The International Monetary Fund (IMF) has warned that the Nepali financial system will face further stress due to the lack of progress in addressing the deficiencies identified by the Asia Pacific Group of the Financial Action Task Force (FATF).

This may further deteriorate Nepali bank balance sheets.

The profits of Nepal’s commercial banks dropped 18.61 percent to Rs13.47 billion in the first three months of the current fiscal year, largely due to low demand for credits caused by the economic slowdown.

Nepal faces the risk of being greylisted by the FATF, a global anti-corruption body, for its deficiencies in controlling money laundering and terrorist financing.

After a field visit to Nepal in December last year as a part of a mutual evaluation of Nepal’s compliance, the Asia Pacific Group prepared a report and shared it with Nepal, pointing out Nepal’s failure to criminalise corruption involving the private sector as one of the country’s deficiencies in complying with the standards on anti-money laundering and terrorist financing.

Nepal’s existing anti-corruption laws—the Prevention of Corruption Act 2002 and the Commission for Investigation of Abuse of Authority Act 1991—criminalise corruption involving the public sector.

“Improving the anti‑money laundering/combating the financing of terrorism (AML/CFT) framework and its effectiveness in line with international standards and peer evaluations is urgently needed to maintain smooth access to the global financial system,” the IMF said.

Reforms to implement the 2021 IMF Safeguards Assessment recommendations regarding the Nepal Rastra Bank (NRB) Act and NRB audit are a priority, it added.

The IMF said that bank supervision and regulation, however, have improved with the rolling out of new supervisory information systems, the Working Capital Loan Guidelines and Asset Classification Regulations.

Nepal’s post-pandemic rebound, fueled by a credit boom, ended last year as growth slowed markedly.

Low domestic demand helped resolve external pressures, but also deflated government revenue and led to a widening of the fiscal deficit despite expenditure control, the IMF said.

“Inflation is declining, but remains high at 8.2 percent in September. Growth is expected to recover to 3.5 percent in the current fiscal year 2023-24, which is below potential, led by increased domestic demand, new hydroelectric capacity, and a continued recovery in tourism.”

It said that risks are skewed to the downside. External sector risks dominate Nepal’s outlook given its high remittance income and dependence on imported goods.

Following the executive board discussion on November 29, Bo Li, deputy managing director and acting chair of IMF, said, “Nepal has made important strides on its economic reform agenda. Decisive actions in monetary policy, bank regulation and rolling off Covid support policies played a major role in overcoming urgent balance of payments pressure in the fiscal year 2021-22.”

He said that reserves continue to rise without the need to use distortive import restrictions.

“Fiscal discipline was maintained in 2022-23 despite a large revenue shortfall. Nepal’s medium-term outlook remains favourable as strategic investments in infrastructure, especially in the energy sector, are expected to support potential growth.”

The IMF said that with growth below potential, boosting the execution of capital spending while maintaining fiscal discipline —growth-friendly consolidation—is critical to provide much-needed stimulus to near-term economic growth and achieve investments that will underpin medium-term growth.

Maintaining momentum on governance reforms is critical to cementing recent gains in fiscal transparency, it said. “Further structural reforms, including to mobilise domestic revenue, strengthen public investment management and address fiscal risks, are needed to bolster medium-term fiscal sustainability.”

The IMF said as monetary policy transmission appears weak in the context of balance sheet repair and inflation is elevated —though declining—maintaining the current cautious and data-dependent monetary policy is appropriate for preserving price and external stability.

Financial policy should remain vigilant and focused on building regulatory frameworks to avoid further boom-bust cycles and establish a more stable, pro-growth financial sector equilibrium, it said.

“Reforms regarding lending practices and asset classification are encouraging and need to be continued as preparations for the loan portfolio review of the ten largest banks gather steam.”

It added that the implementation of the financial sector reform agenda should continue with a view to aligning the local framework more closely to international standards.

Meanwhile, on November 29, the executive board of the IMF completed the third review under the four‑year Extended Credit Facility (ECF) for Nepal, allowing the authorities to withdraw $52.25 million.

This brings total disbursements to Nepal under the ECF for budget support thus far to $222.5 million. The ECF arrangement for Nepal was approved by the executive board on January 12, 2022.