NEPAL DEVELOPMENT UPDATE September 2016 Powering Recovery NEPAL DEVELOPMENT UPDATE Powering Recovery September 2016 Standard Disclaimer: This volume is a product of the staff of the The World Bank does not guarantee the accuracy International Bank for Reconstruction and of the data included in this work. The boundaries, Development/The World Bank. The findings, colors, denominations, and other information interpretations, and conclusions expressed in this shown on any map in this work do not imply any paper do not necessarily reflect the views of the judgment on the part of The World Bank Executive Directors of The World Bank or the concerning the legal status of any territory or the governments they represent. endorsement or acceptance of such boundaries Copyright Statement: The material in this publication is copyrighted. 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Acknowledgements The Nepal Development Update is produced Rajib Upadhya and Gayatri Sharma managed twice yearly with the following two main aims: to media relations and dissemination. Sally Acharya report on key economic developments over the edited the document and Sunita Kumari Yadav preceding months, placing them in a longer term managed the publication process. and global perspective; and to examine (in the Special Focus section) topics of particular policy The team is grateful for collaboration and data within significance. The Update is intended for a wide the World Bank and from various agencies in Nepal. audience including policymakers, business leaders, In particular, we would like to thank Avani Dixit the community of analysts and professionals (World Bank), Sabin Shrestha (World Bank), Yagya engaged in economic debates, and the general Dhungel (Ministry of Finance), Pradeep Paudyal public. (Nepal Rastra Bank), Dinesh Bhattarai (Department of Agriculture), Kedar Neupane and Gaurav This Update was produced by the World Bank Dhungel (Department Immigration), Binod Acharya Macroeconomics and Fiscal Management team for (Department of Customs), Durga Manandhar, Sajina Nepal consisting of Damir Cosic, Roshan Shakya and Anand Pradhananga (Department of Bajracharya, Sudyumna Dahal and Saurav Rana Hydrology and Meteorology). under the guidance of Shubham Chaudhuri and Takuya Kamata. Rabin Shrestha and Barsha Cut-off date for data included in this report was Pandey contributed to the Special Focus. September 15, 2016. Table of Contents EXECUTIVE SUMMARY ............................................................................................................... i A. RECENT ECONOMIC DEVELOPMENTS ............................................................................. 1 1. Global economic outlook has weakened, but activity in South Asia remains resilient........... 1 2. Recovery is underway after a challenging year in Nepal .............................................................. 1 3. External sector is resilient thanks to high level of remittances, but risks remain .................... 4 4. Monetary policy stance remains accommodative ......................................................................... 6 5. Credit growth has recovered while deposit growth remains strong .......................................... 6 6. Inflation is on the rise, eroding competitiveness, albeit temporarily ......................................... 7 7. Stock market remains disconnected from the real economy ...................................................... 9 8. Realism of government budget, particularly on the expenditures, has deteriorated ............. 10 B. OUTLOOK, RISKS AND CHALLENGES............................................................................... 11 C. SPECIAL FOCUS: ENERGY FOR NEPAL............................................................................. 15 1. Current state of Nepal’s electricity sector .................................................................................... 15 2. What could Nepal’s electricity energy sector look like? ............................................................. 16 3. How to mobilize investments in hydroelectricity ....................................................................... 17 4. Government’s policy response ...................................................................................................... 19 5. What would a comprehensive reform program look like? ........................................................ 19 LIST OF FIGURES: Figure 1: Monsoon during 2016 has improved compared to previous years............................................2 Figure 2: Housing reconstruction grants are finally picking up .................................................................2 Figure 3: Imports have recovered quickly following the end of trade disruptions ..................................3 Figure 4: Fuel imports have also normalized ................................................................................................3 Figure 5: However, exports of goods have not .............................................................................................3 Figure 6: Primarily due to sluggish recovery of exports to India ................................................................3 Figure 7: As well as weak service exports .......................................................................................................4 Figure 8: The trade deficit normalized, but remittances grew at a faster rate in the last quarter ...........4 Figure 9: Resulting in historic high foreign reserves ....................................................................................4 Figure 10: Remittances picked up in the three months ending in July ... ...................................................5 Figure 11: But when controlling for seasonality, growth in remittances has been negative ....................5 Figure 12: Migrant worker departures have remained stagnant ....................................................................5 Figure 13: Similarly, when controlling for seasonality, growth rate has been negative .............................5 Figure 14: High liquidity in the system has kept interest rates low...............................................................6 Figure 15: Following the earthquake and trade disruptions, bank lending has picked up ........................6 Figure 16: While the deposit growth has moderated ......................................................................................7 Figure 17: Resulting in an increase in the credit-deposit ratio .......................................................................7 Figure 18: After moderating, inflation climbs back to double digits ............................................................7 Figure 19: Primarily driven by housing and utilities inflation within non-food prices ..............................7 Figure 20: Non-food price differential has been driving Nepal’s recent inflation gap with India ...........8 Figure 21: Rising inflation is causing appreciation of the real exchange rate ..............................................8 Figure 22: Surging credit may be fueling a bull market...................................................................................8 Figure 23: While other regional stock markets have remained subdued......................................................8 Figure 24: Revenue targets were exceeded on account of large one-off collections..................................9 Figure 25: But expenditures did not materialize as planned ..........................................................................9 Figure 26: GDP growth is forecasted to accelerate in the forecast period ............................................... 13 Table of Contents (continued): Figure 27: With rebound services contributing the most ............................................................................ 13 Figure 28: Domestic electricity demand and supply ..................................................................................... 15 Figure 29: Projected generation capacity addition ........................................................................................ 16 LIST OF TABLES: Table 1: Selected Fiscal Indicators ............................................................................................................... 10 Table 2: Nepal Macroeconomic Outlook .................................................................................................. 12 Powering Recovery Nepal Development Update Executive Summary During 2016, global economic prospects have termined to be eligible for the rural household re- weakened and developing economies are facing construction grant; of this group, 447,000 house- stronger headwinds, yet economic activity in South holds had signed the grant agreement and 376,000 Asia has been resilient. Robust domestic demand, of those households had received the first of the the key driver of growth, held up through the first three tranches. half of 2016. Imports have rebounded fast following the end of Nepal, however, experienced its slowest growth in trade disruptions and have recovered to the same 14 years during FY2016. Real GDP growth, which level as last year. Exports, however, are yet to re- had already fallen to 2.7 percent in FY2015 after cover to their pre-disruption level. Consequently, the April 2015 earthquake and its frequent and the trade deficit for FY2016 has increased to powerful aftershocks, was dragged down further around 30 percent of GDP. While the growth rate to 0.6 percent in FY2016 as a result of the sluggish of remittances has slowed to the lowest in 5 years, post-earthquake reconstruction activities and dis- they are still high at 29.6 percent of GDP, helping ruption in cross-border trade with India. to offset the trade deficit. Nevertheless, economic activity in Nepal is recov- Despite normalization in supplies and a favorable ering. Following two years of sub-par rainfall, the external environment (i.e. low food and oil prices current monsoon is progressing well with precipi- and moderating inflation in India), inflation in Ne- tation averaging 102 percent of the long-term aver- pal continues to be elevated. A sharp uptick in age. Expected rice production is forecasted to be housing rental prices following the earthquake is 4.8 million tons, up from 4.2 million tons a year the largest contributor to headline inflation. ago, giving a much-needed income boost to the 60 percent of the population that works in agricul- In contrast with other economic activities, govern- ture. ment revenues performed well. Driven by surging imports in the last six months of the fiscal year, as Post-earthquake reconstruction activities are pick- well as one-off improvement in collection of out- ing up speed after a slow start. By September 15, standing taxes, revenues increased from the year ago. 2016, over half a million households had been de- year. Expenditure, driven in part by higher spending September 2016 THE WORLD BANK GROUP i Powering Recovery Nepal Development Update on reconstruction activities increased but not as The external environment is likely to be less favor- much resulting in a surplus. able as well. With remittances comprising nearly 30 percent of GDP, the Nepalese economy is ex- Outlook tremely dependent on these flows. Oil-exporting Gulf Co-operation Countries and Malaysia, are a Growth in FY2017 is expected to recover to five key destination for Nepalese migrants. As oil prices percent after two years of sub-par growth and re- in particular, and commodity prices in general, are main in line with potential thereafter. The rebound likely to remain at present levels during the fore- in growth comes on the back of a normal mon- cast period, the possibility of a slowdown in remit- soon that will boost agricultural output and is sup- tances has increased. ported by increased investment (both public and private) as the political process stabilizes and Special Focus: Powering Recovery earthquake recovery gathers speed. Over the past decade, power outages have increased The fiscal deficit is expected to widen during the substantially. Availability of reliable and affordable forecast period, but to remain within manageable electricity has become a major constraint for Nepal’s limits. The government’s recurrent expenditure is development as it hampers the ability to improve living expected to grow substantially in the forecast peri- standards, raise agricultural productivity and income, od owing to an increase in earthquake-related cash and help youth transition from farming to non-farm assistance as well as measures introduced to in- employment through creation of new industries at crease social protection, pensions, and civil serv- home. ants’ compensation, while growth in revenues is expected to moderate. Given Nepal’s natural endowments, it is not difficult to envision an electricity sector that can support green Risks and Challenges growth, poverty reduction, and shared prosperity. Such an electricity sector would not only meet domestic Domestic risks predominate and are on the down- demand reliably, affordably, and cleanly, but would side. The political environment remains fluid as coali- earn revenue from export of surplus hydropower tion governments have changed once a year on aver- through enhanced regional electricity markets to neigh- age since 2007. The latest government was sworn in boring countries by integrating the wider South Asia during July, for a term announced to last only nine power market. months, as part of the power-sharing agreement among the coalition partners. The new constitution Wholesale structural reforms of the electricity sector adopted last year stipulates a series of elections by the are needed to achieve this. In the Special Focus of this beginning of 2018, which will further add to policy Update, we take a closer look at what it would take for uncertainty. the electricity sector to power Nepal’s recovery. September 2016 THE WORLD BANK GROUP ii Powering Recovery Nepal Development Update A. Recent Economic Developments 1. Global economic outlook has weakened, but 2015, making it the fastest-growing developing activity in South Asia remains resilient region. Robust domestic demand momentum, the main growth driver, continued through the first Growth prospects have weakened throughout half of 2016. India is the region’s largest and fast- the world economy. Emerging market and devel- est-growing economy, but Pakistan, Bangladesh, oping economies are facing stronger headwinds, and Bhutan also show strengthening activity. Most including weaker growth among advanced econo- South Asian economies have benefitted from the mies, persistently low commodity prices, and lack- decline in oil prices and the resulting benign infla- luster global trade and capital flows. In addition, tionary environment as well as steady remittance for oil importers, the sizeable positive terms of flows. Monetary policies have been accommoda- trade shock represented by falling prices has not tive. Some economies have benefitted from a pick- translated into the large boost to growth initially up in the pace of reform or from improvements in expected, as other challenges and uncertainties the security situation. Nonetheless, to varying de- have held back activities. As a result, global growth grees, weak external demand, a challenging busi- for 2016 is projected at 2.4 percent, unchanged ness environment (e.g. energy and infrastructure from the disappointing pace in 2015. In low in- constraints), and fiscal pressures have encumbered come countries (LICs), lower commodity prices as activity in some of the region’s economies (Global well as persistent security and political challenges Economic Prospects, World Bank, June 2016). are expected to create headwinds for growth. However, while the difficult external environment 2. Recovery is underway after a challenging confronting LICs will likely continue, the projected year in Nepal growth of 5.3 percent in 2016 is supported by the resilience of domestic investment and the expected Following the earthquakes and trade disrup- implementation of reforms (Global Economic Pro- tions, economic activity is recovering in Ne- spects, World Bank, June 2016). pal. Real GDP growth, which had already fallen to 2.7 percent in FY2015 after the devastating Economic activity in South Asia has remained earthquakes and its frequent and powerful after- strong despite headwinds from the global shocks, was dragged down further to 0.6 percent economy. GDP growth reached seven percent in (market prices) in FY2016 as a result of the slug- September 2016 THE WORLD BANK GROUP 1 Powering Recovery Nepal Development Update gish post-earthquake reconstruction activities and ades. Trade disruptions lasted almost five disruption in cross-border trade with India. Fol- months, from mid-September 2015 until end- lowing two years of sub-par rainfall, the current January 2016. At the peak of the disruption in monsoon is progressing well with precipitation mid-November, imports were reduced by two averaging 102 percent of the long-term average thirds compared to the pre-disruption level. The (Figure 1). Expected rice production is forecasted trade disruptions ended in January 2016, and by to be 4.8 million tons, up from 4.2 million tons a mid-February, imports had recovered and reached year ago, giving a much-needed income boost to the pre-disruption level and continued to grow the 60 percent of the population that works in strongly in the remaining five months of the fiscal agriculture. year (Figure 3). By April, imports of fuel —the hardest hit commodity—had also fully recovered Housing reconstruction, despite a slow start (Figure 4). Despite the quick recovery, the total in FY2016, is also picking up. The delay in the imports, measured in NPR, contracted by 0.7 per- establishment of the National Reconstruction cent in FY2016, compared to the year before, a Authority and the appointment of its CEO, fol- first in decades. Contraction of imports was pri- lowed by trade disruptions, were the major fac- marily driven by oil imports, which contracted by tors contributing to the slow start of the post- 42 percent for the year as a whole, driven both by earthquake reconstruction. Of the severely affect- trade disruptions and lower oil prices. ed 11 districts where the housing survey has been completed, over half a million households have Exports of goods, however, are yet to recover been determined to be eligible for the rural to their pre-disruption levels. Exports were household reconstruction grant. By September reduced by half during the peak of the trade dis- 15, 2016, 447,000 of the households determined ruption and were not as quick to recover follow- to be eligible had signed the grant agreements and ing its end. What is more worrisome is that the 376,000 of these households had received the exports are still far below average six months after first of three tranches (Figure 2). The damages the end of the disruptions (Figure 5). As a result, survey in the three districts of Kathmandu Valley exports of goods, measured in NPR, contracted is still ongoing, while the survey is yet to begin in by 24 percent in FY2016, compared to the previ- 17 districts that were moderately affected. ous year, making this one of the highest contrac- tions recorded in decades. Imports managed to rebound quickly after the trade disruptions, but the growth rate in The slow recovery of exports is primarily on FY2016 contracted for the first time in dec- account of the sluggish growth of exports to Figure 1: Monsoon during 2016 has improved Figure 2: Housing reconstruction grants are finally compared to previous years picking up (in mm, monthly average, cumulative) (in thousands) 600 Thousands 1,200 2016 Eligible Households in 11 Surveyed Districts 500 1,000 400 800 Enrolled 2015 Households 300 Received First 600 Tranche 400 30-year Average 200 200 2014 100 0 0 June July August 1-Jul-16 17-Jul-16 2-Aug-16 18-Aug-16 3-Sep-16 19-Sep-16 Source: Department of Hydrology and Meteorology Source: National Reconstruction Authority September 2016 THE WORLD BANK GROUP 2 Powering Recovery Nepal Development Update Figure 3: Imports have recovered quickly following Figure 4: Fuel imports have also normalized the end of trade disruptions (USD millions, 3-month moving average) (percent change, y/y) (Petrol, diesel, air turbine fuel in kiloliters; LPG in metric tons) 800 80 140,000 Non-oil Imports 5-year Average 120,000 Diesel 600 60 100,000 400 40 80,000 200 20 60,000 0 0 Oil Imports 40,000 Petrol -200 -20 LPG Total Imports, 20,000 Growth (right) -400 -40 Air Turbine Fuel 0 Sep-13 Dec-13 Mar-14 Dec-14 Mar-15 Dec-15 Mar-16 Jun-14 Sep-14 Jun-15 Sep-15 Jun-16 -600 -60 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Source: Nepal Rastra Bank (NRB) and WB Staff Calculations Source: Department of Customs Figure 5: However, exports of goods have not ... Figure 6: Primarily due to sluggish recovery of ex- ports to India … (USD millions, 3-month moving average) (percent change, y/y) (USD millions, 3 month moving average) (percent change, y/y) 110 110 90 Exports to Other 90 Exports Exports to China Countries 5-year Average Exports to India 90 90 70 70 (5-year Average) 70 70 50 50 50 50 30 30 30 30 10 10 10 10 -10 Exports to India -10 -10 -10 Export Growth -30 (right) -30 -30 -30 Growth of Exports to India (right) -50 -50 -50 -50 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Source: NRB Source: NRB India. India is Nepal’s largest export partner, ac- tween FY2011-2015, service exports suffered by counting for 70 percent of total exports. Neither contracting 7.2 percent during FY2016 (y/y, NPR of the two major export categories—food/ terms). This is a result of poor tourist arrivals animals and manufactured goods —has recovered following the earthquake (Figure 7). Following a to pre-crisis level (Figure 6). Reportedly, the in- sharp contraction after the April 2015 earthquake, troduction of non-tariff barriers has been one tourist arrivals were expected to pick up in the reason why exports to India have been slow to fall of 2015; however, trade disruptions hampered recover. the rebound. Trade disruptions made travel to and from Nepal more difficult, given the acute Exports of services were also hard hit. After a shortage of fuel supplies, contributing to contrac- robust growth averaging 25 percent per year be- tion of tourist arrivals by 15 percent in FY2016. September 2016 THE WORLD BANK GROUP 3 Powering Recovery Nepal Development Update 3. External sector is resilient thanks to high the same period of FY2015, surged by 28 percent level of remittances, but risks remain (y/y) in July 2016 (Figure 8). At the same time, remittances also picked up in the last three months As the trade deficit increased, a rise in remit- of the fiscal year, resulting in a cumulative surplus tances helped reduce the current account defi- of USD 1.3 billion for the whole of FY2016 or 4.1 cit. The trade deficit, which had narrowed sharply percent of GDP. This directly contributed to an during the disruption in FY2016, boomed quickly increase in foreign reserves, with USD 9.7 billion to above pre-crisis levels and has stabilized at this being accumulated by the end of FY2016, up from higher level in the last few months. This is not USD 8.1 billion at the end of FY2015, and cover- only because imports rebounded much faster than ing 14 months of merchandise and service imports exports, but also because imports are seven times (Figure 9). larger than exports. The trade deficit, which was down by 26 percent in January 2016 compared to Remittances picked up in the three months to July, but the effect is largely seasonal. Remittanc- es surged following the April 2015 earthquake, but Figure 7: As well as weak service exports since then their growth has slowed. By October 2015, they were recording negative growth rates (in thousands, 3-month moving average) (percent change y/y) (3m/3m). However, a clear seasonal effect is evi- 90 90 dent, as each October records the lowest receipts of 80 Tourist Arrival 80 remittances in the year while each July records the 70 70 highest. This effect was even more pronounced in 60 60 FY2016, with remittances contracting 15 percent in 50 50 three months to October 2015 and then swinging to 40 40 a growth of 17 percent in the three months to July 30 30 2016 (Figure 10). Using a common statistical tech- 20 20 nique, developed by the US Census Bureau, we ad- 10 10 justed the data to remove this seasonal effect. Ana- 0 0 lyzing seasonally adjusted data, we can observe that a -10 Services Export Growth -10 contraction in remittances started in August 2015, -20 (right) -20 and since then the growth rate has remained nega- -30 -30 tive. In the three months ending in July, remittances Mar-13 Aug-13 Jan-14 Jun-14 Nov-14 Apr-15 Sep-15 Feb-16 Jul-16 contracted by 0.7 percent on a seasonally adjusted Source: NRB, Ministry of Tourism annualized rate (saar). This means that if the growth Figure 8: The trade deficit normalized, but Figure 9: Resulting in historic high foreign reserves remittances grew at a faster rate in the last quarter (USD millions, 3-month moving average) (USD millions) (months) 800 12000 20 Trade Deficit Total Reserves 700 18 10000 Import Coverage 16 600 (right) 14 500 8000 12 Remittances 400 6000 10 300 8 200 Current 4000 Account 6 100 4 2000 0 2 -100 0 0 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Source: NRB Source: NRB September 2016 THE WORLD BANK GROUP 4 Powering Recovery Nepal Development Update rate in remittances observed in the last quarter of pull factors have contributed to this slowdown: (i) FY2016 is maintained for the entire following year, in the aftermath of the earthquake, potential mi- we would see a contraction in remittances for the grants are increasingly choosing to stay at home to year as a whole. (Figure 11). support their families with rebuilding homes and livelihoods; and (ii) there has been a weaker de- Migrant workers’ departures settled at a new mand for workers from oil producing host coun- lower level after the earthquakes. From an aver- tries (e.g. GCC countries) where decline in interna- age departure of 45,000 per month prior to April tional oil prices have dented incomes and weighed 2015, migrant worker departures have slowed and on fiscal balances. In FY2016, the departure of are now averaging 33,000 per month (Figure 12). migrant workers remained stagnant, and despite However, this slowdown in departures of migrant some pickup at the end of the fiscal year, the workers predates the earthquake and has only ac- growth rate remains negative when controlling for celerated since then (Figure 13). Both push and seasonal effects (Figure 12, Figure 13). Figure 10: Remittances picked up in the three Figure 11: But when controlling for seasonality, months ending in July growth in remittances has been negative (USD millions, 3-month moving average) (percent change, 3m/3m) (USD millions, 3-month moving average, (percent change) seasonally adjusted) 700 35 Remittances Remittances 700 70 600 Growth (right) 30 600 Remittances 60 500 25 (seasonally adjusted) 500 50 400 20 400 40 300 15 300 30 200 10 200 20 100 5 100 10 0 0 0 0 -100 -5 -100 -10 -200 -10 -200 Growth Rate, -20 3m/3m saar (right) -300 -15 -300 -30 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Source: NRB and WB Staff Calculations Source: NRB and WB Staff Calculations Figure 12: Migrant worker departures have Figure 13: Similarly, when controlling for seasonali- remained stagnant ty, growth rate has been negative (thousands, 3-month moving average) (percent change, 3m/3m) (thousands, 3-month moving average, (percent change) 60 60 seasonally adjusted) Thousands 60 300 Migrant Workers Trend (HP Filter) 50 50 Outflow 50 Migrant Workers Outflow 250 40 40 (seasonally adjusted) 30 30 40 200 20 20 30 150 10 10 20 100 0 0 10 50 -10 -10 0 0 -20 -20 -30 -30 -10 -50 Migrant Workers Growth Rate, Outflow Growth (right) 3m/3m saar (right) -40 -40 -20 -100 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Source: Department of Foreign Employment (DoFE) and WB Staff Calc. Source: DoFE and WB Staff Calculations September 2016 THE WORLD BANK GROUP 5 Powering Recovery Nepal Development Update 4. Monetary policy stance remains accommo- cent, the floor rate (called Term Deposit Rate) is set at dative 0.3 percent. This is the rate at which commercial banks can deposit money with the central bank. Con- Monetary policy operations have increased, sequently, the difference between the ceiling and the but interest rates have remained very low. In floor of the interest rate corridor is 6.7 percent, with FY2016, Nepal Rastra Bank (NRB) conducted the goal to gradually narrow the difference to 4.2 per- open market operations (outright sale auctions, cent. reverse repos, and deposit auctions) to soak up liquidity totaling NPR 542.6 billion, which was 5. Credit growth has recovered while deposit 13.8 percent more than the previous fiscal year. growth has moderated However, interest rates for these operations re- mained extremely low for much of the fiscal Credit by the banks has recovered strongly year. In July 2016, the weighted average interest after the earthquake and the trade disrup- rate for NPR 25 billion reverse repo was 0.0001 tions. Credit growth had slowed sharply after percent (Figure 14). Persistently low interest the earthquake and general uncertainty caused rates, despite increasing efforts by the NRB, sig- by the trade disruptions further depressed new nal that excess liquidity has not been contained. loan issuance (Figure 15). Following the end of trade disruptions, credit growth picked up From FY2017, the central bank has introduced strongly, growing by 22.6 percent for the entire changes in the way monetary policy will be con- FY2016, compared to 19.4 percent in FY2015. ducted. Starting in FY2017, monetary policy will be This growth was particularly driven by service conducted through the introduction of an interest rate and industry sectors. Credit growth was led by corridor. The corridor is comprised of three interest credit in categories including alcohol and food rates: ceiling rate, policy rate, and floor rate. This rep- production; equipment and machineries (such as resents a shift to interest rate-based targeting in mone- electrical and communication equipment and tary operations from the targeting of the quantity of construction machinery); vehicles; automotive the money supply utilized previously. At present, the parts; and wholesale and retail businesses. ceiling rate is set at the Standing Liquidity Rate (SLR), which is seven percent currently. SLR is the rate at Deposit growth has moderated since the end of which NRB lends to banks in case of a liquidity short- the trade disruptions. Between March and July age. The floor rate is set at 10 basis points (one basis 2016, the growth of deposits declined from 23.4 per- point is 100th of a percentage point) lower that the cent (y/y) to 19.1 percent (y/y) (Figure 16). Individu- current interbank rate. As interbank was at 0.4 per- als and businesses may have curtailed consumption Figure 14: High liquidity in the system has kept Figure 15: Following the earthquake and trade interest rates low disruptions, bank lending has picked up (NPR billions) (percent) (contribution to growth, percentage points) (percent change, y/y) 140 6 25 25 Thousands Total Credit Growth (right) 120 Deposit 5 20 20 Reverse Auctions Repos 100 4 15 15 80 3 10 10 60 RR DA Interest Interest 2 5 5 40 Rate Rate (right) (right) 1 0 0 20 Others Agriculture Industry Construction Services 0 0 -5 -5 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Source: NRB Source: NRB and WB Staff Calculations September 2016 THE WORLD BANK GROUP 6 Powering Recovery Nepal Development Update during the trade disruptions due to unavailability of to double digits. Inflation, which had been goods and services, but once normal economic activi- moderating through FY2015, ended up reach- ties resumed, they may have increased consumption, ing its highest level since FY2009, climbing to thus depleting the stock of deposits in the banks. 12 percent (y/y) in January of FY2016 as a re- Taken together, the moderation in deposits and the sult of the trade disruptions. After the end of pick-up in credit have steadily pushed the credit- the trade disruptions, inflation moderated for deposit ratio to a level similar to the level before the three months before increasing again to double twin shocks (Figure 17). digits by the end of the fiscal year (Figure 18). Despite normalization in imports and a favora- 6. Inflation is on the rise, eroding competitive- ble external environment —low food and oil ness, albeit temporarily prices and moderating inflation in India — elevated inflation, which was at 10.5 percent After moderating following the end of the (y/y) in July, continues to be a source of con- trade disruptions, inflation increased again cern. Figure 16: While the deposit growth has moderated Figure 17: Resulting in an increase in the credit-deposit ratio (contribution to deposit growth, percentage points) (percent, y/y) (Ratio) 30 30 115 Deposit Growth (right) 110 25 25 105 20 20 Individuals C/D Ratio 100 15 15 95 10 10 90 5 5 85 0 0 80 C/D Ratio Foreign Currency Non-bank Fin. Corporations (excluding Deposits Institutions Others government) -5 -5 75 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Source: NRB and WB Staff Calculations Source: NRB and WB Staff Calculations Figure 18: After moderating, inflation climbs back Figure 19: Primarily driven by housing and utilities to double digits … inflation within non-food prices (Contribution to headline inflation, percentage points, y/y) (Contribution to non-food inflation, percentage points, y/y) 14 Food & Beverage Non-food & Service Overall 8 Housing & Utilities Other Non-food & Services 12 7 6 10 5 8 4 6 3 4 2 2 1 0 0 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Source: NRB and WB Staff Calculations Source: NRB and WB Staff Calculations September 2016 THE WORLD BANK GROUP 7 Powering Recovery Nepal Development Update The record high uptick in rental prices of by more than 10 times in FY2016. It is possible housing and utilities following the April that slow recovery and reconstruction of the and May earthquakes is the largest contrib- houses destroyed by the 2015 earthquakes utor to headline inflation. While food infla- (more than half a million houses) could be fuel- tion has somewhat moderated, non-food infla- ing housing and utilities inflation (Figure 19). tion is driving overall inflation. The contribu- tion of food inflation, though elevated, has re- While Nepal’s food -inflation divergence mained at four to five percentage points in with India is narrowing, the non-food infla- FY2016. However, the contribution of non- tion wedge has increased sharply. Inflation food inflation to headline inflation has doubled in Nepal has diverged significantly from India’s from three percentage points to six percentage inflation since mid-2014, driven primarily by points. This is primarily driven by the cost of food prices in Nepal. By February 2016, the gap housing rent and utilities, which have increased in headline inflation had reached a record high Figure 20: Non-food price differential has been Figure 21: Rising inflation is causing appreciation driving Nepal’s recent inflation gap with India of the real exchange rate (Percentage points) (Index number, 2010=100) 10 Total Inflation Differential with 115 India 8 110 Real Effective Exchange 6 Rate Food & Beverage Differential 105 4 100 2 95 0 Nominal Effective 90 -2 Exchange Rate Non-food & Services Differential -4 85 -6 80 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Source: NRB, Central Statistical Office India Source: WB Staff Calculations Figure 22: Surging credit may be fueling a bull Figure 23: While other regional stock markets have market … remained subdued (index number) (percent change, y/y) 2000 120 1800 100 1600 80 NEPSE 1400 NEPSE index 60 India: Nifty 500 1200 1000 40 800 20 600 Commercial banking Index 0 400 Bangladesh: -20 DSE 30 Bangladesh: CSE 200 All Shares Index India:SENSEX 0 -40 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16 Dec-13 Apr-14 Aug-14 Dec-14 Apr-15 Aug-15 Dec-15 Apr-16 Aug-16 Source: NRB and WB Staff Calculations Source: Regional Stock Markets and WB Staff calculations September 2016 THE WORLD BANK GROUP 8 Powering Recovery Nepal Development Update of 6 percentage points. While the food-inflation Nifty 500 (12.3 percent, y/y) in India, and DSE 30 divergence started to moderate from a peak of (-5.0 percent, y/y) and CSE Index (-4.7 percent, 8.5 percentage points in February, non-food y/y) in Bangladesh—remained well below the ten prices in Nepal have started to diverge from percent mark while the NEPSE grew by 48 per- non-food prices in India. It is up from almost cent. no gap in July 2015 to a gap of 6.3 percentage points in July 2016 (Figure 20). Given stable 8. Realism of government budget, particularly nominal effective exchange rate and rising infla- of expenditures, has deteriorated tion, the real effective exchange rate has appre- ciated by 15 percent from the average level in The Government of Nepal exceeded its reve- FY2014 (Figure 21). nue target despite a difficult year for the econ- omy. Government revenues which fell precipi- 7. Stock market remains disconnected from tously during trade disruptions, picked up sharply the real economy after April 2016 as imports normalized following the disruptions. As a result, the total domestic The NEPSE index has reached historic highs, revenue collection in FY2016 grew 18.9 percent in sharp contrast to weak economic perfor- compared to the previous year (Figure 24) and mance in Nepal and to other stock exchanges exceeded the target set by the government. De- in the region. From July 2015 to September 2016, spite the worst economic performance in more the NEPSE index nearly doubled, reaching historic than a decade, domestic revenue performed ex- highs of over 1,800 points (Figure 22) and growing tremely well and reached 21.5 percent of GDP in 78.7 percent in FY2016. This occurred on the back FY2016. of twin shocks that severely dented economic ac- tivities in Nepal. With a rapid rise in credit issu- Growth of domestic revenue was driven by ance occurring simultaneously, there is concern income and excise taxes as well as non-tax that those loans are being directed from their origi- revenue. Growth in revenue was driven by in- nal intent towards the stock market, fueling the come tax (56.5 percent, y/y), excise (29.7 percent, stock market bubble. In contrast, other stock ex- y/y) and non-tax revenue (22.9 percent y/y). One- changes in the region have remained subdued off payments—capital gains tax payment by Ncell from July 2015, when the rapid rise in Nepal’s eq- Private Limited and a transfer from Nepal Tele- uity prices started, until the present (Figure 23). In com—drove the income tax and non-tax revenue August 2016, the growth rates of these four major growth respectively. All these revenue sources stock exchanges—SENSEX (8.3 percent, y/y) and collected a large share of their total collections Figure 24: Revenue targets were exceeded on Figure 25: But expenditures did not materialize as account of large one-off collections planned (NPR billions, 3-month moving average) (percent change y/y) (NPR billions, 3 months moving average) (percent change y/y) 80 80 120 60 Total Expenditure Growth Total Revenue Revenue Growth (right) Expenditure (right) 100 50 60 60 80 40 40 40 60 30 20 20 40 20 20 10 0 0 0 0 -20 -20 -20 -10 -40 -40 -40 -20 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Source: NRB and WB Staff Calculations Source: NRB and WB Staff Calculations September 2016 THE WORLD BANK GROUP 9 Powering Recovery Nepal Development Update Table 1: Selected Fiscal Indicators (annual percent change unless noted otherwise) FY2013 FY2014 FY2015 FY2016 b FY2016 e FY2017 b FY2017 f Total Revenue and Grants 19.5 20.6 20.9 26.1 23.2 24.7 23.1 Total Domestic Revenue 17.5 18.5 19.1 21.1 21.5 20.8 20.8 Tax Revenue 15.3 15.9 16.8 19.0 18.7 18.7 18.7 Non-Tax Revenue 2.2 2.6 2.4 2.1 2.7 2.0 2.0 Grants 2.1 2.1 1.8 4.9 1.8 3.9 2.4 Total Expenditure 19.0 20.0 21.9 33.5 23.0 36.5 24.3 Recurrent 14.6 15.5 16.0 21.5 16.3 22.6 17.1 Capital 3.2 3.4 4.2 9.3 5.2 11.4 6.0 Net Lending 1.2 1.1 1.7 2.7 1.5 2.4 1.2 Fiscal Balance 0.5 0.6 -1.0 -7.5 0.3 -11.8 -1.1 Sources: MoF, NRB for History and WB Staff for Estimates and Forecasts Notes: b=budget, e=estimate, f=forecast during the last month of the fiscal year: 21 per- is likely to have severely worsened, because 71 per- cent, 19 percent, and 35 percent for income tax, cent of the total capital expenditure was spent in excise and non-tax revenue respectively. the last quarter and a massive 50 percent just in the last month of the fiscal year. This is a significant On the other hand, the ambitious target for deterioration compared to the last four years. post-earthquake government expenditure did not materialize. The government managed to The realism of the budget has worsened in the increase total spending by 1.3 percent of GDP past two years. During the past two fiscal years, compared to FY2015 spending. Initially, the gov- the adopted budgets have called for a substantial ernment planned to increase spending by 11 per- increase in expenditures, driven to a large extent by cent of GDP, largely on account of larger spend- increased needs in post-earthquake reconstruction. ing on earthquake recovery efforts. However, to- The planned outlay for the FY2016 budget was tal spending remained depressed for much of 33.5 percent of GDP while the actual expenditure FY2016 due to the impact of the trade disrup- remained at 23 percent of GDP, i.e. the deviation tions, and there was no robust recovery similar to was more than 11 percent of GDP. The FY2017 the pick-up in revenue collection except for a budget has been even more ambitious, with a tar- considerable hike of spending in the last month of get of 36.5 percent of GDP—i.e. an increase of 14 the fiscal year (Figure 25). percent of GDP compared to FY2016 actual spending—which is also unlikely to materialize. Bunching of expenditure worsened, especially Just increasing planned spending, without for capital expenditure. Capital spending regis- measures to improve the public investment man- tered a robust growth of 30 percent in nominal agement process in particular, will not lead to an terms, which can be considered impressive given improvement in the quantity nor, more important- the political disturbances and trade disruption ly, the quality of spending on infrastructure, which during the year. However, the quality of spending is critically needed (Table 1). September 2016 THE WORLD BANK GROUP 10 Powering Recovery Nepal Development Update B. Outlook, Risks and Challenges After disappointing growth for two years in a tion sub-sector as well. Services are expected to row, economic activity is expected to rebound. rebound in FY2017 with the revival of transport The rebound in growth comes on the back of a and full normalization of wholesale and retail trade normal monsoon that will boost agricultural out- sub-sectors. Tourism in particular is expected to put and is supported by increased investment give a boost to services in FY2017, as 80 percent (both public and private) as earthquake recovery of the flights for the fall tourist season have al- gathers speed. GDP growth in FY2017 is forecast- ready been booked (Figure 27). ed to accelerate to five percent and is expected to moderate in line with the country’s potential dur- Similarly, demand side components of GDP ing FY2018 (Table 2). are expected to rebound. Private consumption is expected to recover in FY2017 in light of full nor- While all supply-side components of GDP are malization of the supply of goods and services and expected to improve, a rebound in the service persistently strong incomes from remittances. sector is expected to contribute the most to Government consumption is expected to grow overall growth. Agriculture output is expected to substantially, owing to increases in civil servants’ improve significantly as the monsoon in 2016 has compensation. Gross fixed capital formation is been above its long term average. Industry is ex- expected to rebound, too, on the back of im- pected to rebound in FY2017 as the manufactur- proved earthquake recovery efforts. Exports of ing, construction and electricity generation sub- services are expected to rebound to the pre-crisis sectors recover. Manufacturing in particular is ex- level as tourism normalizes. However, exports of pected to get a modest boost starting from goods are expected to grow only modestly in light FY2017 as the apparels and garment industry will of below-average recovery of exports after the be receiving duty-free access to the US market. As trade disruptions and increasing non-tariff barriers reconstruction activities are expected to speed up with the major exporting partner, India (Figure in FY2017, the construction sector is expected to 26). benefit. Hydropower projects, which were delayed by the earthquakes and trade disruptions, are ex- The fiscal deficit is expected to widen during pected to be completed in FY2017, which will add the forecast period, but to remain within man- a positive contribution from the electricity genera- ageable limits. The FY2017 budget calls for an September 2016 THE WORLD BANK GROUP 11 Powering Recovery Nepal Development Update Table 2: Nepal Macroeconomic Outlook (annual percent change unless noted otherwise) FY2013 FY2014 FY2015 FY2016 e FY2017 f FY2018 f Real GDP Growth, at Constant Market Prices 4.1 6.0 2.7 0.6 5.0 4.8 Private Consumption 2.9 4.1 2.9 -0.6 5.0 4.5 Government Consumption -6.6 10.1 7.3 -5.4 11.0 11.0 Gross Fixed Capital Investment 16.8 11.4 19.6 -12.2 12.6 6.0 Exports, Goods and Services 10.3 18.4 7.5 -3.2 13.6 8.9 Imports, Goods and Services 14.2 21.0 9.5 3.5 10.1 5.9 Real GDP Growth, at Constant Basic Prices 3.8 5.7 2.4 0.6 5.0 4.8 Agriculture 1.1 4.5 0.8 1.3 3.5 3.0 Industry 2.7 7.1 1.5 -6.3 4.0 4.0 Services 6.2 6.0 3.8 2.3 6.3 6.2 Inflation (Consumer Price Index) 9.9 9.1 7.2 9.9 9.0 8.0 Current Account Balance (% of GDP) 3.1 4.8 3.8 4.1 0.3 -1.6 Fiscal Balance (% of GDP) a/ 0.5 0.6 -1.0 0.3 -1.1 -1.4 Debt (% of GDP) 32.2 28.5 25.6 25.1 25.9 26.3 Sources: CBS, NRB, MoF for History and World Bank Staff for Estimates and Forecasts Notes: a/ fiscal balance includes net lending, e = estimate, f = forecast expenditure increase of nearly 14 percent of GDP sures that arise from the pickup in reconstruction over the estimated expenditures in FY2016. How- activities and government spending during the ever, as in previous years, significant under- forecast period will continue to contribute to infla- spending of the budget is likely. The government’s tion. In particular, the sharp uptick in rental prices recurrent expenditure is expected to grow sub- of housing and utilities following the earthquake is stantially in the forecast period, owing to an in- expected to continue in FY2017 due to slow re- crease in earthquake-related cash assistance, the construction activity in FY2016. hike in civil servants’ salaries, increase in pensions, and other social security expenditures. The slow Risks and Challenges pickup in capital expenditures, particularly those related to earthquake reconstruction, resulted in a Domestic risks predominate and are on the fiscal surplus in FY2016. The healthy growth in downside. Despite a pickup in the first tranche revenues is expected to continue, particularly in of housing reconstruction grants, uncertainties light of increased imports for reconstruction activ- remain in regards to the actual construction of the ity. However, with the pace of expenditures pick- destroyed houses and the disbursement of the ing up as reconstruction efforts take full shape, second and third tranches. Furthermore, signifi- the fiscal balance is expected to turn negative in cant political risks still exist. The boundaries of FY2017. Similarly, the current account, which had the provinces that were the subject of protests remained in surplus over the past several years, is have not been resolved, while the tussle surround- expected to narrow and turn into a deficit as im- ing the demarcation and restructuring of local- ports pick up, driven by reconstruction efforts and level governmental bodies has become controver- slower growth in remittances. sial. The high inflation induced by the trade dis- The overall political environment continues to ruptions is expected to moderate somewhat in be fluid, with the coalition government having FY2017, but will remain elevated owing to per- changed yet again in July 2016. On average, the sistent supply-side bottlenecks. Although both government has changed once a year since 2007. global oil prices and prices in India are expected The latest government was sworn in during July to remain around their present levels, inflation is for a term announced to last only nine months as likely to remain elevated in Nepal. Persistent sup- part of the power-sharing agreement among the ply-side bottlenecks as well as the demand pres- coalition partners. The new constitution adopted September 2016 THE WORLD BANK GROUP 12 Powering Recovery Nepal Development Update Figure 26: GDP growth is forecasted to accelerate Figure 27: With rebound services contributing the in the forecast period most (percentage points, contributions to growth) (percent change, y/y) (percentage points, contributions to growth) (percentage change, y/y) 20 20 7 7 Statistical GDP Growth, Discrepancy Basic Prices 15 15 6 6 GDP Growth, Services (right) Private Market Prices 5 5 10 Consumption (right) 10 GFCF 4 4 5 5 3 3 0 0 2 2 1 1 -5 -5 Government Net 0 0 -10 Consumption Exports -10 Agriculture -1 Industry -1 -15 -15 -2 -2 FY2017 f FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2018 f FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 f FY2018 f Source: CBS for History and WB Staff for Calculations and Forecasts Source: CBS for History and WB Staff for Calculations and Forecasts last year stipulates a series of elections (local, pro- to curtailing economic opportunities for Nepalese vincial, federal) by the beginning of 2018, which abroad. will further add to policy uncertainty. There are several near and medium-term The external environment is likely to be less challenges ahead for Nepal. Effective mobi- favorable as well. The Nepalese economy is ex- lization of post-earthquake reconstruction, full tremely dependent on remittances, which comprise recovery of exports, and the successful holding around 30 percent of GDP. The oil-exporting Gulf of various upcoming elections are key near- Co-operation Countries and Malaysia are the desti- term challenges. Additionally, the trade disrup- nations of almost 97 percent of Nepali migrants tions have highlighted the urgent need to diver- (excluding those going to India) and a key source of sify the Nepalese economy, particularly in remittances. As oil prices in particular, and com- terms of fuel trade and transport options. In modity prices in general, are expected to remain at the medium term, Nepal faces several simulta- their current levels during the forecast period, the neous and daunting challenges. These include possibility of a slowdown in remittances remains. the challenges of completing the political tran- Given that remittances enable the consumption- sition and setting up a new federal structure centric structure of the Nepalese economy and that while attempting to leverage its endowments the government relies on taxation of imports as a (such as hydropower potential and human capi- major source of revenue, even a modest contraction tal) to achieve faster growth, reduce poverty, in remittances would have an adverse effects on and create economic opportunities for its citi- growth and fiscal and external accounts, in addition zens at home. September 2016 THE WORLD BANK GROUP 13 Powering Recovery Nepal Development Update C. Special Focus: Powering Recovery 1. Current state of Nepal’s electricity sector the monsoon season (from May to September) the installed capacity is not sufficient to meet the de- At present, electricity covers only three per- mand, resulting in average daily power cuts of cent of Nepal’s energy consumption, with tra- about six hours (Figure 28). ditional biomass (i.e. wood) and imported petrole- um products covering the rest. Three out of four To bridge this gap, Nepalese have resorted to Nepalese have some access to electricity, with two diesel generation or rooftop solar photo- out of four connected to the grid and one out of voltaic solar panels, with businesses and industry four serviced by off-grid solutions. However, ac- relying heavily on diesel generators, which are cess to electricity does not guarantee its availabil- ity. Addition of new generation capacity did not keep up with increasing demand, and as a result, Figure 28: Domestic electricity demand and supply Nepalese suffer from serious power outages that, on average, last 50 percent of the time during the (MW) year. 1,400 Peak Demand Installed Capacity These power cuts have plagued the country 1,200 for the last decade, especially during the winter 1,000 months when electricity demand is highest and production is lowest. For example, in 2015, the 800 peak demand reached 1,385 MW while the present installed capacity is just 827 MW, all hydropower. 600 To make matters worse, the peak demand occurs 400 during the dry season (between November and March) when glacial water flows decrease sharply, 200 making only about 350-400 MW of capacity actu- 0 ally available. This results in shortfall of about 900 2011 2012 2013 2014 2015 MW during peak demand period, leading to an average daily power cuts of 16 hours. Even during Source: Nepal Electricity Authority (NEA) September 2016 THE WORLD BANK GROUP 15 Powering Recovery Nepal Development Update some of the most expensive sources of electricity tion to these natural endowments, there are a sig- at a cost of $0.5 to $1.0 per KWh. This captive- nificant number of projects that are under various type generation capacity is estimated at around stages of development. Since 1993, when the Gov- 500 MW. In addition, Nepal imports about 300 ernment of Nepal opened hydropower generation MW of electricity from India. to the private sector, some 13,000 MW hydropow- er projects have been licensed to potential develop- Nepal’s national power utility (Nepal Elec- ers. tricity Authority, NEA) is a government- owned monopoly that is facing various prob- More recently, Project Development Agree- lems. It has high costs of service, as it loses about ments (PDAs) for two large export-oriented one quarter of the electricity that it supplies hydropower projects were signed in late 2014. through its transmission and distribution systems. PDAs were signed for the Upper Karnali and Arun In addition, tariffs charged for the electricity can 3 projects, each with a capacity of 900 MW and an cover only about 80 percent of the costs. The estimated investment cost of around $2 billion. result is a utility that is financially weak, is unable There are five additional large projects with a ca- to generate needed cash flow for investments, and pacity of 2,500 MW and investment costs of about relies on the subsidies from the government’s $4 billion that are in the preparation stage by inter- budget to stay afloat. national companies. Furthermore, there are some 2,600 MW (around $4 billion in investments) of In short, electricity in Nepal is unreliable, smaller hydro projects which are at different stages insufficient, and expensive. As such, it has be- of development by private independent power pro- come a major constraint for Nepal’s development ducers (IPPs) in Nepal. Put differently, at present and hampers its ability to improve living stand- there are about 7,000 MW of projects under devel- ards, raise agriculture productivity and incomes, opment, with investment costs of about $10 billion and help its youth transition from farming to non or almost 50 percent of GDP. Of this, however, -farm employment though creation of new indus- only about 1,800 MW of projects have actually mo- tries at home. bilized sufficient financing and are under construc- tion at present (Figure 29). 2. What could Nepal’s electricity energy sec- tor look like? Historically, the development track record of new generation capacity is dismal. Since 2002, It does not have to be this way. Nepal is abun- NEA has commissioned only 70 MW of new hy- dantly endowed with hydropower resources that dropower capacity, while IPPs have added about can both meet the domestic electricity needs and enable it to become an important player in region- al power markets. Nepal’s hydropower potential is Figure 29: Projected generation capacity addition estimated at 84,000 MW, of which 43,000 MW is deemed economically viable. At present, less than (MW) two percent of this potential is being exploited. 10,000 Long-term Projects 9,000 In addition, with an average of 300 days of 8,000 3,600 sunshine per year, the commercial potential of solar power for grid connection is estimat- 7,000 Medium-term ed at around 2,100 MW. Nepal also has poten- 6,000 Projects tial for wind power generation, although explora- 5,000 2,900 tion of this potential and mapping of sites is in 4,000 the early stages. There are no fossil fuel resources 3,000 Under Construction in the country and it relies fully on imported pe- 2,000 1,800 troleum products for transportation and other Commissioned needs. This leaves hydropower as the least-cost 1,000 820 option not only for meeting domestic demand, 0 2015 2020 2025 2035 but also to transform Nepal into a significant power source for the South Asia region. In addi- Source: NEA and WB Staff Estimates September 2016 THE WORLD BANK GROUP 16 Powering Recovery Nepal Development Update 325 MW. In other words, NEA was able to add tor are needed. Something radically different needs only 5 MW of new capacity per year on average, to be done if the country wants to construct more while IPPs added about 25 MW per year for a new capacity in the next 10 years than the 300 combined 30 MW per year. Transmission and dis- MW commissioned in the past 10 years. In the tribution suffer from similar problems. In this absence of such reforms, the most likely result is a same period, only a few new transmission line pro- repeat of the past performance. jects were completed. Issues that need to be resolved can be grouped Nepal can and should do much better. Its elec- into four broad categories: tricity sector is unreliable, insufficient, and expen- sive not because of lack of natural endowments or (i) Improvement in Strategic Planning: lack of planned projects, but because it is orga- nized and regulated in a way that is not generating Power System Master Planning is needed to sufficient new investments. guide investments. In all aspects of the electricity sector (i.e. generation, transmission, distribution, 3. How to mobilize investments in hydroelec- and electrification), a set of compatible master tricity plans is needed to determine the least-cost in- vestment plan. Given its natural endowments, it is not a big stretch to envision an electricity sector in Ne- The creation by the government of a master plan pal that can support green growth, poverty re- for electrification would be critical to enabling duction, and shared prosperity for the country. effective estimates of future demand for electric- Such an electricity sector would not only meet the ity. Once the demand projection is established, a domestic demand reliably, affordably, and cleanly, generation master plan can be developed to meet but would also earn revenue from export of sur- this demand. Generation projects need to be plus hydropower through enhanced regional elec- planned on a least-cost basis in the context of tricity markets to neighboring countries by inte- river basins. Once the source and end destina- grating with the wider South Asia power market. tion of electricity is identified, a master plan for transmission can be developed that connects the However, strategic planning for the sector has two. Planning the generation in terms of river been erratic. Since 2001, there have been five basins enables construction of transmission cor- strategic documents, one every three years on aver- ridors that minimize the cost of transmission age. In 2001, the Government of Nepal adopted a lines. As a result, these master plans would give a Water Resource Strategy which was revised in 2005 reliable indication of investment needs in the into a National Water Plan. In 2007, a plan calling generation, transmission, and distribution seg- for construction of 10,000 MW in 10 years was ments of the electricity sector. These master adopted, which was then altered in 2009 to be- plans should be done for a 10-20 year planning come a plan for 25,000 MW in 10 years. Finally, in horizon and updated in a timely manner as re- the wake of the trade disruptions that affected the quired. import of petroleum products acutely, the govern- ment came out with another revamped plan, this (ii) Improvement of the Regulatory Frame- time calling again for 10,000 MW in 10 years. work: While these plan focus on the investment Traditionally, the electricity market is considered goals, they lack measures needed to develop a to be a natural monopoly requiring either nation- clear and well-regulated environment. Attract- alization or strong regulation. With technological ing and retaining investment in the tens of billions development and innovations in information of dollars requires mechanisms for sharing risks, technology, electricity is no longer a monopoly the provision of common infrastructure such as business. Different market models are in opera- transmission corridors and roads, and streamlined tion in the electricity sector, including wholesale procedures within the context of a clear and strong competition, retail competition, and operation of legal and regulatory framework. Put simply, a power pool system. Nonetheless, all these mar- wholesale structural reforms of the electricity sec- ket mechanisms still require proper regulation. September 2016 THE WORLD BANK GROUP 17 Powering Recovery Nepal Development Update Establishment of an independent sector regulator fit-sharing policy to allow developers to make in- that will oversee planning so that future demand formed decisions and ensure achievement of the can be met with an adequate supply at the lowest sector vision in a sustainable way. There is a need cost possible and to determine the prices that will to enhance the regulations in cumulative impact generate the appropriate level of investment is, assessment, environmental flows, and benefit shar- simply, critical. The key role that the new electrici- ing and to provide clear guidelines for developers ty regulator would have is to set tariffs for electric- to follow. ity. Tariffs need to be set at a level that covers reasonable operational costs (i.e. limiting the level Similarly, adoption of a transmission line right-of- of system losses) and also offers a reasonable re- way (RoW) policy is needed to speed up imple- turn on assets. Such tariffs achieve two things. mentation of new transmission lines. This policy First, they would allow the utility to phase out would define the appropriate consultation policies government subsidies, and second, they would that need to take place with affected communities generate cash flows that would enable invest- and set up parameters for compensation for land ments. A crucial complement to such tariffs is a acquisition and livelihood restoration. Once these social safety net that protects the poor and their issues were streamlined through a country-wide basic needs for electricity services though a target- policy, they would not need to be negotiated on a ed subsidy. project-by-project basis. (iii) Improvement of Investment Environ- (iv) Improvement in organization of the sector: ment: At present, the Nepal Electricity Authority (NEA) One of the chronic problems in Nepal in general, is a vertically-integrated, government-owned mo- and in the power sector in particular, is the inabil- nopoly. As it is inefficient (large losses) and una- ity of the public sector to execute capital projects ble to deliver sufficient power to consumers (large in a timely manner, which results in incomplete power cuts), there is a need to restructure the physical assets. Some hydropower projects under NEA’s generation, transmission, and distribution implementation by NEA (e.g. Chamelia and Ku- operations into separate businesses. Already com- lekhani 3) are taking more than 10 years. Similarly, petition exists in generation, with NEA and inde- many transmission lines could not be completed pendent power producers developing power for more than five years due to the delay in ac- plants and foreign companies having signed power quiring the land and forest clearance permits, as purchase agreements to develop new ones as well. well as other obstacles. In order to ensure a level playing field among the- As indicated above, power system master planning se different producers, the transmission network is crucial to the strategic selection of least-cost needs to be separated and independent from any investment projects. Similarly, a transparent and generation company, so that it does not offer competitive selection of hydropower developers preferential treatment to any of them. For exam- for identified projects is central to developing pro- ple, we would not want one bus company owning jects that will result in electricity produced at the the roads and interfering with the work of other lowest tariff possible. In order to do that, feasibil- transport companies. Consequently, establishing ity studies and preferably conceptual design and operationalizing a National Transmission and should be completed for each project before it is Grid Company (NTGC) is necessary in order to offered for bidding. Developers should be re- transfer the transmission assets and corresponding quested to bid a capacity and energy profile rather liabilities from the NEA. than a single value to take into account finance availability and terms for hydropower develop- Similarly, the remaining distribution assets and ment. Bids should be evaluated based on the pre- liabilities should be transferred to a distribution sent value of the tariff offered, taking into account company that would be supplying the electricity to the alternative cost of imported power and energy. consumers. At the end of the reform process, NEA would be reorganized into three different Clear guidance and requirements on environmen- companies (generation, transmission, and distribu- tal and social requirements should include a bene- tion). September 2016 THE WORLD BANK GROUP 18 Powering Recovery Nepal Development Update So what could Nepal’s power sector look like drafting of a whole set of sector policies, namely a by 2030 to ensure a reliable, affordable, and suffi- National Energy Security Policy (NESP), Integrat- cient supply of electricity to meet not only the do- ed Water Resources Management Policy mestic demand but also to export electricity to pro- (IWRMP), and National Renewable Energy Policy mote and sustain green growth? (NREP).  Nepal’s power sector would be transformed In terms of strengthening the regulatory envi- into separate commercially sustainable genera- ronment, an update of the Electricity Act, a new tion, transmission, distribution, and power National Energy Regulatory Commission (NERC) trading entities, along with strong and inde- Act, and an update of the Water Resource Act are pendent regulatory agencies with clearly de- either drafted or are in the final stages of prepara- fined roles and responsibilities; tion.  Sufficient generating capacity would be in- In terms of institutional restructuring, the Na- stalled through both public and private invest- tional Transmission and Grid Company (NTGC) ments to meet the domestic demand and ex- has been established and the company registration port significant hydropower through a number process completed. A study on power trading has of export-oriented projects; been completed and the establishment of a Power Trading Company (PTC) recommended. A study  An expanded system of transmission lines on the road map for NEA restructuring and on a would be developed to deliver electricity to all market structure for roles and functions of these major urban and rural areas and link with new sector institutions has been initiated. neighboring countries to enhance the regional energy trade; 5. What would a comprehensive reform pro- gram look like?  A financially self-sustaining, reliable, and effi- cient local distribution network would be de- Obviously, not everything could or should be livering power to all consumers; tackled at the same time. A recommended strategy for the Government of Nepal to achieve the  An independent regulator would be ensuring above-stated objective could be as follows: competition, fairness, and efficiency for expan- sion and smooth operation of the power sec-  Prepare sector restructuring (1-2 years) tor, including setting wholesale and retail elec- i) Complete or initiate (as appropriate) plan- tricity tariffs. ning exercises in the areas of generation, transmission, distribution and rural elec- 4. Government’s policy response trification; ii) Advance preparation of project docu- To be fair, the Government of Nepal has ments for medium and large domestic and thought through many if not most of these is- export-oriented hydropower projects and sues. A concept paper released in February 2016 transmission lines which previous studies (National Energy Crisis Prevention and Electricity have indicated to have high priority; Development Decade, 2016) calls for the construc- iii) Carry out a tariff study dealing both with tion of a 10,000 MW capacity through hydropow- the structure and level of tariffs and com- er, solar, and wind projects over the next 10 years. mence the process of tariff adjustment; It urges immediate tariff and institutional reforms iv) Develop a comprehensive time-bound and proposes re-visiting the sector policies, passing power sector reform plan that is agreed to enabling legislation, and establishing a regulatory by all stakeholders to address key sector framework. This concept paper grew out of two issues, starting with a workshop involving years of work by various government agencies. all stakeholders. In terms of strategic planning, government  Reduce power cuts (1-2 years) agencies have initiated preparatory work for the i) Rehabilitate existing generation plants to envisaged policy and reform actions, including the increase supply; September 2016 THE WORLD BANK GROUP 19 Powering Recovery Nepal Development Update ii) Rehabilitate distribution network to re- i) Meet domestic demand reliably and afford- duce system losses; ably; iii) Expand critical cross-border transmission ii) Generate electricity exports by transform- lines that can bring additional power and ing Nepal from an 800 MW country to a expand the supply. 10,000 MW country with full integration into South Asia’s regional power system.  Achieve supply-demand balance (3-5 years) i) Commission hydropower under construc- Nepal does not have to do this alone. Develop- tion (about 1,800 MW); ment partners have welcomed the recent concept ii) Expand imports (300-600 MW); paper and the Action Plan on National Energy Cri- iii) Implement sector policy and reform ac- sis Prevention and Electricity Development Dec- tions in accordance with the agreed-upon ade prepared by the government. Development plan. partners have offered support to key activities un- der this plan and can help the Government of Ne-  Generate surplus electricity for export sup- pal to formulate a vision, strategy, and achievable ply (10-20 years) plan to transform the power sector. September 2016 THE WORLD BANK GROUP 20 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