publication

Nepal Development Update


A woman working in a factory in Nepal and Nepal Development Update tagline
Nabin Baral/World Bank

The Nepal Development Update is produced once a year to report on key economic developments that occurred during the year, placing them in a longer-term and global perspective, and to examine topics of particular policy significance. The Update is intended for a wide audience including policy makers, business leaders, the community of analysts and professionals engaged in economic debate, and the general public.

Download the latest Nepal Development Update ( April, 2022)  here 

Recent Economic Developments

Nepal continues to struggle with the COVID-19 pandemic, but the ongoing COVID-19 vaccination drive has helped to reduce the fatality rate. The country experienced a first wave in March 2020, a second wave in mid-April 2021, and a third wave in January 2022. In response, social distancing measures were imposed but gradually became less stringent as COVID-19 progressed from the first to the third wave, driven in part by the COVID-19 vaccination drive that began in January 2021. Vaccination also contributed to a reduction in the fatality rate. As of March 2022, more than 60 percent of the population has received two doses of COVID-19 vaccines.

High frequency indicators suggest that the economy continued to recover in the first half of FY22 after rebounding in FY21 from a contraction in FY20. The services sector is estimated to have been a primary driver of growth in the first half of FY22, with mobility data indicating a strong recovery in wholesale and retail trade, transport, and financial services, supported by an increase in vaccinations and continued COVID-19 related fiscal and monetary stimulus packages. Tourism and tourism-related activities have also recovered with a rise in international tourist arrivals, although they remain below pre-pandemic levels. The industrial sector also contributed to growth on the back of higher installed capacity of electricity, including from the recently completed Upper Tamakoshi Hydropower Project (456 MW). However, the agricultural sector is estimated to be a drag on the growth due to a significant drop in main season paddy production following unseasonal rains in October 2021.

Labor market exposures to the COVID-19 crisis in Nepal were significant, and vulnerable households in Nepal face the risk of falling back into poverty. New analysis based on the SAR COVID-19 phone monitoring survey1 suggests that job recovery, for those who lost jobs during the pandemic, was low and accompanied by a decline in job quality and earnings. Of those employed in January 2020, 52 percent experienced a job or earnings loss during the first COVID-19 wave in 2020, the highest in the region. While men and women experienced a similar overall shock, more women reported permanently losing a job (30 percent versus a 23 percent for male workers), and the employment effects were concentrated amongst women and younger age cohorts. Inflation will increase the cost of basic needs, which will adversely impact the poor and vulnerable, although this may be partially mitigated by rising remittances.

Inflation is accelerating due to higher non-food inflation. Non-food price inflation rose with higher transportation prices associated with the increase in global fuel prices, alongside increased educational fees, and housing prices. However, food inflation slowed reflecting a continuation of lower vegetable price increases. Government policies to subsidize the electricity tariff for lower-income households and liquefied petroleum gas prices has helped to keep inflation manageable despite increasing global commodity prices.

Private sector credit growth remained strong in the first half of FY22, and efforts have been taken to reduce the pace of credit growth. Credit expansion was broad-based with credit to the agriculture, industry, and services sectors all increasing in an environment of accommodative monetary policy. At the product level, overdraft, real estate loans, and vehicle loans were primary drivers of private sector credit growth. However, deposit growth remained low in the first half of FY22, leading to a considerable gap between credit and deposits, and consequently a liquidity shortage for banking and financial institutions. In response, the central bank raised its policy rate by 2 percentage points in February 2022 to 5.5 percent, higher than the pre-pandemic rate of 5 percent.

Higher merchandise imports and lower remittances contributed to a widening of the current account balance. The current account deficit widened in the first half of FY22 to 7.9 percent of projected GDP, up from 1.2 percent of GDP in the same period of FY21, as remittances declined, and imports continued to grow. In the absence of significant FDI inflows, the current account deficit was largely financed by trade credits, external concessional loans, and reserves drawdowns. As a result, foreign exchange reserves fell to United States dollar (USD) 9.9 billion in mid- January 2022 from USD 11.8 billion in mid-July 2021, equivalent to 6.6 months of imports and below the central bank’s target of 7 months.

Fiscal revenue growth remained relatively strong in the first half of FY22, the fiscal balance improved, and debt declined as a percentage of GDP. Revenue collection expanded on the back of strong import growth and a recovery in housing and stock markets. Recurrent spending also expanded as public social assistance payments – including those for senior citizens, single women, widows, and child protection – were increased by 33 percent, and more conditional grants were devolved to subnational governments. However, capital spending declined marginally due to a delay in FY22 budget implementation, thereby limiting overall spending growth. As a result, the federal fiscal balance recorded a surplus, as in the first half of previous fiscal years. Following the fiscal surplus, debt declined to 38.2 percent of projected FY22 GDP from 48.1 percent of GDP in end FY21. Nepal continues to remain at low risk of debt distress.

Outlook, Risks, and Challenges

The Russia-Ukraine conflict presents new challenges. While Nepal’s direct trade with Russia and Ukraine is limited, higher global commodity prices are expected to increase the costs of fuel, agricultural products, metal, and mineral imports. These higher prices are expected to widen the current account deficit, reduce the growth rate, and increase inflation. A conservative estimate is that the current account deficit as a share of GDP will widen by around 1.5 percentage points in FY22 and FY23 relative to the January 2022 forecast. Transportation prices, construction costs, and other consumer prices are rising which will dampen overall demand and in turn reduce the real GDP growth rate by an estimated 0.2 and 0.6 percentage points in FY22 and FY23, respectively. Services exports are expected to be less affected given the relatively low share of tourist arrivals from these two countries. On the bright side, higher fuel prices may lead to stronger demand for migrant workers in the oil exporting GCC countries, and consequently an increase in remittances.

Taking into account the impact of the war, the Nepali economy is expected to recover gradually over the medium-term under a baseline scenario. Assuming the absence of new nationwide strict containment measures, a near complete vaccination of the eligible population by the end of FY22, and a gradual increase in international migration and tourist arrivals, the economy is projected to grow by 3.7 percent in FY22, accelerate to 4.1 percent in FY23, and rise further to 5.8 percent in FY24 close to its estimated long-term potential growth rate. Higher commodity prices, recently spurred by the war in Ukraine, are expected to increase construction costs as well as consumer prices, dampening overall demand and in turn reducing growth by an estimated 0.2 and 0.6 percentage points in FY22 and FY23 as compared to previous projections. Inflation is expected to average around 6 percent annually in the medium term.

current account deficit is projected to narrow over the medium term after widening in FY22. The current account deficit is expected to widen in FY22 reflecting higher merchandise imports and lower remittances, and narrow thereafter. The forecast anticipates a moderation in merchandise imports, reflecting the completion of most post- 2015 earthquake reconstruction and the gradual replacement of imported fossil fuels by electricity use in households and firms as the country generates an additional 4,000 MW of hydropower electricity. Remittances are expected to stabilize as a share of GDP, supported in part by new overseas employment opportunities. Goods exports are expected to grow in FY22 as Nepal continues to take advantage of tariff exemptions on exports of palm and soybean oil to India under the South Asian Free Trade Area agreement. An increase in electricity exports under an energy exchange and trade agreement with India is expected to drive merchandise export growth from FY23 onwards. Services exports and imports are expected to recover robustly but remain below their pre-pandemic levels through FY24.

The fiscal deficit is projected to continue falling in the medium term. Revenues are expected to remain strong due to growing import-related revenues, efforts to widen domestic tax bases, stronger economic activity including the recovery of tourism, and a rollback of COVID-19 related tax breaks beginning in FY23. Expenditures are likely to peak in FY23 due in part to electoral spending, and then decline from FY24 onwards as COVID-19 related support programs are unwound and measures to reduce duplication of spending responsibilities across levels of government are enacted. As a result, the fiscal deficit is projected to narrow in the medium term. Total public debt is expected to reach 43.1 percent of GDP in FY22 and rise further to 44.5 percent of GDP by FY24. However, the country’s debt is expected to remain sustainable.

A downside scenario highlights growth and fiscal risks. A downside scenario considers a situation in which the central bank uses stronger import control measures to maintain foreign exchange reserve cover at 7 months of imports and in which expenditure consolidation progresses less swiftly than projected under the baseline. This scenario results in adverse growth impacts following the import contraction, depressing domestic output as well as consumption. Limited spending consolidation could also result in reduced capital spending to compensate for persistent elevated recurrent spending, which could depress growth further. The fiscal deficit would be larger under this scenario reflecting higher spending and a decrease in import-related revenues, which would jointly lead to substantially higher debt levels.

The economic outlook is subject to additional downside risks. A new COVID-19 variant reducing vaccine effectiveness could require the re-imposition of stricter containment measures, weakening the rebound momentum. Climate-related and natural disasters are a perennial risk which could impact agricultural production, government finances, and consumer prices. The unwinding of accommodative fiscal and monetary policy will need to be carefully sequenced to avoid large shocks to the private sector.

Staying the course on policy reforms to address fiscal imbalances, improve spending efficiency, accelerate private sector growth and bring into focus the pandemic’s impact on the financial sector can help mitigate downside risks. The government has committed to efforts to improve revenues and reduce spending while continuing to protect the vulnerable. Efforts are underway to allow subnational governments greater flexibility in their use of conditional grants, which can raise their low budget execution rates and provide greater responsiveness to local needs. Simplified approval procedures can help attract foreign direct investment to Nepal to support job creation and growth. Revised financial sector regulations will strengthen identification of non-performing assets and provide clear guidance on restructuring and rescheduling. Maintaining traction on these and other ongoing reforms is important as the country’s fiscal space has been reduced and households are yet to fully recover from the past two years’ job losses and border closings.

The economic scars from two years of the pandemic run deep, and the policy response must be bold. Recovery of tourism and services exports remain muted, job losses have been extensive, and buffers have been reduced to meet large financing needs. The government has done an admirable job providing vaccinations to a large swath of the population, but more can be done on economic reforms to stimulate the domestic economy. Encouraging foreign direct investment (FDI) inflows, currently the lowest in the region, would not only support foreign exchange reserves but also make the private sector more competitive through skill transfers and know-how. A more dynamic and competitive private sector will boost production for both domestic and external markets and create jobs. FDI has the added benefit of not adding to the country’s debt2 and reducing pressure on foreign exchange reserves, thus mitigating the risks that further import and capital flow restrictions could have on growth. As households and firms confront the challenges of a warming climate and a nascent economic recovery, the government’s commitment to a green, resilient, and inclusive development (GRID) approach should build a foundation for greener and more resilient growth ensuring that no one is left behind.

Last Updated: Apr 13, 2022



Contacts

Kathmandu
Alice Joan Brooks
Senior Country Economist
Email

Kathmandu
Akash Shrestha
External Affairs Officer
Email



Welcome