RECENT ECONOMIC DEVELOPMENTS
After the strong rebound in FY22, economic growth slowed in H1FY23 reflecting tighter monetary policy, higher international prices, and the continuation of import restriction measures. Real GDP growth slowed in Q1FY23 despite positive growth in the services and agricultural sectors, as the industrial sector contracted. A decrease in construction activities, the lower registration of new businesses, slower credit growth to the private sector, and lower imports of intermediate and capital goods suggest a decline in private investment during H1FY23.
Inflation has been broad-based, with food prices expanding by 7.5 percent y-o-y and non-food price inflation increasing to 8.7 percent (y-o-y) in H1FY23. Contributing factors to the price increases include higher vegetable prices associated in part with supply shocks in India, cereal grain prices triggered by India’s export ban on wheat and rice, higher transportation prices associated with the increase in global energy prices, and housing and utility prices.
The current account deficit widened from 7.8 percent of GDP in FY21 to a historic high of 12.8 percent of GDP in FY22, associated with a drop in remittances and a larger trade deficit. During H1FY23, a combination of lower goods imports and higher remittances narrowed the current account deficit to 0.5 percent of GDP, the lowest since H1FY17.
The smaller current account deficit allowed for renewed accumulation of foreign exchange reserves during H1FY23. Foreign exchange reserves climbed to USD 10.5 billion in mid-January 2023 from USD 9.5 billion in mid-July 2022. This stock covers 9.4 months of concurrent imports, higher than the policy floor of 7 months of imports coverage.
There is no guarantee that imports will not surge again in the future. To avoid a repetition of imposing damaging import restrictions, continued import demand management through interest rate policies and attracting additional sources of external financing will be critical.
Capital adequacy indicators remain above minimum floors, and non-performing loans (NPLs) remain very low by international standards. Total average capital to risk-weighted assets ratio – a measure of bank capital adequacy – ended H1FY23 at 13.1 percent, above the regulatory minimum of 11 percent. At the same time, the NPL ratio ticked up to 2.6 percent at the end of H1FY23. Although financial institution soundness indicators remain reassuring, some forbearance measures in place through the end of FY23 may be masking actual asset quality in the banking sector.
Monetary policy at the start of FY23 was designed to balance support for the economic recovery with the tightening required for economic and financial stability. The policy rate was increased by 200 basis points (bps) in H2FY22, followed by an additional increase of 150 bps in H1FY23 August 2022. The combined impact of higher international prices, requirements for importers to make cash deposits in bank accounts prior to obtaining letters of credit for importation, and policy rate hikes led to further slowdowns in credit to the private sector during H1FY23. The last remaining import restrictions were lifted in January 2023.
Continued high demand for liquidity was met by the standing liquidity facility in H1FY23 along with the overnight liquidity facility introduced at the beginning of FY23. These windows proved effective at shifting the interbank lending rate to within the interest rate corridor beginning in December 2022. Tighter restrictions on credit-to-deposit ratio contributed to limiting the credit supply.
Nepal relies heavily on imports as a tax base, which contribute about half of total tax revenues through VAT, excise and import duties. For the first time in five years, Nepal’s fiscal balance was negative in the first half of FY23 at -0.3 percent of GDP as revenues fell across the board while expenditures remained flat. The downturn in revenue growth reflects not only lower imports, but more sluggish economic activity as well. Expenditures, on the other hand, remained broadly stable during a period of electoral activity. The H1FY23 fiscal deficit increased the public debt to GDP ratio from 35.6 percent to an estimated 38.3 percent between H1FY22 and H1FY23.
The government’s FY23 Finance Bill incorporated an ambitious tax revenue target of 21.3 percent nominal growth for the year, which a mid-term review adjusted downwards. The mid-year FY23 budget review undertaken by the Ministry of Finance in February 2023 reduced the budgeted revenue estimate downwards from 26 percent of GDP to 23 percent of GDP (a 2.9 pp of GDP reduction). The mid-term review cut expenditures by a greater amount, from 28.9 percent of GDP to 24.7 percent of GDP (a 4.2 pp of GDP reduction), narrowing the budgeted budget deficit for the year from 5 percent of GDP to 3.6 percent of GDP (a 1.3 pp of GDP reduction).
OUTLOOK, RISKS, AND CHALLENGES
The high demand for imports witnessed as Nepal emerged from the pandemic has moderated, foreign exchange reserve buffers are accumulating, credit is growing in a more sustainable fashion, tourists are returning to the country, and remittances are
growing strongly as outmigration surges. The less positive aspects of the economy’s evolution include lower growth prospects than previously anticipated, a fiscal deficit in the first half of the year, and the continuation of a challenging external environment as global interest rates continue to rise and commodity prices remain moderately high as Russia’s invasion of Ukraine continues.
The assumptions built into the baseline scenario of this macroeconomic forecast include: (i) a gradual easing of Nepal’s monetary policy repo rate, (ii) declines in global commodity prices in FY24 and FY25 relative to FY23; (iii) a gradual increase in international tourist arrivals, reaching pre-pandemic levels by FY25; and (iv) the commitment of the central bank to maintain foreign exchange reserves at a minimum equivalent of 7 months of concurrent imports during FY23-FY25.
The forecast projects growth declining to 4.1 percent in FY23 before accelerating once again to 4.9 percent growth in FY24 and further to 5.5 percent growth by FY25, close to the country’s estimated long-term potential growth rate of 5.4 percent. The services sector is expected to continue to be the primary driver of real GDP growth over the medium term, slowing to 5.2 percent in FY23 then averaging 5.8 percent in FY24-FY25.
Agricultural sector growth is projected to average 2.6 percent per year over FY23-FY25 reflecting increased rice paddy production in FY23 and a five-year agreement on the supply of chemical fertilizers between the governments of India and Nepal signed in February 2022. Industrial sector growth is envisioned to pick up as newly commissioned hydroelectric power plants drive electricity production higher and boost industrial growth in the medium term.
Average annual inflation is expected to rise to 6.8 percent in FY23 as the impact of Russia’s invasion of Ukraine keeps commodity prices elevated. Inflation is projected to then decline to 6 percent in FY24 and 5.5 percent in FY25, reflecting a moderation of global commodity prices and the containment of domestic price pressures through monetary policy.
Strong remittance inflows, the country becoming a net exporter of electricity beginning in FY23, and moderate growth of imports are projected to narrow the current account deficit from 12.8 percent of GDP in FY22 to 2.8 percent of GDP in FY23. While imports are expected to rise in the later years of the forecast, their growth is projected to be gradual which is reflected in the current account deficit forecast of 4.2 percent of GDP for FY24 and 3.6 percent of GDP in FY25.
The fiscal deficit is expected to remain under 3.5 percent of GDP throughout the forecast, as underspending of the budget continues, and revenues pick up alongside the growth revival beginning in FY24. This forecast includes measures to avoid the duplication of spending among the three tiers of governments, the adoption of revenue-enhancing reforms such as the removal of VAT tax exemptions, and improved capital spending with the implementation of new guidelines for the National Project Bank. Total public debt is projected to reach 41.7 percent of GDP in FY23 and then decrease marginally to 41.6 percent in FY24 and further to 41.5 percent in FY25 as GDP growth outpaces debt accumulation in the outer years of the forecast.
No new shocks are included in the forecast; given the increasing frequency of shocks in recent years, this may be optimistic. Local elections in May 2022 and national and provincial elections in November 2022 were followed by successive changes in administration, the most recent being the collapse of the ruling coalition in March 2023. Political stability remains important to manage the economy and ensure continued pursuit of development priorities. Higher than expected inflation would reduce household purchasing power and drag growth. Welfare recovery remains
uncertain due to rising inflation and risks to agricultural production. Reduced investments in human capital, especially amongst those yet to recover from a job loss following COVID-19, also impose risks to rising inequality.
Last Updated: Apr 04, 2023