As we have seen both within South Asia and globally,
the Nepali economy is expected to grow by 3.7 percent in the current fiscal year and 4.1 percent in FY2022/23, led by a recovery of the services sector amid high COVID vaccination rates. The data speaks for itself. However, there remain several challenges.According to our latest projections,
Unpacking External Sector Developments
As the Nepali economy begins to recover from closed borders, supply chain disruptions, and movement restrictions, not all sectors of the economy are recovering at the same time. Imports have boomed before tourism has recovered and remittances have been able to stabilize, opening a wide external deficit financed by foreign exchange reserves.
The war between Russia and Ukraine has sent shockwaves through commodity markets, raising the price of fertilizers, food, and fuel that Nepal relies on to keep its economy growing. The delicate task of unwinding pandemic-era support to keep credit flowing to the private sector has been further complicated by rising inflation.
These factors together have increased external pressure and have resulted in a decline of official foreign exchange reserves. Despite their decline, however,
Official reserves in mid-January 2022 stood at USD 9.9 billion, covering 6.6 months of imports. While this level is below the NRB’s target of 7 months of import cover, it exceeds the reserve levels of many other countries and is above the minimum recommended threshold of 5.5 months.
Reserves also comfortably cover Nepal’s external debt service, standing at over 30 times the country’s external debt obligations coming due in the second half of FY2022. Additionally, according to the IMF and World Bank assessment in December 2021, Nepal remains at low risk of debt distress. Among a total of seventy low and lower middle-income countries, Nepal is one of only six to remain at low risk worldwide.
According to the IMF and World Bank assessment in December 2021, Nepal remains at low risk of debt distress. Among a total of seventy low and lower middle-income countries, Nepal is one of only six to remain at low risk worldwide.
It is also important to recognize that high imports and a large trade deficit is a by-product of Nepal’s economic model.to overcome the difficulties in finding well-paying jobs domestically.
Migration reduces domestic production, both directly because more people now work abroad, and indirectly because remittances contribute to an appreciation of the real exchange rate, reducing competitiveness. As a result, a large import bill is necessary to provide goods for domestic consumption and production and can be sustainable as long as foreign exchange earnings from all sources, including remittances, FDI, and exports, are sufficient to finance them.
This also means that a restriction of imports, especially for non-luxury items, can cause supply bottlenecks that impact consumption, poverty, and growth by depriving households and firms of critical items.
A restriction of imports, especially for non-luxury items, can cause supply bottlenecks that impact consumption, poverty, and growth by depriving households and firms of critical items.
A Fine Balance
Considering these factors,Indeed, there are good reasons to believe that the ballooning current account deficit is a transitory phenomenon. Economic recovery from a crisis as profound as COVID-19 is unlikely to be the same across sectors.
This is very visible in Nepal, where domestic consumption experienced a boom from accumulated savings which, combined with loose monetary policy, drove a rapid rise in imports. Nepal’s traditional financing sources for imports - tourism and remittances - take longer to recover as travel restrictions are removed and global mobility gradually resumes.
As a result, the World Bank’s latest projections foresee an elevated current account deficit of between 9 and 12 percent of GDP until FY23, and a gradual narrowing after as remittances and service exports increase, and as excess demand for imports driven by accumulated savings subsides. While reserves would continue declining until FY23 in this scenario, they would remain sufficient to cover external balances and would recover as the current account rebalances.
In this regard, government policies can accelerate the rebalancing of the current account. A critical and urgent approach could involve attracting more FDI to the country. As FDI is largely equity financing it does not increase Nepal’s external debt burden, and instead can replace reserves as a financing source for imports one-to-one.
Increasing FDI inflows is also likely to benefit the wider economy by transferring skills and technology from globally leading firms, thus enhancing domestic productivity, and helping Nepal create much needed high-quality jobs. Policy measures to attract more FDI could focus on regulatory reforms that make it easier to obtain approval for projects.
Also, reducing or eliminating the current FDI threshold is a priority. These can be complemented by policy measures that carefully unwind financial sector the stimulus that was enacted during the pandemic and is no longer needed. This could help reduce financial sector vulnerability and is a key driver of import demand. In reality, these measures may be more effective than the import restrictions which restrict access to consumption goods and production inputs, and which may impact economic growth.
A critical and urgent approach could involve attracting more FDI to the country. FDI can replace reserves as a financing source for imports one-to-one. Increasing FDI inflows is also likely to benefit the wider economy by transferring skills and technology from globally leading firms, thus enhancing domestic productivity, and helping Nepal create much needed high-quality jobs.
Amid the challenges, it is a credit to the resilience of Nepalis that the country continues to stay the course for a gradual recovery while maintaining a sustainable and resilient economy.
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