Nepal needs to deepen FDI reforms to encourage new inflows of investment and technology

As Nepal faces one of the most challenging times in its history economically due to various external and internal factors, the support of multilateral partners like the World Bank has become more important than ever for the country. The Washington DC-based agency has been supporting the Himalayan nation in diverse areas for a long time and says it will extend its support in the future.

Faris Hadad-Zervos is the World Bank’s Country Director for Maldives, Nepal and Sri Lanka since July 2020. Prior to this assignment, he was the bank’s Country Director for Nepal. In a conversation with the HRM, he talked about the World Bank’s assessment of the economic slowdown in Nepal, the challenges the country faces at the moment, and the agency’s support in strengthening fiscal federalism, among other topics. Excerpts: 

How is the World Bank assessing the macroeconomic situation of Nepal as the country reels under an economic slowdown? What macroeconomic or policy headwinds the World Bank has identified as causing the economic slowdown in Nepal?
Nepal’s economy grew less than two percent in FY 2022/23, and our analysis traces a chain of events that contributed to this slowdown. Import restrictions in FY2021/22 and tighter monetary policy were successful at reducing import demand and increasing foreign exchange reserves, but the abrupt policy adjustment disrupted private sector activity. We recommend using pricing signals such as interest rates instead of import restrictions. However, this approach requires patience and early action, as changes in interest rates take months to affect private investment and consumption decisions. Around the same time, international commodity prices surged following Russia’s war on Ukraine, contributing to rising inflation in Nepal, which reached 8.6 percent in September 2022. Lower growth and higher inflation together negatively impacted household and firm purchasing power. Here we recommend a cautious approach to easing monetary policy until inflation is brought under control.

Overall, we expect higher growth for Nepal’s economy in FY 2023/24. The last of Nepal’s import restrictions were lifted in January 2023, international commodity prices have largely stabilized, remittance inflows are up by 13 percent compared to last year, and India is set to remain the world’s fastest-growing economy this year. However, India’s recent ban on non-basmati rice exports is a cause for concern. We also urge policymakers to avoid excessive stimulus to credit growth, which could set off another cycle of high import growth. Controlling inflation remains crucial to help vulnerable households afford food.

How effectively have the government and the central bank faced internal and external challenges to the country’s economy? What are the shortcomings in their efforts to face the situation?
The central bank has done a good job analyzing data and taking action as the economy emerged from the Covid-19 pandemic. However, as explained in our April 2023 Nepal Development Update, policy adjustments require careful consideration of unintended consequences. For instance, while import restrictions reduced imports as intended, the resulting decline in fiscal revenue and a sharp decline in economic activity may have not been fully anticipated. Prioritizing evidence-based policymaking is critical. On this front, the World Bank will continue its technical support to help the Ministry of Finance, Nepal Rastra Bank, National Planning Commission, and other institutions develop data-driven macroeconomic forecasts.

As a result of the measures implemented last year to curb imports and check the private sector credit growth, the government is facing a severe resource crunch. A huge gap in the government’s resources has emerged. How the gap can be narrowed?
There is immense potential to improve the efficiency and effectiveness of public spending. In our June 2023 Nepal Fiscal Federalism Update, we recommended amending the legal framework to clarify concurrent and shared responsibilities among the three tiers of government. This can reduce the gap between spending and revenue by addressing the duplication of expenditures. We also support the government’s intention to gradually shift from import-based taxation to domestic revenue mobilization, which will reduce risks from large swings in international prices and domestic import demand. However, the transition will take several years, and policymakers must be patient and fine-tune revenue adjustments to ensure that the private sector can adapt.

How is the World Bank supporting the government to face the challenges in fiscal management? Will there be more budgetary support for the government in FY 2023/24?
We are working with the government to finalize two budget support operations this year – one on fiscal policy improvements and another to strengthen financial sector stability and diversify financial services.

Q: Nepal’s weak absorptive capacity to utilize foreign support and aid is often cited as one of the key reasons behind the ineffective development results. How is the World Bank working to enhance the capacity of the agencies of federal and sub-national governments to expedite capital expenditure?
A: The National Planning Commission has announced significant reforms this year, issuing new guidelines for the National Project Bank, the repository for all large capital investment projects under the federal government. These guidelines strive to enhance climate-resilient infrastructure spending and make compliance mandatory. They are also expected to improve the preparation and selection of public capital projects, addressing the issue of project readiness that leads to the underspending of capital expenditure in Nepal. Through future reforms, provincial governments will develop their own provincial project bank guidelines for development projects funded by their budgets.

What is the World Bank’s assessment of the past six years of Nepal’s transition to federalism? How has Nepal’s performance been in terms of fiscal federalism? 
Nepal’s transition to federalism has had huge implications for inter-governmental fiscal relations and public finance management. Our Nepal Fiscal Federalism Update highlights the progress made in the last four years, including the development of progressive regulatory and institutional frameworks. The fiscal framework and financial management functions for federalism are fully integrated into the government’s planning and budgeting system. In FY 2021, the inter-governmental fiscal transfer system enabled provincial and local governments to receive nearly 36.7 percent of the federal budget, amounting to 64.8 percent of their revenue. However, Nepal is still in the early stages of consolidating its fiscal federalism institutional architecture. To improve implementation, the government needs to develop a fiscal federalism roadmap that complements existing strategies (e.g., the PFM Reform Strategy under development) and forges broader ownership among the stakeholders.

How is the World Bank working with the federal and sub-national governments to strengthen their delivery of services to the people? 
Nepal’s federalism agenda underpins the World Bank’s programs at all levels – strategic, policy, and operational. We work with the government at the federal and subnational levels to help strengthen institutions and service delivery. A few examples include:

The Covid-19 Emergency Response and Health Systems Preparedness Project supported federal and sub-national government strategies to test, trace, and treat COVID-19 patients.

The Strengthening Systems for Social Protection and Civil Registration Project has helped improve service delivery at the local level through digitization. Over 97 percent of wards have transitioned to the online registration of births, deaths, marriages, and migration, and all 3.5 million social security beneficiaries now receive allowances directly into their bank accounts.

To improve accountable service delivery and efficient public expenditure across the three tiers of government, ongoing support focuses on building effective systems and procedures for planning, public investment management, budgeting, internal controls, financial reporting, and oversight.
Ongoing support seeks to help integrate key aspects of citizen engagement, gender, equity, and social inclusion into planning, budget preparation, execution, and oversight phases.

Three years ago, the World Bank board approved Youth Employment Transformation Initiative (YETI) Project, which the bank said was aligned with the Prime Minister Employment Programme (PMEP). Over the years, questions have been raised about the effectiveness of the PMEP. Do you think, the bank’s support of the program has been effective? 
YETI is aligned with PMEP, helping provide temporary employment to over 100,000 individuals, 49 percent of whom are women. Scaling up during the pandemic helped an additional 44,000 people. There has also been progress in strengthening the capacity of employment service centers, providing skills training for temporary work, and establishing a management information system to improve program transparency and efficiency. To ensure effective implementation, continued focus on strategic partnerships with the private sector, developing capacity, and improving local-level engagement is necessary.

The World Bank has often emphasized a transformative change in the FDI regime of the country. There have been some changes. How do you review the recent changes that have taken place in our FDI regime? And are the changes enough or is there more to be done?
Nepal’s historically low FDI inflows hinder sustainable growth. In FY21, FDI inflows were less than 0.5 percent of GDP, and only 0.2 percent of GDP in FY22, lower than other countries in South Asia and Southeast Asia. That said, the government has taken positive steps to reform the FDI entry regime, such as reducing the minimum FDI threshold, using an automatic approval process for foreign investments under NPR 100 million in selected sectors, and removing the minimum FDI threshold for the ICT sector. However, Nepal needs to deepen FDI reforms to encourage new inflows of investment and technology. The institutional framework for foreign investment in Nepal is still complicated by legal and legislative overlaps. Developing a national investment policy could help sequence reforms and establish streamlined and efficient approval processes, including streamlining the roles and responsibilities of government agencies to avoid duplication.

The World Bank in the past had suggested the central bank to reduce the number of commercial banks operating in the country. Now, the number of commercial banks has come down to 21 with a series of mergers last year. Do you think the current number of BFIs in the country is good enough or do you see the need for further consolidation in the banking system?
It is important to note that the World Bank has not suggested an ideal number of commercial banks for Nepal. The number a country needs depends on factors such as population size, economic activity, financial transaction complexity, and geographical distribution. Too many banks can lead to fragmentation and inefficiency, while too few can limit competition and access to financial services.

Overall, Nepal has improved financial access while reducing the number of financial institutions. A decade ago, a high number of financial institutions presented regulatory challenges. In 2014, the World Bank supported the government’s policy to consolidate the banking system through a moratorium on new licenses to financial institutions (excluding microfinance institutions) and a new bylaw to facilitate mergers and acquisitions. As a result, total BFIs have reduced from 190 in July 2012 to 55 in June 2023.

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