KATHMANDU: The International Monetary Fund (IMF) has released a comprehensive report highlighting significant shifts in Nepal's credit growth patterns post-pandemic, contrasting with previous stable credit cycles, and addressing fiscal pressures and financial sector vulnerabilities.

A report prepared by the IMF following the Fourth Review of the Extended Credit Facility to Nepal states that the country experienced demand-driven credit growth before the COVID-19 pandemic, primarily fueling investment activities. This period saw robust economic expansion without significant inflation, supported by large remittance inflows and accommodative monetary policies.

In stark contrast, the post-pandemic credit boom has been largely supply-driven, facilitated by broad-based financial regulation relaxations. This surge disproportionately favored households and non-tradable sectors, leading to excessive credit accumulation. The subsequent economic slowdown and deleveraging highlight the vulnerabilities of this approach, the IMF warned.

The report also notes that revenue growth in FY2023/24 has remained subdued despite several tax measures introduced in the budget. By mid-May, tax revenue grew by only 9.1 percent year-on-year, broadly in line with the nominal GDP growth projection. The tax revenue-to-GDP ratio declined from the pre-pandemic average of 18.5 percent to 16.2 percent in FY2022/23, due to factors such as weaker imports, the transition to electric vehicles with lower import duties, increased informal trade, and restrictions on Indian exports.

In response to near-term fiscal pressures, the government has reduced expenditure. Despite lower-than-expected revenue collection, spending restraint through the mid-term budget review in January 2024 is expected to improve the primary balance by +0.7 percent of GDP in FY2023/24.

The IMF report points out that Nepal’s private sector credit has expanded significantly in recent years, driven by rapid credit growth and pandemic-related stimulus. The credit-to-GDP ratio now stands near 100 percent, suggesting financial deepening levels are excessive for Nepal’s economic development stage.

Analyzing the credit-to-GDP gap reveals that recent credit expansion has been unprecedented. At its peak, the credit gap exceeded 10 percentage points (pp), far above historical norms. The subsequent correction has brought the gap down to around -5 pp, indicating a sharp reversal and raising concerns about future credit cycles.

The report highlights increasing financial sector vulnerabilities as banks face mounting capital pressure. Following the post-pandemic credit boom, banks have adjusted lending practices, reclassifying loans and absorbing losses amid a challenging economic environment. Improvements in working capital loan guidelines in 2022 and asset classification regulation in 2023 have led to a healthy shift to term lending but also a reassessment of client relationships and an increase in gross non-performing loans (NPLs).

The NRB phased out forbearance on restructuring and rescheduling loans in mid-April, causing banks to face higher NPLs and retroactive taxation, which have hurt profitability, added the report. Although the banking system remains adequately provisioned with a coverage ratio of 70 percent, potential differentiation among individual institutions warrants close monitoring. A downturn in the real estate market has further complicated efforts by banks to sell seized collateral.

Historically, Nepal’s business cycles led credit cycles, but this trend has reversed since the pandemic. Credit expansion now appears to drive economic activity, reversing the pre-pandemic relationship where economic output influenced credit growth, the IMF report further states

The IMF emphasizes the importance of understanding these credit dynamics to prevent future boom-bust cycles. It suggests that sustained regulatory adjustments by the Nepal Rastra Bank (NRB) can support sustainable, pro-growth credit allocation, and help stabilize the financial sector.

By detecting early financial imbalances through measures like the credit-to-GDP gap, authorities can take proactive steps to mitigate risks and ensure financial stability. The IMF report underscores the need for continued vigilance and policy refinement to navigate the complexities of Nepal’s evolving credit landscape.