IMF Approves $41.8M for Nepal’s Economy

The International Monetary Fund (IMF) has recently completed the fifth review of Nepal’s Extended Credit Facility (ECF) arrangement, marking a significant milestone in the country’s ongoing economic reforms. This review has led to the approval of an additional disbursement of approximately $41.8 million, bringing the total IMF financial support for Nepal under the ECF to around $283.9 million. The review reflects Nepal’s steady progress in implementing key structural reforms, especially in strengthening its financial sector and boosting post-crisis economic recovery.

Economic Growth and Recovery Prospects

Nepal’s economic growth is on the rise, with the IMF projecting a growth rate of over 4% for the fiscal year 2024/25. This increase in GDP growth is attributed to a range of factors, including heightened capital expenditure on post-flood reconstruction efforts, which have injected much-needed resources into infrastructure projects. Additionally, robust remittance inflows, combined with subdued imports, are expected to support further economic recovery in the second half of the fiscal year.

Elaboration:

• Growth Acceleration:Nepal’s economic growth has been increasing in the first half of the fiscal year (FY25), with a projected growth of 4.5% for FY25, up from 3.9% in FY24, according to the World Bank.
• Industrial Growth:The industrial sector, especially the electricity and construction sectors, is expected to drive significant growth, leading to an average of 5.4% annual growth in FY26-27, according to the World Bank.
• Inflation Easing:Headline inflation has eased to 5% in the first half of FY25, down from 6.5% in the same period of FY24, according to the World Bank. Inflation is projected to further moderate to 4.4% on average in FY26-27.
• Financial Sector Challenges:The financial sector faces ongoing challenges related to asset quality, profitability, and capital adequacy, according to the World Bank.
• Fiscal Deficit:The fiscal deficit narrowed significantly in the first half of FY25, driven by strong revenue growth outpacing slower expenditure increases, according to the World Bank. 

The IMF report highlights the importance of remittance-driven consumption in keeping Nepal’s economy resilient. Remittances contribute significantly to domestic demand, while government capital spending on reconstruction post-natural disasters has provided an extra boost. According to Kathmandu Post, these factors are critical to sustaining economic recovery in the long term.

Progress in Structural Reforms

The Nepali government has demonstrated progress in implementing critical structural reforms, particularly in the areas of anti-money laundering (AML) and financial oversight. Notably, amendments to the anti-money laundering law have been introduced to align Nepal’s legal framework with international standards, a significant step in curbing financial crimes and increasing investor confidence.

Here’s a more detailed look:

Areas of Progress:

• Structural Transformation:Nepal has witnessed a slow but steady shift of labor from the agriculture sector to more productive sectors, with a decline in agriculture’s contribution to Gross Value Added (GVA). 
• Service Sector Growth:The service sector has been a primary driver of growth, with increasing contributions to the GVA. 
• Infrastructure Development:Efforts are underway to improve infrastructure, including the Tribhuvan International Airport upgrade, which is expected to boost tourism and other related sectors in the long term. 
• Energy Sector:Government efforts to increase electricity capacity and exports are expected to accelerate industrial growth. 

Challenges and Areas Needing Reform:

• Low Productivity:Nepal’s overall labor productivity remains low, hindering economic growth and job creation. 
• Stagnant Industrial Sector:The manufacturing sector has seen limited growth, and the industry sector as a whole has struggled to create jobs. 
• Limited Exports:Subpar infrastructure and weak competition in logistics and transport have hindered exports, limiting their contribution to economic growth. 
• Underdeveloped Tourism Sector:The tourism sector, a key potential growth area, remains underdeveloped and needs further development. 
• Digitization Challenges:Limited infrastructure, regulatory challenges, and digital literacy gaps are holding back digitization efforts. 
• Electricity Pricing:The current electricity pricing system, which is not based on consumer affordability, is leading to revenue losses and limiting investments in the sector. 
• Governance Weaknesses:The shift to federalism, while offering opportunities, also presents challenges related to clarifying functions and accountabilities of the different levels of government and addressing governance weaknesses. 
• Financial Sector Reforms:While Nepal has initiated financial sector reforms, further progress is needed to ensure the sector’s efficient mobilization and allocation of financial resources. 

Key Reforms Recommended:

• Focus on increasing returns from migration:This could involve policies that support remittances and enhance their value. 
• Boosting exports:Improving infrastructure, reducing regulatory barriers, and promoting exports in key sectors are crucial. 
• Efficient hydropower use:Developing hydropower projects efficiently and strategically can contribute significantly to economic growth. 
• Digitalization:Addressing digital literacy gaps, improving infrastructure, and streamlining regulations are necessary to unlock the potential of digitalization. 
• Private sector development:Creating a conducive environment for private sector investment and supporting the development of private sector capabilities are essential for growth. 
• Fiscal and structural reforms:These reforms should address areas like taxation, social security, healthcare, education, and public finance management. 
• Long-term national growth strategy:Nepal needs a long-term national growth strategy to guide energy and other sector investments. 
• Addressing governance challenges:Strengthening institutions, clarifying responsibilities, and improving governance are crucial for sustained development. 

Furthermore, an audit of the Nepal Rastra Bank (NRB) for the fiscal year 2023/24 was completed using international expertise, enhancing the transparency and credibility of Nepal’s financial oversight. Strengthening public enterprises’ governance remains a top priority for the government, as this will ensure more efficient management of resources and promote sustainable economic development. For more on Nepal’s progress in economic reforms, read the IMF Country Report here.

Financial Sector Vulnerabilities

Despite notable progress, Nepal’s banking sector continues to face increasing vulnerabilities. The review noted a rise in non-performing loans (NPLs), which reached 4.4% by October 2024. This figure underscores growing concerns about the health of the financial sector, particularly savings and credit cooperatives (SACCOs), which have shown signs of financial distress.

In response to these challenges, the Nepal Rastra Bank is undertaking a comprehensive Loan Portfolio Review (LPR) of major banks to identify areas of weakness and mitigate risks in the banking system. The NRB initially faced procurement challenges in conducting the LPR, but efforts have resumed, and the review is set to be completed soon. This initiative is crucial for ensuring that the financial sector remains stable and resilient in the face of external shocks. For further details on the financial sector, visit the IMF country profile.

IMF’s Support and Nepal’s Future Outlook

The IMF’s continued financial support is critical for maintaining macroeconomic stability and promoting growth-friendly fiscal policies in Nepal. One of the key objectives of the ECF arrangement is to help Nepal achieve fiscal consolidation without compromising growth. The government is focusing on improving the execution of capital expenditure projects, which are vital for the country’s long-term economic development.

IMF Support and Nepal’s Economic Outlook:

• Economic Growth:Nepal’s economy is projected to grow at 4.5% in FY25, driven by the services sector and recovery in merchandise imports. The IMF expects this growth to be supported by stronger domestic demand and capital spending, including reconstruction efforts after floods. 
• Financial Sector Reforms:The IMF is urging Nepal to strengthen its anti-money laundering framework, reduce fiscal risks, and improve financial sector regulation. Reforms are underway to align financial sector regulations with international standards, conduct loan portfolio reviews, and address issues with savings and credit cooperatives. 
• Fiscal Policy:The IMF emphasizes the importance of executing planned capital spending while maintaining fiscal discipline through domestic revenue mobilization. This includes improving the public investment strategy and accelerating capital spending. 
• Structural Reforms:The IMF is advocating for structural reforms to foster investment and more inclusive growth, including improving the business climate, building human capital, and strengthening social safety nets. 
• External Sector:Nepal’s external sector continues to strengthen due to remittances, increasing tourism, and subdued imports. However, weak domestic demand and high migration rates weigh on near-term growth. 
• Political Uncertainty:Political uncertainty, with frequent government changes, poses a challenge to long-term economic planning and development. 
• Natural Disasters:Nepal’s vulnerability to natural disasters, including flooding and landslides, can impact economic activity and require reconstruction efforts. 

While progress has been made, Nepal’s economic outlook remains subject to risks. Delays in executing large capital projects could hinder growth, while continued vulnerabilities in the financial sector might undermine investor confidence. As a result, the Nepali government, in collaboration with the IMF, must address these risks to maintain momentum toward achieving its economic goals.

Challenges and Risks Ahead

Despite the positive outlook, there are concerns about the under-execution of capital projects. Delays in infrastructure development and reconstruction projects pose risks to Nepal’s ability to sustain growth. The government has acknowledged these challenges and is working closely with the IMF to overcome them by ensuring the timely execution of projects and managing financial vulnerabilities in the banking sector.

Economic Challenges and Risks:

• External Risks:Nepal’s economy is vulnerable to external shocks like geopolitical uncertainties and trade restrictions, which could lead to higher commodity prices and a slowdown in remittances and tourism, both of which are major drivers of economic growth. 
• Domestic Risks:Deteriorating financial sector asset quality, frequent bureaucratic reshuffles, and delays in implementing critical capital expenditure reforms could hinder infrastructure development and economic efficiency. 
• Financial Sector:Nepal’s presence on the Financial Action Task Force (FATF) Grey List poses a significant risk to the economy. 
• Dependence on Remittances and Tourism:A slowdown in partner countries’ growth could significantly impact Nepal’s economy, which heavily relies on remittances and tourism. 
• Infrastructure:Subpar infrastructure and weak competition in logistics and transport limit exports, hindering economic growth. 
• Labor Productivity:Nepal’s overall labor productivity remains low, impacting economic growth. 

Environmental Concerns:

• Climate Change:Nepal is highly vulnerable to climate change impacts, including accelerated glacier melting, which can exacerbate flooding and water scarcity. 
• Air Pollution:Outdoor air pollution in Nepal is a significant health hazard, with higher per capita deaths than in other low-income countries. 
• Natural Disasters:Nepal experiences frequent earthquakes, landslides, and floods, requiring preparedness and mitigation strategies. 

Political Instability and Governance Issues:

• Political Instability:Frequent government changes and policy inconsistencies can undermine development efforts and create uncertainty for investors. 
• Corruption and Mismanagement:Rampant corruption and mismanagement in various sectors hinder development planning and implementation. 
• Inefficient Development Planning:Lack of effective development planning and implementation, particularly in areas like agriculture and infrastructure, further exacerbates challenges. 

Other Challenges:

• Food Security:Nepal faces challenges in achieving food security and addressing income inequality. 
• Lack of Domestic Manufacturing:The absence of a robust domestic manufacturing sector limits export trade and economic diversification. 
• Limited Infrastructure Access:A significant portion of the population lacks access to reliable and adequate infrastructure services like water and sanitation. 

To mitigate these risks and improve Nepal’s future outlook, the government must address the following:

• Strengthen Economic Resilience:Diversify the economy beyond remittances and tourism, improve infrastructure, and promote domestic manufacturing. 
• Address Climate Change:Implement climate adaptation and mitigation measures to protect vulnerable communities and infrastructure. 
• Enhance Governance:Promote transparency, accountability, and good governance to combat corruption and improve policy implementation. 
• Invest in Education and Human Capital:Improve education and training to enhance labor productivity and create a skilled workforce. 
• Promote Inclusive Growth:Address income inequality and ensure that development benefits all segments of the population. 

Nepal’s financial sector also requires close monitoring. If the rising trend in non-performing loans is not adequately addressed, it could affect the broader economy. This is particularly concerning as the financial health of SACCOs continues to deteriorate, threatening the livelihood of individuals reliant on these cooperatives.

Nepal’s future economic prospects rely heavily on sound fiscal management, continued structural reforms, and mitigating risks associated with financial sector vulnerabilities. By addressing these challenges in collaboration with the IMF, Nepal can continue its journey toward long-term sustainable growth.

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