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Country Commercial Guides for FY 2000: Nepal Report prepared by U.S. Embassy Kathmandu, released July 1999 Note*

CHAPTER II. ECONOMIC TRENDS AND OUTLOOK

* MAJOR TRENDS AND OUTLOOK

With a per capita income of only $200, Nepal is one of the poorest countries of the world. Limited natural resources, a landlocked location, difficult topography, poor infrastructure, a weak human capital base with extremely poor levels of education and health, poor public management capacity and a long history of public intervention in the economy are only some of the handicaps with which this economy must struggle. Growth potential exists both in agriculture, which accounts for approximately 40 percent of GDP and 80 percent of employment, and in export-oriented manufacturing, tourism and hydropower generation. However, major investments by both the public and private sectors will be necessary to realize that potential.

Major changes in policy are also necessary. With the advent of democracy, Nepal has embarked on a basic economic reform program, privatizing public enterprises, freeing trade and prices, establishing a convertible currency (at least for current account transactions), revitalizing the stock market and setting in place a program to attract private investment, particularly in the generation of hydroelectric power. The economy has responded to this program, but remains heavily dependent on rain-fed agriculture and, consequently, vulnerable to bad weather. Over the past four years, real GDP growth has averaged less than four percent per annum. While some recovery is expected in 1999, growth in Nepal will still likely lag behind that of other states in South Asia.

The government faces the difficult task of establishing a basis for sustained growth (through hydropower development, tourism and exports) while dealing with the potentially problematic financial imbalances that have emerged in recent years in the fiscal accounts. It must re-focus public expenditures on areas of economic value, restart the liberalization process and integrate Nepal with the other economies of South Asia.

Fortunately, Nepal's new majority government appears to have a well-thought-out program, which includes tax reform, expenditure controls, the privatization of additional public enterprises, and measures to liberalize markets and strengthen the financial system. It is pushing forward with international negotiations aimed at better market access in neighboring countries, including India. In December 1995, Nepal joined India and the other states of the South Asian Association for Regional Cooperation (SAARC) in the South Asian Preferential Trade Area. It has endorsed SAARC's goal of initiating a regional free trade area by the year 2001. Nepal has applied for admission to the World Trade Organization. In June 1998, it submitted its memorandum on trade policy to the WTO and, in the fall of 1999, direct negotiations with the WTO working party are expected to begin.

* PRINCIPAL GROWTH SECTORS

There are four major growth sectors in Nepal: tourism, transport (particularly air transport), telecommunications and hydropower generation. Tourism is one of the traditional foreign exchange earners for Nepal. However, its growth over the past several years has been hampered by limited airline seats available on routes reaching Kathmandu. In June 1997, this bottleneck was partially relieved by a new air transport agreement with India, which increased the number of seats on flights between India and Nepal by 50 percent. However, even this higher level (6,000 seats per week) is not enough to meet demand and problems will likely remain in this area until Nepal's request for an "open skies" agreement with India is met.

The other three sectors are all in the process of being privatized by the Government of Nepal. Hydropower is the most significant. The Government of Nepal has now laid the legal basis for full-scale private development of its massive hydropower resources and for private exports of hydropower to India. The first fully private projects are now underway and multi-billion dollar projects have been proposed for the West Seti and Karnali-Chisapani sites.

Air transport was vitalized when domestic routes were privatized in the early 1990s, resulting in a quadrupling in domestic air traffic. In 1996, the first steps were taken to re-assign international air routes previously held by the state-owned Royal Nepal Airline Corporation to private carriers. In January 1998, the Government of Nepal granted permission to Alpine Air, a private airline, to operate flights between Nepal and European destinations via Sharjah in the UAE. Alpine Air is also scheduled to operate to New Delhi, India. In addition, Necon Air, another private airline, has been given permission to carry passengers to and from Calcutta in India.

Progress in telecommunications has been slower, but should take off over the next two years as Nepal commercializes and privatizes the Nepal Telecommunications Corporation, and opens the market for basic services to full competition. The Government of Nepal has already opened 13 high value-added telecommunications service areas to private participation and is committed to entirely privatizing the sector by the close of the year 2000.

* GOVERNMENT ROLE IN THE ECONOMY

Recent governments in Nepal have demonstrated a consistent commitment to the liberalization and privatization of the Nepali economy. While this commitment has varied depending upon the exact character of the government in power, all of the major political parties in Nepal are committed to the establishment of democracy, the rule of law and a market-oriented economy. They differ over the role of the state in the economy - left-wing parties favoring relatively more state control and interference, and parties from the right relatively less.

Nepal has also made significant progress on economic reform. Since 1990, Nepal has privatized a number of public enterprises, eliminated public monopolies in air transport and hydropower generation, eliminated price controls on most products, reduced consumer subsidies, established a convertible currency for all current account transactions, modernized its commercial and company laws, and set in place a program to attract foreign investment, especially in the generation of hydroelectric power. It has also begun a program of tax reform, which culminated in November 1997 in the introduction of a new value-added tax in place of older sales and excise taxes. It has eliminated the "octroi," a local tax on trade that has been a major disincentive to economic activity, and has simplified both corporate income taxation and customs duties.

In addition, beginning with the Finance Minister's budget speech of July 11, 1999, the Government of Nepal made a number of further commitments regarding planned liberalization measures. These include plans to develop new bankruptcy and debt-recovery laws and new intellectual property rights legislation, particularly in the area of patents and trademarks. They also include plans to open the Nepali market to international accounting and auditing firms, to license (for the first time), foreign branch banks in Nepal and to develop the legislative framework for an international financial center (i.e.; offshore banking center) in Nepal.

However, additional steps are necessary before Nepal will have a truly business-friendly climate. Tax administration remains arbitrary with tax assessors effectively imposing levies which may or may not have any relation to the company's or the individual's true financial situation. Similarly, access to foreign exchange, even for trade purposes, is hedged with restrictions, which effectively limit one's choice of instruments to one vehicle -- the letter of credit.

In short, for all the progress Nepal has made in recent years in liberalizing its economy, it is not a Shangri-La for private entrepreneurs. There are still multiple restrictions on trade, payments and investment which require constant interaction with government officials at all levels of the bureaucracy.

* BALANCE OF PAYMENTS SITUATION

Nepal has traditionally run large trade and current account deficits which have been offset by equally large service, transfer and capital account surpluses. It has never rescheduled its debt and, even today, maintains foreign reserves sufficient to cover only about eleven months of imports.

In Nepali FY 1997/98 (from mid-July to mid-July), Nepal ran an overall balance of payments surplus of about 106 million USD as a result of higher exports, lower imports and increased aid receipts. During the first eleven months of Nepali FY 98/99, these trends continued, with exports again up (to 488 million USD) while imports continued their slow decline.

The vast majority of Nepal's officially recorded exports are of carpets and garments, exported to Germany and the United States respectively. Trade with India, however, has increased significantly in recent years. During the first eight months of FY 98/99, exports to India rose to 51 percent of Nepal's recorded exports as more and more consumer product firms established themselves in Nepal to serve the Indian market.

* INFRASTRUCTURE

Nepal remains isolated from the world's major land, air and sea transport routes. While airlinks with major transshipment centers such as Hong Kong and Singapore are relatively good, the cargo facilities at Tribhuvan International Airport in Kathmandu are limited and the airport itself is outdated. The Civil Aviation Authority of Nepal is interested in a second international airport in the flat Terai region south of Kathmandu, but has not yet been able to decide on the exact site.

Surface transport in and out of Nepal is severely constrained. There is only one reliable road route from India to the Kathmandu Valley. The only practical seaport of entry for goods bound for Kathmandu is Calcutta in India. The Government of India has agreed in principle to allow Nepal to import goods in bond, and to establish transit facilities at the port of Khandala, north of Bombay. This 25 mile route, through the border towns of Kharkadvitta (in Nepal), Phulbari (in India) and Banglabandha (in Bangladesh) is open seven days per week. As of September, 1997, India has allowed good landed at the Bangladeshi port of Banglabandha to transit India in bond to the Nepali border. It has yet to become a major trade route.

Internally, the poor state of development of the road system (22 of 75 administrative districts lack road links altogether and the entire country has only some 6300 miles of roads) means that distribution in volume is unrealistic for many products. Within the hill and mountain regions, goods are generally transported by air to remote airstrips, and then hand-carried by porters or animals to final customers. In contrast, the southern Terai region is relatively flat and is served by a good road network, so that distribution in this area, and from this area down to India, is relatively easy.

Telecommunications links are still poorly developed. While generally good in the capital city of Kathmandu, where the quality of international fax and telephone services is high, outside such major populations centers, there are few facilities at all. Nepal's telephone density is among the lowest in the world, with less than one phone per hundred people.

Below are the major infrastructure projects being undertaken or considered within Nepal at this time:

Multimodal Transit & Trade Facilitation Project

A World Bank-financed project worth $27 million USD for developing a "dry port" near the Indo-Nepal border town of Birgunj features an inland container terminal connected directly to India's national railways system. Construction work began in December 1997; completion is expected by the end of 1999. The project is expected to make a significant contribution in lowering land transportation costs to and from Nepal.

Sixth Telecommunications Project

This is a $222 million project that the Nepal Telecommunications Authority plans to take up from 1998 through 2001. Under the plan, another 200,000 phone lines will be added to Nepal's network, wireless in local loop and cellular telephone systems will be established in the Terai, four new V-sat terminals will be established and the optical fiber and micro-wave transport systems will be expanded. NTC is now mobilizing funding for this project.

Kali Gandaki A Hydropower Project

This is a 144-megawatt project that will generate 842 gigawatt-hours of renewable energy annually using the flow of the Kali Gandaki River in western Nepal. The total projected cost of the project is $453 million, out of which $320 million shall be financed by the ADB and the Government of Japan. The balance of $133 million will be borne by the Government of Nepal and Nepal Electricity Authority. The Asian Development Bank (ADB) has already finalized loan assistance of $160 million USD for the project and the Government of Japan is also providing an equal amount. Construction work for the project has already begun.

Karnali-Chisapani Multipurpose Project:

The Karnali Chisapani Multipurpose Project, with a potential installed capacity of 10,800 MW, is not only the largest infrastructure project in Nepal, but also one of the largest hydropower projects in the world. It is in preliminary planning stages only at this time.

Arun III Project:

Arun III, is a 402 MW, run-of-river project situated in Arun valley of the Sankhuwasabha district in the eastern Nepal. In December 1997, the Government of Nepal put out a request for qualification for this project, which is to be developed on a build, own, operate and transfer basis.

Pancheshwore Multipurpose Project

The Pancheshwore Multipurpose Project is the second largest hydropower project of Nepal. The Pancheshwore Multipurpose Project is situated on the Indo-Nepal border on the Mahakali River and has an installed capacity of 6,480 MW. The site is 40 miles from the East-West Highway. This project is being developed under the Mahakali Treaty signed between the Governments of Nepal and India in 1996. The estimated cost of the Pancheshwore project is $3 billion. The Governments of India and Nepal are now jointly completing the Detailed Project Report.

Medium and Small Hydropower Projects

These are several additional small and medium-sized hydropower projects that have been screened and ranked for Nepal by consultants from the World Bank. Three of these projects are to be developed by the Government of Nepal; the others will be distributed to private developers for development on a build, own, operate and transfer basis. They represent the best of 118 projects in Nepal and will be eligible for support from the World Bank's $100 million Power Development Fund. Included in the group are the following projects:

Upper Karnali Project - The 300 MW Upper Karnali project is one of Nepal's most economically attractive, run-of-the-river schemes, with daily peaking capacity and high firm energy. The site is located in the Far Western Development Region, 420 miles from Kathmandu. An all-weather road from Birendranagar to Jumla is under construction and will pass immediately by the headworks. In 1989 Himalayan Power Consultants (HPC), a consortium of Canadian and American consulting firms, completed a hydropower ranking of potential sites within the Karnali River Basin. The economic ranking of the six most promising sites in the 100 to 500 MW range prepared at that time showed Upper Karnali to be the most attractive site in the basin.

Dudh Koshi -1 Project - The 134 MW Dudh Koshi-1 Project dam site is located in the Eastern Development Region in the Okhaldhunga/ Khotang district. The project is about 3 miles and one hour's walking distance from the Lamidanda airport. Dudh Koshi-1 was identified in the Koshi Basin Master Plan as a peaking run-of-the-river plant (PROR). An alternative project development scheme has also been identified, which could develop an additional 124m of head, raising the potential installed capacity to approximately 300 MW.

Budhi Ganga Project - The 22 MW Budhi Ganga Project is located at Achham district in far-western Nepal. The nearest approach to the site is from Sanfebagar, which has an air link with Nepalgunj. The nearest access road to the headwork site is Sanfe Bazaar - Martadi Road, which is currently under construction. This is a simple run-of-the-river project. The feasibility study is scheduled to start in the June/July 1998 timeframe.

Likhu - 4 Project - The 34 MW Likhu-4 Project is located on the boundary between Ramechhap and Okhaldhunga districts in the Central Development Region. The intake is located downstream of the confluence of Bhuji and Likhu Kholas. The proposed powerhouse is located near the confluence of Sapre Khola and Likhu Khola on the right bank of the river. A 20 mile long access road will be required from Jiri to the intake site and a further 5 mile road will be required to the powerhouse. Likhu 4 is a run-of-the-river project.

Rahughat Project -The 24 MW Rahughat Project is located in the Myagdi district of the Western Development Region of Nepal. The nearest town is Beni. A blacktop road is presently under construction to Beni, the district headquarters. When this road has been completed, construction of a 10 mile road from Beni to the intake site will be required. The Rahughat Project is a small 24 MW run-of-the-river scheme.

Tamur Project -The 72 MW Tamur Project is located in the Taplejung district of eastern Nepal. Approximately 8 miles of access road would be required from Banade Village at the road head of the Phidim Taplejung portion of the Mechi Highway to the site. The Tamur River is a tributary of the Sun Koshi and the catchment area at the project intake site is 2560 square kilometers. The total installed capacity of the plant is 72 MW and the average and firm energy outputs are 393 GWh and 303 GWh respectively. In order to increase the capacity of the Tamur scheme, the feasibility of diverting water from the Mewa Khola to the forebay of the Tamur scheme is being investigated. This flow will be turbined at the Tamur intake site as well as at the Tamer powerhouse site, increasing the installed capacity of the combined scheme to around 110 MW.