82383 NEPAL DEVELOPMENT UPDATE POVERTY REDUCTION AND ECONOMIC MANAGEMENT SOUTH ASIA REGION OCTOBER 2013 N E PA L D E V E LO P M E N T U P D AT E 1 Table of Contents Summary 2 Recent Economic Developments 4 Policies and Short- to Medium-term Development Challenges 13 Short and Medium-term Economic Projections 17 Bank Support and Activities 20 Special Focus 22 This report was prepared by a team composed of Aurélien Kruse, Roshan Darshan Bajracharya and Deb Narayan Mahato with inputs from Johannes Zutt, Tahseen Sayed, Johannes Widmann and Rajib Upadhya. 2 N E PA L D E V E LO P M E N T U P D AT E Summary Nepal’s political developments continue to budget in FY13 depressed public spending and overshadow and impede its economic develop- negatively affected investor sentiment, while agri- ment. Since the end of the monarchy, politics have culture sector activity suffered from a weak mon- trumped economics, a trend that needs to be re- soon. Overall, economic growth is estimated to versed to put Nepal on a higher growth trajectory. have dipped to a relatively anemic 3.6 percent, with With elections for a new Constituent Assembly average inflation just under the double-digit mark. expected in November, political volatility and un- certainty continue to hamper growth-oriented fis- While Nepal’s macroeconomic fundamentals cal policies and have prompted the private sector to remain stable, sources of vulnerability have not adopt a wait-and-see position regarding future in- disappeared. Despite a large – and growing – trade vestment. While the Government of Nepal (GoN) imbalance, the current account remained in surplus has tackled some of the bottlenecks (particularly and significant foreign exchange reserves were ac- with respect to budget preparation and execution) cumulated in FY13, thanks to the countervailing that hampered public policy in FY13, it will need impact of remittances, which continued to grow to continue and expand this effort in FY14, which robustly (albeit at a slower pace than in previous will be a challenging year. years). However, whether Nepal’s dependence on remittance income is sustainable or desirable in the Over the short term, whether the scheduled elec- long run is an open question. On the fiscal side, tions are held and, if so, whether they achieve the combined effect of low spending and contin- a modicum of consensus will be a major test. If ued impressive revenue growth has allowed the elections are held successfully, both public and pri- government to reduce its overall stock of debt as a vate investments are expected to recover from the percentage of GDP, but low public investment also low levels seen in recent years. But increased po- negatively affected the economy’s future growth litical stability and a short-term economic recovery potential. in themselves would not be enough to put Nepal on a solid growth path. Over the medium term, Although the financial sector has rebuilt political stability needs to be followed by structural strength, it remains an important source of reforms that tackle enduring sources of fragility, weakness. All key indicators of financial sector including financial sector consolidation, public health –credit-to-deposit ratio (CDR), exposure financial management reform, investment climate to real estate, non-performing loans (NPLs)– have improvements, and a strategy to address the gradu- registered significant improvements, on the back of al erosion of Nepal’s external competitiveness. resolute policy interventions by the Nepal Rastra Bank (NRB) though concerns about underlying as- Political instability clouded the outlook in FY13 set quality data remain and accommodative mone- and remains the principal source of vulnerabil- tary policy has facilitated rapid credit growth. Even ity going forward. The delayed adoption of a full so, further consolidation is needed, with key policy N E PA L D E V E LO P M E N T U P D AT E 3 actions still pending or in progress, and it may also Nepal has ample scope to increase spending, while be necessary to adopt a tighter monetary stance in maintaining overall fiscal sustainability targets - an coming months. opportunity that ought to be put to good use by boosting capital spending. Important initiatives to improve the governance environment have been taken, but these initia- While important psychologically and for some tives could be amplified further. In past months, sectors of the economy, the recent depreciation the government has taken steps to address major of the Nepal rupee is not expected to hold back bottlenecks to public expenditures and private growth or to threaten macroeconomic stability. sector development. These include streamlining Nepal does not share the twin current account and the budget preparation/adoption process (which fiscal deficit problems of the Indian economy and could be further institutionalized), undertaking it has important buffers against currency shocks, high-profile anti-corruption initiatives (as part of a including most notably strong remittance inflows. broader effort to strengthen public financial man- That said, specific sectors of the economy will suf- agement (PFM)), and establishing the Investment fer. Of particular concern are (i) the financial health Board Nepal, which appears to be on track to ap- of major state-owned enterprises (SOEs) facing in- prove several transformational infrastructure proj- creased import costs, and (ii) possible inflationary ects in the coming months. pressures, which may need to be managed proac- tively. While a revision of the peg with India may For FY14, the baseline scenario is a gradual re- eventually be warranted, the report agrees with turn to trend, with higher growth and sustain- Nepali policy makers that this is not the time – able fiscal expansion. If elections are held on time when markets are unstable – to move impulsively. and the result achieves broad consensus, macro- Instead, such a major policy shift should be based economic projections point to a gradual return to on clear policy objectives and in-depth analysis of economic growth of 4.0 to 4.5 percent, with infla- likely economic outcomes, including the long-term tion remaining in single digits. The government of impact on Nepal’s trade competitiveness. 4 N E PA L D E V E LO P M E N T U P D AT E Recent Economic Developments E conomic growth fell to 3.6 percent in FY13, as shortfalls in public expenditure depressed aggregate demand and agricultural output suffered from poor rainfalls. Political uncertainty continued to hamper industrial activity, with services providing the only source of dynamism in the economy. While fiscal balances improved, this was partly a result of low public spending, which contracted in real terms. Despite lackluster growth and fiscal contraction, inflation remained high and significantly above target. On the external side, Nepal’s growing trade deficit continues to be financed by robust remittance transfers. Economic growth slowed as political budget adoption, and informal cross border trade uncertainty accentuated structural was unable to fill the gap. Beyond its impact on weaknesses overall economic growth, the poor performance of The overall growth rate for FY13 is estimated to the agricultural sector is bound to have adversely have been 3.6 percent, down from 4.9 percent in impacted the incomes and consumption of some of FY12. This weak performance is essentially due to the poorest segments of the population. historically low levels of activity in both the agri- culture and industrial sectors, which grew respec- Industrial output performed only margin- tively at only 1.3 percent and 1.6 percent in FY13. ally better, as structural bottlenecks were com- For agriculture, this was the weakest performance pounded by weak public demand and political of the past five years and for industry an improve- uncertainty. In FY13, the industrial sector grew at ment only relative to FY09, when industrial output a weak 1.6 percent, down sharply from 4.3 percent contracted (Figure 2). By contrast, services growth and 3.0 percent in FY11 and FY12. Manufactur- reached 6 percent, accounting for over 80 percent ing activity growth slowed to 1.8 percent (from 3.6 of total GDP growth. percent the previous FY) as unresolved structural bottlenecks were compounded by political uncer- Low agricultural output reflected adverse cli- tainty. Although construction activity picked up matic shocks as well as undersupply of key in- from FY12 (1.6 percent vs. 0.2 percent growth), puts. The agriculture sector, which accounts for when the real estate bubble burst, it remained con- 34.4 percent of gross value-added, grew by just 1.3 strained by delays in budget execution, low levels percent in FY13, compared to 5.0 percent and 4.5 of public spending on capital projects, restrictions percent in FY12 and FY11. The impact of an un- on bank lending to the real estate sector as well as favorable monsoon was compounded by shortages investor nervousness over possible further price in chemical fertilizers during the peak planting sea- corrections in Kathmandu and other major cities. son as public procurement of fertilizers to be pro- In addition, the depreciation of the rupee –though vided at subsidized prices was affected by delays in modest during FY13– led to higher costs of im- ported inputs and raw materials. N E PA L D E V E LO P M E N T U P D AT E 5 The only source of relief came from the services FIGURE 1: Historically low levels of agricultural and industrial sector, which accounts for an ever-growing share activity depressed growth in FY13 of total value-added (Figure 2).In FY13, the ser- GDP growth rate by sectors vices sector experienced a healthy growth of 6.0 7.0 percent, up from 4.5 percent and 3.4 percent in 6.0 5.0 FY12 and FY11. Within the sector, wholesale and 4.0 retail trade (+9.5 percent), hotels and restaurants 3.0 (+6.8 percent), transport, storage and communica- 2.0 tions (+6.7 percent), and financial intermediation 1.0 0.0 (+6.6 percent) saw considerable growth, whereas in FY09 FY10 FY11 FY12R FY13P -1.0 the remaining sub-sectors (real estate and public/ Agriculture Industry Service GDP at producers price community services) it was more muted. Interest- Source: CBS ingly, services sector growth has been unaffected by the deceleration in remittance growth in FY13, FIGURE 2: Services account for over half of total value added possibly because of lag effects (Figure 3). Gross value added to GDP by selected sectors 100% Cost-push inflation close to double 90% 80% digits 45.9 46.6 47.3 47.9 48.9 49.7 49.5 49.5 50.6 70% Inflation rose in FY13, reversing a trend of 60% % of GDP 50% steady decrease since FY09. Overall inflation 16.6 16.7 16.8 16.2 15.5 15.5 15.5 15.3 15.0 40% reached 9.9 percent in FY13, closing well above the 30% NRB’s initial target of 7.5 percent (and the mid- 20% 37.4 36.6 35.9 35.9 35.6 34.8 35.0 35.2 34.4 10% term revised target of 9.5 percent). It remained 0% above 10 percent until mid-March 2013 (except in FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13P mid-January 2013 when it dipped to 9.8 percent) Agriculture Industry Service and moderated only in the last four months of the Source: CBS+WB Staff estimate fiscal year. Despite the onset of the depreciation in May, inflation was down at the end of the fiscal FIGURE 3: The services sector unaffected by lower remittance growth year, reflecting seasonal trends, similar movements Remittance and services sector growth in Indian prices, and the ability of firms to mobilize 60.0 8.00 inventories. 7.00 50.0 6.00 Services Sector growth The persistence of high prices despite low growth Remittance growth 40.0 5.00 is essentially attributable to “cost-push” factors 30.0 4.00 (Figure 4). The disappointing harvest in FY13 trig- 3.00 gered a surge in imports of food items (with im- 20.0 2.00 ports of rice and vegetables from India growing at 10.0 1.00 98 percent and 76 percent) and an upswing in food prices, which increased by 9.7 percent in FY13, 0.0 0.00 FY06 FY07 FY08 FY09 FY10 FY11 FY12R FY13P compared to 7.6 percent in FY12. In parallel, non- Remittance Growth Services Sector Growth food prices also increased by 10 percent in FY13, Source: NRB+CBS compared to 9 percent in FY12. The increase was 6 N E PA L D E V E LO P M E N T U P D AT E FIGURE 4: Inflation close to double digits largely due to structural factors –supply-side rigidi- 20 ties– and adverse developments such as (i) higher 18 prices of petroleum products (following needed 16 increases in administered prices for diesel, petrol, 14 and LPG in September and December 2012) that 12.6 12 raised transport costs, and (ii) the onset of the ru- 10 9.6 9.6 9.9 pee’s depreciation against major convertible cur- 8.3 8 rencies, affecting simultaneously the price of (for- 6.7 6 eign currency denominated) imported goods and 4 domestic costs of production (via imported inputs 2 and raw materials). 0 FY08 FY09 FY10 FY11 FY12 FY13 Given Nepal’s close integration with the Indian Overall Price Rise Food and Beverage Non-Food and Services market and its currency peg with the Indian ru- Source: NRB+WB Staff estimate pee, inflation in Nepal has closely followed price trends in India (Figure 5). Indeed, with the open border between the two countries, any sharp mis- alignment in prices –particularly of foodstuffs and petroleum products – would give rise to informal trade on a vast scale. FIGURE 5: Overall price movements are closely aligned to India’s CPI Nepal and India (y-o-y percent change) 25.0 20.0 15.0 10.0 5.0 0.0 Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Jul FY09 FY10 FY11 FY12 FY13 Nepal Food Nepal Non-Food CPI India Industrial CPI Nepal Source: NRB and RBI N E PA L D E V E LO P M E N T U P D AT E 7 A growing trade imbalance matched Growing remittance transfers are both a driver of by robust remittance import growth – and possibly export atrophy – Nepal’s trade balance continued to deteriorate and a lifeline. Workers’ remittances grew by 20.9 in FY13, with adverse developments in both ex- percent in FY13 on top of the remarkable 41.8 per- ports and imports. The trade deficit reached 27.1 cent increase in the previous year (in local currency percent of GDP in FY13, a record low (down from terms). As a result, officially recorded private trans- 24.3 percent the year before). Export growth decel- fers amounted to over 25.5 percent of GDP in FY13 erated to a mere 3.6 percent in FY13 (compared to and 79.4 percent of the total merchandise import bill 15.4 percent in FY12), while imports growth rose (over four times the oil import bill). Private transfer to 20.6 percent in FY13 (compared to 16.5 percent volumes are 13 times higher than official grant assis- the previous year). Merchandise imports as a share tance received by the government. While contributing of GDP reached 32.2 percent, from 29.6 percent in to Nepal’s staggering import growth (via demand for FY12, while exports accounted for barely 5 percent imported consumer goods and food), private transfers of GDP. The structural drivers of import growth are also a lifeline allowing Nepal to finance its trade include (i) increased demand for fuel in a period of deficit and maintain current account balance. rapidly increasing prices, (ii) adverse relative prices that induced agents to substitute domestic prod- The current account remained in surplus in ucts for foreign ones, and (iii) increased domestic FY13, although by a smaller margin than in demand driven by remittance inflows (Figure 6). FY12. With a modest net surplus in services trade BOX 1: Domestic agents substituting foreign for domestic products Nepalese firms and consumers appear to be analysis shows a robust positive correlation between the substituting foreign for domestic products. real exchange rate (RER) and import trajectory conditional The ratio of Nepalese imports of industrial sup- on income (GDP and remittance). plies to GDP has been growing from about 0.1 to more than 0.25 over the last five years, suggest- Rolling relationship between RER and imports conditional on ing that Nepalese firms are increasingly moving GDP and remittance to technologies more reliant on foreign inputs. Analogously, at the consumption level, the ratio 6 of imports of consumer goods to GDP acceler- ated after 2008, growing from 0.1 to slightly less 4 than 0.25 in a three-year period. 2 The Nepali rupee’s real appreciation as a re- 0 sult of fast increasing domestic prices com- -2 bined with the nominal exchange rate peg to 1994 1996 1998 2000 2002 the Indian rupee partly explain this dynamic. Start Coefficient RER During the 2003-10 period, the ratio of the CPI to Coeff. RER Upper Bound (90% Conf.) the official nominal exchange rate increased at an Coeff. RER Lower Bound (90% Conf.) annual rate of 8 percent, and simple regression NB: Ten year rolling relationship; 2002 data point includes ten years onward (to 2012) Source: Trade Competitiveness Assessment of Nepal, World Bank (forthcoming) 8 N E PA L D E V E LO P M E N T U P D AT E FIGURE 6: The trade deficit, growing with remittance inflows (0.45 percent of GDP) and stable net income re- 30.0 Remittance, Reserve, Current Account and Trade Deficit (percent of GDP) ceipts (0.77 percent of GDP), the current account 25.0 surplus recorded in FY13 (3.3 percent of GDP) is 20.0 almost entirely attributable to net current transfers 15.0 (29.3 percent of GDP). Transfers also account for 10.0 the steady build-up in gross official reserves from 5.0 USD 4.3 billion to USD 4.97 billion between 0.0 FY12-13. Import coverage remained at a comfort- -0.0 able 7.6 months of imports, up from 7.2 in FY12. -10.0 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 Trade deficit Reserves, Worker Current account The Nepal government underspends incl. service net change remittances balance on both recurrent and capital outlays Source: NRB+WB Staff estimate Nepal experienced a (real) fiscal contraction in FIGURE 7: Lackluster investment over the past decade FY13. Significant delays in budget approval (a full 25.00 budget was adopted only in the fourth quarter) de- pressed public spending, which grew modestly in 20.00 nominal terms (by 1.75 percent on a cash basis, ex- % of nominal GDP 15.00 cluding “financing” expenses) and declined in real terms. Recurrent expenditures, which accounted 10.00 for 71 percent of total government spending, grew 5.00 by a modest 1.55 percent in nominal terms, while 0.00 capital expenditures recorded a 2.7 percent in- FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12R FY13p crease. As a result, public expenditure as a share of Gross Fixed Capital Formation (GFCF) Government share of GFCF Private Share of GFCF GDP declined from 19.2 percent in FY12 to 18.8 Source: CBS+WB Staff estimate percent in FY13. Actual spending was significantly below budgeted amounts, reaching 90.5 percent of FIGURE 8: Revenue growth driven by customs and income tax plan for recurrent expenditures and only 81 per- Revenue growth (% change) cent for capital expenditures, reflecting both some 50.0 45.0 40.0 degree of fiscal responsibility (moderate recurrent 35.0 30.0 25.0 spending) as well as Nepal’s chronic inability to 20.0 15.0 10.0 upgrade its public infrastructure, despite having 5.0 0.0 ample fiscal space to do so. Value added Tax Customs Income Tax Excise Registration Fee Vehicle Tax Educational Service... Indeed, in contrast to expenditures, total rev- enue continued to rise sharply – above ambi- 2011/12 2012/13 tious budget targets – owing to both higher imports and greater tax efficiency. Total revenue Source: NRB 1 Particularly vehicles and spare parts for which the import duty ranges from 32.88 percent to 138.66 percent. N E PA L D E V E LO P M E N T U P D AT E 9 growth was above 20 percent for the second year FIGURE 9: Composition of total revenue in FY13 in a row (21.2 percent in FY13 vs. 22.2 percent Composition of total revenue in FY13 in FY12). Total revenue amounted to 17.4 percent of GDP in FY13, and taxes alone accounted for Educational Service Tax, 0.1 15.3 percent of GDP. The increase was driven by Other Tax*, 1.7 Non - Tax Revenue, 12.3 custom receipts (31.1 percent growth on the back Value Added Tax, 28.2 of sharp import value and volume growth1) and Customs, 19.2 Income Tax, 22.6 income tax payments (28.1 percent growth) as ef- Excise, 12.4 forts to strengthen the Inland Revenue Division2 Registration Fee, 2.0 Vehicle Tax, 1.5 continued to pay off (Figure 8). As a result, customs and personal income tax (PIT) together accounted for just under 42 percent of total revenue. While Source: NRB value-added tax (VAT) receipts also grew at a healthy FIGURE 10: Revenue, expenditure and overall balance before grants as a share of GDP rate (15.7 percent), their share in the total declined 25.0 from 29.6 percent to 28.2 percent (Figure 9). 20.0 Strong revenue growth shrank the overall budget 15.0 deficit (after grants) to its lowest level in years. % of GDP 10.0 After grants, the budget balance as reported by the 5.0 NRB ended up in a deficit position equivalent to 1.1 percent of GDP – against a deficit of 1.45 per- 0.0 FY11 FY12 FY13P cent and 3.7 percent in the preceding fiscal years3. -0.0 Given limited alternative spending opportunities, Total Revenue Total Expenditure Overall Balance Before Grants -10.0 the government chose to channel domestic borrow- Source: NRB ing to draw down previous debt. With limited financing needs, domestic borrow- FIGURE 11: Overall and primary balance ing was partly channeled to retire high interest Overall and primary balance ( In percent of GDP) bearing debt and to cover past overdraft bal- 4 ances. In FY13, domestic borrowing amounted to 2 1.1 percent of GDP. Of that, 41.4 percent was used 0 to cover the government’s financing needs (includ- 2006 2007 2008 2009 2010 2011 2012 2013 2014 ing “financial expenditures”, which increased by 51 -2 Budget percent in FY13 from FY12), while the remaining -4 58.6 percent went toward past overdraft clearance. -6 Overall debt levels are comfortably – and in- -8 creasingly – low. In spite of low GDP growth, to- Overall balance before grants (fiscal) Domestic financing (net) Primary Balance tal public debt declined to 30.8 percent of GDP Source: NRB+WB Staff estimate 2 Including measures to increase tax compliance (links to the company registrar’s office) and reduce the cost (online filing and payments and Any Branch Banking Services) as well as to promote greater internal supervision. 3 Following IMF data and classification of Government Operations, the GON was a net lender in FY13 with total revenues and grants in excess of total expenditure by 2 percentage points of GDP. 10 N E PA L D E V E LO P M E N T U P D AT E (from 33.6 percent the previous fiscal year) as total declined to 16.3 percent in FY13 from 22.7 per- domestic and external debt shrank (to 11.1 and cent in FY12 (Figure 12). 19.7 percent of GDP from 12.9 and 20.7 percent the previous year). While significant fiscal revenue Financial sector consolidation is growth has limited the need for domestic borrow- gradually paying off ing, the government of Nepal’s prudent stance is The financial year ended with a significant easing also a reflection of limited productive spending of liquidity pressure, rising profits, declining re- opportunities, when significantly higher levels of ported NPLs, and an improved capital position. domestic borrowing – up to 2 percent of GDP – However, only once the results of ongoing stress would remain perfectly consistent with debt sus- tests and in-depth diagnostics of financial sector in- tainability. stitutions are known will it be possible to confirm that risks from real estate and other credit exposure Debt service remains low and sustainable. While as well as vulnerability to potential loss of depositor total debt service payments (interest and amorti- confidence have been substantially lowered. zation) amounted to just under 9 percent of total expenditure in FY13 (1.63 percent of GDP), the After increasing sharply at the end of FY12 and external debt service (interest and amortization) ac- in the first three quarters of FY13, liquidity pres- counted for roughly half – 53 percent – of the total. sures eased. The overall credit-to-deposit ratio of commercial banks (local currency) reached a peak Although fiscal balances are healthy, quasi-fiscal of 83.4 percent in Q3 before declining back to 79.2 liabilities are believed to be significant. Improve- percent (as deposits grew sharply in the last quarter ments in the government’s fiscal position should in synch with public spending). This is still signifi- be welcomed with some caution as quasi-fiscal li- cantly above 76.2 percent in Q4 of FY12 as credit abilities are believed to have increased significantly. grew faster than deposits (21.7 percent vs. 17.7 The Nepal Oil Corporation (NOC) and the Nepal percent) (Figure 1). Overall risk declined as only Electricity Authority (NEA) have been accumu- three commercial banks (9 percent market share) lating net losses for years in excess of 1 percent of recorded CDRs in excess of 90 percent, compared GDP, which will increase further in FY14 as a re- to seven (17 percent of market share) the previous sult of the rupee’s loss of value relative to the dollar fiscal year. (in which both IOC sales to the NOC and NEA’s power purchase agreements with some indepen- With abundant liquidity, commercial banks dent producers are denominated). In parallel, the posted record annual net profits. The commercial government’s pension related obligations have in- banking industry posted a record annual net profit creased to over 2 percent of GDP in FY13 with no of NRs 20.1 billion in the fourth quarter of FY13 provision to cover them. compared to NRs 15.5 billon in the same period of FY12 – a year-over-year (y-o-y) growth of 30 per- Monetary policy cent. This was thanks to higher net interest income Money growth slowed in FY13. Slower remit- (NII – growth by 35 percent), foreign exchange tance growth, higher imports relative to exports earnings and write back of loans. NII accounted for and a decline in foreign grants led to a slowdown 79 percent of the Total Operating Income. Based in the growth of Net Foreign Assets (NFA) – to 18 on data from 28 (of 31) banks, although the aver- percent in FY13 from 59.5 percent in the previous age yield declined from 11.7 percent in Q4FY12 year. As a consequence broad money (M2) growth to 10.3 percent in Q4FY13, the interest spread in- N E PA L D E V E LO P M E N T U P D AT E 11 creased from 4.0 percent to 4.6 percent with the FIGURE 12: Evolution of key monetary aggregates decline in average industry cost of funds from 7.4 Monetary Sector (% change) percent to 5.6 percent. With an improved liquid- 70.0 ity position, banks were able to reduce interest on 60.0 deposit, while there was a lag in reduction of lend- 50.0 % Change ing rates. One private sector bank (Kist Bank, 2.1 40.0 30.0 percent of the system) incurred a net loss of NRs 20.0 89 million due primarily to making loan loss provi- 10.0 sions of NRs 720 million for realty sector related 0.0 loans. All three state-controlled banks registered Net Foreign Net Domestic Broad Money Broad Money Assets Assets (M2) Liquidity (M3) net profits (totaling NRs 4.6 billion). 2010/11 2011/12 2012/13 The overall capital position of the commercial Source: NRB+WB Staff estimate banking industry has improved significantly owing to capital injections in state-controlled FIGURE 13: Strong deposit growth in Q4 eased liquidity constraints banks and increased retained earnings. The aver- Credit-Deposit Ratio of Commercial Banks age Capital Adequacy Ratio (CAR) is computed as 14.2 percent compared to 12.1 percent last year. All 90 banks meet the minimum CAR of 10 percent (plus 85 1 percent buffer capital) except two state-controlled banks (representing 14.8 percent of the system). 80 Percentage These banks – NBL and RBB – have improved their 75 CAR y-o-y from (-) 5.5 percent to (-) 0.5 percent and (-) 9.3 percent to (+) 3.3 percent respectively 70 as a result of equity injection from the government 65 (recapitalization plan) and operational profits. CD Ratio LCY CD Ratio FY FY FY FY FY FY FY FY FY FY FY FY FY FY FY FY FY FY FY FY FY FY FY FY 08 08 08 08 08 08 08 08 08 08 08 08 08 08 08 08 08 08 08 08 08 08 08 08 Real estate exposure has decreased to historically 01 02 03 04 01 02 03 04 01 02 03 04 01 02 03 04 01 02 03 04 01 02 03 04 low levels. Total exposure to real estate declined y- Source: NRB o-y from 17.1 percent to 14.9 percent of the total loan portfolio between the last quarters of FY12 FIGURE 14: Real estate exposure down significantly and FY13 (as overall portfolio outstripped real es- tate credit growth – ). As a result, in FY13 only six Real Estate Exposure as a % of Total Loan Portfolio 23.0% commercial banks (16 percent of the system) had 22.0% 21.2% 21.2% 21.3% 21.4% exposure in real estate in excess of 20 percent as op- 21.0% 20.4% posed to 13 banks (33 percent of the system) in the 20.0% 19.7% 19.9% 19.0% 19.0% previous fiscal year. None of the banks today have 18.9% 18.9% 18.0% 18.1% real estate exposure in excess of 25 percent. 17.0% 17.8% 17.1% 16.0% 16.3% Reported non-performing loans (NPLs) have 15.0% 15.1% 15.1% 14.9% 14.0% also gone down sharply as a share of the total Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 loan portfolio. NPLs made up 2.5 percent of the total loan portfolio as of Q4FY13, the lowest Source: NRB+WB Staff estimate 12 N E PA L D E V E LO P M E N T U P D AT E FIGURE 15: NPLs at a decade low Total Non Performing Loan (NPL) of Commercial Banks 20% 17.33% 15% 14.08% 12.41% 10.99% 10% 10.36% 8.99% 8.71% 6.18% 5.61% 5% 5.89% 5.06% 3.70% 3.72% 3.15% 3.15% 3.31% 3.12% 3.49% 3.82% 2.54% 3.57% 3.21% 3.11% 2.62% 2.79% 3.06% 3.02% 2.47% 0% FY 07 Q1 FY 07 Q2 FY 07 Q3 FY 07 Q4 FY 08 Q1 FY 08 Q2 FY 08 Q3 FY 08 Q4 FY 09 Q1 FY 09 Q2 FY 09 Q3 FY 09 Q4 FY 10 Q1 FY 10 Q2 FY 10 Q3 FY 10 Q4 FY 11 Q1 FY 11 Q2 FY 11 Q3 FY 11 Q4 FY 12 Q1 FY 12 Q2 FY 12 Q3 FY 12 Q4 FY 13 Q1 FY 13 Q2 FY 13 Q3 FY 13 Q4 Source: NRB NPL ratio recorded in the last 10 years and a fur- (ADBL – 6 percent of the system). Eight banks ther improvement from the same period of the last (22 percent of the system) recorded NPLs below financial year (2.6 percent – ). At the same time, 1 percent of the total loan portfolio. Most of the there is some risk that officially reported NPL data remaining banks had NPLs between 1 percent and may understate the asset quality problem owing to 2 percent. The two state-owned banks, NBL and ever-greening and other reporting issues. Total loan RBB, appear to have achieved a significant turn- loss provision coverage vis-à-vis the total NPLs is around in loan recovery. 134 percent for the commercial banking industry, although significant variations exist among institu- With ample liquidity in the system, the cost of tions; three banks had coverage of less than 100 borrowing has remained low. High deposit and percent. Six banks (28 percent of the system) re- slow credit growth in the last quarter of the fis- ported NPLs in excess of 3 percent, of which only cal year brought down the cost of borrowing, with two (8 percent of the system) had NPLs in excess Treasury-bill (91 days) and average interbank rates of 5 percent, including one state-controlled banks falling to 1.1 percent and 0.47 percent. N E PA L D E V E LO P M E N T U P D AT E 13 Policies and Short- to Medium- term Development Challenges F iscal year 2013 has been exceptional, as the constitutional vacuum resulting from the dissolution of the Constituent Assembly added to overall political uncertainty and significantly hampered the budget preparation and adoption process, which both depressed investment in the economy. To some extent, this was only an amplification of deeply-rooted pre-existing structural problems, which remain to be tackled. Moreover, new sources of vulnerability have surfaced: the depreciation of the Indian rupee, to which the Nepali currency is pegged, will undoubtedly affect the Nepalese economy, of which specific segments will suffer. Managing the fallout of the rupee’s depreciation will require policy makers closely to monitor macroeconomic developments and to deepen their efforts to consolidate financial sector reforms. Short term challenges include affected negatively. Since January 2013, retail prices (i) managing the impact of the rupee’s for petrol, diesel, and aviation fuel have been in- depreciation on prices, and creased twice, in August and September. By contrast (ii) deepening financial sector consolidation the retail price of LPG was left unchanged. Even at Although the overall effect of the depreciation the higher prices, the NOC continues to operate at of the rupee on the economy is likely to be am- a loss equivalent to NRs 1.69 billion per month, of biguous, policy makers will need to address spe- cific challenges in the coming fiscal year. (Fuller FIGURE 16: NOC profits eroded by higher world prices and depreciation discussion of this is contained in the Special Focus Evolution (% change) of PP prices since January 2012 1.4 section below.) 1.3 The depreciation of the rupee will affect the finan- 1.2 cial health of key public sector enterprises, most 1.1 notably the Nepal Oil Corporation and the Nepal 1 Electricity Authority. While the NOC imports all 0.9 of the petroleum products it sells from the Indian Oil Corporation, the IOC prices, too, vary with ex- 0.8 1/1/2012 2/1/2012 3/1/2012 4/1/2012 5/1/2012 6/1/2012 7/1/2012 8/1/2012 9/1/2012 10/1/2012 11/1/2012 12/1/2012 1/1/2013 2/1/2013 3/1/2013 4/1/2013 5/1/2013 6/1/2013 7/1/2013 8/1/2013 9/1/2013 change rate fluctuations.4 Unless the NOC is able to reflect increases in the purchase price of petroleum Petrol Diesel Aviation LPG Brent crude NR products into retail prices, its balance sheets will be Source: NOC and NRB data 4 IOC export prices for petrol and diesel are adjusted fortnightly while those of kerosene, aviation fuel, and LPG are adjusted on a monthly basis. 14 N E PA L D E V E LO P M E N T U P D AT E which 52 percent is accounted for by LPG alone erty impacts. While the NOC makes net profits (Figure 16). The tradeoff for the government to on the sale of petrol, kerosene and aviation fuel, consider, therefore, is whether to absorb additional the bulk of losses are accounted for by diesel losses through the budget (via mounting quasi-fiscal (which is sold at a 12.5 percent premium rela- liabilities) or to allow higher import prices to trans- tive to IOC prices) and LPG (which is sold at a late into retail prices, with an impact on overall in- 5.2 percent mark-down relative to IOC prices). flation, consumer purchasing power, and operating Given that LPG is consumed essentially by ur- costs faced by firms. Likewise, the NEA has power ban, non-poor households and firms, and that purchase agreements with independent producers, inflationary effects would be minimized (since denominated in dollars, while its sources of revenue LPG prices do not affect transport costs), the are in local currency. centerpiece of a cost recovery strategy could fo- cus on LPG pricing. Complementarily, social Both companies are already struggling financial- safety nets could be mobilized to cushion the ef- ly and are a source of large quasi-fiscal liability. fect of retail price increases on the most vulner- The NOC and NEA alone accounted for the bulk able; of public enterprise net losses in FY12 (respectively NRs 9.5 billion and NRs 9.9 billion, or jointly n Bring quasi-fiscal liabilities on budget. Un- 1.26 percent of GDP)5. They have also accumulat- til such time as cost recovery is achieved, and ed large – albeit difficult to quantify – unfunded li- given Nepal’s overall comfortable fiscal position, abilities linked to the pension benefits of their staff. interim losses should be accommodated within There is anecdotal evidence that the two SOEs have the budget and a roadmap adopted for gradually further struggled in FY13 and FY14, as they have clearing outstanding debt and arrears. asked the government for exceptional lending (as recently as September 2013, a NRs 2 billion loan Another key – related – policy challenge will be was made to the NOC – short of the NRs 4 billion to contain inflationary pressures brought about requested – via the Citizen Investment Trust and by the rupee’s relative loss of value. The deprecia- the Employee’s Provident Fund to cover debt to the tion of the rupee will add significant pressure on IOC). In the short term, given the additional pres- prices via (i) higher prices of imports – with fuel sure put by the exchange rate on the companies’ prices translating into transport prices, (ii) higher balance sheets, the government of Nepal could con- remittance inflows – with both volume and value sider taking steps to: effects, and (iii) generally-higher inflation expecta- tions and second-round effects via wages. Given n Reduce system losses at the NEA. NEA system that the government is committed to an expansion- losses, and therefore the cost of service, are very ary fiscal policy (see section on short- and medium- high at about 27% vs. 10% in comparable coun- term economic projections) to tackle the country’s tries such as Laos or Cambodia; therefore reduc- large public infrastructure needs and to honor a ing system losses ought to be a priority to restore significant wage increase of civil service employees, NEA’s financial health; Nepal’s monetary authorities will need to closely monitor the evolution of prices and may need n Rationalize the pricing of retail petroleum further to dampen the accommodative monetary products, with specific consideration for pov- policy stance followed in recent years. 5 See ADB Macroeconomic Update August 2013, volume I #2 N E PA L D E V E LO P M E N T U P D AT E 15 Financial-sector consolidation will need to be Medium term challenges involve deepened, especially in a context of possibly promoting investment-led growth by tighter monetary policy. Tighter liquidity man- (i) reforming PFM and (ii) facilitating agement by the NRB would affect the profitability private investment. of banking and financial institutions. Moreover, The sharp delays in budget adoption and imple- the impact of the rupee’s relative loss of value on mentation had important ripple effects on the corporate indebtedness could raise risks in specific economy in FY13. While delays in FY13 were financial institutions via an increase in NPLs. To dramatic – a full budget was adopted only in the insulate the sector from risks and address issues in fourth quarter – the extension of budget discus- problem institutions the government will need to sions well into the fiscal year and the bunching of maintain the reform momentum. Key possible next capital expenditure near its end are recurrent prob- steps include: lems in Nepal; similar, if smaller, delays occurred n Enacting key pieces of draft legislation includ- in previous years as well (Figure 17). In FY14, the ing the revised NRB Act and the new bill on government has managed to reverse this trend by Deposit and Credit Guarantee; and building the adopting a full budget on time and fast-tracking capacity of regulatory bodies to enforce the le- the review and approval process for key capital gal/regulatory framework; projects by the NPC. The government could use this momentum to streamline and institutionalize n Developing and adopting a comprehensive these improvements, possibly by: Financial Sector Development Strategy, in- cluding measures to expand access to finance, n Initiating joint consultations with the MoF, based on the findings of the upcoming Financial NPC, and line ministries to reach a common Sector Assessment Program (FSAP); understanding about restructuring the budget process to promote a clearer separation between n Enforcing capital requirements for banking planning, formulation and execution phases; financial institutions (BFIs), including state- controlled institutions, by either (i) increasing n Simplifying the budget release process for paid-up capital, (ii) issuance of shares, or (iii) capital projects through prior (to budget ap- mergers (such as the successful merger of NIC bank with Bank of Asia Nepal); and implement- ing the Prompt and Corrective Action (PCA) FIGURE 17: Timing of capital expenditures for different government ministries, and Problem Bank Resolution (PBR) frame- 2009 to 2012 works for weak institutions; n Enhancing supervision of cooperative insti- 80% 70% tutions, following an internal NRB assessment 60% that 27 cooperatives were ‘troubled’ and impos- 50% ing caps on deposit and lending; and 40% 30% n Extending the moratorium on new class A, B, 20% 10% and C Banks. 0% Source: ODI Operational Risk Assessment of PFM Reform in Nepal 16 N E PA L D E V E LO P M E N T U P D AT E proval) completion/approval by the NPC of for (i) political stability, (ii) government effective- work and procurement plans for capital projects; ness, (iii) rule of law, and (iv) control of corruption and (Figure 19). Unsurprisingly, a 2012 regional study of firm level surveys found that political instability, n Developing national-level norms for project electricity, transport, and corruption are the top- costing. ranked constraints to firms in Nepal (in order of Removing structural bottlenecks to private in- importance). vestment will be a long-term endeavor, but there are important policy steps which the govern- Short-term measures to address ment can take in the short term. Firm-level sur- these concerns could include: veys confirm that political instability, regulatory n Managing the electoral process. The elec- uncertainty, and corruption are key bottlenecks tions scheduled for November 2013 constitute for private sector development and investment in an important milestone and test of Nepal’s in- Nepal. Indeed the country performs poorly (in the stitutional maturity. Successful and legitimate bottom quarter) on World Governance Indicators elections would go a long way to boost private- sector confidence in the economy; FIGURE 18: World Governance Indicators for Nepal 1996-2011 n Maintaining and amplifying good-gover- NEPAL nance initiatives. The appointments in 2013 of Comparison between 2011, 2006, 2002, 2000, 1996 (top-bottom order) top executives to key constitutional accountabil- ity offices, including the Auditor General and Voice and Accountability the head of the Commission for Investigation on the Abuse of Authority (CIIA), are welcome signals that the government is willing to tackle Political Stability/Absence of Violence corruption head on. Going forward, it will be important to maintain this momentum and empower the relevant agencies to bring wrong- Government Effectiveness doers to account; n Strengthening the capacity of the Investment Regulatory Quality Board Nepal. By establishing the Investment Board Nepal (IBN) in 2011, the government sought to facilitate the identification and conclu- Rule of Law sion of public-private partnerships for large in- dustrial and infrastructure projects. A milestone may be reached in 2013, if the IBN approves Control of Corruption – as anticipated – a first significant investment 0 25 50 75 100 proposal. A further test will be the IBN’s ability Country’s Percentile Rank (0-100) to reach closure on a large hydroelectric project, as this would constitute a precedent and provide Source: Kaufmann D., A. Kraay, and M. Mastruzzi (2010), The Worldwide Governance Indicators: Methodology and Analytical Issues template agreements for structuring other such deals in the future. N E PA L D E V E LO P M E N T U P D AT E 17 Short- and Medium-term Economic Projections T he outlook for FY14 and beyond is predicated on a return-to-normal scenario, after an exceptional fiscal year. Under this baseline scenario, most macroeconomic aggregates are projected to revert to medium-term trends. That said, a number of largely unpredictable developments could significantly tilt the outlook, most importantly, the outcome of the scheduled elections and economic developments in India. Economic growth is projected to recover from Employment grew by 18 percent over the previous the FY13 dip to reach 4.0-4.5 percent in FY14, year to exceed 450,000. At the same time the de- short of official budget and Three-Year Plan preciation of the Nepali rupee constitutes a strong (TYP) targets. Agricultural production is ex- price incentive for migrants to remit a larger share pected to recover, on the back of a good monsoon of their income, whose rupee value is higher. There and adequate supply of chemical fertilizers – with is evidence from India that such price incentives are paddy planted in over 95 percent of land used for indeed powerful. rice production, against 64 percent the previous year. Likewise, increased mechanization should Public spending is projected to pick up sharply boost productivity5. While manufacturing growth in FY14, although fiscal balances should remain may remain subdued, the construction sector is consistent with macroeconomic sustainability expected to rebound, thanks in part to resurgent objectives. Two factors should contribute to boost and timely public expenditure on capital projects. spending in FY14: Finally a surge in remittance, reflecting both higher numbers of migrants and greater incentives to re- n First, the proposed budget is expansionary mit, could further boost services sector growth. to start with. The total budgeted amount for FY14 is NRs 517.2 billion, which constitutes a Remittance will continue to support services sec- 40 percent increase over the previous year’s to- tor growth and aggregate demand. In the base- tal. Compared with actual spending realized in line scenario, remittance transfers are projected to FY13 (NRs 347.7 billion), the proposed budget grow at a rate of 7 percent (in dollar terms). This represents a whopping 49 percent increase; is a conservative estimate. Indeed, the number of n Second, the efforts of the government to Nepalis seeking employment abroad has continued streamline budget preparation and ex- to grow sharply over the past year, and therefore the ecution should pay-off. A full budget for number of potential remitters: in FY13 the number FY14 was presented and adopted on time of approvals granted by the Department of Foreign on the first day of the fiscal year. Moreover, According to the Department of Transport Management, registration of tractors and power tillers grew significantly in recent years (9,795 in FY13 against 4663 five years ago) 5 18 N E PA L D E V E LO P M E N T U P D AT E the clearance of priority capital projects by (net) domestic and foreign borrowing to grow to the NPC has been fast-tracked and over 90 1.7 percent and 0.3 percent of GDP. percent of projects have already been cleared. The Ministry of Finance has furthermore With the uptick in economic growth and resil- begun implementing a system for real-time ient remittance inflows, the current account is monitoring of budget execution and project expected to remain in surplus, but by a narrower implementation. margin. The trade balance is projected to deterio- rate further, from 27.1 percent of GDP in FY13 While recurrent expenditure is expected to grow to 29.5 percent in FY14 as export growth picks up significantly, actual spending on capital projects (to 4 percent) and imports continue to rise at a rate is likely to undershoot the – ambitious – bud- of over 10 percent (in dollar terms). With remit- get targets. Recurrent spending is expected to rise tance growth slowing down from 11.7 percent to “mechanically” as a result of the government’s firm 7 percent (in dollar terms), the current account is commitment to increase public service wages and expected to remain slightly positive (0.1 percent of benefits (by 18 percent) and to account for elec- GDP) before grants, and 1.4 percent of GDP once tion-related expenses. The envelope set aside for transfers to the government are accounted for. capital spending (NRs 85.1 billion) amounts to 4.4 percent of GDP, which is well above the average of While inflation should ease somewhat, down to 3.2 percent of the past five years. 9 percent, this is a conservative estimate. With food accounting for close to 47 percent of the CPI The government has set ambitious revenue tar- basket, a rebound in agricultural production – in gets, with the depreciation of the rupee pro- both Nepal and India – is expected to significantly viding an unexpected boon to the budget. The alleviate inflationary pressures. At the same time, budget anticipates further significant growth in tax adverse developments could tilt the outlook in the and non-tax revenues of 20 percent in FY14 (on other direction. These include: the back of a 21.1 percent and 22 percent increases in FY13 and FY12). If this target were achieved, n Further depreciation and/or persistent weak- the ratio of total revenue to GDP would reach 18.3 ness of the Indian and Nepalese currencies percent, up from 15.9 percent and 17.4 percent in against other currencies raising domestic prices the preceding years. While it may not in fact be of imported goods and expectations of further realistic to expect revenues from the PIT or the inflation; VAT to continue to grow out of synch with over- n Wage pressures following the government’s all economic activity, the depreciation of the rupee commitment to raise civil service salaries against major convertible currencies combined (by 18 percent) and allowances (by NRs 1,000 with further growth of imports is expected to boost per month) and the minimum wage for non- customs receipts significantly. agricultural workers (by 29 percent), which will trickle down to the broader economy and affect The overall deficit is expected to widen although production costs for firms; and remaining compatible with debt sustainabil- ity objectives. The overall budget deficit, before n Election-related spending as well as the pos- grants, is expected to reach 2.9 percent of GDP and sible disruptive effect of strikes and social move- ments on distribution and supply of goods. N E PA L D E V E LO P M E N T U P D AT E 19 Given planned fiscal expansion and election- deposit levels have grown significantly, thanks related spending, monetary policy will be the to private-transfers growth ahead of the Dashain main variable of adjustment to contain infla- festivals and to the rupee’s loss of value relative tionary pressures. The monetary policy document to convertible currencies. At the same time, with for FY14 assumes somewhat optimistically that the announcement of elections for November but inflation will be contained at around 8 percent. considerable uncertainty about their outcome, in- Based on this premise, it maintains a relatively ac- vestors have been postponing loan decisions for ex- commodative stance with total credit and money pansion and new ventures. (M2) growth targets of 17 percent and 16 percent, designed to support overall economic activity and Looking ahead, the main sources of weakness are lending to productive sectors. It remains to be seen related to the fate of the rupee and the outcome whether price stability and economic growth objec- of elections. Despite the improvement in NPLs tives can be pursued jointly in a context of high over the past two years, the recent fall in the rupee cost-push inflationary pressure and low productiv- has led to concern over corporate indebtedness and ity growth potential. the impact on the banking sector via rising NPLs. Moreover the outcome of the elections, particularly Both lending and deposit rates have remained whether it is perceived as broadly legitimate and particularly low in early FY14. On the one hand, representative, will affect investor sentiment. 20 N E PA L D E V E LO P M E N T U P D AT E Bank Support and Activities n A Country Partnership Strategy (CPS) for FY14- FY09 when total commitments were only about 17 is under preparation. The new CPS will focus US$0.9 billion. Average new commitments per on two pillars – (i) increasing economic growth year during FY11-13 were about US$330 mil- and competitiveness; and (ii) promoting human lion. Under IDA16 (FY12-14), Nepal’s indica- resilience while addressing vulnerability – while tive allocation is about US$634 million (with a also seeking, in a cross-cutting manner, to en- grant/credit share of 45 percent to 55 percent). hance governance, accountability and citizens’ Despite its fragile country context, Nepal has empowerment. There will also be some ten maintained a relatively stable track record in specific outcomes for Bank Group contribution. IDA disbursements, better than similar coun- Given Nepal’s fluid political situation, the CPS tries. IDA disbursement ratios (disbursements has been developed through extensive consulta- during a fiscal year versus the undisbursed tions with key stakeholders, including political balance at the beginning of a fiscal year) have parties, which are remarkably aligned around been above IDA averages for previous years and Nepal’s development priorities. reached 33 percent in FY11 and 24 percent in FY12. While FY13 was a challenging year, due n Total IDA commitments to Nepal averaged mainly to political uncertainties, IDA disburse- about US$1.4 billion over the past three years ments still reached 26 percent. (FY11-13), which is a sharp increase since Nepal: Selected Economic Indicators – 2010-2014 2013 2014   2010 2011 2012 Estimates Projections Annual percent change GDP 4.8 3.4 4.9 3.6 4.5 CPI (period average) 9.5 9.6 8.3 9.9 8.9 Broad Money 14.1 12.3 22.7 16.3 18.8 In percent of GDP Total Revenue and Grants 18.0 17.6 18.6 19.2 20.3 Expenditure 18.8 18.5 19.2 17.2 20.7 Net incurrence of Liabilities 1.8 2.0 2.2 -0.9 2.0 Foreign 0.0 -0.3 -0.2 -0.3 0.3 Domestic (above the line) 1.7 2.3 2.4 -0.6 1.7 Current Account -2.4 -0.9 4.8 3.3 1.4 Trade Balance -25.5 -23.4 -24.3 -27.1 -29.5 Gross official reserves ( in months of goods and services) 5.4 5.8 7.2 7.6 7.7 Public Debt 35.4 33.1 33.6 30.8 30.4 Source: WB / IMF  N E PA L D E V E LO P M E N T U P D AT E 21 n The current IDA portfolio comprises of 19 ac- operation of US$60 million supports the gov- tive projects with a net commitment of about ernment’s objective of “providing safe, reliable US$1.53 billion. Current cumulative dis- and cost effective bridges” on Nepal’s Strategic bursements, as of August 31, 2013, amount Roads Network. A US$30 million development to US$805 million (about 52.6 percent policy operation, approved in FY13, will pro- of net commitments). In addition, there are vide support to the implementation of a finan- three regional projects with net commitments cial sector reform program initiated by the Nep- of US$240 million, about US$11.5 million of alese authorities to reduce the vulnerability of which (about 4.8 percent of net commitments) the banking sector and increase its transparency. have been disbursed. One of the three regional New projects are planned in energy, transport, projects, Nepal India Regional Trade and Trans- and water and sanitation including additional port project (US$99 million), was approved financing for an ongoing irrigation project. at end-June 2013. The portfolio also includes three active Trust Fund projects with commit- IDA engagement in Nepal contributed to devel- ments above US$5 million each. The total com- opment results in health, including reductions in mitment of these three projects is US$87.50 maternal mortality, education, including increases million. in school enrollment and gender parity, poverty n The portfolio consists primarily of investment reduction, including providing safety nets to poor lending operations with sector-wide approaches communities, and connectivity, including linking in education and health. A Program-for-Results people to markets. 22 N E PA L D E V E LO P M E N T U P D AT E Special Focus The Falling Rupee: Cause for Concern specific weaknesses of the Indian economy), the but no Panic fate of the rupee is also reflective of broader emerg- On Monday August 26 2013 a symbolic thresh- ing market trends (as institutional investors reacted old was crossed when the dollar traded for over to a possible earlier-than-anticipated withdrawal of 100 Nepali rupees. This was the first time since the US’s quantitative easing policy and associated the Nepali currency was pegged to India’s at 1.6/1, increase in expected returns on US investments) in 1993. The falling value of the rupee (following (Figure 19). Therefore, the perception that the Ne- the fate of India’s currency) caused some alarm in pali rupee would have remained unscathed in the the public and triggered calls from pundits and absence of a peg is speculative at best. Presumably some experts to rethink the country’s exchange rate it would have still depreciated vis-à-vis the dollar, policy. Policy makers have also focused on the fate although by less than the Indian currency. of the currency with the Prime Minister carrying out “internal consultations” with MoF and NRB While significant, the fall of the rupee is unlikely officials in September 2013. to translate into full blown crisis. Indeed, we are still far from observing the types of movements This report argues that fears of serious negative that accompanied the balance of payment crises of economic consequences are mostly exaggerated, 1997-1998, (Figure 20) when exchange rates shot although some specific groups and sectors of the widely out of line with the trend. Such a scenario economy might lose out. First, we consider the remains unlikely as, today, the basic fundamentals basic pros and cons of the currency peg and nuance of emerging market economies (most notably the the perception that a ‘falling’ currency is necessarily level of dollar denominated debt and levels of re- bad for the economy. Second, we show that Nepal serves) including India are incomparably healthier -unlike India – has important buffers against the than they were in the late 1990s. adverse macro and micro effects of currency depre- ciation. Nonetheless, we also recognize the need to Basic pros and cons of a currency peg carefully manage the effect of the recent deprecia- Under the currency peg, Nepal has no control of tion, particularly in relation to inflation and social the rupee’s exchange rate. Given the peg of the outcomes. Nepali rupee (NR) to the Indian currency and the relative size of the two economies, movements of How bad is it really? More than a the NR against major currencies are entirely deter- mere realignment but no full-fledged mined exogenously, following the vagaries of the crisis INR. In other words, any depreciation of the INR The recent, sharp fall in the value of the rupee re- against major currencies must be met with com- flects specific weaknesses in the Indian economy, mensurate depreciation of the NR, despite the fact but also broader global shifts. Since the beginning that Nepal exhibits none of the fundamental weak- of May, the Indian Rupee lost some 15 percent of nesses that are behind the current crisis in India its value vis-à-vis the US dollar. While the drivers (large current account deficits, exposure to short of depreciation are partly internal (i.e., linked to term capital flows, a ballooning budget deficit and slowdown in growth). N E PA L D E V E LO P M E N T U P D AT E 23 But there are advantages to tying one’s own FIGURE 19: The depreciation of the rupee is reflective of emerging market woes hands. Currency pegs are constraining (often com- Daily ASK rates - Monday, Sep 2, 2013 @ +/-0% pared to tying one’s own hands). All other things USD/INR USD/IDR USD/BRL USD/PHP USD/THB 24.66% 12.38% 18.93% 8.24% 9.82% equal, this is good (i) for pairs of countries that 30.00% have significant trade and investment relations, 25.00% and (ii) in nations with limited ability to carry-out 20.00% prudent monetary policy autonomously or high 15.00% levels of perceived country risk. On the flip side, 10.00% a peg can become problematic if there is a diver- 5.00% gence in economic needs or interests between the 0.00% pegging country and that to which it has anchored -5.00% its currency. A recent example has been the case of May 1, 2013 Jun 1, 2013 Jul 1, 2013 Aug 1, 2013 Sep 1, 2013 Greece, committed to a strong Euro, when the state Source: Oanda (http://www.oanda.com/currency/historical-rates/) of its external current account would have required a weaker currency. In the analysis below we focus on the specific case of Nepal. FIGURE 20: Exchange rates during the 97-98 Asian crisis Daily ASK rates - Friday, Jan 23, 1998 @ +/-0% No reason to “throw the baby out USD/IDR 514.63% USD/PHP 68.68% USD/THB 120.91% with the bathwater” 600.00% Given the significant integration of the Nepali and 500.00% Indian economies, the peg makes a lot of sense. 400.00% Currency pegs (and their extreme form of monetary 300.00% unions) make particular sense for nations that trade 200.00% intensively in goods and capital. This is because the 100.00% stable exchange rate eliminates currency risk from 0.00% cross-country transactions. For instance traders can -100.00% agree on delayed payments without fear that the val- Jul 1, 1997 Sep 1, 1997 Nov 1, 1997 Jan 1, 1998 Mar 1, 1998 ue of these payments would be affected by unantici- Source: Oanda (http://www.oanda.com/currency/historical-rates/) pated movements of the exchange rate and without the need to procure sophisticated insurance against FIGURE 21: Evolution of Nepal’s trade with India such risks. The same goes for investments whose 80.0 earnings can be repatriated safely. The importance 70.0 of Nepal’s trade and investment relations with India 60.0 was certainly at the core of the decision to establish a 50.0 currency peg to start with. If anything, that rationale 40.0 30.0 has grown stronger over time. Today, India is more 20.0 than ever a dominant partner for Nepal, accounting 10.0 for 67 percent of its exports and 65 percent of its 0.0 imports (2011/12), up 20 percentage points from a FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12R FY13P decade ago. Likewise Indian investments in Nepal Ratio of Export to Import to India Share of Total Exports to India amounted to 32.6 percent of total FDI in FY12 (65 Share to Total Imports from India percent the year before). Source: NRB 24 N E PA L D E V E LO P M E N T U P D AT E Abandoning the peg would come at a cost. Any Nominal depreciation correcting for adjustment to the peg (whether a redefinition of real appreciation? the peg or the decision to abandon it altogether) While unintended and exogenous, the rupees’ would sharply disturb the flow of goods and capi- depreciation may benefit the Nepali economy, tal between the two countries by adding significant though there are important caveats. The peg of uncertainty to trans-border transaction. Moreover the NR to the INR at a rate of 1.6/1 was decided there is no good model to predict how well the in 1993 and not adjusted since. Arguably, in recent NR would fare if delinked to its Indian homonym: years the Nepali rupee was modestly overvalued. while Nepal’s macroeconomic fundamentals are According to the IMF’s November 2012 Article IV sound, perceptions of political stability and coun- report (Figure 22), overvaluation was in the range try risk also play a large part in driving exchange of 9 percent (macroeconomic balance approach), rates and it can be questioned whether the NRB 11 percent (external sustainability approach) and would be ready and trusted, tomorrow, to carry out 16-19 percent (Purchasing power parity approach). a fully independent monetary policy. From that perspective, the depreciation of the A stronger NR vis-à-vis the Indian currency NR vis-à-vis foreign currencies would amount, would translate into a greater trade deficit with at least in part, to a welcome if unintended re- the southern neighbor. In the current environ- alignment with equilibrium levels. It does not ment, the immediate effect of an exit from the peg address possible misalignment with the Indian would presumably be (i) an appreciation of the currency itself but, then again, achieving greater Nepali rupee vis-à-vis the Indian currency; (ii) an trade competitiveness vis-à-vis India would require even greater trade gap with Nepal’s neighbor (as In- a depreciation/devaluation – not an appreciation – dian imports become cheaper in domestic currency relative to the Indian currency. Given Nepal’s fast terms), and (iii) additional stress on Nepali produc- growing trade deficit, a real depreciation (driven ers competing with Indian imports (most notably by nominal depreciation) could spell good news farmers who would have to lower prices or face de- for the country’s ailing export sector and introduce creased demand for their products). Ironically the automatic adjustment mechanisms on the import end result could be greater long-term dependence side. on India, rather than less. Impact on the current account Therefore, to assess the ‘opportunity cost’ of the Currency depreciation serves to restore current currency peg it is important to understand how account balances, but only over time. In India, the current depreciation is affecting the Nepali the battered rupee is both a reflection and an ag- economy. As discussed above, the flipside of a gravating factor (at least in the short run) of a de- predictable exchange rate with the INR is that the teriorating current account. The weakening rupee exchange rate with all other major convertible cur- reflects growing trade imbalances: with the trade rencies is exogenously determined. Today, the fall deficit ballooning, importers need more foreign of the Indian rupee is taking the Nepali currency exchange to purchase foreign goods while ailing along. The key question, therefore, is to determine exports fail to earn the country the required hard if and to what extent the lower value of the rupee is currency. Excess demand for foreign exchange hurting Nepal’s economy. over supply drives the rupee’s depreciation, which N E PA L D E V E LO P M E N T U P D AT E 25 is compounded by significant capital outflows. In FIGURE 22: Estimated NR misalignment theory, the depreciation serves to restore equilibri- Nepal: Estimated Exchange Rate Misalignment (in percent) um: while the unit price tag of imports grows (price Misalignment effect), domestic demand for imports is expected (+ is overval.) to slow (volume effect) and foreign demand for ex- MB approach 1 9.1 ports to grow (as domestic goods become cheaper ES approach under alternative benchmarks (mean)2 11.6 in foreign currency terms). Stabilize NFL-to-GDP at 3.4 percent 2.0 Stabilize ext. debt-to-GDP at 24.1 percent 17.1 Stabilize ext. debt-to-GDP at 26.9 percent 15.6 However, in the short run things have to get PPP approch 16.3 worse before they can get better. The price effect 1 The current account norm underpinning the derived misalignment is an on the import bill is immediate, while volume ef- average estimate from pooled and fixed-effect models in CGER. fects (imports and exports) are slower to material- 2 The benchmarks of 3.4, 24.1 and 26.9 represent end -2011 rations to GDP of Nepal’s NFL its ext. debt, and average ext. debt of LICs. ize. This initial deterioration followed by gradual improvement is known in economics as the J curve Nepal REER and Export Share in India’s Imports (Figure 24). 0.6 120 Share in India’s imports (%) REER (2005 = 100; RHS) REER (Average sionce 2002) Nepal’s ability to reap the full trade benefits of 0.5 115 depreciation is modest. The country’s trade bal- 0.4 110 ance is heavily tilted toward imports which, in dol- lar value terms, are more than six times larger than 0.3 105 exports and it is fair to assume that the elasticity 0.2 100 of imports and exports to the exchange rate is lim- ited. Unlike in well diversified economies that are 0.1 95 not overly dependent on foreign sources of energy, 0.0 90 the ability of Nepal to quickly curb import demand 2002 2003 2004 2005 2006 2007 2008 2009 2010 2012 Proj in response to price shocks is modest (i.e., imports are largely price inelastic). This is because domestic Sources: IMF INS and Direction of Trade Statistics (DOTS) database. substitutes to imported goods (whether consumer or manufacturing) and services are limited and be- FIGURE 23: The J curve showing the impact of depreciation (at time t) on the cause of the sheer weight of petroleum products in current account balance Nepal’s total import basket (Table 1). Likewise, a NX quick rebound in exports is unlikely given struc- tural bottlenecks to rapidly expanding production capacity (from a very narrow base) as well as the significant import content (including oil) of export products both leading to higher domestic costs of t C production. time A B 26 N E PA L D E V E LO P M E N T U P D AT E TABLE 1: Nepal’s import basket, price inelastic. Nepal Top 10 Imports from India FY13 value Currency Existence of local sub- Elasticity of demand (NRs million) stitute 1. Petroleum products 107,138.8 Quoted in $ None Low 2. Vehicles and spare parts 26,297.6 Paid in dollars None Medium 3. M.S. Billet 22,303.6 Paid in dollars Limited supply Medium 4. Medicine 13,337.4 Paid in dollars None Low 5. Other machinery and parts 12,014.3 Paid in dollars Limited supply Medium 6. Cement 9,425.2 Paid in INR Limited supply Medium 7. Chemical fertilizers 8,485.5 Paid in INR Imperfect substitutes Medium 8. Rice 8,455.8 Paid in INR Limited supply Low 9. Agric equipment and parts 7,380.3 Paid in INR None Medium 10. Coal 7,009.9 Paid in INR None High Nepal Top 10 Imports from ROW FY13 value Currency Existence of local sub- Elasticity of demand (NRs million) stitute 1. Gold 26,113.9 FX None Medium 2. Telecom equip. 13,489.4 FX None Medium 3. Crude soybean oil 10,627.5 FX Yes High 4. Silver 8,783.1 FX None High 5. Other machinery and parts 8,131.0 FX Indian substitutes High 6. Electrical goods 5,795.0 FX Indian substitutes High 7. Readymade garments 5,454.5 FX Imperfect substitutes High 8. Chemical fertilizers 4,838.7 FX Indian substitutes High 9. Computer and parts 4,543.3 FX None Medium 10. Polythene granules 4,524.6 FX None Medium Source: Authors’ elaboration. (Nb Imports from ROW not all for domestic consumption) In the same boat with India but with a India with which no exchange rate impact, by con- life jacket struction, will be felt. At most, imports from India While the Nepali currency’s fate is tied to In- may become more expensive to the extent that they dia’s, unlike its southern neighbor, the country themselves use imported inputs or are subject to has important additional buffers to mitigate the overall inflationary pressures. All in all, therefore, macro and micro impacts of the currency shock. the brunt of the import bill shock will be borne on In India, the rupee’s depreciation has (i) severely imports from other nations or those imports from affected the overall trade balance, (ii) exposed the India, which are priced in foreign currency (i.e., country to capital outflows and, as a result, (iii) its dollars). current account position has deteriorated sharply. Nepal’s situation – and exposure to the currency Second, relative to India, Nepal is much more shock – is very different in all of these respects. moderately exposed to capital flow reversals and investor sentiment. In India, the fall of the rupee First, Nepal’s trade is overwhelmingly with In- has triggered (in a reinforcing spiral) significant dia to begin with. Most of Nepal’s trade is with outflows of capital as investors seek safer havens. N E PA L D E V E LO P M E N T U P D AT E 27 BOX 2: Nepalese firms highly reliant on imported inputs Nepalese large firms and exporters are, on average, high- Exporters are particularly vulnerable to energy costs ly reliant on foreign inputs for production. For the sample fluctuations. Reliance on diesel fuel (that increased by of 2006/07, a 10 percent increase in sales is associated with a a factor of 2.5 on average, from 2001/02 to 2006/07) falls 6 percent increase in the import content of sales. In fact, while more heavily on exporters. Already in 2001/02, exporters the average import content of sales for small, non-exporting displayed a higher reliance on diesel than non-exporters. firms was 1.66 percent, it jumps to 2.69 percent for medium Within a given manufacturing sector, the ratio of expendi- sized non-importing firms and to 15.47 percent for large non- ture on diesel over total fuel expenditure was about 3 per- exporting firms. For large exporters, the indicator reaches centage points higher for exporters than for non-exporters. 30.46 percent. On average, the import content of sales is 7 This premium increased to 6 percentage points in 2006/07. percentage points higher for exporters than for non-export- The exporter/non-exporter gap in diesel reliance is particu- ers, and this shows in higher shares of imported inputs from larly high in Textiles (21 versus 11 percent) and Apparel (29 third countries, rather than from India. Interestingly, unlike versus 16 percent) – the most important export sectors in exporters, foreign firms do not show a higher intensity of use the economy, as well as in Non-Metallic minerals (50 versus of imported inputs in production. This type of firms exports 19 percent) and Basic Metals (45 versus 13 percent). predominantly to the Indian market. Source: Trade Competitiveness Assessment of Nepal, World Bank (forthcoming) In Nepal, because of its shallow capital markets and TABLE 1: Impact of depreciation on the current account because much of the investments into Nepal take the form of FDI (more stable/virtually no portfolio Components of the current account  and the impact (price effect) of depreciation investment) or trade credits and originate from In-   Effect dia to start with, such rapid reversal is unlikely to ($ denominated) ↑ Imports happen. Nepal has accumulated substantial foreign Trade (INR denominated) ≈ currency reserves equivalent to over 5 billion dol- Exports (NR) ≈ lars (over 25 percent of GDP) or 7.6 months of Receipts (NR) ≈ imports. Services (INR denominated) ≈ Payments ($ denominated) ↑ Finally, remittance inflows from the Nepali dias- ($ denominated) ↓ pora constitute a robust “countercyclical” buf- Credit Income (INR denominated) ≈ fer. At over 25 percent of GDP, remittance transfers Debit (NR) ≈ constitute a stable source of foreign exchange. Con- ($ denominated) ↓ trary to more traditional exports, remittances can Credit gov (INR denominated) ≈ adjust quickly. For instance, there is some evidence Transfers Credit pri- ($ denominated) ↓ that private transfers are significantly responsive to vate (INR denominated) ≈ price incentives. Given the now higher local curren- Debit (NR) ≈ cy value of their income foreign workers may seek to repatriate a larger share of their income. Higher volumes of remittances would provide needed for- eign exchange (macro buffer), while their higher local currency value would help insulate household from price shocks (micro buffer). 28 N E PA L D E V E LO P M E N T U P D AT E Still there are important clouds on the get is NRs 18.57 billon or 0.96 percent of GDP), as horizon the bulk of the government’s external debt is to of- While Nepal is largely insulated from shocks to ficial entities (multilateral organizations or bilateral its current account, the weakening rupee will partners) with low interest rates. Domestic bonds have an impact on the government’s fiscal po- have been issued in FY13 (T-Bills worth NRs 19 sition and add inflationary pressures. None of billion) at low rates of 1.48 percent. Assuming that these shocks are expected to have a sizeable macro the government meets its budget deficit target, total or micro impact but they will require careful moni- financing needs would be below 2 percent of GDP toring and management by policy makers. and therefore, even with higher interest rates, the impact on fiscal balances would not be too severe. Fiscal impact via subsidies and debt The most significant source of pressure will be via Public finances may come under stress. The subsidies for fuel and fertilizers. impact on customs revenues will depend on the relative importance of price and volume effects. Adjusting fuel subsidies involves a delicate trade- However given the low elasticity of Nepal’s import off between fiscal, monetary and political con- basket (on foreign currency denominated goods) siderations. The government subsidizes fuel and the price effect is likely to dominate in the short fertilizers although in largely ad hoc and therefore run. Likewise, payments/amortization on foreign- possibly adjustable manner. Fertilizers are provided currency denominated obligations (debt) will rise at discounted price as part of the government’s ag- but, they will be more than offset by the rising do- riculture promotion programs. The actual extent of mestic value of inflows via fresh grant and loan dis- the subsidy varies from year to year depending on bursements. Total government debt is 27.8 percent budgetary allocations and needs. In fact their actual of GDP of which external debt represents 16.2 per- amount is difficult to gauge as it is not reflected cent of GDP. Current external debt servicing costs in any specific budget line (but lumped together are relatively low (total repayments amounted to with transfers). Likewise the government does not 0.9 percent of GDP in FY13 and the budget allo- directly subsidize petroleum products – it does so cated for foreign debt repayment in the FY14 bud- indirectly by bailing out the NOC and by clear- ing increases in retail rates. With the depreciation, despite successive increases in retail prices, the FIGURE 24: Countervailing effects on public finances NOC’s monthly losses amount to NRs 1.7 billion Positive Negative (or annually NRs 20.4 billion amounting to over 1 percent of GDP). Therefore, a key question will be whether and to what extent the government will allow higher oil prices (in domestic currency terms) to be passed through to customers. Corporates and banks are largely insulated. - Import Duties (Price effect) - Import Duties (Price effect) - Foreign debt service Short term external debt remains moderate and - Foreign grants and loans - Fuel/fertilizer subsidies corporates need prior NRB clearance to contract foreign currency denominated debt. The largest component of this is short-term trade credits but these are largely hedged. N E PA L D E V E LO P M E N T U P D AT E 29 The risk of contagion to the financial sector via dearer (as importers pass-on some of the loss at least NPLs is therefore limited. After the significant to consumers). Second, inflation in India will affect stressed experienced in 2011, banks have taken ag- the price of all tradable goods as any significant dis- gressive steps to clean up their balance sheets (Sec- crepancy between retail prices in the two countries tion ii). would lead to informal trade and de facto arbitrage. In turn second round effects will be at work via (i) Inflation, poverty and social impact higher production prices in industries dependent The fate of the rupee has garnered such high me- on imported inputs, and (ii) expectations of further dia attention in Nepal because of its impact on depreciation / inflation affecting wage demand in the purchasing power of citizens. The deprecia- the public and private sectors. tion of the rupee will put upward pressure on prices principally for two reasons. First, imported goods The price of petroleum products in particular that are paid for in foreign currency will become has a tangible effect. Higher fuel prices directly TABLE 3: Main items in the consumption basket of Nepalis   Share of Total Consumption (Percent) NLSS ITEMS Poor Non-Poor All Coarse rice 19.4 7.4 8.7 Rent Housing 7.2 13.4 12.7 Wheat flour 4.8 1.8 2.2 Educational and professional 4.4 8.6 8.1 Milk 3 3.6 3.5 Maize flour 2.9 0.8 1 Mustard oil 2.8 1.8 1.9 Ready-made clothing and a 2.6 2.5 2.5 Cloth, wool, yarn 2.2 1.6 1.7 Chicken 2.1 2 2.1 Potatoes 1.9 1.3 1.4 Mutton 1.9 2.3 2.3 Cigarettes 1.7 1.1 1.2 Wine 1.6 1.1 1.2 Fine rice 1.5 3.4 3.2 Lentil (Musuro) 1.5 1 1 Public transportation (buses, etc.) 1.4 2.4 2.3 Ghee 1.3 1.5 1.4 Millet 1.2 0.3 0.4 Curd/Whey 1.2 1.1 1.1 Green leafy vegetables 1.2 0.9 0.9 Fish 1.2 1.1 1.1 Beer/jandh 1.2 0.8 0.8 Kerosene oil 1.2 1.8 1.7 Footwear (shoes, slippers 1.2 1 1 Maize 1.1 0.5 0.5 Buffalo meat 1.1 0.8 0.8 Sugar 1.1 1.1 1.1 Source: Nepal Living Standards Survey 2010-11 30 N E PA L D E V E LO P M E N T U P D AT E affect the price of transport (for households and accounts for 1.4 percent of the consumption basket of firms alike) and production costs for firms. The ex- the poor, although the urban poor (a fraction of the tent to which the authorities allow administratively total) may be much more severely impacted. All in all, controlled prices, including fuel and indirectly from a social standpoint the quality of the harvest and transports, to reflect higher purchase prices will af- strength of agricultural output will be the single most fect the pass-through. So far price increases have important determinant of well-being in FY14. been modest – since May 2012, retail prices of pet- rol, kerosene and LPG have increased by 8 percent, 15 percent and 4 percent respectively – and most Winners and losers: the impact on the of the burden has been absorbed by the govern- private sector Although the overall impact on the economy ment/NOC. is ambiguous, the depreciation of the currency will create winners and losers. The table below From a social point of view the key is to understand summarizes the effect on households and firms. how inflation will affect the purchasing power of poorer households specifically. In Nepal the vast majority of poor households are rural and ‘local’ con- Conclusions and policy options From the discussion above it is not clear that sumers of food products which account for 67 per- Nepal is losing out from the current weakness cent of the total consumption basket of a poor family. of the Indian currency. While (some) consumers Nepal’s poor tend to consume relatively less imported will be hurt in the short term by rising prices for goods (other than food). Rising transportation costs imports, the overall effect will be overcompensated would have a marginal effect as public transportation TABLE 4: Winners and losers from depreciation Firms Winners Losers Energy intensive activities Higher prices of fuel impacting production costs Firms reliant on imported Higher domestic price of imported inputs inputs Import competing industries Domestic price advantage relative to foreign competitors Firms with $ denominated debt Higher cost of debt servicing affecting balance sheets Services Greater demand via remittances Households Winners Losers Urban households Higher transportation costs and price of imported goods Rural households Net food producers gaining from higher food prices Limited exposure to transport costs Limited exposure to price of imported goods Remittance receiving Higher local currency value of households remitted income Remittance sending Higher local currency cost of foreign expenditure households (students) Net borrowers Higher interest rates (all other things equal) N E PA L D E V E LO P M E N T U P D AT E 31 by the more-than-proportional increase in the local n Carrying out a detailed assessment of the NOC currency value of remittances. Moreover, the Ne- and NEA, including pricing policy and subsidies; pali rupee’s depreciation – if it is followed up by n Updating existing calculations of RER equilib- structural reforms – could help address the steady rium and developing exchange rate policy sce- decline of Nepal’s export and import competing narios in the context of a thorough assessment of industries. their economic –particularly trade competitive- ness- impacts. In the short run, in the absence of a well thought out plan and in a context of significant remain- The depreciation could be used as an opportu- ing political uncertainty, abandoning or revising nity to revive Nepal’s ailing export industries and the peg appears to be a risky strategy. Instead the activities. While the country has lost market share authorities should adopt mitigation/management over the years in its most important export prod- strategies including: ucts and markets the variety of its export basket has doubled since the mid-1990s, meaning that there is n Closely monitoring inflation, particularly on a broad export base from which export-led growth items prominent in poor people’s baskets; could be triggered. While the nominal depreciation of the rupee can provide a short term boost to im- n Maintaining a tight, and possibly tighter, mon- port competing and exporting industries, translating etary policy so as to avoid too wide a spread with such short term gains over time will only be possible India; via structural reforms to address the weak business climate. 32 N E PA L D E V E LO P M E N T U P D AT E The World Bank Group Nepal Office P.O. Box 798 Yak and Yeti Hotel Complex Durbar Marg, Kathmandu, Nepal Tel.: 4226792 Fax: 4225112 Email: infonepal@worldbank.org www.worldbank.org/np www.facebook.com/WorldBankNepal