AT A GLANCE
In 2018, the World Bank came up with its Country Partnership Framework (CPF) covering the five-year period of FY2019-2023. Coincidentally, this came at a time of historic transformation in Nepal, as a new government took up office in February 2018. The signing of the Comprehensive Peace Agreement in 2006 ended a 10-year conflict that came at a significant cost of lives and foregone economic development. Since then, Nepal has gone through lengthy and complex transitions towards a new Constitution in 2015 that set in place a federal structure. By the end of 2017, elections were successfully held at the federal, state, and local tiers. There is a newfound optimism for greater political stability, inclusion, good governance and sustainable growth. The new federal structure presents unprecedented opportunities for Nepal to reset its development storyline, as outlined in the Systematic Country Diagnostic (SCD).
At the same time, the shift to federalism poses new challenges and source of fragility, given the heightened popular aspirations and expectations. Key challenges include the need to clarify the functions and accountabilities of the federal, state, and local governments; deliver basic services and maintain infrastructure development; create a conducive environment for the private sector; and address governance weaknesses that may worsen in the early years of the new federal system.
COUNTRY CONTEXT
In Nepal, the government formed in 2018 was preceded by elections for all three tiers (local, state and federal) of the state architecture defined by the new constitution, marking a protracted but successful conclusion of a political transition that began with the signing of the Comprehensive Peace Agreement in November 2006. State governments largely mirror the coalition at the center. At the sub-national level, funds, functions and functionaries hitherto managed by the central, district and village authorities are moving to the seven new states and 753 local governments for which new legislation, institutions and administrative procedures are being formalized as constitutionally prescribed. Meanwhile, the central level authority is being streamlined with a focus on oversight. These exercises at state restructuring are expected to result in improved outreach and service delivery but will likely take time before they become fully operational.
Significant adjustments need to be made to the government structure. They include amending over 400 existing acts, restructuring the civil service at all levels, devolving fiscal management, and determining the division of funds, functions, and functionaries between various levels of government. State restructuring on this scale is uncharted territory for Nepal and smoothening the transition from the previous unitary system to the new federal one will remain a daunting task. The new system, in principle, provides opportunities to decentralize development benefits and make service delivery more effective and accountable. However, the risks of jurisdictional overlap between the three tiers of government, lack of clarity and coherence between policies and devolved powers, and duplication of efforts will remain high during the coming few years. Key aspects of the new system require further definition and may continue to be contested by different population groups.
RECENT ECONOMIC DEVELOPMENTS
Nepal’s real GDP growth accelerated to 3.9 percent in FY24, up from 2 percent in FY23. The services sector was the key driver, fueled by a 30.7 percent surge in tourist arrivals, which boosted activities in transportation, accommodation, and food services. Increased hydropower production, by over 450 MW, plus a 4.3 percent rise in paddy production also contributed to the growth.
On the demand side, private consumption was bolstered by strong remittance inflows. Private consumption, accounting for more then 80 percent of GDP, grew by 1.1 percent in FY24, up from record low growth of 0.7 percent in FY23. Private investment, on the other hand, slowed, as evidenced by declining high-frequency indicators such as lower private investment commitments, reduced imports of intermediate and capital goods, and decreased credit to non-financial businesses. Public investment remained weak due to persistently low capital expenditure implementation, with public consumption following a similar downward trend, partly influenced by austerity measures.
Reduced imports and robust remittance inflows bolstered the current account balance, resulting in a surplus of 3.9 percent of GDP—the first in eight years. Remittance inflows increased to a nine-year high on the back of record high migration in FY23. Trade-related measured led to lower merchandise imports, particularly of intermediate goods, including reduced imports of crude edible oil following India’s tariff cuts, a drop in imports of broken rice and rice in husk (paddy or rough) driven by India’s export restriction (on broken rice) and the imposition of a 20 percent export duty (on rice in husk), and a decrease in unwrought gold imports due to higher customs duties. Electricity exports reached a record high, and service exports grew on the back of increased tourist arrivals. As a result, official foreign exchange reserves grew, covering 13 months of imports by the end of FY24.
Nepal’s fiscal deficit narrowed despite stagnating revenues, due to a sharp contraction in spending in FY24. The fiscal deficit (including grants) dropped to a seven-year low of 2.6 percent of GDP in FY24, largely due to a 2.2 percentage point reduction in recurrent spending, which resulted from lower fiscal transfers to subnational governments and austerity measures targeting recurrent expenditures. The spending reductions were focused on allowances, fuel, office supplies, and other administrative expenses. Government revenue (including grants) remained stable at around 19 percent of GDP in FY24, the lowest level of revenues in eight years.
The decline in spending also reflects deteriorating budget execution, a persistent issue since FY18, with budget execution rates falling below 80 percent both FY23 and FY24. Poor revenue collection and chronically low capital expenditure execution have affected budget execution since FY18. In addition, the common practice of bunching expenditures towards the last quarter or month of the fiscal year continues to be problematic, resulting in lower quality investments and inflationary pressures from surges in aggregate demand.
The lower fiscal deficit led to a slight reduction in public debt to 42.7 percent of GDP in FY24 from 42.9 percent at end FY23. Public debt remains sustainable, supported by a high share of concessional external debt, with domestic debt comprising 49 percent of the total and external debt accounting for 51 percent as of end FY24. Banks and financial institutions hold the bulk of the domestic debt.
Average headline inflation moderated to 5.4 percent in FY24, down from 7.7 percent in FY23, below the Nepal Rastra Bank (NRB)’s target of 6.5 percent. This decline was driven by a significant drop in non-food and services inflation, which fell from 8.6 percent in FY23 to 4.6 percent in FY24. Lower housing and utility prices, as well as reduced transportation costs due to lower fuel prices, contributed to this easing. Food and beverage inflation saw a slight decline of 0.2 percentage points to 6.7 percent, largely due to lower ghee and oil prices.
Monetary policy remained cautiously accommodative. At the start of FY24, the NRB reduced the policy rate by 50 basis points to 6.5 percent, followed by a further 100-basis point reduction to 5.5 percent in December 2023. The NRB aggressively absorbed over NPR 3.5 trillion liquidity in the second half of FY24, through the newly introduced standing deposit facility, which kept the interbank rate close to the lower bound of the policy corridor. During the first half of FY24, the actual interbank rate remained below the corridor’s lower bound.
Short- and medium-term nominal market interest rates declined, reflecting the lagged impact of lower policy rates and increased liquidity in FY24. Although real interest rates rose as inflation moderated, which, alongside higher remittance inflows, increased banking and financial institutions’ deposits as a share of GDP by 6.3 percentage points to 113.3 percent in FY24. However, private sector credit as a share of GDP remained stagnant. In response, the NRB introduced several measures aimed at stimulating credit growth, particularly in the real estate and manufacturing sectors.
The banking sector faced mounting pressures on asset quality, profitability, and capital adequacy. The nonperforming loans (NPLs) ratio reached a record high of 3.8 percent by mid-July 2024, leading to a 29.5 percent increase in loan-loss provisions. This, in turn, reduced net profits by 8.8 percent in FY24. While the banking sector’s capital adequacy ratio (CAR) remained well above the regulatory minimum of 11.5 percent (including a countercyclical buffer of 0.5 percent), emerging pressures are starting to challenge the sector’s resilience.
Outlook, Risks, and Challenges
Nepal’s real GDP growth is projected to accelerate to 5.1 percent in FY25 and 5.5 percent in FY26. Wholesale, retail, construction, and manufacturing sectors- that collectively account for over one-fifth of GDP-are poised to benefit from the NRB’s loosening of monetary policy and easing of regulatory requirements, including the relaxation of working capital requirements, easing of loan classification and loan-loss provisioning for businesses that continue servicing loans despite closures due to unforeseen circumstances. These measures are expected to stimulate private investment, while remittance-driven private consumption and increased exports of hydropower and tourism are anticipated to further bolster economic growth.
The services sector is forecasted to remain a key growth driver, with tourism, real estate, and trade leading the way. Accommodation and food services are expected to benefit from an increase in domestic and international tourism, fueled by government initiatives aimed at attracting 1.6 million international visitors in FY25 through various tourism promotion programs. This growth will also be supported by the presence of international five-star hotel chains currently operating in Nepal. Additionally, a recovery in merchandise imports is anticipated to boost the wholesale and retail sectors. Real estate services are poised for expansion, driven by NRB’s policies that include increased loan limits, higher debt-to-income ratios, and reduced risk weights for first-time homebuyers.
Consumer price inflation is expected to remain moderate, supported by softer global commodity prices and increased agricultural production. Lower inflation in India would help mitigate imported inflation, given Nepal’s currency peg. Although rising minimum paddy support prices, the removal of VAT exemptions on select goods, the imposition of VAT on services such as offline air transport and digital payments, and the introduction of excise duties on items like laptops may exert upward pressure on inflation, these effects are likely to be offset by the factors mentioned above.
The current account surplus is expected to narrow as the trade deficit widens. This widening will stem from a rise in both merchandise and service imports. Merchandise imports are projected to increase due to expected recovery of domestic demand, although their values may stay below the record high FY22 levels because of lower commodity prices and reduced electricity imports. On the export side, electricity exports are expected to rise significantly. Service imports are likely to increase as more Nepalese citizens emigrate for work and study, and as foreign exchange restrictions for outbound travel are relaxed. Conversely, service exports are expected to grow, driven by a strengthening tourism industry. Remittances are expected to stabilize at around 25 percent of GDP over the projection period, assuming peak migration in FY23. Under the baseline scenario, foreign exchange reserves are projected to remain sufficient to cover nine months of imports by the end of FY26. A low foreign direct investment (FDI) remains a key weakness.
A gradual reduction in the fiscal deficit is expected over the medium term, driven by decreased recurrent expenditure. New tax measures introduced in the FY25 budget, such as a green tax, the implementation of the recently approved Domestic Revenue Mobilization Strategy, the removal of VAT exemptions on select goods, and planned increases in duties on certain items, are expected to increase revenue collection. However, these effects may be partially offset by the reversal of certain tax amendments, for example, the cancellation of VAT on few food items. While capital expenditure is projected to rise, its execution is likely to remain constrained by the slow implementation of the national project bank. Public debt is projected to decline to 41.3 percent of GDP by the end of FY26, driven by smaller fiscal deficits and higher economic growth.
While the medium-term outlook for Nepal remains positive, it is subject to several downside risks. Increased vulnerabilities in the financial system, marked by a rise in non-performing loans, could curtail private sector credit growth. Policy discontinuity resulting from frequent changes in political administrations, along with the short tenures of officials, might deter investors. Delays in implementing capital expenditure could hinder infrastructure development, negatively impacting growth. Externally, regional instability and trade disruptions could reduce tourism and domestic demand. Natural disasters also pose additional risks to sustaining welfare gains.
There is also a risk that economic growth could slow if there is a shock in migrant-receiving countries. International remittances play a significant role in Nepal’s economy, affecting household consumption, poverty reduction, and human capital development. However, migration also poses challenges, such as high costs, unequal opportunities, and poor working conditions for migrants. The special topic section of this Nepal Development Update on international migration and household well-being highlights these key challenges and the necessary reforms. To maximize migration benefits and ensure long-term economic growth, the reforms should focus on implementing an effective and inclusive migration management system. This includes reducing migration costs, investing in education and training, promoting entrepreneurship among returnees, and improving the domestic economic environment.
Last Updated: Oct 02, 2024
