From a macroeconomic perspective, Nepal hit a sweet spot in 2016/17. Real GDP growth rebounded strongly, inflation declined to the lowest level in many years, the current account was roughly in balance, and international reserves rose further. Fiscal spending increased substantially but the overall balance remained within manageable limits. Risks from brisk credit growth were of concern but other economic outcomes were generally encouraging.
Can Nepal continue to deliver high growth with low inflation and external stability going forward? While policymakers deserve much credit, last year’s outcomes were also helped by favourable conditions such as low capacity utilisation following the earthquake and trade disruptions, good rains, improved power supply, and low imported inflation. As these conditions dissipate, macroeconomic trade-offs will get starker and will need to be managed cautiously. For instance, as production approaches potential, strong demand for consumption and reconstruction will tend to push up prices, imports, and the current account deficit. Against this backdrop, achieving sustained high growth with stability will require both an acceleration of structural reforms and, importantly, a strengthening of macroeconomic policy frameworks and institutions.
Without a pick-up in private investment and productivity, growth will remain constrained. Creating a more conducive business environment will therefore be essential, including opening product and services markets to meaningful competition, streamlining regulations and bureaucratic processes, making labour and land markets more flexible, and stepping up investments in infrastructure. Ongoing deliberations on new labour, social security, and foreign investment and technology transfer bills provide immediate opportunities to move such reforms to the top of the policy agenda.
Nepal’s exchange rate peg to the Indian rupee provides an important anchor for the economy. Still, monetary policy retains influence on activity, price stability, and the external balance given capital controls. Efforts by the Nepal Rastra Bank (NRB) to make the monetary policy framework more transparent and forward-looking are therefore welcome. Measures announced in the 2017/18 monetary policy statement include establishing a floor for the interest rate corridor and identifying an explicit policy rate (two-week repos) and target level (initially 5%). Properly implemented, these steps should help stabilise interbank interest rates, providing banks with greater certainty on funding costs and guiding market expectations. Key priorities are now to strengthen liquidity forecasting and use deposit collection auctions proactively to keep interbank rates within the targeted corridor. Over time, these steps could be followed by a narrowing of the interest rate corridor and, ultimately, the announcement of a medium-term inflation target.
Macroprudential instruments such as ceilings for the credit-to-capital-cum-deposit (CCD) ratio, or loan-to-value ratios for risky loan categories should remain a part of the NRB’s policy toolkit. There is also a need to continue strengthening financial sector supervision. Strict enforcement of the existing regulation remains important given rapid credit growth in recent years, which carries risks of excessive asset-price inflation and risk-taking by financial institutions.
In the fiscal area, Nepal faces at least two major institutional challenges. At the central government level, strengthening public financial management (PFM) and budget implementation remains key to allow a gradual scaling up of high-quality spending. Some progress was made in 2016/17 but the continued bunching of spending in the last few weeks of the fiscal year remains a problem from a macroeconomic perspective and raises concerns about waste. Addressing these issues will require moving to more realistic budget envelopes that effectively prioritise spending, strengthening project and programme preparation and implementation capacity, and integrating disparate PFM systems across ministries.
The process of fiscal decentralisation that has been initiated following successful local elections holds the potential for major improvements in the delivery and quality of public services across the country. However, cross-country experience suggests that such outcomes require autonomy and strong accountability of subnational governments and decentralised expenditure responsibilities with appropriate resources (vertical balance).The establishment of a robust and sustainable framework for intergovernmental fiscal arrangements is therefore both urgent and essential for the success of federalism in Nepal, along with a major effort to build implementation capacity at the subnational level.
Admittedly, the outlined policy agenda is extensive and demanding, requiring consensus-building, persistence, and strong ownership for implementation. At the same time, the likely rewards in terms of growth and stability dividends are sizeable. Can policymakers step up to the challenge?