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The International Bank for NW, Washington, DC 20433, USA, fax 202-522- Reconstruction and Development/The World 2422, e-mail pubrights@worldbank.org. Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, http://www.copyright.com/ Cover page, page i, page 1, page 11 photos by Damir Cosic/World Bank; Page 15 photo by Nabin Baral/World Bank. The Nepal Development Update is produced twice analysis of the financial sector. Mona Prasad, a year with the following two main aims: to report Christian Eigen-Zucchi and Bigyan Pradhan on key economic developments over the preceding provided helpful comments. Rajib Upadhya and months, placing them in a longer-term and global Richa Bhattarai managed media relations and perspective; and to examine (in the Special Focus dissemination. Diane Stamm edited the section) topics of particular policy significance. The document. Sunita Kumari Yadav managed the Update is intended for a wide audience including publication process. policy makers, business leaders, the community of analysts and professionals engaged in economic The team is grateful for insights and data from debates, and the general public. various agencies in Nepal. In particular, we would like to thank Nar Bahadur Thapa, This Update was produced by the World Bank Gunakar Bhatta and Pradeep Paudyal (all from Macroeconomics and Fiscal Management (MFM) Nepal Rastra Bank); Suman Aryal and Ishwori team for Nepal consisting of Damir Cosic, Bhandari (Central Bureau of Statistics); Pratibha Sudyumna Dahal, Saurav Rana, Roshan Manandhar and Sajina Shakya (from Bajracharya under the guidance of Manuela Department of Hydrology and Meteorology). Francisco. Jyoti Pandey and Jasmine Rajbhandari contributed to the special focus Cut-off date for data included in this report was section. Sabin Shrestha contributed to the April 9, 2018. ............................................................................................................................... ................................................................................................................... .......................................................................................... 1. Global growth picked up and growth in South Asia remained strong despite adverse weather conditions .................................................................................................................... 1 2. In Nepal, agriculture has been affected by floods, but other sectors remain strong ........ 1 3. Imports continue to grow at a double-digit rate while exports are finally showing some signs of recovery ........................................................................................................................ 3 4. While central government revenue remains strong, growth of spending has increased even faster .................................................................................................................................... 4 5. The widening trade deficit and declining growth of remittances are pushing the current account deeper into deficit ........................................................................................................ 6 6. Inflation continues to remain subdued ................................................................................... 7 7. Money supply growth is at a record low ............................................................................... 7 8. Credit growth has moderated but deposit mobilization declined faster, squeezing banks ’ ability to lend .............................................................................................................................. 8 9. Stock market turns downward ............................................................................................... 10 ........................................................................................... ......................................................................................................................... .................................................................................................................................. Figure 1 Rainfall was below average during the early part of the monsoon, followed by a severe floods ............................................................................................................................................ 2 Figure 2 …resulting in the contraction of rice production .................................................................. 2 Figure 3 Housing reconstruction has picked up ................................................................................... 2 Figure 4 Tourist arrivals are at a record high ........................................................................................ 2 Figure 5 Imports continue their double-digit growth ........................................................................... 3 Figure 6 …driven by imports of industrial and capital goods ............................................................ 3 Figure 7 In volume terms, imports of petroleum products have reached a record high ................. 3 Figure 8 Exports of goods are showing signs of recovery… ............................................................... 4 Figure 9 …largely because exports to India are picking up ................................................................ 4 Figure 10 As imports grow, government revenue continues to remain strong ................................... 4 Figure 11 Growth of government spending has increased even faster ................................................ 4 Figure 12 Departure of migrant workers has slowed ............................................................................. 6 Figure 13 …as the number of workers leaving for main destination markets remains soft .............. 6 Figure 14 Growth of remittances continues to slow ................................................................................ 6 Figure 15 ...and is being outpaced by the widening trade deficit, resulting in larger current account deficit ............................................................................................................................................ 6 Figure 16 …leading to a decline in foreign reserves ............................................................................... 7 Figure 17 Inflation has remained broadly stable, with the exception of February 2018 .................... 7 Figure 18 As a result, the REER has depreciated for the first time in five years ................................ 7 Figure 19 Money supply (M2) growth is at a record low ....................................................................... 8 Figure 20 as the contribution of net foreign assets to growth of money supply has dissipated ....... 8 Figure 21 Credit growth slowdown continues......................................................................................... 8 Figure 22 …as bank lending to most segments of the market has slowed........................................... 8 Figure 23 The slowdown in deposits reflects the slowdown in remittances ....................................... 9 Figure 24 Banks’ CCD ratio is approaching the regulatory limit again ............................................... 9 Figure 25 Government borrowing has gone up significantly even as deposits remain high ............ 9 Figure 26 Higher deposit rates, with broadly unchanged spread, continue to drive up lending rates 10 Figure 27 The NEPSE is in self-correction mode ................................................................................... 10 Figure 28 …as limitations are imposed on margin lending and overdrafts ...................................... 10 Figure 29 GDP growth is expected to moderate .................................................................................... 13 Figure 30 Managing the “twin deficits” will be a challenge ................................................................ 13 Figure 31 Recurrent spending has increased substantially in the last three years ............................ 15 Figure 32 Capital spending has more than doubled ............................................................................. 15 Figure 33 Public sector pensions are increasing in Nepal .................................................................... 17 Figure 34 Social assistance spending in Nepal is among the highest in South Asia ......................... 18 Table 1 Selected fiscal indicators ............................................................................................................ 5 Table 2 Nepal macroeconomic outlook ................................................................................................ 2 Table 3 Estimates of transition costs to a federal system of government ...................................... 16 Table 4 Old, current and newly proposed offices in Nepal .............................................................. 20 CCD credit-to-core-capital-and-deposits ratio FDI foreign direct investment FY fiscal year GDP gross domestic product M2 broad money supply MoF Ministry of Finance NEPSE Nepal Stock Exchange NPLs nonperforming loans NPR Nepalese rupee NRB Nepal Rastra Bank REER real effective exchange rate SSA Social Security Allowances y-o-y year-over-year reached a five-year low in FY2017, continues to contract. There has been a broad-based upturn in the global economy on the back of a rebound in Owing to weak growth in remittances, growth of investment, manufacturing activity, and trade. deposits in the banking sector has also slowed. Despite a marginal slowdown, growth in South Credit growth, which peaked during first half of Asia remained strong at 6.5 percent in 2017. The FY2017, moderated to 16 percent, but remained slight slowdown was a consequence of higher than the growth of deposits at 12 percent. temporary disruptions from adverse weather Consequently, the availability of loanable funds conditions across the regions. at the banks has remained tight. Banks can lend up to 80 percent of their local currency deposits Economic activity in Nepal, after a strong and core capital and are running up against this rebound in FY2017, was adversely affected by regulatory limit. As a result, banks have floods during the first half of FY2018. As a result increased interest rates to attract new deposits of severe flooding in the southern plains, paddy and, with unchanged spreads, lending rates production is estimated to have contracted by 1.5 have also increased, reaching a five-year high. percent from the record-high output the year Money supply growth is the lowest in recent before. The contribution of industry and service years because of no contribution from net sector is expected to have remained strong. foreign assets and a slowdown in private sector credit growth. Exports are showing signs of recovery, primarily driven by higher exports to India as disruptions With increased imports, tax collection was from demonetization and introduction of the strong in the first half of FY2018, growing at 19.3 Goods and Services Tax dissipate. However, percent year-over-year. However, expenditure increased imports of reconstruction-related growth has been double that of revenue. Both capital and industrial goods has widened the recurrent and capital spending of the central trade deficit. With slower growth in remittances, government have picked up considerably the current account deficit is pushed deeper into compared to previous years. The first year of a deficit. The outflow of migrant workers, which budget system under a federal setup has resulted in a sizable increase in the fiscal transfers to subnational governments. However, given the unfinished fiscal architecture in the federal setup, execution has been low. Of almost 8 percent of GDP transferred to the subnational governments so far in FY2018, less than 40 percent has been spent. Further, lack of consolidated data on public spending is posing a challenge in assessing government’s fiscal position within an on-going fiscal year. Economic growth in FY2018 is projected at 4.6 percent and is expected to average 4.3 percent during the forecast period, as growth moderates in line with potential. Construction is expected to remain strong, driven by reconstruction efforts, capital projects and construction of several big hotels. The industrial sector is also expected to remain strong with commissioning of new hydropower projects and cement factories, and due to improvements in power supply to industries. The services sectors are, however, expected to be adversely affected by the possibility of a further slowdown in growth of remittances. Inflation is expected to be below the central bank’s target of 7.5 percent. Meanwhile, the current account deficit, which was marginal in FY2017, is expected to widen as the growth of imports remains strong, while remittances ease and exports grow modestly. The persistence of a large current account deficit will likely put pressure on Nepal’s foreign exchange reserves, which are currently adequate. With increased government expenditure the fiscal deficit is expected to widen in FY2018 and during the forecast period. Debt-to-GDP ratio is low at 27 percent in FY2017 and is likely to grow relatively faster but remain sustainable during the forecast period. Nepal successfully conducted elections at all three tiers of government, that is, the local, provincial, and federal levels, thereby completing decade-long political transition. The coalition government commands more than a 3/4 majority in the parliament. However, the After a strong rebound in FY2017, economic There has been a broad-based upturn in the activity, primarily agriculture, has been global economy on the back of a rebound in adversely affected by floods during the first investment, manufacturing activity, and trade. half of FY2018. Severe floods in mid-August of Global growth in 2017 increased to 3 percent from last year, the third major shock in three 2.4 percent in 2016. Global investment growth— consecutive years, caused widespread accounting for three-quarters of the acceleration devastation. Over 1.7 million people have been in global growth—was supported by favorable affected by flooding and landslides affecting financing costs, rising profits, and improved more than one-third of the country. Bridges, business sentiment across both advanced roads, and other infrastructure were also economics and emerging markets and developing damaged (United Nations 2017). As a result, economies. This investment-led recovery is economic activity, and primarily agriculture, was providing a substantial boost to global exports affected. Agricultural sector output, which was and imports in the near term (World Bank 2018). earlier expected to be bountiful, was already somewhat affected by below-average rainfall Despite a marginal slowdown, growth in South during June and July (Figure 1). The brief but Asia remained strong at 6.5 percent in 2017. The heavy downpours during mid-August caused slight slowdown was a consequence of temporary severe flooding in the southern plains and disruptions from adverse weather conditions destroyed 64,000 hectares of standing crops. As a across the regions. In India, businesses’ result, paddy production is estimated to contract adjustment to the newly introduced Goods and by 1.5 percent from the record-high output of Services Tax also played a role. Growth in South 5.23 million tons the year before (Figure 2). Asia continues to be higher than in other regions, albeit marginally from East Asia, which grew at Other sectors, although temporarily affected, 6.4 percent in 2017 (World Bank 2018). rebounded quickly and have remained robust. The contribution of industry is expected to have remained strong with the addition of picked up, but third-tranche disbursements are hydropower capacity and the post-flood and still low. Capacity utilization of manufacturing post-earthquake reconstruction. Nearly 61 industries has also improved on the back of megawatts were added to the national grid in improved power supplies. Growth in the the first half of FY2018. The much awaited services sector continues to be driven by trade Chameliya hydropower project (30 megawatts), and hotels. Tourist arrivals have remained which was originally planned to be completed in strong and reached a record high in the fall 2011, finally came online in early 2018. After two tourist season (September–November) of 2017 years of slow progress, post-earthquake housing (Figure 4). reconstruction has also picked up. Of the 667,662 beneficiaries eligible for housing grants, over 85 On the demand side, a pickup in both private percent have been enrolled and received the first and public investment has supported growth. tranche in February 2018 (Figure 3). More than Though still very low at less than 1 percent of 40 percent of the houses are under construction GDP, FDI in the first half of FY2018 was at a as beneficiaries start receiving grants, and record high of US$140 million, an increase of 94 disbursement of the second tranche has also percent year-over-year (y-o-y), driven by (mm, monthly average, cummulative) (million tons) 1,600 5.4 Paddy Output 1,400 5.2 Long-term average 2017 1,200 5.0 1,000 2016 2015 4.8 800 4.6 600 4.4 400 4.2 200 0 4.0 Jun Jul Aug Sept FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 FY2018 (thousands) (thousands, 3-month moving average) 800 100 Tourist Arrival 700 90 Eligible households in 13 surveyed 80 600 districts Enrolled 70 500 60 400 Received First Tranche 50 Received Second 300 Tranche 40 200 30 20 100 Received Third 10 Tranche 0 0 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Feb-17 Mar-17 Apr-17 Nov-17 Dec-17 Mar-18 Jan-17 May-17 Jul-17 Aug-17 Sep-17 Oct-17 Feb-18 Jun-17 Jan-18 Apr-13 Aug-13 Dec-13 Feb-14 Apr-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Dec-15 Feb-16 Apr-16 Dec-16 Apr-17 Dec-17 Feb-18 Jun-13 Oct-13 Jun-14 Jun-15 Aug-15 Oct-15 Jun-16 Aug-16 Oct-16 Aug-17 Oct-17 Feb-17 Jun-17 - investment in the cement industry. Consumption, however, is expected to have (US$ millions, 3-month moving average) (percent change, y/y) 1400 140 softened as remittances have grown at one of the 1200 120 lowest rates in years. Government consumption is robust, especially as the transition to a new 1000 100 Nonoil Imports federal structure is necessitating an increase in 800 80 spending at the subnational levels, and due to 600 5-Year Average 60 election-related spending. Even after netting out 400 40 the fiscal transfers, the recurrent spending is 30 200 20 percent (y-o-y) in the first half of the fiscal year. 0 0 Oil Imports -200 Total Imports, -20 - Growth (right) -400 -40 -600 -60 Aug-12 Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 Aug-15 Feb-16 Aug-16 Aug-17 Feb-18 Feb-12 Feb-17 Higher imports have become a new normal. Goods imports continue robust double-digit growth averaging US$833 million per month in the first half of FY2018. This is well above the five-year average of US$557 million (Figure 5). (NPR billions, 3-month moving average) 80 The growth has been driven by both oil and Imports of Imports of Imports of Imports of Food Industrial Capital Consumer and Beverage, nonoil imports. Among nonoil imports, 70 Goods Goods Goods Households consumer goods and household food items have 60 remained fairly flat most likely due to a 50 slowdown in growth of remittances. Both industrial and capital goods imports, however, 40 have remained strong driven by materials 30 needed for reconstruction and infrastructure 20 projects (Figure 6). 10 Oil imports are reaching pre-commodity 0 collapse-era levels (Figure 7). Oil imports, Aug-14 Aug-15 Aug-16 Aug-17 Nov-13 May-14 Nov-14 Feb-15 Nov-15 May-15 Feb-16 Nov-16 Feb-17 Nov-17 Feb-18 Feb-14 May-16 May-17 which were averaging US$73 million per month after the commodity price collapse of 2014, reached US$106 million per month in the first half of FY2018. This is similar to the level recorded before the collapse of international oil prices in 2015. However, this increase is driven (petrol, diesel, air turbine fuel in kilo liters; LPG in metric tons) 180,000 not just by price, because international oil prices Diesel have remained well below the pre-2014 prices. 160,000 Hence, oil imports in volume terms have also 140,000 increased considerably. While some of the oil 120,000 imports may have been driven by activities 100,000 related to reconstruction and capital projects, the 80,000 imports have particularly spiked in the election months. Hence, whether this is a temporary 60,000 Petrol phenomenon or a permanent level shift is yet to 40,000 be seen. 20,000 LPG 0 Air Turbine Fuel Exports are finally showing signs of recovery Aug-14 Aug-15 Aug-16 Aug-17 Nov-13 May-14 Nov-14 Feb-15 Nov-15 Feb-16 Nov-16 Feb-17 Nov-17 Feb-18 Feb-14 May-15 May-16 May-17 (Figure 8). Nepal’s exports, which never fully recovered following the end of the trade blockade, steadily picked up pace through the first half of FY2018, growing 28.8 percent (y-o-y) only 5 percent of total exports, while exports to for the three months until February 2018. India account for 60 percent. Hence, even a Following the earthquake and trade disruption, smaller growth of exports to India provides a the exports demand may have further been greater thrust on overall improvement in dampened by disruptions caused by exports. demonetization and the introduction of the Goods and Services Tax in India. As these disruptions dissipated and as the Indian economy regains its footing, Nepal’s exports to India are also recovering (Figure 9). The recovery in exports is primarily driven by Central government revenue continues to industrial supplies and food products. However, remain strong on the back of growing imports. with average exports of US$72 million per Both tax and nontax revenues are growing at month so far in FY2018, they remain below their healthy rates and the central government has five-year average (Figure 9). Exports to China met the six-month revenue target. Taxes and have also seen robust growth but still comprise levies on imports (including the value-added tax (US$ millions, 3-month moving average) (percent change, y/y) (US$ millions, 3 months moving average) (percent change, y/y) 110 110 90 90 Exports to Other Countries Exports Exports to India 90 90 Exports to China (5-Year Average) 5-Year Average 70 70 70 70 50 50 50 50 30 30 30 30 10 10 10 10 -10 Exports to -10 -10 -10 India Growth of Exports -30 to India (right) -30 -30 Exports Growth -30 (right) -50 -50 -50 -50 Feb-12 Feb-13 Feb-14 Jun-12 Jun-13 Oct-13 Jun-14 Oct-14 Jun-15 Oct-15 Feb-16 Jun-16 Oct-16 Feb-17 Jun-17 Oct-17 Feb-18 Oct-12 Feb-15 Aug-14 Aug-15 Aug-16 Aug-17 Nov-13 Feb-14 Nov-14 Feb-15 Nov-15 Nov-16 Nov-17 May-14 May-15 May-16 Feb-17 May-17 Feb-18 Feb-16 (NPR billions, 3-month moving average) (percent change y/y) (NPR billions, 3-months moving average) (percent change y/y) 80 120 100 100 Revenue Growth (right) 100 60 80 Total Expenditure 80 80 40 Total Revenue 60 60 60 40 20 40 40 20 0 0 20 20 -20 -20 0 0 -40 Expenditure Growth (right) -40 -60 -20 -20 Nov-12 Feb-13 Aug-13 Nov-13 Feb-14 Aug-14 Feb-15 Feb-16 Feb-17 May-14 Nov-14 May-15 Aug-15 Nov-15 Aug-16 Nov-16 Aug-17 Nov-17 Feb-18 May-13 May-16 May-17 Aug-13 Aug-14 Aug-15 Aug-16 Aug-17 Nov-12 Feb-13 Nov-13 Feb-14 May-14 Nov-14 Feb-15 May-15 Nov-15 Feb-16 May-16 Nov-16 May-13 Feb-17 May-17 Nov-17 Feb-18 - - - - - - and excise imports) amount to approximately 43 place, but eight months into the fiscal year, many percent of the government’s domestic revenue or are still grappling with basic functions, nearly 10 percent of GDP. The strong growth of especially at the provincial level. As a result, imports is translating into strong revenue given the unfinished fiscal architecture in the collection for the government, which has federal setup, realizing expenditure is proving to increased by 19.3 percent (y-o-y) in the first half be difficult. Subnational governments, while of FY2018 (Figure 10). receiving funds from the federal government, may not have the capacity or be ready to execute However, expenditure growth has been double public services assigned in the constitution, that of revenue (Figure 11). Both recurrent and leading them to retain the funds in the Local capital spending of the central government have Authorities Account at the central bank. In picked up considerably compared to previous addition, in federal Nepal, subnational years. While capital spending has increased on government spending from own-source the back of the construction of various revenues also needs to be consolidated, not an government projects, recurrent spending growth easy task due to the lack of a system to track the has been driven by a sizable increase in fiscal spending. transfers to subnational governments and election-related spending. Even after netting out Budget deviation, which increased sharply in the fiscal transfers to local governments, the last two years due to unrealistic budget recurrent spending growth has been high at 30 estimates, continued in FY2018. Despite the percent (y-o-y). increase in spending so far in FY2018, including record-high capital spending, the ambitious More importantly, transfers to subnational expenditure envisioned in the budget is unlikely governments are not necessarily translating to materialize (Table 1). Hence, the Ministry of into higher spending. Of the NPR 147 billion Finance (MoF) in its midyear budget review has transferred to subnational governments in the revised its expenditure estimate down by 25 first half of FY2018, NPR 93 billion remained percent of the original FY2018 budget. The unspent. The Constitution (2015) stipulates overly ambitious and unrealistic appropriations mandatory grants to subnational governments, envisioned in the budget is becoming a recurring which started in FY2018 and to be transferred in theme in Nepal. three tranches. By mid-March, all three tranches amounting to NPR 225 billion had been transferred. FY2018 is the first year under the federal setup; subnational governments are in The outflow of migrant workers, which reached pressures from the persistently low crude oil a five-year low in FY2017, continues to contract. prices in international markets. During the first half of FY2018, an average of 30,000 Nepalese workers per month departed for Slowing remittances are being outpaced by the employment opportunities abroad (Figure 12). growing trade deficit, and have resulted in a This is the lowest monthly average outflow of record-high current account deficit. While the migrant workers since FY2011, when the global volume of remittances continued to average over economy was still recovering from the impact of US$550 million per month in FY2018, its growth the 2007–08 global financial crisis. Workers has been slowing (Figure 14). In contrast, the trade leaving for Qatar, Malaysia, Saudi Arabia, and the deficit continues to surge (Figure 15). With United Arab Emirates—four main destinations— remittances no longer able to finance the trade continues to remain soft (Figure 13). There are deficit as in the past, the current account deficit several reasons behind this decline, but the has significantly increased to US$737 million in primary one is the cutback of these oil-producing the first six months of FY2018, up from US$9 countries on public spending to ease fiscal million compared to the same period in FY2017. (thousands, 3-month moving average, seasonally (percent change, 3m/3m (thousands) adjusted) SAAR) 35 70 350 Malaysia Qatar Saudi United Kuwait Others Migrant Workers Arab Arabia Outflow (seasonally Emirates 60 300 30 adjusted) 50 250 25 40 200 20 30 150 20 100 15 10 50 10 0 0 Growth Rate, 5 -10 -50 SAAR (right) -20 -100 0 May-13 May-15 May-17 Nov-12 Nov-13 May-14 May-16 Feb-13 Aug-13 Feb-14 Aug-14 Nov-14 Feb-15 Aug-15 Nov-15 Feb-16 Aug-16 Nov-16 Feb-17 Aug-17 Nov-17 Feb-18 Aug-12 Aug-14 Aug-16 Aug-11 Aug-13 Aug-15 Aug-17 Nov-11 Feb-12 Nov-12 Feb-13 Nov-13 Feb-14 Nov-14 Feb-15 Nov-15 Feb-16 Nov-16 Feb-17 Nov-17 May-12 May-13 May-14 May-15 May-16 May-17 Feb-18 (US$ millions, 3-month moving average, (percentage change, 3m/3m (US$ millions, 3-month moving average) seasonally adjusted) SAAR) 1000 700 70 Remittances Trade Deficit 600 (seasonally adjusted) 60 800 500 50 600 400 40 400 Remittances 300 30 200 20 200 100 10 0 0 0 -100 -10 Remittances -200 Current Account -200 Growth, -20 -300 SAAR (right) -30 -400 Oct-11 Feb-12 Oct-12 Feb-13 Jun-12 Jun-13 Oct-13 Feb-14 Feb-15 Jun-14 Oct-14 Jun-15 Oct-15 Feb-16 Oct-16 Feb-17 Feb-18 Jun-16 Jun-17 Oct-17 Feb-12 Oct-12 Feb-13 Oct-13 Oct-14 Feb-15 Jun-15 Oct-15 Feb-16 Feb-17 Oct-17 Feb-18 Jun-12 Jun-13 Feb-14 Jun-14 Jun-16 Oct-16 Jun-17 Foreign exchange reserves have fallen. With FDI and other financing sources remaining low, (US$ millions) (months) Nepal’s foreign exchange reserves have been used 12,000 20 Import Coverage to finance the growing deficit. Although still Total Reserves (right) 18 comfortable at US$10.2 billion in February 2018 10,000 16 and able to cover 9.8 months of imports (Figure 14 16), foreign reserves have declined in the last few 8,000 12 months from a peak of US$10.6 billion in October 6,000 10 2017. 8 4,000 6 4 2,000 Inflation has remained low and stable for the 2 last year. Inflation reached a 13-year low in July 0 0 Aug-11 Nov-11 Feb-12 Aug-12 Nov-12 Feb-13 Aug-13 Nov-13 Feb-14 Aug-14 Nov-14 Feb-15 Aug-15 Nov-15 Feb-16 Aug-16 Nov-16 Aug-17 Nov-17 May-12 May-13 May-14 May-15 May-16 May-17 Feb-18 Feb-17 2017, and has continued to remain broadly stable, except for February 2018, when it spiked to 5 percent (y-o-y) (Figure 17) due to a sharp increase in vegetable prices. Nonfood items have been driving inflation but have moderated compared to the same period last year. The contribution of (contribution to headline inflation, percentage points, y/y) nonfood prices to headline inflation declined to 13 Food & Beverage Nonfood & Service Overall 3.3 percentage points in February 2018 from 3.5 percentage points, year-over-year. The 11 contribution of food prices has slightly increased 9 but remains stable. Food prices contributed 1.7 percentage points to headline inflation in 7 February 2018. Lower and stable inflation has also had a positive impact on Nepal’s external 5 competitiveness, with the real effective exchange 3 rate (REER) depreciating over the last six months for the first time since 2013 (Figure 18). 1 Nov-11 Nov-12 Nov-13 Nov-14 May-12 Aug-12 Feb-13 May-13 Aug-13 Feb-14 May-14 Aug-14 Feb-15 May-15 Aug-15 Nov-15 Feb-16 May-16 Aug-16 Nov-16 Feb-17 Aug-17 Nov-17 Feb-18 Feb-12 May-17 -1 Money supply (M2) growth has slowed because of no contribution from net foreign assets and a slowdown in private sector credit growth. At 13.5 percent (y-o-y) in February 2018, money supply (index number, 2010=100) growth is the lowest in recent years (Figure 19). 120 With the slowdown in foreign reserve 115 Real Effective Exchange Rate accumulation, the contribution of net foreign assets to M2 growth has been steadily declining 110 over the last two years. From contributing 18 105 percentage points to M2 growth in February 2016, 100 its contribution fell to 0.3 percentage points in February 2018 (Figure 20). Similarly, the 95 contribution of private sector credit to M2 90 Nominal Effective Exchange Rate declined to 13.2 percentage points in February 85 2018 from a peak of 23.1 percentage points in February 2017. 80 Nov-11 Feb-12 Aug-12 Nov-12 Feb-13 Nov-13 Nov-14 Nov-15 Nov-16 Nov-17 May-12 May-13 Aug-13 Feb-14 May-14 Aug-14 May-15 Aug-15 Feb-16 May-16 Aug-16 Feb-17 May-17 Aug-17 Feb-18 Feb-15 expired, growth rates of vehicle loans, margin lending, and overdraft loans have remained subdued because criteria to provide loans to these sectors have remained relatively stricter than Credit growth continued to slow as lending to before. In contrast, lending for commercial most segments of the market declined. Credit purposes (such as working capital loans, term growth in February 2018 stood at 16.7 percent (y-o- loans, and so forth) picked up to 17.9 percent (y-o- y), which is a significant decline from the peak of y) in February 2018 after having slowed to 14.1 31.9 percent in February 2017 (Figure 21). The percent (y-o-y) at the end of FY2017, indicating a initial credit slowdown during the second half of likely pickup in commercial activity (Figure 22). FY2017 was precipitated by a temporary restriction on lending channeled for consumption and for Deposits have not picked up and continue to speculative purposes when the availability of squeeze banks’ ability to lend. Deposit growth loanable funds dried up in the banking system. The decelerated to 11.1 percent (y-o-y) in February 2018 aim of these restrictions was to slow the overall (Figure 23). The growth in deposits has declined growth of credit. While the restrictions have since steadily for two years since it peaked at 24.2 (contribution to M2 growth, percentage points) (percentage change y/y) (contribution to M2 growth, percentage points, y/y) 50 50 40 Net Foreign Net Claims on M2 Growth Net Domestic assets Net Foreign Assets Broad Money (M2) Assets Government (right) 35 40 Private Sector Other Net 40 Credit Domestic Assets 30 30 30 25 20 20 20 15 10 10 10 0 0 5 -10 -10 0 Feb-12 Aug-12 Nov-12 Feb-13 Aug-13 Nov-13 Feb-14 Aug-14 Nov-14 Aug-15 Nov-15 Feb-16 Aug-16 Nov-16 Feb-17 Aug-17 Nov-17 Feb-18 May-12 May-13 May-14 Feb-15 May-15 May-16 May-17 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16 Aug-17 May-12 Nov-12 May-13 Nov-13 May-14 Nov-14 May-15 Nov-15 Feb-16 Nov-16 Feb-17 Nov-17 Feb-18 Feb-12 Feb-13 Feb-14 Feb-15 May-16 May-17 (contribution of growth percentage points) (percent change, y/y) (percent change, yly) 80 35 Agriculture Construction Others Total Credit Growth, 35 Industry Stock (right) Service 70 30 30 60 Margin 25 25 Lending 50 Vehicle 20 20 40 15 15 Overdraft Real 30 Lending to 10 10 Estate Commercial 20 Residential 5 5 Home Loan 0 0 10 -5 -5 0 Nov-15 Dec-15 Feb-16 Mar-16 Apr-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Feb-17 Mar-17 Apr-17 Sep-17 Nov-17 Dec-17 Jan-16 May-16 Jun-16 Jul-16 Jan-17 May-17 Feb-18 Jun-17 Jul-17 Aug-17 Oct-17 Jan-18 Feb-13 Aug-13 Nov-13 Feb-14 May-14 Aug-14 Nov-14 Feb-15 Aug-15 Nov-15 Feb-16 Aug-16 Nov-16 Feb-17 Aug-17 Nov-17 Feb-18 May-13 May-15 May-16 May-17 percent (y-o-y) in December 2015. The cumulative impact of slower deposit growth compared to (contribution to growth, percentage points) (percentage change, y/y) credit growth once again led to a rise in the credit- 30 30 Foreign Nonbank Individuals Deposits to-core-capital-and-deposits ratio (CCD) to 77.2 Deposits Financial Growth (right) 25 Institution percent in January 2018 (Figure 24). It is 25 approaching a similar level to a year ago (78.1 20 20 percent in January 2017), when the central bank 15 intervened with measures to curb lending and, to 15 10 allow banks some extra space for lending, 10 temporarily changed the method of calculating 5 CCD ratio of banks. While these measures did slow 5 0 lending, and provided breathing space for banks, Others 0 the fundamental issue of the credit crunch persists -5 Corporations because banks have not been able to increase -10 -5 Aug-13 Aug-14 Aug-15 Aug-16 Aug-17 Nov-12 Feb-13 Nov-13 Feb-14 Nov-14 Feb-15 May-15 Nov-15 Feb-16 Nov-16 Feb-17 Nov-17 May-13 May-14 May-16 May-17 Feb-18 deposit mobilization even as credit growth has dampened. The government’s continued borrowing, even as it accumulates large deposits, is likely to have contributed to the problem. Government (ratio) borrowing reached NPR 365 billion in February 82 2018, even as the government’s deposit in the NRB Regulatory Limit 80 account stood at NPR 302 billion (Figure 25). The 78 government borrowed heavily at the end of FY2016 in anticipation of massive spending in FY2017, 76 CCD Ratio which did not materialize. As a result, the 74 Government of Nepal’s deposits remained in the 72 central bank. This situation has been repeated in 70 the current fiscal year as well. The government 68 borrowed from the market primarily to fund the fiscal transfers of the local bodies. However, as the 66 spending of the local bodies has been low so far, 64 Nov-11 Feb-12 Aug-12 Nov-12 Feb-13 Aug-13 Nov-13 Feb-14 Aug-14 Nov-14 Feb-15 Aug-15 Nov-15 Aug-16 Nov-16 Feb-17 Aug-17 Nov-17 Feb-18 May-12 May-13 May-14 May-15 Feb-16 May-16 May-17 the government deposits at the Local Authorities Account of the central bank has increased. These deposits, which are held at the NRB, effectively remain outside the banking system, and have contributed to creating and sustaining the credit squeeze in the financial system. The effect is similar (NPR millions, 3-month moving average) to monetary operations by central banks employed 400,000 to “mop up” excess liquidity. 350,000 While deposit and lending rates have gone up, 300,000 there are signs of anti-competitive behavior by 250,000 commercial banks to maintain them at these 200,000 levels. With bank CCD ratios approaching the Government Credit regulatory limit, some banks are attempting to 150,000 mobilize deposits more aggressively by offering 100,000 Government Deposit higher interest rates. As a result, the weighted average deposit rates reached 6.4 percent in 50,000 February 2018 (Figure 26), the highest recorded 0 May-12 May-13 May-14 May-15 May-16 May-17 Nov-11 Feb-12 Aug-12 Nov-12 Feb-13 Aug-13 Nov-13 Feb-14 Aug-14 Nov-14 Feb-15 Aug-15 Nov-15 Feb-16 Aug-16 Nov-16 Feb-17 Aug-17 Nov-17 Feb-18 0 2 4 6 8 10 20 30 40 50 60 70 10 12 14 100 120 -40 -20 0 20 40 60 80 Oct-15 Nov-12 Feb-14 Apr-14 Feb-13 Dec-15 Jun-14 May-13 Feb-16 Aug-14 Aug-13 Oct-14 Nov-13 (percent change, yly) (percent change, yly) Apr-16 NEPSE Dec-14 Feb-14 Jun-16 Feb-15 May-14 (percent, weighted average) Apr-15 Aug-16 Aug-14 Margin Jun-15 Lending Oct-16 Aug-15 Nov-14 Oct-15 Feb-15 India:SENSEX Dec-16 Lending Rate Dec-15 May-15 Feb-17 Feb-16 Aug-15 - Apr-16 Apr-17 Nov-15 Jun-16 Aug-16 Feb-16 Jun-17 Oct-16 May-16 (right) Aug-17 Dec-16 Aug-16 Feb-17 Overdraft Oct-17 Nov-16 Apr-17 NEPSE Index Feb-17 Dec-17 Jun-17 Deposit Rate May-17 Aug-17 Shares Index Feb-18 Aug-17 Oct-17 0 Dec-17 Nov-17 200 400 600 800 Bangladesh:CSE All Feb-18 1,000 1,200 1,400 1,600 1,800 2,000 Feb-18 (index) International Airport, the only international airport in Nepal, is already reaching its limit in terms of Looking ahead, economic growth is expected to be passenger arrivals per year. While agriculture will in line with earlier forecasts of 4.6 percent in be affected in FY2018, it is expected to grow FY2018. Economic activity, particularly agriculture, thereafter in line with its historical average growth which was expected to progress well in FY2018, rate, as no major irrigation projects are expected to was set back by the worst flooding in decades. Over be completed during the forecast period. Industry the medium term, growth will remain moderate, in is likely to continue getting a boost in FY2018, as line with the potential, averaging 4.3 percent in the the construction subsectors continue to perform forecast period (Figure 29). By 2020, output growth well. Reconstruction activities are expected to will be close to its potential rate of 4 percent. The continue to pick up at a relatively faster pace in the key challenge for the Nepalese economy during the remainder of FY2018 and are expected to grow forecast period will be managing both a fiscal and during the forecast period. Construction of several current account deficit, which are expected to big hotels is also expected to aid this subsector. persist. Manufacturing is also expected to pick up due to better availability of electricity, new cement On the supply side, the service sector is expected factories, and improving prospects for export to to continue driving growth but is likely to be India. affected by uncertainty stemming from a further slowdown in remittances. Services are expected to On the demand side, gross investments are grow at 5.5 percent on average in the forecast expected to drive growth, while consumption is period, more slowly than in previous years. expected to slow. Growth in gross fixed capital Growth will be driven by trade, tourism, and formation is expected to remain strong during the transport. However, the outlook in services is also forecast period. Public investment will remain dependent on remittances, particularly given the robust in FY2018, with projects like the Babai large share of wholesale and retail trade subsectors. Irrigation Project picking up. Private investment is The boost in tourism is expected to continue in the also expected to remain strong. The record-high forecast period but will be constrained by the FDI in FY2018 is a positive sign and could be infrastructure deficit. For example, Tribhuvan sustained with improvement in overall - - - - - - - - - - - - - - - (percentage points, contributions to growth) (percentage change, y/y) (percent of GDP) 8 GDP Growth, Market 8 40 Agriculture Industry Services Prices (right) Government Spending 7 7 35 Remittances 6 6 30 5 5 25 4 4 20 3 3 15 2 2 10 1 1 5 0 0 0 Current Account Balance -1 -1 -5 Fiscal Balance -2 -2 -10 FY2013 FY2014 FY2015 FY2016 FY2017 FY2018 FY2019 FY2020 FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 FY2018 FY2019 The new government faces a challenging agenda. Nepal successfully conducted elections in all three tiers of government, that is, local, provincial, and federal, a first under a new constitution. The new coalition government has been sworn by a 3/4 majority in the parliament has increased the prospect of a stable government for the next five years. The new government faces a challenging agenda with the transition to a federal state. Managing spending pressure in the context of federalism will pose a challenge. The cost of establishing and running a federal country, the need for post-earthquake and post-flood reconstruction, higher spending on social assistance programs, and larger outlays on much- needed infrastructure could all lead to significant increases in spending. In addition, capacity in the newly created subnational governments is a critical constraint. The risks to the external environment are increasing as well. The decline in migrant worker outflow has continued. Remittances growth has significantly slowed in the last two years. A further slowdown is likely with the recent policy changes in Gulf Cooperation Council countries, such as the imposition of a value-added tax to ease fiscal pressures arising from low crude oil prices affecting migrant workers’ earnings. A sharper deterioration in the balance of payments could a slowdown in remittances could also affect liquidity in the banking sector. delivery and to transform Nepal from a centralized polity to a much more decentralized The successful completion of historic elections system of administration. Nepal has chosen to in 2017 marks the completion of the political base its new federal structure on two levels of transition in Nepal that has lasted for more subnational governments that are being than a decade. The Comprehensive Peace established from scratch. Though there were Agreement ended the decade-long insurgency districts and village development committees in 2006 and paved the way for a peaceful before, the decision to establish 753 new local settlement of Nepal’s political conflict. After governments at the lowest level of the federal more than a decade, the political transition system means that extensive institutional ended in 2017, with successful elections at the capacity will have to be built before local federal, provincial, and local levels. Following governments have the required capability to the elections, the new prime minister was sworn perform their constitutional functions effectively. in. The coalition government commands more Similarly, little government infrastructure exists than a two-thirds majority in the federal at the provincial level. The government has parliament. In addition, the same coalition taken some significant steps towards in parties forming the government at the federal implementing federalism for example, the Inter- level also command a majority in six of the Governmental Fiscal Arrangement Act has been seven provincial governments. These results adopted, the Fiscal Commission has been have significantly increased the prospect of a established and some key laws pertaining to stable government for the duration of its five- provincial and local government operations have year term. been approved. Hence, while some basic mechanisms for the new federal arrangements The central task of the new government relates are being put in place full framework of fiscal to the successful transition to a federal state. arrangements, needed civil servants, and robust Nepal has embarked on an ambitious path to financial management and reporting systems shift from a unitary to a federal system of will need to be developed and capacities government. The new system is expected to augmented at both the state and local levels. fundamentally transform the nature of service search and matching programs, and improved labor regulations. From adoption of the new constitution in late 2015 Similarly, capital spending, which historically to formation of new governments in early 2018, averaged 3 percent of GDP, increased to almost 8 government spending has picked up significantly. percent of GDP by FY2017. Capital spending has Over the last decade, Nepal’s fiscal policy has primarily been driven by reconstruction related to maintained balanced budget thanks to strong earthquake expenditures, but also by much needed revenue growth and underspending of the capital spending on capital goods. budget, in particular. However, government spending started to increase from FY2015, and there As a result, before any concrete steps toward has been a shift upwards in the level of spending implementation of the federal system of since. From an average of 20 percent of GDP government were taken, fiscal pressures have (FY2012–FY2014), total government spending mounted. The salient fact of this period is that increased to 30 percent of GDP by FY2017. increased spending had little to do with new spending that relates to transition costs to the new Both recurrent and capital spending have federal system of government. The fiscal deficit contributed to the increase. (Figure 31 and Figure reached 3.9 percent of GDP in FY2017, from a 32) Recurrent spending as a percent of GDP situation of surplus or marginal deficit in the increased from an average of 15 percent of GDP previous years. While some of the increased during FY2012–FY2014, to about 20 percent of GDP spending was for legitimate needs, such as for post- in FY2017. The increase in spending has primarily earthquake reconstruction, flood recovery, and been driven by higher civil service wages, increased public civil works, much of the increased spending social protection spending, and partly by increases has gone to other uses as well. For example, more in transfers to local governments. For example, than 40 percent of the increase in recurrent social protection spending has grown from 2.5 spending from FY2016 to FY2017 came just from the percent of GDP in FY2011 to 3.7 percent in FY2017. increase in civil service salaries and social protection Social protection programs include three categories: spending. The net increase in civil service salaries (a) social insurance: contributory programs such as was about NPR 30 billion (or 1 percent of GDP) in pensions and unemployment insurance; (b) social FY2017. Due to the complex indexation assistance: noncontributory cash transfers such as methodology of pensions to civil service salaries in social security allowances, school feeding and Nepal, pension expenses also increased by about targeted food assistance, and subsidies; and (c) labor NPR 30 billion, another 1 percent of GDP. In market programs: skills-building programs, job- addition, the largest social assistance program, the (percent of GDP) (percent of GDP) 20 9 Recurrent Spending 18 8 3-Year Average - Capital Spending 16 Recurrent Spending 7 14 6 12 5 10 3-Year Average - 4 8 Capital Spending 3 6 4 2 2 1 0 0 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 SSA (old-age allowance, single women’s allowance, so far. Given that considerable uncertainty exists on disability allowance, child grant, and allowance for the scope and pace of the implementation of endangered ethnicities) was doubled in FY2016, federalism, this is just an estimate. In the process, which resulted in the total social assistance program some critical assumptions have been made that reaching NPR 35 billion in FY2017. This is one of the drive the results. Should these assumptions not highest expenditures on overall social protection in materialize, the results could be radically different. South Asia as a share of GDP. While increased spending on social protection is needed, current At present, transition costs of restructuring the programs and delivery systems need to be government are estimated at 3 to 4 percent of GDP reviewed and strengthened for better overage of the per year over the next four years (Table 3). The poor and vulnerable. employed methodology is a simple one. The current fiscal outlook anticipates total expenditures In addition, some of the spending increases have for all levels of government in Nepal going forward. also been for unproductive uses such as Then a counterfactual scenario of future discretionary funds for parliamentarians (known expenditures assuming a no-change, or trend- as constituency funds) or new vehicles for election growth, scenario is built. The difference between the commission officers. In FY2017, funding for the two scenarios is the transition cost. Increased constituency fund known as the constituency spending for the transition is due to establishment development program was increased to NPR 5 costs for state and local governments, additional million per constituency, and funding for the infrastructure spending by state and local constituency fund known as the constituency governments, and, additional expenditures for infrastructure special program was increased to decentralized service delivery. Critical assumptions NPR 30 million per constituency. These funds were have been made in this outlook, which are spent per the direction of individual described below. parliamentarians, which resulted in total spending of about NPR 10 billion (0.4 percent of GDP). Critical assumption #1: The consolidated wage bill Globally, and in Nepal, such funds to of the overall government is not expected to parliamentarians have been criticized as being change significantly. It is expected that the wage unproductive and wasteful. bill at the central level will decline with the decentralization of service delivery, as central-level civil servants get reassigned to subnational governments and the federal-level ministries are Transition from a unitary to a federal system of significantly reduced. Concurrently, with the government will invariably involve one-off costs. devolution of service provision to state and local Given the radical restructuring of the system of governments, the civil service bill will increase at government that Nepal is undertaking, it is to be the subnational levels. Initial estimates of the expected that it will involve costs, as the new number of civil servants to be transferred from the subnational levels of government need to be built federal government to state and local governments, up while existing national and local levels require along with an offer of voluntary retirement restructuring. These “transition costs” have been packages to those who are not willing to be estimated using the information publicly available reassigned, has been included in the calculation. - - - - - - - - Critical assumption #2: Spending by subnational review, consolidate, and improve the efficiency of governments, and fiscal transfers financing this these programs. spending, will grow gradually as the capacity of local and provincial government increases. The essence of a federal system of government is decentralized public service delivery. As Public sector pensions have increased in the last subnational governments are constituted and their few years, but their coverage is extremely low in capacity is built up over time, they will increasingly terms of total labor force. Nepal’s public sector shoulder greater responsibility for decentralized pension system mostly comprises a service delivery. Given the current revenue noncontributory civil service pension scheme and a structure, the bulk of financing for decentralized mandatory retirement savings scheme via the service delivery will occur through fiscal transfers. Employee Provident Fund. Public pension Consequently, fiscal transfers are expected to grow expenditure as a share of GDP has increased from from an average of 2 percent of GDP in the pre- 0.5 percent of GDP in 2007 to 1.5 percent in 2017 federalism era (FY 2013–FY2016), to 6.6 percent of (Figure 33). However, the pensions cover less than 3 GDP by FY2021. Critically, the bulk of this spending percent of the total labor force. A majority of the by subnational governments will be reallocation of labor force, for example, agricultural workers, who existing functions, not provision of new or are two-thirds of the labor force, are involved in duplicative functions. informal activities without any such facilities or benefits. Critical assumption #3: One-off establishment costs of subnational governments are expected to Realizing the discrepancy, the government has account for the bulk of additional spending drafted a bill to introduce a contributory pension needed. This spending category is also assumed to system, which is a longer-term objective. It is be large with additional buildings and vehicles important, however, to carry out parametric required at the local and state levels for carrying out reforms that will provide immediate benefits in the their activities. The additional cost in this category is short and medium term. The government has assumed to be about 3 percent of GDP between drafted a bill that will reform the public sector FY2017–FY2021 at the local and state levels. Costs of pension as a contributory scheme, and this will be both temporary and permanent structures have important as a long-term reform. Nepal is among been included in the calculations. The standard per the few countries that still have a noncontributory unit cost provided by the government has been public pension system. However, given Nepal’s used to derive the calculation. nascent capital market and regulatory mechanism, it could be challenging to implement such schemes. If not addressed adequately, the increased spending needs could lead to fiscal vulnerabilities in the future. To manage these pressures more adequately, we propose a two-pronged approach. (percent of GDP) First, it would be necessary to revisit increases in Public Sector Pension 1.6 spending over the last few years and eliminate wasteful spending, while improving the efficiency 1.4 5-Year Average- Public Sector Pension of necessary and productive spending. Second, a 1.2 properly sequenced and time-bound plan that will guide the transition process needs to be developed 1.0 and implemented. 0.8 0.6 0.4 The government can further improve efficiency by carrying out reforms in several other areas, 0.2 thereby extending the benefits to a greater 0.0 number of citizens. Several programs have FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 increased in the last few years and it is important to Hence, the government first needs to focus on The social assistance programs have weak delivery parametric reforms, as well, which will bring systems and are fragmented and could be made immediate results. For example, currently, civil more efficient. The social assistance programs are servant pensions in Nepal increase with the increase also constrained by the lack of robust delivery in civil service wage, making it difficult to systems. Paper-based systems with manual delivery administer the wage and pension policies of cash hinder both efficient and timely delivery of separately. Decoupling pension increases from civil benefits and their monitoring, and allow for service wages could lead to substantial government potential leakages. The government has initiated savings. Second, government employees can ask for modernization efforts, which include digitization of early retirement and claim their pension at any age the civil registry and SSA beneficiary database, after 20 years of service. This means that someone drafting a strategy to roll out e-payments, and who started a job in their 20s can begin receiving a development of a management information system. pension in their 40s, even though the retirement age It is expected that these measures could lead to the is 58. Clearer definitions on when pensions can be elimination of an estimated 22 to 25 percent of claimed, with adequate reductions for early ineligible SSA beneficiaries. Further, the existing retirement, will help reduce pension costs. social protection programs are fragmented and Reforming the pension system at the federal level implemented by over 15 government agencies and before the full rollout of federalism will also be lack an overarching vision and strategy. For important to allow provincial and local example, two public works programs, the Rural governments to also set up similar systems. Community Infrastructure Works and the Karnali Employment Program, within the Ministry of Federal Affairs and Local Development, have existed in parallel for about 10 years. In addition, the Nepal’s social assistance programs have evolved lack of clarity of vision and of the roles of each level and expanded significantly over the last decade, of government in delivering social protection has but many people remain poor and vulnerable. The resulted in the announcement of the arbitrary government implements a wide portfolio of social expansion of programs or benefits by newly elected assistance programs that include cash transfers, officials at the local level. Clarity about the roles of public works programs, scholarships, and various each level of government and a careful review of health schemes aimed at protecting the poor and social protection expenditures is necessary before vulnerable. The largest program is the Social expansion of any programs. Security Allowance (SSA), which comprises the old- age allowance, the single women’s allowance, the disability allowance, child grants, and the allowance for endangered ethnicities. The SSA benefits, which ranged from NPR 200 for a child grant to NPR 1,000 for the monthly old-age allowance, which reaches over 2.3 million beneficiaries, were doubled in (percent of GDP) FY2016. Nepal’s spending on social assistance 1.6 programs increased from 0.3 percent of GDP in 1.4 FY2008 to an estimated 1.4 percent in FY2017, Social Assistance Programs in South Asia making it one of the highest in South Asia (Figure 1.2 34). However, the existing programs have limited 1.0 poverty impact and are not scalable in times of disaster. A quarter of the population is poor, and a 0.8 large portion remains vulnerable to falling into 0.6 poverty in the event of shocks (natural disasters, health, or economic). Almost half of households 0.4 reported experiencing a shock in FY2015 and 0.2 FY2016, and about 30 percent reported two or more shocks during the same period. 0.0 India Nepal Bangladesh Sri Lanka Pakistan FY2017/18 is the first year of transition to a federal the ground, while civil service staff are yet to be structure of government. By the start of the fiscal assigned. Also, relevant supporting legislation is yet year in July 2017, heads of local governments and to be adopted. As a result, of the allocated NPR 150 councils had been elected in three rounds of local billion to local governments, more than NPR 90 elections. Remaining elections took place in the first billion remained unspent in the first half of the fiscal half of FY2018, and the new federal and provincial year. government and parliaments were constituted in February 2018, effectively leaving little more than Further, the existence of old structures has added one-quarter of the fiscal year where all three tiers to the confusion. The new constitution created new were in place. This process ends the political federal structures, but old structures remain in transition; however, administrative transition to a place, which has resulted in administrative federal structure of government is just starting. confusion. There are vestiges from the Panchayat era, such as zonal and regional offices, of which While considerable preparatory work has been there are at least 1,000, representing more than 10 done, a comprehensive transition plan needs to be percent of total government offices in Nepal (Table formally adopted. Until the formation of the new 4). As a result, there are now at least the following federal government, the preparatory work for seven layers, depending upon the sector, of transition to a federal structure of government was administrative bodies: carried out by three different groups within the civil service. These working groups focused on three i) The central government, ministries, and thematic areas—fiscal, administrative, and various constitutional bodies and functional restructuring. Fiscal restructuring has commissions progressed the furthest, resulting in the adoption of ii) Regional administrative offices and key legislation. However, the new government has directorates (remnants of five different yet to make formal decisions on the regions) recommendations made under the administrative iii) Old zonal offices (subregional offices) and functional restructuring. Thus, institutional iv) New elected provincial governments and responsibility for the management of the transition parliaments remains scattered across different agencies. As a v) District-level offices consequence, greater clarity on the overall transition vi) Local governments is needed through development, adoption, and vii) Ilaka (area)-level offices execution of an adequately sequenced and time- bound plan. Such a plan would ensure greater In some cases, particularly in infrastructure service accountability on the part of whoever is preparing delivery, there is a lack of capacity in the local and decisions and adopting them, and whoever is provincial governments. Hence, there is a need for tasked with their implementation. Further, such a the previous structure to help build the capacity of plan would enable the government to sequence the the local and provincial governments during the transition across several fiscal years in order to transition period. For example, though districts provide a clearer set of costs associated with this have no functional assignment as per the transition. constitution, there is need for the District Technical Office to help particularly in implementing local The problems caused by the lack of a unified roads projects. However, in other cases, for transition management plan are evident from example, in education, the parallel structure is FY2018 activities. The central government creating confusion and spending pressures. appropriated nearly NPR 225 billion to the Primary education has been devolved to local subnational governments, and particularly to local governments, which have started taking on this role governments. Consequently, the central and responsibility. Hence, it is unlikely that District government transferred NPR 150 billion of the Education Offices are needed. appropriated amount to accounts designated for subnational governments by the first half of the current fiscal year, and the remaining amount by March 2018. However, there has been confusion on A comprehensive transition plan is urgently the functions of the new levels of government on needed in Nepal. The government has carried out - - - considerable preparatory work for transition to a governments and provinces during the transition federal structure, particularly on three thematic phase or should be abolished. A transition areas—fiscal, administrative, and functional management plan should provide a deadline by restructuring. However, a comprehensive transition which functions and functionaries of old institutions plan and a responsible authority to oversee the are either transferred or abolished. Hence, it is transition are needed. In the absence of a clear important for the transition plan to be realistic, transition management plan, the implementation of practical, and credible. The transition plan could be the federal constitution in terms of devolution of a living document to be amended as needed to funds, functions, and functionaries will be neither address emerging realities. However, it needs to be smooth nor well sequenced. To ensure strong local based on cost and resource estimations, bearing in and provincial institutions, and to make state mind critical assumptions, such as transforming the restructuring a success, a strong and capable center civil service with no net increase in costs. Finally, is equally important. The outcomes of the transition without a strong institutional mechanism to lead toward a federal system of public administration the transition plan, its effectiveness will be diluted. and the creation of new institutions (and the associated realignment of public sector employees To successfully transition to the new government across the three federal levels) are hard to predict, structure, authorities should (a) eliminate wasteful and have the potential to introduce uncertainty and or duplicative spending, (b) improve efficiency of tension into the implementation process. Even in spending to reach the greatest number of neediest countries where constitutional reforms are well citizens, and (c) adopt and implement a plan to planned and well coordinated, such a transition transition to federalism. It is important for the process usually takes at least three to five years and government to carry out a spending review and involves several iterative, incremental rounds of identify wasteful spending (such as constituency policy improvements and investments focused on funds or vestiges of old institutions) that can be building organizational and institutional capacity eliminated. In addition, the government can further for accountable and inclusive service delivery. improve efficiency by carrying out reforms in several other areas, thereby extending the benefits The transition plan needs to be credible and to a greater number of citizens, such as social realistic. Clearly, the existing institutional structures security programs. Above all, a clearly defined and need to be streamlined in accordance with the new properly executed multiyear plan would allow the constitution. However, some existing institutional authorities to effectively manage the transition structure should be transferred to local process and anchor citizen expectations. United Nations. 2017. “Nepal Flooding Response Plan.” United Nations, Kathmandu. World Bank. 2014. “Improving Social Protection for the Vulnerable in Nepal: A Review of Social Assistance Programs and Expenditures.” Unpublished World Bank report. World Bank, Kathmandu. World Bank. 2017. “Nepal Development Update: Fiscal Architecture for Federal Nepal. World Bank, Washington, DC. World Bank. 2017. “Climbing Higher: Toward a Middle-Income Nepal.” World Bank, Washington, DC. World Bank. 2017. “Global Economic Prospects.” World Bank, Washington, DC. World Bank. 2017. “Risk and Vulnerability in Nepal: Report on Wave One of the Household Risk and Vulnerability Survey.” Unpublished World Bank report. World Bank, Kathmandu. World Bank. 2018. Global Economic Prospects. Washington, DC: World Bank.