NEPAL DEVELOPMENT UPDATE May 2017 Strong rebound, mounting risks NEPAL DEVELOPMENT UPDATE Strong rebound, mounting risks May 2017 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 twice analysis of the financial sector. Jayandra Shrestha yearly with the following two main aims: to report on provided data on hydropower sector. Volker key economic developments over the preceding Treichel provided helpful comments. Rajib months, placing them in a longer term and global Upadhya and Richa Bhattarai managed media perspective; and to examine (in the Special Focus relations and dissemination. Diane Stamm edited section) topics of particular policy significance. the document and Sunita Kumari Yadav managed However, in this edition, we are foregoing the the publication process. Special Focus section due to an upcoming release of Nepal Country Economic Memorandum. The Update is The team is grateful for insights and data from intended for a wide audience including policymakers, various agencies in Nepal. In particular, we would business leaders, the community of analysts and like to thank: Narayan Paudel, Maheshwor Shrestha professionals engaged in economic debates, and the and Pradeep Paudyal (all from Nepal Rastra Bank), general public. Dinesh Bhattarai (Department of Agriculture), Gaurav Dhungel (Department Immigration), Binod This Update was produced by the World Bank Acharya (Department of Customs), Durga Macroeconomics and Fiscal Management team for Manandhar, Sajina Shakya and Anand Pradhananga Nepal consisting of Damir Cosic, Roshan (Department of Hydrology and Meteorology). Bajracharya, Sudyumna Dahal and Saurav Rana under the guidance of Manuela Francisco and Cut-off date for data included in this report was Takuya Kamata. Sabin Shrestha contributed to the May 5, 2017. Table of Contents EXECUTIVE SUMMARY ............................................................................................................... i A. RECENT ECONOMIC DEVELOPMENTS ............................................................................. 1 1. Global economic growth is low but turning around while South Asia continues to outper- form ..................................................................................................................................................... 1 2. Activity is rebounding in Nepal, leading to a broad-based recovery for FY2017 ................... 1 3. Inflation has slowed down to a decade low ................................................................................... 3 4. Government revenue and spending has performed well, but the budget execution continues to underperform ................................................................................................................................. 4 5. Imports continue to grow while exports are still struggling to recover .................................... 5 6. External sector pressure building up as the slowdown in remittances persists ...................... 7 7. Rapid credit growth and slowing deposit has contributed to the diminishing availability of loanable funds .................................................................................................................................... 9 8. Stock market remains disconnected from the real economy .................................................... 12 9. In sum, FY2017 resulted in highest growth since 1994............................................................. 13 B. OUTLOOK, RISKS AND CHALLENGES............................................................................... 15 REFERENCES .............................................................................................................................. 18 BOXES: Box 1: Credit crunch ................................................................................................................................... 11 FIGURES: Figure 1: The rice production is estimated to have reached a record high ...............................................2 Figure 2: Hydropower capacity addition in FY2017 to going to be a record high too ...........................2 Figure 3: Tourist arrivals have reached pre-crisis levels ...............................................................................2 Figure 4: Transport, Industrial and Capital goods imports have picked up in FY2017 ..........................2 Figure 5: Inflation slows down to a decade low primarily due to food prices ..........................................3 Figure 6: Non-food inflation also slowdown, but is still somewhat elevated ...........................................3 Figure 7: Inflation gap with India in the negative territory ..........................................................................3 Figure 8: Revenue continues to perform well ................................................................................................4 Figure 9: Expenditures has significantly increased as well ..........................................................................4 Figure 10: Capital spending has been a record high ........................................................................................4 Figure 11: Imports have reached a new higher trend level ............................................................................5 Figure 12: Goods exports may, however, have been permanently lowered ................................................6 Figure 13: Primarily because exports to India have not recovered ...............................................................6 Figure 14: But also due to continued appreciation of the real effective exchange rate .............................6 Figure 15: Industrial supplies exports have been slow to recover ................................................................7 Figure 16: Textile, Iron and recently Jute exports have seen the largest decline ........................................7 Figure 17: Controlling for seasonality, growth of remittances continues to be negative ..........................8 Figure 18: Migrant worker departures have also stabilized at a new lower level ........................................8 Figure 19: Following a stabilization of workers going to Malaysia and Saudi Arabia ................................8 Figure 20: Lending grew at breakneck speed… ...............................................................................................9 Figure 21: Driven by new vehicle and margin lending ...................................................................................9 Figure 22: While deposit growth has slowed ....................................................................................................9 Figure 23: As a result, the CCD has reached highest since 2011 ..................................................................9 Figure 24: Adding more funds to the treasury and soaking liquidity from the market .......................... 10 Table of Contents (continued): Figure 25: Pushing interest rates to a 3-year high ......................................................................................... 10 Figure 26: Overdraft and margin lending may have been fueling speculative behavior in the stock mar- ket ...................................................................................................................................................... 10 Figure 27: NEPSE remains disconnected from the regional market ........................................................ 10 Figure 28: GDP growth a record high in FY2017 ....................................................................................... 13 Figure 29: All sub-sectors have rebounded in FY2017 ............................................................................... 13 TABLES: Table 1: Selected fiscal indicators ................................................................................................................... 5 Table 2: Nepal macroeconomic outlook .................................................................................................... 16 Strong rebound, mounting risks Nepal Development Update Executive Summary Economic activity is rebounding strongly in Nepal growth in previous year) was a major contributor following two challenging years. to the estimated growth rate in FY2017. Had the growth rate in FY2016 been in line with the aver- On the back of one of the best monsoons in re- age of recent years, the growth rate in FY2017 cent years, rice production is estimated to have would not have been so spectacular. reached a record high at 5.2 million tons, up from 4.2 million tons a year ago, boosting agricultural This cyclical rebound follows two challenging output. Postearthquake reconstruction activities are years where real GDP growth fell to 3.3 percent in picking up after a slow start. All eligible houses— FY2015 due to the devastating earthquake and about half a million—have received the first of declined even further to a 14-year low of 0.4 per- three tranches of the housing grant. The second cent in FY2016 due to a complete disruption in tranche of the housing grant has started, and is cross-border trade with India. expected to pick up by the end of FY2017. More than 100 megawatts (MW) of hydropower capacity, High inflation in the past two years induced by which was delayed by the earthquakes and trade disruptions has moderated sharply in the first half disruptions, have come on-stream. There has been of FY2017. Normalization of imports and a favor- a revival of transport and full normalization of able external environment, particularly the moder- wholesale and retail trade. Tourism is also recover- ating inflation in India as a result of demonetiza- ing as arrivals reached precrisis levels during the tion, are the primary reasons for a deceleration of September–December 2016 tourist season. inflation. Food prices have also declined. As a result, growth has rebounded and has reached The new government has initiated a series of man- 7.5 percent in FY2017 (at market prices) according agement reforms in electricity and health, with the to the first estimate by the Central Bureau of Sta- most visible impact in the electricity sector with tistics (CBS). This is the highest growth rate since the elimination of power cuts in several major cit- 1994 and is a result, in part, of a base-year effect, ies across Nepal. Efforts to reduce the financial increased agricultural output, improved availability and technical losses of the electricity utility, the of electricity, and greater investment as earthquake Nepal Electricity Authority, are also showing re- reconstruction gathered speed. Base effect (lower sults. May 2017 THE WORLD BANK GROUP i Strong rebound, mounting risks Nepal Development Update Government revenue and spending have also per- ance on hand, financing is not expected to be a formed well. Revenue has exceeded the six-month problem. The FY2017 budget called for an ex- target, and spending, including on capital goods, penditure increase of nearly 15 percent of GDP has also significantly picked up compared to previ- over actual expenditures in FY2016. However, as ous years and is on par with revenue. Neverthe- in previous years, significant underspending of the less, overly ambitious expenditure envisioned in budget will continue. The government’s recurrent the budget has not materialized, leaving previously expenditure is expected to continue to grow sub- accumulated government deposits (10 percent of stantially in FY2018, particularly as a result of the GDP) intact. implementation of the new federal constitution, which calls for creation of an entirely new level of Credit has grown rapidly over the past year, and government. The growth in revenues is expected growth reached its highest rate since 2012, while to continue, but it will likely slow given sharp deposit growth slowed. However, banks are run- growth over the past couple of years. With in- ning up against prudential limits on lending. In creased government spending as a result of a new addition, government’s large cash balances have federal structure and earthquake reconstruction, had the effect of a monetary tightening at a time the fiscal balance is expected to be negative in when the banks are trying to increase their capital FY2018. Meanwhile, the current account, which base to meet the increased regulatory requirements had remained in surplus over the past several years, for paid-up capital. is expected to narrow and turn into a deficit as import growth is expected persist while remittanc- Imports, which, had rebounded quickly following es is expected to remain sluggish. the end of trade disruptions, have reached a rec- ord high. Exports, despite some recovery, are yet Challenges and Risks to reach their predisruption levels, particularly on account of sluggish recovery of exports to India. There are an increasing number of downside risks Exports recovery is also affected by continued to this forecast with domestic risks predominating. appreciation of the real effective exchange rate. As The political environment remains fluid as the a result, the trade deficit has continued to increase. term of the current government is coming to an The cumulative effect of a sharp trade balance end. In addition, a series of elections needs to be deterioration and a slowdown of remittances has held by early 2018, as stipulated by the new consti- put the current account into deficit. Although still tution. Implementation of a new federal structure high, foreign reserve accumulation has slowed and could pose a challenge. Despite improvements, the the external sector pressure is building up. overall pace of earthquake reconstruction remains a concern too. Outlook Increased vulnerability in the financial sector could Looking ahead, the economic growth will remain add a challenge during the remainder of the fore- strong, but it is expected to moderate in line with cast period. Banks are running up against regulato- country’s potential, averaging 5 percent over the ry limits for lending, and this risks a sudden halt in next two fiscal years. While healthy growth is ex- new credit. pected to continue in agriculture, construction and industry sectors, the activity in remaining sectors is The external environment is likely to be less favor- expected to be affected by uncertainty stemming able, as well. Continued underperformance of ex- from transition to the federal structure, several ports, despite the end of disruptions, remains a elections and the possibility of further slowdown persistent challenge. Remittances account for near- in remittances. Inflation is expected to be below ly 1/3 of GDP, with the majority of migrants go- the central bank’s target of 7.5 percent for all of ing to oil-exporting Gulf Cooperation Council FY2017, but likely to pick up somewhat in (GCC) countries. Significant spending cuts, includ- FY2018 as the effect of demonetization tapers off ing on capital spending, announced in the GCC in India. countries, and persistent contraction in departures of migrants, have contributed to lower growth of The fiscal deficit is expected to widen during the remittances and risk a possible sharper slowdown forecast period; however, given the large cash bal- during the forecast period. May 2017 THE WORLD BANK GROUP ii Strong rebound, mounting risks Nepal Development Update A. Recent Economic Developments 1. Global economic growth is low but turning effort at the end of the year. Growth in South Asia around, while South Asia continues to outper- was higher than in East Asia, where it stood at 6.3 form percent. Other regions are growing either much more slowly or are even contracting (World Bank After a disappointing year, a pickup in global 2017a). growth is finally in sight. In 2016, global growth was at a postcrisis low, and the first six months of It is estimated that officially recorded remit- the year were characterized by especially weak tances to developing countries amounted to growth in advanced economies. At 2.3 percent, on US$429 billion in 2016, a decline of 2.4 percent average, glob-al growth in 2016 was 0.4 percentage from US$440 billion in 2015. This is a trend not points lower than in 2015. Uncertainty has been seen in three decades. Low oil prices and weak high, global trade has stalled, and investment has economic growth in the Gulf Cooperation Council been weak. However, since the last quarter of (GCC) countries and the Russian Federation are 2016, there have been reasons for optimism. Eco- taking a toll on remittance flows to South Asia and nomic activity in both emerging and advanced Central Asia, while weak growth in Europe has economies is strengthening. In the Euro area, un- reduced flows to North Africa and Sub-Saharan employment has fallen to an eight-year low, and Africa. As a result, many large remittance-receiving the United States is experiencing a broad-based countries saw sharp declines in remittance flows upswing in manufacturing activity (World Bank (World Bank 2017b). This is certainly a concern 2017a). for Nepal but not surprising, as the Nepal Devel- opment Update: Remittances at Risk (World Bank South Asia has by now consolidated its posi- 2016) projected a slowdown in remittances to Ne- tion as the global leader in economic growth. pal and associated risks. While the pickup in growth in the first quarter of 2016 was only temporary, South Asia is still ex- 2. Activity is rebounding in Nepal, leading to pected to have grown by an impressive 6.7 percent a broad-based recovery for FY2017 (year-over-year [y/y]) over the year as a whole. This strong performance was despite the tem- Economic activity is picking up across the porary setback caused by India’s demonetization board. On the back of one of the best monsoons May 2017 THE WORLD BANK GROUP 1 Strong rebound, mounting risks Nepal Development Update in recent years, rice production is estimated to power is expected to supply power to the grid in have reached a record high at 5.2 million tons, up FY 2017, a record high hydropower capacity addi- from 4.2 million tons a year ago, boosting agricul- tion (Figure 2). Imports of electricity from India tural output (Figure 1). Postearthquake reconstruc- have also increased, which has helped regularize tion yet again faced some challenges with the electricity supplies. There has been a revival of change in leadership. However, all eligible hous- transport and full normalization of wholesale and es—about half a million—received the first of retail trade. With the purchase of new aircraft by three tranches of the housing grant, and the dis- Nepal Airlines, the sector is expected to get a sig- bursement of second tranche of housing grants nificant boost (Figure 3). The two shocks of 2015 has started, albeit at a slower pace. Hydropower that had hit the tourism industry hard, with the projects, which were delayed by the earthquakes largest contraction in 13 years, is seeing a strong and trade disruptions, have started coming on- rebound. The tourism sector is recovering as arri- stream. As a result, more than 100 MW of hydro- vals reached the precrisis level during the Septem- Figure 1 Rice production is estimated to have Figure 2 Hydropower capacity in FY2017 is going reached a record high to increase to a record high, as well (Million tons) (Megawatt) 6 120 Paddy Output Hydropower, Capacity Addition 5 100 4 80 3 60 2 40 1 20 0 0 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 Source: Department of Agriculture. Source: Nepal Electricity Authority. Figure 3 Transport, industrial, and capital goods Figure 4 Tourist arrivals have reached precrisis imports have picked up in FY2017 levels (Percent change, 3-month moving average, yly) (In thousands, 3-month moving average) 350 90 Fuel and Lubricants Tourist Arrival 300 80 250 70 200 Transport and Equipment 60 150 50 100 Capital Goods 40 50 30 0 20 -50 Industrial Goods 10 -100 0 Nov-14 Feb-15 May-15 Aug-15 Nov-15 Feb-16 May-16 Aug-16 Nov-16 Feb-17 Apr-13 Apr-14 Apr-15 Apr-16 Aug-16 Aug-13 Dec-13 Aug-14 Dec-14 Aug-15 Dec-15 Dec-16 Source: .Department of Customs. Source: Department of Tourism. May 2017 THE WORLD BANK GROUP 2 Strong rebound, mounting risks Nepal Development Update ber–December tourist season (Figure 4). Food prices have contracted while nonfood prices, despite a slowdown, still remain some- The new government has initiated a series of what elevated. The contribution of food prices management reforms in electricity and health, has contracted to a record low at 0.2 percent with the most visible impact in the electricity points (y/y). A sharp decline of food prices, in sector. “Load-shedding,” or scheduled power particular, has been a big relief to the Nepali popu- blackouts, had been common all over Nepal in lation after two years of severe hardship and high recent years, reaching up to 16 hours per day. prices. The contribution of nonfood inflation has However, with the proper management and opti- also slowed from a high of 6 percent points (y/y) mization of power, including additional electricity in July 2016 to 3.1 percent points (y/y) in March imports from India, the new government was able 2017. However, prices of housing rent and utilities to eliminate power cuts in several major cities continue to put upward pressure on nonfood in- across Nepal. Efforts to reduce the financial and flation (Figure 6). The slow recovery and recon- technical losses of the electricity utility, Nepal Electricity Authority, are also showing results. Figure 6 Nonfood inflation also slowed, but is still 3. Inflation has slowed to a decade low somewhat elevated (Contribution to non-food inflation, percentage points, y/y) High inflation in the past two years induced 8 Housing & Utilities Other Nonfood & Service by shocks and disruptions has moderated 7 sharply. After the end of the trade disruptions in February 2016, it took almost seven months for 6 inflation to moderate to predisruption levels. Nor- 5 malization of imports and a bumper agricultural 4 harvest were the primary reasons for this modera- tion. As a result, by October 2016, inflation had 3 moderated to 6.9 percent (y/y). Inflation further 2 sharply decelerated starting in November 2017, 1 particularly due to a favorable external environ- ment, that is, moderating inflation in India as a 0 Nov-11 Mar-12 Nov-12 Mar-13 Nov-13 Mar-14 Nov-14 Nov-15 Mar-16 Nov-16 Mar-17 Jul-11 Jul-12 Jul-13 Jul-14 Mar-15 Jul-15 Jul-16 result of demonetization. Consequently, overall inflation declined to 2.9 percent (y/y) in the first eight months of the FY2017, reaching the lowest Source: NRB and WB Staff Calculations. level in a decade (Figure 5). Figure 5 Inflation slowed to a decade low primarily Figure 7 Inflation gap with India is in negative due to food prices territory (Contribution to headline inflation, percentage points, y/y) (Percentage points) 13 Food & 10 Nonfood & Service Overall Total Inflation Differential with Beverage India 8 11 6 Food & Beverage Differential 9 4 7 2 5 0 3 -2 -4 Nonfood & Services Differential 1 -6 Jul-11 Nov-11 Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Jul-14 Nov-14 Mar-15 Jul-15 Nov-15 Mar-16 Jul-16 Nov-16 Mar-14 Mar-17 Mar-12 Nov-12 Mar-13 Nov-13 Nov-14 Nov-15 Mar-16 Nov-16 Mar-17 Jul-12 Jul-13 Mar-14 Jul-14 Mar-15 Jul-15 Jul-16 -1 Source: Nepal Rastra Bank (NRB) and WB staff calculations. Source: NRB, Indian Central Statistics Office, and WB staff calculations. May 2017 THE WORLD BANK GROUP 3 Strong rebound, mounting risks Nepal Development Update struction of the houses destroyed in the 2015 (Figure 7). This is a record-low gap since Novem- earthquakes (more than half a million houses) is ber 2013, when Nepal’s inflation was 1.5 percent- likely adding pressures on the housing and utilities age points lower than India’s. inflation. 4. Government revenue and spending has per- Nepal’s inflation divergence with India is in formed well, but budget execution continues negative territory, after more than two years. to underperform Nepal’s inflation gap with India had increased sig- nificantly since mid-2014, and had reached a rec- Government revenue continues to perform ex- ord high of 6 percentage points during the time of tremely well. Government revenue collection has trade disruptions in January 2016. The gap contin- exceeded the six-month target, and all the revenue ued to narrow since the end of disruption and streams (value-added tax, customs, income tax, and reached -0.4 percentage points in February 2017 nontax) are growing at a healthy rate. As a result, revenue growth was 20 percent (y/y) for the three months until March (Figure 8) and is expected to Figure 8 Revenue continues to perform well comfortably meet the FY2017 revenue target. (NPR billions, 3-month moving average) (Percent change y/y) Government spending has increased consider- 80 120 ably compared to previous years (Figure 9). Total Revenue Revenue Growth (right) 100 Government spending in the first quarter was driv- 60 en by housing grants, following which capital 80 goods expenditure has significantly picked up. 40 60 Capital spending has been a record high in the first 40 eight months of the fiscal year, which is primarily 20 20 driven by civil works (Figure 10). 0 0 With the increase in capital spending, the -20 -20 quality and effectiveness of spending is going -40 be a major concern going forward. Between -40 -60 2001 to 2007, the incremental capital output ratio Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 Mar-17 for Nepal was 5.7, the highest among comparator countries such as Bangladesh, Cambodia, and Vi- Source: NRB and WB Staff calculations. Figure 9 Expenditure has significantly increased as Figure 10 Capital spending has been a record high well (NPR billions, 3 months moving average) (Percent change y/y) (Percent change, 3-month moving average, yly) 100 100 250 Total Expenditure Growth Expenditure (right) 80 80 Capital Spending Recurrent Spending 200 Growth Growth 60 60 150 40 40 100 20 20 50 0 0 0 -20 -20 -40 -40 -50 Aug-13 Nov-12 Nov-13 Aug-14 Nov-14 Aug-15 Nov-15 Aug-16 Feb-13 Nov-16 May-13 Feb-14 May-14 Feb-15 May-15 Feb-16 May-16 Feb-17 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 Mar-17 Source: NRB and WB Staff Calculations. Source: NRB and WB Staff Calculations. May 2017 THE WORLD BANK GROUP 4 Strong rebound, mounting risks Nepal Development Update Table 1: Selected Fiscal Indicators (percent of GDP unless noted otherwise ) FY2013 FY2014 FY2015 FY2016 b FY2016 e FY2017 b FY2017 f Total Revenue and Grants 19.5 20.6 20.8 26.1 22.9 25.9 24.1 Total domestic Revenue 17.6 18.8 19.3 21.1 21.6 21.8 22.3 Tax 15.3 15.9 16.7 19.0 18.7 19.6 19.5 Nontax 2.2 2.6 2.3 2.1 2.7 2.1 2.8 Grants 2.1 2.1 1.8 4.9 1.4 4.1 1.8 Total Expenditure 17.8 18.8 20.1 33.5 22.0 38.3 24.4 Recurrent 14.6 15.5 15.9 21.5 16.5 23.7 17.9 Capital 3.2 3.4 4.2 9.3 5.5 12.0 6.5 Net Lending 1.2 1.1 1.8 2.7 1.7 2.6 1.5 Fiscal Balance 0.5 0.6 -1.1 -7.5 -0.8 -12.4 -1.8 Sources: MoF, NRB for history and estimates; WB staff for forecasts. Note: b=budget, e=estimate, f=forecast. etnam. Figure 11 Imports have reached a new higher trend level (US$ millions, 3-month moving average) (Percent change, y/y) 1400 140 1200 120 1000 Non-oil Imports 100 800 80 5-year Average 600 60 400 40 200 20 0 0 -200 Oil Imports -20 Total Imports, -400 Growth (right) -40 -600 -60 Sep-11 Mar-13 Mar-14 Mar-12 Sep-12 Sep-13 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 Mar-17 Source: NRB and WB staff calculations. May 2017 THE WORLD BANK GROUP 5 Strong rebound, mounting risks Nepal Development Update Figure 12 Goods exports may, however, have been Figure 13 Primarily because exports to India have permanently lowered not recovered (US$ millions, 3-month moving average) (Percent change, y/y) (US$ millions, 3 months moving average) (Percent change, y/y) 110 110 Exports to Other Countries Exports Exports to China 90 90 90 5-year Average 90 70 Exports to India (5-year Average) 70 70 70 50 50 50 50 30 30 30 30 10 10 10 10 -10 -10 -10 Exports to India -10 -30 Exports Growth (right) -30 -30 -30 -50 -50 Growth of Exports to India (right) -50 -50 Sep-11 Mar-12 Sep-12 Sep-13 Mar-14 Sep-14 Mar-15 Mar-13 Sep-15 Mar-16 Sep-16 Mar-17 Sep-13 Sep-14 Sep-15 Sep-16 Nov-13 Mar-14 Mar-15 Jan-14 Nov-14 Nov-15 Mar-16 Nov-16 Jul-13 May-14 Jul-14 Jan-15 May-15 Jul-15 Jan-16 May-16 Jul-16 Jan-17 Mar-17 Source: NRB and WB Staff Calculations. Source: NRB and WB Staff Calculations. a considerable role, which led to weaker Indian demand. There could also be other reasons for this slow recovery. Reportedly, the introduction of nontariff barriers has been cited as one of the ma- jor reasons why exports to India have been slow to recover. Also, a countervailing duty on jute ex- ports—though recently lifted—could have been another reason. Exports to other countries are driven by pashmina, garments, and carpets. Over- all, exports are also adversely affected by contin- ued appreciation of the real effective exchange rate of the Nepali rupee (Figure 14). Figure 14 But also due to continued appreciation of the real effective exchange rate (Index number, 2010=100) 115 110 Real Effective Exchange Rate 105 100 While exports to India continue to be weak, 95 exports to other countries are recovering. The 90 slow recovery of overall exports is primarily due to Nominal Effective Exchange Rate the sluggish growth of exports to India (Figure 13), 85 because India accounts for 70 percent of total ex- ports. Industrial goods exports to India, in particu- 80 Feb-12 Feb-13 Feb-14 Feb-15 Feb-16 Feb-17 lar, have not been able to recover (see next para- Source: WB staff calculations. graph). The demonetization is likely to have played May 2017 THE WORLD BANK GROUP 6 Strong rebound, mounting risks Nepal Development Update Figure 15 Industrial supplies exports have been Figure 16 Textile, iron, and recently, jute exports, slow to recover have seen the largest decline (US$ million, 3-month moving average) (US$ million, 3-month moving average) 50 14 Industrial Supplies 45 Textile, Yarn, Fabrics 12 40 Industrial Supplies - 2-year Average 35 10 Iron, Steel, Copper 30 8 25 Consumer Goods 6 20 15 4 Jute 10 2 5 Food and Beverege 0 0 Oct-13 Dec-13 Feb-14 Apr-14 Aug-14 Oct-14 Dec-14 Apr-15 Dec-15 Feb-16 Apr-16 Jun-14 Jun-15 Aug-15 Oct-15 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Feb-15 Oct-13 Dec-13 Feb-14 Apr-14 Aug-14 Jun-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 Feb-16 Apr-16 Aug-16 Oct-16 Dec-16 Feb-17 Jun-16 Source: Department of Customs and WB staff calculations. Source: Department of Customs and WB staff calculations. May 2017 THE WORLD BANK GROUP 7 Strong rebound, mounting risks Nepal Development Update 2015, and remained positive between August and Departures of migrant workers have further December 2016 before contracting again. In the fallen to a new level. A slowdown in departures three months ending in March, remittances con- of migrant workers predates the earthquake, but it tracted by 7.3 percent on a seasonally adjusted has accelerated following the earthquake and has annualized rate. However, as in the past, large further fallen to a new level in the first six months amounts of remittances are received via informal of FY2017. From a six-month average of 47,000 in channels and are not captured in these data. For FY2015, it fell to 37,000 in FY2016. In the first example, a recent survey by the Nepal Rastra six months of FY2017, the average further de- Bank showed that only 30 percent of remittances clined to 31,000. As a result, the growth rate be- from the Republic of Korea were being sent via came slightly negative when controlling for season- formal channels (Figure 17). al effects (Figure 18). Figure 17 Controlling for seasonality, growth of remittances continues to be negative (US$ millions, 3-month moving average, (Percentage change, 3m/3m SAAR) seasonally adjusted) 700 Remittances Growth, 70 Remittances (seasonally 600 adjusted) SAAR (right) 60 500 50 400 40 300 30 200 20 100 10 0 0 -100 -10 -200 -20 -300 -30 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 Mar-17 Source: NRB and WB staff calculations. Note: 3m/3m = three months over three months. Figure 18 Migrant worker departures have also sta- Figure 19 Following a stabilization of workers go- bilized at a new, lower level ing to Malaysia and Saudi Arabia (Thousands, 3-month moving average, (Thousands) (Percent change, 3m/3m SAAR) seasonally adjusted) Kuwait 70 Malayasia Qatar Saudi Arabia UAE Others 70 300 Migrant Workers Outflow Remittances Growth, 60 (seasonally adjusted) SAAR (right) 250 60 50 200 50 40 150 30 40 100 20 50 30 10 0 20 0 -10 -50 10 -20 -100 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jan-15 Jan-16 Jan-17 Jul-14 Jul-15 Jul-16 0 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Source: DoFE and WB staff calculations. Note: 3m/3m = three months over Source: DoFE and WB staff calculations. three months. SAAR = seasonally adjusted annualized rate. Note: UAE = United Arab Emirates. May 2017 THE WORLD BANK GROUP 8 Strong rebound, mounting risks Nepal Development Update Figure 20 Lending grew at breakneck speed… Figure 21 Driven by new vehicle and margin loans (Percentage points) (Percent change, y/y) (Percent change, yly) 35 35 80 Agriculture Industry Construction Service Others Vehicle Loan 30 30 70 Total Credit 25 25 60 Margin Loan Growth (right) 20 20 50 15 15 40 Residential Commercial Home Loan 10 10 30 5 5 20 Real Estate 0 0 10 Overdraft -5 -5 0 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Jul-15 Nov-15 Mar-16 Jul-16 Nov-16 Mar-17 Oct-15 Mar-16 Oct-16 Aug-15 Sep-15 Nov-15 Dec-15 Feb-16 Apr-16 Jan-16 Jun-16 Aug-16 Sep-16 Nov-16 Dec-16 Jul-15 May-16 Jul-16 Jan-17 Source: NRB and WB Staff Calculations . Source: NRB. Figure 22 While deposit growth has slowed Figure 23 As a result, the CCD has reached highest level since 2011 (Contribution to growth, percentage points) (Percentage, y/y) (Ratio) 30 Foreign 30 82 Individuals Others Deposits Deposits Growth 25 80 (right) 25 Regulatory Limit 78 20 20 CCD Ratio 76 15 15 74 10 72 10 5 70 5 0 68 Non-bank Financial Corporations 0 66 -5 Institution 64 -10 -5 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Nov-12 Mar-13 Nov-13 Mar-14 Nov-14 Mar-15 Nov-15 Mar-16 Nov-16 Mar-17 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Source: NRB and WB Staff Calculations. Source: NRB. Deposit growth is slowing in FY2017. Since the beginning of FY2017, deposit growth has slowed from 20.6 percent y/y in August 2016 to 16.8 per- cent y/y in March 2017 (Figure 22). Deposits from all sectors, with the exception of corpora- May 2017 THE WORLD BANK GROUP 9 Strong rebound, mounting risks Nepal Development Update tions, slowed during FY2017. Notably, the contri- funds in the banking system (see Box 1). Banks’ bution of foreign deposits to total deposits de- credit to core capital plus deposit (CCD) ratios are clined from 0.71 percentage points in August being squeezed tight. NRB regulation caps banks’ 2016 to 0.09 percentage points in February 2017, CCD at 80 percent, but with credit growth outpac- while that of the “others” category, consisting of ing deposit growth, at the end of Q2 FY2017, the deposits of the private sector, local governments, CCD ratio of all commercial banks (Class A) nonprofit organizations, and miscellaneous, de- reached 78.3 percent, the highest industry average clined from 0.54 percentage points to -2.59 per- since 2011 (Figure 23). centage points. Government cash balances amounting to near- The cumulative effect of rapid credit growth ly 10 percent of GDP and parked in the govern- and slowing deposit growth has contributed ment’s account at the NRB have further added to the diminishing availability of loanable to the credit crunch. The government’s large Figure 24 Adding more funds to the treasury and Figure 25 Pushing interest rates to a three-year soaking liquidity from the market high (NPR millions, month moving average) (Percent, weighted average) 250,000 14 12 200,000 Government Credit Lending Rate 10 150,000 8 100,000 6 Government Deposit 50,000 Deposit Rate 4 0 2 Nov-08 Mar-09 Nov-09 Mar-10 Nov-10 Mar-11 Nov-11 Mar-12 Nov-12 Mar-13 Nov-13 Mar-14 Nov-14 Mar-15 Nov-15 Mar-16 Nov-16 Mar-17 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Nov-12 Mar-13 Nov-13 Mar-14 Nov-14 Nov-15 Mar-16 Nov-16 Mar-17 Jul-12 Jul-13 Jul-14 Mar-15 Jul-15 Jul-16 Source: NRB. Source: NRB . Figure 26 Overdraft & margin loans may have been Figure 27 The NEPSE remains disconnected from fueling speculative behavior in the stock market the regional market (Percent change, yly) (NEPSE Index) (Percent change, yly) 60 2,000 120 Bangladesh:CSE All NEPSE India:SENSEX Margin Loan Shares Index 1,800 100 50 1,600 80 NEPSE Index 1,400 40 (right) 1,200 60 Overdraft 30 1,000 40 800 20 20 600 400 0 10 200 -20 0 0 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Mar-16 Apr-16 Nov-16 Dec-16 Jul-15 Jan-16 Feb-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Jan-17 -40 Dec-13 Mar-14 Sep-14 Dec-14 Mar-15 Sep-15 Dec-15 Mar-16 Dec-16 Mar-17 Jun-14 Jun-15 Jun-16 Sep-16 Source: NRB and WB Staff Calculations. Source: Regional stock markets and WB staff calculation. May 2017 THE WORLD BANK GROUP 10 Strong rebound, mounting risks Nepal Development Update Box 1 Credit Crunch Background FY2017 (mid-January 2017), the CDD ratio (industry average) was estimated to have reached Liquidity management in Nepal is seemingly 78.3 percent, and it was reported that six banks becoming a persistent challenge. Nepal faced a had already reached or exceeded the regulatory liquidity crisis in FY2011, which was followed by requirement of 80 percent. Clearly, injecting li- a number of years of high liquidity. High liquidi- quidity through repos would have had little or no ty was bolstered by high inflow of remittances impact on banks facing a CCD squeeze, because that the central bank was not able to fully steri- banks required deposits to ease their CCD posi- lize, and kept interest rates low. The Nepali tion more than cash holdings or borrowings. economy is now contending with a credit crunch. In the last few months, the availability Factors contributing to the credit crunch of loanable funds has steadily dried up in the banking system. The effect has been rising inter- Rapid expansion of credit: The initial growth est rates and, more pressingly, it has led to the in credit began on the back of an economic re- deterioration of the liquidity ratio, computed as covery following the end of the trade disrup- credit to core capital plus the deposit ratio tions, but it has since been sustained by credit to (CCD)—close to the regulatory limit. Four pri- sectors such as vehicle and margin loans (Figure mary factors have contributed to this: rapid ex- 21). Between August 2016 and January 2017, the pansion of credit, weak regulatory supervision, contribution of commercial loans (including term the government accumulating nearly 10 percent loans, working capital loans, import loans, de- of GDP in the treasury, and a slowdown in re- prived sector loans, and bill purchases) to overall mittances. credit growth increased from 11.8 percentage points to 13.3 percentage points. The contribu- What happened tion of credit to other sectors (such as overdraft, home loans, real estate, margin loans, and vehicle In January 2017, the Nepalese banking system purchase) to overall credit growth grew from started reporting shortages of loanable funds, 12.7 percentage points to 18.3 percentage points. although signs were already present when the Simultaneously, banks have also been increasing lending rates started increasing in November their capital base over the last year and a half as 2016. Initially, it was thought that only a few mandated by the FY2016 monetary policy. This banks were offering highly competitive interest has provided them with more space to disburse rates to attract more deposits. While the remain- more credit, but has also pushed banks to lend ing banks also increased their interest rates to more aggressively to generate greater profit to maintain their deposit base, the speculation of a maintain or increase the return on equity for looming liquidity crisis was laid to rest when shareholders. there was an undersubscription of repo worth NPR 30 billion issued by the Nepal Rastra Bank Weak regulatory supervision: The rapid in- (NRB) to ease the shortage, which was followed crease of credit to nonproductive purposes (for by another NRB notice published on January 17 example, margin loans, real estate loans) should and 18, 2017, to buy back NRB bonds worth have been observed by the regulators and NPR 40 billion to inject liquidity. Few banks brought under control prior to the situation esca- showed interest indicating that liquidity was not lating. However, the NRB was relatively slow to a problem. However, the shortage of “loanable react and initially carried out an unnecessary repo funds” was real. As banks are allowed to lend to ease the situation. Only in February 2017 did only 80 percent of their deposit and core capital, it introduce new restrictions and provide tempo- they started offering higher interest rates to at- rary relief measures in its midterm monetary pol- tract new deposits. New deposit rates offered icy review. To curtail credit toward were as high as 10 to 12 percent on fixed depos- “unproductive purposes”, the NRB has restrict- its and call deposit accounts, up from a range of ed banks from financing more than 50 percent 5 to 8 percent previously. Based on estimates of a vehicle through auto loans, and also reduced shared by the Nepal Banking Association, by Q2 the limit of personal overdrafts from NPR 10 May 2017 THE WORLD BANK GROUP 11 Strong rebound, mounting risks Nepal Development Update Box 1 Credit Crunch (continued) was out of the banking system and further added to government deposits. As a result, by mid- January, the Government of Nepal had a cash surplus of more than NPR 200 billion (almost 10 percent of GDP) locked up at the Central Bank. Slowdown of remittances: Remittances from migrant Nepali workers abroad have been a sig- nificant source of liquidity for the economy, and consequently deposits for the banking sector, in recent years. They continuously grew, providing a source that could be extended for credit. As a The government’s fiscal and borrowing poli- percentage of GDP, remittances more than dou- cy has been a major culprit, as well: Govern- bled in a decade to almost 30 percent of GDP in ment borrowed heavily at the end of the previ- FY2016. However, remittance growth has ous fiscal year in anticipation of massive spend- slowed, growing by only 0.8 percent (y/y, U.S. ing this fiscal year which it did not materialize. dollars) in FY2016. This trend has continued, As a result, the Government’s cash surplus has and remittance growth rates in FY2017 have remained locked up in the central bank. The been the slowest in recent years. A weak invest- situation was exacerbated in December 2016, ment environment and lack of investment op- when corporate taxpayers had to deposit 40 per- portunities has pushed the credit to nonproduc- cent of their income tax by the end of Q2 as an tive use, but lower liquidity inflow from external advance amount to the treasury. This amount is sources has slowed the deposit mobilization, as estimated to be around NPR 36 billion, which well. cash balances have had the effect of monetary has reached a four-and-a-half-year low. In contrast, tightening. As this balance is held at the NRB and credit to the private sector has reached a historic out of the banking system, it has in effect high and has driven the growth of M2. The contri- “mopped up” nearly 10 percent of GDP of liquid- bution of net foreign assets in M2 growth has de- ity from the domestic market (Figure 24). As a clined to 3.2 percentage points, while the contribu- result, with less liquidity in the market there are tion of private sector credit reached above 20 per- less deposits, which has created additional pres- centage points. sure on banks’ ability to disburse more credit. 8. The stock market remains disconnected Tighter liquidity in the banking system has from the real economy pushed interest rates up. The first half of FY2017 has bucked the multiyear trend of de- Proliferation of overdraft borrowing is a con- clining interest rates (Figure 25), with both lend- cern, because it may have led to speculation, ing and deposit rates shooting up in the past few including in the stock market. With NPR 341.3 months. The weighted average lending rate rose billion in overdrafts in March 2017, it is approxi- from 8.9 percent in August 2016 to a three-year mately 18 percent of total loans outstanding, and it high of 10.6 percent in March 2017. Similarly, the is the second-largest category of lending after weighted average deposit rate was up from 3.3 working capital loans (21.2 percent in March 2017). percent in August 2016 to 5 percent in March In one year, the growth rate of overdraft tripled 2017—the highest rate since the beginning of from 10.5 percent y/y in March 2016 to 31.7 per- FY2014. cent y/y in FY2017. This has also coincided with the stellar rise of the Nepal Stock Exchange Growth of broad money (M2) has slowed to (NEPSE), raising concerns that funds acquired 17.4 percent (y/y) and reached a two-year low. through overdrafts may be channeled into stock With the deceleration in remittances, the growth market speculation (Figure 26). Because no or few of net foreign assets has significantly slowed and conditions are attached to overdrafts, it is a non- May 2017 THE WORLD BANK GROUP 12 Strong rebound, mounting risks Nepal Development Update Figure 28 GDP growth is a record high in FY2017 Figure 29 With all sectors rebounding strongly in FY2017 (Percentage points, contributions to growth) (Percentage change, y/y) (Percentage points, contributions to growth) (Percentage change, y/y) 20 20 8 8 GFCF Statistical GDP Growth, Market Discrepency 7 7 Prices (right) 15 15 6 6 Private Services 10 Consumption 10 5 5 4 4 5 5 3 3 0 0 2 2 -5 Government -5 1 1 Consumption 0 0 GDP Growth, Agriculture -10 -10 Industry Net Market Prices -1 -1 Exports (right) -15 -15 -2 -2 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 Source: CBS and WB staff calculations. Source: CBS and WB staff calculations. transparent instrument. These funds can be di- Base effect was a major contributor to the esti- verted to risky and speculative activities such as mated growth rate in FY2017. Growth in stock market and real estate and land purchases, FY2016 was exceptionally weak, coming in at 0.4 potentially fueling asset bubbles. percent after second revision by the CBS. This gives a very low base for comparing the growth in The stock market has moderated from its FY2017. Had the growth rate in FY2016 been in peak in October 2016, but still remains dis- line with the average of recent years, the growth connected from the real economy and region- rate in FY2017 would not have been so spectacu- al stock exchanges. NEPSE’s historic rise, lar. For example, if the GDP growth rate had been which saw the NEPSE index peak at 1,820 in Oc- 4 percent instead of 0.4 percent in FY2016, tober 2016, has turned to a bear market. Since its growth in FY2017 would have been 3.8 percent in peak in October, the NEPSE slid to 1,246 in Feb- FY2017, implying that nearly half of the headline ruary 2017, before recovering to 1,700 in mid- growth rate in FY2017 can be attributed to the April. The credit crunch is likely to have impacted low starting point of 2016. Similarly, the high the stock market. A lower number of margin growth recorded in FY2017 will set up a high base loans and overdrafts—which may be used in for next year and it will be difficult to sustain such stock market speculation—might be driving the high rates of growth in FY2018. stock market down. The overall effect has been a lowering of the NEPSE growth rate. However, On the supply side, all three major sectors the stock market in Nepal still remains discon- have grown at above trend rates in FY2017 nected from the real economy, and from regional (Figure 29). Agriculture grew at a rate of 5.3 per- stock exchanges (Figure 27). cent on the back of a record high agriculture pro- duction which was mostly a result of very good 9. In sum, FY2017 resulted in highest growth monsoon. Industry’s growth has been high at 10.9 since 1994 percent, but this comes after a contraction 6.3 percent in the previous year. Electricity with a rec- First estimate for FY2017 shows growth is ex- ord high hydropower capacity addition and con- pected to reach 7.5 percent in FY2017, the struction on the back of earthquake reconstruc- highest rate since 1994 (Figure 28). The rebound tion in particular drove the industry sector. in growth is a result of base effect, increased agri- Growth in service sector also has been above av- cultural output, increased availability of electricity, erage at 6.9 percent. Wholesale/retail trade and and greater investment as earthquake reconstruc- hotels sub-sectors rebounded from the shocks of tion gained speed. previous two years. Transport, communications May 2017 THE WORLD BANK GROUP 13 Strong rebound, mounting risks Nepal Development Update and real estate particularly gave a significant boost to service sector in FY2017. Education and finan- cial sector, however, have slowed down in FY2017. On the demand side, gross investments con- tributed the most to headline growth. Gross fixed capital formation is estimated to have reached 25 percent of GDP in FY2017, up from 21 percent the year before. Private investment rebounded strongly reaching 20 percent of GDP with the remainder going to the public investment. Consumption, while it still the largest contributor to GDP, has shrunk to 89 percent of GDP, down from a 5-year average of 94 percent. However, growth in public consumption rebounded strongly at 12 percent while private consumption was more muted at 2.5 percent in FY2017. The quality of national accounts data, in particular from the ex- penditure side, remains weak as the “change in stock/statistical error” category account for 29 percent of GDP in FY2017, the highest level on record. May 2017 THE WORLD BANK GROUP 14 Strong rebound, mounting risks Nepal Development Update B. Outlook, Risks and Challenges Looking ahead, the economic growth will re- to come online, FY2018 will have record-high main strong, but it is expected to moderate in hydropower generation in the country. Additional line with country’s potential, averaging 5 per- small hydropower projects will provide a further cent over the next two fiscal years. While boost to the electricity subsector. As a result, elec- healthy growth is expected to continue in agricul- tricity is also expected to bolster the manufactur- ture, construction and industry sectors, the activity ing sector in FY2018. Reconstruction activities are in remaining sectors is expected to be affected by expected to pick up at a relatively faster pace in uncertainty stemming from transition to the feder- FY2018, as they did not gather speed as expected al structure, several elections and the possibility of in FY2017. This will benefit the construction sec- further slowdown in remittances. tor. On the supply side, the service sector is ex- On the demand side, gross investments are pected to continue driving the growth. Ser- expected to drive the growth. Growth in gross vices are expected to grow at 6.2 percent, on aver- fixed capital formation is expected to remain age, during the forecast period driven by trade, strong during the forecast period. In particular, transport, and tourism. The outlook in services is private investment is expected to drive the growth also dependent on remittances stabilizing at the with hydropower plants coming online and spur- present level, particularly in light of the large share ring investments in other private activities. Public of wholesale and retail trade subsectors. However, investment on the other hand is likely to face chal- the boost in tourism, in particular, is expected to lenges as the country implements a new political continue in the forecast period. The good harvest and bureaucratic structure. Growth in private con- of agricultural products is expected to continue in sumption is expected to moderate during the fore- FY 2018, as the monsoon is forecasted to be nor- cast period in line with a more sanguine outlook mal, that is, at the long-term average. Industry is for growth of remittances. Government consump- likely to get a further boost in FY2018 as electrici- tion, however, is expected to grow substantially as ty generation, manufacturing, and construction the country starts transitioning towards the federal subsectors continue to perform relatively well. structure. In addition, federal and provincial elec- With the Upper Tamakoshi (465 MW) and Rasu- tions scheduled in FY 2018 will further add to the wagadhi (111 MW) hydropower projects expected government consumption. Exports of services are May 2017 THE WORLD BANK GROUP 15 Strong rebound, mounting risks Nepal Development Update Table 2: Nepal Macroeconomic Outlook (annual percent change unless noted otherwise) FY2014 FY2015 FY2016 FY2017 e FY2018 f FY2019 f Real GDP Growth, at Constant Market Prices 6.0 3.3 0.4 7.5 5.5 4.5 Private Consumption 4.1 2.9 -0.9 2.5 2.5 3.0 Government Consumption 10.0 7.4 -0.4 12.2 15.0 15.0 Gross Fixed Capital Investment 11.4 19.6 -12.3 27.2 15.5 12.0 Exports, Goods and Services 18.8 6.8 -13.7 16.9 12.0 6.0 Imports, Goods and Services 20.9 9.6 2.8 22.0 7.0 7.5 Real GDP Growth, at Constant Basic Prices 5.7 3.0 0.0 6.9 5.5 4.5 Agriculture 4.5 1.1 0.0 5.3 3.7 3.0 Industry 7.1 1.4 -6.3 10.9 5.8 3.5 Services 6.1 4.8 2.0 6.9 6.6 5.8 Inflation (Consumer Price Index) 9.1 7.2 9.9 5.2 6.0 7.0 Current Account Balance (% of GDP) 4.6 5.1 6.2 1.0 -0.7 -1.2 Fiscal Balance (% of GDP) a/ 0.6 -1.1 -0.8 -1.8 -2.1 -2.1 Debt (% of GDP) 28.3 25.6 28.0 26.1 25.7 25.4 Sources: CBS, NRB, MoF for history and estimates; World Bank staff for forecasts. Notes: a/ fiscal balance includes net lending, e = estimate, f = forecast. expected to continue as tourism normalizes. Ex- ernment spending as a result of a new federal ports of goods are also expected to grow in structure and earthquake reconstruction, the fiscal FY2018 in light of increased power availability in balance is expected to be negative in FY2018. Nepal, and with the normalization of demand in Meanwhile, the current account, which had re- India as the demonetization effect subsides but mained in surplus over the past several years, is expected to moderate in line with their long-term expected to narrow and turn into a deficit as im- average thereafter. port growth is expected to remain high while re- mittances and exports are expected to slow. The fiscal deficit is expected to widen during the forecast period; however, given the large From a significantly moderated rate of cash balance on hand, financing is not ex- FY2017, inflation is expected to pick up dur- pected to be a problem. The FY2017 budget ing the forecast period. Inflation will be much called for an expenditure increase of nearly 15 below the central bank’s target of 7.5 percent for percent of GDP over actual expenditures in all of FY2017. However, it is expected to pick up FY2016. However, as in previous years, significant in FY2018 as the effect of demonetization tapers underspending of the budget will continue. Realiz- off in India. The sharp uptick in the prices of ing this, the government’s midyear budget has rental housing and utilities following the earth- already lowered the spending targets. Neverthe- quake, which continued in FY2017 due to slow less, government spending will grow substantially reconstruction, is expected to moderate somewhat in FY2017 owing to increases in earthquake- in FY2018 as housing reconstruction is expected related cash assistance and proposed election- to gather speed. related spending, as well as measures introduced to increase civil servants’ compensation, pensions, Challenges and Risks and social protection. The government’s recurrent expenditure is expected to continue to grow sub- There are an increasing number of downside stantially in the forecast period, particularly as a risks to this forecast with domestic risks pre- result of the implementation of the new federal dominating. The political environment remains constitution, which calls for creation of an entirely fluid as the term of the current government— new level of government. The growth in revenues which was sworn in during July 2016 as part of is expected to continue, but may slow if the inflow the power-sharing agreement among the coalition of remittances slows further. With increased gov- partners—is coming to an end. A series of elec- May 2017 THE WORLD BANK GROUP 16 Strong rebound, mounting risks Nepal Development Update tions (local, provincial, federal) needs to be held fewer than 1,000 households had received all by early 2018, as stipulated in the new constitu- three tranches of government subsidy for housing tion, with a date for local elections announced for reconstruction by the second anniversary of the May and June 2017. earthquake. Reconstruction in other sectors (cultural heritage, schools, hospital, public build- With the confusion surrounding budget ap- ings, and so forth) has barely started. The Ministry proval for the upcoming fiscal year, elections, of Finance has confirmed that nearly all of the and the fiscal architecture in the new federal money pledged during the donor conference has structure, budget execution is going to be been committed by the donors, and the risk of particularly challenging in FY2018. Budget nondelivery from the Nepali government is in- execution has been a persistent problem in the creasing. past. This has been exacerbated since the FY2016 budget, which called for a substantial increase in Increased vulnerability in the financial sector expenditures driven to a large extent by increased could pose a challenge in the remainder of the needs in postearthquake reconstruction. However, forecast period. Banks that are running up the execution of this very large increase in budget against regulatory limits for lending may face ad- appropriations did not materialize. This has con- ditional pressure if deposit growth does not im- tinued in the FY2017, both in unrealistic budget- prove. Banks are allowed to lend up to 80 percent ing and weak execution. FY2018 is going to be of their local currency deposits and core capital. even more challenging because of the confusion As a result, the central bank announced regulatory around the second phase of local elections and the measures to ease the constraints, and also warned timing of budget approval, which are both sched- six banks in mid-January that have breached the uled for June. Furthermore, provincial and federal lending limit. elections expected to be held during FY2018 as stipulated in the constitution, which will add fur- The external environment is likely to be less ther challenges for timely budget execution. Nor- favorable, as well. Continued underperformance mally, the government stops all major activities in of exports despite the end of disruptions remains the runup to elections. In addition, as the country a persistent challenge. Remittances account for 30 moves to a federal structure, there is lack of clarity percent of GDP, with the majority of migrants of fiscal architecture in the federal context, which going to oil-exporting GCC countries. Significant can cause unintended interuptions in service deliv- spending cuts, including in capital spending an- ery and execution of capital projects. nounced in the GCC countries, and persistent contraction in departures of migrants, have con- Despite improvements, the pace of earth- tributed to lower growth of remittances and risk quake reconstruction remains a concern. The of a possible sharper slowdown during the fore- delay in disbursement of the second tranche of cast period. the housing reconstruction grant has meant that May 2017 THE WORLD BANK GROUP 17 Strong rebound, mounting risks Nepal Development Update References Warner, Andrew. 2014. “Public Investment as an Engine of Growth.” International Monetary Fund, Washington, DC. World Bank. 2016. “Nepal Development Update: Remittances at Risk.” World Bank, Washington, DC. ———. 2017a. “South Asia Economic Focus.” World Bank, Washington, DC. ———. 2017b. “Migration and Development Brief 27.” World Bank, Washington, DC. ———. 2017c (forthcoming). “Nepal Country Economic Memorandum, Climbing Higher: To- ward a Middle- Income Nepal.” World Bank, Washington, DC. May 2017 THE WORLD BANK GROUP 18 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