Saturday, November 5, 2011

Nepal needs structural reforms to raise productivity and economic growth, says the IMF

The IMF, in its latest 2011 Article IV Consultation with Nepal, argues that Nepal needs to work on enacting structural reforms to raise productivity and potential growth. Nepal’s productivity growth has not kept pace with neighboring countries and lacks competitiveness. Furthermore, it notes that banking sector risks have intensified due to the proliferation of BFIs amidst weak supervision. Maintaining macroeconomic stability and managing financial sector risks are the two most challenging tasks of the Nepalese economy. The IMF thinks that the exchange rate with India is overvalued and is hampering Nepal’s competitiveness.

The report report notes that “living standards in Nepal have improved markedly over the past decade thanks to increased remittances, supportive social programs, and generally prudent fiscal policy that almost halved public debt as a share of GDP”. Here is a previous assessment by the IMF.

Prospects for 2011/12

  • It expects the Nepalese economy to grow at 3.8 percent in 2011/12 (revised downward from preliminary estimate released in August), with good agriculture output compensating for subdued non-agriculture activity.
  • Inflation is expected to be 8 percent due to an expected moderation in India’s inflation and a stabilization of commodity prices.
  • The external current account deficit is projected to remain around 1 percent of GDP, but the import cover of foreign reserves is expected to decline.
  • The target to limit net domestic financing to 2 percent of GDP might not be achievable due to moderate economic activity and a significant increase of current spending.
  • Total revenue and grants are expected to be 18.3% of GDP, but expenditure is expected to be 21% of GDP.
  • Net domestic financing is expected to increase to 3.3% of GDP from 2.8% of GDP in 2010/11.
  • Money supply growth is expected to 11.1% from 9.5% in 2010/11.
  • Gross investment is expected to be 32.8% of GDP and gross savings is expected to be 32% of GDP.
  • Current account is expected to remain negative by around US$ 156 million. Trade deficit is expected to touch 24.4% of GDP. Exports growth is expected to be 9%, but imports growth are expected to be 10.8%.
  • With the expected reserves, Nepal is expected to fund imports of goods and services of 5 months only, down from 5.4 months in 2010/11 and 6 months in  2008/09.

Performance in 2010/11

  • Inflation has remained high, averaging about 9.5 percent in 2010/11.
  • The balance of payments was under pressure for most of the year due to high oil prices, slowing remittances, and weakening competitiveness, though it ended with a modest surplus.
  • The adoption of the budget by the Constituent Assembly was delayed by 7 months due to the political situation.
  • Revenue and spending underperformed the budget targets, net domestic financing exceeded its target, and large losses were incurred by the Nepal Oil Company. Reflecting these developments and heightened stress in the banking system, growth slowed to 3.5 percent from 4.5 percent the previous year.
  • Mixed progress was made in implementing policy commitments under the Rapid Credit Facility (RCF), approved in May 2010.
  • In the banking sector, asset quality has deteriorated and liquidity pressures increased following the bursting of a bubble in the real estate market, to which banks are significantly exposed.
  • In response, monetary policy eased and liquidity support was extended to institutions in stress, regulatory forbearance measures were implemented, and a widening of deposit insurance was announced. Restructuring of the weak state banks and reform of key bank legislation have been delayed.

Needed reforms

  • Address the substantial risks in the financial sector with utmost priority. The existing regulatory forbearance is unsustainable.
  • There is a need to strengthen supervision, regulatory environment, and banks’ corporate governance.
  • Improving the central bank’s emergency liquidity facilities. Develop an effective crisis management framework that would facilitate timely intervention and resolution of problem banks.
  • Strictly enforce the moratorium on new bank licenses.
  • Timely adoption of the 2011-12 budget with an appropriate target for net domestic financing.
  • Boost revenue by further strengthening administration and refocusing the tax structure toward domestic sources.
  • Phase out unproductive subsidies while safeguarding pro-poor spending.
  • Introduce an automatic fuel price adjustment mechanism to limit the losses of the Nepal Oil Corporation.
  • The exchange rate peg has served Nepal well and continues to be a near-term policy priority, and safeguarding it requires a firmer monetary policy stance and targeted rather than blanket liquidity provision for solvent banks facing short-term pressures.
  • The exchange rate appears overvalued, and stressed the importance of boosting productivity.
  • If sustained and significant downward exchange-rate pressure were to emerge, preservation of official reserves and an adjustment of the peg would need to be considered.

There are signs that the government will not and won’t be able to adhere to the recommendations of the IMF. Here are few examples:

  • The call for a moratorium on new bank licenses will not be adhered to as the government has pretty much made up its mind to upgrade Sanima Bank to commercial bank category from development bank category. The priority should have been consolidation of BFIs in all the four categories. The recent banking troubles can be attributed to the large number BFIs amidst weak supervision and limited playing field, among others. Read my earlier long pieces on the same issue here and here.
  • With the recent plan to integrate up to 6,500 Maoist combatants in the national army, provide rehabilitation package of Rs 0.6 million to Rs 0.9 million to a combatant depending on his rank, and cash incentive of half million to 800,000 million rupees to combatants opting out of integration as well as rehabilitation package, the government will need at least an additional Rs 10 billion on top of the amount allocated in the budget. It means the plan to stick net domestic borrowing to 2% of GDP (it was 2.8% of GDP in 2010/11) will be breached (also due to weak economic activities leading to low growth of revenue receipts and high growth of current expenditure). Donors have already signaled that they don’t have funds allocated for this new development.
  • The banking sector reforms are slow. There still is not a dedicated fund or facility (something like the Troubled BFIs Relief Package) to look after troubled BFIs. Things are done in ad hoc basis.
  • Keeping inflation below 10 percent will be a challenge because of the hike in transport prices; a potential hike in petroleum prices (India recently did it); high demand for diesel and petrol to run generators during the dry season when load-shedding could reach up to 16-19 hours a day, leading to high NOC losses plus increase in general prices as cost of production increase.
  • With plans to introduce Employment Guarantee Scheme and a number of other employment-focused programs, there will be pressure on finding funding sources, given higher growth of recurrent expenditures than revenue receipts. The employment guarantee scheme could cost as much as 1.29 percent of GDP (or 2.14 percent of budget).
  • The exchange rate won’t be changed even though it appears overvalued right now.
  • The trade deficit is expected to further worsen without the needed industrial reforms to boost competitiveness of Nepalese exported items.

Selected Economic Indicators (IMF estimate and projection)
  2008/09  2009/10 2010/11 (Est.) 2011/12 (Proj.)
Output and prices (annual percent change)
Real GDP 4.4 4.6 3.5 3.8
Non-agricultural GDP 4.1 5.4 3.1 2.9
CPI (period average) 12.6 9.6 9.5 8
CPI (end of period) 11.1 9 9.4 8.1
Fiscal Indicators (in percent of GDP)
Total revenue and grants 16.6 18 18.4 18.3
Expenditure 19.2 19 20.1 21
Expenses 16.4 16.1 16.8 17.7
Net acquisition of NFA 2.8 2.9 3.3 3.3
Net lending/borrowing -2.6 -1 -1.8 -2.7
Net acquisition of FA -0.4 -1 -1.2 -1.1
Net domestic financing 3 2 2.8 3.3
Money and credit (annual percent change)
Broad money 27.3 14.1 9.5 11.1
Domestic credit 27.1 16.8 13.2 15
Private sector credit 29 14.2 11.8 6.4
Velocity 1.6 1.6 1.7 1.7
Investment and saving (in percent of nominal GDP)
Gross investment 31.5 35.8 35 32.8
Private 24.6 28.6 27.1 24.8
Central government 6.9 7.2 7.9 8
Gross national saving 35.7 33.4 34.1 32
Balance of payments
Current account (in millions of U.S. dollars) 536 -378 -167 -156
In percent of GDP 4.2 -2.4 -0.9 -0.8
Trade Balance (in millions of U.S. dollars) -2,707 -4,078 -4,474 -4,975
In percent of GDP -21.1 -26 -24.4 -24.4
Exports value growth (percent change) 0.5 -6.1 13.9 9
Imports value growth (percent change) 14.1 36.4 10.4 10.8
Gross official reserves (in millions of U.S. dollars) 2,907 2,844 3,098 3,180
In months of imports of goods and services 6 5.4 5.4 5
Memorandum items
Public debt (percent of GDP) 39 36 34 35
GDP at market prices (in billions of Nepalese rupees) 988 1,171 1,327 1,487
GDP at market prices (in billions of U.S. dollars) 12.9 15.7 18.3 20.4
Exchange rate (Nrs/US$; period average) 76.9 74.5 72.4
Real effective exchange rate (eop, y/y percent change) 3.5 7.3