Nepal Development Update

June 17, 2017

The World Bank, 12 May 2017

The latest Nepal Development Update out in May 2017, focuses on the country's economic rebound after two challenging years, and also discusses challenges ahead. Read the synopsis in our news release.

Economic activity is rebounding strongly in Nepal following two challenging years. On the back of one of the best monsoons in re-cent years, rice production is estimated to have reached a record high at 5.2 million tons, up from 4.2 million tons a year ago, boosting agricultural output. Post-earthquake reconstruction activities are picking up after a slow start. All eligible houses—about half a million—have received the first of three tranches of the housing grant. The second tranche of the housing grant has started, and is expected to pick up by the end of FY2017. More than 100 megawatts (MW) of hydropower capacity, which was delayed by the earthquakes and trade disruptions, have come on-stream. There has been a revival of transport and full normalization of wholesale and retail trade. Tourism is also recovering as arrivals reached pre crisis levels during the September–December 2016 tourist season.

As a result, growth has rebounded and has reached 7.5 percent in FY2017 (at market prices) according to the first estimate by the Central Bureau of Statistics (CBS). This is the highest growth rate since 1994 and is a result, in part, of a base-year effect, increased agricultural output, improved availability of electricity, and greater investment as earthquake reconstruction gathered speed. Base effect (lower growth in previous year) was a major contributor to the estimated growth rate in FY2017. Had the growth rate in FY2016 been in line with the average of recent years, the growth rate in FY2017 would not have been so spectacular.

This cyclical rebound follows two challenging years where real GDP growth fell to 3.3 percent in FY2015 due to the devastating earthquake and declined even further to a 14-year low of 0.4 percent in FY2016 due to a complete disruption in cross-border trade with India.

High inflation in the past two years induced by disruptions has moderated sharply in the first half of FY2017. Normalization of imports and a favorable external environment, particularly the moderating inflation in India as a result of demonetization, are the primary reasons for a deceleration of inflation. Food prices have also declined.

The new government has initiated a series of management reforms in electricity and health, with the most visible impact in the electricity sector with the elimination of power cuts in several major cities across Nepal. Efforts to reduce the financial and technical losses of the electricity utility, the Nepal Electricity Authority, are also showing results.

Government revenue and spending have also per-formed well. Revenue has exceeded the six-month target, and spending, including on capital goods, has also significantly picked up compared to previous years and is on par with revenue. Nevertheless, overly ambitious expenditure envisioned in the budget has not materialized, leaving previously accumulated government deposits (10 percent of GDP) intact.

Credit has grown rapidly over the past year, and growth reached its highest rate since 2012, while deposit growth slowed. However, banks are running up against prudential limits on lending. In addition, government’s large cash balances have had the effect of a monetary tightening at a time when the banks are trying to increase their capital base to meet the increased regulatory requirements for paid-up capital.

Imports, which, had rebounded quickly following the end of trade disruptions, have reached a record high. Exports, despite some recovery, are yet to reach their pre-disruption levels, particularly on account of sluggish recovery of exports to India. Exports recovery is also affected by continued appreciation of the real effective exchange rate. As a result, the trade deficit has continued to increase. The cumulative effect of a sharp trade balance deterioration and a slowdown of remittances has put the current account into deficit. Although still high, foreign reserve accumulation has slowed and the external sector pressure is building up.

Looking ahead, the economic growth will remain strong, but it is expected to moderate in line with country’s potential, averaging 5 percent over the next two fiscal years. While healthy growth is expected to continue in agriculture, construction and industry sectors, the activity in remaining sectors is expected to be affected by uncertainty stemming from transition to the federal structure, several elections and the possibility of further slowdown in remittances. Inflation is expected to be below the central bank’s target of 7.5 percent for all of FY2017, but likely to pick up somewhat in FY2018 as the effect of demonetization tapers off in India.

The fiscal deficit is expected to widen during the forecast period; however, given the large cash balance on hand, financing is not expected to be a problem. The FY2017 budget called for an expenditure increase of nearly 15 percent of GDP over actual expenditures in FY2016. However, as in previous years, significant underspending of the budget will continue. The government’s recurrent expenditure is expected to continue to grow substantially in FY2018, particularly as a result of the implementation of the new federal constitution, which calls for creation of an entirely new level of government. The growth in revenues is expected to continue, but it will likely slow given sharp growth over the past couple of years. With increased government spending as a result of a new federal structure and earthquake reconstruction, the fiscal balance is expected to be negative in FY2018. Meanwhile, the current account, which had remained in surplus over the past several years, is expected to narrow and turn into a deficit as import growth is expected persist while remittances is expected to remain sluggish.

Challenges and Risks
There are an increasing number of downside risks to this forecast with domestic risks predominating. The political environment remains fluid as the term of the current government is coming to an end. In addition, a series of elections needs to be held by early 2018, as stipulated by the new constitution. Implementation of a new federal structure could pose a challenge. Despite improvements, the overall pace of earthquake reconstruction remains a concern too.

Increased vulnerability in the financial sector could add a challenge during the remainder of the forecast period. Banks are running up against regulatory limits for lending, and this risks a sudden halt in new credit.

The external environment is likely to be less favorable, as well. Continued underperformance of exports, despite the end of disruptions, remains a persistent challenge. Remittances account for near-ly 1/3 of GDP, with the majority of migrants going to oil-exporting Gulf Cooperation Council (GCC) countries. Significant spending cuts, includ-ing on capital spending, announced in the GCC countries, and persistent contraction in departures of migrants, have contributed to lower growth of remittances and risk a possible sharper slowdown during the forecast period.

Download the latest Nepal Development Update here.