In Autocracy, Nepal Economy Goes Down

Renewing its warning issued a month ago, Kathmandu based economic watchdog Institute for Development Studies(IfDS) today said, ” While stagnant income and increasing inflation mean hardships for the ordinary people, capital flight points out that the future economic prospects of the country are bleak.” Here i s the complete text of the report disclosed by the organization:

The Economic Level and Directionafter February 2, 2006……

Institute for Development Studies(IfDS)

Executive Summary

1. After the publication of our report on February 20, a new wave of interest was shown by all on the state of Nepalese economy. But no improvements have been noticed yet in the overall performances of the economy. Instead, a number of new policies and programs initiated by the government in the recent past have helped the economy to deteriorate further. Against this background, it is not necessary to change the following hypothesis discussed in our first report:

(a) “In the lack of proper measures to improve the situation, the economy may fall together abruptly;”

(b) “If the present trend continues, the government may be financially bankrupt by the end of June”;

(c) “Once the economic problem is exploded, we will not have long time in the name of finding alternative programs. We will not be surprised if total anarchy prevails in the country….The national identity itself will be at stake”.

2. In Nepal, two concepts of development strategy have been in use. The one, popularized by the political parties, claims that development is possible only after the end of national conflict. The other one, followed by the government, claims to end the Maoist conflict first to pursue development programs. At the outset, it is clear that development program is not in the priority list of both the government and the political parties. In the meantime, Maobadis have announced a program to blockade the district head quarters from March 14 and then, after a few days, the initiation of Nepal Banda program for the indefinite period until the political problem is totally resolved. This is sufficient to indicate that the economic activities that are of general interest to the public are not taken into account. On the contrary, it has been used as a means to further accelerate the conflict in the country so that it can be used to achieve democracy in the country. The economic activities have thus been used as a political strategy and hence any deterioration in the national economic system will have no consequence. It is not possible to quantify the possible impact of the new political strategy on economic activities once they are implemented.

[I]n the name of the political conflict, the indifference of policy makers to the need for effective measures to deal with the economic crisis or the misuse of fiscal and monetary policies and programmes are worsening both economic and political problems. It is already late for corrective action. Failure to do so in days to come too might plunge the country into unprecedented crisis; then the government and the political parties would have nothing left to do but to repent or blame others for their failures. The existence of the nation may be in danger. Therefore, everybody must act with a high sense of national responsibility.

3. In this circumstance, the young people are migrating outside the country in search of jobs. In the first seven months of the current fiscal year, a total of 104,000 persons or about 2 percent of the young (15-29 years) have migrated to the countries other than India. If the current trend continues, Nepal will be a nation of children and old people in the near future. The remittances received from the Nepalese workers have not only supported the national economy but have also been able to give a false impression that the economic activities in Nepal are well planned and in the right track. This has perhaps enabled the government and political parties to devote all their energy in political games. No new programs of national economic importance have been announced recently. One of the main reasons for such behavior lies in the members of the National Planning Commission, an agency responsible to develop working policies and programs for development, with their irresponsible behavior in the economic area, too much inclination on foreign travels and, again, too much involvement in publicity oriented jobs only. The meeting of the National Development Council, the highest policy making authority in the country, has not been held since last four years.

4. It is now officially recognized by the government that the problem of inflation has reached almost a crisis stage. In the first six months of the current fiscal year price level increased by 8.8 percent: this is double the rate prevailing in India. The rising political conflict, the increase in inflationary expectation of the general public and the rise in the price of petroleum products will further aggravate the price situation. The general public have suffered a loss of Rs. 25. 8 billion from inflation in the first six months of the current fiscal year.

5. The purchasing power of money has been sharply reduced by inflation. The public are reducing their holdings of money as much as possible. In the fiscal year 2000/2001, the general public were holding about 65 days of their income in money but now they are holding only 51 days of income. This will decline further in proportion to the rise in the rate of inflation.

6. The government has initiated no new measures to control inflation. In the meantime, the price of petroleum products has been increased but one of the main reasons for the increase in the price of petroleum products is the high tax of the government, especially on petrol. The government has not, to the best of our knowledge, contemplated any measures to adjust both price and tax on petroleum product to control inflationary pressure. On the contrary, it has given the false impression that inflation is not only controlled but also it will decline a few points shortly.

Nepal Rastra Bank has similarly given the impression that inflation can be controlled by controlling money supply in the country. Given the current economic structure, Nepal can neither control money supply nor inflation. This is consistent with the experiences of the other countries of the world that are maintaining fixed exchange rate system. In the meantime, Nepal Rastra Bank has proposed to increase bank rate by 0.25 percent to control inflationary expectation and, subsequently, inflation. It may be recalled that bank rate is not used by the commercial banks in their internal transaction or with the banks or the public. Against this background, the increase in the bank rate even by 50 percent will not make any changes on major macro variables. The use of a policy instrument that is expected to produce no change in the economic structure to control inflation in the country just shows the bankruptcy in the policy management capability of the Nepal Rastra Bank.

7. The value of major macro variables, including price, balance of payments, and interest rate in Nepal is determined from the values prevailing in the Indian market because of the policy of fixed exchange rate and full convertibility followed by Nepalese currency vis-à-vis Indian currency. Nepal Rastra Bank, as a central bank, is only free to determine exchange rate of Nepalese currency vis- a vis Indian currency. Nepal Rastra Bank appears simply as a branch of Reserve Bank of India; it may not be acceptable in the political circle but this is a reality. If Nepal intends to follow independent price, balance of payments and interest rate policy, it has to follow flexible exchange rate policy with respect to Indian currency too. We have raised some questions (page 12) expecting responsible answers from the Nepal Rastra Bank.

8. The investment by the private sector in the bank and financial institutions after the political change of 1990 has been huge. Unfortunately, some banks in the private sector are at very alarming state. Nepal Rastra Bank is fully aware of this fact but the Board of Directors of the Nepal Rastra Bank, either because of their own interest or in the direction of the “power center” has tried to neglect the situation. It is claimed that management itself has used the resources of the banks far in excess of legal limit, and similarly has shown a tendency to provide loans to friends and relatives without proper security and limit, leading to a tendency to delay loan recovery as far as possible. If the problems of these banks are not solved in time, it will effect adversely the operation of other well managed banks and the fiscal structure of the country itself may be in difficulty.

9. When the problem of inflation has reached a critical stage, the gross domestic product in constant price in the current fiscal year will not increase, according to official estimates, by 4.5 percent but 3.5 percent. The official estimates still appear ambitious. It is expected that gross domestic product will not increase by more than 2.5 per cent, that is, equal to the annual growth in population. The per capita income will remain constant at the previous year level. The economic characteristics characterized by rising prices and stagnant income is popularly known as Stagflation, a situation in which Nepal is trapped at present. We have indicated this in our first report. Now the government officials have also confirmed this finding. In such circumstances, monetary policy will not be able to play the desired role due to various economic limitations and the burden will be solely on the fiscal policy. But the fiscal situation of Nepal at present has its own problems.

10. There has been no improvement in the fiscal position of the country, though the use of word ‘bankrupt’ in our first report has made them very aware. But the bizarre pattern of the government expenditure (the contingency fund that was set aside for the current fiscal year has already been finished), the facilities are provided to the industries owned by the decision makers themselves and the unnecessary interference in the business of private sector etc. clearly show the difficulties that the country is faced in the fiscal field. It is,however, not possible (a) how much of the difficulty is due to the mistakes in policy or program and (b) how much is the direct result of the unethical behavior of the decision makers.

11. His Majesty’s Government has estimated the current year revenue to be about Rs. 81.82 billion. We, on the other hand, have estimated that it can not exceed Rs. 76.56 billion. But after the publication of our report on February 2, the estimates prepared by the economists, former planners, finance minister as well as the estimates made in several articles, reviews, and editorials of the leading newspapers show that the revenue of the government in the current fiscal year will be lower by Rs. 8 to 11 billion than the original estimates. In the meantime, the government has reduced the growth rate of gross domestic product for the current fiscal year which will, no doubt, effect the government expected revenue for the current year. In the light of this information, it is estimated that the government revenue in the current fiscal year will be only Rs. 74 billion, further Rs. 2 billion less than our original estimate of Rs 76 billion. The regular expenditure is not expected to decline from the original estimates. Viewed from this angle, His Majesty’s Government will have difficulty not only to meet regular expenditure but also to pay back its both foreign and domestic loans. Available information suggests that His Majesty’s Government needs an additional Rs. 6.20 billion to meet its regular expenditure and to pay the mature loans. It is not clear how the government will manage the required funds. In the meantime, it is suspected by many that the government may use internal loan to finance regular expenditure. Similarly, the local counterpart funds of several cancelled projects and programs may have been used in the regular side. Detail information is expected to be available soon.

12. The government has expected the total revenue in the current fiscal year to total Rs. 81.82 billion but the amount raised in the first eight months total only Rs. 41 billion. The revenue is increasing at less than a satisfactory rate. The demand and need of financial resources has increased at a very high rate. For example, Nepal Oil Corporation is in need of Rs. 2-3 billion. On the other hand, the expected receipts of Rs. 2 billion from India are not expected to realize due to various reasons. The government even appears to have made public several financial data after modifying it to meet its need. For example, in the press release issued in February, the government has claimed that it has budgetary surplus of Rs.2.93 billion and “therefore in a comfortable position with respect to income and expenditure”. It is ironic to note that it was not the budgetary surplus of the government but the remaining balance in the account of local authorities. It is not ethical on the part of government to show the balance of other agencies as its surplus of total income over expenditure. This is a sign of rising financial problem. Against this background, the overall financial transactions of the government itself has become the mystery to all rather than a subject of analytical research.

13. We are all familiar with the problem of capital flight. The problem is expected to increase further due to possible increase in the deposit rate offered by the commercial banks of India which will further widen the interest rate disparity between Nepal and India. Now even the Nepal Rastra Bank appears worried. The Resident Representatives of the World Bank, Asian Development Bank, and DFID together have recently expressed their concern about the problem of capital flight.

The Economic Level and Direction after February 2, 2006……….

1. Introduction
The politics and economics of the country are at present in an abnormal and uncertain state, made worse by the political conflict, the remote possibility of its resolution, indications of open corruption on the part of policy makers and increasing unethical practices in the private sector. As a result, the general people appear to be uncertain about their future. Against this background, the government’s claim that “the economy is moving forward smoothly and is on course to meet the targets and that any projections removed from this reality will only mislead the public” appears ridiculous. Those who monitor the movements of the economy like IfDS find no grounds for consolation as the overall economic signs are far from hopeful. Indeed, every citizen, and IfDS too, would like to see all dire predictions about the economy to be proved false, including those IfDS had made in its last report, namely a) the entire economy may may fall abruptly….if the present situation is not corrected; b) the government may go bankrupt by June even if the present trend continues; and c) an explosion of the economic problem, unlike a political problem, will not allow enough time for its resolution, thus plunging the country into anarchy and even endangering the existence of the nation.

Unfortunately, the government has shown no sign of taking corrective action. On the contrary, some of the policies and programmes it has announced since our last report have helped make things worse. The government’s course of action has lacked a clear direction, shown apathy to public welfare as well as a predominance of personal egos and interests of those in power over moral values and norms and a sense of public responsibility. All this has had, and will have, an adverse impact on the economic sector of the country.

However, it is a matter of satisfaction that our last report has helped draw the attention of all to the problems bedevilling the economic sector. The daily and the weekly press prominently covered the report; some of them even published the full text; and most of the electronic media put on their Web sites the full text. Some of the international media analytically highlighted the report. Most of the national dailies editorialized the problems pointed out by IfDS and there has been good reader response in the letters columns of newspapers. The radio and television broadcast a spate of discussions and interviews on the issues raised by the report.

We have published this second report as part of our effort to regularly shed light on the state of the economy and draw the attention of all concerned to the key economic issues and the direction of the economy. We hope the present report will also be useful, as our last report. Any suggestions for improvement of our work will be welcome.

The government reacted sharply to our last report. On February 7, four days after the publication of our report, His Majesty’s Government held a press conference at the Department of Information at which Minister of State for Finance read out a written response and fielded questions raised by Nepalese and foreign journalists. The minister of state for information and communication, the Governor of the Nepal Rastra Bank and senior officials of the finance ministry were also present on the occasion. It was claimed that IfDS report “lacked a solid foundation, was prejudicial, arbitrary and fabricated”. Besides, there was no truth in the news published in newspapers that poverty had increased in the country. The next day IfDS issued a rejoinder stating that “there was no basis [for IfDS] to change our stand”. The IfDS executive director even wrote an open letter to the Minister of State for Finance (The Kathmandu Post, February 10, 2006) pointing out the misconceptions that the government’s response sought to create. We find it mysterious why the government overreacted. But we got the impression that, by creating controversy about one or two issues, the government tried to hide the deteriorating economic condition of the country and divert public attention from the major issues we had raised.

2. Development … And Implementation

In Nepal, as we have said before, there are currently two schools of thought regarding the country’s development, but both have failed to give due priority to development programmes. One (mainly the political parties) sees development possible only after the end of the national conflict; and the other (particularly the government) sees the need to end the Maoist insurgency first to speed up development. There is no doubt that the political crisis is the most pressing problem of the country, but there is no theoretical and empirical basis for both views. Sri Lanka is a case in point. According to the World Bank country representative for Nepal, “ Political stability is the first condition for the development of any nation, but this does not mean that economic development cannot take place until the political problem is resolved.” (Himalaya Times, March 1, 2006)

Admittedly, Nepal’s situation is somewhat strange. While there is the problem of stagflation, even the existing economic infrastructure is being destroyed, particularly in the hilly region. The deteriorating economic condition is certain to make the conflict worse. The blockade of districts headquarters that began on March 14, 2006 and the nationwide general strike scheduled to begin on a few days thereafter (a Maoist programme) on the one hand and the ‘tempest of movement’ the seven political parties are trying to create in the country in order to bring about far-reaching democratic political change, including the fall of this government, are likely to have widespread negative implications for the country. Amid this political storm, the economic issues of particular concern to the general public have become non-issues for all political forces, and the economic mess could provide the political parties with a political tool for intensifying the conflict.

If the political action of the Maoists and the parties becomes strong, it is likely to have the effect of lowering production, raising the price level further, and even making a number of goods scarce, closing educational institutions and making access to health facilities difficult because of the halt to transport services. It is therefore difficult to assess the economic consequences of these things and equally difficult to predict where all this will exactly lead to. The fact that a number of responsible people have said that, in this time of conflict, it will be useless even to discuss economic issues gives cause for concern.

Amid all this, the youth of the country appear to be confused. Some of them may even have been attracted to the Maoists just because they saw no future for them in the normal course of things. Job creation in the country has remained stagnant for a long period of time. This has forced the Nepali youth to seek employment abroad as far as possible. As a result, in the first seven months of this fiscal year, the number of people going abroad for employment has reached 104,000, that is, 41 per cent higher than the figure for the corresponding period of the previous year. This accounts for 2 percent of the youth (15-29 age group) population of the country. If this exodus continues, Nepal will ultimately be peopled only by children and senior citizens. Therefore, job creation in the country is necessary to contribute to both crisis resolution and national development. The rise in remittance income is an indication of the level and spread of poverty in the country. However much this income may have made things easier for the government, it is far more important to run development programmes and create jobs within the country to help resolve the crisis. Sadly, even some of the planners hold the view that “it is impossible to improve the socio-economic situation in the country until a permanent solution to the Maoist problem is found”. (Vice-Chairman of the National Planning Commission, presenting the Nepalese viewpoint at Asia 2015.)

But a number of donor countries and agencies are of the view that the economic growth rate could be improved even under the present conditions. According to a joint statement issued (March 6, 2006) by the Kathmandu-based representatives of DFID, ADB, and the World Bank, “Many Nepalese are thinking of freedom from political and security crises first and of development only after that. Most of the political leaders are thinking likewise. But the situation is never as easy as it is thought to be. …therefore we say – Nepal should not give up its economic agenda. A more rapid growth rate could well be one of the major conditions even to cut the ‘knot of conflict’. A decline in the growth rate, unemployment reaching a new high, and conflict are revolving round the same axis”.

Undoubtedly, it is possible to increase the economic growth rate and employment, though it has not been done. Perhaps it will not be an exaggeration to say that this is mainly due to the lack of a sense of responsibility, the excessive interest in foreign travel as well as in publicity shown by planners and policy makers such as those at the National Planning Commission (NPC). Who is coordinating the Ministry of Finance (fiscal policy), the Nepal Rastra Bank (monetary policy) and the NPC (development programmes) – the agencies responsible for the formulation and coordination of national development policy and programmes – has now become a principal question. The annual meeting of the National Development Council, the apex body for the formulation of national development policy, has not been held for the past four years. The Tenth Plan has now become useless even much before the expiry of its five-year term, but no new strategies and programmes to meet the new national conditions have been worked out in order to implement development programmes.

It would be in order here to discuss briefly the economic activities and the pace and state of the national economy between the publication of our first report and now.

3. Monetary Policy

The Nepal Rastra Bank (NRB), the central bank of the country, issued its mid-term evaluation report on monetary policy on February 16, 2006. It is said that the report could have been a fine research document prepared by a well-trained staff but, unfortunately, it did not deal with some of the key issues while discussing monetary policy. We have already explained these in the press release issued earlier. The important national issues, for example, inflation, increasing poverty, capital flight, the deteriorating balance of payments situation with our major trading partner and the expected impact of deteriorating fiscal situation on the monetary sector were not adequately covered. Similarly, no new policy measure was announced to deal with the emerging situation, nor were any changes made in the existing policy and programmes in the light of current experiences. Therefore, the very purpose of this mid-term evaluation report is not clear. It is claimed that the “operational strategy of monetary policy proposed at the beginning of the current fiscal year” has remained unchanged. The bank rate, however, has been increased by 0.25 percent to ‘check the inflationary pressure’ in the country, and this has become a subject of analysis and debate in the press.

NRB claims that the increase in the bank rate will check the inflationary expectations in the country. However, it may be recalled that the bank rate is not used in Nepal in any financial transactions conducted by the bank. This has been clearly admitted in the report itself. Against this background, the increase in the bank rate – a policy instrument that has never been, or is expected to be, operational – even by 50 percent would not have made a difference to the major macro-variables of the country. It is therefore safe to argue that the objective of the NRB to control inflationary pressure by controlling inflationary expectations by means of raising the bank rate appears to be a joke at best or the bankruptcy of NRB’s capacity to formulate policy. It is up to NRB to decide which description fits it better.

A thorough review of annual monetary policy strategy issued by NRB in mid-July 2005 and its recent mid-term evaluation suggests that NRB is still not clear about what monetary policy can do or cannot do. At the outset, NRB has tried to give the impression that the value of basic macro-variables of the economy, including (1) price (2) balance of payments (3) the economic growth rate (4) the growth rate of money supply and (5) the interest rate, can be maintained at the desired level by the monetary authority through a manipulation of policy instruments. The monetary policy of the country appears to have been based on this assumption. (Monetary Policy 2005/06, pp. 2-11). It is not possible to achieve all these objectives. In fact the establishment of NRB was not meant to accomplish so many objectives. It was established, in accordance with the Nepal Rastra Bank Act 2002, to “maintain price and balance of payments at appropriate level by formulating appropriate monetary and foreign exchange rate policy and its management”.

NRB has maintained a policy of fixed exchange rate with the Indian currency to fulfill these tasks. As a result, it is not difficult to analyse the level of price and balance of payments in the country or to forecast its future trends. Both of these – the level and trends of price and balance of payments – will be determined by the level and trends of the exchange rate with respect to the Indian currency. Similarly, the interest rates charged or offered by the commercial banks of both countries need to be almost at the same level, given the open border and the absence of any restriction on the movement of resources on both current and capital accounts. If they are not equal, it is generally believed that the process of capital flows between the two countries will be speeded up to bring them into equilibrium.

The policy makers of NRB are well aware of this act. According to NRB, “For an open economy like that of Nepal, it is not appropriate to allow a big difference in interest rates for a long time. …It will encourage capital flight and will make the task of management of Indian currency reserve difficult.” Viewed thus, the level of and change in the price level, balance of payments, and interest rate in Nepal follow the trends in India. As the central bank, NRB is free to determine only the exchange rate of the Nepalese currency vis-à-vis the Indian currency. In a sense, NRB has been reduced to the role of a branch of the Reserve Bank of India. This statement, no doubt, will be unacceptable at the political level but this is a reality. If Nepal wants full independence in the area of price determination, balance of payments and interest rate, it should follow a flexible exchange rate policy with respect to the Indian currency as well. The experiences of other countries with small populations – for example, Canada – with an open border with a big country supports the above hypothesis.

In this context, the only aim of the monetary and the foreign exchange rate policy of Nepal is to fix objectively the exchange rate of the Nepalese currency vis-a-vis the Indian currency and to maintain that rate by means of manipulating policy instruments at its disposal to give the public a sense of certainty. The report drawn up by the staff of the International Monetary Fund (IMF) that visited Kathmandu from October 20 to November 2, 2005 also supports the above hypothesis. The report says, “Monetary policy should remain geared to supporting the peg to the Indian rupee. The peg has served Nepal well, given its close ties with India and has helped to keep inflation at a low level. (We will discuss at an appropriate place the reasons for the current divergence in the inflation rate experienced by Nepal and India). The level of the peg appears to be broadly appropriate for now, but should remain under review…” The Directors of IMF have also agreed that monetary and exchange rate policies should remain geared to supporting the exchange rate peg.

Against this background, NRB should clearly review the following issues in order to provide a satisfactory explanation to the public:

(1) Has the current foreign exchange rate policy based on fixed exchange rate with the Indian currency served the national economy as expected or is there a better alternative? If there is, what is it? If it is appropriate to maintain the current system, is it not appropriate to allow the general public to keep deposits in the Indian currency with commercial banks, as it is legal for people to maintain deposits in other currencies?

(2) Has the current exchange rate of the Nepalese currency vis-à-vis the Indian currency been fixed at the appropriate level? If it is, how can we explain the deteriorating balance of payments position with India, the import of more than two hundred goods from India by paying convertible currencies only and the reasons for buying Indian currency time and time again from India to meet domestic demand.

(3) In a country following a fixed exchange rate regime, it is generally agreed that the central bank will have no control over changes in money supply. In Nepal, the receipts from remittances are the primary reason for a major change in money supply, but the central bank has no control over receipts from remittances. The receipts from remittances in convertible currencies will increase money supply and, according to available estimates, lead to a rise in demand for the Indian currency. This process shows that due to stagnant economic growth the rise in receipts from remittances in convertible currencies will automatically lead to a rise in demand for the Indian currency and further deterioration in the balance of payments with India. Under these circumstances, how can the foreign exchange reserve be managed and used?

(4) Are the policy makers facing any difficulty in opting for a flexible exchange rate policy with the Indian currency?

We hope NRB will provide answers to these questions soon to satisfy public curiosity about the formulation and management of monetary policy.

The next important objective of NRB is “to provide stability in the banking and financial system and to generate adequate liquidity” in the system. The banking and the financial system depend on mutual trust. Any deviation from this may plunge the nation into a financial crisis. Thus, NRB has been charged with the responsibility of developing the banking system by means of raising public confidence in it as well as by discharging the functions of inspection, supervision and monitoring of the banking system. A number of banks and financial institutions have been established in the country in recent years. But no information is available about how they are being run, what are the difficulties, if any, they are facing, as well as the measures adopted by NRB to resolve them.

The lack of transparency in the banking system has led us to examine the problems through the information provided by various other institutions and media. Available information indicates that the state of the banking and financial system is not as strong as it is claimed to be, so much so that the a few banks and financial institutions have been dominated by a few individuals, or a small group and even family members. The offices of banks and financial institutions may look impressive from outside but it is unfortunate to note that several foreign banks that had started joint ventures with Nepali partners after the 1990 pro-democracy movement have already withdrawn their investment and gone back home. Unfortunately, we have taken this also as a national success whatever that indicates.

It is not difficult to suppress the problems of banks and financial institutions for a long time. But if the public become aware of such activities performed by a bank or a financial institution, it may create unexpected difficulties not only for the institutions concerned but also for several others which have been run smoothly and fairly. NRB should, therefore, be aware of the activities of the financial system both at micro and macro levels, and the management of the banks and financial institutions should also try to run the institutions efficiently and in a transparent manner. But available information indicates that in a number of banks, the management itself has used the resources far in excess of the legal limit, and similarly has shown a tendency to provide loans to friends and relatives without proper security and limit, leading to a tendency to delay loan recovery as far as possible. Available information also suggests that NRB is fully aware of this fact.

It has been well reported that the NRB staff have proposed to the bank board that they take control of three specific commercial banks of the private sector that are now on the verge of collapse but the members of the NRB Board of Directors, either because of their own interest or on the direction of some ”power center.” has tried to kill the proposal. This will not be possible in the long run but the attempt has been made and this is just one example. But the situation is deteriorating rapidly and it now appears adequately linked with the issue of national security. True, the Governor and the members of the Board of Directors of the Nepal Rastra Bank have to act not only to fulfill their statutory responsibility but also to do so at an appropriate time. It is an independent and organized body entrusted with responsibility ranging formulation to implementation of monetary policy.

We can control the situation of the banking system by following appropriate policy and programmes. This is, however, a very sensitive issue and we do not want to prolong our discussion for the moment in the hope that it will be resolved soon. The most important task of the members of the Board of Directors of the Nepal Rastra Bank is to act in a responsible way. But surprising is their silence even in the face of questions being raised about their integrity. It is almost late to solve the existing problems. But it is never too late to move in the right direction.

4. Inflation

Although NRB has acknowledged the grave reality of price spiral during the current fiscal year (2005/06), no measures to check it have been introduced so far. In view of the growing confrontation in the country and the relevant foreign exchange system – fixed exchange rate with the Indian currency and its implications for the economy – there is a remote possibility that NRB will have any effective role in correcting this anomaly. NRB can neither control the money supply in this situation nor check inflation. As such, the impression NRB has tried to create that it can control the money supply is baseless. This is proved by the experiences of those countries which have pegged the exchange rate of their currency to some particular foreign currency, as in Nepal.

During F/Y 2004/05, the gross domestic product (GDP) increased by 2.3 percent only, according to NRB statistics and mid-term evaluation report. It is estimated that there will be no significant increase in per capita income because of the virtual stagnation in GDP during the current fiscal year as well. On the other hand, the rate of inflation during the first half of 2005/06 jumped to 8.2 percent. The current inflation rate in Nepal is double the rate prevailing in India. The coexistence of increasing inflation with no significant increment or almost stagnation in per capita income in the Nepalese economy is called stagflation in economic terms. We have already pointed out this serious anomaly in our first report. Of late, the government too has acknowledged this crisis. The inflation rate tends to increase at a greater rate than in the Indian economy. It is now well established that this trend is attributed to the inflationary expectation of the people caused by the growing political conflict in the country. It is an undisputed fact. Actually stagflation is a very serious problem facing the Nepalese economy and calls for various fiscal measures.

The government, on the other hand, has not yet adopted any anti-inflation measures. It seems the government is not serious about cutting down financial expenditure to avoid bankruptcy in coming May/June as projected by IfDS; nor are the policy makers and officials clear about what the word ‘bankruptcy’ actually means. Accordingly, the government shifted the authority of fixing the retail prices of petroleum products to the private sector on Falgun 1 and raised the prices of diesel, kerosene and petrol by 15, 22 and 4 per cent respectively after 4 days. This hike in petro-prices has reduced the monthly loss of Nepal oil Corporation (NOC) Rs. 57 crore to Rs. 20 crore. The government could have reduced tax on petroleum products instead of increasing the prices to control the general price rise. The government raises Rs. 7 billion annually by levying Rs. 21.35, Rs. 2.52 and Rs, 2.10 as taxes on petrol, diesel and kerosene respectively.

The government could have controlled the price increases by waiving the customs duty on petroleum products but could not do so due to its weak financial condition. Consequently, it was forced to raise the prices of petroleum products to save NOC from bankruptcy. Further, there are reasons behind the decision to authorise the private sector to fix the retail price of petroleum products. This measure is a mockery of liberalization as the government is the sole importer and wholesale price fixer of the petroleum products.

The increase in the price of petroleum products has naturally led to the price rise in all the related sectors. Transportation price was increased by 28% immediately. The government, on the other hand, is misleading the public that it was on the way to checking the inflation by controlling the two major components of general price rise – the hikes in the prices of petroleum products and in the rate of VAT – and both are the government’s own creation! This reveals the fact that the government itself is confused about the basic cause and effect of the inflation. The country is now facing price rise not only in a few items but generally. The whole price index has been rising in an inflationary spiral. A glance at the general price index reveals the seriousness of the prevailing inflationary trend. The first five months of the current fiscal year shows a price rise of 14.6 % in food grains, 28.7 % in fruit and vegetables and 11% in pulses (dalhan). This rising trend will continue as the whole price index reflects retail prices in the market.

Inflation is actually a tax to the commoners. As per NRB reports, the total money supply till the end of January was Rs.315 billion whereas the inflation rate during the first six months of the current fiscal year stood at 8.2 percent. Accordingly, the purchasing power of money supply decreased by Rs. 25.8 billion, which is the “inflation tax” the general public are made to pay. We have to undertake a separate study on how some people benefit form such a situation. The experiences of other countries show that the common people tend to hold less money and invest more in the real estate under inflationary conditions. The trend in Nepal is also the same. As the study shows, one average Nepali used to keep his 65 days’ earnings in cash in fiscal year 2000/01 whereas it has decreased to 51 days during the current fiscal year. It is decreasing day by day.

The inflationary spiral results in the fall of public savings in the form of money to the negligible amount in proportion to the GDP. Other countries’ experiences show that the increment in government’s revenue in prevailing prices is followed by the inflation but it is not the same in our context. The increment in government revenue at fixed prices is negative. The first six months of the current fiscal year has seen a fall in revenue against the rise in the rate of inflation.

5. Fiscal Situation

An important word enclosed in the report published in February 2, has upset the H MG/N, and the Minister of State for Finance individually. This has astonished many experts. So much so that the ex-governor of NRB, Dr. Tilak Rawal, has said, “The Minister of State for Finance is strangely terrified of a glimpse of the situation. He got frightened as if the stick was aimed at him. This behaviour of the state minister breeds suspicion”. (Abhiyan 1-7 January). It has been observed that the main reason for upsetting him is implicit in the following sentence and the word “bankrupt “: “The trends of government revenue and expenditure up to the current month, the structure of the current economic activities, the likely negative implications of supplementary budget on revenue, and the overall impact of the reduced customs duty etc. suggest that, given the current trend alone, there is every possibility of bankruptcy of the government by mid-June.”

Yet no sign of change has been discernible in this situation. So it does not seem necessary to change the word and sentence used above either. It is true that the decision maker concerned has been alarmed at the word, “bankrupt “ even without being effortful to understand its meaning. Due to this, many of the good policies are also perceived to have been used for accomplishing an undesirable objective. Likewise, a rapid deterioration has been seen in the coordination among different aspects of fiscal policy. The most important aspect of the current year is the inadequacy of the revenue to cover the regular expenditure. The reasons, already published in many newspapers, are: unplanned government expenditure, the efforts on the part of those in power to extend benefits to their own businesses to the possible extent, even unethically etc. As such no further elaboration is needed here. (See: Himal Fortnightly, Feb 28—Mar 132006.)

The allegation is that the proposal for revenue rebate rejected by the previous government has been accepted this time by the decision maker himself. (Kantipur, January 15.) If need be, we are in a position to cite many examples of similar nature, of which some have already been published in various newspapers. It has been almost difficult to decompose the issues witnessed in the fiscal situation arising from: 1) mistakes in policy, programme and implementation, and 2) corrupt behaviour of decision-makers. Whether the Commission for the Investigation of Abuse of Authority (CIAA) should be alert to the formulation of and implementation of fiscal policy or an institution such as ours needs to carry out economic analysis in the traditional way is a topic for research.

There was a consensus that the revenue was overestimated and expenditure, particularly the regular one, was underestimated while formulating the budget of the current fiscal year. Moreover, on the revenue front, M0F itself had estimated an additional burden on the budget amounting to Rs.1 .7 billion due to several tax concessions granted in the supplementary budget. The government had estimated revenue at Rs.81 .82 billion for the current year while this institute had estimated revenue not to exceed Rs.76.56 billion based on current economic growth rate, and also on the findings of studies and research on current economic activities. Now, the situation seems to be very critical. While formulating the budget for the current year the economic growth rate was assumed to be 4.5 percent and this figure was used for forecasting the revenue. Few believed the growth rate to be double in the current year from the low rate of 2.3 percent of the previous year (2004/ 05). Now the government itself has revised the growth rate to 3.5 percent. Even this rate seems to be ambitious in the context of the previous year.

A study conducted by the International Monetary Fund has shown that frequent changes in the government lead to a decline by one percent in growth rate in Nepal. Primarily, accepting a decline in growth rate as forecast by the government, there is every reason to accept a decline in revenue but an increase in fiscal deficit. These data should have been revised by the ministries concerned but it has not attracted their attention so far. There is every possibility of decreasing the credibility of fiscal policy if changes or adjustments are made in data and estimates the way the government likes.

Even the estimates made by us seemed to be overestimated in view of the gravity of the problem as revealed by public comments. According to the opinion of the ex-vice chairman of the National Planning Commission, Mr. Prithibi Raj Ligal, there is no possibility of revenue exceeding Rs.74.0 billion in the current year. Similarly, according to the ex-minister for finance, Dr. Prakash Chandra Lohani, revenue collection is likely to be around Rs.73.0 billion. “In case the present trends of administrative disorder and economic anarchism remain unchecked, it will be no surprise if the revenue collection comes to Rs.70 billion, (Samaya, Feb 16, 2006). Likewise, as per the editorial of the daily, The Himalayan Times, the estimate made by this Institute is on the higher side. (The Himalayan Times, Feb 11, 2006.)

Thus, in this context, the views of economists, ex-planners, former finance ministers, and editorials and articles written in various newspapers and journals suggest that there will be a revenue shortfall in the range of Rs. 8- 11 billion in the current year. Decline in regular expenditure or trend thereof has not been seen. According to an article published in Himal magazine, cited above, the amount earmarked for contingency expenditure for the whole year has been squandered within the first three months of the current year and further expenditure has been met by unethically transferring money earmarked under certain account heads to other account heads. In this context, as per the ex-minister for finance, Dr. Lohani, if income were to amount to Rs.70 billion and expenditure (regular) to Rs.76 billion, the government has already met one of the norms of “ bankruptcy”.

Income and Expenditure Position 2005/ 6 (New estimates)
(Rs. in billions)

Headings Budget estimate IfDS’s new estimates
1. Total resources 93.67 85.85
Revenue 81.82 74.00
Internal Loan 11.85 11.85

2. Total expenditure 89.65 92.05
Current expenditure. 75.85 75.85
Principal repayment 13.80 14.50
Supplementary budget( custom rebate) – 1 .70

3. Current expenditure (saving) (-deficit) 4.02 -6.20

According to the above table, the government is short of resources not only to meet the current expenditure but also to repay the domestic and foreign debts. The gap between the total resources and total income has been increasing daily. Based on the available information, the government is in need of additional resources amounting to Rs.6.20 billion for financing current expenditure and repayment of matured loans. The lack of transparency regarding many of the pubflc activities and also the unethical use of data by the government in many cases have hindered the research institute like ours from understanding the gravity of the problems. An example is a rare possibility of reimbursement by India of the amount of claims made by HMG/N worth Rs. 2 billion for the current year. There is no possibility at all of the reimbursement if account is taken of the expenses to be reimbursed by HMG for the import of military hardware from India.

As far as revenue is concerned, there is no sign of raising it as per the Government estimates. The revenue collection in the first eight months of the current fiscal year amounted to Rs. 41 billion against the annual target of Rs. 81.82 billion. In a situation like this , it is the duty of the Government to be transparant as to how it has been managing expenditure. In the press conference held last February, the Government had in its press communique stated a saving of Rs. 2.93 billion, and it claimed, “The Government seems to be in surplus in view of normal income and expenditure”. but the surplus was the unspent amount of the local bodies. It is not ethical to claim the amount as Government ‘surplus’. If it is so, in the absence of the parliament, should we consider the salaries and allowances of the parliamentarians and other related expences as the ‘surplus’ of the Government? NRB has not included the amount of the money in the account of the local bodies and is understood to have advise the Government accordingly. (Nepal Rastra Bank, Country’s Current Economic Situation, March 2006).

In an environment like this, the transactions of the government have become sensational and beyond research. In the meantime, there is a belief that the “MoF is vigorously involved in the exercise of the preparation of the revised fiscal ordinance” (Abhiyan, Feb.19, 2006.) We had also expected the same for several days. These are the signals of deepening fiscal crisis. On the other front, the Nepal Oil Corporation (NOC) has become a burden to the government due to its own obstinacy and in turn to the nation although the recent revision in the prices has been successful enough to reduce the corporation’s losses considerably. But the accumulated losses of NOC and the arrears to be settled with the Indian Oil Corporation suggest that the Corporation is in need of Rs.2 to 3 billion, otherwise it will face a deep crisis. The reluctance of the commercial banks to provide credit to the Corporation also reflects the crisis it is currently facing. Yet no reliable information is available as regards the ways of resolving this problem

Many have suspected that the Government probably has used even the domestic loan component of the budget for financing the current expenditure. In the meantime, after the suspension of foreign assistance by most of the multilatral agencies, the Government, it is suspected, has used the socalled counterpart funds too for meeting the current expenditure. It is hope that more information will be available in the near future regarding these issues.

6. To Conclude

We are all familiar with the growing problem of capital flight. Clearly, the widening inequality between the rates of interest offered on bank deposits in Nepal and India will accelerate capital flight. Now one can feel that NRB too is getting somewhat worried about this trend. The Indian Union Budget presented on March 1 announced measures to encourage competition among banks to mobilise more deposits and it is therefore likely to push up interest rates in India. This, according to the chief of the NRB’s Research Department, will increase the risk of large-scale capital flight from Nepal to India. (nepalnews.com, March 4, 2006) But Nepalese commercial banks are unlikely to raise interest rates on deposits. Rather, the interest rates the commercial banks provide in Nepal will turn out to be negative if calculated at constant prices. The money received from remittances from abroad seems to be running our commercial banks. Now there is a kind of competition in Nepal to establish new banks and financial institutions. But there has been little research on how many banks and financial institutions the country’s economy can sustain, nor has anybody shown interest in assessing the present and future impact of the investment made by commercial banks.

As discussed above, there is rather a harmful tendency developing among the boards of directors of some banks — to use banking resources illegally, to invest in certain companies irrespective of financial prudence and creditworthiness of applicants, and to show unwillingness to recover loans. The present calm in the financial and mainly banking sector may well be a harbinger of the storm ahead. One negative effect of the remittance money has been that as it has eased the financial problem, the policy makers have become self-complacent about the situation in the country, which calls for urgent corrective measures.

Now international donor agencies have also, formally and openly, started to stress the need to be alert to the danger of capital flight. The above- mentioned article jointly penned by the representatives of the World Bank, Asian Development Bank, and DFID draws attention to this danger clearly. Accordingly, “What does the remittance money indicate? Certainly, it indicates a high demand for Nepalese labour. It might be good for Nepal, but it also means that good jobs and opportunities exist abroad, instead of in Nepal. Then naturally, big foreign investment flows into those very countries. The idea of a common fund for Nepalese investing in India and other countries has been put forward. Obviously, there is no shortage of capital in Nepal but it is on the way out of the country. If such a fund were set up in India, Nepal would even lose the resources put together with great difficulty”.

While stagnant income and increasing inflation mean hardships for the ordinary people, capital flight points out that the future economic prospects of the country are bleak. In order to improve the situation, it is indeed necessary to resolve the complex political crisis facing the country. But in the name of the political conflict, the indifference of policy makers to the need for effective measures to deal with the economic crisis or the misuse of fiscal and monetary policies and programmes are worsening both economic and political problems. It is already late for corrective action. Failure to do so in days to come too might plunge the country into unprecedented crisis; then the government and the political parties would have nothing left to do but to repent or blame others for their failures. The existence of the nation may be in danger. Therefore, everybody must act with a high sense of national responsibility.

Few words

Institute for Development Studies (IfDS) is happy to publish the second report on the state of the economy obtained from the regular monitoring of the national economic activities. It also contains, where possible, a brief analysis and evaluation of new policies and programs undertaken by the Government after February 2, 2006. We will continue to disseminate our findings regularly through various channels.

Dr. Raghab D. Pant
Executive Director
Institute for Development Studies
27 March, 2006