The role of international financial agencies like the International Monetary Fund (IMF) has become crucial for Nepal which is facing a deeper economic downturn. The Washington DC-based agency has been supporting Nepal ever since the country became a member in 1961. Currently, IMF is actively supporting with assistance like the Extended Credit Facility (ECF), and other programs, to help Nepal face the difficult situation.
Teresa Daban Sanchez is IMF Resident Representative to Nepal since April 2022 when the agency reopened its residential office in Nepal after closing it in 2008. Before coming to Nepal, she was Senior Economist at IMF. She also worked as IMF Resident Representative to Pakistan from March 2018-February 2022. In a conversation with the HRM, Sanchez talked about the current state of Nepal’s economy, support for Nepal, and the asset quality check of major Nepali banks, among other topics. Excerpts:
Q: How is the International Monetary Fund (IMF) assessing the macroeconomic situation of Nepal as the country reels under an economic slowdown? What macroeconomic or policy headwinds IMF has identified as causing the economic slowdown in Nepal?
After the Covid-19 pandemic, Nepal’s economy rebounded strongly, reflecting the reopening of the economy, rapid credit growth, a gradual recovery in tourism, and sustained remittances. The strong rebound led to a rapid increase in imports, inflation, and the emergence of external imbalances, which were exacerbated by the impact of the war in Ukraine on commodity prices. These developments required the Nepal Rastra Bank (NRB) to tighten monetary policy, which together with the gradual unwinding of Covid-19 support measures, helped moderate credit growth, inflation, and imports. The import bans and mandatory use of letters of credit and cash margins introduced last year on selected heavily taxed import items, added to the slowdown in imports, yet at the cost of dampening tax collections significantly and distorting trade patterns. This necessitated the adoption of a mid-year budget review to rationalize expenditure and preserve fiscal discipline and debt sustainability.
As a result of these developments, and in the context of resilient remittances, Nepal’s external sector has stabilized, while domestic demand is softening more than originally anticipated.
The quarterly data through Q2 FY2022/23 recently released by the National Statistics Office (NSO) indicate that the economic slowdown is not affecting all economic sectors in the same way, with some sectors performing quite well, such as electricity and tourism, non-trade services and others registering a decline such as construction, retailers and wholesalers, and manufacturing. This reflects many factors, such as last year’s much-needed monetary policy tightening and the slow execution of budget capital spending, but also the distortionary import restrictions implemented last year. As a result, the NSO preliminary estimate for FY2022/23 real GDP growth is around 2 percent, below most analysts’ expectations.
However, there are several other factors that point out to an improvement in the outlook for Nepal’s growth, such as the ongoing recovery of tourism, strong remittance inflow, the ongoing dissipation of global commodity prices, and robust growth in neighboring countries (India’s stronger than expected growth in the fourth quarter and growth is estimated at 6.8 percent).
Q: How has been the response from the government so far to handle the challenging situation? What shortcomings IMF has identified in this regard?
In the context of the implementation of the IMF-supported Extended Credit Facility (ECF), the authorities have taken decisive policy actions to maintain a stable macroeconomic environment. First, monetary policy tightening began last year amid external pressures and rising inflation. This was needed given the post-pandemic strong resumption of economic activity and the ensuing increase in demand for credit and banks’ appetite for credit risk. To support external stability and control inflation, last year NRB raised the interest rate corridor in February and again in July (by 350 bps in total) and increased the cash reserve ratio in August.
Second, the NRB also tightened macroprudential tools, by for example introducing a 90 percent cap on the credit-to-deposit ratio, streamlined liquidity provided through the Standing Liquidity Facility, and phased out pandemic-related support measures such as payment moratoria and forbearance.
Third, the Ministry of Finance adopted early this year a mid-year budget review which included a significant rationalization of expenditures, which is critical to preserve fiscal discipline and debt sustainability in a context of a large shortfall of import-related taxes and surging interest payments. On a less positive note, the authorities also introduced last year import bans and mandatory use of letters of credit and cash margins for a broad set of imports. While these measures affected import growth somewhat, they are distortionary, they dampened tax collections. Cross-country experiences show that they are not a sustainable solution to external pressures. Fortunately, these measures were gradually eased in the first half of FY2022/23 and the remaining restrictions were removed completely in January 2023.
Q: With the ECF, IMF is supporting Nepal at a time when the government is facing a severe resource crunch creating difficulties even to meet recurrent and administrative expenditures. Do you think the ECF arrangement has helped Nepal to face current economic challenges?
The ECF arrangement has helped mitigate the impact of global shocks on Nepal’s economy. First by fostering the implementation of policies and reforms aimed at protecting vulnerable groups (e.g. targeting social spending), at preserving macroeconomic and financial stability (e.g. fostering the implementation of a cautious and data-driven monetary policy, a prudent fiscal policy, a revenue mobilization strategy, and improved financial regulation and supervision), and supporting sustained growth and poverty reduction (e.g. by targeting higher execution of capital spending).
Second, since its approval by IMF Executive Board on January 12, 2022, and after the recent completion of the 1st and 2nd reviews on May 1st, 2023, total disbursements under the ECF for budget support have so far amounted to about USD 157.4 million. Third, progress with the implementation of the IMF ECF is also helping to catalyze additional financing from Nepal’s development partners.
Q: What areas does the government need to focus on for prudent fiscal management currently? How can the government strike a good balance between income and expenditure?
Fiscal policy can play a large role in supporting growth while ensuring debt sustainability and reducing financial risks. This can be done by focusing on ensuring the effective execution of high-quality infrastructure and social spending, both of which could spur growth, and promote stronger revenue mobilization and greater access to external concessional financing.
Currently, the ongoing revenue shortfall is mostly driven by a slowdown of import-related taxes which used to account for around half of the government’s tax revenue. This in turn is partially driven by the import restrictions that were in place for much of the current fiscal year. In situations like this one, the recommendation is for the government to make room for priority spending and to explore tax measures that could help broaden the tax base (and diversify it out of imports) and improve tax administration. But in addition, and with a more medium-term perspective, the recommendation is for the government of Nepal to formulate a comprehensive revenue mobilization strategy to enhance tax collection and diversify the source of revenues towards more domestic revenue, as opposed to imports. This is one of the key actions of Nepal’s ECF-supported program.
IMF has provided technical assistance to the government in developing such a strategy. On the expenditure side, the government should accelerate its efforts to reduce expenditures that are duplicated with subnational governments, which will reduce budgeted grants and subsidies, as well as spending on goods and services and the wage bill. The remaining Covid-19 relief measures (tax rebates to small taxpayers and businesses severely impacted by the pandemic) should be removed. High-quality infrastructure and social spending should be protected to support economic growth and enhance social inclusion.
Q: The government seems to have realized that restrictions on the import of certain goods that lasted for eight months starting from late April last year as a futile move that caused the current resources constraint. How should the government explore new areas for financial resources?
The IMF team has conducted analytical work on last year’s import bans and forex restrictions such as the cash margins and mandatory use of letters of credit. Our analysis shows that imports really started to slow after the monetary policy tightening last year in February and July. The import categories affected by the restrictions just slowed more. But the restrictions affected a small portion of imports, so these restrictions helped to reduce imports by only an amount of USD 80 million per month, which clearly was not enough to compensate for the USD 200 million losses that Nepal experienced in the first part of 2022.
Overall, cross-country experience shows that this type of restriction is not a sustainable solution to balance of payment pressures. They are not effective, especially as they may induce under-invoicing and the use of informal payment mechanisms. Besides, as Nepal’s case shows, they also may lead to lower government revenue, as most of the restricted imports are heavily taxed. Import restrictions could also lead to scarcity and therefore to inflation.
Nepal should diversify its economy to rely less on remittances and agriculture and attract foreign direct investment (FDI). To achieve that, Nepal should reduce the costs of doing business, by implementing numerous reforms, such as strengthening anticorruption efforts, streamlining the regulatory framework to boost competition and innovation, and conducting higher public investment in infrastructure.
After the Finance Minister repeatedly called for a relaxation in monetary policy, Nepal Rastra Bank appeared to have addressed some of the concerns of the government. Why is the IMF insisting on the continuation of the tighter monetary policy as the economy is expected to grow by just over two percent and needs a stimulus package to boost the economy?
The Nepali authorities can employ a range of policies to support sustainable growth, including fiscal and monetary policies as well as structural reforms. Regarding monetary policy, IMF advises a cautious and data-driven approach. Monetary policy is the responsibility of the NRB, which needs to base its decision on hard data, calibration of risks, and the trade-off between maintaining external and financial stability and addressing elevated inflation. Since the last rate hike in July 2022, NRB paused and kept the policy interest rate unchanged. At the same time, the interbank and bank deposit and lending rates declined, thanks to improved liquidity management. As the global commodity prices shock dissipates, inflation in India moderates, and domestic demand slows down, some space has emerged for gradual domestic policy normalization.
More recently, NRB allowed for a reduction of 100 basis points in the Standing Liquidity Facility rate. All in all, the priority is to keep a monetary policy stance — supported by macroprudential measures — that helps Nepal avoid the large boom-bust credit cycles of the past. Fiscal policy is better placed to play an important role in supporting growth by focusing on ensuring the effective execution of high-quality infrastructure and social spending. Both could spur growth, and foster revenue mobilization and external concessional financing, which will help fund the priority spending while ensuring debt sustainability. Nonetheless, Nepal’s near-term growth outlook remains broadly favorable, as tourism recovers, remittances remain strong, and Nepal’s neighbors continue to grow at a robust rate. Sustainable medium-term growth will also require structural policies to reduce the cost of doing business, lowering barriers to foreign direct investment, and enhance governance.
Q: Nepal government has committed to the IMF for the asset quality check of some major Nepali commercial banks by international auditors. Why is the IMF seeking such an audit? Does this mean IMF is not convinced with the capacity of the NRB as regulator and domestic auditors?
The government’s economic program supported by the IMF’s ECF, as approved in early 2022, envisaged in-depth on-site inspections for the 10 largest banks as part of the financial sector reform agenda. As such, this is not a new policy measure introduced recently, but a part of the authorities’ longer-term efforts to strengthen Nepal’s banking system. Conducting an in-depth on-site inspection of banks is a routine exercise done by central banks all over the world. It will give the authorities a more granular picture of the health and soundness of the banking system and provides an opportunity to re-calibrate policy measures, as needed, to ensure financial stability. This exercise was last done in Nepal a few years ago, also based on IMF-World Bank recommendations.
Q: Nepal’s debt liability has also been rising rapidly though it has not still reached an alarming level. What should Nepal do to save itself from plunging into high indebtedness like Sri Lanka?
A key anchor to the fiscal path of the Nepal government’s economic program supported by the IMF’s ECF is putting debt on a downward trajectory by the end of the program. We already see some progress in this regard. Our most recent debt sustainability assessment finds that both external and overall public debt levels in Nepal are assessed at low risk of debt distress. All external debt indicators are below their respective indicative thresholds in all stress tests, except those linked to exports.
Remittances are the major source of foreign exchange earnings in Nepal, which along with concessional external financing, help the country maintain an adequate level of reserves and meet its debt obligations despite small exports. The public debt-to-GDP ratio stood at 44 percent of GDP in FY2021/22, lower than projected in last year’s assessment due to higher-than-projected GDP growth and better-than-expected fiscal outturns. The debt is projected to peak at 50 percent of GDP in FY2025/26 and gradually subside afterward. The debt sustainability assessment nevertheless is contingent upon the prudent execution of the medium-term fiscal consolidation strategy (as envisaged in the ECF-supported program), including tax revenue and spending reforms, and continued utilization of external borrowing at concessional terms as envisaged in Nepal’s Medium Term Debt Management Strategy.
The assessment also stresses the importance of reforms to diversify Nepal’s exports, improve productivity and competitiveness, and enhance resilience to shocks, in particular natural disasters.
