The government had proposed an Extended Credit Facility (ECF) with the International Monetary Fund (IMF) due to the country's widening current account deficit and balance of payments deficit following the COVID-19 pandemic, and a sharp decline in foreign exchange reserves. Nepal has received US$ 384.1 million from the Fund through the facility, which is divided into seven tranches. The Fund had set conditions for this loan facility, including economic recovery, improvement in foreign exchange reserves, financial sector stability, improvement in credit quality, and risk-based supervision. With this facility, Nepal's foreign exchange reserves have also improved. In this context, Kantipur spoke to Sarbat Jahan, Head of IMF's Sub-Division and Chief of Mission for Nepal, and Sonali Jain, Deputy Director of the Asia-Pacific Department, who have in-depth knowledge of Nepal affairs, – Chandra and Rupadatta Gupta : Nepal has recently completed the arrangement under the IMF's Extended Credit Facility. What achievements has this program achieved in Nepal?

Rupadatta Gupta: The objective of this program, approved in early 2022 amid the post-Covid tensions, was to maintain broad financial stability, rebuild the economic buffer, and provide protection to vulnerable people. Despite the change of government in the past four years, the strong commitment of the Nepali people to economic reform has brought tangible results. The program has confirmed that there is strong local ownership of the reform priorities set.

Core macroeconomic indicators have strengthened. In particular, foreign exchange reserves have been able to cover more than 12 months of imports, and the fiscal balance has been strengthened while maintaining a sustainable public debt. Inflation was declining in West Asia before the outbreak of the war. However, economic growth has not been as expected. Nepal's economy, which was gaining momentum due to successive shocks, has been hampered by external shocks such as the earthquake of Baisakh 2072, the devastating floods and landslides of Asoj 2081 and the unrest of Bhadra 2082, and the increase in global energy prices caused by the ongoing West Asia war.

The structural reforms made under the Extended Credit Facility Program have strengthened institutions. They have improved policymaking. The main achievements include modernizing monetary operations, improving financial sector supervision, completing bank loan portfolio reviews, enhancing the fiscal framework and transparency, and strengthening public investment management. Good governance and accountability have also been further strengthened through activities such as upgrading the anti-money laundering framework, policy reforms, increasing external audits of Nepal Rastra Bank, strengthening the Rastra Bank Act, and improving the accountability of public enterprises.

While the global economy has recently appeared to be on track, the ongoing conflict in West Asia is projected to cause serious disruptions. The IMF indicates that its impact will be twice as large in developing countries as in developed countries. What are the factors that will have a greater impact on countries like Nepal?

Sonali Jain-Chandra

: Nepal needed a strong foundation for economic reform when the unexpected increase in oil prices occurred. The strong external buffer accumulated during the Extended Credit Facility Program will help to absorb this shock to some extent. But a prolonged war could weaken the economic growth outlook, push inflation above the Nepal Rastra Bank's target, and cause permanent damage to output levels. Nepal is completely dependent on petroleum products imported from India. India itself imports oil from West Asia. High fuel prices will continue to increase import costs, disrupt the trade balance, and fuel domestic inflation. About 40 percent of Nepal’s remittances, which account for about a quarter of its GDP, come from the labor market in West Asia. Conflicts in West Asia could affect Nepal’s remittance inflows.

Tourism activity could slow down as air travel through major transit hubs in the Gulf is disrupted. Since Nepal imports half of its fertilizer from three Gulf countries—Qatar, Bahrain, and Saudi Arabia—fertilizer supplies could also be affected. Rising energy costs will put pressure on the agriculture sector. In Nepal, the agriculture sector contributes about a quarter of GDP and employs more than half of the total labor force.

Nepal was recently placed on the Financial Action Task Force’s (FATF) ‘grey list’ due to weaknesses such as the informal economy, corruption, and problems with the rule of law. Can these problems be corrected and Nepal be removed from the grey list?

Sarvat Jahan:

Anti-money laundering and countering the financing of terrorism (AML/CFT) and good governance are intertwined. Weaknesses in good governance, including the lack of rule of law, can undermine the effectiveness of the AML/CFT framework. This can weaken institutions and the economy as a whole. IMF staff, in coordination with key partners including the Financial Action Task Force and the Asia/Pacific Group, have supported Nepal’s AML/CFT reforms. Nepal’s amendments to the AML/CFT law in line with international standards were significant, supported by IMF technical assistance and program conditions.

Nepal has agreed to an action plan with the Financial Action Task Force to address remaining deficiencies. The IMF is actively supporting 180 government and private sector participants through technical assistance and training. Countries are removed from the FATF list after completing the agreed action plan. The IMF's objective is to help Nepal implement the necessary reforms quickly and effectively. This will enable Nepal to exit the grey list as soon as possible.

On the recommendation of the IMF, Nepal Rastra Bank has supervised 10 systemically important commercial banks through independent auditors. Did the banks' loan quality meet the IMF's suspicions?

Sarvat Jahan:

The recently completed Loan Portfolio Review (LPR) of Nepal's 10 largest 'A' category banks was an important supervisory initiative. It will enable the NRB to better understand the asset quality of the banking sector. Although the IMF had suggested conducting an LPR for an in-depth analysis of the banking sector, there was no preconceived idea of ​​what this analysis would reveal. The review has shown to what extent banks need to reclassify loans and take additional steps to manage loan losses. The NRB should now move beyond the traditional approach and move towards a system of supervision that looks at the real risks of banks.

It should emphasize the actual assessment of the state of the loans distributed by the banks. The institutional governance of the banks should be further strengthened. The size of the capital fund should be increased to make the balance sheets of the banks resilient. This helps in correcting the deterioration in the quality of loans, controlling bad loans and resolving the weakness in the banks due to insufficient capital (weak capitalization).

Furthermore, the Rastra Bank should also direct the banks to improve the weaknesses in their lending style. For this, it is necessary to strengthen the criteria for lending, ensure that the borrowers comply with the terms, and take immediate steps to address the outstanding amounts. The lessons learned from the loan portfolio review should be applied and the remaining portfolios of the 10 largest banks and the remaining 10 commercial banks should be expanded to the full portfolios of the remaining 15 trillion rupees to strengthen the supervision of the banking sector. 

More than 1.5 trillion rupees have been accumulated in the banks and financial institutions of Nepal, there is excess liquidity in the market, what are the reasons for the inability to effectively manage liquidity, and what can be the solution to this?

Sarvat Jahan:

The main reason for the increase in excess liquidity in Nepal's banking system is the large inflow of foreign currency. Remittances have increased by about 50 percent in the last three years in particular. The slowdown in private sector credit expansion has reduced the credit-deposit ratio (CD ratio) of banks. This has made excess liquidity high. To control liquidity, the NRB is increasing the scope of open market operations (OMO) to withdraw long-term deposits from banks and also withdraw money from banks by issuing bonds. But the inflow of foreign currency is so rapid. The NRB is adding more money to the market than the steps taken by the NRB to withdraw money from the market (open market operations).

The NRB can further strengthen its response by improving the calibration of open market operations, expanding its use as needed, and enhancing liquidity projections. Strong monetary policy will help bring short-term rates, such as the interbank rate and the open market transaction rate, closer to the policy rate and improve the effectiveness of monetary policy under the interest rate corridor system.

Nepal has taken forward the IMF’s good governance and anti-corruption process, and the new government also seems interested in improving good governance. How will this process help Nepal?

Sonali Jain-Chandra:

The Governance and Corruption Diagnosis (GCD) has been launched to strengthen good governance in Nepal and reduce the risk of corruption. It examines where corruption is possible and where good governance is weak at the government agency, policy and practical level. Its objective is to identify such serious weaknesses in the mechanisms, policies and working style of the state. The GCD will provide concrete, sequential and prioritized reform recommendations to address the risks of corruption that hinder Nepal’s economic development. Nepal has become the second country in the Asia-Pacific region after Sri Lanka to adopt this practice.

Countries that have practiced this, including Sri Lanka, have benefited by developing their own ‘home grown’ action plans with time-bound reforms based on the recommendations of the GCD. We welcome the commitment of the Government of Nepal to good governance. Nepal now has a valuable opportunity to advance the transformative agenda of good governance and pave the way for strong and inclusive medium-term economic growth.

Dr. Dutta Gupta, it is understood that the seventh review under the Extended Credit Facility is your last engagement with Nepal, what was the perception or image of Nepal, how do you see Nepal’s economic future?

Rupadatta Gupta:

I am proud to have had the opportunity to engage with the Nepalis at a crucial juncture in Nepal’s economic history. The Extended Credit Facility program was launched in the midst of the global COVID crisis. It ended as another crisis erupted in the Middle East. The reforms undertaken under the program have put Nepal in a much stronger position to withstand economic shocks. This achievement belongs to the Nepali people. Their strong commitment to reform has helped restore macroeconomic stability and drive structural change. This will benefit the country in the years to come. These important achievements of Nepal should be seen as a basis for further progress with a sustained pace of reforms.