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Nepal Development Update


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Rajendra Malla/World Bank

The Nepal Development Update is produced twice yearly with two main aims: to report on key economic developments over the preceding months, placing them in a longer term and global perspective; and to examine (in the Special Focus section) topics of particular policy significance. The Update is intended for a wide audience including policymakers, business leaders, the community of analysts and professionals engaged in economic debates, and the general public.

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Recent Economic Developments

Gross domestic product (GDP) growth in Nepal is estimated at 7.1 percent in FY2019, driven mainly by the service and agriculture sectors. The service sector is likely to grow by 7.5 percent due to a boost in the retail, hotel, and restaurant subsectors, driven by an uptick in tourist arrivals and remittance-fueled private consumption. Agriculture is estimated to grow by 5 percent in FY2019, well above its 30-year average of 3.1 percent, due to good monsoons, increased commercialization, availability of fertilizers and seeds, and improved irrigation facilities. Industrial growth is also likely to be strong at 8.1 percent, well above its 30-year average of 5 percent, mainly due to improved power availability from increased electricity generation. Private investment and consumption are likely to be the main contributors to growth on the demand side. However, public investment is projected to contract due to a slowdown in post-earthquake reconstruction and delays in national pride projects like Melamchi water supply and Upper Tamakoshi hydroelectric.

Average inflation remained low, despite an increase in the money supply by 18.7 percent. Inflation, which typically mirrors the trend in India, has remained subdued throughout FY2019 due to low food prices and stood at 4.2 percent in March 2019. Growth in the money supply exceeded the monetary policy target of 18 percent, driven largely by private sector credit which grew by 22.5 percent (y/y) in March 2019. Most of the credit is directed to working capital, overdraft, and real estate, which together account for almost 80 percent of total credit. Early in FY2019, Nepal Rastra Bank adopted macroprudential measures that helped reduce lending to the real estate sector and on overdraft facilities. Deposits grew by more than 20 percent in March 2019 but lagged credit growth. The growth in deposits was driven by the provision allowing local governments to deposit 50 percent of their fiscal transfers in local commercial banks. It was also supported by higher individual deposits, underpinned by remittance inflows. The higher levels of credit relative to deposits caused the credit to core capital plus deposit ratio to breach the 80 percent regulatory limit in December 2019, for the first time since 2012.

Imports growth decelerated, but the trade deficit remained high because of high imports relative to persistently low exports. The growth in imports decelerated during FY2019 but remained high at 18 percent (y/y). Imports were primarily driven by industrial goods, oil, and transport equipment, which were needed to support the growth in the industrial and service sectors. In contrast, exports grew by only 7.5 percent (y/y) in the first eight months of FY2019, led by food and beverages and industrial supplies. The current account was supported by higher remittances which grew by 14.4 percent (y/y) in the first eight months of FY2019. This was primarily because of increased use of formal channels to remit money, a depreciation of the Nepalese rupee, and outmigration to destinations like Japan and the Republic of Korea, where wages are higher. Foreign exchange reserves fell to US$9.6 billion in March 2019 as the higher external deficit was partly financed by drawing down international reserves. However, reserves remain comfortable at 7.9 months of imports.

Continued underspending of the budget coupled with reforms to raise revenues are likely to result in a lower fiscal deficit in FY2019, compared with the previous year. Consolidated government revenues grew by 17.5 percent (y/y) in the first eight months of FY2019. This growth was led by tax revenues, especially, the value-added tax (VAT), and customs, income, and excise taxes. The recent reforms by the government to increase tax revenues by removing VAT exemptions, raising taxes on luxury items and high-earning households, and higher excise on tobacco and vehicles supported growth in tax collection. In contrast, consolidated
expenditures increased marginally by 0.3 percent (y/y) in the first eight months of FY2019, and was primarily driven by recurrent spending. The limited number of staff at the provincial and local levels along with constraints on capacity led to weak execution of the budget at the subnational levels. The execution of the capital budget by the central government was also low because of a tapering off of reconstruction spending and further delays in national pride projects. Although capital spending typically picks up in the last quarter of the year, the fiscal deficit is likely to remain lower than last year at 3.4 percent of GDP in FY2019.

Outlook

GDP growth is projected to average 6.5 percent over the medium term, driven by services and underpinned by a steady inflow of remittances. New international job markets for Nepalese migrants are opening up, while migrants are increasingly using formal channels to remit money. The continued inflow of remittances will support domestic trade and private consumption. In addition, high tourist arrivals expected under the Visit Nepal 2020 program, the completion of the second international airport, and the construction of big hotels will also support the service sector. Assuming normal monsoons, agricultural growth is expected to average 4.4 percent over the forecast period supported by programs to promote improved inputs, storage facilities, irrigation, and agribusiness value chains. In addition, recent structural reforms will provide an impetus to private investment. The signing of the protocol to implement the Transit and Transport Agreement with China will enable Nepal to use China’s seaports and improve regional connectivity and transit. Newly enacted laws including the Foreign Investment and Technology Transfer Act, the Public-Private Partnership and Investment Act, and the Special Economic Zone Act will help ease restrictions on foreign investment and reduce transaction costs. In addition, 13 Special Economic Zones are being constructed in various parts of the country. These efforts will further support growth.


The trade deficit is expected to decline as imports growth slows and exports begin to pick up. As the one-time spending on federalism-related infrastructure and post-earthquake reconstruction taper down, the growth in imports will slow. A continued shift to investment-led growth will bring with it some demand for related imports that will translate to the trade deficit. Some increase in exports, particularly of hydroelectricity, is anticipated in the next few years that would help contain the trade deficit, and reduce the current account deficit. Broader growth in overall exports will happen only in the longer term as structural reforms start yielding results. Remittances as a share of GDP are expected to stabilize at 27 percent over the medium term. By FY2021, the current account deficit is expected to moderate to 5.5 percent of GDP, and international reserves are likely to cover around five months of imports. The external gap will be financed primarily by long-term borrowing and a drawdown of foreign exchange reserves. There are negligible portfolio investments in the country, and despite some expected increase in foreign direct investment, it will continue to remain low.

The fiscal deficit is projected to average around 4 percent of GDP, over the medium term. Recent underspending has helped reduce the fiscal deficit. In subsequent years, as the provincial and local governments become fully functional, the fiscal deficit is projected to increase, rising to 5.1 percent of GDP in FY2021. The government has set up a commission to review and suggest measures to improve spending efficiency. Reforms to broaden the tax base will help increase revenues to 30 percent of GDP by FY2021. Non-tax revenues are also expected to increase because of royalties from new hydropower projects. At the subnational levels, efforts are underway to establish the legal and institutional framework to support enhanced own-tax revenue collection. The fiscal deficit is likely to persist as the government proceeds with key reforms to implement fiscal federalism and ease constraints to investment and finance.

Public debt is projected to increase to 32.7 percent of GDP by FY2021.

Despite the increase, Nepal continues to remain at low risk of debt distress. Debt sustainability stress tests show a vulnerability to growth shocks and natural disasters and underscore the importance of implementing sound macroeconomic policies and structural reforms.

Risks and Challenges

A sudden reduction in remittance inflows could lower deposits, limiting the availability of loanable funds in the economy. This could affect private investment and imports, consumption and growth. Remittance inflows have supported household consumption, helping to reduce poverty. It has also helped the economy to earn foreign exchange for imports. The lower outflow of migrants may continue and conditions in migrant-receiving countries could deteriorate, with increasing geopolitical tensions in the Gulf region and uncertain oil prices. These trends could put pressure on remittance inflows, especially if new markets attract only a limited number of laborers from Nepal. Lower credit to the economy that leads to lower growth would also reduce exports. This points to the need to reduce the heavy reliance on remittances as a source of foreign exchange and savings. Greater focus is needed on incentivizing and diversifying exports.

Risks from climate-related natural disasters are also high and may impact Nepal’s growth trajectory, requiring early action to ensure that sources of growth are climate resilient to the extent possible. Erratic monsoons can lead to climate-related disasters such as drought, floods, and landslides that undermine agricultural production, negatively impact infrastructure, and reverse gains in poverty reduction. The Global Climate Risk Index ranks Nepal as the 11th most affected country in the world in the last 20 years. The vulnerability to climate change is further reinforced by the country’s first tornado that hit two Terai districts in March 2019 and resulted in a loss of US$4.6 million worth of crops and livestock. To mitigate these risks, the implementation of the 2017 Disaster Risk Reduction and Management Act will be crucial at all three levels of government.

The implementation of federalism is expected to improve service delivery in the medium to longer term, but capacity challenges persist and need to be addressed immediately. These challenges could manifest themselves through the under-execution of the provincial and local budgets, which could impact service delivery. Therefore, efforts are needed on two fronts: (a) the move of civil servants to the provincial and local level under the Civil Servants Adjustment Ordinance, and (b) capacity building of these staff.
Finally, an acceleration of and greater consistency and coordination in reform implementation, particularly those reforms that boost investment in physical and human capital, will be necessary to sustain growth. Nepal needs infrastructure investments of around 10 to 15 percent of GDP annually for the next 10 years. To boost investments, the government organized the Nepal Investment Summit in March 2019, which resulted in investment proposals worth about US$17.5 billion from both domestic and foreign investors. The success of these investments will depend on the timely implementation of investment-related legislations that meet good practices. It is equally important to ensure the availability of skilled labor to meet the needs of the private sector, complement investments in infrastructure, and facilitate innovation. The Special Focus section of this edition of the Nepal Development Update outlines the key issues and reforms, to support scaled up investments in people and lay the foundation for increasing human capital and labor productivity.

Special Focus – Investing in People to Close the Human Capital Gap

Investing in people and building human capital are critical if Nepal is to accelerate its growth and rapidly reduce poverty. Human capital investments raise individual earnings potential, which in turn contributes to aggregate economic growth. For instance, one additional year of schooling in Nepal can raise an individual’s earnings by 8 to 10 percent. Undernutrition reduces learning potential and productivity and can reduce GDP by as much as 11 percent. Investing in psychosocial stimulation during a child’s early years can raise his or her adult income by up to 25 percent. School deworming can have a large and sustained impact on labor market outcomes in adulthood. Increases in life expectancy are positively correlated with economic growth.

Investing in people is also critical for increasing Nepal’s competitiveness. Firms note that the lack of skills aligned to the needs of the private sector is a key constraint to firm growth and movement up the value chain. Inability to scale-up production affected firm competitiveness. Human capital also affects growth indirectly through its effect on the productivity of capital, technological change, and innovation. Thus, investments in both the future and current workforce, combined with policies to increase labor productivity and encourage labor force participation, matter for higher, sustained, and inclusive growth.

Now is an opportune time for Nepal to scale-up its investments in human capital before the demographic dividend window closes. According to the World Bank’s 2015/16 Global Monitoring Report,1 Nepal is an early dividend country, defined to include countries where total fertility is below four births per woman. When a country finds itself with a working-age population or labor force that is growing faster than the population that depends on it (such as children and the aged), it creates a window for higher economic growth because the economy can potentially employ more people, savings grow and become a financing source for economic growth, and lower fertility rates result in healthier women. When there are fewer economic pressures and more resources to invest in children, GDP per capita increases due to a decreasing dependency rate. For the demographic transition to be accompanied by significant improvements in per capita GDP, it is therefore essential to scale-up investments in human capital to raise the productivity of future generations and existing cohorts of youth and adults.

A child born in Nepal today will be only 49 percent as productive when she grows up as she could be if she enjoyed complete education and full health. This is based on the estimate of Nepal’s Human Capital Index, developed by the World Bank’s Human Capital Project. Nepal’s GDP can be compared under two scenarios, one in which the current status quo continues and another in which a child gets full education and health. Under the scenario in which a child gets full education and health, Nepal’s GDP could be as much as two times larger than the GDP under the status quo scenario. Achieving the full education and health scenario will require a significant reduction in stunting beyond past progress that led to a reduction of stunting from 57 percent in 2001 to 35.8 percent in 2016. At 26 percent, the stunting rate remains a public health concern. Similarly, significant improvements would be needed for schooling outcomes. A child who starts school at age four can expect to complete 11.7 years of school by her 18th birthday. However, if what children actually learn is factored in, expected years of schooling drops from 11.7 years to 6.9 years. This means that, on average, around 4.8 years of schooling are lost due to poor quality.

Attention to labor market effects, particularly for youth and women, will be an important catalyst of investment in human capital. Labor market outcomes and earnings can affect human capital investment decisions, which in turn affect skills, productivity, and earnings. Increased investments in the human capital of youth and women is important given Nepal’s recent history and the interplay between poor labor market conditions, the prospects for youth, and social unrest. Unemployment is highest among young people, who account for 48 percent of the labor force but make up 69 percent of those unemployed. Among all age groups, women’s labor force participation (on average 26 percent) is much lower than men’s participation rate (54 percent). Also, the share of young women who neither work nor study has increased in rural areas. Cross-country surveys suggest that only 41 percent of working Nepalese youth are satisfied with their employment status. This contrasts with youth in Bangladesh, Cambodia, and Vietnam (where over 80 percent are satisfied).

For Nepal to realize its full human capital potential, renewed efforts are needed to reduce inequity, improve service quality, and minimize vulnerabilities.

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Last Updated: Jul 26, 2019



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