Nepal: IMF Reaches Staff-level Agreement on 4th Review Under the Extended Credit Facility

The Nepali authorities and the IMF have reached a staff-level agreement on the 4th reviewa staff-level agreement on the 4th review of under the Extended Credit Facility, which was approved in 2022. 

The agreement is subject to approval by the IMF’s Executive Board. Completion would make available SDR 31.4 million (about US$41.6 million), bringing total disbursements under the ECF thus far to SDR 188.3 million (about US$249.7 million), from a total of SDR 282.42 million (about US$380.2 million).

Important achievements during the review period include:

• Domestic Revenue Mobilization Strategy by the Ministry of Finance aimed at strengthening tax collection
• Action Plan by the National Planning Commission (NPC) aimed at improving execution of budgeted capital projects. 
• Incorporating most Extra Budgetary Funds accounts in the annual financial statements published by the Financial Comptroller General Office
• Publishing audited financial statements for some key public enterprises
• Finalization and full implementation of the Supervisory Information System for all banks
• Progress on the procurement of an independent international consultant to assist NRB in the conduct of the Loan Portfolio Review (LPR) of the 10 largest banks. 

Planned reforms include:

• Launch the LPR of the banking system
• Submit to Parliament amendments of the NRB Act
• Involve the service of experts with international experience in auditing and central bank auditing for an audit of NRB’s FY23/24 financial statements. 
• Publish annual financial statements by all majority and wholly owned public enterprises
• Publish audit of the financial statements of four priority public enterprises
• Implementation of key reforms in the 2023 Financial Sector Stability Report. 
• Publish a comprehensive tax expenditure report
• Publish a fiscal risk statement
• Revise and approve the National Project Bank Operational Procedures and the Unified Directives related to project development, prioritization, and selection
• Report consolidated financial information of all extrabudgetary operational funds
• Develop a strategy to deal with issues in the SACCO sector, including to reform the supervisory framework and architecture

Macroeconomic outlook

• Economic activity is expected to pick up with growth reaching 4.9 percent in FY2024/25, supported by stronger domestic demand. The cautiously accommodative monetary policy stance, planned increase in capital expenditure in the FY2024/25 budget, additional hydropower generation, and continued increase in tourist arrivals are expected to boost domestic demand and growth. 
• Inflation is expected to remain within the NRB’s target ceiling of 5.5 percent. 
• Nepal’s external position continues to strengthen, reflecting prudent policies, buoyant remittances, and subdued imports.
• Nepal’s medium-term outlook remains favorable as strategic investments in infrastructure, especially in the energy sector, are expected to support potential growth.

Macroeconomic stability and structural transformation in Nepal

It was published in The Kathmandu Post, 19 September 2023.

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Macro struggle and transformation

Latest data from fiscal year 2022-23 indicate a challenging economic landscape. While the external situation has improved and the banking sector is gradually emerging from a recurring liquidity crunch, fiscal and real sectors are under stress. Specifically, the large current account deficit and depleting foreign exchange reserves reversed course, and the availability of loanable funds in the banking sector improved along with the declining interest rates and sizable liquidity. However, gross domestic product (GDP) growth decreased while fiscal deficit, public debt and inflation increased.

It gives the impression of an economy struggling to maintain macroeconomic stability, especially after the onset of the pandemic. The effect is compounded by the unresolved structural issues affecting economic and social transformation for a long time.

Macroeconomic stability has been challenging due to external and internal reasons. Exogenous shocks, such as the Russian invasion of Ukraine and the ensuing effect on fuel and commodity prices have increased trade costs and inflation. Monetary tightening in the developed countries has depreciated the Indian rupee, to which the Nepali rupee is pegged. These are negatively affecting Nepal’s external sector performance. In response, the Nepal Rastra Bank tightened monetary policy, and the government banned the import of certain goods that were draining foreign exchange reserves. These were internal policy choices in response to the exogenous shocks—the interaction of both has affected macroeconomic performances.

Mixed performance

The cumulative effect is seen in the 2022-23 macroeconomic data. GDP growth is estimated to have dropped to 1.9 percent from above 4.5 percent in the last two fiscal years. This is primarily due to the contraction in both public and private investment and a slowdown in consumption and exports. In fact, public and private fixed capital investments are expected to contract by 20.2 percent and 55.9 percent, respectively, reflecting not only lower public capital spending but also dismal private sector investment. Manufacturing, construction, retail and wholesale trade activities—which account for about 28 percent of GDP—have also contracted.

The fiscal performance of the federal government was worse than expected. The contraction in revenue mobilisation and grants amidst high expenditure levels widened the fiscal deficit to over 7 percent of GDP, up from about 5.4 percent in the last fiscal year. According to the latest data from the Financial Comptroller General Office, tax revenue decreased by 12.1 percent and grants by 22.5 percent in 2022-23. It primarily reflects the sharp decrease in imports, in particular, as trade-based tax collections account for nearly half of the total tax revenue and economic slowdown in general. The government increased domestic and external borrowings to bridge the revenue and expenditure gap, pushing total outstanding debt to 41.3 percent of GDP in 2022-23. It was just 22.5 percent in 2014-15. Domestic debt servicing nearly doubled in 2022-23 due to high interest rates on government bills and bonds. The interest rate on 91-day treasury bills averaged 9.5 percent, the highest since 1997-98.

Monetary sector performance was broadly in line with expectations as tight monetary policies dampened credit growth. Deposit grew faster than credit (12.3 percent versus 5.5 percent) owing to a surge in remittance inflows and high interest rates. However, the high-interest rates and slowdown in aggregate demand discouraged private sector investment, resulting in private sector credit growth of just 4.6 percent compared to 13.3 percent in the previous fiscal. The weighted average deposit and lending rates reached 8.2 percent and 12.6 percent, respectively—the highest in the last decade. Inflation increased by 7.7 percent, the highest since 2015-16, owing to high fuel and commodity prices.

External sector performance, the main target of policy choices in the last two years, fared better. The current account deficit sharply decreased to 1.3 percent of GDP from 12.6 percent in 2021-22. It was mainly due to a drastic drop in imports (nearly 10 percentage points of GDP) and a pickup in remittance inflows, amounting to 22.7 percent of GDP. Foreign exchange reserves also increased to cover 10 months of import of goods and services, up from 6.9 months in 2021-22.

Structural issues

Beyond the short-term effects, this volatility or sharp readjustment of macroeconomic indicators points to unresolved structural issues that must be addressed through legal, regulatory, policy and institutional reforms. These structural issues should not be masked by the rosier economic outlook for 2023-24 compared to the last fiscal.

The vulnerability to exogenous shocks will continue to compound until a meaningful structural economic transformation. For instance, shifting from low- to high-value-added sectors with increasing productivity and employment opportunities will require less reliance on remittances for growth, poverty reduction, revenue mobilisation, banking sector liquidity and external sector stability. A high inflow of remittances supports high consumption (over 90 percent of GDP), which is fulfilled by imported goods and services without adequate domestic output. Foreign exchange earned from remittances is used to finance imports. Large-scale outmigration and remittances have been critical in reducing poverty, propping up real estate and housing businesses, and facilitating internal migration from rural to urban areas.

The government must ramp up capital budget execution to fund critical physical and social infrastructure and services and promote private sector investment to lay the foundation for a meaningful structural transformation. Capital budget execution, which averaged 61 percent in the last three fiscal years, is affected by prolonged government procedures leading to approval delays and coordination failures, structural weaknesses in project preparation, including inadequate consideration for climate change and natural hazards, and allocative inefficiency. The government needs to increase capital budget execution by addressing these constraints and also secure additional resources to improve overall capital expenditure. Amidst stagnating revenue growth and high fiscal deficit, they must rationalise recurrent expenses and reform loss-making public enterprises to create extra fiscal space to boost capital expenditure. The quality of capital spending is also crucial as it was hastily spent in the last quarter of the fiscal year when about 54 percent of actual spending or disbursement happens. In 2021/22, capital spending, a share of GDP, of federal, provincial and local governments was 4.4 percent, 2.2 percent and 3.4 percent, respectively.

Structural issues related to the financial sector—particularly, perennial asset-liability mismatch and the impact of high credit growth on the productive sector and aspired structural transformation—need rethinking. This might require reorientation of the monetary policy, addressing long-term structural issues in addition to short-term credit flows and interest rate volatility. To boost output and exports, overall productivity needs to be enhanced by lowering the cost of doing business, which will incentivise private sector investment and increase industrial capacity utilisation. 

Economic outlook and fiscal budget in Nepal

It was published in The Kathmandu Post, 11 May 2022. Background details are in this blog and Twitter thread.

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Economic outlook and fiscal budget

On the backdrop of disappointing national accounts estimates recently released by National Statistics Office (NSO), and an unsatisfactory fiscal performance but improving external sector situation so far this year, the government is busy in budget preparation for next fiscal year 2023/24. While tight monetary and fiscal policy measures mitigated external sector risks, particularly fast depleting foreign exchange reserves, they also squeezed aggregate demand as banking sector lending slowed down, industrial capacity utilization decreased and revenue mobilization shortfall widened as obligatory spending on salaries and social spending increased. It indicates a weak economy with unresolved structural issues and macroeconomic imbalances, which the upcoming budget will have to focus on.

Economic slowdown

The NSO projected gross domestic product (GDP) to grow by 1.9% in 2022/23, down from 5.6% revised estimate for 2021/22 and 4.8% for 2020/21. The growth estimate for this fiscal is also lower than the 8% target in budget and the recent estimates by multilateral institutions. The NSO estimate is based on data and information up to the first nine months of this fiscal (mid-July 2022 to mid-April 2023) and assumption of normal economic activities during the rest of the fiscal, which is not likely given the lower private sector confidence and lack of pick up in capital spending in the last quarter. Consequently, the statistics office may revise down estimates when it releases data next year. Note that seasonally unadjusted data show that the economy grew at just 1.7% in the first quarter and contracted by 1.1% in the second quarter of this fiscal. Seasonally adjusted quarterly GDP estimates show two consecutive quarters of economic contraction. 

The lower growth projection is attributed to contraction in manufacturing, construction, and retail and wholesale trade activities, which together account for about 28% of GDP. Specifically, manufacturing activities contracted by 2% owing to lack of adequate electricity supply during dry season— this despite electricity subsector registering the largest growth, 19.4%, in 2022/23 due to addition of new run-of-the-river type hydroelectricity to national grid, high interest rate, import restrictions and generally low government and consumer demand.  Nepal Electricity Authority cut supply by almost 12 hours to industries due to a slump in power generation during dry season. It increased the cost of production— including those of cement, rods, and steel industries—, leading to lower output and demand. 

Similarly, construction activities contracted by 2.6%, because capital spending slowed down and residential housing and real estate was hit by policy restrictions on real estate plotting and tight as well as high interest rates. This subsector previously benefitted from a highly accommodative monetary policy and lax supervision. Meanwhile, wholesale and retail trade activities contracted by 3% owing to restrictions on imports of goods, a slowdown in domestic industrial output, and lower income growth as lack of adequate electricity supply, inflation, and high input costs hit businesses and households. 

Overall, the tight monetary policy to maintain external sector balance, especially to narrow current account deficit and increase foreign exchange reserves, and lower public spending dampened aggregate demand, leading to lower-than-expected real GDP growth. While public and private investments contracted by 20.2% and 7.6% respectively, consumption expenditure grew by just 3.7%. The external sector situation and to some extent the financial sector indicators have improved but this has come at the cost of a slowdown in imports and overall economic activities.

Budget focus

Against this background, the next federal budget should focus on propping up aggregate demand while rectifying short-term macroeconomic imbalances. These include reducing fiscal deficit in view of large revenue expenditure gap, boosting private sector investment, reducing inflationary pressures, lowering interest rate volatility, maintaining financial stability, and maintaining external sector balance even after the withdrawal of policy restrictions on imports.

Expenditure-based fiscal consolidation through rationalization of subsidies and general government expenses, and better targeting of social protection programs including pensions system are urgently needed. Else, it will be difficult to manage recurrent spending with revenue mobilization. On revenue measures, the focus at the federal level could be on avoiding an inverted tax regime where tax rate on inputs is higher than that for final goods. Rationalizing distortionary tax expenditures such as exemptions, concessions, preferential rates, amnesties, and deferrals could also be prioritized. At the subnational level, strengthening revenue system and administration to bring more activities, including property levies, under the tax net could be helpful to reduce the overreliance of subnational governments on the federal government to meet their expenditure needs.

The budget should also focus on capital budget execution, which has receded to less than 60% in recent years. A public investment management regime that focuses on systematic identification, appraisal, approval and monitoring of investment projects, and a procurement regime that also priorities strict contract management could be helpful in this regard. 

Meanwhile, a single fiscal budget cannot resolve all structural issues, but it can take corrective steps as a part of a medium-term reform agenda to sustain high, inclusive, and sustainable growth. These include long running structural issues such as boosting overall productivity, inducing an industry-oriented structural change from low value-added services activities, promoting high-value and climate-smart agricultural sector, enhancing governance of and lowering fiscal risk from public enterprises, ensuring effective contract management and good governance, rationalizing as well as targeting of social protection programs, enhancing quality and climate-resilient infrastructure, and boosting human capital development. 

The budget could take preparatory steps to facilitate industry-oriented structure change by overhauling our energy generation and use strategy.  The share of the industry sector will naturally increase as more hydroelectricity projects get connected to the national grid. Hydroelectricity output now accounts for about 2.1% of GDP, sharply up from less than one percent a decade ago. It should be thought of both as a final product as well as an input to enhance economy-wide output and productivity. The budget could facilitate strategic use of excess electricity generation during non-dry season to boost output and productivity in manufacturing and services sectors. This will not only reduce imports and lower the current account deficit, but also boost growth and employment. Export of electricity should be a second priority for now. Furthermore, given the risk from climatic hazards, it is a good idea to start working on diversifying energy sources to wind and solar, and to increase the peaking or reservoir type hydroelectricity projects. Year-round adequate supply of electricity needs to be managed well so that the industries do not face shortage during certain months, and that consumers have incentive to shift to electric goods and appliances.

NSO projects Nepal’s GDP to grow by 1.9% in FY2023

On 02 May 2023, the National Statistics Office (NSO) estimated that Nepal’s economy will likely grow by 1.9% in FY2023, down from a revised estimate of 5.6% in FY2021. The latest estimate by NSO is lower than the estimates by the IMF, WB and ADB – all of which projected growth to hover around 4-4.5%. In its FY2023 budget, the government had targeted an ambitious 8% growth but lowered it to 4% during the mid-year review of the budget. Overall, performance in all sectors slowed down but manufacturing, construction, and retail and wholesale trade contracted. FYI, fiscal year (FY) starts from mid-July of t-1 year and ends on mid-July of t year (for instance, FY2023 refers to the period between mid-July 2022 and mid-July 2023).

FY2022 performance (revised estimate)

GDP grew by an estimated 5.6% in FY2022 led by industry and services sectors performance, thanks a surge in industrial output driven by hydroelectricity generation and services output driven by travel and tourism activities.

Agricultural output is estimated to have grown by 2.2%, down from 2.8% in FY2021 as unfavorable monsoon affected paddy output. Paddy harvest was affected by unseasonal torrential rain in October that also damaged physical infrastructure and killed over 100 people. The Ministry of Agriculture and Livestock Development said that an estimated 424,113 tonnes of paddy on 111,609 hectares had been destroyed. Industrial output grew by 10.6%, up from 6.9% in FY2021, thanks to substantial increase in additional hydroelectricity generation. Services output grew by 5.3%, up from 4.5% in FY2021 as travel and tourism, and wholesale and retail trade activities picked up pace.

FY2023 performance (provisional estimate)

NSO projected GDP to grow by 1.9% in FY2023, down from 5.6% revised estimate in FY2022 and 4.8% in FY2021. This was due to a slowdown in economic activities in general and contraction in manufacturing, construction, and retail and wholesale trade activities. Electricity, gas and related utility grew at the fastest pace (19.4%), followed by accommodation and food services activities (18.6%), and financial and insurance activities (7.3%).

The estimates are based on data and information up to the first nine months of FY2023 (mid-July 2022 to mid-April 2023) and assumption of normal economic activity during the rest of the fiscal year (mid-April 2023 to mid-July 2023). Note that the economy contracted by 1.1% in the second quarter of FY2023 and grew by just 1.7% in the first quarter. The government rolled back import restrictions from December 2022 and interest rates have began to come down in the last quarter of FY2023.

Agricultural output is projected to grow at 2.7%, up from 2.2% in FY2022, largely due to a normal monsoon that boosted paddy production. However, winter were affected by adverse weather and there was also a drop in production of milk, eggs, and meat, leading to less-than-expected agriculture output.

Industrial output is projected to grow at 0.6%, down from 10.8% in the previous year due to lower hydroelectricity addition compared to FY2022 and contraction in manufacturing and construction sectors.

Mining and quarrying activities are projected to grow at 1.1%, substantially down from 8l8% in FY2022, owing to the slowdown in construction sector, which affected mining and quarrying of stones, sand, soil and concrete. Construction activities contracted by 2.6%, from a growth of 7.1% in FY2022, because capital spending decreased that affected infrastructure projects, and residential housing and real estate got affected due to policy restrictions on real estate plotting and tight as well as high interest rate from banks. This subsector saw two consecutive years of about 7% growth after FY2020, thanks to highly accommodative monetary policy as credit growth shot up relative to deposit growth. A part of refinancing and business continuity loans, which were rolled out as a part of relief measures to help struggling businesses, also made their way to housing and real estate sectors.

Manufacturing contracted by 2%, from 6.7% growth in FY2022, as industrial capacity utilization dropped due to high cost of production, thanks to higher input prices and inflation, and lower consumer demand. This subsector has been suffering from low private sector investment, and loss of both domestic and external markets due to eroding cost and quality competitiveness. A stable supply of electricity and improved industrial relations were not sufficient to markedly boost manufacturing output as expected. Meanwhile, the addition of hydroelectricity to national grid has not been sufficient to bridge the electricity demand-supply gap during the dry season. NEA cut electricity supply by almost 12 hours to industries due to a slump in power generation. This has increased the cost of production, including those of cement, rods, and steel. Electricity gas and utility subsector grew at 19.5%, down from 53.4% in FY2022, as new small and medium scale hydroelectricity projects started generating electricity. Last year’s high growth was due to the addition of 465 MW Upper Tamakoshi hydroelectricity to the national grid.

Services output is projected to grow by 2.3%, down from 5.3% in FY2022, largely due to a contraction in wholesale and retail trade activities, which accounts for about 15% of GDP, by 3%. The monetary policy tightening, which not only discouraged imports but also led to an increase in interest rates, and restrictions on imports of certain goods squeezed wholesale and retail trade activities. This subsector contracted in FY2020 and FY2016— both times affected by supplies disruptions. Accommodation and food service activities are expected to keep growing at a robust pace— 18.6%, up from 12.6% in FY2022—, thanks to a strong pick up in domestic and international travel and tourism.

Information and communication activities are expected to grow by 4.1%. Financial intermediation is projected to grow by 7.3%, higher than 6.9% in FY2022, reflecting improved income of NRB, BFIs, insurance board and companies, securities board, social security fund, EPF and CIF. Real estate activities are expected to increase by 2.2%, up from 1.6% in FY2022, as the government loosened real estate plotting that facilitated sale, purchase, lease and other activities related to real estate. The spending related to parliamentary elections in November 2022 and byelections in April 2023 on security and public administration is expected to increase public administration and defense activities by 5.3%, up from 4.1% in FY2022. Healthcare related demand continues to remain strong, keeping its growth rate above 5% since FY2017.

Agriculture, industry and services sectors are projected to account for 29.4%, 16.4% and 54.2% of GDP in FY2023.

On the expenditure side, consumption is expected to slow down to 3.7% from 7.1% in the previous two years. Gross investment is expected to contract by 13%. Within it, public and private fixed capital investments are expected to contract by 20.2% and 55.9% respectively, reflecting not only lower public capital spending, but also dismal private sector investment. The former is affected by lower domestic resource mobilization and foreign aid and receding budget execution capacity of the government. The latter is affected by a range of factors such as government instability, high interest rate, high inputs costs including imported goods and energy, and low external demand. Even change in stocks contracted by 20.2%. While exports growth slowed down to 5.5% from 34.1% growth in FY2022, imports contracted by 17.2%.

Here are quick takeaways from the latest GDP projection.

First, the projection by NSO is slower than the estimates related days earlier by the IMF (4.4%), WB (4.1%), and ADB (4.1%). Quarterly provisional GDP data show that the economy contracted by 1.1% in the second quarter of FY2023 and it grew by just 1.7% in the first quarter. If economic activities do not pick up pace as expected, then annual growth may be even lower than currently projected by NSO. The industries are complaining about interrupted electricity supply (with some forced to use costly diesel generators during blackouts), low cash flow, rapid draw down of inventory and lack of stocking, high cost of imported inputs, high interest rates and low aggregate demand.

Second, the tight monetary policy to maintain external sector balance, especially to narrow current account deficit and increase foreign exchange reserves, and lower public spending dampened aggregate demand, leading to lower than expected real GDP growth, which at 1.9% is the lowest since FY2016 (except for the contraction in FY2020). While public and private investments contracted by 20.2% and 7.6% respectively, consumption expenditure slowed down to 3.7%. Moreover, while export growth moderated, the restrictive import regime as well as monetary policy tightening contracted total imports. Consequently, the external sector and to some extent the financial sector indicators have improved but this has come at the cost of a slowdown in imports and overall economic activities. Lower than expected capital spending and recurrent spending rationalization, partly due to lower revenue mobilization, also affected economic activities and banking sector liquidity.

Third, manufacturing, construction, and retail and wholesale trade— which together account for about 28% of GDP— contracted. It indicates not only lower industrial capacity utilization due to higher cost of higher cost of production including issues with electricity supply, inflation, and input costs, but also direct and indirect policy restrictions on real estate transactions, and deliberate measures to discourage imports. In April 2022, due to fast depleting foreign exchange reserve, the government imposed outright import restrictions on certain goods, including vehicles, and the central bank asked importers to maintain a 100% margin amount to open a letter of credit. These were relaxed in the third quarter of FY2023.

Fourth, nominal GDP increased by just 10.3%, lower than 13.1% increases in FY2022. This affected the level of public debt as a share of GDP. In FY2022, outstanding public debt stood at 42.6% of GDP, up a percentage point of GDP from FY2021.

Fifth, the size of Nepali economy is estimated at US$41.2 billion. Per capita GDP and per capita GNI are estimated at $1399 and $1410, respectively. GNDI (GNI + net current transfers incl remittances) is estimated to reach 125.2% of GDP. Gross domestic savings (GDP – consumption) is around 6.4% of GDP, reflecting a high level of consumption. The country’s population in FY2022 is estimated to be 29.5 million.

Sixth, with more hydroelectricity projects connected to the national grid, the share of the industry sector in GDP will also increase over time. Some sort of structural shift is happening. One of the major policy focuses should be to not only increase hydroelectricity generation, but also diversify energy sources to wind and solar to lower vulnerabilities associated with reliance in one sector and to strategically use excess electricity generation to boost production and productivity in manufacturing and services sectors. This should be prioritized before exporting electricity to neighboring countries. Hydroelectricity should be thought of both as a final product as well as an input to enhance economy-wide output and productivity. Moreover, since most of the hydroelectricity projects are run-of-the-river type, dry or winter season will see shortage of hydroelectricity output, forcing NEA to cut electricity supply to industries. Year-round adequate supply of electricity needs to be managed well so that the industries do not face shortage during certain months, and that consumers have incentive to shift to electric goods and appliances. Nepal's installed capacity was 2,650 MW as of April 2023, but during dry season it drops to around 800-1300 MW.

Seventh, with the lifting of policy restrictions on imports, gradual lowering of interest rates, decreasing inputs costs including fuel, loosening of real estate plotting and housing restrictions, and positive outlook for tourism as well as remittance inflows, the economic activities will pick up pace next year. Inflation may stay above 7% due to high food and energy prices. As imports increase and FDI and foreign aid (loans and grants) decrease, the current account balance may quickly deteriorate from current levels despite the expected rise in remittances. Banking sector liquidity will continue to be an issue due to less lending headroom, lower credit demand, and lower spending by the government. Long running structural issues such as stagnating revenue but rising expenditure thanks to fiscal profligacy, low capital budget absorption capacity, asset liability mismatch, evergreening of troubled assets and high non-performing loans, low exports but rising imports, sectoral bubbles, low private sector confidence, etc remain unchanged. Improving domestic resource mobilization and budget execution rate and taking decisive policy reforms to boost private sector confidence will be key.

India: Recent developments and economic outlook

In its 2022 Article IV consultation report on India, the IMF noted that the economy rebounded strongly from the pandemic-related downturn, supported by fiscal policy targeted at vulnerable groups and to mitigate the economic impact of commodity price increases. Front-loaded monetary policy tightening is addressing elevated inflation and a robust public digital infrastructure is facilitating innovation, productivity improvements and access to services. 

However, the India economy is facing new headwinds, including the adverse effect of climate change. These include high fiscal deficit that requires consolidation anchored on stronger revenue mobilization and spending efficiency; monetary policy tightening to rein in inflation and financial sector vulnerabilities; and financing and technology transfer to move to a carbon-neutral economy. This blog post includes key highlights from the report.

Recent developments

The economy benefited from broad-based recovery from the deep pandemic-related downturn. Real GDP grew by 8.7% in FY2022. All sectors recovered to pre-pandemic levels by end-FY2021/22 except for contact-intensive services, which remained 11% below FY2019/20 levels.

Due to growing domestic demand, commodity and food price shocks, and supply chain disruptions, inflation has been at or above the RBI’s inflation band of 4±2% since January 2022. The report notes that long-term inflation expectations remain relatively well anchored, but the risk of second-round effects from fuel and commodity price shocks remains high.  

Credit growth increased following relatively subdued growth over the past two years. Non-food bank credit growth was driven by stronger credit growth by private banks, mostly to MSMEs in the industry sector. However, credit gap (credit to GDP gap) remains negative, i.e. credit-to-GDP ratio remains below its long-term trend.

The external position in FY2022 was considered broadly in line with that implied by medium-term fundamentals and desirable policies (level of per capita income, favorable growth prospects, demographic trends, and development needs). Current account surpluses and large capital inflows boosted international reserves during the pandemic. The IMF assessed current account gap at 1% of GDP after accounting for transitory impacts of the COVID-19 shock. Current account deficit in FY2022 was 1.2% of GDP, reflecting recovering domestic demand and rising commodity prices. The widening current account deficit and portfolio investment outflows have depleted foreign exchange reserves in FY2023.  External shocks such as global financial tightening and the Russian invasion of Ukraine, and recovering domestic demand have put pressure on the exchange rate. Reserves are enough to cover around 7 months of prospective imports. 

General government fiscal deficit is estimated to decrease to 9.9% of GDP in FY2023 from 10% of GDP in the previous fiscal. Central government fiscal deficit declined to 6.7% of GDP in FY2022 (in its definition of central government deficit, the IMF also includes NSSF loans to central government PSUs and fully serviced bonds). The phasing out of some pandemic-related expenditures contributed to 1% of GDP reduction in spending. Buoyant GST and income tax revenues, thanks to improvements in tax administration and additional taxes on domestic crude oil production and fuel exports, helped boost revenue. The state government’s deficit is estimated to decline close to the medium-term target of 3% of state-level GDP, but variations in fiscal performance persist.  

The pandemic-related disruptions reduced access to education and trainings, adversely impacting human capital accumulation. Most affected were vulnerable groups, including females, youth, less skilled and educated, and daily wage and migrant workers. 

Economic outlook

Growth is projected to moderate amid higher oil prices, weaker external demand, and tighter financial conditions. The IMF projected GDP growth at 6.8% in FY2023 and 6.1% in FY2024. Growth is projected at around 6% over the medium-term. 

General government fiscal deficit is projected to moderate but will remain high: 9.9% of GDP in FY2023, 9% of GDP in FY2024 and then around 7-8% of GDP over the medium-term.

Inflation is projected to moderate to 6.9% in FY2023 as core inflation remains sticky and near-term uncertainties in food prices and input costs affect prices. Inflation is projected to return to the tolerable band over the medium-term. 

Current account deficit is projected to increase to 3.5% of GDP in FY2023 owing to higher commodity prices and import demand, and will decline to about 2.5% of GDP over the medium-term. 

Foreign exchange reserves are projected to cover about 6.5 months of imports over the medium-term. Net FDI inflows are estimated to be about 1.4% of GDP.

Risks to outlook: Uncertainty about the economic outlook is considered high and risk tilted to the downside. A materialization of these risks would worsen the economic outlook (lower growth and trade). 

External risks include a sharp global growth slowdown (affects India through trade and financial channels), and intensification of spillovers from the Russian invasion of Ukraine combined with supply and demand shocks in the global food and energy markets. These can worsen inflation and de-anchor inflation expectations. Over the medium-term, broadening of conflicts and reduced international cooperation can disrupt trade, increase volatility of commodity price, and fragment technological and payments systems. 

Domestic risks include rising inflation impacting vulnerable groups, emergence of more contagious COVID-19 variants, tighter financial conditions (weaken asset quality and result in financial sector stress), high financing costs due to weakening of fiscal position, climate change. 

However, upside risks include a resolution of the war in Ukraine and de-escalation of geopolitical tensions (will boost international cooperation, moderate commodity price volatility, and promote trade and growth). Also, successful implementation of structural reforms and greater than expected dividends from ongoing digital advances could increase medium-term growth potential. 

Fiscal policy: India’s fiscal space is at risk and debt sustainability risks have increased. The government will need to improve targeting to lower public spending. For instance, the reduction in fuel excise taxes and additional fertilizer subsidies are not well targeted. Revenue have been improving due to buoyant GST and income tax revenues. High debt levels (84% of GDP in FY2022) and substantial gross financing needs (15% of GDP) due to higher effective interest rates together with monetary policy tightening have increased debt sustainability risks. These risks are somewhat mitigated as the bulk of public debt are fixed-rate instruments denominated in domestic currency and predominantly held by residents per regulatory requirements. DSA shows that debt dynamics remain favorable in the medium-term and support a sustainable debt path. 

The government has targeted 4.5% of GDP central government deficit, implying a general government deficit of 7.5% of GDP (down from 9.9% of GDP in FY2023). The IMF recommends a clearly communicated medium-term fiscal consolidation plan to enhance policy space and facilitate private sector-led growth. It will also reduce uncertainty, lower risk premia, and help to maintain price stability. 

Fiscal consolidation should be facilitated by stronger revenue mobilization and improving expenditure efficiency. General government primary consolidation of around 1% of GDP and debt of around 80% of GDP by FY2028 could be targeted. 

Expenditure efficiency is possible through better targeting of subsidies, greater utilization of the existing social support infrastructure (DBT) to reduce leakages, rationalization of central schemes, reforming electricity tariffs and improving the financial viability of electricity distribution companies. 

Revenue measures can include reversing the fuel excise tax cuts, further broadening the corporate and personal income tax bases, simplifying the goods and services tax (GST) rate structure, rationalizing the items subject to preferential GST treatment, and continued improvements in tax administration, in line with international good practice. These measures would help narrow India’s tax gap, estimated at around 5% of GDP. Asset monetization and privatization agenda could generate additional receipts. 

Fiscal transparency will improve PFM. For instance, recognizing previously off-budget expenditure at the center and state level has improved transparency. Digital solutions have helped streamline PFM processes, advancing transparency and governance, including through e-procurement, faceless income tax assessments and the recent rollout of e-bills. Integrated Government Financial Management System along with a dedicated platform for central, state, and local governments to share fiscal information will support timely production of consolidated fiscal reports and identification of fiscal risks at the subnational level.  

Development beyond country averages

McKinsey Global Institute has an interesting article that highlights the importance of microregions as opposed to country averages to account for changes in growth and development. 

The concentration of global economic activity looks very different under a microregional lens. For instance, India and Portugal at the country level might have large difference (5x) in per capita GDP, but if we look at Goa (India) and Porto (Portugal) there is not much difference (GDP per capita of $33,000 in 2019).  We will see similar pattern in other countries and their cities in terms of life expectancy. 

MGI's analysis shows that half of the additional GDP generated from 2000 to 2019 came out of 3,600 microregions from a total of 40,000 as ranked by the increase in GDP per square kilometer. These 3,600 microregions were scattered across 130 countries but cover just 0.9% of the world’s land mass. 27% of the global population lived in them in 2019, totaling two billion people.

In India, they found 270 microregions home to 114 million people in 2019 where GDP per capita grew more than $7,100. The country average excluded them. Microregions with GDP per capita gains of at least $7,100 (or the top 30% globally) were considered. 

They also regressed five-year moving average annual growth rates at the microregional level on annual growth at the country level to estimate the explanatory power of country-level growth. The result showed that a country’s GDP per capita growth rate can explain only 20% of the variation in the microregional growth rates in that country.

CBS projects Nepal's GDP to grow by 5.8% in FY2022

On 29 April 2022, Central Bureau of Statistics (CBS) estimated that Nepal’s economy will likely grow by 5.8% in FY2022, up from 4.2% growth in FY2021 (this is revised estimate). This projection is a bit more optimistic than what most have expected but is still lower than the government’s 6.5% growth target. The gradual resumption of economic activities, including tourism and hydroelectricity generation, with no disruption caused by the pandemic and the expectation of local elections related spending have driven the optimistic projection. FYI, fiscal year (FY) starts from mid-July of t-1 year and ends on mid-July of t year (for instance, FY2022 refers to the period between mid-July 2021 and mid-July 2022).

FY2021 performance (revised estimate)

GDP in FY2021 grew by 4.2%, up from a contraction of 2.4% in FY2020, thanks to a combination of base effect and resumption of economic activities as the pandemic related restrictions eased. Base effect refers to the tendency of achieving an arithmetically high rate of growth when starting from a very low base.

Agricultural output is estimated to have grown by 2.8% in FY2021 owning to favorable monsoon and a surge in agricultural workers (lockdowns forced reverse migration and contributed to more migrant workers’ engagement in agricultural work) that had a positive effect on paddy output. Industrial output grew by 4.2% from a contraction of 4% in FY2020 as mining and quarrying, manufacturing, and construction activities picked up pace after contraction in FY2020. Services output grew by 4.2% from a contraction of 4.5% in FY2020 as wholesale and retail trade, travel and tourism, financial and insurance and healthcare activities gradually recovered from severe slump in the previous year.  

FY2022 performance (provisional estimate)

The CBS projects GDP to grow by 5.8% in FY2022, up from 4.2% revised estimate for FY2021, thanks to a surge in industrial output driven by hydroelectricity generation and services output driven by travel and tourism activities. Overall, while public investment contracted, private investment and consumption increased. 

Agricultural sector will likely contribute 0.7 percentage points, industrial sector 1.6 percentage points, and services sector 3.2 percentage points to the overall projected GVA growth (basic prices) of 5.5%. GVA at basic prices + taxes less subsides = GDP at market prices.

The sectors with highest growth include electricity, gas and related utility (36.7%), followed by accommodation and food service activities (11.4%), construction (9.5%), wholesale and retail trade (9.1%), mining and quarrying (8.2%), and human health and social work activities (6.9%) among others. 

The estimates are based on data and information up to the first nine months of FY2022 (mid-July 2021 to mid-April 2022) and assumption of normal economic activity during the rest of the fiscal year (mid-April 2022 to mid-July 2022). 

Agricultural output is projected to grow at 2.3%, up from 2.8% in FY2021, largely due to unfavorable monsoon, which affected paddy output. Paddy harvest was affected by unseasonal torrential rain in October that also damaged physical infrastructure and killed over 100 people. The Ministry of Agriculture and Livestock Development said that an estimated 424,113 tonnes of paddy on 111,609 hectares had been destroyed.

Industrial output is projected to increase by 10.2%, up from 4.5% in the previous year, on the back of a substantial increase in additional hydroelectricity generation. Mining and quarrying activities grew by 8.2%, up from 7.5% in FY2021, as residential housing and real estate and development work including hydropower, picked up pace. Mining and quarrying of stones, sand, soil and concrete also get affected by construction sector. Construction activities grew by 9.5%, up from 5.2% in FY2021, as supplies of construction materials normalized (both import and domestic supply), and households, commercial and infrastructure projects picked up pace. It was aided by highly accommodative monetary policy as credit growth shot up relative to deposit growth. A part of refinancing and business continuity loans, which were rolled out as a part of relief measures to help struggling businesses, also made its way to housing and real estate sectors.

Manufacturing grew by 6.1%, up from 4.1% in FY2021, as industrial capacity utilization improved from resumption of economic activities. It has been suffering from low private sector investment, and loss of both domestic and external markets due to eroding cost and quality competitiveness. A stable supply of electricity and improved industrial relations were not sufficient to markedly boost manufacturing output as expected. Meanwhile, the addition of 456MW of electricity from Upper Tamakoshi hydroelectricity project sharply increased electricity output, propelling its growth to 36.7% from just 2.6% in FY2021. However, this has not been sufficient to bridge the electricity demand-supply gap during the dry season. The NEA recently was compelled to introduce loadshedding for industries due to large demand-supply gap and lower imports from India. This could weigh in on the sector’s eventual gross value added output. 

Services output is projected to grow by 5.9%, up from 4.2% in FY2021, thanks to pick up in travel and tourism, and wholesale and retail trade activities. The latter is expected to grow by 9.1%, up from 5.7% in FY2021 as supplies disruptions eased and consumer demand picked up pace, which was also aided by loose monetary and fiscal policies. Surge in import of agricultural and industrial goods in the first two quarters aided. Due to the deterioration of external sector stability and a decline in forex reserves, the government and the central bank started tightening import financing and, in some cases, outright ban on imports. This will affect the sector’s growth in the last quarter of FY2022. Transportation and storage activities are expected to grow by 4.5%, almost at the same rate as in the previous year, despite loosening of international and domestic travel restriction. However, travel is still expensive, which is exacerbated by the increase in fuel prices triggered by Russia’s invasion of Ukraine. Accommodation and food service activities are expected keep growing at a robust pace— 11.4%, up from 10.7% in FY2021—, thanks to a strong pick up in domestic travel and tourism.

Information and communication are expected to grow by 3.6%, up from 1.8% in FY2021. Financial intermediation is projected to grow by 6.1%, higher than 4.0% in FY2021, reflecting improved income of NRB, BFIs, insurance board and companies, securities board, social security fund, EPF and CIF. Real estate activities are expected to increase by 3.8%, up from 2.4% in FY2021, as sale, purchase, lease and other activities related to real estate picked up pace. The proposed local elections related spending on security and public administration is expected to increase public administration and defense activities by 4.4% from 2.3% in FY2021. Healthcare related demand continues to remain strong, keeping its growth rate above 5% since FY2017. 

Agriculture, industry and services sectors accounted for 29.4%, 16.3% and 54.4% of GDP in FY2022.

On the expenditure side, consumption is expected to increase by 5.4%, up from 3.7% in FY2021. While public grows fixed investment contracted by 6%, private fixed investment grew by 8.8%. They grew at 22.2% and 5.6%, respectively in FY2021. Net exports are expected to grow at 12.1%, thanks to exports growth being much higher than imports growth. In fact, imports are expected to grow at a lower rate in FY2022 than in FY2021 as the government and the central bank tightened import financing and at times imposed outright import ban. 

Here are quick takeaways from the latest GDP projection.

First, it may be a bit optimistic projection even after accounting for local elections related spending and normal economic activity in the last quarter of FY2022. The remains three months will be anything but normal in terms of economic activities. Import restrictions, deceleration of official remittance inflows, depreciation of Nepali rupee, rising energy and commodity prices, restrain in government recurrent spending to some extent, and the scheduled electricity blackouts for industries, among others, will depress output and aggregate demand. When revised or actual figures are released, it might be adjusted to around 4.5-5.0%.

Second, the outlook for FY2023 is not rosy. 

• First, despite the projection of above average monsoon (June to September 2022), the uncertainty over supply of other inputs (chemical fertilizers, access to seeds, access to finance, etc) dims agricultural sector’s growth prospects. Specifically, the shortage of chemical fertilizers will be painful because a good monsoon may increase the area of paddy plantation, but it will not necessarily increase output per hectare of land. Chemical fertilizers are key ingredients to boosting total output and output per hectare of land (productivity). 
• Second, the slowdown in residential and commercial real estate and housing will affect mining and quarrying, and construction activities. The surge in real estate and housing prices, fueled by easy financing even during the pandemic, has started to taper off as banks and financial institutions tighten lending. 
• Third, with no drastic addition of hydroelectricity to the national grid and the scheduled electricity blackouts for industries, utility and manufacturing activities may not pick up pace. In fact, industrial capacity utilization may decrease because of both high fuel prices and shortage of electricity. This will be exacerbated by the shortage of imported industrial inputs (industrial raw materials and intermediate goods) either due to outright ban on import of certain goods or tight foreign currency financing to slowdown imports. Factories are enduring up to 14 hours of blackouts due to low generation during dry season and expensive import price of electricity through the power exchange from India. Between 2007 and 2017, the country is estimated to have lost over 6% of GDP due to loadshedding. 
• Fourth, high energy and fuel prices will also affect services sector activities because a rise in cost of production and inflation will dampen consumer demand. For instance, wholesale and retail trade, and transportation and storage will get affected by both import restrictions and high energy and commodity prices, especially through lower consumer demand as real purchasing power weakens. These two sectors account for about 21% of GDP. Similarly, international and domestic travel, and accommodation and food services will remain expensive, restraining these sectors from sustained recovery.

Against the backdrop of dampening consumer demand due to high cost, deceleration of remittances and tighter monetary policy, slight pick up in travel and tourism and federal and provincial elections related spending may not be enough to sustain GDP growth above 5%. A sustained V-shaped recovery looks less likely.

Third, external sector stress is building up. Since import of petroleum fuel constitutes about 15% of total imports, the import bill is rising sharply. Import demand for petroleum products is relatively inelastic given the lack of immediate substitutes. The import bill of petroleum products in the first eight months of this fiscal year 2021/22 is already higher than the total import of petroleum products for the whole of 2019/20. Note that rise in petroleum fuel prices passes through to other goods as well because it is used in production process and transportation of the goods. Hence, import bill of other goods such as vehicles, machinery and agricultural items is also increasing. Import bill of wheat, rice, crude soya bean oil and edible oil has also increased. Despite gradual recovery in exports, the large import bill has increased import bill by 34.5% in the first eight months of this fiscal. This combined with the deceleration of remittance inflows amidst modest services recovery led by tourism sector widened current account deficit by around 200% in the first eight months of this fiscal. Consequently, balance of payments remains in negative territory with a depletion of foreign exchange reserves which are sufficient to cover 6.7 months of import of goods and services. It was 11.3 months in mid-March 2021. The rapid rise in energy and food prices poses a significant risk to external sector stability. Restricting non-essential imports is a band-aid solution to the structural issue.

Fourth, the recent deterioration of macroeconomic indicators precedes the highly accommodative fiscal and monetary policies after the pandemic started. The vulnerabilities were building up, but the accommodative policies simply masked them. As exogenous forces triggered external sector stress amplify and pandemic related support measures are gradually withdrawn, the vulnerabilities not only unmasking but also exacerbating (stagnating revenue but rising expenditure, low capital budge absorption capacity, asset liability mismatch, evergreening and non-performing loans, low exports but rising imports, sectoral bubbles, etc). For instance, fiscal profligacy led to higher deficit especially after federal, provincial, and local elections in FY2017. Total federal expenditure increased by an average 19.3% between FY2017 and FY2022 (includes budget estimates), but total federal receipts increased by only 14.2%. Consequently, average fiscal deficit was above 5% of GDP. Fiscal balance was either under 3% of deficit or outright surplus (due to low capital spending) before FY2017. This large and growing fiscal deficit increased public demand (consumption and investment) and boosted imports. Meantime, public debt also started rising rapidly. It was just 22.7% of GDP in FY2017 but rose to 40.6% of GDP by FY2021. With this also increased debt servicing costs. 

Similarly, the loose monetary policy and a weak oversight encouraged higher credit growth relative to deposit growth. It was fueled by remittance inflows as well. For instance, the average annual growth rate of deposit over FY2017-FY2021 was 18.3% compared to credit (loans and advances) growth of 21.2%. The weak banking sector oversight fueled real estate, housing, and stock markets bubbles, and encouraged imports. The increase in imports, which increased revenue that incentivized the government to ignore early warning signs of vulnerabilities build up (45% of revenue is import based), started draining foreign exchange reserves after the pandemic at a pace that is perceived to be unsustainable unless corrective actions are taken. During the first eight months of FY2022, foreign exchange reserves were sufficient to cover 6.7 months of import of goods and services. It was 11.3 month in mid-March 2021. Given the currency peg with the Indian rupee, vulnerability to natural disasters and the need for an additional buffer for remittances and tourism-related vulnerabilities, the optimal level of reserves is estimated to be 5.5 months of prospective import of goods and services. The country earns foreign exchange reserves mainly through exports, travel and tourism, investment income, remittances, grants and loans, and foreign direct investment— all of which are below the pre-pandemic level. So, the raft of measures to discourage imports recently in response to the fast-depleting foreign exchange reserves is just a band-aid solution to structural issues. The solution should start with tightening of monetary policy and measures to rein in government spending.

Fifth, the rising inflation— thanks primarily due to high prices of petroleum fuel, LNG, and imported goods— will have a disproportionate effect on the most vulnerable people. The lowest income and poorest households are hit the hardest by increase in fuel and food prices because it constitutes about 65% of their consumption expenditure. For the richest households in the consumption quintile, it is just 34.6%

Sixth, the size of Nepali economy is estimated at US$40.2 billion. Per capita GDP and per capita GNI are estimated at $1364 and $1380, respectively. GNDI (GNI + net current transfers incl remittances) is estimated to reach 123.3% of GDP. Gross domestic savings (GDP – consumption) is around 9.3% of GDP, reflecting high level of consumption. The country’s population in FY2022 is estimated to be 29.5 million.