Country Assistance Plans

Economic Performance Assessment

1. Despite a series of development plans, and assistance from international aid agencies, Nepal's economic growth has barely kept pace with its expanding population. In FY2000, gross domestic product (GDP) per capita was less than $245, making Nepal one of the poorest countries in South Asia (economic, population, social and environmental indicators are provided in Appendix 1). Several structural factors hinder the country's attempts at development such as (i) the difficult terrain of a mountainous, landlocked country; (ii) heavy dependence on subsistence agriculture; (iii) low levels of physical infrastructure and human capital; (iv) low domestic resource mobilization and the consequent dependence on foreign assistance; (v) inadequate institutional capacity for development management; and (vi) poor governance.

2. Growth in total output, as measured by GDP at factor cost, reached 5.9 percent in FY2000, the highest annual growth rate in six years and about equal to the 6 percent growth rate projected under the Ninth Five-Year Plan (FY1998-FY2002). The higher overall growth was led by a recovery in agriculture, which grew by 5.0 percent compared with 2.7 percent growth in FY1999. The recovery in the agriculture sector is attributed to a favorable monsoon and wider usage of fertilizer, which led to a strong recovery during the first half of the current fiscal year. The industrial sector also performed well growing at 8.3 percent for the year, driven by an 11.8 percent expansion in manufacturing

3. Consistent with an economy that is dominated by agriculture, the labor force participation rate is high and the unemployment rate is low. About 86 percent of the population aged 15 and over is economically active, with 73 percent of them employed in agriculture1. The unemployment rate for the country as a whole is less than 2 percent, but the rate in urban areas is more than 7 percent. The rate of underemployment is, however, quite high. Another challenge is providing gainful employment to the additional 300,000 economically active population that enter the labor market every year.

4. Domestic revenue collection in FY2000 was substantially lower than budgeted, remaining at the previous year's level of less than 11 percent of GDP, although revenue collection increased by 21 percent compared to FY1999. The introduction of the value added tax (VAT) in November 1997 was meant to be the centerpiece of an overall tax reform. However, weak administration as a result of key vacancies in the VAT Department has delayed its full implementation, despite the Government's announced commitment to the full implementation of the VAT during the FY2000 budget speech.

5. The FY2000 budget deficit remained stable compared to FY1999, at 3.9 percent of GDP. This is because development expenditures were reduced in part to compensate for the revenue shortfall, which had the effect of making up for the poor revenue performance. Development expenditures rose by 17 percent, a significant improvement over the marginal decline the previous year, but far short of the 20 percent envisaged in the budget. Foreign grants and loans financed about 50 percent of development expenditures in FY2000. The dependency on foreign resources is expected to continue with foreign loans and grants again expected to cover 55 percent of budgeted development expenditures in FY2001.

6. Government military expenditures have declined over time in total, as a share of GDP, and in comparison to social expenditures. In 1985, $51 million was spent on defense, compared to $37 million in 1998. Defense expenditure as a percentage of GDP in 1998 decreased to 0.7 percent, from 1.5 percent in 1985, compared with the global average of 4.2 percent of GDP. Defense expenditure per capita also decreased in this period from $3 to $2, compared with $229 per person on average worldwide and $38 per person in South Asia2. Military expenditures as a percentage of combined health and education expenditures in Nepal contracted from 42 percent to 24 percent between 1985 and 1998. As a percent of total expenditures, military spending fell from 6.2 percent to 5.1 percent in this period.

7. The budget for FY2001 was presented to the Parliament in May 2000, two months earlier than in previous years. In his budget speech, the Finance Minister stated, "The foremost goal of our entire development endeavor and of this budget is to achieve the prime objective of poverty reduction as envisaged by the Ninth Plan." However, a focused poverty reduction strategy is not yet in place, but will be formulated in this fiscal year with ADB assistance. The budget has a total outlay of NRs82.4 billion ($1.2 billion) in FY2001, representing an increase of 35.8 percent over the revised estimate of NRs 60.7billion ($876 million) for FY2000. The fiscal deficit is expected to be about 5 percent of GDP. Development expenditures are projected to grow by 45 percent, to be financed mainly by foreign grants, which are projected to more than double. Domestic revenue estimates are also optimistic with a projected growth rate of 25 percent. The budget speech also emphasized the need for raising the efficiency of the civil service and calls for a freeze on hiring until after the completion of restructuring of ministries. However, increases in civil service salaries will be implemented before the restructuring, putting more pressure on scarce domestic resources in the short run. Financial sector reform and private sector development also feature prominently within the budget statement.

8. Broad money (M2) increased by about 22 percent in FY2000 compared with 21 percent in the previous year. The influx of foreign assets and growth in domestic credit to the private sector generated the increase in the money supply. Money growth is somewhat high given projections for GDP growth and inflation, but the comfortable foreign exchange reserve position means the current peg with the Indian rupee is sustainable. Because of the relatively open border and the exchange rate peg to the Indian rupee, inflation in Nepal generally follows India's inflation rate. Inflation was a low 3.3 percent in FY2000, compared to the 11.3 percent increase in prices during the previous year. The increased agricultural production due to favorable weather throughout South Asia kept the prices of food items in check. The slower growth in food prices-which increased by only 1 percent on average in Nepal-helped to counteract rising fuel, electricity, and water prices. Given a favorable monsoon, Nepal should continue to experience relatively moderate inflation.

9. As in the previous year, Nepal experienced a slight current account deficit in FY2000. The dollar value of imports expanded by 20 percent with aid-related imports recovering from the contraction of the previous year. However, strong export growth, particularly to India, led to a current account deficit of only 4.5 percent of GDP. By the end of FY2000 Nepal had $981 million in foreign exchange reserves, an increase of 24 percent over the previous year, and enough to cover about 6 months of imports. External debt as a percent of GDP had been rising, but the trend has reversed itself in the last two years. At the end of FY2000, external debt was less than 48 percent of GDP, compared with the nearly 51 percent of GDP in FY1999. The debt service ratio has also fallen and, due to the concessional nature of Nepal's external debt, was at a manageable level of 5.3 percent of exports during the year.

10. Macroeconomic indicators published by the Nepal Rastra Bank for FY2000 show an increase of 16 percent in domestic revenue collection compared to FY1999, but rising expenditures (15 percent). Foreign grants increased by 21 percent and substantially financed the budget deficit, which remained stable at 3.9 percent of GDP. Foreign trade surged in FY2000, with exports growing by 42 percent and imports by 20 percent in rupee terms compared to FY1999. Foreign exchange reserves of the overall banking system remained sound at almost $1.0 billion, enough to cover about six months of imports. The rate of inflation declined to 3.3 percent during FY2000 compared to 11.3 percent in FY1999.

11. While the country has been moving toward a more market-oriented economy since the early 1990s, frequent changes in government have hampered the implementation of policy reforms and delayed the implementation of development projects. The majority government elected in 1999 raised expectations of reform, but progress to date has been limited. The increase in VAT registrations is a promising sign, but key vacancies in the VAT department need to be filled soon to improve administration, clear the filing backlog, initiate collection visits, and intensify audit activity. These changes are necessary if the Government is to achieve its ambitious revenue target. The Government also recently raised prices of kerosene, diesel, and electricity and removed all subsidies on fertilizer. Despite vocal public protests against these measures and a special parliamentary session called by the opposition to review the price increases, the Government has so far stood firm in its decisions. However, if the country is to achieve the levels of sustained growth necessary to lift it out of its poverty, the Government needs to take advantage of its majority position to pursue a broad-based reform agenda, with financial sector reform and governance reform forming the core of this agenda. Reform in these areas will require sweeping changes to the financial and governance architecture and the way in which business and government is conducted in Nepal. To remedy the serious defects in the financial and governance environment, and to implement the reforms in a sustainable manner will require a high level of commitment and ownership by the Government and concerned stakeholders.