– NISCHAL DHUNGEL

The opinion piece originally appeared in The Kathmandu Post on 26 July 2023. Please read the original article here.

Almost two months after the Government of Nepal unveiled its fiscal policy for 2023-24, which includes a budget of Rs1.75 trillion, the Nepal Rastra Bank (NRB), on July 23, released its monetary policy for the same fiscal year. The policy aims to support economic recovery, control inflation, stabilise interest rates and ensure credit demand. Nepal experienced a recession until the second quarter of the last fiscal year, leading to a projected annual economic growth of 1.86 percent. Despite the sluggish growth in the past year, the combination of the budget and the recent monetary policy aims to achieve an ambitious growth rate of 6 percent for the current fiscal year.

Monetary indicators

The NRB plans to control inflation by maintaining an accommodative monetary policy. The overall year-on-year consumer price inflation decreased from 8.56 percent in mid-June 2022 to 6.83 percent in mid-June 2023. Despite making profits, the Nepal Oil Corporation (NOC) has decided not to reduce the prices of petroleum products, owing to its outstanding debt. This adds to the burden on consumers, as the high petroleum product costs in Nepal significantly contribute to escalating inflation. In this context, the new monetary policy aims to maintain inflation at 6.5 percent. While the NRB is cautiously optimistic about the inflation trajectory, it remains vigilant about the potential risks that could impact price stability in the future.

The NRB aims to maintain seven months of forex reserves to cover goods and services imports in 2023-24. Based on imports during the 11 months of 2022-23, the banking sector’s forex reserves cover 11.2 months of merchandise imports and 9.6 months of both merchandise and services imports. An import ban was initially implemented to protect dwindling forex reserves, leading to an 11.5 percent increase in reserves when the ban ended. The International Monetary Fund attributes the improvement in forex reserves to monetary policy normalisation. However, import restrictions alone do not address the underlying causes of external pressures, such as persistently high global commodity prices expected in 2023 and robust domestic demand.

Policy rates

The NRB has lowered the policy rate by 50 basis points to 6.5 percent. The policy rate represents the interest rate the NRB charges to commercial banks for overnight loans. Lowering the policy rate is aimed at making borrowing more affordable for businesses and consumers and stimulating economic activity. The bank rate, however, remains unchanged at 7.5 percent. As of November of the fiscal year 2022-23, the average inter-bank rate of banks and financial institutions stood at 6.69 percent, compared to 7 percent a year earlier. Several factors, including the recent decline in inflation, influenced the NRB’s decision. To ensure credit demand, the NRB plans to provide liquidity to banks and financial institutions, reduce the policy rate and increase the lending capacity of banks.

The capital adequacy indicators in Nepal show positive signs for the health of the banking sector as they remain above the minimum requirements. The total average capital-to-risk weighted assets ratio stands at 13.1 percent, surpassing the regulatory minimum of 11 percent. The maximum threshold of 100 percent capital-to-risk weighted assets ratio will be raised to Rs5 million from Rs2.5 million. The deposit collection rate has been lowered to 4.5 percent from 5.5 percent. The Cash Reserve Ratio (CRR) is set at 4 percent, requiring banks to hold that portion of their total deposits as cash reserves with the NRB. The statutory liquidity ratio (SLR) is set at 12 percent for commercial banks, while development banks and finance companies have an SLR of 10 percent. These reserve ratios are essential tools used by the NRB to regulate the money supply, stabilise the financial system and manage inflation by controlling the lending capacity of banks.

On-going concerns

NRB Governor Maha Prasad Adhikari stated that the real sector’s growth has not kept up with the rapid credit flow directed towards it. An abrupt slowdown in the share market and the real estate sector caused a credit surge and subsequent bust, impacting borrowers’ ability to meet loan and interest obligations and negatively affecting manufacturing, construction and trade. The IMF has expressed concern over significant credit fluctuations in Nepal’s financial sector, suggesting that excessive credit expansion and high borrowing rates have reduced borrower repayment capacity. To address the credit concern, the monetary policy states that the NRB will provide clear guidance on loan restructuring and rescheduling for hard-hit sectors and small and medium enterprises facing cash flow crises.

The non-performing loan (NPL) ratio in Nepal, at 2.6 percent, is notably lower than the average NPL ratio of 7.5 percent observed in emerging markets. This suggests that the overall asset quality in the banking sector is considered satisfactory. However, some measures such as classifying overdue loans as “standard” could mask the actual asset quality, and the NPL ratio might be artificially lower. The NRB aims to ensure that banks’ loan classification correctly reflects the asset quality of the banking system and will review the loan classification policy, implement Nepal Financial Reporting Standards (NFRS 9) and the expected credit loss model (ECL). Furthermore, the NRB will review the directed lending guidelines and credit concentration to guide BFIs to concentrate on credit management rather than credit creation.

Commendable step

The NRB has taken steps to decrease the number of microfinance institutions through mergers and acquisitions. As of mid-June 2023, 63 microfinance financial institutions are currently in operation. The NRB is committed to establishing a dedicated regulatory body for the cooperative sector, as outlined in the 2023-24 budget. The lack of regulation has resulted in the collapse of cooperatives and increased instances of fraudulent activities. It is necessary to establish a dedicated regulatory body to tackle these issues effectively. The NRB will also implement a centralised “Know Your Customer” (KYC) system, introduce Macro Stress Testing Framework, improve regulatory capacity, enhance the quality of supervision, and upgrade data and regulatory systems to improve its autonomy and accountability framework.

The NRB disclosed its intention to conduct research on the Central Bank Digital Currency (CBDC) in its monetary policy for the fiscal year 2021-22. The central bank has successfully prepared the concept report titled “Central Bank Digital Currency (CBDC): Identifying Suitable Policy Goals and Design for Nepal” to explore the implementation of the CBDC. On the digitalisation front, the NRB recently amended a digital payment licensing policy that will allow non-business businesses like hotels and travel to establish their digital payment system. Moreover, Nepal also inked an agreement with India, China and Sri Lanka for cross-border digital payment. These developments on the digital front facilitate smooth digital payment services inside and outside the country.

The NRB’s monetary policy presents several positive measures, and its effectiveness in implementing these measures will be crucial. Increased foreign reserves due to higher remittances and lower interest rates are gradually making the country’s economy vibrant. Lower interest rates can encourage borrowing and investment, potentially impacting consumer spending, business expansion and overall economic growth. The central bank appears mindful of the potential adverse effects of higher interest rates on economic recovery while remaining committed to keeping inflation in check. However, taming inflation will require a coordinated approach between monetary and fiscal policies.

– NISCHAL DHUNGEL

The opinion piece originally appeared in The Kathmandu Post on 21 February 2023. Please read the original article here.

The Nepal Rastra Bank (NRB), the central bank of Nepal, took an accommodating policy stance during the pandemic to support households and businesses. The average inflation rate in fiscal year (FY) 2020/21 stood at 3.6 percent and doubled to 6.32 percent in FY 2021/22. For the first six months of the current FY 2022/23, it stands at 7.2 percent. Inflation has significantly increased due to the detrimental effect of the supply chain post-Covid19 pandemic and the Russia-Ukraine war. Rising inflation raised the cost of fuel and raw materials, causing production costs to skyrocket. As a result, the output capacities of both small and large-scale industries have decreased. The government imposed an import ban to safeguard the diminishing foreign exchange reserves, but it lifted the ban recently as the demand for goods and services increased amidst economic recovery.

These factors contributed to the first half of the current fiscal year’s revenue collection falling short of expectations. The revenue collection for the first six months of mid-January 2023 decreased by 15 percent compared to last year. The Finance Ministry reduced the federal government’s budget by 20 percent because of its inability to generate revenue as projected. The increased liabilities for wages, pension, social security, and subsidies for chemical fertiliser and disaster management have strained ongoing government expenses. The government needs to pay the interest on international and domestic loans. The depreciation of the Nepali rupee versus the US dollar will prove expensive to re-pay foreign loans.

World Bank and IMF support

The International Monetary Fund (IMF) approved $395.9 million as part of the Extended Credit Facility (ECF) Arrangement for Nepal. The ECF provides financial support to nations with a persistent balance of payments issues. This arrangement would help the government lessen the pandemic’s effects on people’s health and economic activity, safeguard vulnerable populations, maintain macroeconomic and financial stability, and promote long-term growth and poverty reduction. The program will encourage significant funding from Nepal’s development partners and help reduce funding shortfalls. These actions supported a subsequent credit boom by cutting loan rates early in the pandemic. To aid Nepal’s tenacious recovery from the Covid-19 pandemic and promote sustainable growth, the World Bank approved a $150 million development policy credit. The Nepal Programmatic Fiscal Policy for Growth, Recovery, and Resilience Initiative, funded by the World Bank, will work to enhance the country’s institutions and laws, especially those governing debt management, public capital investment, and tax and customs systems.

Effect of monetary policy

At the beginning of FY22, NRB monetary policy aimed to strike a balance between tightening needed for economic and financial stability and assistance for the nascent economic recovery. The NRB’s main policy targets are maintaining the policy floor of foreign exchange reserves covering seven months of imports and setting the inflation ceiling at 7 percent for the year FY 2022/23. The goal of monetary policy is to limit total credit to the private sector by 12.6 percent and total money supply by 12 percent for FY 2022/23. NRB raised the cash reserve ratio (CRR) from 3 percent to 4 percent. As a result of the credit boom, imports peaked in the first half of FY22, and foreign exchange reserves declined. The NRB increased its policy repo rate targeting both credit demand and supply. A change in monetary policy was in response to worries about faster-than-expected credit expansion, the growing import bill, dwindling reserves, and rising inflation as loan growth soared beyond estimates in the first half of FY22. To bring down inflation and discourage credit lending, the NRB increased the interest rates. The weightage average interest rate for inter-bank rose from 4.76 percent in mid-January 2021 to 7.48 percent in mid-January 2022. Similarly, weightage average interest rates for lending increased from 9.44 percent in mid-January 2021 to 12.79 percent in mid-January 2022.

A credit constraint occurred as the additional liquidity injections weren’t enough to make up for the drop in loanable funds. By the end of FY22, private sector credit had fully returned to FY21 levels as a proportion of GDP due to the higher lending interest rates offered by commercial banks to borrowers, which increased from 8.5 percent to 11.6 percent between mid-July 2021 and mid-July 2022. Credit to the private sector stabilised at comparatively higher prices, falling from 102 percent of GDP at the end of FY21 to 101.5 percent of GDP at the end of FY22. The NRB injected a total of Rs3094.76 billion in liquidity until mid-January 2023. NRB provided Rs318.09 billion through a repo, Rs83.85 billion through an outright buy auction, and Rs2692.83 billion through a standing liquidity facility (SLF).

The NRB introduced a merger and acquisition policy with the aim of strengthening financial stability. After the mergers of the commercial banks, the number of commercial banks decreased from 27 in mid-July to 22 in mid-January 2023. Micro-finance institutions decreased from 70 in mid-July to 64 until mid-January 2023. The central bank of Nepal mandates that banks maintaining higher paid-up capital help reduce the number of banks and financial institutions. Bank and financial institutions’ (BFIs) private sector credit increased by Rs137.33 billion (3 percent) during the first six months of FY 2022/23 compared to a growth of Rs492.63 billion (12.1 percent) during the same time last year. Out of the total outstanding credit held by BFIs until mid-January 2023, 67.2 percent went to real estate and 12.2 percent to current assets (such as goods used in agriculture and non-agriculture).

BFI soundness

Despite liquidity restrictions, indicators of BFI soundness were high. The average capital-to-risk-weighted assets ratio, which measures the sufficiency of bank capital, remained more elevated than the legal requirement of 11 percent. After massive credit expansion, NRB raised interest rates which is also the byproduct of the misuse of loans. In addition, due to the lengthening of loan repayment schedules as part of the central bank’s response to Covid-19, the overall number of BFIs’ nonperforming loans (NPL), defined as loans that are past due by 90 days or more, also marginally decreased. As of mid-July 2022, commercial banks had an NPL ratio of 1.3 percent, development banks had an NPL ratio of 1.5 percent, and finance businesses had an NPL ratio of 7 percent. Even though these numbers are encouraging, some swift forbearance measures should be in place to assess the asset quality in the banking sector. Banks are issuing fresh disbursements to reduce the level of nonperforming assets.

Nevertheless, given the adverse economic effects of Covid-19, the IMF should closely monitor the system to ensure NPLs are accurately measured and that all banks’ provisioning and capital are still sufficient. The NRB should improve the regulatory environment to offer precise restructuring guidance to address BFI assets and loan quality. NRB issued Working Capital Loan Guideline 2079, which mandates banks to issue working capital loans secured by the current assets. Credit Policy Guidelines of the licensed institution shall clearly mention the margin and adequacy of the existing assets required for the security. Hence, the NRB should encourage banks to monitor borrowers’ creditworthiness continuously and establish asset categorisation and reclassification criteria that accurately evaluate banks’ asset quality. Lastly, Nepal should facilitate bank financing to productive businesses, invest in infrastructure and education, and adopt digital technology and research and development.

– ANUSHA Basnet

Foreign Direct Investment (FDI) is defined as a “category of cross-border investment” in which an investor from one country invests in another country wherein the investor has significant control over the business it invests in (IMF, 2009). It may also involve a “transfer of technical know-how, managerial and organizational skills”. For a country aiming to expedite its development process, FDI has been one of the factors aiding the development process of Nepal especially in recent years. The government has also made provisions to make Nepal a more investment friendly country. Acts such as The Foreign Investment and Technology Transfer Act (FITTA) 2019 and Foreign Direct Investment Policy 2015 have been created by the government in an effort to create a better environment for foreign investors. The FITTA states that “investors need to bring 25 percent of the pledged investment within a year from the date of registration, 70 percent by the start of operation, and the remaining 30 percent within the next two years.” The Department of Industry (DOI), Nepal Rastra Bank (NRB), and Investment Board Nepal (IBN) are three agencies that implement the laws regarding FDI. 

As of 2018/19, the stock of FDI in Nepal was Rs. 182.92 billion of which 48.2 percent was paid-up capital, 42.8 percent were reserves, and 9.0 percent was loans. Of the total FDI stock, the service sector accounts for 51.1 percent and the industrial sector accounts for 48.8 percent. Furthermore, within the industrial sector manufacturing, mining and quarrying industry accounts for 28.6 percent and electricity, gas, and water sector accounts for 20.0 percent of FDI stock. While the level of FDI pledge is high, the actual inflow of FDI is still low. 

Looking into the provincial breakdown of FDI statistics, we see the following numbers:

Figure 1: Provincial Breakdown of FDI figures (Data taken from NRB)

From the above graph, we can see that Sudurpaschim province has received the least amount of FDI in all three years (2017, 2018, 2019). The province received FDI of Rs. 13.2 million, 10.8 million, and 27.93 million for the years 2017, 2018, and 2019 respectively. The increase in FDI for the year 2019 can be attributed to the investment brought in for the manufacturing sector (cement industry) and information technology sector (software development industry). Comparatively, Sudurpaschim province lags behind other provinces in terms of being able to attract foreign investment. Years of lack of concrete development plans from the central government, lack of investment in the infrastructure sector and other factors such as a difficult geographical terrain have caused the province to lag behind in terms of development which has affected its current ability to seek investment. Furthermore, delays in current projects have not inspired confidence from the investors. 

However, the provincial government in Sudurpaschim has made efforts to bring in foreign investment. The provincial government has started a process to create a Provincial Investment Board in order to streamline projects that require higher investment (projects requiring investment from Rs. 1 billion to Rs. 5 billion). The government also put in extra effort to woo investors during the Investment Summit organized by the Nepal Investment Board. In terms of attracting foreign investment, tourism, manufacturing sector, energy sector, and transportation sector are few sectors that are being prioritized by the provincial government. The provincial policies and programs for the fiscal year 2078/79 has emphasized completing the ongoing projects in order to attract new investment. The recent agreement between the Investment Board of Nepal and NHPC for the development of Seti river hydropower projects also shows promising signs for the province. 

As the Sudurpaschim government has been creating ambitious plans to expedite the development process of the province, FDI will play an important role in the process. While the province has a lot to do in terms of catching up to other provinces for bringing in FDI, the steps initiated by the government show their commitment and dedication to the economic development of the province.

– NISCHAL Dhungel, Non-Resident Fellow

The opinion piece originally appeared in The Kathmandu Post on 4 September 2022. Please read the original article here.

Nepal has faced tremendous hitches in the path of economic development. Keeping natural barriers (landlocked externally and challenging topography internally) aside, the nation has been undergoing a protracted era of political change over the past two decades, graduating from a monarchy to multiparty democracy, marred by armed war, ethnic unrest and frequent changes in power. Frequent changes in government, irrespective of a unitary or federal form of government, has directly hampered Nepal’s development path, compounded by poor policy decisions. Poor policy decisions have led to weak performance of the primary agricultural and industrial sectors, low public investment and capital accumulation, and low productivity growth.

Given this context, it is not surprising that foreign employment has become more pervasive, particularly in the years following Maoist conflict. The Department of Foreign Employment started issuing labour permits in the late 1990s. The number of labour permits issued peaked in 2013-14 at a high of 519,638. In 2020-21, the number of labour permits issued plunged to a 16-year low of 72,081 due to the Covid-19 outbreak and the ensuing restrictions on people’s freedom of movement. At present, formal overseas employment procedures have become cumbersome due to the bureaucracy that requires foreign employment agencies to produce authentic labour demand letters, get the demands attested from the Nepali embassies in target countries, and provide several other documents. Despite the cumbersome out-migration procedures, foreign employment has become a lucrative area to escape Nepal’s job market.

Remittance trap

Remittances in Nepal have surged at an unprecedented pace. Personal remittances received were less than 1 percent of GDP up until the late 1990s, lower than Bangladesh and India. This share dramatically increased during the first half of the 2000s, rising from 2 percent in 2000 to 22 percent in 2010 and 30 percent in 2015. Following the pandemic, it was anticipated that Nepal would experience a sharp fall in remittance inflows, impacting imports, the balance of payments, foreign exchange reserves, consumption, savings, loans and interest rates. However, according to the data released for fiscal 2020-21, Nepal performed better in remittance inflows.

Given the extraordinary increase in remittances, they are probably the main driver of the improvement in living standards seen in Nepal, directly (households receiving remittances) and indirectly (increased labour income of those that remained). Research published by Nepal Rastra Bank showed that compared to households that do not get remittances, households that receive remittances have a 2.3 percent lower chance of falling into poverty. With every 10 percent increase in remittance inflows to households, the likelihood of those households falling into poverty lowers by approximately 1.1 percent.

Large-scale migration is a symptom of underlying, long-standing issues rather than a sign of strength. One of the world’s most extensive and dense anti-poverty initiatives is likely to be found in Nepal. Unfortunately, more resources go into the process of delivering benefits to “the poor” rather than achieving impact (making “the poor” rich). Economists Yurendra Basnett, Chandan Sapkota and Sameer Khatiwada have rightly pointed out that much effort is also put into process innovation and complexity (how to get the goodies to “the poor”) while neglecting the apparent reality that a great job with a high salary would go a long way in reducing poverty in one of the chapters of the book entitled Politics of Change.

Large-scale migration and the resulting remittances have facilitated the expansion of low-productivity services. Still, they have also contributed to the low competitiveness (via appreciation of the real exchange rate). As a result, this cycle intensifies already-existing problems that Nepal has faced for a while, further impeding its competitiveness and limiting its economic potential. Because of all these factors, Nepal, home to some of the most hardworking and adventurous people in the world, may remain in a high migration and remittance trap for years to come.

Domestic employment

The pandemic provided the government with a fantastic opportunity to learn a lesson from the existing policy gap to keep the people who had returned to help with the need for the nation’s development. It is a monumental task to switch from foreign employment to domestic employment. Approximately 500,000 young people enter the workforce each year, and 80 percent of them manage to find work abroad. Due to a lack of investment that may have helped produce output, Nepal is now entirely dependent on imports. Ironically, Nepal imports even agricultural items, even though 66 percent of the country’s population is employed in agriculture. Agriculture, which accounts for two-thirds of the workforce and one-third of GDP, has to undergo reforms to increase productivity, reduce poverty and free up labour for new sources of economic growth.

For Nepal, unleashing massive hydropower investments would be a game changer. It would not only result in considerable increases in productivity and new investments, but it also has the potential to raise wages dramatically, reverse migration and boost competition in downstream industries. According to the National Planning Commission and UNICEF report Demographic Changes of Nepal: Trends and Policy Implications, Nepal will have an ageing population by 2028 and an elderly population by 2054. Therefore, Nepal has a very limited window of opportunity to capitalise on the demographic window. It is necessary to invest in the skills of Nepali youth to fully realise the demographic dividend. For Nepal to continue on a more robust and sustainable growth path, more human capital must be put to productive use.

History also shows us that Nepal has implemented significant reforms in the past and is capable of doing so again. The broad-based reforms that Nepal implemented between 1986 and 1996 positively impacted the economy. The share of commerce in GDP and exports, as well as the share of manufacturing, virtually doubled, increasing the economy’s openness and diversification. The political shift to democratically elected administrations, which also gave the populace a new purpose, served as the foundation for these reforms. Today, they serve as a sobering reminder that Nepal can undergo significant and complex reforms. To escape the out-migration and remittance trap, a clear set of plans and policies to increase domestic employment should be the top priority of the federal, provincial and local governments. Without rethinking our development model, the country cannot prosper or graduate to a middle-income country.