Nepal Development Forum - economic update 2002

NEPAL DEVELOPMENT FORUM - -I -I m ri Uddfl - 2 O O 2 The World Bank January 30, 2002  I_-  Table of Contents I. INTRODUCI'ON 1 II. RECENTECONOMICDEVELOPMENTS 4 Overall Growth 4 Agricultural Sector 4 Non-Agricultural Sector 6 External Sector 7 Fiscal Developments 8 Monetary Developments, Prices and Interest Rates 9 III. PROGRESSINEIMPLEMENTINGREFORMS 11 Economic Policy Management and Regulatory Reforms 11 Governance Reforms 15 ii IV. CONCLUSION 17 BOX Box 1 Key Recommendations of the PERC 12 FIGURES Fig. 1 Contribution of Different Sectors to GDP Growth 4 Fig. 2 Growth of GDP by Demand 6 Fig. 3 Trends in the Current Account Balance and Reserves 8 Fig. 4 Fiscal Trends 9 Fig. 5 Money Supply and Domestic Credit 9 Fig. 6 Inflation and Lending Rates 10 Fig. 7 Ratio of Bank Assets to GDP 14 TABLES Table 1 Selected Economic Indicators, 1997/98-2001/02 5  Al  Statistical Appendix SECTION 1: National Accounts Table 1.1: Nominal Gross Domestic Product by Sector, 1994/95-2001/2002 Table 1.2: Real Gross Domestic Product by Sector, 1994/95-2001/02 Table 1.3: Gross Domestic Product Deflators, 1994/95-2001/02 Table 1.4: Gross Domestic Product by Expenditure Component, 1994/95-2000/01 Table 1.5: Savings and Investment, 1994/95-1999/00 SECTION2: Balance of Payments: Current Account Table 2.1 (a): Balance of Payments, 1995/96-2001/02 Table 2.1(b): Balance of Payments with India, 1995/96-1999/00 Table 2.1 (c): Balance of Payments with Third World, 1995/96-1999/00 Table 2.2(a): Foreign Trade, 1995/96-1999/00 Table 2.2(b): Foreign Trade with India, 1995/96-1999/00 Table 2.2(c): Foreign Trade with Third World, 1995/96-1999/00 Table 2.3: Exports of Major Commodities, 1994/95-1999/00 Table 2.4(a): Services and Current Transfers, 1995/96-1999/00 Table 2.4(b): Services and Current Transfers with India, 1995/96-1999/00 Table 2.4(c): Services and Current Transfers with Third World, 1995/96-1999/00 Table 2.5: Tourism Indicators, 1994-1999 Table 2.6: Average Customs Duty by Main Category of Goods, 1999/2000 v SECTION3: Balance of Payments: Capital Account Table 3.1: External Debt and Debt Service, 1994/95-1999/00 Table 3.2: Gross International Reserves, 1994/95-1999/00 SECTION 4: Public Finance Table 4.1: Summary of Central Government Operations, 1994/95-2001/02 Table 4.2: Central Government Revenue, 1995/96-2001/02 Table 4.3: Central Government Expenditure by Economic Classification, 1995/96-2001/02 Table 4.4: Central Government Expenditure by Functional Classification, 1995/96-2001/02 SECTION 5: Monetary Survey Table 5.1: Monetary Survey, 1994/95-2001/02 Table 5.2: Structure of Interest Rates, 1994/95-2000/01 Table 5.3: Non-Performing Loans of Public Enterprises, 1996/97-1999/00 SECTION6: Social Sector, Agriculture, Energy, Industry, Prices and Wages Table 6.1: Social Indicators Table 6.2: Agricultural Production and Yield, 1995/96-1999/00 Table 6.3: Manufacturing Production Indices, 1997/98-1999/00 Table 6.4: Energy Consumption, 1994/95-1999/00 Table 6.5: Changes in the Consumer Price Index, 1994/95-1999/00 Table 6.6: Monthly Wages in Major Sectors, 1994/95-1999/00  IA  Introduction 1. With a per capita income of US$220 per annum, Nepal is the 12th poorest coun- try in world and the poorest in South Asia'. Despite per capita growth rates averaging 2.2 percent per annum in the last two decades, poverty reduction in Nepal has been slow. The 1995/96 Household Survey found that about 42 percent of the population lived below the poverty line, approximately the same poverty rate as found in the 1984/85 multi-purpose household budget survey. While the 1995/96 survey showed that poverty rates had fallen compared to the 1991 rural credit survey, the difference was statistically insignificant.2 Pov- erty reduction has been slow in Nepal for two reasons: (i) per capita income growth rate has been low-and at this 2.2 percent growth rate, it will take Nepal around 31 years to double its per-capita income level; and (ii) growth has been concentrated primarily in the urban areas and particularly in Kathmandu valley, largely excluding 86 percent of the population who live in rural areas, where per capita agricultural production has grown minimally and the overall level of economic activity has been sluggish. 2. While reduction in "consumption/income" poverty has been slow, good progress was made in some aspects of human development in the 1990s: reducing infant and maternal mortality, increasing primary school enrollment, reducing the gender gap in education and increasing access to drinking water. But Nepal's human develop- ment remains low compared to other South Asian countries. Also, there is wide variation in human development within Nepal, with rural areas lagging sharply be- hind urban areas. Low incomes, lack of employment opportunities especially in rural areas, a delayed start in development, poor public services, and inefficient use of public resources have all contributed to this low and unequal human development. These same factors have also contributed to creating social unrest and political instability. 3. In the 1990s, Nepal's economic performance improved with per capita income growth increasing to more than 2.5 percent3, as the economy responded to macro- economic stability and the first round of liberalization and population growth rates fell. The economy became much more open with rapidly growing trade-especially exports- (more than 15 percent per annum in US dollar terms) to both OECD countries and India (which accounts for 40 percent of Nepal's exports and imports). However, although growth These are based on nominal per capita incomes in US dollars. In purchasing power parity terms, Nepal's per capita income makes it the 30^ poorest country in the world. It is worth noting that National Income Accounts are weak in Nepal, especially in the non-agricultural sector. 2 It is worth noting that difference of methodology between these surveys make a straightforward comparison difficult. Also, the recent mid- term NPC review of poverty carried out in 2000 shows poverty rates to have declined to 38%. 3 Unless otherwise indicated, macroeconomic data in this note have been taken from IMF documents.  accelerated and became more broadly based towards the end of the decade, this perfor- mance could not be sustained in the face of extemal economic shocks, a "stop-go" pattem of reform and internal political instability. 4. Since the last Nepal Development Forum (NDF) in April 2000, Nepal's eco- nomic growth has slowed down and medium term prospects are somewhat bleak. Growth in FY200 14-now estimated to be less than 5 percent5 -was less than expected and projected GDP growth for FY2002 has been revised downward from 5.5 percent to only 3 percent. Nepal's medium term prospects also face major challenges in the road to recovery: * The effects of the global economic slowdown starting in the spring of 2001 and worsening in aftermath of the events of September 11th. These have affected Nepal's small open economy particularly harshly as key economic activities-manufac- tured exports to OECD countries and the hotel and tourism businesses-have been badly affected. * Continued political instability with more than half a dozen governments and nine changes in Prime Ministers in the last ten years and recent escalation of vio- lence. Following the breakdown of peace talks in November 2001, the Maoists have resumed and escalated their attacks, with the resulting declaration of a state of emer- gency. * Growing fiscal pressures. Revenue collections have fallen in recent months while 2 expenditures and domestic borrowings have increased. As a result, the risk of fiscal instability is growing. * Diminishing export markets. When the Multi-Fibre Agreement (MFA) is repealed on January 1, 2005, export quotas will be removed and countries like Nepal will have to significantly enhance productivity to maintain their apparel exports. As apparel consti- tutes 25 percent of export earnings and has grown rapidly-by more than 60 percent in US dollar terms-in the last three years, the challenge of increasing competitiveness in apparel and diversifying away from garments to other export sources is very serious and remains to be addressed. Similarly, exports to India will be threatened if the Indo-Nepal free trade agreement is not renewed. 5. Progress with implementing the reform program-very convincingly articulated in the last NDF-has been mixed and far slower than promised. Progress has been good in areas such as tax reform and infrastructure regulatory reforms. Although the pace of implementation has picked up, progress has also been slow in the financial sector, decentrali- zation and public expenditure reforms. Despite starting several years ago, there has been little progress in civil service reforms, and privatization. More generally, the tremendous challenge of ensuring better governance to make the investment climate better for the private sector, reduce the cost of doing business, improve the equity of the development process and enhance the effectiveness of public service delivery remains to be addressed. 4 The fiscal yearruns from July 15 to July 14, with FY2001 coveringJuly 15, 2000 to July 14, 2001. This number is the most recent estimate by the Central Bureau of Statistics (CBS). As it not yet official, the tables in this note show growth of 5.3 percent in FY200 1.  6. It has now become urgent for Nepal to accelerate the pace of reforms to over- come the twin challenges posed by the Maoist insurgency and the state of emer- gency and the deteriorating economic and fiscal conditions. The agenda of reforms that will help Nepal confront these challenges is reasonably clear and is being implemented: * Restoring security. The Maoist insurgency poses a major challenge to the Govern- ment to accelerate the implementation of policy reforms. Thus, restoring and maintain- ing security will require not only implementing security measures but also: (i) improving public services and economic conditions so that rural poverty and unemployment is re- duced; (ii) empowering people and communities and increasing their stake in their own development through decentralization and support to community development schemes; and (iii) involving all stakeholders-in particular political leaders-in a dialogue to de- velop consensus around a development agenda so that implementation is unhindered by political interests. The consultations around the Tenth Five Year Plan-i.e., "Tenth Plan" which will define Nepal's Poverty Reduction Strategy-can serve as a useful instrument in this regard. * Maintaining fiscal and macroeconomic stability. Successful stabilization in the 1990s provided resources and a climate of predictability for private sector activity. This progress has now been jeopardized by the emerging stress on the fiscal and trade balances. Thus, to maintain fiscal stability, the revenue collection drive of the past few years will need to be reinvigorated. To this end, the Government has announced supplementary measures to raise revenues by Rs. 2 billion in FY2002. But given the difficulties in meeting existing revenue targets, implementing these measures will be a challenge. More importantly, public expenditures will need to be better prioritized in an environment of constrained 3 resources, while also improving the implementation of spending plans (i.e., translating budget into high-quality public service delivery). Concurrently, the threat to macroeco- nomic stability posed by the poor financial position of the two dominant banks-that own 60 percent of all banking assets-has to be urgently addressed. * Increasing economic productivity and competitiveness. This includes: (i) imple- menting infrastructure reforms to facilitate efficient private sector participation, lower production costs and provide reliable services; (ii) improving financial sector efficiency to ensure that capital can be mobilized efficiently and finance productive activities; (iii) implementing trade and exchange rate policies to provide adequate incentives to produce tradeable goods and exports; (iv) reducing the regulatory burden imposed by tax, inspec- tion and labor laws and the other red tape that discourages domestic and foreign inves- tors; (v) paying special attention to the agricultural sector to ensure that key inputs (i.e., fertilizer, irrigation, extension services, agricultural credit and infrastructure) are supplied efficiently and in a sustainable manner and (vi) investing in greater human capital devel- opment as a key condition for long run growth. * Improving governance and public service delivery. Reforms here include: (i) im- proving the effectiveness of public resources through better budget management, expen- diture prioritization within the context of a medium term framework, (ii) promoting a greater role of community, NGO and private sector in delivering public services; (iii) more effective monitoring of performance (e.g., use of social audits); (iv) implementing decentralization and supporting community-driven development schemes to empower communities and increase accountability; and (v) implementing financial management and civil service reforms to raise the efficiency and accountability of the public sector.  7. The development challenge facing Nepal is formidable, but the "twin crises" of the state of emergency and the fiscal difficulties have also made reform imperative. There is already increasing national attention to the need for a more effective development strategy to overcome the present crisis. Also, the severely constrained fiscal position is prompt- ing a more serious effort at prioritizing public spending. Whether Nepal can turn today's crises into a springboard for a major breakthrough depends critically on the ability of the authorities to be bold and engage the broad public in the policy debate to build a national consensus on the road forward. 8. The rest of this note provides a review of: (i) recent economic developments (Section II); and (ii) the status of implementation of the reform program (Section III). 4  Recent Economic Developments Overall Growth 9. On average, economic growth in Nepal increased to 5 percent per annum in the 1990s, while population grew by 2.3 percent annually. Macroeconomic management strengthened during the mid 1990s, resulting in healthy improvements in the external and internal balances (See Table 1). Inflation was kept low and stable, and exchange rates- pegged to the Indian rupee-depreciated gradually to maintain stability and export competi- tiveness. Growth was mainly led by the non-agricultural sector, which accounted for 75 percent of growth during this period (See Figure 1) and exports (18 percent of GDP) played a key role on the demand side (See Figure 2, page 6). Growth also became more broadly based as agricultural growth picked up in the second half of the 1 990s. i~~~~~~~~~~~~~~~j ~~~~~~~~~~~~~5 j t 4, .1. .Nep l's e o perf has m e d i rh $ *6 I~~~~~~~~~~~~~~~~~ cent months, halting the acceleration of output and export growth. Growth in the non-agricultural sector is projected to decelerate by one-third in FY2002 and manufactur- ing value added is expected to contract. Other constraining factors are the decline in export demand caused by the global economic slowdown, the relatively slower growth of India and internal factors, such as frequent strikes, Maoist attacks on economic targets and power shortages. Growth in the agricultural sector will be adversely affected by the untimely rainfall in September 2001, which has harmed paddy crops. Agricultural Sector 11. While agriculture in Nepal has long been lagging, it has shown some signs of dynamism in the last few years. Agriculture's share in GDP is more than 35 percent, but its contribution to growth has been below potential and has accounted for less than one-fourth of growth  Table 1: Nepal: Selected Economic Indicators, 1997/98-2001/02 l/ Nominal GDP (2000/01): US$5,568 million Population (2000/01): 23.2 million 1990-95 1995-99 1997/98 1998/99 1999/00 2000/01 2001/02 Estimate Projection 2/ Growth (percent change) Real GDP at market prices 5.2 4.8 3.0 4.4 6.5 4.9 3.0 Agriculture and allied 1.5 3.4 1.2 2.7 4.8 4.0 1.5 Industry 9.3 6.4 1.9 7.4 8.9 5.1 3.9 Manufacturing 13.6 7.5 4.3 5.5 12.5 3.6 -0.5 Services 7.4 7.0 5.8 5.8 3.3 5.9 4.7 CPI (average) 11.0 8.7 8.3 11.4 3.4 2.4 5.5 Savings and investment (percent of GDP) Gross investment 21.1 25.6 24.8 20.5 24.3 25.7 25.5 National savings 14.1 16.5 22.0 21.0 24.8 26.1 24.9 Government budget (percent of GDP) Total revenue 9.5 11.0 10.5 10.2 10.7 11.4 12.3 Total expenditure 17.3 17.2 16.8 15.4 15.7 18.0 19.1 Current expenditure 10.2 9.8 9.2 9.3 9.6 11.3 11.8 Capital expenditure and net lending 7.0 7.3 7.6 6.1 6.1 6.7 7.4 Overall deficit before grants 8.7 7.1 6.3 5.2 5.0 6.6 6.9 Domestic financing (net) 2.2 2.0 0.6 1.4 0.9 2.7 2.2 Money and credit (percent change; end-of-period) Broad money .. 17.0 21.9 20.8 21.8 15.0 11.5 Domestic credit .. 18.8 14.8 16.1 17.8 19.2 13.5 External trade (percent change) Export value 3/ 29.5 3.7 11.8 18.0 37.4 7.4 2.0 Import value 4/ 14.7 2.1 7.1 -2.0 27.6 8.2 3.8 6 Balance of payments (U.S. dollars million) Current account balance (excluding grants) -287 -177 -135.0 24.0 28.0 26.0 32.0 (in percent of GDP) .. -3.5 -2.8 0.5 0.5 0.5 0.6 Official grants and loans (net) 254 360.0 216.0 199.0 171.0 243.0 Overall balance .. 86.5 176.0 145.0 209.0 123.0 94.0 Other external indicators Gross official reserves (U.S. dollars million; end-of-period) 7/ 532 593 715.9 795.0 946.5 1,020.0 1,069.0 In months of imports of goods and services 5/ 5.9 4.1 5.3 4.9 5.5 5.8 5.5 Public and public guaranteed debt/GDP (in percent) .. .. 49.7 50.3 56.6 58.8 58.0 Debt service 6/ .. .. 6.7 5.9 4.7 4.8 5.5 1/ This table defers from Statistical Annex Table 1.2 by having more updated GDP numbers. 2/ Fiscal year ends July 15. Data reflect GDP deflator revisions made by the authorities for the period between 1997/98 and 1999/2000. 3/ Cumulative, excluding re-exports. 4/ Cumulative, excluding gold. 5/ Ratio is in terms of projected imports of goods and services. 6/ In percent of exports of goods, services, and private transfers; including debt service to the Fund. Source: IMF and CBS during the 1990s. Although in the first half of the 1990s per capita agricultural value added actually fell, this trend was reversed in the second half of the 1 990s. Despite the drought of 1999, per capita agriculture growth increased to nearly 1 percent during this period. 12. Specifically, the factors contributing to the higher growth in agriculture include: (i) an increase in the use of fertilizer (23 percent in FY2000) as higher food prices in FYI 999 increased returns to fertilizer use and there was greater private sector supply and "unofficial" imports of fertilizer from India; (ii) private sector entry in the supply of inputs; (iii) better  educated farmers6 ; (iv) diversification of crop production as cash crops and exports grew rapidly; (v) growth of agricultural credit; (vi) some improvements in rural roads and irrigation; and (vii) good rainfall. 13. Nevertheless, agricultural and rural economic growth remains constrained by inadequate infrastructure, weak irrigation and inadequate other complementary in- puts. Nepal's poor road infrastructure-one of the least developed in the world7 -prevents the development of markets and hence, the growth of both farm and non-farm incomes. Only 15 I i ZItrr 2: Ctrorho aCDtP by Dnemd 4t ~ ~ ~ ~~~~~~ tv r Itz.CiaX:4nlt2 prv tely-ownedl,. fanner mange irrigation sysem hav prvne an exaso: oria yasDepire t e ofNeals rcential growth frilizner apliar-round perrigcareion anepa isom estimate signifcatly below that of neighboring countries. A critical input - land - is highly fragmented and infor- mal/non-transparent tenancy arrangements deter investment in land. These constraints will have to be removed in order to boost agriculture production. Non-Agricultural Sector 14. Growth in the non-agricultural sector accelerated markedly during the 1990s as the economy liberalized and became more stable. Economic liberalization in the early 1 990s' and successful stabilization of the economy in the mid 1 990s helped to create an enabling environment. The positive response in the non-agriculture sector was widespread: industry grew by 8 percent per year, the manufacturing sector by over 10 percent and ser- vices by over 7 percent. The rapid manufacturing growth was primarily export-led, but 6 This is a finding from the sectoral review by the Ministry of Agriculture and the Asian Development Bank (ADB). 7 The normalized roads index in Nepal was about 70 compared with 1 19 for low income countries in 1997/98. The normalized roads index is the total length of roads in a country to the expected length where the expectation is conditioned on population, population density, per capita income, urbanization and region-specific characteristics. Thus, road density in Nepal is low compared with its own expected value, as well as with other countries. From M. Fafchamps and F. Shilpi, "Infrastructure Location and Development in Nepal", Research Proposal, World Bank, 2002.  supplemented by growth in the utilities sector as new power sources-the Khimti and the Puwa Khola hydroelectric projects-increased power production capacity by 25 percent to- wards the end of the decade. The rapid growth of tourism also contributed to non-agricul- tural growth until it fell off sharply after the Indian Airlines hijacking incident in 1999. 15. However, non-agricultural growth is expected to slow sharply in FY2002 and manufacturing may contract. Factors accounting for this include the: (i) drop in domestic demand due to falling agriculture growth that especially affects small industries and services; (ii) decline in export demand as growth in both OECD countries and India has decelerated; (iii) cancellation of export orders caused by trade disruptions and higher insurance costs after the events of September 11 th; and (iv) rising costs and uncertainty due to power disruptions, bandhs (general strikes) and direct terrorist attacks by Maoists and other groups on carpet and garment factories and on the liquor business. 16. The tourism, hotel and restaurant, and transport industry-which account for around 10 percent of GDP-has been badly affected in recent years. Initially, the hi- jacking of the Indian Airlines flight in December 1999 caused tourism to fall. The decline was compounded by the tragedy affecting the Royal family in June 2001. Subsequently, the September 1th attacks, the escalation of Maoist violence and the declaration of a state of emergency have further undermined tourism prospects. As a result, in November 2001 tourism earnings were down 50 percent from the previous year. 8 17. The medium-term prospects for the non-agricultural sector appear gloomy, unless strong measures are taken to revive these activities. Several factors contrib- ute to this bearish outlook. First, security concerns and attacks on economic targets by the Maoists have worsened the business climate and increased investor uncertainty aside from directly adversely affecting sales of the tourism, hotel, and restaurant sectors. Second, the prospects for Nepal's exports to OECD countries-which have contributed significantly to the growth of demand-are endangered both by the on-going global slowdown and by the forth- coming repeal of the MFA quotas. Successful implementation of reforms will be critical to fight the adverse effects of these shocks and put the economy on a sustained growth path. In this regard, there is a need to: (i) contain political turmoil and restore security and confidence of the private sector by protecting it against acts of terrorism; (ii) maintain macroeconomic and fiscal stability that helped to create an enabling environment for the private sector in the past few years; and (iii) take urgent measures to increase productivity and reduce the costs of doing business in the face of increasing global competition. These issues are discussed in more detail in Section III of this note. External Sector 18. Foreign trade-notably exports-was the engine of growth for the Nepali economy during most of the 1990s (see Figure 2, previous page). Helping to produce an export- friendly environment were the economic liberalization in the early 1990s, the successive 8 Liberalization measures included: (i) reform of investment regulations, including easing of entry barriers; (ii) trade and financial sector reforms that facilitated the supply of mw materials, intermediate and capital goods; and (iii) regulatory reforms that allowed private sector participation in infrastructure.  rounds of trade liberalization (Nepal now has an average tariff of 13 percent) through the 1990s and the nearly complete dismantling of non-tariff barriers to imports. In response to these measures, trade and exports grew at 15 percent in US dollar terms throughout the 1990s and the share of exports and trade in GDP doubled. 19. Exports have grown particularly rapid in recent years with 18 percent growth in US dollar terms in FY1999 and 37 percent in FY2000. Most of the export growth has come from garments, carpets and pashmina (mostly to OECD countries), accounting for more than 50 percent of all export earnings. Taking advantage of the Indo-Nepal trade agreement of 1996-under which India granted duty free access to certain imports from Nepal-exports to India of vegetable ghee and light consumer products (e.g., toiletries and processed food) also grew rapidly. In FY200 1, export growth slowed to 8 percent partly because of global slow- down and partly as exports to India were affected by transport strikes. Simultaneously, imports-mainly of consumer goods, machinery and transport equipment-have also grown rapidly in the last few years. The pegging of the Nepali rupee to the Indian rupee has enabled Nepal to maintain a stable and competitive exchange rate as the Indian rupee gradually depreciated during the past few years. 20. Unfortunately, export growth has sharply decelerated in recent months. In the first four months of FY2002, exports to countries other than India, declined by 35 percent (compared to growth of 32 percent in the same period in FY2001) while export growth to India decelerated from 58 percent (in the same period last year) to 32 percent. These de- clines were caused by steep falls in exports of carpets, garments, and pashmina in the case of 9 exports to OECD countries. In addition, the fall has hurt industry badly and reportedly only one-third of garments factories are currently still operating. Correspondingly, import growth has fallen to 3.5 percent in FY2002 (compared to 12.5 percent in FY2001), indicating an economic slowdown. 21. The recovery of trade-especially exports-is crucial for the Nepali economy, but prospects are uncertain. The recovery of exports will depend on several factors including: (i) the renewal of the Indo-Nepal Trade agreement9; (ii) a recovery in the global economy that would revive demand for Nepali products in OECD countries; and (iii) maintaining a competitive position after the MFA is phased out. Of these three factors, it is the third factor that challenges Nepal's medium term prospects the most. Unless Nepal can rapidly increase its competitiveness and productivity through the much needed structural and governance reforms, it is unlikely that export growth can be restored. 22. Despite the slowdown in exports, the current account and balance of payments position remain strong at present (See Figure 3) and represents a significant improve- ment from the mid 1990s. Contributing factors have been: (i) the increase in labor remittance earnings by 145 percent in the last three years to more than US$400 million last year; (ii) the slowdown of imports; and (iii) the fall in petroleum prices. Overall, the balance of payments has remained strong, with reserves equal to over 5 months (of which one month of reserves are in Indian rupees). However, despite the current comfortable position, medium term sustainability is unclear as it depends on the resumption of export earnings, stability of foreign concessional assistance and the continued inflow of remittances by Nepali workers. If con-  i F i g u r e 3: T r e n d s i n t h e C u fidence in the economy is shaken due to political and Re s e fiscal instability, then this vitally important remittance in- flow could be diverted, threatening the current comfort- ; 2. C retAc-7 . . . I 01 <6. able foreign exchange position. 0. | l F-rign _ S. 4 4. Fiscal Developments 61 6 Al 23. Fiscal management in FY2000 and FY2001 im- 7' . _ T_ proved significantly mostly due to good revenue policies and improved administrative measures (See Source paragraph 33), with revenues increasing by 35 percent in L.__ __. _ ....______ ___ ____ . these two years. The revenue increase, combined with lower than expected development expenditures, contrib- uted to reducing the fiscal deficit to less than 5 percent of GDP in FY2000, and a lowering of the domestic financing requirement. In FY2001, there was a good start to initiating public expenditure reforms with the work of the Public Expenditure Review Commission (PERC), which recommended important measures to improve the effectiveness of public expendi- tures (See Box 1, page 12). Expenditure prioritization also noticeably improved in the FY2002 budget (See paragraph 35). 24. But, the fiscal position has deteriorated over the past three quarters due to the economic slowdown and political disturbances. Revenue collection is falling while ex- penditure pressures are increasing. An increase in the wage bill in FY2001 and difficulties in 10 revenue collection in the last quarter of FY2001 contributed to an increased fiscal deficit of nearly 7 percent of GDP and a sizeable increase in domestic borrowing (to 2.7 percent of GDP). Initial reports for the first six months of FY2002 suggest that revenue collections are running below FY2001 trends-i.e., revenue collection has increased by 4 percent compared to a 17 percent increase in the same period in FY2001. Factors that have contributed to this have been the decline in imports, the low level of economic activity and the attacks on liquor sales. Expenditures are under pressure because of higher security-related expenditures to finance the implementation of emergency measures and the Integrated Security and Development Program (ISDP). Additional expenditure demands from these sources amount to more than 1 percent of GDP. -- *** . - 5, -- 1 25. The positive fiscal developments of recent years sup- porting the relatively good macroeconomic performance and t growth are now under threat. A major slippage in fiscal manage- ment will set back growth prospects by increasing inflation and inter- 1 i , ; ' i est rates, causing real exchange rate appreciation and increasing un- certainty. Thus, high priority must be given to improving fiscal man- _ _ iL agement. While the revenue share in GDP is still relatively small and t < E W - t -; t t there is considerable scope to increase resource mobilization, in the __________________________________ short term the revival of revenue collection will depend more on the 9 While trade talks have been held since August 2001 they appeared to stall as India sought clearer rules of origin and safeguards against re-exports of other country products via Nepal before renewal. However, the recent announcement by the Indian Prime Minister holds out hope that the treaty will be renewed soon.  recovery of the economy. Hence, the agenda of improving public expenditures reforms- discussed in detail in Section III-takes on greater urgency. Monetary Developments, Prices and In- terest Rates O "49 Puuv* 26. In recent years, broad money growth (See Figure A, 5) averaged nearly 19 percent but was consistent with i i , -. nominal GDP growth, low inflation and the increasing l demand for money as the economy became more mon- etized. Monetary growth has been led by an increase in foreign assets (26 percent per year) and by a healthy growth of credit to the private sector (19 percent per year) in recent . years. However, recently public sector borrowing re- quirements-especially in the last quarter of FY2001 increased significantly. In FY2002 also domestic borrow- ing pressures have increased due to lower revenues. 27. Consumer inflation rates have been low-averaging about 3 percent per annum in the past two years. The recent low inflation rates have benefited from good crops. A relatively stable exchange rate and import prices (imports are 31 percent of GDP) have also helped to keep inflation low. Although relatively low, inflation rates have varied across the different regions of the country. Consistent with the impact of low food prices, in FY2001 inflation was lowest (less than 1 percent) in the agriculture surplus Terai region, while it was 3 percent and 5 percent in Kathmandu and the hill regions respectively. In FY2002, . rifr ,g inflation is expected to increase to more than 5 percent partly because of the shortfall in paddy production. The trend in ... nominal interest rates in recent years has mirrored the de- cline of inflation rates partly in response to NRB policies of lowering interest rates and the growth of broad money. Both deposit and lending rates have fallen and a spread of around 5 percent has been maintained. While the responsiveness of - -, interest rates to inflation rates is encouraging, the continued - . . _ _ _ high spread between deposit and lending rate testifies to the structural problems in Nepal's financial sector, which is dis- cussed in the next section.  12  Progress In Implementing Reforms 28. The review of recent economic developments shows that the Nepali economy is going through a downturn at present. Without a strong program of reforms to reverse this downtum, Nepal will face difficult medium term economic prospects. This in tum will constrain Nepal's ability to attack poverty and accelerate human development. 29. Presentations during the NDF 2000 and the FY2001 and FY2002 budget speeches promised a new era of reforms, based on a poverty reduction agenda and with priority given to improvement in economic policy management, governance and regulatory reforms. Subsequently, an Interim Poverty Reduction Strategy Paper (I-PRSP) was pre- pared and as previously mentioned, the Tenth Plan-which will be the final PRSP-is now 13 under preparation. 30. The I-PRSP highlighted the following points: (i) poverty rates have been stagnant since the mid-1980s, despite an improvement in the first half of the 1990s; and (ii) slow progress in poverty reduction has been caused by low per capita income growth, stagnant agricultural growth, inadequate rural infrastructure and ineffective public expenditures. The main goal of the I-PRSP is to reduce the poverty rate to 10 percent in the next two decades. To achieve this, key intermediate targets are to: (i) raise GDP growth to 6.2 percent by FY2004, with the agricultural sector growing by 4 percent; (ii) reduce the popula- tion growth rate; (iii) build up rural infrastructure (power, irrigation and roads); (iv) improve Govemment services through decentralization; and (v) achieve universal primary education. 31. Reforms have been initiated in several areas, but in general, the implementa- tion of reforms has been uneven and much slower than expected. Reforms have been launched in fiscal and financial management, decentralization, infrastructure, the financial sector, and social sectors. The last session of Parliament (ending in October 2001) approved 22 bills, some of which legislate far-reaching reforms in economic management. Reforms that have progressed relatively well include those in taxation and infrastructure. There has been slower progress with the reforms in decentralization, financial sector and public expen- diture management, but the pace of reforms in the latter two sectors have picked up recently. Despite declared intentions, there has been very little progress in implementing civil service reforms and privatization.  Economic Policy Management and Regulatory Reforms 32. Fiscal Management: Fiscal management has been effective since the mid 1990s in maintaining fiscal and macroeconomic stability, but has been less effective as an instrument of development policy. Actual deficits have been less than budgeted and most of the deficits have been financed by concessional assistance or grants. On the other hand, the low tax-to-GDP ratio (about 11 percent) and weak management of public expendi- tures have hindered domestic resource mobilization and their effective use. Domestic re- sources have been inadequate and spread too thinly, especially in the case of development expenditures. The number of development projects-many of which were politically moti- vated-increased from 400 to more than 700 in the second half of the 1990s before being lowered to 613 project in the current fiscal year. Consequently, project implementation slowed and returns to public investment fell. Expenditure allocations for important items such as operations and maintenance have been severely under-funded. 33. A wide ranging program of tax reforms is being developed through the following measures: (i) passing legislation to strengthen VAT procedures, including requiring better maintenance of records; (ii) updating the import valuation system for customs and requiring payments to be handled through banks; (iii) passing the Income Tax Act of 2000 that consoli- dates tax laws, simplifies payment procedures and includes taxes on inheritance; (iv) expand- ing the income tax base to include commercial farming, exports, dividends and interest; (v) 14 Box 1: Key Recommendations of the PERC The PERC made several important recommendations on prioritizing public expenditures and functions, and improving financial management and civil service accountability in its March 2001 report. These recommen- dations included: (i) streamlining and rationalizing the role of the Government, Ministries and Departments with the aim of merging, delegating and eliminating functions to increase public focus on key public goods and services; (ii) prioritizing development programs and projects through: (a) establishment of more rigorous screening criteria for project selection and funding; (b) identification of projects to be cut, merged or given greater resource allocations; and (c) use of a project implementation performance system to allocate resources; (iii) identifying a five year expenditure prioritization framework (FY2002 to FY2006) that seeks to increase public savings, provide for debt servicing, contain the wage bill and rationalize defense and police expen- diture; (iv) pension reform (in the Civil Service Act) to make pension fimding more sustainable through a shared contribution system and a changed retirement age; (v) civil service/governance reforms to improve accountability and promote right-sizing in key Ministries (Agriculture and Cooperatives; Health, Information and Communications; Education and Sports, and Forest and Soil Conservation) that account for 61 percent of all civil service posts; (vi) strengthening administrative cost control systems through setting up of clear expenditure norms; (vii) improving financial management and internal auditing systems; and (viii) expanding the decentralization program, especially in education and agricultural extension services.  strengthening tax administration by combining the Departments of Taxation and VAT into the Inland Revenue Department; and (vi) strengthening anti-corruption measures by reducing harassment of taxpayers and requiring annual asset declarations by taxation officials. These are impressive reforms, which now need to be properly implemented. 34. On the expenditure side, the most important development has been the work of the PERC, whose March 2001 report made a number of far reaching recommendations to reform public expenditures (See Box 1). Several of these recommendations - prioritizing the development budget, introducing a medium term expenditure framework, pension re- forms, expanding decentralization - were adopted in the FY2002 budget. 35. To sharpen prioritization, the FY2002 budget increased the share of overall expenditures on important public goods and services, including education, health, local development, and agriculture. Appropriately, the share of public expenditures to sectors where the private sector has shown more interest has been cut-most notably, in the power sector. At a more disaggregated level, the budget contains signs of more intra-sectoral prioritization and provides higher allocations (relative to FY2001 actual expenditures) to the following important pro-poor programs. * primary education (an increase of 26 percent); * school textbooks (an increase of 5 percent); * primary health posts and sub-posts (increase of 216 percent); * HIV/AIDs prevention (increase by 124 times); * supply of medicine and instruments (increase of 29 percent); 15 * infectious disease control (increase of 129 percent); * family planning and mother and child programs (increase of 43 percent); and * extended vaccination program (increase of 104 percent). The FY2002 budget also incorporates a pruning of the development budget by announcing a core list of 100 projects whose implementation will be given priority. But there are still impor- tant issues in expenditure prioritization-e.g., the share of expenditures on road maintenance, rural water supply and maternal and peri-natal care appear to have been decreased. 36. After a hiatus, implementation of expenditure management reforms has picked up in recent weeks as the government has embarked on an exercise to prepare a Medium Term Expenditure Framework (MTEF) in five key Ministries10-Health, Education, Physical Planning and Works, Agriculture and Water Resources-to prioritize public expenditures in line with the preparation of the Tenth Plan/PRSP. Teams in these ministries have been working with the Ministry of Finance and the National Planning Com- mission (NPC) to prepare: (i) sectoral goals and outcome targets based on their missions; (ii) policies and programs to achieve those goals; and (iii) expenditure requirements to fund these programs. The final step is to prioritize these programs within realistic budget ceilings. While the exercise is off to a good start, it will be vital to ensure that the expenditure prioritization takes place within realistic budget ceilings, especially in the case of development expendi- tures.  37. The successful introduction of the MTEF will help to achieve three important goals. First, if done well, the MTEF will provide a budget constraint within which to design a realistic Tenth Five Year Plan, and in turn serve as the detailed financing plan of this Five Year Plan". Second, implementation of the MTEF will force the budget to focus on out- comes and results. Third, the MTEF will help to strengthen coordination of donor funding by putting Nepal in the drivers seat in deciding expenditure priorities in the context of well- designed sector strategies. But to be effective, progress with the implementation of the MTEF will need to be monitored through a proper expenditure tracking system and monitoring outcomes. Political support will also be needed to ensure that MTEF targets are respected in the actual implementation of the budget. 38. Poverty monitoring and analysis capacity also needs to be strengthened as an integral part of economic management. The I-PRSP has declared poverty reduction to be the over-riding objective of Government policies. In the context of the Tenth Plan/PRSP, it will be necessary to have a good poverty monitoring system and institutions to collect, monitor and analyze information on the impact of policies. The I-PRSP also refers to the importance of developing poverty monitoring systems. In this context, the next Nepal Living Standards Survey (NLSS) is being launched in the spring of 2002 to update household level information on trends in incomes and poverty and their determinants. However, institutional capacity for poverty analysis and its linkage to policy-making remains weak. To ensure consistent and regular evaluation, a small number of key indicators should be tracked at various levels of dis-aggregation and with different frequency. Work in this area has started 16 with support from UNDP and the World Bank. 39. Financial Sector Reforms: Nepal's financial sector development lags consider- ably behind neighboring countries as indicated by the low share of banking assets to GDP (See Figure 7, next page) and future development is threatened by the poor health of the banking sector. Around 60 percent of the banking sector assets are owned by two large banks-the Rastriya Banijya Bank (RBB), which is wholly Government-owned, and the Nepal Bank Limited (NBL), which is majority privately-owned. Through weak management, politically motivated lending and, possibly, insider lending, it has become evident that the quality of the assets owned by these two banks has sharply deteriorated-e.g., the share of RBB's non-performing loans is conservatively estimated to be 25 percent and the net insolvency of the two banks together might well exceed 6 to 7 percent of GDP. 40. A number of reforms are being implemented to strengthen the financial sector in line with the Financial Sector Strategy Statement issued in December 2001. These include: (i) reforming the Nepal Rastra Bank (NRB) to strengthen its autonomy and author- ity; and (ii) strengthening supervision and management of commercial banks. The approved NRB Act increases the independence and authority of the central bank, establishes transpar- ent rules governing hiring and firing of the Governor of NRB and gives NRB greater author- ity to supervise commercial banks, including taking over the management of troubled banks 10 The MTEF exercise focused on the following sectors: Health, Education, Agriculture, Irrigation, Roads and, Hydro Power. 11 Previously, the implementation of Five Year Plans has badly suffered from being de-linked from annual budget  and severely punishing irregularities by bank officials. In addition, the Deposit Taking Institu- tions Act (placed before Parliament) will tighten regulatory rules governing all bodies, includ- ing numerous non-banking financial institution that take deposits. Finally, after much delay, external management teams are being contracted to take over the management of RBB and NBL to help address their deep rooted management and financial problems. The manage- ment contract for RBB will be awarded to Deloitte and Touche, and the bid evaluation pro- cess is nearly complete for management contract offers in the case of NBL. The ability to move ahead steadily with the much-needed reforms in the financial sector will be important for restoring business confidence and accelerating financial development. Figure 7: Ratio of Bank Assets to GDP, period average 40% 1 35% 30% 25% 20%~ '15%4 10% 05% - Bangladesh India Nepal Pakistan Sn Lanka r