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FEATURE STORY

Nepal Economic Update April 2014 - Dealing With Excess Liquidity

April 22, 2014

STORY HIGHLIGHTS
  • Economic growth in Nepal is expected to recover to 4.5% in 2014.
  • The new government should focus on removing constraints to public and private investment to achieve accelerated growth.
  • The significant buildup of liquidity in the financial sector reflects both strong push factors and weak pull factors.

Recent Economic Developments

After a difficult year in FY13, economic growth in Nepal is expected to recover to 4.5% in 2014, according to the Nepal Economic Update April 2014. The rebound is expected to be driven by increased agricultural production and continued service sector growth supported by strong remittance inflows.

Inflation remains high in FY14, with the average for the fiscal year expected to be around 9.8%. This year, unlike in FY13, the main driver of inflation is food prices, despite expanded agricultural production, reflecting the extent to which prices of food in Nepal are tributary to those prevailing in India.

Nepal should achieve a twin surplus for the second year in a row, reflecting healthy developments - particularly domestic revenue mobilization - but also deep absorptive bottlenecks, which are really missed opportunities for growth.

First, the slow pace of budget execution has translated into a sizeable budget surplus that is not leveraged to build the country’s infrastructure. Second the sharp increase in remittances has more than made up for Nepal’s chronic trade gap but it has also resulted in a buildup of liquidity in the financial system that may be in excess of the private sector’s ability to translate it into sound credit.

The enabling environment for development has improved. The successful election and subsequent formation of a popularly mandated government provide a more conducive environment for private sector activity and economic policy. Going forward, it will be important for the government to signal, from the start, that increased political stability will be put to profit to tackle the country’s formidable challenges.

Policies and Development Challenges

The new government will have to focus resolutely on removing constraints to public and private investment without which growth will not accelerate significantly in the near future. 

Areas where the major bottlenecks to unlocking investment-supported growth include improving Public Financial Management systems, addressing systemic weaknesses in the budget preparation and execution process, continuing good governance initiatives and tackling issues in the two big and critical infrastructure sectors – transport and energy.

Outlook and Risks

For FY14, the outlook is cautiously optimistic. The previous assessment estimated that growth would reach 4-4.5% in FY14, essentially driven by increased agricultural output and improved execution of the budget. While the pace of capital expenditure may be below initial expectations, inward remittance inflows have been significantly above projected levels and should provide an additional boost to the services sector. On balance therefore, growth is projected to reach 4.5%, especially if capital spending picks up in the second half of the year.

Excess Liquidity – A “Fortunate Problem” … If Well Managed

As remittances have become a defining feature of the Nepali economy the country must learn to manage excess liquidity. The significant buildup of liquidity in the financial sector reflects both strong push factors (remittance inflows translating into a build-up of net foreign assets) and weak pull factors (slowing credit growth and loose monetary policy).

In the short term, the central bank, Nepal Rastra Bank (NRB) will need to strike a delicate balance between encouraging sound credit growth –so as to not compromise economic activity objectives- and containing inflation. At present this balance is particularly difficult to achieve because of uncertainties over the true health of the banking sector, weak risk management systems and market failures. The NRB may need to expand its toolset to deal with excess liquidity.

In the medium run, resolving structural bottlenecks to efficient credit market functioning is a precondition for monetary policy to operate more smoothly and efficiently and for ample available resources to be allocated to grow Nepal’s productive potential.