Nepal Development Update October 2023 Restoring Export Competitiveness © 2023 International Bank for Reconstruction and Development / The World Bank The World Bank 1818 H Street, NW Washington, DC 20433, USA Tel: 1-202-473-1000 Fax: 1-207-477-6391 www.worldbank.org Standard Disclaimer This volume is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the view of the Executive Directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries colors, denominations, and other information shown on any map in this work do not imply any judgement on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Copyright Statement The material in this publication is copyrighted. 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NEPAL DEVELOPMENT UPDATE October 2023 NEPAL DEVELOPMENT UPDATE ACKNOWLEDGEMENTS The Nepal Development Update is produced twice a year to report on key economic developments that occurred during the year, placing them in a longer-term and global perspective. 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. This report was produced by the World Bank Macroeconomics, Trade and Investment (MTI) team for Nepal led by Alice J Brooks (Senior Economist, MTI) and Nayan Krishna Joshi (Economist, MTI) and consisting of Sebastian Michael Essl (Senior Economist, MTI), Prabin Dongol (Consultant, MTI), and Anima Maharjan (Team Assistant, MTI). The report benefitted from consultations with Dr. Prakash Kumar Shrestha (Executive Director, Nepal Rastra Bank), Mr. Baburam Subedi (Joint Secretary, Ministry of Finance), and Mr. Hikmat B. Bhandari (Undersecretary, Ministry of Finance). The team thanks Mathew Verghis (Director, Equitable Growth, Finance and Institutions (EFI), South Asia Region), Faris Hadad-Zervos (Country Director for Maldives, Nepal and Sri Lanka), Shabih Ali Mohib (Practice Manager, MPSTI), Lada Strelkova (Manager, Operations), and Meriem Slimane (Program Leader, EFI) for their guidance and comments on the report. Akash Shrestha and Avinashi Paudel managed media relations and dissemination. The cutoff date is September 15, 2023, and includes data released up until that date. 2 CONTENTS ACKNOWLEDGEMENTS 2 EXECUTIVE SUMMARY 5 A RECENT ECONOMIC DEVELOPMENTS 11 A.1 Real Sector 12 A.2 External Sector 17 A.3 Monetary and Financial Sector 21 A.4 Fiscal Sector 25 B OUTLOOK, RISKS, AND CHALLENGES 31 C SPECIAL FOCUS: DRIVERS OF EXTERNAL COMPETITIVENESS C.1 Introduction 37 38 C.2 Nepal’s Productivity Challenges 39 C.3 How have Real Exchange Rate Dynamics Affected Exports? 43 C.4 Conclusions and Recommendations 45 References 46 Annex 47 THE WORLD BANK | 3 NEPAL DEVELOPMENT UPDATE 4 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 EXECUTIVE SUMMARY THE WORLD BANK | 5 EXECUTIVE SUMMARY The economy faced Recent Economic Developments a slowdown in FY23 primarily due to Real GDP growth decreased to an estimated 1.9 percent in FY23, the lowest rate since monetary tightening FY20 and substantially below the 10-year average growth rate. Monetary tightening and import restriction and the effects of import restrictions contributed to the slowdown. Economic activity measures. 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 Hydropower manufacturing and construction outputs shrank. Hydroelectric generation increased production contributed significantly for the second year in row and added close to 500 megawatts of to the industrial sector hydroelectric power to the national grid. Nepal nevertheless remains a net energy growth. importer. Slow credit growth and import restrictions contributed to a reduction in private Total investment investment on the demand side. Lower capital expenditure and revenue cooled while private underperformance drove lower public investment. As a result, total investment consumption remained strong. 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 broad- Inflation rose for a based. Food prices rose due to supply side shocks and domestic policy changes. third consecutive year Non-food prices were pushed by higher housing and utility prices. The persistence of in part due to supply shocks and domestic high inflation impedes an effective policy mix to stimulate growth while containing policy changes. external imbalances. Domestic policies and India’s trade restriction measures invoked a steep reduction External imbalances of goods imports. Remittance inflows increased in FY23, following high outward improved significantly migration in the previous year. Exports stagnated below their pre-pandemic level, as goods imports caused also by a real appreciation due to Nepal’s persistently high inflation. Overall, fell and remittance the current account deficit decreased significantly, and the level of foreign currency inflows increased. reserves increased above its policy floor. 6 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 The central bank raised its policy rate in early FY23 to slow credit growth to the Credit growth to private sector and to support the correction of external imbalances. In synergy with the private sector import restrictions and higher international prices, credit growth to the private sector slowed owing to slowed compared to the previous year. Deposits grew at the same time, supported policy measures taken by higher real interest rates and several government incentives targeting remittance to help correct the deposits. external imbalances. 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 Fiscal space diminished slower pace than revenues, the fiscal deficit nearly doubled to 6.1 percent of GDP, the further with the highest deficit recorded in more than two decades. Overall, public debt increased contraction of revenues. 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 Economic activity is loosening of monetary policy. The continued expansion of hydroelectric production expected to gradually gain momentum. 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 The current account one-off imports, including of COVID-19 vaccines, are expected to keep imports below deficit is expected to its FY22 historic high. Near-record migration of Nepali workers should be reflected increase moderately. 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 A rebound in revenues on capital investment and fiscal transfers to subnational governments, yet higher should reduce the debt servicing costs. Overall, the recovery of revenues is expected to reduce the fiscal fiscal deficit and deficit to 3.5 percent in FY24 and 3.3 percent in FY25. Together with the rebound contain public debt. 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 Prudent policies to stimulate growth and and inflation. Lumpy skin disease and an erratic monsoon could way more than contain downside expected on agricultural output, and services and industry could be affected by risks are key. 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. THE WORLD BANK | 7 EXECUTIVE SUMMARY Special Focus The special focus section presents first empirical results of how exchange rate Nepal’s export and productivity dynamics have contributed to Nepal’s dwindling external performance has competitiveness. Exports of goods and services have fallen substantially compared continuously declined. to the early 2000s and have reached a level substantially below that of peer countries. Stronger exports could help Nepal achieve stronger growth, create better domestic jobs, and increase resilience by decreasing dependence on remittance inflows. The analysis finds that the real appreciation of bilateral exchange rates contributed A real appreciation significantly to lower exports. Larger firms were more affected by exchange rate of exchange rate movements, but diversification in terms of products and export markets helped. and productivity Nepal also accumulated a sizeable productivity gap across all sectors compared to deficit negatively peer countries and its main trading partner, India. This deficit likely contained labor affected exports. market movements and had a negative effect on Nepali firms’ ability to compete for export markets in terms of prices and product quality. Key Recommendations This requires budget to be based on a more realistic macroeconomic framework The budgetary so that policy makers would be able to better determine the expenditure envelope process needs further that can be afforded, given expected revenues and the level of deficit that can be strengthening to better safely financed. Ongoing efforts by the Ministry of Finance and other government support planning. entities to improve their evidence-based macroeconomic forecasting capabilities are expected to provide a more realistic macroeconomic framework in the future. Increasing the domestic productivity requires (a) changing the current tax model Increasing domestic by shifting taxation away from the border and reducing high import tariffs; productivity and (b) improving the implementation of fiscal federalism which would facilitate effective containing domestic investments in infrastructure and services; and (c) simplifying and streamlining inflation key to processes to attract more FDI which would create significant knowledge and improving external spillover effects. In addition, containing domestic inflation would reduce the inflation competitiveness. differential with trading partners. This would help avoid further real appreciation of the exchange rate. 8 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 THE WORLD BANK | 9 NEPAL DEVELOPMENT UPDATE 10 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 RECENT A ECONOMIC DEVELOPMENTS THE WORLD BANK | 11 RECENT ECONOMIC DEVELOPMENTS A RECENT ECONOMIC DEVELOPMENTS A.1 REAL SECTOR ECONOMIC ACTIVITY WEAKENED Real GDP growth slowed sharply to an estimated 1.9 percent in FY23, the lowest rate post FY20 (Figure 1). The slowdown occurred on the back of import restrictions and the continued tightening of monetary policy, aimed at addressing the significant widening of external imbalances. The central bank raised its key interest rate by 150 basis points (bps) in July 2022, on top of the 200-bps hike taken during FY22. Import restriction measures were introduced by authorities on December 29, 2021, and were in place until January 19, 2023.1 ZĞĂů Figure 1. Real GDP growth slowed in FY23. ;ĐŽŶƚƌŝďƵƚŝŽŶƚŽƌĞĂů'WŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ ŐƌŝĐƵůƚƵƌĞ /ŶĚƵƐƚƌLJ ^ĞƌǀŝĐĞƐ 'WĂƚďĂƐŝĐƉƌŝĐĞƐ ϭϬ ϴ ϲ ϰ Ϯ Ϭ ͲϮ Ͳϰ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Zϭ Sources. National Statistics Office and World Bank staff calculations. ;ƉĂĚĚLJƉƌŽĚƵĐƚŝŽŶ͕ŵŝůůŝŽŶŵĞƚƌŝĐƚŽŶͿ ϲ͘Ϭ ϱ͘ϱ ϱ͘Ϭ 1 The combined impact of higher interest rates and import restrictions reduced credit growth as intended. ϰ͘ϱ A more detailed discussion follows in the Monetary and Financial Sector section of this report. 12 ϰ͘Ϭ ϯ͘ϱ ϴ ϲ ϰ Ϯ NEPAL Ϭ DEVELOPMENT UPDATE | OCTOBER 2023 ͲϮ Ͳϰ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Zϭ ;ƉĂĚĚLJƉƌŽĚƵĐƚŝŽŶ͕ŵŝůůŝŽŶŵĞƚƌŝĐƚŽŶͿ ϲ͘Ϭ GROSS DOMESTIC PRODUCT BY INDUSTRIAL CLASSIFICATION ϱ͘ϱ ϱ͘Ϭ ϰ͘ϱ Agricultural Sector ϰ͘Ϭ ϯ͘ϱ Agricultural output remained resilient and expanded Figure ϯ͘Ϭ 3. Strong growth in the electricity sub-sector &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ by 2.7 percent in FY23. Rice paddy production supported ZϮ prevented a contraction of industrial output in FY23. ZĞĂů the sectoral growth and increased by 6.9 percent, reflecting ;ĐŽŶƚƌŝďƵƚŝŽŶƚŽƌĞĂů'WŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ a good summer monsoon and improved seed varieties DŝŶŝŶŐĂŶĚƋƵĂƌƌLJŝŶŐ DĂŶƵĨĂĐƚƵƌŝŶŐ ůĞĐƚƌŝĐŝƚLJĂŶĚŽƚŚĞƌƐ ;ĐŽŶƚƌŝďƵƚŝŽŶƚŽƌĞĂů'WŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ tĂƚĞƌƐƵƉƉůLJ ŽŶƐƚƌƵĐƚŝŽŶ /ŶĚƵƐƚƌLJ 1 and 2). However, (Figures ŐƌŝĐƵůƚƵƌĞ /ŶĚƵƐƚƌLJ a lumpy skin disease ^ĞƌǀŝĐĞƐ has affected 'WĂƚďĂƐŝĐƉƌŝĐĞƐ ϯ͘Ϭ ϭϬ livestock as of early April 2023, infecting more than 1 million Ϯ͘ϱ ϴ Ϯ͘Ϭ andϲ killing close to 50,000. The resulting lower dairy product ϭ͘ϱ andϰ meat production could negatively affect agricultural ϭ͘Ϭ Ϭ͘ϱ output Ϯ growth. Updated statistics will be released by the Ϭ͘Ϭ Ϭ National Statistics Office in April 2024. ͲϬ͘ϱ ͲϮ Ͳϭ͘Ϭ Ͳϰ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Figure 2. Rice paddy production expanded in FY23, but the Zϯ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Zϭ yield was the second lowest since FY18. Sources. National Statistics Office and World Bank staff calculations. ;ƉĂĚĚLJƉƌŽĚƵĐƚŝŽŶ͕ŵŝůůŝŽŶŵĞƚƌŝĐƚŽŶͿ ϲ͘Ϭ Figure 4. Hydroelectric generation expanded by almost 500 megawatts during FY23. ϱ͘ϱ ϱ͘Ϭ ;ĂĚĚŝƚŝŽŶĂůŝŶƐƚĂůůĞĚĐĂƉĂĐŝƚLJ͕ŵĞŐĂǁĂƚƚͿ ϰ͘ϱ ϴϬϬ ϰ͘Ϭ ϳϬϬ ϯ͘ϱ ϲϬϬ ϱϬϬ ϯ͘Ϭ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϰϬϬ ϯϬϬ ZϮ Sources. National Statistics Office and World Bank staff calculations. ϮϬϬ ;ĂĚĚŝƚŝŽŶĂůŝŶƐƚĂůůĞĚĐĂƉĂĐŝƚLJ͕ŵĞŐĂǁĂƚƚͿ ϭϬϬ ;ĐŽŶƚƌŝďƵƚŝŽŶƚŽƌĞĂů'WŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ DŝŶŝŶŐĂŶĚƋƵĂƌƌLJŝŶŐ DĂŶƵĨĂĐƚƵƌŝŶŐ ϴϬϬ ůĞĐƚƌŝĐŝƚLJĂŶĚŽƚŚĞƌƐϬ Industrial Sector tĂƚĞƌƐƵƉƉůLJ ŽŶƐƚƌƵĐƚŝŽŶ /ŶĚƵƐƚƌLJ Zϰ ϳϬϬ ϲϬϬ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϯ͘Ϭ Ϯ͘ϱ ϱϬϬ Sources. Department of Electricity Development and World Bank staff Strong growth in the electricity sub-sector helped to calculations. Ϯ͘Ϭ ϰϬϬ avoid a contraction of the industrial sector. Electricity Note. Includes only hydropower installed with a capacity greater than 1 ;ĐŽŵƉŽŶĞŶƚƐŽĨŵĂŶƵĨĂĐƚƵƌŝŶŐƉƌŽĚƵĐƚŝŽŶŝŶĚĞdžͿ ϯϬϬ ϭ͘ϱ megawatt. ůůŽƚŚĞƌƐ production expanded by 23 percent in FY23, after close ϮϬϬ DĂŶƵĨĂĐƚƵƌĞŽĨďĂƐŝĐŝƌŽŶĂŶĚƐƚĞĞů ϭ͘Ϭ to Ϭ͘ϱ 500 megawatts of hydroelectric power were added to ϭϬϬ ĞŵĞŶƚ theϬ͘Ϭcountry’s grid (Figures 3 and 4). Manufacturing and Zϰ Figure Ϭ 5. The manufacturing and construction sectors sĞŐĞƚĂďůĞŽŝůƐ͕ƌĞĨŝŶĞĚ͗ƐŽLJĂďĞĂŶŽŝů͕ƐƵŶĨůŽǁĞƌŽŝůĂŶĚŵƵƐƚĂƌĚŽŝů DĂŶƵĨĂĐƚƵƌŝŶŐƉƌŽĚƵĐƚŝŽŶŝŶĚĞdž &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϮϬ construction, on the other hand, shrank by 2 percent and contracted during the first half of FY23 due to lower ͲϬ͘ϱ ϭϱ 2.6 percent, respectively. The decline was partly due to Ͳϭ͘Ϭ production ϭϬ of edible oils and construction materials… &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϱ Zϯ lower production of key construction materials (cement, Ϭ ;ĐŽŵƉŽŶĞŶƚƐŽĨŵĂŶƵĨĂĐƚƵƌŝŶŐƉƌŽĚƵĐƚŝŽŶŝŶĚĞdžͿ basic iron, and steel) and vegetable oils2 in the first half of Ͳϱ ůůŽƚŚĞƌƐ ͲϭϬ DĂŶƵĨĂĐƚƵƌĞŽĨďĂƐŝĐŝƌŽŶĂŶĚƐƚĞĞů FY23 (Figure 5). Higher frequency indicators suggest that the Zϱ Ͳϭϱ ĞŵĞŶƚ sĞŐĞƚĂďůĞŽŝůƐ͕ƌĞĨŝŶĞĚ͗ƐŽLJĂďĞĂŶŽŝů͕ƐƵŶĨůŽǁĞƌŽŝůĂŶĚŵƵƐƚĂƌĚŽŝů decline continued in the second half of FY23 (Figure 6). Lower &zϭϳ &zϭϴ &zϮϬ DĂŶƵĨĂĐƚƵƌŝŶŐƉƌŽĚƵĐƚŝŽŶŝŶĚĞdž &zϮϭ &zϮϭ &zϮϮ &zϮϯ ϮϬ demand resulting from the elevated prices of manufactured ϭϱ ϭϬ goods and construction materials (Figure 7) further weighed ϱ ;ŝŵƉŽƌƚƐŽĨĐŽŶƐƚƌƵĐƚŝŽŶ͕ǁŽŽĚ͕ŐůĂƐƐ͕ƐƚŽŶĞ͕ďĂƐŝĐŵĞƚĂůƐ͕ ŚŽƵƐŝŶŐ͕ĞůĞĐƚƌŝĐĂů on industrial output, which increased by a meager 0.6 Ϭ ĂƉƉůŝĂŶĐĞƐ͕ĨƵƌŶŝƚƵƌĞ͕ EWZďŝůůŝŽŶͿ Ͳϱ &ŝŶĂůĐŽŶƐƵŵƉƚŝŽŶ 'ƌŽƐƐĨŝdžĞĚĐĂƉŝƚĂůĨŽƌŵĂƚŝŽŶ percent (Figure 3). ͲϭϬ /ŶƚĞƌŵĞĚŝĂƚĞĐŽŶƐƵŵƉƚŝŽŶ dŽƚĂůŝŵƉŽƌƚƐ Zϱ ϯϬϬ Ͳϭϱ ϮϱϬ &zϭϳ &zϭϴ &zϮϬ &zϮϭ &zϮϭ &zϮϮ &zϮϯ ϮϬϬ Sources. National Statistics Office and World Bank staff calculations. ϭϱϬ Note. ϭϬϬ only FY23 includes the data for the first 2 quarters ŚŽƵƐŝŶŐ͕ĞůĞĐƚƌŝĐĂů ;ŝŵƉŽƌƚƐŽĨĐŽŶƐƚƌƵĐƚŝŽŶ͕ǁŽŽĚ͕ŐůĂƐƐ͕ƐƚŽŶĞ͕ďĂƐŝĐŵĞƚĂůƐ͕ ĂƉƉůŝĂŶĐĞƐ͕ĨƵƌŶŝƚƵƌĞ͕ ϱϬ EWZďŝůůŝŽŶͿ 2 A more detailed discussion of the edible oils export market follows in the External Section of this Ϭ &ŝŶĂůĐŽŶƐƵŵƉƚŝŽŶ report. 'ƌŽƐƐĨŝdžĞĚĐĂƉŝƚĂůĨŽƌŵĂƚŝŽŶ /ŶƚĞƌŵĞĚŝĂƚĞĐŽŶƐƵŵƉƚŝŽŶ dŽƚĂůŝŵƉŽƌƚƐ ϯϬϬ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Zϲ ϮϱϬ THE WORLD BANK | 13 ϮϬϬ ϭϱϬ ůůŽƚŚĞƌƐ DĂŶƵĨĂĐƚƵƌĞŽĨďĂƐŝĐŝƌŽŶĂŶĚƐƚĞĞů ĞŵĞŶƚ sĞŐĞƚĂďůĞŽŝůƐ͕ƌĞĨŝŶĞĚ͗ƐŽLJĂďĞĂŶŽŝů͕ƐƵŶĨůŽǁĞƌŽŝůĂŶĚŵƵƐƚĂƌĚŽŝů DĂŶƵĨĂĐƚƵƌŝŶŐƉƌŽĚƵĐƚŝŽŶŝŶĚĞdž ϮϬ RECENT ECONOMIC DEVELOPMENTS ϭϱ ϭϬ ϱ Ϭ Ͳϱ ͲϭϬ Zϱ Ͳϭϱ 6. ...and Figure &zϭϳ &zϭϴimports &zϮϬ data show&zϮϭ &zϮϭ &zϮϮ contraction that the &zϮϯ (Figure 9). Real estate transactions plummeted by 39.4 percent continued in the second half of FY23. in FY23 (Figure 10), due to the inability of more than 500 local governments to implement the 2022 Land Use Regulations, ;ŝŵƉŽƌƚƐŽĨĐŽŶƐƚƌƵĐƚŝŽŶ͕ǁŽŽĚ͕ŐůĂƐƐ͕ƐƚŽŶĞ͕ďĂƐŝĐŵĞƚĂůƐ͕ ŚŽƵƐŝŶŐ͕ĞůĞĐƚƌŝĐĂů ĂƉƉůŝĂŶĐĞƐ͕ĨƵƌŶŝƚƵƌĞ͕ EWZďŝůůŝŽŶͿ which require a classification of land into agriculture and ;ĐŽŵƉŽŶĞŶƚƐŽĨǁŚŽůĞƐĂůĞƉƌŝĐĞŝŶĚĞdžͿ &ŝŶĂůĐŽŶƐƵŵƉƚŝŽŶ 'ƌŽƐƐĨŝdžĞĚĐĂƉŝƚĂůĨŽƌŵĂƚŝŽŶ use. Credit growth non-agricultureDĂŶƵĨĂĐƚƵƌŝŶŐ of real estate lending also ŽŶƐƚƌƵĐƚŝŽŶŵĂƚĞƌŝĂůƐ /ŶƚĞƌŵĞĚŝĂƚĞĐŽŶƐƵŵƉƚŝŽŶ dŽƚĂůŝŵƉŽƌƚƐ ϭϲϬ ϯϬϬ slowed (Figure 11) and contributed to the lower real estate ;ĐŽŵƉŽŶĞŶƚƐŽĨǁŚŽůĞƐĂůĞƉƌŝĐĞŝŶĚĞdžͿ ϭϰϬ ϮϱϬ the growth of the transactions, butDĂŶƵĨĂĐƚƵƌŝŶŐ real estate sub-sector was ŽŶƐƚƌƵĐƚŝŽŶŵĂƚĞƌŝĂůƐ ϭϲϬ ϭϮϬ ϮϬϬ relatively unchanged due to an increase in housing rental ϭϱϬ ϭϬϬ ϭϰϬ ϭϬϬ activities ϴϬ (Figure 8). ϭϮϬ ϱϬ ϲϬ ϭϬϬ Ϭ Zϳ 8. Services Figure &zϭϲ &zϭϳ &zϭϴ sector &zϭϵ growth &zϮϬ &zϮϭ slowed &zϮϮ due to the &zϮϯ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϴϬ Zϲ contraction in the wholesale and retail trade sub-sector. ϲϬ Sources. Department of Electricity Development and World Bank staff &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Zϳ ;ĐŽŶƚƌŝďƵƚŝŽŶƚŽƌĞĂů'WŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ calculations. ĐĐŽŵŵŽĚĂƚŝŽŶĂŶĚĨŽŽĚƐĞƌǀŝĐĞĂĐƚŝǀŝƚŝĞƐ ZĞĂůĞƐƚĂƚĞĂĐƚŝǀŝƚŝĞƐ dƌĂŶƐƉŽƌƚĂƚŝŽŶĂŶĚƐƚŽƌĂŐĞ tŚŽůĞƐĂůĞĂŶĚƌĞƚĂŝů KƚŚĞƌ;ƐĞƌǀŝĐĞƐͿ ^ĞƌǀŝĐĞƐ Figure 7. Lower demand reflecting higher prices of ϲ ϱ ;ĐŽŶƚƌŝďƵƚŝŽŶƚŽƌĞĂů'WŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ manufacturing goods and construction materials further ϰ ϯ ĐĐŽŵŵŽĚĂƚŝŽŶĂŶĚĨŽŽĚƐĞƌǀŝĐĞĂĐƚŝǀŝƚŝĞƐ ZĞĂůĞƐƚĂƚĞĂĐƚŝǀŝƚŝĞƐ weighed on industrial output. Ϯ dƌĂŶƐƉŽƌƚĂƚŝŽŶĂŶĚƐƚŽƌĂŐĞ tŚŽůĞƐĂůĞĂŶĚƌĞƚĂŝů ϭ KƚŚĞƌ;ƐĞƌǀŝĐĞƐͿ ^ĞƌǀŝĐĞƐ Ϭ ϲ ;ĐŽŵƉŽŶĞŶƚƐŽĨǁŚŽůĞƐĂůĞƉƌŝĐĞŝŶĚĞdžͿ Ͳϭ ϱ ͲϮ ϰ Ͳϯ DĂŶƵĨĂĐƚƵƌŝŶŐ ŽŶƐƚƌƵĐƚŝŽŶŵĂƚĞƌŝĂůƐ ϯ Ͳϰ ϭϲϬ Ϯ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Zϴ ϭ ϭϰϬ Ϭ Ͳϭ ϭϮϬ Sources. ͲϮ National Statistics Office and World Bank staff calculations. ;ŝŶƚĞƌŶĂƚŝŽŶĂůƚŽƵƌŝƐƚĂƌƌŝǀĂůƐ͕ƚŚŽƵƐĂŶĚƐͿ Ͳϯ ϭϬϬ Ͳϰ ϭ͕ϰϬϬ ϴϬ Zϴ Figure 9. International ϭ͕ϮϬϬ &zϭϮ &zϭϯ &zϭϰ &zϭϱ tourist arrivals &zϭϲ &zϭϳ rose &zϮϬ &zϭϴ &zϭϵ in FY23 &zϮϭ but &zϮϮ &zϮϯ remained below pre-pandemic levels. ϭ͕ϬϬϬ ϲϬ ϴϬϬ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Zϳ ϲϬϬ ;ŝŶƚĞƌŶĂƚŝŽŶĂůƚŽƵƌŝƐƚĂƌƌŝǀĂůƐ͕ƚŚŽƵƐĂŶĚƐͿ ϰϬϬ ϭ͕ϰϬϬ Sources. Department of Customs and World Bank staff calculations. ϮϬϬ Zϵ ϭ͕ϮϬϬ Ϭ ϭ͕ϬϬϬ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ;ĐŽŶƚƌŝďƵƚŝŽŶƚŽƌĞĂů'WŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ External factors also contributed to the contraction ϴϬϬ ĐĐŽŵŵŽĚĂƚŝŽŶĂŶĚĨŽŽĚƐĞƌǀŝĐĞĂĐƚŝǀŝƚŝĞƐ ZĞĂůĞƐƚĂƚĞĂĐƚŝǀŝƚŝĞƐ of manufacturing output in FY23. India dƌĂŶƐƉŽƌƚĂƚŝŽŶĂŶĚƐƚŽƌĂŐĞ implemented a tŚŽůĞƐĂůĞĂŶĚƌĞƚĂŝů ϲϬϬ complete ϲ export restriction on wheat beginning in May 2022, KƚŚĞƌ;ƐĞƌǀŝĐĞƐͿ ^ĞƌǀŝĐĞƐ ϰϬϬ followed ϱ by a partial restriction on wheat exports beginning ϮϬϬ ϰ Zϵ Ϭ in December ϯ 2022. These measures led to the closure of a &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Ϯ significant ϭ number of Nepali flour mills and consequently reduced Ϭ the production capacity of manufacturing firms Sources. Nepal Rastra Bank and World Bank staff calculations. Ͳϭ ͲϮ wheat flour as raw material. using Ͳϯ Ͳϰ Figure 10. Real estate transactions decreased in FY23… Zϴ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Services Sector ;ŶƵŵďĞƌŽĨƌĞĂůĞƐƚĂƚĞƚƌĂŶƐĂĐƚŝŽŶƐ͕ƚŚŽƵƐĂŶĚƐͿ Sluggish wholesale and retail trade slowed the pace ϵϬϬ ;ŝŶƚĞƌŶĂƚŝŽŶĂůƚŽƵƌŝƐƚĂƌƌŝǀĂůƐ͕ƚŚŽƵƐĂŶĚƐͿ ϴϬϬ of services sector growth. Authorities estimate that the ϳϬϬ ϭ͕ϰϬϬ services sector expanded by 2.3 percent in FY23, the slowest ϲϬϬ ϭ͕ϮϬϬ ϱϬϬ pace since ϭ͕ϬϬϬ FY20 (Figure 8). Growth of the wholesale and retail ϰϬϬ tradeϴϬϬ sub-services sector declined 0.5 percent due to high ϯϬϬ ϮϬϬ ϲϬϬ and lower goods imports. Tourism and tourism- inflation ZϭϬ ϭϬϬ related ϰϬϬ activities, which were severely impacted by COVID-19, Ϭ ϮϬϬ &zϮϭ &zϮϮ &zϮϯ Zϵ continued to experience double-digit growth, boosted by a Ϭ significant &zϭϳrise in &zϭϴ international &zϭϵ tourist &zϮϬ arrivals. &zϮϭ The number &zϮϮ &zϮϯ Sources. Department of Land Management and Archive and World Bank of arrivals nevertheless remains below pre-pandemic levels staff calculations. ;ŶĞƚŶĞǁĐƌĞĚŝƚƚŽƌĞĂůĞƐƚĂƚĞ͕EWZŵŝůůŝŽŶͿ 14 ZĞĂůĞƐƚĂƚĞůŽĂŶƐ ZĞƐŝĚĞŶƚŝĂůƉĞƌƐŽŶĂůŚŽŵĞůŽĂŶƐ;ƵƉƚŽEWZϭϱŵŝůůŝŽŶͿ dŽƚĂůĐƌĞĚŝƚƚŽƌĞĂůĞƐƚĂƚĞ ϭϬϬ͕ϬϬϬ NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 Figure 11. …in part to the decrease in net new credit to real estate. ;ŶĞƚŶĞǁĐƌĞĚŝƚƚŽƌĞĂůĞƐƚĂƚĞ͕EWZŵŝůůŝŽŶͿ ZĞĂůĞƐƚĂƚĞůŽĂŶƐ ZĞƐŝĚĞŶƚŝĂůƉĞƌƐŽŶĂůŚŽŵĞůŽĂŶƐ;ƵƉƚŽEWZϭϱŵŝůůŝŽŶͿ dŽƚĂůĐƌĞĚŝƚƚŽƌĞĂůĞƐƚĂƚĞ ϭϬϬ͕ϬϬϬ ϴϬ͕ϬϬϬ ϲϬ͕ϬϬϬ ϰϬ͕ϬϬϬ ϮϬ͕ϬϬϬ ;ŶƵŵďĞƌŽĨƌĞĂůĞƐƚĂƚĞƚƌĂŶƐĂĐƚŝŽŶƐ͕ƚŚŽƵƐĂŶĚƐͿ ϵϬϬ ϴϬϬ ϳϬϬ Ϭ ϲϬϬ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϱϬϬ ϰϬϬ ϯϬϬ Sources. ϮϬϬ Nepal Rastra Bank and World Bank staff calculations. ZϭϬ ϭϬϬ Ϭ &zϮϭ &zϮϮ &zϮϯ GROSS DOMESTIC PRODUCT BY DEMAND ;ŶĞƚŶĞǁĐƌĞĚŝƚƚŽƌĞĂůĞƐƚĂƚĞ͕EWZŵŝůůŝŽŶͿ in public and private investment contributed The reduction ZĞĂůĞƐƚĂƚĞůŽĂŶƐ ZĞƐŝĚĞŶƚŝĂůƉĞƌƐŽŶĂůŚŽŵĞůŽĂŶƐ;ƵƉƚŽEWZϭϱŵŝůůŝŽŶͿ lower domestic production of construction materials, and to the slowdown in overall real GDP growth (Figure 12). Total dŽƚĂůĐƌĞĚŝƚƚŽƌĞĂůĞƐƚĂƚĞ lower imports of intermediate and capital goods (Figure 13). ϭϬϬ͕ϬϬϬ investment declined by 10.9 percent in FY23, greater than the Public investment declined by 20.2 percent and contributed ϴϬ͕ϬϬϬ contraction registered in FY20. Private investment fell by 7.6 negatively by 1.9 pp to the overall real GDP growth, driven ϲϬ͕ϬϬϬ percent and provided a negative contribution of 2 percentage by reduced capital expenditure and reflecting revenue ϰϬ͕ϬϬϬ points (pp) to the overall real GDP growth. The main drivers of underperformance.3 ϮϬ͕ϬϬϬ this decrease were slower credit growth to the private sector, Ϭ Zϭϭ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Figure 12. Lower investment slowed growth on the demand Figure 13. …in part due to lower imports of intermediate side… and capital goods. ;ĐŽŶƚƌŝďƵƚŝŽŶƚŽ'WŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ ;ŽǀĞƌĂůůŝŵƉŽƌƚƐ͕EWZďŝůůŝŽŶͿ WƵďůŝĐĐŽŶƐƵŵƉƚŝŽŶ WƌŝǀĂƚĞĐŽŶƐƵŵƉƚŝŽŶ WƵďůŝĐŝŶǀĞƐƚŵĞŶƚ ĂƉŝƚĂůŐŽŽĚƐ /ŶƚĞƌŵĞĚŝĂƚĞŐŽŽĚƐ dŽƚĂůŝŵƉŽƌƚƐ WƌŝǀĂƚĞŝŶǀĞƐƚŵĞŶƚ ŚĂŶŐĞŝŶŝŶǀĞŶƚŝŽƌLJ EĞƚĞdžƉŽƌƚƐ ϭ͕ϰϬϬ 'WŐƌŽǁƚŚ ϮϬ ϭ͕ϮϬϬ ϭϱ ϭ͕ϬϬϬ ϭϬ ϴϬϬ ϱ ϲϬϬ Ϭ Ͳϱ ϰϬϬ ͲϭϬ ϮϬϬ ZϭϮ Ͳϭϱ Ϭ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Zϭϯ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Sources. National Statistics Office and World Bank staff calculations. Sources. Department of Customs and World Bank staff calculations. ZĞŵŝƚƚĂŶĐĞƐ͕h^ďŝůůŝŽŶ ϭϬ 3 ϴ Section of this report. A discussion on the evolution of fiscal revenues and expenditures during FY23 follows in the Fiscal ϲ THE WORLD BANK | 15 ϰ Ϯ ϭ͕ϮϬϬ ĂƉŝƚĂůŐŽŽĚƐ /ŶƚĞƌŵĞĚŝĂƚĞŐŽŽĚƐ dŽƚĂůŝŵƉŽƌƚƐ ϭ͕ϰϬϬ ϭ͕ϬϬϬ ϭ͕ϮϬϬ ϴϬϬECONOMIC DEVELOPMENTS RECENT ϭ͕ϬϬϬ ϴϬϬ ϲϬϬ ϲϬϬ ϰϬϬ ϰϬϬ ϮϬϬ Ϭ ϮϬϬ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Private consumption remained robust owing to strong Zϭϯ Figure 14. Private consumption remained strong reflecting Ϭ remittances inflows. Remittances rose by 12 percent in higher remittances. ϭϯ FY23 and fueled&zϭϳ &zϭϴ the increase in private&zϭϵ consumption&zϮϬ of 4.1 &zϮϭ &zϮϮ &zϮϯ percent during the year (Figure 14). The decline in goods ZĞŵŝƚƚĂŶĐĞƐ͕h^ďŝůůŝŽŶ ϭϬ imports and domestic goods production suggest that ϴ services consumption, rather than goods consumption, contributed to the growth in private consumption. Public ϲ to lower fiscal transfers consumption declined in part due ZĞŵŝƚƚĂŶĐĞƐ͕h^ďŝůůŝŽŶ ϰ toϭϬ subnational governments, as discussed in the Fiscal Ϯ Section of this report. Ϭ ϴ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Zϭϰ Sources. Nepal Rastra Bank and World Bank staff calculations. ϲ Inflation has accelerated ϰ Average consumer price inflation reached a seven-year ;ĐŽŶƚƌŝďƵƚŝŽŶƚŽŚĞĂĚůŝŶĞŝŶĨůĂƚŝŽŶ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ prices rose by 8.5 percent, driven by higher housing and peak in FY23. Average inflation amounted to 7.8 percent in utility prices, and an increase inEŽŶͲĨŽŽĚĂŶĚƐĞƌǀŝĐĞƐ &ŽŽĚĂŶĚďĞǀĞƌĂŐĞ KǀĞƌĂůůŝŶĚĞdž the consultation fee of ϭϮ FY23, Ϯ above the central bank’s 7 percent policy ceiling, driven medical doctors in May 2023. The decline in edible oil ϭϬ by both food and non-food prices (Figure 15). Key drivers of prices from February 2023 onwards, reflecting global price food prices, which increased by 6.9 percent, included supply reductions, had an offsetting effect on prices. The persistence ϴ Ϭ side shocks such as India’s wheat and rice export restrictions4, of high ϲ inflation impedes policies to stimulate growth. &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϭϰ and domestic policy changes including the removal of VAT Particularly, ϰ Nepal’s vulnerability to external shocks implies exemptions on multiple basic food items and price support a difficult Ϯ trade-off between policies that boost growth and to producers of rice paddies, milk, and wheat5. Non-food those that contain inflation. Ϭ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Zϭϱ Figure 15. Average consumer inflation increased in FY23 due to both food and non-food inflation. džƚĞƌŶĂů ;ĐŽŶƚƌŝďƵƚŝŽŶƚŽŚĞĂĚůŝŶĞŝŶĨůĂƚŝŽŶ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ &ŽŽĚĂŶĚďĞǀĞƌĂŐĞ EŽŶͲĨŽŽĚĂŶĚƐĞƌǀŝĐĞƐ KǀĞƌĂůůŝŶĚĞdž ϭϮ ϭϬ ϴ ϲ ϰ Ϯ Ϭ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϭϱ Source. Nepal Rastra Bank and World Bank staff calculations. džƚĞƌŶĂů 4 India introduced bans on wheat exports in May 2022. During September to November 2022, India also introduced an export ban on broken rice and a 20 percent custom duty on various types of rice exports. 5 Authorities announced the removal of VAT exemptions in May 2023. 16 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 A.2 EXTERNAL SECTOR EXTERNAL SECTOR IMBALANCES HAVE IMPROVED The current account deficit narrowed to a six-year low in Domestic policies and external factors contributed to a FY23, driven by lower imports and higher remittances. significant reduction in goods imports. Industrial supplies The current account deficit fell from 12.6 percent of GDP in were the goods category that experienced the most FY22 to 1.3 percent of GDP in FY23 (Figure 16). The reduction pronounced reduction (Figure 18). Overall, key reasons for occurred through lower imports of goods and services, which lower goods imports included (Table 1): i) the government’s fell from 42.6 percent of GDP in FY22 to 34.5 percent of GDP ban on the import of select luxury goods from April 26, 2022 in FY23. Exports on the other hand remained stable, and to December 15, 2022 ( 0.4 percent of GDP6 ); ii) the central remittances rebounded strongly. Foreign reserves ended bank’s imposition ;ĂƐĂƐŚĂƌĞŽĨ'W͕ of a 50-100 percent cash margin on ƉĞƌĐĞŶƚͿ 'ŽŽĚƐŝŵƉŽƌƚƐ 'ŽŽĚƐĞdžƉŽƌƚƐ FY23 at a comfortable level of 10 months of concurrent of select goods through a^ĞƌǀŝĐĞŝŵƉŽƌƚƐ the import^ĞƌǀŝĐĞĞdžƉŽƌƚƐ letter of credit from ZĞŵŝƚƚĂŶĐĞ ƵƌƌĞŶƚĂĐĐŽƵŶƚďĂůĂŶĐĞ import cover, above the policy floor of 7 months of import December ϰϱ 20, 2021 to January 19, 2023 (- 2 percent of GDP); ϯϱ cover (Figure 17). iii) India’s Ϯϱ restrictions on the export of broken rice and levying of a 20 percent customs duty on the export of other rice ϭϱ ϱ Figure 16. The current account deficit narrowed varieties Ͳϱ from September to November 2022 (-0.5 percent Ͳϭϱ significantly in FY23… of ͲϮϱGDP); iv) India’s ban on the export of wheat beginning Ͳϯϱ May Ͳϰϱ 2022 (-0.2 percent of GDP); v) a reduction in COVID-19 ;ĂƐĂƐŚĂƌĞŽĨ'W͕ ƉĞƌĐĞŶƚͿ ϭϲvaccine imports &zϭϮ ( -0.5 &zϭϯ &zϭϰ &zϭϱpercent &zϭϲ &zϭϳ GDP); of &zϭϴ vi) &zϮϬ &zϭϵ reduced edible &zϮϭ &zϮϮ &zϮϯoil 'ŽŽĚƐŝŵƉŽƌƚƐ 'ŽŽĚƐĞdžƉŽƌƚƐ ^ĞƌǀŝĐĞĞdžƉŽƌƚƐ ^ĞƌǀŝĐĞŝŵƉŽƌƚƐ imports (- 0.7 percent of GDP)7 ; viii) the government’s policy ZĞŵŝƚƚĂŶĐĞ ƵƌƌĞŶƚĂĐĐŽƵŶƚďĂůĂŶĐĞ ϰϱ to discourage billet imports and promote the domestic /ŵƉŽƌƚĐŽǀĞƌĂŐĞŝŶŵŽŶƚŚƐ;>,^Ϳ ϯϱ Ϯϱ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ ƉĞƌĐĞŶƚͿ billet by reducing the customs duty on raw production of&ŽƌĞŝŐŶĞdžĐŚĂŶŐĞƌĞƐĞƌǀĞƐĂƐƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚ;Z,^Ϳ ϭϱ ϭϲ ϰϱ 'ŽŽĚƐŝŵƉŽƌƚƐ 'ŽŽĚƐĞdžƉŽƌƚƐ ϱ ^ĞƌǀŝĐĞĞdžƉŽƌƚƐ ^ĞƌǀŝĐĞŝŵƉŽƌƚƐ materials ϭϰ (sponge iron, scrap iron, pig iron and ferro alloys) ϰϬ Ͳϱ ϯϱ ϰϱ Ͳϭϱ ZĞŵŝƚƚĂŶĐĞ ƵƌƌĞŶƚĂĐĐŽƵŶƚďĂůĂŶĐĞ used ϭϮ to produce billets (0.4 percent of GDP) and levying ϯϬ the ϯϱ ϭϬ ͲϮϱ Ϯϱ Ͳϯϱ custom ϴ duty and excise duty on billets import (-0.5 percent Ϯϱ ϮϬ ϭϱ Ͳϰϱ of GDP); ϲ and viii) transition from fossil fuel to electricity ϭϱ by ϭϲ ϱ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϰ Ͳϱ manufacturing Ϯ firms and households 8 (-0.7 percent of GDP). ϭϬ Ͳϭϱ ϱ ϭϳ ͲϮϱ Ϭ Ϭ Sources. Nepal Rastra Bank and World Bank Bank staff calculations. Ͳϯϱ /ŵƉŽƌƚĐŽǀĞƌĂŐĞŝŶŵŽŶƚŚƐ;>,^Ϳ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Ͳϰϱ &ŽƌĞŝŐŶĞdžĐŚĂŶŐĞƌĞƐĞƌǀĞƐĂƐƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚ;Z,^Ϳ Figure 18. Goods imports plunged in FY23. ϭϲ ϭϲ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϰϱ Figure 17. …leading to an accumulation of reserves. ϭϰ ϰϬ ϯϱ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ϭϮ ϭϬ ϯϬ &ŽŽĚĂŶĚĞǀĞƌĂŐĞƐ /ŶĚƵƐƚƌŝĂůƐƵƉƉůŝĞƐ &ƵĞů /ŵƉŽƌƚĐŽǀĞƌĂŐĞŝŶŵŽŶƚŚƐ;>,^Ϳ Ϯϱ ĂƉŝƚĂůŐŽŽĚƐ dƌĂŶƐƉŽƌƚĞƋƵŝƉŵĞŶƚ ŽŶƐƵŵĞƌŐŽŽĚƐ ϴ &ŽƌĞŝŐŶĞdžĐŚĂŶŐĞƌĞƐĞƌǀĞƐĂƐƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚ;Z,^Ϳ ϮϬ dŽƚĂůŝŵƉŽƌƚƐ ϭϲ ϲ ϰϱ ϭϱ ϰϬ ϭϰϰ ϰϬ ϭϬ ϯϱ ϭϮϮ ϱϯϱ ϯϬ ϭϳ ϭϬϬ ϬϯϬ Ϯϱ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Ϯϱ ϮϬ ϴ ϮϬ ϭϱ ϲ ϭϱ ϰ ϭϬ ϭϬ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ϱ Ϯ ϱ ϭϳ Ϭ Ϭ &ŽŽĚĂŶĚĞǀĞƌĂŐĞƐ /ŶĚƵƐƚƌŝĂůƐƵƉƉůŝĞƐ &ƵĞů Ϭ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ĂƉŝƚĂůŐŽŽĚƐ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ dƌĂŶƐƉŽƌƚĞƋƵŝƉŵĞŶƚ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ ŽŶƐƵŵĞƌŐŽŽĚƐ &zϮϮ &zϮϯ ϭϴ dŽƚĂůŝŵƉŽƌƚƐ ϰϬ Source. Department of Customs and World Bank staff calculations. ϯϱ Sources. Nepal Rastra Bank and World Bank staff calculations. Note. Goods imports do not include electricity imports. ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ϯϬ Ϯϱ &ŽŽĚĂŶĚĞǀĞƌĂŐĞƐ /ŶĚƵƐƚƌŝĂůƐƵƉƉůŝĞƐ &ƵĞů ϮϬ ĂƉŝƚĂůŐŽŽĚƐ dƌĂŶƐƉŽƌƚĞƋƵŝƉŵĞŶƚ ŽŶƐƵŵĞƌŐŽŽĚƐ ϭϱ dŽƚĂůŝŵƉŽƌƚƐ ϰϬϭϬ ϱ 6 ϯϱ Increase of imports suggests that imports increased in the second half of FY23 after lifting of restrictions, leading to the overall increase in FY23 relative to FY22. ϯϬϬ 7 Nepal has &zϭϰbenefitted &zϭϳ from in the past &zϭϱ &zϭϲ trade &zϭϴ preferences &zϭϵ &zϮϬ in edible &zϮϭ oils, despite &zϮϯ not producing crude edible oil itself. During FY23, India reduced its import duties with non-SAARC &zϮϮ ϭϴ Ϯϱ countries on crude and refined edible oils (palm, soybean, sunflower). As the advantage that Nepal previously enjoyed by refining imported crude edible oils and exporting ϮϬ those oils to India dwindled, Nepal’s imports of crude edible oils declined accordingly. ϭϱ 8 Total sales (Gigawatt hour) increased by 5.7 percent between FY22 and FY23. ϭϬ ϱ Ϭ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ THE WORLD BANK | 17 ϭϴ RECENT ECONOMIC DEVELOPMENTS Table 1. Impact of key policy changes on import value and import revenue of FY23.   Import value Import revenue share share Key policy changes NPR million of GDP, NPR million of GDP, percent percent Imposition of import restriction and cash reserve requirement on -186880 -3.5 -97735 -1.8 select goods o/w: Imposition of import restriction on select goods 22256 0.4 4467 0.1 o/w: Imposition of cash reserve requirement on select goods -105820 -2.0 -40499 -0.8 o/w: Imposition of cash reserve requirement and import restriction -103316 -1.9 -61703 -1.1 on select goods (both) India's trade restrictions on select goods -76084 -1.4 -5066 -0.1 o/w: export of broken rice and levying of a 20 percent customs duty -28090 -0.5 -2530 0.0 on the export of other rice varieties o/w: export of wheat -11262 -0.2 -199 0.0 o/w: reduced custom duties on imports of edible oil -36732 -0.7 -2337 0.0 Dissipation of one-off import of COVID-19 vaccine -25981 -0.5 0 0.0 Government policy to discourage imports of billet and encourage the -7422 -0.1 -2780 -0.1 domestic production of billet o/w: Reduction in the custom duty on raw materials (sponge iron 21015 0.4 3072 0.1 and pig iron) used to produce billet o/w: Imposition of the custom duty and excise duty on import of -28437 -0.5 -5852 -0.1 billet Transition to electricity -35238 -0.7 -15057 -0.3 Total -331604 -6.2 -120637 -2.2 Sources. Department of Customs, National Statistics Office, and World Bank staff calculations. Note. Negative sign indicates decrease. Imports of services, on the other hand, expanded by 0.4 Figure 19. Exports of goods and services increase pp to 5.1 percent of GDP. Educational service imports rose marginally. to 1.9 percent of GDP in FY23. During FY23, the authorities issued more than 100,000 no objection certificates (NOC) to ;ĐŽŵƉŽŶĞŶƚƐŽĨŐŽŽĚƐĂŶĚƐĞƌǀŝĐĞƐĞdžƉŽƌƚƐĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ students for studying abroad, as required by the Ministry of ůĞĐƚƌŝĐŝƚLJ WĂůŵŽŝů ^ŽLJĂďĞĂŶŽŝů ĂƌĚĂŵŽŵ Education. KƚŚĞƌŐŽŽĚƐ ĂƌƉĞƚ ^ĞƌǀŝĐĞƐ KǀĞƌĂůůĞdžƉŽƌƚƐ ϵ ϴ Exports of goods and services stagnated and remained ϳ ϲ below their pre-pandemic level. Total exports rose by a ϱ meager 0.1 percent of GDP between FY22 and FY23, from 6.8 ϰ ϯ to 6.9 percent of GDP (Table 2). Goods exports decreased by Ϯ ϭ 0.9 percent of GDP, owing to lower exports of refined edible Ϭ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ oils (Figure 19). This was offset by a 1 percent of GDP increase ϭϵ in services exports, due to higher international tourist Sources. Department of Customs, Nepal Rastra Bank, and World Bank staff arrivals. Electricity exports to India continued to increase calculations. ;ŶƵŵďĞƌŽĨŽƵƚͲŵŝŐƌĂƚŝŽŶ͕ƚŚŽƵƐĂŶĚƐͿ ϲϬϬ ϱϬϬ ϰϬϬ 18 ϯϬϬ ϮϬϬ ϭϬϬ NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 ;ĐŽŵƉŽŶĞŶƚƐŽĨŐŽŽĚƐĂŶĚƐĞƌǀŝĐĞƐĞdžƉŽƌƚƐĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ůĞĐƚƌŝĐŝƚLJ WĂůŵŽŝů ^ŽLJĂďĞĂŶŽŝů ĂƌĚĂŵŽŵ KƚŚĞƌŐŽŽĚƐ ĂƌƉĞƚ ^ĞƌǀŝĐĞƐ KǀĞƌĂůůĞdžƉŽƌƚƐ ϵ ϴ Table 2. Selected External Sector Indicators (percent of GDP). ϳ ϲ ϱ   FY17 FY18 ϰ FY19 FY20 FY21 FY22 FY23 ϯ Current Account Balance -0.3 -7.1 Ϯ -6.9 -0.9 -7.7 -12.6 -1.3 ϭ Ϭ Balance of Goods and Services -29.1 -32.9 -33.3 &zϭϲ &zϭϳ -27.3 &zϭϴ &zϭϵ -31.1 &zϮϬ &zϮϭ -33.7 &zϮϮ -26.0 &zϮϯ ϭϵ Total Exports of Goods and Services 7.8 7.8 7.8 6.8 5.1 6.8 6.9 Total Imports of Goods and Services 36.8 41.4 34.1 40.6 ;ŶƵŵďĞƌŽĨŽƵƚͲŵŝŐƌĂƚŝŽŶ͕ƚŚŽƵƐĂŶĚƐͿ 37.9 42.6 34.5 ϲϬϬ Remittances 22.6 21.8 22.8 22.5 22.1 20.4 22.7 ϱϬϬ Net Foreign Direct Investment 0.4 0.5 0.3 0.5 0.4 0.4 0.1 ϰϬϬ Gross Official Reserves (USD billion) 10.2 10.6 ϯϬϬ 9.2 12.1 11.9 10.1 11.8 Sources. Nepal Rastra Bank and World Bank staff calculations ϮϬϬ ϭϬϬ Ϭ alongside higher domestic production of hydroelectricity ϮϬ 21. ...increasing Figure &zϭϲ &zϭϳ &zϭϴ the remittances &zϭϵ &zϮϬ inflows &zϮϭ sent&zϮϯ &zϮϮ back, and rose to 0.2 percent of GDP in FY23, up from less than 0.1 with a lag. percent of GDP in FY22. Nepal, however, is still a net importer of electricity.9 Exports of cardamon and carpet rose by ZĞŵŝƚƚĂŶĐĞƐĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚ;>,^Ϳ ZĞŵŝƚƚĂŶĐĞƐ͕h^ďŝůůŝŽŶ;Z,^Ϳ approximately to 0.1 percent of GDP. ϯϬ ϭϬ Ϯϱ ϴ Official remittance inflows surged to a five-year high in ϮϬ ϲ FY23. Remittance inflows climbed from 20.4 percent of GDP ϭϱ in FY22 to 22.7 percent of GDP in FY23 (Figure 21). The increase ϭϬ ϰ reflected i) the lagged impact of high outmigration in the ϱ Ϯ previous year (Figure 20); ii) the 8.2 percent depreciation of ;ĐŽŵƉŽŶĞŶƚƐŽĨŐŽŽĚƐĂŶĚƐĞƌǀŝĐĞƐĞdžƉŽƌƚƐĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ Ϭ Ϭ the NPR against &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ůĞĐƚƌŝĐŝƚLJ the US dollar; iii) the WĂůŵŽŝů regulatory requirement ^ŽLJĂďĞĂŶŽŝů ĂƌĚĂŵŽŵ Ϯϭ to set aside 10 percent KƚŚĞƌŐŽŽĚƐ of Initial Public ĂƌƉĞƚ Offering (IPO) ^ĞƌǀŝĐĞƐ shares KǀĞƌĂůůĞdžƉŽƌƚƐ Sources. Nepal Rastra Bank and World Bank Staff calculations. ϵ of Nepali ϴ companies for Nepalis working abroad, beginning in November ϳ 2022; and iv) the expansion of social security ϲ benefits to Nepalis working abroad, beginning in March ϱ ϰ 2023.10 Previous remittance incentives include a one ϯ Ϯ Figure 20. Outmigration of Nepalis for work outside the percentage point fixed deposit interest rate boost for Nepali ;ƵŐƵƐƚϮϬϬϮсϭϬϬͿ ϭ country surged following the pandemic and the lifting of Ϭ migrant workers that open a remittance-funded account &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϭϵ movement and border restrictions… with domestic banks or financial institutions. In the first 10 months of FY23, the share of such remittances deposits in the ;ŶƵŵďĞƌŽĨŽƵƚͲŵŝŐƌĂƚŝŽŶ͕ƚŚŽƵƐĂŶĚƐͿ overall fixed deposits stood at 2.3 percent. ϲϬϬ Despite a nominal depreciation, the Nepali rupee (NPR) ϱϬϬ appreciated in real terms against the currencies of trading ϰϬϬ partners during FY23, as it has in many prior years. The ϯϬϬ real effective exchange rate (REER) of the NPR appreciated ϮϬϬ by 0.6 percent in FY23 (Figure 22), reflecting higher inflation ϭϬϬ in Nepal relative to trading partners. Removing inflation Ϭ ϮϬ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ from the calculation, the nominal effective exchange rate (NEER) depreciated by 1.7 percent against Nepal’s trading Sources. Nepal Rastra Bank and World Bank Staff calculations. partners (Figure 22). The NEER depreciation reflects the US ZĞŵŝƚƚĂŶĐĞƐĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚ;>,^Ϳ ZĞŵŝƚƚĂŶĐĞƐ͕h^ďŝůůŝŽŶ;Z,^Ϳ ϯϬ ϭϬ Ϯϱ ϴ ϮϬ ϲ Imports of thermal-produced electricity from India during the dry season rose to 0.4 percent of GDP in FY23. ϭϱ 9 By the end of FY23, more than 237,000 migrant workers have enrolled in theϰ 10 social security plan. ϭϬ ϱ Ϯ THE WORLD BANK | 19 Ϭ Ϭ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Ϯϭ EZ ZZ ;ƵŐƵƐƚϮϬϬϮсϭϬϬͿ EZ ZZ ϭϱϬ ϭϱϬ ϭϰϬ ϭϰϬ ECONOMIC DEVELOPMENTS RECENT ϭϯϬ ϭϯϬ ϭϮϬ ϭϭϬ ϭϮϬ ϭϬϬ ϵϬ ϭϭϬ ϴϬ ϭϬϬ 22. Nepal’s real effective exchange rate (REER) ϮϮ Figure Figure ϳϬ 23. The depreciation of the NPR against the USD &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ appreciated during FY23 reflecting higher prices in Nepal directly reflects the depreciation of the INR against the ϵϬ relative to that of trading partners. USD. ϴϬ ϳϬ ;ƵŐƵƐƚϮϬϬϮсϭϬϬͿ EZ ZZ /EZͬh^ ϭϱϬ ϵϬ ϮϮ ϭϰϬ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϴϬ ϭϯϬ ϭϮϬ ϳϬ ϭϭϬ ϲϬ ϭϬϬ ϱϬ ϵϬ ϴϬ ϰϬ ϳϬ ϯϬ ϮϮ /EZͬh^ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Ϯϯ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϵϬ Sources. World Bank staff calculations. Sources. IMF ϴϬ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ ƉĞƌĐĞŶƚͿ ŚĂŶŐĞƐŝŶƌĞƐĞƌǀĞŶĞƚ ŝƌĞĐƚŝŶǀĞƐƚŵĞŶƚŶĞƚ džƚĞƌŶĂůůŽĂŶƐŶĞƚ /EZͬh^ to the Indian rupee (INR) Dollar (USD) appreciation relative (Figure 24). Foreign direct investment ^ŚŽƌƚͲƚĞƌŵĐƌĞĚŝƚŶĞƚ KƚŚĞƌƐŶĞƚ remained negligible KǀĞƌĂůůĨŝŶĂŶĐŝŶŐ ϳϬ ϵϬ and other major currencies. Due to the peg, Nepal’s nominal and contributed ϵ a mere 0.1 percent of GDP. Trade credit and ϴϬ exchange rate with convertible currencies is exogenous advances ϲ contributed 2.2 percent of GDP, while errors and ϲϬ ϳϬ to Nepali policy and instead directly reflects movements omissions ϯ in the balance of payments are estimated by the ϲϬ Ϭ ϱϬ the INR and other currencies (Figure 23). between central bank to have reached USD 1.1 billion during the year, ϱϬ Ͳϯ equivalent to 2.5 percent of GDP. As the financing exceeded As the ϰϬ current account deficit narrowed and external Ͳϲ ϰϬ the current account deficit, foreign exchange reserves rose debtϯϬservicing obligations remained low, foreign reserves by 4 Ͳϵ percent of GDP in the year to 28.6 percent of GDP in FY23, Ϯϯ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ͲϭϮ ϯϬ during FY23. Net external borrowing provided 1.7 increased equivalent to 10 months &zϮϬ &zϭϵ of concurrent imports of goods &zϮϭ &zϮϮ and &zϮϯ Ϯϯ GDP in percent of&zϭϮ &zϭϰto &zϭϱ financing &zϭϯ &zϭϲ account the current &zϭϳ &zϭϴdeficit &zϭϵ Ϯϰ &zϮϬ services. &zϮϭ &zϮϮ &zϮϯ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ ƉĞƌĐĞŶƚͿ ŚĂŶŐĞƐŝŶƌĞƐĞƌǀĞŶĞƚ ŝƌĞĐƚŝŶǀĞƐƚŵĞŶƚŶĞƚ DŽŶĞƚĂƌLJ džƚĞƌŶĂůůŽĂŶƐŶĞƚ Figure 24. Current account deficit ^ŚŽƌƚͲƚĞƌŵĐƌĞĚŝƚŶĞƚ was financed by net KƚŚĞƌƐŶĞƚ external loans and other sources. KǀĞƌĂůůĨŝŶĂŶĐŝŶŐ ϵ ϲ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ ƉĞƌĐĞŶƚͿ ϯ Ϭ ŚĂŶŐĞƐŝŶƌĞƐĞƌǀĞŶĞƚ ŝƌĞĐƚŝŶǀĞƐƚŵĞŶƚŶĞƚ džƚĞƌŶĂůůŽĂŶƐŶĞƚ Ͳϯ ^ŚŽƌƚͲƚĞƌŵĐƌĞĚŝƚŶĞƚ KƚŚĞƌƐŶĞƚ KǀĞƌĂůůĨŝŶĂŶĐŝŶŐ Ͳϲ Ͳϵ ϵ ͲϭϮ ϲ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Ϯϰ ϯ DŽŶĞƚĂƌLJ Ϭ Ͳϯ Ͳϲ Ͳϵ ͲϭϮ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Ϯϰ Sources. Nepal Rastra Bank and World Bank staff calculations. DŽŶĞƚĂƌLJ 20 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 A.3 MONETARY AND FINANCIAL SECTOR Monetary policy objectives and challenges Liquidity and solvency indicators in the The primary objective of the central bank, Nepal Rastra banking sector appear healthy Bank (NRB), is to implement monetary and exchange rate The number of banks and financial institutions (BFIs) policy to achieve price and balance of payments stability for continued to fall in FY23. Following the introduction economic stability and sustainable economic development.11 of a merger and acquisition policy by the regulator in During FY23 particular attention was paid to closing the wide previous years, the combined number of commercial banks, current account deficit resulting from high import demand development banks, and finance companies fell from 60 to 54 and the nominal depreciation of the NPR against convertible during FY23.14 currencies. Indicators of bank soundness appear strong. Total capital When the FY23 Monetary Policy was released, NRB anticipated to risk-weighted assets ratio among BFIs - a measure of bank difficulties in maintaining foreign exchange reserves above capital adequacy – ended FY23 at 13.4 percent, relatively the policy floor of seven months of import cover, even if all unchanged compared to FY22. Non-performing loans (NPLs) foreign grants and loans in the government’s budget were of BFIs, –those loans that are overdue by 90 days or more, to materialize.12 Continued gradual removal of regulatory have increased to 3 percent of total loans by end-FY23.15 pandemic-era forbearance was planned, as well as reducing While this is the highest NPL ratio registered in the past six the concentration of credit. years, it remains low by international standards. The final import restriction imposed during FY22 was Although financial institution soundness indicators dismantled in January 2023. In January 2023, the requirement remain reassuring, some forbearance measures in place of a cash deposit (cash margin, equivalent to 50-100 through the end of FY23 may mask actual asset quality in percent of import value) to be placed in a bank account the banking sector. As of mid-July 2023, NPR 197.1 billion in when an importer opened a Letter of Credit was removed. loans has been provided to 147,778 borrowers at subsidized The central bank noted that the three import restriction interest rates under the government’s concessional lending measures imposed in FY22 – bans on specific goods imports, program. Other examples of continued forbearance measures requirements to open a Letter of Credit for importation, and cited in the central bank’s FY23 mid-term review of monetary the further requirement of cash deposits (cash margins) policy include waiving penalty interest charges on repayments backing such Letters of Credit – contributed to the 21 percent when payment is made within one month of the maturity date, decline in goods imports during the first half of FY23.13 and the possibility to restructure SME loans under NPR 20 NRB’s inflation ceiling of 7 percent for FY23 was not met. million. As described in more detail in the Real Section of the current The government envisions a closer look at the asset report, average consumer prices rose by 7.8 percent in FY23. High quality of Nepali banks. As part of its larger reform program, inflation weighs on growth and aggregate demand, in addition by end-April 2024 the government will launch in-depth on- to appreciating the country’s real effective exchange rate site inspections of the largest 10 banks. These inspections and reducing the competitiveness of Nepali firms. Further will be assisted by independent international third-party discussion of these impacts is provided in the Special Focus auditors with the aim of reviewing loan portfolios in line with of the current report. the new regulatory framework, paying special attention to loan and collateral valuation, evergreening, group borrowing, Paragraph 1 of the Nepal Rastra Bank “Monetary Policy for 2022/23” statement 11 Paragraph 58 of the Nepal Rastra Bank “Monetary Policy for 2022/23” statement 12 Paragraph 40 of the Nepal Rastra Bank “Half-Yearly Review of Monetary Policy for 2022/23” 13 The combined number of commercial banks, development banks, and finance companies has fallen steadily since 2018, when they numbered 86. (NRB Financial Stability 14 Report FY 2021/22). Nepal Rastra Bank, “Banking and Financial Statistics, Monthly”, Mid-July 2023 15 THE WORLD BANK | 21 RECENT ECONOMIC DEVELOPMENTS and concentration risks.16 Following these assessments, the NRB removed COVID-19 related credit relief measures such as government intends to develop a plan to address the review’s the extension of grace periods for industries or projects under findings, and any bank with a capital shortfall will be required construction, the extension of loan payment schedules, and to submit a capital management plan that sets out how they generous provisions on restructuring and rescheduling of loans. will return to full compliance with regulatory requirements. The inflation ceiling was set at 7 percent (0.5 pp higher than the previous year’s ceiling), the policy floor of foreign exchange Market capitalization of the Nepali stock market relative reserves covering 7 months of imports was maintained, and to GDP fell for the second year in a row during FY23. Market growth of broad money and credit to the private sector were capitalization ended FY23 at 57.3 percent of GDP, 0.9 pp lower projected at 12 and 12.6 percent, respectively. than at the end of FY22 and 34.9 pp lower than at end FY22. Two years of successive contraction in market capitalization NRB raised the policy rate at the beginning of FY23 when the economy grew at 5.6 percent and 1.9 percent to continue slowing credit growth. The policy rate (the suggests there is not a close relationship between economic repo rate) was increased by 150 bps to 7 percent in August growth and equity market expansion. Instead, within the 2022 (Figure 27) and maintained at this level throughout confines of an economy subject to capital controls, Nepali the year. Contextually, higher rate policies are viewed investors have relatively few investment choices.17 The top as a normalization of the monetary stance following the three sectors in terms of market capitalization ending FY23 expansive policies during and immediately following the were commercial banks (30.9 percent), insurance companies COVID-19 dislocations in the private sector. Before the policy (15.4 percent), and hydropower companies (13.2 percent). rate was raised to 7 percent in August 2022, the policy rate was range-bound between 3 and 5.5 percent from FY18 to FY22. The bank rate was set at 8.5 percent and the deposit Policy focused on moderating credit collection rate at 5.5 percent. These rates, together with the growth and thus import demand policy rate, determine the interest rate corridor (IRC). Credit growth was exuberant in FY21 and FY22 (Figures NRB announced that a deposit collection auction would 25 and 26), and a host of measures were deployed during be established and activated when the interbank rate FY22 and FY23 to moderate credit growth and thus import decreases by more than 1.5 pps below the policy rate. EĞƚŶĞǁƉƌŝǀĂƚĞƐĞĐƚŽƌĐƌĞĚŝƚ͕EWZϮϬďŝůůŝŽŶ;>,^Ϳ demand. Monetary policy at the start of FY23 was designed However, as shown in Figure 27, two episodes of excess tĞŝŐŚƚĞĚĂǀĞƌĂŐĞůĞŶĚŝŶŐƌĂƚĞ͕ƉĞƌĐĞŶƚ;Z,^Ϳ ϲ ϭϮ to balance support for the economic recovery with the liquidity lowered the interbank rate below the tolerance ϱ ϭϬ tightening required for economic and financial stability. NRB’s ϰ during FY23. It is unclear why excess liquidity wasϴ not limit Monetary Policy for FY23 aimed at reallocating credit to the ϯ absorbed during June and July 2023, as excess liquidityϲcan Ϯ ϰ productive sector rather than focusing on credit growth.18 lead to higher inflation. ϭ Ϯ Ϭ Ϭ Figure 25. Higher average lending rates, higher international Figure 26. As a result, import growth contracted on an ƉƌͲϮϬ ƉƌͲϮϭ ƉƌͲϮϮ ƉƌͲϮϯ :ĂŶͲϮϬ :ĂŶͲϮϭ :ƵůͲϮϭ :ĂŶͲϮϮ :ƵůͲϮϮ :ĂŶͲϮϯ KĐƚͲϭϵ :ƵůͲϮϬ KĐƚͲϮϭ KĐƚͲϮϮ :ƵůͲϮϯ KĐƚͲϮϬ prices, and import restrictions led to new credit declining&ŝŐϮϱ annual basis while credit growth continued to slow. sharply. ;ϲŵŽŶƚŚŵŽǀŝŶŐĂǀĞƌĂŐĞͿ ;ϲŵŽŶƚŚŵŽǀŝŶŐĂǀĞƌĂŐĞ͕ƉĞƌĐĞŶƚͿ EĞƚŶĞǁƉƌŝǀĂƚĞƐĞĐƚŽƌĐƌĞĚŝƚ͕EWZϮϬďŝůůŝŽŶ;>,^Ϳ /ŵƉŽƌƚŐƌŽǁƚŚ;>,^Ϳ WƌŝǀĂƚĞĐƌĞĚŝƚŐƌŽǁƚŚ;Z,^Ϳ tĞŝŐŚƚĞĚĂǀĞƌĂŐĞůĞŶĚŝŶŐƌĂƚĞ͕ƉĞƌĐĞŶƚ;Z,^Ϳ ϴϬ ϯϱ ϲ ϭϮ ϲϬ ϯϬ ϱ ϭϬ Ϯϱ ϰ ϴ ϰϬ ϮϬ ϯ ϲ ϮϬ ϭϱ Ϯ ϰ Ϭ ϭϬ ϭ Ϯ ͲϮϬ ϱ Ϭ Ϭ ͲϰϬ Ϭ KĐƚͲϭϵ KĐƚͲϮϬ KĐƚͲϮϭ KĐƚͲϮϮ :ƵůͲϮϬ ƉƌͲϮϬ ƉƌͲϮϭ ƉƌͲϮϮ :ƵůͲϮϭ :ƵůͲϮϮ :ƵůͲϮϯ :ƵůͲϭϵ ƉƌͲϮϯ :ƵůͲϮϯ KĐƚͲϭϵ ƉƌͲϮϬ KĐƚͲϮϬ ƉƌͲϮϭ KĐƚͲϮϭ :ĂŶͲϮϬ ƉƌͲϮϮ KĐƚͲϮϮ ƉƌͲϮϯ :ƵůͲϮϬ :ĂŶͲϮϭ :ƵůͲϮϭ :ĂŶͲϮϮ :ƵůͲϮϮ :ĂŶͲϮϯ :ĂŶͲϮϬ :ĂŶͲϮϭ :ĂŶͲϮϮ :ĂŶͲϮϯ &ŝŐϮϱ &ŝŐϮϲ Sources. Nepal Rastra Bank and World Bank staff calculations. Sources. Nepal Rastra Bank and World Bank staff calculations. ;ƉĞƌĐĞŶƚĂŐĞ͕ǁĞŝŐŚƚĞĚĂǀĞƌĂŐĞͿ IMF, April 12, 2023. Attachment 1 “Memorandum of Economic and Financial Policies” of the “Nepal: Staff Report for the 2023 Article IV Consultation, First and Second 16 /ŶƚĞƌďĂŶŬƌĂƚĞ Reviews under the Extended Credit Facility Arrangement, Requests for Waivers of Nonobservance of Performance hƉƉĞƌďŽƵŶĚƌĂƚĞ Criteria, Extension of the Arrangement, >ŽǁĞƌďŽƵŶĚƌĂƚĞ and Rephasing of WŽůŝĐLJƌĂƚĞ Disbursements” ϭϬ ϵ ϴ by non-resident Nepalis in the stock market is currently under consideration Foreign participation in the Nepali stock market is not permitted. A proposal to allow investments 17 by the Nepal Securities Board. ϳ Nepal Rastra Bank, July 22, 2022 “Monetary Policy for 2022/23 (unofficial translation)” delivered 18 ϲby Governor Mr. Maha Prasad Adhikari ϱ ϰ ϯ 22 Ϯ ϭ Ϭ Ͳϭ Ϭ ϭϬ ͲϮϬ ϱ ͲϰϬ Ϭ NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 KĐƚͲϮϬ KĐƚͲϮϭ KĐƚͲϮϮ KĐƚͲϭϵ ƉƌͲϮϬ ƉƌͲϮϭ ƉƌͲϮϮ ƉƌͲϮϯ :ƵůͲϭϵ :ƵůͲϮϯ :ĂŶͲϮϬ :ƵůͲϮϬ :ĂŶͲϮϭ :ƵůͲϮϭ :ĂŶͲϮϮ :ƵůͲϮϮ :ĂŶͲϮϯ &ŝŐϮϲ Figure 27. A gradual reduction in the upper bound of the Interest Rate Corridor was observed at the end of FY23, accompanied by lower interbank lending rates in the second half of the year. ;ƉĞƌĐĞŶƚĂŐĞ͕ǁĞŝŐŚƚĞĚĂǀĞƌĂŐĞͿ /ŶƚĞƌďĂŶŬƌĂƚĞ hƉƉĞƌďŽƵŶĚƌĂƚĞ >ŽǁĞƌďŽƵŶĚƌĂƚĞ WŽůŝĐLJƌĂƚĞ ϭϬ ϵ ϴ ϳ ϲ ϱ ϰ ϯ Ϯ ϭ Ϭ Ͳϭ ƉƌͲϭϴ :ĂŶͲϭϵ ƉƌͲϮϮ ƉƌͲϮϯ :ƵůͲϮϬ :ƵůͲϮϭ ƵŐͲϮϯ ƵŐͲϭϴ ƵŐͲϭϵ ĞĐͲϮϬ :ĂŶͲϮϯ ĞĐͲϭϵ :ƵŶͲϭϴ :ƵŶͲϭϵ KĐƚͲϭϵ KĐƚͲϮϬ :ƵŶͲϮϮ :ƵŶͲϮϯ EŽǀͲϭϴ EŽǀͲϮϮ EŽǀͲϮϭ DĂƌͲϭϵ DĂƌͲϮϬ DĂLJͲϮϬ DĂLJͲϮϭ &ĞďͲϮϭ ^ĞƉͲϮϮ ^ĞƉͲϮϭ &ĞďͲϮϮ &ŝŐϮϳ Source. Nepal Rastra Bank and World Bank staff calculations. Notes. The Interest Rate Corridor is composed of (a) an upper bound, the Standing Liquidity Facility (SLF), (b) the policy rate, which is the central bank’s repo rate, and (c) a lower bound, the Deposit Collection Rate. NRB expanded liquidity facilities for commercial banks.19 from FY22 to FY23 (Figure 29). Year-on-year nominal credit These consisted of: (a) an Intraday Liquidity Facility (ILF) at growth slowed from a peak of 30 percent in FY22 to a trough the bank rate; (b) an Overnight Liquidity Facility (OLF) at the of 5 percent in FY23, applying a 6-month moving average bank rate; (c) a Standing Liquidity Facility (SLF) provided for a (Figures 25 and 26). maximum period of 5 days at the bank rate; and (d) lender of last resort facilities available once all other liquidity provision is exhausted, at 2 pp above the bank rate. Once credit growth was controlled, Several regulatory settings for the financial sector were gradual policy rate relaxation could revised midway through FY23, though interest rates commence remained unchanged.20 The OLF facility was activated and set at the policy rate of 7 percent, and the ILF was set at the Financial market liquidity conditions began to ease in the bank rate of 8.5 percent. Working capital loan guidelines second half of FY23, as evidenced by greater interbank were amended, and the Intraday Liquidity Facility Procedure rate fluctuations and lower banking sector demand for was amended. central bank liquidity. After pegging for months at the upper end of the IRC, the interbank rate fell below the SLF The combined impact of higher international prices, import rate in December 2022 and began fluctuating within the restrictions, and policy rate hikes led to a slowdown in corridor as the interbank market was able to supply sufficient credit to the private sector as a share of GDP during FY23. liquidity to its members within the prevailing interest rate Nominal credit to the private sector grew at a slower rate regime (Figure 27). The amount of liquidity requested by the than GDP during FY23. Hence, relative to GDP, credit to the banking system of the central bank also declined relative to private sector shrank from 100 percent to 94 percent of GDP that of FY22 (Figure 32). ILF, OLF, and SLF liquidity available to commercial banks on demand, collateralized with government securities. 19 Regulatory changes in the financial system announced in the Nepal Rastra Bank “Half-Yearly Review of Monetary Policy for 2022/23” include requirements for commercial banks 20 to maintain a statutory liquidity ratio (SLR) of 12 percent, while development banks and finance companies are required to maintain an SLR of 10 percent as of January 2023. The counter-cyclical buffer was reinstated in July 2023 following suspension of the measure during the pandemic. THE WORLD BANK | 23 ŐƌŝĐƵůƚƵƌĞ /ŶĚƵƐƚƌLJ ŽŶƐƚƌƵĐƚŝŽŶ ^ĞƌǀŝĐĞ KƚŚĞƌƐ dŽƚĂůĐƌĞĚŝƚͬ'W ϭϮϬ ϭϬϬ RECENT ECONOMIC DEVELOPMENTS ϴϬ ϲϬ ϰϬ ϮϬ Ϭ &ŝŐϮϵ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Figure 28. Nominal interest rates have been falling since Figure 30. …real deposit rates remained positive following they peaked in March 2023 interest rate hikes … ;ƉĞƌĐĞŶƚͿ ;ƉĞƌĐĞŶƚͿ /ŶĨůĂƚŝŽŶƌĂƚĞ ZĞĂůĚĞƉŽƐŝƚƌĂƚĞ ZĞĂůůĞŶĚŝŶŐƌĂƚĞ tĞŝŐŚƚĞĚĂǀĞƌĂŐĞĚĞƉŽƐŝƚƌĂƚĞ tĞŝŐŚƚĞĚĂǀĞƌĂŐĞůĞŶĚŝŶŐƌĂƚĞ ĂƐĞƌĂƚĞ ϭϬ ϭϰ ϴ ;ƉĞƌĐĞŶƚͿ ϭϮ ϲ tĞŝŐŚƚĞĚĂǀĞƌĂŐĞĚĞƉŽƐŝƚƌĂƚĞ tĞŝŐŚƚĞĚĂǀĞƌĂŐĞůĞŶĚŝŶŐƌĂƚĞ ĂƐĞƌĂƚĞ ϭϬ ϰ ϭϰ ϴ Ϯ ϲ ϭϮ Ϭ ϰ ϭϬ ͲϮ Ϯ ƵŐͲϭϵ ĞĐͲϮϬ ĞĐͲϭϵ ƵŐͲϮϬ ĞĐͲϮϭ ƵŐͲϮϮ ĞĐͲϮϮ ƵŐͲϮϭ KĐƚͲϭϵ &ĞďͲϮϬ KĐƚͲϮϬ KĐƚͲϮϭ &ĞďͲϮϮ KĐƚͲϮϮ &ĞďͲϮϯ ƉƌͲϭϵ ƉƌͲϮϬ &ĞďͲϮϭ ƉƌͲϮϭ ƉƌͲϮϮ ƉƌͲϮϯ :ƵŶͲϮϬ :ƵŶͲϮϭ :ƵŶͲϮϯ :ƵŶͲϭϵ :ƵŶͲϮϮ ϴ KĐƚͲϭϲ KĐƚͲϭϳ KĐƚͲϭϴ KĐƚͲϭϵ KĐƚͲϮϬ KĐƚͲϮϭ KĐƚͲϮϮ ƉƌͲϭϲ :ĂŶͲϭϳ ƉƌͲϭϳ :ĂŶͲϭϴ ƉƌͲϭϴ :ĂŶͲϭϵ ƉƌͲϭϵ :ĂŶͲϮϬ ƉƌͲϮϬ :ĂŶͲϮϭ ƉƌͲϮϭ :ĂŶͲϮϮ ƉƌͲϮϮ :ĂŶͲϮϯ ƉƌͲϮϯ :ƵůͲϭϲ :ƵůͲϭϳ :ƵůͲϭϴ :ƵůͲϭϵ :ƵůͲϮϬ :ƵůͲϮϭ :ƵůͲϮϮ :ƵůͲϮϯ &ŝŐϮϴ ϲ &ŝŐϯϬ ϰ Source. Nepal Rastra Bank and World Bank staff calculations. Source. Nepal Rastra Bank and World Bank staff calculations. Ϯ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ;ĚĞƉŽƐŝƚƐďLJƐŽƵƌĐĞ͕ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ KĐƚͲϭϲ KĐƚͲϭϳ KĐƚͲϭϴ KĐƚͲϭϵ KĐƚͲϮϬ KĐƚͲϮϭ KĐƚͲϮϮ ƉƌͲϭϲ ƉƌͲϭϳ :ĂŶͲϭϴ ƉƌͲϭϴ :ĂŶͲϭϵ ƉƌͲϭϵ :ĂŶͲϮϬ ƉƌͲϮϬ :ĂŶͲϭϳ :ĂŶͲϮϭ ƉƌͲϮϭ :ĂŶͲϮϮ ƉƌͲϮϮ :ĂŶͲϮϯ ƉƌͲϮϯ :ƵůͲϭϲ :ƵůͲϭϳ :ƵůͲϭϴ :ƵůͲϭϵ :ƵůͲϮϬ :ƵůͲϮϭ :ƵůͲϮϮ :ƵůͲϮϯ ŐƌŝĐƵůƚƵƌĞ /ŶĚƵƐƚƌLJ ŽŶƐƚƌƵĐƚŝŽŶ ^ĞƌǀŝĐĞ KƚŚĞƌƐ dŽƚĂůĐƌĞĚŝƚͬ'W &ŝŐϮϴ Figure 29. Strong credit growth beginning in FY17 moderated ϭϮϬ Figure 31. …and deposits rose as a share of GDP… ϭϬϬ during ϴϬ FY23, while … ϲϬ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ϰϬ ;ĚĞƉŽƐŝƚƐďLJƐŽƵƌĐĞ͕ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ϮϬ ŐƌŝĐƵůƚƵƌĞ /ŶĚƵƐƚƌLJ ŽŶƐƚƌƵĐƚŝŽŶ &ŽƌĞŝŐŶĚĞƉŽƐŝƚƐ EŽŶďĂŶŬƐĨŝŶĂŶĐŝĂů ŽƌƉŽƌĂƚŝŽŶƐ Ϭ ^ĞƌǀŝĐĞ KƚŚĞƌƐ dŽƚĂůĐƌĞĚŝƚͬ'W /ŶĚŝǀŝĚƵĂůƐ KƚŚĞƌƐ dŽƚĂůĚĞƉŽƐŝƚƐ ϭϮϬ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϮϵ ϭϮϬ ϭϬϬ ϭϬϬ ϴϬ ϴϬ ;ƉĞƌĐĞŶƚͿ ϲϬ ;ĚĞƉŽƐŝƚƐďLJƐŽƵƌĐĞ͕ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ /ŶĨůĂƚŝŽŶƌĂƚĞ ZĞĂůĚĞƉŽƐŝƚƌĂƚĞ ZĞĂůůĞŶĚŝŶŐƌĂƚĞ ϲϬ ϭϬ ϰϬ &ŽƌĞŝŐŶĚĞƉŽƐŝƚƐ EŽŶďĂŶŬƐĨŝŶĂŶĐŝĂů ŽƌƉŽƌĂƚŝŽŶƐ ϴ ϰϬ /ŶĚŝǀŝĚƵĂůƐ KƚŚĞƌƐ dŽƚĂůĚĞƉŽƐŝƚƐ ϲϮϬ ϮϬ ϭϮϬ ϰ Ϭ Ϭ ϭϬϬ &ŝŐϮϵ Ϯ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϯϭ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϴϬ Ϭ ϲϬ Sources. ͲϮ Nepal Rastra Bank and World Bank staff calculations. Source. Nepal Rastra Bank and World Bank staff calculations. ƵŐͲϭϵ ĞĐͲϭϵ ƵŐͲϮϬ ĞĐͲϮϬ ĞĐͲϮϭ ƵŐͲϮϮ ĞĐͲϮϮ ƵŐͲϮϭ KĐƚͲϭϵ &ĞďͲϮϬ KĐƚͲϮϬ KĐƚͲϮϭ &ĞďͲϮϮ KĐƚͲϮϮ &ĞďͲϮϯ ƉƌͲϭϵ ƉƌͲϮϬ :ƵŶͲϮϬ &ĞďͲϮϭ ƉƌͲϮϭ :ƵŶͲϮϭ ƉƌͲϮϮ ƉƌͲϮϯ :ƵŶͲϮϯ :ƵŶͲϭϵ :ƵŶͲϮϮ ϰϬ &ŝŐϯϬ ;ƉĞƌĐĞŶƚͿ ϮϬ /ŶĨůĂƚŝŽŶƌĂƚĞ ZĞĂůĚĞƉŽƐŝƚƌĂƚĞ ZĞĂůůĞŶĚŝŶŐƌĂƚĞ ;ůŝƋƵŝĚŝƚLJŝŶũĞĐƚŝŽŶ;нͿĂŶĚĂďƐŽƌƉƚŝŽŶ;ͲͿ͕EWZďŝůůŝŽŶͿ Real ϭϬ deposit rates have remained in positive territory FigureϬ 32. EĞƚŝŶũĞĐƚŝŽŶ improved liquidity …leading to EĞƚĂďƐŽƌƉƚŝŽŶ conditions EĞƚůŝƋƵŝĚŝƚLJ &ŝŐϯϭ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ sinceϴ November 2022, but are falling again. The weighted ;ĚĞƉŽƐŝƚƐďLJƐŽƵƌĐĞ͕ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ the financial system and a moderation of demand for inϭϭ͕ϬϬϬ ϲ average deposit rate among commercial banks did not liquidity ϵ͕ϬϬϬ injections. ϰ ϳ͕ϬϬϬ respond quickly enough to stay in positive real territory from Ϯ ϱ͕ϬϬϬ March to October 2022 (Figures 28 and 30), but the situation ;ůŝƋƵŝĚŝƚLJŝŶũĞĐƚŝŽŶ;нͿĂŶĚĂďƐŽƌƉƚŝŽŶ;ͲͿ͕EWZďŝůůŝŽŶͿ Ϭ ϯ͕ϬϬϬ EĞƚŝŶũĞĐƚŝŽŶ EĞƚĂďƐŽƌƉƚŝŽŶ EĞƚůŝƋƵŝĚŝƚLJ was ͲϮ reversed in November 2022 with an increase in the ϭϭ͕ϬϬϬ ϭ͕ϬϬϬ nominal weighted average deposit rate to 8.3 percent. In a ƵŐͲϭϵ ĞĐͲϭϵ ƵŐͲϮϬ ĞĐͲϮϬ ĞĐͲϮϭ ƵŐͲϮϮ ĞĐͲϮϮ ƵŐͲϮϭ KĐƚͲϭϵ &ĞďͲϮϬ KĐƚͲϮϬ KĐƚͲϮϭ &ĞďͲϮϮ KĐƚͲϮϮ &ĞďͲϮϯ ƉƌͲϭϵ ƉƌͲϮϬ &ĞďͲϮϭ :ƵŶͲϮϬ ƉƌͲϮϭ :ƵŶͲϮϭ ƉƌͲϮϮ ƉƌͲϮϯ :ƵŶͲϮϯ :ƵŶͲϭϵ :ƵŶͲϮϮ ϵ͕ϬϬϬ Ͳϭ͕ϬϬϬ &ŝŐϯϬ liberalized market, when faced with a shortfall of loanable &ŝŐϯϮ ϳ͕ϬϬϬ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ funds, banks would be expected to raise the deposit interest ϱ͕ϬϬϬ rates offered to the public to encourage them to increase ϯ͕ϬϬϬ ;ĚĞƉŽƐŝƚƐďLJƐŽƵƌĐĞ͕ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ their deposits. There are several mechanisms in the Nepalese &ŝƐĐĂů ϭ͕ϬϬϬ banking sector that make this type of dynamic adjustment Ͳϭ͕ϬϬϬ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ &ŝŐϯϮ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ more difficult for deposit-taking institutions, including KƚŚĞƌƌĞǀĞŶƵĞ sd džĐŝƐĞ ŝƌĞĐƚƚĂdžĞƐ monthly caps on adjustments to interest rates that cannot Sources. Nepal dĂdžĞƐŽŶŝŶƚĞƌŶĂƚŝŽŶĂůƚƌĂĚĞ EŽŶͲƚĂdžƌĞǀĞŶƵĞ Rastra Bank and World Bank staff calculations. dŽƚĂůĚŽŵĞƐƚŝĐƌĞǀĞŶƵĞ exceed 10 percent of the previous month’s rate. Nominal &ŝƐĐĂů Ϯϱ deposit rates declined monotonically each month in the The ϮϬ incentives of positive real deposit rates have ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ϭϱ second half of FY23, driving down the real deposit rate to 0.4 boosted deposit growth. During FY23, KƚŚĞƌƌĞǀĞŶƵĞ sd total deposits grew ϭϬ percent by mid-July 2023. At the end of FY23, the nominal to ϱ106 percent džĐŝƐĞ ŝƌĞĐƚƚĂdžĞƐ of GDP compared to of GDP, up 3 percentEŽŶͲƚĂdžƌĞǀĞŶƵĞ dĂdžĞƐŽŶŝŶƚĞƌŶĂƚŝŽŶĂůƚƌĂĚĞ weighted average deposit rate was 7.9 percent. FY22 Ϯϱ (Figure dŽƚĂůĚŽŵĞƐƚŝĐƌĞǀĞŶƵĞ 31). Deposits by individuals remain the largest Ϭ &ŝŐϯϯ category, ϮϬ &zϭϳ accounting for 62 percent of total &zϭϴ &zϭϵ &zϮϬ &zϮϭ deposits &zϮϮ &zϮϯ at the endϭϱ of FY23. ϭϬ ϱ 24 Ϭ &ŝŐϯϯ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 ;ĚĞƉŽƐŝƚƐďLJƐŽƵƌĐĞ͕ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ &ŽƌĞŝŐŶĚĞƉŽƐŝƚƐ EŽŶďĂŶŬƐĨŝŶĂŶĐŝĂů ŽƌƉŽƌĂƚŝŽŶƐ /ŶĚŝǀŝĚƵĂůƐ KƚŚĞƌƐ dŽƚĂůĚĞƉŽƐŝƚƐ ϭϮϬ ϭϬϬ Once credit and import growth moderated, reducing to 6.5 percent, and a 100 bps decline in the deposit collection ϴϬ pressures on foreign exchange reserves, a gradual relaxation ϲϬ 4.5 percent , thus compressing the upper segment of rate to 21 of rates began at the beginning of FY24. The new Monetary the IRC to 100 bps while expanding the lower segment of the ϰϬ ϮϬ Policy for FY24 enacted a 50 bps reduction in the policy rate IRC to 200 bps. Ϭ &ŝŐϯϭ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ A.4 FISCAL SECTOR ;ůŝƋƵŝĚŝƚLJŝŶũĞĐƚŝŽŶ;нͿĂŶĚĂďƐŽƌƉƚŝŽŶ;ͲͿ͕EWZďŝůůŝŽŶͿ EĞƚŝŶũĞĐƚŝŽŶ EĞƚĂďƐŽƌƉƚŝŽŶ EĞƚůŝƋƵŝĚŝƚLJ Fiscal revenues declined significantly during FY23, as over half of all ϭϭ͕ϬϬϬ ϵ͕ϬϬϬ revenues are trade related and imports fell sharply. Expenditures also fell ϳ͕ϬϬϬ as a percentage of GDP, but by much less. The resulting fiscal deficit of 6.1 ϱ͕ϬϬϬ ϯ͕ϬϬϬ percent of GDP is the largest since the 1990s. ϭ͕ϬϬϬ Ͳϭ͕ϬϬϬ &ŝŐϯϮ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ Nepal’s high reliance on goods imports to generate Figure 33. As import-related revenues fell, total revenues fiscal revenues exposes government finances to volatile &ŝƐĐĂů dropped by 3.8 pp of GDP between FY22 and FY23. trade flows. Over half of all fiscal revenues are levied on ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ goods imports and collected at the border through VAT, KƚŚĞƌƌĞǀĞŶƵĞ sd excise, and customs duties. This vulnerability crystallized in džĐŝƐĞ dĂdžĞƐŽŶŝŶƚĞƌŶĂƚŝŽŶĂůƚƌĂĚĞ ŝƌĞĐƚƚĂdžĞƐ EŽŶͲƚĂdžƌĞǀĞŶƵĞ FY20 during the pandemic when borders were closed, and Ϯϱ dŽƚĂůĚŽŵĞƐƚŝĐƌĞǀĞŶƵĞ again in FY23 when import restrictions led to a sharp drop ϮϬ in goods imports. One of the ways that the fiscal authority ϭϱ can reduce this vulnerability is by changing the composition ϭϬ of revenue collections. Pivoting revenue collection toward ϱ Ϭ domestic sources such as income taxes and strengthening &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϯϯ of the domestic VAT net, and away from import taxation, could be done without lowering total revenue collection. Sources. Ministry of Finance and World Bank staff calculations. An additional benefit of shifting revenues away from trade taxation would be a reduction in tariff rates, which are high in Nepal and discourage exports and job creation.22 Figure 34. Expenditures fell by 0.9 pp of GDP, with As goods imports fell in FY23, revenues declined by 3.8 reductions in both recurrent and capital expenditures. pp of GDP between FY22 and FY23 (Figure 33). The import restrictions imposed in FY22 and eventually lifted in January ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ 2023, plus slower economic growth, reduced the current ĂƉŝƚĂů ZĞĐƵƌƌĞŶƚ dŽƚĂůĞdžƉĞŶĚŝƚƵƌĞ ϯϬ account deficit and stabilized foreign exchange reserve Ϯϱ stocks as intended. The unintended consequences of this ϮϬ policy include a broad-based decline in revenues, with total ϭϱ tax revenues declining 3.9 pp of GDP, taxes on international ϭϬ trade by 1.3 pp of GDP, and VAT by 1.1 pp of GDP, among ϱ others. The FY23 revenue collection including grants of 19.2 Ϭ percent of GDP is the lowest ratio since FY15 (18.6 percent) &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϯϰ when the earthquakes and trade blockade affected the country. Sources. Ministry of Finance and World Bank staff calculations. ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ &ŝƐĐĂůĚĞĨŝĐŝƚ dŽƚĂůƌĞǀĞŶƵĞĂŶĚŐƌĂŶƚƐ dŽƚĂůĞdžƉĞŶĚŝƚƵƌĞ ϯϬ Ϯϱ 21 Nepal Rastra Bank, July 2023 “Monetary Policy for Fiscal Year 2023/24” ϮϬ Nepal has a simple average effectively applied tariff rate of 10.2 percent, placing it among the world’s 22 ϭϱ top quartile of most-protected countries. For a more detailed discussion, please see Chapter 3 of World Bank (2021). ϭϬ ϱ Ϭ THE WORLD BANK | 25 Ͳϱ ͲϭϬ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ϮϬ ϭϱ ϭϬ RECENT ECONOMIC DEVELOPMENTS ϱ Ϭ Ͳϱ ͲϭϬ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϯϱ Total expenditures also declined but by a smaller amount Figure 36. Fiscal transfers to subnational governments fell of 1.1 pp of GDP (Figure 34). Fiscal expenditures are difficult for the second year in a row as a percentage of GDP. to reduce in the short term due to their recurrent nature. ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ The FY23 budget included a 15 percent salary increase for ƋƵĂůŝnjĂƚŝŽŶ ŽŶĚŝƚŝŽŶĂů ^ƉĞĐŝĂů government employees, leading to a 0.6 pp of GDP increase ŽŵƉůĞŵĞŶƚĂƌLJ dŽƚĂůŐƌĂŶƚƐ ϭϬ in wages and compensation during the year. ϴ The result of the stronger decline in revenues than ϲ expenditures was a deficit of 6.1 percent of GDP in FY23, ϰ almost double the deficit of 3.2 percent recorded in FY22 Ϯ (Figure 35). This deficit figure does not include the net Ϭ acquisition of financial assets (NAFA),23 which amounted to &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ &ŝŐϯϲ an additional 0.8 percent of GDP during the year. The deficit Sources. Ministry of Finance and World Bank staff calculations. ĂƉŝƚĂů ZĞĐƵƌƌĞŶƚ dŽƚĂůĞdžƉĞŶĚŝƚƵƌĞ ϯϬ and the associated debt figures presented in this figure current Ϯϱ report also do not include changes in the Treasury The authorities significantly increased total fiscal expenditures ϮϬ Account (TSA) balance with the Nepal Rastra Bank in Single ϭϱ after the transition to federalism in FY18, as the federal FY23. 24 Public debt is estimated to have increase in line with government began transferring resources through grants to theϭϬhigher deficit to 41.3 percent of GDP. ϱ subnational governments (SNGs), without a commensurate Figure 35. A historic drop in revenues and a smaller Ϭ reduction in federal government direct spending levels.25 While &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϯϰ decline in expenditures led to a deficit of 6.1 percent of grant transfers to SNGs should be complemented over time GDP in FY23. by rising own-source revenue raised by provinces and local governments, SNGs have not yet raised much revenue in the ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ first five years of fiscal federalism. Prematurely reducing grant &ŝƐĐĂůĚĞĨŝĐŝƚ dŽƚĂůƌĞǀĞŶƵĞĂŶĚŐƌĂŶƚƐ dŽƚĂůĞdžƉĞŶĚŝƚƵƌĞ ϯϬ transfers from the federal government to SNGs could place Ϯϱ the provision of goods and services at local levels at risk, ϮϬ ϭϱ until and unless own source revenue generated by provincial ϭϬ and local governments gains momentum. ϱ Ϭ The fiscal deficit and NAFA were financed by net new Ͳϱ ͲϭϬ domestic and external borrowing, and positive fiscal &ŝŐϯϱ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ account balances accumulated in previous years. Net new Sources. Ministry of Finance and World Bank staff calculations. domestic borrowing was 2.6 percent of GDP and net new external borrowing was 1.3 percent of GDP in FY23 (Table 3 Areas where expenditures were reduced include fiscal and Figure 37). The remaining 3 percent of GDP in financing transfers from the federal government to provincial and ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ to complete FY23 financing needs may have come from ƋƵĂůŝnjĂƚŝŽŶ local governments, which ŽŶĚŝƚŝŽŶĂů fell from 8.2 to 7.4 ^ƉĞĐŝĂů percent of ŽŵƉůĞŵĞŶƚĂƌLJ dŽƚĂůŐƌĂŶƚƐ accumulated surpluses in government accounts with the GDPϭϬ between FY22 and FY23 (Figure 36). After peaking at central bank. At the time of this publication, the financial percent of GDP in FY21, total grant transfers to subnational 9.1 ϴ controller’s office (FCGO) has not yet published the FY23 governments ϲ have fallen two years in a row as a share of GDP. closing balance of the Treasury accounts in the central bank Between ϰ FY22 and FY23, equalization and conditional grants to verify the account drawdowns (Table 3). wereϮ reduced due to the shortfall in federal revenue. Conditional grants, which are earmarked for special sectors and projects by The government’s FY24 Budget Speech assumes a real Ϭ the federal &zϭϴgovernment, &zϭϵ &zϮϬ the largest remain &zϮϭ grant type transferred &zϮϮ &zϮϯ growth rate of 6 percent and an inflation rate of 6.5 &ŝŐϯϲ to SNGs. Equalization grants are untied resources that can be percent during FY24. Budgets in the past have been subject spent at the discretion of the recipient SNG. to significant growth optimism (Figure 38). Basing the budget NAFA is largely loans and capital injections to state-owned enterprises from the government. 23 The government does not include the negative TSA balance in its calculation of public debt. The IMF and the World Bank include the negative TSA balance in the public debt 24 stock assessed in the periodic Debt Sustainability Analysis (DSA) estimations, per the Government Finance Statistics Manual and Public Sector Debt Statistics Guide. World Bank NDU publications follow the government convention, excluding the negative TSA balance from the public debt stock, to help the reader compare the data reported here with government publications. For further discussion, please see the World Bank (2021). . 25 26 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 Table 3. Central Government Fiscal Balance and Financing (share of GDP, percent).   FY19 FY20 FY21 FY22 FY23 Revenues and Grants 22.4 22.2 23.3 23.1 19.2 Expenditures 27.3 27.6 27.2 26.3 25.3 Fiscal Deficit -5.0 -5.4 -4.0 -3.2 -6.1 Financing Needs Including NAFA (A) -7.5 -6.9 -5.4 -4.5 -6.8 Financing Sources Domestic Net Borrowing (B) 1.6 4.1 4.3 3.8 2.6 External Net Borrowing (C) 2.7 2.4 3.4 2.1 1.3 Total Net Borrowing (D=B+C) 4.3 6.5 7.7 5.8 3.9 Financing Other Sources* (E=A-D) -3.2 -0.4 2.4 1.4 -3.0 Sources. Financial Comptroller General Office, Ministry of Finance, National Statistics Office, and World Bank staff calculations. Note. *Including fiscal account surpluses from prior years. A positive figure indicates a balance accumulation, while a negative figure indicates a balance drawdown. ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ŽŵĞƐƚŝĐĚĞďƚ džƚĞƌŶĂůĚĞďƚ dŽƚĂůĚĞďƚ ϱϬ Figure 37. The deficit was financed by new external a more realistic macroeconomic framework would enable on ϰϬ and domestic debt, and possibly by drawdowns on ϯϬ makers to better determine the expenditure envelope policy accumulated savings in Treasury accounts. that ϮϬ can be afforded, given expected revenues and the level of deficit that can be safely financed. Ongoing efforts ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ϭϬ by the Ministry of Finance and other government entities to ŽŵĞƐƚŝĐĚĞďƚ džƚĞƌŶĂůĚĞďƚ dŽƚĂůĚĞďƚ Ϭ ϱϬ &ŝŐϯϳ improve their evidence-based &zϭϳ &zϭϴ &zϭϵ macroeconomic &zϮϬ &zϮϭ &zϮϮ forecasting &zϮϯ ϰϬ capabilities are expected to provide more realistic growth ϯϬ forecasts in the future, thus improving the usefulness of the ;ƉĞƌĐĞŶƚͿ budget as a planning tool. ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ ϮϬ ZĞĂů'WŐƌŽǁƚŚƉƌŽũĞĐƚĞĚ ZĞĂů'WŐƌŽǁƚŚĂĐƚƵĂů ϭϬ ŽŵĞƐƚŝĐĚĞďƚ džƚĞƌŶĂůĚĞďƚ dŽƚĂůĚĞďƚ ϭϬ ϱϬ Spending ϴ continues to be skewed towards the end of ϰϬϬ the ϲfiscal year. Bursts of spending clustered at the end of &ŝŐϯϳ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ the ϰfiscal year not only place in question the efficiency of ϯϬ spending, Ϯ but these large seasonal spending variations Sources. ϮϬ Ministry of Finance and World Bank staff calculations. ;ƉĞƌĐĞŶƚͿ alsoϬ impact aggregate demand and inflation. “Use it or ZĞĂů'WŐƌŽǁƚŚƉƌŽũĞĐƚĞĚ ZĞĂů'WŐƌŽǁƚŚĂĐƚƵĂů ͲϮ ϭϬ ϭϬ Ͳϰ &ŝŐϯϳ Figure Ϭϴ 38. Budgets tend to overestimate next year’s&ŝŐϯϴ Figure&zϭϱ 39. &zϭϲ … and &zϭϳspending &zϮϬ sharply &zϭϴ &zϭϵrises &zϮϯ end at the &zϮϭ &zϮϮ &zϮϰ of &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ growth... ϲ every fiscal year. ϰ Ϯ ;ƉĞƌĐĞŶƚͿ ;ϲŵŽŶƚŚŵŽǀŝŶŐĂǀĞƌĂŐĞ͕EWZďŝůůŝŽŶͿ Ϭ ZĞĂů'WŐƌŽǁƚŚƉƌŽũĞĐƚĞĚ ZĞĂů'WŐƌŽǁƚŚĂĐƚƵĂů dŽƚĂůĞdžƉĞŶĚŝƚƵƌĞ ZĞĐƵƌƌĞŶƚ ĂƉŝƚĂů ϭϬ ϭϰϬ ͲϮ ϭϮϬ ϴ Ͳϰ ϭϬϬ &ŝŐϯϴ ϲ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &zϮϰ ϴϬ ϰ ϲϬ Ϯ ϰϬ Ϭ ;ϲŵŽŶƚŚŵŽǀŝŶŐĂǀĞƌĂŐĞ͕EWZďŝůůŝŽŶͿ ϮϬ ͲϮ dŽƚĂůĞdžƉĞŶĚŝƚƵƌĞ ZĞĐƵƌƌĞŶƚ ĂƉŝƚĂů Ϭ ϭϰϬ KĐƚͲϮϬ KĐƚͲϮϮ KĐƚͲϭϴ KĐƚͲϭϵ KĐƚͲϮϭ ƉƌͲϭϵ ƉƌͲϮϬ ƉƌͲϮϭ ƉƌͲϮϮ ƉƌͲϮϯ :ĂŶͲϭϵ :ƵůͲϮϬ :ƵůͲϮϭ :ƵůͲϮϯ :ƵůͲϭϵ :ĂŶͲϮϬ :ĂŶͲϮϭ :ĂŶͲϮϮ :ƵůͲϮϮ :ĂŶͲϮϯ Ͳϰ ϭϮϬ &ŝŐϯϴ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &zϮϰ &ŝŐϯϵ ϭϬϬ ϴϬ Sources. Ministry of Finance and World Bank staff calculations. Sources. Ministry of Finance and World Bank staff calculations. ϲϬ ϰϬ ;ϲŵŽŶƚŚŵŽǀŝŶŐĂǀĞƌĂŐĞ͕EWZďŝůůŝŽŶͿ ϮϬ dŽƚĂůĞdžƉĞŶĚŝƚƵƌĞ ZĞĐƵƌƌĞŶƚ ĂƉŝƚĂů ϭϰϬ Ϭ ϭϮϬ KĐƚͲϮϬ KĐƚͲϮϮ KĐƚͲϭϴ KĐƚͲϭϵ KĐƚͲϮϭ ƉƌͲϭϵ ƉƌͲϮϬ ƉƌͲϮϭ ƉƌͲϮϮ :ĂŶͲϭϵ :ƵůͲϮϬ :ĂŶͲϮϭ :ƵůͲϮϭ ƉƌͲϮϯ :ƵůͲϮϯ :ƵůͲϭϵ :ĂŶͲϮϬ :ĂŶͲϮϮ :ƵůͲϮϮ :ĂŶͲϮϯ ϭϬϬ &ŝŐϯϵ ϴϬ ϲϬ THE WORLD BANK | 27 ϰϬ ϮϬ Ϭ ϭϮϬ ϭϬϬ ϴϬ ;ĂƐĂƐŚĂƌĞŽĨŽƌŝŐŝŶĂůďƵĚŐĞƚ͕ƉĞƌĐĞŶƚͿ RECENT ECONOMIC DEVELOPMENTS ϲϬ dĂdž EŽŶͲƚĂdž ϭϮϬ ϰϬ ϭϬϬ ϮϬ ϴϬ Ϭ ϲϬ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϰϬ lose it” budget rules and spending bunching at the end of Figure ϰϬ 41. … and capital budget execution has been the year have been shown to result in lower quality project consistently low. ϮϬ Ϭ investment.26 Significantly higher spending at the end of &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϰϬ the year can lead to less effective management of these ;ĂƐĂƐŚĂƌĞŽĨŽƌŝŐŝŶĂůďƵĚŐĞƚ͕ƉĞƌĐĞŶƚͿ ZĞĐƵƌƌĞŶƚ ĂƉŝƚĂů investments due to staff time constraints. As shown in Figure ϭϬϬ 39, fiscal expenditures surging at the end of the year has ϴϬ long been evident in Nepal in both recurrent and capital ;ĂƐĂƐŚĂƌĞŽĨŽƌŝŐŝŶĂůďƵĚŐĞƚ͕ƉĞƌĐĞŶƚͿ ϲϬ spending. Smoothing expenditures throughout the year ZĞĐƵƌƌĞŶƚ ĂƉŝƚĂů would support spending efficiency and avoid inflationary ϰϬ ϭϬϬ pressures resulting from spending spikes. ϮϬ ϴϬ ϲϬ Ϭ Budget execution across expenditures and revenues has &ŝŐϰϭ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ been low over the past five years in Nepal. On the revenue ϰϬ Sources. Ministry of Finance and World Bank staff calculations. side from FY19 to FY23, tax revenues have averaged 82 percent ϮϬ realization compared to budget, while non-tax revenues have Ϭ averaged an 80 percent realization rate (Figure 40). Over the &ŝŐϰϭ Figure 42. &zϭϳ While &zϭϴ domestic ;ĂƐĂƐŚĂƌĞŽĨŽƌŝŐŝŶĂůďƵĚŐĞƚ͕ƉĞƌĐĞŶƚͿ &zϭϵ borrowing &zϮϬ &zϮϭ has materialized &zϮϮ &zϮϯ close to planned, ŽŵĞƐƚŝĐďŽƌƌŽǁŝŶŐ less than džƚĞƌŶĂůďŽƌƌŽǁŝŶŐ half of planned external same period, the execution of budgeted recurrent spending ϭϮϬ has averaged 86 percent, while the average execution rate of borrowing ϭϬϬ has materialized. capital expenditures was 61 percent (Figure 41). Increasing ϴϬ ;ĂƐĂƐŚĂƌĞŽĨŽƌŝŐŝŶĂůďƵĚŐĞƚ͕ƉĞƌĐĞŶƚͿ budget execution, especially for capital investments, would ϲϬ ŽŵĞƐƚŝĐďŽƌƌŽǁŝŶŐ džƚĞƌŶĂůďŽƌƌŽǁŝŶŐ ϭϮϬ support growth and help to close Nepal’s wide infrastructure ϰϬ ϭϬϬ deficit. It was estimated in 2018 that Nepal needs to invest ϮϬ ϴϬ between 8 and 12 percent of GDP each year in infrastructure Ϭ &ŝŐϰϮ ϲϬ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ to meet its development aspirations. Capital expenditure in 27 ϰϬ FY23 was 4.3 percent of GDP and has been falling year on year ϮϬ since FY21. Ϭ &ŝŐϰϮ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ On the financing side, the Nepal Natural Resources and Fiscal Commission (NNRFC) sets the ceiling on domestic Sources. Ministry of Finance and World Bank staff calculations. borrowing each year. For FY23, the ceiling was set at 5.5 percent of forecast GDP, and almost all of the budgeted domestic borrowing in FY23 was obtained (Figure 42). External financing exhibits a very different trajectory – on Figure 40. Revenue realization has been volatile … average over the past five years, only 47 percent of planned external borrowing has materialized. External borrowing is ;ĂƐĂƐŚĂƌĞŽĨŽƌŝŐŝŶĂůďƵĚŐĞƚ͕ƉĞƌĐĞŶƚͿ dĂdž EŽŶͲƚĂdž the most affordable source of financing to the government ϭϮϬ of Nepal, given the country’s access to long maturity ϭϬϬ concessional financing. ϴϬ ϲϬ The stock of public debt was roughly equally divided ϰϬ between external and domestic financing in FY23 (Table ϮϬ 4). Multilateral concessional financing represents the largest Ϭ category, comprising 44 percent of total public debt, followed &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϰϬ by domestic development bonds (29 percent) and Treasury Sources. Ministry of Finance and World Bank staff calculations. bills (20 percent). ;ĂƐĂƐŚĂƌĞŽĨŽƌŝŐŝŶĂůďƵĚŐĞƚ͕ƉĞƌĐĞŶƚͿ ZĞĐƵƌƌĞŶƚ ĂƉŝƚĂů ϭϬϬ ϴϬ ϲϬ an examination of expiring budget spending in US federal procurement, see Liebman and Mahoney (2018) “Do Expiring Budgets Lead to Wasteful Year-End Spending? For 26 Evidence from Federal Procurement”, National Bureau of Economic Analysis NBER, Working Paper 19481. ϰϬ further discussion, see World Bank (2017). For 27 ϮϬ 28 Ϭ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϰϭ NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 Table 4. Stock – Public and Publicly Guaranteed (PPG) External and Domestic Debt. (NPR billion unless mentioned otherwise)           FY20 FY21 FY22 FY23 Share Share Share Share Share Share Share Share of of of of of of of Financing Source Stock Stock Stock Stock of GDP total GDP total GDP total GDP total (%) (%) (%) (%) (%) (%) (%) (%) External 819.7 57.2 21.1 934.7 53.8 21.5 1025.8 51.0 20.8 1132.8 50.2 21.1 Multilateral 709.5 49.5 18.2 822.0 47.3 18.9 894.5 44.4 18.1 993.5 44.0 18.5 o/w World Bank 386.1 26.9 9.9 471.2 27.1 10.8 509.7 25.3 10.3 572.4 25.3 10.6 o/w ADB 268.8 18.8 6.9 293.8 16.9 6.8 315.0 15.6 6.4 349.1 15.5 6.5 o/w IMF 26.4 1.8 0.7 32.8 1.9 0.8 43.7 2.2 0.9 45.7 2.0 0.8 Bilateral 96.7 6.7 2.5 112.7 6.5 2.6 131.4 6.5 2.7 139.4 6.2 2.6 o/w Non-Paris Club 52.7 3.7 1.4 63.9 3.7 1.5 75.8 3.8 1.5 77.4 3.4 1.4 o/w China 26.1 1.8 0.7 31.3 1.8 0.7 35.3 1.8 0.7 34.2 1.5 0.6 o/w India 24.9 1.7 0.6 30.8 1.8 0.7 36.4 1.8 0.7 38.4 1.7 0.7 o/w Paris Club 44.0 3.1 1.1 48.8 2.8 1.1 55.6 2.8 1.1 62.0 2.7 1.2 Domestic 613.7 42.8 15.8 802.9 46.2 18.4 987.4 49.0 20.0 1128.3 49.9 21.0 Treasury Bills 215.2 15.0 5.5 279.6 16.1 6.4 355.8 17.7 7.2 457.8 20.3 8.5 Development Bonds 389.9 27.2 10.0 513.9 29.6 11.8 620.4 30.8 12.6 656.4 29.0 12.2 Others 8.6 0.6 0.2 9.4 0.5 0.2 11.2 0.6 0.2 14.1 0.6 0.3 Total 1433.4 100.0 36.9 1737.6 100.0 39.92 2013.30 100.0 40.81 2261.1 100.0 42.1 Nominal GDP (NPR billion) 3888.7 4352.6 4933.7 5381.3 NPR/USD avg 116.3 117.9 120.8 130.8 Sources. Financial Comptroller General Office and World Bank staff calculations. Notes. External debt is as of FY23Q3. Domestic debt is for all four quarters of FY23. Paris Club creditors include Japan, Korea, Belgium, and France. Non-Paris Club creditors include India, China, Kuwait, and Saudi Arabia. Figure 43. Domestic debt servicing rose quickly in FY23, while external debt servicing rose more slowly. Public debt servicing grew significantly during FY23 (Figure ;EWZďŝůůŝŽŶƐͿ džƚĞƌŶĂůĚĞďƚĂŵŽƌƚŝnjĂƚŝŽŶ džƚĞƌŶĂůĚĞďƚŝŶƚĞƌĞƐƚƉĂLJŵĞŶƚƐ 43). Although Nepal’s external debt is largely denominated ŽŵĞƐƚŝĐĚĞďƚĂŵŽƌƚŝnjĂƚŝŽŶ ŽŵĞƐƚŝĐĚĞďƚŝŶƚĞƌĞƐƚƉĂLJŵĞŶƚƐ in convertible currencies, the 8.3 percent depreciation of the ϮϱϬ NPR against the USD during FY23 (see Table 4) did not have a ϮϬϬ large impact on either external debt amortizations or interest ϭϱϬ repayments. Domestic debt servicing was affected by both ϭϬϬ large redemptions and by higher domestic interest rates, as the ϱϬ tighter liquidity conditions in the financial sector increased the &ŝŐϰϯ Ϭ Treasury Bill rate. Total domestic and external debt servicing &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ amounted to 4.1 percent of GDP in FY23. Sources. Ministry of Finance and World Bank staff calculations. THE WORLD BANK | 29 NEPAL DEVELOPMENT UPDATE 30 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 OUTLOOK, B RISKS, AND CHALLENGES THE WORLD BANK | 31 OUTLOOK, RISKS, AND CHALLENGES B OUTLOOK, RISKS, AND CHALLENGES The lower growth (1.9 percent), wide fiscal deficit (6.1 percent of GDP), and high inflation (7.8 percent average) registered during FY23 represent significant headwinds to Nepal’s macroeconomic outlook in the short and medium term. While there are reasons for optimism in FY24, including robust remittances, tourist inflows, and hydroelectric production, the authorities are facing difficult tradeoffs in the context of a slowing economy with high inflation. Nepal is not facing these difficult choices alone. In June 2022 the World Bank observed a steep slowdown in growth across emerging market and developing economies, associated with the fallout of the war in Ukraine and the rise in energy and food prices globally.28 At that time, global growth was projected to slow by 2.7 pp and the danger that above-average inflation and below-average growth would persist for several years was deemed considerable. Nepal’s policy choices are constrained. Monetary policy cannot simultaneously raise interest rates to control inflation, and lower interest rates to support growth. Greater fiscal stimulus for growth is hampered by still-recovering revenues following the historical drop in revenues registered in FY23. The authorities remain rightfully wary of credit booms and import spikes, concerned that foreign exchange reserves may be used again to finance a large current account deficit, as occurred during FY22 when reserves fell below the 7-months of import cover policy floor. Relative prices (the exchange rate between the NPR and the currencies of trading partners) cannot automatically adjust within the confines of Nepal’s fixed exchange rate peg to the INR. Staying focused on the long-term investments necessary for sustainable development remains crucial, even as the short-term recovery consumes the attention of policymakers. Frequently the conversation in Nepal focuses on the needs of the business community for firms to grow and remain profitable. It is equally important to prioritize the needs of the most vulnerable members of the community during the economic downturn. Rising consumer prices are more worrisome for those who spend a greater share of their income on basic goods and necessities. Investing in human capital through education and health and improving the conditions for job creation are long-term investments that can take years to bear fruit. As policymakers weigh the balance of stimulus and prudence going forward, 28 World Bank Blog, June 10, 2022 “The supply solution to stagflation” 32 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 the Special Focus section of the current report outlines some results, but which have the potential to leverage Nepal’s of the pending productivity and competitiveness challenges demographic dividend and improved domestic electricity that remain largely unaddressed in Nepal. A host of measures provision to make workers and firms more productive and are identified that require years of sustained effort to yield competitive in the decades to come. THE UPDATED MACROECONOMIC FORECAST ENVISIONS GROWTH RISING FROM A LOWER BASE The baseline forecast scenario assumes the following: i) a international tourists and new hotels, but the removal of the gradual reduction in interest rates in FY24 and FY25 relative former VAT exemption29 on air transport (domestic flights and to FY23; ii) that lumpy skin disease, first reported in April 2023 the outbound international flights) and the imposition of a and which has infected more than 1.3 million animals, will luxury tax on services provided by four and five-star hotels be under control by mid-January 2024; iii) that India’s export and resorts could weigh on sub-sector growth. ban on select cereal and vegetables will be withdrawn by the Agricultural sector growth is projected to slow to 2.1 beginning of FY25; iv) that electricity exports to India and percent in FY24, due in part to lumpy skin disease, then Bangladesh will reach 1000 MW by FY25; and v) that foreign rise to 2.5 percent growth in FY25. A decline in the main exchange reserves remain above equivalent of 7 months of season rice paddy plantation area and paddy planted area concurrent imports during FY24-FY25. by 1.1 and 0.7 percent in FY23, respectively, relative to the previous year would also contribute to lower agricultural growth in FY24. Real Sector Inflation is expected to remain elevated in FY24 reflecting Under the baseline scenario, GDP growth will rebound to the removal of VAT exemptions on select basic food 3.9 percent in FY24 and 5 percent in FY25 (Table 5). The items and necessities, India’s food export restrictions, lagged impact of lifting the final import restriction measures and the recent international increase in fuel prices. High in January 2023 and the gradual loosening of monetary inflation in FY24 will weigh on real disposable income and policy are expected to support growth in the industrial and in turn private consumption growth. Inflationary pressures services sectors. Sub-sectors that suffered the brunt of the are expected to recede and remain within the central bank’s import restrictions and monetary policy tightening in FY23, ceiling in FY25 alongside a projected decline in commodity including wholesale and retail trade, construction, and prices. manufacturing, are expected to gradually recover over the forecast period. Growth of the industrial sector is projected to be 3.2 and External Sector 6.3 percent in FY24 and FY25, respectively. The electricity sub-sector will continue to grow robustly with significant The trade deficit is projected to widen over the medium new hydroelectric capacity scheduled for commissioning term, rising to 30.1 percent of GDP in FY24 and then to 31 during the projection timeframe. percent of GDP in FY25 reflecting higher goods imports. Merchandise imports are expected to rise from a seven-year The services sector is projected to accelerate growth to low in FY23 with the lifting of import restriction measures 5.1 percent in FY24 and to 5.9 percent in FY25 (Table 5). and the gradual easing of monetary policy. However, goods The real estate services sub-sector should benefit from the imports are not expected to return to FY22’s historic high by recent amendment of the 2022 Land Use Regulations for the end of the forecast period as the central bank also tightens land zoning, and the raised ceiling for lending to first time working capital loan regulations and focuses on greater homebuyers to NPR 20 million. Accommodation and food productive use of credit rather than an expansion of credit to service activities will be supported by growing numbers of private sector. Lower international commodity prices and the For international flights, VAT is not applicable on the inbound flights. Thus, the removal of the VAT exemption is not expected to impact international tourists coming to Nepal 29 but may make the outbound flights more expensive. THE WORLD BANK | 33 OUTLOOK, RISKS, AND CHALLENGES Table 5. Macroeconomic projections of selected key indicators. (annual percent change unless indicated otherwise)     FY20 FY21 FY22 FY23e FY24f FY25f Real GDP growth, at constant market prices -2.4 4.8 5.6 1.9 3.9 5.0   Private Consumption 3.6 8.0 6.8 4.1 3.7 4.5   Government Consumption 3.8 -1.7 9.6 -35.2 -19.3 8.5   Gross Fixed Capital Investment -8.9 9.8 3.8 -10.9 14.5 8.5   Exports, Goods and Services -15.9 -21.3 34.1 5.5 12.1 18.4   Imports, Goods and Services -20.8 18.8 15.1 -17.2 10.3 9.7 Real GDP growth, at constant factor prices -2.4 4.5 5.3 2.2 3.9 5.0   Agriculture 2.4 2.8 2.2 2.7 2.1 2.5   Industry -4.0 6.9 10.8 0.6 3.2 6.3   Services -4.5 4.7 5.3 2.3 5.1 5.9 Inflation (Consumer Price Index) 6.1 3.6 6.3 7.8 7.5 6.4 Current Account Balance (% of GDP) -0.9 -7.7 -12.6 -1.3 -3.7 -4.6 Net Foreign Direct Investment (% of GDP) 0.5 0.4 0.4 0.1 0.3 0.5 Fiscal Balance (% of GDP) -5.4 -4.0 -3.2 -6.1 -3.5 -3.3 Revenues (% of GDP) 22.2 23.3 23.1 19.2 19.8 20.8 Debt (% of GDP) 36.9 39.9 40.8 41.3 41.4 41.2 Primary Balance (% of GDP) -4.7 -3.2 -2.3 -4.7 -1.8 -1.9 Sources. Ministry of Finance, Nepal Rastra Bank, and National Statistics Office for history. World Bank staff for estimates and forecasts. Notes. e =estimate; f = forecast. reduction of one-off imports including COVID-19 vaccines will (CAD) is expected to widen to 3.7 percent of GDP in FY24 and also help maintain goods import below that of FY22 over the further to 4.6 percent of GDP in FY25, reflecting a persistent medium term. Electricity trade is expected to reach surplus goods trade deficit that is not completely compensated for by FY25 as the country continues to expand production by remittance inflows. The CAD is expected to be largely and exports of electricity to India and Bangladesh. Higher financed by concessional external borrowing, in the absence domestic production and the consumption of electricity of significant foreign direct investment (FDI). Private external should also lower fossil fuel imports. The size of Nepal’s trade borrowing is highly regulated and while it represented only in edible oils is projected to shrink over the next two years as 0.5 percent of GDP in FY23, it is expected to expand gradually India is expected to continue its policy of low custom duties over the forecast. FDI is expected to increase from a low base on imports of edible oils from non-SAARC countries. The in the forecast period due to the recent policy of lowering the services account will remain in deficit over the medium term minimum threshold for FDI inflows, but the contribution of as transport and travel costs, reflecting a significant number FDI towards financing the CAD will continue to remain low of Nepalis going abroad for work and study, continue to form until further significant reforms are implemented. a large part of the services import bill. A recovery in services exports as international tourist arrivals rise is not expected be sufficient to completely offset services imports in FY24 Fiscal Sector and FY25. The fiscal deficit is expected to narrow over the next two years, reaching 3.3 percent of GDP by FY25 as revenues Remittances inflows are expected to remain robust recover. Revenue growth will increase with stronger GDP and over the medium term, reflecting the lagged impact goods imports growth. The FY24 federal budget envisions of near-record worker out-migration in FY23. The lower capital spending, lower fiscal transfers to subnational government of Nepal has currently opened 111 countries for governments, and higher public debt servicing costs. Public foreign employment, but most Nepali worker migrants are investment execution is expected to rise through FY25 concentrated in only 10 countries. alongside the rebound of revenues. Implementation of the The current account deficit is forecast to slowly widen National Project Bank integrated guidelines, issued in March over the next two years, while remaining significantly 2023 by the National Planning Commission, is expected to below the historic high of FY22. The current account deficit facilitate the development, selection, and prioritization of 34 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 projects within the National Project Bank, boosting capital projection through a gradual expansion of real base money. spending execution by FY25. The fiscal deficit is expected The projection ensures that foreign exchange reserves to be financed by external concessional borrowing and remain sufficient to cover at least seven months of imports domestic borrowing in a 40:60 ratio, similar to the financing throughout the forecast horizon. mix over the last 10 years. Total public debt is projected to decline to 41.2 percent of GDP by FY25 from a peak in FY24, The forecast is subject to multiple downside risks. An reflecting smaller fiscal deficits and higher growth. erratic monsoon could dampen agricultural growth, which alongside potential livestock losses, would negatively impact the poor and vulnerable. Political uncertainty could Monetary Sector hold back investment. A renewed spike in commodity prices A gradual reduction in the policy rate through FY25 is or continued food export bans by India would raise prices incorporated in the forecast. The central bank’s stated intent and widen the current account deficit. Higher inflation could of setting the FY24 policy stance such that the real interest keep policy rates elevated, increase domestic debt servicing rate on deposits remains positive is incorporated in the costs, and drag on growth. THE WORLD BANK | 35 NEPAL DEVELOPMENT UPDATE 36 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 SPECIAL FOCUS: C DRIVERS OF EXTERNAL COMPETITIVENESS THE WORLD BANK | 37 SPECIAL FOCUS: DRIVERS OF EXTERNAL COMPETITIVENESS C SPECIAL FOCUS: DRIVERS OF EXTERNAL COMPETITIVENESS C.1 INTRODUCTION Nepal’s dependence on the export of workers and remittance inflows increased sharply over the past two decades. Goods and services exports have fallen significantly since the early 2000s as a percentage of GDP. In FY23, total exports amounted to 6.9 percent of GDP, only one-third of what the average South Asian middle-income country exports. Not surprisingly, the 2019 World Economic Forum Global Competitiveness Index ranked Nepal 108th out of 141 countries.30 Net foreign direct investment (FDI) has also underperformed. Remittance inflows on the other hand increased to 22.7 percent of GDP in FY23, are the main source of foreign currency, and the main driver of private consumption and economic growth (Figure 44). Figure 44. Nepal’s sources of foreign exchange earnings. ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ 'ŽŽĚƐĞdžƉŽƌƚƐ ^ĞƌǀŝĐĞƐĞdžƉŽƌƚƐ &ŽƌĞŝŐŶĚŝƌĞĐƚŝŶǀĞƐƚŵĞŶƚ ZĞŵŝƚƚĂŶĐĞƐ ϯϬ Ϯϱ ϮϬ ϭϱ ϭϬ ϱ Ϭ &ŝŐϰϰ &zϬϲ &zϬϵ &zϭϮ &zϮϬ &zϮϯ &zϬϭ &zϬϮ &zϬϯ &zϬϰ &zϬϱ &zϬϳ &zϬϴ &zϭϬ &zϭϭ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϭ &zϮϮ Sources. Nepal Rastra Bank and World Bank staff calculations. https://www3.weforum.org/docs/WEF_TheGlobalCompetitivenessReport2019.pdf 30 38 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 A country’s export performance depends on many competitiveness, including domestic and foreign policies, factors, but productivity and real exchange rate dynamics infrastructure, and innovation, to mention a few. are key determinants. More productive countries can produce more goods and services at lower costs, which This special focus is a preview of a comprehensive can lead to higher export volumes and earnings. Favorable forthcoming analysis of the interplay between productivity, real exchange rate dynamics can further boost exports. exchange rates, and exports in Nepal. The analysis is not A depreciating real exchange rate would make them exhaustive but precedes a more detailed discussion that more affordable abroad and could increase demand. An will be published in the forthcoming Country Economic appreciating exchange rate could have the opposite effect. Memorandum, a recurring flagship publication of the World Productivity and real exchange rates themselves are linked Bank that was most recently published in 2017 for Nepal.31 most prominently through the Balassa-Samuelson effect, This special focus chapter is intended to spur a debate which suggests that more productive countries have higher among analysts and policymakers on Nepal’s continuous levels of non-tradeable goods prices, which appreciates lackluster export performance, the associated productivity ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ their real exchange rate. However, it is of course important and exchange rate dynamics, and 'ŽŽĚƐĞdžƉŽƌƚƐ opportunities for ^ĞƌǀŝĐĞƐĞdžƉŽƌƚƐ &ŽƌĞŝŐŶĚŝƌĞĐƚŝŶǀĞƐƚŵĞŶƚ ZĞŵŝƚƚĂŶĐĞƐ to note that several other factors determine external improvement. ϯϬ ;ĂƐĂƐŚĂƌĞŽĨ'W͕ƉĞƌĐĞŶƚͿ Ϯϱ 'ŽŽĚƐĞdžƉŽƌƚƐ ^ĞƌǀŝĐĞƐĞdžƉŽƌƚƐ ϮϬ &ŽƌĞŝŐŶĚŝƌĞĐƚŝŶǀĞƐƚŵĞŶƚ ZĞŵŝƚƚĂŶĐĞƐ ϯϬ ϭϱ C.2 NEPAL’S PRODUCTIVITY CHALLENGES Ϯϱ ϭϬ ϮϬ ϱ ϭϱ Ϭ ϭϬ &zϬϭ &zϬϮ &zϬϯ &zϬϰ &zϬϱ &zϬϲ &zϬϳ &zϬϴ &zϬϵ &zϭϬ &zϭϭ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϰϰ Ͳϱ Productivity growth is a key driver of external Figure ϱ 45a. Agriculture value added per worker. Ϭ competitiveness, the main source of lasting per capita &zϬϭ &zϬϮ &zϬϯ &zϬϰ &zϬϱ &zϬϲ &zϬϳ &zϬϴ &zϬϵ &zϭϬ &zϭϭ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &ŝŐϰϰ Ͳϱ income growth, and therefore the primary driver of ;ĐŽŶƐƚĂŶƚϮϬϭϱh^͕ƚŚŽƵƐĂŶĚƐ͕ϮϬϭϵͿ poverty reduction.32 Productivity measures the amount Ϯϱ͕ϬϬϬ of output produced with a given set of inputs. The more ;ĐŽŶƐƚĂŶƚϮϬϭϱh^͕ƚŚŽƵƐĂŶĚƐ͕ϮϬϭϵͿ ϮϬ͕ϬϬϬ productive a worker or country is, the more it can produce Ϯϱ͕ϬϬϬ ϭϱ͕ϬϬϬ and export. This brief measures it at the national level in ϮϬ͕ϬϬϬ ϭϬ͕ϬϬϬ two ways: i) as labor productivity (the output produced by the average worker); and ii) as aggregate or total factor ϭϱ͕ϬϬϬ ϱ͕ϬϬϬ productivity (TFP, the economy-wide output produced with ϭϬ͕ϬϬϬ Ϭ factor inputs). &ŝŐϰϱĂ ϱ͕ϬϬϬ  DE > W ^Z ^^ As a region, South Asia’s labor productivity under Ϭ  DE ;ĐŽŶƐƚĂŶƚϮϬϭϱh^͕ƚŚŽƵƐĂŶĚƐ͕ϮϬϭϵͿ > W ^Z ^^ performed considerably over the past decade (Figure &ŝŐϰϱĂ Figure 45b. Industry value added per worker. Ϯϱ͕ϬϬϬ 45b). Labor productivity data come from the World Development Indicators (WDI) and measure the value added ϮϬ͕ϬϬϬ ;ĐŽŶƐƚĂŶƚϮϬϭϱh^͕ƚŚŽƵƐĂŶĚƐ͕ϮϬϭϵͿ per worker in each sector. In agriculture and services, South 33 Ϯϱ͕ϬϬϬ ϭϱ͕ϬϬϬ Asia significantly trailed other regions and only marginally ϮϬ͕ϬϬϬ ϭϬ͕ϬϬϬ outperformed Sub-Saharan Africa (Figures 45a and 45c). ϭϱ͕ϬϬϬ ϱ͕ϬϬϬ The labor productivity gap to other regions was even more ϭϬ͕ϬϬϬ pronounced in the industry sector, where the average South Ϭ W  > DE ^^ ^Z Asian worker is the least productive by a margin, adding only &ŝŐϰϱď ϱ͕ϬϬϬ roughly one-fifth of the value the average East-Asian worker Ϭ W  > DE ^^ ^Z adds. &ŝŐϰϱď World Bank (2017) 31 Dieppe (2021) 32 THE WORLD BANK | 39 SPECIAL FOCUS: DRIVERS OF EXTERNAL COMPETITIVENESS ;ĐŽŶƐƚĂŶƚϮϬϭϱh^͕ƚŚŽƵƐĂŶĚƐ͕ϮϬϭϵͿ Ϯϱ͕ϬϬϬ Figure 45c. Services value added per worker. Nepal suffers from a considerable labor productivity deficit compared to its regional and structural peers, and ϮϬ͕ϬϬϬ ;ĐŽŶƐƚĂŶƚϮϬϭϱh^͕ƚŚŽƵƐĂŶĚƐ͕ϮϬϭϵͿ the gap to India widened. The comparator countries used Ϯϱ͕ϬϬϬ in Figures 46a and 46b are structural peers, those countries ϭϱ͕ϬϬϬ ϮϬ͕ϬϬϬ that share similar characteristics with Nepal, e.g., landlocked, ϭϱ͕ϬϬϬ high remittances. Some of them are also regional peers. ϭϬ͕ϬϬϬ Nepal’s labor productivity gap against peers is especially ϭϬ͕ϬϬϬ striking in the agriculture and industry sectors, where Nepal’s ϱ͕ϬϬϬ ϱ͕ϬϬϬ productivity is lower than in any other peer country (Figure Ϭ 46a). In the industry sector, the average Nepali worker adds &ŝŐϰϱĐ ϬW  > DE ^Z ^^ less than one-third of what the workers in peer countries W Sources: World Development Indicators.  > DE ^Z The value add on average. ^^added by an industrial worker in &ŝŐϰϱĐ Notes. i) LAC = Latin America and Caribbean; EAP = East Asia and Pacific; Nepal is less than half of that of a domestic service worker. ECA = Europe and Central Asia; MNA = Middle East and North Africa; However, even though labor productivity in services was SAR = South Asia; and SSA = Sub-Saharan Africa ii) Regional averages exclude high income countries higher, compared to peer countries Nepal again lags, with the average service worker adding around 80 percent of the ;ĐŽŶƐƚĂŶƚϮϬϭϱh^Ϳ value that workers in peer countries add. Figure 46b shows ϭϵϵϲͲϮϬϬϲ ϮϬϬϳͲϮϬϭϰ ϮϬϭϱͲϮϬϭϵ that Nepal’s productivity gap relative to India widened across ϭϮ͕ϬϬϬ ϭϬ͕ϬϬϬ all sectors over the past decades. ϴ͕ϬϬϬ Figure ϲ͕ϬϬϬ 46a. Labor productivity by sector. ϰ͕ϬϬϬ Ϯ͕ϬϬϬ ;ĐŽŶƐƚĂŶƚϮϬϭϱh^Ϳ Ϭ ϭϵϵϲͲϮϬϬϲ ϮϬϬϳͲϮϬϭϰ ϮϬϭϱͲϮϬϭϵ <LJƌŐLJnjZĞƉƵďůŝĐ <LJƌŐLJnjZĞƉƵďůŝĐ <LJƌŐLJnjZĞƉƵďůŝĐ >ĂŽWZ >ĂŽWZ ŽůŝǀŝĂ ŽůŝǀŝĂ >ĂŽWZ ŽůŝǀŝĂ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ EĞƉĂů ,ŽŶĚƵƌĂƐ EĞƉĂů EĞƉĂů ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ ĂŶŐůĂĚĞƐŚ ϭϮ͕ϬϬϬ ϭϬ͕ϬϬϬ &ŝŐϰϲĂ ϴ͕ϬϬϬ ŐƌŝĐƵůƚƵƌĞ /ŶĚƵƐƚƌLJ ^ĞƌǀŝĐĞƐ ϲ͕ϬϬϬ ϰ͕ϬϬϬ Ϯ͕ϬϬϬ Ϭ <LJƌŐLJnjZĞƉƵďůŝĐ <LJƌŐLJnjZĞƉƵďůŝĐ <LJƌŐLJnjZĞƉƵďůŝĐ >ĂŽWZ >ĂŽWZ >ĂŽWZ ŽůŝǀŝĂ ŽůŝǀŝĂ ŽůŝǀŝĂ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ EĞƉĂů ,ŽŶĚƵƌĂƐ EĞƉĂů EĞƉĂů ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ů^ĂůǀĂĚŽƌ ĂŶŐůĂĚĞƐŚ ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ &ŝŐϰϲĂ ŐƌŝĐƵůƚƵƌĞ /ŶĚƵƐƚƌLJ ^ĞƌǀŝĐĞƐ Sources. World Development Indicators. Value added is the value of the gross output of producers less the value of intermediate goods and services consumed in production before accounting for consumption of 33 fixed capital in production. Value added per worker is calculated by dividing the value added of a sector by the number employed in the sector. 40 &ŝŐϰϳ &ŝŐϰϳ &ŝŐϰϲď &ŝŐϰϲď ϰ ͲϮ ϳ Ϭϭ ϭϭ Ϯϯ ϯϯ Ϭ ϭϮ ϮϮ ϯϰ ͲϮ Ͳϭ Ͳϭ Ϭ Ϭϭ ϯϰ ϰϱ ϱϲ ϭϮ Ϯϯ ϲϳ EĞƉĂů EĞƉĂů EĞƉĂů EĞƉĂů ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ;ŝŶĚĞdž/ŶĚŝĂсϭͿ ;ŝŶĚĞdž/ŶĚŝĂсϭͿ ĂŵďŽĚŝĂ >ĂŽWZ ĂŵďŽĚŝĂ >ĂŽWZ >ĂŽWZ >ĂŽWZ ŽůŝǀŝĂ ŽůŝǀŝĂ ŽůŝǀŝĂ ŽůŝǀŝĂ Sources. World Development Indicators. ŐƌŝĐƵůƚƵƌĞ Sources. World Development Indicators. ŐƌŝĐƵůƚƵƌĞ <LJƌŐLJnjZĞƉƵďůŝĐ ŐƌŝĐƵůƚƵƌĞ ŐƌŝĐƵůƚƵƌĞ <LJƌŐLJnjZĞƉƵďůŝĐ <LJƌŐLJnjZĞƉƵďůŝĐ <LJƌŐLJnjZĞƉƵďůŝĐ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ Figure 46b. Labor productivity by sector. ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ ϭϵϵϲͲϮϬϬϲ ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ ϭϵϵϲͲϮϬϬϲ Figure 47. Labor productivity growth by sector. EĞƉĂů EĞƉĂů EĞƉĂů EĞƉĂů ;ĂŶŶƵĂůŝnjĞĚŐƌŽǁƚŚƌĂƚĞϭϵϵϲͲϮϬϭϵ͕ƉĞƌĐĞŶƚͿ ;ĂŶŶƵĂůŝnjĞĚŐƌŽǁƚŚƌĂƚĞϭϵϵϲͲϮϬϭϵ͕ƉĞƌĐĞŶƚͿ ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ĂŵďŽĚŝĂ ĂŵďŽĚŝĂ >ĂŽWZ >ĂŽWZ >ĂŽWZ >ĂŽWZ ŽůŝǀŝĂ ŽůŝǀŝĂ ŽůŝǀŝĂ /ŶĚƵƐƚƌLJ /ŶĚƵƐƚƌLJ ŽůŝǀŝĂ /ŶĚƵƐƚƌLJ /ŶĚƵƐƚƌLJ ϮϬϬϳͲϮϬϭϰ <LJƌŐLJnjZĞƉƵďůŝĐ ϮϬϬϳͲϮϬϭϰ <LJƌŐLJnjZĞƉƵďůŝĐ <LJƌŐLJnjZĞƉƵďůŝĐ <LJƌŐLJnjZĞƉƵďůŝĐ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ EĞƉĂů EĞƉĂů EĞƉĂů EĞƉĂů ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ĂŶŐůĂĚĞƐŚ ϮϬϭϱͲϮϬϭϵ ĂŵďŽĚŝĂ NEPAL DEVELOPMENT UPDATE ϮϬϭϱͲϮϬϭϵ ĂŵďŽĚŝĂ >ĂŽWZ >ĂŽWZ >ĂŽWZ >ĂŽWZ ŽůŝǀŝĂ | ŽůŝǀŝĂ ŽůŝǀŝĂ ^ĞƌǀŝĐĞƐ ^ĞƌǀŝĐĞƐ ŽůŝǀŝĂ ^ĞƌǀŝĐĞƐ ^ĞƌǀŝĐĞƐ <LJƌŐLJnjZĞƉƵďůŝĐ <LJƌŐLJnjZĞƉƵďůŝĐ <LJƌŐLJnjZĞƉƵďůŝĐ THE WORLD BANK <LJƌŐLJnjZĞƉƵďůŝĐ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ ,ŽŶĚƵƌĂƐ | ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ ů^ĂůǀĂĚŽƌ 41 OCTOBER 2023 SPECIAL FOCUS: DRIVERS OF EXTERNAL COMPETITIVENESS Figure 48a. Agriculture 1996-2019 worker was higher in 1996 than it was in 2019.34 Nepal’s Productivity Growth vs. Change in Employment. decline in industrial output per worker was particularly pronounced during 2007-2014. ϮϬ ϭϬ Nepal’s labor productivity deficit in the non-agriculture ŚĂŶŐĞŝŶĞŵƉůŽLJŵĞŶƚƐŚĂƌĞŝŶ sectors manifests in slower structural labor market shifts. Ϭ ,E Labor movements away from agriculture were lower in Nepal ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐ ^>s ϮϬ ͲϭϬ K> EW> than in most peer countries included in the analysis (Figures ϭϬ ŚĂŶŐĞŝŶĞŵƉůŽLJŵĞŶƚƐŚĂƌĞŝŶ ͲϮϬ >K ' <' 48a-48c). From 1996 to 2019, employment in agriculture as a Ϭ ͲϯϬ ,E <,D share of total employment fell by 25 pp in Bangladesh and ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐ ^>s ϮϬ ͲϭϬ K> EW> ͲϰϬ 36 pp in Cambodia for example, while the reduction in Nepal ϭϬ Ͳϭ Ϭ ϭ Ϯ ϯ ϰ ϱ ϲ ŚĂŶŐĞŝŶĞŵƉůŽLJŵĞŶƚƐŚĂƌĞŝŶ ' &ŝŐϰϴĂ ͲϮϬ >K ĂŐƌŝĐƵůƚƵƌĞƉƌŽĚƵĐƚŝǀŝƚLJŐƌŽǁƚŚŝŶƉĞƌĐĞŶƚ <' amounted to 13 pp. As a result, Nepal continues to exhibit the Ϭ ͲϯϬ ,E <,D largest share of workers employed in agriculture by a margin, ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐ ^>s ͲϭϬ K> EW> Sources.ͲϰϬ World Development Indicators with more than 60 percent as of 2021, more than double the &ŝŐϰϴĂ ͲϮϬ Ͳϭ Ϭ ϭ Ϯ >K ϯ ϰ ' ϱ ϲ average of peer countries’ share.35 Employment shares in ĂŐƌŝĐƵůƚƵƌĞƉƌŽĚƵĐƚŝǀŝƚLJŐƌŽǁƚŚŝŶƉĞƌĐĞŶƚ <' Figure ϮϬ 48b. Industry 1996-2019 ͲϯϬ <,D the industry and services sectors increased moderately, but Productivity Growth vs. Change in Employment. productivity gains from these movements were limited due ŚĂŶŐĞŝŶĞŵƉůŽLJŵĞŶƚƐŚĂƌĞŝŶ ͲϰϬ <' ' ϭϬ Ͳϭ Ϭ ϭ Ϯ ϯ ϰ ϱ ϲ &ŝŐϰϴĂ EW> >K to the inherent low sectoral productivity in these sectors. ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐ ĂŐƌŝĐƵůƚƵƌĞƉƌŽĚƵĐƚŝǀŝƚLJŐƌŽǁƚŚŝŶƉĞƌĐĞŶƚ Ϭ ϮϬ K> ,E ^>s <,D Several factors hinder labor productivity growth in ŚĂŶŐĞŝŶĞŵƉůŽLJŵĞŶƚƐŚĂƌĞŝŶ <' ' ͲϭϬ ϭϬ Nepal, including the continuous large-scale emigration. >K EW> The substantial outflow of workers can result in a brain ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐ ϮϬ K><,D ͲϮϬ Ϭ ,E ^>s Ϯ drain, where the country loses its most talented workers to ͲϮ Ͳϭ Ϭ ϭ ϯ ϰ ŚĂŶŐĞŝŶĞŵƉůŽLJŵĞŶƚƐŚĂƌĞŝŶ &ŝŐϰϴď <' ' ϭϬ ͲϭϬ ŝŶĚƵƐƚƌLJƉƌŽĚƵĐƚŝǀŝƚLJŐƌŽǁƚŚŝŶƉĞƌĐĞŶƚ foreign markets. This can lead to a shortage of skilled labor >K EW> in the domestic market and suppress labor productivity ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐ Ϭ K> ͲϮϬ ,E ^>s growth. High emigration can also have negative effects on ͲϮ Ͳϭ Ϭ ϭ Ϯ ϯ ϰ &ŝŐϰϴď ͲϭϬ domestic labor force participation among the recipients of ϮϬ ŝŶĚƵƐƚƌLJƉƌŽĚƵĐƚŝǀŝƚLJŐƌŽǁƚŚŝŶƉĞƌĐĞŶƚ >K <,D <' remittances. These factors may outweigh some positive effects ŚĂŶŐĞŝŶĞŵƉůŽLJŵĞŶƚƐŚĂƌĞŝŶ ^>s K> ' ͲϮϬ ϭϬ Sources. World Development Indicators ͲϮ Ͳϭ Ϭ ϭ Ϯ,E EW> ϯ ϰ of emigration, such as increased investments in education ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐ &ŝŐϰϴď ŝŶĚƵƐƚƌLJƉƌŽĚƵĐƚŝǀŝƚLJŐƌŽǁƚŚŝŶƉĞƌĐĞŶƚ by remittance-receivers. Other factors that contributed to Figure Services 1996-2019 >K 48c. Ϭ ϮϬ <,D <' low productivity include low levels of capital investment and Productivity Growth vs. Change in Employment. ŚĂŶŐĞŝŶĞŵƉůŽLJŵĞŶƚƐŚĂƌĞŝŶ ^>s ' K> ͲϭϬ ϭϬ technology. High import tariffs and capital flow restrictions EW> ,E were key disablers of technological advances, preventing ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐ ϮϬ >K ͲϮϬ Ϭ <,D <' foreign investments and knowledge and technology transfers. ŚĂŶŐĞŝŶĞŵƉůŽLJŵĞŶƚƐŚĂƌĞŝŶ ͲϬ͘ϱ Ϭ͘Ϭ ^>s Ϭ͘ϱ ϭ͘Ϭ ϭ͘ϱ ' Ϯ͘Ϭ Ϯ͘ϱ K> ϭϬ ƐĞƌǀŝĐĞƐƉƌŽĚƵĐƚŝǀŝƚLJŐƌŽǁƚŚŝŶƉĞƌĐĞŶƚ &ŝŐϰϴĐ ͲϭϬ EW> ,E Another challenge in Nepal is the slowing overall productivity ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐ Ϭ of the economy (Figure 49).36 In the period immediately ͲϮϬ ͲϬ͘ϱ Ϭ͘Ϭ Ϭ͘ϱ ϭ͘Ϭ ϭ͘ϱ Ϯ͘Ϭ Ϯ͘ϱ following the end of the armed conflict (2007-2014), TFP ͲϭϬ ƐĞƌǀŝĐĞƐƉƌŽĚƵĐƚŝǀŝƚLJŐƌŽǁƚŚŝŶƉĞƌĐĞŶƚ contributed 1.2 pp of growth on average to Nepal’s total &ŝŐϰϴĐ ͲϮϬ growth. In the previous and subsequent periods, however, ͲϬ͘ϱ Ϭ͘Ϭ Ϭ͘ϱ ϭ͘Ϭ ϭ͘ϱ Ϯ͘Ϭ Ϯ͘ϱ the contribution of TFP to economic growth in Nepal was ƐĞƌǀŝĐĞƐƉƌŽĚƵĐƚŝǀŝƚLJŐƌŽǁƚŚŝŶƉĞƌĐĞŶƚ &ŝŐϰϴĐ negative, illustrating the underperformance of the Nepalese Sources. World Development Indicators and International Labor economy given the factor inputs. Low TFP in Nepal can be Organization linked to several factors, including high emigration if the net Nepali labor productivity dynamics are particularly effect of it on human capital development was negative. dire in the industry sector. Nepal and Honduras were Inefficient technologies have also impeded production the only countries in the sample to experience decreasing processes and efficiency and therefore suppressed TFP. productivity between 1996 and 2019. Figure 47 shows how Other factors include the inefficient use of resources, and labor productivity within each country has changed over poor management and functioning of firms. Again, Nepal time, and that in Nepal the average output of an industrial underperforms compared to its peer countries as well as India, particularly during the later 2010s. Measured in constant 2015 US dollars, data series NV.AGR.EMPL.KD, NV.IND.EMPL.KD, and NV.AGR.EMPL.KD at data.worldbank.org. 34 Data can be found with code SL.AGR.EMPL.ZS on data.worldbank.org 35 Due to data limitations, less peer countries are included in this figure, while India, Nepal’s main trading partner, was added. 36 42 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 Figure 49. Drivers of growth. ;ĐŽŶƚƌŝďƵƚŝŽŶƐƚŽŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ /dĐĂƉŝƚĂů EŽŶͲ/dĐĂƉŝƚĂů ,ŽƵƌƐǁŽƌŬĞĚ >ĂďŽƌƋƵĂůŝƚLJ d&W KƵƚƉƵƚŐƌŽǁƚŚ ϭϬ ϴ ϲ ϰ Ϯ Ϭ ͲϮ Ͳϰ ϮϬϭϱͲϭϵ ϭϵϵϲͲϬϲ ϭϵϵϲͲϬϲ ϮϬϬϳͲϭϰ ϭϵϵϲͲϬϲ ϮϬϬϳͲϭϰ ϭϵϵϲͲϬϲ ϮϬϬϳͲϭϰ ϮϬϬϳͲϭϰ ϮϬϭϱͲϭϵ ϮϬϭϱͲϭϵ ϮϬϭϱͲϭϵ ;ĐŽŶƚƌŝďƵƚŝŽŶƐƚŽŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ &ŝŐϰϵ /dĐĂƉŝƚĂů EŽŶͲ/dĐĂƉŝƚĂů ,ŽƵƌƐǁŽƌŬĞĚ >ĂďŽƌƋƵĂůŝƚLJ d&W KƵƚƉƵƚŐƌŽǁƚŚ ϭϬ EĞƉĂů ĂŶŐůĂĚĞƐŚ ĂŵďŽĚŝĂ /ŶĚŝĂ ϴ ϲ Sources. World Development Indicators ϰ Ϯ ;ƉĞƌĐĞŶƚͿ Ϭ EĞƉĂů /ŶĚŝĂͲϮ ϭϲ HOW HAVE REAL EXCHANGE RATE Ͳϰ C.3 DYNAMICS AFFECTED EXPORTS? ϮϬϭϱͲϭϵ ϭϵϵϲͲϬϲ ϭϵϵϲͲϬϲ ϮϬϬϳͲϭϰ ϭϵϵϲͲϬϲ ϮϬϬϳͲϭϰ ϭϵϵϲͲϬϲ ϮϬϬϳͲϭϰ ϮϬϬϳͲϭϰ ϮϬϭϱͲϭϵ ϮϬϭϱͲϭϵ ϮϬϭϱͲϭϵ ϭϰ &ŝŐϰϵ ϭϮ 2023 marks the 30th anniversary of Nepal’s ;ĐŽŶƚƌŝďƵƚŝŽŶƐƚŽŐƌŽǁƚŚ͕ƉĞƌĐĞŶƚĂŐĞƉŽŝŶƚƐͿ February Nepal’s realEĞƉĂůexchange rate ĂŶŐůĂĚĞƐŚ ĂŵďŽĚŝĂ appreciated against its trading /ŶĚŝĂ ϭϬ ϭϬ current /dĐĂƉŝƚĂů EŽŶͲ/dĐĂƉŝƚĂů ,ŽƵƌƐǁŽƌŬĞĚ >ĂďŽƌƋƵĂůŝƚLJ exchange rate peg of 1.6 NPR to the INR. From d&W KƵƚƉƵƚŐƌŽǁƚŚ partners, despite a nominal depreciation (Figure 51). The the ϴ Nepal’s exchange rate peg was set in FY93 to FY14, ϴ time ;ƉĞƌĐĞŶƚͿ effective exchange rate (NEER) measures the value of nominal ϲ EĞƉĂů /ŶĚŝĂ annualϲ inflation in Nepal was on average 0.1 pp lower than the ϭϲNPR against the currencies of its main trading partners. The ϰ in India. (Figure 50). From FY15 onwards, annual inflation ϭϰ effective exchange rate (REER) measures the price-level real Ϯ ϰ ϭϮ Nepal was on average 1.1 pp higher than in India, due in in Ϭ adjusted value of the NPR against the same currencies. The part Ϯ ϭϬ ͲϮ to the 2015 Gorkha earthquakes and India’s 2015 trade dynamics ϴ of the two rates began to diverge from FY05, when Ϭ on Nepal. blockade Ͳϰ theϲNEER index depreciated, and the REER index appreciated. ϰ &zϵϯ &zϵϵ &zϬϱ &zϭϭ &zϭϱ &zϭϳ &zϮϭ &zϮϯ &zϵϱ &zϵϳ &zϬϭ &zϬϯ &zϬϳ &zϬϵ &zϭϯ &zϭϵ ϮϬϭϱͲϭϵ ϭϵϵϲͲϬϲ ϭϵϵϲͲϬϲ ϮϬϬϳͲϭϰ ϭϵϵϲͲϬϲ ϮϬϬϳͲϭϰ ϭϵϵϲͲϬϲ ϮϬϬϳͲϭϰ ϮϬϬϳͲϭϰ ϮϬϭϱͲϭϵ ϮϬϭϱͲϭϵ ϮϬϭϱͲϭϵ Ϯ &ŝŐϱϬ Ϭ &ŝŐϰϵ Figure 50. Annual average consumer inflation Figure 51. Exchange rate dynamics FY03-FY23. of India and /ŶĚŝĂ &zϵϯ &zϵϱ &zϵϳ &zϵϵ &zϬϭ &zϬϯ &zϬϱ &zϬϳ &zϬϵ &zϭϭ &zϭϯ &zϭϱ &zϭϳ &zϭϵ &zϮϭ &zϮϯ EĞƉĂů ĂŶŐůĂĚĞƐŚ ĂŵďŽĚŝĂ Nepal FY93-FY23. &ŝŐϱϬ ;ƵŐƵƐƚϮϬϬϮсϭϬϬͿ ;ƉĞƌĐĞŶƚͿ ;ƵŐƵƐƚϮϬϬϮсϭϬϬͿ ϭϲ EĞƉĂů /ŶĚŝĂ ZZ EZ ϭϰϬ ZZ EZ ϭϰ ϭϰϬ ϭϯϬ ϭϮ ϭϮϬ ϭϬ ϭϯϬ ϭϭϬ ϴ ϭϮϬ ϭϬϬ ϲ ϵϬ ϰ ϭϭϬ ϴϬ Ϯ ϳϬ Ϭ ϭϬϬ ϲϬ ϵϬ &ŝŐϱϭ &zϬϯ &zϬϰ &zϬϱ &zϬϲ &zϬϳ &zϬϴ &zϬϵ &zϭϬ &zϭϭ &zϭϮ &zϭϯ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &zϵϯ &zϵϱ &zϵϳ &zϵϵ &zϬϭ &zϬϯ &zϬϱ &zϬϳ &zϬϵ &zϭϭ &zϭϯ &zϭϱ &zϭϳ &zϭϵ &zϮϭ &zϮϯ &ŝŐϱϬ ϴϬ Sources. Nepal Rastra Bank and IMF Sources. World Bank staff calculations ϳϬ ;ƵŐƵƐƚϮϬϬϮсϭϬϬͿ ZZ EZ ϭϰϬ ϲϬ ϭϯϬ &ŝŐϱϭ &zϭϰ &zϭϱ &zϭϲ &zϭϳ &zϭϴ &zϭϵ &zϮϬ &zϮϭ &zϮϮ &zϮϯ &zϬϯ &zϬϰ &zϬϱ &zϬϲ &zϬϳ &zϬϴ &zϬϵ &zϭϬ &zϭϭ &zϭϮ &zϭϯ ϭϮϬ THE WORLD BANK | 43 ϭϭϬ ϭϬϬ SPECIAL FOCUS: DRIVERS OF EXTERNAL COMPETITIVENESS The following analysis investigates how the real used as a robustness test. Nominal exchange rates data stem appreciation of the NPR affected Nepal’s export from the IMF. The BRER is measured such that an increase performance. The empirical approach follows the literature corresponds to an appreciation and is lagged one year examining how bilateral real exchange rates (BRER) affect throughout the analysis to avoid mechanical simultaneity. firm-level export outcomes. The most relevant paper Standard errors are clustered at the destination level. All methodologically is Fitzgerald and Haller (2018), who lay regressions include firm, product, destination, and year out the theoretical foundation for this type of analysis using fixed effects (i.e., dummy variables) to control for potential an exporter decision model. The empirical analysis and omitted variables. These are referred to as the “baseline” set theoretical foundation are also similar methodologically to of fixed effects. The “extended” set of fixed effects includes a large firm-level literature examining the effect of exchange firm-product-year interaction fixed effects and destination rates on prices (partly reviewed by Burstein and Gopinath, fixed effects. 2014). The baseline estimates imply that a 10 percent appreciation The analysis comprises annual data for two time periods, of the BRER is associated with a 3 percent decrease in 2010-2014 and 2018-2021, determined by data availability.37 Nepali exports. Table 6 presents evidence that the BRER Export data are expressed in USD, stem from the Nepali has a significant negative effect on exports (Specification 1, customs dataset, and differentiate between firms, products, (S1)). The results are similar when using the CPI instead of and destinations. World Bank GDP deflator data are used by GDP deflator to calculate price indices S2 and when using the default for the price index, IMF consumer price index data are extended set of fixed effects S3. Table 6. Baseline Regressions: Impacts of bilateral RER on exports (S1) (S2) (S3) -0.294 *** -0.299 ** Log(BRER) (0.111) (0.136) -0.284 ** Log(BRER), CPI (0.122) Observations 91,408 91,315 44,041 R-squared 0.524 0.524 0.63 Fixed Effects Baseline Baseline Extended Notes. i) Dependent variable is the log of exports; ii) Robust standard errors in parentheses. *** p<0.01, ** p<0.05, * p<0.1 Analysis including data on the size of firms shows that Nepal’s exports to India are more sensitive to variations the effect of BRER movements is stronger for larger firms in the BRER than exports to other destinations. Annex (Annex Table A1). This could be because small exporters Table A3 shows that the net effect for India - the sum engage in less systematic and possibly experimental of the coefficients - is about 1.2 While both coefficient participation in export markets, in which case the amount estimates are statistically significant, they are based on they sell may be less responsive to exchange rates. For larger limited observations, only 9 distinct values of the BRER exporters, the relationship between changes in their price with respect to each trading partner, one for each year in competitiveness and export value may be more elastic. the sample. The BRER effect is weaker for firms that export to more The effect of a BRER change on exports generally materializes destinations or that export more products. A possible in the subsequent year. As mentioned previously, by default explanation is that these firms are more diversified and can we lag the BRER variable by one period to avoid mechanical ride out BRER shocks more easily. They may not have to cut simultaneity. In Annex Table A3 (S14) we also include the 2-year exports as much in response to short-term fluctuations in lag and the contemporaneous year values. We see that the exchange rate conditions. results are driven by the one-year lag, with the two-year lag and contemporaneous RER effects being very close to zero. The analysis was designed and carried out by Rishi R. Sharma, Associate Professor of Economics, Colgate University 37 44 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 The data suggest that a 30 percent appreciation of the The regressions test whether the BRER has a significant BRER could account for a 13 percent reduction in Nepal’s impact on Nepal exporting new products over time. We total goods exports when accounting for export shares. could expect a negative coefficient, meaning that a depreciation Alternatively stated, a 10 percent appreciation could account (fall in BRER), which increases external competitiveness, would for a 4.2 percent reduction in Nepal’s goods exports. This lead to more types of products being exported. For this analysis, specification uses a weighted least squares (WLS) regression the data are aggregated to the firm-destination-year level and that weights destinations according to their share of total the dependent variable is the (log) number of products. The exports (S15, Annex Table A3). While this estimate is less baseline set of fixed effects are used in S16 and S17 of Annex precise with the coefficient significant at the 10 percent Table A4, the extended one in S18. level, the weighting makes it a more natural analog to the commonly used REER measures. The effect of the BRER on the number of products exported by Nepal is not as strong as the BRER effect on export values Finally, we investigate the relationship between the of existing products found in the earlier tables. While S16 number of exported goods and the real exchange rate. There provides a statistical significance of 10 percent that the are two ways that a country’s export flows can expand. First, BRER negatively affects the number of products exported, over time Nepal can export more of what it already produces this finding is not statistically significant across the different which is called the intensive margin – deepening existing specifications. markets. Second, over time Nepal can begin exporting new products which is an extensive margin – opening new markets. C.4 CONCLUSIONS AND RECOMMENDATIONS Nepal is experiencing a sizeable productivity deficit continuously over the past decade, productivity increased and poor export performance. Labor productivity is low only sluggishly. A more detailed analysis will be necessary compared to peers across all sectors and the mobility of to confirm these dynamics, including the role remittances labor across sectors has been slower. Low productivity played in the real appreciation.39 impedes domestic firms’ ability to compete with foreign There is significant empirical evidence that Nepal’s real firms for export markets, both in terms of prices and product appreciation has hampered its export performance. quality. It hinders the diversification of export products and Results show that a 10 percent appreciation of the bilateral labor market shifts away from less productive agricultural real exchange rate (BRER) is associated with around a 4 jobs to more productive jobs in manufacturing or services percent decline in exports. The results were more pronounced that could stimulate exports. Low productivity also likely for larger firms and exports to Nepal’s main trading partner, disincentivizes FDI inflows, which can enhance productivity India. Firms that export more products and to more markets through knowledge and spillover effects. appear less affected by BRER movements, underscoring the The evidence suggests that prices inside Nepal may be importance of diversification. increasing due to strong and sustained foreign exchange Increasing Nepal’s productivity is one of the most inflows (remittances), rather than to improvements in important efforts the country can undertake to improve productivity.38 According to theory, productivity and the export performance.40 Changing the current tax model by real exchange rate would move in the same direction as an economy develops. The first glance at the dynamics shifting taxation away from the border and reducing high undertaken in this chapter, however, suggests this was not import tariffs41 could increase firms’ productivity and export the case in Nepal. While the real exchange rate appreciated orientation. A review of capital control measures could help Productivity and real exchange rates themselves are linked most prominently through the Balassa-Samuelson effect, which suggests that more productive countries have 38 higher levels of non-tradeable goods prices, which appreciates their real exchange rate. The present analysis did not uncover evidence of this relationship in Nepal. See Narayan, Narayan, and Mishra (2011) for the impact of remittances on inflation. 39 Cusolito and Maloney (2018) offer a detailed framework for enhancing productivity. 40 A discussion of tariffs can be found in World Bank (2021). 41 THE WORLD BANK | 45 SPECIAL FOCUS: DRIVERS OF EXTERNAL COMPETITIVENESS identify those that could be lifted to allow for imperfect Getting a better grip on inflation would support real capital mobility and international payment flows without exchange rate stability. Simply changing the value of the peg jeopardizing usage of monetary policy. A more complete is unlikely to realign the real exchange rate, as the second order implementation of fiscal federalism could facilitate effective impacts of a devaluation include higher inflation resulting investments in infrastructure and services, which in turn from an increase in import prices. Inflation in FY23 continued could boost productivity. Evidence in other countries has to remain above the central bank’s target. Reducing the also shown that FDI inflows, which are negligible in Nepal inflation differential with trading partners would suppress so far, can create significant knowledge and spillover effects. domestic prices, help avoid further real appreciation, and In general, Nepal’s productivity deficit compared to peer help Nepal preserve external competitiveness. More analysis countries strongly suggests that authorities should shift their and discussion are also required to better understand the focus towards policies that enhance the ability of workers, role of remittances in Nepal’s real appreciation. firms, and industries to produce and compete. REFERENCES Cusolito, A. P. and William M. (2018). Productivity Revisited: Narayan, P. K., Narayan, S., and Mishra, S. (2011). Do Shifting Paradigms in Analysis and Policy. Remittances Induce Inflation? Fresh Evidence from Washington, D.C.: World Bank. Developing Countries. Southern Economic Journal, 77(4): 914-933 Dieppe, A. (Ed.). (2021). Global Productivity: Trends, Drivers, and Policies. Washington, DC: World Bank World Bank. (2017). Climbing Higher: Toward a Middle- Income Nepal. Washington, D.C.: World Bank Group. Fitzgerald, D. and Haller, S. (2018). Exporters and shocks. Journal of International Economics, 113, 154-171. World Bank. (2021). Fiscal Policy for Sustainable Development. Nepal Public Expenditure Review. Washington, D.C.: World Bank Group. 46 NEPAL DEVELOPMENT UPDATE | OCTOBER 2023 ANNEX Table A1. Impacts of bilateral RER and firm characteristics on exports (S4) (S5) (S6) (S7) -0.265 ** -0.298 *** -0.311 *** -0.294 *** Log(BRER) (0.109) (0.110) (0.112) (0.110) -0.071 *** -0.083 *** Log(BRER) x Larger (0.011) (0.011) 0.012 ** 0.014 ** Log(BRER) x Many Destinations (0.006) (0.006) 0.035 *** 0.047 *** Log(BRER) x Many Products (0.006) (0.007) Observations 91,408 91,408 91,408 91,408 R-squared 0.525 0.524 0.524 0.526 Fixed Effects Baseline Baseline Baseline Baseline Notes. i) Dependent variable is the log of exports; ii) Robust standard errors in parentheses. *** p<0.01, ** p<0.05, * p<0.1 Table A2. Impacts of bilateral RER and additional firm characteristics on exports (S8) (S9) (S10) (S11) (S12) -0.306 *** -0.299 ** -0.304 *** -0.338 *** -0.398 *** Log(BRER) (0.107) (0.116) (0.114) (0.115) (0.119) 0.063 Log(BRER) x Agriculture/Food (0.043) 0.003 Log(BRER) x Depreciation (0.004) 0.008 Log(BRER) x Large Depreciation (0.005) 0.046 Log (BRER) x Homogeneous (0.039) 0.021 Log (BRER) x Ext. Finance Dependent (0.037) Observations 91,408 91,408 91,408 86,207 74,887 R-squared 0.524 0.524 0.524 0.520 0.518 Fixed Effects Baseline Baseline Baseline Baseline Baseline Notes. i) Dependent variable is the log of exports; ii) Robust standard errors in parentheses. *** p<0.01, ** p<0.05, * p<0.1 Table A3. Impact of lagged bilateral RER and India on exports THE WORLD BANK | 47 ANNEX (S13) (S14) (S15) -0.292 ** -0.295 *** -0.423* Log(BRERt-1) (0.112) (0.111) (0.227) 0.0016 Log(BRERt-2) (0.004) 0.0077 * Log(BRERt) (0.004) -0.935 *** Log (BRER) x India (0.156) Observations 91,408 91,393 91,408 R-squared 0.524 0.524 0.735 Fixed Effects Baseline Baseline Baseline Notes. i) Dependent variable is the log of exports; ii) S15 uses weighted least squares regression that weights destinations according to their share of total exports; and (iii) Robust standard errors in parentheses. *** p<0.01, ** p<0.05, * p<0.1 Table A4. Impact of bilateral RER on the number of products exported (S16) (S17) (S18) -0.077 * -0.054 Log(BRER) (0.047) (0.046) -0.069 Log(BRER), CPI (0.042) Observations 44,815 91,393 91,408 R-squared 0.334 0.524 0.735 Fixed Effects Baseline Baseline Extended Notes. i) Dependent variable is the log of number of products exported; ii) Robust standard errors in parentheses. *** p<0.01, ** p<0.05, * p<0.1 48 NEPAL DEVELOPMENT UPDATE The World Bank Nepal Country Office, P.O. Box 798 Yak and Yeti Hotel Complex Durbar Marg, Kathmandu, Nepal Tel.: 4236000, Fax: 4225112 Email: infonepal@worldbank.org www.worldbank.org/np www.facebook.com/WorldBankNepal 50