External Debt Management In Nepal- Tarun Das

Economic Situation and Management of External Debt in Nepal Prof. Tarun Das, Institute for Integrated Learning in Management, New Delhi Formerly Eco. Adviser, Min of Finance and Planning Commission, Govt. of India. 1. Background In recent years Nepal made significant progress toward sustainable economic growth and is committed to the so-called LPG (viz. liberalization, privatisation and globalisation). It completed its ninth economic development plan in 2002, its currency was made convertible, and 17 state enterprises were privatized. Foreign aid accounted for more than half of the development budget. Government priorities over the years focused on the integrated development of agriculture, industry, transportation and communications. Agriculture remains Nepal's principal economic activity, employing 80% of the population and providing 37% of GDP. Rice and wheat are the main food crops. Out of total land, only 20% is cultivable; another 33% is forested; and the rest is mountainous. Resources Nepal made significant progress in exploiting major economic resources such as tourism and hydroelectricity. With eight of the world's 10 highest mountain peaks- including the Mount Everest at 8,850 m (29,035 ft)- hiking, mountain climbing, and other tourism is growing. Swift rivers flowing south through the Himalayas have massive hydroelectricity potential to service domestic needs and the growing demand from India. India and Nepal have joint irrigation-hydroelectric projects on the Kosi, Trisuli, and Gandaki Rivers. Negotiations with India for a power purchase agreement had been underway for several years, but agreement on pricing and capital financing remains a major problem. Population pressure on natural resources is increasing. Over-population is already straining the "carrying capacity" of the middle hill areas, particularly the Kathmandu Valley, resulting in the depletion of forest cover for crops, fuel, and fodder and contributing to erosion and flooding. 2. Current Economic Situation (a) Economic Growth Nepal’s economic growth has been adversely affected by the recent political conflicts. Real GDP growth rate declined from an average of five percent per annum in 1990s (contributed by an improvement in agricultural productivity and significant trade liberalisation) to only 2 percent during 2000−2005. However, inflation remained moderate and international reserves were adequate. Inflation remained in the low single digits, although it rose to 7¾ percent in mid-October 2005 due to poor agricultural performance caused by weather shocks, a VAT rate increase in January 2005, and partial pass-through of higher international oil prices by the Nepal Oil Corporation.

1

(b) Financial Sectors Financial soundness indicators improved in recent years due to banking reforms and significant improvement in the performances of banks. Nepal Bank Limited (NBL) and Rastriya Banijya Bank (RBB) are the two leading banks and account for 50 percent of banking system deposits. Both these banks were loss-making entities in 2000/01, but they made profits in 2003/04 and 2004/05 as a result of lower cost of funds and downsizing staff through voluntary retirement schemes. Management and credit evaluation practices in the banks also improved significantly. In addition, Asian Development Bank supported restructuring plans for Agricultural Development Bank of Nepal. In contrast, the financial condition of Nepal Industrial Development Corporation remained poor. Despite this progress, the share of non-performing assets in NBL and RBB remained high. Improvements in the legal and institutional framework over the last two years and new debt recovery mechanisms (such as blacklisting directors, establishment of the Debt Recovery Tribunal, and an Appellate Tribunal) helped recoveries from small and medium-sized defaulters. But, recoveries from large, willful and politically connected defaulters remained limited. The banks were reluctant to pursue these cases in the Debt Recovery Tribunal due to concerns about its limited staff and capacity. (c) Money Supply and Exchange rate Monetary and exchange rate policies remained geared to supporting the exchange rate peg to the Indian rupee. Broad money growth slowed from 12¾ percent in 2003/04 to 8 percent in 2004/05 reflecting substantially lower Net Foreign Assets accumulation by the Nepal Rastra Bank (NRB). While budget financing from the banking system was limited, private sector credit grew by 13¼ percent, mainly in consumer lending. Balance sheet consolidation by the two largest banks undergoing restructuring limited the growth of loans for manufacturing and services sectors. With high remittances, liquidity was ample, T-bill rates remained low, and interest rates edged lower. (d) Fiscal Situation The overall fiscal deficit of Nepal remained manageable in 2004/05. Despite an increase in the VAT rate was from 10 percent to 13 percent in early-2005, which helped revenue to increase by ¾ percentage point to 13 percent of GDP, there were revenue shortfalls due to weaker economic growth, continued excise leakages and delayed excise duty refunds from India. On the expenditure side, the higher civil service wages and allowances, and security-related expenditures were more than offset by lower spending on development and social sector projects, especially in the conflict-affected areas. The overall deficit was significantly lower than budgeted (1 percent of GDP compared to 2½ percent of GDP). External loans fell short of the budget target, as assistance from the World Bank, Asian Development Bank, and donors dwindled. The domestically financed deficit was also lower than budgeted (at ½ percent of GDP). (e)

External sector

2

Principal imports of Nepal consist of gold, machinery and equipment, petroleum products and fertilizers, and major sources of imports in 2004 were India (47%), China (10%), UAE (9%), Singapore (4%) and Saudi Arabia (4%). Nepal's principal export destinations include India (50%), United States (22%), Germany (8%), United Kingdom (3%), and France (2%). Nepal's merchandise trade balance has improved somewhat in recent years with the growth of the carpet and garment industries, which account for approximately 70% of merchandise exports. Trade with India rose rapidly after conclusion of the 1996 bilateral trade treaty between the two countries, and now accounts for 50% of all exports and 47% of all imports. Strong export performance, including earnings from tourism, and external aid have helped improve the overall balance-of-payments situation and increase international reserves. Nepal receives substantial amounts of external assistance from India, China, the U.K., Japan, Germany and the Scandinavian countries. Multilateral organizations, such as the World Bank, ADB and UNDP also provide substantial development assistance. Current Account Balance The current account and overall balance of payments remained in surplus. Despite disruptions related to the insurgency and the elimination of textile quotas, total exports rose by 10 percent in 2004/05, mainly due to booming exports to India which rose by 30 percent, while exports to other countries declined by over 15 percent. Export performance in traditional sectors such as garments, carpets and pashmina remained weak. Total import growth was stagnant due to weak economic activity. A 35 percent increase in oil imports caused by hardening of international prices of oil was offset by a 6 percent decline in non-oil imports. Remittances continued to be buoyant, and the current account surplus (excluding official transfers) increased from 1 percent of GDP in 2003/04 to 3 percent of GDP in 2004/05. A surplus in the overall balance of payments led to an increase in international reserves to around US$1.5 billion (equivalent to 7¾ months of imports of goods and services) at end-2004/05. 3. External Debt Situation The external debt stock has increased almost fourfold during the period. As the country's investment requirements far exceed the internal savings, access to external capital, in the form of loans or grants, is inevitable. The savings-investment gap spills over to the current accounts deficit, which was around 3 percent of GDP in 2003. Compared to other South Asian countries, this is very high. There is a changing profile of external assistance in Nepal. Unlike in the good old days when external funding came mainly as grants from bilateral sources, loan has emerged as the principal form of development assistance in recent years. After the end of the Cold War, the multilateral banking institutions like the

3

World Bank and the Asian Development Bank have emerged as the principal funding sources and there is a concurrent reduction in bilateral assistance. These developments cannot be regarded as trend towards a debt trap. In dollar terms, the total outstanding external debt rose from US $ 1.64 billion in 1990 to US $ 3.25 billion in 2004, an increase of 98 percent (Table-3). During the same period the exports of goods and services in dollar terms increased by 319 percent. As a result, debt/service ratio declined from 15.7 per cent in 1990 to 6 percent in 2003. The apparently sharp growth in external debt in terms of domestic currency is not due to over-borrowing, but largely due to the depreciation of Nepali rupee vi-a-vis the international reserve currencies against which the borrowings were made. For example, one US dollar was equivalent to 74.75 rupees in 2003 as against 42.70 rupees in 1991. In fact, Nepal has managed external debt very well although there are mixed trends of major sustainability indicators over time. Along with other countries, World Bank publishes external debt statistics for Nepal in the Global Development Finance (GDF). In the latest issue of GDF (2005), the World Bank has classified Nepal as a moderately indebted low-income country. As per the World Bank statistics summarized in Table-2, the external debt to GNI ratio increased from 45 per cent in 1990 to 56 per cent in 2003, but external debt service ratio declined from 15.7 per cent to 6 per cent, external debt to export ratio decreased from 367 per cent to 174 per cent and the share of concessional loan in total external debt improved from 88 to 97 per cent over the same period. The share of multilateral debt in total debt also improved from 77 per cent to 84 per cent and that of short-term best remained low around 1.5 per cent during 1990-2003. The country has foreign exchange reserves, equivalent to 7.7 months imports cover. The WB and the IMF have developed various benchmark ratios to cast a country's indebtedness in terms of the country's potential capacity to service debt. They relate to net present value of debt service in relation to GNP and to exports. Based on these NPVbased debt indicators for the year 2003, the IMF considers Nepal's foreign debt position better than that of Sri-Lanka, Pakistan, Bhutan and Maldives among the SAARC countries and categorizes Nepal as a low income and low indebted country along with India and Bangladesh (Table-1). There are also simpler benchmark rules governing the national debt management. It is said that the total outstanding debt should not exceed 60 percent of GDP. Similarly, the foreign debt servicing should not exceed 20 percent of the export value, and domestic debt servicing should not exceed 20 percent of the domestic revenue. Even based on these criteria, Nepal's situation is within manageable limits.

4

Table-1: External Debt Situation in South Asian Economies in 2003 Country and Rank in PV of Debt PV to GNP PV to XGS Indebtedness and income terms of EDT $ Bln Ratio Ratio Classification 1. India 100.3 19 106 Less/ Low 2. Pakistan

29.7

41

189

Moderate/ Low

3. Bangladesh

12.8

25

128

Less/ Low

4. Sri Lanka

8.4

51

110

Moderate/ Middle

5. Nepal

2.1

38

131

Less / Low

6. Bhutan

0.4

74

252

Severe/ Low

7. Maldives

0.2

35

41

Severe/ Middle

Additionally, it may also be noted that Nepal's external debt stock is composed of concessional loans with long maturities and nominal interest charges. Some of the bilateral loans, like those from Japan and some Western countries, are eventually converted into grant. This explains Nepal's low NPV of external debt and the comfortable debt-servicing situation, although the total debt stock as percentage of GDP cannot be regarded as low. At present, the international climate for poor and indebted nations is very congenial. Nepal does not fall under the category of highly indebted countries and hence does not qualify for relief under the HIPIC initiative. Nevertheless, demand for debt relief to poor countries like Nepal is increasing. The UK government has already agreed to pay back 10 percent of Nepal's total debt to the WB. 4. Economic Outlook and Risks Nepal's growth prospects are contingent on political stability and improved security. Real GDP growth rate is estimated in the range of 2½−3½ percent in 2005/06. If implementation of structural reforms continues along with political stability and better security conditions, there will be a distinct improvement in agricultural, manufacturing and service production, tourism earnings and government activities. This will help Nepal to achieve growth rates around 5−5½ percent in the near and medium term. With the rupee peg, inflation is expected to broadly follow price developments in India, which are moderate and under control. Export growth is projected to average 8 percent with further diversification of Nepalese exports beyond traditional sectors. Both oil and non-oil imports are projected to pick up with improved economic activity. Consequently, the balance of payments surplus is projected to decline in the near term. Trade deficits could be covered by remittances and aid. International reserves are projected to remain around 6−7 months of imports of goods and services.

5

5. Conclusions and Recommendations (a) Structural Reforms Nepal is presently passing through a critical political and economic juncture. Although authorities may be complemented for maintaining macroeconomic stability and implementing reform program under a difficult economic-political environment, they are advised to resolve political and economic uncertainties and make progress toward sustained peace and security, which are essential steps for poverty reduction and private sector led growth. They are advised to continue with the policies envisaged under the Nepal's Poverty Reduction Strategy Paper (PRSP) accepted by the Fund-bank, which remains an appropriate framework to address key constraints on growth, macroeconomic stability, and reduction of poverty. This would help mobilize external assistance and lay the foundation for possible debt relief under the HIPC Initiative and the Multilateral Debt Relief Initiative. (b) Fiscal Policies Nepal has made significant progress on revenue mobilization, expenditure prioritization, social sector spending and containment of budget deficit. However, there are concerns that security-related spending pressures remain high, and development spending is low relative to budget targets, especially in conflict-affected areas. There is a need to increase fiscal transparency, improve public expenditure management, contain contingent liabilities and address donors’ concerns about the quality of spending. Authorities should make all efforts to improve tax administration and to increase revenue collections. They should also raise spending on infrastructure and social sectors to achieve PRSP goals. Administrative pricing of petroleum products may be replaced by an automatic pricing mechanism to improve the financial conditions of the Nepal Oil Corporation and to avoid additional burden on the budget. (c ) Financial sectors reforms In the banking sector, efforts should be made to recover non-performing assets from the willful defaulters in order to improve the balance sheets of the NBL and RBB, reduce contingent liabilities for the budget and pave the way for their privatization The legal framework for financial sector activity can be further improved through amendments to the Banking and Financial Institutions Ordinance. NRB may be encouraged to enhance financial sector supervision, and raise its internal audit and accounting standards. Authorities are also advised to move forward with implementation of strong anti-money laundering and combating the financing of terrorism regime.

6

(d) Agrarian Reforms Given the importance of agriculture and the high level of rural poverty, there is need to initiate progressive agrarian reforms such as providing complementary inputs to land and improving rural infrastructure to promote commercialization and market access for agricultural products. (e) Trade and Exchange Rate Policy The exchange rate peg to the Indian rupee remains appropriate, as it enables the economy to benefit from close ties with India and helps to keep inflation at low levels. However, the level of the peg should be monitored and kept under review, given Nepal's growing integration in the world economy through its membership in the WTO and regional trading arrangements. External competitiveness should be enhanced through structural reforms and infrastructure investments to lower transactions and transportation costs. Despite the concessional nature of external debt, the exchange rate risk is high. Due to steady depreciation of rupee value in relation to convertible currency in the past, the pay back liability to the taxpayers has mounted. Therefore, a prudent public debt policy is necessary with adequate emphasis on the quality of debt. (f) Public sector reforms The pace of public enterprises and governance reforms need to be accelerated to improve the efficiency of large public enterprises. It is desirable to proceed decisively with the liquidation of unviable loss-making enterprises and encourage privatisation mechanisms such as share sales and management contract. The regulatory framework needs to be strengthened and labor markets be made more flexible to create an enabling environment for private sector participation. The promulgation of the Secured Transactions, Company, Securities, and Insolvency Ordinances is in the right direction. However, the draft Labor Ordinance needs to be promulgated early. . (g) Debt Recovery System Nepal provided inaccurate information related to the second disbursement made in November 2004 under the Poverty Reduction and Growth Facility arrangement under the IMF due to weaknesses in its debt recording system. As a result of this misreporting, the disbursement was noncomplying. The arrears, which were attributable to the weak debt management and coordination problems and led to the noncomplying disbursement, have now been cleared. However, there is an urgent need to address data deficiencies to improve policy formulation and monitoring, and full implementation of the Fund technical assistance recommendations on external debt management.

7

Table-2: Nepal: Selected Economic Indicators, 2000/01-2004/05 2000/01 2001/02 2002/03 2003/04 2004/05 (Percent Real GDP Growth Rate (%) 5.6 -0.6 3.4 3.4 2.5 CPI Inflation Rate (end-period) 3.4 3.5 6.1 2.0 6.6 (Percent of GDP) Budgetary operations Total revenue 11.4 11.5 12.3 12.2 13.0 Total expenditure 17.5 17.2 16.0 15.5 16.0 Current expenditure 11.1 11.5 11.4 11.2 11.7 Capital exp. And net lending 6.4 5.6 4.6 4.3 4.3 Overall deficit 4.5 4.3 1.6 1.0 0.9 (Percent of GDP) Money and credit Broad money 15.2 4.4 9.8 12.7 8.0 Domestic credit 18.8 9.2 12.0 9.3 13.3 (In millions of U.S. dollars, unless otherwise indicated) External sector Exports, f.o.b. 945 754 653 748 826 Imports, f.o.b. 1,710 1,448 1,556 1,801 1,806 Current account 162 106 16 59 226 (In percent of GDP) 2.9 1.9 0.3 0.9 3.1 Overall balance 38 -39 93 235 24 Gross official reserves 1,020 1,048 1,178 1,471 1,507 Rupees per US$ (end-period) 74.7 78.0 74.8 74.1 70.0 Source: International Monetary Fund (IMF) Fact Sheet of Nepal Surface area: 147 thousand sq km Population: 26.6 million (2004) Exchange rate: A$1 = 54.1241 Rupees (Jun 2005) GDP -composition by sector: agriculture: 40%, industry: 20% and services: 40% Population below poverty line: 42% (1995-96) Household income or consumption by percentage share: lowest 10%: 3.2% highest 10%: 29.8% (1995-96) Inflation rate (consumer prices): 2.9% (2002) Labour force: 10 million (1996) Unemployment rate: 47% (2001) Labor force - by occupation: agriculture 81%, services 16%, industry 3%

8

Table-3: External Debt in Nepal (in US$ million)

1970 Total Debt stock (EDT) Long term debt Public & guaranteed Private non-guaranteed Use of IMF credit Short-term debt Total debt service (TDS) Principal repayments Interest payments (INT) Interest on long term debt Interest on short term debt Interest on IMF loan Gross national income (GNI) Exp.of goods and services (XGS) Workers remittances Imp.of goods & services (MGS) International reserves (RES) Current account balance EDT/ XGS EDT/ GNI TDS/ XGS INT/ XGS INT/ GNI RES/ EDT RES/ MGS (months) Short-term/ Total debt Concessional/ EDT Multilateral/ Total debt Public debt as % of total debt Currency composition (%) Japanese Yen US dollars Multiple currency Others

1980

2000

2001

2002

2003

205 1640 2846 156 1572 2805 156 1572 2805 0 0 0 42 44 12 7 24 29 8 70 103 3 41 72 5 29 31 2 25 28 1 2 0 2 2 3 1958 3640 5514 272 447 1456 0 0 111 419 845 … 1825 272 354 987 94 … -39 -289 -131 Sustainability Debt indicators (in per cent) … 75 367 195 0.3 10.5 45.1 51.6 … 2.9 15.7 7.1 … 1.8 6.5 2.1 0 0.3 0.8 0.6 3133 132.7 21.6 34.7 … 7.8 5.0 6.5 0 3.4 1.5 1.0 69.5 75.7 88.5 98.4 7.2 62 77 86 100 97 99 99 100 100 100 100 0 8 8 9 9 50 50 39 4 31 33 42 87 11 9 10

1990

2716 2654 2654 0 8 54 93 65 28 26 0 2 5598 1351 147

2973 2929 2929 0 4 40 102 74 28 27 0 1 5554 1649 678

3253 3176 3176 0 11 66 113 82 31 30 0 1 5843 1873 785

1759

1733

2016

1080 -165

1070 215

1286 171

201 48.5 6.9 2.1 0.5 39.8 7.4 2.0 97.6 87 98 100 7 41 41 11

180 53.5 6.2 1.7 0.5 36.0 7.4 1.3 98.3 88 99 100 7 40 42 11

174 55.7 6.0 1.7 0.5 39.5 7.7 2.0

3 3 3 0 0 0 2 2 0 0 0 0 866 … 0

Source: (1) World Bank, Global Development Finance 2005

9

97.4 84 98 100 11 43 36 10