An International Monetary Fund (IMF) staff mission, led by Mr. Alexander Pitt, met with the Nepalese authorities in Kathmandu during April 9-22, 2014, to conduct the Article IV Consultation discussions.

The mission held discussions with Finance Minister Dr. Ram Sharan Mahat, Nepal Rastra Bank Governor Dr. Yuba Raj Khatiwada, Finance Secretary Yuba Raj Bhusal, and other senior officials. The mission also met with private sector representatives and development partners.

At the conclusion of the mission, Mr. Pitt issued the following statement:

“GDP growth slowed to 3½ percent in 2012-13, largely due to a weather-related slowdown in agriculture, but the delay in passing a full budget also resulted in low capital spending. Inflation rose to over 10 percent year-on-year in December 2013 in the wake of the sudden drop in the value of the Indian rupee, but moderated to 8.9 percent in March. Remittances have continued to grow rapidly, leading to a balance of payments surplus. Broad money and private sector credit grew at 21.5 and 15.5 percent respectively in March.

“Growth is recovering, and inflation is moderating. Output growth is expected to pick up to around 4½ percent in 2013-14, driven by a recovery in agriculture, strong services, and rising public spending underpinned by timely budget approval. Inflation is projected to moderate further from recent levels but remain high, at 8 percent (year-on-year). Growth of remittances is expected to moderate, but international reserves should continue to rise.

“Key external risks to the outlook stem from a possible slower-than-projected recovery in India, or a slowdown in countries that host Nepali workers. Domestic risks arise from the financial sector, especially cooperatives. On the other hand, decisive reforms to increase public investment would likely strengthen confidence and private investment, raising growth beyond baseline projections.

“The mission notes that the level of the exchange rate appears broadly in line with fundamentals, if remittances are taken into account. However, remittances skew domestic activity to non-tradables and contribute to reducing the competitiveness of agriculture and industry. The peg to the Indian rupee serves as a useful and transparent anchor, and continues to benefit Nepal in view of its close economic relationship with India. Moreover, the depreciation of the Indian rupee has created an opportunity to benefit from enhanced competitiveness vis-à-vis third countries.

“Harnessing the financial sector and remittances to support economic development is difficult. Care must be taken to preserve financial sector soundness, and it needs to be recognized that monetary and macroprudential policies alone cannot compensate for a lack of infrastructure and other structural impediments to growth. In this context, the volatility and level of excess liquidity should be reduced, and policies implemented to facilitate monetary management, and to lean against inflation.

“Financial sector reforms need to be pushed forward. The Nepal Rastra Bank (NRB) has made progress in addressing financial sector risks. Nonetheless, the recent assessment under the Financial Sector Assessment Program found that risks are still significant. Asset quality remains a concern, while connected lending is widespread and the fragmentation of the banking system makes supervision difficult. Furthermore, outside the banking system supervised by the NRB, a largely unsupervised cooperative sector is growing rapidly. Supervision, despite improvements, needs further strengthening. In this context, the NRB should not hesitate to exercise its corrective and sanctioning powers. The legal framework for the financial sector also needs to be upgraded.

“Fiscal policy needs to support growth and poverty reduction through much-needed capital expenditure. Strong revenue growth in recent years, and ongoing efforts to improve revenue administration, are creating the fiscal space for this. Key areas for investment with a large impact on potential growth are power generation and distribution, and upgrading and expansion of the transport network. Investments in these areas would also likely crowd in private sector investment, as they would provide essential infrastructure for agriculture and industry. Broader structural reforms are also needed. Notably, the expansion of telecommunications infrastructure and services, especially financial services through mobile telephony, could transform access to finance.

“Nepal Oil Corporation (NOC) losses need to be addressed to free up resources for investment and social spending. The mission welcomes the recent adjustment of fuel prices, and encourages the authorities to implement further price increases, ideally through an automatic price adjustment mechanism to avoid recurrent losses, which ultimately have to be financed by the government.

“The IMF will continue to provide intensive support for Nepal’s reform efforts in the areas of banking regulation and supervision, anti-money laundering, and crisis management, as well as for tax administration, and tax policy.”