Directors urged the authorities to address the substantial risks in the financial sector with utmost priority. They viewed regulatory forbearance as unsustainable, and stressed the need to strengthen supervision, the regulatory environment, and banks’ corporate governance, while merging and improving the central bank’s emergency liquidity facilities. Directors encouraged the authorities to develop an effective crisis management framework that would facilitate timely intervention and resolution of problem banks. They advised the authorities to press ahead with restructuring the weak state banks—with a few Directors stressing an audit of Nepal Bank Limited by a reputable international auditor—and to strictly enforce the moratorium on new bank licenses.

Directors underlined that continued fiscal prudence remains essential to ensuring macroeconomic stability. They commended the authorities for continuously improving debt dynamics, and for the timely adoption of the 2011-12 budget with an appropriate target for net domestic financing. Given the challenging backdrop of moderate activity and a significant increase of current spending, Directors encouraged the authorities to boost revenue by further strengthening administration and refocusing the tax structure toward domestic sources. Efforts are also needed to restrain administrative expenses and to phase out unproductive subsidies while safeguarding pro-poor spending. Directors called on the authorities to enhance the public finance management framework and to introduce an automatic fuel price adjustment mechanism to limit the losses of the Nepal Oil Corporation.

Directors emphasized that the exchange rate peg has served Nepal well and continues to be a near-term policy priority, and safeguarding it requires a firmer monetary policy stance and targeted rather than blanket liquidity provision for solvent banks facing short-term pressures. They noted the staff’s assessment that the exchange rate appears overvalued, and stressed the importance of boosting productivity. At the same time, if sustained and significant downward exchange-rate pressure were to emerge, preservation of official reserves and an adjustment of the peg would need to be considered. Directors welcomed the authorities’ commitment to remove the exchange restriction to comply with Article VIII of the Fund’s Articles of Agreement.

Directors encouraged the authorities to press ahead with structural reforms to raise productivity and potential growth. Addressing key structural bottlenecks, along with macro-financial stability, would help Nepal achieve higher sustainable growth and promote poverty reduction, and Directors expected these issues to be at the core of a strong reform program that could be supported by an Extended Credit Facility (ECF) arrangement.

Background

Living standards in Nepal have improved markedly over the past decade thanks to increased remittances, supportive social programs, and generally prudent fiscal policy that almost halved public debt as a share of GDP. Notable progress has also been made towards the Millennium Development Goals. However, productivity growth has not kept pace with neighboring countries, and structural reforms needed to boost growth and enhance competitiveness have lagged. At the same time, Nepal remains in a lengthy political transition: the Constituent Assembly and the interim Constitution were recently extended for a third time to November 2011.

Maintaining macroeconomic and financial stability has become increasingly challenging since the last Article IV consultation in May 2010, with financial sector risks in particular elevated. Inflation has remained high, averaging about 9½ percent in 2010-11. The balance of payments was under pressure for most of the year due to high oil prices, slowing remittances, and weakening competitiveness, though it ended with a modest surplus. The adoption of the budget by the Constituent Assembly was delayed by 7 months due to the political situation. Revenue and spending underperformed the budget targets, net domestic financing exceeded its target, and large losses were incurred by the Nepal Oil Company. Reflecting these developments and heightened stress in the banking system, growth slowed to 3½ percent from 4½ percent the previous year. Mixed progress was made in implementing policy commitments under the Rapid Credit Facility (RCF), approved in May 2010.

Banking sector risks have intensified as financial institutions proliferated in an environment of weak supervision. Asset quality has deteriorated and liquidity pressures increased following the bursting of a bubble in the real estate market, to which banks are significantly exposed. In response, monetary policy eased and liquidity support was extended to institutions in stress, regulatory forbearance measures were implemented, and a widening of deposit insurance was announced. Restructuring of the weak state banks and reform of key bank legislation have been delayed.

The outlook is subject to high degree of uncertainty, with risks on the downside chiefly owing to banking sector fragility. Real GDP growth is expected at 3¾ percent in 2011-12, with good agriculture output compensating for subdued non-agriculture activity. Inflation should ease to 8 percent due to an expected moderation in India’s inflation and a stabilization of commodity prices. The external current account deficit is projected to remain around 1 percent of GDP, but the import cover of foreign reserves is expected to decline. The 2011-12 budget appropriately targets net domestic financing of 2 percent of GDP; however, achieving this will not be easy given ambitious revenue targets set against the backdrop of moderate activity and a significant increase of current spending.

Against this background, the 2011 Article IV consultation focused on maintaining macroeconomic stability and managing financial sector risks.