Outlook for 2011-12

Nepal has undergone a transformation since its decade-long civil war ended in 2006, but complex and seemingly intractable issues relating to the structure of the state are unresolved, and political effectiveness will remain very poor. The election (after a delay of seven months) of a new prime minister and the formation of a new coalition government is more likely to be a temporary reprieve than a harbinger of greater political stability to come in the months ahead. Nepal is likely to face a period of continued instability, characterised by disputes over constitutional and factional issues. Economic performance will be strongly influenced by political developments. The Economist Intelligence Unit forecasts real GDP growth (by expenditure) at an average annual rate of 4.5% in fiscal years 2010/11-2011/12 (July 16th-July 15th), following estimated growth of 5% in 2009/10.

The political scene

More than two months after his election, the prime minister, Jhala Nath Khanal, has yet to finalise his cabinet. Relations between the Communist Party of Nepal (Unified Marxist-Leninist), or CPN (UML), and its main coalition partner, the Unified Communist Party of Nepal (Maoist), or UCPN (M), have broken down. The Chinese government has pledged aid totalling NRs1.4bn (US$20m) to the Nepalese Army to finance infrastructure development.

Economic policy

A proposal by the finance minister, Bharat Mohan Adhikari, to present a full budget for 2011/12 to the constituent assembly in early May has been criticised by the UCPN (M). On March 14th the Nepal Oil Corporation decided to increase the wholesale price of a litre of petrol by NRs9 (13 US cents), to NRs97.

The domestic economy

The Asian Development Bank has presented a downbeat assessment of Nepal's economic prospects. Consumer prices fell by 0.4% month on month in mid-February, yet prices still rose by 10.2% year on year, according to the Nepal Rastra Bank (NRB, the central bank). The amount of credit extended by Nepal's commercial banks to the private sector has slowed, partly as a result of the tighter monetary policy pursued by the NRB.

Foreign trade and payments

Nepal recorded a balance-of-payments deficit (before official financing) of NRs12.5bn in the first seven months of 2010/11, compared with a shortfall of NRs22bn in the year-earlier period. Workers' remittances rose by 11.7% year on year in the period, to NRs138.9bn.

Land area

147,181 sq km

Population

29.3m (2009; IMF)

Main towns

Population in '000; 2001 estimates (Central Bureau of Statistics)

Kathmandu (capital): 671.8

Biratnagar: 166.6

Lalitpur: 162.9

Pokhara: 156.3

Birgunj: 112.4

Climate

Varies from cool summers and severe winters in the north to subtropical summers and mild winters in the south (extreme cold at high altitudes)

Weather in Kathmandu (altitude 1,337 metres)

Hottest month, July, 20-29°C (average daily minimum and maximum); coldest month, January, 2-23°C; driest month, December, 3 mm average rainfall; wettest month, July, 373 mm average rainfall

Languages

Nepali (official). There are other languages and English is widely used in commerce

Measures

Metric system; local units also used include 1 seer = 0.933 kg; 1 maund = 40 seer; 1 ropani = 0.05087 ha; 1 bigha = 0.6773 ha

Currency

Nepali rupee (NRs) = 100 paisa. Since 1993 the currency has been subject to a de facto peg to the Indian rupee at the rate of NRs1.6:Rs1. Annual average exchange rate in 2010: NRs73.2:US$1

Fiscal year

July 16th-July 15th

Time

5 hours 45 minutes ahead of GMT

Public holidays

Basanta Panchami, January 8th; Martyrs' Day, January 30th; Rashtriya Prajatantra Divas (Democracy Day), February 18th; Holi, March 19th; Nepalese Women's Day, March 8th; Ghode Jatra (Festival of Horses), April 3rd; Navabarsha (New Year's Day), April 14th; Buddha Jayanti (Buddha's birthday), May 9th; Krishna Janmashtami, August 22nd; Maha Asthami, September; Ghatasthapana, September 28th; Fulpati, October 3rd; Maha Nawami, October 5th; Vijaya Dashami, October 6th; Laxhmi Puja, October 26th; Gobardhan Puja, October 27th; Constitution Day, November 9th; and various holidays for different religious groups

Official name

State of Nepal

Form of state

Republic. Nepal was a constitutional monarchy until parliament approved an interim constitution in January 2007. The constituent assembly (the transitional legislature) voted to abolish the monarchy, and the new state structure was confirmed by the newly elected constituent assembly in May 2008

Head of state

The president, presently Ram Baran Yadav, is head of state, as set out in the interim constitution

The executive

The prime minister is chosen by a ballot of the constituent assembly; the cabinet is chosen by the prime minister in consultation with his party and any coalition partners

National legislature

The constituent assembly has 601 members. Of these, 575 are elected and 26 are appointed by a Council of Ministers. The assembly was charged with drafting a new constitution by May 28th 2010, but the deadline was missed and the assembly's term has been extended for another year

Legal system

The Supreme Court acts as the court of appeal and review and has powers of original jurisdiction; it presides over 16 appellate courts and 75 district courts

National government

The current government is a coalition led by the Communist Party of Nepal (Unified Marxist-Leninist), or CPN (UML), and supported by the Unified Communist Party of Nepal (Maoist), or UCPN (M)

National elections

The constituent assembly election was originally planned for June 2007. It was first rescheduled for November of that year, and was finally held in April 2008

Main political organisations

UCPN (M); CPN (UML); Nepali Congress (NC); Madhesi People's Rights Forum (MPRF); Terai Madhesi Loktantrik Party (TMLP); Rashtriya Prajatantra Party (RPP); National Democratic Party (NDP); Nepal Majdoor Kisan Party (the Nepal Workers' and Peasants' Party, or NeWPP); Nepal Sadbhavana Party (Anandi Devi), or NSP (A); Jana Morcha Nepal, or People's Front Nepal; Samyukta Baam Morcha (United Left Front), or ULF

Prime minister: Jhala Nath Khanal-CPN (UML)

Deputy prime minister: Krishna Bahadur Mahara-UCPN (M)

Key ministers

Defence: Bishnu Prasad Poudel-CPN (UML)

Education: Gangalal Tuladhar-CPN (UML)

Energy: Gorkarna Bista-CPN (UML)

Finance: Bharat Mohan Adhikari-CPN (UML)

Foreign affairs: Vacant

Home affairs: Vacant

Information & communications: Krishna Bahadur Mahara-UCPN (M)

Labour & transport management: Top Bahadur Rayamajhi-UCPN (M)

Local development: Gangalal Tuladhar-CPN (UML)

Peace & reconstruction: Barshaman Pun-UCPN (M)

Central bank governor

Yubraj Khathiwada

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The election by Nepal's constituent assembly (the transitional legislature) of Jhala Nath Khanal as prime minister on February 3rd brought to an end a seven-month period during which political paralysis had caused government to grind virtually to a standstill. The election of a new prime minister, and the subsequent formation of a coalition government, was therefore a welcome development, but it does not at all preclude the possibility of further political strife. Numerous contentious political issues remain unresolved. In short, the Economist Intelligence Unit believes that the resolution of the most recent crisis is more likely to be a temporary reprieve than a harbinger of greater political stability in the months ahead.

Mr Khanal announced immediately after his election that he would form a "national consensus government", and he did succeed in securing the participation in the government of the largest party in parliament (with 238 seats), the Unified Communist Party of Nepal (Maoist), or UCPN (M). However, disagreements about the balance of power among the main political parties in the cabinet have prevented the appointment of a full cabinet. Moreover, relations between the UCPN (M) and Mr Khanal's Communist Party of Nepal (Unified Marxist-Leninist), or CPN (UML), are tense, and policy-related and ideological fault lines between the two parties remain entrenched.

It is just as likely that the UCPN (M)'s leader, Pushpa Kamal Dahal, decided to adopt a conciliatory approach because he believed this to be a way of returning the Maoists to power as it is that his gesture reflected a desire to improve Nepal's political stability. Indeed, the UCPN (M) leant its support to Mr Khanal's bid for the prime ministerial post only after the prime minister and Mr Dahal agreed explicitly that power in the cabinet would be shared. There is therefore no guarantee that the coming months will not see the Maoists revert to their previously intransigent ways, particularly if the composition of the government is not to their liking or if major disagreements about contentious policies persist. It is also possible that between their overt and covert influence, the Maoists will wield such power as to render the CPN (UML), which is the third-largest party in parliament, and the Nepali Congress (NC), the second-largest, in effect powerless.

Mr Khanal must also oversee the process of promulgating a permanent constitution before a May 28th deadline expires. The constituent assembly has already missed one deadline (of May 28th 2010) for agreeing a constitution to replace the temporary charter that has been in place since 2006. Co-operation between the country's main political parties-the UCPN (M), the CPN (UML), the NC and an alliance of ethnic-Madeshi parties from the southern Terai plains known as the United Democratic Madeshi Front (UDMF)-is essential if another constitutional crisis is to be averted. It seems unlikely, however, that the assembly will meet the upcoming deadline. Mr Khanal conceded as much when, speaking in early April, he said that the term of the assembly could be extended again. A ruling by the Supreme Court after the assembly missed the previous May 2010 deadline would provide a legal precedent of sorts for another extension to the assembly's term.

Meanwhile, the UDMF, which as a bloc holds 82 parliamentary seats, seeks the creation of an autonomous Madheshi state and the inclusion in the Nepali army of ethnic Madheshis. The NC, the CPN (UML) and the UCPN (M) have all refused to provide written commitments to the UDMF on the issue of Madheshi statehood. Moreover, there is little cohesion within the Madheshi political community (despite its nominal organisation under the UDMF banner), which is riven by differences over what autonomy should mean and how it should be achieved. For example, at least 30 underground militant groups operate in the southern Terai plains of the Madhesh region, the most extreme of which have issued threats against Madhesh leaders who co-operate in any way with a Nepali-speaking government. Nepal is therefore likely to face a period of continued instability characterised by disputes over constitutional and factional issues. Continued inter-party hostility could conceivably lead to political paralysis or, worse, the disruption or even the collapse of the peace process that has been ongoing since the end of the civil war in 2008.

Another source of potential political strife is the disagreement over the future of what remains of the People's Liberation Army (the Maoists' former rebel force). Re-integration of former rebel fighters into the national army has long been a UCPN (M) demand, but the Nepalese Army is opposed to admitting its previous foes. A new proposal that would create a separate force of former rebel fighters nominally under the command of the government would address the Nepalese Army's concern, but it would also serve to heighten suspicions that the former rebels could again take up arms against the government under the direction of their political leaders.

Nepal's interim constitution, promulgated in 2007, provided for a constituent assembly. The April 2008 constituent assembly election was a landmark event in Nepal's transition from absolute monarchy to parliamentary democracy and resulted in an overwhelming victory for the UCPN (M). The interim constitution stipulated that the term of the constituent assembly would be two years, until May 2010. This coincided with the deadline for the drafting of a new, permanent constitution. However, the assembly missed this deadline and voted to give itself until May 2011 to complete the job. Technically, this contravened the interim constitution, which states that "the term of the constituent assembly may be extended for up to six months by a resolution of the constituent assembly, in the event that the task of drafting the constitution is not completed due to the proclamation of a state of emergency in the country". (In addition to the fact that the timeframe for an extension has been exceeded, another unconstitutional element of the current situation is the fact that it was not a state of emergency that was responsible for the legislature's failure to draft the constitution on time.) The legislative system is in transition, and the process has not proceeded according to the agreed guidelines. The government and the transitional legislature are thus currently making decisions on an ad hoc basis. The constituent assembly seems likely to miss even the extended deadline of May 2011 for drafting the new constitution. If and when the document is ever completed, it will presumably include guidelines for a permanent parliament and the timing of legislative elections.

The Maoists' election victory in April 2008 was a severe foreign policy setback for the US, which still officially considers the UCPN (M) a terrorist organisation. (The party is not on the US State Department's list of foreign terrorist organisations, but it is on the terrorist exclusion list, which designates terrorist groups for immigration purposes. The latter is a slightly more benign designation than the former, but it still indicates that the US government believes that the party commits and/or supports terrorist acts.)

More importantly, the victory was also a serious blow to India. The activities of militant Maoist separatists in India are among that country's primary security concerns, and the Indian government is wary of the Maoists' political legitimacy in Nepal. For this reason, it will be displeased by the likelihood that the UCPN (M) will once again play a prominent role in government after more than a year in opposition. Nevertheless, efforts to improve bilateral relations are ongoing.

China, meanwhile, has been supportive of the UCPN (M), both because of its own Maoist credentials and owing to the fact that Nepal acts as a tiny yet strategically important arena for Indo-Chinese rivalry. In recent months China too has taken steps to bolster bilateral ties with Nepal, and is likely to continue to do so, much to the consternation of India.

There is considerable uncertainty about the economic policy priorities of the new coalition government. The previous administration was unable to persuade the transitional legislature to pass the budget for fiscal year 2010/11 (July 16th-July 15th), and the budget was finally promulgated by executive order four months into the fiscal year. The budget outlines plans to stabilise the external sector, encourage economic growth, reduce inflation and maintain fiscal stability. However, persistent political uncertainty means that the focus of the document is on ensuring the continuity of existing programmes rather than initiating new ones. Moreover, the priority for the government will continue to be to ensure the performance of the basic functions of day-to-day governance, including trying to make sure that the political and security environment is as conducive to economic growth as possible. The government has proposed presenting the 2011/12 budget in early May, but this may also be held hostage to inter-party political tensions.

The 2010/11 budget calls for total expenditure of NRs337.9bn (US$4.5bn), while resources are expected to amount to NRs281.9bn. The projected fiscal deficit is to be funded by domestic borrowing and, to a lesser extent, foreign grants. Spending plans focus heavily on infrastructure development, while fuel and agricultural subsidies will continue. The government is also keen to shore up its fiscal position by increasing its revenue base.

Nepal Rastra Bank (NRB, the central bank) has said that Nepal's monetary policy is designed to promote economic growth "through price [stability] and external sector stability" and to maintain financial sector stability through the development of a sound and healthy financial sector. The main policy focus is the maintenance of the Nepali rupee's peg to the Indian rupee. NRB will therefore continue to conduct open-market operations in order to monitor and adjust the money supply in support of the currency peg and to help control inflation.

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Economic revival hinges largely on the political situation, as Nepal's poor security and extreme political instability limit the state's capacity to spend money and boost rural incomes. However, given the large share of GDP contributed by the agricultural sector (at an estimated 31% in 2009/10) and the fact that the farm sector employs the majority of the population, crop-growing conditions will remain the most important determinant of the country's overall rate of economic growth in 2010/11-2011/12.

The political environment is unlikely to prove conducive to much greater economic stability in 2010/11-2011/12. We therefore forecast that real GDP will grow (by expenditure) at an average annual rate of 4.5% in the two-year period, down from an estimated 5% in 2009/10. Growth in private consumption, the largest component of the economy, will be supported by slightly lower inflation than in 2009/10, but government consumption growth will be curtailed by the problematic political situation, which has resulted in significant budgetary underspending. Growth will also be supported by a continued improvement in the global economic environment-and in particular, persistent strong GDP growth in India, Nepal's largest trading partner.

Inflation as measured by the consumer price index averaged 9.5% year on year in the first seven months of 2010/11. This exceeds by a significant margin the 7% target set by the then finance minister, Surendra Pandey, in his budget presentation in November 2010, but it represents some progress compared with the double-digit inflation rates recorded in 2008/09. Given high inflation in India, as well as the political uncertainty in Nepal, a 7% average inflation target for 2010/11 seems an unrealistic aspiration. We expect inflation to remain elevated, albeit below its 2009 average of 11.6%. The rate of inflation is estimated to have averaged 10.4% in 2010, and we forecast that it will moderate further in 2011-12, to an annual average of 6.8%.

The Nepali rupee is pegged to the Indian rupee at NRs1.6:Rs1. We expect the Indian rupee to average Rs45:US$1 in 2011, representing nominal year-on-year appreciation of 1.7%. In 2012 we expect the Indian currency to continue appreciating against the US dollar, rising by 2.5% in nominal terms, to average Rs43.9:US$1. As a result, we forecast that in 2011 the Nepali rupee will average NRs72:US$1, appreciating to NRs70.2:US$1 in 2012.

We expect the merchandise trade account to remain in deficit in 2011-12 as growth in imports outpaces that in exports by a considerable margin. In addition, continued political uncertainty in Nepal, which will limit the number of visitors to the country from developed nations, means that tourism receipts, which have historically given additional support to the balance of payments, will not have as great an effect in 2011-12. A sustained rise in inflows of remittances from Nepali workers overseas (albeit slower than previously) will provide limited support to the current account, but we expect the balance of payments to remain in deficit in 2011-12.

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More than two months after his election, the prime minister, Jhala Nath Khanal, has yet to finalise his cabinet. As of mid-April Mr Khanal had appointed 12 ministers from his own party, the Communist Party of Nepal (Unified Marxist-Leninist), or CPN (UML), along with four ministers from his main coalition partner, the Unified Communist Party of Nepal (Maoist), or UCPN (M). But disagreements over how to distribute the most powerful ministries-notably home affairs-have prevented the appointment of a full cabinet. As a result, opposition parties, led by the Nepali Congress (NC), are already calling for Mr Khanal's resignation-threatening to plunge Nepal back into political crisis.

Mr Khanal's election by the constituent assembly (the transitional legislature) in early February had raised hopes that the country would at last have a stable government, after the seven months of political paralysis that had followed the resignation of the previous prime minister, Madhav Kumar Nepal. The early signs were encouraging, with four members of the UCPN (M) appointed to the cabinet on March 4th, ending a month of speculation about whether the former rebel Maoists would participate in government. The UCPN (M) is the largest party in the 601-member constituent assembly, with 238 seats. Mr Khanal was elected prime minister only with the backing of the Maoists, and the stability of his administration depends on retaining their support-or, at least, on not driving them into outright opposition. However, relations between the CPN (UML) and the UCPN (M) have since broken down, with the Maoists accusing the CPN (UML) of reneging on a seven-point agreement under which that party agreed to support Mr Khanal as a candidate for prime minister.

The seven-point agreement, concluded on the eve of the prime ministerial ballot by Mr Khanal and the Maoist leader, Pushpa Kamal Dahal, provided no detailed guide for the distribution of ministerial portfolios. However, the agreement stated that powerful portfolios, such as defence and home affairs, should be shared in an "appropriate" manner. The defence portfolio is presently held by a member of the CPN (UML), Bishnu Prasad Poudel. The details of the agreement caused considerable concern among the ranks of the CPN (UML) when they became public; party members accused Mr Khanal of making too many concessions to the Maoists. The prime minister therefore faces considerable pressure not to appear to be seen as making further concessions to the Maoists in relation to the home affairs portfolio.

One clause in the agreement has proved particularly controversial: a proposal to create a security force either composed solely of the remnants of the Maoist's People's Liberation Army (PLA), or a force comprising both former PLA fighters and members of other security forces. The future of the estimated 19,000 former rebel fighters has dogged Nepali politics since the 2006 ceasefire that ended the country's decade-long civil war. In late January Mr Dahal formally relinquished command of the PLA to a committee made up of representatives of Nepal's main political parties.

The Chinese government has pledged aid totalling NRs1.4bn (US$19m) to the Nepalese Army to finance infrastructure development. On March 24th two separate agreements were signed in the capital of Nepal, Kathmandu, by General Chen Bingde, the chief of staff of the Chinese PLA, and his Nepali counterpart, General Chhatra Man Singh Gurung. General Chen's visit to Nepal was the first by a high-level Chinese military delegation in ten years. His arrival in Kathmandu at the head of a 15-member delegation followed a visit to the Nepali capital in late February by China's vice-commerce minister, Fu Ziying. Mr Fu announced a loan of Rmb640m (US$98m) through the state-owned Export-Import Bank of China to finance a hydropower project, along with a grant of Rmb50m to extend and widen the ring road surrounding Kathmandu. The two visits are likely to cause some concern in India, which has historically considered Nepal to be firmly within its own sphere of influence.

Competition between China and India has intensified in recent years, often with destabilising consequences for Nepal. The UCPN (M) has traditionally sought to use China as a counterweight to India's influence in Nepal and has called repeatedly for a revision to the 1950 India-Nepal Friendship Treaty, a bilateral treaty establishing a close strategic relationship.

Although it is a small, resource-poor country, Nepal is strategically situated between Asia's two emerging superpowers. It also shares a border with Tibet and is home to a community of around 20,000 Tibetan exiles. Popular demonstrations are commonplace in Kathmandu, and the police allow most to occur without interference. However, the authorities have no tolerance for anti­Chinese rallies. On March 10th baton-wielding riot police dispersed a demonstration by hundreds of Tibetan exiles to mark the 52nd anniversary of a failed uprising against China. The 1959 uprising led to the flight to India of Tibet's spiritual leader, the Dalai Lama. In mid-February police prevented exiled Tibetans from electing new leaders to the Chushi Gangdruk, a welfare organisation that campaigns against the Chinese occupation of Tibet. Police in Kathmandu seized ballot boxes to prevent the election from taking place.

A proposal by the finance minister, Bharat Mohan Adhikari, to present a full budget for fiscal year 2011/12 (July 16th-July 15th) to the constituent assembly in early May has been criticised by the UCPN (M). Previous proposals, supported by the Maoists, for a supplementary budget had been opposed by the main opposition party, the NC. Despite criticism from his party's coalition partner, and the fact that budgets are usually announced in June, Mr Adhikari said in early April that he would present a full budget on May 3rd. Whenever the next budget is presented-the UCPN (M) continues to oppose the earlier date on the grounds that the coalition has yet to agree a common programme of policies-the government must get a grip on fiscal policy. As a result of the political paralysis that beset the country after June 2010, the president, Ram Baran Yadav, enacted the budget for 2010/11 five months late, in November 2010-and then too without the assent of the legislature. Government ministries have faced considerable uncertainty owing to the fiscal confusion.

There has, however, been some sign of an improvement in the fiscal position in the past year or so. Including foreign grants, the government recorded a budget surplus of NRs12.3bn in the first seven months of 2010/11, compared with a surplus of NRs8.4bn in the year-earlier period. There was some improvement in revenue, with the government's four main sources of tax revenue all posting strong growth. Receipts from value-added tax (VAT) were up by 18.6% year on year, at NRs34.7bn. Income tax receipts stood at NRs21.2bn, representing a rise of 28%, while customs and excise receipts were up by 7.8% (to NRs20.7bn) and 17% (to NRs15.1bn) respectively. But the budget surplus also reflected underspending by official ministries. Of the NRs123.7bn in expenditure sanctioned for the seven-month period, the government spent only NRs108bn, representing a shortfall of NRs15.7bn-more than accounting for the budget surplus.

A recent spike in global oil prices has forced the state-owned oil company, the Nepal Oil Corporation (NOC), to raise the domestic price of some fuel products. On March 14th the corporation's board decided to increase the wholesale price of a litre of petrol by NRs9 (13 US cents), to NRs97. It also increased the price of aviation fuel. But the board made no changes to the price of kerosene, diesel or cooking gas. The international price of oil (dated Brent Blend) has risen sharply so far in 2011, but the Nepali government's latest round of price increases has not kept pace. According to local press reports, in early April the NOC faced losses of NRs3.75 per litre of petrol, NRs21 per litre of diesel, NRs11.3 per litre of kerosene and NRs288.8 per cylinder of cooking gas.

Given that its total monthly loss was estimated at NRs1.8bn, the NOC appealed to the government to release additional loans so that the firm could pay its sole supplier, the Indian government-owned Indian Oil Corporation. However, on April 13th, after the government failed to release any additional loans, the NOC was forced to slash imports of petroleum products from India by 45%. The move has led to renewed fuel shortages and long queues outside filling stations.

The Asian Development Bank (ADB) has presented a downbeat assessment of Nepal's economic prospects. In its annual Asian Development Outlook report, published on April 6th, the bank said that real GDP growth in 2010/11 would slow to 3.8%, from 4% in 2009/10. Agriculture is expected to expand by 4%, up from 1.3% a year earlier, owing to a recovery in farm production following crop failures in the previous year, which were caused by a monsoon. Agriculture remains Nepal's most important economic sector, accounting for only around 35% of GDP but providing the livelihoods of most of the country's population. However, the ADB said that the recovery in agriculture would not be sufficiently strong to offset continued weakness in non-farm sectors. Political strife and power shortages are expected to depress the industrial and service sectors, which account for 15% and 50% of GDP respectively. The ADB forecast that industry would expand by only 1% in 2010/11, down from 3.3% in the year-earlier period, owing to a slowdown in construction and higher fuel costs. Meanwhile, the decision by the Nepal Rastra Bank (NRB, the central bank) to tighten monetary policy in its most recent statement is expected to curtail growth in the service sector, which is forecast to grow by 4.5% in 2010/11, down from an expansion of 6% in 2009/10. In 2011/12 the bank expects economic growth to continue to accelerate, to 4%.

Among the downside risks facing the economy, the ADB cited the possibility of an escalation in political disruptions, a sudden correction in real-estate prices, a fall in remittances from conflict-ridden countries in the Middle East and North Africa, a drop in tourist arrivals, and a decline in aid disbursements from Japan following the earthquake and tsunami that devastated that country in March. The surge in global oil prices also poses risks to Nepal's external position, according to the bank. Consumer price inflation is expected to accelerate to 10% in 2010/11, in line with higher global prices for oil and food, before slowing to 8% in 2011/12.

Consumer prices fell on a monthly basis by 0.4% in the month to mid-February, but prices still increased by 10.2% year on year, according to the NRB. This represented a slowdown from the rate of inflation in the previous month, of 11.3%, but was still faster than the 9.5% average rate recorded in the first seven months of 2010/11. Inflation also accelerated faster than the government's projection for the year as a whole, of 7%, as was announced in November 2010 by the then finance minister, Surendra Pandey.

At a year-on-year rate of 16.6%, inflation in the food and beverages category, which has a weighting of 46.8% in the overall consumer price index (CPI), was the main contributor to overall inflation in mid-February. There were especially sharp rises in the prices of cereals and grains (12.2%), vegetables (73.1%), fruits (26.1%) and spices (20%). Meanwhile, non-food inflation stood at 5% year on year, down from 6.1% in the previous month. At 13.3% year on year, the rate of inflation was fastest in the Kathmandu Valley, followed by the Hills region (at 11.3%) and the southern Terai plains (7.3%).

Wholesale price inflation also slowed on a year-on-year basis in mid-February, with prices up by 11.8%, compared with 12.8% in the previous month. The 13.7% year-on-year rise in the price of agricultural commodities, mainly owing to a 24.7% increase in the price of fruit and vegetables, was the main contributor to wholesale price inflation. The price of domestically manufactured commodities rose by 9.8% in mid-February, while the price of imported commodities was up by 9.6%, partly owing to an 18.3% surge in the price of imported petroleum and coal. In the first seven months of 2010/11 wholesale price inflation averaged 9.7% year on year.

Salaries and wages continue to rise more rapidly than the CPI, meaning that those in paid employment are on average still better off in real terms, despite the fast pace of inflation. In mid-February overall salaries and wages were up by 3.6% month on month and by 16.5% year on year. However, the overall increase was wholly owing to higher wages among agricultural, industrial and construction workers, with year-on-year wages rising by 28.5%, 10.6% and 20.2% respectively. The salaries paid to those employed in the civil service, public corporations, banks and financial institutions, the army and police, education establishments, and other private institutions were unchanged on both a monthly and a yearly basis. Salaried professionals have therefore seen a sharp decline in their real earnings owing to the high pace of inflation recorded in the first seven months of 2010/11.

Growth in the amount of credit extended by Nepal's commercial banks to the private sector has slowed, partly as a result of the tighter monetary policy pursued by the central bank. In the first seven months of 2010/11 the value of bank loans rose by 8.2% year on year, to NRs38.5bn, about one-half of the year-earlier growth rate of 16.6%. Loans to the country's main productive industries, mainly food packing and processing companies, expanded by 18.2% year on year, from 11.3% in the year-earlier period. Such industries account for 22% of total loans outstanding. However, most other categories of borrowers took out new loans at a much slower pace than they did a year earlier. Growth in loans to wholesalers and retailers slowed to 12.3%, from 25% in the year-earlier period; growth in loans to finance and insurance companies slowed to 3.1% from 41.1%; and growth in loans to construction companies slowed to 4.2% from 9.6%. Although the slower pace of credit growth may point to a weakening in overall economic activity, the authorities have welcomed a slowdown in lending to "unproductive" sectors of the economy. In the first seven months of 2009/10 bank lending to the real estate sector rose by 60.4%, however, in the first seven months of 2010/11 real-estate loans expanded by only 3.4%.

Nepal's current-account deficit shrank in the first seven months of 2010/11. According to the NRB, the country recorded a balance-of-payments deficit (before official financing) of NRs12.5bn, compared with a shortfall of NRs22bn in the year-earlier period. The current-account deficit stood at NRs6.8bn in mid-February, representing only around one-fifth of the year-earlier deficit, which stood at NRs31.7bn. A rise in net transfers-which were up by 13% year on year in the period, at NRs170.6bn-was the main reason for the narrower current-account deficit. Workers' remittances rose by 11.7% in the period, to NRs138.9bn.

The goods and services balances also showed some improvement. The deficit on the merchandise trade balance narrowed, to NRs174.6bn from NRs180.2bn in the year-earlier period, while net services recorded a deficit of NRs6bn, compared with a year-earlier deficit NRs8.6bn. However, Nepal recorded a smaller income surplus, which fell to NRs3.2bn from NRs6.2bn in the year-earlier period. Meanwhile, the capital and financial accounts recorded a combined surplus of NRs7.2bn in the first seven months of 2010/11, compared with a deficit of NRs5.4bn a year earlier. Direct investment in the country rose to NRs4.8bn from NRs1.4bn. In mid-February Nepal's stock of international reserves (NRB definition) stood at US$3.5bn, equivalent to 7.2 months' imports of goods and services.

On a customs basis, Nepal's merchandise trade deficit narrowed very slightly during the first seven months of 2010/11, to NRs180.7bn, from NRs183.2bn in the year-earlier period. Exports rose by 6.6% year on year, to NRs37.9bn, while imports fell by 0.1% in the period, to NRs218.6bn. Exports to India, Nepal's main export market, accounting for around 70% of total receipts, rose by 10.8% year on year, to NRs25.1bn. However, exports to Nepal's other markets fell by 0.8%, to NRs12.8bn, mainly owing to a 17.3% fall in exports of readymade garments. The decline in imports in the period was despite a 55.9% rise in shipments of petroleum products, to NRs37.2bn. Petroleum products are the main item on the country's import bill.