be underpinned by measures to improve financial intermediation, access to finance, and long-term financing, including easing restrictive policies on borrowing from foreign lenders, foreign finance, and the development of capital markets. These would need to be complemented with reforms to strengthen public investment management, including PPPs to support infrastructure finance, including issues of contingent liability and debt management. Overall, for Nepal, Maximizing Finance for Development (MFD) will require a systematic approach to leveraging all sources of finance, expertise, and technologies to accelerate growth November 2018 World Bank Group 23 Maximizing Finance for Development Nepal Development Update Table 2: Priority Reforms to Maximize Finance for Development and Crowd in the Private Sector for Nepal’s Accelerated Growth Key Constraint Selected Key Recommendations and Priority Interventions Improving Competitiveness and Integration with Global Markets Complex procedures for firm • Introduce a single-window interface to facilitate regulatory compliance entry and operations • Establish mechanisms to promote public-private-sector dialogue (such as the Nepal Business Forum) High cost of trade, which • Adopt measures to facilitate trade and deepen integration by lowering import undermines exports tariffs, streamlining border processes to reduce time and cost of trading, making the duty drawback accessible to both direct and indirect exporters, simplifying certification rules and providing faster duty refunds, and providing support to firms to meet the Generalized System of Preferences rule of origin FDI restricted through limits • Adopt measures to promote FDI by reducing and rationalizing the negative on foreign exchange, foreign list; adopting a revised Foreign Investment Act aligned with international borrowing, repatriation of practice and obligations; streamlining investment approvals, repatriation, and funds; unclear FDI policies exit; and reassessing interest rate caps on foreign currency loans; and clarifying the rules on funds repatriation and Double Taxation Agreements Outdated land acquisition law; • Adopt measures that facilitate increased firm/investor access to land by poor land records; weak implementing land zoning, updating the Land Act and making it consistent institutions that make it with the Land Acquisition Policy, and developing industrial parks tailored to difficult to deploy land for specific industries productive uses Low availability of highly • Facilitate improved skills of the labor force and managerial capabilities by skilled workers investing in domestic skills, simplifying visa procedures for skilled foreign workers, and introducing publicly supported management extension programs for firms in key sectors. Sector-specific constraints • Ease sector-specific constraints by (a)Tourism: upgrading airport safety, that limit exports and improving road access to key destinations, allowing investments in protected economic growth areas that are aligned with conservation; (b) Agribusiness: allowing private sector participation in distributing fertilizers, seeds; identifying priority activities to improve food safety to facilitate access to higher-value markets; and (c) ICT: improving the existing IT park through greater private sector investment Enhancing Financial Inclusion and Capacity for Long-Term Finance Low access to finance and • Increase access to finance for SMEs by strengthening the legal and regulatory limited-to-nonexistent facility framework for movable assets; expanding coverage of the credit bureau; for long-term finance and promoting digital financial services weak capital markets • Develop a long-term capital market by regularly issuing government bonds to create and maintain a yield curve; further developing capital markets by strengthening the independence and capacity of the securities supervisor and November 2018 World Bank Group 24 Maximizing Finance for Development Nepal Development Update updating the legal infrastructure of the securities market; adopting legal and regulatory reforms for alternative investment funds to promote private equity and venture capital • Strengthen the capacity of institutional investors by strengthening the independence of the insurance sector supervisor, the capacity for risk supervision and asset liability management • Reinforce and signal to investors government commitment to reforms by establishing a sovereign rating Strengthening Public Investment Management and PPPs Weak public investment • Establish a coordinating mechanism for infrastructure (or an infrastructure management and coordination unit) to support strategic planning, selection, prioritization, and coordination for selecting and implementing among agencies projects • Improve the quality of public investment by strengthening capital project screening, appraisal, prioritization including contingent liabilities; building capacity within NPC and selected line ministries with large capital investments; developing an integrated database of projects within the central coordinating unit Weak PPP laws and • Strengthen the PPP Law and including a contingent liability framework by framework including missing reviewing the draft PPP Law with respect to the roles of the National processes and limited Planning Commission, Investment Board of Nepal and Ministry of Finance, coordination across relevant and also in relation to the key sector-specific issues in energy, transport, and agencies urban • Develop PPP guidelines and a pipeline of PPPs clearly articulating functional roles and responsibilities and the treatment of local government projects, identification, screening, preparation, procurement and including unsolicited projects, guidelines of managing fiscal commitments and liabilities; prioritizing PPP investments and allocating financing according to risk, with commercial financing taking priority if it is available and cost-effective • Address key constraints in core infrastructure sectors by (a) preparing a transport master plan and a program that consists of a few strategically important and economically high-priority projects under the Strategic Roads Network using performance-based contracts, adopt a strategic plan for airports along with a financing plan and operations and maintenance contracts; (b) fast-tracking the pipeline of independent power producers (IPPs) in the energy sector through clarifying the licensing and permitting, facilitating land acquisition and forest clearances, supporting long-term financing and complementary investments in transmission and distribution; and (c) improving credit worthiness of local bodies and identifying projects for private participation in the urban sector Poor public and private • Increase awareness around the appropriate use and role of PPPs by sector awareness of the designing and delivering a communications strategy and capacity-building important and appropriate program for both public and private stakeholders that outlines the GoN’s role of PPPs limits their objectives, implementation timeline and approach, stakeholders, and development messages for each category of stakeholder November 2018 World Bank Group 25 Maximizing Finance for Development Nepal Development Update ............................................................................................................................................................................................................................................................................................................................................................ References ............................................................................................................................................................................................................................................................................................................................................................ World Bank. 2018a. Global Economic Prospects – The Turning of the Tide. Washington, DC: World Bank. World Bank. 2018b. Nepal Infrastructure Assessment- Main Report. Draft. World Bank, Washington, DC. World Bank. 2018c. Nepal Country Private Sector Diagnostic. Draft. World Bank, Washington, DC. FINDEX. 2017. https://www.worldbank.org/en/ events/2018/04/23/global-findex-fintech- inclusion. Narain, Ashish, and Gonzalo Varela. 2017. “Trade Policy Reforms for the Twenty First Century: The Case of Nepal.” World Bank Report No. 122063. World Bank, Washington, DC. November 2018 World Bank Group 26 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