Nepal: Political stability expected until the next parliamentary elections despite a darkening economic outlook

Event

At the end of February, the Nepalese parliament eventually ratified the Millennium Challenge Corporation (MCC) that had been signed with the US aid agency in 2017 to give access to USD 500 million grants for developing transport and power infrastructures. Violent protests erupted across the country before and after the agreement in parliament. The MCC is indeed politically controversial as some see it as part of the US Indo-Pacific strategy, while the country is already under China’s and India’s deep influence, and fears to see its sovereignty eroded.

Impact

Reaching a long-delayed deal with the US agency could strengthen PM Deuba’s large coalition and could allow for political stability until the next parliamentary elections, scheduled in November 2022. However, the outcome of the next elections will be uncertain, as each of the coalition’s communist parties will be participating individually in the elections, which won’t ensure political stability afterwards. The MCC ratification will allow Nepal to obtain economic support from a third large economy in addressing its lasting infrastructure gap. However, the risk is for tensions with top partner China to increase, as Nepal is part of China’s BRI and Beijing was opposed to the MCC ratification. Hence, Kathmandu might lose some external financial support in the future. Moreover, further protests against infrastructure projects are expected and might hamper the evolution of several MCC projects due to their environmental impact and disputes around land rights.

Short-term political stability would be welcome in the current economic context. Nepal’s economy contracted by 2.1% in FY 2019/2020 (ending in June 2020), before rebounding by a moderate 2.7% in FY 2020/2021. The Covid-19 impact on economic activity and the collapse in tourism weighed on the recovery. The tourism shock was reinforced by the travel ban Beijing imposed on (most) Chinese tourists, who make up the second-biggest tourist flow in Nepal. Tourism is expected to continue to gradually recover this year on the back of a waning pandemic – after a severe second wave in the spring of 2021 – and full vaccination for nearly 2/3 of the population. However, China’s zero-Covid policy and global inflation pressures might harm the tourism sector in 2022. Increased imports related to economic normalisation, including more expensive fuel imports, are affecting the current account deficit which has been rapidly widening (from 1% of GDP in FY 2019/2020 towards more than 9% this FY). As a result, foreign exchange reserves have been diminishing, while the rupee has been facing depreciating pressures.

In addition to the risk of a new Covid-19 variant, the outlook is uncertain and negative, as high commodity prices will hit Nepal hard given its large net fuel and food import position. Hence, stronger import payments are likely to more than offset large and robust workers’ remittances (around 75% of current account receipts), which would maintain pressures on the currency and foreign exchange reserves (at an adequate 6.5 months of import cover in January). Therefore, a downgrade for both the business environment risk and the ST political risk later this year cannot be ruled out. On a positive note, Nepal got the IMF approval in January for a 38-month Extended Credit Facility (of nearly USD 400 million) to mitigate the Covid-19 impact on its budget and to help maintain financial stability.

Analyst: Raphaël Cecchi – r.cecchi@credendo.com