Nepal - 1997 Economic update: the challenge of accelerating economic growth

Report No. 17034-NEP Nepal 1997 Economic Update: The Challenge of Accelerating Economic Growth November 11, 1997 Poverty Reduction and Economic Management Division South Asia Region H_ S3  CURRENCY Currency NRs/US$ 1980 12.00 1981 12.34 1982 13.24 1983 14.55 1984 16.46 1985 18.25 1986 21.23 1987 21.82 1988 23.29 1989 27.19 1990 29.37 1991 37.26 1992 42.72 1993 48.61 1994 49.40 1995 51.89 1996 56.69 1997 June 57.03 Note: The Nepali fiscal year runs from July 16 through July 15. Source: IMF, International Finance Statistics (IFS), line "rf" (period average). a Starting November 30, 1985, the Nepali Rupee was linked to a basket of currencies. Subsequently in early 1992, a two-tier exchange rate system with partial convertibility was introduced. In February 1993, the dual exchange rate system was replaced by a unified market-determined exchange rate system providing de facto convertibility for all current account transactions. Vice President Mieko Nishimizu, South Asia Region Country Director,: Hans M. Rothenbuihler, Nepal Sector Manager : Roberto N. Zagha, SASPR Staff Member : Para Suriyaarachchi, Principal Economist  ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank ADB/N Agricultural Development Bank of Nepal AIC Agricultural Inputs Corporation APP Agriculture Perspective Plan CAS Country Assistance Strategy CRR Cash Reserve Ratio DANIDA Danish International Development Association ECG Environmental Coordination Group ESAF Enhanced Structural Adjustment Facility FCGO Financial Comptroller General's Office GDP Gross Domestic Product GNP Gross National Product ICOR Incremental Capital Output Ratio IDA International Development Association IMF International Monetary Fund IPA Industrial Pollution Act MOH Ministry of Health MOPE Ministry of Population and Environment NBL Nepal Bank Limited NEPAP Nepal Environment Policy and Action Plan NGOs Non Governmental Organizations NIDC Nepal Industrial Development Corporation NPC National Planning Commission NRB Nepal Rastra Bank ODA Overseas Development Administration PEs Public Enterprises RNAC Royal Nepal Airlines Corporation RBB Rastriya Banijya Bank SAPTA. South Asian Preferential Trade Arrangement TYREP Three Year Rolling Expenditure Program USAID United States Agency for International Development VAT Value Added Tax WTO World Trade Organization  t  IABLE OF CONTENTS Currency Abbreviations and Acronyms Acknowledgements Economic Development Data Social Indicators Executive Summary CHAPTER 1 - Recent Economic Performance .1....................................................... A. Introduction: Nepal's Development Challenges and Achievements ..................................1 B. Scope of the Report ........................................................2 C. Recent Economic Performance ........................................................2 Macroeconomic Performance ........................................................2 Growth Performance ........................................................5 Fiscal Developments ........................................................6 Financial Sector Developments ........................................................9 Progress in Economic Reforms ....................................................... 11 D. Summary ....................................................... 13 CHAPTER 2 - The Task Ahead ....................................................... 15 A. Nepal's Development Strategy ................................................. 15 The Ninth Plan ................................................. 16 B. The Development Agenda ................................................. 17 I. Improving Public Resource Management ................................................. 17 Expenditure Management ................................................. 18 Tax Reform ................................................. 19 II. Creating an Enabling Environment for the Private Sector .................................. 20 Financial Sector Reformn ................................................. 20 Privatization ................................................. 21 Trade and Investment Policies ................................................. 22 III. Sector Policies in Key Areas .............................................. 23 Agriculture ................................................. 23 Tourism ................................................. 24 Power Development ................................................. 25 Human Resource Development ................................................. 25 Environmental Management ................................................. 27 C. Conclusion ................................................. . 28 ANNEX List of Tables Table 1.1 Indicators of Macroeconomic Performance, FY86-97 .4 Table 1.2 GDP Growth, FY86-97 .5 Table 1.3 Average Annual Government Expenditure and Its Financing, FY86-98 ....7 Annex Table I Ninth Plan - Key Macroeconomic Indicators, FY97-2002 ................... 1 of 3 Annex Table 2 Macroeconomic Projections, FY97-2000 ............................................. 3 of 3  t  ACKNOWLEDGEMENTS This report was prepared by a team led by Para Suriyaarachchi. It draws on contributions from Shakti Shrestha, Tashi Tenzing, Brajesh Pant, Badrud Duza and Tirtha Rana. Renton De Alwis (UNDP Advisor on Tourism Development) and Champak Pokhrel (local consultant) also made important contributions on tourism and agricultural development respectively. Roberto Zagha (Sector Manager, SASPR) provided valuable guidance and helped improve the focus and clarity of the report. The report also benefited from comments from Robert Drysdale (Operations Director), Hans M. Rothenbuhler (Country Director), Joe Manickavasagam (Resident Representative), Peter Dattels (Peer Reviewer, IMF), Richard Westin (Peer Reviewer), Rui Cutinho, Rohil Hafeez, Peter Nicholas, Jeeva Perumalpillai - Essex, Bigyan Pradhan, Giovanna Prennushi and Eric Spitaeller (IMF). Primary statistical and computational assistance was provided by Shakti Shrestha, while Lystra Antoine also contributed to the social and economic development data. Nina Shrestha and Jennifer Manghinang efficiently managed the production of the report. The report benefited from discussions held with the government authorities in Nepal in October 1997. We gratefully acknowledge the cooperation extended by government officials, especially in the Ministry of Finance, the National Planning Commission and the Nepal Rastra Bank.  t  ECONOMIC DEVELOPMENT DATA GNP Per Capita (US$, 1995): 200 a/ Gross Domestic Products (FY96) bl FY96 Annual Growth Rate (% p. a., constant prices) US$ Million % of GDP FY86-90 FY91-94 FY95-96 GDP at Factor Cost 4282 96.1 4.8 5.6 4.1 GDP at Producers' Prices 4455 100.0 4.6 5.6 4.4 Gross Domestic Investment 1033 23.2 1.6 11.1 5.9 Gross National Saving 464 10.4 -2.7 20.7 -17.2 Current Account Balance -569 -12.8 - -7.9 59.1 Output, Employmnent and Productivity Value Added, FY 91bl Labor Force c/ V.A. per Worker US$ Million % of Total Million % of Total US$ % of Average Agriculture 1710 47.9 15.0 81.2 114 59.0 Industry 626 17.5 0.5 2.7 1245 644.6 Services 1234 34.6 3.0 16.1 416 215.3 Total/Average 3570 100.0 18.5 100.0 193 100.0 Government Finance d/ NRs. billion % of GDP As % of GDP FY96 FY86- FY9i-94 FY95-96 Revenue Receipts 27.9 11.3 9.0 9.2 11.3 Total Expenditures 46.5 18.9 18.6 17.4 18.4 Regular Expenditures 21.5 8.7 6.4 6.5 8.8 Development Expenditures 25.0 10.2 12.3 10.9 9.6 Overall Deficit -18.6 -7.6 -9.6 -8.2 -7.1 External Assistance 14.2 5.8 7.3 6.2 5.5 Domestic Borrowings 4.4 1.8 2.4 2.0 1.6 Money, Credit, and Prices el FY91 FY92 FY93 FY94 FY95 FY96 NRs.Billion outstanding, end of period Broad Money (M2) f/ 37.7 45.7 58.3 69.8 81.0 92.6 Bank Credit to Government (net) 16.8 19.0 23.4 23.5 25.2 27.5 Bank Credit to Private Sector 15.6 19.8 23.9 32.3 44.8 57.7 percentage or index number Broad Money as % of GDP Consumer Price Index (1983/84=100) 197.6 239.1 260.4 283.7 305.4 330.2 Annual Percentage Changes in: Consumer Price Index 9.8 21.0 8.9 8.9 7.6 8.1 Broad Money (M2) 19.5 21.1 27.7 19.6 16.1 14.4 Bank Credit to Government (net) 20.9 13.1 23.2 0.4 7.2 9.1 Bank Credit to Private Sector 20.9 26.9 20.7 35.1 38.7 28.8 a/ World Development Report 1997, The World Bank. dt/ Economic Survey FY97, Minstry of Fcance. b/ National Accounts of Nepal 1997, Central Bureau of Statistics. e/ Nepal Rastra Bank. c/ Population Census 1991, Central Bureau of Statistics. V Includes money supply (Ml) and time deposits.  Balance of Payments (US$ Million) e/ Merchandise Exports (Average FY91 - FY96) e/ FY94 FY95 EY96 US$ Million % of Total Exports of Goods & NFS 965.2 1062.9 1002.7 Woolen Carpets 164.4 48.5 Merchandise, fob 392.1 354.0 359.9 Readymade Garments 87.5 25.8 Imports of Goods & NFS 1278.3 1518.8 1652.4 Others 87.3 25.7 Merchandise, cif 1048.1 1276.3 1391.1 Total 339.2 100.0 of which POL products 98.2 94.5 101.6 Trade Balance -656.0 -922.3 -1031.2 Total External Debt,1995 al Non Factor Services (net) 342.8 466.4 381.5 US$ Million External Debt 2398.0 Resource Balance -313.1 -4559 -649.7 Net Factor Income 11.9 5.4 -2.6 Debt Service Ratio for 1995 a/ Net Transfers 76.5 107.4 83.5 % of current Receipts Debt Service 7.8 Current Account Balance 2247 -343.1 5688 Official Grants 61.7 106.9 137.3 IDA Lending, June 1996 g/ Medium & Long Term Capital US$ Million Gross Inflows 263.4 228.2 186.2 Outstanding & Disbursed 1012.6 Principal Repayments -45.7 -51.9 -52.2 Undisbused 286.2 Miscellaneous Capital Flows 79.9 50.1 278.4 Overall Balanc 134.6 -9.6 -19.1 Gross Reserves (end year) 866 865 801 Rate of Exchange Period Average Rate (US$/NRs.) 49.26 49.94 55.22 g/ The World Bank.  Nepal Social Indicators 1.fgsh11 _"r Same reglonfliacin group South Low. 1970-75 _fh" 190-9 Asia ncome POPULATION Total popaon, mi-year (milons) 12.8 16.7 21.5 1,243.0 3,179.9 Growh rat (%A au average) 2.6 2.6 2.5 1.9 1.6 Urban populaion (% ofpopulaton) 5.0 8.5 13.7 26.4 28.6 Total fedilty rte (bs per woman) 65 63 5.3 3.5 32 POVERTY (% Of popdah) Natonal headcourntd _ 42.0 Urban headcouat hb x _ 23.0 Rural headcout hbxe _ 44.0 INCOME GNP per cap aJS$) 120 160 200 350 430 Corsumer price nda (1990.100) .. .. Foodpriemnd"e(1990-100) 57 159 INCOMEICONSUMPIION DISTRIBUTION (X of kioe orcon Jmpfion) Lowest quinble 9.1 7.6 Highest quinile 39.5 44.8 SOCIAL INDICATORS Public expenditure (% o GDP) Heath _ - 12 Educatlon _ 2.4 2.7 Social security an wifare 0.1 0.1 Not primary school enolilment rate (% of Sp gop) Total _ 59 Male Female Access to safe waer (% Of popUlIon) Total 8.0 23.9 44.0 63.2 53.0 Urban 85.0 78.4 66.0 Rural 5.0 19.8 41.0 Immunization rate (f under 12 monts) MeasIs _ 34 78 80 77 DPT _ 32 77 84 80 Child malnutrWon (% unr 5 years) 70 _ 70 61 42 Life expectancy at bii (f) Total 43 49 55 61 63 Male 44 50 56 61 62 Female 43 48 55 62 64 Mortality Infant(perthousandhebirfs) 160 125 91 75 69 Under 5 (pr thousand We birfs) _ 131 106 104 Adult (1549) Male (per 1,000 population) _ 327 239 244 Female (per1,000populadon) _ 354 230 211 Maenal (wr 100.OW Ole bus) _ 515 Would Developr_rt hdkbs CD ROK. World BanK Febriuary 1997   ExECUTIVE SUMMARY 1. Nepal, with a per capita income of around US$ 200 p.a., is one of the poorest countries in the world. Handicapped by numerous constraints, economic development is a challenging task in Nepal. A series of economic reforms in the late eighties and early nineties enabled Nepal to achieve good progress in terms of accelerating economic growth and modestly improving its social and economic indicators, while on the political front, it made a major transition from an absolute monarchy to a democratic government in 1991. 2. In the past few years, however, Nepal has witnessed considerable political instability with five different governments. Against this background, successive governments have found it difficult to forge a consensus to implement key reforms which are necessary to improve economic management. Despite these problems, a measure of progress has been achieved: Macroeconomic stability has been maintained so far with tight monetary and fiscal policies, the domestic inflation rate remains relatively low, the balance of payments situation appears to have stabilized, preparations are under way for implementing a Value Added Tax, and the privatization process, though somewhat limited to date because of political constraints, seems to be moving forward again. Notwithstanding these achievements, given the inadequate political support for a coherent reform agenda, the overall quality of economic management has suffered. Economic growth has decelerated, fiscal management has been weak, the financial sector is under considerable strain and economic reforms have significantly slowed down. These developments are taking place in Nepal at a time when neighboring countries are adopting bold economic reforms and their economic performance is improving significantly. 3. Given the widespread poverty in Nepal--nearly half the population is below the poverty line- -recent economic performance has not been good enough; and Nepal needs to grow more rapidly and equitably in order to make tangible progress in reducing poverty. There is little scope in Nepal for improving living standards of the poor through income redistribution, and higher growth is necessary both to increase income levels and to generate additional resources to provide better services and infrastructure to the poor. In the context of widespread poverty, generating adequate income-earning and employment opportunities is essential for maintaining social and political stability as well. 4. Despite its limited resources base, Nepal still has considerable scope for accelerating economic growth by exploiting the potential in agriculture, power, tourism and human resource development and its proximity to the large Indian market. Better policies and programs could increase agricultural production by about 2 percent p.a. and directly benefit the rural poor. Similarly, development of tourism would help generate incomes/employment in some hill areas and strengthen the balance of payments. Over the longer term, hydropower development for export could provide Nepal much needed resources to significantly improve its human resource and infrastructure base. This will however take time; and in the meantime, Nepal needs to channel more of its own, as well as aid, resources to improve literacy, skills, health and nutrition levels in order to enhance living standards and to improve the competitiveness of its labor force, to take advantage of emerging opportunities in neighboring India and third country markets.  - ii - 5. Recognizing the need and potential for higher growth, the government, in its Approach Paper for the Ninth Plan and the FY98 budget, has articulated a four-pronged development strategy focusing on: (i) accelerating economic growth to 6.5-7.2 percent p.a.; (ii) pursuing liberal, market- oriented economic policies to promote private sector-led development; (iii) bringing rural areas into the mainstream of development through promotion of agriculture and involving village communities closely in human resource development; and (iv) developing special programs for the most vulnerable and underprivileged groups. The budget also states that it gives priority on a sectoral basis to agriculture, tourism, power, human resource development and rural infrastructure. However, the government's current plans are over-ambitious in relation to resource availabilities; the budget itself is not adequately prioritized; and given the likely shortfalls in resources, the targets outlined in the Approach Paper and the budget are unlikely to be achieved. 6. Within the more limited resources which are likely to be available, Nepal can still increase the economic growth rate and its impact on reducing poverty by improving its economic management in three key areas: (i) utilizing public resources efficiently; (ii) providing a more conducive atmosphere to facilitate the vibrant growth of the private sector; and (iii) improving policies and programs in key sectors to exploit their potential for economic growth and poverty reduction. 7. Given the government's weak fiscal position and competing demands on limited public resources, it is essential to allocate and use public resources efficiently in order to maximize their potentialfor accelerating economic growth and reducing poverty. To this end, (i) the public sector needs to phase out its direct involvement in areas where public resources are being inefficiently used, such as transfers to loss-making public enterprises and subsidies on fertilizer and water, or where the private sector can provide goods and services more efficiently, such as air and road transport and telecommunications. In this context, the Government has already made a start with reducing subsidies and encouraging private investment, for example by eliminating the lower limit of Rs. 20 million on foreign investments; but much remains to be done. It is also necessary to look at how effectively funds are being used in the newly created spending programs such as grants to parliamentary constituencies and village development programs, and adjust allocations to such programs on the basis of capacity for effectively using such funds. This would enable limited public funds to be allocated to those sectors where the private sector is unlikely to come in, such as primary education, primary health care and provision of drinking water in rural areas, as well as rural infrastructure. Even in areas such as education, health, and drinking water, intra-sectoral allocations need to be reviewed, so that public funds can be used more effectively. While the government will continue to have an important role in improving the coverage and quality of secondary and tertiary education and health care, greater private involvement should be encouraged in these areas, as well as in the provision of urban sanitation and sewerage services. (ii) Second, project implementation and aid utilization need to be improved. Focusing limited public resources which are now scattered thinly over too many areas on a smaller number of projects and programs, making sufficient funds available to them as needed, and closely monitoring and supervising their implementation would enable such projects to be completed faster and help disburse much needed external aid for supporting the development program. (iii) To achieve these objectives, a number of specific initiatives will be needed, including more realistic budgeting, prioritization of the expenditure program (for example by formulating a Three Year Rolling Expenditure Program and a Core Program of high priority projects), limiting new project starts to high priority projects for at least the next 1-2 years, as well as strengthening the project implementation and monitoring capacity within  - iii - the government. To bring about such improvements, a serious political commitment to maintaining fiscal discipline and ensuring better use of public resources is essential. 8. If such actions are taken to improve the effectiveness of public spending, then additional revenue mobilization by the government would be warranted. To increase the elasticity of the tax system and enhance revenue generation over the medium term, Nepal needs to move away from its heavy dependence on import taxes to a more broad-based system mainly relying on domestic taxation of consumption (such as a Value Added Tax -- VAT -- and selective excise taxes), supplemented by low rates of customs duty and income tax at the central level. Nepal is now focusing on the implementation of the VAT as the cornerstone of its tax reform effort. The VAT, however, has been opposed by the business community, both because of perceptions of inadequate government preparations for its implementation and because additional information on earnings would help draw them into the tax net. To ensure successful implementation of the VAT and secure the co-operation of the business community, the preparations for VAT implementation need to be accelerated, and the business community needs to be more involved in the preparatory process. In addition, strong efforts are needed to further widen the tax base, rationalize other taxes (particularly income taxes and customs duties), simplify tax legislation and improve tax administration. 9. To accelerate economic growth and development, Nepal's small but growing private sector will need to play an increasingly active and eventually leading role. Economic reforms in the early nineties have already led to significant improvements in the economic climate for the private sector. Nevertheless, further improvements are needed in a number of areas, notably through (i) financial sector reforms, (ii) privatization and (iii) further liberalization of trade and investment policies. 10. Financial sector reforms are critical for ensuring that Nepal's financial system will be able to intermediate efficiently in mobilizing domestic savings and providing financial resources and services for private investment and activities. The financial sector is currently facing serious problems. As a result of ongoing problems of government-owned banks, intermediation margins and real interest rates for borrowers are high, and the availability of credit especially for private investment has been tight. To develop a well-functioning financial system: (i) the rehabilitation of Rastriya Ban qya Bank (RBB), which owns 35 percent of the banking system's assets, is the highest priority. While there has been some improvement in RBB's finances recently, the extent of this improvement cannot be determined until the ongoing assessment of RBB's portfolio is completed. Following such completion, effective programs need to be developed to improve RBB's loan recovery performance, capital adequacy and lending practices, as well as management capability and technology in both RBB and Nepal Bank Limited, which owns another 30 percent of the banking system's assets; (ii) Deeper sector policy reforms are also needed to increase the efficiency of the banking system, for example by eliminating mandated priority lending requirements, removing prevailing restrictions on opening of branches by joint venture banks and improving the legal framework to facilitate loan recovery efforts by banks; (iii) In view of the rapid proliferation of financial institutions such as joint venture banks, finance and leasing companies, the regulatory and supervision capacity of the central bank (Nepal Rastra Bank) also needs to be significantly strengthened. 11. Apart from reducing the drain on limited budgetary resources, privatization ofpublic enterprises would help improve the economy's performance in several ways: breaking up public sector monopolies, such as telecommunications and airlines, will open up new and profitable avenues for private investment and provide important signals to the private sector; removing price controls and subsidies will help eliminate remaining distortions in the economy, and create a level playing field where the private sector can compete with public enterprises on equal terms. The private sector in turn can bring in management  -lv - skills and enterprise, and help improve the quality and delivery of services. To create such an environment, (i) the privatization program needs to be accelerated. To make the privatization process more meaningful, the government will need to focus on larger and potentially profitable enterprises, and not merely on loss-makers. Moreover, changes in ownership structure, for example, through share issues, alone will help very little to bring about the management and entrepreneurial changes that are needed to improve performance; and other alternative to bring in capital, know-how and better management need to be considered; (ii) For enterprises that will remain in the public domain, increased autonomy, particularly in management, pricing, and employment decisions will be essential. Such enterprises will need to be subjected to a hard budget constraint, without domestic borrowing guaranties from the government. 12. Nepal's trade and foreign exchange regime is already quite liberal. Nevertheless further improvements in trade and investment policies can help stimulate exports, private sector activity and economic growth: (i) To take advantage of emerging opportunities through its membership in World Trade Organization (WTO) and SAPTA and economic liberalization in India, Nepal needs to improve its competitiveness through technological upgrading, skill development, export and tourism promotion, as well as joint investments aimed at supplying the neighboring Indian market. Nepal also needs to work out appropriate administrative arrangements with India and undertake the necessary investments in transport improvements, in order to take advantage of recent bilateral trade and transit agreements. (ii) Given its land-locked location and small domestic market, Nepal is unlikely to attract significant amounts of foreign investment except in areas where it has a comparative advantage - power development, tourism, and possibly some services. To this end, the government will need to clearly define its privatization policy (e.g. in telecommunications) and remove existing obstacles to foreign and domestic investment. For example, the "one window" licensing system for the approval of new industrial units needs to be made effective; administrative bottlenecks which are holding up foreign investment in the services sector need to be removed; the Foreign Exchange Regulation Act will need to be amended in order to reflect liberalization of the foreign exchange market; and a clear and transparent tax system needs to be developed. 13. Improvements in policies in key sectors are needed to enhance the effectiveness of both public and private investments, encourage greater private sector involvement and facilitate faster project implementation. While such improvements are needed in almost all sectors, some important examples are cited below. In agriculture, a strong government commitment to implementing the Agricultural Perspective Plan (APP) by prioritizing critical investments which are needed in the short-to-medium term, providing adequate budgetary allocations for such priorities and taking critical policy decisions in time is essential. For example, to create a level playing field for the private sector in fertilizer distribution, fertilizer subsidy will need to be phased out; and in the interim, the subsidy which is currently provided to the parastatal responsible for the import and distribution of fertilizer, will need to be extended to the private sector also. Unless such actions are taken soon, it will be difficult to promote private sector participation in fertilizer distribution, with adverse effects on agricultural production and rural incomes. Similarly in tourism, where the government has designated 1998 as Visit Nepal Year, in order to increase earnings Nepal needs to adopt more pro-active policies, such as vigorous marketing and promotion, and improvements in tourism infrastructure and services and urban environment. While many of these activities would need to be undertaken by the private sector, the government in particular would need to address the issue of improving airline access, which is a critical bottleneck. The adoption of a more open policy of permitting entry of additional international as well as private domestic airlines, instead of protecting the inefficiently-run and unreliable national airline, would be helpful in this regard. Similar improvements in sector policies, inter-and intra-sectoral allocations and project implementation  are needed in the social sectors (education, health and drinking water) also, in order to reduce widespread poverty which is documented in the Poverty Assessment, currently under preparation. CONCLUSION 14. To accelerate economic growth in order to reduce widespread poverty, the Government needs to address a number of difficult problems. The agenda for dealing with these issues is clear, although taking the specific measures which are needed will be challenging. Therefore, strong political will and commitment is necessary for effectively addressing these issues. Such a commitment is important because Nepal's economic future depends on achieving satisfactory progress in the critical areas outlined above.   O ~ -R-ECENT ECONOMIC PERFORMANCE A. INTRODUCTION: NEPAL'S DEVELOPMENT CHALLENGES AND ACHIEVEMENTS 1.1 Nepal, with a per capita income around $200 p.a, is one of the poorest countries in the world. Its development has been affected by a number of long-standing constraints. Its resource endowments (except for its scenic beauty and hydropower potential) are limited. Given its rugged terrain and a land-locked location, Nepal has also inherited serious competitive disadvantages in comparison with neighboring countries in terms of higher transport and investment costs, a fragmented domestic market and limited access to the outside world. The country's social and economic infrastructure remains undeveloped and highly inadequate; while a poor administrative system, weak institutions and a high rate of population growth have been major impediments to development. The budget and the balance of payments remain dependent of foreign assistance, with government revenues financing only about 60 percent of total expenditures and export earnings covering barely 25 percent of merchandise imports. 1.2 Against this background, the political and economic gains that have been achieved by Nepal since the mid-eighties are noteworthy. On the political front, in 1991 Nepal made a relatively peaceful transition to a parliamentary democracy. In the ensuing years, the democratic process has been consolidated, although frequent changes in governments over the past three years have not been conducive to economic development. On the economic front, a series of reform programs have led to a number of improvements: (i) Economic growth over the past two decades has averaged about 4.5 percent p.a., with per capita income rising by about 2.0 percent p.a.; (ii) Macroeconomic management has been on the whole reasonably good. Nepal so far has avoided macroeconomic crises of the kind that has plagued many Latin American and African countries; (iii) There has been considerable opening up of the economy, especially during the early nineties. A series of reforms between 1991 and 1994 have led, among other things, to relatively liberal trade and industrial policies, full convertibility of the Nepalese currency for current account transactions, opening up of trade (both imports and exports) with third countries and the gradual emergence of a significant private sector; (iv) Nepal's social indicators, though still very poor and lagging behind those of neighboring Asian countries, have also somewhat improved over time. 1.3 Economic performance in the last 2-3 years has remained steady, if unspectacular, in an environment of continuing political instability. Five governments (including three minority coalitions) have been in power in that period. These governments have maintained macroeconomic stability, while overall GDP growth averaged 4 percent p.a. Nevertheless, this seemingly satisfactory macro-economic performance masks some emerging problems which are likely to undermine Nepal's ability to address its fundamental development challenge -- that of reducing poverty. Recent studies indicate that poverty continues to be  -2 - widespread, especially in rural areas and that recent economic performance has not been sufficient to reduce poverty. Second, fiscal management has been weak. The new FY98 budget is also unlikely to stimulate development activity, unless strong efforts are made to channel public resources into priority areas and use them efficiently. Third, the financial sector is facing serious problems, hampering the availability of credit to the private sector, especially for investment. Financial sector reforms are essential in order to enable the private sector to play an important role in Nepal's development. Finally, recent political instability has slowed down the economic reform process and weakened economic management. B. SCOPE OF TH REPORT 1.4 This report is one of the documents which are being prepared for the Nepal Aid Group meeting scheduled to be held in Paris in early 1998. These include an assessment of the poverty situation in Nepal by World Bank staff, a note on agricultural development -- "Nepal: Agriculture in Perspective" -- by the Asian Development Banic, and an update on the current economic situation and issues prepared by the International Monetary Fund. In its presentation to the Aid Group, the Government of Nepal is also expected to provide a briefing on power sector developments in Nepal. Accordingly, in order to avoid duplication of issues covered in other reports, this report focuses selectively on a limited set of key issues which are critical to accelerating economic growth and improving development management in the short-to-medium term. The report is organized into two chapters. Chapter 1 reviews recent economic developments focusing particularly on economic growth, fiscal management, financial sector and progress in economic reforms. Chapter 2 looks at the development agenda which needs to be pursued in order to accelerate economic growth and development on a sustainable basis. C. RECENT ECONOMIC PERFORMANCE 1.5 Overview. Key indicators of Nepal's recent macro-economic performance suggest that demand management has been reasonably satisfactory in the last 2-3 years (Table 1). Indeed, short-term economic management has been quite good in many respects. However, from a development perspective, performance has not been as satisfactory. Little progress has been achieved in reducing poverty and addressing Nepal's key structural problems, while fiscal management has not been supportive of development activity. Macroeconomic Performance 1.6 Table 1.1 below reveals a number of positive developments in regard to recent macro economic performance: (i) Economic growth averaged 4.0 percent p.a. over the FY95-97 period. Though slower than the high rate of growth (5.6 percent p.a) achieved in the early nineties, it enabled per capita incomes to increase by about 1.5 percent p.a.; (ii) macroeconomic stability has been broadly maintained. Although the budget and the external position remain weak, there is little likelihood of any immediate crisis. On the fiscal front, although domestic borrowing by the government consistently exceeded budget targets, the overall fiscal deficit has been maintained at  - 3 - around 7 percent of GDP, financed largely by external aid. Credit and broad money growth decelerated to 11% and 13% p.a respectively because the monetary authorities took a number of actions to restrain credit expansion and because of liquidity problems of government-owned banks. The external payments position which had been under pressure in FY95 and FY96, improved somewhat in FY97, due to some recovery in exports and a slowdown in non-gold imports, in turn reflecting lower Investmentl development activity and tight fiscal and monetary policies. Though the external deficit still remains high (at 10.3 percent of GDP in FY97), it is fully financed by external aid and miscellaneous capital inflows, mainly from India. And, gross foreign exchange reserves have stabilized around $830 million, equivalent to 5.2 months' imports, down from 8.0 months' equivalent three years ago; (iii) Domestic inflation (largely driven by price movements in India) has remained at around 8 percent, modest by historical standards. 1.7 These are noteworthy achievements, particularly during a period of rapid political change. However, there have also been a number of less favorable developments: (i) Domestic investment declined by about 2.0 percent of GDP in FY97 due to stagnant development spending in the public sector and financing constraints faced by the private sector. Moreover, productivity of capital remains low, as indicated by high ICORs in excess of 5.0 in recent years; (ii) Domestic/national savings appear to have fallen correspondingly in the last 2-3 years, as the current account deficit widened. (iii) As noted, despite reasonably good economic growth, poverty still remains widespread in Nepal. A recent Living Standards Measurement Survey indicates that nearly half of the population was below the poverty line in FY96, with most of the poor living in rural areas. This raises questions about the pattern and impact of recent economic growth and the need for a re-orientation of development strategy in order to reduce poverty; (iv) The focus of recent fiscal and monetary policies has been primarily on maintaining macroeconomic stability. While this is essential for creating a strong foundation for sustainable growth, it has not been accompanied by strong efforts to stimulate development activity. This is not a desirable outcome for Nepal; and given its extreme poverty, it is essential to improve the effectiveness of development spending. (v) Thefinancial sector is also under considerable strain. The liquidity problems of government-owned financial institutions -- RBB, NIDC and ADB/N -- (due to poor loan recovery performance, declining deposits/resources, poor management etc.), are affecting their capacity to lend, in turn driving up intermediation margins and real lending rates to borrowers and constraining the availability of credit to the private sector. RBB's finances appear to have somewhat improved in recent months due to stronger efforts to recover overdues. Notwithstanding this improvements, early action needs to be taken to put the financial system on a stronger footing; (iv) The implementation of the reform program slowed down markedly in the last 2-3 years, and the ESAF program with the IMF lapsed in October 1995. These reforms which are necessary to correct structural weaknesses in the economy and lay the basis for sustained economic growth should be accelerated. The key issues relating to economic growth, fiscal management, financial sector reforms and the development agenda are discussed in the remainder of this report.  -4 - Table 1.1: Indicators of Macroeconomic Performance, FY86-97 FY86-90 FY91-94 FY95-96 FY97/e Economic Growth: GDP Growth (Real) a/ 4.8 5.6 4.1 3.8 Per Capita GDP Growth (Real) 2.3 3.1 1.6 1.3 Investment/Savings Total Investmnent / GDP 19.8 21.9 23.3 21.5 Public Investment / GDP 7.6 6.9 6.9 6.5 National Savings / GDP 12.2 14.2 13.0 9.9 Public Savings / GDP/b -2.1 -1.7 -0.9 -0.9 Government Finances: Government Revenue Growth 19.1 20.7 19.5 8.9 Govermnent Budget Balance / GDP -9.6 -8.2 -7.1 -6.9 Balance of Payments: Export Value Growth /c (in US$) 4.5 22.2 -4.0 9.4/f Import Value Growth /cd (in US$) 8.4 13.2 15.4 24.8/f Current Account Balance I GDP -7.6 -7.6 -10.3 -10.3/f Aid Disbursement(gross) / GDP 7.0 7.1 7.5 7.5/f Gross Foreign Exchange Reserves (In months of imports of goods 4.7 7.4 6.2 5.2 and services) Monetary Data: Broad Money Growth 20.8 22.0 15.3 10.7 Domestic Credit Growth 18.9 18.2 23.8 13.0 Inflation: Consumer Prices 11.6 12.2 7.9 7.8 a/ At factor cost. b/ Difference between government revenues and recurrent expenditures (i.e. govermnent consumption as estimated in national accounts data) and debt service payments. c/ Exports of goods and imports of goods only. d/ Includes imports of gold & silver --US$ 191 million in FY94, US$ 268 million in FY95, US$ 250 million in FY96 and an estimated $551 million in FY97. eI Estimate. f/ Provisional estimate by NRB. Source: Ministry of Finance, Nepal Rastra Bank and Central Bureau of Statistics.  -5- Growth Performance Table 1.2: GDP Growth, FY86 -97 FY86-90 FY91-94 FY95-97 1.8 How is it possible to explain the phenomenon of persistently Rate of Growth widespread poverty in Nepal at a time Agricultue 4.1 2.0 2.5 when the country has been Non-Agriculture 5.5 8.7 5.1 experiencing fairly robust economic Total GDP 4.8 5.6 4.0 growth? The answer lies in the Share of GDP dualistic nature of the economy and Non-Agriculture 50.7 55.3 548.5 the past patterns of economic growth. Industry/a (16.0) (18.4) (19.4) Trade, Transport/b (16.6) (17.7) (19.1) 1.9 Nepal's economy still Other Services/c (18.1) (19.2) (20.0) remains highly dualistic, with a large Total GDP/d 100.0 100.0 100.0 agricultural sector and a relatively a/ Includes manufacturing, mining, electricity and construction. b/ Includes trade, transport and communications, hotels, modern and fast-growing urban restaurants, etc. economy. Almost 90 percent of the c/ Financial, real estate, community and social and other services. Nepali population live in rural areas d/ GDP, at factor cost, in constant (1984/85) prices. and much of the employment and ISource: Central Bureau of Statistics. income generation in rural areas depend directly or indirectly on agriculture. Agriculture however, has been virtually untouched by recent economic reforms and remains at subsistence levels, characterized by low input use and low productivity. Agricultural growth in the present decade has averaged only about 2.3 percent p. a -- less than the rate of population growth. At the same time, non-agriculture (which includes, among others, industry, trade, transport, tourism, construction and services) has grown at an average rate of 6.5 percent per annum over the past decade (Table 1.2), recording vibrant growth benefiting from economic liberalization and deregulation, as well as from a more stable political environment prevailing in the early nineties. Since most of the non-agricultural activities have been urban-based, they directly and indirectly benefited the urban economy. In contrast, the stagnation of agriculture (due to poor policies and ineffective use of public resources) has meant that the rural economy continued to languish, even as overall economic growth (driven by non-agricultural activities) remained high. However, in the last few years, non-agricultural growth itself decelerated (due to a slowdown in exports and domestic demand, low levels of public and private investment etc.), in turn pulling down overall GDP growth. 1.10 A number of systemic factors (including inadequate institutional capacity) have been responsible for the continuing poor performance of agriculture. Since only 20 percent of cultivable land is perennially irrigated, agricultural production is heavily dependent on the vagaries of weather. Second, the delivery of key inputs to farmers -- particularly fertilizer, water, seeds and technology/extension services -- remains poor. The Agriculture Inputs Corporation (AIC) -- which has a de-facto monopoly over import and distribution of fertilizer -- has been able to supply only about half of farmers' requirements on an annual basis. Thus, the use of inputs and crop yields in Nepal remain well below the levels prevailing in neighboring countries. A previous attempt by the Government (in FY93) to encourage the private sector to import and distribute fertilizer in competition with AIC was not successful, because fertilizer prices in Nepal are heavily subsidized, and until the subsidy (provided to AIC) is either eliminated or made  -6- available to the private sector also, it is not possible for the private sector to compete with AIC on level terms. To revitalize agricultural growth, a number of policy changes together with considerable public and private investment and institutional reforms are urgently needed. Such an investment, technology and policy package is now being formulated by the Government, with technical and financial support from the Asian Development Bank. But much remains to be done to make this program effective (para. 2.27). Fiscal Developments 1.11 Fiscal management continues to be a major challenge in Nepal. Although the government has been able to limit the overallfiscal deficit to about 7.0 percent of GDP and gross domestic borrowing to around 1.5 percent of GDP, this has been achieved largely at the expense of development activity. To better exploit the economy's potential for growth and poverty reduction, the public expenditure program needs to be managed more effectively. 1.12 Recent fiscal difficulties have arisen from a number of weaknesses in budget planning and implementation: First, government budgets over the last 2-3 years have been unrealistic. Projections of major sources of financing -- revenues and foreign aid --'have been overestimated by wide margins. For example, the FY97 budget projected revenues to grow by 23 percent and aid disbursements by 37 percent; but actual growth in revenues was only 9 percent and in aid disbursements barely 1 percent. This has enabled too many new projects and programs to be included in the development budget, without serious consideration of their financing implications. As a result, the development budget has become heavily overcommitted, with the total number of projects/programs rising from 400 in FY94 to about 600 in FY96, many of which are inadequately funded with negative effects on their economic returns. Second, the government's revenue effort has been unsatisfactory. The revenue/GDP ratio has fallen in the last two years from 11.3 percent of GDP in FY95 to 10.9 percent in FY97, instead of rising by 0.5 - 1.0 percent of GDP p.a. as expected. The poor revenue performance in turn has been due to a slowdown in the growth of non-gold imports (about 50 percent of tax revenue is derived from customs duties and sales taxes on imports); low elasticity of the tax system, in part due to tax exemptions, tax holidays and tax rebates which have undercut the direct tax base; rate reductions, especially for customs and sales taxes; and an inefficient tax administration. Third, public enterprises have been a major drain on the budget. On average, about half of the public enterprises have been making losses; and when the few larger enterprises making significant profits are excluded, the rate of return on net capital employed in other public enterprises has been consistently negative. To cover the losses of such enterprises and to provide for their capital requirements, budgetary transfers in excess of Rs. 2.0 billion annually, equivalent to about 7-8 percent of government revenues, have been required over the past few years. Fourth, in actual implementation, the needed adjustments in the public expenditure program have not been well managed. As resources fell short of budget targets, the government resorted to ad hoc funding cuts, without any serious expenditure prioritization (the core program was not utilized for this purpose), relying on its fund release mechanism to ration funds. Since the regular budget consists mainly of wages and salaries and debt service payments, the cuts fell partly on the operations and maintenance component of the regular budget, but more so on the development budget. Moreover, the fund release process generally favored quick spenders rather than priority  -7- projects. Consequently, expenditure cuts mainly fell on the social sectors (health, education, drinking water) and agriculture. In contrast, infiastructure projects (such as road transport, which is politically favored) were relatively less affected. Although the government generally tried to accommodate the needs of foreign aided projects, nevertheless these projects were also adversely affected because, given the general shortage of local currency, cash advances to such projects for carrying out project activities were curtailed substantially. Table 1.3: Average Annual Government Expenditure and Its Financing FY86 - FY98 In Rupees billon FY86-90 FY91-94 FY95-96 FY97/b FY98 Budget Total Expenditures 14.6 27.8 42.8 49.7 62.0 Regular /a 4.9 10.3 20.4 23.9 28.0 Development 9.7 17.5 22.4 25.7 34.0 Government Revenue 7.0 14.7 26.2 30.4 37.0 Tax 5.5 11.3 20.7 n.a 29.6 Non-Tax 1.5 3.4 5.6 n.a 7.5 Overall Deficit -7.6 -13.0 -16.6 -19.3 -25.0 Foreign Financing 5.8 9.8 12.8 14.2 21.6 Grants 1.6 2.5 4.4 n.a 6.0 Loans 4.1 7.3 8.4 n.a 15.5 Domestic Borrowing 1.8 3.3 3.8 5.1 3.4 GDP at Market Prices 77.8 160.1 232.6 279.2 311.7 Key Ratos - In Percent of GDP Total Expenditures 18.6 17.4 18.4 17.8 19.9 Regular 6.4 6.5 8.8 8.6 9.0 Development 12.3 10.9 9.5 9.2 10.9 Government Revenue 9.0 9.2 11.3 10.9 11.9 Tax 7.0 7.0 8.9 n.a 9.5 Non-Tax 2.0 2.2 2.4 n.a 2.4 Overall Deficit -9.6 -8.2 -7.1 -6.9 -8.0 Foreign Financing 7.3 6.2 5.5 5.1 6.9 Grants 2.1 1.6 1.9 n.a 1.9 Loans 5.2 4.6 3.6 n.a 5.0 Domestic Borrowing 2.4 2.0 1.6 1.8 1.1 a/ The budget classification was changed in FY95 by transferring salaries of teachers and health workers from development to the regular budget. This added about 1.5 percentage points of GDP equivalent to regular expenditures from FY95 onwards. b/ Estimate. Source: Ministry of Finance. 1.13 Project implementation has also been hampered by other problems. Limited institutional capacity for project implementation, monitoring and expenditure control in many sectors has been a persistent problem in Nepal. In addition, in a period of political change, project implementation and monitoring has generally received less attention. Involvement of  -8 - political authorities in project/program management (e.g. in procurement matters) and the tendency of government officials to push up decision-making to higher levels in order to protect themselves in an environment of job insecurity, have also contributed to implementation delays. These developments in turn have affected aid utilization performance. According to available data, despite ambitious budget projections, total aid disbursements increased by only about 3 percent p.a in dollar terms since FY94. 1.14 Despite this weak overall project implementation and aid disbursement performance, there have been some bright spots. Disbursement rates of key multilateral lenders (such as IDA and Asian Development Bank) improved or remained satisfactory during this period. For example, IDA's disbursement ratio for project aid rose from 12.4 percent in FY94 to 20.4 percent in FY97; while in the case of ADB, the ratio has generally remained around 18-20 percent p.a. However, the absolute amounts of disbursements declined, in the case of IDA, from $82 million in FY96 to $58 million in FY97 because of a smaller project pipeline -- see below. In the case of ADB, total disbursements increased slightly from $76 million in FY96 to $81 million in FY97. However, $16 million of the latter amount was associated with the recently approved Kali Gandaki power project, so that disbursements on all other projects fell from $76 million in FY96 to $65 million in FY97. Moreover, the improvement in disbursement ratios of IDA and ADB has been due to a number of special factors. Both IDA and ADB cleaned up their portfolios, closing/canceling poorly performing projects. Thus, the number of IDA-financed projects under execution was reduced from 27 to 13, while its undisbursed pipeline of project aid fell from a peak of around $600 million FY93 to only $285 million in FY97. Similarly, ADB's project aid pipeline was reduced from $525 million in 1991 to about $300 million in 1996. In addition, both IDA and ADB have been proactive in improving the quality of their projects, enhancing their monitoring and supervision capacity especially in the field, and working closely with concerned government agencies to overcome implementation bottlenecks and improve procurement and disbursement procedures. Indeed, IDA's and ADB's recent experience offers some important lessons for improving Nepal's overall project implementation performance: i.e. cleaning up the portfolio, focusing on a smaller number of priority projects and closely monitoring their implementation can help significantly improve the implementation of the development program. 1.15 The FY98 budget, announced in July 1997, does not take steps to ensure that the development program will be better managed. The budget's stated objectives -- to accelerate economic growth and reduce poverty through greater emphasis on agricultural development, social services and rural infrastructure; pursuing liberal, market-oriented policies; and promoting participatory development/rural empowerment -- are laudable. The budget however does not provide a sustainable fiscal framework within which these objectives can be pursued in a prioritized manner: (i) As in the recent past, budget targets for revenues (22 percent increase) and foreign aid (38 percent increase) are unrealistic, and are unlikely to be achieved; (ii) The expenditure program, based on these optimistic resource projections, is unsustainable. The over- programming of the development budget has permitted the addition of numerous -- over 100 -- new projects, including a large number of new road projects. Although the allocations for most of these projects are relatively small, they represent open-ended commitments for the future and imply that resources are not being deployed effectively; (iii) In regard to expenditure priorities,  -9- although the budget speech emphasizes the importance of agricultural development, budget allocations for agriculture and irrigation are inadequate. Although they represent an increase of 12 percent in nominal terms over last year's actual expenditures, this increase is significantly smaller than the 31 percent increase in the overall development budget (or the 20 percent increase for all development activities excluding the Kali Gandaki power project). Moreover compared to last year's budget allocations, they represent a 4 percent reduction. In contrast, the transport sector (which consists mainly of road projects) allocation continues to be almost as large as the combined allocation for both agriculture and irrigation. The largest increases in funding in the budget are for local development (primarily politically favored village development programs), other social services (which includes several new programs), drinking water, power and health. In short, the budget is not realistic, and the expenditure program is not sufficiently prioritized in order to support economic growth and development objectives in a sustainabe manner. Financial Sector Developments 1.16 Nepal'sformalfinancial sector is dominated by two commercial banks, which together hold about 65 percent of banking system's assets. Of these, the Rastriya Banijya Bank (RBB) is fully govermnent-owned, while the government now holds 41 percent (following the recent sale of 10 percent of the government-held shares to the public) in'the Nepal Bank Limited (NBL). Other government-owned institutions include Agricultural Development Bank of Nepal (ADB/N) which is a major provider'of agricultural credit, and the Nepal Industrial Development Corporation (NIDC), an important source of industrial finance. Over the past few years, the development of other financial institutions has been encouraged; and presently there are 11 joint venture banks, 40 finance companies, 2 leasing companies, 5 regional development banks and a small stock exchange. In addition, the government also runs several micro-finance programs. 1.17 Reforms introduced since the late eighties have led to some significant improvements in the financial sector: among others, liberalization of interest rates, creation of a regulatory framework (including prudential regulations regarding capital adequacy and single borrower exposure, and the establishment of a separate supervision department in the central bank), developing longer term securities to facilitate non-bank financing of government deficits and reducing the cash reserve ratio to 12 percent. These reforms have led to a greater degree of competition in the banking system than in the eighties, and the scope of banking services available to the private sector has increased. Despite these improvements, a number of serious problems remain. 1.18 By and large, the private sector banks are believed to be profitable and appear to be well-run. However, the fully government-owned banks are in poor shape, negatively affecting the overall system's performance. RBB, NIDC and ADB/N are all constrained by shortages of liquidity and investible resources. A number of problems are common to all three institutions: Lack of commercial orientation, poor quality of loan appraisal and lending practices, unsatisfactory loan recovery performance (ADB/N's current loan recovery rates are only about 45 percent; and as of December 1996, about 18 percent of RBB's outstanding loans were reportedly classified as non-performing); stagnant/declining deposits; weak management  -10- information systems; poor accounting practices; and in the case of RBB, a high cost structure due to an extensive rural branch network and over-staffing etc. Despite "privatization", NBL still operates as a parastatal enterprise and needs to address its' deteriorating rural portfolio. According to RBB sources, its financial condition has improved recently due to renewed efforts to recover overdues. However, the extent of this improvement cannot be assessed until the ongoing portfolio evaluation of RBB is completed. 1.19 The problems of government-owned banks, especially RBB's, have had several adverse consequences on the financial system: (i) RBB's efforts to mobilize deposits through higher interest rates to larger depositors has driven up deposit rates and its own cost of funds; (ii) Moreover, given high loan losses and inefficiencies of government-owned banks, the intermediation margins of the banking system are high -- around 712-8Y2 percentage points. However, the smaller joint venture banks have little incentive or need to reduce spreads in order to compete with government-owned banks. As a result, real lending rates in the economy remain abnormally high -- around 9-10 percent; (iii) Given its liquidity problems, RBB's new lending has been curtailed. This, together with resource shortages of NIDC and ADB/N, has significantly affected the availability of credit to the private sector. Although such a situation should normally create new opportunities for smaller banks, they are presently unable to take advantage of the situation because most of them have a small capital base, and because they are already heavily lent. 1.20 Apart from the difficulties of government-owned banks, the financial sector also suffers from other problems. Two key issues are: The central bank's weak regulatory capacity, and institutional and legal constraints imposed on commercial bank lending. NRB's capacity for on- site and off-site supervision is weak. NRB is unable to effectively supervise the banking institutions, much less the larger number of financial and leasing companies in the country. These weaknesses in turn could mask capital inadequacies in the financial institutions and could create systemic risks. Mandated priority sector lending, conditions imposed on private banks for opening new branches, restrictions on entry of foreign banks into the market, and a weak and vague legal framework also affect the financial system's efficiency. A multiplicity of acts (such as the NRB Act, Commercial Banks Act, Finance Companies Act, Development Banks Act, etc.) and NRB regulations overlap and sometimes contradict each other, lending themselves to incorrect interpretations in regulating the financial system's behavior. Lack of clear and concise bankruptcy laws hamper banks and other creditors from recovering their loans. This in turn discourages not only the growth of larger investment credits in the banks' portfolios, but also the growth of the small business sector. 1.21 In regard to rural credit, over the years the government has taken initiatives to provide credit in the rural areas through: (i) forced priority sector lending from commercial banks; (ii) expansion of the public commercial banks' rural branch network; (iii) establishment of the Agricultural Development Bank of Nepal (ADB/N); (iv) opening of five Grameen-type development banks; (v) supporting private NGO involvement in the sector and Savings and Credit Cooperatives. However, as noted, priority lending and forced expansion of rural branches reduce the banking system's efficiency in intermediating savings in the economy. Moreover, ADB/N - the other major provider of rural credit - is facing resource problems, as donor  - 11 - assistance (which has been the major source of its funds) has dried up, due to its poor loan recovery performance. Some of the micro-finance programs are also facing difficulties. Most of the current programs have high operating costs and low repayment rates. There are however some bright spots, as some of the Grameen type banks and the Savings and Credit Cooperatives are performing well. The well run Grameen-type banks, which serve only women from below the poverty line households, have reached some 60,000 borrowers with small loans of up to NRs. 5000 and have achieved recovery rates of 98 percent. 1.22 Thus, the financial sector is in urgent need of reform. Any deterioration of the financial condition of RBB could lead to serious consequences, in terms of credit availability to the private sector, savings mobilization and the stability of the financial system itself. The rural credit programs also need to be refonned to support the private NGO - type programs and savings and credit cooperatives. Progress in Economic Reforms 1.23 Nepal has been implementing an economic reform program supported by the International Monetary Fund and the World Bank from the late eighties. The program has been aimed at laying the basis for sustained economic growth with macroeconomic stability by facilitating the transition to a more market-oriented and private sector-led economy, improving the incentive regime, and removing structural bottlenecks. In the early nineties, considerable progress was made in this regard. Notable achievements included liberalization of the trade and foreign exchange regime, improvements in industrial and foreign investment policies, tax reforms and strengthening public expenditure management. The second stage of reforms in the mid nineties envisaged a broadening and deepening of these reforms and focused on further improving expenditure management, accelerating tax reforms, strengthening the financial system, privatization of public enterprises, and a series of structural reforms in agriculture, power and human resource development to enhance the economy's productive potential and its capacity for sustained growth. 1.24 As noted, in the last 2-3 years progress in implementing the reform program has been slow. In an environment of political instability, successive governments have found it difficult to forge a consensus to tackle difficult economic issues, because of differences of views among major political parties. Thus, despite stated commitment to economic reforms, actual progress in implementing them has significantly lagged behind intentions. The state of play in regard to key areas of reforms is summarized below. * Tax Reform. The implementation of VAT -- the center piece of the tax reform program -- initially planned for FY96, has been delayed till November 1997. The main reasons for slippage include a change of government in late 1994 which slowed down the preparatory work for VAT implementation, and opposition from the business community on grounds that necessary preparatory work has not been done. Since then, preparatory work has resumed, with technical assistance from USA and DANIDA. Technical assistance is also being provided by the Asian Development Bank for strengthening the customs valuation  -12- system. As noted below, there is an urgent need to introduce more comprehensive reforms in other areas to broaden the tax base and strengthen tax administration. * Public Expenditure Management. A number of innovations have been developed recently to strengthen expenditure monitoring and management -- a core program, a new budget classification, and revised fund release procedures -- while the monitoring of reimbursement claims has been tightened. However, as noted, the expenditure program needs to be better managed. Budgeting has become increasingly unrealistic; there is little prioritization of the expenditure program; and the recent innovations, particularly the core program, are not being effectively used to protect development "priorities. Moreover, a Three-Year Rolling Expenditure Program has not been prepared so far. * Privatization. The privatization process slowed down in 1994 and 1995 because the incoming government had different perceptions regarding the role of PEs in the economy and reservations about the privatization experience up to that time. Accordingly, the privatization unit in the Ministry of Finance as well as the technical assistance program were disbanded. Since then, renewed efforts are being made to move forward the privatization program. Technical capacity within MOF has been rebuilt with new assistance from ODA and USAID. In 1996 and 1997, three PEs have been sold outright, one PE was closed, two PEs were put under private management and govermnent shareholding in another PE has been significantly reduced. Preparations are underway for readying another batch of smaller and loss-making enterprises for privatization over the coming year. e Financial Sector. Progress has been mixed. An additional 10 percent of the shares of Nepal Bank Limited was sold to the public, making it a majority private bank. However little has been done so far to address the problems of Rastriya Banijya Bank - which owns about 35 percent of banking system assets. Despite some recent improvement in loan recoveries, RBB's financial position remains weak and its new lending has been curtailed. A portfolio assessment of RBB is underway; and both banks need considerable managerial and technical support. * Economic Agreements with India. A significant positive development has been improved economic relations with India. A new trade agreement has been signed with India, allowing Nepalese goods preferential access to Indian markets. A new transit corridor for Nepal to Bangladesh ports through Indian territory has also been recently agreed. Similarly, two landmark treaties have been signed between India and Nepal which would permit joint development and sharing- of water resources and power exchange agreements between private parties in both countries. These agreements, if effectively exploited, would provide major opportunities for Nepal to strengthen its balance of payments and accelerate its development process.  - 13 - D. SUMMARY 1.25 Over the past 2-3 years, successive governments have maintained macroeconomic stability and achieved modest rates of economic growth, with relatively low rates of domestic inflation by historical standards. These are useful achievements in a period of political change and instability. However, Nepal needs to do much better in order to ensure that economic growth and development activities make a significant impact in terms of reducing poverty. Recent economic growth has not been fast or equitable enough to benefit the predominantly rural population, fiscal management has been poor, and progress has been slow in implementing economic reforms aimed at improving the economy's capacity for faster growth and development. Moreover, growing problems in the fmancial sector pose a serious threat to economic activity, especially by the private sector. To provide a basis for faster and more sustainable economic growth and development, signfieqnt improvements in economic policies are required in a number of critical areas. These are discussed in Chapter 2 below.  I  F] THE TASK AHEAD A. NEPAL'S DEVELOPMENT STRATEGY 2.1 Reduction of widespread poverty is Nepal's biggest development challenge today. In order to make tangible progress in reducing poverty, Nepal needs to grow more rapidly. There is little scope in Nepal for improving living standards of the poor through income redistribution, and higher growth is necessary both to increase income levels and to generate additional resources to provide better services and infrastructure to the poor. In the context of widespread poverty, generating adequate income-earning and employment opportunities is essential for maintaining social and political stability as well. 2.2 Nepal's strategy for accelerating economic development and poverty reduction is not new.' The main elements of the strategy include the following: (i) Nepal needs to achieve sustained high rates of economic growth, together with strong efforts to reduce its high population growth rate. Moreover, economic growth needs to be broad-based and more equitable in order to improve the living conditions of the predominantly rural poor; (ii) In addition, concerted efforts are necessary to promote human resource development and provide basic infrastructure and services. Improvements in education, health and nutrition are essential for enhancing literacy, skills, productivity and income-earning capacity of the population; while increased provision of basic infrastructure would directly help support economic activities and improve living standards; (iii) To take care of those who will not directly benefit from the growth process, special programs will need to be developed, especially for vulnerable and underprivileged groups, including women. Given the pervasiveness of poverty, however, such programs cannot be implemented on a large scale in Nepal; and will need to be small and well targeted to assist the most needy. 2.3 Accelerating economic growth itself is a difficult challenge for Nepal because its resource endowments are limited and structural constraints more severe than in many developing countries. (i) Nevertheless, there is considerable potential in a number of areas to promote faster growth: In the backward agricultural sector, appropriate investments, inputs and policy packages can help increase output and incomes by about 2 percent p.a. in the short-to-medium termn. Rapid agricultural development, moreover, will directly benefit the rural poor; (ii) Given Nepal's unique location and scenic beauty, vigorous development of tourism can provide significant opportunities for increasing incomes and employment, especially in mountain and hill areas where such opportunities are presently very limited, as well as benefit the balance of payments in I The World Bank's last Economic Update prepared for the Nepal Aid Group meeting held in April 1996 as well as its Country Assistance Strategy paper (April 1996) provide clear statements of this strategy.  - 16- the medium-term. The private sector needs to play a crucial role in this regard, although policy changes by the government, especially to liberalize airline access, will also be important; (iii) Nepal's virtually untapped water resources could provide significant irrigation benefits and major possibilities for export of hydropower in the longer tern. While hydropower development will be expensive and will require collaborative arrangements with neighboring countries, recent progress of bilateral discussions (as well as private investment projects under consideration) indicate that this could be a promising possibility for the longer term; (iv) With the rapid liberalization of the Indian economy, closer economic integration with India and further opening up of Nepal's economy to world markets through trade liberalization and improved global communications offer further possibilities for promoting trade, investment and economic growth; (v) Finally, Nepal's as yet underdeveloped human resources could gradually become a potentially important source of growth in the longer term, provided that appropriate investments in health, education, nutrition, etc. are undertaken now in order to improve skills, knowledge and technology in the country. 2.4 In pursuing higher economic growth with well-directed efforts to develop human and physical infrastructure, Nepal needs to pay sufficient attention to sustainability issues, both environmental and macroeconomic. (i) Agriculture and tourism in Nepal involve intensive use of natural resources; and if growth in these and other areas is to be sustainable, environmental concerns will need to be integrated into the design of policies and programs at both macro and sectoral levels in order to ensure the preservation of natural resources; (ii) Similarly, in regard to macro-economic sustainability, the investment requirements for implementing a strategy focusing on high growth and provision of basic infrastructure will still be quite large. However, the Government's financial and administrative capacities are limited; and given the unfavorable global outlook for concessional aid, Nepal cannot continue to depend on sustained increases in external aid to finance its development budget in the future. In such a context, Nepal cannot resort to heavy domestic borrowing without serious macroeconomic consequences, particularly in view of its fragile balance of payments. (iii) To successfully implement its development strategy, Nepal needs a collaborative partnership between the government, the private sector and important elements of civil society, including NGOs and local level beneficiaries. The government will have an important role in providing the appropriate policy and incentive framework and undertaking critical social and infrastructure investments which the private sector may not find profitable. Nevertheless, the private sector, local level institutions and beneficiaries and NGOs need to be actively involved in the development process. The Ninth Plan 2.5 The government has broadly endorsed and adopted this strategy. The Approach Paper for the Ninth Plan, which is currently under preparation, as well as the FY98 budget emphasize that eradication of poverty is the government's major development objective. The Ninth Plan's goal is to reduce poverty to 32 percent by FY2002 and to 10 percent in twenty years - by FY2017. This is to be achieved by: (i) Accelerating economic growth rate to an average of 6.5 percent p.a over the Ninth Plan period (and to 7.2 percent p.a in later years); (ii) Bringing rural population into the mainstream of development by giving priority to agriculture, water resources,  -17- tourism, rural infrastructure and agro-based industries (to increase employment opportunities), and promoting human resource development, involving local communities closely in this process; (iii) Reducing economic disparities between regions and communities by increasing access to basic services and developing special programs for the most vulnerable and underprivileged groups (for the latter purpose, a poverty alleviation fund and an employment generation fund are to be created out of the government's own resources on an experimental basis); and (iv) Emphasizing decentralization of programs (especially human resource development and rural infrastructure) as a mechanism for involving local communities in the development process. Despite its good intentions, however, the Plan is overambitious both in regard to its development targets and its macroeconomic framework (see Annex 1). For example, the plan seeks to eliminate illiteracy (currently 73 percent) by FY2005, increase electricity generation capacity (currently 290 mw) to 20,000 mw, reduce child mortality rate (currently 79 per thousand) to 25 per thousand, and increase average life expectancy for males (currently 55.9 years) to 72 and for women (currently 53.4 years) to 75 -- all by FY2017. The Plan thus runs the samne risks as recent budgets which have failed to achieve their development targets because they are overcommitted in too many areas, without adequate prioritization and without due regard to resource availabilities. B. THE DEVELOPMENT AGENDA 2.6 Alternative scenarios (summarized in Annex 1) show that under more realistic assumptions, resource availabilities and sustainable levels of public and private spending will be significantly less than anticipated in the Ninth Plan. Nevertheless, by adopting appropriate economic policies and reforms it would still be possible for Nepal to achieve economic growth rates of the order of 4.8 percent p.a or more, and improve the pattern of growth (for example by accelerating agricultural growth) to benefit the rural areas, while making modest improvements in national savings and the balance of payments. Reforms in three areas are over-arching and critical to the government's effort to accelerate economic growth and reduce poverty over the short-to-medium term: (i) Improving fiscal management in order to use limited public resources more efficiently; (ii) Creating a conducive environment to facilitate the vibrant growth of the private sector through reforms in the financial sector, public enterprises and further improvements in foreign investment and trade policies; and (iii) Improving sector policies and programs in key areas - such as agriculture, tourism, power, human resource development etc. - in order to exploit their potential for economic growth and poverty reduction. I. Improving Public Resource Management 2.7 Accelerating economic growth and providing essential human and physical infrastructure will require substantial investments - both public and private. However, the government's fiscal position is weak. Given the many competing demands on limited public resources, (i) significant improvements in expenditure management to allocate and use resources more efficiently (for example by prioritizing both donor-supported and fully government-financed projects, improving expenditure management and control mechanisms, and strengthening project implementation) will be needed. (ii) In addition, domestic resource  -18- mobilization will need to be improved to the extent that such additional resources can be effectively channeled to support priority development activities. Expenditure Management 2.8 In order to enhance the effectiveness of the public expenditure program, (i) the public sector needs to phase out its direct involvement from areas where public resources are being inefficiently used, such as transfers to loss-making public enterprises and subsidies on fertilizer and water, or where the private sector can provide goods and services more efficiently, such as air and road transport and telecommunications. It is also necessary to look at how effectively funds are being used in the newly created spending programs (such as grants to parliamentary constituencies and village development programs) and adjust allocations to such programs on the basis of capacity for effectively using such funds. This would enable limiited public funds to be allocated to those sectors where the private sector is unlikely to come in, such as primary education, primary health care and provision of drinking water in rural areas, as well as rural infrastructure. Even in areas such as education, health, and drinking water, intra-sectoral allocations need to be reviewed, so that public funds can be used more effectively. While the govermment will continue to have an important role in improving the coverage and quality of secondary and tertiary education and health care, greater private involvement should be encouraged in these areas, as well as in the provision of urban sanitation and sewerage services 2.9 To facilitate better expenditure allocation, the budgeting process needs to be made more realistic: (i) Projections of revenues, aid inflows and the size of the development budget would need to be in line with recent performance and reasonable expectations; (ii) In addition, the expenditure program needs to be prioritized so that adequate resources could be allocated to the more important projects/programs in critical areas; (iii) A Three Year Rolling Expenditure Program (TYREP) would considerably facilitate a more rational resource allocation process. Such a program has been under preparation for the past 3-4 years, but has not seen the light of day so far. (iv) Dropping or downsizing projects/programs which are not working well and limiting new project starts to high priority projects for at least the next 1-2 years would also help to avoid spreading resources thinly over too many projects. (v) To enforce better discipline over the project approval process, project screening and evaluation capacity in the National Planning Commission, Ministry of Finance and the line ministries would need to be strengthened by providing adequate staffing and budgetary resources. 2.10 Once formulated, the expenditure program would need to be better managed, without resorting to ad-hoc expenditure cuts which disrupt project implementation. To strengthen expenditure management and control, a number of steps can be taken: (i) The mid year budget review process could be used to reassess resource outlook during the year and to make expenditure adjustments in a more systematic manner. Currently, this review is undertaken too late in the fiscal year to be of any practical usefulness; (ii) To protect priority projects from any resource shortfalls, a core program of priority projects could be formulated and fund releases to projects/programs would need to be based on the core program. If expenditure cuts are needed, fund releases to low priority projects would need to be accordingly reduced; (iii) Expenditure reporting by spending units need to be improved, both in terms of timeliness and quality of  - 19- reporting. To facilitate such reporting, a uniform budget classification system was introduced in FY97; and it needs to be made fully operational; (iv) The monitoring capacity of the Financial Comptroller General's Office (FCGO) needs to be further strengthened; with authority to withhold fund releases to those who do not comply with reporting requirements. (v) The proposed introduction of a treasury system of accounts (where check issuing as well as expenditure reporting responsibilities would be borne by district treasury offices, instead of numerous implementing units), and the creation of a new debt reporting system in the Ministry of Finance would also help improve expenditure monitoring. 2.11 Recent experience of major donors suggests that the key to improving project implementation is to clean up the portfolio, focus attention and resources on a smaller number of projects/programs and to monitor their implementation closely. In addition to measures outlined above, other steps can be taken to address problems which currently hamper implementation: (i) To reduce procurement delays, standard bidding documents have been recently adopted by the Government. This system needs to be made effective; (ii) To encourage project managers to make project-related decisions and to hold them accountable, an atmosphere conducive to such decision-making needs to be created by reducing insecurities associated with frequent political changes. Continuity of tenure of project managers, senior government officials etc. is essential in this regard; (iii) Strong commitment at the highest levels of the government is necessary for improving project implementation and aid disbursements. The monthly review of project implementation by the Prime Minister (which proved effective in the recent past) should be resumed, together with greater emphasis on project monitoring by NPC and the line ministries; (iv) Finally, as noted, the capacity of the FCGO as well as of NPC and line ministries for monitoring financial and physical progress of projects needs to be further strengthened by providing adequate staffing, computerization and operating budget, so that they could effectively monitor the implementation of the core program, or at least 50-100 of the larger development projects, on a timely basis. 2.12 Reducing the hemorrhaging of the budget by public enterprises is an important aspect of improving the use of public resource management. For this purpose, the privatization of public enterprises needs to be vigorously pursued (see below). (i) This would help reduce budgetary transfers to loss-making enterprises; (ii) For those few enterprises which need to remain in the public sector, programs need to be adopted (such as management contracts) to improve their operational and managerial efficiency; (iii) Adjustments in administered prices on a timely basis, for example for petroleum products, fertilizer etc., would be necessary in order to protect the financial position of such enterprises; (iv) subsidies (to public enterprises such as the Food Corporation) need to be limited only to meeting pressing social needs; and (v) To enforce greater market discipline on enterprises and to protect the budget from unforeseen liabilities, government guarantees on public enterprise borrowing need to be stopped. Tax Reform 2.13 To the extent that the efficiency of the public expenditure program can be significantly improved and increased resources can be channeled to support development priorities, then additional resource mobilization by the government would be warranted. To improve revenue  -20 - performance, Nepal needs to move away from its heavy dependence on import taxation to a more broad-based tax system relying mainly on domestic taxation of consumption (such as a VAT and selective excise taxes), supplemented by low rates of customs duty and income tax at the central level, together with property taxation and selective local taxes at the local level. To this end, Nepal is currently focusing on a Value Added Tax (VAT) as the cornerstone of its tax reform efforts to be implemented in November 1997. To ensure its successful implementation, the Government will need to win the support of the business community (which is currently opposed to the VAT) by accelerating the necessary administrative arrangements and preparatory work and involving the business community closely in such preparatory work. 2.14 At the same time, it is necessary to make strong efforts to increase the elasticity of the tax system and enhance revenue growtl over the medium term. While the VAT will contribute to this goal, additional measures are needed to: (i) widen the tax base (recent initiatives have focused more on reducing tax rates in order to encourage voluntary compliance rather than on specific base-widening measures); (ii) enhance the yields from other major taxes, especially customs duties and direct taxes; (iii) simplify tax legislation in order to make it more transparent and enhance public confidence in the tax system; and (iv) strengthen tax administration, in order to develop a well-trained and independent revenue service. II. CREATING AN ENABLING ENVIRONMENT FOR THE PRIVATE SECTOR 2.15 Improved public resource management would help enhance the development effectiveness of public sector initiatives. However, the public sector's financial and administrative capacity is limited; and the private sector needs to play a greater role in undertaking necessary investments and the provision of services. Nepal's private sector, though growing rapidly, is still relatively small and cannot be expected to replace public sector initiatives in many areas (for example in the provision of capital-intensive infrastructure, human resource development etc.) for years to come. Nevertheless, there are many areas in the economy where the private sector can play an increasingly active and eventually leading role; and its further development needs to be fostered and encouraged. Economic reforms undertaken by successive governments in the early nineties have already led to significant improvements in the economic climate for the private sector. Nevertheless, further improvements can be made in a number of areas, particularly through (i) financial sector reforms; (ii) privatization; and (iii) further liberalization of trade andforeign investment policies. Financial Sector Reform 2.16 Financial sector reforms are needed in three key areas: (i) restructuring the government-owned banks; (ii) strengthening regulatory and institutional capacity; and (iii) improving the rural credit system. 2.17 The rehabilitation and eventual privatization of RBB, together with financial and managerial improvements in NBL, are essential in order to improve the intermediation efficiency and stability of the financial system. A turnaround strategy for RBB will require actions in several areas including cleaning up of RBB's accounts in order to get a clear idea of its non-  - 21 - performing assets and its net worth (this work has already been started and is expected to be completed by end October); further improving loan recovery; reducing operating costs by consolidating the branch network and by reducing excess staff; and recapitalizing the bank as part of the restructuring process. A technology upgrading program will need to be developed for both RBB and NBL; together with training in credit and managerial techniques and better management information systems. Finally, in the case of RBB, a privatization strategy will need to be developed; while the NBL needs to be transformed into a truly commercially managed bank. 2.18 Deeper sector policy reforms are also needed to increase the efficiency of the banking system. The monetary authorities' preference is to continue mandated lending, together with restrictions on opening branches in urban areas, in order to increase rural lending. Our view, however, is somewhat different. To reduce the tax on financial intermediation and free bank resources, the CRR (currently at 12 percent) needs to be reduced, provided that such reductions are consistent with the need to maintain appropriately tight monetary conditions. Mandated priority lending and the prevailing restrictions on banks on opening branch offices will need to be eliminated. The government also needs to consider allowing fully foreign owned banks to open wholly owned subsidiaries in Nepal. Simultaneously, the legal framework needs to be improved, with clear and concise bankruptcy laws to facilitate banks' loan recovery efforts. With the rapid proliferation of institutions in the financial sector, prudential supervision of banking as well as other financial institutions, such as finance and leasing companies, is of crucial importance in ensuring continued stability of the financial system. For this purpose, the regulatory and supervision capacity of NRB needs to be significantly strengthened, through increased staff and better training, and keeping trained staff in place. Co-ordination between the Banking Regulation and Supervision Departments of NRB need to be improved; and the capacity of NRB, MOF and NPC for collation and analysis of financial information and for undertaking financial reform need to be enhanced. 2.19 The Government is currently working with the Asian Development Bank to improve delivery mechanisms for rural credit which is vital for supporting agricultural development and poverty reduction in rural areas. In this context the present institutional structure and policies need to be reviewed. ADB/N needs to be rehabilitated, and its loan recovery and lending practices would have to be substantially improved. Since it would be desirable to eliminate mandated rural lending by commercial banks as part of a strategy for strengthening the commercial banks, alternative arrangements for rural lending as well as for taking over the rural branch network of RBB and NBL will need to be considered. A reform of these programs should orient them towards market-determined credit policies, and towards supporting private NGO programs and savings and credit cooperatives which are currently working well. Privatization 2.20 The privatization ofpublic enterprises can help improve the economy's performance in several ways: As noted, it would directly help reduce the drain on limited budgetary resources. It would also provide important signals to the private sector: Breaking up public sector monopolies such as telecommunications and airlines would open up new and profitable avenues  -22 - for private investment, in turn reducing the need for public investment in such activities; and the removal of price controls and subsidies (as in the case of fertilizer) would create a level playing field where the private sector can compete with public enterprises on equal terms. The private sector in turn can bring in management slills and enterprise, and help improve the quality and delivery of services. 2.21 The privatization program has been held back so far because of frequent government changes, philosophical differences with regard to the objectives and modes of privatization and lack of technical capacity within the government. However, significant progress has been made recently in rebuilding such capacity with technical assistance from US and UK; and the government appears ready to move ahead with the privatization of a number of PEs over the coming year. The privatization process needs to be continued as rapidly as possible. There are, however, several issues which needs to be addressed in order to accelerate the privatization programn. So far, the government is focusing on the privatization of smaller and loss-making enterprises. Secondly, divestment through share issues is being encouraged in order to broaden ownership and participation. Thirdly, legal challenges to the privatization process have stymied progress in some areas, such as telecommunications. While the latter represents a major impediment at present, the Government needs to consider alternative approaches in order to accelerate the privatization process. For example, it is now important to focus on the larger and more profitable enterprises, such as airlines and utilities, where it would be easier to attract potential investors. Secondly, change in ownership structure, for example through share issues, alone will help very little to bring about the management and entrepreneurial changes that are needed to improve performance; and other alternatives to bring in capital, knowhow and better management need to be considered. 2.22 For enterprises that will remain in the public domain, increased autonomy, particularly in management, pricing, and employment decisions will be essential. These enterprises would need to be subject to a hard budget constraint, without receiving domestic borrowing guarantees from the government. They need to have full authority to adjust prices as necessary to reflect changes in input costs. All enterprises should be required to submit audited accounts on a timely basis, to ensure that their financial records accurately reflect performance. Trade and Investment Policies 2.23 Nepal's trade and foreign exchange regime is already quite liberal. Nevertheless further improvements in trade and investment policies can help stimulate exports, private sector activity and economic growth. 2.24 Nepal has applied for membership in WTO, is already a member of SAPTA (which is committed to moving to a regional free trade arrangement), and stands to directly benefit from economic liberalization in India. To take advantage of these opportunities, Nepal needs to progressively reduce its tariffs at least in line with those in India. Nepal also needs to improve its competitiveness through technological upgrading, skill development and export promotion measures; and diversify its export products and markets. Developing new high value agricultural crops/products (through effective implementation of the Agricultural Perspective Plan) and  - 23 - promotion of tourism for the Indian market and joint ventures for supplying light manufactures to neighboring Indian states (a good start has been made already in the last two years), provide possibilities in this regard. Nepal also needs to take full advantage of bilateral trade and transit agreements which were concluded recently with India. The- recent trade agreement has waived the prevailing 50 percent value-added requirement on Nepalese exports to obtain duty free access to the Indian market; while the new transit agreement provides for a new land route to Bangladesh ports through Indian territory and the establishment of a dry port at Birganj which will considerably reduce transport delays and costs for Nepal. Nepal now needs to work out appropriate administrative arrangements with India to implement the trade arrangement and undertake the necessary investments for transport improvements. 2.25 Nepal so far has had little success in attracting foreign private investment on a significant scale, except in the power sector. Given its land-locked location and small domestic market, Nepal is unlikely to attract substantial amounts of foreign investment except in areas where it has a comparative advantage - power development, tourism, and some services. Foreign investment in power development is being actively sought and encouraged; but in other areas, such as telecommunications and airlines, the government will need to clearly define its privatization policy and overcome legal obstacles to privatization in order to attract foreign investment. A number of other impediments to foreign and domestic investment also need to be removed: (i) The "one window" licensing system for the approval of new industrial units is not working well, and needs to be made effective. (ii) Similarly, despite the recent removal of the lower limit of Rs. 20 million on foreign investments, administrative bottlenecks are holding up such investments, particularly in the service sector; and these need to be removed. (iii) The Foreign Exchange Regulation Act will need to be amended in order to reflect liberalization of the foreign exchange market. (iv) The development of the stock market would also require broadening the regulatory authority of Securities Exchange Board and improvements in the accounting standards and reporting of financial statements by listed companies. (v) Finally a clear and transparent tax system (rather than tax holidays and special incentives) is essential for attracting foreign investment. III. SECTOR POLICIES IN KEY AREAS 2.26 In addition to macroeconomic policies outlined above, further improvements in sector policies in key areas such as agriculture, tourism, power and human resource development will help to harness the growth potential and lay the foundations for a more sustainable and dynamic economy. Agriculture 2.27 Recognizing the critical importance of agricultural development for improving Nepal's overall growth performance and reducing rural poverty, the Government has indicated its commitment to the Agricultural Perspective Plan (APP). The Asian Development Bank is supporting the APP with technical assistance and a proposed quick-disbursing loan. A separate paper on the APP -- "Nepal: Agriculture in Perspective" -- has been prepared for the Aid Group meeting by the ADB. This report therefore does not address APP-related issues, except to touch  - 24 - upon some immediate concerns with its implementation. First, despite its declared priority, allocations for agriculture in this year 's budget appear to be inadequate (para 1.15). Second, some policy decisions which are critical for achieving APP's goals - i.e. reducing fertilizer subsidies and, in the interim, finalizing arrangements for passing on the subsidy (which is currently given to the parastatal, Agricultural Inputs Corporation) to the private sector also (until the fertilizer subsidy is eventually eliminated) - have not been taken so far. If these decisions are not taken soon, it will be difficult to. promote private sector involvement in the import and distribution of fertilizer; and supplies to farmers will be severely constrained, with adverse effects on agricultural production and rural incomes. Tourism 2.28 Although the number of tourists to Nepal and foreign exchange earnings have increased significantly in recent years, Nepal's considerable potential in tourism as an important source of economic growth, employment and foreign exchange, remains to be effectively developed. A number of constraints have hampered tourism development so far: among others, political instability and associated disruptions in recent years, adverse publicity regarding problems of pollution in Kathmandu and quality of tourism services, coupled with unregulated entry of tourism operators, constraints on air access and lack of concerted marketing efforts due to inadequate funds and organization. As a result, Nepal over the past decade or so has assumed a low-end market status with relatively low per-capita earnings as compared to many comparable countries. 2.29 The Visit Nepal Year (1998) provides an important opportunity for addressing these problems. To effectively develop tourism, a concerted effort is necessary largely involving the private sector in several areas: (i) Nepal needs to develop a vision about what kind of tourism market it wants to be; (ii) It needs to focus more on developing an upscale market for enhancing earnings, with more emphasis on quality (and less on numbers) of tourists; (iii) Given the heavy competition among various tourist destinations in the Asian region, it must develop environmentally sustainable, quality products, for which it is uniquely placed. (iv) For this purpose a strong marketing/promotional effort, which has been lacking so far, is necessary; (v) It must also improve its airline access which is a critical bottleneck. Implementing a more open policy (without protecting the inefficiently-run and unreliable RNAC) by permitting entry to domestic private companies and established foreign airlines and negotiating with India the removal of restrictions which presently limit the uptake of passengers are essential in this regard; (vi) The tourism infrastructure needs to be upgraded by improving airport facilities and accommodation especially outside Kathmandu, training of human resources engaged in tourism, more effective regulation of tourism operators to enhance quality of services, and cleaning up the environment, especially in Kathmandu ; (vii) Finally, foreign investment (for example, joint ventures) needs to be encouraged to help develop infrastructure, and improve marketing and the quality of services. Recognizing these needs, the Government has recently set up a new Tourism Development Board to undertake, among others, longer-term promotion and regulation of the industry. This initiative needs to be effectively supported by attracting committed and experienced private sector representatives and by providing adequate resources for the Board's operational activities.  - 25 - Power Development 2.30 In the short-to-medium term, an assured power supply is essential for expanding economic activity and investment in key areas such as manufacturing, agriculture and the service sectors. Even more important, in the longer term, successful exploitation of the potential for large scale power exports can help transform the Nepalese economy by generating revenues to finance much needed human and physical infrastructure. While much work remains to be done to realize this longer term goal, significant progress has been achieved in some areas: (i) A number of power generation projects which will help meet domestic requirements over the medium term and permit some power exports are currently under implementation; (ii) An important start has also been made in harnessing private foreign and domestic investment for power development. In the context of these projects, a framework for private sector participation in power development has been developed; (iii) Preparations for setting up a Power Development Fund to catalyze private and public investment in power development are well advanced; and in this context a screening and ranking exercise for prioritizing potential projects for development (which is a model for many countries), has been completed; (iv) Finally, a landmark treaty with India for water-sharing and joint power development in the Mahakali basin has been signed. 2.31 While recent progress in the power sector has been encouraging, a number of important issues will need to be addressed to facilitate future development. (i) In view of the limited availability of concessional aid, Nepal needs to increasingly rely on private financing for power development, especially for export. However, given its weak balance of payments, Nepal cannot afford to underwrite large amounts of service payments such as interest, principal repayments, dividends and profit remittances. Hence, privately financed projects would have to make their own arrangements with potential clients for ensuring payments for their power exports, as well as for convertibility of such payments. The latter problem will eventually disappear as India moves to full convertibility on the capital account; (ii) In the case of larger projects, sharing of downstream benefits that result from large storage dams remains an unresolved issue. A framework needs to be developed to capture such benefits through appropriate pricing of exports or through other arrangements; (iii) Managing the domestic lobbies successfully is critical to the development of medium-to-large power projects, particularly in an environment where there is considerable public debate and differences of views about water sharing arrangements with India and private foreign financing of power development. This will require greater openness and public disclosure of project-specific arrangements with both India and foreign companies, as well as a more effective public information effort. Human Resource Development 2.32 Nepal's human resource base is both a source of weakness in the short-to-medium term and a potential source of strength in the longer term. Low levels of literacy, lack of skills, and poor nutrition and health facilities contribute to low productivity and lack of adaptability of the workforce, hampering economic performance. A high population growth increases the demand for social services and basic infrastructure, and makes poverty reduction more difficult. Against this background, undertaking much needed investments and policy changes now to improve the  - 26 - quality and coverage of social services will help Nepal to make the transition to a more dynamic and sustainable economy over time. 2.33 In education, the key challenges are to improve the quality and coverage ofprimary and secondary education, provide for the skill needs of a growing economy, and evolve a strategy to focus public resources to achieve sectoral priorities in a cost effective manner: (i) The government's highest priority is basic and primary education, with particular emphasis on increasing the enrollment of girls. However, given the limited resources for the education sector, efforts should focus on improving internal efficiency and quality of primary education, coupled with selective expansion. The government is also emphasizing expansion of coverage and quality of secondary education and short duration job training programs to equip new entrants to the labor force with skills that match the requirements of a growing economy; (ii) To provide resources for these priorities, streamlining the existing degree level vocational education system as well as university education, improving cost recovery and encouraging greater private financing of university level education are needed. Reforms in secondary education transferring grades 11 and 12 from the university to the higher secondary levels would also help in this regard; (iii) Private involvement should also be encouraged in expanding coverage of secondary education, where the private sector is already very active, with public efforts focusing on improving the quality of government schools and providing overall supervision; and (iv) Finally, the government is encouraging the active involvement of village development committees and local beneficiary groups to mobilize local resources (coupled with matching funds from the government) for construction of schools, and to improve supervision and quality of primary education. 2.34 In health, major priorities include (i) the effective implementation of population and family health programs to slow down population growth rate (by reducing fertility levels and improving maternal and child health), and (ii) expansion of the coverage and quality of health care service delivery upto the village level. Much needs to be done to achieve these priorities: (i) Effective government commitment to the population program is still lacking, and should be strengthened. Although a National Committee for Population headed by the Prime Minister was set up in 1991, it does not meet regularly, or provide guidance to concerned agencies; (ii) Institutional capacity in the Ministry of Health (MOH) for prioritizing health sector expenditures as well as for program implementation, expenditure monitoring and supervision is weak. Consequently, resource allocation within the health sector is largely driven by ad-hoc decisions and availability of donor resources. MOH's institutional capacity needs to be substantially strengthened, together with complementary efforts to enhance community participation and encourage partnerships with NGOs for service delivery in rural areas. (iii) Resource allocation in the health sector is still biased in favor of secondary and tertiary care which are mostly urban- based, and serve the relatively better-off segments of the population. As a result, primary care across the country continues to be neglected. Health infrastructure and personnel deployment in rural areas, as well as the supply of drugs and medicines, remains poor. To improve the situation, a redirection of programs and strengthening their management are needed. Public efforts need to focus more on primary care in rural areas, while encouraging the private sector to play an increasing role in the provision of secondary and tertiary care in urban areas; (iv) Donor co-ordination in the health sector needs to be strengthened. As a result of weaknesses of  -27 - government institutions, donors are effectively running programs on their own in several areas, which are weakly co-ordinated; (v) Finally, program implementation should be strengthened. Despite the availability of substantial donor resources at the project level, the country is losing a major opportunity to strengthen service delivery mechanisms and primary care infrastructure in rural areas because of slow decision making, weak implementation capacity and lack of deternined leadership at higher levels in the health sector. While there has been some encouraging progress recently at the project level, this needs to be nurtured and sustained. Environmental Management 2.35 Recognizing the need for sound environmental management, the government in 1993 formulated a Nepal Environment Policy and Action Plan (NEPAP) to integrate environmental management into its overall development policy. NEPAP focused on five critical areas: better management of natural resources; addressing the consequences of rapid population growth, poor health and widespread poverty; protection of cultural heritage; mitigating the impact of unplanned urban, industrial and infrastructure development; and developing a clear legal and institutional framework to facilitate better environmental management. Actions have been initiated in most of these areas to implement the NEPAP. The more important of these include: the creation of a Ministry of Environment and Population (MOPE) in 1995; the issuance of environmental guidelines and undertaking training of administrative and project officials for environmental assessments; the recent approval by the Parliament of an Environment Protection Bill; undertaking various measures to reduce vehicular emissions and improve energy efficiency in industrial plants; and the formation of an Environmental Coordination Group involving the government and key donors to coordinate and monitor environmental protection activities. 2.36 Notwithstanding these initiatives, progress in implementing the NEPAP so far has been slow: (i) MOPE is still struggling to find an effective role. To be more effective, the respective roles of MOPE and those of other agencies, particularly municipalities, in carrying out environmental protection activities need to be clearly defmed and their technical capacity strengthened; (ii) Stronger efforts are needed to control land, air and water pollution, especially in urban areas. The early formulation of an Industrial Pollution Act, together with defining appropriate technical standards and strengthening monitoring facilities should considerably facilitate such efforts; (iii) To ensure more effective implementation, the participation of a wider range of stakeholders such as the private sector and local community groups in the planning and implementation of environment activities is also needed; (iv) Finally, in view of limited implementation capacity, it is necessary to undertake a stocktaking of ongoing and planned activities and develop an action program for the short-to-medium term, focusing on priority areas, as well as identifying technical assistance needs for strengthening environmental management capacity.  -28 - C. CONCLUSION 2.37 To accelerate economic growth in order to reduce widespread poverty, the Government needs to address a number of difficult problems. The agenda for dealing with these issues is clear, although taking the specific measures which are needed will be challenging. Therefore, strong political will and commitment is necessary for effectively addressing these issues. Such a commitment is important because as outlined above, Nepal's economic future depends on achieving satisfactory progress in these critical areas.  ANNEX page 1 of 3 THE NINTH PLAN AND MACROECONOMIC PROJECTIONS The Ninth Plan 1. The Approach Paper for the Ninth Plan (which is currently under preparation) as well as the FY98 budget emphasize that eradication of poverty is the government's major development objective. The Ninth Plan's goal is to reduce poverty from an estimated 45 percent to 32 percent by FY2002 and to 10 percent in twenty years - by FY2017. This is to be achieved by: (i) Accelerating economic growth rate to an average of 6.5 percent p.a over the Ninth Plan period and to 7.2 percent p.a in later years; (ii) Bringing rural population into the mainstream of development by giving priority to agriculture, water resources, tourism, rural infrastructure and agro-based industries (to increase employment opportunities); and promoting human resource development, involving local communities closely in this process; (iii) Reducing economic disparities between regions and communities by increasing access to basic services and developing special programns for the most vulnerable and underprivileged groups (for the latter purpose, a poverty alleviation fund and an employment generation fund are to be created out of the government's own resources on an experimental basis); and (iv) Emphasizing decentralization of programs, especially human resource development and rural infrastructure, as a mechanism for involving local communities in the development process. Despite its good intentions, however, the Plan is overambitious both in regard to its development targets and its macroeconomic framework. For example, Annex Table 1: Ninth Plan - Key Macroeconomic Indicators, FY97 - FY2002 (At FY97 prices) FY97 FY2002 Average growth Marginal I ______________________________________ ______________ _______________ rate p.a change/a Macro Balances - In percent of GDP Real GDP 100.0 100.0 6.5 100.0 Total Consumption 89.3 81.7 4.6 61.3 Total Investment 25.1 26.3 7.5 29.7 National Savings 12.1 19.8 17.6 40.7 lmports of Goods & Non factor Services 39.2 43.4 8.7 54.7 Exports of Goods & Non factor Services 24.5 35.6 14.5 64.8 Curent Account Balance -13.0 -6.2 -8.1 -12.2 FY97 Five Year Total Annual Average Growth Rate (FY98 - FY02) percent p.a Financing the Government Budget -Rs. Bilion Total Expenditures 49.7 374.1 74.8 14.6 Regular 24.0 148.8 29.8 7.5 Development 25.7 225.3 45.1 20.5 Total Revenue 30.4 234.0 46.8 15.4 Foreign Aid (Grants and Loans) 14.2 130.5 26.1 22.5 Domestic Borrowing 5.1 9.6 1.9 -17.8 Memo Item Revenue Surplus/b - Rs. bilion 6.4 85.2 17.0 38.5 Domestic Inflation rate - percent p.a 7.0 6.5 - a hndcate the proportion of the incremental GDP between FY97 and FY2002 that is assumed to be consumed, invested, saved b Goverment revenue minus regular expenditures. Source: Ninth Plan Approach Paper, National Planning Commission  ANNEX page 2 of 3 the plan seeks to eliminate illiteracy (currently 73 percent) by FY2005, increase electricity generation capacity (currently 290 mw) to 20,000 mw, reduce child mortality rate (currently 79 per thousand) to 25 per thousand, and increase average life expectancy for males (currently 55.9 years) to 72 and for women (currently 53.4 years) to 75 -- all by FY2017. (i) As in the case of recent budgets, its resource projections are unrealistic (Annex Table 1). Total revenues are projected to increase by 15 percent p.a and aid disbursements by 22 percent p.a in real terms -- equivalent to nominal increases of 23 percent p.a and 30 percent p.a respectively; (ii) Expenditure targets, based on these projections in turn, are unlikely to be attainable. Development spending is projected to increase by 20 percent p.a and total expenditures by 15 percent p.a in real terms, equivalent to nominal increases of 28 percent p.a. and 22 percent p.a. respectively; (iii) To finance its overall investment levels, national savings are envisaged to rise from 12 percent of GDP (as estimated in the Approach Paper) in FY97 to nearly 20 percent of GDP by FY2002, with a corresponding reduction in foreign savings (i.e. improvement in the current account deficit) from 13 percent of GDP (estimated in the Approach Paper) to 6 percent of GDP. The achievement of these targets would require that 40 percent of the incremental GDP between FY97 and FY2002 should be saved and the equivalent of 65 percent of incremental GDP should be exported over the same period. The Plan thus runs the same risks as recent budgets which have failed to achieve their development targets because they are overcommitted in too many areas, without adequate prioritization and without due regard to resource availabilities. Macroeconomic Projections 2. Alternative scenarios show that under more realistic assumptions with regard to resource availabilities and sustainable levels of public (and private) spending, the Nepalese economy can still grow at a more moderate rate and still make some reasonable progress in poverty reduction and development effectiveness. Such a scenario is shown for illustrative purposes in Annex Table 2 below. The scenario assumes that the Government will implement policy reforms and adhere to macroeconomic targets for revenues, expenditures, domestic borrowing, money growth and foreign exchange reserves which are necessary in order to maintain a sustainable macro-fiscal framework. Thus, government revenues are projected to grow by around 0.5 percent p.a from 10.9 percent of GDP in FY97 to 12.5 percent of GDP by FY2000; current expenditures are projected to remain stable at 9.0 percent of GDP, gross domestic borrowing is assumed to be limited to less than 1.0 percent of GDP p.a (equivalent to 0.5 percent of GDP p.a in net terms); and foreign financing of the budget is expected to remain of the order of 6.3 percent of GDP over the next three years. This would permit development spending to rise by about 1.8 percent of GDP (from 9.2 percent in FY97 to about 11.0 percent in FY2000. Since a significant part of this increase and foreign financing (about 1 percent of GDP) would represent investments related to the Kali Gandaki Power Project, other development spending could increase only modestly -- by less than 1 percent of GDP over FY97 levels. Nevertheless, by focusing pubic spending on critical areas and by improving the business environment for the private sector, it may still be possible to achieve an average economic growth rate of the order of 4.8 percent p.a, and improve the pattern of growth (for example by accelerating agricultural growth) to benefit the rural areas; while making modest improvements in national savings and the balance of payments. 3. Slippage from this scenario in terms of lower revenues and/or higher regular expenditures would affect development expenditures directly, as lack of counterpart funds would slow down project implementation, and with it aid utilization. Slippage in terms of higher government borrowing would lead to higher interest rates and a crowding-out of private investment. Such developments would.have a  ANNEX page 3 of 3 negative impact on GDP growth, which could slow to 3 Y2-4 percent. Conversely, particularly good revenue performance might allow for an expansion of public investment if regular expenditures are contained, and sound credit management policies could lead to higher private investment, thus accelerating growth to five percent or more. Annex Table 2: Macroeconomic Projections, FY95 - FY2000 FY95-96 FY97 FY98 FY99 FY2000 _Estimate Projections Real GDP at factor cost 4.1 3.8 4.6 4.8 5.0 Gross Investmnent/GDP 23.3 21.5 23.5 24.5 25.0 National Saving/GDP 13.0 9.9 12.0 13.6 14.5 Consumer Prices 7.9 7.8 7.5 7.0 6.5 Broad Money Growth 15.3 10.7 13.4 12.9 12.4 Export Value Growth/a 2.2 29.1 6.6 7.5 7.8 Import Value Growth/a 13.8 18.5 5.8 5.9 6.6 Current Account Balance/GDP -10.3 -11.6 -11.4 -10.9 -10.5 Aid Disbursements (gross)/GDP 7.5 7.5 8.0 8.1 8.1 Gross Reserves - US $ Million 833 829 877 898 930 - Months of Imports 6.2 5.2 4.8 4.7 4.5 C-overnment Revenue/GDP 11.3 10.9 11.5 12.0 12.5 Total Expenditures/GDP 18.4 17.8 18.7 19.3 20.0 Regular Expenditures/GDP 8.8 8.6 9; 9.0 9.0 Development Expenditures/GDP 9.5 9.2 9.7 10.3 11.0 Overall Deficit/GDP -7.1 -6.9 -7.2 -7.3 -7.5 Foreign Financing of the budget 5.5 5.1 6.2 6.3 6.5 Domestic Financing (gross) 1.6 1.8 _ 1.0 1.0 1.0 a Goods and non-factor services in US $. Source: Bank Staff Projections. 4. The base case macroeconomic scenario helps to illustrate the importance of economic reforms in order to effectively implement the development/poverty reduction agenda. For example, without a significant improvement in the government's revenue performance and strong efforts to curtail the growth of salaries and debt service payments, it would not be possible to expand the development budget even modestly. Similarly, given the limited availability of public resources, better public resource management is necessary to ensure that such resources would be effectively used to maximize their development impact. Economic reforms are also needed in several other areas to help improve the business environment for the private sector, (for example through financial sector reforms, tax reform and privatization of public enterprises) and improve the efficiency of resource use in the economy. Thus, economic reforms are an important means of improving the effectiveness of development programs - public and private - at both macro and sectoral levels.