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.
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
Real GDP growth decreased to an estimated 1.9 percent in FY23, the lowest rate since FY20 and substantially below the 10-year average growth rate. Monetary tightening and the effects of import restrictions contributed to the slowdown. Economic activity was particularly subdued in the industry and services sectors, while agricultural output remained more resilient.
Strong energy sector growth helped to avoid an industrial contraction, since manufacturing and construction outputs shrank. Hydroelectric generation increased significantly for the second year in row and added close to 500 megawatts of hydroelectric power to the national grid. Nepal nevertheless remains a net energy importer.
Slow credit growth and import restrictions contributed to a reduction in private investment on the demand side. Lower capital expenditure and revenue underperformance drove lower public investment. As a result, total investment decreased by more than 10 percent, a sharper reduction than in FY20. Private consumption remained robust, owing to strong remittance inflows.
Inflation increased for the third successive year in FY23, and the increase was broadbased.Food prices rose due to supply side shocks and domestic policy changes.Non-food prices were pushed by higher housing and utility prices. The persistence of high inflation impedes an effective policy mix to stimulate growth while containing external imbalances.
Domestic policies and India’s trade restriction measures invoked a steep reduction of goods imports. Remittance inflows increased in FY23, following high outward migration in the previous year. Exports stagnated below their pre-pandemic level,caused also by a real appreciation due to Nepal’s persistently high inflation. Overall,the current account deficit decreased significantly, and the level of foreign currency reserves increased above its policy floor.
The central bank raised its policy rate in early FY23 to slow credit growth to the private sector and to support the correction of external imbalances. In synergy with import restrictions and higher international prices, credit growth to the private sector slowed compared to the previous year. Deposits grew at the same time, supported by higher real interest rates and several government incentives targeting remittance deposits.
The contraction of imports caused a sharp decline in fiscal revenues, as more than half of total revenues are trade related. Because expenditures contracted at a much slower pace than revenues, the fiscal deficit nearly doubled to 6.1 percent of GDP, the highest deficit recorded in more than two decades. Overall, public debt increased due to the weaker fiscal performance to 41.3 percent of GDP.
OUTLOOK, RISKS, AND CHALLENGES
Growth is expected to rebound to 3.9 percent in FY24 and 5 percent in FY25, supported by the lagged impact of lifting import restrictions and the gradual loosening of monetary policy. The continued expansion of hydroelectric production through the commissioning of new projects is expected to carry stronger growth in the industrial sector. Wholesale and retail trade are expected to benefit from the lifting of import restrictions and boost service sector growth. Only agricultural sector growth is expected to slow in FY24, due to the impact of the lumpy skin disease on livestock and a decline in rice paddy production. Inflation is expected to remain elevated, weighing on people’s real disposable incomes and private consumption.
Looser monetary policy and the lifting of import restrictions imply an increase in goods imports over the medium-term. Policies to contain credit growth and lower one-off imports, including of COVID-19 vaccines, are expected to keep imports below its FY22 historic high. Near-record migration of Nepali workers should be reflected in strong medium-term remittance inflows which, however, are not expected to balance the goods and services trade deficit. Consequently, the current account deficit is expected to widen to 3.7 percent of GDP in FY25, and 4.6 percent of GDP in FY25.
Revenues are expected to increase in line with higher goods imports, given that taxation focuses heavily on trade. The FY24 budget envisions lower federal spending on capital investment and fiscal transfers to subnational governments, yet higher debt servicing costs. Overall, the recovery of revenues is expected to reduce the fiscal deficit to 3.5 percent in FY24 and 3.3 percent in FY25. Together with the rebound in growth, tighter fiscal policy is expected to keep the overall public debt burden contained at around 41 percent of GDP in FY24 and FY25.
High inflation expectations continue to weigh on the outlook and require a careful balancing of policies to stimulate growth and to contain external imbalances and inflation. Lumpy skin disease and an erratic monsoon could way more than expected on agricultural output, and services and industry could be affected by higher-than-expected import prices or further export bans from India. The recent sharp increase in debt servicing costs highlights the importance of containing the fiscal deficit and ensuring sufficient fiscal space to undertake longer-term investments.
Last Updated: Oct 03, 2023