NEPAL DEVELOPMENT UPDATE Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery April 12, 2021 Standard Disclaimer: Photo credits: This volume is a product of the staff of the • Cover Concept and Design by Pycus Holdings International Bank for Reconstruction and Pvt. Ltd. Development/The World Bank. The findings, • All photos by Mr. Nabin Baral and Mr. interpretations, and conclusions expressed in this Narendra Shrestha  paper do not necessarily reflect the view of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries colors, denominations, and other information shown on any map in this work do not imply any judgement on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Copyright Statement: The material in this publication is copyrighted. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202- 522-2422, e-mail: pubright@worldbank.org Acknowledgments The Nepal Development Update is produced once (President, Garment Association of Nepal) and a year to report on key economic developments that government counterparts: Mr. Shreekrishna Nepal occurred during the year, placing them in a longer- (Joint Secretary, Ministry of Finance), Dr. Ram term and global perspective, and to examine (in the Prasad Ghimire (Joint Secretary, Ministry of Special Focus section) topics of particular policy Finance), Mr. Yam Lal Bhusal (Director General, significance. The Update is intended for a wide Department of Customs), Dr. Gunakar Bhatta audience including policy makers, business leaders, (Executive Director, Nepal Rastra Bank), Dr. the community of analysts and professionals Prakash Kumar Shrestha (Executive Director, Nepal engaged in economic debate, and the general public. Rastra Bank), Mr. Ishwori Prasad Bhandari (Director, Central Bureau of Statistics), Mr. Dhananjay This Update was produced by the World Bank Regmi (Chief Executive officer, Nepal Tourism Macroeconomics Trade and Investment (MTI) Board) and Mr. Prem Upadhyay (Under Secretary, team for Nepal consisting of Kene Ezemenari Ministry of Finance). The team thanks Zoubida (Senior Economist, MTI), Nayan Krishna Joshi Allaoua (Director, Equitable Growth, Finance and (Economist, MTI), Florian Blum (Economist, MTI); Institutions (EFI), South Asia Region), Faris Hadad- with a Special Focus Section prepared by Gonzalo Zervos (Country Director for Maldives, Nepal and Varela (Senior Economist, MTI) and Federico Ganz Sri Lanka), Lada Strelkova (Manager, Operations), Carulla (Consultant, MTI). Inputs were also received Manuela Francisco (Practice Manager, MTI), Tae from Nethra Palaniswamy (Senior Economist, Hyun Lee (Lead Country Economist, EFI) and POV), Alen Mulabdic (Economist, MTI), Shaun Aurélien Kruse (Lead Country Economist, MTI) Mann (Senior Operations Officer, FCI), Erik for their guidance and comments on the report. Nora (Senior Operations Officer, FCI), Sabin Raj Akash Shrestha and Avinashi Paudel managed Shrestha (Senior Financial Sector Specialist, FCI), media relations and dissemination. Diane Stamm and Peter Mousley (Lead Private Sector Specialist, edited the document. Anima Maharjan managed the FCI). The report also benefitted from consultations publication process. with the following private sector representatives: Mr. Vijay Kumar Dugar (President, Nepal Pashmina The cutoff date is March 15, 2021, and includes data Industries Association), Mr. Chandi Prasad Aryal released up until that date. i Abbreviations BFIs Banking and Financial Institutions CCD Credit-to-Core Capital and Deposit CISE Cash Incentive Scheme for Exporters DoC Department of Customs DoFE Department of Foreign Employment DoI Department of Industry DoT Department of Tourism GSP Generalized System of Preferences IRC Interest Rate Corridor JOCEX Jobs Content of Exports KYC Know-your-Customer LDC Least Developed Country MoF Ministry of Finance NRB Nepal Rastra Bank RPS Retail Payment Strategy SAR South Asia region SPS Sanitary and phytosanitary standards WITS World Integrated Trade Solution UNCTAD United Nations Conference on Trade and Development TRAINS Trade Analysis and Information System WTO World Trade Organization ii Table of Contents Acknowledgments............................................................................................................................................. i Abbreviations.................................................................................................................................................... ii Executive Summary..........................................................................................................................................vi A. Recent Economic Developments.................................................................................................................. 1 B. Outlook, Risks, and Challenges.................................................................................................................. 15 C. Special Topic: Trade as a platform for resilience and recovery.................................................................. 19 C1. Nepal’s export performance: a beyond COVID-19 perspective............................................................20 C2. Challenges and opportunities ahead to build back better.....................................................................25 C3. Challenges to meeting Nepal’s export potential...................................................................................29 C4. Policy options......................................................................................................................................... 33 References........................................................................................................................................................ 37 Tables Table ES1. Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery............................. ix Table 1. Macroeconomic projections of selected key indicators.................................................................... 16 Table 2. Major markets with multilateral preferential access for LDCs.........................................................32 FiguresFigure 1. Daily COVID-19 cases fell sharply by mid-March 2021........................................................2 Figure 1. Daily COVID-19 cases fell sharply by mid-March 2021.....................................................................2 Figure 2. GDP contracted by 1.9 percent in FY20 due to COVID-19-related social distancing and lockdown….3 Figure 3. …led by a decline in the investment on the demand side.................................................................3 Figure 4. Private consumption remained subdued despite an increase in remittance in H1FY21..................4 Figure 5. A declining number of new domestic and foreign businesses indicates anemic private investment.....4 Figure 6. Tourism remains at a standstill due to the collapse of international tourist arrivals........................4 Figure 7. Growth in paddy production has contributed to agricultural output in FY21..................................4 Figure 8. Mobility to nonresidential places has been increasing since October, indicating recovery in economic activity…...........................................................................................................................................5 Figure 9. Headline inflation declined in H1FY21, driven by a fall in both food and non-food inflation.........5 Figure 10. Losses in effective employment (percent economically active in 2020)..........................................6 Figure 11. Policy rates were lowered to enhance credit conditions...................................................................7 Figure 12. M2 growth still remained below the target......................................................................................7 Figure 13. Private credit growth picked up in FY21 but remains below pre-pandemic levels .........................7 Figure 14. Significant amounts of private credit were used for overdraft and margin lending .......................8 Figure 15. Eased credit conditions amidst weak credit demand contributed to the recent stock market rally...8 Figure 16. Deposits expanded by 9.2 percent in the first half of FY21............................................................8 Figure 17. Imports contracted during the pandemic…....................................................................................9 Figure 18. …partly reflecting the effects of depreciation in the real effective exchange rate..........................9 Figure 19. Exports also declined…...................................................................................................................9 Figure 20. …but remittance inflows picked up in H1FY21............................................................................. 10 Figure 21. Recovery in remittances and the improved trade balance narrowed the current account deficit.... 10 Figure 22. Foreign exchange reserves increased............................................................................................ 11 Figure 23. Revenues have dropped since the outbreak of the pandemic… .................................................. 11 Figure 24. …forcing fiscal adjustment especially through reduced capital expenditures............................. 12 Figure 25. Smaller fiscal surplus in H1FY21 reflects tighter fiscal conditions............................................... 12 Figure 26. Public debt increased to 36.4 percent of GDP............................................................................... 12 Figure 27. Compound annual growth rate of exports of goods and services in current US$, 1999–2019......20 Figure 28. Exports and remittances, cross-country comparison, 2019 or last available data......................... 21 Figure 29. Composition of merchandise exports............................................................................................ 21 Figure 30. Composition of services exports................................................................................................... 22 Figure 31. Share of manufactured exports classified as high-tech, last available year...................................22 Figure 32. Price obtained by relevant exports relative to competitors, 2019...................................................23 Figure 33. Survival of Nepalese exports, 2007–18........................................................................................... 23 Figure 34. GDP growth decomposition, 2001–17 ........................................................................................... 24 Figure 35. Per-worker value added (VA), current level and recent growth, Nepal compared to comparators.....24 Figure 36. Value added (VA) per worker, by sector, current level and recent growth, Nepal compared to comparators..................................................................................................................................................... 24 Figures Figure 37. Missing exports.............................................................................................................................. 26 Figure 38. Nepal’s missing exports, in million US$, 2010–17.........................................................................26 Figure 39. Nepal’s missing exports per trading partner and their import growth.........................................27 Figure 40. Nepal export performance compared to counterfactual scenarios and its export potential........28 Figure 41. Missing jobs in Nepal due to export underperformance, in thousands........................................28 Figure 42. Foreign direct investment, net inflows........................................................................................... 30 Figure 43. Upstream import duties, by sector................................................................................................. 31 Figure 44. Preference utilization..................................................................................................................... 32 Boxes Box 1. Estimating jobs created from US$1 million of exports........................................................................27 Box 2. Nepal’s Least Developed Country graduation and its potential impacts............................................32 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Executive Summary Recent Economic Developments Nepal has been hit hard by COVID-19, about 5.9 percent of the population (or 1,791,606 although the situation has improved more people) were inoculated by mid-March 2021. Thus, recently. As the outbreak became widespread there are good prospects that further outbreaks of in mid-2020, a nationwide lockdown was COVID-19 can be contained. implemented from March to July in 2020, followed by localized lockdowns, including in After contracting for the first time in 40 years the Kathmandu Valley up until mid-September. in FY20-by 1.9 percent-the economy showed During this time transportation, education signs of moderate recovery in the first half and tourism-related activities were significantly of FY21. Activity resumed in wholesale and restricted. Since October, the number of cases retail trade, transport, and financial services, while has been declining steadily, allowing a gradual favorable monsoons drove agricultural growth. easing of movement restrictions. Nepal launched However, tourism remained at a standstill and its vaccination program on January 27, 2021, and private investment anemic given high levels of April 2021 World Bank Group vi Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update overall uncertainty related to the epidemic as well falling by 3.4 percent in FY20). Given limited as political developments. Uncertainty arising from amounts of foreign direct investment (FDI), the epidemic has also contributed to fiscal risks external concessional loans have primarily financed due to the degree of fiscal stimulus provided to the current account deficit. The central bank’s support individuals and firms and which will need foreign exchange reserves increased moderately to to eventually be rolled back for fiscal sustainability. US$11.3 billion by mid-January 2021, equivalent to Political uncertainty also heightened in December 11.3 months of imports. 2020 when the Prime Minister dissolved Parliament. The Supreme Court overturned Spending was higher and revenue lower, y-o-y, the decision, reinstating Parliament in February over the first half of FY21. Higher spending was 2021 and precipitating the split of the two-party driven by purchases of COVID-19-related health majority coalition in March. equipment and investments at the subnational levels, which offset a significant reduction in Economic hardship is likely to have an impact capital spending at the central level. Meanwhile, on income and employment. The increasing revenues fell slightly. Tax revenues declined by 2.1 number of unemployment applications and percent y-o-y, with trade and consumption taxes, returning migrants could adversely affect progress as well as corporate income taxes performing in poverty reduction. The recent World Bank poorly. Non-tax revenues continued to suffer from COVID-19 monitoring survey suggests there the near standstill in tourism. Consequently, public were widespread impacts of the pandemic on debt increased by 8.2 percent over the first half of jobs and incomes, with more than two of every FY21, relative to the end of FY20, to 36.4 percent five economically active workers reporting an of the projected FY21 gross domestic product incidence of job loss or prolonged work absence. (GDP). Despite these changes, Nepal remains at Women, young workers, and those engaged in low risk of debt distress. nonagricultural activities have been the most severely affected. Outlook, Risks, and Challenges Credit growth recovered in recent months, The economy is expected to recover steadily albeit moderately. In the wake of the COVID-19 but gradually from FY21 onward. Assuming a crisis, the central bank lowered its policy rate and successful vaccination rollout domestically and took additional measures to support credit to the globally, and a gradual resumption of international private sector, including refinancing programs for tourism, real GDP is projected to grow by 2.7 COVID-19-affected firms. As a result, credit to the percent in FY21 and 3.9 percent in FY22. Growth private sector grew by 11.6 percent in the first half is expected to be driven by services as social of FY21, still below pre-pandemic levels. Over the distancing eases up further, and by agriculture, same period, deposits increased significantly due on the back of recent favorable monsoons. possibly to three key factors: higher precautionary However, the pandemic is expected to have lasting savings, repatriation of savings by returning effects. Without reforms to readjust towards a migrants, and reduced consumption amidst social post-COVID-19 tourism market that includes distancing measures. improvements to nature-based tourism, enhanced infrastructure for better access, environmental Muted domestic demand has contributed management and tourism diversification, the to an improvement in the current account sector may not fully recover. This would stall balance. The current account deficit narrowed by the growth recovery, limiting its resilience. Tepid 39.6 percent year-on-year (y-o-y) in the first half exports of goods, and services, matched against of FY21, thanks to a sharp contraction in imports increasing imports, as consumption returns to (by 11.8 percent) and a recovery of remittance normal, would widen the current account deficit inflows (which grew by 6.7 percent y-o-y, after to 3.2 percent of GDP by FY22. April 2021 World Bank Group vii Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update The fiscal deficit is projected to remain elevated livelihoods and conservation. This in turn would but to stabilize gradually over the medium support greener growth, resilience, and inclusion. term. Revenue performance is expected to remain weak, and additional spending will be required Special Focus― Harnessing Export Potential for economic relief measures, vaccinations, and for a Green, Inclusive, and Resilient Recovery the resumption of project implementation. As a result, the fiscal deficit is expected to widen to The Special Focus section of this report just under 8 percent of GDP in FY22 and public explores options to promote trade, particularly debt is projected to reach 46.7 percent of GDP through exports, as a transformative pathway by FY22. However, the country’s debt will remain to support Nepal’s resilient recovery. Over the sustainable. past two decades, Nepal’s export growth has been stagnant. Indeed, with export growth at 4 percent The economic outlook is subject to significant on average since the turn of the century, Nepal downside risks. The recent political uncertainty, features among the 20 countries in the world with if prolonged, may further undermine investment the least dynamic exports. Stronger exports could sentiment. On the upside, effective vaccination help increase Nepal’s economic resilience, and campaigns could facilitate a resumption of tourism accelerate recovery from the devastating shock and hospitality services. A resilient recovery could that the COVID-19 pandemic has posed for the be further supported by investments, to enhance private sector. Exports can not only bring foreign quality, market access, and livelihood opportunities currency into the economy to finance well-needed for local communities in tourism and related value imports, but also spur the creation of “good chains. jobs” in higher value-added activities. Indeed, export orientation tends to drive productivity To mitigate downside risks to the outlook, gains through increased scale and exposure to it will be critical to address structural sophisticated global clients. weaknesses in the economy that have been exacerbated by the pandemic. Over the This report estimates Nepal’s untapped years, remittance inflows have supported private export potential or “missing” exports at consumption, poverty reduction, government around US$9.2 billion, 12 times its actual revenues, and foreign exchange reserves. However, annual merchandise exports. Realizing that this heavy reliance on remittances has come at a potential is achievable in the medium term. Had cost, driving a real appreciation of the exchange Nepal’s exports grown at the average of the South rate, and undermining export competitiveness Asia region since 2000, the unrealized export while encouraging imports. In turn, weak job potential would have been reduced by 73 percent. creation has fueled further outmigration, while This export potential represents an opportunity high imports have resulted in a heavy reliance on to create an estimated 220,000 new jobs, with trade taxes, further weakening firm productivity. significant implications for productivity growth. Developing exports to drive job creation and firm productivity is therefore central to a quick and For Nepal to achieve its export potential, six resilient recovery. This will require higher levels of key priorities need to be tackled (Table ES1). much needed FDI to leverage technical know-how First, Nepal will need to reform the tourism and skills from abroad. Complementary reforms to sector to meet the expected changes to demand promote exports would also be needed, including and preferences, following the pandemic. A quick investments in resilient infrastructure to close and resilient recovery of the sector could come existing gaps that undermine growth. Investments about through investments to improve planning, could also go to develop high value tourism conservation, and resilient infrastructure. It would targeted at the mid-range segment and focused also entail coordination with the private sector to on nature-based tourism to support community upgrade skills and develop nature-based tourism April 2021 World Bank Group viii Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update that is environmentally sustainable, with potential streamlined procedures and processes. Similarly, to support jobs creation and inclusive growth. reducing import duties – particularly on raw Second, to attract FDI, crucial for integration materials and intermediates – is crucial to ensure into regional and global value chains, it will be exporters have access to the most efficient inputs at important to simplify and streamline processes world prices. Fifth, investments to improve phyto- for multinationals setting shop in Nepal, as well as sanitary infrastructure will be needed for increased actively engage in economic diplomacy to attract standards and safety of exports. Sixth, measures FDI. Third, modernizing export promotion will to boost digital trade, and e-commerce in general require links to digitization, simplification of – could potentially be a game changer for Nepal processes, skills development, and incentives for – through adopting a robust policy framework. exporters. Fourth, a reduction of trade costs This would include, inter alia, efficient domestic will be critical, particularly given the country’s and cross-border digital payment systems, and landlocked location and the mountainous terrain. consumer protection and data privacy regulations This would entail reducing border crossing aligned with international good practices. congestion through upgraded infrastructure and Table ES1. Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Priorities Key recommendations 1. Reform the tourism • Coordinate with the private sector to strengthen market analysis and sector for a quick and development resilient recovery • Build back better through investments and adoption of reforms that promote green tourism and community livelihoods • Provide skills development and improve access to credit for communities engaged in nature-based tourism 2. Simplify and • Reduce the minimum threshold for FDI and streamline the approval streamline processes to process attract more FDI • Actively engage in economic diplomacy 3. Modernize export • Digitize, automate, and simplify the process for availing the Cash promotion and upgrade Incentive Scheme for exporters exporters’ capabilities • Base export promotion investments on evidence • Support exporters and potential exporters to upgrade their capabilities 4. Reduce trade costs • Continue improving customs operations • Increase digitization through promoting greater transparency and simplifying processes • Gradual rationalization of import duties 5. Invest in • Increase the capacity for plant pest surveillance and diagnostics and phytosanitary- and food safety testing quality control-related • Adopt a risk-based sanitary and phytosanitary system infrastructure • Negotiate mutual recognition agreements with India and other key trading partners 6. Boost digital trade • Develop an e-commerce framework reflecting international good and e-commerce for more practices opportunities linked to global value chains April 2021 World Bank Group ix Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update A. Recent Economic Developments A.1 Context The pandemic has brought about major in vaccination between advanced and developing disruptions in the global economy and trade. economies, remains a cause for concern. Global growth is estimated to have contracted by 4.3 percent and world trade to have declined Nepal has also been hit hard by the pandemic, by 9.6 percent in 2020.1 South Asia has also felt but infection rates were tapering off in March. the devastating impacts of the pandemic, amidst As of mid-March 2021, 275,210 COVID-19 cases stringent lockdowns and a standstill in tourism. (0.9 percent of the total population) have been Regional output is estimated to have contracted by reported, with 271,401 recovered (a recovery 6.7 percent2 in 2020. In 2021, ongoing vaccination rate of 98.6 percent) and 3,014 dead. Around 50 campaigns and declining numbers of COVID-19 percent of cases have been reported in Kathmandu cases give ground to cautious optimism. At the Valley which is the most densely populated and same time, the lingering possibility of a resurgence economically important part of the country. As of outbreaks, especially given the incidence of the pandemic first unfolded in March 2020, a more transmissible variants and uneven progress strict nationwide lockdown was imposed through 1 World Bank 2021. 2 World Bank 2021. April 2021 World Bank Group 1 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update July. It was followed by localized lockdowns in responsibility for managing substantial amounts various municipalities including the Kathmandu of public resources. Significant achievements Valley in late August, with restrictions on land have been made, such as the establishment of a and air transportation, educational institutions, legal framework for federalism and the allocation and tourism. Lockdowns and social distancing of expenditure responsibility across the three measures helped to bring down the number of tiers of government. However, concurrent areas daily cases from 3,000 in October 2020 to less than of responsibility still needed to be clarified. By 100 cases in mid-March 2021 (Figure 1), which in placing increased demands on service delivery and turn allowed for a gradual easing of movement relief, the pandemic has tested the nascent federal restrictions. As of January 27, 2021, vaccination system and exposed weaknesses at the local has also started, adding to the prospect of further level in terms of human and financial resources, containing the outbreak. As of mid-March 2021, technical capacity, and infrastructure. It has also 1,791,606 people, or 5.9 percent of the total brought to light weaknesses in coordination across population, have received the first dose of vaccine, the different levels of government. with administration of the second doses planned in late April. A.2 Real Sector The COVID-19 pandemic has tested Nepal’s The shock from the pandemic caused an young federal system. With the adoption of economic contraction in FY20 the 2015 Constitution, seven provincial and 753 local governments have been placed at The pandemic struck at a time when growth the frontline of service delivery, with direct was already decelerating. Growth had already Figure 1. Daily COVID-19 cases fell sharply by mid-March 2021 Sources: Ministry of Health and Population and World Bank staff calculations. April 2021 World Bank Group 2 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update begun to moderate in the first half of FY203 , Aggregate demand was weighed down with depressed tourist arrivals and a slowdown by a decline in investment and depressed in remittance inflows –due to restrictions in consumption (Figure 3). Investment contracted outmigration and shocks to migrant receiving by 3.5 percent in FY20, as construction economies. Agricultural activity had also been activity came to a halt and government capital affected by delays in the monsoons and crop expenditures fell in the second half of the year. damage from army worms and fake seeds. Private consumption grew y-o-y, but at a three- year low of 3.7 percent. This was mainly due to Against this backdrop, the pandemic caused a decline in remittance inflows (by 3.4 percent) in the first economic contraction in 40 years. FY20 as approvals for foreign employment were Real GDP contracted by 1.9 percent in FY20, halted in March and borders were subsequently as prolonged nationwide mobility restrictions closed. The only mitigating factors were higher from March to July 2020 significantly impacted public spending on wages and COVID-19-related all sectors of the economy. Their effect was expenditures on health and social assistance as well pronounced on service sector activities, whose as net exports (reflecting a sharp fall in imports). output contracted by 3.6 percent (Figure 2): tourism activity ground to a halt (with ripple Figure 3. …led by a decline in the investment on effects on tourism-linked activities) and transport the demand side and wholesale and retail trade were also deeply hampered. About 1 million jobs are believed to have been lost in services linked to tourism and transport.4 Meanwhile, industrial output contracted by 4.2 percent as manufacturing and construction were affected by shortages in inputs and restricted labor mobility and constrained market access. Agriculture remained the single driver of growth, expanding 2.2 percent despite shortages in fertilizer supply and disruptions in production distribution channels. Sources: Central Bureau of Statistics and World Bank staff calculations. Figure 2. GDP contracted by 1.9 percent in FY20 Note: I, C, X, and M stand for investment, consumption, due to COVID-19-related social distancing and exports, and imports. lockdown… Economic activity was subdued in early FY21 but there are early signs of moderate recovery Domestic demand remained subdued in H1FY21. The persistence of social distancing measures and the effect of income losses incurred at the peak of the crisis (whether linked to permanent jobs losses or temporary shocks) are believed to have depressed private consumption over the festival season (mid-October to Sources: Central Bureau of Statistics and World Bank staff mid-November 2020), despite an increase in calculations. 3 Nepal’s fiscal year runs from mid-July to mid-July 4 Overseas Development Institute 2020. April 2021 World Bank Group 3 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update remittances during H1FY21(Figure 4). Meanwhile, increasing mobility for shopping, recreation, and private domestic investment and FDI fell by 7.8 work (Figure 8) indicates that economic activity percent and 36.7 percent (y-o-y), respectively. has resumed, including in wholesale and retail These trends were reflected in the fact that the trade, transport, and financial services, as social number of new domestic and foreign businesses distancing measures are being relaxed, even if tourism and tourism-related activities are still fell y-o-y by 13.8 and 61.6 percent, respectively almost completely frozen (Figure 6). Moreover, (Figure 5). Lastly, government investment also fell mobility indicators improved again in February by 19 percent (y-o-y) as current spending increased to meet COVID-19 related needs. Figure 6. Tourism remains at a standstill due to the collapse of international tourist arrivals Figure 4. Private consumption remained subdued despite an increase in remittance in H1FY21 Sources: DoT, DoFE, and World Bank staff calculations. Note: Data are for the first six months of FY. Figure 7. Growth in paddy production has Sources: DoC, NRB, and World Bank staff calculations. contributed to agricultural output in FY21 Note: Data are for the first six months of the FY. Figure 5. A declining number of new domestic and foreign businesses indicates anemic private investment Sources: Ministry of Agriculture and Livestock Development and World Bank staff calculations. (Figure 8), coinciding with the rollout of vaccine, Sources: DoI and World Bank staff calculations. which suggests that further improvements Note: Data are for the first six months of the FY. could take place in FY21, assuming a smooth vaccination rollout for the remainder of the Nonetheless there are incipient signs of a fiscal year. Meanwhile, on the side of the moderate recovery in consumer sentiment rural economy, paddy production grew by 1.3 and economic activity. Since October 2020, percent, suggesting a continued expansion of April 2021 World Bank Group 4 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 8. Mobility to nonresidential places has been increasing since October, indicating recovery in economic activity… Sources: Ministry of Agriculture and Livestock Development and World Bank staff calculations. agricultural output in FY21 (Figure 7). grew by only 0.2 percent y-o-y). Inflation has decelerated recently Figure 9. Headline inflation declined in H1FY21, driven by a fall in both food and non-food In FY20, average inflation rose to 6.1 percent inflation from 4.6 percent in the previous year. The uptick inflation was mostly driven by higher food inflation (8.6 percent), caused partly by a ban on exports of onions by India (between September 2019 to March 2020), as well as COVID-19-related supply and trade disruptions in the agriculture sector since mid-March. Weaker domestic demand, on the contrary, put downward pressure on non- food inflation, which fell to 4.6 percent in FY20 (from 5.9 percent in FY19). Over the first half of FY21, inflation fell to a three-year low of 3.7 percent (y-o-y) (Figure 9). Sources: NRB and World Bank staff calculations. Food price inflation slowed to 5.5 percent (y-o-y) (from 8.2 percent in the same period of FY20) Economic hardship has a disproportionate thanks to an increased supply of vegetables, meat, impact on the most vulnerable house holds and fish, as the national lockdown was lifted in July 2020. Non-food prices rose moderately by The pandemic has adversely impacted 2.3 percent (y-o-y) in the same period, the lowest employment and income, particularly for price increase since H1FY08, mostly on account the most vulnerable. With roughly a third of of subdued prices of housing and utilities (which the population living close to the poverty line April 2021 World Bank Group 5 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 10. Losses in effective employment (percent economically active in 2020) Source: World Bank’s Random Digital Dialing Survey. before the pandemic, widespread jobs and earning still reported earnings losses. These job-related losses are likely to have increased poverty, even losses were the largest measured in monitoring if temporarily. Women, younger age cohorts, and surveys in the South Asia region. They affected workers in non-agricultural sectors will be most women, younger age cohorts, and nonagricultural adversely impacted. A precise estimate of the workers disproportionately (Figure 10). poverty impact is difficult to estimate given that the last available official estimate of poverty was A.3 Monetary and Financial Sector based on 2010/11 data. However, the pandemic Developments is likely to increase the poverty rate since a large share of the population was close to the poverty Money supply growth remained below target line before the pandemic (about a third of all despite an accommodative monetary policy Nepali earning between US$1.90 and US$3.20 a day). The central bank lowered its policy rate and took additional measures to support the real There were widespread losses in jobs and economy. The Nepal Rastra Bank (NRB) has income. According to a World Bank COVID-19 been using an interest rate corridor (IRC) since monitoring survey, more than two in every five FY17 to manage volatility in short-term interest economically active workers reported a job loss or rates (weighted average interbank rate). In FY21, a prolonged work absence in 2020. An estimated the lower limit of the IRC and the policy rate were 44 percent of all workers who were economically lowered by 1 percentage point (to 1 percent) and active at any point in 2020 experienced a loss in 0.5 percentage point (to 3 percent), respectively, effective employment5 , and 25 percent of the to enhance liquidity (Figure 11). The central bank economically active population lost their jobs. also took additional credit relief measures for In addition, 19 percent reported a prolonged the ailing private sector. Major actions included absence, with an average absence of 4.4 months (i) refinancing programs for COVID-19-affected and a gap of 4 months since they were last paid. firms; (ii) concessional lending to the agriculture More women reported permanent job losses (30 sector; (iii) the requirement that at least 15 percent percent compared to 23 percent for male workers). of credit from commercial banks should go to Among those who did not lose a job, 46 percent the agriculture sector by FY23; and (iv) more directed lending to micro, small, and medium- 5 The economically active population in 2020 is defined as the current labor market participants (either working for pay or unemployed in the past seven days prior to the interview), or those who were ever employed in 2020. April 2021 World Bank Group 6 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update sized enterprises by FY24. Private sector credit growth has picked up recently Figure 11. Policy rates were lowered to enhance credit conditions In FY20, private sector credit growth slowed to 12.4 percent from 19.3 percent in FY19, due to a combination of weak demand on the borrowing side and risk aversion on the lending side in the second half of the fiscal year. The decline was particularly steep during the lockdown, with net issuance of private sector loans plummeting by 57.5 percent year-on-year between mid-March and mid-July 2020. It was also concentrated in specific sectors. Credit to activities that were directly hit by the pandemic – such as construction, tourism, and import businesses – Sources: NRB and World Bank staff calculations. declined sharply, while credit growth in retail and agriculture sectors remained relatively robust. In Despite the NRB’s accommodative stance, contrast, deposits increased by 18.6 percent in M2 growth remained below the FY21 FY20, reflecting increased precautionary savings monetary policy target. M2 grew by 9.6 percent and the deferment of tax payments. in H1FY21, at a rate below the annual FY21 Figure 13. Private credit growth picked up in FY21 target of 18 percent, reflecting subdued economic but remains below pre-pandemic levels activity (Figure 12). This was despite an increase in foreign exchange reserves and government deposits which contributed to M2 growth through higher net foreign assets and lower negative net claims on the government. Figure 12. M2 growth still remained below the target Sources: NRB and World Bank staff calculations. Note: Data are for the first six months of FY. Private credit growth has recovered to 11.6 percent (y-o-y) in H1FY21 from a contraction in H2FY20. The observed sequential recovery in credit is consistent with the gradual resumption Sources: NRB and World Bank staff calculations. of economic activity, thanks to the relaxation Note: Data are for the first six months of FY. of movement restrictions and the effects of credit relief measures (Figure 13). However, the composition of credit growth suggests that April 2021 World Bank Group 7 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update much of it has been on account of overdrafts,6 Deposits further increased in H1FY21 (Figure likely to provide economic relief to businesses 16). Deposits grew by 9.2 percent in the first whose earnings were adversely impacted during half of FY21, primarily driven by individual the pandemic, and for margin lending for stock deposits. The robust expansion of deposits can market investments7 (Figure 14). Indeed, the stock be attributed to three key factors: (i) increasing market reached a historic high in mid-January official remittances, (ii) higher precautionary 2021, supported by excess market liquidity and savings by households (reflecting heightened lower borrowing costs amidst subdued investment uncertainty about future economic prospects), and demand and higher risk aversion from lenders (iii) a temporary and “forced” increase in savings (Figure 15). by high-income households who remain unable to Figure 14. Significant amounts of private credit consume high-value services such as international were used for overdraft and margin lending travel and restaurant meals. Figure 16. Deposits expanded by 9.2 percent in the first half of FY21 Sources: NRB and World Bank staff calculations. Note: Data are for the first six months of FY. Figure 15. Eased credit conditions amidst weak Sources: NRB and World Bank staff calculations. credit demand contributed to the recent stock Note: Data are for the first six months of FY. market rally The banking sector’s prudential indicators remained generally within the regulatory targets in H1FY21. The NRB introduced several measures to increase the availability of loanable funds in H1FY21. These included (i) an increase in the Credit-to-Core Capital and Deposit (CCD) ratio to 85 percent (from 80 percent); (ii) an increase in the existing refinancing fund by up to five times; and (iii) the suspension of the countercyclical capital buffer requirement. As a result, the volume of loanable funds has risen even though credit uptake remains low. In turn, this has Sources: Nepal Stock Exchange, NRB, and World Bank staff resulted in sound banking sector indicators. The calculations. ratio of net liquid assets to total deposits (26.8 6 On December 1, 2020, the NRB issued a circular to Banking and Financial Institutions that would require them to lower the individual overdraft loan to NPR 5 million. Borrowers do not have to state the purpose of loan when the overdraft loan is provided. 7 Margin lending is provided against the collateral of stocks and bonds. April 2021 World Bank Group 8 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update percent), remained above the regulatory threshold Service imports fell by 24.3 percent in FY20 and of 20 percent; the CCD ratio (74.9 percent) also again by 32.4 percent in H1FY21 year-on-year, as stayed well below the 85 percent regulatory limit, international travels for leisure and outmigration and; banking and financial Institutions (BFIs) for study and work ground to a halt. Meanwhile, remained well capitalized, with sound asset real effective exchange rate depreciation (Figure quality. The capital adequacy ratio was above the 18), from April 2020 onward also disincentivized requirement of 11 percent, and nonperforming imports. loans to total loans – defined as the ratio of loans that are overdue by 90 days or more to total loans Figure 18. …partly reflecting the effects of – was in the low single digits (2 percent).8 depreciation in the real effective exchange rate A.4 External Sector Imports have plummeted given demand shocks and trade disruptions Imports of goods and services dropped sharply in the first half of FY21. Goods imports contracted by 17.6 percent in FY20 in nominal terms, reflecting the impact of subdued demand, sectoral dynamics (particularly the halt in reconstruction activities), and policy initiatives (including an import ban on energy and flavored Sources: IMF and World Bank staff calculations. synthetic drinks, and a ban on onion exports by India). These trends continued in H1FY21, with Exports also declined, but to a lesser extent. imports goods falling by 8.4 percent (y-o-y) in Goods exports declined by 1.8 percent in FY20 nominal terms, the sharpest drop since FY16 but increased moderately by 2 percent in H1FY21 (Figure 17). Figure 17. Imports contracted during the Figure 19. Exports also declined… pandemic… Sources: DoC and World Bank staff calculations. Sources: DoC and World Bank staff calculations Note: Data are for the first six months of FY. Note: Data are for the first six months of FY. 8 The low nonperforming assets could be due to the NRB’s policy that allow BFIs to restructure and reschedule loans, which were in the performing category in mid-January 2020 after collecting 10 percent of the accrued interest, by mid-January 2021. As per the policy, loans amounting to NPR 94.7 billion were restructured in H1FY21. The NRB extended the period for restructuring and rescheduling loans to mid-July 2021 through the FY21 midterm monetary policy review. April 2021 World Bank Group 9 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update (y-o-y) (Figure 19) as increased exports of refined Figure 20. …but remittance inflows picked up in soybean oil largely offset lower exports of refined H1FY21 palm oil to India. The products supported by the Nepal Trade Integration Strategy (NTIS) 2016 – for which exports grew by 6.7 y-o-y in H1FY21 - also contributed to the export recovery, thanks to strong growth of tea exports (60.8 percent y-o-y). However, predictably, services exports plummeted by 18.6 percent in FY20 and a further 56.8 percent in H1FY21 year-on-year due to the shutdown of tourist arrivals. The current account deficit has narrowed The trade deficit has narrowed in H1FY21, Sources: NRB and World Bank staff calculations. given the sharp contraction in imports. Total Note: Data are for the first six months of FY. exports and imports of goods and services fell by 36.6 percent (y-o-y) and 11.8 percent (y-o-y), Figure 21. Recovery in remittances and the respectively, in H1FY21. With the contraction in improved trade balance narrowed the current imports far outweighing the decline in exports in account deficit absolute terms (given the large imbalance between the two to begin with). As a result, the trade deficit narrowed to 14.8 percent of projected GDP in H1FY21 from 15.7 percent of GDP in the same period of the previous year. Remittance inflows have picked up in H1FY21 after declining the previous year. Remittances declined by 3.4 percent in FY20, reflecting the standstill in outmigration and economic shocks in the destination countries. However, remittance inflows showed signs of recovery in H1FY21, increasing by 6.7 percent (y-o-y), as remittances Sources: NRB and World Bank staff calculations. Note: Data are for the first six months of FY. were increasingly routed via formal cannels9 and returnees repatriated their savings (Figure 20). in imports largely offset the reduction in As a result of the lower trade deficit and higher remittances and exports. The current account remittances the current account balance deficit further narrowed in H1 FY21 on a y-o-y basis improved slightly (Figure 21). In FY20, the to 1.2 percent of projected FY21 GDP (US$422 current account deficit narrowed to 0.9 percent of million), 39.6 percent lower than in the same GDP (US$341 million) from 6.9 percent of GDP period in FY20. With foreign direct investment (US$1,036 million) in FY19, as the contraction comparatively low (reaching US$64.8 million in H1FY21) and portfolio inflows nonexistent, the 9 This could be partly due to the new policy introduced from September 2019 that made it mandatory for migrant workers to have a bank account in Nepal in order to obtain a work permit to work abroad. It could also be that the increase in remittances captures the decrease in positive net errors and omission of 6.6 percent y-o-y, (compared to the increase of 18.8 percent, y-o-y, in the same period of FY20), which primarily reflects the informal transactions that are not captured by workers’ remittances and compensation of employees. April 2021 World Bank Group 10 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update current account deficit was primarily financed Figure 23. Revenues have dropped since the through external concessional loans. outbreak of the pandemic… The improved balance of payments conditions was reflected in increased external buffers. The foreign exchange reserves of the NRB increased to US$11.3 billion at mid-January 2021, equivalent to 11.3 months of imports (Figure 22). Figure 22. Foreign exchange reserves increased Sources: NRB and World Bank staff calculations. Note: Data are for the first six months of FY. During the first half of FY21, total revenue continued to fall by 2.1 percent (y-o-y). Income tax revenue declined by 12.2 percent (y-o-y) due to reduced corporate income tax receipts (Figure 23). Revenue collection from other taxes also declined, Sources: NRB and World Bank staff calculations except for customs. Given that the travel and Note: Data are for the first six months of FY. tourism sector remained anemic non-tax revenues (including tourism-related royalties and visa and A.5 Fiscal Sector passport fees) fell by 13.5 percent (y-o-y). The pandemic has triggered a revenue Expenditure was adjusted in FY20 to shock contain the fiscal deficit Tax revenue collection decreased by 5 percent In response to the abrupt revenue shock, the in FY20, to 17.8 percent of GDP from 19.1 Government of Nepal (GoN) took steps to percent of GDP in FY19. Specifically, trade- contain discretionary spending toward the end related taxes fell by 15.7 percent in FY20 given of FY20. Tighter expenditure directives, together widespread trade restrictions, supply chain with practical difficulties in executing budgets disruptions, and weak demand. The value-added under the lockdown, led to a shortfall in budget tax – over 60 percent of which is collected at the execution in FY20. Only 71.4 percent of the total border – and excises declined by 7.3 and 18.8 budget and 47 percent of the capital budget were percent, respectively. However, direct tax revenues executed. The capital expenditures of the federal increased by 13.2 percent in FY20, largely reflecting government were the main variable of adjustment higher incomes taxes from government wages and (declining to 4.9 percent of GDP in FY20, from the payment of tax arrears from a large taxpayer. 6.3 percent of GDP in the previous year), while Subnational government own-revenues dropped recurrent expenditures increased slightly due to mostly due to lower tourism royalties. higher health-related expenses as well as wages (Figure 24). April 2021 World Bank Group 11 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 24. …forcing fiscal adjustment especially form of higher and faster disbursing conditional through reduced capital expenditures grants to provincial and local governments to procure COVID-19-related equipment and health infrastructure investments (although they are recorded as current transfers in the budget of the federal government). However, government delayed some capital spending causing it to decline by 19 percent (y-o-y) in H1FY21, while current spending increased to support relief measures. Some large capital projects were stalled by the absence of skilled foreign workers. As a result, only 14.4 percent of the annual amount budgeted for capital was spent in the first six months of the Sources: NRB and World Bank staff calculations. year. Note: Data are for the first six months of FY. The bunching of expenditures over the second Figure 25. Smaller fiscal surplus in H1FY21 half of the fiscal year (and the resulting reflects tighter fiscal conditions positive fiscal balance in the first half of the fiscal year) is a recurrent problem in Nepal. This pattern has been repeated in H1FY21, albeit to a lesser extent than usual, given the recurrent spending push and weak income tax revenue collection. Indeed, the H1FY21 fiscal surplus was lower compared to the same period of the previous year, by 35.6 percent. Public debt has been rising in recent years. In H1FY21, total public debt is estimated to have increased to 36.4 percent of GDP, from 27.2 percent of GDP in FY19 (Figure 26). The increase Sources: MoF and World Bank staff calculations. Figure 26. Public debt increased to 36.4 percent Note: Data are for the first six months of FY. of GDP However, the federal fiscal deficit widened slightly in FY20 (Figure 25). This was largely due to the decline in revenues coupled with a slight increase in total spending. As a result, the fiscal deficit reached an estimated 5.2 percent of GDP in FY20, up marginally from 5 percent of GDP, in the previous year. Budget performance remained weak in the first six months of FY21 Total federal expenditures increased by 5.6 percent (y-o-y) in H1FY21 due mostly to Sources: MoF and World Bank staff calculations. higher recurrent expenditures for health- Note: Data are for the first six months of FY. related measures. Notably, these took the April 2021 World Bank Group 12 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update of total public debt reflects a number of factors: magnified by COVID-19. For example, some local the widened fiscal deficit in FY20; increased municipalities still do not have their full staff on domestic financing in H1FY21 mobilized to cope board, due to delayed enactment of the Federal with high uncertainty over revenue projections; and Civil Service Act10 . increasing spending needs expected in the second half of the fiscal year due to delayed spending However, the GoN sought to improve public and bunching. A medium-term debt strategy is investment management. A national project under preparation to guide debt management. In bank has been established to improve the process addition, all three tires of government adheres to of projection selection and preparation, and all debt ceilings set by the National Natural Resource projects above NPR 500 million are required to and Fiscal Commission. be appraised, prior to their inclusion in the project bank and prior to inclusion in the inclusion into The GoN has sought to address the the budget. perennial issue of poor budget execution Poor budget execution undermines the credibility of fiscal planning. It reflects weaknesses in the selection and preparation of public investment projects, along with deficiencies in procurement. It has resulted in expenditure bunching, in the last months of each fiscal year, especially in public investment projects, and to repeated midyear downward revisions of the budget. The problem is also acute at the subnational level, particularly given the current crisis. In H1FY21, only 14.1 percent of the capital budget, 15.8 percent of the recurrent budget, and 14.9 percent of the total budget of provincial governments have been executed. For local governments, only 21.5 percent of total budget was spent. The poor budget performance reflects institutional weaknesses and technical capacity gaps. Nepal has guidelines for project preparation, but their implementation is poor. In some instances, budgets are allocated to projects that lack detailed cost estimates, realistic timelines, and procurement plans. Consequently, projects are often selected that are not adequately prepared or ready for implementation. Poor budget execution also reflects the lack of staff with adequate technical capacity, and weak coordination across the three tiers of government, which have been 10 In the absence of the Act, the government recently developed the Staff Adjustment Standards that would allow federal staff with at least three years of service remaining to be transferred to the local and provincial level, partly addressing the staff shortage. April 2021 World Bank Group 13 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update April 2021 World Bank Group 14 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update B. Outlook, Risks, and Challenges The economy is expected to continue to and high government expenditure for COVID-19 recover, with growth projected to reach 2.7 testing and vaccines. Private consumption growth percent in FY21. Services are expected to lead the is expected to pick up over time as the economy recovery, driven initially by the easing of domestic stabilizes and employment conditions improve. confinement measures even if the most impacted Private investment should start recovering in FY21, subsectors (such as tourism and hospitality) will supported by low interest rates and government only recover fully from FY22 onward. Agriculture relief programs, but is expected to return to pre- is also projected to perform well with continued pandemic levels only in FY22 due to weak firm government programs to invest in irrigation, balance sheets and lingering political uncertainty. promote the use of improved seeds and fertilizer, and support commercialization. Industrial However, inflation is projected to remain activities are expected to rebound in FY21, but stable as food supply improves. In FY21, an only gradually as manufacturing and construction increase in food supply against higher demand output is expected to remain below pre-pandemic is expected to moderately increase inflation to 5 levels until FY22. percent by FY22. Over the medium term, inflation is expected to accelerate gradually due to a rise in On the demand side, consumption will drive global oil prices and recovery in domestic demand, economic recovery in FY21, reflecting improved stabilizing at around 6 percent, as the exchange consumer sentiments, modest remittance growth, rate peg with the Indian rupee provides a sound nominal anchor. April 2021 World Bank Group 15 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Table 1. Macroeconomic projections of selected key indicators FY18 FY19 FY20 e FY21 f FY22 f Real GDP growth, at constant market prices 7.6 6.7 -1.9 2.7 3.9 Private Consumption 6.2 5.6 3.7 4 4.2 Government 2.1 7.3 6.2 11.8 15.4 Consumption Gross Fixed Capital Investment 11.8 11.3 -3.5 4.2 9.2 Exports, Goods and Services 7.7 5.5 -16 -18 11.1 Imports, Goods and Services 19 5.8 -15.3 4.5 12.4 Real GDP growth, at constant factor prices 7.4 6.4 -2 2.7 3.9 Agriculture 2.6 5.2 2.2 2.5 2.7 Industry 10.4 7.4 -4.2 3.1 4.6 Services 9.3 6.8 -3.6 2.7 4.4 Inflation (Consumer Price Index) 4.1 4.6 6.1 4.8 5.1 Current Account Balance (% of GDP) -7.1 -6.9 -0.9 -1.2 -3.2 Fiscal Balance (% of GDP) -5.8 -5 -5.2 -6.9 -7.7 Debt (% of GDP) 26.5 27.2 36 41.9 47.9 Primary Balance (% of GDP) -5.4 -4.5 -4.5 -6.2 -6.8 Sources: MoF, NRB, and CBS for history and estimates. World Bank staff for forecasts. Note: e = estimate; f = forecast. The monetary policy stance should remain a full resumption of international tourism is accommodative. The NRB, through its monetary possible. As a result, the current account deficit policy, aims to maintain price and external stability is projected to widen to 3.2 percent of GDP in and support the economic growth target set out FY22. However, foreign exchange reserves are in the government’s fiscal policy statement. To expected to remain at a comfortable level. minimize volatility of interbank rates, the NRB is expected to maintain the existing lower bound The fiscal deficit will remain elevated but (1 percent), upper bound (5 percent), and policy gradually decline over the medium term. While rates (3 percent) of the Interest Rate Corridor and revenue performance is expected to remain weak, continue credit relief programs through FY21. additional spending on economic relief measures, vaccinations, and the resumption of project The current account deficit should widen implementation should contribute to an increase gradually over the medium term. In FY21, in the fiscal deficit to close to 7 percent of GDP in the current account deficit is projected to remain FY21 and 8 percent of GDP in FY22. Given this close to its FY20 level as a share of GDP (1.2 rapid rise in spending and slower improvement in percent). Remittances are forecasted to increase to revenues, public debt is projected to reach 41.9 23 percent of GDP in FY21 and stabilize around percent of GDP in FY21 and 47 percent of GDP that level in FY22. The trade deficit is expected in FY22. Still, the recent debt sustainability analysis to widen modestly in FY21 as imports recover indicates Nepal should remain at low risk of debt faster than remittances and exports. Over the distress, even in the extreme shock scenario. medium term, import growth will accelerate as consumption and investment return to normal, The outlook is tilted to the downside. Delays while service exports will remain subdued until in the deployment of vaccines and new outbreaks April 2021 World Bank Group 16 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update domestically or globally would dampen the nascent firm growth. In turn, the lack of private sector recovery momentum, with a particularly detrimental dynamism has depressed job creation and spurred impact on tourism. Also, widespread or global outmigration. Also, over-reliance on revenues from outbreaks could cause a return to travel restrictions, import taxes has led to fiscal volatility, further leading to a reduction in outmigration and undermining the competitiveness of domestic firms remittances. Shocks in migrant receiving countries (through high input prices). Meanwhile, inefficient would also reduce remittances. Finally, should there public investment management has prevented the be another dissolution of Parliament or similar level government from decisively addressing significant of political incident as occurred recently, this could infrastructure gaps that constrain growth. The dampen investor sentiment. COVID-19 crisis exacerbated these structural weaknesses as returnee migrant workers contributed The government has outlined a program to to unemployment, and the sharp drop in import- address the impact of COVID-19, to mitigate related taxes strained the fiscal space. Against the risks to the outlook. The government’s this backdrop, the Special Focus of the Nepal program lays the foundation for sustained, inclusive, Development Update presents Nepal’s huge export and green growth,11 phased over three stages: potential or “missing exports”, and highlights the from crisis relief, to restructuring for recovery, equally great potential for jobs creation. The Special to reforms that support greater resilience. So far, Focus identifies the main constraints underlying the government’s relief efforts have focused on stagnant export growth and proposes policy options containing the outbreak through lockdowns and to harness Nepal’s untapped export potential. travel restrictions. Declining infection rates suggest that the country is now transitioning to the recovery phase. Fiscal and monetary measures, which were announced in March and April 2020 and extended as part of the FY21 budget speech and monetary policy statement, have provided some economic and social relief. Many of these measures will continue into FY22, supported by additional fiscal space provided by Nepal’s participation in the G-20 Debt Service Suspension Initiative. During the restructuring and resilient recovery stages, the government plans to focus on reforming the health system and prioritizing job creation in a greener and more digital economy. However, improving export competitiveness will be critical for a resilient economic recovery. Strong remittances have supported private consumption and poverty reduction, as well as government revenue (through import taxes) and also raised foreign exchange reserves. However, this has come at the cost of appreciating the exchange rate, eroding export competitiveness, and reducing 11 Green growth is a growth pattern that is efficient in its use of natural resources, clean in that it minimizes pollution and environmental impacts, and resilient in that it accounts for natural hazards and the role of environmental management and natural capital in preventing disasters (World Bank 2012). April 2021 World Bank Group 17 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update April 2021 World Bank Group 18 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update C. Special Topic: Trade as a platform for resilience and recovery Exports could be a powerful platform to growth and job creation. This contrasts with increase Nepal’s economic resilience and other countries that have used exports to leapfrog accelerate the recovery from the devastating to higher productivity, better jobs, and more shock to the private sector caused by the foreign exchange inflows. Instead, Nepal has relied COVID-19 pandemic. Exports bring foreign on remittances, which have fueled consumption currency into the economy, which is essential growth and lowered productivity. The related to finance much-needed imports and to reduce exchange rate appreciation has helped stimulate macro risks. They can help create good-quality imports, causing a heavy reliance on import taxes jobs to pull labor out of low-productivity informal as a revenue source, which has resulted in higher activities. And, importantly, exports are associated inputs cost for firms and lower exports. with productivity gains through increased scale and exposure to sophisticated global clients. Exports Nepal can change this dynamic and use can therefore be a means to accelerate growth. exports as a platform for resilience and recovery from COVID-19. This would entail Over the past two decades, Nepal has failed to investments and reforms to address the key tap into exports as a platform for accelerating challenges, taking advantage of opportunities, and April 2021 World Bank Group 19 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 27. Compound annual growth rate of exports of goods and services in current US$, 1999–2019 Source: Based on World Development Indicators data. adopting the needed policies to make exports an Over the past two decades, Nepal’s export engine of recovery and a source of resilience for growth has been stagnant. During that period, Nepal. A key focus would need to be on reducing many developing countries tapped into exporting trade costs that undermine firm competitiveness, as a platform for productivity upgrading, job increasing investments in infrastructure, and creation, and securing inflows of foreign exchange. promoting the digital economy. Nepal has not. With export growth at 4 percent on average since the turn of the century, Nepal C1. Nepal’s export performance: a features among the 20 countries in the world with beyond COVID-19 perspective the slowest export growth in the past two decades (Figure 27). Rather than exporting goods and The COVID-19 pandemic and its associated services, Nepal exports its talent (Figure 28). Since shock to Nepal’s export sector exacerbated 2010, over 4.2 million workers have left Nepal, long-standing structural challenges. Specifically, accounting for nearly 22 percent of the country’s Nepal’s exports have been low, concentrated in working-age population. These migration outflows only a few countries, and with export flows that are at the basis of a remittance-dependent external are short in duration. The export performance of financing model: large inflows of remittances Nepal can be assessed based on its export growth, (Nepal ranks fifth in terms of received remittances diversification, quality and sophistication, and as a share of GDP) that finance (and to some survival. extent contribute to) one of the highest trade deficits in the world, at 37 percent of GDP as of April 2021 World Bank Group 20 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update 2018.12 Diversification has also been elusive. Nepal’s export basket has not substantially changed, Figure 28. Exports and remittances, revealing the stagnation of innovative capabilities cross-country comparison, 2019 or last available (Figure 29 and Figure 30). Even within broadly data defined sectors, there has not been substantial innovation, in terms of introduction of new products. In 2009, Nepal exported 1,167 product varieties, while in 2017 it exported 1,093, which places Nepal in the 125th position among 154 countries in terms of number of product varieties exported. Diversification in terms of destinations is key for building resilience through the reduction of risks, but has also been limited. In 2009, Nepal’s exports reached 146 countries, while by 2017 they reached only 124, placing Nepal in 101st position among 154 countries by this metric. The sophistication and quality of exports is Source: Based on World Development Indicators data. Note: Countries with more than 100 percent of GDP in also relatively low. In terms of technological exports are excluded. sophistication, only 1 percent of exports of Nepal qualify as high-tech, a level comparable to Figure 29. Composition of merchandise exports Source: Based on Atlas of Economic Complexity data. 12 Portugal and Zildzovic (2016) show that in Nepal, increases in remittance inflows are associated with an increase in the trade deficit, by contributing to the appreciation of the real exchange rate. They estimate that a 10 percent nominal increase in remittances leads to a 0.5 percent real exchange rate appreciation in the long run, eroding export competitiveness. April 2021 World Bank Group 21 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 30. Composition of services exports Cambodia but far from comparators such as Lao PDR and Mongolia (Figure 31).13 Another metric to measure quality and sophistication is the price products fetch in international markets, relative to those of competitors. Nepal’s underperformance becomes clear when we analyze two of the largest and most paradigmatic export products: shawls and cardamom. For cardamom, Nepal fetches prices slightly below the median across all competitors. For shawls, it fetches prices in the lower quartile of the distribution (Figure 32, Panel b). Source: Based on data from Ministry of Finance, Balance of Export flows also show low survival. The average Payments, Nepal. export spell14 lasts less than two years, and only four Note: Monthly data, accumulated 12 months. Last included datum corresponds to March 2020. out of 10 export flows that start each year survive past the first year. This is about 20 percent lower Figure 31. Share of manufactured exports classified than in Cambodia. The average length of an export as high-tech, last available year spell is about 2.7 years, 10 percent shorter than in Cambodia (three years).15 The rapidly declining probability of survival after the first year is a feature of Nepal’s exports: it occurs regardless of the proximity and income of the trading partner, and of the initial value of exports and type of product exported (Figure 33). Slow export growth is both a cause and consequence of low productivity growth in Nepal. Exporting requires a minimum threshold of productivity of firms. At the same time, as firms export, their productivity increases through more Source: Based on World Development Indicators data. exposure to competition, and knowledge transfers Note: Last available year for Nepal is 2017; for Kyrgyz Republic, Lao PDR, Cambodia, Myanmar, and Mongolia it is 2019. (“learning by exporting”).16 Thus, the lack of 13 A caveat is in order: in an era of global production sharing, technological groupings of high-tech and medium-tech products may be misleading, as a country may export supposedly high-tech goods (like computers), but its role may simply be in the final stages of low- value-adding assembling operations. 14 An export spell from Country A to Country B of product X is the number of consecutive calendar years that product X is exported from Country A to Country B. If the exporting of the product stops for one or more years and is then revived, it constitutes a new spell even though the product-country pair is identical. 15 A spell death is not necessarily a poor export achievement, especially if it occurs more frequently in product categories that are dynamic with characteristic short life cycles (for example, components that are part of global production networks). However, in the case of Nepal, such types of manufacture hold a small share, so poor longevity of its traditional exports adds urgency to the need for diversification. Well- diversified economies outperform less successful ones not in introducing new exports or entering new markets, but in sustaining exports after they have been introduced. 16 Atkin et al. (2017) provide the most direct evidence on productivity gains through exporting. They randomly provide opportunities to export to Egyptian rug manufacturers. They find that several years after the initial export opportunity, firms that receive the opportunity (the treated firms) display higher quality-adjusted productivity. Treated firms produce higher-quality rugs while the time it takes to manufacture them does not change. The authors document productivity improvements that come in part from knowledge flows between foreign buyers, local intermediaries, and producers (exporters). April 2021 World Bank Group 22 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 32. Price obtained by relevant exports relative to competitors, 2019 Panel A. Cardamom Panel B. Shawls, price per unit Source: Based on data from WITS UNCTAD TRAINS. Note: Singapore excluded from the right-hand side graph (value per unit of 34). Figure 33. Survival of Nepalese exports, 2007–18 Source: Neopané and Waglé 2020. April 2021 World Bank Group 23 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 34. GDP growth decomposition, 2001–17 (Figure 34). A similar picture emerges when examining patterns of productivity per worker. Nepal lags its comparators both in level and growth rates of labor productivity (Figure 35). This is generalized across sectors and is particularly salient in agriculture, the country’s largest employing sector (Figure 36). Figure 36. Value added (VA) per worker, by sector, current level and recent growth, Nepal compared to comparators a. Agriculture Source: World Bank staff calculations using the World Bank Growth Accounting Tool. Note: Solow model. Growth rates are weighted according to the income share of capital (%) = 40%. Selected growth rate formula: Natural Log (continuous compounding). Decomposition for Tajikistan corresponds to 2001–13 and for Mongolia to 2005–17 Figure 35. Per-worker value added (VA), current level and recent growth, Nepal compared to comparators b. Industry Source: Based on World Development Indicators data. competitiveness observed in Nepal’s exports also reflects on poor productivity performance.17 In the past two decades, total factor productivity contributed only 0.8 percentage points to overall annual growth, substantially below the 2.3 and 3.2 percentage-point contributions, respectively, observed in structural or aspirational comparators 17 Neopane and Waglé (2020) point to the perverse regulatory incentives, poor institutions and infrastructure, and inadequate trained workforce as the main drivers of the lack of export dynamism and the poor export performance. April 2021 World Bank Group 24 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update c. Services Nepal’s “missing exports” are generalized across destinations and products. From the perspective of destinations, Nepal’s largest missing exports are with China (by over US$2.2 billion), followed by India (US$1.2 billion), the United States (US$800 million), and Japan (US$700 million) (Figure 38, Panel A). From a sectoral perspective, except for final textiles and intermediate apparel, missing exports are substantial across all sectors. Of note is the high level of missing exports in final apparel products (over US$1.2 billion), as well as intermediate and Source: Based on World Development Indicators data. final processed food (US$800 million and US$500 million, respectively) (Figure 38, Panel B). C2. Challenges and opportunities ahead to build back better A large share of Nepal’s “missing exports” corresponds to countries that are geographically close and have fast-growing Nepal’s export potential is substantial, but imports. Figure 39 shows export destinations so are the challenges ahead to tap into it. of Nepal according to the value of the untapped Recovering from the COVID-19 shock and export potential of that destination (vertical building a more resilient economy will require axis) and according to the destination’s import addressing these challenges. By using the necessary dynamism (horizontal axis). It also identifies those policy levers to increase its export orientation, destinations that offer “large markets” (bold black Nepal can both create more and better jobs at circles, for destinations with average import levels home and move into a path of productivity-based above the world’s median). “Attractive” destinations growth. from an export promotion perspective are those in the top-right quadrant: they exhibit high untapped Nepal’s untapped export potential or potential for Nepal, and their imports have been “missing exports” are estimated at US$9.2 growing fast. The bottom-left quadrant instead billion. Taking into account the characteristics features the least attractive destinations: low of Nepal, including size, geographic location and untapped export potential for Nepal, and stagnant land-lockedness, level of development, and factor imports. Nepal has substantial missing exports endowments, and relying on a gravity model of with regional partners such as China, Bangladesh, international trade, it is estimated that Nepal’s the Philippines, and Vietnam, while there is still untapped export potential (or “missing exports”) room to further expand trade with India. All these are equivalent to 12 times its actual annual Asian markets are large (above the world median merchandise exports.18 Indeed, across a sample in terms of import value) and are growing fast. of 104 countries, Nepal ranks first in terms of the index of missing exports (Figure 37, Panel a). Tapping into the export potential is achievable Moreover, the comparison of this index across in the medium term. Nepal could create a two periods, 2000–07 compared to 2010–17, significant number of additional jobs from new reveals little change in recent decades for Nepal exports (Box 1). Had Nepal’s exports grown at (Figure 37, Panel b). 18 The characteristics included to define the bilateral potential exports include geographic distance, the existence of regional trade agreements, common colonial past, common language, GDP, GDP per capita, whether the importer or exporter is a mineral producer, a remoteness indicator (GDP weighted distance to the rest of the countries), the capital intensity per worker, and tariffs. The estimates are based on the methodology developed by Mulabdic and Yasar (2021). April 2021 World Bank Group 25 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 37. Missing exports a. Cross-country comparison, average 2010–17 b. Cross-country comparison, average 2000–07 compared to average 2010–17 Source: Based on Mulabdic and Yasar (2021). Note: The Missing Export Index for country i in year t is calculated using the following equation, where is the predicted exports from country i to country j at year t according to the gravity model, and is the observed exports: The Missing Export Index varies between 100 and -100. The maximum value of the index (that is, 100) is obtained when observed bilateral trade flows are equal to zero, but the model predicts positive exports to destination market, while the minimum value (that is, -100) is obtained when the predicted value is equal to zero and we observe positive values. Figure 38. Nepal’s missing exports, in million US$, 2010–17 Panel A. By country of destination Panel B. By product Source: Based on Mulabdic and Yasar (2021). Note: Top 30 destinations in terms of missing exports are reported. April 2021 World Bank Group 26 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 39. Nepal’s missing exports per trading partner and their import growth Source: Based on World Development Indicators data. Note: The small and big circles represent destinations with imports below the world median and the destinations with imports above the world median, respectively. Box 1. Estimating jobs created from US$1 million of exports Nepal could potentially create an additional 38 jobs in agriculture and 13 additional jobs in manufacturing for every US$1 million worth of new exports. Based on this estimate, if Nepal were able to increase exports to their full potential, an additional 220,000 jobs could be created. This estimate draws on the elasticity of jobs creation to exports derived from the “Jobs Content of Exports” (JOCEX) dataset, which captures the variation in elasticities according to the country and sectors concerned. The JOCEX dataset, developed by Calí et al. (2012), uses global input-output tables and aggregate data from the Global Trade Analysis Project to calculate the number of jobs embedded in exports for 65 countries and 11 sectors. While in advanced economies such as Luxembourg, Norway, or Singapore, US$1 million of exports embed less than four jobs, for countries more comparable to Nepal, such as Guatemala, Ethiopia, and the Philippines, they embed more than 100 jobs. The median across countries is 14.6 jobs per US$1 million of exports, with the first- and third-income quartile of countries generating 7.3 jobs and 35.5 jobs, respectively. At the sector level, mining and energy exports have the smaller job content per US$1 million (a median of four jobs), while service exports, such as commercial services and trade and sales, have a much larger jobs content (median above 50 jobs). Agriculture is the third-highest sector in terms of job content per value exported (38 jobs), while manufacturing (generally more capital intensive and with more intermediate consumption than agriculture) is the third lowest (13 jobs). In the case of Nepal, to estimate the “missing” jobs associated with “missing exports,” the median jobs-to-exports elasticity is assumed (38 additional jobs per US$1 million of agricultural exports and 13 additional jobs per US$1 million of manufacturing exports) across comparable countries. April 2021 World Bank Group 27 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update the average rate of the South Asia region since potential (or no missing exports), Nepalese firms 2000, the gap between the actual and potential could create an additional 223,000 jobs in export- exports would have been 73 percent smaller than related industries (Figure 41).19 This would have it currently is. Had exports grown at the same meant retaining about two-thirds of the Nepalese rate as Lao PDR’s, the gap would have been closed by 2016. Tapping into the export potential Figure 41. Missing jobs in Nepal due to would bring the ratio of exports to GDP from export underperformance, in thousands the current 9.5 percent (average 2015–19) to 46 percent, moving Nepal from being the sixth least- export-oriented economy in the world to 64th out of 188 countries. Looking forward, if Nepal manages to achieve the export growth rate of Lao PDR, it would reach its potential within 10 years (Figure 40). Figure 40. Nepal export performance compared to counterfactual scenarios and its export potential Source: World Bank staff calculations. Note: US$9.2 billion of missing exports are assumed to have the same composition as 2019 exports (44 percent agriculture, 56 percent manufacturing). First quartile, median, and third quartile sector (Agriculture/Manufacturing) elasticities are used. workers that migrate in a given year, or aboutt 6 percent of those who emigrated in the past decade.20 The dynamism these potential workers could have added to the domestic economy is an Source: World Bank staff calculations. additional missed opportunity. Note: “Lao PDR’s growth” corresponds to the evolution of Nepal’s exports if they had grown, since 1999, at Lao PDR’s Closing the gap between actual and potential average period pace (14.5 percent). Same criteria are applied exports will also impact informality, wages, to SAR (10.6 percent growth). Current potential exports of and poverty. In a study of South Asian countries, goods and services is the sum of 2019 exports of goods and services (US$2.7 billion) and the missing merchandise exports Artuc et al. (2019) identify a positive impact of (US$9.2 billion). SAR = South Asia region. exports on wages and informality. Exporting firms tend to pay higher wages than non-exporting “Missing exports” imply “missing jobs” ones. In addition, exporting pulls workers out estimated at over 220,000. The opportunity cost of informal activities, often also displaying in terms of forgone jobs of not tapping into the lower productivity levels, which in turn leads export potential is large. Given the current export to aggregate productivity growth. The impact is structure, and if Nepal’s exports matched their heterogeneous across groups: the benefit is greater 19 See Box 1 for details on the methodology used to estimate ‘missing jobs’. 20 If Nepal had full employment, then tapping into the export potential would have required labor to be reallocated from the non-export sector to the export sector. However, given the substantial outflows of migrant workers, the creation of these job opportunities in the export sector at home are not likely to put pressure on other sectors of the economy, but rather to reduce the outflow of migrant workers. April 2021 World Bank Group 28 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update for highly educated males in urban areas than for Nepal will need to improve planning, workers with low levels of formal education, conservation, infrastructure improvement females, and those working in rural areas. In and private sector upgrading to develop addition, Nepal could accelerate inclusive growth nature-based tourism and environmental and poverty reduction by raising exports in those sustainability. Most protected areas and nature- sectors where the poor are employed. The Nepal based tourism destinations have limited connectivity, Country Economic Memorandum 2017 and the basic services (water, waste management and Nepal Jobs Diagnostic 2020 indicate that the poor electricity), and climate resilient infrastructure. are primarily engaged in subsistence agriculture Nepal faces climate change and disaster risks, and low-value and informal urban services and which require enhanced infrastructure resilience, tourism. Increased exports from these sectors particularly in mountainous areas where trekking coupled with increased value addition would be key and mountaineering is the main occupation and to raising productivity, promoting rapid structural the main source of income of the local people. transformation, and generating inclusive growth. Equally important are investments in higher C3. Challenges to meeting Nepal’s export value potential tourism targeted at the potential midrange tourist segment. Midrange tourists require higher levels of comfort, convenience, and Tapping into Nepal’s potential requires service quality. This requires more investments, overcoming substantial challenges related to training and knowledge sharing for local developing higher value-added tourism, low communities who derive their livelihoods from levels of foreign direct investment, high trade tourism. These local communities often derive costs, inadequate trade phytosanitary- and their livelihood through homestays and sale of quality-control-related infrastructure, and agricultural products, with limited revenues due inadequate digital infrastructure.21 to the poor facilities for hygiene and heating, and limited access to tourism training and assistance. Investing for high-value and sustainable The central bank has issued directives to banks tourism and financial institutions to lend at least 5 percent of their total loan portfolio to the tourism sector. However, the loans remain concentrated Indications are that the tourism sector is likely in urban areas and large corporate clients, due to to be different post-COVID-19, reflecting high collateral requirements and the low capacity changes in tourist preferences and origins. of the local small and medium enterprises to For Nepal, domestic and neighboring tourism conceptualize and develop bankable projects for markets (i.e., China and India) may bounce the midrange tourist segment. back, but preferences and the type of tourism could change, requiring adaptation of tourism offerings. Concerns over health are likely to Leveraging foreign direct investment to increase demand for solo and small group travel better integrate into global value chains and crowd avoidance. More tourists might prefer opportunities to connect with nature and engage Nepal has not leveraged foreign direct in activities to improve wellbeing. To compete investment (FDI) for promoting exports internationally, Nepal’s tourism will need to adapt and productivity upgrading (Figure 42). to this new reality. Attracting FDI has been a crucial platform for many developing countries to integrate into 21 The list of challenges is not exhaustive. For example, energy costs, access to finance, and the complexity of the business environment also affect the competitiveness of exports. Yet, these are factors that affect domestic and exporting firms alike. In this section the focus is placed on the factors that predominantly affect exporters. April 2021 World Bank Group 29 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 42. Foreign direct investment, net inflows Source: Based on World Development Indicators data. Note: Cayman Islands (533%), Liechtenstein (396%), and Cyprus (64%) are not shown. global value chains (GVCs) and become export and policies. Being a landlocked country with a powerhouses. Vietnam, Cambodia, and Lao PDR mountainous terrain, geography naturally makes are examples. However, Nepal’s FDI inflows as trade costs high. Yet, policies and infrastructure a share of GDP have been low, at 0.4 percent in also play a role. Border crossings are congested FY19, which puts Nepal in the bottom decile of due to inadequate infrastructure and lack of the distribution internationally. To a large extent, streamlined procedures and processes. These low FDI inflows are related to restrictive policies. constraints increase product losses and raise Foreign investments are subject to both negative logistics costs, both for the transportation of final and positive lists, a high minimum investment products and of raw materials and intermediates, threshold, foreign equity caps, duplicate thus reducing Nepal’s export competitiveness. It is screening processes, and discretionary assessment worth mentioning, however, that notable progress procedures. has been made in recent years in reducing border crossing time at key land borders with India. For Reducing trade costs to make Nepalese example, clearance time at the Birgunj-Raxhaul firms more competitive Integrated Check Post (ICP) for imports and exports declined from 1.5 days and 1 day to 1.1 Nepal faces high trade costs due to geography days and 0.24 days, respectively. April 2021 World Bank Group 30 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Figure 43. Upstream import duties, by sector Source: Based on Nepal’s customs data and Upstream Tariff Simulator (UTAS) under product homogeneity assumption. Note: Only industries that produce goods are shown. the firms’ capacity to compete in world markets. Import duties, particularly those on raw Estimates suggest that a 10 percent reduction in materials and intermediates, further increase upstream import duties would result in increases in trade costs. Import duties on intermediates and exports by approximately 5 percent, all else being raw materials increase the relative price of the equal.23 Tariffs imposed by partner countries on imported input, altering a firms’ technological Nepalese exportable products also reduce their choice and reducing their productivity.22 The international competitiveness. Yet, with major burden imposed by import duties on inputs (or trading partners, Nepal enjoys preferences due upstream duties), measured as the ratio of these to its least-developed-country status. The extent upstream duties to total costs varies considerably to which Nepalese firms take advantage of these among industries, from over 24 percent in the case preferences depends on, among other factors, of beverages, to 7 percent for food production their ability to certify that their product complies and textiles (Figure 43). This heterogeneous with the set rules of origin (see Box 2). impact on production costs across industries has negative implications in terms of efficiency and on Investing in quality control infrastructure 22 Studies for Indonesia (Amiti and Konings 2007), China (Yu 2015), Pakistan (Lovo and Varela 2020), and India (Khandelwal and Topalova 2011), for example, have found that input tariff reductions positively affect the efficiency of firms that use those inputs in downstream sectors 23 Based on Mulabdic and Varela (2021). April 2021 World Bank Group 31 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Box 2. Nepal’s Least Developed Country graduation and its potential impacts What advantages does Nepal have as a Least Developed Country (LDC) in terms of access to markets? Preferential market access for LDCs for exports of goods: mainly provided through duty-free, quota-free (DFQF) market access or preferential tariffs, and preferential origin of trade (Table 1). Table 2. Major markets with multilateral preferential access for LDCs Market Description Duty-free tariff line coverage and major exclusions China Duty-free treatment for LDCs, adopted 96.6 percent (exclusions: chemicals, July 1, 2010. transport vehicles, machinery and mechanical appliances, electrical machinery, paper). European Union GSP everything but arms initiative, 99.8 percent (exclusions: arms and adopted: March 5, 2001. ammunitions). United States Generalized System of Preferences 82.2 percent (exclusions: apparel and (GSP) for least developed countries. clothing, cotton fibers, footwear, dairy Currently expired, but can be potentially and other animal products). renewed with a retroactive effect on paid duties.a In addition, the Nepal Trade Preference Program (NTPP) provides duty-free access to about 77 products and runs until 2025. Sources: Authors’ elaboration based on Nepal Human Development Report 2020, and on Nepal Trade Preference Program. Note: a. “GSP was first authorized for 10 years, until 1985. Since then, 14 more reauthorizations have generally lasting 2 to 3 years. Congress most recently extended the program until December 31, 2020, in Division M, Title V of the Consolidated Appropriations Act, 2018 (P.L. 115-141). Congressional practice has been to extend the program retroactively from the original expiration date, so that importers are refunded (without interest) for the duties incurred during the lapse” (Congressional Research Service, January 6, 2021). Is Nepal currently tapping into these preferences? Figure 44. Preference utilization Nepal is not fully exploiting preferences. Preference utilization varies according to the destination of exports. It is highest in the European Union (92 percent), followed by the United States (81 percent), Norway (75 percent), and Australia (63 percent). It is particularly low in large Asian markets, such as the Korean (40 percent) and Chinese markets (36 percent) (Figure 44). This last fact reinforces the idea that there are potentially large benefits from improving export channels with China, the largest untapped export destination for Nepal. According to the Nepal Human Development Report 2020, the reasons behind low exports and low preference utilization are supply-side constraints that affect productive capacity and trade and production costs and market access conditions in export markets. Source: Nepal Human Development Report 2020. Note: Preference utilization is the proportion of trade eligible for preferences that receives them. Will Nepal graduate from the LDC group? Nepal has improved in the three dimensions considered for LDC definition – gross national income per capita, the Human Assets Index, and the Economic Vulnerability Index – and is above the threshold in the latter two.a This implies that Nepal is eligible for graduation from the LDCs at the 2021 triennial review of the United Nations Capital Development Fund (UNCDP). However, given the negative impacts of the COVID-19 pandemic, the decision on graduation demands a detailed assessment of socioeconomic fallout. April 2021 World Bank Group 32 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update Note: a.The Human Assets Index consists of four indicators, three on health and nutrition (the percentage of the population undernourished, the under-five mortality rate, and the maternal mortality ratio) and two on education (gross secondary enrolment ratio and adult literacy rate). The Economic Vulnerability Index threshold is a composite index encompassing exposure and shock indexes. It consists of an indicator of size (logarithm of population); geographic exposure to shocks (index of remoteness); human exposure to shocks (share of population living in low-lying coastal areas); economic exposure to shocks (share of agriculture, forestry and fisheries in GDP; index of merchandise export concentration); natural shocks (share of victims of natural disasters in the population; index of the instability of agricultural production); and trade-related shocks (index of instability of exports of goods and services) (Nepal Human Development Report 2020). for higher value-added agricultural exports to the outbreak of the global pandemic, will face increased demand. In the same way that people Quality control infrastructure is crucial to discovered they can run their meetings from increase Nepal’s exports of value added, their living rooms, firms are increasingly opting particularly in agriculture. However, the lack of for remote suppliers for many enabling services accredited trade laboratories to certify agricultural such as telemarketing, IT support, accounting, exports undermines Nepal’s opportunities and other professional services.24 Leveraging to upgrade the value of its exports. Existing these opportunities can help Nepal weather the laboratories are not internationally accredited and negative tourism shock and increase opportunities therefore Nepal’s trading partners, including India, to retain skilled talent at home. Yet, the sector do not recognize their certifications. This results faces several challenges related to (i) an inadequate in traders having to undergo costly and time- digital connectivity infrastructure – for example, consuming rounds of inspections in accredited broadband access across the country, (ii) slow labs in India. Currently, samples of Nepalese implementation of an e-payments gateway that export products are sent for testing to laboratories pushes e-commerce users to rely either on the in India, which takes a minimum of nine days banking sector (with associated high costs) or but often up to three to four weeks. For Nepal on informal payment methods, (iii) lack of an to increase agricultural exports, investments are e-commerce framework that could spur digital needed in infrastructure, equipment, and human trade, (iv) lack of skilled manpower, and (v) resources to certify that its goods achieve the difficulties securing work visas for foreign talent.25 various sanitary and phytosanitary standards (SPS) requirements of key regional and global export C.4 Policy options markets. Addressing the challenges requires a Increasing digitization for upgrading coordinated effort by different government services trade agencies with mandates in areas that directly affect export competitiveness. Developing The service sector faces challenges and high-value tourism and attracting FDI are critical opportunities moving forward. On the one areas that could bring about a faster recovery. The hand, tourism, currently the largest foreign following should be considered as priorities. currency source in the country, is likely in the short run to continue facing a decline in demand Reform the tourism sector for a quick due to COVID-19 restrictions. On the other hand, recovery and greater resilience the information and communications technology sector, which had been showing dynamism prior Coordinate with the private sector to 24 To be sure, this trend had started substantially prior to the outbreak of the COVID-19 pandemic, but it was exacerbated by it. 25 See Joshi and Antoni (2019) for a detailed assessment. April 2021 World Bank Group 33 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update strengthen market analysis and development. the automation for FDI approvals in some sectors, Recovery of the tourism ecosystem, in the will further facilitate FDI inflows. aftermath of the COVID-19 pandemic, will likely be heterogeneous across the sector. In Actively engage in economic diplomacy to the short term, setting up a National Response, attract FDI. Active pursuit of linked export Communications and Recovery Task Force with and FDI promotion is a needed to complement high-level representation from the public and regulatory reforms. private sector is crucial to position the destination as responsible, inspiring trust and confidence Modernize export promotion and upgrade among stakeholders. Destinations that are clear exporters’ capabilities in their messaging around health and safety and that prioritize easy and streamlined access will Digitize, automate, and simplify the process likely be more successful. This will in turn require for availing the Cash Incentive Scheme for investing in regulation and policy to open air Exporters (CISE). First, introduce a trust- routes, increasing visa openness, supporting peer- based system for certification of value addition to-peer (P2P) accommodation, and increasing through cooperation with exporters associations health and hygiene in hotels and along the entire and through random audits. Second, increase visitor experience. digitization and automation for the application process. Third, ensure the allocation of funds for Build back better through investments and the CISE is enough for all eligible exporters to adoption of reforms that promote green avail it. tourism. Measures to increase preparedness for future shocks, while improving competitiveness Base export promotion investments on and resilience, should be a priority. These include, evidence. Consider high-potential destinations for example, defining zoning policies to assure for export promotion support, and increasingly sustainable development, particularly in areas rely on automated matchmaking platforms to of natural and cultural heritage sites; supporting support new exporters in the search of global sector sustainability through greening of the clients. tourism sector and protecting against increased single-use plastics and improper disinfectant use; Support exporters and potential exporters diversifying geographically, considering the mid- to upgrade their capabilities. Coordinate with hills, which offer wide diversity for tourism, and exporters’ associations to support exporters, which is open year-round; and improving data particularly the small and new ones, to build collection to identify future market demand and capabilities. One particular area in which evidence new product development to enable a fast recovery. points to the need for support is on input- traceability systems so that exporters can better use Simplify and streamline processes to trade preferences that many developed countries attract more FDI offer to Nepal, such as the Generalized System of Preferences or the Nepal Trade Preference Reduce the minimum threshold for FDI and Program, and that require compliance with rules streamline the approval process. The reduction of origin. of the minimum threshold, which can be achieved through a directive issued by Ministry of Reduce trade costs Industry, Commerce and Supplies, will contribute to facilitating entry of FDI. In addition, the Continue improving customs operations to approval of the new Foreign Investment and reduce trade costs. A risk management approach Technology Transfer Rules, which will introduce for cross-border cargo movements can significantly April 2021 World Bank Group 34 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update increase the facilitation of legitimate trade across digitization and automation. For example, digital Nepal’s borders. Around 30 percent of low-risk signatories are not mandatory, and hard copy consignments are currently allowed to proceed documents must be submitted at border crossing without any Customs interaction, also known as points, which dilutes the value of automation. “green lane” facilitation. The Government of Nepal recognizes the value of improved trade A gradual rationalization of import duties is facilitation and has set a target to achieve green needed to reduce costs to exporters. It is crucial lane utilization in line with good international to commit to an import duty rationalization plan practice (over 90 percent). However, a recent gap and communicate the timeline transparently to the assessment on Nepal’s alignment with the World private sector to reduce policy uncertainty. This Trade Organization (WTO) Trade Facilitation plan needs to be consistent with the government’s Agreement suggests that risk management is not financing needs, as well as with the objective of improving clearance times for low-risk traders. In increasing trade and productivity. In the short run, fact, there is little difference between green and the strategy could focus on import duty reductions yellow lanes as both require documents to be on raw materials and intermediates, and capital submitted and endorsed, with additional approvals goods will increase the competitiveness of and documentary checks for commodities moving domestic firms and facilitate productivity gains. In through the yellow lane. Therefore, reformed the long term, the strategy should aim at reducing procedures need to be implemented that will result the anti-export bias of tariff policy by focusing on in immediate clearance on arrival at the border tariff reductions on final goods. control post for all green lane transactions. More rigorous risk profiling and selectivity criteria, that Invest in phytosanitary- and quality are validated and continuously monitored and control-related infrastructure updated based on Revised Kyoto Convention good-practice approaches, will also be required. The Government of Nepal has given Furthermore, risk management approaches priority to achieving compliance with the need to be expanded by other border agencies SPS Agreement under the WTO’s Trade with appropriate coordination among them to Facilitation Agreement. Short-term priorities maximize the benefits to low-risk traders. include (i) increasing the capacity for plant pest surveillance and diagnostics and food safety testing Increased digitization through promoting in microbiology, pesticide residues, and other greater transparency and simplifying pollutants and mycotoxins; (ii) adopting a risk- processes can contribute to significantly lower based SPS system, shifting attention from routine trade costs. Nepal has made great strides toward controls to prevention and targeted controls; and digitizing and automating trade processes. The (iii) negotiating mutual recognition agreements Nepal Trade Information Portal, a single source with India and other key trading partners. for trade-related information, will help improve regulatory transparency. The Nepal National Single Window, a common digital platform for Boost digital trade and e-commerce for fulfilling import and export procedures (expected more opportunities linked to global value to become fully operational by the end of 2021), chains will significantly reduce manual processes. Furthermore, close to 100 percent of customs Develop an e-commerce framework reflecting declarations and supporting documents are international good practices. Data privacy, submitted digitally under the UNCTAD Automated consumer protection, and intellectual property System for Customs Data (ASYCUDA). However, regulation are crucial elements in an e-commerce there remains much greater scope for further framework that need to be carefully addressed, as do the following: April 2021 World Bank Group 35 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update (1) Digital signatures. Digital signatures are crucial to reduce costs, and regulations are needed in this area. A digital signature framework will contribute to advancing customs reforms around digitization and automation, with its corresponding savings for traders and firms and households in general, through seamless movements of goods, lower inventory costs, and optimal use of logistics infrastructure. (2) Digital payments infrastructure. Boosting e-commerce requires facilitating the flow of payments within and in and out of Nepal. For these purposes, improving the digital payments infrastructure is crucial. The Nepal Rastra Bank has developed jointly with the International Finance Corporation a Retail Payment Strategy (RPS) to unlock the potential and move toward safe and efficient payment systems in Nepal. A crucial step in this direction is the adoption of the RPS, along with action plans on (i) achieving interoperability for payment transactions using transaction accounts, (ii) enabling new models for digital payments (notably the standardization of QR codes), (iii) enabling the growth of agent networks and explicitly banning exclusivity arrangements for agent networks, and (iv) rationalizing customer fees and charges. In addition, and to complement the above- mentioned steps, it is crucial to comply with “Know-your-Customer” (KYC) standards. The following policy actions will contribute to this objective. First, remove restrictions in government rules that allow transfer of government-to-person (G2P) payments only to bank accounts and open it up for all types of transaction accounts operated by licensed financial service providers. Second, allow sharing of KYC-related information on customers among licensed entities with adequate and robust customer data protection measures to facilitate immediate activation of accounts and opening of transaction accounts remotely. Third, establish government payment systems, including an interface that connects various government systems, with the aim of leveraging the national payment system, to enable a choice of payment mechanisms to users, for receiving payments from and making payments to government. April 2021 World Bank Group 36 Harnessing Export Potential for a Green, Inclusive, and Resilient Recovery Nepal Development Update References Amiti, M. and J. Konings. 2007. “Trade Liberalization, Intermediate Inputs, and Productivity: Evidence from Indonesia”. American Economic Review, 97 (5): 1611-1638. Artuc, E., G. Lopez-Acevedo, R. Robertson, and D. Samaan. 2019. “Exports to Jobs: Boosting the Gains from Trade in South Asia.” South Asia Development Forum. 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