Nepal is expected to reach a growth rate of 6.5 percent in fiscal 2018-19, largely due to ongoing reconstruction, investment in hydropower projects, a rebound in agricultural production, and strong tourism-related activities, according to the International Monetary Fund.

If this growth momentum can be sustained in the coming years, Nepal will join an ‘elite group of countries’ which have enjoyed ‘persistent growth accelerations’, said the Article IV Consultations report released on Sunday. The executive board of the International Monetary Fund concluded the consultations with Nepal on February 8.

The International Monetary Fund baseline projection for the level of Gross Domestic Product in Nepal is compared to two more optimistic variants—one in which Nepal grows at 6 percent over the medium term, and another in which it grows at 8 percent—as well as a set of growth acceleration episodes in other countries, the report said.

“These persistent growth accelerations are rare—the IMF Working Paper has identified only 95 of them in a set of 125 countries over the period from 1970-2014. If growth follows the International Monetary Fund baseline path in the coming years, Nepal will find itself in the midst of a broadly ‘average’ persistent growth acceleration. This would be a truly noteworthy feat,” the report said.

An economic growth rate of 8 percent would imply that Nepal was benefitting from especially strong persistent growth acceleration, in the upper end of the distribution of those ever witnessed, on par with the experience of China in the early 2000s. However, the Fund views such a strong growth scenario as unsustainable, leading to severe economic imbalances in Nepal, the consultations report added.

The Fund has cautioned that the current economic expansion also comes with some challenges that need to be carefully managed. It has called for a measured tightening of policies to safeguard macroeconomic and financial stability.

“The fiscal deficit has risen substantially, reaching 6.5 percent of the Gross Domestic Product in 2017-18, and credit growth has been high, accelerating to 25 percent most recently in October. The resulting expansion of domestic demand has contributed to a sharp increase in Nepal’s current account deficit, which reached 8.2 percent of the Gross Domestic Product in 2017-18 and has led to some outflows of reserves,” states the Fund.

In order to manage fiscal and external-sector pressures and promote a more durable economic expansion, the Fund is of the view that a measured tightening of policies is warranted—higher interest rates, tighter macro prudential policies, and a smaller fiscal deficit than currently budgeted would be more suited to current economic circumstances.

Nepal’s economy’s productive capacity [potential growth] is also assessed to have increased due to reduced political uncertainty, as well as more reliable electricity supply. Inflation is projected to increase, touching 6.5 percent this fiscal year. The report has suggested that to sustain strong growth over the medium term, the economy’s productive capacity must be increased through higher investment and greater competition. This involves strengthening institutions and reducing corruption.

“Perceptions-based indicators suggest corruption is a significant problem in Nepal, even relative to its South Asia peers,” the report said. Examples of corruption in Nepal include key facets of the public procurement process, such as facilitation payments, favoritism in awarding contracts, and lack of proper costing, it said. “This is critically important, as these issues lead to misappropriation of public resources and chronic underinvestment due to frequent project delays.”

To improve the timeliness and quality of execution of investment projects under the public procurement process, several amendments to existing laws are necessary, it said. The Public Procurement Act should be strengthened, extending the scope of misconduct which can be pursued as corruption by the Commission for the Investigation of the Abuse of Authority, the report said.

“Such an amendment could impose penalties for improper project assessment, for example, relating to a lack of thorough costing and not ensuring that contractors are suitably prepared to carry out a project. In addition, contracts awarded under the procurement process should feature a well-enforced performance guarantee, with penalties for contractors who do not perform,” the report said.

“Indications are that the current government is treating corruption as a serious issue. The prime minister has repeatedly stated publicly a zero-tolerance policy on corruption, and encouraged the anti-graft body to fulfill its mandate—this has led to numerous arrests and the investigation of thousands of complaints over the past year. This is encouraging and should continue.”

The near-term outlook for growth is favorable but macroeconomic and financial vulnerabilities continue to build. The ongoing sharp credit expansion raises concerns about the quality of lending.

An important share of bank lending is channeled to real estate related lending, as well as overdrafts and working capital collateralised by land and real estate. “As a consequence, the rapid credit growth has fueled a sustained rise in asset prices which may prompt future corrections, and likely build up substantial credit and liquidity risks in the banking system,” according to the report. The requirement to allocate 25 percent of credit to priority sectors—including minimums to agriculture, hydropower and tourism—may also affect underwriting standards, it said.