Economic Situation and Management of External Debt in Nepal

Prof. Tarun Das, Institute for Integrated Learning in Management, New Delhi
Formerly Eco. Adviser, Min of Finance and Planning Commission, Govt. of India.

1. Background

In recent years Nepal made significant progress toward sustainable economic growth and
is committed to the so-called LPG (viz. liberalization, privatisation and globalisation). It
completed its ninth economic development plan in 2002, its currency was made
convertible, and 17 state enterprises were privatized. Foreign aid accounted for more than
half of the development budget. Government priorities over the years focused on the
integrated development of agriculture, industry, transportation and communications.
Agriculture remains Nepal's principal economic activity, employing 80% of the
population and providing 37% of GDP. Rice and wheat are the main food crops. Out of
total land, only 20% is cultivable; another 33% is forested; and the rest is mountainous.

Resources

Nepal made significant progress in exploiting major economic resources such as tourism
and hydroelectricity. With eight of the world's 10 highest mountain peaks- including the
Mount Everest at 8,850 m (29,035 ft)- hiking, mountain climbing, and other tourism is
growing. Swift rivers flowing south through the Himalayas have massive hydroelectricity
potential to service domestic needs and the growing demand from India. India and Nepal
have joint irrigation-hydroelectric projects on the Kosi, Trisuli, and Gandaki Rivers.
Negotiations with India for a power purchase agreement had been underway for several
years, but agreement on pricing and capital financing remains a major problem.

Population pressure on natural resources is increasing. Over-population is already

straining the "carrying capacity" of the middle hill areas, particularly the Kathmandu
Valley, resulting in the depletion of forest cover for crops, fuel, and fodder and
contributing to erosion and flooding.

2. Current Economic Situation

(a) Economic Growth

Nepal’s economic growth has been adversely affected by the recent political conflicts.
Real GDP growth rate declined from an average of five percent per annum in 1990s
(contributed by an improvement in agricultural productivity and significant trade
liberalisation) to only 2 percent during 2000−2005. However, inflation remained
moderate and international reserves were adequate. Inflation remained in the low single
digits, although it rose to 7¾ percent in mid-October 2005 due to poor agricultural
performance caused by weather shocks, a VAT rate increase in January 2005, and partial
pass-through of higher international oil prices by the Nepal Oil Corporation.

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 (b) Financial Sectors

Financial soundness indicators improved in recent years due to banking reforms and
significant improvement in the performances of banks. Nepal Bank Limited (NBL) and
Rastriya Banijya Bank (RBB) are the two leading banks and account for 50 percent of
banking system deposits. Both these banks were loss-making entities in 2000/01, but they
made profits in 2003/04 and 2004/05 as a result of lower cost of funds and downsizing
staff through voluntary retirement schemes. Management and credit evaluation practices
in the banks also improved significantly. In addition, Asian Development Bank supported
restructuring plans for Agricultural Development Bank of Nepal. In contrast, the financial
condition of Nepal Industrial Development Corporation remained poor.

Despite this progress, the share of non-performing assets in NBL and RBB remained
high. Improvements in the legal and institutional framework over the last two years and
new debt recovery mechanisms (such as blacklisting directors, establishment of the Debt
Recovery Tribunal, and an Appellate Tribunal) helped recoveries from small and
medium-sized defaulters. But, recoveries from large, willful and politically connected
defaulters remained limited. The banks were reluctant to pursue these cases in the Debt
Recovery Tribunal due to concerns about its limited staff and capacity.

(c) Money Supply and Exchange rate

Monetary and exchange rate policies remained geared to supporting the exchange rate
peg to the Indian rupee. Broad money growth slowed from 12¾ percent in 2003/04 to
8 percent in 2004/05 reflecting substantially lower Net Foreign Assets accumulation by
the Nepal Rastra Bank (NRB). While budget financing from the banking system was
limited, private sector credit grew by 13¼ percent, mainly in consumer lending. Balance
sheet consolidation by the two largest banks undergoing restructuring limited the growth
of loans for manufacturing and services sectors. With high remittances, liquidity was
ample, T-bill rates remained low, and interest rates edged lower.

(d) Fiscal Situation

The overall fiscal deficit of Nepal remained manageable in 2004/05. Despite an increase
in the VAT rate was from 10 percent to 13 percent in early-2005, which helped revenue
to increase by ¾ percentage point to 13 percent of GDP, there were revenue shortfalls
due to weaker economic growth, continued excise leakages and delayed excise duty
refunds from India. On the expenditure side, the higher civil service wages and
allowances, and security-related expenditures were more than offset by lower spending
on development and social sector projects, especially in the conflict-affected areas. The
overall deficit was significantly lower than budgeted (1 percent of GDP compared to
2½ percent of GDP). External loans fell short of the budget target, as assistance from the
World Bank, Asian Development Bank, and donors dwindled. The domestically financed
deficit was also lower than budgeted (at ½ percent of GDP).

(e) External sector

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Principal imports of Nepal consist of gold, machinery and equipment, petroleum products
and fertilizers, and major sources of imports in 2004 were India (47%), China (10%),
UAE (9%), Singapore (4%) and Saudi Arabia (4%).

Nepal's principal export destinations include India (50%), United States (22%), Germany
(8%), United Kingdom (3%), and France (2%).

Nepal's merchandise trade balance has improved somewhat in recent years with the
growth of the carpet and garment industries, which account for approximately 70% of
merchandise exports. Trade with India rose rapidly after conclusion of the 1996 bilateral
trade treaty between the two countries, and now accounts for 50% of all exports and 47%
of all imports.

Strong export performance, including earnings from tourism, and external aid have
helped improve the overall balance-of-payments situation and increase international
reserves. Nepal receives substantial amounts of external assistance from India, China, the
U.K., Japan, Germany and the Scandinavian countries. Multilateral organizations, such as
the World Bank, ADB and UNDP also provide substantial development assistance.

Current Account Balance

The current account and overall balance of payments remained in surplus. Despite
disruptions related to the insurgency and the elimination of textile quotas, total exports
rose by 10 percent in 2004/05, mainly due to booming exports to India which rose by
30 percent, while exports to other countries declined by over 15 percent. Export
performance in traditional sectors such as garments, carpets and pashmina remained
weak. Total import growth was stagnant due to weak economic activity. A 35 percent
increase in oil imports caused by hardening of international prices of oil was offset by a
6 percent decline in non-oil imports. Remittances continued to be buoyant, and the
current account surplus (excluding official transfers) increased from 1 percent of GDP in
2003/04 to 3 percent of GDP in 2004/05. A surplus in the overall balance of payments led
to an increase in international reserves to around US$1.5 billion (equivalent to
7¾ months of imports of goods and services) at end-2004/05.

3. External Debt Situation

The external debt stock has increased almost fourfold during the period. As the country's
investment requirements far exceed the internal savings, access to external capital, in the
form of loans or grants, is inevitable. The savings-investment gap spills over to the
current accounts deficit, which was around 3 percent of GDP in 2003. Compared to other
South Asian countries, this is very high. There is a changing profile of external assistance
in Nepal. Unlike in the good old days when external funding came mainly as grants from
bilateral sources, loan has emerged as the principal form of development assistance in
recent years. After the end of the Cold War, the multilateral banking institutions like the

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World Bank and the Asian Development Bank have emerged as the principal funding
sources and there is a concurrent reduction in bilateral assistance.

These developments cannot be regarded as trend towards a debt trap. In dollar terms, the
total outstanding external debt rose from US $ 1.64 billion in 1990 to US $ 3.25 billion in
2004, an increase of 98 percent (Table-3). During the same period the exports of goods
and services in dollar terms increased by 319 percent. As a result, debt/service ratio
declined from 15.7 per cent in 1990 to 6 percent in 2003. The apparently sharp growth in
external debt in terms of domestic currency is not due to over-borrowing, but largely due
to the depreciation of Nepali rupee vi-a-vis the international reserve currencies against
which the borrowings were made. For example, one US dollar was equivalent to 74.75
rupees in 2003 as against 42.70 rupees in 1991.

In fact, Nepal has managed external debt very well although there are mixed trends of
major sustainability indicators over time. Along with other countries, World Bank
publishes external debt statistics for Nepal in the Global Development Finance (GDF). In
the latest issue of GDF (2005), the World Bank has classified Nepal as a moderately
indebted low-income country. As per the World Bank statistics summarized in Table-2,
the external debt to GNI ratio increased from 45 per cent in 1990 to 56 per cent in 2003,
but external debt service ratio declined from 15.7 per cent to 6 per cent, external debt to
export ratio decreased from 367 per cent to 174 per cent and the share of concessional
loan in total external debt improved from 88 to 97 per cent over the same period. The
share of multilateral debt in total debt also improved from 77 per cent to 84 per cent and
that of short-term best remained low around 1.5 per cent during 1990-2003. The country
has foreign exchange reserves, equivalent to 7.7 months imports cover.

The WB and the IMF have developed various benchmark ratios to cast a country's
indebtedness in terms of the country's potential capacity to service debt. They relate to
net present value of debt service in relation to GNP and to exports. Based on these NPV-
based debt indicators for the year 2003, the IMF considers Nepal's foreign debt position
better than that of Sri-Lanka, Pakistan, Bhutan and Maldives among the SAARC
countries and categorizes Nepal as a low income and low indebted country along with
India and Bangladesh (Table-1).

There are also simpler benchmark rules governing the national debt management. It is
said that the total outstanding debt should not exceed 60 percent of GDP. Similarly, the
foreign debt servicing should not exceed 20 percent of the export value, and domestic
debt servicing should not exceed 20 percent of the domestic revenue. Even based on
these criteria, Nepal's situation is within manageable limits.

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 Table-1: External Debt Situation in South Asian Economies in 2003
Country and Rank in PV of Debt PV to GNP PV to XGS Indebtedness and income
terms of EDT $ Bln Ratio Ratio Classification
1. India 100.3 19 106 Less/ Low
2. Pakistan 29.7 41 189 Moderate/ Low
3. Bangladesh 12.8 25 128 Less/ Low
4. Sri Lanka 8.4 51 110 Moderate/ Middle
5. Nepal 2.1 38 131 Less / Low
6. Bhutan 0.4 74 252 Severe/ Low
7. Maldives 0.2 35 41 Severe/ Middle

Additionally, it may also be noted that Nepal's external debt stock is composed of
concessional loans with long maturities and nominal interest charges. Some of the
bilateral loans, like those from Japan and some Western countries, are eventually
converted into grant. This explains Nepal's low NPV of external debt and the comfortable
debt-servicing situation, although the total debt stock as percentage of GDP cannot be
regarded as low. At present, the international climate for poor and indebted nations is
very congenial. Nepal does not fall under the category of highly indebted countries and
hence does not qualify for relief under the HIPIC initiative. Nevertheless, demand for
debt relief to poor countries like Nepal is increasing. The UK government has already
agreed to pay back 10 percent of Nepal's total debt to the WB.

4. Economic Outlook and Risks

Nepal's growth prospects are contingent on political stability and improved security. Real
GDP growth rate is estimated in the range of 2½−3½ percent in 2005/06. If
implementation of structural reforms continues along with political stability and better
security conditions, there will be a distinct improvement in agricultural, manufacturing
and service production, tourism earnings and government activities. This will help Nepal
to achieve growth rates around 5−5½ percent in the near and medium term. With the
rupee peg, inflation is expected to broadly follow price developments in India, which are
moderate and under control.

Export growth is projected to average 8 percent with further diversification of Nepalese

exports beyond traditional sectors. Both oil and non-oil imports are projected to pick up
with improved economic activity. Consequently, the balance of payments surplus is
projected to decline in the near term. Trade deficits could be covered by remittances and
aid. International reserves are projected to remain around 6−7 months of imports of goods
and services.

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 5. Conclusions and Recommendations

(a) Structural Reforms

Nepal is presently passing through a critical political and economic juncture. Although
authorities may be complemented for maintaining macroeconomic stability and
implementing reform program under a difficult economic-political environment, they are
advised to resolve political and economic uncertainties and make progress toward
sustained peace and security, which are essential steps for poverty reduction and private
sector led growth.

They are advised to continue with the policies envisaged under the Nepal's Poverty
Reduction Strategy Paper (PRSP) accepted by the Fund-bank, which remains an
appropriate framework to address key constraints on growth, macroeconomic stability,
and reduction of poverty. This would help mobilize external assistance and lay the
foundation for possible debt relief under the HIPC Initiative and the Multilateral Debt
Relief Initiative.

(b) Fiscal Policies

Nepal has made significant progress on revenue mobilization, expenditure prioritization,

social sector spending and containment of budget deficit. However, there are concerns
that security-related spending pressures remain high, and development spending is low
relative to budget targets, especially in conflict-affected areas. There is a need to increase
fiscal transparency, improve public expenditure management, contain contingent
liabilities and address donors’ concerns about the quality of spending.

Authorities should make all efforts to improve tax administration and to increase revenue
collections. They should also raise spending on infrastructure and social sectors to
achieve PRSP goals. Administrative pricing of petroleum products may be replaced by an
automatic pricing mechanism to improve the financial conditions of the Nepal Oil
Corporation and to avoid additional burden on the budget.

(c ) Financial sectors reforms

In the banking sector, efforts should be made to recover non-performing assets from the
willful defaulters in order to improve the balance sheets of the NBL and RBB, reduce
contingent liabilities for the budget and pave the way for their privatization

The legal framework for financial sector activity can be further improved through
amendments to the Banking and Financial Institutions Ordinance. NRB may be
encouraged to enhance financial sector supervision, and raise its internal audit and
accounting standards. Authorities are also advised to move forward with implementation
of strong anti-money laundering and combating the financing of terrorism regime.

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 (d) Agrarian Reforms

Given the importance of agriculture and the high level of rural poverty, there is need to
initiate progressive agrarian reforms such as providing complementary inputs to land and
improving rural infrastructure to promote commercialization and market access for
agricultural products.

(e) Trade and Exchange Rate Policy

The exchange rate peg to the Indian rupee remains appropriate, as it enables the economy
to benefit from close ties with India and helps to keep inflation at low levels. However,
the level of the peg should be monitored and kept under review, given Nepal's growing
integration in the world economy through its membership in the WTO and regional
trading arrangements. External competitiveness should be enhanced through structural
reforms and infrastructure investments to lower transactions and transportation costs.

Despite the concessional nature of external debt, the exchange rate risk is high. Due to
steady depreciation of rupee value in relation to convertible currency in the past, the pay
back liability to the taxpayers has mounted. Therefore, a prudent public debt policy is
necessary with adequate emphasis on the quality of debt.

(f) Public sector reforms

The pace of public enterprises and governance reforms need to be accelerated to improve
the efficiency of large public enterprises. It is desirable to proceed decisively with the
liquidation of unviable loss-making enterprises and encourage privatisation mechanisms
such as share sales and management contract.

The regulatory framework needs to be strengthened and labor markets be made more
flexible to create an enabling environment for private sector participation. The
promulgation of the Secured Transactions, Company, Securities, and Insolvency
Ordinances is in the right direction. However, the draft Labor Ordinance needs to be
promulgated early.
.
(g) Debt Recovery System

Nepal provided inaccurate information related to the second disbursement made in

November 2004 under the Poverty Reduction and Growth Facility arrangement under the
IMF due to weaknesses in its debt recording system. As a result of this misreporting, the
disbursement was noncomplying. The arrears, which were attributable to the weak debt
management and coordination problems and led to the noncomplying disbursement, have
now been cleared. However, there is an urgent need to address data deficiencies to
improve policy formulation and monitoring, and full implementation of the Fund
technical assistance recommendations on external debt management.

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 Table-2: Nepal: Selected Economic Indicators, 2000/01-2004/05
2000/01 2001/02 2002/03 2003/04 2004/05
(Percent
Real GDP Growth Rate (%) 5.6 -0.6 3.4 3.4 2.5
CPI Inflation Rate (end-period) 3.4 3.5 6.1 2.0 6.6
(Percent of GDP)
Budgetary operations
Total revenue 11.4 11.5 12.3 12.2 13.0
Total expenditure 17.5 17.2 16.0 15.5 16.0
Current expenditure 11.1 11.5 11.4 11.2 11.7
Capital exp. And net lending 6.4 5.6 4.6 4.3 4.3
Overall deficit 4.5 4.3 1.6 1.0 0.9
(Percent of GDP)
Money and credit
Broad money 15.2 4.4 9.8 12.7 8.0
Domestic credit 18.8 9.2 12.0 9.3 13.3
(In millions of U.S. dollars, unless otherwise indicated)
External sector
Exports, f.o.b. 945 754 653 748 826
Imports, f.o.b. 1,710 1,448 1,556 1,801 1,806
Current account 162 106 16 59 226
(In percent of GDP) 2.9 1.9 0.3 0.9 3.1
Overall balance 38 -39 93 235 24
Gross official reserves 1,020 1,048 1,178 1,471 1,507
Rupees per US$ (end-period) 74.7 78.0 74.8 74.1 70.0
Source: International Monetary Fund (IMF)
Fact Sheet of Nepal
Surface area: 147 thousand sq km Population: 26.6 million (2004)
Exchange rate: A$1 = 54.1241 Rupees (Jun 2005)
GDP -composition by sector: agriculture: 40%, industry: 20% and services: 40%
Population below poverty line: 42% (1995-96)
Household income or consumption by percentage share:
lowest 10%: 3.2% highest 10%: 29.8% (1995-96)
Inflation rate (consumer prices): 2.9% (2002)
Labour force: 10 million (1996) Unemployment rate: 47% (2001)
Labor force - by occupation: agriculture 81%, services 16%, industry 3%

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 Table-3: External Debt in Nepal (in US$ million)

1970 1980 1990 2000 2001 2002 2003

Total Debt stock (EDT) 3 205 1640 2846 2716 2973 3253
Long term debt 3 156 1572 2805 2654 2929 3176
Public & guaranteed 3 156 1572 2805 2654 2929 3176
Private non-guaranteed 0 0 0 0 0 0 0
Use of IMF credit 0 42 44 12 8 4 11
Short-term debt 0 7 24 29 54 40 66
Total debt service (TDS) 2 8 70 103 93 102 113
Principal repayments 2 3 41 72 65 74 82
Interest payments (INT) 0 5 29 31 28 28 31
Interest on long term debt 0 2 25 28 26 27 30
Interest on short term debt 0 1 2 0 0 0 0
Interest on IMF loan 0 2 2 3 2 1 1
Gross national income (GNI) 866 1958 3640 5514 5598 5554 5843
Exp.of goods and services (XGS) … 272 447 1456 1351 1649 1873
Workers remittances 0 0 0 111 147 678 785
Imp.of goods & services (MGS) … 419 845 1825 1759 1733 2016
International reserves (RES) 94 272 354 987 1080 1070 1286
Current account balance … -39 -289 -131 -165 215 171
Sustainability Debt indicators (in per cent)
EDT/ XGS … 75 367 195 201 180 174
EDT/ GNI 0.3 10.5 45.1 51.6 48.5 53.5 55.7
TDS/ XGS … 2.9 15.7 7.1 6.9 6.2 6.0
INT/ XGS … 1.8 6.5 2.1 2.1 1.7 1.7
INT/ GNI 0 0.3 0.8 0.6 0.5 0.5 0.5
RES/ EDT 3133 132.7 21.6 34.7 39.8 36.0 39.5
RES/ MGS (months) … 7.8 5.0 6.5 7.4 7.4 7.7
Short-term/ Total debt 0 3.4 1.5 1.0 2.0 1.3 2.0
Concessional/ EDT 69.5 75.7 88.5 98.4 97.6 98.3 97.4
Multilateral/ Total debt 7.2 62 77 86 87 88 84
Public debt as % of total debt 100 97 99 99 98 99 98
Currency composition (%) 100 100 100 100 100 100 100
Japanese Yen 0 8 8 9 7 7 11
US dollars 9 50 50 39 41 40 43
Multiple currency 4 31 33 42 41 42 36
Others 87 11 9 10 11 11 10
Source: (1) World Bank, Global Development Finance 2005